To say the first half of 2023 took me by surprise would be an understatement. Despite numerous negative factors that should be causing a decline in securities prices, such as rising interest rates, shrinking profit margins, a sluggish economy, and persistent inflation, the market continues to rise. Read about the first quarter of 2023 here.
A wise investor once said the price of being a bear can be costly to careers. I concur. Of course, if you know me, my position has always been to own great businesses with competitive advantages through thick and thin. We then manage our risk around the edges.
As a result, most of you have done very well so far this year, which is excellent. In spite of that, we will be more active in protecting your gains for the rest of this year.
The Last Bull Market of Our Lifetime?
While irrational exuberance exists around certain stocks and industries, such as AI, we still believe strongly that specific sectors exhibit a lack of interest after an extended period of virtually no capital investment.
As to the exuberance part, one only needs to look at Nvidia. A market average valuation of 18 times earnings seems insufficient, so “investors” have bid up the stock to 240 times earnings, a nearly 20-fold premium to the market.
To justify such a rarified stock price, the chip maker must grow to dwarf market leaders like Amazon, Google, and Microsoft, all added together. Of course, that doesn’t mean it can’t continue to go up for a while. I think it may very well be the poster child of the end of the last bull market of many of our lifetimes.
What’s Going On With the Banking Sector?
As to the lack of interest, banks of all sizes seem to be thrown into the recycle bin. If you’ve followed along, I’ve been pretty bullish on this sector. Citing the big banks and small and regional entities, many of which were priced for extinction, we took that pessimism and added some small regional bank positions to our client accounts, including New York Community Bank and Western Alliance.
As to the large banks, they are doing just fine, thank you. Wells Fargo just reported a stunning quarter. Net income soared for Wells from $3.1B to $4.9B. The bank’s return on equity (a metric we follow and examine) is 11.4%. Earning 11.4% on an equity base of $ 183B implies the bank makes around $20B annually. Applying a super conservative 12 multiple on the earnings would give us an equity value of $240B or about $65 a share, 40% above today’s stock price. AND they’re aggressively buying back shares which will boost earnings a little more. Nobody wants to own it. It’s the anti-Nvidia.
PayPal Seems Like a Great Opportunity
As the market progresses, it’s becoming more challenging to find opportunities that go against the norm. And it reminds me of the late 1990s. I do believe we found a jewel of a business in payment processor Paypal.
Paypal exhibits sustainable competitive advantages in a sector estimated to grow at a mid-double-digit rate for the next decade. Mr. Market just hated the fact that Paypal’s business was slowing and knocked down the stock price from $300 to the $70s.
Charlie Munger once said, “Investing is about doing lots of research, and when the market gives you the opportunity to buy a great business at a really attractive price, you back up the truck. Then you sit on your a** for a decade or so.” We think Paypal is precisely this type of business.
Berkshire Hathaway Is Still the Best
Speaking of sitting on our backside, we have been owners of Berkshire Hathaway since the 1990s. The result for our most senior clients is a 13% compound annual return. Given today’s somewhat modest valuation plus an 8-10% growth in earnings per year should yield a low double-digit return for existing investors. As my friend Whitney Tilson says, Berkshire is the best retirement stock in America. The safest stock in the US, accompanied by a around 10% annual return. It just doesn’t get much better than that.
Paramount Global: It’s Complicated
Our investment in Paramount Global has been a disappointment so far. Paramount suffers from severe headwinds in the form of a more competitive streaming market and now the Hollywood strike. It’s clear that Paramount is not a sit-on-your-backside business. What is clear is that it is an asset story.
Paramount has very valuable assets in the form of its movie and TV library. They also own CBS. If the company were liquidated today, it would be worth arguably $40-50 a share—or 2 to 3 times its current stock price. The catalyst here might well be a buyout of either CBS or some of the movie assets.
We’re in good company here as Berkshire is the largest owner of Paramount stock, taking a sizeable position shortly after we started buying ourselves. Buffett has owned CBS before and knows all the principals involved in Paramount very well. We don’t know how this will play out but suffice it to say that at the price we paid for the stock, our margin of safety is large enough that we can afford to wait. Be patient. This might take a while.
We Sold Activision
In other portfolio activity, we sold our position in Activision Blizzard. To review, Activision was another foray into merger arbitrage. Let me explain: Company A proposes to buy Company B at a pre-determined price in the future. Once this is announced, the market will handicap the odds of the merger really happening.
Microsoft announced that they were buying Activision Blizzard within the next 18 months at a price of $93 a share. Activision stock was trading at $77 at the time of the announcement. The stock initially popped up a little but then settled back into the high $70s. It was clear that the market did not think that the merger would go through. We felt that if the merger didn’t happen, we were paying a modest price for an excellent business. In which case, we would own it for a while.
On the other hand, if the merger went through, we would make a 20% gain in less than a year’s time. The latter happened, and we closed the position for a 20% gain in 6 months or 40% annualized. Heads we win, tails we don’t lose anything. I love those types of investments!
Fixed Income and CDs
With interest rates somewhat normalizing, we have become more active in the fixed-income realm. CD rates of 5-6% give us the opportunity to park cash and actually get paid to do so. Gone are the days of return-free risk in fixed income — for the interim, anyway.
An Update on Gold
As to gold, we have added to our position in Seabridge. Seabridge owns the largest undeveloped gold deposit in the world, KSM. KSM is no industry secret. A massive project in British Columbia boasts proven and probable reserves of 47 million ounces of gold, 7.3 billion pounds of copper, and 160 million ounces of silver. While this may sound impressive, there is a catch. The project is situated in a remote area of northern British Columbia, where roads are scarce or non-existent. This hurdle has recently been remedied with access roads built right up to the project.
Seabridge has invested $150m on infrastructure such as roads, bridges, and work camps. Seabridge will not operate the mine once it goes into production. As they say, that is not their strength. They will license ongoing operations to a larger operator such as Newmont or Barrick. With an operating life of over 50 years, the project will be a long-term royalty payment back to Seabridge.
We think Seabridge is an excellent way to leverage your gold investment. You’re investing in a debt-free company with little operating costs and the potential to grow to an enormous royalty stream with little risk over time. I would expect an announcement of a joint venture sometime in late 2023 or 2024. The upside here is multiples of the stock price.
Low Expectations are the Key to Happiness
Our buy list is getting thinner all the time, a sign of the times for sure. As Mr. Munger has told us, low expectations are one key to happiness in life. A recent study found that the average investor expected the market to return 17% per year—certainly not low expectations.
If history is any guide, returns will be pretty modest as we advance. We will ignore the market gyrations and forge ahead, looking at businesses with sound balance sheets. We will buy when they go on sale and offer us a definable margin of safety. Then we will sit on our a** for a while.
My five largest personal holdings to date are Berkshire Hathaway, Occidental Petroleum warrants, Meta Platforms, Amazon, and Triad Business Bank.
Thank you for your continued trust,
C. Steve Henry
Certified Financial Planner
Registered Investment Advisor