What do Sherlock Holmes and the market have in common? They both love a good case. While Holmes is more inclined towards the murder variety though, in its never-ending quest to make a different sort of killing, the market prefers thematic investment cases – plausible arguments as to why it should now be buying into artificial intelligence, say, or autonomous cars.
Here on The Value Perspective, we instinctively believe these sorts of themes will likely turn out to be poor long-term investments – at least, that tends to be the case when lots of investors are trying to buy into something on the back of the same good-news story. To put it another way, if you are hoping to find a bargain at a furniture auction, you will be better off avoiding those with standing room only.
Still, while instinct is all very well, let’s see if we cannot back it up with some facts by considering how some thematic investments have performed in the past. One particularly easy target would be the so-called ‘BRIC’ economies – an emerging markets term coined towards the start of the century to highlight the theoretical investment potential of Brazil, Russia, India and China.
While we might not condone the wags who suggest the acronym could equally stand for ‘Blatantly Ridiculous Investment Concept’, here on The Value Perspective, we have always struggled with the idea that anyone should blindly buy shares just because they were listed in certain countries and regardless of the businesses into which they were investing – or their valuations.
To be fair, as the following chart shows, the BRICs did enjoy two periods of strong performance – albeit with much higher volatility than the wider equity market. Still, over the last five years, while the FTSE World index has risen 37%, the FTSE BRIC 50 index has fallen 27% and in fact there is no period ending 1 January 2016 when you would have been better off buying the latter over the former.
Source Bloomberg, 2016
Furthermore, the inclination of many investors to overpay for perceived future growth means our criticism of thematic investment holds as true for individual stocks as it does for markets. To illustrate our point this time, we are going to use the much more obscure example of a Japanese wig company – and not because, even in this cold weather, your author harbours any secret longings for hair.
Rather, it is an example of overpaying for a theme that was flagged up in Round the world trip, the note from Cha-Am Advisors that originally set us thinking on this point (and which also has some pertinent views on the end of the “BRIC era”). It concerns the well-rehearsed investment theme of an ageing population – specifically Japan’s, which is in the process of developing in the following way.
The Cha-Am note tells an anecdote about a 2004 meeting with the wig company’s investor relations representative – resplendent in an orange wig. “All he would talk about was Japan’s ageing population and how wig usage was going to increase,” the note continues. “Questions from us about falling ROEs [returns on equity], the ballooning balance-sheet etc were referred to the accounting department.”
At first, perhaps, one might be inclined to concede the wig enthusiast had a point – after all, what could offer greater certainty of an upturn in wig demand than a steeply aging population? The problem, of course, was that most investors overpaid for the business, splashing out up to 2.5x price-to-book – that is, up to two and a half times the cost of the company’s assets.
Source Bloomberg, 2016
While the company may indeed have managed to grow its sales from around ¥64bn (£370.3m) in 2000 to the most recently available figure of ¥80bn (£482bn), as the two charts show, that valuation premium has trended steadily lower, which has in turn led the shares to underperform the wider Japanese market.
Maybe wig companies – and indeed artificial intelligence and autonomous cars – will reward investors in the future or maybe they will not. Here on The Value Perspective, the only thing we feel able to say with any certainty on the matter is that, if you pay a large premium for the assets of a business on the assumption it will grow continually, you are likely to be disappointed.