“Picks and Shovels” Investing: What Is It & How Does It Work?
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Summary:
Pick-and-shovel investing (aka “picks and shovels”) is an investment strategy that refers to investing in businesses that supply the tools, services, or underlying technology needed to produce a final product. It’s an indirect way of investing in an industry without the greater risk of investing directly in the company that produces the finished product. One example of a pick-and-shovel business would be a company that supplies drilling equipment to the oil industry.
As an investor, it can be tempting to get in early on a hot, new trend. After all, you could start buying up shares in firms just before they explode and produce huge returns. But that’s a pretty risky proposition. Even a long-standing business with a successful history can make a wrong turn now and then.
That’s where pick-and-shovel investing comes in. Rather than take a risk on seemingly major players directly involved in a trend, take a look at the (often undervalued) companies that support those market leaders. But first, what is all this picks and shovels business about, anyway?
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How pick-and-shovel investing got its name
Back in the mid-1800s, during the California Gold Rush, people flocked to the west coast to find their fortune in gold. The tools of the trade were, quite literally, picks and shovels. Of course, there was no guarantee that they were going to strike it rich by actually finding gold.
However, the demand for the tools was high, and if you were one of the people supplying the picks and shovels to gold rush prospectors, you were probably doing a lot business at the time.
Therefore, those in the pick-and-shovel business were making a tidy profit without taking nearly the same risks as gold rushers. Levi Strauss (yes, the famous maker of denim pants) was one of those who profited from the Gold Rush with his San Francisco-based dry goods store that, among other things, sold picks and shovels.
What is pick-and-shovel investing?
For the most part, pick-and-shovel investing is considered a lower-risk strategy than investing directly in the market leaders. Instead, you put your investment dollars into the companies that supply and support the major players. This then dilutes your risk and diversifies your portfolio with companies less susceptible to economic or industry fluctuations.
This is particularly true when there’s an emerging trend and many competitors are vying for the space. It can be pretty tough to predict who is going to come out on top.
Pick-and-shovel investing is similar to the theory of investing in stocks that tend to perform well during economic downturns. Those are known as defensive stocks and include companies that provide goods and services like healthcare, utilities, and consumer staples.
The idea is that people still need these goods and services even in a recession, so they are less prone to stock market volatility. Shares in these companies may not make you rich, but they’re certainly less risky than, say, a cryptocurrency company, and can still produce a modest return even when the economy is bad.
Is the pick-and-shovel strategy always smart?
While the pick-and-shovel strategy helps insulate you from fluctuations or even a recession, it can’t guarantee good returns. If you’re trying to make pick-and-shovel investments and the industry in question is experiencing some troubles, the suppliers to that field are likely also negatively affected.
Let’s return to our earlier example of a drilling equipment supplier. If the oil and gas industry is experiencing a decrease in oil production, logic would dictate that a company that supplies drilling equipment would also experience a decrease in demand and thus a loss in sales revenue.
That said, if that company also supplies drilling equipment to multiple industries, the risk may very well balance out. This is because they still have plenty of other companies to supply with their equipment. A firm that supplies multiple industries would be the ideal pick-and-shovel play.
Pro Tip
If you like the sound of stable investments, you may also want to consider investing in index funds or exchange-traded funds (ETFs). These funds are baskets of securities, which immediately help you diversify your investment portfolio and reduce the effect market volatility can have on your money. To start investing in these funds, talk to one of the brokerages below.
Examples of pick-and-shovel plays
The electric vehicle market
The electric vehicle industry (or EV market) is a big trend right now, and one that isn’t likely to go away as the world turns toward cleaner energy initiatives. So a savvy investor might wonder how to best invest in this hot industry.
One idea would be to invest in the car manufacturers themselves, like Tesla or Toyota. That would be the most direct type of investment — betting on the final output, which is the electric automobile.
A pick-and-shovel investor, however, may look to capitalize on this upward trend while (hopefully) minimizing the risks. That type of investment might mean buying stocks in companies that supply the batteries to the car manufacturers who make the EVs.
Technology
As you know, the tech world grows by leaps and bounds practically on a daily basis. Though it can be a boomtown for investors, this market is also known to be very volatile. For example, 5G, which describes the next generation in wireless technology, is a hot trend that has potential applications across multiple industries.
