I state in the title of this chapter that California is a country. Technically, it is not. It is one of 50 states in a union, a political determination. But as I see it, California is a giant and a true player on the world stage. As a territory, it ranks consistently among the top countries in the world in terms of economic output. California also is an open, free-market society that does business not only with other states in the U.S., but with countries around the globe. Considering all this, I see California as a country, one with an integrated economy.

Increasingly, countries worldwide are considered integrated within a global economy. When economies are integrated, trade, information, and capital flow freely, although to different degrees, from one location to the next. The U.S. itself is an integrated economy. So is California, on its very own. A nonintegrated economy, on the other hand, can be characterized as one that is, to a degree, self-sufficient and in which trade flows to it or from it in a limited or restricted way. Before the collapse of communism, the Soviet Union could have been considered a nonintegrated economy, as can Iran and Cuba today, although to differing degrees. The U.S. and the “country” of California rank among the most integrated.

In good part, economic integration is all about the flow and the ease of flow, of goods, information, and capital between locations. An air hockey table might help describe this. When the table is turned on, a layer of air forms over it, making air hockey a low-friction game. Simply nudge your puck, and it glides (or flows) to the other end of the table; lessen or remove that air, and moving the puck takes much greater effort.

This example is an ideal, and, unquestionably, the real world is not always ideal: Grades of friction exist between locations. Sometimes the “puck,” or product, flows almost effortlessly between points A and B, as if across a cushion of air. Sometimes it labors to move or gets stuck, as if someone pulled the plug and shut off the air.

In practical terms, the friction that plays on the free flow of goods is in large part the cost of moving those goods from one place to another. Just as we discussed transaction costs in previous chapters, now we’re talking transportation costs. In the past, I’ve gone to the orange to illustrate this concept: If it generally costs 5¢ to transport an orange from California to New York, that 5¢ becomes the accepted level of friction for the flow of that good. If the friction increases and it costs 6¢ to transport that same orange, New York might turn to Florida, which can deliver the fruit for 5¢. This introduces another investment term: arbitrage, the process of attempting to profit by exploiting price differences of identical or similar financial instruments on different markets or in different forms. By looking elsewhere for cheaper oranges, New York involves itself in “arbitraging,” or taking advantage of the difference in prices between locations. (Economists would refer to that 5¢ as the protection shield New York enjoys. If California can’t deliver at 5¢, New York is protected because it can maintain that 5¢ cost by going elsewhere.) Conversely, if the friction lowers and it costs less than 5¢ to transport an orange between California and New York, the supply of oranges between the localities will increase. At the same time, New York will not have an incentive to arbitrage or go elsewhere for its oranges because it would not be profitable to do so. This latter situation also protects California’s orange growers against foreign competition: If it is not profitable for New York to arbitrage the difference in the price of oranges, foreign competition (which here could mean Florida or South America) against California will not arise.

As we turn to the California energy shock, try to think in terms of pucks and oranges—in terms of the flow of energy into California and the differences of energy prices between regions. Jumping ahead a little bit, certain California “pucks” weren’t gliding so well, while the price of “oranges” it was forced to buy was too high.

In March 2001, the sun pulsed over California with a bit more muscle than usual for that time of year. The mercury, which in a more normal spring might slide between 60°F and 70°F, pushed through the 80s and even into the 90s in parts of the state. High summer had come early to the West Coast, and as one might expect, the air conditioners went on—an annual event that in most other years would mean cooler Californians and business as usual. But this year was different: When the ACs powered up, California fell deeper into crisis.

Signs of a crisis first asserted themselves in 2000 when it was announced that rolling blackouts might be enacted in the state. Rolling blackouts are typically unique events that occur when the supply of energy falls to a certain level below demand, forcing power companies to unilaterally shut off customers town by town and sector by sector for a period of 60 or 90 minutes. In June 2000, rolling blackouts went into effect in San Francisco, and in January 2001, they again rolled through the north of the state. But the March 2001 episode marked the first time they crept into Southern California. No longer was this an inconvenience; it was a sustained statewide crisis.

Media reports that March described the damage: People got stuck in elevators, teachers moved classes outside, store workers led shoppers through aisles by flashlight, drivers went to hand signals at darkened intersections—all problematic but manageable events. On the more serious side of the ledger: fatalities occurred, businesses came to a complete stop, workers idled, technicians delayed research, chain stores turned away customers, factories came to a pause, deliveries fell behind, and clients—those companies that purchased goods from California’s firms—began looking for alternatives.

