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2023 Third Quarter Commentary


For a printable version which includes all graphs and tables, click here.​​​​

If you are a client, click here for a copy of the client commentary which includes discussion of recent investment activity.


Perspective


Much like life, a large portion of events in investing are not unambiguously good or bad. Each person’s perspective on each event is a function of their individual situation. Interest rates are a great example of this phenomena. Many people think of higher rates as a bad thing, and they are if you are the one paying interest expense. If you do not pay your credit card balance off every month, you probably have been hurt by an increase in your interest rate. If you are in the market to buy a house, your mortgage payment will be higher. In other words, if you are a borrower at today’s rates, higher interest rates are not putting a smile on your face. The perspective of our clients is different. Our clients generally do not rely on debt. Consequently, higher rates mean that our clients are finally able to earn a real return on their cash and bonds.


A 5-year U.S. Treasury Note yields 3.63 percentage points more than what it yielded two years ago (see nearby chart) and a 2-year U.S. Treasury Note yields 4.76 percentage points more than it did back then. Whether it be in the form of a bank deposit, CD or bond, your savings now earns more interest for a given maturity and a given level of credit risk. It was only in June that the market started providing bond investors a real return, one in which the 10-year U.S. Treasury Note yield exceeds inflation as measured by the Consumer Price Index (see chart near the top of page 2). For the last 50 years, real returns have averaged 1.99%. Currently, we are at 0.86%, so it is not unreasonable to think there could be more room for real rates to increase. We feel better investing in an environment where bonds have the ability to offset inflation’s persistent erosion of your purchasing power.


Artificially low rates are punishing to savers and investors, as well as, good businesses. From our perspective, good businesses require less leverage. Rates that have been manipulated lower via monetary subsidize borrowers at the expense of savers. Investors that require a certain level of return are forced to participate in a chain reaction of risk. Bond investors have to accept ever greater levels of credit and maturity risk in order to achieve the same return. Some bond investors that can’t find a sufficient income generating opportunity in the bond market will move further out on the risk spectrum to equities, resulting in higher stock valuation. As for equity investors, artificially low rates are like a siren song luring capital to be dashed against speculative reefs. The siren’s victim count is directly related to the length of time the song is allowed to be sung. It is a tragedy that repeats throughout history. Sometimes the song is brief. There were only five years between the depths of the dotcom-driven bear market and the 2007 peak of the housing-fueled bull market. The latest iteration has persisted for around 15 years. While there were three years of rate hikes between late 2016 and late 2019, we would argue that raising rates to 2.5% during that period did little to convince investors that the Fed was committed to driving speculation from the market. Of course, they were not. As soon as recession concerns surfaced in 2019, the temptation to cut rates returned. In 2020, the pandemic wiped any thought of monetary policy tightening from the collective will of the Fed’s Board of Governors.


Meanwhile, artificially low rates allowed money-losing ventures to attract capital. Although low rates and stimulus during the midst of the pandemic helped prop up good businesses that were suffering from lockdown policies, it also propped up businesses whose survival was questionable prior to lockdowns. The rampant stock speculation in meme stocks such as the overly indebted movie theater chain, AMC, and the video game retailer at risk of obsolescence, Game Stop, are just a couple examples of the kind of chaos caused by idle hands full of cash. Special purpose acquisition companies (SPACs) that raised money with no known target acquisition and locked up capital for years at very low returns, is further evidence of the capital misallocation that results from low interest rates.


"Only when the tide goes out do you discover who's been swimming naked." – Warren Buffet


The rise in interest rates is the economic tide receding. The receding tide makes it painfully obvious which businesses are not pulling their economic weight and are instead “swimming naked.” The businesses left most exposed by the receding tide typically suffer from either a lack of competitive advantages or too burdensome levels of debt, or both. These weaknesses in turn contribute to low or no profitability. The artificial suppression of rates is the high tide that allows subpar companies to continue to compete with the many profitable companies that have invested in creating competitive advantages and are providing superior products and services for their customers. When interest rates increase while returns on capital remain the same, returns on equity decline quickly as illustrated in the nearby chart. A return to more normalized rates is forcing capital allocators to reestablish discipline in their investing decisions, because higher rates put them at risk of being caught naked as well.


