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Chris DeMuth Jr. talks about investing in 2023, the current state of the market (0:30) and why he likes the energy sector, especially oil and gas (4:40). This is an abridged conversation from Seeking Alpha’s Investing Experts podcast.
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Transcript
Rena Sherbill: Chris DeMuth, welcome back to the show. It’s always nice to talk to you. How are you thinking about the markets? What are you thinking about as you’re looking broadly speaking? And you can narrow it down as you keep going?
Chris DeMuth: Sure. Last year 2022, so thinking about the calendar year, made a lot of sense to me. It was very cathartic, especially on the short side, especially looking at the kind of things that were preemptively getting crushed with the onset of reality of real interest rates and the cost of capital.
You had this kind of weird, suspended animation era where as long as there’s no cost of capital, kind of the more dramatic, the total addressable market, the more of a story you have to say about what can happen over the next 10 years, has very little cost. So you’re just stuck with what is the most dramatic benefit that you can describe, which is a kind of a, a childish, and strange enterprise.
And then as interest rates rose, you have a real cost of capital and you can’t just do that anymore. And a lot of things that I thought looked probably worthless, and certainly worth much less than where they were trading, did badly. They kind of bounced back a lot this year. It’s been a hard one on the short side. It’s been a hard one for skeptics and debunkers and value investors on the short side.
This past month actually has been a very good one, but this year has been a very bad one for nonsense getting kind of inflated. And weirdly enough, I guess the market’s a discounting mechanism, it’s done that as the interest rates actually rose as opposed to the prediction of them rising. I don’t think that’ll last. I don’t think it can last for years.
A lot of these guys are kind of frantic producers of press releases and incremental shares. Whatever their stock price is doing, the stock count is kind of going up into the right full time. And they kind of put out a press release for every little thing they do. So a lot of kind of never profitable tech. Interestingly it was kind of on its last legs.
And then the AI enthusiasm really saved it. Not only did it save it, but it saved a lot of the huge asset allocators, including SoftBank (OTCPK:SFTBY), where they were going to just have to dump inventory on the market. And we’re probably weeks away from kind of dramatically impacting the market. And then we’re able to hang on because of AI enthusiasm. So that has some very good things in it, that has some legitimate investments, but also has a lot of nonsense that it rescued.
On the long side, ditto, last year, kind of started to have this revival of small cap over large and value over growth and that’s kind of dissipated a bit. I can say where I’m spending a lot of my time in energy and capital is really on two categories.
The first is ESG service provider for buying all the stuff that ESG sells price insensitively for mandates energy mostly and specifically oil and gas where there are equities that are just wildly mispriced relative to the underlying commodities.
And then secondly, an area that I think is most for better or for worse, uncorrelated over the next few years, is litigation. We have some major litigation efforts underway. Some I can talk about, some I can’t yet. And that’s going to kind of make our luck between those two. We have this and that elsewhere.
I’m certainly always paying attention to the M&A market. I’m very involved in researching arbitrage. My arbitrage books is as light as it’s ever been, kind of directional bets and equities are pretty light outside of litigation and outside of oil and gas. If those two areas work well, I would have a hard time hurting myself elsewhere, just how we’re sized and scaled.
If those two things go badly, I’d have a hard time saving my bacon elsewhere. Again, just how we’re sized. So these are kind of our two firm exposures. And then we have this and that as opportunistically things arise.
RS: All right. Talk to us about energy. What are you seeing over there?
CD: I think thematically my job is always to find arbitrariness, to find counterparties. I always assume if you come to me with really any bet that you want to make me, Rena, I’m going to say, no. Because I’m going to say, well, I first suspect that you’re at least as smart as I am. Then I suspect you have at least as good judgment as I do. And I suspect if you want to bet me, you’ve worked at least as hard as I have on it.
And then, I won’t say this about you, but I’ll say this generally. What if somebody’s cheating and what if they win all the bets they cheat? And say they were just cheating 1% of the time. So I assume that I’m going to have an expectancy based on, I don’t know, mid-forties percentage, likelihood of winning stuff my default against kind of fair game.
So what I really love is counterparties, not where I’m pitting my judgment against somebody else, which sounds like an awful idea. I like finding somebody who’s constrained. Who comes to me and says, I have to do this. I have to buy this. I have to sell this.
In my PA which is much, much, much smaller than my fund, all of my investments are in the dark export market where most retail brokers literally say, you have to sell this security, if you want to trade it, you may not buy it. And they’re just like hoovering stuff up at a tiny fraction of their value where many people have, literally contractually have to sell something, or indexes that have to buy it.
I like constrained counterparties, people who are forced to do something and I’m just kind of making my way in this world as a service provider who just takes the other side of the train because they need somebody to take the other side of the train.
That opportunity today is in energy, especially oil and gas. And especially situations where you’re a service provider to ESG mandated funds. It’s not rational or self-seeking in the economic case, but as an agent that might be completely rational or self-seeking, we might figure while they’re making more in fees than they’re giving up in returns, and I can pick up the returns. So, oil, gas, to some extent uranium, other kind of real stuff, energy, and areas that have an environmental impact.