All this added up. And even when the blackouts were not in effect, the wrath of the energy crisis was still being felt. For instance, many California companies were given incentives to save on power use, such as discounted rates if they cut their energy consumption. The idea here was to “play team ball” while the state grappled with the power crunch. But companies complained that the productivity losses that came with reduced energy use negated any savings that showed up on their monthly energy bills.

California-wide, productivity, sales, and profits were all taking a hit. And when these drop, economies suffer.

The San Diego Regional Chamber of Commerce is one of the most influential forces in local government and regional economic development. With more than 3,000 members, the Chamber of Commerce is actively involved in public policy and providing valuable resources to its members. The chamber economist for San Diego County, Kelly Cunningham, took the March 2001 episode seriously. He had been bullish on the area’s prospects coming into the year, but when the lights rolled out for the first time in Southern California, he knew he had to alter his projections. Rather than stick to his forecast of 3.5 percent growth, he began to contemplate recession.^[1]

Would you as an investor have made the same call? And what would you have done if you had companies in your portfolio with operations based in California during the energy crisis of 2000–01?

If you had owned stocks of California companies at the time of the blackouts and you feared for their performance overall, your gut reaction would have been correct. The energy crisis was a particularly bad one. Lost productivity, sales, and profits infected thousands of California’s businesses. If you were uninvested in California during the period, you would have considered yourself lucky.

Of course, you don’t need to rely on luck when you can see a shock coming.

My crisis indicators were flashing well before March 2001, the point at which we can say the shock fully manifested in California. As the media reported it, the statewide blackouts were the result of a confluence of factors: reduced energy imports by the major utility companies, power plants unable to supply energy because they were offline for repairs, alternative-energy plants shutting down operations because they hadn’t been paid, and those summer temperatures that arrived in earliest spring. The root cause, many concluded, was a combination of energy deregulation in the state and the rate “ceilings,” or caps, that were placed on California’s utility companies. Those ceilings were below what it cost the utilities to purchase the energy they were to supply customers, which is hardly a good way to do business. (Another source of the crisis can be traced to Enron, the pariah of all pariah companies these days. But this connection wasn’t made in the media until the crisis period in question had ended.)^[2]

Each of these factors played a part in the March 2001 wave of rolling blackouts, but I and a few others look at the origins of the crisis a bit differently. For years, environmental groups had pressured California’s politicians to mandate a reduction in the use of conventional “dirty” fuels, such as coal and oil, or new-age “dangerous” options, such as nuclear power. That pressure worked, and environmental regulations were passed that made it difficult for companies in the state to build plants that burned anything other than “clean” natural gas. It follows that the demand for natural gas increased in the state, as did the price of a fuel that had historically sold at a discount to light crude oil.

Added to this, the state could acquire the energy it needed at the time of the crisis in basically two ways: import the energy itself or import the fuel to generate the energy. The problem in California in 2000–01 was that the pipelines transporting natural gas were running at full capacity. Hence, it was virtually impossible to increase that supply. Energy itself needed to be imported, which came at quite an expense.

From here the energy crisis boils down to an instance of supply not meeting demand. When the temperatures soared in March 2001, the demand for the energy needed to keep people air-conditioned, refrigerators operative, and factories powered outpaced the ability of suppliers to deliver. If you lived in California, read the papers, watched the local news, and were tuned to the forces of supply and demand, you might have been among those who predicted the arrival of this shock.

But questions remain. In this instance, with supply not able to meet demand, don’t we have a classic inelastic situation in which price increases will restore equilibrium?

Not necessarily—or, at least, not automatically.

As discussed, the delivery mechanisms for the preferred fuel, natural gas, were running at capacity. Buying and bringing in suddenly expensive natural gas and pure power from out-of-state suppliers wasn’t working that well because California’s utilities had trouble paying their bills. And why couldn’t they pay? Because California’s government had put caps on what its utilities could charge customers.

