Get your portfolio ready for the profitless global economic recovery

01/19/2010 10:49 am EST


Jim Jubak

Founder and Editor,

So what should investors do about it?

What’s “it”? The global crisis in profits caused by excess supply over demand.

Take a look at how “it” is at work across the global economy.

The aluminum industry—awash in excess global capacity with more scheduled to come on line.

The auto industry—awash in excess global capacity with more scheduled to come on line.

The steel industry—awash in excess global capacity with more scheduled to come on line.

The memory chip industry—awash in excess global capacity with more scheduled to come on line.

I think you get the idea. (I’ve described the problems in some of these industries in recent posts such as for the auto industry and for the aluminum industry.)

 As I’ve written about repeatedly in the last week or two, because the world hasn’t begun to address the problems of excess capital and the excess production capacity that it creates under current economic rules, the global economic recovery is going to turn out to be extraordinarily profitless in industry after industry as producers with excess capacity cut prices in an effort to buy market share.

This isn’t a short term problem. With the short-term success of the Chinese economy in recovering more quickly from the depths of the downturn than any other global economy, China’s “solution” of flooding the economy with cash, building new plants, and then exporting the excess has become a model to emulate. The mis-match between global supply and demand in many areas of the global economy will go on for years, and in some sectors the excess of supply over demand will get worse before it gets better. (I spelled out the way that China’s economic model contributes to this problem in )

The problem is too big and too long-lasting to ignore. So what are investors supposed to do about it?

How about building a portfolio to, in general, avoid niches, industries, and sectors where global over capacity will create a profit-less recovery?

Well, Duh! Of course. Simple. Easy.

How about some advice on what to avoid and where to put money to work? Sure, like most advice—“Never put anything smaller than your elbow in your ear” to “Buy low and sell high”—this admonition isn’t very useful without specifics.

I’m going to start with three sectors that you should target now and in the next few years that will avoid the worst of these problems. (I’ll even throw in a glancing reference to a niche or two that has the characteristics you want to buy.) And I’m going to end by naming three stocks that you should own (one is already in Jubak’s Picks, one is in the Jubak Picks 50, and one is a new buy)—from one of these sectors.

To avoid the trap of excess capacity killing even modest profits I think you have to look for sectors that have barriers that prevent excess capacity from driving down all prices as companies slit each other’s throats to acquire profitless market share.

I can think of three big barriers like that.

First, brands. In markets and for products where consumers are willing to pay for a brand, the brand provides protection from excess capacity running prices so low that the producer can’t make a profit. This isn’t some new intellectual breakthrough on my part: its right out of the Warren Buffett playbook. It’s why he owns brands like American Express (AXP) and Coca Cola (KO). American Express manages to charge more for its cards (and to merchants who accept its cards) and Coke sells for more than the no-name sodas that my Dad used to buy because of their brand names. Unfortunately, there are fewer and fewer brand names that are able to withstand the onslaught of excess capacity. Cereal brand names such as Kellogg (K) are losing the pricing war to store brands. The Washington Post (WPO), another Buffett holding, has lost the news and ad battle to the excess capacity of the Internet. (Frankly, I think Buffett owns the Post these days for its Kaplan testing and electronic education business. Which is busy eating away at the brand names that support brick and mortar Halls of Ivy.) Look at your own buying habits: How many brand names do you pay extra for these days?

Second, distribution and service networks. Building new production capacity is relatively fast and easy these days. But distribution and service? That’s tough. Give me access to cheap capital and I can be turning out Jubak’s Cola—“The cola that talks back”--within a year and undercutting Pepsi and Coke on price too. But getting the stuff into stores? That’s the work of consistent investment running into the billions over a decade if you hope to compete with the system that puts PepsiCo’s (PEP) sodas, juices, water, and Frito-Lay snacks into every store from Buffalo Gap to Beijing. You can make a cheaper tractor than Deere (DE) sells—lots of companies do and more are trying—but Deere’s network of service centers and dealerships has been crafted over decades. Wal-Mart (WMT) is able to eat competitors alive every day not because it sells stuff for less but because it has a purchasing and distribution system that lets it sell stuff for less and still make a five-year average gross margin of 24.5%. And the company never stops honing this competitive weapon. If I were a Wal-Mart competitor I’d be up late almost every night worrying about news that Wal-Mart is going to up the percentage of the goods it sells that it buys straight from manufacturers.

