The Paradox of Persistence: Why Underperforming Companies Still Command Capital
Navigating Institutional Inertia, Strategic Patience, and the Long Game in Global Markets
There’s something perplexing about the capital markets. You’ve seen it: companies that bleed market share, miss targets, and drag through revenue declines still manage to attract vast amounts of capital. Why do investors, including institutional players, stay stuck in these laggards? What are they seeing that we’re not? It’s a paradox that sits at the intersection of human psychology, structural factors, and—sometimes—hidden value.
The Power of Herd Behavior and Institutional Constraints
At its core, the market isn’t driven by rationality alone. There are behavioral biases that even sophisticated investors fall prey to, and one of the most pervasive is herd behavior. When major institutional players like BlackRock or Fidelity maintain large stakes in underperforming companies, it sends a powerful signal to the market. Other fund managers feel compelled to follow, fearing the reputational risk of moving against the crowd.
Career risk is often more salient than portfolio risk for many institutional investors. There’s a saying in finance that sums it up: “No one ever got fired for buying IBM.” Investors would rather underperform in a way that’s explainable and aligned with market consensus than take a risk that could be seen as reckless. This creates a perverse situation: underperforming stocks remain buoyed by institutional inertia, even when all the data suggests they should be cut loose.
Take the case of Fundsmith Equity managed by Terry Smith, one of the most celebrated fund managers of the past decade. Despite delivering remarkable returns over the long term, Fundsmith’s recent underperformance, partly due to its exclusion from high-flying sectors like AI and energy, has drawn criticism. Yet large institutions stick with him because the underlying thesis—focused on high-quality companies—is sound, even if recent market rotations favor other sectors.
Structural Factors: The Role of Size and Liquidity
Institutional investors aren’t just grappling with career risk—they’re contending with size. When you manage billions or even trillions of dollars, selling a position in an underperforming company isn’t as easy as hitting a button. For a sovereign wealth fund or pension fund, unloading a stake in a company could trigger a significant market reaction, tanking the price of the very stock you’re trying to exit.
In addition, liquidity is a key factor. Large institutions hold vast amounts of capital that need to be deployed somewhere. In bull markets, where liquidity is ample, the need to park capital often forces investors to spread money across more sectors and companies, including the underperformers. This liquidity-driven demand creates a paradox: even companies that don’t perform well continue to attract investments because the sheer size of the capital pool is too large to be focused exclusively on top performers. Index hugging, or sticking closely to market benchmarks, further entrenches this dynamic. Large-cap companies that make up significant portions of benchmarks may continue to receive capital simply because they’re too big to be ignored.
The Mirage of the Turnaround Story
Every seasoned investor knows the allure of the turnaround story. There’s something emotionally satisfying about catching a stock at its bottom, just before it stages a massive recovery. But the data paints a different, more sobering picture. Research from McKinsey indicates that fewer than 20% of corporate turnarounds succeed in delivering sustained outperformance over a five-year period.
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Onto the post
One high-profile example is General Electric (GE). For much of the last decade, GE was a case study in underperformance—debt-laden, operationally inefficient, and hemorrhaging market share. Yet, despite this, institutional investors stuck around, largely due to the company’s valuable divisions in aviation and energy. These were strategic assets that couldn’t easily be replicated, making GE a company worth holding onto despite its broader struggles.
This raises an important question for investors: how do you distinguish between a company with hidden value and one that’s simply a value trap? The line between strategic patience and outright stubbornness can be razor-thin, and it’s this nuance that often separates winners from losers.
Inertia vs. Risk Management: Why Selling Isn’t Always Easy
We’ve discussed institutional inertia and size constraints, but let’s look at this from the perspective of risk management. Large funds often manage long-horizon capital, and short-term fluctuations don’t always warrant immediate action. Selling out of a position can be costly, not only in terms of market impact but also in transaction costs and tax liabilities. Moreover, there’s the reinvestment risk—if you sell, where do you put that capital to work? In a market environment where high-quality opportunities are scarce, investors may choose to hold onto an underperformer simply because the alternatives aren’t much better.
It’s also important to note that large institutions often have mandates that require them to remain invested in certain sectors or geographies, irrespective of individual company performance. For example, ESG mandates have caused some funds to hold onto stocks in renewable energy companies, even as their performance faltered over the past three years. Renewables, once seen as the darlings of the investment world, have struggled, with the MSCI Global Alternative Energy Index declining for three consecutive years.
Yet, ESG-focused funds continue to hold these positions, hoping for a long-term rebound driven by regulatory changes and shifts in consumer behavior.
Value Traps: Recognizing When to Cut Losses
The concept of the value trap is central to this conversation. A value trap occurs when a stock appears cheap based on traditional valuation metrics, but it continues to underperform because the underlying business fundamentals are flawed. Lehman Brothers is a classic example. Even as the global financial crisis was brewing, institutional investors remained invested, convinced that the firm was undervalued relative to its peers. By the time they realized the depth of the firm’s troubles, it was too late.
Today, we see similar dynamics in sectors like retail and telecom. These industries are often viewed as ripe for a turnaround, but structural changes—such as the shift to e-commerce or the rise of alternative communication platforms—have left many legacy players struggling to stay relevant. Investors hoping for a turnaround may find themselves stuck in a slow bleed, where capital is tied up in companies that will never regain their former glory.
Narrative vs. Reality: The Tesla Effect
Finally, let’s address the role of narrative in sustaining underperforming companies. We’ve seen how powerful a compelling story can be. Tesla is a prime example. There were times when its fundamentals didn’t justify its valuation—production issues, cash burn, and growing competition were all red flags. Yet, the market bought into Elon Musk’s vision, and that belief created momentum. The same phenomenon plays out at smaller scales in less glamorous sectors. Investors hold onto underperformers because they believe in the optionalities—the idea that there’s hidden potential that will one day be unlocked.
Knowing When to Hold and When to Fold
For institutional investors, the decision to stay invested in underperforming companies is rarely black and white. It’s a complex dance between structural constraints, psychological biases, and the occasional glimmer of hope that a turnaround is just around the corner. As markets continue to evolve, the challenge is to remain flexible, knowing when strategic patience is warranted and when it’s time to cut your losses.
After all, as we’ve seen time and again, capital abhors a vacuum. If you can’t deploy it wisely, someone else will.:
I always enjoy engaging with fellow institutional investors who have their finger on the pulse of the markets. If you're interested in exchanging insights on how we're positioning and trading in today's dynamic environment, feel free to reach out at kam@amanahcapital.uk.