finding the focus

One of the most creative (and successful) investors I’ve ever encountered–and, luckily for me, one of my earliest mentors–gave me this example of his investment style:

Suppose, he said, Washington has decided to stimulate the economy and we’re in the early days of a nationwide road building boom.  What stocks do you buy?

–Your first inclination is to look at construction companies.  That’s what most people buy.  But they’re usually conglomerates, with significant non-public works subsidiaries. There are also lots of them.   It’s difficult to predict who will get contracts and how profitable they will be.

–Your next thought is probably construction materials, like cement or asphalt.  Certainly, roadbuilding will require lots of that stuff.  But the same problem arises here, on a smaller scale–determining who, among many possible suppliers, gets the contracts and how important they are for the overall profits.  One extra quirk:  the low value-added nature of construction materials and their high weight (meaning big transportation costs) make individual plant locations crucial.  Figuring that out is especially hard.

My friend’s answer?  …cement trucks.  Buy stock in the one or two companies whose main business is making cement trucks.  No matter who gets the government construction contracts, no matter which suppliers they choose, they’ll need to transport cement to the construction sites.  As orders build, they’ll have to upgrade their truck fleets.  Large-scale contracts also mean large-scale upgrades.  That’s where the economic energy from the government road building program is going to be focused.

cascades of energy…

This is absolutely right, in my opinion.  It’s Levy Strauss selling blue jeans to Gold Rush miners all over again.

To recap, the surest and safest way to play any economic phenomenon is to find, if you can:

–the sole supplier

–of an essential component

–whose price makes up a very small cost in the creation of the ultimate end product made or sold.

This most likely means that buyers of the component will be much more concerned with the quality of the component than the price.  So the component maker should be able to make unusually high profits.

In my experience, I’ve found there’s also another–time-related– aspect to investor behavior in playing any powerful source of economic energy.

Institutional investors typically proceed as follows:

–initially they tend to buy largest-cap and most obvious ways to play whatever the theme is.  In the context of my friend’s road example above, they buy the general construction companies.

–after the prices of these stocks have gone up for a while, the big investors’ attention begins to move to the most obvious derivative plays–the cement companies–and buy them.

–ultimately they “discover” the cement truck companies and add them to their portfolios as well.

If you know the industries involved well enough, you can see a cascade of successive waves of investment that chronicles the travels of the consensus deeper and deeper into the derivative plays.

…forming a timeline

This changing, and ever narrowing, focus of big investors typically forms a timeline that we can use to judge how much energy remains in a given economic phenomenon in stock market terms.  Once the big guys work their way to the metaphorical cement trucks, that signals most of the money from the theme has already been made.

At this point, the market either goes back to the start of all the excitement–the general construction companies–and begins the cascade process all over again.  More commonly, the market moves on to other areas.

where are we now?

Although it’s relatively early in the 1Q12 earnings season, I’m struck by two characteristics of the market reaction to earnings announcements so far.

The first is that positive reaction is highly company-specific and relatively narrowly focused in the sense I’ve been writing about.  To me, this means that before long the market will no longer be following ever more indirect ways to play the fact of economic recovery from the Great Recession.  It will be looking for new areas of interest instead.

I’ve also noticed that my portfolio, which is more of the cement truck type–and which had been in the dumps for the past several months–is beginning to perk up again.  Yes, my stocks have had an extraordinary two years or so before starting to fade away, but that’s the past and not relevant for today.  I’m also reading my recent outperformance as evidence of an ongoing maturing–maybe even an upcoming sea change–in stock market focus.   More about this in my next Current Market Tactics, on Monday.