Peyto Exploration (TSX: PEY) $11.00 – What's wrong with Peyto? (Cheap Gas, Even Cheaper Peyto)

 

DISCLOSURE: Some of us own this.

Back in February of last year, we did a write up on Peyto Exploration, noted as having what we believe to be some of the best natural gas assets in Canada led by a very focused and diligent management team (see our write up).

http://www.canadianvalueinvestors.com/home/2017/2/11/peyto-exploration-tsx-pey-2800-a-great-company-stuck-in-a-cheap-gas-world

Since we wrote Peyto has declined from $28.00/shre to ~$11.00, a tremendous drop that has happened along with most of the Canadian energy patch. A drop like that deserves a revisit.

So, what’s the problem? Canada is 1) at the start of the pipe for both natural gas and crude oil – where most of it gets shipped to the U.S. or back east and 2) Canada can’t seem to get any new pipelines built – either oil or natural gas. While U.S. WTI oil has had a nice run up and natural gas has held up (at approximately $3.00 / MMBTU per below), realized current and expected future prices of Canadian producers have not. 

Source: https://www.eia.gov/dnav/ng/hist/rngwhhdm.htm

Canadian Natural Gas – What’s happening?

While there are issues with oil differentials, we want to focus on natural gas and the following chart says it all. Since this time last year the curve has shifted dramatically, with natural gas this summer floating around $1.00/mcf compared to ~$2.40 a year ago. To put this into perspective, Peyto’s best in class all in cash cost to get gas out of the ground (operating costs + transportation + G&A + interest) is approximately $0.70/mcf. And there are some assets in western Canada that are closer to $3.00 breakeven (never mind recovery of capital, or a return on investment..).

Source: http://www.gasalberta.com/gas-market/market-prices

Peyto – A “Defensive Bias”

 In response to this absolutely brutal pricing environment, Peyto has materially cut its capital program, cut its dividend almost in half to $0.06/share/month (from $0.11), announced a share buy back plan, and says they will shift capital to more liquids rich properties (which we also believe would have a higher ROI based on today’s prices). We agree with all of their decisions, though would strongly prefer for them to have eliminated the dividend completely and instead focus on debt repayment and share repurchases. You can’t always get everything you want though right?

Analysis – What do you get if you buy today?

When we’re looking at Peyto, we’re 1) very comfortable with the management team and the asset base and 2) don’t believe that $1.35 AECO gas prices are sustainable, but also don’t know when they will recover and what “recovery” would mean.

 This leads to two questions: 1) Can Peyto survive and prolonged downturn and 2) At today’s stock price, what natural gas price do you need for a reasonable return?

Scenario 1 – Cheap gas through 2021

 Under this scenario, we assume: 1) gas is $1.35 for the next three years and “recovers” to $2.50 in 2021, 2) the Company manages is debt profile to stay within covenants (3.00x max), 3) prudently eliminates its dividend in 2019, and 4) begins to increase capex again in 2021.

Long story short, Peyto survives (helped by their strong hedging program) and you end up buying an asset today at ~9.5x 2021 free cash flow.

Scenario 2 – A bit faster recovery, return the growth

 Under this scenario, we assume gas (and capex) increases to $2.00 in 2019, and $2.50 in 2020, and have run both a $2.50 and $3.00 2021 scenario. Under this scenario you are getting the company for between 6-10x 2021 FCF.

Things we don’t consider

Our mindset is not “What will happen?”, but rather, “What is a reasonable conservative base case and would we be happy with this based on today’s share price?” We consider three years at $1.35 and an improvement to $2.50 a pretty conservative case (reasonable considering a US$3.00 MMBTU Henry Hub price), and under this you get a company for 10x FCF. We don’t consider things such as share buybacks, the impact of a shift in capital towards liquids rich wells, or improved capital efficiencies. These are basically free upside options and our analysis does not depend on them happening. 

We’re not sure where commodity prices are going to go but this is potentially the best risk/return buying point in Peyto’s recent history. In the meantime, Peyto will keep on standing.

Transcript: Vinod Khosla - How to build and manage a team

We have put together another transcript - This time a great talk by Vinod Khosla, Founder of Khosla Ventures and previously the founding CEO and co-founder of Sun Microsystems. The focus is on his belief systems around hiring, and how to manage your company’s growth internally.

 He was interviewed by Anu Hariharan, Partner at YC Continuity.

 The full original video can be found here:

FULL TRANSCRIPT

AH: You've talked a lot about company building and hiring, and I know that you've often said that a company becomes the people that it hires, not the plan it makes. Can you elaborate? What should founders focus on in hiring?

 VK: This is one of my favourite topics. When you start you know very little about what you're doing because if you did know enough, you wouldn't start the company. If you were really sensible and pragmatic, you wouldn't start companies.

 I'm an entrepreneurship zealot - that's self-described - and I'm a real fan of people trying companies and trying to build things, especially when you're younger and can afford to take risks. There's no reason to go work for someone else in my book, and I never did.

 What I find is people have plans, but it is very, very rare for a company to achieve that plan. So the way to think about where you're starting is a collection of ideas in a relatively rich space that you find that you can be passionate about. That's the way to think about a plan.

 I have a separate talk on flexi-planning which don't plan, just plan to plan.

 But the critical part of that is the team you build ends up making all the iterative decisions about where you're going to end up. Whether you're going to hire the next person from this area or that area, or that strength or some other strength, or take path A or B, is very critical to where a company ends up.

 Mixing the right experience, where you can identify the problems, with first-principles thinking, from fresh new ideas from people who have never worked in the domain, or people who are just fresh graduates and have no idea, but can ask fundamental questions - those are the best kinds of founders. Put differently, in big companies you need people with good process. In start-ups you need people with good iteration and good adaptation. Those are very different skills because in start-ups you invent 90% of stuff, and in big companies 90% of what you do this year will be what you did last year. So there's little innovation and it takes a different kind of person.

