Who’s doom and gloom now, Australia? From mortgage Armageddon to nuclear Armageddon, from inflation spiral to stagflation, from energy price spikes to energy shortages, from excess deaths to labour shortages, and from severe recession to red alert, the Australian mainstream media’s headlines have you covered this week.
It’s as if nobody has been warning them what the consequences of mad government and central bank policies would be…
But rather than focusing on the discredited, conspiracy theory-spreading, doom-mongering mainstream media, let’s ask whether all this bad news is good or bad for investors.
At first glance, it should be obvious. Bad news is bad news, right? It makes company earnings fall, valuations drop, and if you put the two together, you get what property investors would call capital gains tax offsets.
But it isn’t that simple in the world of investors. It’s worth mentioning some examples of what I mean before I explain the phenomenon.
The decline of smoking hasn’t stopped tobacco stocks from lighting up investors’ portfolios. They’re amongst the best performers over long periods.
Coal stocks have been booming since green energy reached fever pitch.
And, as market historian Russell Napier likes to remind us, there’s no correlation between economic booms and good stock market returns either.
So, what does determine stock returns then?
The answers are manifold. But let’s take a narrower look at how and when bad news can be good news for investors, without referring to the ‘bad news is good news because it makes central bankers rescue us again’ argument. I’ve had quite enough of that, thank you very much.
There are a few reasons why bad economic, financial, geopolitical, and social news can be good for investors.
First and foremost is the ‘relative to expectations’ idea. If you’re expecting mortgage Armageddon, or reading about it in the newspaper, then it’s probably priced in already, to some extent.
Prices are set based on expectations of the future, not the present state of things. Prices move based on how reality plays out relative to these expectations.
The question for investors is whether Australia’s mortgage Armageddon will be worse or better than currently expected. It might seem odd when discussing an Armageddon, but the point stands.
Another issue is relative performance. How are your returns compared to your neighbours or the benchmarks you compare yourself to?
Did Australia play well when they beat Italy 66–6 at the Rugby League World Cup? We don’t know. And not just because the TV rights made life difficult. But because the result in and of itself doesn’t really tell the story. Beating the Italians hasn’t been notable for almost 1,500 years.
Perhaps we should focus more on economics…
Companies have inputs and outputs. Focusing on just one of the two gives an incomplete picture of investor returns.
Sure, consumer prices are soaring, delivering revenue booms for companies. But have you seen the state of producer price indices? They’re rising about twice as fast in many places around the world.
The result is being called a ‘profits recession’ by some, completely confounding the narrative that inflation is driven by suddenly more greedy companies than usual. Not only are they equally as greedy as ever, but their margins are likely getting absolutely crushed despite increasing their prices.
There’s also the issue of reinvesting in future production. Companies that cut such investment may seem more profitable at first, because they’re, well, more profitable at first. One of their largest expenses — their capital stock, like machines — is cut, leaving more profit at the end of the month.
But fast-forward a few months or years and, as Joe Biden can now tell you, a lack of investment in oil and gas production eventually means less production. And that’s hardly good for investors or profits.
Unless, of course, prices go up as supply falls. Which reveals another way economic trouble can be good for investors.
Whether you produce a lot at low margins or less at high margins, doesn’t necessarily tell you how profitable you are in total.
Perhaps the government’s restriction on fossil fuel production will deliver sustainable profits for the companies producing fossil fuels for years to come. The government constrained supply, making fossil fuel companies more profitable. Ironic, but also predictable.
A similar argument applies to tobacco stocks. Banning management from wasting shareholder money on advertising may have been quite a subsidy, as far as investors are concerned.
My point is that there is a painful number of moving parts to the equation of what delivers investor returns in the end. And ‘bad’ news can interact with those variables in a surprising number of ways.
But there are a few signals that you might want to pay attention to as you hunt your next opportunity.
Economist Bruce Yandle noticed long ago that regulation tends to get lots of support from two groups. The first group, known as the Baptists, believe in the cause. The second group, known as the bootleggers, understand that regulations increase profit margins and reduce competition — the perfect result for incumbent industries (and their investors).
Part of this process is called regulatory capture. Industries tend to end up controlling the government departments set up to control them. That’s because they have the incentive to do so.
But the point is that companies benefit from regulation. And investors benefit from what companies benefit from. Which suggests you should invest in heavily regulated industries. Tobacco a decade ago. Fossil fuels today.
This bootlegger and Baptist situation is a business model for generating profits for several reasons. It protects businesses from new competition. It allows them a steady amount of profit because the regulators don’t want to kill their host. It restricts supply, which raises prices artificially. And it puts companies on the right side of ‘politically correct’ by a mere box-ticking exercise.
Investors are wise to invest in such industries, given the artificially secure profit streams they create.
Pharmaceuticals are the best example of this. It’s almost impossible to innovate in the industry that is so bogged down in red tape and regulation. Only a select few companies actually operate profitably. The rest hope to be bought by them. This isn’t because of the nature of pharmaceuticals, but because of the regulatory state and the conditions it has created.
But the same idea applies to many other parts of the economy. I’d like to focus on one more, though.
How many companies are capable of developing a mine? Probably a lot. But a lot less can make their way through the maze of government requirements for funding, permitting, building, and actually mining resources.
It’s incredibly difficult to compete with the incumbent resource producers because of their expertise in navigating government bottlenecks. They have acquired a huge advantage in their expertise of doing so. The time it takes to get through the process is extreme. That’s why a few big producers exist, and a satellite industry of companies hoping to be bought by those companies.
My point is that the resources industry is far from a free market. And this raises the returns of resources dramatically, raising investor returns too.
It leads to resource price spikes to be unnaturally large. It maintains resources prices at artificially high levels by constraining supply and adding costs. And it allows a select few companies to capture those gains nicely for their investors.
It’s not like companies can just decide to produce more resources when the price goes up. They have to put up with years of paperwork and lobbying first. Few even know how.
That makes resources such a profitable corner of the market to invest in. It’s the tailwind of the bootlegger and the Baptist.
But while you’re out there looking for the right bootlegging resource stocks, you might want to notice something that all this implies…
You might think that capitalism and free markets are good for investors. But you’d be wrong.
Capitalism abhors an unusually large profit, after all. The very one that investors are chasing. It’s like a vacuum under capitalism — a space that must be filled with competition or lower prices.
Capitalism benefits consumers, not cronies. That’s why we don’t have it. How else would investors get rich?
Until next time,
Editor, The Daily Reckoning Australia Weekend