Why Megatrend Investing is a Winning Formula
Success is a lousy teacher. It seduces smart people into thinking they can’t lose.
Issues to be addressed in this research paper
Investors assign different importance to different investment themes. Those distinct views drive financial asset prices up and down, and that is essentially what makes the market move every day. Obviously, valuations affect the decision process as well, but most investors take a relatively simple approach to investing. They either like a story or they don’t and, in that context, valuation parameters become less important. That is at least my experience from my 16 years on the sell-side.
Now, let’s assume we are not only talking about a trend but about a megatrend. In our book, a megatrend is a transformative trend, which is destined to unfold over time, whether you like it or not. Therefore, unlike thematic investing in general, if you stick to megatrend investing, you are likely to have the wind in your back most of the time. You can be wrong on timing, but the ultimate outcome is virtually set in stone.
The easiest megatrend of them all to explain is probably Changing Demographics. Admittedly, Africa’s population is still getting younger, but the rest of the world is ageing at a very predictable pace, and that will have grave consequences over the next few decades. We have identified six other megatrends, most of which are investable (Exhibit 1).
How does our megatrend view compare to the consensus view?
Not everybody agrees as to what justifies ‘upgrading’ a certain trend to a megatrend. Let me give you an example. Many of our peers have classified Urbanisation as a megatrend; however, we have taken the view that it is an investable theme underneath two of the megatrends we have identified – Rise of the East and The Era of Disruption (Exhibit 2).
The distinction between a megatrend and an investable theme is not always crystal clear but does it matter? In our opinion, what matters is the ability to invest with the wind in the back – not what you choose to call it.
Last September, Opium Research did a survey on behalf of RBC Blue Asset Management (BAM) on megatrend investing (Exhibit 3). Although BAM’s list of megatrends is not identical to our list, the two lists are quite similar, which should hardly come as a surprise. After all, there are only so many megatrends. Adding to that, if you incorporate our list of investable themes, you can find every single megatrend on BAM’s list below in megatrend jigsaw above.
As you can see, in the opinion of those investors participating in BAM’s survey, two megatrends stand out at present – Climate Change and Technological Advances. That sort of information has implications when we invest – an issue I will come back to later. This doesn’t imply that the other megatrends in BAM’s survey don’t matter. Not at all, but one should expect the average investor to dedicate much of his attention every day to the two megatrends at the top of BAM’s list.
This poses a very interesting question. Could the megatrends in vogue (like the two at the top of BAM’s list) lead to crowding and thus to declining returns? If so, should we (and other investors) instead focus on the less well-known megatrends? This is work in progress.
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The interaction between megatrends and investment themes
Let’s zoom in on Changing Demographics for a minute or two, as that is a good example as two how to invest in megatrends. Underneath this particular megatrend, we have identified five investment themes:
1. Out-of-Control Public Deficits
2. Declining Spending Powers of the Middle Classes
3. The Digital Revolution
4. Retirement of the Baby Boomers
5. The Rise of Millennials
Out-of-Control Public Deficits
The public sector faces a massive increase in the cost of patient care, as the populace ages. Take for example the UK. The National Health Service in that country (the NHS) spends 6-7 times more annually on men in their 70s than they do on men in their 20s (Exhibit 4). Even worse, the populace is ageing at a time where public balance sheets are already stretched in many countries.
I am pretty sure that this is going to result in a financial accident or two. If western governments think they can get away with Japan-style public balance sheets (Japanese public debt is now about 260% of GDP), they ignore the fact that most countries depend far more on international investors to finance their debt than Japan does. This is going to provide plenty of investment opportunities, primarily in distressed debt.
Declining Spending Powers of the Middle Classes
Data from various OECD countries paints more or less the same picture – that the spending powers of the average household are relatively stable, as long as the primary income earner in the household is younger than 65. Thereafter, the spending powers decline meaningfully. The data in Exhibit 5 below is from the UK, but the picture is not significantly different elsewhere.
