September 07, 2021

September 07, 2021 | Adviser News

The Seven Sins of Thematic Investing: Sin No. 4 Puzzling Purity

by Lazard Asset Management


Stocks that appear to be valid candidates for a theme might actually have very little relevance. Managers must look beyond simple purity metrics and choose companies that truly stand to benefit from the diverse potential drivers of structural change. Managers should also cross-check for idiosyncratic risk and valuation. Finding the right pieces to solve a thematic puzzle necessitates going beyond the obvious.


Implementation Risk


Lazard Global Thematic Approach

Tenuous fit between theme and stock Stocks within a theme are purported to be related to the theme, but in practice, the fit is weak or immaterial. Fundamental analysis of thematic fit - not just screening - is supported by a deep research platform.
Thematic purity Analysts arbitrarily or simplistically quantify assessment of thematic fit, resulting in false precision. Fundamental assessment of thematic fit between analyst and portfolio manager, with portfolio management team owning responsibility
Capitalization bias Strategy embeds small and mid cap bias to express themes through “pure plays” or “disruptors,” while ignoring the benefits of scale and ability of incumbents to evolve. All cap mandate, permitting balanced assessment of thematic versus idiosyncratic drivers, including both disruptors and incumbents
Idiosyncratic drivers ignored Thematic fit is emphasized, but idiosyncratic factors are insufficiently analyzed or conveniently ignored. Fundamental stock analysis by research platform ensures that, at a minimum, idiosyncratic factors do not offset the merits of thematic fit.
Lack of valuation discipline Thematic fit is taken as justification for portfolio inclusion at any price. Modeling and scenario analysis of long-term return drivers

The expression of themes through stock holdings requires thorough scrutiny. This is because stocks that appear to be valid candidates for a theme might actually have very little relevance. Whether due to lack of rigor or sleight of hand, investors in a theme may not be getting what they signed up for.

Some managers refer to the concept of a stock’s thematic fit as “purity” and quantify that purity by mapping to a simplistic investment driver such as the current or future revenue mix. We do not consider that kind of analysis sufficient for determining genuine thematic fit, however. Broad revenue exposure to a thematic narrative is meaningless without understanding the specific structural drivers involved. We believe identifying stocks that can benefit from the precise structural changes behind a theme, not just those that have some weak form of exposure to them, is the only way to determine true thematic fit. In addition, a simple focus on revenue exposure suggests a focus on companies selling products that are exposed to a shift in demand. However, product cycles are notoriously hard to forecast, particularly given the pace of change in disruptive areas. Many products have generated high short-term sales but low long-term profitability. We generally consider such product-driven investment themes as high risk. A product cycle is not a theme.

We take a broader view of structural change than the size of an addressable market or revenue growth, as a thematic thesis could also play out as a wider moat, a longer duration for returns, or the potential emergence of new opportunities. Ultimately, we anticipate these outcomes to be reflected in improved long-term fundamental performance, which includes not only revenue but also margins, cash generation, returns, and cyclicality, to name but a few. A broad, inclusive view of how structural change can manifest itself produces a better sense of thematic fit.

Stocks that fit the thematic thesis will have additional, idiosyncratic factors that drive future performance. Stock-level analysis should at a minimum ensure that these factors do not materially offset the thematic merits of the investment. Ideally, a stock’s idiosyncratic investment considerations would actually be additive to overall investment asymmetry. In either case, access to a deep, independent research platform is an essential cross-check.

We often hear that small or mid cap companies are better thematic candidates because they are “purer plays.” We have some sympathy for this point of view in certain cases, but we are loath to disregard decades of study into the significant benefits that accrue to large companies because of some arbitrary measure of “thematic purity.” On the other hand, if we only use large cap companies to populate themes, we risk losing focus on the thematic fit and access to smaller, more disruptive companies. We believe drawing from companies of all sizes is a reasonable compromise to optimize the theme between thematic fit and idiosyncratic factors such as incumbency advantages and economies of scale.

Finally, there is the question of valuation: Our philosophy is to focus on key inputs that matter to long-term valuations. Given that the majority of a stock valuation is driven by its prospects 3– 10 years from today and beyond, our emphasis is on changes to these expectations. We believe the presence of structural change, as reflected in our theme design and stock selection, is a strong foundation for differentiated long-term performance. Our work on valuation allows us to assess whether our insights are material and whether they are reflected in the stock price today.

Questions to Ask the Manager

  1. Is there undue emphasis on addressable market size or revenue growth?
  2. Are all stocks unrealistically portrayed as a perfect thematic fit?
  3. What is really behind a quantified measure of purity?
  4. Are idiosyncratic issues that fall outside the thematic scope properly analyzed, or are they conveniently ignored or dismissed?
  5. Is there an implicit market cap bias?
  6. Is valuation ignored in favor of eye-catching “potential”?

September 07, 2021

Insights from our Partners: The Seven Sins of Thematic Investing

Lazard Asset Management’s Global Thematic Equity team shares its decades of experience in identifying and avoiding the seven sins of thematic investing.

September 07, 2021

Insights from our Partners: Sin No. 1 Narrative Fallacies

Thematic strategies are particularly vulnerable to building themes around slick, but ultimately empty, marketing narratives rather than genuine return opportunities.

September 07, 2021

Insights from our Partners: Sin No. 2 Foggy Forecasting

Forecasting, particularly as far out as the next decade, is at best imprecise and at worst dangerous. Investors should ask managers where their ideas originate and prioritize sources grounded in real-world experience rather than popular consensus.

September 07, 2021

Insights from our Partners: Sin No. 3 Sledgehammer Scope

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.

September 07, 2021

Insights from our Partners: Sin No. 5 One-Trick Pony

Having multiple themes is of no benefit if they are all the same underneath the surface.

September 07, 2021

Insights from our Partners: Sin No. 6 Failure to Integrate

We observe that managers tend to make three mistakes when claiming to incorporate sustainability into their investment processes: failing to do it, pretending to do it, or doing it badly.

September 07, 2021

Insights from our Partners: Sin No. 7 The Wrong Resume

Genuine thematic experience is scarce. We believe it is crucial that investment teams on thematic strategies have had specific training and experience in analyzing many structural changes, not just time in the market.


Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated August 2021, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such.  Past performance is not a reliable indicator of future performance and should be used as a general guide only. Neither Zurich Australia Limited ABN 92 000 010 195 AFSL 232510, nor Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 118 Mount Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich.

Past performance is not a reliable indicator of future performance. GINN XYY9MQ.00000.SP.03. DFOY-017433-2021