Tuesday, February 8, 2022

Thematic Investing by David Krause, Marquette University


Thematic Investing Essay

by David S. Krause, Marquette University

February 2022


What is thematic investing? The term is first believed to have been coined by Kevin O'Leary, a Canadian television personality who is a regular panelist on Shark Tank. The business magnate, investor, and entrepreneur gave the first televised presentation on the concept and benefits of thematic investing on CNBC's Squawk Box in July 2004.

Thematic investing is an approach which focuses on predicted long-term trends rather than detailed analysis of specific companies or sectors, enabling investors to access structural, one-off shifts that can change an entire industry. Thematic investing focuses on investing in stocks based on underlying risk factors. These factors can be derived from external sources, such as economic trends or fundamental sciences. Frequently, these risk factors change, and new themes become available. Sometimes these risk factors drive stock valuations significantly higher benefiting thematic investors; however, as witnessed in January 2022, it also can be a dual-edged sword with dramatically lower valuations over short time periods.

Thematic investing can be combined with other investing strategies, such as fundamental analysis which involves the evaluation of stocks based on a company’s financial condition. Thematic investing treats economic data as a key indicator, while a traditional fundamental investment analyst focuses heavily on long-term company fundamentals. This traditional approach to investing involves the use of discounted cash flow and relative value comparisons with related stocks in order to evaluate their investment merit. On the other hand, thematic investing examines stock opportunities relative to their present situation.  

In short, thematic investing is considered to be a niche investment strategy. It differs from the traditional fundamental valuation approach in that the focus is on analyzing an industry or technology rather the detailed analysis of a specific company.

What is secular investing? This type of investment strategy involves the identification of 3-to-5-year waves that are often referred to as cyclical trends or movements. If the overall direction of the market in a longer-term wave is down, this is called a cyclical bear market. While if the overall direction of the market over a longer-term period is up, then it is called a cyclical bull market. For example, during the latter part of the 2010s and early 2020s, a cyclical bull market existed.

Secular investing involves attempting to time cyclical markets. Often times, the long-term secular movements that drive these patterns are nearly impossible to predict. Sometimes a secular trend can be anticipated, such as when a change in government monetary and fiscal policies is clearly announced. Other times a secular trend can be driven by macro factors such as demographic patterns or new technological innovations, as was the case with the Internet in the late 1990s.

It is possible to employ thematic investing within a secular trend. For example, many secular themes revolve around demographic, behavioral, and macro trends that can be driven by certain economic, social, political, and technological changes. Behavioral trends can be impacted by cultural, economic, and environmental events, while macro trends are those which are driven by global forces that impact economies, cultures, societies, people, and the environment.

Is Cathie Wood of ARK Investment a thematic or secular investor? Her firm, ARK Investment Management, employs a classic thematic investment strategy. ARK’s approach, which focuses on predicted long-term trends rather than a specific company’s or sector’s fundamentals, enables investors to access structural, one-off shifts that can change an entire industry. Interestingly, some people call Cathie Wood to be a secular investor because she invests in stocks regardless of the overall trend and pays little attention to valuation. However, ARK invests in companies that disrupt business in one way or another – they do not invest basic on secular trends.

Some examples might help understand Wood’s approach. For instance, ARK invested in Alibaba, which is a business that disrupted the way people sell and purchase products online. Thematic investors put their funds toward industries that will disrupt other businesses in the future. Presently, ARK is investing in companies that make and sell cryptocurrencies believing that this technology is going to disrupt the traditional banking and financial services industry. Another example of a disruptive innovation that ARK is currently investing is artificial intelligence (AI), which is a technology that experts believe is likely to disrupt many industries, including the manufacturing and financial sectors.

What is the relationship between disruptive innovation and thematic investing?  There are many people who believe that disruptive innovation is the major driver of change and that it is the driving force behind the technological revolution. Disruptive innovations such as social media, artificial intelligence, big data, and blockchain are influencing the lives of billions of individuals worldwide. These technological innovations are able to change how individuals interact with each other, with their environment and conduct commerce.

