An Investment Harking Back to the 19th Century Robber Barons
Your Smart Money Masters portfolio closed mixed last month, as the broader stock market paused to consolidate its recent gains.
This past month, Charlie Munger’s long-suffering position in Costco Wholesale (COST) took the gold medal, rising 11.25%. Munger’s partner Warren Buffett’s Berkshire Hathaway (BRK-B) earned silver by clocking a gain of 6.41%. The “Baby Berkshire,” Tom Gaynor’s Markel Corporation (MKL), took the bronze by rising 3.73%. Bruce Berkowitz’s The St. Joe Company (JOE) and The Priceline Group Inc. (PCLN) rounded out the top five with gains of 3.64% and 3.54%, respectively.
You were stopped out of Carl Icahn’s bet on PayPal Holdings Inc. (PYPL) with a gain of 70%. Fiat Chrysler (FCAU) is now your Smart Money Masters portfolio’s top performer, up 53% since my initial recommendation.
You were stopped out of Carl Icahn’s bet on PayPal Holdings Inc. (PYPL) with a gain of 70%. Fiat Chrysler (FCAU) is now your Smart Money Masters portfolio’s top performer, up 53% since my initial recommendation.
A big beneficiary of this shift was your holding in Costco Wholesale (COST). Shares soared by double-digit percentages last month after the retailer reported upbeat November sales figures. Broker Raymond James called Costco’s recent sales “nothing short of impressive,” putting a target price of $202 on the stock. That’s a 7.5% upside compared with current levels.
Costco’s earnings also could benefit tremendously from U.S. tax reforms. Costco’s current tax rate stands at about 33.5%. I estimate that if corporate tax rates fall to 20%, Costco’s 2018 earnings per share (EPS) will rise by $1.35 per share from $6.49 to $7.84. That would put Costco shares at a forward price/earnings (P/E) ratio of 24, down from the current 31.
Betting on Wall Street’s Most Unusual Business Model
This month’s Smart Money Masters recommendation, Texas Pacific Land Trust (TPL), is probably the most unusual among your Smart Money Masters recommendations so far. Texas Pacific is also the largest position in value investor Murray Stahl’s Horizon Asset Management.
Stahl began investing in Texas Pacific back in first-quarter 2015. According to its most recent 13F filings with the Securities and Exchange Commission (SEC), Horizon has invested a whopping 21.54% of its assets in Texas Pacific. Today, Horizon is Texas Pacific’s largest individual shareholder, owning 18.99% of its outstanding shares. It’s a position that has served Horizon well this year, rising 33.01%.
Murray Stahl’s Investment Philosophy
Like many of the other Smart Money Masters I have profiled in previous issues, Murray Stahl is a confirmed value investor.
Stahl believes that two primary insights distinguish his approach to value investing.
First, Stahl argues that stocks have a yield curve like bonds do, only a stock’s curve is much steeper.
That’s a fancy way of saying that investors prefer short-term gains over long-term gains. This universal preference for immediate profits means that the market always undervalues potential long-term stock gains. Put another way, a stock investor can generate bigger profits by merely increasing his time horizon.
Second, Stahl believes he can predict share prices based on certain factors. The factors Stahl looks at include (i) owner-operated companies (ii) dormant assets and (iii) spin-offs.
Stahl points out that, more often than not, companies run by an “owner-operator” outperform the market. Warren Buffett is the owner-operator of Berkshire Hathaway. Another owneroperator is John Malone, CEO of your current position in Liberty Broadband (LBRDK), which is George Soros’ #1 bet.
Stahl also seeks out value in a company’s “dormant assets.” Dormant assets include intellectual property rights, patents, undeveloped land and unused real estate capacity. Short investor time horizons consistently overlook the potential of the long-term value of these valuable dormant assets.
Finally, Stahl believes corporate spin-offs also tend to outperform. A company’s checkered past discourages investors from buying into a revamped company or division. Yet, experience confirms that many spin-offs run by motivated managers become some of the market’s top performers.
More generally, Stahl likes businesses with long product cycles, say, corn flakes as opposed to cell phones, since there’s less risk of technological obsolescence. He looks for companies that scale so that revenue growth does not require significant capital expenditures. He also prefers a company that has little competition.
Stahl’s formula for valuing a company is straightforward. He estimates earnings four to five years out, applies a reasonable multiple on those earnings and then discounts the result using a 20% annual required rate of return. If a stock’s price today implies a potential return more than that 20% hurdle, Stahl will consider it a buy. Put another way, Stahl invests only in stocks he expects to generate at least a 150% return within five years.
