Investors are faced with a tough choice when investing in newer stocks. On the one hand, there are incredible new opportunities with innovative companies. But on the other hand, these companies are approaching face-melting valuations not seen since the dot-com bubble. Thankfully there is a way to jump onto an emerging trend without taking the risk of investing in a possibly overvalued company. The strategy, called pick and shovel investing, ironically doesn’t come from the world of investments at all and is over 150 years old.
To understand how modern-day investors can use the pick and shovel strategy to protect and grow their wealth, we have to go back to a humble denim inventor.
The Connection Between Shovels and Investing
When we talk about jeans, there are a few brands that have become synonymous with the clothing. Chief among them is Levi’s Jeans.
However, the eponymous Levi actually made his fortune in the Gold Rush. The son of a merchant immigrant family in New York, a young Levi Stauss saw the huge influx of people and trade into California in the 1840s. Seeing an opportunity, he set off on his own to the West Coast.
Levi set up shop in San Francisco. He noticed that miners would come in daily to ask for the same excavating tools. Levi understood the demand and the opportunity and proceeded to buy these vital supplies en masse. He then went from mining camp to mining camp selling his wares directly to miners in need.
Levi Strauss was making a fortune supplying but saw that the Gold Rush was coming to an end. He decided to take his profits and reinvest them into a particular product that sold well: denim pants. The rest is history.
The principle behind Levi’s strategy is, coincidentally, a great investing framework. At the end of the day, when you purchase a company’s shares, you are buying a piece of its business and profiting while they do the work.
What Is a Pick and Shovel Play?
Taking a cue from Levi, we can mold his strategy into one that works with stock investing. Essentially, the pick and shovel investment strategy involve finding a major trend taking shape — in Levi’s case, it was the California Gold Rush — and investing in the businesses that are essential to the supply chain of that trend. This could be any business selling key ancillary products, or services to industries that are taking part in the trend. Going back to Levi, those products were pickaxes, shovels, and hard-wearing jeans.
When a big trend is underway, a flood of money and competitors start vying to dominate the market. As an investor, it’s like a game of roulette trying to figure out who will come out on top (you can also think of Yahoo and Google in the early days of the search engine game).
Investors could take a diversified approach and invest in all of these companies, but this essentially guarantees that you will see losses on some of your positions — some of which will be permanent. The pick and shovel play allows investors to take part in the upside of a trend while hopefully minimizing its risk.
However, supplier businesses generally work with all the major competitors. If one major competitor goes bankrupt, the supplier business still has others to supply to. This greatly minimizes the risk for an investor deciding which company to back. Rather than guessing which business will come out on top, why not bet on the company all the competitors rely on?
In addition, most of the attention is on major competitors during an emerging trend. Many of these “supplier” businesses are undervalued in relation to the big names of the trend. This undervaluation provides another layer of downside protection and a larger margin of safety.
How Pick and Shovel Investing Works
Now we can start putting together an actionable plan on how to find picks and shovel investments.
1. Identify the Trend
The most important part of this strategy is finding the right trend. If the trend you’re investigating doesn’t have a big economic impact, there might not be enough money going into it to make it worth your while. Think back to Levi and the California Gold Rush: this was a national phenomenon attracting people from around the world to the far reaches of California. It was also a trend where big fortunes were made. If there isn’t a lot of money in a trend, then there won’t be that much demand for suppliers to keep that trend going.
We will get into concrete examples later in this article, but some examples of recent trends include 5G and electric vehicles.
2. Identify Market Leaders
Once you have found a large, market-moving trend, you want to identify the market leaders in that niche. Pull up any investing website and either search the trend itself or look into the sub-categories and see who the largest players are. For some trends, the players are so visible that everyone knows them – in the mobile phone space, everyone knows Apple and Samsung, along with others such as LG and Huawei.
3. Learn Which Products Are Essential to Those Businesses
Once you have identified market leaders in the field, focus on the products that they are selling. Then, ask yourself what is essential to this product. Is there something that the company would not be able to produce its product without it? For Apple, it’s chips for their phones and computers. For Tesla, it is clearly the battery. Remember that you are not looking for the company’s secret sauce, but rather its essential component.
