10/30/24

We believe the confluence of events that have occurred during the last 3 months is significant and bode well (extremely well) for our investments. This letter goes into detail on each. We believe the market has shifted and we are in an early stage-renaissance for active investment management. We believe over the next 10 years investment returns will be driven by stock selection, owning the right companies and assets will determine success, not simply being in the market.

In January we wrote in our quarterly client letter: 

“It is frustrating when we fail to deliver profits within a calendar year when the “broader market,” such as it is, was positive. We and our families are the largest investors at Mad River.  We are here to grow our personal capital and family capital right alongside you.

Historically, a year of under-performance is typically followed by significant outperformance. We outlined what we perceive as a coiled spring of potential with many core investments in our portfolio. Given recent developments we believe we are on the right course and our prospects are bright.”

Patience and confidence have been extremely well rewarded in 2024. Our Model Account rose 41.0% through September 30th, outperforming our benchmark the S&P 500 return of 22.1% *.

*Please refer to important performance disclosures below*

“I skate to where the puck is going to, not where it has been.”

~ Wayne Gretzky

In 2016 we began positioning our investments to protect and profit from the mounting risk that inflation would increase and debase the purchasing power of the dollar. We were also cognizant and concerned about general market valuations as mega-cap tech companies have come to dominate the market. The so called “Magnificent 7” which now accounts for ~30% of the entire S&P 500 Index, drove 64% of the gains in the first half of this year. Further, just 3 companies, Nvidia, Google & Microsoft drove 49.3% of the gains.

Our portfolio holdings are radically different from the holdings of the conventional indexes like the S&P 500 or Nasdaq 100. We own a deliberately concentrated portfolio of high quality, durable and long duration businesses and assets. We believe, these companies are uniquely structured to not only endure inflationary pressures, but to thrive in a prolonged inflationary environment. Given the high profit margins and strong cash flow generation of these businesses we do not need high inflation to do well. Although this is not a one directional bet, in an environment of higher commodity prices we believe our portfolio has asymmetric profit potential. 

Activity during the 3rd Quarter heightens our confidence that we are well-positioned for investment success.

What caught our attention?

While many in the country are losing their mind over the upcoming election, we were more intrigued by the 0.50% interest rate cut the Federal Reserve announced. They did not have much choice given the Federal debt levels, interest expense burden and ongoing budget deficits (www.usdebtclock.org). That news was quickly followed by the Peoples Republic of China announcing a massive injection of capital into their struggling banking system, akin to the 2008 bank bailouts in the US.  

Even more interesting was an announcement that Microsoft and Blackrock had formed a joint venture and intended to raise $100 billion to make investments in data centers and supporting power infrastructure. As technology companies shift their focus to all things artificial intelligence (AI) they will need to adapt to a more capital-intensive business plan. This is in stark contrast to their high margin, cash generative business models of the past 20 years. The changing nature of mega-cap tech companies will likely result in lower profit margins and returns on invested capital.  This usually results in lower valuations.

It is conceivable that the expansion of data centers will be so expensive that it may require more cash than their businesses generate, a likely explanation for the joint venture. In the press release announcing the deal, Brad Smith, Microsoft Vice Chairman and President, is quoted, “The capital spending needed for AI infrastructure and new energy to power it goes beyond any single company or government. This financial partnership will not only help advance technology, but enhance national competitiveness, security and economic prosperity.”

Even if outside capital is not required, the AI initiative will require tremendous amounts of resources in terms of land, electric power and water. It is reasonable to anticipate that the owners of these scarce critical resources will expect a high return for their assets.

West Texas has the potential to become one of the most important regions for power generation in the country, potentially hosting next generation high performance computer data centers, used for AI. Our investment in Texas Pacific Land provides us with pro-rata ownership of 869,000 acres and Landbridge another 220,000 acres. We also own royalty interests in oil, gas, water and other materials via those investments. We believe these investments are positioned to benefit handsomely from AI initiatives.

3rd Quarter Activity:

In July, Texas Pacific Land (TPL) paid a $10 per share special dividend. The special dividend is the largest dividend in the company’s nearly 130-year history and represents a 50% increase to the previously split-adjusted special dividend. 

We quickly deployed the cash into a new investment - Landbridge (LB). Landbridge is a high conviction investment with attributes similar to TPL, albeit with a different focus. We also jettisoned several investments with inferior prospects to generate cash to fund the purchase. 

