I came across this video that I’ve never seen before. It’s a video of a young 31-year old Warren Buffett giving an interview to a journalist about the stock market decline that occurred in the first half of 1962:

Buffett’s comment at the very beginning of the video regarding President Kennedy’s “actions on steel” referred to this press conference on April 16, 1962.

Basically, JFK announced that the Department of Justice was opening an investigation into the pricing strategies of the major steel companies. Steel prices and steel company profit margins had been rising despite excess capacity, lower input prices (steel scrap and coal), stable labor costs (according to the BLS). Steel company dividends exceeded $600 million in each year between 1957 and 1961. These facts, along with the 100,000 steel workers that lost their jobs in the three years leading up to 1962 was too much for the populist president to take.

I haven’t investigated this, but I wouldn’t be surprised if the steel industry made more money in 1961 than it did in most years of the recent decade or two.

The Difficulties of Investing in Highly Regulated Businesses

Buffett just referenced the steel industry, and although he has made investments in cyclical businesses at times, he has often talked about the headwinds an investor faces when doing so. JFK’s 1962 press conference is an example of one such headwind that recurs over and over again in highly regulated industries.

I heard someone talking about the cyclicality of the airline business and how regulators and lawmakers are constantly trying to balance the opposing desires of customers (who desire low prices) and airline companies (who desire high profitability). Throw in a third party with a third desire (labor unions who desire higher wages) and you have a never ending tug-of-war.

Regulators and lawmakers generally desire to pass legislation designed to keep prices low for consumers, which has the side affect of curbing airline revenue–often to the point at which airlines collectively lose money. Inevitably, it dawns on the bureaucrats that it’s good to have airlines around, and so mergers are allowed and airlines are once again allowed to make profits. For a time the airlines are allowed to make money, but inevitably the profits once again attract the attention of the lawmakers and regulators (not to mention labor unions), who begin looking for ways to tilt the scales back in favor of customers, and the cycle repeats.

The same cyclical battle between lawmakers (who supposedly have a proxy for consumers) and corporations (who supposedly want to make money for their owners) have existed since the days of John Sherman and more specifically, since 1909 when the Justice Department sued John D. Rockefeller’s Standard Oil Company for running an illegal monopoly.

Halfway in between that time and now, JFK was griping about the excess profits and dividends that the US steel industry was making, and he vowed that the Justice Department and Congress would do something about that.

1962 Stock Market Decline

According to Buffett, the JFK press conference precipated the stock market decline (which was presumably top-heavy with steel companies at the time).

However, Buffett seemed a) like he couldn’t care less, and b) like he had no idea where the market would go next.

His apathetic attitude toward general stock market prices should be put into context. Interestingly, in 1962 the Dow dropped from a high of 731 to a yearly low of 535 (a decline of 27% in the span of a few months)! And everyone was panicky over the 12% decline we just had over the summer…

I went back and looked at the history books, and it appears that the Dow had dropped 15% or so when Buffett gave this interview and then went on to drop another 10% for a total top to bottom drawdown of more than 25%. The 1962 Dow rallied strong to close the year down 7.6%. Buffett meanwhile finished the year up 13.9% after being down 7% at the halfway point, a result he was quite pleased with given the sizable margin he achieved over the market.

Although the interview is very brief, it provides a glimpse into how Buffett thought about stock price movements even in his early days. I don’t think much has changed for him, as 53 years later he again is talking about how macroeconomic and geopolitical events (like the horrific terrorist attack this weekend in Paris) do not influence his investment decisions.

But, I started the post with a point about the difficulties of investing in highly regulated businesses. I would say that it helps to think independently, and I would never say never (after all, one could argue that airlines have provided some of the greatest returns over the past four years), but I think as a rule of thumb, it’s helpful to consider why Buffett has often guided investors away from investing in these cyclical businesses.

There are probably easier places to make money.

“In the end, banking is a very good business unless you do dumb things.” – Warren Buffett

Buffett has been investing in bank stocks since the 1950’s, and I think one of the things he probably likes most about banking is the predictability of deposit growth. As he says, if you don’t do dumb things—if you stick to taking in deposits and lending them out, you’ll mint money.

All the money center banks reported earnings a couple weeks ago. In the process of reviewing their filings, I also spent some time doing some research on the FDIC website and I found a table that the FDIC updates on industry-wide total deposits at all US commercial banks. At the end of 2014, US commercial banks held $10.9 trillion in deposits.

High and Predictable Deposit Growth

Here is the incredible statistic: US commercial bank total deposit growth has grown every single year (not a single down year) since 1948! There have only been 3 years where industry-wide deposits shrank from the year before (1937, 1946, and 1948, and these three years were all very modest declines).

So deposits across the industry have grown for 66 consecutive years.

Even more incredible is the rate of growth in deposits over the past 80 years. Since 1934, deposits held by US commercial banks have grown 7.3% per year. In the past 50 years, they’ve grown at 7.4%. In the past 25 years, they’ve grown at 6.0%. In the past 10 years, they’ve grown at 7.0%.

Bank Deposits

So incredibly, the growth rate doesn’t seem to be slowing down much. I’ve always thought of deposits as something that would grow at maybe just a very slight premium to whatever GDP does over time (2-4%). But at least over the past 80 years, they’ve basically doubled the growth rate of GDP.

I remember Buffett saying something about servings of Coca-Cola sold has risen every single year for 100 years or so. I bet he feels the same about the predictability of deposit growth.

He probably feels the same way about loan growth as well as bank earnings for that matter (which have also risen steadily and unlike airlines, the US banking industry has been profitable in 78 of the past 80 years).

And unlike Coke, since deposit gathering is a commodity type business, the lowest cost business will have the biggest advantage.

Unfortunately for the small community banks which have decreased in number by 2/3rds in the past few decades, the big regionals and the really big guys have these cost advantages. Wells Fargo is currently paying 0.08% (8 basis points) for its $1.2 trillion in deposits. WFC largely funds its asset base with these low cost deposits (the total cost of their funding sources is just 25 basis points), meaning that even in this low yielding environment, it makes a healthy return on assets. Other big money center banks also gather deposits very cheaply, but because deposits make up most of WFC’s liabilities (which also fund a more traditional higher yielding asset base—loans and securities), the bank achieves better returns on capital than the majority of its competitors.

Throughout its history, WFC has always taken market share. I took a look at the 1974 WFC annual report. In 1974, WFC had deposits of $10 billion, today they have $1,202 billion. So in the last 40 years, WFC has a 12.7% deposit CAGR. They’ve grown overall deposit market share from 1.3% in 1974 to 10.9% today:

WFC Deposit Share

(By the way, www.wellsfargohistory.com is one of the best company investor sites: 50 years of annual reports and other info).

So WFC has grown deposit market share, and grown share almost every year—especially in the past 3 decades. Given certain banking regulations and WFC’s size, you could argue that they’ll stop taking share, but as long as they just maintain their share (a pretty good bet given their track record), it seems pretty predictable to rely on steady mid-single digit deposit growth year in and year out. These deposits are the raw material that is used to create loans, which also have grown steadily over the past 80 years (loans have grown at a CAGR of 8.1% since 1934).

If you look at WFC’s ROE, it’s been a consistently profitable bank throughout history:

WFC 40 Year ROE

For the past few decades, the bank has consistently produced better than 1.5% ROA. At 10x leverage, this is about 15% ROE. Recently in this zero interest rate world the ROA has slipped to around 1.3%, so maybe you would say 13% is a better estimate of what shareholders can expect the bank to earn on their capital, but I doubt that a) interest rates remain this low forever and b) ROA doesn’t begin rising once ZIRP comes to an end.

With the deposit numbers and the low-cost moat of WFC, it’s hard to see value per share not compounding at 8-10% (at least) over time through a combination on asset and book value growth, steady returns on assets, and capital returns via buybacks and dividends.

The Investment Case for the Warrants

I have owned Wells Fargo through the warrants in the past, and bought them back during the August swoon when Wells traded down to 50 and the warrants got down to 17. What are the warrants? They are unique securities that were created by the government as part of the TARP Capital Purchase Program, where the government injected $205 billion of capital into the US banking system in exchange for debt securities, preferred stock, and in some cases, warrants to buy common stock.

