Published October 24, 2013

The Markets Are Rigged! How to Opt Out and Still Profit

"A weak jobs report sent stock futures soaring this morning, as it became clear the Fed won't be tapering any time soon."

Call me nostalgic, but I remember a time when a bad jobs outlook sent the large-cap companies down, not up. The economy is weak, so a company's profit expectations suffer. The logic makes sense.

Today, however, we live in the topsy-turvy world of government-manipulated markets, where such asinine statements make complete sense… until they don't. The problem with a market that lives at the teat of Washington's policies is that it can be reversed in mere moments. One election. One popular news story. One social media outcry. One back-channel policy. One bloody coup d'état. That's all it takes.

I'm not just talking about quantitative easing and similar marketwide meddling. Even an individual company can be caught in the crosshairs of the ever-increasing political in- and out-fighting.

No Democracy, No Software

Take the continually escalating best-frenemies slap fight with China… in the last few months its government has closed the doors to American technology companies in a big way. Just look at the recent revenue shortfall for data-warehousing giant Teradata, whose Asian revenues fell 21% last quarter, sending shares tumbling, in the wake of an unofficial "Buy Chinese" campaign led by its politburo.

This same policy is likely to have big follow-on effects for many other large consulting and infrastructure vendors, from IBM to Cisco to Microsoft, if it's not nipped in the bud (which will likely not happen by suddenly discovering mutual trust, but instead by the US levying some other threat behind closed doors, like a tariff, thereby adding to the resentment but effectively forestalling the problem for the next electorate to deal with).

It's also completely understandable on China's part. I hold no ill will toward the Chinese for their nationalism, as they wholly embraced American tech—heck, they manufactured most of the hardware parts for us, so why wouldn't they embrace it?—until we started slapping them in the face.

It's been almost exactly a year since Congress called to ban China's largest network-equipment maker, Huawei, from providing equipment to the world's biggest buyer—the US military complex—for fear it might contain snooping software.

Even though it was never made official (just as China's new policy won't be), the net effect was the loss of Huawei's business for anyone—including the major telcos which were its top customers—that might want to do business with the military down the road. And it came with lots of very public posturing from politicians about the importance of protecting ourselves from the China threat…

As the saying goes, however, "He who smelt it dealt it." We were worried about them using their equipment to spy on us because we were doing it to them at every turn. Nothing personal: we were doing it to everyone. But to a country that so values its separation from Western political meddling, for it to go from widely suspected to outright confirmed publicly was to add insult to injury from its "ally."

We've seen this kind of nationalism creep up before, with the pushes to "Buy USA" in clothing and American cars. In the end, it's always settled out in the marketplace naturally, over time. Never—so far—has it come down to the foreign trading partners being wiped from the scene.

But never before have so-called national security interests been so intertwined with economic matters. This could be a new chapter in nationalism that finds its way into law, cutting off important growth markets for homegrown companies on either side of the debate.

Pushing It Under the Private Sector's Rug

The political wrangling is far from a cross-national phenomenon, of course.

Here at home, this summer IBM found itself in the political fray after failing to deliver a workable unemployment benefits system for the state of Pennsylvania.

The project, originally projected to cost $106.9 million, had run 42 months past deadline and more than $60 million over budget when it was canceled by Pennsylvania's Secretary of Labor and Industry (DLI), the department working on the project with IBM.

The cancelation came complete with a press release foisting blame on IBM—an exercise in political butt-covering, of course, as why else issue a press release about having wasted millions of tax dollars? Like most fights that go public, it quickly turned into a tit-for-tat finger-pointing match.

IBM fired back that it had been meeting weekly with the department to keep it apprised of how far off the rails the project had gotten; that the budget overruns had been approved right up to the top; and that the reason it all went on so long was that in four years' time no project leader had ever been assigned. Per a report from Carnegie Mellon commissioned by the DLI:

"From the start, DLI was not able to provide adequate resources to staff its planned management and governance approach. Further, DLI made no formal delegation of roles, responsibilities, and authority for management of the program. DLI's approach to managing the UCMS [unemployment compensation] program from contract award to early 2011, led to a situation in which no one in DLI was accountable and responsible for the administration of the program. As a result, there was no effective oversight or timely action to make definitive decisions to mitigate the systemic risks that were continually highlighted by the IV & V contractor."

Blame, of course, cuts both ways in such a debacle. So IBM was equally taken to task for its own practices, including a high employee turnover:

"The size and churn within the Contractor's workforce has also contributed to program discontinuity. Since the start of the project, 638 different contractor staff members have worked on the project with the majority of the workforce having less than one year on the project and 75 percent having less than two years."

No project owner assigned and no oversight provided? Who could blame talented developers from recognizing the extent of the problem and jumping ship quickly?