 Every start-up, if they're successful, will need some process people later. But process people early in a start-up can be a disaster. Too good a manager is a bad thing for early start-ups. But at some point, you really need to add that.

 So that's what I mean by diversity. If you have a bunch of PhDs, how many are experienced PhDs and how many are fresh? How many are from within your area, and how many are from completely outside your area? Every dimension of diversity will help because they'll bring a different point of view. As long as they have this ability to think from first principles - not say, this is done this way because we did it this way before.

Full transcript can be found at the link below.

Charlie Munger Talk At Ross University 2017 – FULL TRANSCRIPT

We came across a great 2017 talk with Charlie Munger at Ross University and found it worthwhile enough to put together a transcript. The talk covers Munger's early years during the Great Depression, his transition away from law into investing, and even Bitcoin! We hope you find this of value, and if you do please let us know. Our newsletter will give you a heads up on future value investing talks and transcripts.  

Here is the original video:

Scott DeRue: So, Charlie, as I was on the flight over this morning I was thinking about and preparing for our conversation this evening, and as I went through my notes, I realized that we share an admiration for a historical figure in Ben Franklin.  

Charlie Munger: Absolutely!   

Scott DeRue: And Ben wants once quoted that there are two things that you can do in life: you can write something that's worth reading or you can do something that's worth writing about, and you've done both of those.  

Charlie Munger: Oh, but not like Franklin.  

Scott DeRue: And so a couple hours ago I went on Amazon books and I just typed in Charlie Munger in the search field, and over a hundred books have been written about Charlie.  

My favorite title was "The Tao of Charlie Munger", which was which was pretty interesting and so what I thought we would do this evening for our conversation is really just explore your life, and many of the moments in your life that have shaped how you think, and what you've been able to accomplish. 

I'll ask a number of questions and at some point hopefully we'll have time to open it up and ask some of the questions that you all are interested in as well. So far we're two for two in Bitcoin so that's that gives you a sense of what's on people's minds.  

But I'd like to go back to your early childhood in Omaha Nebraska. So you were raised in Omaha, and what are some of the moments in your experience in Omaha that you really find memorable that shaped you and who you are today and how you think? Can you talk a little bit about growing up in Omaha?  

Charlie Munger: Well yes, I really liked Omaha. It was a size where I knew a lot of the people, no matter what they did - I wasn't lost in a great metropolis. I was very fortunate in my nature of my parents, and my parents friends, and I was fortunate in the public schools I attended were pretty remarkable by the standards of the time.  

And of course, most of my schooling was in the Great Depression, but that means I'm one of the very few people that's still alive who deeply remembers the Great Depression. That's been very helpful to me. It was so extreme that people like you have just no idea what the hell was like. 

It was really there was just nobody had any money the rich people didn't have any money. People would come and beg for a meal at the door, and we had a hobo jungle not very far from my grandfather's house. I was forbidden to walk through a good amount, so I walked through it all the time.  

And I was safer in that hobo jungle the depths of the 30s when people are starving, practically, than I am walking around my own neighborhood now in Los Angeles at night. The world has changed on that. You'd think the crime would be less [now], but the crime was pretty low in those days.  

So anyway, I saw I had a very unusual bunch of experiences, to go through civilization in various phases including the greatest recession. Wellm I say it's one of the greatest recessions and 600 years in the English-speaking world - it was really something. It was very interesting to watch and also to watch it fixed, and it was fixed by the accidental Keynesianism of World War II.  

And Hitler had fixed the Great Depression in Germany by the deliberate Keynesianism, but he wasn't doing to stimulate the economy he wanted to get even with all the people he hated. But he borrowed all this money and created all these armaments. Hitler's Germany by 1939 was the strongest economic power in Europe, and nobody else was close.  

So you wouldn't understand that as well as I do, if you haven't lived through it. You could see the place gaining traction, more and more and more, and pretty soon it was fixed. Of course, in those days there were all kinds of people - most of my family - that believed in hard money based on gold, and not much welfare, and so on. So I was raised among fairly backward people by modern standards.  

But they were backward in kind of a self-reliant way that I think was helpful. I've never regretted that I wasn't raised in a more liberal establishment. I had a liberal aunt (she was really my mother's cousin) and she was the second lady Dean at the University of Chicago. She did her thesis on conditions in the coal mines, and of course she was a screaming leftist. I would be extreme leftist if I observed the way the coal miners of yesteryear were treated. 

You couldn't be a human being with any decency on you without feeling that it was deeply improper to have misery that great and that manipulated - for the benefit of the mine owners, and so forth. But, she sent me all these left-wing books - one every Christmas - and I always thought she was a little nuts. 

[Laughter] 

Which shows that sometimes the very vivid and extreme acts as evidence [and] misleads you. You've got to be a guard on that against that all your life.  

In fact, the whole trick in life is to get so that your own brain doesn't mislead you, and I have found that just a lifelong fun game, and I can't remember a time I wasn't doing it. I was not a prodigy, but I was I was a prodigy in having adult interests.  

I was interested in what worked, and what didn't, and why. I could see that very eminent people that I loved and revered we're nuts in some ways. I would to say, I certainly like Doctor Davis but he's a little naughty in one way and I'm not gonna be that way like that. So, I was very judgmental and I think that helped me.  

And it also helped me that I kept changing my judgments as I learned more and more facts came in. That created lifelong habits that were very useful.  

Another thing that really helped me is, particularly on my father's side of the family, my paternal grandfather was the only federal judge in Lincoln Nebraska (capital city of Nebraska). He'd been there forever, and he stayed there forever after...I think when he left he was the longest-serving federal judge in the country.  

He was a brilliant man and he'd risen from nothing. He was a child of two impoverished schoolteachers, and when he was raised in a little town in Nebraska they gave him a nickel, to go buy the meat and he'd go to the butcher shop, and he would buy the parts of the animal nobody else would eat. That's what two schoolteachers lived on in those days. 

