Ask anyone who has invested serious time analyzing the commodity markets and you will quickly come to understand the power of supply, demand, and prices to work in harmony to create balance. Think of Adam Smith’s “invisible hand” at work. Today we analyze the California power market as one example of the importance of thinking clearly about what is really going on and the dangers in well-meaning but flawed government policies. In our experience, indulging in unscientific thinking, unmoored to cause and effect, is a great way to lose a lot of money fast – and to create unintended consequences of even the most well-intentioned policies. The good news is even flawed policies create opportunity for profitable investment solutions – if you know how look for them.
“The road to hell is paved with good intentions.” – Samuel Johnson (1775)
How to Explain Rolling Blackouts in California, One of our Most Prosperous States?
I was asking myself this question the other day, as I pondered why it was that in this day and age, one of our most economically advanced states, the very cradle of the high tech industry, is unable to deliver to its citizens reliable electric power? Is reliable electricity not one of the most basic preconditions of civilization in our modern world? The reality of rolling blackouts is just such a profound failure, almost a third world problem. Can we really do no better?
Reasonable people can disagree about the forces driving this electricity chaos. To me, from a supply and demand perspective, it is yet another clear example of the Law of Unintended Consequences. In this instance, it comes from California’s push towards “clean energy.” There is no doubt that renewable fuels such as solar or wind leave a smaller carbon footprint than those of traditional fuels. However, those benefits come at a price, and that is their uneven supply and – in many cases – higher cost. Electricity is a fickle thing because its cost-effective storage has proven to be elusive. This places a huge burden on the ability of the electrical system to balance supply and demand instantaneously when supply becomes more inflexible. The more inflexible supply becomes, the greater the problems managing it. Now, with 33% of California’s electricity supply from renewable sources, this challenge is getting to be a real problem.
Each individual “is led by an invisible hand to promote an end (the public interest) which was no part of his intention. It is not from the benevolence of the butcher, or the baker, that we expect our dinner but from regard to their own self-interest.” – Adam Smith
It’s not just policy makers that can benefit from thinking clearly about consequences, unintended and otherwise. Certainly, you would have thought that the unblemished track record of markets beating central planners to create a more efficient outcome would not be questioned. But there you would be wrong. At least in the California power market, the regulators seem to be on the wrong side of history, again.
It’s the job of the intelligent investor to evaluate, dig deeper and think harder, beyond the obvious – to the truth. Clear thinking about applied microeconomics, the power of prices and the brute fundamentals of supply and demand to create predictable outcomes can all be powerful tools in the hands of the disciplined investor. If you ever doubted for a moment why the small handful of the world’s most respected commodity trading companies have been around for more than 100 years and are among the world’s largest private employers – this is why. Because these firms do superior supply and demand analysis. Because better work wins. Decade after decade after decade. Our experience is that those who can correctly anticipate the consequences – both intended and otherwise – should naturally be more successful. The history of the commodity market makes this point clearly.
We believe no investor’s education is complete until they thoroughly understand the power of supply and demand, what we have in the past described as applied microeconomics, for at least two reasons. First, the forces of “commoditization” strive relentlessly and at all times to standardize products, lower margins, and diminish capital returns in all businesses. Its why there are so few truly special businesses in the world. The drive for efficiency from competition is relentless.
So, you cannot understand, in my view, the challenges faced by most of the world’s businesses without understanding commodities. Second, the best way to identify a great – “un commoditized” business – is to contrast it with a deep knowledge of weaker, more common commoditized ones. This takes a lot of practice. Investors may find themselves kissing a lot of frogs to find that rare prince. A successful outcome is worth it though! But the investment lessons of unintended consequences go deeper still.
As Big Government Gets Bigger, Look for More Unintended Consequences and Lower Growth
As big government gets bigger, the efficacy of market-based signals, fades. Distortion grows with political polarization. Worse policies create slower growth. Slower growth tends to depress bond yields and returns on capital. This can lead to more political polarization and hence more government meddling. Does this sound familiar? Is this why interest rates are so low and falling? Is this why precious metals are competing – and winning – in many investors’ asset allocations? We think the answer is yes.
Even more disturbing is this: when these flawed policies form feedback loops with other flawed policies, they create even more extreme outcomes. Look no further than the potential of higher income taxes and wealth taxes to prompt an exodus of wealthy individuals from states with rising tax burdens, such as California or the Northeast United States to friendlier tax climes, such as Florida. Certainly, the budget pressures of the Covid-19 pandemic exacerbate all these trends. But don’t let these worries get you down. We believe strongly that there is always a way forward.
“There’s always a bull market somewhere.” – Wall Street Wisdom
My point today is not to catalog a litany of woes but rather to demonstrate that there is truly, always a bull market somewhere. The best investors, in our opinion, go beyond simply identifying problems and focus rather on identifying and investing in solutions. After all, it is through solutions that society progresses, which is one key reason that the most powerful investments with the strongest returns are solutions. Worried about low growth and falling interest rates? We believe in buying higher quality, longer dated bonds – and gold. Rising state tax rates troubling you? We believe in investing in homebuilders that build new homes for tax refugees fleeing to lower tax states. We believe, too, that the ongoing fetish for renewable energy may have the un-intended consequence of creating a surprising reaction in the price of traditional energy commodities, especially those with low prices, dramatically constrained supply, and lower carbon footprints. Why? Just as high prices are indeed the cure for high prices, low prices are the cure for low prices. This is where powerful upcycles come from. Such examples include natural gas and uranium, in our view. Our analytical team right now is kicking the tires on all these sectors. Some of them we already own. For almost every problem you can name, there is a profitable solution waiting to reward your investment dollar. You just have to look for it.
The good news for us as value investors, who focus on cause and effect, is that the world is always changing. Changing policies, changing cycles, changing challenges, changing prices. Each new threat creates the need for a profitable solution - if society is to continue to progress. This is one key dynamic behind the rise of new investment ideas. This is a healthy thing that you should welcome. It keeps the portfolio fresh. We certainly welcome it. So, the next time you find yourself focusing on the wrong thing – on problems and unintended consequences – go deeper and think further. Identify solutions. The difference in your returns – over the long run as always - may shock you.