Stockholm (HedgeNordic) – History shows that most stock market returns usually come from a tiny fraction of companies. In the past decade or so, a handful of technology heavyweights – such as Apple, Facebook, Amazon, Microsoft, Netflix, and Google’s parent company, Alphabet – have carried the S&P 500 on their shoulders. Ernst Grönblom (pictured), the architect of a high-conviction strategy – currently powering equity fund UB Thales Argo – that previously propelled HCP Focus to the top of BarclayHedge’s and Citywire’s rankings of the world’s best long-only equity funds, argues that this phenomenon to a large extent explains the longer-than-expected – “anomalistic” – run of outperformance of growth stocks against their value counterparts.
“Growth stocks have been outperforming value stocks for the past ten years or so quite dramatically. This is something of an anomaly,” says Grönblom. “If you look at long stretches of time, value has outperformed growth, with growth usually outperforming during very short stretches,” he continues. “However, we have observed a very long stretch of outperformance by growth over the past ten years, which is a mystery in some ways.” According to Grönblom, the growth universe has performed so well due to “a very small minority of growth stocks performing astonishingly well.” This, in turn, means that the large majority of growth stocks have been relatively bad investments.
“The growth universe has performed so well due to a very small minority of growth stocks performing astonishingly well. There is a small number of very successful firms that have lifted up the whole category.”
“There is a small number of very successful firms that have lifted up the whole category,” argues Grönblom. “It is therefore misleading to say that growth as a category has outperformed value, because it is a very small subset of the growth universe that has outperformed.” Grönblom goes on to explain that, to a large extent, “the outperformance of growth stocks can be explained by the superstar or winner-take-all phenomena.” Over a time span of more than two decades, the Finnish fund manager has sought to build and nurture a portfolio that can benefit from the superstar and winner-take-all phenomena.
“The outperformance of growth stocks can be explained by the superstar or winner-take-all phenomena.”
“If I would have to put it in a nutshell, UB Thales Argo employs a high-conviction long-only strategy that attempts to identify and exploit what Jack Treynor calls slow-traveling ideas, i.e. non-obvious investment ideas,” explains Grönblom, who re-launched his strategy under the umbrella of United Bankers last year after leaving Helsinki Capital Partners and the HCP Focus Fund he managed since 2012. Under his care, HCP Focus ranked among the world’s top ten equity long-only hedge funds in 15 quarters out of the 19 quarters over the period of 2016 through 2020 based on three-year annaulized returns. No other fund in this category managed to join the top ten quarterly leaderboard compiled by BarclayHedge this many times during the period.
“UB Thales Argo employs a high-conviction long-only strategy that attempts to identify and exploit what Jack Treynor calls slow-traveling ideas, i.e. non-obvious investment ideas.”
One of Grönblom’s favorite slow-traveling ideas in recent years been the “network effects” phenomenon, more formally known as demand-side economies of scale. “In a nutshell, network effects describe a situation where the utility of a product or service increases as the number of users increases,” explains Grönblom. “This is not in any way a new phenomenon, network effects have been in existence for as long as economic activity. However, the relative importance of this phenomenon has increased dramatically as a result of digital acceleration.”
The network effects phenomenon has been one of the most important contributors to the winner-take-all dynamic, according to Grönblom. “If I had to pick one contributing factor to the winner-take-all dynamic, my pick would be network effects,” says Grönblom. “That is not to say that there are no other explanations for this dynamic. But I do think that the network effects phenomenon is the most powerful driver towards what you could call natural monopolies, which is a state where one firm can supply the whole output for a single market.”
“If I had to pick one contributing factor to the winner-take-all dynamic, my pick would be network effects.”
In almost any market, crowds of companies are fighting for business within their niches. With few exceptions, a small number of companies end up dominating their industries at some point. Finding these future leaders is a daunting task that is becoming harder and harder day by day. “It is a scary thing to admit. If we assume the winner-take-all phenomena is correct and accelerating as I claim, my job is getting harder and harder all the time,” acknowledges Grönblom. “It resembles looking for needles in a haystack. The problem is that the haystack is getting bigger all the time while the number of needles is decreasing,” he elaborates. “The material of the needles is changing from silver to gold, with successful businesses getting more and more valuable, but they are getting increasingly scarce and thus harder and harder to find.”