The very indignity of it bothered him so much that he just determined to get out of poverty, and never go back. He did. He got ahead like Abe Lincoln, and educated himself in lawyers offices. He had to leave college because he couldn't pay the tuition anymore, but since he educated himself, and since he was utterly brilliant, it wasn't all that hard.  

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He had an attitude that was pretty damned extreme, and I would say his attitude was: you have a moral duty to make yourself as an un-ignorant and un-stupid as you possibly can. And that it was pretty much your highest moral duty - maybe taking care of your family came first. He was conventionally religious so it may have been a religious duty to him. But he really believed that rationality was a moral duty, and he worked at it, and he scorned people who didn't do it.  

On the other hand, as a judge, he started with the idea - you know, why would anybody rob a train or whatever a federal crime on those days. He was pretty hard on people who did it, and I noticed as he got older, he was willing to call a man a good man on easier terms than he started out. I think that was a correct a correct development, by the way, when he relaxed a little. He was still pretty tough, but he did relax a little, which I thought was appropriate.  

It was influenced by people when the thirties came. [There was] one son-in-law, who was a musician, and of course he couldn't make a living. So my grandfather, who didn't have that much money, sent him to pharmacy school, carefully picking a profession that couldn't fail, and found him a bankrupt pharmacy to buy and loaned him the money. My uncle was soon prosperous and remained prosperous the rest of his life.  

My other uncle at a bank in Stromsburg, Nebraska, but there were 968 people in Stromsburg, and there were two national banks. The capitalization of my uncle's bank was $25,000 and of course he was a lovely man, but he was an optimist - and a banker should not be an optimist. 

[Laughter] 

And when they closed the banks in 1933, the bank examiners came in, and they said you can't reopen, and it was the only business he had! 

Well, Judge Munger had always saved his money, and he had a lot of good first mortgages on homes occupied by tee-totaling German butchers and people he'd carefully picked, of course he never had a default. Houses were in the right neighbourhood, and the people were sober and hard-working.  

And so what my grandfather did was to take a third of his good mortgages, put them into the bank and took all the lousy assets out of the bank. He saved two out of the three of his children, and I thought it was a pretty good thing to do - and very shrewd the way he did it. And he actually got most of his money back 10 or 15 years later out of the lousy assets of the bank during World War II. That was a good lesson.  

My grandfather on the other side, his main business had gone broke in 1922 with all the other wholesale dry goods [companies]. His son went broke and [my grandfather] cut his house in half and moved that family in. And in the other family - the guy was an honors graduate of the Harvard School of Architecture - and he was very prosperous in the 20s in Omaha, and had a wonderful life.  

Then the 30s came, and the total building permits in Omaha would sometimes be $25,000 a month and that was for furnace repairs or something. There was just no work - none, zero.  

He moved to California, and he lived for several years and he finally got the County of Los Angeles to hire this great Harvard architect, and he got $108.08 a month after deductions, and they had him do drafting work but they classified him as a laundry man to save money. And he could actually rent a house for $25 and feed himself and drive an old car. He could live on $109 a month. Amazing how poor everybody was. 

And what happened to that grandfathers along came the FHA and they had a competitive civil service examination. He was a very brilliant man, of course he was first in the exam, and that made him a chief architect for the FHA in Los Angeles, where he spent the rest of his life. 

I watched all this family coping with all this difficulty, and I'll say this: it sounds awful, but they weren't all that unhappy. You can cope pretty well because you get used to it. That's a nice thing about the human condition. I mean, you get to be my age, and you got a lot of horrible things to get used to. 

[Laughter] 

It's just one new indignity all the time. A friend of mine says a good day when you're old is when you wake up in the morning and nothing new hurts. 

[Laughter] 

So anyway, that's my experience in Omaha. But that background of all these people were educated, and civilized, and generous, and decent. A lot of them had good senses of humor. It was a pretty damn good place to grow up in, and my memory is of being surrounded by a lot of very fine people. I think the whole thing was privileged. I look at my background is absolutely privileged, and I'm proud of being an Omaha boy. I sometimes use the old saying, “They got the boy out of Omaha but they never got the Omaha out of the boy”, and so all those old-fashioned values family comes first: Be in a position so you can help others when troubles come; a prudent sense and a moral duty to be reasonable. It's more important than anything else, and more important than being rich, more important than being important. An absolute moral duty because none of my intelligent relatives suffered terribly because they didn't advance higher. 

Scott DeRue: Yeah, I mean this was in the 20s and 30s in the level of detail that you recall about their experiences and how that shaping your experience is... 

Charlie Munger: I'm trying to give people a flavor of something that nobody else can remember. 

Scott DeRue: I mean you're a student of the people that you're that you're experiencing. So you grow up in Omaha Nebraska, and you find yourself in Ann Arbor Michigan, how does that happen? 

Charlie Munger: Very simple. I wanted to go to Stanford. 

[Laughter] 

And my father said to me, Charlie (I was the only son, two sisters), I've got two daughters that have got to be educated right after you. I don't have unlimited money, he says I will send you to Stanford if it really means a great deal to you. But I'd rather you pick a university in the Midwest much better than mine, which was the University of Nebraska, and that was obviously gonna be Michigan. What was I gonna say, well screw you sent me to Stanford? 

[Laughter] 

Well, I didn't say that I went to Michigan.  

Scott DeRue: So, you come to Michigan… 

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Charlie Munger: I have never regretted that at all. People came to Stanford in the 30s with their string of polo ponies! It was a very upscale fraternity-sorority culture. I used to call it the co-educational Princeton of the West. People loved it and so forth but literally, you go to Stanford with a string of polo ponies? I'm bringing back to you, young people, a time you can't remember. Who did you ever know in college that came with a string of polo ponies?!?! 

Scott DeRue: Not very many people… 

Charlie Munger: No, they go they'd be in the ROTC, but they had their own string of polo ponies. You could win better if you have your own string. 