The warrants are similar to deep in-the-money options, only with a very long time period before expiration as well as a few other small benefits. Originally held by the Treasury, these warrants were eventually sold at auction to the public and now trade on the NYSE. The warrants give the holder the right to buy a share of common stock between now and late 2018 for around $34 per share. The warrants have an anti-dilution clause which means dividends will reduce this strike price to around $33 by expiration.

I bought a decent amount when they traded down in August, but wish now that I would have really loaded up. I was somewhat reluctant to really back up the truck as I have sizable positions in a couple other banks. But I should have swung harder, and actually am considering buying more. With the warrant price around 21, the strike price around 34, and the current stock price around 55, it’s nearly free leverage so it allows me to keep a sizable cash position in the portfolio for other investments.

Buying the warrant is like putting a 30% “downpayment” (cost of warrant) on a share of WFC, but without having to pay any interest while I own the warrant and I’m not even required to pay back the “loan” (the value of the rest of the stock) if I decide to sell. I think the warrants of the big banks are some of the best investment opportunities in this market because of the quality of the underlying businesses, the value of the underlying common stocks, and the long-dated nature of the security itself.


WFC had a book value of $33.69 as the end of the quarter, up 7% from the previous year. At low-teen returns on equity and factoring in the dividend payout, I think it’s a safe bet that WFC compounds book at 7-8% annually. This puts book value around $42 per share in 3 years when we will have to convert our warrants into common stock (or sell them). If Wells can do 13% ROE (historically low, but what it has been doing this year), the bank will earn around $5.50 per share. At 12-14 times earnings, this equates to a price of around 32 to 44 for the warrants, which are currently priced around 21.

I think that’s a pretty good return over the next 3 years—especially given that I think the downside chance of losing any money is extremely remote. Banks are much safer, much better capitalized, more streamlined, and their stocks are much more cheaply valued than the pre-crisis days. Short of an environment that leads to either severe financial stress and/or single digit P/E ratios (which is possible but not probable), it is unlikely these stocks will be lower in 3 years than they are now—in which case the warrants don’t lose. If ROE begins to rise a bit when rates rise, the returns for the warrants start to get extreme, but that doesn’t need to happen for the investment to work out very well.

I think Wells is the best bank among the big money center or regional banks—it’s not the cheapest and I think some other banks might offer more interesting returns, but I think it’s the highest quality bank of the group. I find these warrants to be attractively priced.

Disclosure: John Huber owns warrants to buy Wells Fargo common stock for his own account and accounts he manages for clients. This is not a recommendation. Please conduct your own research.

Fastenal (FAST) reported earnings yesterday. I love reading Fastenal’s press releases. They are more like investor letters than they are press releases. I didn’t even see one “Adjusted EBITDA” reference in the entire release—which is written in layman’s terms more than corporate jargon. Management’s candidness and depth of discussion regarding the company’s operating results is a breath of fresh air.

So I thought I’d jot down a few notes and put it into a post. This is not really an analysis of the company, but more or less just a clipping of portions of the letter I thought were worth commenting on. It’s mostly a summary of the press release, but I’d definitely recommend getting in the habit of reading these once a quarter. If nothing else, it’s a respite from the typical corporate-speak that permeates most of what I find in the company filings I read.

To briefly summarize, the company has an outstanding history of growth, but that growth has been challenged lately—in small part due to Fastenal’s increasing size, but much more likely due to the significant difficulties in the heavy manufacturing and commodity-based businesses (who represent a sizable portion of Fastenal’s customer base).

Fastenal has always been able to grow throughout the business cycle, but this cyclical downturn is proving to be one of the more difficult periods that they’ve had to navigate so far.

That said, to this point they are still squeaking out some growth:


They think that revenue has been hit because their customers have felt the effects of a strong dollar, and of course the slowdown in the oil and gas business.

Making Their Own Luck

Interestingly, they have been aggressively adding employees during this downturn. Fastenal has always felt that they employees are one of the largest competitive advantages they have. A knowledgeable, well-trained sales force that understands how to effectively engage with the customer base is an advantage that often doesn’t show up directly in the numbers, but like the left tackle that is diligently and thanklessly protecting the quarterback all game, it’s an invaluable part of the team.

Fastenal has ramped up hiring:


In addition to expanding the headcount, they plan to open an additional 60-75 stores (around a 2-3% increase in store count) in the next year.

Fastenal management describes the company as two businesses:

  • Fastener distributor (40% of business)
  • Non-fastener distributor (60% of business)

Fastener Business

This is the business Fastenal started with 50 years ago. Fastenal is a distributor. They supply their customers with a variety of basic fasteners such as nuts, bolts, screws, washers, etc… The company sources these products from many different suppliers, and then sells to their more than 100,000 customers at a healthy markup (Fastenal’s gross margins generally are around 50%). Fastenal’s customers are usually the manufacturers at the end of the supply chain (farm manufacturers, oil producers, truckers, railroads, miners, etc…). The company also sells to non-residential construction contractors (plumbers, electricians, general contractors, etc…).

Roughly half of this business is production/construction and the other half is maintenance. The production portion of this business is very cyclical, with 75% of the customers engaged in some type of heavy manufacturing. This business is struggling right now. Fastenal mentioned that although they are steadily adding new national accounts (large customers), 44 of its largest 100 customers are reducing their spending on Fastenal products, many because they are seeing significant revenue declines in their respective businesses and thus tightening the spending belt is a necessary result. This hurts Fastenal in the near term, although the company expects this cyclical capital spending to work in their favor once the recessionary conditions in the energy and mining businesses subside.

But the downturn in commodities and the heavy manufacturing sector has caused growth in Fastenal’s industrial production business to go negative:

FAST-Industrial Business

Non-Fastener Business

Fortunately for Fastenal, the sale of fasteners is a sticky business because it’s difficult (expensive and time consuming) for customers to change their supplier relationships. This stickiness has probably even improved as Fastenal grows its vending machine business which primarily focuses on distributing non-fastener products (instead of candy bars, FAST is popping out tools, equipment, and other non-fastener products through vending machines at their customers’ own facilities):

So with a Fastenal vending machine onsite at the customer’s location (along with knowledgeable Fastenal employees providing service and product replenishment), this creates a resilient line of business for FAST. In fact, they now have around 53,000 machines onsite at their customers’ facilities—all doing an average of around $1000 per month of business (that’s a $600 million business that grew 17% in the last year).

So strong results from the industrial vending business is helping the non-fastener segment of Fastenal’s business, but the overall segment has seen growth slow from 18% in the last half of 2014 to 6% growth in Q3:


So this non-fastener business is still growing, albeit at a much slower rate. And management says that they are still taking market share.

Macro Winds Impacting Fastenal’s Business

Fastenal believes growth is impacted generally by three categories:

  • Execution
  • Currency Fluctuations
  • Economic Fluctuations

My take is Fastenal is executing very well–as best as they can in this environment. So the latter two are the culprits. Currency fluctuations only impacted Fastenal’s growth by 1.1%, so not a significant decline due to the weak Canadian dollar. However, Fastenal’s US customers represent 89% of sales, and many of those customers are impacted by the strong US dollar. So I think that Fastenal is probably impacted much more indirectly by the strong US dollar than they are directly as a result of their Canadian operations.

Economic Conditions

Sales to customers engaged in heavy manufacturing are estimated to be about 20% of overall FAST net sales. These businesses include the mining, agrictultural, and construction end markets, and all of these sectors have been hit hard by the bear market in oil and other commodity prices and a slowdown in construction and weak Chinese demand for heavy equipment.

PMI Index

The Institute for Supply Management conducts monthly surveys of private sector companies to gauge the health of the manufacturing sector. The oft-cited Purchasing Managers’ Index (PMI) oscillates between 0 and 100 (spending most of its time between 40 and 60) and basically measures manufacturing expansion when readings are over 50 and contraction when the index drops below 50. The PMI can be thought of as a general barometer of the current strength or weakness in the buying power of Fastenal’s customers that do business in the heavy manufacturing sector (again, approximately 20% of Fastenal’s revenue is impacted here). The PMI has spent most of its time since the recession in the mid-high 50’s but dropped to 50.2 in September, the lowest reading in 3 years:


So who knows what economic conditions will look like in a year (I certainly don’t), but the slowdown in the manufacturing sector has, for the first time, really affected Fastenal’s top line growth.