The truth is, neither party in such a contract is incentivized to succeed, let alone early or under budget.

On its side, if DLI staff managed to finish the project for $50 million, a year early, and saved the state another few million in labor costs from the efficiencies the software was to provide… what would they get for putting in more hours and working harder? Maybe a token bonus… certainly not the type of reward the private sector could pony up directly.

IBM would have made half the revenue and, given that it's selling services, less than half the profit—because all the costs of selling are amortized over less revenue to fulfill, reducing net margins.

As if to make my point for me, the Pennsylvania dustup came right on the heels of a similar incident where the Queensland, Australia government publicly hung IBM out to dry. A projected $1.2-billion cost overrun for its health payroll system had the government engaging in the usual pointing of fingers. It did so at IBM, whose project billings actually comprised less than 2% of the projected total.

With all this bad publicity, there is probably no one happier that crashed so thoroughly than IBM, which had nothing to do with that particular spectacle…

Speaking of the recent fiasco, it is itself a gentle reminder of how easily and quickly these things turn sour. I won't belabor a topic that is being covered to death in the mass media, except to point out one universal irony of working with government that the situation demonstrates so perfectly.

In his apology to the nation over the state of the website at launch, President Obama vowed to bring in outsiders—from the private sector of all places—to help solve the problems with the site. Sounds like a great solution, until…

You consider that the website was already built by the private sector, sort of. The Frankenstein monster was stitched together by a half-dozen different federal contractors, including:

  • Canada's CGI Group (GIB), which is of course suddenly infamous for its missteps with huge government contracts;
  • Quality Software Services Inc., a private outfit whose clients are dominated by Medicare/Medicaid centers, National Institutes of Health, Department of Health and Human Services, and so on;
  • National Government Services Inc., a division of WellPoint (WLP);
  • Terremark Federal Group, a unit of Verizon (VZ);
  • MITRE Corp., a $1.5 billion/year "not-for-profit" which works almost exclusively with the government and is known for compensating its mostly ex-government executives very well despite the charity-like moniker;
  • Genova Technology, a privately held business with a $16 million contract, despite which the Iowa state government ironically certifies as a "disadvantaged business"… a status complete with tax breaks, since it is female owned.

The vow to bring in outsiders is little more than political-speak for, "You guys failed to make our unorganized mess look organized. You're fired. Next!"

I've learned from personal experience that for a government or nonprofit project to be successful, there must be strong leadership at the helm. And the cause must be championed for reasons other than financial reward.

It is solely the responsibility of government or the NGO seeking the contract to ensure that a project be successful. If a vendor is not performing, it should be let go 42 months before deadline, not 42 months after.

In the private sector, it's simple: fiduciary responsibility and financial reward provide a compelling push in the right direction. That's an advantage the public sector does not enjoy.

Its decisions are driven by wholly different, often opposing, motivations.

Worse, those decisions can flip around overnight with no real benefit for the end consumers of the work.

Nor for the shareholders who so often find themselves victims in the unending struggle between companies living off government largess and the fickle ambitions of political types.

Step Out of the Fray

How then, short of bribing a few politicians, is one to profit in the face of such a complex and changing relationship?

Big or small, there's no legal or ethical way to know how government policy may swing fortunes in one direction or another. What you can do, however, is recognize the risk and how to avoid it. And occasionally, leverage it to your advantage as well.

The former is the easier half of the mix. The first thing to watch out for is companies that have become addicted to government revenues. As an executive or a middle manager at a public company or the owner of a smaller private one, the revenues available from the government (especially the massive federal one in the US) are tempting fruit. The first time a $50 million/year company nabs a $25 million contract from the feds, it finds itself caught between two irresistible forces:

  1. With just one contract, even if it were a little slow to happen as is typical, revenue jumps big-time.
  2. Once certified to work with the government (which places all sorts of compliance hoops in front of would-be contractors), doors begin opening. Get accepted by one agency, and it's like being invited into the old boys' club. The next bid or contract is much easier to land.

Next thing you know, you have a dedicated federal government business, raking in huge revenues… like CGI Group, the top-billed culprit of the fiasco. It's a company that has grown revenues over the past 15 years from $230 million to $5.2 billion, with half its business dedicated to government contracts. Most of the rest derives from highly regulated business as well, with a quarter from finance and over ten percent from utilities and telcos.

At the beginning of that period, it earned less than $30 million from government contracts. Now it's a few billion.

As a large owner of a smaller company, the bait is tempting.

It's enough growth to power huge profits, and can make you fabulously wealthy off of one client instead of thousands.

As a small owner of a large company—which all of us public-market investors are—it's dangerous territory.

Navigating the minefield well can create huge growth, no doubt. But it also adds monumental political risk, which is not accountable anywhere on a balance sheet.