Given the large number of baby boomers and the wealth they have accumulated, it shouldn’t really come as a surprise that equity markets have gone through a stunning bull run since the mid-1980s. The first boomers were born nine months after World War II ended (!) and turned 45 around 1990. The youngest boomers were born in the early 1960s and turned 55 only a handful of years ago.
Obviously, various policy programmes (QE, etc.) have ‘polluted’ the numbers somewhat, but it is no coincidence that consumer spending and financial markets have been so strong since 1990. Now, as more and more boomers retire (see below), the spending powers of the middle classes have begun to decline. This is going to affect overall economic activity and may encourage investors to think of the economy differently – not being as consumer-led, as we were brought up to believe.
The Digital Revolution
According to feedback we have received, The Digital Revolution has nothing to do with Changing Demographics. We happen to disagree. Because of the ageing process underway, the work force is shrinking. However, many services shall still be required. This has forced both governments and private companies to think out-of-the-box when looking for solutions.
Let me give you one example from my home country, Denmark. In that country, there is a near-catastrophic lack of qualified people in the healthcare industry. Several councils have begun to recruit refugees from Ukraine for healthcare jobs, provided they have the appropriate educational background. Take for example elderly care. The new recruits have been equipped with an app that allows them to speak with the elderly without speaking much Danish.
Retirement of the Baby Boomers
This invest theme is broadly similar to the first one I brought up (Declining Spending Powers of the Middle Classes), but the two themes are not identical, hence our decision to separate them. When it comes to the Baby Boomer theme, the key is to understand that older consumers spend their money very differently.
I can best illustrate that through a couple of examples. For example, did you know that the typical buyer of a Harley Davidson is a man in his late 50s? You will probably be less surprised when I tell you that retired couples make up most cruise ship guests. As I looked further into this topic, a certain pattern emerged that made me realise that it can be used as a guide when researching what to invest in and what not to touch.
As you can see in Exhibit 6 below, over the last 12-13 years, boomers have begun to retire; however, as you can also see, we are still only about halfway. I would expect consumer spending to continue to be negatively affected, and shopping patterns to continue to change, as more and more boomers retire. This theme should have a noticeable impact on equities for at least another ten years.
The Rise of Millennials
Millennials are anyone born between 1981 and 1996. Therefore, most millennials are children of baby boomers. From an investment point-of-view, think of millennials as a halfway solution to the problems created by the ageing of the boomers. Whereas the boomer dad may spend his pennies on a new Harley, his millennial son would most likely prefer to spend his savings on a new kitchen, which is in need of an upgrade after the kids have left home. Therefore, in principle, one should offset the other. The problem with that argument is that the birth rate is dwindling, i.e. there are not enough millennials to offset the negative impact from the boomers.
That said, millennials will one day inherit significant amounts of wealth from their boomer parents, and that will probably go a long to offset the effect declining birth rates are likely to have on spending patterns; however, I have no hard facts to prove this point.
Another point worth mentioning is that millennials appear to be far more concerned about global warming than their boomer parents. Therefore, as millennials mature and take political control of society, much more is likely to be done to save our planet. This has significant investment implication, which can be taken advantage of.
The case for and against megatrend investing
If you are an experienced cyclist, as I am, you will know how much easier cycling is with the wind in the back. Think of megatrend investing in the same way. If you can stomach the occasional market upset, which may set you back temporarily, investing this way virtually guarantees the outcome, so long as you are equipped with a bit of patience.
Unfortunately, few of us are equipped with the patience it takes to wait for months, sometimes years. Therefore, you should never invest in only one megatrend. Investors’ appetite come and go, and it can be a costly exercise to be on the wrong side of that equation. Take for example Climate Change. At the moment, global warming is on everybody’s lips, and investors continue to look feverishly for investment opportunities that stand to benefit from global warming. However, if my recollection is correct, only 5-6 years ago, people who worried a great deal about the climate were widely considered oddballs, trying to make a mountain out of a molehill.
