The changing face of investing - Part 1

Over Christmas, I took a metaphorical hatchet to my bookshelves. Filling countless boxes with cherished tomes, I drove to the local St. Vinnies with an overloaded car and a heavy heart.

It wasn't exactly a Nazi-style book burning but it felt uncomfortably close; Emile Zola and Peter Lynch were surely looking down with contempt, aghast at my cultural vandalism. The Kindle arrived a few days later, my first electronic book a copy of one I had just chucked out (Hitler, by Ian Kershaw, if you must know. The paperback is really heavy).

The clear-out was no fatuous, Marie Kondo-style weighing of earthly objects that whisper of one's inner life. Instead, it was a confession. Jeff Bezos, I realised, knew me better than I knew myself. All he had to do was wait a decade until I caught on and I, along with my credit card, were his. Bezos had dragged me towards the future, reduced my expenses and created storage space for more alcoholic beverages. And how I love him for it.

We know digitisation and the internet have changed book publishing, and just about everything else. We are less informed about how these gargantuan forces have affected the practice of investing, and what that might mean for how we should go about valuing stocks and assessing businesses.

This is no small matter. Intelligent Investor's enviable track record is a result of an investment approach applied judiciously over the decades. If the internet hadn't changed things, we could simply carry on doing what we've always done and expect to get the same results.

Unfortunately, this is unlikely to be the case. Digitisation and the internet, plus a few less-heralded factors, have almost certainly changed the dynamics of investing as much as they have publishing. We need to adapt.

What follows is therefore an accounting of sorts, of the forces that have changed investing, and what it means for investors: how our mindset and processes should change and how we should allocate our time.

Here, we'll cover the ways in which we believe investing has changed. In part two next week, we'll examine the implications for your own investing activities, and those of your analytical team. Let the book burning begin.

1. Markets are now more efficient

The success of the value investing approach relies on market inefficiency, a broad failure of investors to recognise the true value of some stocks. It used to be a straightforward, Ben Graham-style assessment; figure out the value of a company's hard assets, tot it all up and see if it come to more than the share price - with a margin of safety. Buffett extended this to less tangible assets but the general approach, aside from the splintering that accompanies all religions, remains unchanged.

What is different is the ease of access to information that can influence share prices. Annual and broker reports were once sent by mail, for readers' eyes only. Now, with everything online and instantly accessible by anyone, any informational advantage that one investor possesses over another is quickly eradicated. Which is to say the market is probably more efficient now, especially in larger stocks, than it was 20 years ago. For value investors, this means fewer opportunities. And when opportunities do arise, the market more quickly recognises them.

2. Short termism is increasing

Offsetting somewhat the increasing efficiency of markets is the tendency to hold stocks for shorter periods. Without online broking, fibre optics and massive computing power, everything from day trading and high frequency trading to starting an index fund or launching an ETF would be all but impossible.

In a bygone era, feeling the impulse to buy or sell would require a phone call and, in the case of a purchase, the writing of a cheque. This was often an effective hedge against impulsivity. Now, not only can one act within seconds but 24/7 news channels that favour emotion over facts stoke the fever.

According to Julian Beaumont of Bennelong Australian Equity Partners, the average holding period of Australian shares was six years in 1986. In 2016, it was just one. If patience is a virtue, many investors seem to lack it. That can only be to our advantage, especially as risk decreases as investment time horizon lengthens.

3. The third industrial revolution is upon us 

The first industrial revolution took hold in northwest England in the late 18th century when agricultural workers came to the cities to work in factories. The second was ushered in by Henry Ford, who used production lines to mass manufacture. The third revolution - digitisation - is now well underway, and reaching into previously impregnable sectors.

Still, areas of our economy are still dominated by monopolies or duopolies. In the lingua franca of value investing, these companies have barriers to entry or 'moats' that offer insulation from competition and are thus highly prized.

First, there are natural monopolies like airports, electricity distributors, toll roads and pipeline operators. Their status means such businesses are typically subject to government regulation. 

Other sectors like gambling, taxis and banking need a government licence to operate, or are so heavily regulated it amounts to much the same thing - insurance companies and pharmacies being but two examples.

Then there are equally concentrated sectors that derive their market power from economies of scale. Supermarkets, fuel and liquor retailing and pathology services are prime examples.

In all three cases, investors are fully aware of the quality of such businesses, and typically price them accordingly.

Prior to the internet, such businesses occupied all-but-unassailable market positions. Some, like pathology and airports, still do. But the technological revolution invites investors to question whether even high barriers to entry will be torn down by digitisation.