UB Thales Argo currently maintains a portfolio of 17 positions, which “is unusually high because my target number of positions is between ten to 15.” The rationale behind the high concentration lies in the law of diminishing marginal returns. “The benefits of diversification are highest in the very beginning when you have just a few securities in the portfolio,” explains Grönblom. “For every additional position, the marginal decrease in portfolio volatility gets smaller and smaller. From the 15th position onwards, the marginal utility of increased diversification is very small. And after 20 positions, it is almost non-existent.”
“Every additional position in a portfolio represents a tiny step towards a market-portfolio or closet-indexing portfolio.”
More importantly, “there is a limited number of truly interesting investment ideas out there,” claims Grönblom. “It is very naive to assume that one can find hundreds of genuinely interesting ideas, especially if you want them to fall, as they should, within your circle of competence,” he continues. “If you have a portfolio with your ten best ideas, and you decide to increase the number of positions to 11, the last portfolio addition dilutes the quality of the portfolio.” Last but not least, “every additional position in a portfolio represents a tiny step towards a market-portfolio or closet-indexing portfolio, which is what truly active managers should strive to avoid.”
The Ideal Company. The Unwritten Checklist
When searching for investment ideas for his concentrated portfolio, Grönblom follows an unofficial checklist of characteristics of the ideal company. “It is quite a long list of qualities or attributes that describe my version of an ideal company,” says Grönblom. “It is quite rare to find all criteria fulfilled in a single company. The more boxes I can check, the better.”
“The most obvious characteristic is that the company should either be dominating in its market or should have fairly good probabilities of achieving this status within a reasonable time frame.”
“The most obvious characteristic is that the company should either be dominating in its market or should have fairly good probabilities of achieving this status within a reasonable time frame,” starts Ernst Grönblom. “Another criteria is that the company should have at least one identifiable competitive advantage such as network effects,” continues the money manager. “In an ideal state, the company benefits from more than one competitive advantage. It can benefit from network effects and then have classic economies of scale, brand recognition and so on. In the perfect case, it has almost all of the classic sources of competitive advantage.”
“The third criteria is that the company has a business model that enjoys operating leverage, which in other words, implies a business with large fixed costs in relation to variable costs,” says Grönblom. “Probably not self-evident to all, this type of companies have the interesting characteristic of enjoying better margins as their business grows. If most operational costs are fixed, as per definition, the fixed costs do not grow as sales grow. Provided that the company keeps growing its sales, it will also expand its margins,” he elaborates. “This is typical for digital companies or intellectual property-reliant businesses. If you have a software business, especially if you sell the software over the internet, the marginal cost of selling another license is almost zero. You do not have to produce anything new.”
“I also like companies with high gross margins because that is a sign of pricing power,” continues Grönblom. Although Grönblom is “quite agnostic” to firm size, he prefers businesses that are not too big. “It is a reasonable assumption to say that the bigger a company gets, at least in theory, it has less room to grow. But the world has changed. Today, even huge companies can grow very fast. Some giantcompanies are still growing at rates that were unheard of one generation ago for companies of that size.” Grönblom is also a fan of companies benefiting from real options. “Real options is just a fancy way of saying that companies have a lot of possibilities, a lot of open doors,” explains Grönblom. “A company that has masterfully exploited a lot of real options is Amazon. Amazon started off by selling books, a very limited product range. Having mastered the selling and distribution of books online created a lot of real options for Amazon to expand their product range.”
“The ideal company should also offer a disruptive product or service. A service or product that has a novel component in some way, either in the product itself or the way it is produced or distributed,” says Grönblom. “It should disrupt legacy industries,” he continues. “Last but not least, the company should ideally be run by the founder or owner-operator,” argues Grönblom. “The most successful founders are visionary geniuses, they are the best to take their companies forward. I am not saying that hired CEOs cannot do the job, there are examples of brilliant hired CEOs. But if you look at the big picture, the most stunning investment successes have historically been run by their founders.”
“My objective is to identify situations where the market underestimates the probability – and thus also the intrinsic value – of an up and coming company achieving superstar status, or where the market underestimates how long an established superstar company is able to maintain its current superstar status.”
As Grönblom says, there is no company out there that has all the above-mentioned quality characteristics. In his pursuit of building a concentrated portfolio of superstar companies, “the more boxes I can check in my checklist, the better,” says Grönblom. “My objective is to identify situations where the market underestimates the probability – and thus also the intrinsic value – of an up and coming company achieving superstar status, or where the market underestimates how long an established superstar company is able to maintain its current superstar status.”