September 07, 2021
September 07, 2021 | Adviser News
The Seven Sins of Thematic Investing: Sin No. 3 Sledgehammer Scope
by Lazard Asset Management
Generic investment ideas are sledgehammers - simple, broadly defined investment propositions that make an immediate marketing impact but can leave lasting damage to portfolios. Themes that are designed too broadly in scope may not target the actual return opportunity. For this reason, we develop our own, proprietary themes that try to isolate specific structural changes that will generate returns. We also permit themes to evolve over time so they avoid obsolescence. Theme design should ultimately be as precise as possible rather than convey a grand vision - managers should use a scalpel, not a sledgehammer.
Lazard Global Thematic Approach
|Generic themes||Generic themes that convey a grand vision without much underlying substance||Proprietary themes that target clearly identified return opportunities|
|Lack of precision||Theme offers vague “exposure” to a perceived return opportunity||Explain how thematic insights could play out in terms of fundamental outcomes that differ from consensus.|
|Themes limited to growth||Assumption that a thematic approach must target growth/innovation/disruption||Consider all stages of the adoption curve and company life cycles, including the ability of companies to evolve.|
|Lack of expiration conditions||Even if theme is correct, lack of sell discipline results in theme remaining in place even when market consensus has caught up.||Themes must evolve to stay ahead of consensus or be retired.|
Many “thematic” managers invest in generic, easily recognizable themes that simplify the marketing process. Yet the narrative fallacies of Sin No. 1 and the humbling experience of forecasting elucidated in Sin No. 2 suggest that we should be deeply wary of assumed knowledge. Extending this thought process to the world of standardized, commonly accepted, generic themes raises a deeply uncomfortable question for many thematic managers: If an investment theme is truly inevitable and widely accepted as such, surely it should be already fully discounted?
We believe that companies that are obvious beneficiaries of popular narratives are often fully valued. Our approach therefore rests on the creation of proprietary themes, each of which attempts to capture a number of structural changes that are likely to result in long-term value creation over and above the common consensus embedded within generic investment themes. In creating these proprietary themes, the scope of each theme warrants careful scrutiny. In particular, we believe that themes are often defined too broadly, necessitating a number of sub-steps to reach the underlying investments. Each of these steps layers assumption on top of assumption. Theme design is an art, not a science, but investors should expect to hear some explanation as to how the thematic insights might play out in terms of fundamental outcomes. We prefer the precision of a scalpel, isolating the intersection of structural changes and investment return opportunities, over the sledgehammer of a grandiose vision of the future.
Many structural shifts follow adoption curves driven by the disruptive impact of technology, but we do not believe early-stage disruption is the only area of relevance for thematic investing. Investing in the early stages of disruptive cycles can offer significant opportunities due to the non-linear pace of change, but we must acknowledge the risks as well. Products or technologies can fizzle out after initial excitement, and many disruptive companies have been overwhelmed by fast followers or deep-pocketed incumbents.
We often see an improved level of risk and reward a little later in an adoption curve, as product offerings go mainstream, industries consolidate around one or more leaders, and the potential for the emergence of stable profit pools becomes more apparent.
Similarly, we do not believe that a thematic approach should be limited to a growth style. There are many forms of structural change, as detailed in our companion paper, “Capturing Structural Change.” We consider companies in all stages of their life cycles when constructing themes.
Finally, even good themes play out over time, and investors who aren’t careful about knowing when to move on may find themselves desperately trying to justify forecasts and valuations. A more disciplined approach would insist that themes must evolve over time or face retirement. Consistent with our scalpel comments above, our themes may become more precise over time as we gain new insights. We believe a dynamic approach, while a little more complicated to explain than a static approach, best represents the reality that the world changes over time and we must stay ahead of these changes and market consensus rather than assume comfortable constants.