Change is a constant for every company and every industry. However, this year has arguably included a relatively large amount of change for a wide range of firms and sectors.
The coronavirus pandemic has shifted consumer demand in many industries. This could prove to be a long-lasting effect. For instance, rising demand for home deliveries may shift more consumers away from in-store shopping towards digital opportunities.
Investors currently seem to be positive about companies that could benefit from changes which are occurring within their industries. In many cases, they have optimistic forecasts that are used to justify their rich valuations.
However, in my opinion, investment opportunities could be more favorable among less popular companies that are less likely to experience major changes within their industry.
Stability at a low cost
While change brings opportunity, it also brings risks. Companies must adapt to shifting industry trends. This can mean they are more likely to make mistakes when deciding where to focus their investments. For example, they may invest in the wrong type of technology when seeking to gain a competitive advantage, or they could misunderstand how consumer tastes will evolve over time.
In my view, businesses that have greater stability within their industries could be more attractive investments. For instance, consumer goods companies may offer resilient and growing demand for their products over the long run without being required to make wholesale changes to their business models.
In addition, many companies that are currently viewed by investors as likely to benefit from change trade on rich valuations. Their stock prices may assume a positive outlook that ultimately fails to materialize. Their lack of a margin of safety may mean that they represent an inefficient allocation of capital.
Learning from Buffett
The significant amount of change currently taking place reminds me of an excerpt from Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) chairman Warren Buffett (Trades, Portfolio)'s letter to shareholders in 1986. In it, he discusses the problem with investing in companies that face significant changes within their industry:
"Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities… Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns."
In my opinion, Buffett's words are extremely relevant in today's investing environment. Investors are assuming that there will be major, permanent changes across many industries that may ultimately fail to take place. Moreover, they are banking on companies within those industries making the right decisions to prosper from change. This may also not occur, and could mean that their high valuations become more difficult to justify.
Therefore, stocks with greater revenue visibility, wide economic moats and only modest amounts of industry change could be more attractive investments. At the moment, they may offer wider margins of safety than popular stocks.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Howard Marks: A Bear Market Is Never Far Away
- Warren Buffett: Don't Dance to the Tune of Speculation
- Benjamin Graham: Company Fundamentals Are King
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