The idea of investing in theme stocks has been around for a while. Most people can remember the mad rush to invest in dotcom stocks in the late 1990s. Any company with a dotcom after its name was considered a potential winner, with investors diving in for fear of missing out. We know how that worked out. But theme stocks are attractive to investors partly because they are trendy and have good stories to tell. Even if their valuations are through the roof, investors want to own them because they’re great water-cooler fodder. But are they good investments? In many cases, they are not.
That’s not to say that all theme stocks are bad investments. There are real opportunities with some themes. The question is whether there is a better way to capitalize on the theme to maximize the opportunity.
The Overly Crowded Apple Theme
Take Apple, for example. Fundamentally, there’s a lot to like about Apple stock. Its consumer products have revolutionized the world and have made Apple one of the most recognizable and valuable brands in the world. However, Apple’s real focus and a growing source of its revenue are as an influential platform for software distribution. More than half its revenue comes from Apple’s services business is led by the App Store. They’ve built a massive investment theme with infinite potential out of reaching consumers at scale through a device they carry with them 24/7. But there’s a problem.
As an investment theme, Apple is so popular it’s owned by the vast majority of money managers. As one of the heaviest weighted stocks on the S&P 500 due to its market capitalization, passive fund managers must continue to buy up the stock to keep up with massive fund inflows. While its stock may not necessarily be overvalued, it is undoubtedly being bolstered due to the sheer global interest in the stock.
I happen to like the Apple investment theme, having argued in the past that the market just doesn’t know how to value its stock, which probably makes it a good investment. But I’m not sure I want to own shares in a company that 90% of the world’s money managers own. As a thoughtful investor, I would rather capture this theme without having to pay up so much for Apple stock by looking downstream at companies helping to drive the theme.
Finding Opportunities Downstream
There’s a much bigger opportunity to find company’s lower on the supply chain with more attractive valuations. And, as long as Apple continues to dominate the world in consumer products and services, those companies should continue to thrive. All you need do is Google Apple’s top suppliers, and you can find a list of the companies that supply all the different chips and screens for its devices, iPhone casings, or the optical components for its 3D sensing cameras. You can bet a large portion of their revenues and growth prospects are attached to Apple.
But that is more reason to carefully assess those companies on their own merits and fundamentals because as Apple goes, so goes those companies. That’s not to say that the Apple theme will evaporate overnight. But any company is not entirely immune from risk events that can change its course.
Follow the Theme, Not the Theme’s Poster Child
However, the theme is likely to survive, even if a company doesn’t. Take Tesla as another example of a theme investment. It has been one of the hottest stocks in the market for the last couple of years. But do investors love the theme of super-powered electric vehicles, or do they love Tesla? Several companies are waiting in the wings to become the poster child of the theme should Tesla falter.
By the way, Tesla is also an investment you might want to avoid because too widely owned, and no one can be certain about its valuation. But, if you like the theme, go down the list of Tesla’s suppliers, and you’re bound to find some fairly or undervalued companies and pay far less for them.
The point is some theme investments hold great promise and have excellent opportunities for investors. But typically, it’s the theme that has staying power, not the company associated with the theme. For example, MySpace.com was the dominant market leader in the social media space for several years, peaking at $12 billion with more than 200 million users. They were the poster child of the social media investment theme. MySpace.com has since died, but the social media investment theme lives on mightily through Facebook.
Whether it’s Apple, Tesla, or Facebook, thoughtful investors need to look beyond the poster child to see what other theme-related opportunities are out there.
