Thematic investing, which involves investing in companies aligned with specific, forward-looking themes such as artificial intelligence, renewable energy, or healthcare innovation, has captured the imagination of many market participants. However, as with any investment approach, it’s essential to weigh the pros and cons. We weigh in from our perspective as value investors.
The Upside of Thematic Investing:
1. Capitalizing on Secular Trends
Thematic investing allows investors to tap into powerful, long-term trends that could drive outsized growth in the years to come. For example, themes like digital transformation or clean energy are backed by structural changes in society and industry. By identifying these trends early, a value investor can potentially benefit from substantial capital appreciation, as companies within these themes often experience robust revenue growth.
2. Diversification Beyond Traditional Sectors
Value investors may be tempted to concentrate their efforts on a handful of maturing industries that may appear inexpensive at any given time financials, utilities, and industrials. The incorporation of elements from Thematic investing, however, could reveal opportunities in emerging sectors that might not be well-represented in traditional portfolios. This can lead to better diversification, especially when the themes selected are less with an investor’s current portfolio.
3. Innovation and Growth Potential
Many themes are centered around innovation, such as biotechnology or fintech. Value investors might typically seek undervalued companies that are further along in their maturity but offer solid fundamentals and an established track record. Thematic investing can offer exposure to innovative firms that are not only disruptors but also future leaders. When investors have the skillset to understand these businesses and they can be found trading below intrinsic value, they might present a compelling value proposition.
Risks Associated with Thematic Investing:
1. Herd Mentality and Overvaluation
One of the most concerning risks in thematic investing is the potential for overvaluation. Themes that capture the public’s imagination—such as artificial intelligence, renewable energy, or biotechnology—often lead to speculative frenzies.
Thematic investing can sometimes attract a herd mentality, where investors pile into the same stocks, driving prices up and creating bubbles. This is particularly concerning for value investors who thrive on finding opportunities that the broader market has overlooked. When a theme becomes too popular, the chances of finding undervalued opportunities within that theme diminish.
We would argue that when investors pay exorbitant prices for growth prospects that are already widely recognized, they expose themselves to substantial downside risk if the company fails to meet these lofty expectations. This overvaluation risk is more likely embedded in the practice of thematic investing because the focus is often on narrative rather than fundamentals.
2. The Impermanence of Themes
Thematic investing is predicated on the assumption that certain trends will continue to grow and shape the future. However compelling today, many themes, may lose their relevance or encounter unforeseen challenges that derail their trajectory.
For instance, regulatory changes, technological disruptions, or shifts in consumer preferences can quickly turn a once-promising theme into a lagging sector. Developments on any of these fronts can increase the difficulty of forecasting and amplify volatility.
3. Concentration Risk
Another significant risk in thematic investing is the concentration of exposure to a narrow set of industries or companies. When investors allocate a large portion of their capital to a single theme, they increase their vulnerability to sector-specific risks.
For example, a portfolio heavily weighted towards renewable energy companies might suffer significant losses if there’s a downturn in the sector due to policy changes or technological setbacks. Klarman’s approach would suggest that investors avoid putting too many eggs in one basket, as this goes against the principles of diversification and risk reduction.
4. The Temptation to Chase Performance
The allure of thematic investing often lies in its promise of high returns driven by the momentum of popular trends. The temptation to chase performance is one that investors should be mindful of no matter the asset class or potential investment, as it can lead to irrational decision-making and increased risk-taking. When investors flock to the latest hot theme, they potentially do so without fully understanding the underlying business models or valuations, driven instead by the desire to replicate past successes.
Conclusion
Thematic investing offers value investors a way to participate in the growth stories of tomorrow, but it is not without its challenges. The potential for significant returns is enticing, especially when investing in transformative themes. However, investors need to be cognizant of risks from overcrowding, theme impermanence and concentration, while seeking to avoid the temptation of chasing recent performance.
For value investors, the key lies in maintaining discipline. It’s crucial to evaluate thematic opportunities with the same rigor as any other investment—focusing on fundamentals, valuation, and a margin of safety. By doing so, thematic investing can potentially complement a value-focused portfolio, allowing one to fish where the fish are without compromising the principles that have stood the test of time.
As always, patience, discipline, and a long-term perspective remain the cornerstones of successful investing.
Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. This report should only be considered as a tool in any investment decision and should not be used by itself to make investment decisions. Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.