From Land to Digital Gold: James Davolos on Bitcoin and Royalty Models in the Age of Inflation.
August 2024: A conversation with James Davolos of Horizon Kinetics.
Welcome to the ROI club.
This week I had the privilege of hosting James Davolos of Horizon Kinetics.
Long time members will know the respect I have for the firm and their work so it was a real thrill for me to go back and forth with James.
Sadly however, our trans-pacific connection was interrupted a few times which lead to large parts of the audio being unusable. Nonetheless, I have dug through the transcript and edited the key points of our discussion below for your reading pleasure.
Please understand I’ve done my best to piece together what James said, but at times I’ve had to add my own interpretation.
James has sportingly agreed to join me again when we are both back from holidays. As such, please enjoy the edited interview transcript below and leave any questions you may have in the comments section so I may put them forth in our next chat.
Kind regards,
Benjamin.
Interview:
BD: Hello and welcome back to the return on investment podcast today. It is my great pleasure to announce that we have James de Vollos from horizon kinetics here to discuss all things.
inflation, how we can protect ourselves from inflation, but not only protect ourselves, but to potentially benefit from it.
James, Welcome to the Channel. Thank you so much for agreeing to discuss some of these topics today.
Would you mind giving us a 2 min synopsis on your background, and how you came to find yourself at the eclectic firm that is horizon kinetics.?
JD: Well, 1st thanks so much for having me today. I'd say that one of the things that comes up time and time again when you talk to people about their career and their career path, and not to discredit hard work and people that are very targeted in what they do, but almost everybody has a massive amount of luck, and or a mentor in kind of getting to where they ultimately are able to flourish and prosper in life, and I would definitely say that I was no different where I had a worked in my family's business, a small seasonal motel down at the shore in the the ocean in New Jersey became very interested in business from an early age went through college with a pretty standard business background, and then came up to New York in 2,005, when it was really boom time and finance, thinking that this was going to be super easy. I then get an entry level job, basically doing order entry at horizon kinetics on the trading desk. So I wasn't necessarily trading for profit. It was more just entering orders from Murray, Peter and Steven, the 3 founders, and then Peter Doyle in particular, I think, took an interest in me and my career and basically became my mentor, and you know, allowed me to then transition out of the trading desk onto the research team, and then ultimately gave me more and more responsibility, so that I can run portfolios on my own.
BD: Can you explain the horizon kinetics approach to value investing, and how it differs from other value, orientated firms?
JD: So I think the easiest way to start is the conventional methodology or the orthodoxy of value investing, and nothing against this process. It's just not what works for us. But I'd say 90 plus percent of value investors, whether it's price to book price to free cash flow and Ebitda price to earnings cheapness. And the problem that we see with that is that A, everybody else is already looking at that screen. But then also B, it tends to highlight certain sectors and industries, and then also companies where there's a problem. And so it leads you towards what you'd call a value trap where a company looks cheap, based on the trailing metrics. But then value is not about the past. It's about the future. And so if those cash flows are falling off a cliff, if margins are getting compressed, if asset values getting impaired, it's just a really difficult exercise.
We have the same methodology where we need what we would call qualitative and quantitative cheapness in order to establish a margin of safety. But We'll look at companies that have owner operators. So where the management team might not operate the business around quarterly earnings, and that might not necessarily be aligned with Wall Street and the multiple (applied).
So we actually look at things very qualitatively.And I think that that is where a lot of value, and a lot of output can be achieved. But it's it's time consuming. And it's a lot of work. And I think that it's difficult to replicate and automate within a team, and that's why fewer and fewer people are doing it.
BD: is inflation the number one threat to to our wealth?
JD: Yes, I think that inflation is a massive threat, particularly if you’re an income oriented worker like almost the unless you own your own business, or you have an enormous amount of net worth where you can kind of compound out of these fiat currencies that are being de-based, meaning your purchasing power is going down each year.
