Is The 'Hard Asset' Concept In Need Of An Update?

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Includes: BF.B, IYT, PRNEX, UNP, VZ, XTN
by: Paleomillennial
Summary

Hard asset investment has traditionally centered around commodities and real estate.

The traditional concept of hard assets may lead investors to overweight stocks in secular decline.

I discuss a number of high-quality stocks which share similarities with hard assets while avoiding the pitfalls of the traditional definition.

Hard assets are an important component of a well-diversified portfolio, given their usefulness as a store of value. Many hard asset companies, however, are fraught with supply risks and lack meaningful competitive advantages. Because of this, investors may benefit by expanding their definition of a hard asset to include sectors which lie adjacent to the traditional definition.

No, I'm not talking about cryptocurrencies.

According to Shawn Driscoll, the manager of the T. Rowe Price New Era Fund (PRNEX), Thomas Rowe Price, Jr. started the fund "because he correctly forecast a 'new era' of inflation ahead for the United States and saw natural resource stocks as protection from inflation".

Like other hard asset producers, natural resource producers provide inflation protection for a few reasons. Their position at the base of the value chain reduces the need for them to raise prices to offset higher input prices. The supply of a hard asset remains relatively fixed regardless of the money supply, and can hold its value during a recession since consumers must continue to purchase basic necessities (i.e. housing and gasoline) regardless of the economic environment.

In the case of the New Era fund, of which over three quarters is energy and basic materials stocks, "natural resources" refers mainly to commodity producers. Unfortunately, commodity producers have proven to be exceptionally risky investments in recent years. In the same 2014 article cited above, Driscoll made the prescient claim that commodities would be in a bear market for the following 15 years, and that stock selection had become especially important for the New Era Fund. If the ongoing boom in renewable energy capacity continues (and barring a major breakdown in global trade), Driscoll may have mischaracterized the bear market in commodities as cyclical rather than secular.

Could the New Era Fund's definition of hard assets have a fatal flaw? What might a more flexible definition look like?

To begin with, let's consider real estate, another traditional hard asset sector. Here again we see the risk of a secular bear market, this time due to declining fertility rates around the world. While urban real estate investments have historically benefited from limited supply, telework and autonomous vehicles are major long-term threats to the urban supply/demand balance. Of the markets with broad REIT offerings, very few may be reasonably insulated from these risks.

If commuter patterns tell us anything about these risks, the Hong Kong market may be a notable exception to the norm, due to the low number of cross-border commuters (near 315,000 in late 2015, out of a workforce of 3.9 million). This is partly explained by political tensions with China, and by the dense populations of the territories bordering Hong Kong (meaning an absence of suburbs to commute from).

The point here is that there are signs of quality in some REITs which are absent among commodity producers. This shows how a quality-conscious single stock approach to real estate may make more sense than broad diversification through sector funds and ETFs.

Next, we can look for quality in other tangible assets with real estate-like characteristics. Railroads are a straightforward example, given the land and/or land rights they possess. Railroad companies even behave like REITs at times by selling off portions of underutilized land. The quality of a North American Class I railroad is undeniable, given the combination of massive barriers to entry and a fuel cost advantage over other modes of transport. Let's include them in our tentative definition of hard assets.

I would argue that wireless spectrum also has similarities to real estate. While not a tangible asset by accounting standards, it is a component of the physical world, with certain physical properties which add a scarcity factor. In other words, there's only one electromagnetic spectrum in the universe, and in the U.S. most of its useful segments seem to be in the hands of an oligopoly of telecom companies.

By now, our definition of hard assets includes a variety of high-quality companies with sustainable competitive advantages. This of course should be weighed against the downside that railroads and telecoms are not at the base of the aforementioned value chain, and therefore may not pass inflation-protection muster for the likes of the New Era Fund. As a store of value, though, the additional companies are worthy candidates.

It's notably difficult to gain meaningful exposure to railroads and telecoms through mutual funds and ETFs, as they lack the aggregate market cap to overcome many diversification criteria. Two leading transportation ETFs—iShares Transportation (IYT) and SPDR S&P Transportation (XTN)—only have around one-quarter and one-tenth exposure to railroads, for example.

My philosophy on hard assets is reflected in my positions in Union Pacific (UNP), Verizon (VZ), and other stocks which offer some of the benefits of hard assets while keeping the bar of quality high for my portfolio.

A final point—which the Twitter heavyweight Bluegrass Capital touched on in the latest Scuttleblurb podcast, in reference to his Brown Forman (BF.B) stake—is that the question of a stock's terminal value often goes overlooked in today's tech-dominated market. Many companies with tangible assets at the core of their business models have created value for generations, and may continue doing so long after today's leading tech platforms have become obsolete.

Disclosure: I am/we are long SUHJY, UNP, VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.