Valuation and Some Commentary

I think FAST is an outstanding business with moderate growth potential over the long run. They operate in a large and fragmented business and their scale, employee expertise (these sales guys know their products well), the sticky nature of their customer relationships, the thriftiness that management has toward expenses, the small ticket price of most of their products, the vending machine program (getting a spot on the customer’s location is huge)—these are all attractive features to me about Fastenal’s business.

By the way, any Harvard MBA who claims that expense management and frugality is not a competitive advantage should read this: The Cheapest CEO in America. They should also pull up a long term chart of Fastenal stock price, and see how a company that sells nuts and bolts and keeps costs low somehow has been able to eat their competitor’s lunch for decades.

By keeping operating costs very low, Fastenal is able to pay their employees incrementally higher wages and thus more effectively develop and retain talented salespeople. The quality of service and depth of knowledge that the employees have eventually brings in more revenue, which grows the business and allows it to further lower operating expenses as a percentage of revenue, thus allowing for more hiring of top quality employees, which brings in more revenue, etc… Maybe an overlooked virtuous circle of sorts.

I think that the business will continue to grind out steady profits and steady growth for a while to come. I think that the business might struggle to grow in the near term given the horrendous state of affairs in certain portions of the commodity-based industries and heavy machinery businesses. But I think over time these are normal aspects of just about every business cycle and this isn’t Fastenal’s first rodeo. They are a very well-managed firm and will no doubt see this through.

What is it worth? The company produced $401 million of operating cash flow in the last 9 months. I’m not sure that the stock is a bargain at 20 times cash flow since

  1. the company has stated that there are still sizable capital investments needed to continue to grow its vending machine business (although those investments have been attractive so far), and
  2. it seems unlikely that the company will be able to achieve the sizable mid-teen rates of growth it has in years past.

Should I be wrong on the latter, the stock is probably cheap. I’m not worried about the capital investments because those seem to be producing solid returns. But I would be concerned about the future growth of the overall company. They claim to operate in a $160 billion market, which implies a long runway ahead, but the larger they grow the more bumps in the road there are (as a friend said, Fastenal used to be a meaningless portion of many of its customers’ expense budgets, but if Caterpillar or some other struggling large heavy manufacturer now sees that it’s paying $30 million to Fastenal, they may become more motivated to spend the time renegotiating that contract).

Eventually, the recessionary conditions many of its customers are facing will subside, and Fastenal will get the benefit of a cyclical upswing. And Fastenal will certainly continue to execute well and grow revenue over a long period of time. I’m just uncertain how fast that growth rate will be, and so at this valuation I’m not sure there is a big margin of safety.

That said, Fastenal has always exceeded expectations to this point (as evidenced by the fact that throughout history the stock has been too “cheap” most of the time—compounding at 23% per year since 1987):

FAST-Stock Chart

Quite the wealth creator over time. Since the IPO in the mid-80’s, the stock has done better than BRK, MKL, WFC, WMT, AAPL, MTB and just about every other long term compounder out there.

If anyone has comments on the business, valuation, future prospects, or anything else, feel free to engage.

Thanks for reading.

I was glancing through the Berkshire letters from the late 1990’s because I recall Buffett briefly mentioning his large silver position he acquired and I was trying to see if Buffett referenced the specific cash cost of production. He didn’t in the letter—only mentioning that Berkshire acquired 111 million ounces. He has mentioned in other interviews that silver was in fact below the cost of production—a supply/demand imbalance that can persist for a while, but not forever.

Buffett felt comfortable loading up on silver (he took down roughly 25% of the world’s available inventory), and then just storing it in the vault until this supply/demand dynamic normalized. He didn’t have to wait long, as silver appreciated modestly back above the cost of production later that year, and Berkshire booked a nearly $100 million gain on Buffett’s unconventional investment.

Today, the cost of production of silver has fallen to around $8 per oz, and the price is around $14, so for anyone hoping that silver might be a bargain after a 3 year bear market, it is still nearly 100% above the relative level where it was when Buffett backed up the truck to load up… (note: this is the so-called “cash cost” of production, which excludes company overhead expenses, exploration costs, and capex–it’s just the actual cost to pull the metal out of the ground, which is the metric I believe Buffett used in his decision to buy it in the late 90’s).

Speaking of unconventional investments—these are ideas that I think Buffett really loves, although he talks far more in the recent letters about the great businesses (and for good reason, those are the businesses that provide the “sure” money).

Of course, in his partnership years, Buffett talks a lot about both “generals” (stocks that are purchased simply because they are undervalued) and “workouts” (stocks with some corporate catalyst or event that will help realize the valuation gap). The workouts tend to be more “unconventional”, but can provide profits that are often uncorrelated to what the general stock market is doing. In Buffett’s early days, this involved things like oil company mergers, cocoa bean arbitrage, closed end fund liquidations, special dividends, spinoffs, activist positions, and many others. These situations provided significant profits to Buffett personally in the early years, and then later for his partners.

Buffett even bought silver in the late 1960’s—although he wasn’t a gold (silver) bug, like so many today.

Anyhow, here is Buffett in the 1997 letter discussing a few unconventional investments that Berkshire participated in. These are quite small relative to Berkshire’s equity, but it still describes his affinity for making profits out of unconventional special situations:

Unconventional Investments 1 Unconventional Investments 2 Unconventional Investments 3

The other interesting takeaway from this clip is that Buffett said he followed the fundamentals of silver for 3 decades without investing in it. Reminds me of how he talked about reading Bank of America annual reports and IBM annual reports for 50 years before ever buying a single share.

Patience—all knowledge is cumulative…

Buy when everyone else is selling and hold until everyone else is buying.” -J. Paul Getty

I recently came across a transcript of a talk that James Tisch gave to a group of students at Columbia. Tisch runs Loews (the conglomerate, not the home improvement store). Loews (L) has struggled in the past few years, but the long term investment record is outstanding. The stock price has compounded at 17% over the past 50 years.

I’ve never invested in Loews—the operating results of the equity investments they control and the returns on capital of the businesses they own have never been attractive to me, but I have high respect for the Tisch family and I read their annual reports each year. They have proven to be disciplined, prudent investors over the years, and have done a superb job compounding shareholder capital over the long term. They are also a company that Charlie Munger would refer to as a cannibal—constantly “eating” away at their own share count by steadily buying back stock. Over the years, Loews has reduced their share count from around 1.3 billion (adjusted for splits) in 1971 to around 370 million today.

Maybe at some point we’ll take a look at the operating businesses under the Loews “hood”, but it’s interesting to note that while Loews has been a compounder through successful investments and steady share buybacks over the years, the businesses and equity investments themselves often have been more opportunistic in nature—in other words, Loews is led by contrarian bargain hunters.

My own style of investing consists of an interplay between high quality businesses that are compounding intrinsic value and the plain bargains that are blatantly mispriced relative to normal earning power.

Stocks in the former category are my favorite types of investments. They are the longer term investments in companies that do the work for you. They generally are businesses that are able to produce consistently high returns on shareholder capital and often have reinvestment opportunities within the business—a dynamic that leads to growing earning power and a compounding effect over time. When these companies become available at cheap prices, it’s time to load up.

However, the latter category also provides really interesting investment opportunities. These are the bargains—the special situations that involve some sort of a corporate event, a misunderstood business division, or maybe a misunderstood event that is driving a gap between price and value. Sometimes these situations arise out of neglect, other times they arise out of disgust. Cyclical companies might fall into this category as well—stocks that fall in and out of favor depending on the economy or industry specific trends.

