Sometimes, the Greatest Risk Is the One Not Taken

The most important date investors don't remember... 'What would Merrill Lynch do?'... The four stages of disruptive innovation... The most disruptive innovation of our lifetime is still emerging... It could turn $500 into $20,000 – or a lot more... Sometimes, the greatest risk is the one not taken...

If the last week reminded us of anything, it's that risk always exists in the markets...

The S&P 500 entered correction territory in only six days – the fastest that has ever happened. Despite bouncing back some today, the benchmark stock index remains down around 9% from its all-time high on February 19.

That's a wild short-term drop... Panic-selling was set off by fears about the coronavirus that has spread to new pockets of the globe outside Southeast Asia, including here in the U.S.

Over the weekend, officials confirmed two deaths from the virus in Washington state and new infections in Oregon, California, Illinois, New York, Florida, and Rhode Island.

Hopefully, as my colleague and Extreme Value editor Dan Ferris discussed in Friday's Digest, you've remained disciplined (adhering to your trailing stops, for instance) and kept the long term in mind. As Dan wrote on Friday – and I (Mike Barrett) agree...

If you use trailing stops and you hit your stops, there's no reason not to sell. If you don't hit your stops, there's no reason not to keep holding. And on the other hand... if you find an attractive stock that meets all your investment criteria, trust your analysis and buy it.

An investment strategy that works is like a contract you make with yourself... One of the most important reasons you make this contract – practicing good risk controls – is to handle big sell-offs like this one. Breaking it now would be a tragic error.

Despite the recent sell-off, we continue to stay dedicated to our long-term perspective...

That means adhering to proper portfolio allocation, position sizing, risk management... and, in my case, unearthing value where I see it and passing the opportunity on to readers.

We do that in a few ways... As I showed in my January 2 Digest on the three warning signs of the next Great Depression, one important method is to look at the past... because history doesn't repeat, but it often rhymes.

We can't predict the future, of course, but we can identify common dynamics that play out over and over again... And in today's Digest, I want to talk about one of these themes in particular – and how we've used our knowledge of it to spot a potentially lucrative return... even amid these rocky times in the market.

You see, May 1, 1975 – 'May Day' – was a momentous day in U.S. financial history...

And yet, most investors don't have a clue why. But May Day is important for a couple of reasons...

For one, the road to commission-free stock trades originated from this day.

And second, the series of events that happened before, on, and after that date provide a blueprint for identifying lucrative investments in the "innovators" and "disruptors" on Wall Street... before everyone else knows about them.

The names involved in the story might surprise you...

Almost 45 years ago, the New York Stock Exchange's board of governors abolished fixed-rate brokerage commissions...

To fully appreciate this stunning move, note that fixed commission rates had been the norm on the exchange for 183 years – almost as long as America had been an independent nation.

Outsized, fixed-rate brokerage commissions – typically about 3% for stocks and 8% for mutual funds – were a gravy train for big stockbrokers like Merrill Lynch back in the 1960s and early 1970s. Their cost to broker a trade was basically the same, whether it involved 100 or 100,000 shares.

The cost of doing business was low and stable, so fixed commissions provided an enormous incentive to brokers to pursue the largest trades they could... For instance, a $5,000 trade was worth about $150 in commissions (3% of $5,000), but a $50,000 trade was worth 10 times more, or $1,500 (3% of $50,000).

With institutional investors accounting for 75% of trading activity, brokers naturally focused their efforts on this group, rather than smaller mom-and-pop individual investors.

The gravy train came to a screeching halt on May Day 1975, despite Wall Street's best efforts to forestall it...

Morgan Stanley (MS) President Robert Baldwin warned that deregulating commissions would turn into a real "mayday," and result in at least 200 investment banks eventually folding.

That wasn't right... A year later, only nine had closed their doors for good.

Wayne Wagner was a partner with management firm Wilshire Associates at the time. And as he told the Wall Street Journal's Jason Zweig in a 2015 column...

The boys in the club, they fought [deregulation] like hell. They pulled out everything they could think of to try to short-circuit the change.

Charles 'Chuck' Schwab was one of the little guys on Wall Street in 1975...

And he sensed deregulation would create a massive opportunity for his upstart firm.

