Value Investing

Kinetics Mutual Funds 3Q16 Conference Call With Peter Doyle

Kinetics Mutual Funds conference call transcript for the third quarter ended September 30, 2016.

Also see 2016 Hedge Fund Letters

Chris Bell: Hello, everyone, and welcome to today’s call. I’d like to remind everyone that all of our presentations and mutual fund factsheets are available on www.kineticsfunds.com, and you can also see samples of our research and white papers at www.horizonkinetics.com.

It’s always nice to have a quarterly call when performance is strong. Year-to-date through September 30, 2016, our flagship Paradigm Fund (no-load shares) has returned 13.19%, compared to 7.84% for the S&P 500 Index, while the Small Cap Opportunities Fund (no-load shares) has returned 14.74%, compared to 11.46% for the Russell 2000 Index.

Kinetics Mutual Funds

Kinetics Mutual Funds

The Paradigm Fund (No-Load Class) has outperformed the S&P 500 thirteen times over the last seventeen years, underperforming in 2008, 2011, 2014, and 2015. While our one-, three-, and five-year performance numbers don’t look very good, our numbers since inception are approximately 400 basis points above the S&P 500 (by clicking on the website list above, you can access the standardized performance figures for each fund). In the last few years, we haven’t owned REITs or utilities, because we believed they were pricey, and we didn’t own any of the bank stocks or pharmaceutical stocks in the Paradigm or the Small Cap Opportunities portfolios.

I’d like to turn it over to Peter, who has some market comments. Peter is a founder of Horizon Kinetics and Kinetics Funds, and President of the Kinetics Funds. Peter, please take it away.

Peter Doyle: Thank you, Chris, and good morning to everyone. Chris gets a little bit more excited about recent performance than I do. James and I tend to look at what we hold and how the business operations are going for those companies, rather than at short-term stock returns. So, I’m going to repeat what I’ve probably said 50 times in the past on these calls.

Our success or failure as investors is going to be predicated on the business operations of the companies that we own. With the passage of time, and in efficient markets, we believe that, if we own companies that have high returns on capital, and we have bought those companies at similar valuations or more attractive valuations than the overall market, it logically follows that we will outperform by that margin. That’s really what has happened since inception, with the exception of those four years of underperformance (in 2008, 2011, 2014, and 2015) mentioned above.

In fact, even in the years where we underperformed, the underlying businesses that we owned were actually performing better (with respect to business results) than the broader markets. It’s just that the stock prices weren’t keeping pace with the underlying businesses:—they got behind. We tend to ignore that, and we tend to have the fortitude and the patience to let that play out for us. That’s been our philosophy from Day One, and it will be our philosophy going forward.

The reason, we believe that our funds, going forward, are likely to get back to their historical outperformance—I can’t guarantee it, but I believe that it will play out this way for us—is that we’ve had, really going back now four or five decades, a trend of lower corporate taxes. You’ve had global markets that opened for companies to exploit. You’ve had tremendous fiscal stimulus, and you’ve had monetary stimulus, particularly in the last seven or eight years, where you’ve had central banks that have increased the size of their debt by $16 trillion.

All of those things have benefited global stocks and large-cap multinational companies to a great degree. It’s hard to envision how that’s going to be replicated in the future. As a result, we think the return characteristics of those large multinational companies, where the bulk of people have their money invested in equities, are going to be far lower than what they have been historically.

We’re doing the mirror opposite of that. We’re off the beaten path. We own esoteric, eclectic type names. And we think that’s the way to get returns going forward. It’s starting to play out in our funds, at least for this current calendar quarter. But we think it’s going to play out well into the future.

It’s clear to us that the global markets are betting on interest rates, and taking risk on or risk off. And now you have the Bank of Japan, the European Central Bank, where they have over $15 trillion of negative sovereign debt—that obviously has an effect on the pricing of assets. The market environment is pushing people into riskier assets, and people are looking at high yielding equities, companies like McDonald’s or Procter & Gamble, as fixed income substitutes. Those stocks are being priced accordingly, based on the low interest rates and the alternatives that they can get in other fixed income investments. We think that’s a very dangerous game. James is going to elaborate on what could happen just by minor shifts: either a rise in interest rates or a change in some other variable within the model that he’s looking at.

