How To Source Investment Ideas? (Part 1)
Go Where Capital is Scarce
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If you’re new here, I am a fan of the Coffee Can Portfolio, an “Active Passive” approach to investing. The idea of a Coffee Can is simple: Buy a basket of the best stocks you can and let them sit for years. You incur no costs with such a portfolio, and it is simple to manage.
Here are the results of our latest Coffee Cans (12 and 13):
[Link To Investment Scorecard]
Portfolio concentration can be a double-edged sword…Over the past few weeks, Coffee Can 12’s P&L has dropped from around +26% down to +14%, meanwhile the S&P 500 has been on a tear. So we are neck & neck after 264 days. That said, I still feel confident that our portfolio will outperform over time. Still lots of time remaining in this one.
We’ve also started building Coffee Can 13 (I’m thinking that I will build one every 6 months so as to maintain a more predictable cadence). We’re about ~60% invested so far. This coffee can is a bit more eclectic compared to the others, as I’ve decided to include some options, as well as some smaller bets unlike before.
Sourcing Investment Ideas (Part 1)
I prefer investing in companies I have interacted with in some way (i.e: I am a customer; the company operates in an industry I have worked in; or perhaps it simply left an impression on me in some way).
That said, in an attempt to grow my circle of competence, I want to put into writing some more structured ways of sourcing investment ideas.
This article is the first in a series about different ways one can source investment ideas.
The first source of investment ideas: Industries with Capital Scarcity.
Capital Scarcity
One way to find investing ideas is to go where capital is scarce. Scarcity of capital creates less competition for assets. And therefore tends to result in lower prices, which can be a great hunting ground for investment opportunities.
Before investing we must ask ourselves, what areas of the stock market are investors fleeing, and why?
China has clearly been one such area (we’ve talked about that here and here). Anything interest rate sensitive has been another. And of course, the coal sector is probably the most well known example.
Let’s discuss the coal industry for a bit, as it provides a good example of how industries with capital scarcity can provide some very lucrative investment opportunities.
“Coal Is Bad”
Financial institutions around the world have been placing restrictions on investing in coal-related assets. The environmental, social, and governance (ESG) movement has become mainstream, and investing with ESG considerations is sometimes referred to as responsible investing. This has clearly been a net-negative for the Coal sector.
So, why might someone want to consider investing in coal companies?
Look At The Returns
I was taking a look at some coal company stock charts, and noticed that their returns over the past few years have been incredible. I did not expect that.
Take for example:
Consol Energy (CEIX): It went from ~$2.5 to ~$100 in less than 4 years.
Alpha Metallurgical (AMR): It went from ~$2 to $450 in less than 4 years.
Arch Resources (ARCH): It went from ~$22 to $180 in just over 2 years.
Yes, the starting prices above are from the post covid lows, but nonetheless, this type of price appreciation in such short time periods is quite incredible.
Why Have Coal Companies Skyrocketed?
The investment case for coal is based on the following:
Demand for coal remains robust
Access to capital has been reduced
Coal mining companies have become more financially disciplined
Despite calls for its abolishment, demand for coal-fired power has remained strong, largely driven by growth in Asian consumption. Coal demand increased by 4.6% in China and more than 8% in India during 2022. This more than offset the 7% decrease in US coal demand.
That said, part of the reason for this was oil and gas supply was disrupted by Russia’s invasion of Ukraine. Additionally, coal was more readily available, and cheaper than gas in many parts of the world.
As a result, profits at coal companies tripled in 2022 to more than $97 billion.
Coal companies have been using these profits to return capital to shareholders, reducing debt levels, and diversifying into other commodities.
Today’s coal mining companies are the survivors of more than a decade of industry changes, where many companies went bankrupt midway through the 2010s. Many re-organized and returned to the market as more financially disciplined companies.
The ESG pressures that limited the coal industry’s access to capital actually became an advantage during the recent rising interest rate environment. Why? Because after the re-organizations, coal companies cleaned up their balance sheets, and used their recent record profits to pay down their debts. As a result, many coal companies had low debt levels and did not feel as much of the pressure from the recent rise in interest rates.
Pros and Cons of Investing in Capital Scarce Markets
The above returns demonstrate that investing in industries where capital is scarce can present some very lucrative opportunities.
However, like with anything, there are tradeoffs:
Advantages:
Less Competition: Scarce capital means fewer players in the market.
Higher Potential Returns: Limited supply of capital can lead to better terms for investors.
Innovation Opportunities: Necessity is the mother of invention…capital scarcity can drive creative solutions.
Risks:
Higher Failure Rates: Industries struggling for funding may potentially experience higher business failure rates. In the coal industry, many companies did go bankrupt. But, post reorganization, this created tremendous opportunity.
Regulatory Challenges: Some capital-scarce industries may face regulatory hurdles.
Market Uncertainty: There might be valid reasons why capital is scarce in a particular industry.
Outside One’s Circle of Competence: The industries where capital is scare may be outside one’s circle of competence, and hence in order to invest, could really require a significant departure from one’s comfort zone.
Overall, as we can see from the above returns, this approach can be quite profitable if you have a deep understanding of what you may be getting into, and if you can be patient and agnostic to the inevitable volatility.
Question: Apart from the ones I’ve mentioned, what industries today are experiencing capital scarcity?
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