Views from the CIO: Thematic Investing – When Does a Good Story Become a Good Investment?

Principal announced on August 22nd the launch of two strategic beta exchange traded funds (ETFs) for investors looking for portfolio growth potential. The Principal Healthcare Innovators Index ETF (ticker: BTEC) and the Principal Millennials Index ETF (ticker: GENY) were listed on Nasdaq. Our Global Systematic Solutions team is managing these strategies which are also called “thematic” investments and can enhance investors’ portfolio returns in growth-style investing.

People who know me also know that I have spoken cautiously about thematic investments in the past. After all, I have always said that buying a good story doesn’t necessarily make a good investment. Familiarity bias plays dangerously in behavioral finance because our brains are designed to affirm simple stories that make sense, but what makes those stories good investments requires objectivity. Investors often fall into the trap when they buy a stock with a great story but they typically overpay and end up disappointed as the stock underperforms. For example, “Internet will change our lives forever” was a great story in 1999 and many people loved the narrative, but many investors lost money in their investments from that story even though the internet truly changed our lives as we know today!

The key for our Global Systematic Solutions team in developing these thematic investments is twofold: find a great story that is likely to work in the long-run but most importantly, find a great story that also has potential to become a good investment. To do so, we look to exploit a bias or a market anomaly that other investors may face in the market. Let me explain our approach:

 

Principal Healthcare Innovators Index ETF (ticker: BTEC)

BTEC identifies early-stage healthcare companies (i.e., biotechnology and life science) that comprise a large and growing segment of small-cap companies that portfolio managers and asset allocators generally have difficulty evaluating. After all, mapping of the human genome in 2012 has been a key inflection point for this industry. There will be more novel treatments and products coming in the next 10-20 years, so this thematic story is underway. But does it make a good investment? What bias or market anomaly will we be exploiting?

 

The Neglect Effect

First, we screen for non-profitable companies for inclusion in this index. Most investors, like us, conduct earnings-based research and because it’s difficult to analyze companies that are losing money, people typically choose to ignore them. These companies behave like growth options rather than stable investments with cash flow generation. On the contrary, they tend to burn cash through their operations with the hope that their single product will be a hit sometime in the future. Some companies in this group will develop a novel cure and their stock will outperform, but most will struggle in developing a cure or getting additional funding and eventually run out of cash resulting in bankruptcy.

It is very difficult to pick stocks in this group for all types of investors due to the unpredictable nature of patent approvals and FDA approvals/rejections that quickly change the fate of these companies. They are binary events and loss aversion (a stock losing all future funding opportunities and going bankrupt after reporting unfavorable treatment data) plays a role for investors to neglect these companies.

Because of these risks, many investors ignore this group of stocks, creating a “neglect effect.”

However, we believe this “neglect” creates an opportunity!  Even though each individual stock is hard to pick and tends to be very risky, we believe a portfolio of stocks that diversifies these company-specific risks works much better in this case. In addition, we found that market capitalization is a better predictor of future performance in this group since it likely proxies for a company’s ability to get future funding and ensures survival for the next stage of testing their novel products. We believe BTEC will help investors gain access to this high risk/high return group of stocks in a diversified way where individual stock picking is difficult.

 

Principal Millennials Index ETF (ticker: GENY)

The story behind GENY is a more familiar one.  Millennials are adults who were born anywhere from the early 1980s to the 2000s and currently make up the largest generation in the United States with 83 million[i], exceeding the baby boomers.  While it is prevalent in the United States, it is also a global phenomenon.  The Millennial generation has a profound influence on global economic landscapes, changing companies’ interactions with customers, using technology effectively, and incorporating social causes into their lifestyles. They are also said to have the most brand loyalty of any generation. In order to capitalize on the spending and lifestyle activities of this large generation, we developed GENY. This ETF provides (a truly global) exposure to the discretionary spending patterns of the largest generation ever. At the core of this strategy is true demographic investing but it is also diversified. Unlike industry-specific sectors, GENY includes innovators in a variety of industries. Yes, high tech, but also apparel, travel, entertainment, and more. What GENY does not include are old school brick-and-mortar retailers who aren’t as attractive to this crowd.

 

The story checks but is it a good investment?

Our proprietary research helps us identify how millennials are disrupting the ways companies do business. We have developed a model that identifies which companies have high exposures to millennial spending. We screen these companies according to certain factors and then passively hold them in the portfolio until the annual rebalance. We’ve determined that these tend to be high-growth companies with expensive valuations. We are not the first ones to discover these companies (contrary to BTEC as discussed above). Here, the bias is too much familiarity; companies that you know and adore so you end up overpaying just to own a piece of that future promise. (It also comes with the bragging rights to tell your neighbor that you own one of these successful companies although you may not have made any money on it as you may have bought it too late; people tend to not communicate the investment part!)

We believe the key to avoiding potential biases within this larger group of “Millennials” companies, is to screen further for their pricing power and sustainability of cash flows and profit margin trends. Higher valuations are justified as these companies continue to benefit from the spending habits of Millennials when they have pricing power so they can mitigate any damage. However, if Millennials’ preferences change towards a specific company over time, it could impact pricing power and earnings prospects, which has the potential to result in declining earnings and profit margins for some companies. This type of company is likely to be dropped out of the index and new companies would be added into the index in the annual rebalance.

We believe GENY will provide a sustainable growth solution to both retail and institutional investors as a part of their growth style investments. Because BTEC and GENY are both Index ETFs, they come with an added perk of being offered at a lower cost when compared to active management fees. We are committed to providing more solutions to investors using our systematic expertise.

Happy Investing!

 

The Principal Healthcare Innovators Index ETF seeks to provide investment results that closely correspond, before expenses, to the performance of the NASDAQ U.S. Healthcare Innovators Index. The ETF employs a passive investment approach designed to track the performance of the Index.

 The Principal Millennials Index ETF seeks to provide investment results that closely correspond, before expenses, to the performance of the NASDAQ Global Millennial Opportunity Index. The ETF employs a passive investment approach designed to track the performance of the Index.

[i] Source: Bank of America Merrill Lynch

 

 

 

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Carefully consider a fund’s objectives, risks, charges, and expenses. For a prospectus, or summary prospectus if available, containing this and other information, visit PrincipalETFs.com or call Sales Support at 800-787-1621. Please read it carefully before investing.

Risks specific to Principal Millennials Index ETF: International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards.

Risks specific to Principal Healthcare Innovators Index ETF: Small and mid-cap stocks may have additional risks including greater price volatility. Investments concentrated in the healthcare industry may be adversely impacted by sector specific market shocks, unforeseen rate controls or regulations, higher than expected costs, or inability to bring new products to market.

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