Most of our clients are fully invested in high quality, high conviction holdings. Fortunately, this year we were able to create liquidity without triggering significant tax liabilities and the strong economic performance so far this year has resulted in mostly unrealized gains - keeping the tax man at bay for another year. Our investments are generating more cash dividend and royalty payments than in previous years. We expect this will accelerate and envision distributions as a funding source for new investments. 

In September, Mesabi Trust (MSB) was awarded damages for underpayment of royalties in 2020, 2021 and the beginning of 2022. We expect a special payment, likely in excess of $5.00 per share.  We believe Mesabi Trust remains one of the more mis-priced securities in the market.

These opportunities exist because the majority of investors are neither long-term nor willing to do the necessary work. Identifying real asset orientated businesses with business models that promote capital preservation and compounding is simple and straightforward. However, success requires fundamental analysis and a long-term investment outlook.

What is Different?

Historically as value investors, we often found ourselves invested in companies in some level of distress. A temporary business impairment that the collective market deems permanent is often a great place to find value.

Today our portfolio is quite different. From a balance sheet standpoint this is by far the highest quality portfolio we have owned. Further, we own profitable high margin businesses with minimal recurring expenses. This results in the companies generating significant free cash flow and paying out increasing dividends. 

We expect commodity prices to move higher, but that is not necessary for this flywheel to accelerate. Increasing cash flows will allow companies to accelerate share repurchases, allowing us to own more of the underlying business or allowing us to fund new investments or add to existing positions on weakness.

Closing Thoughts

For 25 years we have grown our business at a measured pace because we believe having clients with the right temperament, consistent with our own, is vital to effectively implementing our strategy.

If you find this of interest and would like to discuss, please do not hesitate to contact us. 

Best Regards,

Rick Silver and Josh Stewart

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Important Disclosure on Model Performance: For the purpose of presenting historical performance information, we reference and present the performance of our Model. While limitations exist with models, we believe our Model offers a reasonable assessment of the typical performance of our historical investment selections for clients. Our Model is based on a taxable portfolio investing since the inception of the investment strategy in March 1999. The Model is presented net of all fees (adjusted to the highest annual fee charged to clients), brokerage expenses, and includes the reinvestment of dividends and interest. The Model generally reflects the performance of portfolios under management since the strategy's inception in 1999. Client performance will deviate from the Model due to, among other reasons, the starting point of a client relationship; client guidelines, circumstances, and directives; the size of a portfolio and its relative costs; additions and withdrawals of funds; the timing and historical position sizing and concentration of investments; and the account type and its ability to participate in certain investments. During this period there were no strategies employed to obtain the results portrayed other than those implemented for clients pursuant to the Model and disclosed in our Form ADV. Please carefully review our Form ADV for further information. We encourage and strongly recommend that you discuss with us the application, correlation, and significance of the Model’s performance to our client’s historical returns.

Important Disclosure on Benchmark Comparison: The S&P Composite is regarded as a gauge of the US equity market. This index includes a representative sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large-cap segment of the market, we believe it serves as a reasonable proxy for the US market. Nonetheless, the use of the S&P Composite as a comparison may not be appropriate for a variety of reasons including, but not limited to, Model and client account(s) being more concentrated; volatile; holding cash, fixed income investments, and/or option contracts; being short securities; or the average capitalization of companies comprising the Index not correlating with the capitalization of the companies comprising the Model.

Important General Investing Disclosure: Inherent in any investment is the potential for loss of capital, past performance is not indicative of future results, and the value of investments and the income derived from investments may increase or decrease. It is not our intention to state, indicate or imply that future investment results will be profitable or equal past results. The information presented is meant to form the basis of a discussion with us and is subject to further clarification and explanation during discussions with us. This information may not be duplicated, redistributed, or communicated to others without our consent. This is not an offer or solicitation to any person in any jurisdiction in which such an action is not authorized or to any person to whom it would be unlawful to make such an offer or solicitation. We do not provide tax or legal advice to our clients, and you are strongly urged to consult a tax or legal advisor regarding any potential investment strategy.

This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as "believe," "estimate," "anticipate," "may," "will," "should," and "expect"). Although we believe that the beliefs and expectations discussed are reasonable, we can give no assurance that such beliefs and expectations will prove to be correct. All expressions of opinion are subject to change. You are cautioned not to place undue reliance on these forward-looking statements. Any dated information is published as of its date only. Dated and forward-looking statements speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any dated or forward-looking statements. Investment process, strategies, philosophies, portfolio composition and allocations, security selection criteria and other parameters are current as of the date indicated and are subject to change without prior notice. 8/28/23