Pick and shovel investing: what you need to know
We have a look at pick and shovel investing and provide some examples of how it works in industries like construction, telecoms, healthcare, and oil and gas.
What is pick and shovel investing?
Pick and shovel investing involves purchasing stocks that provide the goods, services or technology needed for an industry to produce a final product. This allows investors to gain exposure to an industry with lower risk by investing in suppliers rather than the stocks that make the end product.
The idea of pick and shovel investing comes from the US gold rush during the 1800s. Many people were searching for gold in the hope of striking it lucky but there was no guarantee who would be successful. The people selling the picks and shovels that are needed to search for gold fared much better because everyone hunting for the precious metal needed to buy these tools.
This means only some of the miners would find gold and most would struggle to bring in any revenue, but they all needed to buy the vital tools, making the supplier of picks and shovels a more reliable and less risky option compared to a miner.
The crux of pick and shovel investing is investing in stocks that supply materials, equipment, services or technology to several companies in the same industry, allowing you to take a position in a market without incurring the risk associated with producing or delivering the final product.
Pick and shovel investing examples
Today, pick and shovel investing is about much more than the gold industry and can be applied to virtually any industry you can think of. Below, we have a look at four modern-day examples of pick and shovel plays that investors can consider:
- Oil and gas
- Telecoms and mobile
Pick and shovel investing: oil and gas
Similar to the gold rush, there are many companies that search for and develop oil and gas resources so they can produce the commodities that power the planet – and they all have to procure equipment and services from other companies to get the job done.
There are companies like BP and Shell that produce oil and gas, and they are supported by a slew of oilfield service companies that help them build rigs, drill wells, operate pipelines, ship oil and offer many other forms of assistance. These are the pick and shovel plays of the oil and gas industry.
Pick and shovel plays include companies such as Schlumberger, Halliburton, Wood Group, or Petrofac, all of which provide a wide array of services to oil and gas companies. Many of them lock-in prices or are able to charge the same prices regardless of what is happening with oil and gas prices.
For example, stocks that operate oil pipelines can maintain their prices even when the price of oil itself falls, or a service provider may sign a contract and agree a price for their work on a new project to protect themselves if commodity prices suffer in the future.
You could also consider stocks that ship large quantities of oil and gas around the world, like Clarkson or Teekay. In early 2020, spot oil prices crashed to new lows as countries entered lockdown to fend off the coronavirus and demand plummeted. However, oil futures remained buoyant and encouraged oil producers to keep pumping, but this required them to store the huge amounts of product they were making until higher prices emerged.
This prompted a surge in demand for those that ship and store oil, demonstrating how some stocks can remain resilient even when producers are suffering.
Pick and shovel investing: construction
There are a wide array of construction companies that produce different types of buildings. Some produce houses or offices, while others build commercial premises or warehouses. Each of these are driven by different factors and operate in different markets.
For example, in the UK, the coronavirus continues to force most people to work from home, which has significantly hurt demand for office space. Commercial outlets, like shops, have also suffered as more people shop online during lockdown.
Meanwhile, housebuilders have seen demand surge as more people look to upgrade their home that they are spending much more time in, and the government offers further assistance to buyers. Warehouse developers also continue to grow to help feed the increase in online shopping.
The pick and shovel play would be to invest in the companies that produce the building materials that are used to make all types of buildings, regardless of what they are used for. This could include diverse suppliers like CRH and Breedon, or ones that focus on more niche areas like concrete and clay maker Ibstock or plumbing and heating supplier Ferguson.
Pick and shovel investing: telecoms and mobile
As the world edges toward faster connectivity with the roll-out of 5G, there will be a flood of new wireless and smart devices entering the market. This will include improved versions of existing products like smartphones and tablets, but it will also make new innovations like autonomous vehicles a reality.
It could be tempting to gain exposure to this trend by backing smartphone makers or telecoms companies, but there are different pick and shovel options to consider. One would be to invest in the stocks that make the equipment that is key to all these new smart wireless devices, such as chips. For example, stocks like Verizon and Qualcomm already have 5G chips available.
Another angle is to consider the telecoms providers of the 5G service that underpins all these devices, like BT Group or Vodafone. But these have a further layer of pick and shovel as you could also invest in the key suppliers providing equipment like antennas and transceivers for 5G equipment, like Nokia and Ericsson, which have both received a boost since Huawei was banned by several countries.
In the early days of 5G it can be difficult deciding where the value will lie – in the smartphone makers, the telecoms companies or even those making self-driving cars. But those providing chips and other key equipment will be in a position to benefit regardless.
Pick and shovel investing: healthcare
There are over 150 potential coronavirus vaccines in development, and investors have ploughed hundreds of billions into stocks that are in the race. However, data suggests that only a handful – if any – will actually be successful, which means most of the added value in the pharmaceutical and biotech space will melt away when their vaccines prove unsuccessful.
Investors understandably want to gain exposure to the value that would lie in any successful vaccine, but picking one or even a few stocks is a risky strategy. Instead, they can consider pick and shovel plays that can benefit regardless of which company finds a vaccine.
This could include the companies that have the ability to manufacture a vaccine. With the entire world needing it, billions of doses will need to be made – and quickly.
It is likely that any pharmaceutical company that can produce significant quantities would be called upon, and that means they can reap rewards without taking on the risk of actually developing the vaccine itself. This could include stocks like Johnson & Johnson or AstraZeneca, although both are helping partners develop potential vaccines too.
Similarly, there are companies providing key equipment needed by all of the companies developing vaccines, tests or treatments for coronavirus. This includes the likes of Thermo Fisher, which supplies laboratory equipment, mask-maker Honeywell, or glass vial producer Corning.
What are the risks of pick and shovel investing?
Pick and shovel investing is not risk free. It may provide a way of gaining exposure to an overall industry at a lower-risk, but pick and shovel stocks are not immune to everything.
For example, an oilfield service provider may prove more resilient than a producer during any period of short-term volatility or pressure on oil prices, but they will suffer just as much as their customers during a prolonged downturn.
Lower oil prices for longer would mean producers would cut back on spending, reprioritise developments and delay exploration, which would feed through to the service providers. Similarly, building material suppliers can often offset a downturn in one sector, like commercial developments, with strength in another, like housebuilding, but they also suffer when the economy is hit and building slows across the board.
At the bottom line, if an industry struggles for a long time then so will the suppliers.
Plus, you are still investing in one company, which carries its own risks. An investor may be able to buy a pick and shovel play like an oil tanker stock in the hope of gaining exposure to the oil and gas industry with lower risk, but there is still a risk that the company you choose could hit financial trouble or suffer an accident, like an oil spill. It is vitally important that you analyse any pick and shovel play in the same way you would any typical stock.
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