Our goal is to find opportunities to purchase companies that not only have prospects for growth and will thrive in good times, but also have the strength to weather recessions and the deleterious effects of inflation. We believe that a majority of the hard-earned savings that you have entrusted to us have been invested in such companies. We do have a small number of small positions in companies that have less than desirable balance sheets, but in these instances, management has defined a strategy for attaining greater economic durability. We hold a considerable number of stocks that possess economic durability and should thrive in the face of inflation. Not all will necessarily be winners. That is why we own more than one stock. Fortunately, investing success does not require perfection, only that you own more winners than losers.


Many of our clients and regular readers may notice the degree of attention we pay to inflation caused by easy money, but it is important to note that we do not invest in companies simply because they may benefit from inflation. We first consider both the operational and financial strength of the business. We then require that any purchase be made only if it can be done at an attractive price. You do not own a mix of energy, financial and materials stocks because we are betting the farm on rising inflation. The nearby chart shows that energy and financial sectors have the lowest price-to-earnings (PE) ratios in the S&P 500. Additionally, while the Materials sector PE is only slightly lower than that of the index, your portfolios have significant exposure to precious and industrial metals miners, as well as agricultural companies priced significantly lower than our estimate of the value of their reserves. These companies are superior operators with balance sheets built for hard times. Higher interest rates will make it harder for their competitors to stay in business. Hard times for competitors should create opportunities for market share gains and attractive acquisitions.


So, while our portfolio companies are attractively priced for an economy with stable prices, they have the added benefit that inflation is likely to be a positive for their businesses. To our benefit, inflation protection is something the market seems to be offering up for free or very little cost. Investors appear to be exhibiting cognitive dissonance regarding the probability of inflation. The two conflicting beliefs being that inflation is not a significant threat and that Congress and the Fed will find a way to cover budget deficits without reverting to irresponsible inflationary fiscal and monetary policies. We do not foresee a scenario in which these two beliefs are congruent. While we cannot control stock prices, we believe your portfolios hold companies whose operations will perform profitably over time whether we experience low or elevated inflation.


China Challenges and Opportunities


To the right are just a handful of the over 95 million results for a Google search on “China economic collapse 2023.” The primary narrative revolves around China’s real estate bubble. There is no denying China has been in a real estate bubble for years. It is a house of cards (pun intended) built with borrowed money raised through retail funds, local government loans and large sums of foreign capital. However, the Chinese government has the ability and incentive to act as a backstop for banks, local governments and retail investors. Foreign investors are a different story. China’s President Xi Jinping is likely unconcerned with western investors’ financial losses and willing to let them bear more than their fair share of pain emanating from China’s real estate fiasco. Concurrent with U.S. efforts to increase our economic resilience by diversifying our supply chains away from China, Xi is pursuing strategies to reduce China’s reliance on the west. Additionally, the Chinese government is making efforts to reduce the impact of China’s real estate problems on retail investors and local governments. Letting them suffer economically might risk large-scale protests and possibly civil unrest. One of China’s efforts to increase their economic independence entails developing a sophisticated domestic semiconductor manufacturing base. The Chinese Communist Party also continues to invest in domestic infrastructure and promote efforts to move up the manufacturing value chain. Finally, China has been hard at work accumulating political leverage in poor nations via a program branded the Belt and Road Initiative, which provides loans and invests for economic development and infrastructure projects.


While we do not expect an overnight collapse in China, we do expect China’s economy to slow significantly. The most significant long-term threat to China’s stability is grounded in the narrow base of its demographic pyramid (see chart above). Each blue (male) and each pink (female) bar represent the percentage of the population in a five-year age window by sex. We apologize for the numbers being so small, but the shape of the pyramids is what is important. China’s median age is nearly 40 years old, and their population pyramid’s narrow base means that without significant immigration (which is unlikely), there will not be enough young workers to replace the older ones. Additionally, China has nearly 45 million more males than females under the age of 40, which is not ideal for reproduction or societal stability.


China’s self-inflicted demographic and geopolitical challenges may benefit India and other developing countries. While India has some ground to make up on the infrastructure front, the subcontinent offers a younger (see chart to the right) manufacturing labor force and a chance to diversify supply chains. Additionally, China’s manufacturing labor costs have increased nearly 16-fold since its admission to the World Trade Organization (see chart to the left). Many regional competitors now offer more attractive manufacturing labor costs relative to China. Mexico is also a very attractive outsourcing option for the U.S. market. Its proximity keeps transportation costs down and gives manufacturers access to cheap U.S. natural gas supplies. Coupled with a young and affordable manufacturing labor force, Mexico should be a growing U.S. trade partner for years to come.


