1Q 2020 portfolio update - Horizon Kinetics › wp-content › uploads › 1Q... · • TPL & Other...

© 2020 Horizon Kinetics LLC.®

April 22, 2020

1Q 2020 portfolio updateSteven Bregman


An Overview

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• Portfolio Positioning Before the PandemicConditions as of Year-end 2019

• That was Then, What’s Happened Since• TPL & Other Royalty-Model Companies• Have We Bought Anything Yet?

First, Where NOT to Be• Have We Bought Anything Yet?

The Conditions Dictating Where We Want to Be• The Kinds of Companies We’re Thinking About,

and the Kinds We’re Not• The Last Pitch on Bitcoin – Changes Are Happening –

Banks, Brokers, and Central Banks


Our Perspectives on Getting Oriented

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Annualized Inflation Rate

1975-1984: 7.8%

Testing Institutional (and Generational) Memory

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A Three-Decade Decline in Reported Inflation

1985-1994: 3.6%

1995-2004: 2.5% 2005--2014: 2.1%2015--2019: 1.8%

Source: U.S. Department of Labor Bureau of Labor Statistic


Pre-existing Concerns Prior to the Pandemic

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Contributing Factors to the Three-Decade Long Decline in Inflation

The Exporting of Inflation

In the mid-1990s, U.S. companies began to make use of a global cost arbitrage by shifting production and employment tolower-wage nations around the world, initially and especially to China. This ‘exported’ inflation, counteracting the Fed’sinflationary monetary policy. However, it devastated U.S. manufacturing jobs. Nor were the excess profits reinvested indomestic capital expenditures and R&D, which would have benefited U.S. workers, but were directed to share repurchases.Atop an already growing counter-reaction to globalization, the global just-in-time-inventory supply chain practice laid bare anational security failure: an inability to secure basic supplies during a national healthcare emergency. There is now a politicalbacklash against China from every almost every corner of the globe. It is almost certain that the U.S. manufacturing base isreturning to the mainland. We will now be ‘importing’ inflation, reversing the trend of the prior two decades.

The Calculation of Consumer Price Index Itself

The methodology has been revised periodically, and each such change seemed to lower the reported rate. The 2% CPI rateof the past decade does not reconcile to the more transparent figure: 6% annualized growth in money supply.

Narrowly Directed Fed Spending during the Credit Crisis

The massive Fed spending during the Credit Crisis was directed to the financial institutions that were the center of the crisis, tohelp them deleverage their balance sheets. The money stayed largely within the finance sector and was not transmitted tothe broader consumer economy. The current situation is entirely different.

Declining Raw Material Costs

Oil had been $100/barrel for several years through 2014, and gold and silver prices had been falling since about 2012. Theycontinue to produce from existing wells and mines, but they are actually depleting their reserves. As a consequence, it couldbe anticipated that there would develop supply shortages, with the attendant price pressures.


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140.0Gross Federal Debt as Percent of Gross Domestic Product

Pre-existing Debt Leverage

6Source: St. Louis Federal Reserve Bank

Rapidly Rising Federal Debt as a Percentage of GDP – After a Decade of Economic Expansion

61.9%(2007)

90.2%(2010)

The CreditCrisis

World War II Spending Program 119%

(1946)

Post Crisis Expansion

105.8%(2019)


Where we stood at the end of 2019, post the 10-year economic expansion, pre-pandemic:

GDP: $21.7 trillion

Policy Choice Freedom Already Reached Its Tipping Points

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Total Debt in the U.S.: $77 trillion(including corporate bonds, credit card debt, auto

loans, mortgages, etc.)Interest Burden on Total Debt: $3.72 billion

Implied Interest Rate: 4.8%

1Includes Defense spending, interest expense and mandatory spending programs like Social Security and Medicare)

A 1%-point rise in rates would translate into $770 billion additional interest, equivalent to 3.6% of GDP.

GDP during the 2008/2009 Credit Crisis Recession declined by 3.25%

Tipping Points for Policy Decisions:The government simply could not afford to permit interest rates to rise.


The Alternative: Fiat Currency Debasement

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Growing Money Supply

Source: St. Louis Federal Reserve Bank

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Apr-19 May-19 Jun-19 Jul-19 Aug-19 Sep-19 Oct-19 Nov-19 Dec-19 Jan-20 Feb-20 Mar-20

The Recent YearPre-Pandemic

7% annualized Money Supply Growth

Post-Pandemic, Pre-CARES Act: 4.9% Money Supply Growth in just one month.


