US markets: Investing even in the second-best stock within a theme can be rewarding

© Nishant Kumar US markets: Investing even in the second-best stock within a theme can be rewarding

Investors worldwide love to invest in the US markets to take exposure to innovative themes, typically, enabled by transformative technologies, but could also be socially driven and are not available in other economies.

Typically, there are a few well-known firms that are identified by Mr. Market as providing exposure to these themes and investor herds chase them until they are significantly overvalued. The overvaluation remains and the stock prices keep going up as long as the growth momentum is in line with Mr. Market’s expectations. The obvious risk is that if the growth momentum falters below the expectations, the share price drops could be catastrophic. Most investors recognize this, but continue buying these stocks because they think that there is no alternative if they want to take exposure to these themes.

However, there is a stealthy way of taking such an exposure. This article will discuss that approach.

Picking themes with care

An approach superior to taking exposure to some stocks within a promising theme is of designing a portfolio with exposure to a diversified bouquet with several promising growth vectors. For example, the US multi-cap portfolio based on Scientific Investing has numerous growth vectors. It provides exposure to well-known growth vectors such as Artificial Intelligence, Internet of Things, 5G, Play-From-Home in the form of OTT or streaming platforms, Electric Vehicles/Autonomous Vehicles or Self-driving cars, but also to lesser-known ones such as Quantum Computing & Quantum AI, Athleisure, Wellness, Life-From-Home, Millionaires and Wealth.

Contrary to the typical exposure to these growth vectors through well-known companies—read extremely expensive on the valuation front—the scientific investing approach seeks to a adopt a different pattern.

Let us consider the Play-From-Home growth vector. While OTT platforms were already quite popular, the long COVID lockdowns gave a huge boost to this trend, accelerated the adoption by many years and probably also delivered a permanent death blow to the conventional theatrical release of movies—at least the ones without extreme special effects and until Virtual Reality Movies—and probably also accelerated the “cord-cutting”, i.e., cutting live broadcast, such as, cable or satellite.

The typical way to take exposure to this theme is to buy the stock of the most popular company which used to be, or still is, the market leader. This popular company has more than 200 million users, revenues of $28 billion and a market cap of $230 billion. This a pretty expensive valuation even for a fast-growing company. The Scientific Investing approach is to take this exposure via two other companies with similar user base and revenues. One of the companies has a division which has a user base of 200 million and revenues of $25 billion while the other one has a user base of 2 billion and revenues of $20 billion. With revenue multiples similar to the most popular company, both these would be valued at around $200 billion or more. However, as divisions of larger companies, this growth vector is underappreciated by Mr. Market since he is fully focused on the primary growth vectors of these companies. This is one way of taking exposure to a promising growth vector in stealth mode and probably getting it for free or for something significantly below its intrinsic value.

Playing growth segments cheaper

Another growth vector is in the Electric Vehicles/Autonomous Vehicles space. Here the most popular name is valued at $700 billion. A better way is to take exposure via a company which actually owns three EV/AV firms focused on different aspects of this growth vector, or via a company which has driven autonomous miles equivalent of 40 trips to the moon and back. The most underappreciated exposure could be via one of the most popular consumer electronics giant, which could launch an EV/AV as early as in 2024! In all these cases, Mr. Market is not valuing this growth vector properly, or at least not as optimistically as the most popular company in this space.

Another growth vector is Athleisure. The most popular company providing exposure to this theme has $5 billion in revenue and carries a market value of $53 billion. The challenger to this brand is a division of another apparel company. This challenger brand has a revenue of $1 billion, which is likely to double in the next three years. With the revenue multiple of around 10 times, this division would be worth more than $10 billion. However, the whole firm, of which this is just one division, is valued at around $16 billion. The remaining $6 billion market valuation accounts for a growing division with nearly $10 billion revenue and two more divisions with multibillion dollar revenues. While the Athleisure consumer appreciates the brand, Mr. Market significantly underappreciates the Athleisure growth vector hidden in this firm.

Most important, all these growth vectors are available as part of highly profitable companies with strong established business operations with persistent competitive advantages, large positive cash flows and which are available at a significant discount to their intrinsic values. Such a conservatively valued portfolio is likely to not only be safer, but also likely to deliver extraordinary returns with high probability given the exposure to multiple growth vectors.