Machiavellian Investing, Part 3 – Picking Winners and Losers

May 29, 2011

Last week’s blog described several trends that will likely influence the success of investment opportunities to a far greater degree than the actions of corporate management.  This week I will look at the implications of those trends for investment strategy.  That strategy has two main principles: invest skeptically and favor well positioned companies.

Invest Skeptically

Favor Small and mid-cap stocks

Owing to the hijacking of big corporations and the fraud plagued U.S. economy, small and mid-cap stocks will probably outperform large-cap stocks. These smaller firms will have the agility and motivation to respond to the new trends and opportunities.   In contrast, large cap firms even when they are doing well, have substantial hidden risks.  Executives may operate these companies in their own short-term best interests at the expense of the long term best interests of the shareholders.    Consequently, we must suspect that these large cap firms may under invest in development and may take on too much risk.  

This does not mean avoid large cap stocks.  However, if you consider a large cap stock you must actively eliminate the possibility that the company looks good but is actually being run into the ground.

Avoid High-price Stocks

Do not pay a premium for fashionable or recommended stocks.  A high price to earnings (PE) ratio relative to the industry is very likely to indicate, not a good investment, but merely a good story.  At best the story may be simply fashionable buzz.   However, because of the pervasive fraud in the American financial system, there is substantial risk that a good story may also be the work of Wall Street promoters who are selling greedy investors the next big bogus investment. 

Well Positioned Companies

The following groups of companies are well positioned to benefit from virtual slave labor, accelerating trade, continuing devaluation of the U.S. dollar, and high cost energy.

U.S. Brand Resellers

Businesses that buy goods at virtual slave labor prices and sell them at luxury goods prices should be highly profitable.     Top American brands will also benefit from the ongoing devaluation in the U.S. dollar. 

Examples:

Aeropostale Inc Common Stock (ARO)

Urban Outfitters, Inc. (URBN)

Hard Assets

As the value of the American dollar disintegrates under the burden of debt, the dollar value of basic materials will increase dramatically.  At the same time, supplies of basic materials will remain under pressure for many years as India and China develop their infrastructure and manufacturing base.  American, Canadian, and Australian materials companies should prove very attractive because they will remain safer investments than companies that are located in unstable countries where there is a greater risk of fraud and government intervention.

Example: Silver Standard Resources, Inc (SSRI)

Integrated Value-added Manufacturing

Developing Asian economies lack the infrastructure for manufacturing products that require layers of subcontractors and a network of tightly integrated manufacturing processes.  In addition, knowledge workers will prefer to live in developed economies.  As social unrest grips the third world, Europe and the U.S. will become the preferred places to produce complex, highly engineered products. 

Integrated value-added manufacturing companies also stand to benefit dramatically from any declines in the U.S. dollar.  Any dollar crisis could breathe new life into several sectors.  American semiconductor businesses are obvious beneficiaries.  Medical equipment manufactures stand to benefit not only from the weak dollar but also from de facto subsidies provided by American University research and by America’s uniquely high cost medical delivery system.

Look for companies that (A) make highly engineered products with a high information content, (B) benefit from an efficient transportation, financial, and information infrastructure (C) export worldwide and can therefore benefit from the weakening dollar.

Examples:

Regal Beloit Corporation Common (RBC)

Enersys Common Stock (ENS )

Oshkosh Corporation Common (OSK ) – I own stock in this company

AngioDynamics, Inc. (ANGO) – I own stock in this company

Biotech

The American biotech industry is well positioned to take advantage of technical and political trends.  Biotech companies benefit from two external resources: the American university system, and government funding of medical research, such as the Human Genome Project.  State governments subsidize the American university system and the Federal Government subsidizes much of the research, which biotech companies can leverage into products.  The university system constitutes a huge shared virtual laboratory for small and midsized biotech companies. 

From the perspective of a skeptical, Machiavellian investor, biotech companies are ideal.  The regulatory filings process makes the biotech product development process transparent to the investor to a degree found in no other industry.   

Finally, biotech company products are patentable.  Patent protection gives these companies a unique asset, a legal monopoly that is transferrable.  Biotech startups can convert their research into cash much more quickly than can any other startup.  

Examples:

Momenta Pharmaceuticals, Inc. (MNTA )

ViroPharma Incorporated (VPHM) – I own stock in this company.

Energy Saving Technology

Energy saving technology is attractive for three reasons.  (1) It requires no change in the energy exploration, producing, or marketing infrastructure.  (2) The energy production process is very inefficient.  Saving the energy equivalent of 1 gallon of gas at the point of use (e.g. the wheels of a car or the room that is heated or illuminated) saves the energy equivalent of 10 gallons of gas in the ground. (3) Energy saving devices may be eligible for patent protection.