In the United States, we're running an approximately 7% budget deficit every year. It's about 2 trillion dollars.so that means debt being added to the US Government debt every single year, and that is going to have a knock-on effect into your purchasing power especially through a lot of these government policies that are basically distributing this debt-based spending through the economy. And so if you're being paid in these dollars that they're effectively issuing more and more of every year through this deficit you're being debased.
I think, is going to be extremely challenging for people that don't understand the dynamic of what's going on with the debasement of currency, which is almost basically the same thing as inflation.
BD: Are there any relief valves in terms of disinflation?
JD: The entire market, I would argue, is collectively betting on artificial intelligence and an AI miracle and productivity.
There are only 2 valves to having sustainably high, real Gdp growth: one is having a higher, like a larger labor force. So basically more working age people entering a labor force, and the more people with static output, the more economic output you have.
The other variable is the productivity of those workers.
When we talk about the disinflationary trends that were somewhat miraculous in the 30 years preceding the global pandemic, one of the biggest was the Internet and all of its applications such that there was almost 3% productivity growth in a lot of Western markets. People are hoping, thinking, praying that AI is going to have a similar step function, change in terms of productivity and labor output.
Generally it seems like it replaces labor as opposed to enhancing labor, so it might enhance a couple of units of labor, but it also gets rid of a bunch of units of labor. Is the net result, a creative or not?
If you do accept the premise that AI is going to have this ubiquitous change to society and productivity. You're saying that the current iterations of AI is going to result in Agi, where you have general intelligence. That would be a game changer.
However, then all of the raw materials that go into that, whether it's iron or copper. Actually, there's a lot of hydrocarbon intensity, that all needs to be pulled forward very rapidly to facilitate the large compute that's required for AI, and then forget about all of the other things involved with the inflation, adoption, act, and chips act around infrastructure, and all of these other things are massively commodity intensive, and so to argue for disinflation and productivity? I would argue that best case - There's going to be a big inflationary, a second wave of inflation before that, if it (disinflation) can exist.
BD: Talk me through the INFL ETF, the thesis behind the types of businesses in that etf, and why that has been your preferred mode of expressing the inflation thesis in terms of an investment.
JD: So at horizon we have let's say, unofficially, been prioritizing business models. One of the things that we recognize during the latest commodity cycle Was that a lot of businesses theoretically had positive leverage to asset prices that were rising, whether it was energy, base metal, agriculture, real estate, or infrastructure were not generating the economic returns that you would expect because the nature of the business model is very capital intensive.So what I mean by that is, they have low returns on assets. So you invest a lot of capital for a low return. You then have a lot of working capital tied up. And then probably you're going to lever that up with debt because you have a low return on assets to get a reasonable return on equity.
So just a quick example. Think about a copper mine. You might have to spend a couple 1 billion dollars to get the copper mine online.You know, if you're lucky, maybe you have $5,000 a ton break evens then you have to reinvest a lot of your free cash flow in, expanding the mine or finding new deposits, and so through a full copper cycle. very ambiguous net return on assets after adjusting for free cash flow.
We emphasise what we call capital like businesses. So companies that have limited capital intensity, such that they have high operating margins and high free cash flow conversion .And this results in a much better economic return to you as a shareholder.
I think the best example of capital white, hard asset businesses would be royalties. So again, juxtapose that copper mine, that gold mine, a oil well, etc.You're maybe a decade in the red before you ever see any cash flow.
If you're a royalty holder it's actually a senior claim to the debt on the asset itself where you have a gross revenue interest in the 3rd party operations of that asset so their breakevens don't really affect you. So quite literally, a royalty and a Us. Juris jurisdiction can have a fully taxed free cash flow of over 70%. Gina Reinhard, the wealthiest Australian. To my knowledge, most of her wealth is actually royalties that her family has retained on legacy, iron, and compromise, and it just shows you the amount of accumulation that can be created from these business models.
