Investing in a Flat World: Six Sectors That Should Outperform (UPS, FXI, LMT, CSCO)

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 |  Includes: ALTR, AVGO, CHRW, CSCO, EPP, EXPD, FWRD, FXI, GD, GE, GLW, GOOG, LMT, PEP, PG, QCOM, QUIK, RTN, SRX, TXN, UIC, UPS, UTX
by: ContraHour

On my recent vacation, I had the opportunity to finish reading Thomas Friedman's excellent book, "The World Is Flat". Friedman puts the current globalization trends into historical context and, somewhat unknowingly, describes the upturn of a new long-term economic cycle. In reading Friedman's book, I was continually reminded of the Kondratieff Long Wave and how this powerful economic wave is actually what is causing the economic boom and social upheaval around the globe.

Friedman argues that a "perfect storm" of technology innovation (Internet and open-source software), financial crisis (Y2K and bursting of the Internet bubble), and business trends (Wal-Mart's drive to lower costs and UPS' drive to improve supply chains) have caused physical boundaries to virtually disappear and the world to open to limitless business opportunity and competition. I want to take Friedman's observations about these "flattening" trends and put them into the context of the Kondratieff Wave cycle which is the unseen force driving this "perfect storm."

The Kondratieff Wave is a long business cycle that lasts between 48 and 60 years. Downswings of the wave (which last approximately 20 to 25 years) are characterized by serious recessions, falling commodity prices, and deflation. On the upswings, which last about 30 to 35 years, the opposite occurs - interest rates and inflation rise, economies are more recession proof and commodity prices increase. If you are truly interested in the forces that are shaping the world today, you should take a week long vacation and read the "The Long Waves In Economic Life" by Nikolai Kondratieff, Marc Faber's "Tomorrow's Gold," in which he discusses in detail and updates many of Kondratieff's ideas and Thomas Friedman's "The World Is Flat" which discusses what these long-term trends mean from a practical perspective. I can't do justice to the broad, powerful and deep ideas presented in these works but I will try to provide a brief outline to help pique your interest and research.

Kondratieff made five empirical observations about Long Waves, the last three of which are particularly applicable and pertinent to Thomas Friedman's Flat World thesis:

1 - “Our investigation demonstrates that during the rise of the long waves, years of prosperity are more numerous, whereas years of depression predominate during the downswing.”

2 - “During the recession of the long waves, agriculture (i.e. commodities), as a rule, suffers an especially pronounced and long depression.”

3 - “During the recession of the long waves, an especially large number of important discoveries and inventions in the technique of production and communication are made, which, however, are usually applied on a large scale only at the beginning of the next long upswing”

4 - "At the beginning of a long upswing, gold production increases as a rule, and the world market for goods is generally enlarged by the assimilation of new and especially of colonial countries"

5 - "It is during the period of the rise of the long wave, i.e. during the period of high tension in expansion of economic forces, that, as a rule, the most disastrous and extensive wars and revolutions occur. "

It's virtually undeniable that we are currently experiencing an upswing in the Kondratieff wave which bottomed during 1998 - 2002. Commodity prices, interest rates and international tensions are all increasing at an exponential rate. According to the long-wave theory, these trends won't come to an end until 2020 - 2025, at which the wave will be on the downswing once again.

In reading "The World Is Flat," I was continually reminded of points three, four and five of Kondratieff's wave theory which have all melded together in the current economic environment. During downwaves, "important discoveries and inventions in the technique of production and communication are made" which, once the wave turns higher, cause the assimilation of "colonial countries" (India and China) into the world economic market and therefore create significant "tensions in expansion of economic forces". Marc Faber recently wrote a two part essay for Whiskey and Gunpowder in which he quotes Kondratieff's "The Long Wave Cycle". Kondratieff stated, during a downward wave:

...the depressed state of economic life stimulates the search for ways of cutting production cost -- the search for new technical inventions that will facilitate such cost cutting. And we have already seen that it is precisely during that period - that is, during the long downward wave in economic conditions -- that technological discoveries and inventions are especially numerous.

Friedman does an excellent job of identifying and explaining these technology inventions which were invented and adopted during the last downwave from 1980 to 1998 and which are currently being "applied on a large scale":

First, the falling of the walls, the opening of the Windows, and the rise of the PC all combined to empower more individuals than ever to become authors of their own content in digital form. Then the spread of the Internet and the coming to life of the Web, thanks to the browser and fiber optics, enabled more people than ever to be connected and to share their digital content with more other people for less money than any time before. Finally, the emergence of standardized transmission popes and protocols that connected everyone's machines and software applications, and also encouraged the development of standardized business processes for how certain kinds of commerce or work would be conducted, meant that more people were not just seamlessly connected but also were able to seamlessly work together on one another's digital content more than ever before.

Put it all together and what you end up with is the crude foundation of a whole new global platform for collaboration. This was the genesis moment for the flattening of the world, and it came together in the mid- to late 1990s. All the elements of this new platform (such as the Business Web) would take more time to fully emerge and converge. That would happen only in the 2000s.

The tremendous economic, political and social changes have lead to significant upheaval in traditional ways of doing business, working and living. Once again, Marc Faber recently highlighted an excerpt from "The Long Wave Cycle" that I want to use to show the relationship between the "flattening" world and the Kondratieff Wave.

...social upheavals are most easily touched off under the strong impact of new economic forces. Thus both wars and social upheavals are a part of the rhythmic process of the development of the long cycles; and they turn out to be not the forces making for its development but forms of its manifestation.

