4 Ways Government Can Mess Up Your Investments

How to invest when your government is in the way...

 

IF THE state were not involved in the workings of the marketplace, an investor's central task would simply be to evaluate companies for their ability to efficiently produce and market what customers want, writes Casey Research economist Terry Coxon.

 

Shrewdness at that one task would lead to the profits investors are looking for. And there would be other consequences.

 

The stocks of companies that succeeded in convincing investors that they had the right stuff (primarily through good performance) would be bid up. Stocks of companies that failed to make their case to investors would tend to drift down, and any company whose stock drifted low enough would become a takeover target. A takeover would replace underperforming management with a new team of officers and directors – individuals picked by the people who laid out their own money to buy enough shares to control the company.

 

That's how things work when the government isn't a player in the process. It's a marvel of efficiency and impartiality. Managers who serve investors by serving customers are rewarded. Investors who identify such managers are rewarded. Unskilled managers eventually lose the corporate positions that enable them to make wasteful, money-losing decisions. And investors who are blind to management weakness or who forgive it too willingly lose their own money.

 

That's how it works when government is absent. But year by year, government has become less and less absent. In fact, it now has a sterling attendance record at occasions where economic decisions are being made. Through subsidies, tax breaks, regulation and spending, government has claimed a virtual seat in the boardroom of most companies. In some cases, government in effect holds a majority of the votes.

 

Government's involvement profoundly alters decision-making for investors. It no longer is enough for an investor to identify the companies that are doing a good job of serving shareholders by doing a good job of serving customers. Now an investor needs to consider how effective a company's management will be in getting favors from government and in avoiding getting punished by government. Even if you've made a cover-to-cover study of classics such as Benjamin Graham's The Intelligent Investor, you need to understand the appendix on political factors that Mr. Graham never wrote. Here's a quick outline.

 

At the big-picture, macro level, you undoubtedly are already familiar with the essentials. Unmanageable deficits and reckless money printing have made bonds dangerous and gold a necessity. That's simple enough. But drill down to the next level and things get messy.

 

Most of the government's involvement in business falls into four categories.

When you consider buying stock in a company that sells primarily to government, the rule of thumb is: Buy on bad news. Bad news knocks down a stock's price. But whatever the bad news – didn't get the contract, got caught handing out money that looks like a bribe – it likely will be old news soon, because government will find a way to help out.

 

Government as regulator. Most businesses must live with regulation of one kind or another. But in some industries, the need to conform to government regulations is at the center of all decisions. Banks and stockbrokerages, for example, are no longer run by financial analysts or operations managers. They are run by compliance officers.

 

It is a sad and stifling fact that regulation weighs the most heavily on small companies. A giant company may need a platoon of lawyers and regulatory specialists to stay out of trouble, but the cost is a minor matter, given the company's size. A small company in the same highly regulated industry, on the other hand, needs a similar platoon of lawyers and regulatory specialists. But for it, the cost is a serious handicap.

 

Big companies seldom complain about regulation. They like it because it handicaps the small-fry competition. It forces upstarts, startups and innovators to run the race with bags of sand on their backs.

 

When you consider buying the stock of a company in an industry that is highly regulated, the first rule of thumb is: Go with size. It may offend your sense of fairness, but the big guys have a built-in advantage that you generally should not bet against.

 

The second rule of thumb is to look for industry subversives with strong strategies. The more arbitrary, wrong-headed and harmful that regulation becomes, the greater the potential reward for a company that can provide what customers want in a way that falls outside the scope of the harmful regulations. Money market funds, for example, began as a product that side-stepped the regulatory limitations on the interest that banks were permitted to pay on checking and savings accounts. While those regulations continued in force, the money market fund industry grew rapidly, and the companies that sponsored and managed the funds profited accordingly. Today, manufacturers and marketers of food supplements operate largely free of regulation and provide (or at least claim to provide) customers with some of the benefits that come from the highly regulated pharmaceuticals industry.

 

Government subsidies. Some industries would be tiny and some companies wouldn't exist at all, but for the subsidies they receive from government. Without subsidies, fuel-grade ethanol would be a micro-industry. (Potable ethanol is another matter.) Without subsidies, Chrysler Corporation would be no more than a chapter in automotive history, like the Packard Motor Car Company.

 

For an investor, profiting from government subsidies is a matter of being a good judge of political fashion. Investors who saw early that ethanol promoters would succeed in convincing the (voting) public that burning crops is a good idea have profited nicely. Investors who are now holding stocks like BioFuel Energy and BlueFire Renewables will get hurt if they are still holding when the public eventually notices that burning food makes as much sense as eating coal.

 

If you don't believe that you are an above-average judge of political fashion, avoid companies that live off government subsidies.

 

Detritus of government. The state's involvement in the economy produces little boomlets here and there that no one intended. They can be profitable for those who do their homework.

 

The "War On Drugs", for example, has become a high-volume recruitment program for another euphemistically named operation, the "criminal justice system." As a side effect, bail bonds have turned into a big industry. The subsidies, government guarantees, tax incentives, banking regulations and money printing that fueled the housing bubble had as a side effect a boom in the mortgage brokering industry. More recently, the bursting of the housing bubble has produced a lucrative cottage industry in buying and brokering tax liens.

 

Such detritus industries come and go. When they arrive, they generally do so with almost no one expecting them. So, typically, there are no stocks you can buy to profit from them. But you can profit, perhaps handsomely, by treating them as business opportunities. That means you can't profit just by putting your capital into them. Either approach them as a business to be managed or stay away.

 

The entire topic of navigating in a politicized economy is, for me at least, a dreary one. It too much resembles "How to Eat Well in a Prison Camp." It is, however, a necessary topic. Ignore it and you raise the odds that you may eventually be eating less well than you expected.