Hello everyone! Welcome to a very volatile market that gyrates with every White House Tweet or announcement! How is everyone feeling? Good? Good!
There’s nothing particularly insightful to say, so I thought I’d leave you with this:
And perhaps a couple relevant quotes:
“I think it's much more interesting to live not knowing than to have answers which might be wrong. I have approximate answers and possible beliefs and different degrees of uncertainty about different things, but I am not absolutely sure of anything and there are many things I don't know anything about, such as whether it means anything to ask why we're here. I don't have to know an answer. I don't feel frightened not knowing things, by being lost in a mysterious universe without any purpose, which is the way it really is as far as I can tell.”
— Richard Feynman
(If you’ve never read physicist Dr. Feynman’s autobiography, you should. He had a fantastic personality, a really interesting life, and some incredible ways of thinking about things. It’s called “Surely You’re Joking, Mr. Feynman!”)
“The question everyone wants to know the answer to is: how long will this last and how bad will it get? Of course, nobody knows the answer.”
— Charlie Munger during COVID, 2020.
Depending on how the trade war goes (I’m surprised nobody has called the US’ actions “Operation: Self-Destruct”), I might write a bit about it. I had something written up but it feels meh. I was essentially going to talk a wee bit about trade and tariffs (how they’ve never worked, and that we already figured out the reasons they don’t. That’s thanks to British economist and politician David Ricardo, whom every business school learns about when they learn Comparative Advantage). But it doesn’t feel insightful or different.
I wrote up a little bit about how we think about our stocks instead.
I am human. I feel fear like anyone else. I thought a lot about selling stocks and raising cash after the election and especially because the S&P 500 was already well above 20x earnings. Many of our businesses, like KKR, traded at high multiples and were about what we figured was fair-ish value. Furthermore, I’m fully aware most of my portfolio is high-quality, but cyclical businesses, which often sell off hard during a downturn. Even some non-cyclicals like Fortrea are turnarounds, and sold off.
I’ve warned several times our portfolio would probably underperform during a market sell-off and outperform on an upswing. Much of our prior outperformance was because it took place during a market/economic upswing.
This said, I just don’t find Procter & Gamble very attractive at >20x earnings, a ~4% growth, 60% ROIC business. I don’t find Berkshire super attractive at twice book value when our modeling has generally shown a better price to pay is around book value to earn an 11-15% return. My mother’s accounts still own Berkshire, but I’ve often been selling it down each time we found new things.
That’s compared to things we own like like Citi, a 3-6% growth, 12-17% ROIC business at 5-8x earnings, and KKR, a 10-15% growth, 50% ROIC (in the asset manager) business we bought for 8x earnings and which now trades around the low teens. And I know these businesses can survive bad economic shocks and will continue to thrive thereafter. All of them are also decently well-managed. They may not grow and earn profits at these rates this year if there’s a trade-driven recession, but I own them because I think they’ll average out attractive (or at least satisfactory) profits and growth over a few years. And I think the portfolio as a whole has relatively low risk of big, permanent capital loss.
We’re a bit excited about the prices of some of our holdings, but not incredibly excited about others. We seem to periodically be able to pick up great assets (good returns on capital, good growth) at 8-12x earnings, and good assets (decent returns & growth) at 4-8x their potential profitability.
KKR still trades in the low teens, probably about two-thirds intrinsic value. The industry’s cycle has usually thrown us one of the good competitors at <10x earnings once every few years, so I don’t feel like there’s anything to do. By being patient, I’ve gotten this type of business much cheaper several times as the market writes off the company’s ability to generate carried interest and investment returns, and its ability to grow AUM. The market tends to think fundraising will be god-awful for years, and discounts the company heavily. I’m thinking that if things get bad enough, then that’ll be the opportunity.
