The role of investment themes
DIS and DAT
Our periodic communication that reminds you to ask, “Should I react to those headlines?”
March 2022
The role of investment themes
“Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.” Peter Lynch
I have written a lot about the investor’s mindset, and we now have two podcast episodes under our belts. In planning the third podcast, a new subject has arisen that we wanted to explore further. This subject is the concept of investment themes.
For purposes of this Dis and Dat, I’ve defined investment themes as our investment related intuition and vision developed through research. Investment themes fit in an area between an investor’s philosophy and the process of company selections. It is the middle ground, if you will, where an investor recognizes their own advantages, as well as areas where they lack the comfort or understanding required to place capital at risk.
As someone focused on the quality of the businesses where I place capital, I didn’t believe investment themes truly affected my investment decisions. Upon deeper review, though, I’ve realized that investment themes are a way of expressing and highlighting my biases.
The first criteria for becoming one of “our favorites” even reflects an influence of investment themes. To review, that criteria is as follows:
“A business that we have confidence in long-term. The business is within our circle of competence. This is personal and tantamount to an art. A lot of things won’t fit. We don’t want to lie to ourselves and say that it is in our circle just to make others happy.”
I will explore three major categories of our investment themes: Continued worldwide expansion of prosperity; the cyclical process to prosperity expansion; and areas I simply do not understand and are therefore non-investable.
Worldwide Prosperity Expansion
My strongest investment belief is that over the long-term, prosperity will continue to expand worldwide through economic development. General economic development is the wind at an investor’s back yet can frustrate the speculator or gambler. An expansion of trade and a need for specialization in value creation highlights this development and shines a light on the importance of intelligent capital deployment. After all, poorly allocated capital can lead to bad results individually and globally. Growing prosperity can be measured and observed in several areas of our modern society such as expanded leisure time and improvements in communications, transportation, and health.
Cyclical Prosperity Expansion
If all was rosy, all the time then problems would develop in the process of prosperity expansion. This reality brings about the next major investment theme, which is that prosperity comes in randomly dispersed waves. Investors would do well to keep in mind the Warren Buffett philosophy of “be greedy when others are fearful and fearful when others are greedy.” I have listed here four sub themes of this major investment theme.
Non-Investment Themes
I now want to share two popular get rich quick “investment” themes which don’t fit our investors mentality. The first is a chain letter type scenario. In this scenario the founders seek to increase their wealth by convincing others to join the party by contributing money and signing up new people to join the party. No real value is being created. Of course, in the end a lot of greater fools soon part with their money. The other is the gambling type scenario. In this type of scenario, the house always wins by taking a slice of the money from matching up two eventual losers. Yes, gambling activities are tolerated under the entertainment category. This same type of entertainment has wrecked a decent number of lives through addiction.
Developing Investment Wisdom
Historically, long-term prosperity comes with setbacks, potholes, and side steps along the ways. This pattern can become so overwhelming to some that they turn capital allocation into a non-investment process. By combining themes such as the above into a mental framework an investor can begin to develop wisdom.
In the end, capital is destroyed in poor businesses and created in great businesses. Active investors work to improve poor businesses with capital and talent, in expectation of reward. They generally seek to avoid situations where their capital and talent will not be rewarded. It took me sometime to figure out bad businesses just don’t turn into great businesses on their own. An investors job it is to bringing capital to where it will be treated well and avoid capital destruction.
When the themes described above work into financial markets, I believe you arrive at the point where markets are irrational, but competitive. In other words, exceptional investment opportunities may appear in specific areas, but not for long. This situation requires an investor to stick in their spots of competency and act aggressively when large opportunities arise. When those type of opportunities are not available, an investor needs to work hard at avoiding errors. This approach can be enhanced by being humbly confident. The investor needs to be willing to admit when new evidence demonstrates that a prior belief was wrong and change behavior. The investor needs to work to become confident and right enough that when the opportunity arises, advantage is taken. Skill maintenance will require lifelong learning and unlearning.
Some active investors search for ways to unlock value in companies. These ways are referred to as “catalysts.” Some of those catalysts include supply constraints which developed when capital left an area. Management changes such as the CEO or CFO can lead the company in a new more profitable direction which improves profits. “Financial engineering” such as mergers, acquisitions, special dividends, and spin offs have been used by management to unlock value. A change in regulation can also create value in a stagnant business.
Share purchases by management, directors, or large investors can lead to or be a sign that value is unlocking. We do not want a selection process that places an emphasis on looking for catalysts first. Yet in hindsight you often see an event acting like a catalyst, and these are good to study. Through the front mirror, we often see when a business manager is investing money into a new direction, their shares fall out of favor with short term investors and analysts. Combing catalysts, in a great business whose shares are out of favor with non-investment types, can give the investors capital a lallapaloosa effect.
I hope you have enjoyed this short discussion on investment themes. I know we have written extensively about overall philosophy of investing (not gambling or speculating) and have now covered the middle ground of investment themes. What remains is to share examples of companies exhibiting these investment themes and favorite characteristics, for that you can “catch us on the podcast !!”
Thanks for your attention, I hope this helps, and please be safe,
James
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