Highlights from Horizon Kinetics "Compendium Compilation" - 2021

These are from the "Compendium Compilation (Eighth Volume)" of essays written by Horizon Kinetics' Murray Stahl in 2021:

• If the supply of goods and services aren't increasing at the rate of the money supply, you have to ask why? One answer is that there are key commodities for which the production level can't increase very much. Not because it's technically impossible to do, but because the extractive industries are under a constraint. The constraint is they cannot increase, in any measurable way, the emission of carbon dioxide and other greenhouse gases. The goal for almost all of them, which you can now read about in their annual reports, is to decrease emissions by about 3%  year. The only way to accomplish that is to not expand production in any meaningful way. Yet, the world population increases by about 80 million people a year, and they're going to need those products - whether it's silicon, soda ash, oil and natural gas, or lithium - whatever it is that's going to be used, there are more people needing more of it.
• [A]t some point, the bondholders do experience the sensation of debasement And when they do, they'll refuse to buy bonds anymore. Then you're in a major financial crisis. The central banks will have no alternative but to buy those bonds, otherwise they're going to create a massive problem. If the central banks have to support the bond market at the current yield levels, you're going to have incredibly serious inflation, much more serious than we have right now. And that's what, I think, is ultimately what we're coming to.
• [T]he production of ordinary commodities in common use... requires enormous amounts of capital. The return on capital is generally rather low and quite cyclical. Moreover, the periods of low return on capital can persist for many years. It should not be surprising to learn, consequently, that investment capital gravitates towards the high return businesses and away from the low return cyclical businesses. If such trends persist, some types of commodity production will at some point become inadequate to meet demand. The result in a free-market society is allocation of scarce resources via price adjustment, a phenomenon otherwise known as inflation. Inflation raises the return on capital for commodities, but the return still remains low even though it is elevated relative to the prior period, and it still remains cyclical. It is still very inferior, on those counts, relative to intellectual capital. The return on capital for commodity production might, even with elevated pricing, be inadequate to attract sufficient funds to remedy the supply deficiencies. The consequences may be a persistent type of inflation we have not generally witnessed in modern history.
• If you're really interested in the study of inflation, the investment challenge is not to simply protect yourself against the ravages of inflation; it is to benefit from inflation, to improve your position via inflation. To merely keep pace with inflation doesn't change anything. 
• The following is a list of 20 publicly traded royalty companies. A few might be left out, but 20 is more or less the total number that exist in the world. [FNV, WPM, SAND, RGLD, OR, MMX, MTA, LBRMF, ATBYF, TPL, PREKF, VNOM, MSB, MNRL, RPRX, DMLP, FRU.TO, ALS.TO, DRR.AU, SBR].
• What you'll find is that in a real crisis, the Federal Reserve steps in as a buyer and you'll get high rates anyway, because there is no amount of money that they could invest that's really going to defend the market. They might be able to protect the treasury market, more or less, but the bond market is vast. I'd estimate that the U.S. bond market is 15x or so the current size of the Federal Reserve balance sheet. So, if the Federal Reserve were to try to defend the entire bond market, you'd have so much money creation, you'd lose money in bonds anyway, because of the loss of confidence in the currency. If a policy of supporting the bond market were sustainable, then no nation would have ever had a problem with money creation. It might've led to a lot of inflation, but it wouldn't have led to a collapse of the country. However, it has always eventually led to a collapse of the credit market - why would you lend money to anybody (that is, buy their bonds) if you knew your principal was going to be debased? As an interim risk reduction step, lenders might require every shorter maturities. But that just means that when a great many maturities come due in a short window of time, the stage is set for another credit crisis, whereupon the central bank would have to intercede and create more money.
• The Tesla net profit margin is not as high as those of Microsoft, Apple, and Alphabet. The relevant figure is a mere 11.76% Yet, this company has the mighest market capitalization to sales ratio [in the S&P 500].
