December 7, 2020
Buying the “Picks & Shovels” providers: getting paid whoever wins the race!

In my previous posts, I explained some hopefully useful and perhaps less understood metrics for identifying attractive investments. Today, I’d like to take a more practical approach, by looking at one investment theme which features heavily in my personal portfolio. Standing back from my investments, it’s interesting to note that my holdings can effectively be grouped into a few investment themes, even though my investment process is primarily bottom-up (i.e. I focus primarily on the company itself as opposed to the sector). The one theme I would like to tell you about today is investing in “picks and shovels” providers. The great thing is that these types of companies can be found in any powerful trend and sector. My rationale behind buying them is that they are often a profitable and lower risk way to benefit from a fast-growing area.

Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

In the bun fight for dominance of any fast-growing area, picks and shovels businesses get paid whoever wins

Companies pursuing picks and shovels strategies basically have a business model aimed at providing the necessary ancillary goods and services to whoever is looking to win a piece of a fast-growing trend.

In the past few decades, we have seen some very powerful investment trends totally transforming a number of industries, often enabled by advances in technology. Some very big winners have emerged out of this change, who now enjoy effective monopoly positions, which is a dream-come-true scenario from an investment standpoint. But don’t forget: in this absolute bun fight for dominance - for example to be where to be where Facebook or Amazon or Apple is now - there were literally thousands of companies that started out, setting out their stalls and investing lots of hope and money to be the winner. The truth is the vast majority didn’t make it very far at all. The familiar dynamics of very few winners emerging from a booming trend has been repeated again and again over decades: in any gold rush, lots of competitors enter the market with big dreams, trying to land grab as fast as they can but sadly only a few emerge triumphant, eventually. So when looking for investments with great prospects, the key insight that I’d like to share with you all today is that, in any given “gold rush”, more people get rich from selling picks and shovels than from mining for gold! I believe you can enjoy the exposure to high growth high profile trends but in a far lower risk and sustainable way by buying these less obvious beneficiaries.

picks and shovels image for pynk community investing community

It’s interesting to note that this picks and shovels business strategy is nothing new. Originally, this strategy comes from The Levi’s story, which is the stuff of legend. During the California gold rush of the late 1870s, Jacob Davis and Levi Strauss wanted to cash-in on the action, but wisely, they didn’t grab their tin pans and head for the hills. The two men invented the riveted-pocket work trousers we know today as jeans. But what’s more important in the story is what the men didn’t do. They didn’t bother to pan for gold at all. When you pan for gold you have a slim chance of a big payoff. For most gold miners, life was very hard, and the vast majority came home with dashed hopes and nothing to show for it having bet everything! But if the miners had taken the Levi’s approach, they would’ve prospered off every single prospector who came through town - regardless of who eventually ended up with the largest gold haul. Levi’s was selling picks and shovels… in their case jeans, of course.

Focusing on companies pursuing this business strategy has been very profitable in my personal portfolio. The basic rationale is this: big global trends are easy to identify so everyone piles in but not all players will benefit and actually, usually there are few winners and lots of losers however powerful the trend. Therefore, instead of making a ‘low odds’ bet that your chosen gold rush player will win, why not buy the picks and shovels companies to de-risk your exposure to the trend? You are far more likely to get paid and therefore your portfolio is far more likely to perform consistently year in and year out.

Binary Bets are High Risk

Taking the gold rush metaphor, when you pan for gold, you gamble the entire business on a single moon-shot. One binary bet - works or it doesn’t. Customers love it or hate it. Picks and shovels are different. The picks and shovels businesses are far less glamorous sometimes, but they enjoy consistency of upside and a significantly larger chance of success. Look at credit card processing companies. They are far lower risk as they are not tied to any particular fashion or product: credit cards don’t care what you buy. They get a percentage of every sale, on both the buying and lending side of the transaction - double-scoops of picks and shovels.

Financial Enlightenment Blog pynk community illustration

What’s Not to Like with Picks and Shovels

Far less glamorous and not world changing

If people only invested in picks and shovels businesses, we’d have no innovation and no cool stuff to buy. If you’re an innovator, you can’t help but build the next widget to change our lives. We obviously need you to keep doing that but as an investor looking to build a balanced portfolio, adding a pick and shovel component is often very attractive in risk/reward terms. The other important factor to recognise is that these seemingly duller businesses are often the enablers of big innovative changes, providing the tools to accelerate the delivery of this new world.

Our picks and shovels companies are beholden to the underlying trend

Yes, it will hurt when your main cash cow trend disappears overnight, but these picks and shovels providers can pivot to another wave. Beanie Babies were unbelievably once a collector’s item but are now worth little more than the stuffing inside each doll. The plastic collectible-protector packaging company was selling picks and shovels. These businesses who sold the protective Beanie Baby collector’s cases were able to sell the cases without speculating on a single stuffed puppy. Once Beanie Babies fell out of favour, it was possible for a plastic packaging company to pivot their package shape to fit the next wave of collectibles.

Like any business, picks and shovels businesses can be commoditised

Sure, there’s a worry you are supplying ancillary goods and services which become commoditised as more people cotton on to the opportunity. The need for the same competitive landscape analysis applies to these companies as others. If I sell shovels, what keeps the guy in the shop next door from selling shovels cheaper? Nothing. If the two of us have nothing to offer but lower prices, we’ll race each other to the bottom until someone goes out of business. Maybe both of us. So apart from price, the same business principles that help companies protect their profits apply to picks and shovels companies. These companies can add service, branding, expertise, tribe, range, track record, and loyalty to their pick and shovel model, to help defend their competitive position, effectively becoming a “tollbooth” to the trend, not just a commoditised supplier.

Steady cash in versus one-time lottery winnings

There are picks and shovels plays in every industry. When we bet on a moon-shot business, we’ve got a chance at limitless upside but a far more likely risk of downside. Companies adopting a pick and shovel approach are more like steady dividend payments, month after month, while the one-shot inventors are like lottery tickets. Picks and shovels may not be glamorous, but they deliver far more consistent payback. Tell that to the girl who bet her house trying to build the next Facebook. These companies let others take the crazy risks and run around frantic. They are in the back, counting their cash….

Now It’s Your Turn!

Now it’s your turn: we in the Investment Committee are very keen to turbo charge our investment process through the wisdom of this amazing crowd and invite you all to tell us your ideas of great picks and shovels businesses we should be looking at and why!

Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

Written by
Pouneh Bligaard
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