Loews often gets lumped in with the Berkshires, the Markels, the Leucadias, the Fairfaxes of the world simply because it’s another conglomerate led by value oriented management. But unlike some of these other investment vehicles whose management have tended to focus more on using the business model of insurance and float to acquire growing businesses at fair prices, I would describe the Tisch family as investors who have done more work in the second category—the category of bargains and special situations—specifically the cyclical businesses. Insurance, shipping, drillers, pipelines, hotels, and a variety of other cyclical industries have been represented in Loews’ portfolio of businesses and equity investments over the years.

Buying Bargains

In this talk to the Columbia students, Tisch talks about a few of his common sense simplistic approaches to investing. Basically, as Paul J Getty said, Tisch spent a lot of his time buying when everyone else was selling. He talks about the supertanker supply glut of the 1970’s when these ships were trading for less than scrap values:

“Let’s go back to 1975, when there was a building boom in supertankers, brought about by relatively low oil prices that had caused large increases in oil demand. A few years later, in the late ‘70s, there was an oil embargo and resulting oil price hike, which drastically reduced the amount of oil coming out of the Persian Gulf – much less oil, but still lots of tankers, now just bobbing in the water.

It was soon afterward, in the early ‘80s, that we started thinking about buying tankers. We had seen from reading newspapers that the worldwide supply of tankers was vastly overbuilt; according to quoted estimates, the market required only 30% of the ships that were afloat. As a result, ships were trading at scrap value. That’s right. Perfectly good seven-year-old ships were selling like hamburger meat – dollars per pound of steel on the ship. Or, to put it another way, one was able to buy fabricated steel for the price of scrap steel. We had confidence that with continued scrapping of ships and increased oil demand, one day the remaining ships would be worth far more than their value as scrap.

We were sure of three other things: First, by buying at scrap value, there was very little downside. Second, we knew that the ships would not rust away while we waited for the cyclical market to turn. And third, we knew that no one would build more ships with existing ships selling at a 90% discount to the new build cost. We were confident that the demand for oil, particularly from the Persian Gulf, would ultimately increase with worldwide economic growth and so the remaining tankers would ultimately be worth much more than their scrap value.”

He references a similar dynamic in the late 80’s after OPEC tough-talked the oil market causing prices to plummet and US production to slow (sound familiar?)—creating an oversupply of offshore drilling rigs. Tisch stepped in to buy his first rig at a price well below replacement cost, knowing that at some point the business would come back. This was the beginning of what is now Diamond Offshore.

Tisch also goes into how Loews got into the pipeline business, and discusses his overall contrarian investment philosophy.

Being a contrarian in and of itself doesn’t guarantee success, but when investing in cyclical industries, or in stocks in general, bargains often come about when “everyone” is selling and pessimism reigns supreme.

I personally don’t get excited about some of the investments that Loews has made over the years, as the businesses they own tend to produce mediocre returns on capital and that becomes a drag on the compounding ability of the conglomerate if these businesses are owned for a long time. Time is the friend of the wonderful business. Markel continues to grow intrinsic value because of its ability to reinvest sizable amounts of retained earnings at above average returns on capital. An offshore drilling business, a hotel chain, or a pipeline tend to throw off cash, but produce low returns on capital and have limited reinvestment opportunities. That’s not necessarily a bad thing for a company like Loews that might have alternative investments elsewhere, but those businesses themselves tend not to compound value of time.

An example would be to look at Diamond Offshore. Just glancing at the stock price will show periods where the stock was presumably trading at bargain levels, and there were certainly opportunities for astute contrarian investors to capitalize at various points in the cycle, but over the past 20 years, the internal returns on capital of the offshore drilling business are average, and lead to an average long term result from owning this business:

Diamond Offshore

Again, there are times when bargains abound in cyclical businesses, and Loews has been able to find a number of them. But as Joel Greenblatt once said, when it comes to stock picking, I’d prefer to “trade the bad ones, invest in the good ones”. Cyclical stocks often become incredible bargains, but these bargains should be sold at fair value because over time the stock price tracks the underlying business results, and cyclical businesses tend to produce average returns on capital over the full business cycle.

So while I love the bargain approach to buying ships below scrap value, drilling rigs when it was unprofitable to drill offshore, and pipelines when no one else wanted them, I wouldn’t be excited about owning them permanently. But then again, neither would most investors and that’s probably why the Tisches have been able to make money–. Reminds me a lot of one of my favorite investors—Walter Schloss—who made a lot of money out of junk over the years.

As an aside, Loews stock happens to currently be trading at a level that implies it’s out of favor itself. The stock currently trades at less than 70% of book value—a valuation level that has rarely been seen throughout the history of the company, possibly in part due to its recent operating results or maybe because of its exposure to energy. The operating results of the subsidiary businesses have been relatively mediocre over the past few years, leading to a subpar stock price performance in the last decade relative to their historical numbers. Nevertheless, I enjoy reading the annual reports and like the simplistic philosophy that has been the foundation of the firm for 50 years.

But regardless of whether you prefer quality compounders, bargains, or maybe a combination of both depending on the situation, I think it’s always interesting to listen to what someone like Tisch has to say.

Here is a transcript of the talk referenced above.

Stock prices have finally entered the much anticipated correction, and so I’ve spent more time lately looking at my watchlist of great businesses that I’d like to own at some point. My portfolio has been largely made up of special situation investments for some time, and although I don’t really have a preference when it comes to value (I’m just looking for the most mispriced investments relative to risk), I’ve always liked the compounders. These types of businesses do a lot of the work for you, and at the right price they can be sized very large as often their quality provides a margin of safety.

That said, I only think great businesses make great investments at great prices, and at least by the looks of my watchlist, it doesn’t appear that we are generally to a market level where great prices can be had yet. Although prices have come down, they could certainly fall much further (and will have to before there are numerous quality businesses at prices that I would really get excited about). So for now, I continue to look under the rocks and in the nooks and crannies for the special situation investments and bargains that are usually present in any market environment. But I have dusted off the “great business” watchlist and may become more interested if (hopefully) stock prices continue their descent.


“A diamond is a piece of coal that stuck to the job” – Thomas Edison

One business I have spent some time on recently is the coal industry (I’ve been reading about coal for a few different reasons, but not because I’m interested in owning coal stocks—if anything the opposite would be the case).

Despite Thomas Edison’s enthusiastic view of the potential of a diligent, hard-working piece of coal, I’m not sure he would have felt the same way about coal stocks. After spending some time researching the industry and a few specific companies, I’ve come to the conclusion that the aggregate equity across the entire US coal industry could be close to being worthless (so no coal stock is on my great business watchlist). Maybe that’s a bit harsh—a few low cost producers in the lower cost basins will probably see their equity survive, but most will have to restructure. There have been numerous bankruptcy filings already, and I think that trend will continue. Like many commodity businesses, these companies borrowed heavily to expand their plants right as the price of their product was reaching all time highs:

Metallurgical Coal

The coal companies leveraged up hugely in 2011 when demand from China—the world’s largest coal consumer—was at an all-time high and metallurgical coal prices were soaring (met coal is a key ingredient in the production of steel). Companies were making huge capital investments to expand capacity in order to meet this growing demand from Chinese steel mills, and since pulling coal out of the ground is a business that often consumes more cash than it throws off, these capital expenditures and expansion projects were financed with massive amounts of new debt.

I’ve found that a simple axiom has helped keep me out of trouble when evaluating companies or investment opportunities:

  • Rising Debt + Shrinking Revenues = Bad News for Stockholders

Debt-fueled Acquisitions at the Top of the Market

Not only did companies take on debt to finance “growth” capex, but some began acquiring other businesses based on overly optimistic outlooks for met coal prices and Chinese demand.

In 2011, Walter Energy paid $3.3 billion to buy a large Canadian met coal producer, Alpha Natural Resources spent $6.7 billion for Massey Energy group, and Arch Coal spent $3.4 billion for International Coal Group. Just 4 years later, Walter and Alpha have gone bankrupt, and Arch has found itself in the midst of an interesting bit of game theory between management and the senior and junior bondholders that may result in a “kicking of the can” down the road a year or two, but will almost certainly at some point see the equity wiped out.

