The rationale for trends investing

The rationale for trends investing

06-09-2017 | インサイト
Everybody loves a good story, but there’s more to trends investing than just good stories. In this article, we will set out our trends investing philosophy, shaping an analytical framework that moves beyond mere story-telling.
  • Steef  Bergakker
    Steef
    Bergakker
    Senior Portfolio Manager
  • Jeroen van Oerle
    Jeroen
    van Oerle
    Trend analyst Robeco

Speed read

  • Trends investing exploits behavioral biases
  • Important biases are over- and underreaction to new technologies
  • The maturity of the technological change determines the portfolio approach
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In today's investment world, the added value of portfolio managers is measured by the outperformance, or alpha, they can deliver. In a landmark paper, Fuller [2000] suggests that there are three sources of alpha:

  • Acquiring superior (private) information to get an analytical edge
  • Using better ways (quant models) to process information for an informational edge
  • Taking advantage of behavioral biases to acquire a behavioral edge

Trends investing aims to exploit the analytical edge in grasping the dynamics of secular change, and to take advantage of the systematic behavioral biases displayed by people.

Behavioral biases

Important biases in trends investing are over- and underreaction. People have a tendency to overreact to new, exciting technologies that promise to revolutionize entire industries. When these new technologies fail to live up to unrealistically high expectations, disappointment sets in and expectations are pared back drastically. However, when these technologies have overcome their teething problems and customer uptake starts to accelerate, people are slow to pick up on this new information. This empirical pattern of overreaction to early-stage new technologies and subsequent underreaction to later-stage acceptance of these technologies, forms the basis of Gartner's Hype Cycle. This is an important input in our investment process.

At the same time, people also have a tendency to grossly underestimate exponential growth. This is well-documented, for example, in a widely cited experimental study by Wagenaar and Sagaria [1975].

People systematically underestimate exponential growth

Source: Wagenaar & Sagaria; Robeco Trends Investing

These behavioral biases are sources of alpha, as they may lead to unrecognized longer term growth opportunities.

There are three main drivers of secular change. It is either driven by government policies, socio-demographics or technology. Technology driven change is most interesting for trends investing. The speed and extreme specialization make it hard to predict the exact way in which new technology will proliferate. Examples are automation, digitization and hyper-connectivity.

The maturity of the change determines the portfolio approach

The Gartner hype cycle is a very helpful tool, providing insights into the best portfolio construction strategy. In the first two stages of the hype cycle (technology trigger and peak of inflated expectations) it is often not yet clear who the winners will be. As the investment community gets excited about a trend and the media pick it up, momentum increases and companies enter the stage where the tide raises all boats: every company that can be associated with the trend increases in value. Expectations are very positive and overreaction can result in bubble-like valuations.

Portfolio construction combined with hype cycle

Source: Gartner; Robeco Trends Investing

Our investment approach during this first stage is twofold. First of all, since there are no clear winners yet, we believe it is best to construct broad baskets of companies with good (preferably pure) exposure to the technology instead of focusing on a few companies. A second approach is to invest in companies that facilitate the new technology. This is the ‘picks and shovels’ approach. Instead of trying to invest in a (presumed) star gold miner during the gold rush, our approach is to invest in the shop in town that is supplying the picks and shovels. Or, in today’s context, the suppliers of sensors and software that all producers of self-driving cars need.

After the hype has peaked, the next phase is difficult from an investment perspective. During the ‘trough of disillusionment’ and part of the ‘slope of enlightenment’, sentiment is still very negative, companies cease to exist and Merger & Acquisition activity peaks. During this shake-out, winners will emerge, but it is hard to invest during this period, which we dubbed the ‘investment chasm’.

The second stage of investment opportunity comes along halfway the ‘slope of enlightenment’ and continues onto the ‘plateau of productivity’. This is where we find the companies that have survived the shake-out period and are able to continue developing the technology. The investment opportunities are especially present during the ‘slope of enlightenment’, where sentiment is still negative because many investors witnessed the crash period. The portfolio approach during this phase is to identify long-term winners and concentrate portfolio holdings into these names as opposed to the basket approach in phase one.

Diversification and long-term focus

The Robeco trends approach combines multiple, low-correlated trends in one portfolio. This allows for substantial diversification benefits, making the portfolio less vulnerable to trends that fall out of favor in certain periods. Furthermore, we believe in long holding periods of typically three to five years. As it is very hard to pin-point when a trend will start to perform, we position for the long run.

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