Scott DeRue: So you come to Michigan, and you study math for a year.  

Charlie Munger: Yes, but I don't get credit for that. When I was young, I could get an A in any mathematics course without doing any work at all. And so I always took math because it meant that I literally never didn't any problems sets. I just did the math and so I should not get credit as some budding mathematician. I was choosing what for me was the easiest way to think about what I want to do, instead of what somebody else wants me to do.  

Scott DeRue: Come to find out it ended up being a subject that has I think paid some dividends? 

Charlie Munger: Hugely! Yeah, but this will interest you, in this world where people have all these algorithms and computer science and fancy math, and so forth.  

Neither Warren or I have ever used any fancy math in business, and neither did Ben Graham, who taught Warren. Everything I've ever done in business could be done with the simplest algebra and geometry in addition, multiplication and so forth. I never used calculus for any practical work in my whole damn life. I was a perfect whiz at it when they taught it to me. And by the way, since I never touched calculus not one after I was 19 years old, I've lost it. The symbols would mystify me. But I think if you really know the basic stuff, its enormously useful and only a very few people are gonna need any calculus. 

Scott DeRue: So you study math at Michigan then the war comes calling? 

Charlie Munger: Yeah.  

Scott DeRue: You moved to California, and you study meteorology.  

Charlie Munger: Well, that was because I was too dumb to do what I should have done. With my background, I should have gone to the naval ROTC, because I hated infantry ROTC, which had done for years open high school - rising to be the second lieutenant...which is a very low rank. 

[Laughter] 

And of course that was about five feet-two - I got my growth late, so I was not your ideal manly soldier in high school. 

Scott DeRue: So, when you went to Harvard Law - why law? 

Charlie Munger: Well my grandfather and father had been lawyers, and I knew I didn't want to do everything else, it's very simple. I didn't want to be a doctor. I didn't want all the blood and misery and so forth, and the repetitive work.  

I knew I didn't want to go to the bottom of a big organization, and crawl my way up. I'm a natural contrarian and that was not going to work for me. I found that people could tell me when I thought they were idiots, and that is not a way to rise in a big organization, and so I couldn't do that. So now I'm left with law. I admired my father and grandfather, and they had a good life for them, so I naturally drifted into it. 

I think people are still going to law school for that reason, and it's the least bad of options considering their interests and ability. I guess now people go to business school...many of the people in this room I think are gonna go to business school, and that's the least bad of their options. And all I can say that that's the way it worked for me, and it'll probably work for you it worked out okay.  

Scott DeRue: So, that's actually what I want to ask, so you moved to California you actually start a law firm and then practice law for some period of time. 

Charlie Munger: I had no alternative, I had an army of children almost immediately. 

[Laughter] 

I painted myself into quite a corner.  

Scott DeRue: Yeah, so zero choice is pretty powerful?  

Charlie Munger: Yes, yes of course. 

Scott DeRue: So you practice law, and then you leave law, in the firm that you helped found, and move over to investments?  

Charlie Munger: Well, but...that sounds miraculous. 

[Laughter] 

In fact, it was rather interesting. I probably got paid about $350,000 in my first 13 years of law practice, total. And I had an army of children and no capital to start with. When I chose this alternative career, I had over $300,000 in liquid instruments, and that was 10 years of living expenses, so I was not a courageous venturesome or some admirable man. I was a cautious little squirrel...saving up more nuts than I really needed it and not going very deep into my pile of nuts. 

It wasn't that courageous, and I kept one foot in the law firm while I tried my capitalist career, but as soon as the capitalist career succeeded I intended to lift that second foot, because I recognized that the potential of law practice as I saw it then (I didn't anticipate the boom that came to the big firms) - I just saw this being more difficult. I wanted more independence than I was going to have as a lawyer. I hated sending other people invoices and needing money from richer people. I thought it was undignified. I wanted my own money, not because I loved ease or social prestige, I wanted the independence. 

Scott DeRue: Well, and when you so you founded Wheeler, Munger, and Company, so that was the investment firm.  

Charlie Munger: Yes and I have 5 real estate projects I did both side by side for a few years, and in a few years I had three or four million dollars.  

Scott DeRue: And for a number of years you outperform the market 2x, 3x, and so why did you then leave Willer Munger and company and then move to now what you're doing? 

Charlie Munger: Well, I had three or four million dollars which was a lot of money then. I also knew how to handle that three or four million dollars very well at that time. I knew I didn't need to get fees and override some other investors, and I found that when you got into things like this '74-75 crunch which was the worst since the 30s, I didn't suffer I knew everything was going to work out but the quoted prices of these things really went down to ridiculous levels.  

Some of my investors I knew were suffering, because they needed the money. Of course, I have enough of fiduciary gene that pained me greatly, and so I said it's just it's like when my grandfather once they asked you how he felt when my aunt divorced my uncle he said I feel just the way I did when they lanced my carbuncle. My fiduciary gene was giving me pain, and I lanced the carbuncle and I just lived on my own money. No fees, no overrides, no salary. Just seemed more manly to do when I knew it would work. 

Scott DeRue: And so, at what point did you meet Warren?  

Charlie Munger: 1959. 

Scott DeRue: And so where did Berkshire Hathaway come from regarding this partnership that you all have now had for two decades?  

Charlie Munger: Well, Warren had been taught by Ben Graham to buy things for less than they were worth no matter how lousy the business was. And you can't imagine a more lousy business than New England textile mills. 

Textile is a congealed electricity, and the electricity rates in New England were about 60% higher than TVA rates. So it was absolute, inevitable, certain liquidation. Now, Warren should have known better than to buy into a totally doomed enterprise, but it was so damn cheap. We could get it at a big discount from liquidating value.  

So he bought a big chunk, and finally ended up controlling the business. But the business was gonna die, so the only way to go forward from there was to wring enough money out of this declining textile business, and to have more money than he paid to get in, and use it to buy something else. 