Since the Pandemic

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The Magnitude of Government’s Actions To Date

The Federal Reserve’s Assets increased by $1.65 trillion (from $4.16 trillion to $5.81 trillion).

The Budget Deficit was already at $1 trillion. The $2 trillion spending bill will raise that to $3 trillion.

But there’s also the loss of tax revenue, because of the mandated business shutdowns: lowerpersonal income taxes, corporate income taxes, capital gains taxes, excise taxes. So the deficit willbe larger still, which means yet more money creation will be needed.

The Federal debt/GDP ratio, even excluding any additional spending beyond the $2 trillion stimulusplan, rises from 105.8% to 116.3%. But if GDP is just 2% lower in 2020, the ratio becomes 118.7%.Going back to the highest ever figure, the World War II figure, that was 119.1%.

As to money supply – the February 24th to March 23rd increase was 4.9% ($964 billion). That’s almosta year’s worth of money supply increase in one month. And this was a week before the CARES Actwas even signed.

And we are just getting started, and are clearly not done spending yet.


The Irreversible Implication of the Stimulus

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The Other Part of Money Creation

Breaking Down the CARES Act:Of the $2 trillion CARES Act funds, the Treasury gets $500 billion to support corporations, states andmunicipalities. A modest portion, $46 billion, is directed to specified industries, like airlines and aircargo carriers.

The remaining $454 billion is governed by Section 4003(b)(4) of the CARES Act, allowing theTreasury Secretary to make loans and other investments “in programs or facilities established by”the Federal Reserve under various Special Purpose Vehicles or SPVs.Federal Reserve sets up an SPV. The Treasury will own the assets. That equity investment isexpected to act as a buffer to absorb any losses, which permits the Federal Reserve to then putmore money in. How much? Up to 10x that amount.

Implications:• The Federal government will now be buying corporate bonds in the open market, including

ETFs.• Scale of buying: based on the $456 billion made available to the Treasury, the additional

money creation could easily be on the order of $3 trillion or more. The government can, prettyshortly, own a large portion of the U.S. fixed income markets.

• The Federal Reserve and the Treasury are working hand-in-glove. The Treasury is, in a fashion,directing the Federal Reserve to create more money, money to provide liquidity tocorporations, but also to prop up securities prices and monetize the debt.


The Old Asset Allocation Models Have Been Rendered Obsolete

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A reversal of conditions that existed for the prior three decades

Central banks around the world will have to continue to create more money, debasing theircurrencies, to buy their bonds, in order to suppress interest rates. This will allow, over the ensuingdecades, debt to be repaid with ever cheaper currency.

For the immediate future, the government will be supporting bonds prices. But beyond the near term,as an asset class, bonds will be more dangerous than equities. The bond/stock asset allocationstandards of the past are over. Bond investors now face a binary choice:

• Either the government is able to maintain interest rates where they are or even lower, in whichcase bonds lose value, via inflation, relatively slowly.

• Or rates rise, in which case bonds lose value fast. What could make rates rise? In 3 months or so,when governments around the world publish the size of their budget deficits, there will be creditrating downgrades of sovereign debt. Debt rating agencies like Moody’s follow strict criteria, suchas debt/GDP ratios, so downgrades should be anticipated.

• A 10-year Treasury, now has a 0.74% yield. If the yield rises to just 3%, the price drops 20%. A 30-yearTreasury, is now 1.33%. If the yield rises to 3%, it loses 33%.

So there is no scenario in which investors escape losing money in bonds. One of the most importantelements in asset management in the coming decades will be finding inflation beneficiaries andbusiness models that are protected from inflationary pressures.


Oil Futures Curve

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Source: CME. As of April 21, 2020 at 14:50:50 CT.

In the Oil futures market, on Tues., 4/21,the July oil futures, at about $20 – theprices change by the minute – cost abouttwice as much as the $9.06/barrel Mayfutures.

The November futures cost $27/barrel,which is 34% more to buy oil six monthslater.

That’s a more informed view, by peoplewho actually buy and sell oil, think theprices will be. There are ‘paper’ buyersof oil and physical buyers.

Crude Oil Futures

Month Closing Price % Differential

Jul-20 20.36

Aug-20 23.2 14%

Sep-20 24.9 7%

Oct-20 26.21 5%

Nov-20 27.28 4%

Dec-20 28.2 3%


The Power of the Asset Light Royalty Business Model

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Oil vs. Oil Producers vs. TPL

Yes, TPL is down 35% from the beginning of theyear, but up 22x over the past 11 years.

