Horizon Kinetics – CalPERS Conundrum, Inflation Beneficiaries, Drilling & Shipping, Precious Metals, Case for Bitcoin


Horizon Kinetics 4Q17 Portfolio Update, January 17, 2018

The CalPERS Conundrum

  • CalPERS has an AUM of $356Bn (2nd largest in the US; 7th worldwide); 194 managers in PE alone; paid $234M in management fees and $455M in incentive fees; paid $33.6Bn of stock trading commission on ~18Bn shares, translating to ~0.2 cent per share
  • Serves almost 2 million public employee members, over 1/3 of whom are already retirees and beneficiaries; paid out an average of about $33,000 each last year; number of members increased by 3% during the year
  • In 2016, Fund lowered its expected rate of return from 7.5% to 7.0%
  • Positions (as of 12/31/16), to name a few: ~2,000 separate corporate bonds; 4,000 domestic publicly traded stocks
    • Seem to be exposed to the very same securities at the center of the indexation fund flows as a retail investor directed by an online robo-advisor
  • In December 2016, the Board voted for a change in its allocation to support the existing plan to reach a 7% discount rate
  • In a low growth, record-high-valuation environment, a major risk to bond prices in particular is an increase in inflation or interest rates
  • Yet, not only did CalPERS increase its weighting to below-required-return bonds as well as stocks, but in order to increase those weightings, reduced allocation to Inflation Assets and Real Assets by 6% points; Fund also reduced cash, which provides flexibility in the event of sudden, large price changes, to almost 0
  • This is only one of the innumerable vectors of buying demand that help perpetuate bubbles

Inflation Beneficiaries and other Diversifying or Counter-Cyclical Holdings

  • Marine drilling & shipping; precious metals; real estate, infrastructure; oil & gas, mining; consensus (crypto) money
    • These are not only markedly different than the broad stock market; they differ markedly from each other
    • In their business models, the way they derive their revenues and customers, and the factors that may cause them to do well or to recover if they happen to be depressed
  • We’ve been preparing our portfolios for preservation of purchasing power:
    • Bond yields are so low, even junk bonds, that they just about guarantee a negative after-tax, after-inflation return; that’s losing money, not so different than CalPERS
    • S&P 500 is at an all-time high P/E (it doesn’t include the companies with very high P/E’s like Amazon with its year-forward P/E of 155x)
  • Timing? The only time to get a good price in a tourist shop is when the season is over, the tourists have left, and the shopkeeper has a long winter ahead
    • One reason for so many counter-cyclicals is pure investing conundrum: the best time to buy, say, an inflation-beneficiary is precisely when no one is concerned about inflation
    • That’s when you usually no one wants them or expects a recovery or is willing to wait for a recovery

Marine Drilling and Shipping

  • These are among the most depressed industries in the world:
    • Lease rates for transporting various raw materials – the Baltic Dry Index – is down 41% from its high at year-end 2013; it declined 87% to its low in 2016
    • Number of offshore drilling rigs has declined by 82% since 2004

Precious Metals Royalty Companies

  • Why not the miners?
    • Many people presume that gold mining companies are good hedges against inflation. It’s not true. The major problem is that when the gold price is higher, miners all increase production
    • Therefore, they also need to acquire new properties to replace depleting reserves, but at a cost that is rising with both inflation and competition for resources
    • The same applies to their need for increasingly scarce mining equipment and labor; rising costs limited the potential for margin expansion
  • A more elegant alternative: Royalty Companies
    • Royalty companies provide a solution to a problem that miners run into. When gold prices are low, the debt approach to funding doesn’t work, because interest payments begin accruing on day one, but the project might take years to develop and produce cash flow. And at such times the equity valuations are low, so that raising money by selling shares would be too dilutive
    • A royalty company simply purchases a proportion of the future gold production, after the mine becomes operational, but at a discounted price. A royalty buyer makes an upfront cash payment to a miner to develop a particular resource. That entitles the royalty company to buy a certain proportion of future production at today’s price but discounted for the time value of money. The effective price at which a royalty buys the production could be as low as 20% of the future market price. The royalty company doesn’t even need gold to go up to make a profit. In fact, it can even go down

Consensus Money and Blockchain

  • How can bitcoin really still go up 1,000x?
    • Microsoft came public in 1986. If you bought Microsoft that year and held to year-end 1999, you would have made 646x. In a $100,000 account, if you risked $1,000, and every other holding went to zero, you finished with $646,000
    • You didn’t have to understand technology or software to make that decision, just have the notion that IF this PC business ever takes off and every household owns one… It was just a study in going from near 0% market penetration to saturation
    • The same for consensus money, if it comes to be accepted, it will no longer be volatile because it will have reached some mature market value in the scores of trillions of dollars. There is about $90 trillion of M2 money supply in the world. There is $85 trillion of assets on the balance sheets of the world’s largest 100 banks. There is $38 trillion developed market sovereign debt and it pretty much all earns a negative real rate of return
      • There is $0.235 trillion of bitcoin as of January 14, 2018
    • A form of insurance
      • Stated policy of the Fed is to inflate the currency at a 2% rate; it could be higher so one needs protection
      • If the number of USD increases by 2.6% more in a given year than GDP, as happened last year, while the number of bitcoins do not increase, then it would take 2.6% more dollars to purchase a given amount of bitcoin
      • What if the world became divided between those who own bitcoin and those who don’t, a world in which bitcoin assumes the reference currency status that the USD did in the generations after WWII? It could become the greatest wealth transference experience in history
        • This is the reason to buy some insurance – appropriately sized – through a stable-monetary-policy consensus money
        • No one seems to mind paying for homeowner’s insurance, and not just once, but year after year; this just needs to be once
      • As a form of insurance for their own protection, everyone should own some consensus money as the ultimate conservative investment

Image Source: Fiserv APL (as of 1/4/18)