BD: How much of a bonus is that to have that call option on surprise production into the future, without having to be the one responsible for cutting the checks to to bring that stuff out of the ground?
JD: That's an enormous value lever that I don't think is fully appreciated in the royalty business model. People that don't understand the valuation of royalties might say that they're expensive or they don't understand them.But you really have 2 call options, and they're 2 very long dated calls (upside production and price).
probably the most famous and prolific royalty of all time was signed by Franco Nevada in the early 1980s, where they paid 2 million dollars for this gold mineIt's already paid them over a billion dollars. There's probably another couple of 100 million dollars of Royalty revenues associated with that.
BD: What would you consider a reasonable rate of return in that early stage before you can hit that escape velocity or critical mass of starting to compound?
JD: So something in the 7 to 8% range is kind of what we're looking at in terms of discount rates depending on the jurisdiction, the operator quality, the commodity, you need a reasonable equity rate of return under your base case scenario and then have that optionality through the call option on the back end.
BD: What would a wave of institutional capital mean given the small collective market cap of this asset class as they proliferate? Because a lot of royalties are actually still held in producers’ portfolios and they've then spun them off into separately listed entities.
JD: Yeah, great, great point. And so I'd say that there's a lot of privately held royalties. The largest holders of royalties in the world are actually governments.There's also a lot of public producing companies that own the royalties and the ability to separate these assets, If you get the appropriate multiple, if done properly, it reduces your cost of capital. And then, if you can get any type of institutional migration towards the asset class. Either a lot more of the private assets need to come public, or there's just gonna have to get bid up.
Murray's thesis has been, if and when, the index stocks stop going up,where does the incremental dollar flow go? And it doesn't take much money to really move something like this, because there's just not as much capacity as, say, a Google Amazon or Nvidia.
BD: How do you go about waiting for a portfolio initially? As sometimes “diversifying”actually acts against compounding.
JD: So I'll juxtapose our managed accounts, and then with INFL which I run it a bit differently. Warren Buffett, Charlie Munger, Walter Schloss you know, basically all of the phenomenal value investors that compounded for decades they allow the portfolio to naturally undiversify. We've actually done studies, and I think I can make it available to you and your readers about what if Warren Buffett was proactively selling Geico on its way to a 10,000 or 100,000 X game. Not only would it have dramatically impaired the value of Berkshire, Hathaway, but you would have been paying taxes on that the whole way. So, if you appreciate the Punch Card philosophy of Warren Buffett, where it says, act as if you have a punch card with 20 slots. And every time you buy a stock you need to basically punch a hole once you hit 20, you're done, you really allow the truly incredible businesses to compound between tax efficiency and the power of compounding. You're just going to blow away this institutional imperative to constantly rebalance. At horizon with our managed accounts, what Marie and his team have really done is establish a great position at 5 or 6% and if it compounds, allow it to do just that where basically, it can then be a generational wealth store.
With INFL a lot of people can't tolerate that level of concentration so you tread the line between what is in the best interest, but then, also what is palliative for investors, because most investors are going to look at a portfolio, and they think a 7% position is just like, Wow, you better start selling that. That's just crazy concentration. So with INFL we have the same methodology, 5% cost. But then, once we get around 7 and a half, we start pulling back. And again, that's just to make this a more palatable to a wider array of investors.
Hard stop- if you can let your winners run. It's shown to be far more value accretive over the years.
BD: The only thing I might point out would be that you have to correctly identify those compounders. And I think that comes back to a lot of the work you guys do around identifying superior business models. If you had one diagnostic that you could look at through a a financial statement that would give you an indication that this thing could be a high quality business model to allow such compounding over time what would it be?
JD: Everything needs to ultimately be reconciled to free cash flow because that's ultimately what you're putting into your pocket. One of the hints that I really like is- Is the business growing organically?.
Is it growing with a very high incremental return on invested capital?
(This is the case) with provided by businesses like royalties, exchanges, brokerages, data companies where the incremental dollar is always going to be higher margin, just by the nature of the platform of the business.
