Focus on Equities: Innovation and Speculative Fervor
- Technological innovation in the financial services industry has helped make investing more attainable for U.S. households, allowing for broader ownership of individual stocks, mutual funds, ETFs, and a variety of other financial products. However, one potential drawback is that easy access to current prices and trading can lead some investors to shorten their investment horizon and opt for riskier investments.
- Our long-term approach to equity investing is to think like a business owner. We buy a stock as if we were buying a whole business. We prefer to invest in high-quality businesses—those we believe have durable competitive advantages, strong balance sheets, shareholder-oriented management.
- It takes effort to not get distracted by the daily inflow of short-term news and stock -price action that’s constantly available at your fingertips. Set reasonable expectations for future returns. Don’t look at the high absolute returns from the U.S. equity market over the past 5 years and extrapolate those into future expectations.
Following a strong first six months in 2021, global equity market total returns were flat to slightly negative in the third quarter. The S&P 500 advanced 0.6%. Foreign stocks, as measured by the MSCI All Country World Ex USA Index, declined 3.0%. Small- and mid-cap U.S. stocks moved lower, with the Morningstar U.S. Small-Mid Cap Index down 1.3%. Dividend stocks declined slightly, with the Dow Jones U.S. Select Dividend Index down 0.8%.
Innovation and Speculative Fervor
Technological innovation in the financial services industry over the past three decades has helped make investing more attainable while lowering transaction costs for U.S. households. This has opened the door for broader ownership of individual stocks, mutual funds, ETFs, and a variety of other financial products. However, one potential drawback caused by innovation that’s not often discussed is the fact that such easy access to current prices and trading can lead some investors to shorten their investment horizon and opt for riskier investments.
We raise this issue because we continue to observe speculative fervor in certain pockets of the financial markets. In our view, relevant examples include high-growth stocks generating material operating losses while trading at sky-high price to sales ratios, meme stocks, various flavors of cryptocurrencies, and the recent increase in options trading by individual investors.
In late July, Robinhood Markets became a publicly traded company. Robinhood targets young investors for its trading app, which adds gamification elements that appear to promote more frequent trading. According to its most recent quarterly financial statements, the company generates about 70% of its revenue from customers trading options and cryptocurrencies. We don’t think this provides a healthy introduction to the fundamentals of sound investing for a new generation of investors.
Robinhood represents just a very small portion of the individual investor market, and the allure of trading options and cryptocurrency extends well beyond its customer base. According to a recent Wall Street Journal article, “individuals’ increasing embrace of risky options trading is unmistakable: By one measure, options trading by individual investors has risen roughly fourfold over the past five years, according to CBOE data.” 1
It's hard to pinpoint why we’re seeing more speculative activity, but we assume the fact that the U.S. equity market has done so well over the past 18 months is a contributing factor, given that humans are wired to find it easier to invest and take on more risk during periods of rising equity prices.
We are all susceptible to FOMO, or fear of missing out. For those that might be tempted by the siren song of more speculative and short-term investing, we offer these excerpts from Jason Zweig’s Sept. 14 Wall Street Journal Intelligent Investor newsletter: 2
“But you don't have to do crazy stuff just because everybody else seems to be doing it. Wealth isn't a zero-sum game: Someone else getting rich doesn't make you poor. Nor does succeeding at something—temporarily—mean that you're good at it, or that doing it is a good idea. ... People who would never try driving 200 mph in heavy traffic because it's risky seem to have no problem taking equally reckless risks in the financial markets. You don't have to copy them. You don't have to play that game. You should just play your game. The point of investing isn't to finish first. It's to finish.”
Our Long-Term Approach to Equity Investing: Think Like a Business Owner
The Select Equities Portfolios’ approach to equity investing is not well-suited for short-term bets and speculating for a quick gain—which we embrace wholeheartedly. We invest for the long run, and, when we buy a stock, we invest as if we were buying a whole business. The value of that business will be determined by its long-term cash-generating power. Therefore, we think like an owner of a business, putting a great deal of thought into buy and sell decisions, including the impact of any changes to the existing portfolio. We prefer to invest in high-quality businesses—those we believe have durable competitive advantages, strong balance sheets, shareholder-oriented management teams, and a history of generating free cash flow—but not at any valuation. In some cases, we’ve waited many years before making an initial investment in a business that we had analyzed and monitored while waiting for what we see as an appropriate price.
It takes effort to not get distracted by the daily inflow of short-term news and stock -price action that’s constantly available at your fingertips. For example, the near-term economic outlook is always uncertain, with a mix of various headlines that can be cherry-picked to make a positive or negative case for the near-term direction of the overall stock market. We shy away from making short-term forecasts even though we are aware of what’s happening in the economy based on general reading, personal experience, and tracking management commentary on earnings calls from companies we own or monitor.
We believe it’s important for our clients to set reasonable expectations for future returns. We’d advise against looking at the high absolute returns from the U.S. equity market over the past 5 years and extrapolating those into future expectations. Your financial advisor can help you make sure your asset-allocation plan is appropriate for your risk tolerance and is on track to help you reach your long-term financial goals.
As always, we thank you for your business.
1 “Individuals Embrace Options Trading, Turbocharging Stock Markets”, WSJ Sept 26, 2021
2 "No, the Rules of the Game Haven't Changed", Intelligent Investor, WSJ, accessed Sept 14, 2021
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