Although a Chinese recession or slowdown is likely to have unfavorable effects for some of our companies, there also should be opportunities to profit from China’s shift towards slower growth. Among the biggest beneficiaries should be the oil, natural gas and uranium producers we own in your portfolios. As other countries strive to attain a higher standard of living, their energy consumption will rise. If India’s per capita energy consumption were to rise to the global average, the result would be an 11.7% increase in global energy consumption. If India’s per capita energy consumption were to rise to that of China, the result would be a 20.2% increase in global energy consumption. To put this in perspective, growth in global energy consumption was 1.86% (0.43% increase in per capita consumption and 1.42% population growth) between 1980 and 2022.


Portfolio company Berkshire Hathaway (NYSE:BRKA/BRKB) should be another beneficiary of efforts to reduce supply chain dependency on China. Berkshire has over $140 billion of cash to deploy when shifting supply chains require capital during periods of scarce capital. Fellow insurance underwriter Fairfax Financial Holdings (TSX:FFH; OTC:FRFHF) has an extraordinarily competent investment team with expertise investing in private and public companies and infrastructure throughout Asia. Fairfax has paid special attention to India where Prem Watsa, Fairfax’s CEO, grew up and earned a degree in chemical engineering. Our investment in Teck Resources’ (NYSE:TECK) copper and zinc mines and its steel-making coal business should benefit from the additional infrastructure that will have to be built for alternative supply chain nodes. Additional steel demand would also benefit our holding GrafTech International (NYSE:EAF) as a supplier of graphite electrodes to electric arc furnace steel mills.


Another opportunity lies in the desire for developed countries to diversify the world’s advanced semiconductor fabrication capacity away from Taiwan due to China’s growing aggression. Economists and politicians are beginning to talk about semiconductor independence in the same manner they do energy independence, and they are putting their countrymen’s money where their mouths are. The United States, Germany, France and a number of other governments are offering grants, subsidies and low-cost loans to entice portfolio company Intel (NYSE:INTC) into building a domestic semiconductor manufacturing base.


Finally, China, Russia, Saudi Arabia and others have discussed establishing a currency or financial system that is independent of the U.S. Dollar. They all have either felt or witnessed the damage economic sanctions can cause, especially when ostracized from the SWIFT global payments system. For the sake of credibility, the de-dollarization crowd will likely back their new currency with gold and silver, which would be a significant benefit for our gold miners.


Feels Like A Cyclical Bottom For Graphite Electrodes


Recently, our investment team initiated a conference call to Timothy Flanagan, the interim CEO of GrafTech International (NYSE:EAF), one of our smaller and poorer performers. Our experience indicates that company insiders are sometimes the most pessimistic of their company’s outlook during down cycles and can also be overwhelmingly optimistic during a company’s up cycle. Consequently, we tend to avoid speaking directly with management. We attempt to avoid being too optimistic or too pessimistic. However, we felt this was a case in which we needed further insight into the economics of the business and what was being done to correct recent company-specific negative events.


GrafTech has a market capitalization of around $900 million and is only followed by four analysts on Wall Street. So, it is a small, under-followed company compared to many of our other holdings. Strong profits through 2022 allowed the company to de-lever its balance sheet. However, in September of 2022, one of their four graphite electrode plants in Monterrey, Mexico was shut down by environmental regulators due to permit issues. Although the plant was restarted two months later, the negative impact to the company was disproportionate since the shutdown occurred during a critical semi-annual contract renewal period. Accordingly, GrafTech lost significant market share in 2022-23 primarily to a Japanese competitor. A year later, as the low-cost producer in the industry, GrafTech is in a good position to regain market share and return to profitability and pruning debt (first maturity in 2028).


The worldwide environmental trend favoring electric arc furnaces to produce steel over basic oxygen furnaces should favor graphite electrode producers like GrafTech. Additionally, GrafTech is one of only five large-scale petroleum needle coke (PNC) producers in the world. PNC is being used to make anodes in electric vehicle batteries. Although GrafTech does not make PNC for this purpose, the additional demand has the potential to increase pricing for PNC, which would benefit GrafTech by giving the company even lower input costs for their graphite electrodes than competitors. Overall, we continue to be optimistic that GrafTech is well-positioned to see improving fundamentals that will lead to greater profitability and a stock price that will better-reflect these circumstances. We continue to buy GrafTech for new clients.