Once they come into being, however, they of course exert, in their turn, a potent and sometimes disruptive influence on the pace and direction of the economic dynamics.... The upward movement in business conditions, and the growth of productive forces, cause a sharpening of the struggle for new markets - in particular, raw materials markets. On the one hand, this makes for an expansion of the orbit of the world market and the involvement of new countries and regions in the trade network.

On the other hand, it makes for an aggravation of international political relations, an increase in the occasions for military conflicts, and military conflicts themselves.

At the same time, the rapid growth of new productive forces, intensifying the activity of the classes and groups within that have an interest in that growth, creates the prerequisite for sharpening the struggle against socioeconomic relations that are obsolescent and hinder development. It creates the prerequisite for big internal upheavals. (Nikolai Kondratieff, ibid)

You can feel these tensions everywhere in daily life across the United States. From New York investment bankers who are hiring Chinese-speaking nannies, to Texas minute-men putting up barbed-wire fencing on the Mexican border, to politicians advocating a free trade backlash, the economic rise of the East is causing great economic and social upheaval.

Friedman's Flat World theory is a detailed history of what happened during the turning of the Long Wave. By melding Kondratieff's Long Wave and Friedman's Flat World theories, we can create some important trends for investors to concentrate on. Remember, we have only experienced four to eight years of these 30 year trends. This should provide many opportunities for investors to profit.

First and most obviously, the demand for natural resources will remain high. China has been building a city the size of Houston, Texas every month, estimates Ed "Y2K now 2008" Yardini. If China sees a slowdown in construction after the 2008 Summer Olympics, I believe that India will pick up the slack. India's physical infrastructure remains in horrendous shape. While Bangalore, India's own Silicon Valley, is dotted with beautiful company campuses, the roads and electrical grids connecting these campuses are often worse than a those in many "Banana republics". The Indian government is only now beginning the process of upgrading this infrastructure. That means continued high steel, cement, copper and oil prices. The assimilation of India and its millions of people should also put upward pressure on grain and food prices. And the economic boom these countries generate will put a floor under gold and silver prices as the new wealth gets spent on shiny new jewelry.

Second, the communication infrastructure will continue to need improving and upgrading. Friedman highlights the United States' need for improved communications infrastructure as the US has fallen from the "most wired" to the 16th "most wired" nation in the world. He correctly points out that you can hardly make a cell phone call in Washington, DC without having the call dropped, but can get reliable broadband wireless access on a bullet train in Japan. The drive to continue upgrading the world's wireless infrastructure will continue to present investing opportunities in this area. Investment ideas include Corning (NYSE:GLW), Qualcom (NASDAQ:QCOM), Cisco (NASDAQ:CSCO), Motorola (MOT), Texas Instruments (NASDAQ:TXN), Broadcom (BRCM) and on the small cap side, Altera (NASDAQ:ALTR), Quicklogic (NASDAQ:QUIK) among many others.

Third, the heightened economic struggles will likely translate into military conflicts. From the "war on terror" in the Middle East to China and Russia's re-emerging military presence, the demand for military equipment should remain strong. A smattering of defense related stocks from large caps such as Lockheed Martin (NYSE:LMT), Raytheon (NYSE:RTN), and General Dynamics (NYSE:GD) to small caps such as United Industrial Corp (UIC) and SRA International (NYSE:SRX) and should be included in a diversified portfolio.

Fourth, I believe that multinational companies should benefit from the combined trend of lowering labor costs but rising world-wide wealth. As one billion consumer finally have the resources to buy what they produce and as governments continue to increase spending on capital equipment, companies such as Proctor & Gamble (NYSE:PG), General Electric (NYSE:GE), Pepsico (NYSE:PEP), and United Technologies (NYSE:UTX) should all do well.

Fifth, logistics and supply chain companies have already benefited from the China boom and businesses will continue to need more logistics services as global supply chains become more intertwined. Friedman makes a case for a long term investment in UPS (NYSE:UPS), a company which now seems to be integrated into every large company's supply chain. In fact, of all the multi-national large-cap stocks, I believe UPS offers the best combination of earnings growth potential and relatively attractive valuation. In addition, freight forwarders such as CH Robinson (NASDAQ:CHRW), Expeditors (NASDAQ:EXPD), and Foward Air (NASDAQ:FWRD) should also continue to see high demand for their services.

Sixth, Asian stocks should continue to benefit from the wealth transfer that is currently occurring from the West to the East. I'm not an expert at international stock investing but many new alternatives exist for investors in this area from old-time classics such as the Tempelton Dragon Fund [XTDFX] to new ETFs such as the FTSE/Xinhua China 25 (NYSEARCA:FXI) and the MSCI Pacific (NYSEARCA:EPP). Marc Faber has written extensively about the opportunity in Asian stocks and for more specific ideas, I would point you to his opinions here and at his GloomBoomDoom.com web site.

If you look at most of the charts of the stocks I mentioned, you'll see that many have already had huge moves. Most of the stocks are expensive, not cheap, because the market has already, in its infinite wisdom, been discounting these trends. However, the main point investors need to take away from the Flat World and Long Wave trends is that these trends are still in the initial stages.

Leading technology stocks such as Intel, Dell and Microsoft had similar performances in the first half of the 1990s. Investors that got off the bandwagon half way through missed much of the upside. Similarly, I believe investors who ignore the Flat World and Long Wave trends will miss similar gains in the next decade. Long term investors should therefore take advantage of corrections in these stocks to position their portfolio for the next upturn.