Investors are fickle creatures, and you never know when the show is over. One solution to that problem is to have exposure to a mix of megatrends in your portfolio; another solution is to reduce the equity beta in your portfolio, either through hedging or by deploying a relative value approach. We do a mix of them all.
How to take advantage
According to the OECD, total assets under management in pension funds domiciled within the OECD amount to about $60Tn, which is a colossal amount of money. Now, many pension funds are notoriously slow in adapting new investment styles and techniques. Therefore, the classic investment approach – i.e. splitting the capital across asset classes and geographies – is still the prevalent methodology in those circles. Investing thematically is gaining traction but is still not widely adopted. As a result, you should expect a lot of institutional capital to be deployed in thematic investing over the next few years. This will bid up prices and become a return driver in itself.
When investing thematically, you begin by identifying the opportunity set. You then decide how best to implement the ideas you have identified, whether that is through bonds, equities, commodities or something else. This way, you can easily end up with your capital allocated in a way you would never dream of, had you done it the conventional way. Take for example our megatrend portfolio. We have a much higher allocation to commodities today than we would probably have had, had we applied a conventional asset allocation approach.
Other issues to consider when investing thematically
When it comes to the choice of geographies to represent the views you wish to express, in many instances, it is a simple choice. Allow me to explain. Unless there is as specific reason to express a particular view through a certain currency, you should let liquidity considerations become a key driver of your investment decisions.
As US markets generally offer better liquidity than most other markets, you will probably end up with a relatively high allocation to the US dollar. Although that may not be an issue for US investors, it adds another risk element to non-US investors, namely meaningful currency risk. That can, and probably should, be hedged.
Another issue to consider is how best to express the views (ideas) you wish to express. In our megatrend portfolio, we currently express 11 different views. Asian Alpha is the name we have assigned to one of those views (which is linked to Rise of the East). We do not pretend to be an expert on absolutely everything. Therefore, when it comes to expressing views in our megatrend portfolio, we do what most macro fund managers do, i.e. we establish a basket of representative names. In the case of Asian Alpha, we have ten underlying stocks in the portfolio.
The next step
Over the past 20 years, our business model has been built around the advice provided to investors who wish to be exposed to our megatrend approach. Over the years, we have therefore built considerable knowhow on how to take advantage of global warming, an ageing workforce, a more powerful Asia, etc., etc.
Then, early last year, one of our clients made us a proposal. As he said, “we like the way you think but suggest you, in addition to advising us on third-party funds, manage a pot of capital for us, where you can only make direct investments”. Long story short, since May of last year, we have managed a portfolio of direct investments, which is invested in a mix of equities and commodities, the latter of which are mostly expressed through ETFs.
2022 was a difficult year. Bad news en masse created plenty of volatility, and the year turned out to be one of the worst on record. Yet, we made a modest profit. Even better, we did so with portfolio volatility being much below market levels. 2023 is off to a pretty good start. As the end of February is approaching, we have outperformed a number of major equity indices and, again, we have done so with lower volatility.
The next step will be to launch a fund that mimics the investment strategy in the megatrend portfolio. The plan is to go live later this year. We aim to offer quite attractive liquidity terms (no more than monthly) while charging fees far away from the 2+20 the hedge fund community has fallen in love with.
One final point. We have decided to distribute this paper through ARP+, as we would appreciate any feedback you may have regarding our plans. As many of you are aware, historically, we have been very active in Malta – one of the three EU domiciles for offshore AIFs. However, early feedback on this project has steered us towards Dublin, which is more widely recognised in large parts of Europe, according to the people who have guided us.
The same people have also told us that it will probably make little difference, whether we choose Dublin or Luxembourg. Dublin appears more suitable for open-ended structures, while Luxembourg is probably more suited for closed-ended structures. Therefore, we will probably go for Dublin. Should you have any thoughts on this topic, please drop me a note.
Niels C. Jensen
23 February 2023