Third, technology. I don’t mean commodity technology like memory chips. Once a technology gets mature enough so that anyone can produce it, technology itself stops being a barrier that protects your profits. Steel and automobiles were once cutting edge technologies too. No I’m talking about technology that’s on the edge of what’s new and where the company gets paid something extra for making something that’s more powerful, or smaller, of faster, or more complex than what existed yesterday. And I’m talking about companies that can produce a relatively constant stream of new technology products like that are able to constantly push the envelope of what’s possible.

Investors are fortunate right now to have two areas of the technology sector that are showing solid growth and that present significant barriers to the destruction of profits by global excess capacity. One is the next generation of networked information technologies. Desktops and laptops, storage devices, and even increasingly servers themselves are on their way to becoming technology commodities (if they’re not there already—have you priced a desktop lately?) where profits get crushed by global excess capacity. (Dell (DELL), for example, has run into this global buzz-saw.) But networked servers, and networked storage, and networked communication devices, and networked software that connects as a unified system both within the corporation and with customers as a cloud of distributed computing —that’s not a commodity. It isn’t because getting all this stuff of work together requires building not just a product but a system of suppliers and sub-suppliers that can provide compatible pieces and then also the service organization that can make sure that it all connects—securely—and keeps on connecting.

In a recent report Forrester Research called for a six- to seven-year cycle of spending on what it calls the new information technology foundations for unified computing (including cloud computing, storage and serve r virtualization, and unified communications. Global spending on information technology, which fell 9% in 2009, will climb 8% this year.

The other technology area with strong barriers to global excess capacity is the upgrading of wireless networks to handle the deluge of traffic that’s overwhelming networks as owners of iPhones, and Nexus Ones, and Blackberries, and Androids all do exactly what the companies that make and sell those devices want them to do: use them to download and send vast quantities of music, video, and graphics, and to run huge numbers of applications over their mobile devices.

Anyone who appreciates irony—well, anyone who appreciates irony but doesn’t work at AT&T (T)—had to chuckle when AT&T shut down iPhone sales in New York for a few days because iPhone users had overwhelmed its network. According to the Federal Communications Commission (FCC) wireless data use is up 700% over the last four years and will grow by 130% a year for the foreseeable future.

Here the barriers to global excess capacity are very similar to those I just ran through for the new generation of information technology. The key to success in this area isn’t the cheapest price but the ability to deliver a seamless networked service.

I’ve got some names that you should own in this sector if you want to protect your portfolio from a profitless recovery created by global excess capacity.

One is Cisco Systems (CSCO). This stock is already in the Jubak Picks (and I think you can still buy it at current prices). Cisco is the IBM of the Internet—companies can buy the company’s gear and know that it will talk to the rest of the gear in their network (because Cisco probably sold them a good part of that gear and because everybody makes sure their gear works with Cisco equipment.) Plus Cisco has used recent acquisitions to continue its transformation from a simple—but globally dominant--seller of routers into a company that builds unified digital communications systems.

A second is Google (GOOG). Yes, Google stands a good chance of getting kicked out of China with its 1.3 billion potential Internet users (How old does a baby need to be to use the Gmail?). But no company is better positioned for the long-term trend toward distributed computing over the Internet than Google. If you own it, hold for the long-term and pick up more on any China-related weakness. (See my update of Google in the Jubak Picks 50 portfolio later today.)

A third is Marvell Technology Group (MRVL). The company has succeeded in driving its system on a chip solution from stand alone hard drives to the network itself in such areas as networked storage and mobile devices. I’m adding Marvell Technology Group to Jubak’s Picks with a buy today. See my post later today for more details including a target price.

These three areas and these three technology picks aren’t the only way to build a portfolio that avoids the danger of a profitless recovery. You can also look for smaller niches where it’s just about impossible to build new capacity—North American trans-continental railroads come to mind. I doubt that anyone will ever build another. Which has something to do with why Warren Buffett is buying Burlington Northern Santa Fe (BNI).

You shouldn’t by any means assume that the only companies with barriers to global excess capacity like those I’ve talked about live in developed economies. One of the reasons that I recently added AmBev (ABV) to the Jubak’s Picks portfolio is because of the barriers created by its strong brands and distribution system in South America. See my post

And finally you shouldn’t assume that the best managed of the world’s companies aren’t aware of this problem. They’re busy working on new ways to differentiate themselves and protect their pricing power in a world of so much excess capacity. But that’s the topic for another column.

Full disclosure: I own shares of AmBev and Cisco Systems in my personal portfolio.
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