So this cycle rhymes with most of the other boom/bust commodity cycles we’ve seen in the past. But with coal, it could be particularly more painful since coal is a commodity—unlike oil, gas or base metals—that likely has already seen its peak demand and could be in a long (but very slow) secular decline. According to the US Energy Information Administration, in April, natural gas topped coal for the first time as the number one source of electrical power generation in the US. This trend might accelerate or slow down based on the price of nat gas, but it does appear to be a trend. 5 years ago, coal-fired power generation was twice the level of nat gas-fired power generation, and now both coal and nat gas have roughly equal share of US power generation.

Adding to the cyclical woes are the regulatory hurdles that the industry currently faces, and will likely continue to face going forward. The US Supreme Court remanded the EPA’s Mercury and Air Toxic Standards on June 29th, which would have cost power plants upwards of $10 billion annually. This was perceived as a victory for the coal industry, but many power plants have already been converting from thermal coal to natural gas in anticipation of regulatory requirements. Who knows what lower courts will decide regarding mercury emissions, but once a plant switches to gas, it’s not going back to coal regardless of price.

But the bankruptcies we’ve seen so far (and likely will continue to see in the next couple years) have more to do with mismanaged balance sheets than regulatory policies or even pricing issues.

Is Trouble Opportunity Here? 

Is the pessimism surrounding the coal industry overblown? My own feeling is the pessimism surrounding coal as an energy source might be overblown, as coal is still used to produce nearly a third of the country’s electricity. This might be in terminal decline, but it will decline slowly over decades, not anytime soon. It takes a lot of time and money to convert a power plant from coal to natural gas or some other energy source. That said, many debt-laden coal stocks will go to $0, so while the industry will survive for a long time to come, current stockholders might not.

So has the carnage in coal brought down other businesses with it?


One place to look is railroads. The rail stocks have been clobbered over the past couple months (partly due to the recent stock market decline, but mostly due to the market suddenly worrying about lower coal volumes). Coal could be a legitimate concern for the railroads. In 2014 coal accounted for 39% of tonnage shipped and 19% of rail revenues, the single largest driver of revenue for the rails:

Rail Tonnage and Revenue Breakdown

I have just started thinking about this and reading about railroads. I don’t have any opinion on the value of rail stocks yet, and maybe this price decline is justified, or maybe it’s simply that rail stocks have been in a huge bull market over the past four years and this pullback is warranted simply from a valuation standpoint.

I’m not sure, but it’s a business that has some qualities that are attractive such as high operating margins, pricing power, and significant barriers to entry. It would be virtually impossible to replicate the rail network that Union Pacific or BNSF have cobbled together over the past century.

It also has certain things that are generally not viewed as positives such as unionized work force and significant capital requirements. The US rail industry will spend an estimated $29 billion in 2015 on maintaining and improving their network, and since deregulation in 1980, the railroads have spent over half a trillion in capex:

Rail Capex

Not exactly the “capital light” business than many investors look for… Of course, businesses that soak up sizable chunks of capital can still create significant value if there is an attractive return associated with that capital investment.

Another data point that could be considered positive or negative is the dramatic increase in crude by rail that coincided with the US energy production boom of the past 7 years—specifically the rise of hydraulic fracturing in the Bakken field of North Dakota. In large part thanks to the frackers, crude by rail has nearly tripled since 2008:

Crude by Rail

This is obviously good for the railroads if it can continue, but this could also be a point of concern if US production begins slowing down due to much lower energy prices. Crude is much less a factor than coal however, at only around 4% of revenue, but when combined with sand and gravel tonnage that is also used in fracking, it becomes a more meaningful revenue contributor.

Of course Buffett famously surprised many people when he bought BNSF back in 2009, a purchase that–despite what he said on Charlie Rose’s show–has provided Berkshire with spectacular returns. One of BNSF’s competitors is Union Pacific, which Buffett said took market share from Berkshire in 2014.

UNP has been clobbered along with the other rail stocks.

Here is a good article on the rail business—UNP specifically—that is worth a read.

It’s been a great decade to be a Union Pacific shareholder as pricing power and operating leverage have combined to triple operating margins from 13% to 37%:

UNP Margins

Operating income has increased to $8.7 billion from $1.8 billion in 2004, and the stock price is up 5x, even when factoring in the recent 30% decline.

I think it’s a good business. But I’m not yet sure what to think about some of the fundamental drivers (namely how will declining coal volumes affect the business, and where will margins be in the coming years).

This post is more of just jotting down some notes/thoughts on these businesses. I may begin writing more shorter-form posts on companies I’m researching as a way to share my notes and also get feedback from readers who may have also done some work on things I’m interested in.

So I have no real conclusion other than to say that UNP is one business on my “companies to read about list” that maybe will set up for an opportunity via a double whammy of a pessimistic coal outlook and an increasingly bearish stock market sentiment. We’ll see… Until then, I may begin parlaying some reading on coal into some work on the railroads.

Have a great weekend.

I just thought I’d put up a quick post as it’s Sunday night and I’m getting ready for the week and listing some things I’m going to be focusing on and researching this week, as is my routine on Sunday evenings.

I don’t often discuss the overall markets, but as I was doing some homework this weekend on individual stocks, I also spent some time reading the papers and various macroeconomic blogs to get a feel for what people are thinking about the dramatic stock market decline last week. I say dramatic, because although it was a swift a fierce selloff on Thursday and especially Friday, I think we should step back and remember that stocks and markets go up and down, not just up. The markets are only down 10% or so from the highs, the S&P down just 7%, which hasn’t even reached correction mode.

As I am typing this however around midnight EST, the Chinese markets are plummeting (again), and markets in Hong Kong and Japan are down 4% in early Asian market trading, bringing the US futures down with them in overnight trading so it appears we will finally get our much anticipated 10% “correction” in the S&P.

One thing that is interesting to me is how swiftly markets decline in recent years, only to bounce back nearly as swiftly. It seems everyone for the past 3 years has been expecting a 10-20% correction, and so at the first sign of trouble, everyone begins rushing for the exits. Those who aren’t pushing the sell button are frantically buying puts for protection or maybe to outright short the market, which has the effect of sending the VIX skyrocketing. In recent years, despite being in a bull market, the VIX has at times seen shocking intraday rallies. Friday’s spike of 46% was I believe the second largest daily spike ever. To put this in perspective, the VIX spiked 23% the day Lehman filed for bankruptcy on September 15th, 2008. The market participants are very quick to anticipate the worst, and are willing to pay up for this protection at just about any cost.

These violent moves can be also due to forced selling from large institutional investment managers as well—hedge funds and mutual funds that either face redemptions or maybe participate in the panic themselves, rushing to sell stocks at any price to preserve returns or prevent further losses in the event the market does enter bear territory.

All of this said, we will at some point see another 20% decline. At some point, those that “panicked” on Friday might end up being right in that stock prices could certainly go a lot lower.

But of course, this type of behavior often creates significant opportunity. I’ve received a few questions lately regarding what I’m invested in, what my views on the markets are, etc… My investment approach is mostly based on two main strategies:

  1. Special situation investments: locating significantly mispriced investments with catalysts, and
  2. Investing in great businesses when they are priced at pessimistic levels.

My approach is very flexible. I often think of it as an opportunistic approach to value investing. I sometimes spend a significant amount of time in cash or with significant cash holdings while I wait for ideas to present themselves. It’s the most comfortable way I know how to manage capital.

As to the questions on what I’ve been up to: I plan to discuss more investment ideas on this blog. I won’t discuss certain situations as some need to remain quiet to preserve the mispricing. But many of the stocks I look at are very liquid and I find it helpful to write down my ideas, and get alternative perspectives from readers as well. I might even discuss stocks that I don’t own as well, simply because I do a lot of research that often doesn’t turn into actionable investment decisions. As for my portfolio now, I have a few positions but a large portion of the capital is in cash. The few positions I am in currently are special situation investments. I prefer those types of investments in these markets, simply because most of the businesses I love are all priced at levels that indicate they are loved by many others. So my favorite compounders rarely make it into my portfolio. This could change based on the action that we’ve seen over the past few days.