4. Research the Companies That Make Those Essential Products
From there, do a little digging and find who is providing that essential component. Continuing on from our Apple example, one of the key providers of chips in Apple smartphones is a company called. For Tesla, its batteries rely on Cobalt, so you could find the largest Cobalt miners in the world. As a bonus and a really bullish sign: If all the major competitors share the same supplier of an essential component, you know you have found a well-protected supplier.
Congratulations: You have just found your pick and shovel investments. Now it’s time to invest in the stock, which you can do with one of our recommended stock brokers like TD Ameritrade or E*TRADE. Remember that with all investments, it’s usually best to take a diversified approach, either within a trend or within multiple trends if you really want to cover all your bases.
Examples of Pick and Shovel Businesses
We have alluded to some of these before, but some of these examples should spark your own thinking and lead you to find your own unique pick and shovel businesses.
- While smartphone chipmakers were mentioned above, the chip-making and semiconductor industry is booming. Some areas are more mature than others, so you want to find the subcategory that is really drawing money and attention right now. A lot of hype is going on around the areas of AI and the Internet of Things. Both of these niches require specialized chips that may only be serviced by a few providers.
- Another trend underway is that the average age of the population in Western countries is aging. This is going to have huge impacts on not only the economy as the biggest spenders enter retirement, but also on policy-making in regards to pensions and healthcare.The boom in older people is likely to lead to a huge demand for retirement facilities and other specialized healthcare services for the elderly. There is little guesswork in this demand because we have the data right now.
- Another more unorthodox way to play on the Levi Strauss investment approach is to keep your eyes and ears open to news of a relatively poor geographic location that has recently discovered a resource such as oil, gold or natural gas. Then start to look for regional companies, real estate or even private businesses that stand to benefit from the influx of cash into the area. This prospecting takes things back to the root of what Levi did during the Gold Rush.
The Pros and Cons of Pick and Shovel Investing
Unfortunately, as the old Wall Street saying goes, there is no such thing as a free lunch. If this strategy was foolproof then everyone would be doing it. Let’s look at the risks, as well as the rewards, of this type of investing strategy.
- Smaller companies are often overlooked and undervalued: Depending on the trend, most of the investment focus will be on the big brand names. This means that smaller companies supplying the trend are often overlooked and undervalued, while other players will be going through a period of overvaluation.
- Undervalued companies have much more downside protection and upside potential: This gives investors a huge benefit, especially as the trend matures and the big money starts looking into all the companies associated with the trend.
- More risk protection: If the superstar of the trend happens to go down over a scandal or some other black swan event, these individual businesses are more likely to survive. The trend will exist with or without a single competitor. The demand for the supplier of that trend won’t disappear either.
- Hindsight is always 20/20: It’s hard to know whether a certain trend has long-term potential. Sometimes, the most unlikely trend ends up being the one with the greatest longevity. Likewise, trends that seemed poised to revolutionize the world can have interest suddenly evaporate due to successive failures or simply a more interesting trend emerging. The risk of choosing the wrong trend is ever-present.
- Choosing the wrong company: These supplier companies are almost always much smaller than the corporate behemoths they service. They also sometimes have a dangerous reliance on continuing sales to these corporations. If a company decides to switch suppliers, it could spell disaster for your supplier company. That is why diversification is so important. And why you should be extra careful to choose companies that don’t have their revenues concentrated in a couple of big customers.
There Is Nothing New Under the Sun
Many of the oldest principles of investing still stand strong today despite the world changing so much in just 100 years. This strategy is another example of that. Due to t timeless principles, which were created as a business strategy, Levi’s picks and shovels investing strategy can offer a great margin of safety for investors. It can also simplify the decision of which stocks to pick among dozens of competitors. Just remember that any type of investing carries a lot of risk and make sure to diversify your holdings.
Written by Isaac Aydelman.
View the original article at here.