Thoughts on Thematic Investing

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Last week, Germany announced a massive infrastructure package of up to 500BN€, aimed at investments in infrastructure, education, and most notably, defense, an area that will further be strengthened by an exception from Germany’s debt brake (Schuldenbremse). It is a continued reversal of Germany’s limited investment into its defense and the Bundeswehr in recent years, accelerated today for good reason given the continued threat of Russian aggression to its EU neighbors.

Unsurprisingly, German defense stocks have seen astronomic rallies: Companies such as Rheinmetall (tanks) or ThyssenKrupp (submarines) have seen rallies of 100% or more since the beginning of the year, continuing strong growth in their share prices ever since Russia’s invasion of Ukraine began. But it’s not just the stock market where defense investments are booming: Over the last year, I’ve seen numerous investors look to launch defense-focused funds, investing in companies that range from developers of ‘dual use’ technologies (i.e. usable for civilian and military use) to outright weapons systems such as weaponized drones or ammunition.

Driven by that rally and the general ‘hype’, many investors have asked over the recent months what I think of investing in defense. When it comes to actual assessment of the sector, I am most likely not the right person to ask, knowing as much as the next person. But what I do know is that investors should be careful, because defense could just be the next flavor of the month. Themes that come to mind include but aren’t limited to crypto (hyped in 2021 before crashing back down until last year), renewable energy (unfortunately out-of-favor amid rising rates and a new US president), or micromobility (scooters did not disrupt walking).

So once again, when investors ask me about such a theme, I try to focus not on whether that individual theme makes sense. Instead, I try to focus on the general question of thematic investing: What is a ‘good’ thematic investment? Who do they make sense for, and in what concentration? Let us touch on all of that today.

Defining Thematic Investing

Before we dive in, it makes sense to talk about how I’d define thematic investing in the first place: To me, thematic investing is an investment strategy that tries to capitalize not on an individual asset class, but on a certain political or technological theme that might span a number of asset classes.

Perhaps it’s easier to give an example. Let’s take said thematic theme of defense investing, along the lifecycle of a company:

• We can invest in innovative businesses in the defense industry through venture capital funds and/or direct investments, providing them with funding to reach technological milestones and/or profitability.

• We can invest in more mature defense firms through specialized private equity firms, who look to grow those businesses before selling them to another investor or by taking them public.

• We can then invest in those listed defense stocks, which are mature businesses that grow steadily, with investors looking to gain through dividends (if available) and capital gains.

• Lastly, we can make (countercyclical) investments adjacent to those businesses, i.e. traded debt investment of a defense firm.

Not all thematic investment strategies are so multi-asset in nature. There’s countless thematic funds and ETFs that focus solely on public equities, or at best, on public equities and public debt.

Which brings us to our next question - what should a good thematic investing strategy look like?

A Question of Timing

In my view, a lot of success in thematic investing comes down to one word: timing.

The ‘easiest’ way to capitalize on a thematic trend, of course, is to be early. If you had bought into crypto back in 2010 or had invested in defense stocks in anticipation of Russia’s invasion, you would’ve made a killing. The question, of course, is how early you can be: There're countless themes out there that someone strongly believes but that have failed to materialize so far. In such cases, it might be easier to be a bit late, i.e. jump on a trend just as it is starting to pick up - few people would’ve likely expected the AI rally to drive stocks such as NVIDIA to such incredible heights from already lofty valuations.

Of course, the challenge with just being ‘long’ a trend, i.e. focusing entirely on its upside through positive adoption, bears the risk that said trend can come to an end. In that case, let’s take the example of renewable energy: While clearly a key theme over the last decade (and the decades to come), renewable energy was particularly in focus amid the Biden Administration’s IRA and a general public interest in fighting climate change. With the new government less favorable on the topic, and as private individuals struggle with higher prices and rising unemployment, renewable energy is falling out of favor - few consumers and companies want to pay more (or are able to pay more) for simply knowing that their electricity is clean. A decline in stock prices of such companies soon followed.

Interestingly enough, many of these companies aren’t struggling - quite the opposite, actually. Many energy producers in Europe saw record earnings in 2022 amid higher volatility in electricity prices after Russian gas became unavailable. Production prices of solar farms, wind turbines continue to come down, further accelerating adoption. But of course, all of this is little solace to a ‘long-only’ thematic investor in renewable energy: They’re down double-digit percentages from their peaks, below high water marks if they have a carry, and struggling to find new investors for an out-of-favor theme. It’s like the struggle of many European small-cap value investors over the recent years - no use if your stocks are trading at 1x P/E and trending even cheaper when nobody wants to buy them.

