The Rational Cloning: Weekly Ideas #17
Wedgewood Partners on Oil, TPL, and TSCO | CoBF's 2022 Best Investment Idea | Canadian Value Stocks on Morguard REIT
Welcome to the 17th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Wedgewood Partners Fourth Quarter 2021 Client Letter
a. Texas Pacific Land
Texas Pacific Land Trust is the best business most investors have never heard of. Today, the Company is an exceedingly profitable, fast-growing, uniquely diversified royalty operation; in arguably the lowest-cost oil basin (Permian Basin) outside of the Middle East oilfields.
After 2013, the Company’s gushing oil and gas equivalent royalties (paid in barrels) began to gush in size to make Jed Clampett blush. From 2013 to 2019, earnings per share would grow from $3.16 per share to $41.09 per share. The collapse in the price of oil in the pandemic year of 2020 cut earnings per share in half to $22.07. The Company should earn +$36.00 per share in 2021. If oil prices stay between $70 to $80 per barrel, the Company should earn at least $50.00 per share.
In the years before developing the Company’s water business, the oil and gas royalty business generated pure profits. Operating margins were consistently in the high 80s and low 90s. The capital spent on building and maintaining the newer water business is relatively small, but not immaterial. Thus, operating margins are still a robust 75-80%. In fact, the Company’s free cash flow margins (+60%) are higher than the most profitable companies within the S&P 500 Index.
Today, if you are an oil or gas exploration and production company and you desire any activity on the Company’s 23,700 royalty acres in the rich Permian Basin as well as 880,000 surface acres (think grazing and hunting leases, plus the huge optionality of future solar panels, wind farms, and mineral rights), this is all at zero cost on the Company’s books.
Furthermore, the Company estimates that just 7-8% of their royalty acres have been drilled, plus they believe that there is 21 years’ worth of inventory under $40 per barrel breakeven oil.
Texas Pacific Land Trust is a pure play on the compelling economics of the Permian Basin. The Company likes to refer to itself as the “ETF of the Permian,” given the diversity of their revenue streams and the diversity of the Company’s royalty operators. Royalty companies are few in number, and rarer still are the handful of those that gush cash and grow like Texas Pacific Land Trust. Our oldest clients may remember our successful investment in FrancoNevada Mining – another “golden” royalty company.
b. Oil
We would not be surprised should the price of oil and gas remain structurally high (higher) over the years to come.
The global oil and gas industry has suffered from underinvestment in exploration and development for years. Today, the worthy societal goals, priorities, and initiatives of Net-Zero 2050 and ESG goals continue to exacerbate the lack of investments in production and exploration of fossil fuels. Nationwide government, public and corporate desires to become carbon neutral as fast as possible continue to collide with the current reality that the world’s demand for fossil fuel shows little sign of abating, while shortages worsen – particularly within the all-important OPEC+.
More aggressive net-zero policies in Europe have left the continent woefully short of stored heating oil before the winter season, only to see prices skyrocket. Fossil fuel shortages in China have led that country to refire coal plants. From the vantage point of 2022, the necessary bridge of fossil fuels looks to be measured in decades. Over the intervening years, the rich, low-cost Permian Basin will become even more critical to our nation’s energy needs.
c. Tractor Supply Company
We have now owned Tractor Supply for more than five years, and we continue to be very pleased with the performance of the business and the superior quality of the management team as well as the performance of the stock. We originally were attracted by the Company’s ability to grow at a healthy pace while generating impressive and steadily improving returns on invested capital – basically what draws us to any company.
Our cash-flow-based calculation of return on invested capital in the table above is the key output from our statistical analysis [between 16-18% since 2011].
As 2021 saw the world starting to head back toward something resembling normalcy, evidence is emerging of beneficial secular trends for the Company that we believe will prove sustainable. The most important of which are increasing pet ownership, increasing rural migration, and increasing Millennial interest in the Company’s key product categories, and the rural lifestyle.