Could Amazon threaten the big supermarkets? Plenty of people think so. Uber and Lyft have already disrupted taxi companies. Their effect on toll road operators in the decades to come is unknown. Will locally sourced and stored renewable energy affect electricity distributors? Can fintech companies eat away at the dominance of the big four banks? These are searching questions to which we have few answers. It is the fact that they can be legitimately asked that is revealing.

If technology can potentially disrupt what Lenin called 'the commanding heights of the economy' one can only imagine its effects on more competitive sectors. In fact, we don't need to imagine. Everything from real estate, funds management and legal services to classified advertising, recruitment and pharmaceuticals have already been disrupted by the third industrial revolution.

Even manufacturing isn't what it once was. As The Economist wrote in 2012: 'Rolls-Royce no longer sells jet engines; it sells the hours that each engine is actually thrusting an aeroplane through the sky.' That wouldn't be possible without the technology to track and report on engine activity.

For investors, this creates a more demanding environment, one where imagination and strategic thinking might play as significant a role in stock picking as spreadsheet skills and keeping one's emotions in check.

4. The importance of culture is growing

Disruption brought about by digitisation means companies are having to reinvent themselves more frequently than ever. Microsoft, for example, was founded in 1975 and over the ensuing two decades established what appeared to be an impregnable monopoly. Mobile computing put paid to that. It is not an overstatement to say that Satya Nadella's appointment as CEO in 2014 transformed and possibly saved the business.

Management and especially culture are more important than ever. In Ford's day the value of a product was in its making, much less the intellectual property and branding behind it. Technology also changed more slowly. Once Ford built a state-of-the-art factory it could be milked for decades. Culture didn't matter so much.

Nowadays, companies must constantly rejig the software embedded in their internal processes and invest untold resources in brand building. These are creative, rather than mechanical skills and the right culture is crucial to developing and harnessing them.

Analysts tend to be rationalists. Taking a dispassionate view of a company, discarding the corporate guff most companies excrete in favour of an analysis of the numbers it produces, makes perfect sense. Unfortunately, this does not prepare us for a world where culture and other intangible factors can have such a major impact.

The problem multiplies. Not only is culture something notoriously difficult to assess from the outside (Facebook excepted), the typical cold-blooded analyst is ill-equipped to read the signs.

5. Opportunities for deep thinking are diminishing

The third industrial revolution is taking its toll in other ways. The internet is a vast ocean in which we can drown ourselves in alluring but pointless crap, reducing the opportunities for idleness, when true creativity tends to emerge.

With less time for deep thinking, when our subconscious brains might, for example, work through the issues of culture in a particular company, we are becoming ill-equipped to deal with such issues. [Incidentally, as someone regularly told by his partner that I spend an inordinate amount of time in a horizontal state, I like to think this does not apply to me.] 

6. The business cycle is dead 

Twenty years ago, there used to be a business cycle. The so-called economic clock offered a (flawed but still useful) guide to the semi-regular boom/bust cycle. Alan Greenspan et al have put paid to that, effectively handing over the power to set interest rates to screen jockeys.

Modern monetary theory, meanwhile, offers banks and politicians the intellectual framework to argue that deficits really don't matter. Both imply that the conventional application of monetary and fiscal policy at various stages of the cycle no longer applies. The result is that after a weak post-GFC recovery, sharemarkets have boomed due to corporate tax cuts, share buybacks and bailouts, whilst economies have gone sideways and wages have stagnated.

An understanding of the business cycle presented value investors with multiple counter-cyclical investing opportunities. Its disappearance, at least for the time being, further reduces the pickings available to us (Gaurav Sodhi's resources picks aside). 

7. The rise of passive investing

According to Morningstar, in 1995 passively managed assets like index funds and ETFs represented less than 5% of total assets under management in the United States. That figure is now approaching 40%. Although this figure is less in Australia, the trend is in the same direction. Passive investing is growing at the expense of active investing.

It's hard to know where this will take us. A paper from Harvard Law School argues that it amplifies volatility while the concentrated nature of the firms offering passive products reduces financial stability. What we can say with confidence is that fewer active investors reduces those engaged in price discovery, and that should be good for those, like us, that persist with it. 

All up, the changes in investing are both good and bad for value investors. We have little influence over central bank policy, the efficiency of markets and the mindset of the general investor. Instead, we must focus on those things we can control whilst assessing businesses and analysing stocks. That will be the focus of part two next week.

Read Part 2 and Part 3