In his latest book, Invested, Schwab recalls taking the elevator up to his small San Francisco office on the morning of April 30, 1975, with only one thing on his mind...

What would Merrill Lynch do?

He didn't have to wait long to find out. The front page of the Wall Street Journal that morning said, "Merrill Lynch will raise securities brokerage fees on most transactions under $5,000."

Schwab had been deeply concerned "the undisputed king of retail brokerage" was going to lower commissions for its smaller customers and steal the opportunity he saw.

Everyone was telling him to get ready.

In Schwab's book, he recalls receiving warnings like, "Wait until Merrill Lynch decides to go into your business" (i.e., serving the smaller individual investor)... "You are going to be crushed."

Instead, Merrill Lynch saw deregulation as an opportunity to lower commissions on its bread-and-butter clients – the institutions placing large block trades – and make up the lost revenue by raising rates on its less important, smaller clients.

Merrill Lynch's surprising move played right into Schwab's hands...

I thought if I could strip away all the fluff surrounding the purchase and sale of stocks – the tainted research, the bogus analysis, the flimsy recommendations, all the ways that Wall Street had historically justified high commissions – and sell just the plain vanilla service of executing trades, I could slash overhead, focus on efficiency, cut prices dramatically – by as much as 75% – and still make a profit.

The meager business Schwab started in 1971 is now the world's largest publicly traded broker, with roughly $4 trillion in assets under management ("AUM"). That will rise to $5 trillion in AUM later this year when its purchase of TD Ameritrade (AMTD) closes.

Meanwhile, Merrill Lynch wouldn't have survived the Great Recession in 2008 had Bank of America (BAC) not acquired it. And today, the bank's wealth-management division, including the former Merrill Lynch, handles one-third the assets Schwab does.

Last year, as part of a major rebranding effort, Bank of America even decided to drop the Merrill Lynch name from some of its businesses.

How did this happen?

How was the 'undisputed king' of Wall Street displaced by a puny upstart it could've easily crushed?

For the answer, we'll turn to the preeminent authority on disruptive innovation, the late Clayton Christensen. (He just passed away in late January.)

In a 2011 poll, thousands of executives, consultants, and business-school professors named Christensen the most influential business thinker in the world.

The Economist has also named Christensen's The Innovator's Dilemma one of the six most important business books ever written.

Christensen saw "disruption" as the process whereby a smaller firm with fewer resources eventually and successfully challenges the well-established incumbent.

The process typically unfolds in several stages, beginning as a small-scale experiment focused on getting the business model right.

This was certainly the case with Schwab's foray into the discount-brokerage business. Four decades ago, he suspected there was a huge market of individual investors who would be attracted to low-cost services.

But the actual concept had yet to be tested. After all, commission rates had been fixed for almost 200 years.

The incumbent market leader, meanwhile, is naturally focused on improving the products and services in greatest demand by its most profitable customers.

Ironically, this is precisely where the seeds of its future disruption are sown.

By focusing so intently on this core group of customers, the incumbent ignores the needs of its other clients...

Disruptors successfully target these overlooked customers. They gain a foothold by offering an acceptable substitute, often at a lower price.

Remember, on May Day 1975, the incumbent Merrill Lynch lowered commission rates for its largest customers, but raised them for smaller individual investors.

Schwab, in sharp contrast, immediately lowered its rates to appeal directly to this neglected Merrill Lynch customer segment.

Incumbents become market leaders over time by listening intently to their core customers.

But Christensen found that this strategy often became "institutionalized in internal processes," making it very difficult for managers to pivot toward a disruptor's competitive assault.

Beth Comstock, former vice chair of international conglomerate General Electric (GE), uses a swimming analogy to make the same point...

In her view, most CEOs want to embrace the new direction that innovative competitors are pushing their enterprises toward. The problem is, their employees aren't prepared to learn new swim strokes, nor are they ready to perform them in new swim lanes.

This explains why incumbents don't tend to respond vigorously, if at all, to new competitive pressure...

Their priorities are elsewhere.

Merrill Lynch, for instance, had a very lucrative business that relied on thousands of brokers touting hot stocks, investment bankers pitching deals, and analysts creating reams of research.

This is what its customers demanded. And after May Day, Merrill Lynch was more committed than ever to delivering it. It couldn't be bothered by the Schwabs of the world... until it was too late.