Still, Stahl’s investment process goes beyond the numbers. He integrates the qualitative with the quantitative. Widely available financial metrics have limited value without historical perspective, sociological context and analysis of competitive positions. Too much data leads to behavioral biases and even irrational decisionmaking. This philosophy, combined with a longterm focus, is Stahl’s edge.
Texas Pacific Land Trust: Flying Below the Radar
Texas Pacific Land Trust (TPL) has traded under ticker symbol TPL since the dawn of the ticker tape. Founded in 1888, the company is four years older than General Electric (GE), the oldest Dow component.
Yet, few investors on Wall Street have ever heard of it.
As one investor put it: “If you asked 1,000 investors, I’d be surprised if five knew about it. It’s not a candidate for any investment banking. It doesn’t owe any money. It’s being ignored by the Wall Street industry.”
That’s Wall Street’s loss.
After all, Texas Pacific has been one of the stock market’s top performers.
A share of Texas Pacific purchased in August 2009 for $30 sells today for $400. That’s an average annual return of 36.33%.
How Texas Pacific Land Trust Makes Money
Texas Pacific’s business model may be the most unusual I have ever come across.
It manufactures no products and provides no services. It has no factories, facilities, equipment, machinery, or inventory. It has no competitors, no liabilities and no debt. Its only assets are approximately 878,000 surface acres and 373,000 gross royalty acres in western Texas.
Texas Pacific’s eight employees occupy a modest 27th-floor suite in an office tower in Dallas. Their primary task? To put Texas Pacific out of business.
Let’s start with some history. Back in 1871, the State of Texas and the U.S. government were eager to spur the construction of the transcontinental Texas Pacific Railway.
The U.S. government offered the Texas Pacific company a massive land grant. It then financed the railway’s construction by selling nearly $9 million in bonds to the public. The land acted as collateral in case the project failed.
Sure enough, the Texas Pacific Railway was never completed, and Texas Pacific went bankrupt. So, in 1888, Texas Pacific Land Trust was formed to liquidate parcels of land to satisfy initial investors. The Trust’s primary objective? Maximize returns while selling off all of its real estate assets and put itself out of business.
This process has taken almost 130 years. What began as more than 3.4 million acres has pared down to 878,000 acres.
Texas Pacific has several sources of cash flow.
First, it slowly liquidates its real estate holdings. This process is painfully slow. A few acres are sold off at a time as buildable parcels near towns or cities.
Second, it derives income from grazing rights and wind farms, as well as surface damages from pipelines and other infrastructure.
But in Texas, the real money comes from oil.
If someone strikes oil on Texas Pacific’s land, its value soars. Thanks to an accident of geography, much of Texas Pacific’s real estate holding is located in the Delaware and Midland Basins within the Permian Basin. By some estimates, the Permian holds up to 70 billion barrels. That’s more oil than Kuwait’s proven reserves.
Recent advances in fracking technology have led to a sharp increase in recoverable oil and gas reserves on Texas Pacific’s land. Drilling activity and infrastructure development have exploded.
As a result, fracking-related activities have become Texas Pacific’s biggest source of revenue.
Is Texas Pacific the Perfect Bear Market Stock?
With U.S. stock market valuations near record highs, many investors worry about a coming market crash.
Investors in Texas Pacific don’t share that worry.
That’s because Texas Pacific spends its cash two different ways.
First, it distributes a tiny fraction of cash to shareholders as dividends. The stock’s current yield is an infinitesimally small 0.09%.
Second, it systematically repurchases and then retires its outstanding shares. In recent years, Texas Pacific has been repurchasing approximately 1.7% of its shares each year.
All this means that a weak stock market is good news for Texas Pacific. As the price of shares fall, the company can buy back more of its shares. As fewer stocks are outstanding, the asset value per share will continue to rise — and at an ever-increasing rate.
Stahl has modeled what might happen to the stock price given a more or less predictable share repurchase rate. He has not made his target price public.
Still, actions speak louder than words. Stahl steadily has been adding more shares to his current position in recent months. That suggests that he believes Texas Pacific remains undervalued.
The bottom line? Texas Pacific is a very unusual company. It doesn’t appear on any stock index. Only an average of 8,900 shares changes hands per day. The company is both too difficult to classify and too small for most mainstream portfolio managers. As a result, most investors just overlook it.
That, of course, is precisely what spells opportunity for individual investors.
So buy Texas Pacific Land Trust (TPL) at market today and place your stop at a wide $300.00. I have given this recommendation a risk rating of 2.
Sincerely,
Nicholas A. Vardy
To view the January 2018 issue in a PDF format, please click here.
