Wherever large enclaves of European immigrants settled in America, it would not take long for a handful of breweries to open for business in the local community. These breweries distributed their fermented concoctions to the local taverns and clubs within close proximity to where the beer was produced. Unlike the Internet companies of today, brewing beer for most of the 19th century was not a scalable business model. Unpasteurized beer with active yeast has to be consumed within a short period of time after the fermentation process is completed. Otherwise, these liquid bread products become moldy and give off a rank odor. Nobody likes to drink stinky beer pumped out of vintage kegs that have been stored for who knows how long.
After a large wave of German immigrants settled into Saint Louis in the mid-1800s, brewing beer became a major local industry. Determined to expand his distribution base outside of the local community, Adolphus Busch in the 1870s incorporated several technological innovations at his Saint Louis brewing plant. Busch was the first American brewer to pasteurize beer, which enabled the suds to have a longer shelf life than did most of the local fare consumed within a short distance around the Saint Louis area. Busch also introduced refrigerated rail car technology. Temperature-controlled rail cars enabled beer to be transported over longer distances without sacrificing a significant loss in quality upon arriving at its final destination. Both the pasteurization and refrigeration technologies enabled Budweiser to grow into a national beer brand, giving Anheuser-Busch the right to call itself the "King of Beers."
These disruptive technologies in the beer making industry would seem to be a force majeure for the smaller craft breweries forced to compete against it. It is counterintuitive to imagine a rinky-dink microbrewery remaining in business against a fermented tide of technological brewing innovation located wherever beer is produced in large quantities. Despite the increased efficiencies of a national brewery due to its economies of scale, microbreweries are opening at a faster rate than ever. Creative Biermeisters are experimenting with different flavors and hops, selling their fermented creations to evermore hipster patrons eager to escape the bland, watered-down alcohol products sold by evil multinational corporations. Fancy refrigeration and pasteurization technologies be damned. Brewing large quantities of beer in oversized Lauder Tubs and shipping the swill cross-country from a centralized location isn't going to cut it for this finicky subset of hop-heads who frequent their local microbrew joint.
In the Internet era, where scalable business models disrupt entire industries, the gurus experimenting with different fermented potions in the dungeons of their local brewpubs have found a way to not only compete against but also thrive in the midst of scalable technology. These smaller establishments have found a niche, avoiding being tapped-out even if drones in the future can drop sanitized kegs of cheap corporate beer on the back porch of a college frat house at breakneck prices.
Those in the investment advisory business can learn a thing or two from these small microbrewers. With robo-advisors gaining a foothold in the investment advisory space, embracing a niche form of investing may be one route that financial advisors can embrace in order to compete against cloud-based scalable Internet technology. In a previous blog, I wrote about the challenges that a robo-advisor faces in an expensive stock market (see Benjamin Graham's Value Investing versus the Robo-Advisor). One way in which a human financial advisor can compete against disruptive technology is by embracing a non-scalable value investing strategy. Instead of lining up alongside robo-advisors at the equity index supermarket, embrace a niche investment strategy, purchasing only a small subset of stocks using a time-tested filtering criterion that outperforms its underlying index over a long time horizon.
Sterile filtration is a process whereby beer passes through a mechanical contraption and any remaining yeast or hop particles still present in the brew are removed before the beer is served to customers. This filtration process is necessary in order to avoid having "floaties" swim along the surface of an ice-cold mug of freshly brewed beer. Applying a similar filter to an equity index fund is one way in which a local financial advisor can gain a performance edge against the onslaught of robo-advisors entering his or her space.
A financial advisor who allocates a portion of his or her client's portfolio into large-cap stocks might consider a non-scalable alternative, purchasing the 10 highest dividend-yielding stocks instead of a large cap index fund. As illustrated in the chart below, the 10 highest dividend-yielding stocks of the largest 100 stocks by market cap in the S&P 500® Index outperforms the underlying index by around five percent on an annual basis.
