Like many, I have benefitted from index fund investing. Paraphrasing Charlie Munger, the diversification provided by an ETF tracking the S&P500 served as a useful protection against my ignorance at the time. I believed in the broader growth of the US public market but did not know which companies would win. A successful decade in VOO and ITOT had me convinced of the index fund strategy. Recent re-reading of value investing texts pushes me to ask if these returns simply reflect an unusually positive period for US equities. Today, while index funds continue to offer retail investors value, I have become less convinced that indexing will outperform informed security selection for me.
Passive index fund investing typically does not depend on valuation. As passive ownership grows, we must ask whether securities not commonly purchased by index funds are undervalued. Many such securities also have smaller market caps, with lower liquidity, institutional participation, and analyst coverage creating potential mispricing. Index funds still serve a purpose for some, but investors with deep business knowledge in specific niches could find opportunities to perform better.
Larger companies do have advantages that cannot be easily achieved by smaller companies, such as economies of scale. However, this is often paired with organizational inefficiencies that enable smaller companies to win in specific industries. In recognition of this seeming contradiction, my goal was to identify an industry satisfying the following conditions:
Smaller companies are not at a disadvantage solely due to their size and can effectively compete with larger companies if run well
When they win, smaller companies have the potential for rapid growth, which would correspond to outsized investment returns
Specialized knowledge can materially improve the accuracy of revenue stream predictions
Companies operating in the life sciences, including biopharmaceuticals, medical devices, and biotechs, satisfy these conditions. Furthermore, the complexity of these businesses may discourage generalist investors, preserving mispricing opportunities for those with expertise. Of note, life sciences companies have a durable value proposition, even in an era of LLMs, since demand for improved health outcomes will not disappear. Even if the method by which they develop and commercialize products evolves, people will continue paying for better health.