The funds have been very defensive this year. We’re still carrying a fairly large amount of cash in most of the funds, despite our outperformance. The reason for that is the opportunity set is not really that attractive. We’re just waiting for opportunities to arise. That’s essentially how we’ve positioned our funds across the board.

With that, I will let James step in here to discuss what could happen if interest rates were to rise slightly, and to talk about some of the individual names.

James Davolos: Thanks, Peter. Just to reiterate something that Peter mentioned: our success or failure is going to be predicated on the operations of the businesses, in conjunction with the price that we pay for those businesses. Unfortunately, the price element of these companies has not been very accommodative. We think that an immense portion of that is related to interest rates being low, and remaining low.

I don’t think that it’s an overstatement to say that risk-bearing assets worldwide are almost universally, and in a very highly correlated way, going short interest rates. And by “short interest rates,” I mean that a lot of investments and a lot of valuations are predicated on the continuation of low rates, or even lower rates than are currently in the marketplace. That’s not a risk to which we want to expose our portfolios. We want to have a highly idiosyncratic portfolio that isn’t necessarily embracing this same element of risk as the broader markets.

Before I go into our portfolios and a specific name or two, and how these are so idiosyncratic, and why we believe that they aren’t as sensitive to the global economy as a lot of the indices are, I’ll talk about a name that we’ve liked to pick on for a while now: McDonald’s. It’s a good company: it’s a franchise model, generates a lot of cash flow. But, again, you need to look at every business within the context of share price relative to the earnings power of the business. I think this is really going to illustrate how profound of a risk people are embracing when they invest in a company purely based on a dividend.

I think anyone can agree that McDonald’s is a very mature company. There are not many expansion opportunities geographically. There aren’t many more menu options. There’s just not a lot to do for that company to grow. If you put it in an academic framework, you would probably justify using some form of a modified Gordon growth model to value the company. Basically, I’ll take next year’s dividend expectation, which is probably a little bit generous, and then divide that by the long-term cost of capital or required rate of return, less the long-term growth rate. In order to justify the current share price of about $115, you need roughly a 6% long-term weighted average cost of capital and a sustained perpetual growth rate in the dividend of 3%.

Now, bear in mind that 3% dividend growth has been achieved recently. But it’s also been accompanied by a 16% compound annual growth rate in the company’s debt over the past five years, while sales have grown at 1.1% compounded over those five years—there’s effectively been a swapping of equity for debt in order to grow and maintain this dividend. Again, I think I’m being very generous to assume they can grow a dividend at 3% forever while growing revenue at 1%, and I won’t even get into my opinion about 6% being a wholly inadequate discount rate, and also below their cost of capital.

In Scenario A, if we increase their cost of capital—whether investors get upset about the increasing leverage, or the cost of equity goes up, you’re looking at a -14% return. Scenario B would be—let’s say the dividend only grows 2.5% a year into perpetuity. Again, a 14% negative return. Scenario C would be where both the growth of the dividend disappoints and the cost of capital increases; in that case, you could have a 24% decline in stock price.

Let’s say that they are actually able to achieve 3% long-term dividend growth, but the company’s weighted average cost of capital or the investors’ required rate of return for equity risk is 10%, which I think is probably justified and certainly historically justifiable. Then you’re losing over half of your money. So, with relatively minor sensitivity to the current framework, you’re looking at anywhere from a 14% to a 54% decline in value, all in exchange for a 3% forward current dividend yield.

But (and I’ll go into this a little bit later) McDonald’s has been a massive beneficiary of the “automatic bid” of the indexation universe, where they’ve been fortunate enough to fall into a minimum volatility ETF as well as a high income ETF, both of which have been beneficiaries of tremendous inflows of capital supporting the stocks of their constituents.