That's a very indirect way to proceed, and I would not recommend it to any of you. Just because we did some dumb thing that worked, doesn't mean you have to repeat our path. Of course we eventually learned not to buy these cigar butts when they were cheap and do these painful liquidations, so we stood by better businesses.  

That's the main secret of Berkshire. The reason that Berkshire has been successful as a big conglomerate - more successful than any other big conglomerate so far as I know, any other big conglomerate in the world. The reason it's been successful is we try and buy things that aren't gonna require much managerial talent at headquarters.  

Everybody else thinks they've got a lot of managerial talent at headquarters, and that's a lot of hubris. If the business is lousy enough and it gets a wonderful manager, and the business has a lousy reputation and the manager has a good reputation, it's the reputation of the business that's going to remain intact.  

You can't fix these really lousy businesses. You can wring the money out whatever comes in liquidation and do something else with it, but most lousy businesses can't be fixed. 

Scott DeRue: But at the time Warren was that's what he was doing and so, how did you convince him?  

Charlie Munger: I helped him. He bought a windmill company in a little town in Nebraska!  

And Warren didn't know anything about running a windmill company. He bought it because it was cheap! He said what do you do, why can't you fix my windmill company, who can you get to help me? I said I've got just the man for you. One of my old colleagues from a transformer business who was an accountant - I said he will fix your windmill company. 

Warren was so desperate, he just hired him on the spot. Harry walked in the first day in this little town which had this big collection of windmills and so forth. And a whistle blew, and the whole plant stopped for 15 minutes. Harry asked, what the hell is this? Well it's respect for every time the town has a funeral, we blow this whistle and stop for 15 minutes. He said that'll be the last time, and he just approached everything that way, and of course another thing he did was to cut away all of the fat that he didn't need. Then he found there were certain parts where we're the sole supplier, and he raised all the prices of those parts. You can see what a business genius we are. 

Scott DeRue: So, how did you convince Warren to stop buying the bad apples and start buying the good apples? 

Charlie Munger: Warren gave me credit, but he was gonna learn it any way. He just made so much money in this other stuff and he'd been taught it by Ben Graham. It was hard for him to quit when he was just coining money.  

But he saw the point, and you couldn't scale that business. It was kind of scroungy and unpleasant when you're firing people, so we just run the money out and bought better businesses, and we've been doing it ever since. Coming to business - not as business school graduates - but as people who had owned portfolios of securities: we thought like capitalists, because we were always in the shareholder mindset. 

A lot of people running the businesses think like careerists. Believe me, you got to think like a careerists to some extent if you're in a career, but it also helps to look at the business strategy problems as though you're an owner. My advice to you is you never want to be a careerist so much that you don't see it from the owners point of view. 

That's what General Motors did. They had a bunch of careerists, and an owner would have seen immediately that situation was hopeless. And they just romped through it with a lot of denials and stupidity and pompousity, and of course they went bankrupt. The mightiest company in the world went bankrupt. None of those hotshot executives thought like an owner, or they would have seen that it was hopeless. 

Scott DeRue: So Charlie, one of the things I've always been fascinated about… 

Charlie Munger: It was hopeless the way they were handling it.  

Scott DeRue: With Berkshire, in the way that you all manage both headquarters and the businesses that you own, you are putting talent in place who think like shareholders, not careerists, so when you're buying a business, or bringing talent into an existing business, how do you evaluate talent to see are they going to think more like a shareholder?  

Charlie Munger: Private equity frequently buy a business where the founder is going to leave then they go out on our talent to run it. That is a tough way to make a buck, and I don't like it.  

We generally buy with the talent in place. Now, maybe there's some guy in the number two place and we put him in the number one place. But I can't think of any place where we bought something and put somebody in after Harry Bottle [who ran Dempster Mills], and no we don't do that. It's amazing how long we have some of those people stay. Warren always says we can't teach the new dogs the old tricks. 

Scott DeRue: What's the implication of not being able to teach the old dogs new tricks, or new tricks to old dogs? When if we look at what's happening in business today, what we see is exactly... 

Charlie Munger: We can’t teach the old tricks to the young dogs - that's what we found. So we keep the old dog in place. 

Scott DeRue: But that's not that's not the norm right? 

Charlie Munger: No, it’s a norm in life. Our practices may not be the norm, but normally it's very hard [to get a young dog to match a wise old dog]. By definition, he's survived a big culling process. He's unique, and he's got a record to prove it. And by the way, everybody thinks you can judge people by an interview - and of course you know who you like, and you know you don't like - but everybody overestimates how much you can tell in prediction by meeting somebody. 

We all like to think that we have that capacity, but it's a vastly stupid type of overconfidence. The paper record has about three times the predictive value than your impression in an interview. And of course we're buying great paper records. It's so simple. 

Scott DeRue: But it's fascinating to me if we look around business, generally, the movement of people across firms, and there's always new dogs. You've taken a contrarian position to that and managed Berkshire differently.  

Charlie Munger: Oh, it doesn't like work, of course, we're still hiring young dogs and into these businesses, but it's amazing how much of the record of Berkshire has come from the old dogs who are in the business when we buy them. You can't believe how good those people have been.  www.canadianvalueinvestors.com

There's one huge exception in the new dog department. I almost despise the business of executive search, because I find that they really want to sell you the best that's available even if they're no damn good, and I don't like that. But the best single expense that Berkshire ever had was when we paid an executive recruiting firm to find us Ajit Jain to come in a little tiny insurance operation.  

He didn't have any experience in insurance at all. He was an honors graduate of the main technical institute in India - he was a very smart man. But he came in and created our whole reinsurance business - it's the only big business we created from scratch, and Ajit did the whole damn thing. Of course, he talked with Warren every night and so it was like father and son.  

