The world is changing. The way investing has always been done is not good enough any more. A certain class of stocks now stands head and shoulders above the rest to offer unprecedented returns to the patient investor. There has never been a more exciting time to invest in the stock market.
The New Millennium Approach:
- No investment silos. We think it is a mistake to have multiple investment “mandates” that distinguish between, for instance, large cap vs. small, emerging markets vs. developed, and growth vs. value, to name three common dividing lines. These restrictions reduce a portfolio manager’s toolkit for balancing return and risk to optimize performance.
- Don’t buy the S&P 500. The most common index by which portfolio performance is measured is the S&P 500, which groups the 500 highest valued stocks in the stock market according to 10 categories: Financials, Consumer Discretionary, Consumer Staples, Energy, Materials, Industrials, Information Technology, Health Care, Utilities, and Telecom. Four of these categories should be avoided all together because 1) they require high levels of investment and 2) their end products are commodities so have no pricing power, a deadly combination.
- Avoid companies that carry inventory. A key feature to avoid in any investment is a company that carries inventory. Investors place a high value on consistency of recurring revenues that are predictable in time and value. Inventory disrupts revenue predictability, destroying shareholder value. Traditional companies suffer from an accounting asymmetry. That is, working capital consists of two assets, i.e., inventory and receivables, but only one liability, i.e., accounts payable. In order to grow, therefore, a traditional company must fund twice the level of its future sales in working capital. Because that is impossible, we have a stock market to provide no-refundable equity to cash-consuming companies that early in their lifecycles consume rather than generate cash. Well more than half of the companies listed on the stock market carry significant inventory. The implication is that well more than half of the companies in the stock market are uninvestable. The case against indexing in the modern age is compelling.
- Invest in managers. When we buy stock in a company, traditional or new, we are investing in the people managing it. A good concept is necessary but not sufficient. Bad managers can ruin a good company, so we don't get hooked on a company concept without knowing and trusting who is implementing it. Does management have skin in the game? Do they listen to customers and change with demand? Do they have the flexibility to stay relevant in a fast-changing world?
We Look For New Era Companies. In the new economy, it is possible to find companies that enjoy three value-additive attributes that were not possible in traditional companies:
- Does not require inventory. Better market intelligence and reduction in delays between order and delivery reduce the need for investments in inventory in new era companies. Virtual products do not go into inventory. Neither do service companies occupy inventory. The product is created at the time it is delivered. The real-time economy is becoming a reality for the first time. Invest in it.
- No limit to scaling up. Traditional companies took years to go from product introduction to global rollout. Today’s next-era companies use technology to scale up production from zero to billions of dollars in revenues with little delay.
- Network effect. First movers in today’s new economy build steep barriers to entry by employing the network effect, by which the utility of a connection rises exponentially as the number of connections rises linearly. These connections enable deep knowledge of customer behavior like never before, enhancing the staying power of responsive companies. Good management is critical to stay in touch with customer needs and build or acquire to stay relevant.
Information Technology and Health Care enjoy the above advantages. These two sectors constitute only 35% of the S&P index but represent 60% of Diamond Head Financial Advisor portfolios. The balance of the portfolio consists of specialty retailers, a well managed railroad, a defense company that enjoys an historic monopoly, and one great bank amidst a morass of mis-managed banks that constitute the Financials portion of the S&P 500.
Invest in the new millennium. Today is indeed the most exciting time for an investor who is ready to take advantage of the new economy to thrive. Enjoy it, don’t avoid it.