Brookfield trades closer to half of intrinsic value and is getting interesting, but has the same drivers as KKR. I also believe it’s very unlikely Brookfield will ever be fully valued by the market in the next 5 years, and believe we will get most of our investment returns from the underlying growth in BAM and the reinvestment of cash flows at BN, as these new investments grow intrinsic value per share at a good clip. For example, we talked about Brookfield’s annuity business extensively, which has added a good chunk of intrinsic value and will continue to add more and more value for years.
DaVita will be virtually unaffected by the trade war and I may use it as a source of capital as it already trades closer to fair value than other positions. We have another small telecom holding we already sold for the same reason, and added slightly to Fortrea.
Fortrea has looked interesting if you believe the business is going to start to turn around the next 2 years. I recently added to Fortrea at $8 and own as much as am willing to own with the information and confidence I currently have. I believe the management is generally doing the right things, but that we can’t predict the shape of the recovery in biotech funding. That will ultimately drive any recovery at Fortrea. Other than an economic slowdown hurting biotech funding, Fortrea won’t be directly affected by a trade war.
GM should actually come out of this fine, even though it’s at the epicenter of the trade war. It’s still a $40-50 billion company that can do $10 billion+ at the peak.
I cannot predict how things will turn out, but it’s plausible the administration will make exceptions for autos. A car is 30,000 parts. The supply chain is global and intricate. For example, because of 30 years of free trade in North America, GM, Ford, and others have components like transmissions that cross the US-Mexico-Canadian borders about 7 times during manufacturing and assembly. I.e., machined gears and such come from different plants, then get assembled into a transmission housing at another plant, which is then moved to another plant where it’s assembled with other powertrain bits, which then goes on to another plant where they mount it to the car chassis and assemble the rest of the car). The tariffs appear to apply to components and whole cars. You can see how the administration didn’t think this through at all. Effects like this are estimated to add $6,000+ (more for larger vehicles) to the cost of many new vehicles (10-20%). In key areas, like pick-up trucks and big SUVs which make up ~2/3rd of GM’s profit and which have pricing power, GM should be able to easily raise prices, just like COVID. In other parts of the industry, prices may also be increased as (1) the industry in North America isn’t oversupplied at all and (2) many other vehicles have loads more imported content, or are imported whole, compared to Ford, GM, Honda, etc. Producers like Volkswagen and Hyundai import most of their volumes, while GM, Ford, Stellantis (Jeep/Dodge/Chrysler), and several others produce more locally. In a high-and-prolonged tariff world, the more local producers will benefit because their costs won’t rise as much as the importers. They’ll get some combination of market share and profits coming from higher prices. In some cases, GM won’t get any benefit and the vehicles will be less profitable, though. It’ll all depend on many factors, e.g., because they’ll renegotiate costs with suppliers or try to change some suppliers, because they’ll try to make the dealers eat some of the costs, and other factors. The consumer won’t bear it all. It mostly depends on the industry structure and the competitive dynamics.
Citi is around 10x current profits, and 4-5x what it’ll be capable of. At the same time, there’s already tons of evidence, and tons of execution from CEO Jane Fraser. However, Citi is about trade! They do stuff like finance inventory in transit around the world. They write letters of credit and guarantees for suppliers, so that buyers in another country will do business with them. Vs. other banks, Citi also does much more foreign exchange and currency hedging for corporate clients. In a bad trade war, trade volumes are going to fall as higher prices causes buyers to purchase less. An economic slowdown, plus the associated uncertainty, will cause dealmaking to fall at Citi’s investment bank as well. The credit card business will also lose more money than usual during a slowdown, and will be Citi’s main loan loss driver. If these happen, Citi has more than enough earning power, capital, and liquidity to make it just fine. For dealing with that, it looks like the market is paying you a huge premium. Citi looks pretty attractive: it’ll one day be earning closer to $15 per share, on $100+ per share in tangible book value, for which you’re paying <$60 today.
Ally would also progress through a recession just fine, and we think the bank will keep moving toward $4.50-6 in earnings per share the next 2-3 years without any big impairment to our capital in a recession.
