There are hidden opportunities in thematic investing

Structural trends are long-term forces that shape behaviours, societies, industries and even financial markets.

They arise from innovations in technology, demographic shifts, changing consumer priorities, or global challenges like climate change and shifting geopolitical dynamics.

We believe markets underappreciate the persistence of these themes, which gives rise to attractive investment opportunities.

For example, longer life expectancies impact labour markets and healthcare spending, but also lead to different choices around education, urbanisation, family formation and a range of associated spending decisions.

Another example is the continued progress in the technology underpinning computer chips, which has led to the rise of smartphones, e-commerce, cloud computing, and more recently breakthroughs in artificial intelligence.

Despite their transformative power, structural trends or themes are consistently underestimated by financial markets. According to efficient market theory, prices should reflect all available information, reacting only to unexpected developments.

However, behavioural and institutional factors mean markets often fail to price in these themes for years, or even decades.

Traditional approaches emphasise a narrow focus on fundamental analysis of individual companies

The structure of the asset management industry inherently incentivises short-termism. Professional managers are agents acting on behalf of clients, their principals, who typically evaluate performance on quarterly or annual timescales.

This focus on short-term results leads managers to prioritise identifying short-term market inefficiencies or attempting to outperform peers by predicting near-term company performance, rather than focusing on longer-term opportunities.

These pressures are reinforced by the quarterly earnings cycle, where corporate reporting often aligns with investors’ near-term priorities, further obscuring the visibility of enduring themes in financial markets.

This well-studied phenomenon is called the principal-agent problem, defined as a “conflict in priorities between the owner of an asset and the person to whom control of the asset has been delegated”.

Conventional investment wisdom also plays a role. Traditional approaches emphasise a narrow focus on fundamental analysis of individual companies, often assuming that themes will ‘cancel out’ over time.

As a result, many investors concentrate on short-term forecasts while conservatively assuming that growth and profitability will steadily decline over longer periods, despite empirical evidence suggesting otherwise.

Behavioural science reveals that cognitive biases often prevent investors from recognising and acting on themes. Investors may rely too heavily on historical averages, leading to slow adaptation to new trends, known as anchoring bias.

Elsewhere, investors confronted with confirmation bias often overweight evidence supporting their existing beliefs while dismissing contradictory information.

Themes and their under-appreciation do not last forever

When presented with complex questions about long-term trends, investors facing substitution bias may simplify their analysis, focusing instead on shorter-term, more tangible opportunities.

These biases encourage a collective focus on short-term market drivers, leaving enduring themes under-researched and undervalued.

Themes and their under-appreciation do not last forever. Economies and societies have self-correcting mechanisms, and the conditions fostering transformative trends eventually change.

Similarly, companies benefiting from structural growth will face competitive pressures that limit returns over time.

Markets also tend to overcorrect, often moving from underestimating themes to overvaluing them just as they begin to reverse. As a result, thematic portfolios should not be purely ‘buy and hold’ with minimal turnover.

An active investment approach, that continually reassesses market expectations and adjusts portfolios accordingly, is critical for sustained long-term success.

In December 2014, Meta – which at that time traded as Facebook – traded on over 40x expected earnings, and was generally considered a relatively expensive, high-growth stock.

Its strong market position underpinned confidence that Meta would continue to benefit from its core tailwind or theme – the growth in digital advertising as marketing spend continued to steadily shift online from offline.

Greg Moss: Helping clients to stop worrying about the good times and love naked rafting

However, it was priced for a steady fade in growth down from above 30% in the upcoming two years, to 10% annual growth over the longer-term.

In reality, revenue growth averaged exactly 30% over the subsequent decade as the thematic tailwind from digital advertising proved very durable, and the company successfully maintained a strong market position.

As a result, while the valuation multiple faded from circa 40x earnings to closer to 20x, the share price increased by 700% over the decade, significantly outperforming both the expectations of investors and wider stock market indices.

Previous predictions of a 2024 share price of $168.4 by 2024 have been greatly exceeded: Meta now ranks among the largest American information technology companies, with a share price of $585.5.

Colm Harney is portfolio manager at Sarasin & Partners