Having secured a less-important slice of the incumbent's market, disruptors then go for the jugular...

They move "upmarket" into their competition's core customer base. They do it by delivering product and service performance that the incumbents' mainstream customers expect, without compromising the advantages that created their early success.

In other words, disruptors gradually improve the value of their offerings until they're capable of garnering wide market appeal at cheaper prices.

This is precisely how Charles Schwab (SCHW) went from a West Coast nobody to the largest publicly held brokerage: providing more and more value at lower and lower prices.

Last fall, Schwab brought the deregulation launched on May Day 1975 to its logical but slow conclusion... with the announcement that it was eliminating its commissions for online stock trades. All other discount brokers at this point have done the same thing.

The point is this...

Getting in early on disruptive innovators and holding them long term can create massive wealth...

Charles Schwab didn't go public until 1987, 12 years after deregulation... yet the company's share price is still up more than 300-fold today.

Over the same period, the S&P 500 is up about 13 times.

In other words, early buy-and-hold Schwab investors have made nearly 25 times more money than if they had simply bought an S&P 500 index fund.

So where are the next innovators lurking?

Dan and I recently recommended what may be one of the most disruptive innovations of our lifetimes...

We shared all the details in the February issue of Extreme Value. Most important, this idea is tracking the same life cycle as other disruptive innovations...

It started as a small experiment... It has been derided for years by entrenched incumbents who have been slow to respond... And now, it's beginning to move "upmarket," as evidenced by the growing amount of capital (and attention) it's attracting.

Disruptive innovations are inherently volatile investments. That's because most market participants aren't sure the disruption will ever work out.

The takeaway, though, is that by the time an innovative technology or company becomes a surer thing, it's too late. The biggest returns have already been earned by more adventurous investors... like anyone who may have backed Charles Schwab way back when.

Let's be clear: Betting on disruptors is not without risk...

We acknowledge that. You don't often hear about the failures of companies that never make the big time.

In fact, Dan acknowledges that our most recent pick is "by far the most controversial recommendation I have ever made since I first became a professional analyst in December 1997."

We're not saying you should throw your entire portfolio into this investment. Not by a long shot. Remember what we said about proper allocations and position sizing...

Last month, we urged subscribers to only invest an amount of money so small, losing 100% of it wouldn't matter to you.

That's the risk we're willing to take for the substantial reward we hope to realize...

That's because today, even if this disruptive innovation we're talking about only achieves a fraction of its potential, which we detail in the issue, we think it could turn $500 into $20,000 or more. As Dan writes in our latest issue of Extreme Value...

What you're about to read is my take on one of the most asymmetrical risk-reward setups of my lifetime, with a reward potentially hundreds of times bigger than the risk.

I'll show you how to keep your bet so tiny, you can safely forget you own this asset... and how that tiny amount of money could generate a fortune over the long term.

Sometimes, the greatest risk is the one not taken. And as we told our subscribers last month, we think this is one of those rare times.

If you don't already subscribe to Extreme Value, click here to learn about how to join today... and get all the details on this great innovation we've identified, how to trade it, and why it could deliver potentially life-changing returns.

New 52-week highs (as of 2/28/20): iShares 1-3 Year Treasury Bond Fund (SHY), ProShares Ultra 20+ Year Treasury Fund (UBT), Vanguard Inflation-Protected Securities Fund (VIPSX), and Vanguard Short-Term Inflation-Protected Securities Index Fund (VTIP).

In today's mailbag, two subscribers appreciate the words of wisdom in Dan's Friday Digest. As always, e-mail us your comments and questions to feedback@stansberryresearch.com.

"This is one of the best opinion articles I've ever read. Great advice in a market that has gone bonkers. I've been an investor, mostly private (VC) for 30 years. The public domain for only five years. I got a lot of great nuggets of wisdom from your article, Dan. Thank you." – Paid-up subscriber M.S.

"As usual, I appreciate your astute analysis. I'm hoping you will be folding in the historic danger from debt in all the investment domains. I believe the high-wire act most governments, companies and investors have been doing will be unhinged if the virus persists and grows." – Paid-up subscriber Dean M.

Regards,

Mike Barrett
Orlando, Florida
March 2, 2020