"Invert, always invert," said the late Charlie Munger

by Seamus Sullivan, Smead Capital Management

Over the last four years, we have maintained that the U.S. middle-class consumer is on firmer ground than many believe. The first wave of inflation that seems to be receding is just that—the first wave of a set—and oil and gas companies are fundamentally well-positioned for the next decade.

Seeing the Consumer Price Index (CPI) rise only 3.4% year-over-year is undoubtedly a welcome change from the nearly 9% increase we experienced in 2022, and just as inflation surged, it is perfectly reasonable that we get a dampening to more moderate levels. However, what most don’t discuss is that it still costs 122% more for a quarter pounder with cheese meal today ($12) than it did ten years ago ($5.39 in 2014).

Source: GlobalData. TS Lombard

We thought it would be helpful to elaborate on two concepts we feel are in play.

We recently read a book titled Essay on the Nature of Commerce in General by Richard Cantillon, who developed the concept of relative inflation, now known as the Cantillon Effect. Cantillon (an Irishman) posited that the introduction of new money into an economy is not distributed evenly across all sectors. Instead, it benefits certain groups first, creating a ripple effect or waves. The result is that different sectors are affected unevenly, with some benefiting more than others, leading to economic imbalances (sound familiar?). He suggested that inflation occurs gradually and that the new money has a localized effect, eventually creating broader inflation as it circulates. We would agree.

Cycles are an inescapable attribute of markets just as in nature. Cantillon’s theory helps further illuminate how these cycles are created and behave within economies. It also explains why we find oil and gas companies so attractive. Since 2014, most have written off oil and gas companies as perennially un-investable for a myriad of reasons, many we have covered in previous missives. What is often not taken into consideration is how the role of monetary interference and the Red Queen Effect have fundamentally altered the oil and gas companies for the better. Both are critical factors that compelled these companies to evolve in order to compete in this new environment.

The Red Queen Effect suggests a constant evolutionary race where entities must continuously adapt to maintain their status relative to others. For example, a frog may improve its ability to catch flies by developing a stickier tongue; the fly then responds by developing a more slippery body. The fly must evolve just to stay where it was before. In nature, it means that to survive another day, you have to co-evolve with the systems you interact with.

These evolutionary tit-for-tat changes, while constant, also follow cycles. It takes generations for the frog to develop and hone their new advantage and generations for the fly population to shrink. This doesn’t mean the flies go extinct. It means the ones that survive have a unique attribute, such as a more slippery body. And it is those flies that are better suited to survive and pass their genes on to the next generation.

Consider this scenario, which should sound familiar. For just under the past two decades, money has been pushed into the economy via artificially low or even negative interest rates. Banks and venture capital firms, flush with new liquidity, decide to bank and invest heavily in a particular sector, tech startups and established tech. These companies use the seemingly unlimited source of funds for R&D, hiring top college talent, expanding operations (massive corporate headquarters), and, more importantly, acquiring any company that could be a potential competitor (Google/YouTube, Meta/Instagram, etc.). As a kicker, these companies can pay the bulk of compensation in equity options or restricted shares. In our view this distorts free cash flow because a great deal of these new employees are a non-cash expense. As long as the company is doing well and the stock price is rising no one cares. As a recipient of the early easy money, these companies can expand their market share quickly and outcompete and outspend other companies.

We like to say, “Dogs chase cars, and people chase stocks,” so it’s not hard to see why the top ten companies in the S&P 500 represent 37% of the index’s market cap yet only produce 23% of its EPS. The energy sector is 4% of the index and produces 7% EPS.¹

Source: S&P Dow Jones Indices, Smead Capital Management, Bloomberg

As the late Charlie Munger would say, “Invert, always invert.” Money is no longer cheap, bonds are a competitive product to equities, and tech companies are so big now that acquiring competition no longer moves the needle. This makes their shares less attractive on a risk-adjusted basis and leaves the employees who are invested in stock-based compensation in a position to have their compensation damaged by poor stock performance. It is effectively introducing beta/risk into that labor market, which has been nonexistent for over a decade.

What have oil companies been up to during this time? They have been evolving and adapting. Yes, they, too, have had the benefits of cheap debt, but they have used it in very different ways. The companies that have survived are now more disciplined in production growth, maintain very sound balance sheets and operate in a consolidated market. They are committed to focusing on shareholder returns, not growth at any cost. They are also very reasonably priced. We can own these evolved, inflation-beneficiary companies producing a 25%+ return on equity for around two times book value. To us, that is a fair risk-adjusted investment and one we expect to continue owning for some time. In our view the bottom in 2020 was a generational low point. In effect, they are the flies with slippery bodies. Now, it’s the frog’s time to adapt.

Fear stock market failure,

Seamus Sullivan

¹ Source: S&P 500 Dow Jones Indices, Smead Capital Management, Bloomberg.

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Seamus Sullivan, Senior Analyst, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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