Clouds Lifting


We first added a small position in crop-science leader Bayer AG (OTC:BAYRY) in April of 2019 and further discussed our position in our 2nd Quarter of 2019 commentary. At the time we bought the stock, the Roundup litigation overhang already had reduced Bayer’s total valuation to less than they had paid for Monsanto only one year prior, essentially valuing their vast Consumer Health and Pharmaceutical businesses at zero. Though the stock price does not yet show it, we believe the cloud could finally be lifting for Bayer, and we continue to buy this undervalued stock for new portfolios.


Bayer is a global leader in health and nutrition across three major business units: Crop Science, Pharmaceuticals and Consumer Health. Crop Science is their largest segment, representing around 50% of sales and earnings. Bayer remains the industry leader in crop science, with revenues from its Crop Protection and Seeds & Traits businesses higher than any competitor and at much higher margins (27% EBITDA[1] margin vs competitors in the 18-19% range). Their crop science portfolio spans herbicides and seeds and traits (both where Bayer maintains a #1 market position), fungicides and seeds (where they are #2 in market share) and insecticides (where they are #3 in industry share). Long-term dynamics in the global food system are favorable for their business. The UN estimates that the global population will increase by ~21% to ~9.7bn people by 2050[2]. National Geographic notes that the spread of prosperity across the world, particularly in China and India, is driving an increased demand for meat, eggs and dairy and boosting the demand for corn and soybeans to feed more cattle, pigs and chickens. As a result, they estimate that crop production will need to double in order to feed ~21% more people.[3] With limited new arable land available without deforestation, crop yields are the necessary source of this growth in food production. We believe Bayer will be a critical part of achieving this necessary growth. Bayer is leading the investment into the next generation of crop science and spends more in annual agricultural research and development than its three largest competitors combined. The company is also investing in data driven agricultural tech, a growing area of innovation and efficiency within farming.


Pharmaceuticals is Bayer’s second-largest business, representing around 40% of sales and earnings. Bayer has three $1bn drug franchises and many more with growing share. Their current blockbuster drug Xarelto, which treats and prevents blood clots and currently represents 23% of the Pharma division’s sales, faces patent expirations beginning in 2026. We are optimistic that recently launched and late-stage pipeline drugs across cardiology and oncology have the potential to offset Xarelto’s likely decline. Bayer has recently focused their research and development on four key therapeutic areas where they believe they have strength to compete (Oncology, Cardiovascular, Neurology and Rare Diseases and Immunology). We see this focus as prudent. We also expect that Bill Anderson, appointed as new CEO in June 2023, could reinvigorate the pharmaceutical business given his prior experience as the CEO of Roche’s Pharmaceutical division. At Roche, Anderson led a transformation of the business that resulted in new product launches, revenue growth and greater productivity. Prior to Roche, he was CEO of Genentech, a biotech pioneer. We look forward to watching Mr. Anderson’s impact on the company, particularly in the pharmaceuticals business.


On the Consumer Health front, Bayer owns many iconic brands such as Aspirin, Alka Seltzer, Claritin, Afrin, MiraLAX, Aleve and One a Day. They have top-ranking over the counter products across a diverse set of treatment areas including Nutritional, Dermatology, Cardiovascular, Pain, Allergy and Digestive Health. Bayer’s Consumer Health business has been growing at higher rates than the overall consumer health market, which we believe is a demonstration of the quality of their products.


All eyes are on Bayer’s continued litigation exposure, but we believe the uncertainty is resolving. In its glyphosate (Roundup) litigation, Bayer continues to execute on their five-point plan to resolve these matters. They have prevailed in the nine most recent trial outcomes. Further, there remains a chance for Supreme Court review should a Circuit split occur in the resolution of future cases. So far, 113,000 of the approximately 160,000 glyphosate claims have been resolved or deemed to be ineligible and Bayer has set aside a litigation reserve totaling $6.4bn for future litigation settlements and expenses, which far exceeds their average settlement per claim to date. The company will also be voluntarily replacing glyphosate-based products in their U.S. residential Lawn & Garden market with new formulations that rely on alternative active ingredients. Going forward, glyphosate will only be marketed and sold to the commercial market where glyphosate remains “mission-critical” for the agricultural industry.


Finally, while the litigation regarding the company’s production of polychlorinated biphenyls (PCBs) has recently been in the news, we believe the company has a strong legal defense for the outstanding claims. Monsanto ceased manufacturing PCBs in 1977, which was two years before the EPA banned their production in 1979. PCBs were used in a wide variety of building materials and other industrial products, most of which were actually manufactured by third party companies, not Monsanto. The company has entered into settlements with 2,500 municipal entities and several states that allege impairments of their water bodies. It still has cases in four states outstanding, but the scope of potential future state litigation regarding environmental impairments should be limited. The company also faces personal injury cases, mostly arising from school buildings built with PCB-containing building materials that were used far beyond their useful lives. We believe the company has strong defenses in these lawsuits, including in many cases indemnification agreements that could result in their recovery of some of the defense expense regarding PCBs.


