April 14, 2015

Dear Investor:

Understandably, I get many questions from clients about investing in high growth, fashionable areas—what I’ll call startup sectors. In past years these would have included pre-revenue dotcoms, alternative energy stocks, and nanotechnology. Today, people ask about artificial intelligence, robotics, and cutting edge biotech.

I have always tried to avoid these sectors for several reasons:

First, for every well-publicized winner, there are scores of unreported losers. Of course, dotcoms were an example, but all high growth sectors have frequent and bloody shakeouts. Once “mighty” companies implode overnight. In a startup sector, by definition, there is little-to-no way to predict the ultimate winners and losers.

Second, cash flows are impossible to predict. They are difficult to predict in any sector, but in startup sectors, it is impossible. The difference between being “hard to predict” and “impossible to predict” is the difference between investing and speculating. I will never do the latter with your money or mine.

Third, startup sectors do not go unnoticed. As a result, their high growth rates come with similarly high valuations, where price ratios to revenues and income can be stratospheric and unsustainable. It’s very easy to lose money at these prices and very hard to make it. These stocks can go up for a long time, but when they fall, they have no underlying floor of value to save them.

Finally, the most unappreciated reason to avoid these startup sectors is that high growth sectors attract huge amounts of misallocated capital. This creates initial stock price gains but fosters intense competition and diminishing returns on capital, even for the winners. As startup sectors emerge, they tend to become victims of their own success. The market grows but returns shrink.

As an avowed contrarian and a value investor, I prefer to follow Warren Buffett’s approach: investing in markets that are often actually shrinking, not growing—which increases return on capital for the survivors.

Consider the oft-cited and highly surprising example of Philip Morris. In the second half of the 20th century, Philip Morris was one of the best performing stocks in the S&P 500 (with approximately 20% annualized returns); at the same time the percentage of smokers in the U.S. declined from 50% to 25%. How is this possible?

Some look to the company’s international growth for explanation. But the real reason Philip Morris did so well—even as their market was cut in half—was that they faced no new competition. Not a single startup cigarette company launched during those years, because no one in their right mind would have opened one. As a result, the returns on capital for Phillip Morris rose, even as their market shrunk.

I am not advising buying companies that produce cancer sticks, but I am often looking for sectors with superficially declining prospects—the opposite of fashionable—in which diminishing markets make new competition unlikely.

My current favorite example is the steel stocks. I can assure you that no one will be opening new steel companies over the next few years. The cyclical glut of supply and soft demand makes that a virtual impossibility. Add to that the unfashionable nature of the steel sector and you have the perfect atmosphere for gradually rising returns on capital as the overall market shrinks. Finally, valuations on steel stocks are very low, reflecting lack of interest in the sector. The price is right.

In the unloved, boring, unfashionable and overlooked, the value investor finds the best opportunities.

Glamor is best left to Hollywood. In the investment world, it can only be dangerous.