Of course, when you’re talking about the secondary stock market and when you’re talking about individual projects, the impact on the global environment is zero because you just take projects that were going to be one place, you move them someplace else. You have somebody else own something and a company that is cash flowing doesn’t need to raise new capital. The secondary market has no impact whatsoever on production.
But you have waves of situations in history. I don’t know how similar this is in other countries, but I can think of many examples in the U.S. where a political regime tries to co-opt the private sector because it wants to use a private sector balance sheet as well as the public on behalf of some political goal.
And in doing so tends to vilify a company or an industry. And in doing so when they settle or come to terms, has a sort of fascistic public partnership, public private partnership with them that ends up wildly accruing to the benefit of the equity holders in situations where they can’t necessarily do CapEx. They can’t necessarily fight the regime, but they can be co-opted in a way that if it were a private contract and not the government, it would be a legitimate antitrust violation.
And the examples I would give are the NSA with tobacco in 1999, ended up being incredibly good for tobacco investors because they basically weren’t allowed to spend money on all sorts of things like advertising. They weren’t allowed to make health claims against each other.
And the U.S. government, or at least the States, basically become limited partners of Philip Morris (PM). And so 100 years from now, people will be smoking Marlboro Reds and Philip Morris, and Altria (MO) will be spewing their distributions to shareholders over this. And so it was really good for them.
UnitedHealth (UNH) and Obamacare. The companies that were supposed to be the pariahs got rich. Politicians, they got rich too, but — on both sides of that trade. But they were insiders, they were partners and at the superficial rhetorical level, they were villainized. But being the villain is a great deal and being the villains can be a great deal in oil and gas and energy right now because the last thing anybody’s going to do is CapEx.
They’re not going to start new projects. The most cyclical of cyclical industries is going to have the cycle broken where these guys, when prices are really high, do a bunch more projects; when they’re really low, they stop, they kind of flail back and forth. Well, at $80 a barrel right now, prices could double and they’ll sit on their hands. They’ll say, okay, we’ll distribute all the money out to investors. Distribute all the money out to investors.
They’re being screamed at by the politicians to stop doing what they’re doing. The politicians want to strangle supply. They are goosing demand with endless fiscal and monetary stimulus and they want demand to skyrocket. They want supply to go away and then they complain if prices are high. So it’s completely an innumerate combination of preferences.
But if anybody in the world understands them, the decision makers in the oil and gas companies do, and people who have tortured shareholders for years because they just keep, they like to drill, they like their business and they’re somewhat insensitive to timing these things well, they’re going to be forced to because they know they’re not supposed to build — you’re not supposed to build refineries. You’re not supposed to drill for oil and gas.
And intermittent energy is a peak supplement in certain geographies at certain times of year, but it is not a substitute. So, if it’s really, really sunny, that’s fine. If it’s really, really windy. But sometimes, the sun sets or is clouded over and some days are still.
And so, maybe we have a consensus forming, kind of a bipartisan across ideologies in favor of nuclear. And we have a big position in physical uranium to cover our bases there.
But until then there is a multi-decade delta between rhetoric and reality and we’ve actually placed our policy bets on the rhetoric. So we’re saying we want this and that and the other thing, but we’re decades away from being able to replace it and everybody that votes, seems to want to be able to turn the lights on at night and wants to be cool in the summer and warm in the winter.
And the fact that this past year had an incredibly mild European winter kind of pushed off the reckoning by 12 months. But not necessarily more than that. And so I think oil and gas is terrific and I think a lot of the equities were trading at big, kind of, discounts to where the commodities imply they should be at. Especially if they are going to become kind of a cash returning machines instead of drilling machines.
RS: We’ve seen a big resurgence lately in energy. Do you feel like that’s going to keep incrementally going up in that sector?
CD: Yeah, just starting. I would say demand is really hard to forecast. And so who the heck knows? Quarter-to-quarter, I think, whether or not we have a recession and how China is kind of post-COVID reopening, kind of how fast they bounce back, a lot of things like that matter are important, maybe not that knowable or at least knowable by me.
But I think that the supply constraints, the intentional supply constraints on projects that take a long time to turn back on if you turn them off, I think it’s going to make the supply picture tricky for oil and gas.
And I think the likelihood is, prices are much, much higher. And that the likelihood is that, at some point you get much more of the value of their companies in this area recognize kind of upstream oil and gas companies.
But I really don’t care. I don’t care just like I didn’t care with tobacco, and I didn’t care with UnitedHealth. And I don’t care if the market cares, as long as we’re getting distributions, right? Like I can get my money back in M&A and regular special dividends, and buybacks.
And if I have to wait for those, fine. If I have to wait for those, it’ll make it easier for me to get bigger. I don’t have to worry about literally everybody in the world, but me, could adopt ESG as a religion. And that’s fine. That’s fine.