Peter Doyle: I’m just going to jump in here. More current news that came out today: Blackrock actually cut fees on 15 of their core ETFs, a lot of those are equity ETFs. That’s about $220 billion of assets under management. They’re trying to anticipate rules that are coming into place in 2018 that will shift more money to passive strategies and put people into names like McDonald’s. We don’t really have a problem with ETFs per se; we have a problem with people blindly buying ETFs without any regard for the price that they’re paying for the underlying assets. It’s just one more example of the craziness going on in the marketplace that, in our opinion, is not going to end well for most of the investors.

James Davolos: That’s a good segue into how we look at risk versus how the market looks at risk. In a world that’s now dominated by “tactical asset allocation” and the desire to quantify every risk, even those that aren’t quantifiable, your typical ETF fact sheet will highlight geographical or sector diversification criteria, in addition to Sharpe ratio and standard deviation figures. These are backward-looking, but they’re also misleading. Just going through five of the top positions in the Paradigm Fund—and many of these are also held in the Small Cap Opportunities Fund, I’ll just go through the GICS sector that these companies are held in, and briefly describe how these companies are highly idiosyncratic and, I would argue, have dramatically different return profiles compared to the broader universe within their sector.

The largest position is Texas Pacific Land Trust. You could argue that it should fall under the Energy sector. I’m going to go into that in a lot more detail later, but, needless to say, it is very, very different from buying an Exxon or a Chevron.

The next company is Howard Hughes Corporation, which is a reasonably sizeable, although still a mid-capitalization, real estate company. But Howard Hughes is a development company: they’re actually building the net asset value of their company. They have a long pipeline of future projects. They have an absolutely exceptional project coming online in New York City in less than a year now. But, because they don’t pay a dividend, they are completely overlooked by the vast majority of real estate investors.

Brookfield Asset Management is one of the best asset management franchises in the world. Peter has mentioned that Blackrock is cutting fees, and a lot of the asset management industry has been under that same pressure. But when you buy a share of Brookfield, you’re getting a very considerable investment alongside outside capital within a variety of vehicles that Brookfield manages. So, there’s a considerable tangible book value component to that investment, which, in our opinion, is going to grow in value over time, in addition to the incremental value that you own as, effectively, the general partner of the asset management business. On top of that, Brookfield has an incredible advantage in what they call “real asset investing.” So, infrastructure, renewable energy, and real estate are their three core areas of operations, and they also have a growing private equity business. But this company manages hundreds of billions of dollars on multiple continents, and they have incredible competitive advantages in operating these assets. Their fees aren’t under pressure because they own and they have an expertise in the assets that the entire world wants right now.

Live Nation is, by far, the largest concert and music festival promoter in the world, in addition to owning and operating Ticketmaster, the ticketing agency. The ticketing business is mature but generates very high cash flow. However, the concert and festival business is really exceptional. Everyone who is investing in media stocks is worried about the disintermediation of different types of content, whether it be through people viewing content over the internet, where ad dollars are getting hurt, or where cable sub-fees are getting hurt by people not paying for the full cable bundle. A lot of the media space has been dramatically altered in even the past 12 months. But if you look at the economics of recording artists these days, it’s absolutely dominated by and highly dependent on the success of their tours and festivals and merchandise. Live Nation is an entity controlled by John Malone, within the Liberty Media complex. This is how these people are going to make money going forward. They’re monetizing these rights dramatically. It’s a very, very different dynamic than what’s plaguing a lot of the other conventional media companies.

Just to stay on the same track with media companies, one of the many entities within the John Malone Liberty empire is Liberty Sirius. This is the company that owns a majority interest in Sirius XM. With Sirius XM, you might see similar concerns to cord-cutting and the cable industry, where they’re churning a lot of subscribers and getting a lot of pressure on their ad dollars. But the churn of Sirius is incredibly low; it’s an incredibly high cash flow business, and it’s being pre-installed on more and more vehicles.

And they don’t have commoditized content. So, the fear was that people could plug in Pandora or Spotify in their cars and pull up a playlist. But the vast majority of Sirius subscribers are there for the live sports, the live entertainment, and the talk radio. And that’s not commoditized; that’s something people are willing to pay for. It has a very different dynamic, compared to the rest of the media landscape.