We are most confident that the longer-term systemic drivers we noted above, as well as management’s accelerated investments for the future, have done nothing but enhance what already was an excellent business model before the pandemic, and we anticipate no meaningful “give-back” as the world heads toward whatever will be normal in the postCOVID world. Furthermore, given management’s performance both during COVID and historically, we expect the company to pursue this enhanced opportunity in a way that will not sacrifice profitability and capital returns. Whenever the world reaches the new normal, we believe Tractor Supply will have emerged with a greater long-term revenue growth outlook, and at higher levels of margins and returns on investment, all of which will deserve a healthier valuation than in the pre-COVID world. In short, the Company is not at the end of an exciting opportunity, but at the beginning.
(2) Corner of Berkshire/Fairfax: Best Investment Idea(s) for 2022
a. Oil (CNQ, SU, CVE, Canadian O&G), Fairfax, Atlas
To get things started my highest conviction idea today is oil. Why? I think supply is more constrained than usual (due to ESG). And i think demand will continue to grow. I am also thinking we could see travel explode this spring and summer when we get to the other side of Omicron.
Oil companies are very profitable with oil at US$70. Given how tight the supply/demand equation is today we could see oil at US$100 in 2022. My picks would be a basket of Canadian Natural, Suncor and Cenovus (there are lots of good choices); i am picking Canadian companies given i live in Canada and most of my portfolio is in CAN$.
In terms of specific companies, i continue to like:
- Fairfax at US$500 (just not as much as US$400). Insurance continues to be in a hard market. Fairfax BV is likely around US$600.
- Atlas at US$14. As new-build deliveries happen we should see EPS growth of 15-20% every quarter for the next couple of years.
- Fairfax India at US$12. BV is likely +$19 (with stocks in India selling off in Q4). India economy should grow nicely next couple of years. We likely will see another Dutch auction from Fairfax India in 2022.
b. Apollo Global Management (APO)
I think APO is attractive at this price. Pro forma for the Athene acquisition, it is trading at less than 15x multiple of 2022 distributable earnings, which is downright cheap compared to BX, BAM, or KKR.
APO has a great PE business, and is definitely leading the pack in the pension risk transfer / annuity business that all of the alternative asset managers are trying to get into now.
I understand that a lot of these earnings are pro forma spread related earnings, and the market certainly values FRE higher, but to me this is a great quality company that is trading at a 25-30% discount to the market, closer to 35-50% discount to its peers in the alternative asset management space, and has laid out what I believe is a persuasive case for 15-20% growth in distributable earnings.
The stock is trading at $74, and expects to do $5.50 in distributable earnings in 22. I feel that a $110 price target is reasonable based on a 20x multiple, and there should be 15%+ earnings growth over the next several years, so I think this can do well.
c. NYC Real Estate (CLPR, office)
On the RE side, I think $CLPR is poised to perform as the rent increases gets passed through via quarterly new leasing and lease renewals. I think 2022 is finally the NYC recovery year. NYC office may catch a bid as well. Maybe?
d. TPB, PINS, TWTR, car/truck suppliers, BERY, DISCK, WRK
I think stuff like TPB could do very well. Seems like a good play to get into weed without getting into the weeds.
From the tech sectors (if you call it like this), I like PINS. They have issues with user engagement but I think the changes that they do to make the platform more shop able are going to improve ARPU and the stock in some ways it cheaper than it was pre-COVID-19. TWTR is a dark horse here. - the platform has engagement but has never been able to make money. Maybe the new CEO is going to make a difference, but it’s hard to tell.
For economy sensitive plays, I think car/ truck suppliers here are worth a look. They are not great business, and have been hit hard by first COVID-19 and then the semi shortage . Unlike car dealers or the car companies themselves, they have not benefited from firm pricing and truly got her short end of the stick. I expect the semis shortage to go away and the higher volumes should lead to a rebound in earnings. Inflation is a risk thing, because gross margins are thin, so even if they eat a little margin, it hurts.