Typically, when it comes to category #2 (the “generals”, or compounders, or stocks without a specific catalyst), I have a hurdle when I think about investing in them. I am basically looking for a large enough valuation gap that provides me with a chance to make 50-100% returns in a year or two. It obviously varies from situation to situation, and larger cap stocks typically provide lower, but more predictable returns. But I’ve found it a useful—if not somewhat unorthodox—checklist item to ask myself if I think the stock can double at some point in the not too distant future. Sort of a forward looking 50-70 cent dollar approach to looking at the valuation. Again, with larger cap compounders this might not be realistic, but even 50% returns over the course of 12-18 months are possible at certain times on the larger high quality compounders. But outside of a few company specific opportunities, we certainly haven’t seen a market environment recently that has brought general valuations down to a level that this hurdle could be achieved.

So the opportunity to invest in one of these high quality companies come from one of two main setups:

  • Pessimism surrounding the company—maybe a short term problem, a poor quarter, or some other temporary negative that allows you to take advantage of time arbitrage (looking out 2-3 years when the market is focused on the next 2-3 quarters)
  • General market fear and lower overall stock prices

I actually welcome either or both of these things, and I hope that stock prices continue lower. However, the market has proved resilient and I don’t necessarily expect a large decline, given the strong economic numbers that have been consistently getting better.

For those that have asked my opinion on the markets—I don’t have one, and I don’t really ever think about where the market will go. Well, sometimes I do—a friend and I have been discussing this over the past week—but I don’t ever make decisions based on where I think the S&P is going to go in the near term. This is simply because I don’t know.

CNBC tonight had a special called “Markets in Turmoil”, which I found to be slightly dramatic, but nonetheless interesting to watch. CNBC of course thrives on market panic. The ratings of financial news media always skyrocket during these times of fear. I can’t blame CNBC—the ratings go through the roof when fear enters the markets. Also, it would have been a thrilling time to be a financial journalist during 2008 when Lehman failed and when markets were crashing. One of my favorite topics to read about is the financial crisis. It’s absolutely incredible to read about the various aspects of the crash including the market turmoil, the investor reaction, the policy decisions, and the general panic.

However, I think it’s a bit premature to begin anticipating disaster. While I said I don’t have a view on where the markets will go—certainly not in the next week, month, or year—I don’t anticipate the worst. Maybe I’m wrong here, but rarely do markets crash when the domestic economy is improving. And rarely do bear markets occur without the economy entering a recession (this has happened twice, but it’s quite rare).

One interesting token of macroeconomics that I read this weekend: The US economy has never entered a recession without the jobless claims spiking 20% year over year first. Again, maybe this spike is going to happen in the coming months, but it hasn’t yet. Like many other economic indicators that are improving, jobless claims continue to decline:

Jobless Claims

Another positive for the US economy is the state of housing. The housing depression was the deepest we’ve seen since the 30’s. The price declines, plummeting sales, and the ensuing near halting of new construction has created a situation that has left a shortage of inventory across the US and pent-up demand in many markets. Housing starts have been climbing for a few years now, but still have a long way to go before reaching levels that would be considered equilibrium:

Housing Starts

I have a spreadsheet of data points that I’ve started to track. I don’t make investment decisions based on economic information, but I find it useful to have a grasp of certain datapoints that impact the overall economy or better yet—specific industries (retail sales, new home starts, railcar loadings, etc…). One other piece of information that I find interesting to look at is investor sentiment. Again, I don’t make investment decisions based on sentiment–I’m looking for specific investment situations that really have nothing to do with the overall stock market. But nevertheless, sentiment–when at extremes one way or another–can provide useful information.

Sentiment isn’t at extreme levels yet, but it is quite bearish. In fact, last week’s AAII investor bullish sentiment was just 26%, which is a level that is fairly close to the bearishness that existed at the March 2009 bottom. Sentiment is volatile, but typically, extreme bearish sentiment exists near market bottoms, not market tops:

AAII Sentiment

Does Any of This Matter?

Things look scary right now, especially if you’re paying attention to the general market perceptions. However, domestic economic data does not seem to indicate impending doom for the US economy and sentiment seems to indicate that it’s probably unlikely that stocks are in for a significant crash.

But that doesn’t mean stocks can’t fall further. They certainly can.

Emerging markets look like they are in real trouble and that could certainly spill over into the US economy at some point, but it doesn’t appear likely as of yet. But we know that stock markets go up and down, and while there is always some reason to point to, the fact that the market is currently going down is nothing to be surprised about.

That said, I agree with some of those who say valuations are stretched, and we are “due” for a correction. I do think in general, that valuations are modestly (but not extremely) overvalued. But this in and of itself doesn’t usually mean that the market will crash. Markets rarely if ever crash because of overvaluation unless it’s the result of a mania (like 1929 or the Nasdaq in 2000, and even in those cases the overall economy was about to enter a recession).

But not having a crash doesn’t mean the markets can’t go down 10-20% (or even more). This is a very normal part of the way markets work, and it’s nothing to be surprised about or panicked about. The memory of 2008 is recent enough to still be in our review mirror, and it probably exacerbates the fear that comes back so quickly, even when the market is less than 10% from all-time highs.

Anyhow, these are just some thoughts I had as we get ready for what could be an eventful week. Not much changes in what I do during weeks like this–lots of reading about companies as usual–but these types of situations do make it more fun when you’re an investor who prefers buying undervalued merchandise.

All in all, it should be an exciting week that hopefully will begin presenting some investment opportunities.

Have a great week.

“One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.” – Warren Buffett, 1965 BPL Partnership Letter

I’ve read a few things lately discussing the benefits of designing a “tax-efficient” investment strategy. I’ve said this before, but I think there is a significant misunderstanding on the tax benefits of a low-turnover portfolio, and there is an even larger misunderstanding on the concept of turnover itself.

I’ve commented on portfolio turnover previously—turnover is neither good nor bad. It gets a bad connotation—especially among value investors—because many people think higher turnover (and more investment decisions) leads to hyperactivity and trading—and eventually results in investment mistakes. While this may be true in many cases, investment mistakes are not due to turnover—they’re due to making investment mistakes, plain and simple. I do believe that too many decisions may lead to this result—and I’m a fan of concentration and a relatively small number of stocks in my portfolio. But it is really important to understand—turnover in and of itself is neither good nor bad.

In fact, as I’ve said in a previous post, turnover is one of the key factors of overall portfolio performance. Just like a business (assuming a given level of tax rates, interest rates, and leverage) achieves its return on equity by two main factors—asset turnover and profit margins—so too does the return on equity (or CAGR) of an investment portfolio get determined by these two factors.

But this post is not about turnover, it’s about taxes. I bring this up because often I find investors lamenting the issue of taxes—especially when it comes to capital gains on their investment portfolio.

I have some thoughts on this topic of taxes and turnover, which I’ll share in the next post. I was going to reference a short passage of the 1965 Buffett partnership letter where he addresses this very same issue. But I thought I’d just post a slightly condensed version of the whole passage here, because I think it’s a good concept to think about.

Here are a few passages that I pieced together from the 1965 Buffett commentary on taxes (emphasis mine):

“We have had a chorus of groans this year regarding partners’ tax liabilities. Of course, we also might have had a few if the tax sheet had gone out blank.

“More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. “One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.”…

“Let’s get back to the West Coast. What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound. Quite obviously if the two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other doesn’t, the latter course is superior. However, we find this is rarely the case.

It is extremely improbable that 20 stocks selected from say, 3000 choices are going to prove to be the optimum portfolio both now and a year from now at the entirely different prices (both for the selections and the alternatives prevailing at a later date. If our objective is to produce the maximum after-tax compound rate, we simply have to own the most attractive securities obtainable at current prices. And, with 3,000 rather rapidly shifting variables, this must mean change (hopefully “tax-generating” change).

“It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now. It is obvious that an inability to “get even” in a security that has declined is of no importance. It is obvious that the inner warm glow that results from having held a winner last year is of no importance in making a decision as to whether it belongs in an optimum portfolio this year.

“If gains are involved, changing portfolios involves paying taxes…

“I have a large percentage of pragmatists in the audience so I had better get off that idealistic kick. There are only three ways to avoid ultimately paying the tax: 1) die with the asset—and that’s a little too ultimate for me—even the zealots would have to view this “cure” with mixed emotions; 2) give the asset away—you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc.. either; and 3) lose back the gain—if your mouth waters at this tax-saver, I have to admire you—you certainly have the courage of your convictions.