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TPL XOM WTI

TPL: +2119%

WTI: -56%XOM: -46%

Why is that?

Basically, because it’s a royalty businessmodel. It has no debt, no capitalequipment and doesn’t have to buyproperty, and doesn’t require very manyemployees. TPL’s after-tax free cashflow margin last year was about 66%.

Therefore, TPL always generates profits.Revenue can be lower, but the profitmargin remains high, and it continues toaccumulate profits. And that meansthat its value is always increasing. Andthose profits can be deployed.

Oil isn’t necessarily the vector, but it isthe case that global reserves have beendropping for years, that demandincreases with population growth, andthat an oil price that will provide a returnon invested capital sufficient to induceproducers to replace their reserves issomewhere higher than $50 or$55/barrel.

Source: Factset


Royalty Contract Calculation Example

Current Gold Price $ 1,200 Discount Rate 15%

Period Present Value

% of Curr. Price

Current Mkt. Val.

1 $ 1,043 87% $ 1,200

2 907 76% 1,200

3 789 66% 1,200

4 686 57% 1,200

5 597 50% 1,200

6 519 43% 1,200

7 451 38% 1,200

8 392 33% 1,200

9 341 28% 1,200

10 297 25% 1,200

11 258 21% 1,200

12 224 19% 1,200

13 195 16% 1,200

14 170 14% 1,200

15 147 12% 1,200

16 128 11% 1,200

17 112 9% 1,200

18 97 8% 1,200

19 84 7% 1,200

20 73 6% 1,200

Total $ 7,511 $ 24,000

The Power of the Royalty Business Model

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• In exchange for an upfront payment to a miner, whichfinances mine development without the need to take ondebt or sell undervalued equity, the royalty company getssome portion of a given mine’s future production, typicallyfor decades. This can be in the form of a percentage ofrevenues or the right to buy a portion of the output at adiscounted price. That discount can easily be on the orderof 70% below the current gold or silver price.

• A royalty company’s assets are contracts; they are notburdened with capital expenditure for earthmovingequipment, replacement parts, labor, or property.

• A gold miner, being asset heavy and labor intensive,suffers from input cost inflation during protracted periodsof higher gold prices.

Asset Light Inflation Beneficiaries

Cumulative present value, as % of cumul. mkt. value ($7,511 ÷ $24,000) 31%

Cumul. PV discount, %, applied to curr gold price (31% x $1,200) $ 375


The Power of the Royalty Business Model

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Fun Facts: Royalty Model vs Operator

Franco Nevada

(Royalty Model)

Newmont

(Operator Model)

Market Cap $24 billion $48 billion

Revenues (FY 2019) $844 million $9.7 billion

Employees38 full-time,

plus 4 contractors

16,600,

plus 15,000 contractors

Cash $132 million $2.2 billion

Debt $80 million $6.1 billion

Free Cash Flow Margin >70% 11%

Source: Company Reports


What Now?

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Preparing for the next 10 or 20 years, and not the next one or two

From the words of Winston Churchill, you don’t want to fall victim to this thinking:

“The danger has not arrived, so the danger has passed.”

Our goal is to position portfolios for the next 10 or 20 years, not the next one or two. One challengeis that governments have so distorted the capital markets, that it’s extraordinarily difficult toconstruct a portfolio.

We believe that what’s coming down the road is going to be a reversal of the conditions thatexisted for the prior three decades; all the old wisdom and the statistics and correlations will be outthe window.

Although our portfolios were very much already positioned the right way coming into 2020, we want to improve upon that, take the opportunity to upgrade the quality of the business models we hold to make use of the shift in global economics. But information is still unfolding.


The Index is Rapidly Undiversifying Itself

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The S&P 500 never had this level of concentration

Indexation has gotten so large -- it passed the 50% mark, 50% of all invested assets, in 2019 -- that ithas become the market, become the marginal trade. And being price-indifferent, it has beenestablishing its own ever-higher clearing prices in an ever-narrower list of the largest companies.And these companies share a strangely rich array of very similar risks: valuation risk, growth limitrisks, emerging competition, profit margin and accounting risks, and regulatory and political risk.

