We were recently prompted by an article by Katrina Booker, "Masterpiece Theater" in the May 15, 2006 edition of Fortune magazine to revisit one of our prior posts. In her article Booker profiles the current CEO of Sotheby's (BID) and the travails he faced rescuing the company from scandal and near-bankruptcy.

We discussed back in October 2005 the concept of "art as a really alternative investment." As a part of that discussion we mentioned Sotheby's as a proxy for the art market as a whole. The thinking being that if art prices continue their ascent the auction houses would benefit from the transactions that would ensue. Little did not we know at the time but the stock of Sotheby's has doubled in the interim.

We now realize that a number of our posts have touched on the subject of "proxy investing" without our being particularly conscious of it at the time. By proxy investing we do not mean anything having to do with proxy voting, but rather investing in stocks that stand to benefit, i.e. proxy for, a certain trend. The Sotheby's-art market example is a good example, of what should investors look for in a good proxy investment.

Proxy investing is necessary only when access or cost impedes an investor's ability to directly invest in the actual underlying asset. For example most investors have neither the assets or the wherewithal to directly invest in hedge funds. However Goldman Sachs (GS) has been called by many a hedge fund masquerading as an investment bank for some time. The logic is not bad. Goldman trades for its own account using hedge fund-like techniques and also acts as a broker and custodian for many of the world's largest hedge funds.

Indeed one could stretch the analogy even further. Goldman could be looked at as an "alternative investment" proxy. With Goldman investing in private equity deals for its own in-house funds and acting as an adviser to both buyers and sellers of companies their profitability is directly related to the health of this industry as well. (A recent Barron's cover story on Goldman relates in greater depth their dealings in these markets.)

Another example of this is the case of ethanol. Few investors have the opportunity (or means) to build their own ethanol plant. We have noted the lack of companies whose sole business is ethanol, forcing investors to search farther afield for ways to play the ethanol trend. While a company like Archer Daniels Midland (ADM) is not a pure play on ethanol it has represented for many a diversified, "safe" way to play the ethanol boom. Some caution that the ethanol market is sowing the seeds of its own demise, but one cannot argue with the strong performance of ADM's stock due in large part to the ethanol halo effect.

There are more examples of proxy plays. This begs the question, what makes for a good proxy investment? We have come up with a six item checklist to run through before making any sort of type of investment based on proxy thinking. Of course none of these should preclude you from your normal investment analysis, due diligence of portfolio management process.

  1. Identify a trend of sufficient economic size for which there are no other suitable ways for the majority of investors to directly access.
  2. Clearly note what catalyst(s) will be required for this trend to become notable and noteworthy. (If nobody notices your trend, your work will have been for naught.)
  3. Note whether said trend is not already played out. (Ethanol and art seem pretty well spent as undiscovered opportunities.)
  4. Identify a company (or companies) that have a substantive part of their business that will benefit from said trend. (This is a bit of a mystery in that there is no magical threshold in which a company becomes a worthy proxy.)
  5. Conduct your normal security analysis and due diligence with a focus on valuation. (A favorable story does not trump a bad balance sheet or a high valuation.)
  6. If an investment is warranteed by the facts, wait patiently for said trend to play out and hope the financial media catches wind of the story.

Proxy investing is in no way guaranteed to succeed and is dependent on the same factors as old fashioned stock picking. We previously noted the poor performance of various medical implant companies that had been pitched as foolproof investments due to the inevitable demographic trend underlying the demand for their products. They could very well be great stocks again, but it is going to come from lower price levels from when they were originally recommended.

Indeed much of the IPO market is focused around the need to satisfy the demand of investors for "pure plays" on various hot trends. Once the investment banks have begun serving up these companies for investors the trend is already on its way to its own demise.

Proxy investing is of course only one way to approach the stock market. However it has two advantages worth reiterating. First, it can provide investors with the means of identifying and profiting from trends that are as of yet unexploited in the marketplace. Second, the companies identified can in a way serve as a potential portfolio diversifier in that they generate their returns from novel, uncorrelated income streams.

As always all stock investments bear some risk and investors should do their homework before making any kind of investment. No one associated with this blog holds a position in any of the stocks mentioned above.

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