Arbitrage—specifically, the practice of taking advantage of differences in prices between markets or regions—ultimately lessened California’s energy crisis. California needed energy, so energy became a profitable enough endeavor to mobilize (or incentivize) market forces to solve the problem. Politicians also started to wake up to the fact that California could not function in a modern world if it could not adequately power its inhabitants. This movement, currently ongoing, is working to reduce regulations in the state. For instance, to the extent that an easing of regulations will put the various fuels on a more even playing field, markets naturally gravitate toward the cheaper fuels—perhaps more coal in the near term and nuclear power in the longer term (because nuclear facilities take longer to build).

In the short run, however, the delivery mechanisms for the supply of power had constricted enough to put the “country” of California at a disadvantage to its neighbors in an integrated economy. Arbitrage would cure the situation, but before it could, California’s companies were left to manage the crisis on their own. This begs another question: If a state or location can arbitrage price differences between regions, why can’t a company?

Our investment opportunity is founded in this answer.

We’ve discussed flow and friction in terms of the supply of fuel and energy to California. These variables exist for companies, too, and can be considered in terms of the mobility of factors of production.

Many factors of production exist, and some are more mobile than others. If you work in a company, you are a factor of production. In a free society, you can stay or go as you choose, and most likely, you’ll go if you can get a better paycheck elsewhere. Capital is a factor of production that displays much mobility in free societies; by nature, it migrates to where it will see the highest return. A company with several factories spread across different locations also exhibits mobility in terms of production—it can shift operations to low-cost areas or away from high-cost ones, with a great incentive (i.e., the lure of increased profits) to do so. This might sound like arbitrage, and it is.

At this point, we can begin focusing on the location effect from an investment perspective.

Size and location are among the “pair-wise” decisions that must be made in constructing a balanced portfolio, and these should be considered together in terms of the location effect. Size-wise, larger-cap stocks represent the biggest public companies, smaller-caps the smallest, and midcaps those companies that fall in between. Companies are usually classified as either large cap, medium cap, small cap, or micro cap, depending on their market capitalization, but the dividing lines are usually arbitrary. As a general guideline, the market capitalization is $5 billion or more for large caps, $1 billion to $5 billion for medium caps, and less than $250 million for micro caps. The market capitalization is based on the value of the outstanding shares. Location-wise, the choice is between international and domestic assets. This is a pretty clear-cut decision when thought of in terms of whether to invest in U.S. companies or businesses based elsewhere around the globe. But the distinction gets a little muddier when you think of, say, a large-cap stock such as Procter & Gamble.

P&G is based in Cincinnati, Ohio, although it has operations throughout the U.S. as well as nearly 80 countries worldwide. Will an economic shock in Ohio—or the U.S., for that matter—affect P&G the way it does a small-cap company that can boast only one plant in that same state? Not at all. Because of its size, P&G can adjust to a shock by sliding operations either toward that shock (if it is a positive one) or away from it (if it is a negative one). The one-plant company in Ohio, meanwhile, must ride out every shock that lands on its location, good or bad.

This idea further extends the concept of elasticity: The inelastic company, this time in terms of its production being fixed in a certain location, will feel the full effect of an economic shock on that location. Conversely, an elastic company, with plants in multiple locations, can move its production either toward good shocks or away from bad ones. In the preceding example, Procter & Gamble, the large-cap company, displays elasticity in terms of location. The one-plant small-cap company exhibits inelasticity.

Sometimes big is better. And sometimes small is stuck.

A single-plant company exhibits immobility in that it cannot easily relocate its operations to take advantage of a better economic environment. It can and will do so in extreme cases, such as when the negative effects of an economic shock in a location threaten to persist for a very long time. But extremes are not the norm, and often businesses by their nature have few options but to operate right where they are. Think again in terms of an orange. If you were a grower in California during the energy shock, you needed that sunshine (i.e., you weren’t about to move your farm elsewhere), although you might have worried about your irrigation systems, which required power to operate.

The basic rules for how companies behave in terms of mobility are similar to those we determined for elasticity:

Know your shocks, the locations they touch, and the size of the companies they touch, and you will be well on your way to implementing a successful location-based strategy. Maybe you can begin implementing it now. If you discovered companies in your portfolio with operations based in California at the time of that state’s energy crisis, which ones should you have abandoned first, large-caps or small?

If you answered “small,” you are correct.

The California energy shock was clearly a negative one, so, in theory, the single-plant small-caps would have underperformed the multiplant large-caps headquartered in the state. Back in 2001, in an attempt to quantify this expected result, my first chore was to separate California’s immobile, single-plant businesses from its mobile, multiplant operations. But I was faced with a practical dilemma: How could I determine the number of plants operated by each of California’s public companies without spending countless hours on research?

