The four most dangerous words in investing

It's different this time

Legendary investor Sir John Templeton warned, “The four most dangerous words in investing are, 'It’s different this time,' ” and we wholeheartedly agree. We believe it is important to keep in mind that just about everything is cyclical. To wit, last year we wrote about cyclicality of the loonie and potential challenges to Canadian housing in the late innings of the cycle. Regrettably, some of these concerns are starting to bear fruit as interest rates have risen to multi-year highs over the past year.

On the other hand, it is important to differentiate between swings within a cycle and structural changes. As we pointed out in a previous Fund Library article, it is clear that the fundamental nature of capitalism and the drivers of successful business models are rapidly changing. It that context, perhaps it is different this time. For some historical context, consider when humanity moved from the agricultural era into the industrial era.

Born in England in 1766, Robert Malthus was one of the world’s first prominent economists. His life coincided with the beginning of the industrial revolution, but his world view was firmly shaped by the very harsh realities in agrarian society across many millennia. The central theme of Malthus’ work was that population growth would always overwhelm food supply growth, which would create perpetual states of hunger, disease and conflict. Malthusians raised the alarm and were sure a catastrophe was inevitable as global population began to soar during the dawning of the industrial era. If nothing had changed, the Malthusians would have been right. Or at least, population growth would have been generally restricted by available resources. But things did change.

The industrial age changed the fabric of society and coincided with new farming techniques and improved livestock breeding, which lead to amplified food production. Later, mechanization created incredible food abundance which enabled the global population to grow rapidly unlike any other time in history. The Malthusians were wrong, because “that time it actually was different,” The old methods that worked so well in the past were no longer useful. The big fortunes of the industrial era were built by the Carnegies, Rockefellers, and Fords of the world, not by the large U.S. agricultural land owners who had relied largely on slave labour during the agrarian era.

Another shift underway

Once again, another huge structural shift is underway. The world is moving from the analog industrial era to the digital-driven world of the information age. Like the transition of the industrial revolution, this new world is harder to comprehend, and requires new ways of thinking.

Human nature has evolved over time to successfully navigate the world based on what is easy to understand. This is the world where, for example, the average person is five to six feet tall, with the tallest about 8 feet and the shortest about tow feet. There are no exceptions to this distribution. In contrast, in the intangible digital-driven world, the tallest man could be 10,000 feet tall one day and the shortest might be negative 1,000 feet. This world is hard to conceptualize because it doesn’t make much sense in the world we live in. It is hard to overcome hardwiring that’s been optimized over thousands of years of human evolution. (For related reading, see Nassim Taleb’s concepts of “Mediocristan & Extremistan” in his classic book, The Black Swan.)

Yet, we must adapt to this new world. The reality is that extreme outcomes are far more common in the intangible digital-driven world than in the tangible world. The rapid rise and domination of companies like Google and Facebook, driven by the winner-takes-all (or most) competitive dynamics of the digital world, are unprecedented. This is largely due to the feedback loop of the network effect, or the positive effect that an additional user of a product or service has on the value of that product or service to other users.

Due to the network effect, the larger the winners of many of these intangible businesses become, the faster they can grow (that is, until they hit critical mass…nothing grows forever!). This dynamic is in sharp contrast to the industrial era, where growth rates generally slowed as businesses became larger, and it took much longer to reach critical mass, often measured in multi-decade timeframes. Rapid growth is far more feasible among large digital businesses than in older industrial industries because they are capital-light and not constrained by time-consuming needs like building factories or distribution centers and maintaining inventories that drive growth for these firms.

On the other hand, there is plenty of evidence that even the big winners, backed by powerful network effects, can still be fragile if they fail to reach true critical mass. Consider that in June 2006, social networking pioneer MySpace surpassed Google as the most visited website in the U.S. By January 2018, MySpace was ranked 4,153 by total web traffic, and 1,657 in the U.S.

If social networking were an Olympic sport, Facebook would have taken the Gold medal whereas MySpace, winner of the Silver medal in social networking, might as well have been in last place. Quite often, the runners-up are practically irrelevant in the digital world, whereas the second- or third-largest and even smaller businesses are still competitive in the industrial era. Winners tend to be singular leaders in their respective categories, so “paying up” for the leader makes sense in a world where there is only one real winner.

Similar to the Malthusians of the past, most people today have a hard time absorbing new mental models that are separate from those needed to thrive for most of human history. Not surprisingly then, investors tend to have a very difficult time conceptualizing exponential growth and are caught off guard when the world works differently than their pre-existing linear view.

In his thought-provoking book Principles, famed investor Ray Dalio explained: “Our biggest barriers to [being radically open minded] are the ego barrier and the blind spot barrier. Our ego barrier is our innate desire to be capable and having others recognize us as such. The blind spot barrier is the result of our seeing things through our own subjective lens; both barriers can prevent us from seeing how things really are. The most important antidote for them is radical open-mindedness…it is the ability to effectively explore different points of view and different possibilities without letting your ego or your blind spots get in the way.”

To grow as investors, then, we need to be our own greatest critic and have the intellectual honesty to kill some of our best-loved ideas.

Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management. He works alongside David Barr, Pender’s President, in setting the direction of Pender’s overall investment strategy. This article first appeared in the Pender blog. Used with permission.

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