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Friday, October 15, 2010

Arms Dealers - An Investors Best Friend?

If you have been reading this blog for any period of time, dear reader, you probably have surmised and correctly so that I believe that our future holds inflation and if the powers that be are not careful then hyperinflation could rule the day. I know you probably think that scenario is only reserved for banana republics and lesser economies especially since Timmy “Turbo Tax” Geihtner went on one of the news talkies and boldly proclaimed that it can’t happen here, just like they told us sub-prime was contained. In an article on Lewrockwell.com by Gary North, for whom I have great respect, feels that America will default on debt rather than hyperinflate, I disagree with that one piece of his article. I feel Mr. North misses the point that the US with its monetary policies is in defacto default and the hyperinflation is more of a psychological event rather than a monetary event, where as normal or even strong inflation is a monetary event. But I digress.

So let us stipulate that inflation in some form will be coming to our shores in the near future; what investments perform well in such an environment? As I am sure you are aware dear reader that precious metals do well as an inflation hedge and I have been pounding the table on the subject. With the metals pushing all-time highs, which they achieved in rather quick fashion there is the risk of a pullback and a great buying opportunity.  Of course it would not be prudent to be only in one asset class even though I believe that the precious metals group will outperform most others. In a time of elevated inflation “things” do well food, water, energy in other words things you can touch or things you need as opposed to paper assets. I have had people ask me about real estate and rental property, but I would shy away from those areas for a couple reasons. First, real estate while it has adjusted downward, however, even with inflation there are additional factors that will prevent a lift on that boat. Second the current foreclosure “mortgagegate” mess will keep a lid on the real estate market too. Third, there is plenty supply out there and no catalyst to spike the prices up to keep up with inflation at least not in the early phases. As for rental property, the rate you can charge a tenant is not that easily adjustable so you probably have to wait to an annual renewal to make an adjustment assuming it is not rent controlled in the first place.

So I view inflation as a war between your income and savings versus your cost of living. The war analogy works at both a personal and corporate level.  At the corporate level the war is between your costs and revenues.

Anytime one looks at a war there are winners and losers. Throughout history people, businesses and nations have backed winning and losing sides. The phenomenon of a winning and losing side gave rise to the expression “to the victor go the spoils”, so naturally those involved want to back the victorious side. The winning side does fare better after the war upon its win, however, there is a group that is over looked and underappreciated; these are the guys that make money during the war and regardless of which side is winning or losing.  The ones who make the serious coin during the war are the “arms dealers”.

I am sure that some of you are thinking to yourself that your author has lost his marbles. I assure you that is not the case. In the case of the stock market the “arms dealers” are the ones who supply businesses with either raw materials or equipment, which are necessary for them to succeed in the marketplace. The “arms dealers” tend to be more volatile than the companies that they supply. Additionally, the “arms dealers” tend to lag the customer in terms of overall gain early on particularly while the customer’s story is improving, although many times the “arms dealer” ends up out performing especially at the peak. Of course the best “arms dealers” are the ones that can and do supply more than one player. To play the “arms dealers” one does have to be a bit more nimble and not utilize a buy and hold strategy; in fact this is where technical analysis can be implemented for timing. There are times where the “arms dealer” will underperform the companies it supplies, however, this discrepancy can be exploited if the “arms dealer’s” customer companies are in an uptrend.

So what does this mean to you dear reader with regards to looking at your investments? We have already decided that this is going to be an era of inflation and “things”. The inflation aspect will drive prices of things higher thereby increasing desire and ability of companies to bring “things” to market. As we have discussed in these pages sectors such as food, water, commodities, energy and mining should do well in the current paradigm.

If we assume our analysis correct then one could invest in the various commodities ranging from wheat, to coal to oil to precious metals and the list goes on. One could also consider what is needed to bring all these items to the market; these are the “arms dealers”.  An example of an “arms dealer” in this environment would be a company like Caterpillar (CAT) as they supply many industries with heavy machinery, but they also are needed by natural resource producers in many areas ranging from Precious metals, coal and even infrastructure which are all inflation hedges. CAT is an example of an “arms dealer” that should retain pricing power in an inflationary environment as they are essential to the livelihood of their customers who in turn are bringing products to market with pricing power too.  John Deere (DE) is also a good bet since they operate in a similar fashion, but the agriculture sector is their base more so than mining and construction.

The “arms dealers” can provide you with a producer that can retain or even improve its margins as well as diversification across sectors if you choose the right one. One should avoid any “arms dealer” that is to heavily dependent on any one sector or customer. Other “arms dealers” for your consideration are Kutoba Corp (KUB), Joy Global (JOYG), Bucyrus (BUCY), Flour(FLR) Foster Wheeler(FLWT), Jacobs Engineering(JEC), Shaw Group(SHAW) and McDermott International(MDR). There are many more of these types of plays if one looks. As always one needs to look at each individual company evaluate their prospects and determine good entry points. The companies mentioned in this post all have redeeming qualities and some are too expensive at the moment while others are recovering from sharp sell offs like MDR.

The point of the post dear reader is not to tell you to run out and purchase any of the issues mentioned here although I do believe that some are good plays and or values; instead the point is to help you think outside the box. When one is investing it is more than just the numbers that are important. Don’t get me wrong the numbers are important even though the market does not always recognize them right away, which is how you get over and under valuation to exploit. What is just as important is to try to get a grip on the trend and get in before as many players in the market as possible, then ride the trend until it has played itself out.  The “arms dealer” can be an investors best friend.
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