Thematic Investing — October 2013
October 23, 2013
Dow Jones Average: 15,413
S&P 500 Index: 1,746
In the latter stages of a bull market investors become increasingly attracted to highly
thematic stocks. As prices for stocks escalate in general it becomes harder and harder
to justify paying more for ordinary companies with average prospects. But for companies
riding the biggest economic and social trends, no price seems too high for investors eager to
deploy more funds to a rising market. If investors are willing to assume an extremely high
growth rate for a particular business, there is virtually no upper limit to near-term valuation
for shares of stock in the business.
The balance between risk and reward is most favorable when an investor spots a trend
or theme in the early stage, just as it is starting to swell into a potentially large wave.
Similar to body surfing, the safest and most rewarding place to be positioned is early in the
wave, staying high in the swell and riding it all the way to the beach. Those who swim into
the wave too late can get trapped under a wall of water and pummeled into the beach. It is
not a pleasant experience when the timing is wrong.
While many investors find fast moving, thematic stocks enticing, some legendary
investors eschew such stocks. Warren Buffett, the most famous value investor in the world,
has shown little appetite or need for the thematic favorites of the day. He views most high
priced, popular stocks as an invitation for losing money. They violate his cardinal rule of
investing, which is to avoid situations that are a set-up for losses. Buffett’s extraordinary
success has been built on his ability to project probable outcomes for businesses ten to
twenty years into the future. He disregards all the short-term market noise that captivates
the attention of most investors. While high growth, thematic companies have added an
important dimension to our client portfolios at times; we understand and appreciate the
merits of investment strategies, such as Buffett’s, that rarely include such stocks.
We are somewhat concerned about the dominance of high growth companies in the
current market environment. When a market has been thoroughly picked over, and few
bargains remain, investors gravitate to thematic stocks that have an air of certainty about
them. Assumptions about the future prospects of such companies are hard to challenge,
because no one really knows how long the favorable trends will last. Investors seize on the
current trend, extrapolate that trend far into the future, and hope that others will follow on
with buy orders at ever-higher prices. It is difficult to predict when this wave will crest,
but we do know that U.S. stock prices have gained at a rate three times faster than profits in
2013, and that investment risk goes up as the gap between stock prices and earnings widens.
The stock market stumbled on two occasions over the past few months, but quickly
recovered when it became clear that the Federal Reserve plans to continue pumping about one
trillion dollars of fresh money into the economy on an annual basis. The market rallied in
September when fears of the Fed tapering its bond-buying program proved to be unfounded.
As soon as the tapering concern abated investors were faced with the prospect of a default
on U.S. Government debt. When Congress finally reached a short-term agreement on the
debt ceiling, markets resumed their upward march. As long as the Fed continues its money
printing policy and Congress agrees to more borrowing, the underpinnings of the bull
market are likely to remain intact.
The portfolios we manage continue to forge ahead even though they hold few of the
biggest, thematic winners that dominate the current market. We have enjoyed some notable
gainers in the higher growth, thematic category over the years, i.e., Stratacom, Texas
Instruments, Whole Foods, Intuitive Surgical, and Cerner were just some of our thematic
selections that had significant impact on portfolio progress. While we are always searching
for companies that could blossom into big winners, we focus equal attention on the timing
of more mature companies. Client holdings of more established, slower growth companies
in the technology, consumer products, telecom, and medical arena have done surprisingly
well in 2013. The investments are largely working out as we hoped, because we were
careful with our purchase prices. Our investment approach works best when it includes an
optimal combination of value stocks, and thematic, growth picks.
We made our first foray into bonds in quite some time when interest rates reached three
percent on U.S. Treasury notes in September. Even though rates could spike much higher
under certain circumstances, we decided that the three percent level was high enough
for a re-entry into the treasury market. We made the purchase right before the Fed’s
surprise announcement that it would not be tapering its bond buying program. Rates were
normalizing before the Fed’s announcement, but have since gone back to the suppressed
level of two and a half percent. While the pullback in rates makes our purchase of three
percent notes look very well timed, it does preclude further buys on our part at this time.
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