Which brings us to the other key component of thematic investing: Investing in the theme across the entire cycle. Finding a thematic trend and riding it to its heights is possible, but brings the issue of what to do once that peak is reached. A good thematic investor is not just a ‘tourist’ in his respective theme or niche, but able to capitalize on that theme across the cycle, using different types of investments and instruments that are properly positioned in each phase.

To exemplify this, let’s take a look at the wider energy sector: Many investors were able to ride the rally in US shale back in the mid-2010s, but if they were just investing ‘long only’, they would’ve run into substantial drawdowns as oil prices collapsed in late 2015. At that moment in time, a skillful thematic investor is able to also use other instruments - such as buying into the high-yield debt of those struggling players, making substantial profits on the recovery or using a debt-to-equity swap to take said companies private at low creation multiples. In recent years, they might’ve been able to avoid the historical event of below-zero oil prices in the early COVID days, before then betting not only on conventional energy but also the aforementioned trend in renewable energy.

As I said earlier, a good thematic investor isn’t just trying to hop from theme to theme. They found their theme in which they have unparalleled knowledge, and know how to find a winning bet, no matter what part of the cycle they find themselves in.

So let’s assume you found such a manager. How do they fit into your portfolio? And should you think about placing thematic bets yourself?

Thematic Investing in a Multi-Asset Portfolio

Fitting such managers into a diversified portfolio can actually be more challenging than one would think. You’d expect such a manager to offer outstanding performance relative to their (industry/sector) benchmark, across the cycle. But the key word here is relative: Nobody is cheering you on for being down just -20% when your industry is down -30%. Of course, the upswings might be comparably larger than for a regular, diversified equity fund. But this higher volatility necessitates a substantial level of diversification, not just investing in one manager next to your portfolio, but ideally adding ten or more managers, each focused on a certain sector or theme.

In the ideal world, the resulting portfolio would offer the same or higher returns and/or lower or the same risk. In either case, an investor in such a portfolio should be prepared for tracking error to conventional benchmarks, especially in the case of underlying managers that stray substantially from conventional portfolio positioning. And as is the case with any form of active management, directly or through manager selection: Be prepared to invest a lot of time into due diligence and ongoing screening, and be prepared that even some managers investing across the cycle might have to be replaced at some point.

Let’s look at a story from my own experience on thematic and sectoral investing in private equity: I vividly remember meeting a private equity fund that was specialized in small-cap healthcare companies in a single US state. They had outstanding returns (think 3-5x across multiple funds). And they were able to let us in as a comparably small investor. But did we go for it? No - given that we were just investing into 3-4 funds per year, and were just starting out with our program, we could not take the risk of picking such a specialized manager. How diversified would we’ve needed to be? I’d compare it to a fund of funds, which  typically diversifies into 8-12 funds, by region, i.e. 16-24 funds if you want to cover US and Europe - which at 1M€ per fund would result in a fund program far beyond our desired size. And that doesn’t even address the complexities of 10 commitments a year, such as due diligence, monitoring, or cash management.

Does that mean we should write off thematic investing entirely unless we can build a massive portfolio? Not necessarily - you can also approach the matter from a core-satellite approach. Here, let’s take a look at venture capital: If you have a diversified ‘core’ portfolio of high-quality, multi-stage and multi-industry managers, I do see benefit in adding niche, specialized managers in smaller allocations. However, when combining those funds, make sure you can stomach the risk if their associated theme happens to run into challenging years for your vintage year fund - which I personally experienced with some ‘top of the cycle’ crypto fund investments. Will they recover? Time will tell.

Direct Thematic Investing

Before we conclude this article, let’s tackle the question of investing in themes yourself - i.e. direct investments into specific companies or instruments, without a skilled manager as an intermediary. 

Generally, I would recommend against trying your hand at thematic investing: Most likely, by the time a hyped theme reaches your desk, it is already past the phase where most value creation for investors took place, yet the theme is still ‘hot’ enough that a manager can make money off of it through management fees. Unless you are razor-focused as an investor or family office on thinking which themes could be relevant in the next 3-5 years, and are willing to make multiple bets of which likely the majority will not pay off, you are better off with long-term, diversified investments in the conventional ‘asset class’ logic.

But there is one exception: I would greatly recommend allocating some of your capital to thematic investing in your personal area of expertise. It is one of the few areas where the ‘operator-turned-investor’ path can be lucrative - I’ve seen many successful operators in industries ranging from fintech to biotech to gaming make some investments on the side in companies that they think can be the next big thing. After all, those operators are typically at the cutting edge of their industry, they can see what new trends are coming over the horizon, and they know where a quick recovery might be most likely if their industry is going through a downturn. It’s a perfect, small allocation for your Aspirational Bucket - not to be taken likely, and the effort not to be underestimated, but a great chance for a shot at outsized returns.

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