For example, blockchain technology is a disruptor that potentially will revolutionize and decentralize the financial sector. The World Economic Forum has predicted that blockchain technology will have a substantial impact on the global economy by 2025. Therefore, thematic investing in this technology can help investors benefit from the upcoming developments likely to be felt across multiple sectors.

Unlike traditional fundamental investing that tends to be focused on analyzing a company in detail within a specific sector, thematic investing is much broader and not as concerned with a specific sector. Thematic investing is more involved with understanding the potential future disruptions that might occur with breakthroughs in solar energy, biotechnology, and FinTech. Conversely, traditional investing involves more conventional sectors like banking, insurance, utilities, and energy companies.

Can traditional and thematic investing co-exist? Certainly, both value and thematic investing seek to minimize risk and maximize returns within a portfolio context. Therefore, investors in both strategies seeks investments in companies that are considered to have solid fundamentals and good future growth potential. Traditional fundamental and thematic investors  believe in investing in companies with strong management teams and sustainable balance sheets. Therefore, investors in value and thematic investing believe in owning companies that are financially sustainable and well-managed.  Both investing strategies can be complementary to each other and are supported by traditional financial and economic theory.

Nevertheless, there are some areas where the two approaches differ. Value investing is not concerned with a specific theme but seeks to invest in companies that are considered to be undervalued. A traditional fundamental value investor aims to invest in stocks that are undervalued because their intrinsic value is higher than their present stock market value. Thematic investors, however, are looking for a specific theme or technology and care more about the long-term growth potential than current valuations.

Is thematic investing more volatile than fundamental investing? Yes, because there are specific thematic strategies, such as Ark’s Genomic Revolution or Autonomous Technology and Robotics funds, these tend to be less diversified than traditional portfolios, and thus more volatile. Sometimes thematic funds will develop a strong momentum trend as market timing investors jump in. For example, if Cathie Wood creates a new Ark fund based on an emerging technology or innovative disruption, many other investors may follow her lead creating strong momentum. These momentum investors will move into and out of various themes depending upon the short-term performance that results in more volatile returns over time. This short-term behavior can also lead to greater volatility of thematic funds.

Are momentum and thematic investing the same thing? Momentum investing is the practice of buying stocks that have recently performed well. This approach is based on the idea that some stocks that are rising can generate a dramatic upside over a short period of time. Momentum investors basically believe that stocks that did well in the recent past will continue to do well in the future. This behavioral bias leads momentum investors to buy stocks that did well recently but they also exit stocks as quickly if performance lags.

Both momentum and thematic investing involve buying stocks based on recent trends; however, two fundamental differences exist. With momentum investing, investors look for stocks with a reputation for performing well over a range of economic conditions. When they enter the market, they will either sell or remain there. With thematic investing, on the other hand, investors buy and hold stocks for longer periods that they believe will outperform the overall market into in the future.

Two trends characterize both momentum and thematic investing. First, these strategies tend to be uncorrelated, meaning if one succeeds, the other might not. Second, thematic investing involves a more qualitative analysis looking to the future, while momentum investing focuses on more quantitative or past technical charting data. Academic researchers have conducted extensive research on momentum investing and have generally found that most are poor relative performers over time. The findings reveal that momentum strategies tend to be characterized by a lack of persistence and underperform relative to other investment approaches.

What is the conclusion? Disruptive technology and innovation appear be occurring more frequently. Thematic investing seeks to identify future ‘disruptors’ early in their lifecycle. This type of investors needs to remain vigilant in identifying new ideas, approaches, and technologies. These investors have to remain agile and adept at evaluating the potential for new technologies if they want to succeed. Investing in disruptive technology can be challenging for those who love traditional firms which is why funds like Ark Investment Management have grown in popularity.

Technology trends constantly change, and as a result, thematic investors are continuously searching for stocks that can profit from new markets and trends. The future of disruptive technology has many people searching for the next Amazon or Google, which is not as easy as it seems. Because today many business practices appear to be shifting, including macro and demographic trends, thematic investors must be on the lookout for companies who are emerging or re-inventing themselves. New technological innovations, which were previously only dreams, are reshaping business and the economy. Thematic investors are wise to find and identify these future disruptors.