• The Tesla valuation is sufficiently unique to suggest that the market expects Tesla will dominate the entire automobile industry. In fact, the Tesla market capitalization of $1.21 trillion already dominates the list of publicly traded automobile manufacturing firms. [...] This not only suggests an investor presumption of the eventual capture of a 100% market share, but at a higher level of profitability than the current industry leaders. Tesla's market capitalization and market capitalization-to-sales ratio might be more understandable if the shares of the traditional automobile manufacturers were in decline, thereby forecasting an impeding decline in profitability as well as a serious loss of market share. However, this is not what is happening. In fact, viewed on a year-to-date basis through November 5, 2021, many automobile manufacturers are actually outperforming the S&P 500, while Tesla shares have advanced by 67.48%.
• Thus, 18 out of 36 holdings in the iShares U.S. Energy ETF, representing 31.31% of the portfolio, produces no hydrocarbon. If the portfolio were limited to hydrocarbon producers, it is questionable whether it would be possible to even operate a bona fide hydrocarbon-producing ETF. Thus, the investment world has nearly divested, consolidated, or bankrupted the energy industry out of existence. As a contrarian, it is an opportune time to purchase.
• The prevailing belief is that the world can eliminate much of its hydrocarbon usage. We're going to find out if that proposition is true or false in the next several years. For myself, I believe that proposition is false. I don't necessarily believe that the most wonderful thing in the world is hydrocarbons, and I also believe that if there were a viable alternative to it, it should be undertaken. I just don't think there is a viable alternative as a practical engineering proposition.
• The inconsistency in the consensus views on the automobile companies is self-evident. Tesla cannot possibly enjoy the level of success consistent with its elevated market capitalization unless it captures significant market share from the traditional firms. Alternatively expressed, the traditional firms cannot possibly retain market share while Tesla enjoys a level of success consistent with its market capitalization. One way or another, all such logical inconsistencies are eventually resolved by changes in valuation.
• Do you believe Honda, Toyota, Mercedes, Audi, and BMW cannot design electric vehicles? If it were practical to produce electric cars, these companies would have them in their fleets. They would have viable offerings on the market. However, they do not have viable offerings on the market. They would rather pay the non-zero-emissions fees imposed by 12 or 14 states. This happens in Europe, too. Car companies would rather pay those charges than take the same amount of money and build a proportionate number of electric vehicles. There has to be a reason for this choice - it's not as if they make large scale capital allocation decisions without careful study - and the reason is that with the technologies available, the project is simply not practical on the scale needed. There is a geologic reality that just has to be faced. It has nothing to do with anyone's political orientation or desire for a better world. It is just a practical reality. A global-scale lithium-battery powered vehicle fleet is not a viable solution.
• The challenge for the pharmaceuticals companies is that, in order for a large market capitalization firm to grow at a sufficiently elevated rate, it is necessary to invent new drugs that either cure or treat, but preferably only treat, widespread ailments. In the case of a decisive preventative or a cure, such as a one-time childhood vaccination for diptheria or polio, or a course of antibiotics for an infection, the revenue opportunities are curtailed by the success of the treatment. In order to secure an ongoing stream of revenue of the type that can qualify as a blockbuster drug, what is required is a chronic but non-fatal disease that can be controlled for many years, but not cured.
• If a gold mining company is not desperate to increase production, there is no reason to take the capital of the streaming companies for the next precious metals deal. The miner does not need to do that, so the bargaining position of the streaming companies is not as strong. In that sense, the streaming business is just not as good as it was historically. That does not mean the streaming companies are a bad investment; it just means that the streaming companies must adopt policies similar to those of the gold mining companies. We are already seeing that in Wheaton Precious Metals, which is going to start returning  capital to shareholders. If the company cannot find lucrative streaming deals to make with its cash flow, it will return capital to shareholders in one way or another, either by increasing dividends or share buybacks, or both.
• The consensus view right now is that the governments of the world will, collectively, eventually eliminate tobacco as a retail consumer product. Thus far, they haven't been able to do it. In fact, in some respects, the industry is enjoying a type of renaissance. If there is legitimacy to that observation, if this renaissance persists, then the tobacco companies are not going to continue to trade at the present low multiples. When that happens, assuming it does happen, the upward valuation rerating of the companies will also happen on a  lower number of shares, because most of the tobacco companies are buying back their own stock. If the rerating really does happen, then it will involve a lower number of shares, which would create a quite a substantial rate of return.
  