Well, I used a shortcut.

I first looked to the entire S&P 1500 universe—that is, the 1,500 public companies tracked by Standard & Poor’s—and from there I extracted all the companies with headquarters in California, 247 in all. After that, I separated the California companies by size (or market capitalization), the idea being that a large-cap company would likely be a multiplant operation (with some out-of-state facilities) and that a small-cap would operate only one or a few facilities (most of which would be anchored in-state). In my California stock basket, I identified 77 large-caps, 106 small-caps, and 64 midcaps. And what did I find out?

Before I show the results, I need to point out that not all economic shocks happen independently. In fact, shocks rarely happen in isolation. In the California example, while the energy crisis was spreading mayhem, the stock market was attempting to recover from the shock of the Internet bubble going “pop.” In other words, back in 2001, many tech companies in California had a lot more to worry about than the lights going out. Thus, if my analysis was to concentrate on the impact of the energy crisis on California’s public companies, I would have to separate out the tech companies. If not, they would infect the sample.

With this in mind, Table 6.1 shows what I uncovered for January to April in 2001 (when the energy crisis was at its height): All of California’s companies, tech included, underperformed their respective benchmarks. (In other words, California large-caps underperformed the greater universe of large-cap stocks; California small-caps underperformed the greater universe of small-cap stocks; etc.) But company performance, after weeding out the tech companies, worsened the smaller you went on the size scale: California’s nontech large-cap firms performed almost on par with their benchmark (the S&P 500), while California’s nontech small-cap firms underperformed their benchmark (the S&P 600) by more than double.

Taking these negative results together, investors clearly would have been smart if they had avoided all California companies for the duration of the energy shock. But the study also confirms the predictability of the location effect: As expected, California’s nontech small-caps suffered the most.

From these results, we can draw some general investing rules:

The Golden Rules of a Location-Based Investment Strategy

Because you can use a stock’s size designation (e.g., large-cap, small-cap, etc.) as a stand-in for whether that stock represents an immobile, single-plant operation or a mobile, multiplant business, this strategy is relatively painless to apply.

Often mitigating factors arise—such as the tech-stock decline in relation to the California energy crisis—when you apply any one investment strategy at any given time. So the idea should be to keep your eyes wide open—but not necessarily for a host of diverse variables. In my opinion, as a good investor, much of what you should be on the lookout for will be similar in nature. You need to identify a location shock, be it a natural disaster, a tax increase, or an energy crisis etc. and then use the multiplant and location approach to identify the companies that will be affected and those that will not be affected by the shock.

I’ve stated that I am an extreme advocate of the simple, and there’s no reason we can’t reduce much of what has been discussed so far in this book to a common denominator. The concept of mobility is much like that of elasticity, which I’ve equated to the idea of flexibility. At this point, I argue that all these terms are, to an extent, interchangeable. Call it what you want, but in the big investing picture, the flexibility, mobility, or elasticity of companies and/or industries most often determines their ability to adjust to, circumvent, or benefit from an economic shock. A bird watcher might look for color, plumage, and shape in identifying a species. But a bird watcher might also take note of how well a bird can fly. In my opinion, this latter case is how a good investor should proceed: Shock to shock, attempt to judge which companies can fly and which are grounded. The investment world will appear somewhat symmetrical, or balanced, when you proceed in this manner.

In economics, as in nature, every shock must have a resolution. A wind blows and a tree bends, but maybe a wind blows and a tree breaks. In the first situation, we have flexibility; in the second, we do not. Companies and industries have a few ways of responding to the economic winds, but the sum of responses is symmetrical—balanced within the larger macroeconomic picture. Sometimes companies reach out with supply to meet a sudden increase in demand, a situation that often means plenty of new competition and a downward pressure on prices. Sometimes companies cannot reach out to meet an increase in demand, but because demand still must be satisfied, prices will rise. In each case, the elasticity (or flexibility or mobility) of any one company in relation to the competition forces it to pass along (either forward to customers or backward to suppliers) the benefits or costs of adverse or positive shocks. In each situation, there is a resolution—and a predictable one when you can grasp the supply-and-demand conditions underlying each movement in price.