Finding the picks and shovels when investing through volatility

Spotting the winners and losers from an emerging investment theme is not always straightforward. What looks like sure things at the outset can end up letting you down, while the big gains are made elsewhere. Investment success is sometimes framed as avoiding those swept up in the gold rush while identifying the suppliers of the picks and shovels.

In a nice irony, the actual modern-day gold rush has turned this investment truism on its head. Gold mining companies are enjoying a renaissance, outperforming both the price of the precious metal they dig out of the ground and the suppliers of the equipment they use to do it. They are cashing in on a record gold price, subdued fixed costs, and a new-found discipline that has prevented them squandering their latest windfall on foolish acquisitions and risky investments in unstable parts of the world.

In today’s figurative gold rushes, however - artificial intelligence (AI), electric vehicle (EV)s, healthcare - the picks and shovels analogy looks as good as it has in every other investment mania over the years. From railways to airlines, from electricity to the internet, picking the winners has required lateral thinking. What seemed like the obvious winners often ended up as duds, while the eventual victors came out of left field.

This is playing out in the nascent deflation of the tech bubble. Until Us Federal Reserve (Fed) chair Jerome Powell rode to the rescue last Friday with a clear hint of a rate cut next month, the story of the week was the cooling in relations between investors and Big Tech.

The trigger for this reassessment was a gloomy note from MIT which said that 95 per cent of organisations are getting a zero return on their investment in AI, while OpenAI boss Sam Altman added that the sector’s recent hype had the hallmarks of a bubble. He concluded, rightly, that irrational exuberance was likely to get in the way of the sensible allocation of resources.

His repetition of former Fed chair Alan Greenspan’s description of the early stages of the internet boom in 1996 is not accidental. The parallels between the torrent of money pouring into AI infrastructure today and the same over-investment in the internet in the late 1990s are striking. In both cases, investors misunderstood who really stood to gain from the technological revolution unfolding before them.

Nvidia’s results this week confirmed that it remains the king of the first wave of AI pick and shovel stocks. Growth may have slowed from its recent giddy levels, but it remains remarkable for a company that, on its own, is worth more than the entire UK stock market. However, I don’t expect that Nvidia will be the ultimate beneficiary of AI. Just as Vodafone and Cisco were not the eventual winners from the emergence of the internet a generation ago.

There is a key difference between now and then. Nvidia trades on an ambitious valuation multiple of around 40 times expected profits but it is a rating that it can feasibly grow into. That was never likely to be the case with the blue-sky investments of 25 years ago. And while Meta, Alphabet and Amazon are pouring huge amounts into AI, if some of the spending turns out to be wasted it is unlikely to be catastrophic in the context of their formidable cashflows.

But investors looking to protect themselves from a pricking of the AI bubble should learn the lessons of the internet boom and bust. It took a second revolution, the invention of the smartphone, to crystallise the real benefits of the internet. Maybe it will require a subsequent development to catalyse the real step change promised by artificial intelligence. And if it is impossible to spot what that is today then it becomes more important than ever not to bet the farm while the outlook is so uncertain.

In other industries, the picks and shovels challenge may be simpler. Take weight loss drugs. Clearly a massive potential market - ask your friends - but one that will not necessarily benefit the pioneers. We don’t know which drug will come out on top, but we do know that it will need to be delivered simply and cheaply. Chances are the makers of low-cost enablers like injection pens are overlooked and undervalued compared with the companies in the headlines.

Same story in aviation. Whichever airline benefits from the resurgence in global air traffic as Covid fades in the memory, it will use the same parts, ground handling and maintenance services for years to come. Boeing predicts a near doubling in the number of commercial planes by 2043. It doesn’t really matter which airline buys them. Many of them will be fitted with a Rolls Royce engine.

When looking for picks and shovels, we need to seek out the ‘inevitables’. You want to be investing in products and services where the odds are stacked in your favour. In electric vehicles, this is likely to be batteries and charging infrastructure. It matters less whether the cars are Chinese or German. It is hard to make EV batteries reliably and at large scale. The number of companies that can do this is much more limited than the makers of the cars they will sit in.

Look for barriers to entry. It might be the technical edge of a CATL in EV batteries. Or it might be a regulatory hurdle, in the case of aircraft parts or pharmaceuticals. It might simply be the level of capital required for advanced manufacturing in a specialised area like semiconductors.

Just as they did 25 years ago, at the end of another long stock market boom, picks and shovels look like a sensible protection from another kind of inevitability - that the winners won’t be who we expect.

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Please note that the views expressed in this article are my own.