Monday Night Links

• A huge issue I see among investors is that they implicitly apply a labor theory of value to their research process--they commit a tremendous amount of time towards achieving a deep understanding of a business/industry and they think that the market will reward that level of effort even if what they are doing is essentially asking to be paid for digging a hole and filling it back up. The reality is that even terrible businesses are often extremely complex and fascinating but a 20 page research report about them is basically just an exercise in communicating how effective capitalism is in coordinating different parties to deliver value to consumers. Very rarely do businesses provide excess economic profit to shareholders over sustained periods of time and those companies that do are often pretty simple. [Psyop Capital]
• In truth, I was simply born too late to attend the meeting when it would have been at the height of its dynamism. The meetings I have most enjoyed watching online are from the 1990s. I’m confident that those from the 1980s would have been even better. To have been able to have attended when Buffett was at the peak of his intellectual powers, when Berkshire was able to invest in very high-grade businesses, and when fellow attendees were more independent enthusiast than lemming would have been a real pleasure. [Forbes Jamieson]
• Fortunately, the likelihood of a massive oil supply glut combined with an oil demand shock seems to have dissipated (on the demand side), but the projected increase in global oil supply in the second half of this year is hard to ignore. Although projections are often incorrect in this sector, particularly when consensus is uniformly bullish or bearish (in this case bearish), we still believe we are approaching a yellow light to pull from last quarter’s "stop light" analogy. Therefore, we have set up our business for the rest of 2025 to hold oil volumes flat while cutting CAPEX, maintain one of the highest Drilled but Uncompleted wells (“DUC”) balances in the industry and use Free Cash Flow to pay down debt and continue repurchasing shares. This will allow us to maintain flexibility for a green or a red light in the short term. But, a green light is eventually inevitable given we believe current oil prices are unsustainable over the long term. [Diamondback Energy, Inc.]
• While Alphabet is described most often as a technology company, in many ways, it’s more accurate to describe it as an advertising company. After all, advertising is the method by which it earns the vast majority of its revenues. Therefore, when analyzing Alphabet’s future growth potential, we must first understand the prospects for global advertising revenues over time. The prospects are quite good for one simple reason: advertising is one of the ultimate relative goods, lending the industry significant pricing power over time. The more businesses spend to develop mindshare, the more other businesses must spend to keep up since what consumers purchase is largely dependent upon relative mindshare. Another way of looking at advertising is that it is, essentially, the meta pricing-power good. Through advertising, companies attempt to develop pricing power by convincing consumers that their products 1) possess small purchase prices relative to the value provided and/or 2) will make consumers more desirable to the groups and individuals with which they wish to belong and connect (i.e. confer social status). Thus, while spending on most goods becomes smaller as a percentage of the economy over time because of innovation, the advertising industry’s share of GDP has stayed remarkably constant, enabling it to fully participate in the economy’s remarkable gains in wealth. [Brian Yacktman]
• How does one find businesses with pricing power in a deflationary world? Well, the answer, as any economist will tell you, is to find the scarce good. And, increasingly, the scarce good is . . . time. Because of innovation, the growth rate of potential experiences, opportunities, and human connections is far outstripping the growth in humanity’s units of attention, causing each unit of our attention to become more valuable over time. As a consequence, goods and services that help us filter through the myriad uses of our attention are also growing in value over time. These are the goods and services in which we seek to invest, and we have found they can be divided into two categories: reliable information filters and reliable people filters. The first category is reliable information filters. Under our definition, these are filters for safety reliability, efficiency, and personal preference in industries indexed to GDP growth or better. An information filter can maintain or raise prices as long as two conditions are met: 1) the cost of searching for an equivalent substitute must be higher than the savings a customer would achieve by doing so, and 2) the cost of creating an equivalent substitute must be higher than the information filter’s price. [Brian Yacktman]
• At the portfolio level, one prediction embedded in our investment allocation is that human innovation will, over the long term, grow the world’s aggregate wealth. This prediction is both broad-based and time-tested, as evidenced by the long-term decline in the cost of necessities (as a percentage of GDP) and the increasing abundance of goods and services available to us all. We express this prediction by owning a diverse collection of businesses that are over-indexed to industries that have historically maintained or grown their share of GDP as wealth grows, such as capital markets, insurance, luxury goods, and advertising, and under-indexed to industries whose share of GDP has historically shrunk, such as energy and materials. Our next portfolio-level embedded prediction is that businesses that own dominant, mission-critical networks will continue to be a great way to reliably capture a proportionate share of an industry’s value growth. [Brian Yacktman]
