Thematic investing has been around since the beginning of investing. The emergence of ETFs made it easier for investors to invest thematically (at first through ETFs such as Tech (QQQ) or energy (XLE)). Most recently, Blackrock has introduced 'thematic ETFs' (such as AGED for aging, RBOT for robotics) to capitalize on megatrends.
Disbelief
Acceptance but underestimation
Mania
Normalization
What is Thematic investing?
Broadly speaking, thematic investing involves buying a group of stocks with exposure to a trend (or pompously called a megatrend) that is expected to persist for an extended period of time. The investor hopes that buying a basket of stocks will protect himself from an stock specific idiosyncrasies, at the same time the portfolio will benefit from the structural tailwinds. History suggests that megatrends do occur frequently and provide huge opportunities who are quick to recognize them. Some of the successful thematics in the recent years have been : Technology in late 1990s, Emerging markets (Asian Tigers) in early 1990s, Emerging markets (China-centric) in mid-2000s, Internet in 2003-2007, Internet in 2009-present ,Energy in 2004-2007, Abenomics theme in 2012-15 and many others. Common among these themes is a 'cycle' that starts with 'faith' and ends in a maniac blowoff top followed by a sharp normalizaion. We can, through empirical observation and generalization, broadly divide a succesful thematic cycle into five stages with very different characteristics.
Typical Stages of Successful Thematic
Faith
The beginnings of a theme starts off with faith -- almost blind faith in the theme. There is great uncertainty about feasibility itself and the roadblocks seems almost insurmountable. Only a handful of investors are drawn to a theme at this stage as investors have typically no analysis that could guide them. Investors' past experience of disappointments and frauds deter all but the faithful at this stage. Investors who can bear volatility, total loss of capital and have long investment horizons are typically drawn into this stage. For example, in 2000-03, few investors could muster courage to invest in Emerging markets, as ghosts of Asian crisis, banking crises, high inflation and balance of payments crises deterred investors.
Low liquidity, high volatility, negative (or indeterministic) valuations
Disbelief
At this point, the proof of concept is here, however investors are unwilling to accept the changed reality. Internet stocks in mid-2000s, Energy in 2004, Chinese Internet in 2012-13 etc. are examples of themes at the disbelief stage. In 2004, oil prices began to climb over $30 -- breaking prior highs, that supply-demand imbalance had occurred due to a shift change in demand from China even though numbers were consistently showing rising demand and stretched supply.
The theme appears 'expensive' at this point. The numbers begun to confirm the theme, but high valuations throw off 'value' seeking investors. Investors need a mindset of 'growth investors' where you are need to think exponentially and not linearly in terms of projected revenue and earnings.
High valuations, elevated volatility. Liquidity improves.
Acceptance but underestimation
By this stage, the theme is no longer proof of concept but well entrenched. Investors accept the new reality (tech in 1997-98, energy/EM in 2006) as numbers rise unequivocally. However, investors long used to linear earnings growth, consistently underestimate the earnings potential. By now, most sell-side is well on to the theme with stock analyst writing beautiful reports and competing with one another to raise target prices. Downside volatility falls, as investors scoop up any weakness. Market gives very little chance to buy weakness. At this stage, the theme is widely featured in mainstream newspaper front pages and becomes known even to the non-investing public.
Much better valuations, low volatility and high liquidity.
Mania
By now the theme is well known and well discussed on CNBC, Bloomberg etc. Retail participation is high and analysts are rushing to justify ever higher valuations. Prices rise higher and faster than expectations and analysts keep revising targets ever higher. Valuations tend to rise (and are somehow justified by analysts). Novel theories emerge as to why prices are set to rise (think of peak oil and oil super spike in 2007-8, use of PEGs during 'dot com' mania in 1999-00). Skeptics are brushed aside by the price action. As shorts get constantly squeezed, few investors are able to hold on to their shorts.
High valuations, high volatility and very high liquidity
High valuations, high volatility and very high liquidity
Normalization
A period of normalization always follows the mania phase, and most often correction in prices erase all the gains in the mania phase and sometimes well beyond. This is the period where prices fall back to fundamentals and value emerges. Some successful themes like Tech (in 00, 07) remain intact despite deep corrections (Tech fell 80% in 99-03) but for some themes reality changes permanently (Japan real estate in '90 onwards). The speed of 'normalization' or 'crash' often stuns investors into disbelief, but it is prudent to cut your positions to a lev. Corrections rarely end before the market positioning is completely reversed.
Value emerges, high volatility and high liquidity
The above stylized life-cycle of cycle of a theme is often far more complicated and noisy in practice. Moreover, the market is constantly trying to discount the probability of a failure. There are plenty of instances when a promising thematic failed to deliver, which can only be analyzed ex post. Biotech in mid-2000s suffered a string of failures in FDA trials and remained a weak under-performing theme for almost a decade. While we will be always hamstrung by the fog of the future, we can observe some general rules by taking advantage of the lessons of how previous themes played out. A sense of where we are in the thematic cycle could help investors evaluate their portfolio from a historical perspective.
