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Absent the state's involvement in the workings of the
marketplace, an investor's central task would be to evaluate companies for
their ability to efficiently produce and market what customers want.
Shrewdness at that one task would lead to the profits investors are looking
for. And there would be other consequences.
The stocks of companies that succeeded in convincing
investors that they had the right stuff (primarily through good performance)
would be bid up. Stocks of companies that failed to make their case to
investors would tend to drift down, and any company whose stock drifted low
enough would become a takeover target. A takeover would replace
underperforming management with a new team of officers and directors –
individuals picked by the people who laid out their own money to buy enough
shares to control the company.
That's how things work when the government isn't a
player in the process. It's a marvel of efficiency and impartiality. Managers
who serve investors by serving customers are rewarded. Investors who identify
such managers are rewarded. Unskilled managers eventually lose the corporate
positions that enable them to make wasteful, money-losing decisions. And
investors who are blind to management weakness or who forgive it too
willingly lose their own money.
That's how it works when government is absent. But year
by year, government has become less and less absent. In fact, it now has a
sterling attendance record at occasions where economic decisions are being
made. Through subsidies, tax breaks, regulation and spending, government has
claimed a virtual seat in the boardroom of most companies. In some cases,
government in effect holds a majority of the votes.
Government's involvement profoundly alters
decision-making for investors. It no longer is enough for an investor to
identify the companies that are doing a good job of serving shareholders by
doing a good job of serving customers. Now an investor needs to consider how
effective a company's management will be in getting favors from government
and in avoiding getting punished by government. Even if you've made a
cover-to-cover study of classics such as Benjamin Graham's The Intelligent
Investor, you need to understand the appendix on political factors that
Mr. Graham never wrote. Here's a quick outline.
Four Categories
At the big-picture, macro level, you undoubtedly are
already familiar with the essentials. Unmanageable deficits and reckless
money printing have made bonds dangerous and gold a necessity. That's simple
enough. But drill down to the next level and things get messy.
Most of the government's involvement in business falls
into four categories.
- Government as customer. No other customer's shopping cart comes close to
the size of the wagon the government pushes through the aisles of the
economy. For many companies, government is the number-one customer. For
some of them, government is the only customer that matters.
- Government as regulator. In some industries, complying with regulations
that customers care little about is a matter of life and death. The big
payoff comes from getting new regulations written that help you and hurt
the competition.
- Government subsidies. There are products and services that would be
sold only at much higher prices and in much lower quantities if government weren't directly or indirectly absorbing
part of the cost.
- Government detritus. Sometimes an industry grows almost accidentally,
as an unforeseen or unintended result of government activity.
Examples and Rules
Government as customer. Government uses certain types of products. Military
equipment is the biggest and the most characteristic example. The large,
established companies devoted to this market are essentially public
utilities. They produce things that government is sure it can't do without.
To give one example, for the government to be assured of sources for
developing and acquiring military aircraft, it needs Lockheed, Northrop Grumman
and Raytheon to stay in business. So when any of them stumbles, you can
expect government to help.
When you consider buying stock in a company that sells
primarily to government, the rule of thumb is: Buy on bad news. Bad news
knocks down a stock's price. But whatever the bad news – didn't get the
contract, got caught handing out money that looks like a bribe – it
likely will be old news soon, because government will find a way to help out.
Government as regulator. Most businesses must live with regulation of one kind
or another. But in some industries, the need to conform to government
regulations is at the center of all decisions. Banks and stockbrokerages, for
example, are no longer run by financial analysts or operations managers. They
are run by compliance officers.
It is a sad and stifling fact that regulation weighs
the most heavily on small companies. A giant company may need a platoon of
lawyers and regulatory specialists to stay out of trouble, but the cost is a
minor matter, given the company's size. A small company in the same highly
regulated industry, on the other hand, needs a similar platoon of lawyers and
regulatory specialists. But for it, the cost is a serious handicap.
Big companies seldom complain about regulation. They
like it because it handicaps the small-fry competition. It forces upstarts,
startups and innovators to run the race with bags of sand on their backs.
When you consider buying the stock of a company in an
industry that is highly regulated, the first rule of thumb is: Go with size.
It may offend your sense of fairness, but the big guys have a built-in
advantage that you generally should not bet against.
The second rule of thumb is to look for industry
subversives with strong strategies. The more arbitrary, wrong-headed and
harmful that regulation becomes, the greater the potential reward for a
company that can provide what customers want in a way that falls outside the
scope of the harmful regulations. Money market funds, for example, began as a
product that side-stepped the regulatory limitations on the interest that
banks were permitted to pay on checking and savings accounts. While those
regulations continued in force, the money market fund industry grew rapidly,
and the companies that sponsored and managed the funds profited accordingly.
Today, manufacturers and marketers of food supplements operate largely free
of regulation and provide (or at least claim to provide) customers with some
of the benefits that come from the highly regulated pharmaceuticals industry.
Government subsidies. Some industries would be tiny and some companies
wouldn't exist at all, but for the subsidies they receive from government.
Without subsidies, fuel-grade ethanol would be a micro-industry. (Potable
ethanol is another matter.) Without subsidies, Chrysler Corporation would be
no more than a chapter in automotive history, like the Packard Motor Car
Company.
For an investor, profiting from government subsidies is
a matter of being a good judge of political fashion. Investors who saw early that ethanol promoters would succeed in convincing the
(voting) public that burning crops is a good idea have profited nicely.
Investors who are now holding stocks like BioFuel
Energy and BlueFire Renewables will get hurt if
they are still holding when the public eventually notices that burning food
makes as much sense as eating coal.
If you don't believe that you are an above-average
judge of political fashion, avoid companies that live off government
subsidies.
Detritus of government. The state's involvement in the economy produces
little boomlets here and there that no one
intended. They can be profitable for those who do their homework.
The "War On Drugs," for example, has become a
high-volume recruitment program for another euphemistically named operation,
the "criminal justice system." As a side effect, bail bonds have
turned into a big industry. The subsidies, government guarantees, tax
incentives, banking regulations and money printing that fueled the housing
bubble had as a side effect a boom in the mortgage brokering industry. More
recently, the bursting of the housing bubble has produced a lucrative cottage
industry in buying and brokering tax liens.
Such detritus industries come and go. When they arrive,
they generally do so with almost no one expecting them. So, typically, there
are no stocks you can buy to profit from them. But you can profit, perhaps
handsomely, by treating them as business opportunities. That means you can't
profit just by putting your capital into them. Either approach them as a business
to be managed or stay away.
The entire topic of navigating in a politicized economy
is, for me at least, a dreary one. It too much resembles "How to Eat
Well in a Prison Camp." It is, however, a necessary topic. Ignore it and
you raise the odds that you may eventually be eating less well than you
expected.
So what's an investor to put money in today? Given the
political uncertainties in the US right now, reasonable individuals' ideas
may differ. That's why Casey Research brought 28 seasoned, well-respected
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