As you evaluate investments, you have to factor in exposure to such risks as part of your due diligence. Not a simple matter, since it changes every day with the political winds. In the case of Teradata, the new China reality may pass, opening the market back up. Or it may be here for some time to come. Either way, the company will have to adapt.

For a company like CGI, the picture is cloudier. What if its failures today shut it out of large numbers of future government contracts? What does that mean to a company that lives and dies by political whims?

The world's governments have pushed debt and spending to new heights as a share of the global economy. How much more growth can come out of that sector? Maybe instead, we're seeing signs of the first punctures in the government spending bubble…

At the end of the day, the surest way to insulate yourself from ANY market risk is to invest in great, well-run companies with products that are in demand. And hopefully, in demand from a large variety of customers, not just one with really shaky finances.

Invest in Undiscovered Growth

The growth to be found from companies that are producing value—be that in inventing the next medical diagnostics breakthrough, mining a huge platinum deposit in Africa, or saving Europe from Russia's energy hegemony with American-style shale drilling—is always rewarded by the market.

You can profit from the winds of change in the government's policy du jour, yes. But it's going to be a wild ride.

Yes, you can clean up in the wake of those messes, as my colleagues at The Casey Report have been demonstrating for quite some time.

But it's growth that will ultimately insulate a company from the shifts of any one customer base. And when the market is discounting the future prospects of the next generation of growth companies in favor of established large caps feeding off of government, that creates a situation to be taken advantage of.

Never before in Casey Research's history have there been so many strong growth opportunities in our collective portfolios—with valuations at stupidly low levels for companies already producing huge value.

David Galland recently wrote a letter to our readers highlighting exactly that.

Let me explain just what kind of ridiculous valuations we are talking about. One company from the Extraordinary Technology portfolio has invented a remarkable new machine. It's about the size of a desktop computer of yore, and in a few hours' time—with no test tubes or microscopes required—it can diagnose sepsis… a disease which is the tenth leading cause of death and one of the most expensive reasons for hospitalization in the US.

Before this machine was developed, it took from 2-7 days and cost more than $2,000 to properly test for and diagnose sepsis. That delay pushed the fatality rate off the charts.

Now, with one simple 2.5-hour test, hospital stays are reduced on average 2.3 days, and each early diagnosis saves more than $20,000. Not to mention the lives saved from the proven 99%+ accuracy rate in prescribing the toughest specialized antibiotics for rare strains of the infection.

It's no wonder, then, that the company is growing revenues rapidly. In 2012, they were up 60%. They're on pace to top 100% growth in 2013.

Moreover, the company is just now bringing a rash of new tests to the market:

  • One to detect a deadly genetic risk from taking a popular blood thinner, a condition that 10% of patients have and rarely know about until too late
  • A test to locate rare proteins circulating in the bloodstream that are a precursor to imminent heart attack
  • Another to detect C. diff infections, which can become a nightmare if the bacterium is antibiotic resistant

And there are many others to follow in their wake, including blood tests to detect various cancers.

How can the company do this so rapidly? Its unique technologies, called spherical nucleic acids, use a gold nanoparticle bound to a reactive biological marker. A unique marker can be found to test for virtually any genetic, protein, lipid, or other biological marker with incredible sensitivity. It has the patents to make it happen, and the machine to allow any doctor or hospital to cut out the mail-away lab test…

Imagine a doctor's office where, instead of swabbing your throat and telling you they'll call you in four days to tell you if you have strep throat, you can be tested right there in the office for a fraction of the cost and time.

Imagine too our surprise when we discovered, vetted, and invested in this company while Wall Street was completely ignorant of its potential. But they'll catch on. They always notice the growth once it starts materializing. It's already begun; and November 1 brings the next report on what we see happening on the street—big growth.

Which is why I'm telling every subscriber I have about the potential behind this excellent long-term investment.

It's opportunities like this—and our energy team's discovery of the potential "Next Bakken," which we've told you about over the last few weeks—that make for real investing success.

Not inching a few points above the S&P, mind you. I am talking about tech's 39-10 track record at selecting winners and an average 42% gain, 4 TIMES the S&P's benchmark. Or the remarkable returns of mining portfolios in 2009 and subsequent years, with 100%+ average returns per position thanks to the panic bottoms.

Our portfolios are literally dripping with small-cap opportunity right now. The stars are aligned after brutal valuation fallouts in energy a few years ago and mining last year. Today, these markets are providing a time machine-like opportunity… s chance to go back to the 2008-'09 market-crash-level valuations and scoop up bargains.

That's why we've decided to open up a unique new program to all of our readers for the first time ever. A chance to get all the buys from all of our newsletters, with no risk. Click here to read the critical letter David Galland just wrote to subscribers.

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