Loan losses are going to completely depend on unemployment, which will drive defaults on car loans, the bank’s main portfolio by far. We showed in our report that Ally’s got about the best underwriting record in the industry, so I’m confident losses will be more than manageable in a high-unemployment world. New car car prices are also likely to rise, which will put upward pressure on used car prices, the bank’s loan collateral. That should help its recoveries on defaulted loans.
Rates: Ally’s also buffered in two ways because of how interest rates behave when going into a recession. Typically, long-term interest rates fall in the US. It’s a safe haven. This “flight to quality” happens even when the US is the problem — such as during the financial crisis — because the USD is the world’s reserve currency, the US doesn’t default, the US tends not to inflate away its debt, and because the Treasurys market is deep and can absorb s***-loads of buying. Short-term rates also tend to fall as the Fed lowers the overnight rate to cushion the economic blow by making debt cheaper.
On the long-end, Ally has a ton of unrealized losses in its Treasury bond and mortgage-backed securities portfolio. All that stuff will be worth more if long-term rates fall (which they already), which will be a capital windfall for the bank and partly make up for losses on car loans. It’s held in the available-for-sale portfolio and can be sold and recycled opportunistically. The unrealized loss is ~$4 billion, and I estimate the excess losses on its automotive loans would roughly equate to this $4b, +/- ~$1 b or so. Meantime, the bank’s normalized earning power is ~$1.5 billion.
On the short-end, when the Fed lowers rates, the bank’s deposit costs will fall. They’re going to fall faster than the rates on its loans, because those loans are mostly fixed rate automotive loans. This will be more obvious when the bank’s interest rate hedges expire. So, there’s a good shot that the bank’s net interest margins rise faster than our thesis contemplates.
These two effects will allow it to easily ride through a recession. I calculate that in a bad recession, the combination of (1) falling short rates lifting their margins, (2) loan losses eating into profits, and (3) falling long rates creating a capital windfall, will result in (4) the bank continuing to build capital even through the recession. The other cool thing is, the worse the recession, the more the loan losses will be, yes, but it also means the Fed is more likely to cut rates lower, long-term interest rates will tend to move lower as well. These are negatively correlated to each other and so they have a great offsetting effect.
This offsetting effect isn’t guaranteed though, and you can’t perfectly predict this will happen to rates. In a world of high inflation but low growth (which a trade war would likely cause), the Fed will be in a difficult position and may not lower interest rates. At the least, Ally’s net interest margins are still going to expand, and this extra profit will eventually cushion loan losses. The “underwater” long-term bond portfolio is also slowly maturing at par value, and so this capital is slowly coming back to Ally regardless over the next several years.
Finally, we already bought the bank’s capital at a discount when we bought the stock. So, from this, and from the price we paid, I feel good about how our capital is protected. Ally will come out of a recession in decent shape and once again be well on its way to earning $4.50-6 per share (and approach $45-55 in tangible book value per share), vs. the $27 we paid. We try to buy decent banks for ~5x what we think they can earn in 2-5 years.
For the stuff like our banks, I’m not making these scenarios or facts up now. I did this work when we bought the stocks. All of it is in our previously-posted reports. We have always walked the talk: I think about downside, and I try hard to protect capital by making sure we don’t see big, permanent impairments in intrinsic value (vs. what we pay). We have always looked to buy durable businesses at exceptional risk/reward, which are run by competent chief executives.
That’s because they all have to survive tough times in order to get to the good times and thrive.
Again, I’ve thought about a bunch of scenarios and such, but I figured it just wasn’t going to be unique for you to read me hypothesize and speculate for 15 minutes. How many times have you guys already heard about trade and tariffs in the last 2 weeks? And already today you’re hearing Trump walk back most of it.
Figured it’d be interesting for you to hear about a bottom-up view of our portfolio and our stocks instead.
If not, let me know in the comments, or reply to this email, or DM me.
Enjoy the trade war!
Chris