A but better may be some packaging plays. BERY is one I own, but have been looking at WRK as well. It seems cheap and their gross margins have been quite stable recently which indicates rational competition.
As a restructuring play, like DISCK . I have a smallish to medium (for me) position , but depending on how this works out, I will make it a full position in 2022. The valuation is compelling and I think HBO and TW studios are great assets and with Malone being on board, there is a large owners who cares about the stock price
I own TPB and PINS and BERY and seriously thinking about buying some car suppliers (maybe a basket of them ) and WRK.
I have decided in 2014/15 to leave the commodity space alone for the most part. I just don’t like price taker companies and have no clue where commodities are going. I have been much happier since I left this sector along. If I were to invest in something it would be behemoth like BBL which has a cost advantaged position and pays out a lot of cash and there is no cartel that determines the supply and hence price.
e. Energy, commodities: ATM/OTM calls on commodities and best in class companies
Psychology is often predictable. And what’s interesting, is look at energy. Outside the US, most of the world is still hiding in their bunkers. Wait til they flip the lights back on. Crude futures still look highly attractive. As do many other commodities.
I think the oil sands producers are well positioned due to lack of capex requirements for maintaining current production. Lots of upfront capex is required for oil sands producers but you don’t need to constantly invest in new wells for lost production once it’s online. Lets them avoid some of the inflationary costs that will be hitting the shale/offshore drillers. Also, there’s the potential tipping point when the market goes from valuing oil producers on pure cash flow to assigning value to the actual reserves. Oil sands producers have decades of reserves which have zero value under the current ESG narrative.
Just my opinion and not investment advice of course, but I’d look to take 5-10% allocation, and buy long dated ATM and OTM calls on both the commodities and the companies that are best in class and carry low risk of being mismanaged. Risk a few % to make 5-10x or more if things get nutty.
The way I see it, is that most people think inflation is one of the main risks to “the market”. So essentially you are putting on a trade that can be classified as protection/insurance while also working regardless. The bigger the inflation the bigger the windfall, assuming it’s structured correctly.
(3) Canadian Value Stocks: Morguard North American Residential REIT
The thesis is actually remarkably simple, and in the interest of your time and mine I’m not going to pad this post with too much extraneous verbiage like I normally do most of the time.
MRG owns over 12,000 apartment units – ~7000 in the US and 5000 in the GTA, Kitchener, and Ottawa (and one building in Edmonton). Much like BSR REIT, these are mostly garden style apartments in the US Sunbelt. It’s a decent quality portfolio: the buildings are relatively young (average 21 years old), the average monthly rent is $1490 and is up 4.4% over last year, and the occupancy is over 96%.
If you plug in MRG’s Canadian NOI/door into that trendline formula, you get $257,700/door, which seems somewhat reasonable and is equivalent to a cap rate of ~3.75%. $200,000 per door would be a cap rate of 4.8%. When you look at cap rates in the GTA (2.75%-4%), Kitchener-Waterloo (3%-4.75%), and Edmonton (4%-5.75%), as well as the valuation of Canadian apartment REIT peers (all sub 5%), I think we can agree that $200,000/4.8% is roughly the floor for the value of these properties. At $200,000 per door, the Canadian properties are worth ~$18.71/unit, at $257,700/door, they’d be worth over $24/unit.
Keeping in mind the US properties justify the entire enterprise value, this means that MRG could have 100% upside (or more) from today’s price of $17.85…. If you want to value MRG on a sum of the parts, as I presented here, you have to believe that Rai would either buy back units of MRG, which he hasn’t shown a willingness to do, or he’d sell some fully priced assets, which he has said he’s not keen to do.
It seems clear to me the sum of the parts is probably conservatively $30+, probably $35+ [current price: $17.54], but it would take a catalyst to realize that and it doesn’t look like a catalyst is likely.
Tweets That Make You Go… Hmm 🤔
