Mark Twain’s quip that during the gold rush, “it is a good time to be in the pick and shovel business” has long ago percolated into an Aesop’s fable of investing.
Does the ASX 200 have any sound pick-and-shovel stocks?
What is a pick-and-shovel strategy?
During a gold rush, sourcing and selling shovels is less labour intensive and hazardous than prospecting for gold. Many will venture out, but few will strike it rich. Yet both the lucky and the unlucky alike will need picks and shovels.
It still takes a shovel for a prospector to realise he’s out of luck.
Therefore, a pick-and-shovel strategy can grant you a safe steady stream of income from customers who take on most of the risk.
It aims to capitalise on stocks providing necessary inputs for an end product without incurring the risks associated with selling the final product itself.
Examples of pick-and-shovel stocks
Apple has wider brand recognition than a company like Intel. Yet it is Intel that quietly manufactures the processors found in most of the world’s personal computers.
While rivals like Apple, HP, Dell, and Lenovo vie for shares of the personal computing market, all of them will have to source their processors from the likes of Intel.
The fortunes of many of these companies will ebb and flow as one or the other releases a hot new product. Yet all the while, Intel will pocket a handy sum from each.
Take Amazon Web Services (AWS). While its name may be unassuming, nothing is modest about its profits. AWS supplies cloud-computing infrastructure to the likes of Netflix, Slack, NASA, and even the CIA. In FY18, it reported a vertiginous US$25.7 billion in net sales.
However, pick-and-shovel stocks are not always a successful investment play.
In market contexts where there are only one or two buyers, suppliers of necessary tools or services will struggle to leverage that necessity into good profits.
Why? Because the bargaining power will not be with them. That’s why you hear reports from disgruntled and struggling suppliers over the Coles Group Limited (ASX: COL) and Woolworths Group Ltd (ASX: WOW) duopoly.
Pick-and-shovel stocks of the tech sector
Australia’s tech sector has seen enormous growth in recent years, led by the WAAAX cabal. And information technology will continue to inform the interconnected enterprise of this digital age, so it’s fruitful to search for pick-and-shovel stocks in the tech sector.
But are there any to be found in the ASX 200?
Altium Limited (ASX: ALU)
Altium is a leader in printed circuit board (PCB) design tools and its share price is up 50%, year to date. Altium’s market leader status in PCB design tools positions it favourably for the explosion in AI and Internet of Things applications.
In its latest investor presentation, Altium reported that the “proliferation of electronics through the rise of smart connected devices continues to drive growth for our business” as PCB are central to the “design and realisation of electronics.”
In FY19, Altium reported continued revenue growth, up 23% to $171.8 million with a healthy EBITDA margin of 36.5%.
Dawn Kanelleas and Michael Joukhador of First Sentier Investors (previously Colonial First State Global Asset Management) recently wrote that “for every traditional device that is redesigned to talk to other devices – and for every new device brought to market – there sits an engineer heavily reliant on Altium.”
NEXTDC Ltd (ASX: NXT)
NEXTDC is Australia’s leading data centre operator, primed to leverage its infrastructure in today’s data-hungry world. It already boasts strategic partnerships with leading tech companies Amazon, Microsoft, Google, IBM, Oracle and Alibaba.
A 2018 report by IDC predicted that the “global datasphere will grow from 33 Zettabytes (ZB) in 2018 to 175 ZB by 2025.” This will create an exponential demand for storage and data centres like NEXTDC.
The report went on to say that the “responsibility to maintain and manage all this consumer and business data supports the growth in cloud provider data centers.”
Not only that, advisory firm Gartner predicts that by 2025, 80% of enterprises will shut down their in-house data centres, preferring to pay specialised firms like NEXTDC for colocation and cloud access.
Importantly, Gartner estimated that only 10% of enterprises have closed their in-house data centres. This means that suppliers like NEXTDC should expect a large flock of new customers over the coming years.
These considerations were enough for Morgans to upgrade NEXTDC shares to an add rating, with a $6.68 price target.
Further, according to the Wall Street Journal’s analyst ratings, 10 out of 11 analysts currently rate NEXTDC a buy, with the remaining analyst deeming it a hold.
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Motley Fool contributor kprakapenka has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Altium. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.