Man, this is a very Confucian company, but that was unbelievable. So we hired an executive recruiter who brings us an Indian with no experience at all in insurance, and he talks about it with an old man every night, and it's now by far the biggest reinsurance business in the world. That's been a gold mine. There's at least 60 billion dollars in Berkshire of net worth that Ajit has created, that we would not have created without him. And the value is way more than 60 billion. I mean there's that much in extra just liquid net worth, but the value of the business is way more than 60 billion. 

Scott DeRue: Wow. So, Charlie, I'm gonna I'm going to turn to a few questions from the audience as we as we start to wrap up. Probably half my questions here are about Bitcoin and cryptocurrency. 

Charlie Munger: I could answer those very quickly. 

[Laughter] 

I think it's perfectly asinine to even pause to think about them. You know, it's one thing to think that gold has some marvelous store of value because man has no way of inventing more gold or getting it very easily, so it has the advantage of rarity.  

Believe me, man is capable of somehow creating more Bitcoin. They tell you they're not going to do it, but they mean they're not gonna do it unless they want to. That's they mean when they say they're not going to do it. They say there are rules, and they can't do it - don't believe them. 

When there's enough incentive, bad things will happen. It's bad people, crazy bubble, bad idea luring people into the concept of easy wealth without much insight or work. That's the last thing on earth you should think about, because if it worked it would be bad for you cause you'd try to do it again. 

[Laughter] 

It's totally insane. And by the way, I've just laid out a wonderful life lesson for you. Give a whole lot of things a wide berth, they don't exist, you know crooks, crazies, egomaniacs, people full of resentment, people full of self-pity, people who feel like victims - there's a whole lot of things that aren't gonna work for you. Figure out what they are, and avoid them like the plague. And one of them is Bitcoin. 

[Laughter] 

And the worst thing would happen if you won because then you do it again! It's total insanity, and it's so easy to simplify life from just all these things there beneath you; I don't even want to know people who are promoting Bitcoin. They are not my kind of people.  

Scott DeRue: So Charlie, what I hear you saying is you're not going to be investing in Bitcoin, is that fair?  

Charlie Munger: I think that’s fair. 

Scott DeRue: So let me move to a similarly maybe controversial topic, if you read the news recently, but there's a lot of tax policy conversation going on, both here in California and nationally as well. What’s your thought on where this ends up in terms of the tax policy? 

Charlie Munger: I think we will get a tax bill, I think they will squeak it through, and they'll make whatever adjustments they have to get the last few votes.  

I don't think it's a bit crazy to give an $2,000 a year to all those people who make $70,000 a year and have a lot of children. That strikes me as good politics and probably good policy.  

I also do not think it is crazy to reduce the corporate income tax on the C corporation, and if you look at the world, a lot of the places that have worked best, including Singapore and so forth, have that policy. It may even have good macroeconomic consequences.  

A lot of the people who are screaming about it and are so sure it won't work - they may not be right. It may actually work pretty well. It causes the capital values of the companies to climb up and there's a wealth effect from the increased market value of all the companies. Everybody recognizes there's an effect, but people some people say it's small, and some people say it's going to be large, and I'll tell you what they all have in common: none of them know.  

It is not totally inconceivable whether it'll work well, and with so much of the world doing well with similar tax policy. The Democrats go berserk on this subject but I think they're wrong, and it may actually help them. So, I'm not sure it'll work - it may not - but it's not totally crazy. www.canadianvalueinvestors.com

Scott DeRue: Well it reminds me of a piece of advice that they you've offered and given to me which is, people often have a point of view and the danger in and having that point of view is you start to assume with certainty that you're right.  

Charlie Munger: Absolutely! Totally Crazy.  

Scott DeRue: And I think what your point of view is you need to have a point of view... 

Charlie Munger: Just a minute, here's a very important subject I've thinking about all my life. You asked for my opinion. I don't really know how well it's gonna work. I don't think anybody else does either. I think it'll work to some extent, but how much, I don't know.  

Now, is it unfair? Well corporations are, by and large, owned by a bunch of charitable endowments and by a bunch of pension plans. The whole world is going into a world where they're trying to have the business interests of the company support their huge pension obligations which are getting bigger all the time.  

China is trying to do exactly what the Republicans are. China wants to have the main businesses in China owned more by the pension plans and the stocks to do well. I don't think China's crazy to have that at all, and I don't think Republicans are crazy either. It could work pretty well. It's not just some evil thing that people are cooking up. It's a disagreement between people, and both sides who have violent hatreds and contempt for the other side - they're wrong.  

It's a disagreement on policy that ought to be civilized. When I see Congress on my television set, and the degree of hatred they have - I mean really serious and way more than as usual - it's evil to hate that much. It's a mistake to hate. It's always been true that anger comes in reason leaves; it's a truism. So, do you want to adopt a political point of view where you're angry all the time? If you do, welcome to the house of misery and pretty low worldly achievement to boot. So if that's what you want, just behave like those people you see on television.  

Scott DeRue: The other thing that's true going back to any earlier comments is the difference between a careerist mindset and a shareholder mindset. In politics we have the emergence of a careerist mindset that is shaping how people behave because they're trying to survive.  

Charlie Munger: Not only that, they have a groupthink just as the Moonies go crazy because they hang around together, so do our politicians. Do you want to go crazy? Is that what your ambition is in life? Just make yourself a violently-believing politician on either side, and you'll turn your brain into cabbage. You got one brain - why would you want to turn in a cabbage? 

Scott DeRue: So, Charlie, I've got a question here what's the new amazing technology that you're most excited about?  

Charlie Munger: Well, I tend not to get very excited about things. I think that technology changes the world - and that reminds me the other thing.  

If I ask you what was the biggest the worst single mistake in the work of Adam Smith: the biggest mistake in the work of Adam Smith was he was totally right about markets and so on and the advantages of trade division of labor and so forth. What he missed was how much the steady advance of technology would advance wealth and standards of living. He in the 1700s, was living not too much differently than the way they lived in the Roman Empire and he just missed it. But - and there in fact had been huge improvements in technology - he just missed. He just wasn't very technically minded and it was really stupid. Now I ask you a harder question: what was the worst mistake David Ricardo made?  

