A new industrial revolution

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Businesses that combine closed-loop, arms dealer and monopoly characteristics represent something fundamental that is shifting in the global economy. They represent automation that is pervasive, smart, and is a layer that sits across the entire economy. Data processing and prediction build these business models. They permeate all services, including supply chains, logistics, mobility, and consumer offerings. Pervasive and innovative, they represent opportunities for increasing investment returns. Incumbents enhance their position, generate increasing value, create challenging barriers, enable more innovation to solidify their position and will sustain their value because of this new competitive dynamic. Innovation is always a threat, and value can be created from a new entrant, but the bar is increasingly higher for both the level of disruption and quality of innovation to an existing or even new market.

To be sure, new opportunities will be created as new technology develops. An example is the wireless data and smart phone market. Essentially, 4G mobile technology enabled the substantial value creation at Facebook, Netflix, Uber and AirBnB. These companies could build their services on top of this technological platform and create not only a new competitive business, but a new market where they could be the dominant player. As 5G develops and we see unimagined high-speed for data, entertainment, communication, and other services, we will have new businesses and opportunities created on this platform – only so much can be imagined today, others which are yet to come. But there will be real-time connection with customers enabling new and innovative products and services, artificial intelligence permeating software and communication enhancing quality and innovation further, enhanced gaming (perhaps even to a professional level), and virtual reality and augmented reality perhaps finally becoming the market opportunity that has been imagined for many years. This list is far from exhaustive, and without doubt, there will be valuable companies created whose business models we can’t quite imagine today.

Building a Portfolio

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Investments are typically analyzed singularly, and collection is considered a “portfolio.” This is a mistake because, while each investment has its own risk and return profile, the combination represents one single combined investment. In other words, a portfolio should be thought of as one investment with its own risk-adjusted return profile. That is, an investment with its own risk-adjusted return. It has dynamic components which consist of each investment within the portfolio. But a portfolio should not be viewed as a collection of investments with different risks.In thinking about where to invest, one of the most important components is to first think about the industry or sector where the company competes. It is important to target specific industries that are worth the investment. A great company within a mediocre sector is not worth the time. As an example, GE, once one of the world’s most valuable companies, has lost most of its market value because it competed in sectors, such as large turbines for energy generation, that were no longer attractive. It doesn’t matter if, according to GE’s standards, it was the number one or number two competitor in that sector. The sector is not worth the time. As it has now been shown, that matters more than how successfully one competes.Of course, it does matter how well a company competes once you chosen an attractive sector. An example here is Nvidia, a company that not only participated in an extremely attractive sector – specialized integrated circuits for intense processing, initially focused on gaining and then artificial intelligence – it competed effectively to become an industry sector leader. As a result, its value has increased almost 10 X in the last seven years.Different sectors have different risk components, and different companies competing within the sectors also have different risk profiles. It is appropriate to combine securities with different risk profiles, in both its sector and competitive position. Each of these companies can be thought of as a growth, defensive, cyclical, or stable investment, for example, depending on these different profiles.Fundamentally, a successful investment strategy combines companies competing successfully in attractive sectors offering unique risk-adjusted return when combined into a single portfolio. It is this investment strategy where the risk-adjusted return is superior. What do we mean by risk-adjusted return? A simple way to explain this is through an “S” curve, as demonstrated below. There is a relatively flat bottom increasing in degree and slope. Sometimes, the slope will increase at an increasing rate, a phenomenon known as “convexity.” We will discuss this later, but convexity is one of the key attributes to an attractive investment. But, as we can see, those returns begin to diminish as we approach a changing slope in the curve.There is a relative flattening at the top of the curve. This is true for every investment. The timescale may be different (attractive returns might be earned for a short time or, potentially, for decades, but, returns eventually flattened). There is no escape from this phenomenon.

no cure for gravity

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You cannot escape physics. The value of every investment starts at zero. Entropy is our natural state (thank you to the Second Law of Thermodynamics) meaning that we are constantly fighting the destruction of value. There is always a force, equivalent to gravity, pushing an investment down. Value is created by the efficient use of capital and the created, sustainable competitive advantage. Consistent investment in a thoughtful portfolio will create sustained value, but it is work, and you will always be fighting natural physical forces. One recent example is the financial crisis of 2008 to 2009. 40% of the average equity value was destroyed in this time. However, if one invested consistently at the height of the market and continue to invest through the crash and then ultimate recovery, and investor still earned over 9% annually. Thoughtfulness, consistency, patience, and determination is the most effective way to fight gravity and thermodynamics. The most important way to fight physics and the ultimate effect of gravity is to determine what you are looking for first. Highlight growth, disruption, sustainability – what will have a long-term value creating effect. What sectors make the most impactful difference? Recently, as we look at technology, biotechnology, and other important sectors, we see above average returns because of the impactful nature of the sectors. But technology is also permeating finance (Fintech) and entertainment (streaming services) that are disrupting incumbents and creating disproportionate value to the new entrants. Is this sustainable? Will the disruptors capture value, or will more established companies ultimately win? Observation, questioning assumptions, testing models, and assuming no knowledge regardless of historical experience are the only cures for gravity.

Animal spirits and the madness of markets

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When to sell is more important than what to buy. One of the biggest mistakes investors make is thinking that their purchase decision is the most important decision they will make. This is misguided because most losses are lost opportunities. They may be buying decisions that were never made, but most likely, they are selling decisions where the decision to sell was made too soon. When Warren Buffett owned 5% of Disney in the 1960s, he made a 50% return. He happily sold the stock. But investment decisions should not be made based on historical returns. Once again, all investments are predictions for the future. Regardless of whether the investment you currently hold has generated a great return or lost you money, what will it do from this point on?

Buying or selling is a crucial investment decision because you are always either buying or selling. There is no such thing as “holding.” If you own something you have bought it. If you would not buy it today but continue to own it simply because you bought it in the past, and not making an investment decision, just simply being inactive. If you are an investor who is buying or selling. Selling decisions tend to be inefficient. One does not need to be active, but one does need to think like an owner. If you own a great company, there is little reason to do anything else other than stay on top of developments within that company and industry to make sure they can remain a great company. Eventually, they will revert to the mean. More than anything, that is an investor’s job – figure out when the company will revert to the mean. That means they will either be losses or tremendous gains in the future as this trend occurs.

Nothing stays above average.

Markets and Valuations

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The current low interest rate environment increases the discounted present value of future cash flows and reduces the return demanded for every investment. In other words, when the Fed funds rate is zero, 6% bonds become disproportionately attractive. Buyers have now bid bond prices up until yields are now significantly less.What does it mean if the prices of stocks and listed credit instruments are at levels not driven primarily by fundamentals reasons (i.e. current earnings and the outlook for future growth), but in large part because of the Fed’s buying, it’s injection of liquidity, and the resultant low cost of capital and the market’s lower demanded returns on financial instruments?