John Mihaljevic, Managing Editor, has just released the July 2016 edition of The Manual of Ideas, dedicated to ‘Wide-Moat Investing.’ The current issue features two interviews I recently conducted and what follows are my favorite highlights from these spectacular conversations:
Edgar Wachenheim is Chairman of Greenhaven Associates and author of Common Stocks & Common Sense:
“There’s a chapter dedicated to the railroad industry, which you discovered quite early. What did you notice?”
Wachenheim: That is also a case where one idea led to another idea, which often happens. I’ll go back to the period of 2000 and 2003. When the stock market collapsed in 2000, the economy pulled back as Clinton left office and Bush came in. We entered a slight recession and then we had 9/11. The Federal Reserve Bank at that particular time became concerned and we did enter recession, it was a little more severe. With the Fed warning that the economy was going to be bad and with the economy actually being bad, many companies cut back their capacity and their employment levels. Union Pacific Railroad was one of those companies that cut back in 2002-2003. As we then developed late into 2003, the economy started coming back. Union Pacific, in retrospect, had cut back too much. They had too few locomotives, too few freight cars and too few people. They developed congesting on their tracks. They now deal with rush hour on a highway. When too many cars go out on a highway, the traffic tends to slow up and move slowly. The traffic was moving slowly on Union Pacific tracks.
The railroads earn money based on ton miles. You pay to move your traffic and you pay a certain number of dollars based on the number of tons and the number of miles it moves, but the cost of a railroad are tied to hourly costs because you pay your employees by the hour. As it developed, Union Pacific’s hourly wages went up sharply because traffic was slowed. Furthermore, they had to pull out of storage certain old locomotives that they were put into storage because they were energy inefficient or because they needed maintenance, so their maintenance costs went up, their energy costs went up and the earnings went down sharply, but Wall Street does not like earnings surprises. The stock declined. Not a lot, but the stock market was going up in 2003. It became, I would say, absolutely attractive and relatively very attractive, so we bought shares in Union Pacific Railroad. After we owned the shares, after a period of a couple years, we noticed that they were doing better than we would have imagined and we started asking ourselves questions.
One was just the economy. The other part was that oil prices went up very sharply in 2004-2006. Trucks are much less energy efficient than railroads. The number depends on the type of commodity you’re hauling, but typically trucks consume on a ton/mile basis two to four times as much gasoline or diesel oil compared to trains. When the price of fuel went up, the trucks put a surcharge on the freight they were carrying so that they got paid back the extra cost of the energy and the railroads put a surcharge, but the railroad surcharge was much less, of course, than the truck surcharge. Instantaneously, the railroads became less expensive to move many kinds of freight that previously had been moving on trucks. The railroads picked up market share from the trucking industry and that is why we notice that the railroads are doing better than they expected.
Secondarily, what happens now when you have a cost advantage over trucks and when you have a lot of business compared to your capacity, you can move prices up. the railroads are not only benefitting from 1) the extra volume, 2) efficiencies of scale because the cost of running a railroad is very little more if you’re running an 80-car train compared to a 70-car train and 3) they were benefitting from increased prices. The pure prices started going up about 5% per year, which is incredible because, of course, around 2% or 3% per year, the margins are going from 15% to 16% to 19% and when you’ve got the extra volume, the earnings were – I’ll use the word – exploded. We realized that and in addition to holding onto Union Pacific, bought shares of Burlington Northern, which is now part of Berkshire Hathaway, Norfolk Southern and CSX and we took a major position in the railroads. We saw that idea before other people because we owned Union Pacific and we saw things were going on in Union Pacific that were positive that other people were not perceiving, so we were able to jump on the railroads. When you get a concept, you’ve got to jump because you’ve got to get the idea before other people do. This, again, comes back to passion. If you have a passion, you’re going to drop everything you do on the weekend and say, “What’s going on with the railroads and, boy, I’ve got to ask fast and act with knowledge.”
(The full interview is 9 full pages densely-packed with extraordinary wisdom.)
Michael Weinberg, CFA is Senior Managing Director and Chief Investment Strategist of Protégé Partners. Based in New York City, Protégé is a specialized asset management firm founded in 2002 to focus on investing in established smaller hedge funds and select emerging managers:
“Invest too early, and don’t know enough. Invest too late, and miss the opportunity. How do you think through this paradox?”
Weinberg: Ceteris paribus, it’s better to have a track record to evaluate than not having one. Moreover, ideally one has a track record through both a bull and bear market. This enables one to have a sense for both upside participation and downside protection.
Both skills are crucial to generating out-sized returns over a cycle or strong risk-adjusted returns.
Of course, the risk to this as framed by the question is that by that time one has this track record, it’s apparent to the market and the manager is no longer open to outside investors. That said, if one develops relationships with managers early on and maintains them over time and a cycle, this is typically conducive to being able to deploy capital with managers.
In my experience, managers love allocators who have been investors themselves and really understand what they are doing. Moreover, allocators generally understand what can go wrong and why a manager may underperform for periods. Ideally, allocators will not only remain with the manager when performance is down, but will add assets. I believe this value-add from allocators enables them to gain capacity to top quality managers with scarce capacity.
According to statistics, there is a universe of roughly 8,000 managers. The 500 largest managers, who are defined as having assets over $1Bn, have 87% of the assets. That implies that the 7,500 smaller managers have only 13% of the assets. Within this massive number of managers, there are many great hedge fund managers who, for various exogenous (or endogenous reasons), are unable to raise capital, but are nonetheless great investors. This provides a constant opportunity set.
“Identifying investment talent is presumably both science and art. What is science, what is art?”
Weinberg: The science of identifying investment talent is more correlated to the quantifiable (for example, historical performance and attribution analysis). The art is more correlated to the qualitative. A manager’s passion and love of investing and securities will not come through in statistics, but it will come through in meetings.
Listening to a great manager describe great investments is like listening to Wagner’s Die Meistersinger Von Nurnberg. For those non-opera aficionados, this one clocks in at over 6 hours but feels like less than 2. The same can be said for having a discussion about a great manager’s portfolio. It is enjoyable and the time goes by at the speed of light.
(The full interview is 3 full pages of unique first-hand perspective.)
Until next post…