While litigious situations are always fluid, we believe that the litigation exposure remaining for Bayer is quantifiable and manageable from this point. We might remind you of our discussion of Merck in our 2nd Quarter 2019 Commentary. We purchased Merck on September 30, 2004, the day they pulled Vioxx from the market. During that one day of trading their stock lost around $26bn in value and ended the day down $145bn in value from a recent high. Merck’s ultimate total cost of the resulting litigation was $9bn, which they paid over the course of 14+ years during which they generated $102.7bn of cash flow in excess of those litigation expenses. Even after four years of owning Bayer, we still believe the litigation overhang provides us with the opportunity to buy a stellar operating business for a tremendously undervalued price. We are optimistic that the clouds are lifting, and the sun will soon shine on the tremendous value that Bayer AG offers.


Patience in the Face of Suffering


We have been receiving many questions about our position in Lumen Technologies, Inc. (NYSE: LUMN). This is not surprising and is completely understandable given that the share price is down substantially since our purchase. Many of you want to know why we have not sold the shares and we continue to own them, especially considering that the company eliminated its sizeable dividend in the fourth quarter of 2022. We hope to address this worthy question here.


Lumen provides broadband, voice and wireless services to consumers and businesses across the country. It was a company in transition when we first established a position in July of 2020, and that transition accelerated with two divestment transactions initiated in the 3rd quarter of 2021. The company sold its non-core Latin American fiber optic cable at 9 times EBITDA[4] and their worst legacy telephone and DSL assets at 5.5 times EBITDA to well respected institutional buyers. The changes continued during the second half of 2022 with the appointment of a new CEO, the elimination of the dividend, and the divestment of the company’s Europe, Middle East, and Africa assets at 11 times EBITDA. The end result has shifted Lumen towards a greater focus on business and enterprise revenue, which should allow for revenue growth over the next several years. However, this has not shown in Lumen’s results to date.


So why do we still own the shares? The shares trade at an enterprise value[5] of 4.7 times EBITDA, a discount to the value placed on each of the three divestment transactions that have taken place over the last two years, even the value placed on their worst legacy telephone and DSL assets. The critical fiber infrastructure owned by Lumen (shown in the chart below) would be very difficult to replace. The original cost of the current infrastructure as reported in the company’s annual 10-K filing is approximately $38 billion for assets purchased and built over decades. The current enterprise value of Lumen is around $21.5 billion. The company claims the network is newer, offers better coverage, is cheaper to update than their competitors’ networks and would cost up to $150 billion to recreate. The new management team is working hard to utilize this fiber infrastructure to offset legacy product offering declines. While this is challenging, the demand for data and related services continues to grow rapidly and Lumen’s infrastructure is well-positioned to take advantage of that opportunity.


One of the things that spooked the market and led to the sell-off in Lumen’s stock price was a sharp reduction in the company’s free cash flow[6] projections for 2023. The current expectation is for free cash flow of between $0 and $200 million. That projection led the market to question whether Lumen’s total debt of around $20 billion was too burdensome. While we agree that the company’s debt is high, we don’t think it is unmanageable. Lumen still produces substantial operating cash flows of somewhere around $3 billion. Of the $2.9 billion to $3.1 billion in total projected 2023 capital expenditures, maintenance capital expenditures are only $0.5 billion. Management has flexibility around how to use the other ~$2.5 billion. Currently, they are investing the cash in Quantum fiber-to-the-home and other growth initiatives. If these investments result in good returns on the capital deployed, we believe that Lumen’s shares are tremendously undervalued. While we have not been purchasing shares for new accounts, we have patiently been holding the shares while the dust settles on the divestment transactions, and the new CEO’s network investment strategy gains traction.


Disclosure


Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. (“FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®).GIPS® is a registered trademark of CFA Institute.CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.

[1] Earnings Before Interest, Taxes, Depreciation and Amortization [2] https://www.un.org/en/global-issues/population [3] https://www.nationalgeographic.com/foodfeatures/feeding-9-billion/ [4] Earnings Before Interest, Taxes, Depreciation and Amortization [5] Enterprise Value = Equity Market Value + Debt - Cash [6] Free Cash Flow = Operating Cash Flow – Capital Expenditures

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