Source: SPDR® S&P 500® ETF Trust, iShares Core S&P 500 ETF

Top 5 Technology Giants April 16, 2020 December 9, 2019 October 20, 2016Microsoft Corporation 5.8% 4.4% 2.4%Apple Inc. 5.1 4.3 3.4Amazon.com Inc. 4.3 2.8 1.7Facebook Inc. 1.8 1.9 1.6Alphabet Inc. 3.2 3.1 2.6

Total 20.3 16.5 11.7

Top 3 Technology Giants April 16, 2020 December 9, 2019 October 20, 2016Microsoft Corporation 5.8% 4.4% 2.4%Apple Inc. 5.1 4.3 2.4 Amazon.com Inc. 4.3 2.8 1.7

Total 15.2 14.8 7.5


The Index is Rapidly Undiversifying Itself

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Two General Possibilities of the future of S&P 500

Option 1: The index organizer can place a ceiling on or arbitrarily reduce company weightings.Outcome: Reducing the company weightings would be disastrous for the index. What massive quantities ofMicrosoft stock would have to be sold? And of Apple, and all the rest?

Option 2: The index continues to undiversify itselfOutcome: The index is no longer a benchmark for the stock market.

Can they do it? These technology giants face observable and predictable growth limitations orprofitability pressures that simply haven’t manifested themselves yet in their financial statements.

* Procter & Gamble, Johnson & Johnson, United Health Care, Visa, MasterCard, Merck, Pepsico

Top 5 Technology GiantsCurrent Y1E Y2E Y3E Y4E Y5E

Revenue $915 bill $1,071 bill $1,263 bill $1,491 bill $1,759 bill $2,076 bill

Consensus Est. Growth 17% 18% 18% 18% 18%Annual Est. Revenue Increase 156 bill 193 bill 227 bill 268 bill 317 bill

Equal to Total Revenues of* P&G, J&J UNH, V, MA, MRK, PEP


The Fab 5’s Known and Observable Challenges

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Looming stresses are going to re-form the character of the S&P 500

Growth Constraints, One ExampleFacebook and Google are essentially advertising companies. They will have roughly 90% market share in a coupleof years at recent growth rates. The global advertising industry only expands by about 3% or so per year. It is amature, somewhat cyclical business. That is what Google and Facebook will inherit in the foreseeable, predictablefuture. Investors will eventually learn that the leading IT companies are becoming slow-growth cyclicals.

Earnings Overstatement Due to Employee Stock CompensationA large part of employee compensation is paid in stock options, recorded on the income statement at a highlydiscounted rate according to the Black Scholes option pricing formula. This understates operating expense andoverstates earnings. Facebook had $18.5 billion net income last year; it recorded $4.8 billion of share-basedcompensation – in shareholders’ equity, not on the income statement – and spent $4.1 billion on sharerepurchases. Google had $34.3 billion of income last year. Separately, it repurchased $18.4 billion of shares lastyear, but the share count didn’t change??

Political RiskIt’s an old pattern, when the leading companies become so large that their business decisions start havingnational policy implications. Some of these companies can be very rich political targets during a trying politicaland social policy period. And the government has different levers of power. Anti-trust is a big hammer thatrequires a large, public political effort. Changing stock option accounting rules would be a different lever.


The Uneven yet Definitive Impact of High Inflation

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High Inflation in a Low Interest Rate Environment

It is typically said that low interest rates support high stock and other financial asset valuations. Buthigh inflation is associated with valuation contraction.Between April 1971 and March 1980, the trailing P/E ratio on the S&P 500 contracted from 19.5x to6.7x. The inflation rate rose from 4.2% to 14.6%. Interest rates rose, too, but if you look at themagnitudes and continue to follow the progress through the recovery, the earnings multiples reallywere associated with the inflation rate.

Source: St. Louis Fed, Macrotrends.com

S&P 500 P/E RatioTrailing 12-mo

CPITrailing 12-mo 10 Yr. Treasury Rate

April 1971 19.5 x 4.2 % 6.08 %

September 1974 7.0 9.2 7.94

June 1975 12.0 9.2 7.86

March 1980 6.7 14.6 12.64

June 1983 13.3 2.5 10.96

June 1987 21.0 3.7 8.38


Hey, What about Delta Airlines?

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A better opportunity would be Boeing

Source: Factset

Boeing stock dropped over 50%, mostlyon well-publicized safety problems with its727 Max jet, not because of thegeneralized market decline.

Since Boeing’s commercial airlinebusiness is roughly 50% of its revenues andearnings, that $90 or $100 billion loss ofmarket value pretty much effaced thevalue of the airline business. As if it’sworth zero.