BD: How do you see Bitcoin's role in protecting purchasing power, particularly in compared to the traditional sources, such as gold, fine art, etc?
JD: There's really 2 ways to look at it. One is the technology platform which does have a lot of potential applications, when you look at Bitcoin at its core it has fixed issuance, and the issuing actually declined on a formulaic basis through this halving cycle for the miners. And I think that that's what really turned Murray on the technology was that it decentralized. So you don't have anybody who can just change the rules and create more Bitcoin. It's naturally deflationary because you're issuing less and less by design over time. That's really the antithesis of what's happening with fiat currencies where we're just issuing more and more or we're adding more and more debt. People have their issues with Bitcoin, I think when you look at it for what it is, a decentralized non fiat system that is not inflationary and not debasing your purchasing power. I can see why more and more people are adopting it.
BD: Is there such a thing as a Bitcoin mining royalty?
JD: So we've seen this, where basically, is that secured by the mining equipment, I guess you could call it a royalty, because your revenue stream is based off of the volume of Bitcoin Mine Times the price. Then similar to a royalty, Your safety net is basically the collateral. Which are these chips and racks and servers, etc. And so it's somewhere on that spectrum of asset-based finance and royalty and I think that if the industry develops that we'll have some fairly high level of involvement in it.
BD: I would like to join you, it seems the ultimate business. Where are we at In terms of Texas Pacific? A lot of people just can't conceptualize this company. And I empathize because there's a bit to get your head around..
JD: Part of the complexity with Texas Pacific is that they don't just own minerals. What makes Tpl really unique is that they have just under 900,000 surface acres. And so with a surface acre you don't have any interest in the oil and gas royalties, but you control everything else on the surface of the land. So if there's pipeline easements, if there's water that is basically being recycled etc. The latest iteration has been Bitcoin mining and data centers. Most people had no appreciation for the value of surface land, and Murray did a tremendous amount of work on the optionality of surface land, he said ‘Look water is going to be a multi multi (million dollar) business’ and ultimately he's been proven right. But it took a lot of people in the market a very long time to appreciate that.
Now I think the most recent development is even more complicated, but even more compelling potentially where the reason Bitcoin miners went into West Texas is many fold, but a. You have very cheap power, and you have cheap power because you have cheap gas, and so these oil wells produce a tremendous amount of gas, which there's not enough pipeline capacity or storage to get it out. That gas can be converted and taken into a generator to basically power a bitcoin mining or data center facility. So one of the biggest constraints of both projects which are basically different iterations of high performance computing is your energy cost and cooling.
So now it's water for every Barrel of oil. That's pretty nasty stuff. You know, in the formation, it needs to be basically treated and desalinated. But if you can desalinate it now, all of the data center, Nvidia's technologies use liquid cooling.That's the other 40% of your energy consumption, and you can reduce that by 70 to 90% with liquid cooling.
So when you look at these different multi legged options, originally you had oil and gas. Then it turns into fracking. Then it turns into a water business. Then you've got wind and solar. And now you've got Bitcoin mining and potential data centers, and again going back to the optionality of a good return base that is worth something, and then, if they strike, the returns can just get truly exceptional. And you know we've been very fortunate where many of the call options on on Tpl have actually been striking.
BD: Well, this has been a wonderful discussion. Is there anything I missed that you would like to share with people?
JD: Just one thing that I think we spoke about offline that's just really relevant today is that as people look at their portfolios and their asset allocation, and think about inflation. All of these variables have been so dynamic lately. It's the dominance of indexation. Just bidding up the large cap complex of the world of stocks has created. I think this artificial sense of no volatility and no risk. It’s like a minsky moment, the lack of volatility, the lack of risk, is creating (risk).
And I think that people just need to really examine the last 10, even 15/20 years, and look at what the proximate causes for these asset level returns have been, and then look at the vulnerability and the durability of their portfolio.