Active Investing in the Age of Disruption. Evan L. Jones

as the biggest asset manager in the world. The market is generally liquid and egalitarian. Although some activist or constructionist public investment firms may try to add value to the public companies they invest in, generally the management team succeeds or fails on their own. For 90+% of public equity investors, their value contribution to their portfolio companies is zero.

      Venture capital (VC) investments are accessible only to the parties invited by the management team to negotiate in the potential investment. An investment from one of the premier VC firms is worth more to an entrepreneur than an investment from a local VC firm. A premier VC firm financial backing adds prestige to the young company and opens doors that would not otherwise open for the entrepreneurs. The VC market is not liquid or egalitarian. VC investing methodologies and processes will not work in the public markets

      For a short period of time when markets are hot and capital is plentiful, greed will be the emotion of the day on Wall Street and high growth, potentially disruptive stocks, will outperform. This was the case in the 2010s. Unfortunately, through cycles, a strategy of investing in these stocks in the public markets will not succeed for very quantitative reasons.

      Too much capital availability makes money flow to the wrong places.

       —Howard Marks

      First, by the time a company goes public it is not a secret. If they have a new technology or some exciting innovation, it is very well publicized. The company and its investors will make sure it is well publicized, because they are trying to get the best valuation possible when going public. This communication and (again) the egalitarian process of buying public stock mean an exciting new company will receive a very high valuation. By definition of buying at a very high valuation, you will not be able to extract the huge gain that a VC investor receives from a portfolio winner, because they were invested before the company was proven affording them a significantly lower valuation. The big winner for the venture capitalist that creates returns for their entire portfolio is often a 100 times and higher return. You are not going to receive that type of return in the public markets. Although the public markets are not strongly efficient, they are clearly much more efficient than private illiquid markets. Second, sheer size becomes a factor. When you invest in a company with $5 million in revenues, you might see it grow revenues 200 times and reach $1 billion in seven years, but if you invest in a public company with $1 billion in revenues, there is very little chance of seeing revenues reach $200 billion in seven years.

For these reasons, a public portfolio of all the high-growth, and therefore high-valuation stocks, will not outperform through cycles. The key here is through cycles. Growth companies can create outperformance if invested in at the right times and right points in a cycle. If you have done research on a high-growth company and get the opportunity to buy during a time when investors have become fearful of the future (causing a lower relative valuation), this may be a compelling, outperforming strategy. Taking a contrarian view and buying an asset at a reasonable valuation of its projected growth trajectory is potentially a good idea. It is the indiscriminate buying at any valuation that will not work over time. The outperformance we are focused on in these discussions is a repeatable, consistent outperformance through business and market cycles. It is, of course, possible to outperform with almost any strategy, if you time the market correctly, but generally this is not a consistent repeatable strategy. After monitoring hundreds of hedge fund managers over the years, it is only a small minority (maybe 5%) that demonstrate the ability to market time correctly over a long career.

Private markets overheating?

When you combine the VC growth discussed previously with the massive increase in private equity firm capital, there is real concern that private market valuations are becoming frothy to the point of disappointing investors. The low public market rate environment has caused many investors who do not usually have large allocations to private equity to increase their allocations in a search for higher returns. In Figure 3.10 detailing private equity dollars awaiting deployment you can see that we are at historic highs. At over $600 billion, private equity looking for opportunities has tripled in five years.

      In a number of institutional capital allocator surveys in 2019, private equity ranked number one as the asset class in which they expect to increase investment over the next few years. Illiquidity is a risk and that risk is being discounted today by a large number of investors trying to meet their investment mandates.

FIGURE 3.10 Private equity dry powder (billions $US)

Contrarianism and paradigm shifts

Investing in a contrary fashion to the current shorter-term trends and beliefs of the market is important to creating sustainable long-term outperformance and goes hand in hand with the ability to invest with a longer time horizon than the average investor. Investors cannot put capital behind a contrarian thesis if their thesis is not given the time to play out or if there is a high probability of a paradigm shift. The necessary time horizon to be compensated for being a contrarian has been analyzed in a number of ways, but three to five years has historically been enough time to comfortably invest behind a contrarian thesis.

      The following cycle has been the challenge in the 2010s. Momentum investors have prospered and any form of value or fundamental investing has struggled. There will come a point where this cycle will break and investors will begin to lose money and start to demand earnings again. As of June 2019, we have still not reached that point.

      The result of this cycle for an entire decade has been a massive increase in capital allocation to passive investing. Allocators have lost faith in active managers' ability to create alpha and become momentum oriented themselves by moving capital into various passive investing alternatives. This trend to passive investing is global in nature.