What my biggest investment mistake teaches us about the software sell-off

 

When shares you own sink, assume that you’re wrong, rather than looking for reasons why you’re right

Simon Edelsten

This article was originally published in the Financial Times

The recent sell-off in software and so-called “quality growth” stocks is reviving some painful memories for me.

Big drops this month in the share price of IBM, Salesforce and, in the UK, Rightmove, are based on the fear that Al tech will not boost their operations, as many had initially predicted, but will instead eat them for breakfast.

It takes me back to my biggest investment mistake — an understandable, but costly, error and one that has haunted me for nearly 30 years. There are some lessons I learnt from it that are pertinent to the current situation, though, so for your benefit, I will relive my pain.

It concerns the Yellow Pages. Launched in Britain in 1966, it was a big, chunky volume that you kept by the telephone. It listed all the phone numbers in a region by trade and was delivered to your door. The company made healthy profits by persuading business owners to pay for bolder entries so they would stand out.

And then came the internet. Many companies believed to be internet winners ended up as internet toast within a few years. Revenues held up for a while, but the market — in the way it does — anticipated the challenges, and the shares started performing badly well ahead of the cash flows sinking.

In 2000, the bubble in telecoms, media and technology stocks burst, but businesses continued to incorporate the internet. I thought that Yellow Pages, quoted as Yell plc, could benefit. It was not completely stupid. After all, huge print and distribution costs would be eliminated, and Yell’s branded online site would surely be where we all looked for traders. I hadn’t accounted for Google!

The shares malingered. I compounded the problem by buying more when they had fallen a fair bit. Eventually, Yell went bust along with its elder US sibling. It remains my largest loss in stock selection over 26 years, but today I find myself applying three lessons:

1. Be ultracritical: When shares you own sink, assume that you’re wrong rather than looking for reasons why you’re right. Buying more is tenable only if you’ve thoroughly reviewed and reconfirmed your original investment thesis.
2. Value a company on tomorrow’s earnings: When technology or other changes weaken the barriers to entry or undermine demand, reassessing a share’s value based on yesterday’s earnings is dangerous. Those historical earnings could collapse, taking future profits with them. Factor this into your calculations and allow prudent leeway.
3. Diversify: The more exciting a sector is, the more uncertain its future. A larger number of smaller holdings might make better sense than a small number of all-or-nothing calls.

These lessons are proving particularly helpful in current market conditions. We might conclude that the barriers to entry for new software writers have reduced more than anticipated. This is an industry where companies started in garages have come from nowhere to dominate specific applications swiftly. The rate of advance of AI applications is speeding up.

In our funds, we sold Salesforce on this basis, but AI won’t overcome all barriers. Many software-based businesses are so embedded that they’re unlikely to be replaced, and some have exclusivity on valuable data needed by their customers. These companies may still need to invest in additional AI functionality to keep up with the competition, but customers may be unwilling to pay extra for those enhancements, which will weigh on profits.

The companies most affected by AI look a pretty diversified group by conventional risk management standards. They’re in different sectors and countries. But on fundamentals they face the same risk (unpredictable AI challenges) and represent a correlated risk to capital — the shares rising and falling together as fear ebbs and flows.

So where might you go instead? Many global equity investors have benefited hugely from the wit and wisdom of Warren Buffett’s stock selection process. Central to his approach is identifying “quality” companies — ones that should enjoy greater profitability because of barriers to entry.

His largest investments were in branded goods, railways, energy and — recently — Japanese holding companies. Many of these areas aren’t seen as “quality” by managers who claim to follow his approach. There seems to be a much greater emphasis on “value for money” in Buffett’s stock selection process, and the diversification between these different areas looks effective. Oil companies and railways are less threatened by AI.

We’re seeing rapid technology changes that look exciting. But these changes should also make you less confident in your predictions about how companies will cope with the challenges. Adding some old-fashioned businesses could be a good way of spreading your portfolio more widely. And the good news is that many of these look relatively attractive value for money.

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