Investor Toolkit: Why “theme investing” is one of the investment strategies to avoid

Investment StrategiesEvery Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you stock market advice and investment strategies.

Today’s tip: “Theme investing may seem to be a good way to simplify your investments by following a developing trend. But it can force investors to pay too much attention to investment fads and predictions and too little to the fundamentals of good companies.”

Theme investing has natural appeal. It simplifies things. Investors like it because they feel it can put their investment returns into overdrive. Some also feel it adds fringe benefits to their investing, by letting them support social objectives.

Brokers like it because it gives them a rationale to recommend a variety of stocks.

If a client thinks gold prices are headed up, a broker can think of all sorts of gold-themed investment opportunities. They include established gold miners; junior gold companies that are working on a promising gold property; or penny golds that are outright speculations. Other possibilities are financial companies that sell gold-related merchandise like gold coins.

If the client supports environmental causes, the broker can propose investments with a “green theme”. They include solar-power equipment makers; companies that claim their products are less harmful to the environment than competitors’ products; or companies that claim to operate with a high degree of environmental concern.

When you focus on an investing theme, however, it’s easy to overlook the fundamentals. If you’re sure gold prices are headed up, for instance, why trouble yourself with tiresome matters like finances or geology?

Predictions are the hard way to make investment decisions

Of course, many investing themes carry a grain of economic sense. Government spending deficits and money-supply growth of recent years will eventually lead to a rise in inflation. Gold may rise in response. The sun could one day become an economically attractive power source (though the solar power industry now mainly runs on government subsidies). But it takes more than a grain of economic sense to turn a company into a profitable investment.

Far better to start by zeroing in on companies with a history of sales and earnings, if not dividends. The best of these companies are like organic machines that can turn human and material inputs into a continuing stream of growing revenue. Any connection with an attractive investing theme is simply a bonus.

That’s why themes should play a secondary role if any in your investing decisions. Even then, you need to be selective about the themes you consider.

After all, some themes are little more than investing fads that may be near-forgotten in six months. A current example is “Canadian retailers that can profit most from the departure from Canada of Target Stores.”

Here’s one theme that’s just starting out. “Companies that will gain (or lose) if oil prices stay weak for the next several years.”

The most rewarding themes reflect secular changes that last beyond the current economic cycle. In the 1990s we often referred to three particularly long-lived themes: the maturing of the baby boomers; the improvements in computer and communications technology; and the liberalization and spread of free enterprise around the world. All three had a hand in turning that decade into a glorious time for investors.

However, all themes revolve around predictions. That’s the hard way to make investment decisions, and the one most likely to lead to expensive mistakes. That’s why we focus on well-established companies. You can spot these companies mainly by description, rather than prediction.

Many views about the future turn out wrong. Well-established companies are most likely to survive the inevitable setbacks and thrive all over again when good times return, as they always do.

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