“So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury—at the lowest rates the rules will allow.”

Buffett ends the section with a tongue-in-cheek reference to the “tax-efficient” funds of his day:

Buffett Tax Table

I thought these were interesting comments—especially regarding Buffett discussing “changing portfolios”, i.e. portfolio turnover. A portfolio of stocks one year will almost certainly not be the same optimum portfolio with the same risk/reward the next year. This implies that the portfolio should be more dynamic—always hunting for value.

Buffett doesn’t operate this way now, but it’s by necessity not by choice. There is only so much you can do when your stock portfolio is over $100 billion. But in the partnership days, there was higher turnover, higher taxes, and higher returns.

Related Posts:

Since oil prices were in the headlines yesterday after an 8% fall, I thought it might be a good time to comment on something I’ve been working my way through while putting in the miles after a day of looking for bargains.

I’m about halfway through the excellent series of podcast called “A History of Oil”. It’s an outstanding series that starts by introducing George Henry Bissell—the father of the oil industry—who in 1853 began experimenting with “rock oil” that was discovered in northwestern Pennsylvania. Bissell commissioned a $526 study of this strange substance and determined that it could be refined into kerosene—a highly demanded fuel used to light homes at night. Since whale blubber was becoming more costly (you could say the world was witnessing “peak whale”—i.e. whale population was plummeting), this newfound oil could prove to become quite lucrative as a whale blubber substitute.

The History of Oil series then moves to the fascinating beginning of the oil industry at “Oil Creek”, the stretch of the Allegheny River where drilling for oil first started in the small town of Titusville. This tiny hillside town in northwestern Pennsylvania quickly became the 1860’s version of the California gold rush. The population went from a sleepy 250 to a bustling 10,000, real estate prices skyrocketed, and fortunes were made. A lucky man named Jonathan Watson became the first millionaire from oil—Watson owned the land where the first successful well was drilled by Colonel Edwin L. Drake—an employee of Bissell’s Pennsylvania Rock Oil Company.

The guys at Oil Creek didn't care if a rig was in their back yard.

The guys at Oil Creek didn’t care if a rig was in their back yard.

The podcast series recounts the early tales of riches and the many booms and busts. I’ve made my way through the portion of oil history that witnessed a 23-year old grocery store owner named John D. Rockefeller, who began selling kerosene in his store—and eventually transitioned into the refining business that later was built into Standard Oil—one of the world’s most valuable, and most intimidating companies of all time.

Indeed, it was the very first Big Oil—later to be broken up when an ambitious populist from Ohio named John Sherman—whose resume included three terms in the House of Representatives, the US Senate, Secretary of the Treasury, and Secretary of State—introduced a bill called the Sherman Antitrust Act. The bill passed 52-1 in the Senate and unanimously in the House. The law sparked the first of many battles between Big Oil and government regulation.

Standard Oil was broken into pieces, but not before John D. Rockefeller became the richest man in the world—creating a net worth that would approach half a trillion bucks in today’s dollars—far more than Gates, Buffett, or any of today’s titans. Not bad for a guy who, as an ambitious young grocer, set a goal of making $100,000 during his lifetime.

This was no ordinary grocer

This was no ordinary grocer

The Oil Business

I began slowly investigating the oil industry last fall as energy prices plummeted. There is one company I have taken small positions in on a couple occasions, but by and large I have stayed on the sidelines as I continue to watch debt-laden businesses continue to struggle and cash flow dry up. Many of these companies are dead companies walking—almost certain to go bankrupt as their revenues fall, margins evaporate, and fixed costs (i.e. interest payments) persistently eat up a larger share of each barrel produced.

I think the oil business is very interesting, and it is one of the industries (especially the “upstream” exploration/production side) that really lends itself to the classic boom/bust cycle.

Soros once said regarding oil prices in his “real time experiment” in 1985:

“The supply curve is inverted. Most producers need to generate a certain amount of dollars; as the price falls, they will try to increase the amount sold until the price falls below the point at which high cost producers can break even. Many of them will be unable to service their debt.”

The more things change, the more they stay the same. In 1985 Saudi Arabia became frustrated that their production cuts weren’t having the impact they desired (which was oil price increases). This led them to decide to shift its focus from prices to market share. In December of 1985, OPEC shocked everyone by formally announcing its intention to maintain market share (i.e. maintain or increase production levels). The price of oil collapsed 50% over the next 6 months from $30 to $15 per barrel.

1986 Oil price collapse

Does this look familiar?

This 1986 price collapse was quite similar to the chain of events that unfolded starting last November 2014 when OPEC again announced its intention to maintain production in an effort to squash US high cost producers and maintain market share.

In both 1985 and 2014, these decisions by producers (both OPEC and US domestic producers) defied the logic of the “rational economic man”.

Where is the “Rational Economic Man”?

The “rational economic man” theory in economics basically says that this hypothetical figure will always act with perfect knowledge and complete rationality in pursuit of his own economic interests—meaning he will act in such a way that the supply/demand balance will always stay close to equilibrium. For example, as the price of a commodity falls, demand should theoretically increase and/or production should decrease—this balance should always trend toward equilibrium.

This makes a lot of sense. For example, chemical companies add capacity and/or increase utilization when prices are rising in order to satiate demand. Like most commodity businesses, this eventually leads to excess capacity and bloated cost structures. As the cycle surpasses its peak, companies are forced to lay off workers, cut back production, and sometimes take capacity out of the system as prices are falling, which then sets the cycle up for another repeat.

So eventually the economic man shows up and the cycle ends. But in the meantime—before this self-correcting process occurs—a self-reinforcing behavior (as Soros calls it) is prevalent—a behavior that takes prices (and supply/demand) far from “equilibrium”—or where they should be based on economic theory.

So sometimes there is a disconnect between reality and economic theory and the “economic man” is nowhere to be found.

For example, banks influence the value of the collateral as they lend more. In the recent case of the mid-2000’s housing bubble, securitization and newfangled financial products such as synthetic CDO’s reinforced home prices—these new products created an entire new market for CDO’s and the demand from investors for these securities fueled more lending. The more loans that were packaged up and sold in the form of securities, the more lenders were willing to give loans, which meant easier credit and more demand for the actual product—the house. This circular cycle was self-reinforcing for a period of years. Banks were willing to lend up to 100% (or more in some cases) on the ever-rising value of a house, but this value was rising in large part because of the fact the bank was willing to lend on it. It’s the chicken and the egg.

This is the same concept that has occurred in virtually every boom/bust cycle in the past.

The oil industry behaves in a similar way. Interestingly, what has happened over the past 9 months has surprised many economists and industry analysts. When prices started falling, many predicted drastic cuts in production by the high cost shale producers. Eventually, this would have to be true as producers run out of money. But what is interesting is that they continue to produce more as long as they have the cash in the bank to do so—even if they destroy value with every barrel that they pull out of the ground. By April 2015, six months after the price declines began, US production was at multi-decade highs:

US Crude Production Chart

So despite what economic theory says, what has actually happened on numerous occasions is that as energy prices decline, sometimes production increases (or at least remains stable) by producers who desperately try to maintain market share or by countries (such as the OPEC nations) who increase volumes to offset price declines in order to meet budgetary needs.

This was true in the late 1960’s when Soros was formulating his reflexivity theory, it was true in 1986 when Saudi Arabia dropped the hammer on the oil market, and it is true today as OPEC—at least for now—continues to maintain its production level.

Interestingly, this very same behavior was prevalent in the 1880’s at Oil Creek.

Even back then, or maybe especially back then, oil prices swung violently as supply/demand fluctuated and the boom/bust cycles repeated themselves over and over again. This nonsense was much to the dismay of Rockefeller, who specialized in the “downstream” business of refining oil—which means he had to buy his raw material from these irrational producers and was thus at mercy to the wild swings of the market.