Strategy
While it does take foresight (and to a certain extent faith) in the early stages of a theme, once you do pick a theme you believe is going to be sucessful, history suggests that the best strategy is to hold on until the mania period is underway when a theme is well known, liquidity is high, analyst bullishness and valuations soar. The usual mistake of investors is to get off too early in a structural thematic story.
Stock selection
Investing in a theme usually means the rising tide lifts all boats, but it can be dangerous to ignore stock selection in the thematic investment process. One of the biggest societal changes in the last ten years has been the rise of smartphones which have become ubiquitous and increasingly powerful. However, such an obvious theme was a very difficult theme to play. In mid-2000s the smartphone market was in its infancy with blackberry dominating the email on phone system, and Microsoft's PocketPC system (sold by vendors like HP, Compaq and Dell) dominating the 'computer' system on a handheld device. Nokia was the biggest phone manufacturer using its own operating system Symbian -- another clunky operating system for phones. If one had invested in the smartphone theme -- arguably the greatest technological theme of the last 10 years -- without stock selection, they would have lost heavily despite being right on the theme. One can make a similar observation about social networking theme (remember Myspace/Friendster?). Tech industry has increasingly been disruptive and evolved into a winner-take-all model. In technology related themes, stock selection should be carefully factored into the thematic approach and one needs to be aware about disruptive technology. As a result, the thematic approach needs to be supplemented by continually re-assessing the stocks involved and industry trends re-evaluated.
Conclusions
Today once again, we have many promising themes that look likely to shape our society in the coming years. Many emerging tech themes such as robotics and EVs have already passed the 'proof of concept' stage. However, like in the past, we are likely under-estimating the change these themes will bring. And once again, stock selection is likely to prove critical in playing these themes. With benefit of hindsight and risk of generalization, we can draw some conclusions on thematic investing.
- If you feel you are on to a successful theme, stick to it and stay long. The most common mistake is for investors to cash out too early.
- Pay little attention to valuations for a large part of the theme time-cycle. Valuations tend to very expensive in the early/mid part of the cycle.
- Pay attention to stock selection, especially in tech-related themes, and watch out for disruptive forces in your theme.
Happy thematic investing!
Value emerges, high volatility and high liquidity
The above stylized life-cycle of cycle of a theme is often far more complicated and noisy in practice. Moreover, the market is constantly trying to discount the probability of a failure. There are plenty of instances when a promising thematic failed to deliver, which can only be analyzed ex post. Biotech in mid-2000s suffered a string of failures in FDA trials and remained a weak under-performing theme for almost a decade. While we will be always hamstrung by the fog of the future, we can observe some general rules by taking advantage of the lessons of how previous themes played out. A sense of where we are in the thematic cycle could help investors evaluate their portfolio from a historical perspective.
Strategy
While it does take foresight (and to a certain extent faith) in the early stages of a theme, once you do pick a theme you believe is going to be sucessful, history suggests that the best strategy is to hold on until the mania period is underway when a theme is well known, liquidity is high, analyst bullishness and valuations soar. The usual mistake of investors is to get off too early in a structural thematic story.
Stock selection
Investing in a theme usually means the rising tide lifts all boats, but it can be dangerous to ignore stock selection in the thematic investment process. One of the biggest societal changes in the last ten years has been the rise of smartphones which have become ubiquitous and increasingly powerful. However, such an obvious theme was a very difficult theme to play. In mid-2000s the smartphone market was in its infancy with blackberry dominating the email on phone system, and Microsoft's PocketPC system (sold by vendors like HP, Compaq and Dell) dominating the 'computer' system on a handheld device. Nokia was the biggest phone manufacturer using its own operating system Symbian -- another clunky operating system for phones. If one had invested in the smartphone theme -- arguably the greatest technological theme of the last 10 years -- without stock selection, they would have lost heavily despite being right on the theme. One can make a similar observation about social networking theme (remember Myspace/Friendster?). Tech industry has increasingly been disruptive and evolved into a winner-take-all model. In technology related themes, stock selection should be carefully factored into the thematic approach and one needs to be aware about disruptive technology. As a result, the thematic approach needs to be supplemented by continually re-assessing the stocks involved and industry trends re-evaluated.
Conclusions
Today once again, we have many promising themes that look likely to shape our society in the coming years. Many emerging tech themes such as robotics and EVs have already passed the 'proof of concept' stage. However, like in the past, we are likely under-estimating the change these themes will bring. And once again, stock selection is likely to prove critical in playing these themes. With benefit of hindsight and risk of generalization, we can draw some conclusions on thematic investing.
- If you feel you are on to a successful theme, stick to it and stay long. The most common mistake is for investors to cash out too early.
- Pay little attention to valuations for a large part of the theme time-cycle. Valuations tend to very expensive in the early/mid part of the cycle.
- Pay attention to stock selection, especially in tech-related themes, and watch out for disruptive forces in your theme.
Happy thematic investing!