Average Annual Return
Non-Scalable Large Stock Value Investing Strategy
1957-2003
* Highest 10 dividend-yielding stocks from largest 100 stocks in the S&P500, taken from
The Future for Investors by Jeremy J. Siegel
A similar non-scalable filter that a robo-advisor would find difficult to replicate can also be applied to the small-cap universe of stocks. An example would be to filter through the universe of small-cap stocks and purchase only the ones that pay a dividend and trade below net current asset value. Stocks trading below net current asset value represent a tiny fraction of the entire small-cap space. In The Net Current Asset Value Approach to Stock Investing, dividend-paying stocks trading below net current asset value were shown to outperform a small-cap index fund with the added benefit of less of a drawdown when stocks hit the skids.
Average Annual Return
Non-Scalable Small Stock Value Investing Strategy
1957-2003
* No more than a 10% weighting in any one dividend-paying stock trading below net current asset value.
When small-cap stocks cannot be found to meet this elite value investing criteria, advisors can leave more of the assets in cash or in a bond fund without a long-term reduction in portfolio performance. Whatever the weighting assigned to dividend-paying small-cap stocks trading below net current asset value, only about one-third of the years would be fully invested in the asset class (see chart below).
* No more than a 10% weighting in any one dividend-paying stock trading below net current asset value.
It might seem a bit restrictive for a financial advisor to follow this small-cap filtering criteria to the letter, but for the independent advisor looking to compete against a robo-advisor, the results are clear. The non-scalable value investing filters illustrated would be difficult for oversized mutual funds to implement, especially in the small-cap stock universe (see Benjamin Graham and the Financialization of Value Investing). Because index funds are the primary fodder that robo-advisors use, the filtering tools outlined above can be considered only by independent financial advisors operating at boutique advisory shops with low overhead. Limited choice in the number of dividend-paying stocks trading below net current asset value is a double-edged sword for independent financial advisors. It leads to periodic underweighting in small-cap stocks, resulting in some years where the portion of the equity portfolio lags an index fund. The highly selective filter also has an upside: providing protection against robo-advisors that can use only mega-sized exchange-traded funds or equity index mutual funds for their online client base because of the liquidity constraints that go along with their scalable business models.
Robo-advisors aren't giving away their services for free. Many of these online options typically charge a 0.5% management fee, and the expense ratio on the stock index funds in which they invest tack on another 0.2%. If an independent fee-only investment advisor charges a one percent fee for his service, the net result using the non-scalable value investing approach illustrated above can still outperform the robo-advisor alternative over the long haul even with the incremental higher fee. A client who uses a reputable fee-only financial advisor in his or her local community can achieve superior long-term performance for the equity portion of a portfolio and also have the added benefit of someone to talk to about other financial planning issues that bubble up to the surface from time to time. The advisor also benefits by having a business model that is somewhat protected against scalable technology beating a disruptive path from Silicon Valley to his or her office door.
Independent financial advisors can learn from microbrewers how to protect their practices from technological displacement. One can offer a client solution that outperforms an index fund with the added benefit of not being easily replicated by a robo-advisor that needs scalability in order to remain solvent. We are now in a world where mega-sized beer companies want to become even larger in size in a race to the bottom in terms of cost. Splashed about the financial press is the recent announcement by the King of Beers, AB InBev, that it was considering an offer to acquire another oversized brewery, SABMiller. This merger is no threat to a microbrewery that is producing an assortment of fabulous beers and serving customers with a discriminating palate who are willing to pay a little more for quality. The independent fee-only advisor can learn from these microbreweries how to maintain customer loyalty. Serving a selection of great-tasting craft beers at a slightly higher price than what a national brewery offers can be replicated in the financial service industry among independent financial advisors. By picking off the menu a limited number of non-scalable stock selection filters, a financial advisor can move his or her financial practice off the grid, fostering a climate of exclusivity for his or her clients. As financial advisors are considering new compensation structures in order to compete against robo-advisors, alternative non-scalable stock selection filters should be included as part of the discussion.
