It’s 1848 and massive gold reserves were found in California, United States. Thousands of people rushed to California in search of gold leading to the Gold Rush. With picks and shovels, they began mining for the precious metal. Many found gold and became very rich but given the large number of people, many others did not.
But there was a completely different set of people other than the miners who became rich from the gold rush. Those were the businesses that sold them picks and shovels. What’s more, during the gold rush, a common problem workers faced was that their clothes would wear off easily in the tough environ of the mines. This led to a Bavarian immigrant, Levi Strauss, to develop waist overalls we now know as jeans. So even though the gold rush may or may not have worked for thousands, it did work create the world's most jeans brand.
Peter Lynch, one of the most famous investors of all time, recommends a similar technique for investing known as proxy investing.
So what is proxy investing?
Proxy investing is, as the name suggests, using a proxy to invest. So, instead of buying stocks that are in some uptrend, you buy stocks that benefit indirectly from that trend. In the context of the gold rush, instead of scouring for gold, you sell picks and shovels and jeans to the miners.
Why does proxy investing work?
Let us go back to the gold rush. Just like in gold rush, any possible uptrend attracts a lot of competition. So, say, you had to invest your money in a miner, what were the chances you would make a fortune from it? Even if you choose 10 miners after analyzing their skills and their locations, the chances of succeeding are still less. But as soon as move up the chain, the number of people selling picks and shovels would be much lesser than the miners. This reduces the competition and you would be in a better position to make money off of the sellers of shovels than the miners. The same happens in investing.
Say you want to invest in a real estate company. As is widely known, the real estate business is a highly cyclical one with frequent boom and bust cycles. Many factors need to be right for the investor to make money in the real estate business. Besides, there are so many real estate companies to choose from, and not all will work for you.
Instead, you could invest in building material companies that make steel pipes, wires, paints, tiles, etc. These companies are relatively stable than real estate companies with better margins, less cyclicality and even better fundamentals. So instead of trying to find that next gem in the building companies, it is better to find stable building material companies with high growth potential.
Similarly, metal sector is highly cyclical with margins that expand and contract ever so quickly. Instead of focusing on steel or copper companies, it would be wise to check out proxy players for the metal companies like refractory companies.
One new trend that you can use proxy investing for:
The age of electric vehicles is upon us. All automakers are putting in billions to crack the code to rule the electric vehicle future. The success of automakers in IC vehicles does not guarantee that the same companies will also do well in the EV business. With so much uncertainty, it is tough to choose from the automakers.
So what can you do about it?
Well, find the proxies for the EV future. Instead of trying to focus on automakers, focus on companies that can dominate the supply chain for electric vehicles. Case in point, battery manufacturers. If there are a 100 electric vehicle manufacturers, there would be about 10 batter manufacturers. But it gets better. You can go up level further and invest in companies that supply to battery manufacturers such as rare earth metal companies. This way, you remove a lot of uncertainty while choosing EV companies. And no matter which automaker makes it, you will win.
Bottom line:
Proxy investing is a good way to insulate yourself from the competition that any major trend faces and increasing your chances of success.
In a gold rush, sell shovels... or make jeans, if you can.
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