• The company benefits from two network effects. The first occurs at the exchanges themselves, which are global, two-sided networks that connect buyers and sellers of futures and options contracts and provide them with unrivaled liquidity. This two-sided network effect is further strengthened by the nature of the futures contracts traded on the exchanges. For most assets, traders have no restrictions on where they can buy and sell them. For instance, if a trader buys Microsoft stock on the NASDAQ, he or she can subsequently sell it on any number of exchanges or on increasingly popular alternative trading systems (ATS) such as dark pools and electronic communication networks (ECN). In fact, ATS platforms have become so popular that, as of April 2019, traders chose to execute nearly 39% of all their U.S. stock trades on them. Futures contracts are different. Futures contracts opened on one exchange cannot be closed at another exchange, making it much harder for competitors to successfully develop alternative sources of liquidity for futures buyers and sellers. CME Group also owns the clearinghouse that validates and finalizes all the futures transactions that occur on its exchange, further enhancing its competitive position through a second, overlapping network effect. Clearinghouses, which serve as third-party intermediaries to ensure that both buyers and sellers honor their contractual obligations, benefit from network effects due to something called position netting. [Brian Yacktman]
• At YCG, our investment strategy is to own a diverse collection of global champions that 1) own dominant networks, preferably with high switching costs and untapped pricing power;  2) possess other checks on competing supply such as not-in-my-backyard (NIMBY) zoning restrictions; 3) operate in categories growing at least as fast as GDP; 4) have conservative balance sheets; and 5) are run by ownership-minded management teams. We favor this approach because we believe it results in a portfolio with enduring pricing power that essentially acts as a toll collector on global GDP. By owning this toll-collector portfolio, we believe we can accomplish all our key investment management objectives. First, we believe this portfolio enables us to participate in the upside of long-term global growth. Second, we believe it helps us to survive the negative economic periods such as financial crises, recessions, stagflations, and depressions that we believe are almost certain to occur from time to time but whose start-date, end-date, and severity are likely impossible to predict in advance. Third, we believe it gives us the best chance of delivering above-average risk-adjusted returns over the long-term because of the tendency of investors to be avaricious, impatient, and overconfident, leading to an overvaluation of the most speculative stocks and an almost perpetual undervaluation of the more boring, high-quality stocks on which we focus. Lastly, we believe our strategy positively exposes us to one of the most important drivers of investment performance: return on invested capital trajectory. [Brian Yacktman]
• Two other areas that we generally avoid because of similar negative convexity concerns are defense and healthcare. In both cases, the federal government is their largest customer. We think it’s unlikely the federal government will, over the long term, accept price increases that significantly raise the defense and healthcare companies’ inflation-adjusted pricing and returns on capital. In contrast, given most countries’ deteriorating fiscal health and increasingly populist politics, we believe there are many scenarios under which they could decide to decrease them. In healthcare, the situation is arguably even worse than in defense. Healthcare regulations often increase complexity and reduce price transparency, which makes it easier for bad actors to engage in unethical regulatory arbitrage that raises costs for both taxpayers and customers. As a result, it’s very hard to figure out how much of a company’s profits are a result of regulatory arbitrage versus actual value provided to customers on a competitive basis. This opacity, combined with the possibility that the government will change its view on what return on capital it deems fair, explains many of the current woes being experienced by the largest and most dominant U.S. health insurer, United Healthcare. [Brian Yacktman]
• Lastly, because aggregates are dense and heavy but also relatively straightforward to mine compared to the more complex processes involved in mining and manufacturing most other goods, they benefit from having an extremely low value-to-weight ratio. This dynamic means that the cost of transporting aggregates quickly exceeds their value (with the delivered price doubling somewhere between 23 and 45 miles), making it uneconomic for non-local aggregates facilities to supply construction sites in most circumstances. As a result, 90% of aggregates are consumed within 50 miles of the place of extraction. Combined with NIMBY, this uneconomic nature of non-local aggregate shipping often turns aggregates mines into local monopolies and oligopolies. [Brian Yacktman]