So, these few names just really show you how misleading a GICS analysis of our portfolios is. But, again, that’s how most people look at asset allocation.

I’m going to quickly talk about Texas Pacific Land Trust, just to go through one company that is highly, highly idiosyncratic and why it’s not correlated with oil. Just to give you some quick numbers, Texas Pacific’s one-, three-, and five-year correlation with West Texas Intermediate Crude is 0.31, 0.23, and 0.24; thus, extremely low correlation to crude. Just to give you a comparison, the NYSE Arca Index for oil and gas integrated companies over that same period has anywhere from 2-3x higher correlations to crude.

Why is this company not as highly correlated to crude? It really has to do with where its assets are. But, instead of focusing simply on the revenue line that you would pull up online or in the Form 10-K, I want you to ignore the land sales, because the land sales are not something that’s that predictable. You can look at the values for references, but the recurring revenue from oil and gas royalties and easement revenue is what you really need to focus on. If you look at that over the last five years, royalty revenue has increased at a compound annual growth rate of nearly 12%, and easement revenue has grown at a compound annual growth rate of nearly 37%. So, this equates to a 1.7 and a 4.8 multiple on 2011 revenues for these respective businesses.

Meanwhile, West Texas Intermediate has gone from nearly $100 a barrel in 2011 to around $50 today, in October 2016. Natural gas has stayed around $3 per million British Thermal Units (MMBtu). So, you’ve basically seen tremendous high-margin growth in Texas Pacific’s businesses despite the energy complex.

How are they achieving this? There are two ways. The royalties are related to nonparticipating perpetual royalty interests in oil and gas minerals in West Texas. Texas Pacific has effectively no cost for doing this; they get a royalty, and this is effectively almost a 100% gross margin business. It’s purely tied to production multiplied by spot prices, so, obviously, production has offset the price decline.

Perhaps more interesting and higher-growth has been the easement revenue. A lot of their acreage is in two specific parts of the Permian Basin in Western Texas, the Delaware Basin and the Midland Basin.

The Midland Basin has been known as one of the most prolific oil and gas resources in North America, if not the world, for quite a while now. It’s actually extensively built and drilled. But there’s still plenty of opportunity with new technology. In the Delaware Basin, the infrastructure is not nearly as developed as it needs to be.

In order for the oil and gas producers to do anything from run a pipeline, run a road, run any type of access to get the infrastructure and processing and different types of necessary requirements into the Southern Delaware Basin, they need to pay easement fees to the landowners. As a function of that, Texas Pacific has grown their easement revenue, primarily from pipelines, but also from other types of access to their properties, at 37% for five years running now.

If anyone wants to understand the level of opportunity we’re talking about here, just simply punch in a Google search on the Delaware Basin. And you will see just incredible activity in the Delaware Basin in terms of the level of transactions and the results that are coming out of wells where we knew there was potential, but we really had no idea until pretty recently how prolific this formation is.

So, just to give you an idea, five counties in the core Delaware Basin are Reeves County, Loving County, Culberson County, Winkler County, and Pecos County. Across these Delaware Basin counties, Texas Pacific owns over 600,000 surface acres and nearly 300,000 gross royalty acres. Then you can look at the Midland, which everybody has already known was phenomenal, with Midland, Glasscock, Upton, Ector, and Howard Counties, where they respectively own about 80,000 surface and 50,000 gross royalty acres.

So, obviously, the acreage is very different from every single parcel. But, if you want to look at reference transactions, there’s a company called Silver Run Acquisition, another called Parsley Energy, others called Diamondback Energy, PDC Energy, and Apache Energy, that have all reported well results and transactions in this Delaware Basin within the last six months. If you look at the share price of Texas Pacific, the recovery in oil prices has helped, but, if you really want to understand the dynamics of what’s been happening, look at those five companies, and some of the results that they’ve been reporting. I think that will give you a much better idea.

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