Invisibility Premium

Below is a short explanation why software and financial service firms seem to have outperformed the other industrial sectors over time and might be, on average, better investments than some other sectors.

It is based on the observation that both sectors produce invisible products in the sense that they only produce, store and move information which has no physical shape in itself. With some reflection on the matter, one can convince oneself that the costs associated with storing and moving information are much lower than those associated with storing and moving "real world" objects. For instance, sending an email seems to be much cheaper than sending anything - be it a letter or candies - by mail.

Now, the common sense will also tell us that if a sector has much lower costs compared to others, its profits are bound to be higher in the long run since profits are revenues minus costs.

This is exactly the story that the numbers tell us. To quantify this effect, look at the Price-to-Book (P/B), Price-to-Earnings (P/E), and Net Profit Margins of the financial services companies vis-a-vis to other industries (see References below). Interestingly, Financial Services seem to have the lowest P/B and P/E ratios (indicating that they are relatively undervalued) while also having the highest net profit margins compared to other sectors.

Also, notice that the financial services industry has the highest combined market cap of all sectors (see References below), indicating they have exhibited the highest growth rates over history, for to grow to be the largest, they must have. Mind you that, money and banks as such were relatively late invention in human history compared to some other activities such as agriculture. And if you think banking - the business of trading trust in a standardised manner - is not novel, you must agree that innovations such as financial securities and derivative instruments are little newer than many of the other everyday activities we perform.

The story with software companies is not as clear since they have a higher failure rate and higher sales costs, espcially in the enterprise software market, but they do share one thing in common with financial services firms - they only produce, move and store information, and no physical objects.

What is the significance of this finding? In short, it is that if you invest in the stock market, you are better off holding more rather than less stock in the financial services companies.

But why would people, on average, still prefer to invest more in non-financial - or what can be "brick-and-mortar" - companies despite the relatively low earnings compared to the stock prices of these companies, as indicated by high P/E and P/B ratios? Because such companies produce "visible" products, or "household-name brands", and we are psychologically more inclined to invest in companies that produce things that we see, understand and can easily identify with. Such things include cars, energy, and retail goods that are constantly visible in our everyday experience. In contrast, fewer people understand what, say, investment banks do, nor can a retail investor from the street easily identify with what they "produce". As a result, one could argue the stock price performance of such companies tends to have an "invisibility premium" over time.

References

Yahoo Sector Browser