Maybe it is worth zero, in which caseBoeing is trading more or less at the valueof its defense business, that is relativelyprotected from the typical inflationarypressures

But if the commercial aircraft businessrecovers – which it almost undoubtedlywill – then you have that optionality.

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SP500 BA LMT RTN

LMT: -4%

S&P 500: -13%

RTN: -28%

BA: -57%


Last but not least: Bitcoin

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The most misunderstood, yet most important, asset class

The largest securities exchange, largest custodian bank, largest software company and largest coffee shop chain in the

U.S. established a joint venture. These are Intercontinental Exchange, BNY Mellon, Microsoft, and Starbucks.

Whatever for? The consortium is called Bakkt. So far it has launched physically delivered Bitcoin Futures, Bitcoin Monthly

Options, and Bitcoin Cash-Settled Futures. It also established a NY State Dept. of Financial Services regulated custodian

to provide Bitcoin custody services to Institutional clients.

The consortium has also been developing a mobile phone app, essentially a digital wallet, using “Bakkt Cash”, which can

include bitcoin. That app has been in beta testing and is expected to launch a consumer app and merchant portal in

the 1st half of 2020.

*Central Bank Digital Currency (CBDC)

In January, the Bank for International Settlements announced that it had formed a group to assess the potential cases

for CBDC* in their home jurisdictions. The participants included the Bank of Canada, the Bank of England, the Bank of

Japan, the European Central Bank, Sveriges Riksbank (Sweden’s central bank), and the Swiss National Bank.

Why would governments and central banks want their own digital fiat currency?

Money supply is now being created on a scale that has no historical parallel. Governments, will have to maintain near

zero or even negative interest rates for a long time. But that risks demonetizing the banking system. When people have

to pay to have their money kept in a bank account, they are likely to withdraw their money from the system and keep it

at home. And governments know that.

But, if all the money is digital, you can’t withdraw it from the system. You can buy something with it, something you think

might retain its value, like a rental property, but that money stays in the system, because you used it. This looks very much

like government cryptocurrency is happening.

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Important Risk Disclosures & Definitions

Past performance is not indicative of future results. The information contained herein is subject to explanation during a presentation.

This is not an offer to sell or a solicitation to invest. Opinions and estimates offered constitute the judgment of Horizon Kinetics LLC (“HorizonKinetics”) and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions.Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not beassumed that the securities transactions or holdings discussed were or will prove to be profitable.

Certain of the material herein is intended to portray the general nature of investor communications provided by Horizon Kinetics from time totime to existing clients. None of the investments or strategies referenced should be construed as investment advice and just because oneinvestment is appropriate for one account does not necessarily mean it is appropriate for another. No investments should be made without theanalysis of, among other things, an investor’s specific investment objectives, which considers their overall portfolio and any income requirements.The accounts referenced herein pursue an unconstrained strategy – meaning they are not limited by capitalization, geographic region, orinvestment techniques. They generally primarily seek capital appreciation with a secondary objective of income.

Note that indices are unmanaged and the figures shown herein do not reflect any investment management fee or transaction costs. Investorscannot directly invest in an index. References to market or composite indices or other measures of relative market performance (a “Benchmark”)over a specific period are provided for your information only. Reference to a Benchmark may not reflect the manner in which a portfolio isconstructed in relation to expected or achieved returns, portfolio guidelines, correlation, concentrations, volatility or tracking error targets, all ofwhich are subject to change over time.

The S&P 500 Index (“SPX”) is a broad based index widely considered as a proxy for overall market performance. It is the property of Standard &Poor’s.

The iShares Core S&P 500 ETF seeks to track the investment results of an index composed of large-capitalization U.S. equities. The iShares U.S.Real Estate ETF seeks to track the investment results of an index composed of U.S. equities in the real estate sector. They are property ofBlackRock, Inc.

Horizon Kinetics LLC (the “Firm”) is parent company to Horizon Kinetics Asset Management LLC ("HKAM"), a SEC registered investment adviser. HKAM and its employees, in addition to the separate accounts and pooled products they manage, may hold certain of the individual securities mentioned herein. For more information on Horizon Kinetics, you may visit our website at www.horizonkinetics.com.Not all investors will experience the same holdings, returns or weightings as the corresponding composite. No part of the research analysts’compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analysts in thisreport.

No part of this material may be copied, photocopied, or duplicated in any form, by any means, or redistributed without Horizon Kinetics’ priorwritten consent.

©2020 Horizon Kinetics LLC ® All rights reserved.

http://www.horizonkinetics.com/

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