I'll tell you the answer, David Ricardo got the first-order consequences of trade perfectly right, and it was not an obvious insight and it was a great achievement.  

But he didn't think about the second-order consequences. He wasn't mathematical enough to see, and he wasn't mathematical to think what would happen in one country had way higher living standards than another. Like Adam Smith, he missed the main issue. In a place like the United States, if you have an advanced nation and some other nation which is numerous but the people if anything are better on average than yours in terms of their innate quality - which I think is roughly true of China - and they're in poverty, living in caves, and they're caught in a Malthusian trap and you got an advanced economy and you suddenly go into free trade...what is going to happen is Ricardo proved it - both sides are going to live better - but the people here that are assimilating all great economies of the world are going to go up way away faster. 

So you go up 2% a year and they go up 12%, and pretty soon they're the other dominant nation in the world and you aren't. Well are you really better off? Well the answer is no. Ricardo never figured out any of that stuff, so I'm telling you this so you can fix your inadequate knowledge of Ricardo. 

One of the interesting problems of that is you can't understand Ricardo properly without thinking about the United States vis-a-vis free trade with China, without thinking about the tragedy of the Commons. 

If we had the only nation in the world, except for China, we could say won't trade with them we'll just leave them in their damned agricultural poverty and we'll just...and we could probably have done that. Well the whole rest of the world will trade with them, and they're gonna rise anyway. 

So, we don't have any power to hold back the rise of China by not trading with him. So we had to do what we did and once you do that now they're going to be a greater power than we are. The two of us are gonna be big enough so we can accomplish pretty much anything we both want to do, so we have to be friendly with China.  

So, you can imagine how I like Donald Trump complaining about these Chinese. It's really stupid. It's a compulsory friendship. You'd be out of your mind to do anything else. Why wouldn't you want to have an intimate, friendly relationship with the biggest other power in the whole damn world?  

Particularly when they got a bunch of atom bombs. It's just nutty. We have no alternative but to do this. And when that happens you're gonna get a certain amount of misery, with the people who are competing with the Chinese as a rise from poverty with trade and so forth. That was inevitable. It's not the fault of evil Republicans who don't love the poor - that is just total balderdash. It just happened, and we didn't have all these choices. 

Scott DeRue: So Charlie, in wrapping up we've got I don't know roughly 250-300 people in the room tonight and many of them looking at their futures, their careers with many decades ahead of them.  

Charlie Munger: I wish I had many decades. I'd trade some large numbers if I could just buy some life expectancy. 

Scott DeRue: As you look back on your life experience, what's the most important piece of advice that you would offer everyone in the room tonight as they look forward and into their futures?  

Charlie Munger: Well there are a few obvious ones. They're all ancient. Marriage is the most important decision you have - not your business career. It'll do more for you good or bad than anything else. Ben Franklin had the best advice ever given on marriage: keep your eyes wide open before marriage, and half shut thereafter. 

[Laughter] 

It's amazing how if you just get up every morning and keep plugging, and have some discipline, and keep learning, it's incredible how it works out okay. I don't think it's wise to have an ambition to be President of the United States or a billionaire or something like that, because the odds are too much against you. Much better to aim low. I did not intend to get rich, I wanted to get independent. I just overshot. 

[Laughter] 

And by the way, while you're clapping, some of the overshooting was accidental. You can be very deserving and very intelligent, very disciplined...but there's also a factor of luck that comes into this thing. 

The people will get the outcomes that seem extraordinary are the people who have discipline and intelligence and good virtue, plus a hell of a lot of luck. Why wouldn't the world work like that? So you shouldn't give credit for the unusual.  

A friend of mine said about a colleague of his in his fraternity: he says old George was a duck sitting on a pond and they raised the level of a pond. There are a lot of people would just walk into the right place and rise and then and there are a lot of very eminent people who have many advantages, and they've got one little flaw or one bit of bad luck, and they 're mired in misery all their lives. But, that makes it interesting to have all this variation. 

Scott DeRue: Well, Charlie on behalf of everyone here thank you. Your wisdom I often say as an educational institution we not only can provide people with knowledge but the most important thing we can do is give them wisdom and judgment and your comments I know for me and I expect for everyone in this room tonight have added to our wisdom and our judgment and also inspiring at the same time thank you very much. 

A Talk with Paul Lountzis, President, Lountzis Asset Management LLC, Wyomissing, PA - November 19 2017

We recently watched a talk from the Ben Graham Center for Value Investing and thought it was worthwhile to post. We have also provided our notes below.

As per their website: “Lountzis Asset Management, LLC is a registered investment adviser founded by Paul Lountzis in October 2000 to manage customized portfolios serving high net worth individuals, institutions and retirement plans.

Our investment objective is to maximize the long term after tax returns for our clients in various economic and market conditions while emphasizing the preservation of capital.

Prior to forming Lountzis Asset Management, LLC, Mr. Lountzis was employed by Ruane, Cunniff & Company, Inc., New York, NY, a registered investment adviser managing the Sequoia Mutual Fund as well as private accounts, from 1990 through 1999 as an analyst, and as a partner from 1995 through 1999.”

Uploaded by Ivey Business School on 2017-06-27.

Talk Notes

·      Make sure you understand the business – Some investors like complexity, I don’t. Simplicity and understanding the business. If I can’t really understand it I don’t even bother

·      We like businesses with favourable long-term prospects. E.g. Amazon. They do $150-160B in business, runway is $4-5 trillion. Google’s advertising business globally is probably $800-900B. Amazon has a much longer runway. If there isn’t a long runway you won’t make a lot of money.

·      Management has to be trustworthy. How honest and capable they are is very important.

·      Attractive price.

·      Remove noise and nonsense. Even if you spent 6 months on a company doing field research, etc. At the end it really comes down to a few key elements. Albert Einstein – “It’s not everything that can be counted counts, and not everything that counts can be counted.”

