April 2, 2018
New companies that emerge to challenge large and long-standing industries are not a modern phenomenon. Historically, this was called innovation or entrepreneurship but a new term has come to the fore – disruption.
Disruptive companies aggressively expand into markets dominated by firms encumbered by their size, old technology, physical footprint or stale branding and products. Here, we may be witnessing some of the repercussions of low interest rates, which allowed large companies to survive on very cheap debt rather than being forced to innovate. Whether or not this is the case, momentum has built up behind disruption as an investment theme.
Other investment themes, past and present, include outsourcing, sustainability, conglomerates, clean energy and technology. Themes tend to gain momentum because investors can easily envisage why they should be successful. This can often leave share prices surging far beyond what could be reasonably estimated as their fundamental value.
When the difference is more nuanced, or even when trying to understand seemingly astronomical valuations, it can be beneficial to be aware of some of the behavioural traps that we as investors can fall foul of.
In everyday life, we are often guided by quick unconscious decisions based upon the information in front of us, with a short feedback loop that confirms or corrects our behaviour. When it comes to more complex decisions, such as those regarding investments, these unconscious processes or ‘shortcuts’ can turn into what are called cognitive errors.
For example, if we can easily recall a recent and similar situation (availability bias) or classify the one in front of us into a stereotype (representativeness bias) we are likely to be swayed in our decision making, while feeling comfortable in doing so.
In investment terms, this can lead to the inclination that historic returns or success is easily and immediately repeatable, or that all companies of a similar ilk will succeed because others in recent history have done so.
Broadly speaking, these errors can be reduced by good investment processes. However, management teams, brokers and other investors interested in ever-higher stock prices find narratives a good way to encourage cognitive errors. A well-built, long-running and complex narrative can help shape investor perceptions and decision making, draw attention away from poorly performing areas of the business, ‘slipstream’ into popular themes or build a cult-like investor base.
Investors that are hungry for further success after being involved in disruptive companies such as ASOS, Purple Bricks and Fever-Tree may be more susceptible to being seduced by the next investment story. When the next opportunity presents itself, a strong narrative may steer investors away from questioning the chances of the disruptor being strong enough to unseat an incumbent. The car industry provides a great example; can we be sure that the production expertise of the large manufacturers can be replicated quicker than they can catch up on the technology front?
Ultimately, if the business results do not hit expectations or justify the share price over the long term, a strong narrative can be worthless in terms of shareholder value. When investing in themes, it can be as much about avoiding the crowd as it is about benefitting from the opportunities.