As investors, we are trained to be conservative, to expect less in future, and to avoid the hype of the moment. This conservative mindset underpins an industry which has the responsibility of managing other people’s money. Could it be though, that this conservative mindset is a net cost to the same investors we are aiming to serve?
The early founders of modern investing – the likes of Benjamin Graham and David Dodd – put forward a sensible approach, premised on “not overpaying”, which lies at the heart of a valuation-based approach. This approach is useful in the case where a company’s prospects are known, its operating costs established and its profit margins observable through analysis over long periods. The Graham and Dodd approach encouraged diligent fundamental analysis. Investors would then do well to buy those shares which were undervalued and sell those which became overvalued.
If diligent analysis is required, then this assumes a company and the industry in which it operates are broadly understood. What happens when a company or industry is entirely new and is set to disrupt the status quo going forward? Where these companies have the potential to put the long-standing companies from the Graham and Dodd world entirely out of business, and to become future leaders?
This segment of the share market – the “blue sky” investment opportunities – often requires a different mindset.
Research by Hendrik Bessembinder[1] highlights that just 4% of shares ever listed in the US have created all of stock market wealth, and just 90 companies out of over 24 000 listed since 1925 have created half of all wealth. The number of truly successful companies is simply very small over time.
There are two significant examples of blue sky investing, both from the US over the past 20 years. The first is Amazon, founded by Jeff Bezos, which initially displaced Barnes and Noble as the leading book retailer. Amazon’s business model enables it to target an ever-increasing spread of industries as the world of e-commerce becomes broadly accepted.
Martin Eberhard and Marc Tarpenning founded Tesla in 2003. The primary initial investor was Elon Musk. Originally set up to manufacture electric cars, it now has its sights set on all forms of mobility, powered by electric energy. With Tesla reporting profit for the first time in late 2019, the share price responded by increasing materially since June 2019.
As a result, Musk may now qualify for a payday of over $346m (given he is paid entirely in shares should the company reach its ambitious targets).
Do investors rejoice in the fact that the potential for this company to start disrupting the world’s largest automakers is starting to bear fruit? Well, for the most part, they don’t. Tesla is not a share favoured by most investors. The following attributes provide some insight as to why not:
- The business has not made a full-year profit, ever.
- No dividends have ever been paid.
- Debt levels are high and climbing (peaking at 80% of total business value).
- Productions targets have consistently been missed.
Typically, these traits would be a no-go zone for most investors. As Graham and Dodd would likely attest, how do you perform diligent research when it’s not possible to observe any reasonable financial outcome for the business?
Tesla has one of the highest “short interests”[2], indicating most investors think the share is wildly overvalued. Why is it so difficult to invest in shares like these? We provide possible reasons next:
1. You don’t know what you are buying
As an investor, you are not buying established businesses with observable business models that are easy to value. You are buying businesses that are generally early in their business cycle; are disrupting incumbents and driving new business models; have no established market as they are often creating new markets; don’t know their client base yet; are often making a loss and have very little foresight of margins. You are buying an idea, often with a visionary leader leading the charge.
2. Very few companies are successful
The nature of these “high-risk start-ups” means that failure rates are high, so the selection is very important. A study performed in the US between the period 2008 and 2018 tracked 1 119 US tech start-ups that received seed funding between 2008 and 2010. The study found that by the end of 2018, 67% of those companies had failed and less than 1% had become “unicorns” (a market cap of over $1bn).[3] Some of these companies are the most-hyped tech companies of the decade, including Uber, Airbnb, Slack, Stripe and Docker.
It is not surprising then that the behavioural bias of risk aversion is hard for managers. No-one wants to be the fund manager who has a share go to zero.
3. You need to be a long-term investor
The nature of these businesses, the stage of their business cycle when you generally first invest, and the fact that selection is so important means that once you choose to invest you need to be invested for the long term. It may take years for the business model of these businesses to materialise.
Often, further capital investments are needed as the company requires funding. Leaders require guidance (or removal, as in the case of Uber’s Travis Kalanick).
Why do traditional investors miss these opportunities?
Traditional active investors can be separated into two broad types:
Quality investors look for businesses which have strong market positions, a stable client base and a defendable long-term product or service. They look for businesses that have a demonstrable business model. They want to see reliable earnings and margins, and determine, with a certain degree of comfort what a business will look like in five years. They are generally not as concerned with the price they are paying if the business can protect and grow its earnings above the market average.
Value investors are typically looking for established businesses which are at a cyclical low, or where a specific event has meant they are trading below their fair value.
What types of investors can capture this type of return?
We identify investors who get excited about businesses like Tesla, as growth investors. Growth investors at their core are trying to identify businesses where expected earnings growth is significantly higher than average and believe that even an expensive price to pay is justified given the potential outcome. They are generally optimistic by nature as they make decisions with little or no sight on earnings or business model. They put a big emphasis on the “what ifs” of an investment case. They are risk-taking rather than conservative as they ride the winners rather than sell them down and generally have a very low turnover of holdings.
They require a very deep level of research and insight into a business, particularly given the business is still finding its growth path. Rather than research being focused on financial statements, they have a focus on emerging industries, changing behaviours and innovation to inform their views.
The number of truly successful companies is simply very small over time
They also need to be comfortable making mistakes, as often they have more losers than winners in their portfolios. Because of the types of businesses they are investing in (businesses that can grow to many multiples of their current size), the contribution of the winners often far outweighs that of the losers.
Growth managers refer to this as asymmetric returns, where you can lose a maximum of 100% of your capital on the losers, but you can make back multiples of your capital on the winners.
What should you expect from a growth manager’s portfolio?
There is a high failure rate in the pool of companies they are investing in, and the concentration risk is high as a large portion of the portfolio returns are generated by few holdings. Often the businesses in the portfolios are still driven by their founders and there is significant key man risk. How much of Tesla’s success is due to Musk, or what does Amazon look like without Jeff Bezos?
Because of this, investors in these funds should expect higher real returns with bigger drawdowns and more volatility. Moreover, there are very few professional investment managers that can successfully manage this sort of portfolio, given how difficult it is to get the selection right as well as the career and business risks attached.
In our efforts to ensure our clients are fully exposed to the full range of investment opportunities in the market, we seek out managers who can deliver on this sort of potential, to complement the overall portfolio.
To invest successfully, we need to come to terms with our own behavioural biases and cast our perspective wider than the more conservative stance that often pervades.
[1] Do Stocks Outperform Treasury Bills, 2017.
[2] Short sellers bet on, and profit from, a drop in a share’s price. Therefore, if an investor believes the share price of a company will decrease in the future they will “short sell” that share.
[3] CB Insights