Previously regarding Horizon Kinetics:

• Horizon Kinetics, Owner-Operators, Indeterminate World, and the Predictability Arb
• Horizon Kinetics on "Corporate Risk Reduction"
• FRMO Corp 2014 Q3 Earnings Call
• Thoughts on Private Equity and High Yield Bond Duration in Latest Horizon Kinetics Quarterly Letter 
• Some Thoughts From 2014 Horizon Kinetics Market Commentaries
  
• Horizon Kinetics On Flawed Diversification Theory
• Latest Horizon Kinetics On Indexing
  
• Horizon Kinetics Fourth Quarter Market Commentary
• Credit Bubble Stocks 2018 Book Review Compendium [review of Compendium Compilation 2015]
• Goehring & Rozencwajg and Horizon Kinetics on Commodities
  

Rethinking Inflation

Last year our correspondent @pdxsag wrote up his notes on Grant Williams and Bill Fleckenstein's podcast interviews of Russel Napier and Lacy Hunt. I called his services, "siting through podcasts so I don't have to." Grant Williams has two new interviews on his own podcast with two guys that I already follow: James Davolos from Horizon Kinetics (he manages their Inflation Beneficiaries ETF, $INFL) and Harley Bassman (aka @convexitymaven).

First, some highlights from his interview with James Davolos:

• [T]here’s another area that we’ve actually been working on at the firm, in some cases for 30 years, and also in particular in the past five years, which has been different areas within the commodity complex. There’s been a lot of changes compared to the past cycle. We looked at upstream producers in the commodity complex, thinking well, under an inflationary scenario they have to do well. We do differentiate fundamental outlook on these markets, which I think we can discuss later, but the biggest deficiency of these names, whether it be an upstream E&P company like a Chevron or a Barrick Gold or Rio Tinto or Vale or BHP, is that they are incredibly capital intensive, both in the sense that they have a lot of working capital requirements, and they also have a lot of balance sheet leverage to lever up an inherently low return on assets.
• Basically what ends up happening is unless you time the cycle perfectly, you can have a really miserable experience going upstream into these companies, which should ultimately be inflation beneficiaries but very difficult to time the cycle. I think a lot of people have been hurt. Some good historical examples going back to the past peaks in these end markets. What we arrived at was a method of trying to look at asset-light ways of playing these hard asset end markets. Hard assets have been something that Murray and Steve and these guys have been focused on, as I mentioned, for decades, but particularly so in the last five to 10 years.
• We begin with the hard asset mindset. What a hard asset is, is just simply a finite high quality asset that there is a very large base of fundamental demand for. Think land, raw land, or energy, precious metals, base metals. And there’s unique fundamentals to all of these hard asset end markets today that I think are really different from past cycles. But we begin with the premise of identifying these quality finite hard assets with a requisite amount of fundamental demand, and then trying to figure out a way to express that view in the most efficient manner possible in a portfolio.
• What we arrived at is these asset-light companies, where they have exposure to these hard assets, but through a business model that has very little working capital requirements, has very low variable costs, and does not require and/or has zero leverage.
• What this has created is these businesses that not only survive but can actually thrive during the down cycle. You never have the insolvency risk. You don’t have the necessity to divest core assets. And then you can compound in the up cycle. That’s why it’s a very efficient mechanism to play an otherwise volatile, precarious industry, rather than going into the higher beta, higher risk upstream names.

And then his interview (with Bill Fleckenstein) of Harley Bassman:

• Why do rates have to go up? The Fed can keep them down. They kept them down post-World War II. Maybe that is what the plan is. They will just buy like Japan. They’ll just buy the bonds and balance sheet them and keep rates at one, one and a half. Even if we have 4% inflation, you’ll have a massive negative rate. That’s really the question here is that once you break the linkage of inflation to rates, a whole lot of things are possible. Now, the answer I think is this. Let’s say they have the three or four-handle inflation. Let’s say the Fed or the government or someone, I mean the government could do it by demanding that banks buy treasuries. They could force banks to do that because they’re regulated entities. So there’s a whole lot of ways for the government to keep rates at the current levels, if they want to. So what happens then, the other side of the balloon gets squishy, which means currency devaluation possibly. We don’t become the reserve currency of the world anymore, which seems unlikely, but whatever. There’s a whole other host of things that could play out where you keep a massive negative interest, real interest rate, which is unclear. But the usual game, if we weren’t the world’s reserve currency, we’d have a devaluation.
  

I've been thinking about inflation and hard assets a lot recently. "Inflation or deflation?" is a political question; you can't determine the outcome from modeling of macroeconomic variables without reference to what the people who control the central bank want.

In the past when we have had deflationary episodes, elites were much more conservatively invested. The book The Framers' Coup (see notes) by Michael Klarman (brother of Seth) says that the supporters of ratification of the U.S. constitution were creditors who were "determined to suppress state debtor relief laws and inflationary monetary schemes." 

In other words, the wealthiest colonists with political power were fixed income investors. They felt that their economic interests as wealthy people would have been hurt by inflation, and so the overriding goal of the constitution was to prevent inflation and legal abrogation of debt contracts, while also preserving the existing balance of power between north and south and big and small states.

