The Best Approach to Invest in Emerging Industries
Use the Basket Approach to invest in new industries and sectors, with lower risk and still a big upside.
The first time I heard about the basket approach was with Jason Moser from the Motley Fool Industry Focus podcast. Basically, he would choose a theme and pick stocks based on this theme. As an example, he is a proponent of the War on Cash Basket, including Paypal, Square, Visa, Mastercard…
The Basket Approach works because if you pick stocks with an unlimited upside, you only need one big winner to have your invested value returned with profits or performance over the market returns.
For example, suppose you pick five companies, and you invest $1000 split evenly between these companies, having $200 on each. In that case, you will need “only” a five-bagger to break even, assuming that all other four companies will go to zero (which has a very low probability of happening).
Thus, we can assume that the Basket Approach works better if you are picking stocks in an emerging industry with a vast potential market and a winner-takes-all or winner-takes-most configuration. The reason is that you will end up only having to be right once. The odds will be in your favor.
Still, we can increase our edge by conducting extensive research on the companies and understanding the space. The more you know, the more your odds of picking big winners will increase.
Also, as a Margin of Safety, we should only select businesses with the potential of growing 10x.
How does it work?
Investing using a Basket Approach is quite simple. In contrast, the goal is to pick a theme and select several stocks (I prefer five stocks per theme, as it is feasible for me to track their thesis).
Imagine that you have a particular interest in the e-commerce or ad space. To get your feet in the water, you could pick 5 companies in each space and form two baskets.
To choose the type of companies in each category, I use Peter Lynch’s approach of separating stocks accordingly with their growth potential and their risk (fast growth, slow growth, stalwart, turnaround).
Another prerequisite for me is that the company should have the potential to grow at least 10 times its market cap. Hence, I am always aiming higher. My entire goal is to always maximize my upside, with optionality, in every aspect of life.
If you are in a Convex payoff structure, your main objective is “survival.” Live long enough, and you will eventually succeed. Thus, I’m always avoiding ruin risks.
We can combine this criterion with our Basket Approach. For example, with the e-commerce space, today, I would pick Shopify, Amazon, MercadoLibre, Sea Limited, and maybe Jumia Tech.
Every single company here has the potential to be strong compounders and grow 10x. E-commerce per se is still tiny compared to its potential. Also, we are picking companies with either sustainable revenue growth above 30% (meaning that every 2.5 years, their top lines will double) or strong moats like Shopify. The Total Addressable Market in this space is also immense, especially for local players like Jumia (our riskier bet, probably the biggest upside).
In this case, we could classify our companies in our E-commerce Basket as:
- Jumia has the biggest upside because it is the smallest one, exploring an enormous market (Africa). However, it also carries the most considerable risk.
- Shopify also has a huge upside, and it is as risky as MercadoLibre. Shopify has a solid MOAT being the top-dog platform for decentralized e-commerce.
- Sea Limited and MercadoLibre are similar, but $SE has some advantages in being exposed to two markets (South Asia and Latin America). SeaLimited is also a strong player in the e-sports and video game industry, carrying the distribution rights for Free Fire and other games via their platform Garena.
- Mercado Libre is the top dog in Latin America. Still, they have a fantastic Fintech business, which brings some tailwinds for this company.
- Amazon is a low-risk player (growing revenues by 20%+ for decades). However, I still think this business could grow 10x more with such a strong moat with so many optionalities.
I will not discuss these companies thoroughly because this is not the purpose of this article. For disclosure, I’m holding shares of MercadoLibre, Sea Limited, and Shopify.
When should I use the Basket Approach?
The best situation for the Basket Approach comes when you don’t have all the information regarding the industry or want to get exposure to an emerging space.
I love Munger’s saying that diversification is insurance against ignorance. You should only pick the best businesses, and diversification is just a tool when you don’t understand a business thoroughly. Hence, the basket is handy for these emerging industries.
For example, I’ve been using it to invest in Defi tokens. In my opinion, you can get gigantic returns in this space with minimal investment. As someone who has almost 10 years of experience in the Financial Industry, I can easily see our old industry being disrupted by smart contracts. But because this space is so new, I cannot go all in or go strong in a token at the moment.
It is like investing in the early internet. Thus, I’d instead put a small amount of cash, even split it into some tokens.
The end goal with the Basket Approach
As investors, our end goal is to build a strong portfolio with a small group of winners, which you will be invested in for decades (Munger-like).
Building a portfolio takes years, decades. As information comes, things could change, or they may not. This is a game of odds, of managing our odds and exposure to uncertainty.
We can resume our job as managing our exposure to uncertainty: we are always trying to reduce our ruin risks and increase our upside potential by investing in the best businesses available. Shortly: we are always putting ourselves into a convex payoff structure.
