Thematic investing: seeking tomorrow’s winners

Thematic investing is gaining steam and many indications suggest that this trend is set to continue.¹ Investors would do well to consider the challenges and the opportunities available in thematic investing.

The heart of a sound thematic investment philosophy is a pure-play approach. Since the investment themes you choose should only be ones that you truly believe in, you will want to gain the highest possible exposure to those themes, while respecting the need for diversification and liquidity.

To achieve that exposure, you should ensure that each company in the investment universe generates more than 50% of its revenue from the provision of solutions and services directly related to your chosen investment theme. This approach naturally leads you away from large conglomerates that may be engaged in many different business areas and directs your investments more toward smaller companies that are focused on and often exclusively dedicated to your selected investment theme. A pure-play approach helps you focus on the specific dynamics of the theme and often results in a diversified portfolio of companies that typically are not owned in core holdings, in index funds, or ETFs.

Since investment themes often cut across traditional sectors and may be global in nature, it can be wise to take a “benchmark-agnostic” unconstrained approach to stock selection and portfolio construction.

This approach leaves you free to search for companies inside your chosen theme that stand out in terms of innovation, technology, business model, strong ESG attributes, or management quality. The aim is to seek to identify standout companies that are poised to win over the next five to ten years by upsetting legacy industry incumbents with disruptive innovations.

Thematic investing cuts through traditional investment classifications of country, region, sector, size, and style. It instead focuses on areas of secular growth in the world that are driven by powerful structural forces of change, such as the advance of technology, demographic shifts, and environmental challenges. Under the thematic approach, you typically start by identifying a specific investment theme and then building a diversified portfolio of stocks that are highly exposed and well positioned to benefit from that theme over the next five to ten years.

How can the power of a thematic approach be applied to equity investing?

One investment lesson from recent history is that predicting the near-term outlook for the stock market with any degree of conviction or consistency is very difficult, if not impossible. For example, in December 2019, US and European markets largely shrugged off what they thought was a local public health problem affecting only China. Just a few months later, though, that consensus swung in the opposite direction, and equity markets fell by more than 30% on the realization that this was just the beginning of a devastating global pandemic.

Many investors who attempted to predict these short-term market movements were caught flat-footed and suffered losses. Alpha generation by large hedge funds and other money managers in 2020 was reported to be the worst since 2011. The lesson? Trying to “time the market” is a dangerous game to play.

Somewhat counterintuitively, our judgements about long-term questions are often more reliable than near-term predictions and frequently can be trusted with greater confidence. Thematic investing poses long-term questions such as: Do you expect digitalization – the increasing penetration of the economy by technology – to continue? Do you believe that the issue of climate change will become even more pressing in the next decade and for the next generation? Do you expect that demographic changes will gradually shift the world’s geopolitical landscape?

These are the types of questions that underpin thematic equity strategies – questions that focus on long-term structural trends and powerful forces of change. Investors seeking opportunities that transcend economic cycles and market volatility are well advised to consider thematic investments if they have a genuine appetite for long-term investments.

We are living in times of unprecedented change and upheaval. The COVID-19 pandemic has unquestionably taken a tremendous toll in human terms. In this time of need, several companies were in a position to offer solutions to directly help with the crisis. Prior to the outbreak of the pandemic, digitalization in the healthcare sector was only just getting off the ground, with a number of promising technologies in nascent stages of adoption. Necessity being the mother of invention, the sudden need for social distancing and for ways of improving the delivery of healthcare services gave a tremendous boost to the adoption of digital solutions in the healthcare industry.

Telemedicine, automated diagnostics, and testing are examples of areas that have seen a sharp acceleration in usage and investment during the pandemic. However, it is important to note that although usage has increased sharply, the penetration rates for many of these innovative solutions remain low, so there is considerable scope for future growth. According to Mercom Capital Group, USD 14.8 bn of venture capital was invested in the digital health space in 2020; a 66% increase over the preceding year.²

Similarly, companies that provide educational technology (EdTech) to enable remote learning also saw a dramatic pickup in growth. The forced adoption of online educational tools and platforms has demonstrated to educators, governments, and students alike the incremental positives and potential of these systems. Many of these tools supplement and enhance traditional classroom learning for children, making learning more engaging and thereby more effective. In addition, these tools can aid training and professional development for adults and can help those displaced by economic downturns to acquire new skills and reenter the workforce. The EdTech venture capital market registered an investment volume of over USD 16 bn in 2020, shattering previous records.³

Thematic equity investing enables investors to gain exposure to a welldiversified range of innovative companies that are well positioned to benefit from their involvement in compelling secular growth trends. A focus on “pureplayer” companies active in these themes typically leads to a small to midcap size bias and provides investors a chance to diversify away from largecaps in the major stockmarket indices and passive funds. It is also worth remembering that thematic investments are geared toward a longterm investment horizon, thus freeing investors from excessive fixation on daytoday market movements and shortterm noise.

¹ Morningstar Research. Global Thematic AuM Growth by Region (USD bn), data as of 31 December 2021.
² https://www.mobihealthnews.com/news/mercom-telemedicine-investments-led-2020s-148b-digital-health-fundraising, accessed in December 2021.
³ https://www.holoniq.com/notes/16.1b-of-global-edtech-venture-capital-in-2020/, accessed in December 2021.