Later on in the country's history, the rich were invested in government debt and also debt issued by the big private enterprises of the day, the railroads and canals that had not only big fixed costs but also big operating costs. Forget about owning equity in something that would go bust during the next panic, the old money wanted a first mortgage so they could get their principal back with reasonable interest. When money was sound, that really meant something. 

It even looks like deflationary panics were deliberate squeezes of the middle class, by the rich, who could relieve them of their assets at cheap prices at the height of the panic. In order for this to work, the rich had to be conservatively invested or at least more conservatively financed than the people they were squeezing. 

Up until the mid-20th century, it was not even considered appropriate for trustee fiduciaries to invest in common stocks. It was only the inflationary post-war era that changed this, as limitations in trust instruments specifying fixed income investments became inconsistent with the always implicit goal of preserving the trust corpus in real terms.

That conservatism is long gone. Our elite - the politicians and the people who back them - have continually upped the financial risk they take as real interest rates have fallen. Now even the inner circle of central bankers with eight figure net worths are day trading to eke out more return on their capital. We just found out that the Dallas Fed president Robert Kaplan was trading in and out of $FLOT, the iShares floating rate ETF, during 2020. We know that Pelosi likes to get super long the market as well. 

It always felt like someone in the Trump admin (Jared & Ivanka?) was repeatedly leaking info, trading on it, walking it back, and repeating for all kinds of economically sensitive matters. And of course Trump spent his career comically over-leveraged in the most leveraged industry of all, real estate.

As I said once, "0% inflation feels like deflation for people who have made commitments that depend on gradual currency devaluation." Remember Trump carping about the Fed and interest rates? How much of that was his reelection prospects, and how much was his own personal balance sheet?

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.)

If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing.

Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.

FRMO On Increasing Difficulty in Trading OTC Listed Companies

In the most recent shareholder letter:

Indeed, the valuation disparities are not always caused by margin-related issues. For example, the Polestar Fund owns shares in a successful company that trades at 40% of book value with a very liquid balance sheet of considerable size. Recently, as an experiment, one of us tried to buy $600 worth for a personal account held at a major brokerage firm. This transaction could not be processed since it was asserted that the company did not disclose audited financials. Naturally, we objected that audited financials did exist and were available on the company website. The financial results are audited by one of the biggest, internationally recognized accounting firms. Unfortunately, we did not reckon with the definition of “available” in the modern cloud-based universe. Available means available on a certain database. Thus, to “protect us from ourselves” and to control risk, the purchase was prohibited.

Latest Horizon Kinetics On Indexing

They're talking about [pdf] how the S&P 500 used to be market cap weighted, but is now float weighted, which means that it will own smaller amounts of the "owner-operator" companies that have historically contributed a significant part of the index return:

"When added to the S&P 500, the share price [of Microsoft] was about $2.41. At January 1999, when the stock was $44.75, insiders still owned 31% of the shares. By September 1999, near the peak of the Great Technology Bubble, when the shares were $47.50 (when Microsoft’s weight in the S&P 500 exceeded 4%), inside ownership had been reduced to 26%, and by early September 2000, the very threshold of the collapse of that bubble, when the stock was $35, inside ownership had dropped to 19%. Today, 15 years later, the shares are only $44.37–a 1.6% annualized return –and were quite a bit lower than $35 only two years ago. Whether by fortune or perception, insiders were dramatically reducing their holdings going into a decade-plus period of decline and stagnation. What did outsiders do? Had the float-adjusted index weighting method been in place at the time, then as insiders sold, such that the float increased, the Index rules would have increased the Microsoft weighting, and mutual funds and other index investors would have been buying more—more of what the insiders were selling."

Index investing has all the signs of an investing fad that will be remembered as an embarrassing flop: nearly universal adulation, unthinking adoption, regulatory blessing.

Horizon Kinetics Fourth Quarter Market Commentary

Worth reading [pdf]. These guys are actually bearish on the indexes. Over the past few decades, equities benefited from falling interest rates (not repeatable), falling corporate tax rate, and rising P/E ratio.

Their way to play it is to own less liquid stuff that's cheaper and not in ETFs (mainly due to insider ownership). They've published commentaries on their major holdings: AN, DWA, HHC, JAH, PAH, SHLD, STRZA, WEN, LB, BAM, IEP, LYV, TPL, etc.

I like the original thinking, but I don't like a strategy that consists of losing less money than everybody else, which I think is what will happen to them in a bear market.

Just goes to show how hard it is for people to keep their powder dry, institutionally speaking.