·      Benchmark nonsense. It some value within reason but we focus on absolute return. If the benchmark is down 40% and your client is only down 35% it’s still not a good story.

·      High fees are egregious. We did not go hedge fun/mutual fund route. Every client portfolio is unique and has its own allocations. It’s based on knowing each individual client. The client owns each individual’s securities allowing them to control their taxes and tax benefits.

·      We have no categorization/are not market cap constrained, no artificial limitation. “We’re small cap growth” restricts you. Your only limitation should be to exercise sound judgement. We started buying fixed income and opportunity led to high single digit pref coupons.

·      Clients get a monthly statement from custodian, Schwab.

·      Warren Buffett’s advantage = permanent capital. Own capital + insurance float (but long-tail, premium comes in and can be for 20 years on hurricane insurance, now $90B while auto insurer does not have long-tail). He doesn’t have clients and so he can sit around and wait. Mututal funds that are run by great people can’t go above 5-6% cash or the financial planner will fire them. We’re trying to do that in our business.

·      We typically have a large percentage of our client’s net worth because we want to build a stable high quality pool of capital.

·      When getting to know clients – Don’t even talk about money at first. Focus on goals and aspirations. Then, questions: 1) what’s the primary purpose of the investment? 2)If they don’t have on the stock portion of their portfolio, if they don’t have at least 3-5 year horizon we tell them to not give us the money. 3) They shouldn’t exceed their risk tolerance emotionally or financially. This is a huge competitive advantage for us. We don’t have to worry about redemptions vs a mutual fund manager that has to sell.

o   E.g. when we were smaller in 2005. Client wanted all stock as opposed to all balanced, don’t want any fixed income. 2006-2007 there was nonsense going on (people leveraging up their homes, etc). I wasn’t comfortable and I kept 50% of his portfolio in cash. When fall in 2008 and 2009 came we filled the portfolio with stock. The privilege of being able to hold cash enabled us to perform. If he made us invest in 2006 we could not have done this.

·      We hate leverage. We never invest borrowed money. You’re just not rational when you’re investing money you don’t have. We also hate it in companies we invest in.

·      Noted Buffett’s use of qualitative decision making, “he never used 400 page sensitivity models”. 

·      Being a good investor is lonely, requires humility because you will make mistakes, and be humble but not fearful, confident and not arrogant (when you will make mistakes) and the ability to really withstand pain.

·      Characteristics of a good investor: 1) Willingness to be lonely, 2) The power of humility 3) the power to take pain

·      I read 13Fs all the time. But just because Buffett buy it doesn’t mean we have to. We have to understand it.

·      We focus on process not outcomes because you can control process. We do post-mortems, etc.

·      Focus on what won’t change – People often look for what is going to change; change is good for consumers but terrifying for investors.

·      Life is really short. Life is really precious. Even more important than investing is the relationships you build throughout your life personally because when you are happy personally it enables you have a foundation to be happy professionally that feeds on itself.

o   Do you want to go into work every day to work with people who make your stomach churn?

Five questions for a money manager:

1) Impeccable integrity

2)What is your research process? How do you find opportunities? How did you find company x? How did you research it?

3) Invest with management teams/firms that are owned by the principals. You’re far better off finding a firm that is owned by the principals.

4) How do they invest their own money? E.g. follow on with client money?

5) Performance and fees

1: When you were young how did you build a track record? How do you convince people at first that they should trust you?

When people talk about starting a business, think about: do you want to deal with employees? Compliance? SEC? Another – Do you really have the confidence to invest someones life savings?

Also, where was the pool of capital. For me, it took 16 years, part of that is my fault. It came down to people who knew me and trusted me. The answer is you have to find people that will make a bet on you because you don’t have a track record.

What is your business investment regret? My biggest regrets are mistakes of omission. E.g. Gibelli Automotive Aftermarket Conference. Met Greg who ran O’riely.. Loved their model – 50% DIY and 50% within auto dealers where they took the product to them to fix cars. Autozone was all do it yourself. The stock was $35 and for whatever reason I never gained the conviction to buy and several years later it hit something like $400.

Given you have no limitations on segmentation, how do you screen? – I have created a list of about 700 companies in developed markets. There’s very few companies you raise that I don’t know about. E.g. Progressive I really know a lot about it. I have six lists. 1) Great companies ignoring valuation.

How do you get more information on companies you are looking it? – We believe in field base research. Why is their return on equity 25% when everyone else is 15%? The numbers give you the questions but everyone can look at the numbers. We try to understand the dynamics of the industry, nature of competition, and look at public and private companies in the space. We go back 20 years. Then we think who are the top few people in the world that could help us understand? We try to find a few people that can make the numbers come to life. E.g. Sam Walton started building in small rural markets and only later went into cities. We do qualitative first, if the numbers aren’t good we don’t even look into it, if they are we do qualitative analysis à Former employees, suppliers, etc. I also never visit managers unless I have done the quantitative analysis up front.

Managing upside scenarios. What is really hard as an investor because you always look at the cost you pay. Every day you go in its buy sell or hold. You can’t look back, you have to look forward. Every time you look at it I say “What is different today?” - With Mohawk flooring company. It went up significantly but when you looked at the business they were expanding into higher margin niches (not considered in the initial analysis) and so were actually worth more and worth holding. Because they held on longer (and had good reason to) their upside doubled.

United Healthcare – Bill Mcquire at United was unique. He was a physician by training, other CEOs were actuarial. What he did is he looked at healthcare needs. Today it is $184B business. The three jewels built by Bill that are going to be much larger than the traditional healthcare business. If I had been smart and recognized and he was different…. E.g. when he was hiring an investor relations lead, most companies hire a mouthpiece to repeat what management wants but he hired a sell side analyst so that they could get strategic insight on their competitors and help Bill formulate strategy. It was all there but I didn’t see it. If I bought United back in the early 90s we would have made 100x our money.