One of the episodes of A History of Oil describes the fascinating turn of events as Rockefeller defies the advice of his own board of directors and—in an effort to fight this irrational behavior of the producers who frantically began drilling more and more in a “race to the bottom” as prices plummeted—began buying up “every barrel” of oil that was produced. Rockefeller eventually forced his company into the upstream (production) business in order to try and get more control over the raw material needed for his kerosene, and thus add an element of “economic man” behavior to the industry.

But whether its human nature or the nature of the oil business (or probably both), this defiance of economic logic repeats itself over and over.

Just this past weekend, Iran pledged to double its own production when/if sanctions get lifted—despite oil prices at half of where they were trading at a year ago.

Meanwhile, US oil production has begun to slow down in the past couple months, but as recently as April, crude output was rising and reached a high not seen since 1972—leaving analysts, economists, and Middle East oil producing nations scratching their heads.

It’s very interesting theater.

I’d recommend A History of Oil to anyone who is interested in locating bargains (or short opportunities) among the carnage in oil that is certain to continue if prices stay where they are. The business is a difficult one—like most commodity businesses. But it’s one that probably provides significant opportunity for the skilled bargain hunter who can be greedy when everyone else is fearful.

Caveat Emptor…

Have a great week.

Someone on the Corner of Berkshire and Fairfax board recently posted this comment referencing Buffett’s well-known piece on inflation from 1977.

In the article, Buffett describes the variables that drive a company’s return on equity. There are only five ways that a company can improve returns:

  1. Increase turnover
  2. Cheaper leverage (reduce interest charges)
  3. More leverage (increase the amount of assets relative to a given level of equity)
  4. Lower income taxes
  5. Wider margins

Notice three of the five drivers of ROE have to do with taxes and leverage. So the pretax returns (as opposed to capital structure variations) are really driven by just asset turnover and profit margins.

Some executives at the DuPont Corporation also noticed these drivers in the 1920’s when analyzing their company’s financial performance. They broadly categorized the drivers as turnover, margins, and leverage. For now, I want to leave leverage out of it and think about turnover and margins.

Portfolio Turnover

I wrote a post a while back discussing the misunderstood concept of turnover in the context of portfolio management. Specifically, the topic of realizing gains (and paying those dreaded taxes). Basically, the idea of short-term capital gains is taboo among many value investors.

I think it’s very important to try and be as efficient as possible with taxes. However, I think that tax consideration is only one of (not the only) factor to consider.

We could take Buffett’s five inputs that increase or decrease a company’s ROE and apply them to the portfolio. Basically, as investors, we are running our portfolio just like a business. We have a certain level of equity in the portfolio, and we are trying to achieve a high return on that equity over time. The exact same factors that Buffett talks about above apply to our portfolio. Those five factors are the inputs that will increase or decrease our portfolio ROE (aka CAGR) over time.

Notice that taxes is one of the (but not the only) factors.

Turnover is also one of the (but not the only) factors.

Michael Masters is not a value investor, but he runs a fund that has produced fabulous returns over the past 20 years or so (from what I’ve read, north of 40% annually). You can read about him in the book Stock Market Wizards by Jack Schwager.

Now, I don’t understand his specific strategy, and I’m not suggesting it’s one that should be cloned, or copied, etc… I’m just focusing on the turnover concept here. Masters, according to the interview, runs a strategy focused on fundamental catalysts, and holds stocks an average of 2-4 weeks. When he was running a smaller amount of money, he was compounding at 80%+ per year.

Of course, he was paying a lot of taxes. His investors—the ones in the highest tax bracket—might be “only” netting 40% or so after tax. But who would be upset with paying a lot of taxes if it means achieving a 40% return on the equity in your capital account?

Obviously an extreme example, but the concept illustrates the point that just because you hold stocks for years and years and pay very low taxes doesn’t mean that your after tax ROE will be any better than an investor who pays a lot of tax and achieves a much higher pretax return.

I think it’s very difficult to compound capital at 20% or more without some amount of turnover in the portfolio. This doesn’t mean I’m promoting higher levels of activity. I’m not. I think making fewer decisions is often better, and trying to do too many things is very often counterproductive. I’m just saying that the math suggests that some level of turnover is needed if your goal is to compound capital at north of 20% over time.

This is one of the reasons I love bargains and deep value special situations in addition to the compounders.

As I’ve said before, very few companies compound their equity and earnings at 20% or more over years and years. Those that do often are priced expensively in the market. But to achieve portfolio returns of 20% without paying taxes, you’d have to not only properly identify these companies in advance, but you’d have to have the foresight to invest your entire portfolio in them.

How Did Buffett and Munger Achieve Their Results?

It’s a difficult proposition to be able to seek out in advance the truly great compounders that will compound at 20%+ for a decade or more, and that’s why investors who focus on bargains and special situations often are the ones with the extreme performance numbers (like Buffett doing 50% annual returns in the 50’s, Greenblatt doing 40% annual returns in the 80’s and 90’s, etc…).

It’s unlikely to do 20% annual returns by buying and holding great businesses for a decade without selling. It’s basically impossible to do 30%+ without ever selling.

Charlie Munger has promoted the idea of low turnover—and I think his reasoning (as usual) is very sound, but I think he was using the Washington Post as an example–and I think that might be (dare I say) somewhat biased in hindsight. But if you’re looking for decent after tax returns, he’s right. If you can find a company that compounds at 13% per year for 30 years, you’re going to achieve good after tax returns on your capital. But, I think finding the Washington Posts of the world are easier said than done in hindsight, especially when thinking about a 30 year time horizon.

Another example I’ve discussed before is Disney. Buffett bought Disney for $0.31 per share and sold a year later for a 50% gain in the mid-60’s. He laments that decision as a poor one, but in fact his equity has compounded at a faster rate than Disney stock over time, making his decision to sell out for $0.50 a good one. And that is an extreme example using probably one of the top 10 compounders of all time. Not every stock is a Disney, thus making the decision to sell at fair value after a big gain in a year or two much more likely to be the correct one.

Back to Munger’s Washington Post example… I like to consider his audience. I don’t necessarily think he was saying this is the highest way to achieve attractive investment results. My guess is he was trying to convey the importance of long term thinking and lower turnover. However, when Munger ran his partnership, he was trying to compound at very high rates, and for years did 30% annual returns. He didn’t do this by buying and socking away companies like the Washington Post. He may have had a few ideas like that, but he was a concentrated special situation investor who was willing to look at all kinds of mispriced ideas.

Buffett/Munger of Old vs. New

I think there is a disconnect between the Buffett/Munger of old, and the Buffett/Munger of today. Their strategies have obviously changed, and their thinking has evolved. But their best returns were in the early years when they could take advantage of the (often irrational) pricing that Mr. Market offered.

They were partners with the often moody Mr. Market back then and they took advantage of his mood swings. When they came into the office and Mr. Market was downtrodden, they’d buy from him. And on the days when Mr. Market was excited and overly optimistic, they’d sell to him.

Their bargain hunting days provided them and their investors with 20-30% annual returns.

They made a lot of money.

They paid a lot of taxes.

As they compounded capital, they began to evolve. Buffett and Munger both have discussed this, but they both have said with smaller amounts of capital, they’d invest very differently. Buffett bought baskets of Korean stocks in his personal account in 2005 when some were trading at 2 times earnings with net cash on the balance sheet. He’s also done arbitrage situations, REIT conversions, and other things in his personal account that provided attractive, low-risk returns (and very high annualized CAGRs).

By the way, this is not an indictment against compounders. As I’ve mentioned before, my investments tend to fall into one of two broad categories: compounders and special situations/bargains.

I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses—and everyone knows they are great).

But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it.

I’m not sure if this post really has a hard conclusion and maybe this is more of a ramble than anything else. I’m not sure how to sum it up, so I’ll just stop here. These are just observations I have had, and the COBF post on Buffett’s 1977 piece (which is a great piece to read if you haven’t) prompted some of these thoughts which I decided to write down and share.

I think it’s important to understand the drivers of investment results (portfolio returns on equity) are the exact same factors that drive the ROE of a business.

Feel free to add to the discussion if you’d like.

Have a great week, and for the golf fans, enjoy the US Open.