Examples

Ameresco, Inc Class A Common St (AMRC)

Orion Energy Systems, Inc. (OESX) – I own stock in this company.

Alternatives to Oil

We may be able to power our cars by electricity or hydrogen (from electrolysis of water), but these options are impractical because they require a massive change in the producing, distribution, and marketing infrastructure.  Electric cars would require a complete retooling of the auto industry.  Hydrogen fueled cars would also require retooling of the fuel distribution infrastructure.  Normal economic forces cannot induce this sort of revolutionary change.  There is no evolutionary development path from today’s auto and oil economy to an electric or hydrogen economy. 

The oil price will rise to the level of the next cheapest substitute. This will guarantee that some alternative fuel technology will succeed.  The following two technologies can develop through incremental changes to the existing infrastructure.

Marginal Sources of oil

Major oil and gas companies are already investing heavily in land and facilities to produce oil from oil sands in Canada, and from the oil shale in the western U.S. 

In addition, exploration companies are developing shale oil deposits in the continental U.S.  Oil in shale is tightly packed and extracting it requires fracking, a technique currently used to extract natural gas from shale.  Fracking involves drilling down (through the water table), and then horizontally into the shale bed.  As the well is drilled the fracking process uses controlled explosions to blast holes in the pipe and into the rock.  Then drillers force slurry under high pressure through the holes to produce fractures between the rock layers and to hold them open.   Oil then flows through the fractures into the well.

There is risk that once disrupted by fracking, the oil and gas trapped in the shale may rise and contaminate the water table. However, the political power of the major oil companies will likely be sufficient to overcome environmental objections and to develop needed road and rail connections. 

Example:

Suncor Energy Inc. (SU ) – I own stock in this company

Chesapeake Energy Corporation (CHK) – I own stock in this company

Ethanol

Ethanol is promising for two unrelated but important reasons. 

First, the U.S. farm lobby is very powerful on a state and national level. Ethanol qualifies as an alternative fuel (eligible for federal subsidies).  Most farm states have local programs that encourage ethanol production and provide incentives for filling stations to install ethanol pumps. 

Second, biotechnology has every incentive to produce genetically engineered plants for feed stocks and enzymes that can digest a wide variety of plant materials (containing cellulose) into starch or directly into sugar.  The economics of corn ethanol are only marginally viable, but genetic engineering should be viable in the next few years.

There are no good examples of ethanol stocks, but I will be keeping an eye on enzyme technology.

Energy Efficient Transportation

High velocity trade will strain transportation systems as (A) raw materials flow into the third world (B) cheap (labor-intensive and knowledge-intensive) products flow into developed economies, and (C) importers will struggle against high energy costs to distribute these goods in their own countries. These trends will favor modes of transport that are inherently fuel-efficient.

Ship

Ship companies that transport bulk raw materials should do will in the long run.  However, at the moment shipping supply seems to have outstripped demand.  I will be looking for a good entry point in the following.

Examples:

Navios Maritime Holdings Inc. (NM ) – I own stock in this company.

Frontline Ltd. Ordinary Shares (FRO) – I own stock in this company.

Rail

Rail freight rates are already climbing and capacity is tight. In addition, coal fired electricity generators need as much as a trainload of coal per day.  Rail companies that own rights of way should be able to add capacity at a small marginal cost and enjoy years of profitability.  Goods, especially food, will flow from the Midwest by rail to the Eastern U.S. where it will be shipped to Asia. The big rail company stocks have been “picked over”, but I think the suppliers to the rail industry may offer some good opportunities.

Example:

Westinghouse Air Brake Technology (WAB )

Bus

Europe has an excellent rail system, because in Europe (especially France and Germany), railroads were a military asset.  The U.S. has not had a similar need to move troops rapidly inside its borders.  In addition, because of its sparse population, rail has less economic value for public transport than it does in Europe. 

However, during World War II, trucks played a critical role in military supply operations.  After the war, President Eisenhower and the Congress found it easy to agree to build the U.S. Interstate Highway system.  This effort has left the U.S. with an extraordinary road infrastructure, which is underused as an asset for mass transit.  We are already seeing a proliferation of special purpose bus operations and we can expect to see more of this as fuel prices remain high.

Examples:

Stagecoach Group Plc (SGC)

New Flyer Industries Inc. (NFI-UN.TO)

Azure Dynamics Corp. (AZD.TO)

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