One of the more direct investments would be to buy shares in businesses that make smartphones and other devices, like Apple or Samsung, because there will certainly be a flood of new products coming out. Another way to go about it is to invest in wireless service providers who are working on building 5G networks, such as Verizon or T-Mobile.
However, if you’re looking to make a pick-and-shovel play within the tech industry, you want to look into companies that provide the underlying technology needed to make the devices, like computer chips, semiconductors, or other electronics. Or you could invest in companies that support infrastructure-building, like businesses that supply antennas or transmitters.
Advantages and disadvantages of pick and shovel investing
Investors who choose to execute pick-and-shovel plays can take advantage of a “trendy” or hot industry without investing directly in what might be an unstable investment.
To use the California Gold Rush illustration, a person prospecting for gold had the chance of striking it rich or the very real possibility of walking out of there with nothing at all. But whichever way it went, they were in need of the tools used for prospecting. Thus, the picks and shovels industry showed stable and steady growth with little risk of failure.
On the other hand, “One disadvantage is that it may not provide the same level of return as directly investing in the industry itself,” Tadrus adds. “While pick and shovel companies may benefit from the growth of an industry, they may not see the same level of return as companies that are directly involved in the industry.”
In addition, if the industry in question begins to struggle, its suppliers may also experience a loss of revenue as a result. So even though a pick-and-shovel style of investing insulates you from extreme volatility in the markets, it does not make you immune to fluctuations.
How to execute pick-and-shovel plays
Pick-and-shovel plays are a solid strategy for building wealth for the future, but what’s the best way to go about doing it? Start by doing some research.
- Identify trends. Watch the news, surf the internet, and check out investment advice. You can’t necessarily expect every trend to pan out, but you might find one or two to focus on.
- Determine the market leaders. Who are the big players in the field and what products or services do they offer? Are there any market leaders planning to expand what they offer?
- Find the essentials. Learn what tools and supplies market leaders need to create the finished product, whatever it might be.
- Locate the suppliers. Find out which companies are supplying the major players with those essential elements and invest in them.
If you need some advice on how start investing, make sure you speak with an investment advisor first, like one of those below.
Pro Tip
Don’t beat yourself up if some of your investment picks don’t pan out right away. Even entire investment management teams don’t have all the answers. Remember that a buy-and-hold investment strategy is recommended by many experts, including one of the world’s most successful investors, Warren Buffett, chairman and CEO of Berkshire Hathaway.
FAQs
Is picking individual stocks a good idea?
Buying shares in individual companies — rather than through more diversified avenues such as mutual funds or ETFs — is one of the quickest ways to earn big money quickly. It’s also one of the quickest ways to lose money.
No one can see the future, and any investor worth their salt will tell you that past performance is not a predictor of future results. However, if you do your research and follow market trends, individual shares can be a solid part of your investment strategy, especially if you choose stocks from trusted businesses and plan to hold onto them long-term.
What is the 70/30 rule in investing?
The 70/30 “rule” of investing suggests that you should invest 70% of your money in stocks and the other 30% in fixed-income assets such as bonds and CDs. This is a riskier allocation of your assets than the more conservative 60/40 split, but less risky than an 80/20 split.
In general, investment experts suggest that when you’re younger — and therefore have more time to earn money and build wealth — your asset allocation should involve more risk. On the other hand, as you get older, you should gradually transition to a more conservative allocation of your assets.
Key Takeaways
- Pick-and-shovel investing is a strategy where you invest in businesses that supply tools or services needed to create a product rather than investing in the companies that actually sell the final product.
- A pick-and-shovel strategy lends itself to a more stable and diversified portfolio instead of trying to pick the hot stocks of the moment.
- It’s a lower-risk strategy because investors can benefit from a trending industry, which could be volatile, without directly investing in the industry.
- Because pick-and-shovel plays are typically more conservative investments, the returns may not be as profitable as more direct investing.
- Pick and shovel investing still involves choosing individual stocks, which is one of the riskier types of investment strategies.
- If the industries struggle, chances are the suppliers will also have reduced sales and revenue.
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