Mark Twain’s wisdom that “during the gold rush it’s a good time to be in the pick and shovel business” remains true to this day, but there’s a catch.

During the gold rushes of the 1840s and 1850s in California and Australia, traders selling picks and shovels did a roaring business as prospectors sought riches. There was no guarantee a prospector would find gold, yet traders selling picks and shovels made money on much lower risks.

The principles behind a “picks and shovels” approach are simple, and can apply to any sector. The goal is to improve the risk-reward equation on an investment idea.

Fundamentally, it involves examining a particular industry’s supply chain, particularly in sectors that could be overvalued or have higher than desired risk factors. There are no guarantees a gold prospector may strike gold, but a trade in a pick or shovel is almost always present while there’s prospecting for gold. In modern investing, this means buying stocks that provide the tools or services an industry uses to produce output, instead of in the output itself.

Resources boom

In the early 2000s, when Australia was experiencing its last resources boom, this investment approach was widely adopted. Investors could choose to invest in resource companies such as BHP, Rio Tinto or OzMinerals. Or they could choose firms servicing these resources companies.

Monadelphous was a prime beneficiary of Rio Tinto’s mine expansion program and the large LNG developments off the North West Shelf. WorleyParsons consulted and managed global oil and gas projects but never took on the risk of owning such projects. Imdex, a drilling fluids and down-hole instrumentation provider, saw strong demand for its equipment as exploration activities ballooned. Technology has grown significantly in the past decade and investors can choose to invest in globally recognisable companies such as Amazon, Google and Microsoft. But just like mining companies, technology firms don’t operate as singular entities. Whole eco-systems evolve around these companies and a supply chain exists around them.
Appen, a company we own in our portfolios, could be considered a company supplying picks and shovels to tech giants Google and Microsoft. Appen is a leading provider of datasets (speech, text and image), which clients such as Microsoft use to enable machine learning and artificial intelligence/cognitive systems.

In our daily lives, we would use these systems via search engines or speech engines. Appen’s datasets help power algorithms for the leading speech recognition, translation and synthesis technologies. As search and speech functionalities grow, demand for Appen’s services should grow in tandem.

Eyes in focus

Growth in technology is also changing our environment. Smart phone use has exploded, we have multiple TVs or screens at work and at home. We spend an increasing amount of time looking at
screens, which also increases exposure to harmful blue light and risk of myopia. Our eyesight is deteriorating at a faster rate than we have experienced in history. In this instance, we have identified a global trend, which is in fact a problem, and have identified a company that supplies an everyday, practical solution to that problem.

The Italian company Essilor-Luxottica is a global leader in lenses. Essilor-Luxottica supplies 41 per cent of the world’s prescription lenses and 25 per cent of the world’s lenses, which makes it likely that if you are wearing prescriptive lenses they would be supplied by Essilor-Luxottica.

Does the “picks and shovels” approach sound like easy money? Unfortunately for investors, there is a catch: the picks and shovels approach doesn’t always work.

One example is Australia’s supermarket sector, where Coles and Woolworths dominate a concentrated sector. History has shown being a supplier to these supermarkets is not easy. Their
dominance gives them an upper hand regarding terms, conditions and pricing.

When Coles and Woolworths ramped up their emphasis on private label baked goods a few years ago, Goodman Fielder, a major supplier of baked goods, suffered significantly from declining sales and lower margins due to reduced prices.

Milk rivalry

This strategy hasn’t worked in the dairy sector either. Consider A2 Milk and Synlait Milk. Synlait is a New Zealand-listed company and a key supplier to A2 Milk. This makes Synlait a great
alternative to investing in A2 Milk’s successful growth profile, at what seems like a cheaper price (Synlait trades at about half of A2 Milk’s price-to-earnings ratio multiple). A year ago A2 Milk and
Synlait Milk’s share price was broadly similar, $10.00 and $10.27 respectively. Today A2 Milk’s share price is $16.56 while Synlait is trading at $9.40. A2 Milk’s share price has appreciated 65 per
cent, but Synlait has declined nearly 10 per cent.

What happened?

In our view, despite Synlait Milk being a key supplier to A2 Milk, the company is carrying the higher risk profile between the two companies. Synlait has incurred capital to build manufacturing facilities and source new customers to fill new capacity. Perhaps more importantly, A2 Milk carries a larger proportion of the bargaining position between the two firms.
The picks and shovels approach is a useful framework to start thinking about industries, supply chains and risks-rewards. It opens up potential opportunities vertically and laterally.

But it is also a useful framework to examine where risks lie, particularly in sectors where the balance of power may be unevenly balanced to one side.

This article was originally published in the Financial Review on July 30,2019. ST Wong is chief investment officer of Prime Value Asset Management

Source – https://www.afr.com/wealth/personal-finance/where-are-today-s-picks-and-shovels-companies-20190729-p52but

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