Electric cars, Chat GPT, green energy, cybersecurity against nefarious state actions, for many of us it can feel like we’re already living in the future. Global seismic shifts are happening all around us, fuelling the appetite for investing in themes that capture these changes.
Thematic funds represent 20 per cent of the $6tn-plus exchange traded fund (ETF)market, according to consultancy, Oliver Wyman, but one pernicious myth remains: that bottom-up valuation discipline goes out the window in a thematic screen.
So, how does one value an innovative company today, based on where you might expect its disruptive market to be in the future?
'Bottom-up' analysis
One should not focus on traditional valuation metrics such as price-to-equity (PE) or price-to-book (PB) ratios. Traditional metrics can be manipulated and are not as effective at forecasting future opportunities in the disruptive innovation market segment, and 12-month periods, typically how these ratios are measured, often don’t capture growth that could reside a few years out.
Instead, they should consider how best to target disruptive companies that aggressively re-invest in the business through research and development (R&D) initiatives. Most new innovative industries – electric vehicles, digital wallets, etc – will be ‘winner-take-most’ market operations. Unlike a winner-take-all model where one business has all of the revenue, the winner-take-most model showcases one clear market leader dealing with several potential competitors.
By aggressively investing back into the company, as opposed to issuing dividends or buying back shares, the business will stand a better chance to "win" that market in the long run. Whereas many traditional investment firms often assess stocks through a short-term lens, a five-year-plus long-term investment horizon enables investors to find opportunities for value accrual from the company’s holdings.
Using the EV/Ebitda (enterprise value to earnings before interest, taxes, depreciation, and amortisation) ratio, projected over five years, can help investors evaluate the long-term financial potential of a company, rather than its short-term earnings fluctuations. This, in turn, enables them to identify companies that, while perhaps appearing highly valued by standard short-term metrics, present significant growth opportunities through technological advancements and market disruptions.
This long-term valuation methodology is particularly suited to areas of technology such as genomics, autonomous technology, and robotics, where development cycles can be prolonged and initial revenues may not fully reflect future profitability.
Contrary to the myth about thematic investment funds, this approach involves meticulously selecting individual stocks based on a rigorous analysis and includes a scoring system, where valuation plays a critical role. It also involves an in-depth analysis of each company’s role within its broader ecosystem. Outside of valuations, investors should also look at metrics such as company, people and culture; execution; barriers to entry; product leadership, and thesis risk.
Investors should score companies based on one to 10, and if a score drops below six, review the holding. All metrics are crucial in understanding a company's ability to potentially outperform peers over time. This comprehensive process reflects a disciplined investment philosophy that balances technology-level research with the rigour of traditional investment principles while tailoring the metrics to best assess the innovation opportunity set.
This blend of innovative thematic investing with grounded, structured, fundamental stock analysis allows you to navigate the highly volatile landscapes of cutting-edge industries, potentially offering high growth opportunities for investors.
Despite common misconceptions, being a thematic investor should still be deeply rooted in a meticulous, bottom-up stock selection process that carefully evaluates both current valuations and prospects.
Thomas Hartmann-Boyce is a portfolio manager at Ark Invest
