Friday File: More Pot Sermonizing, a Portfolio Update, and some Hedging

What does it feel like to miss a bubble? Plus updates on Insurance stocks, Disney, Altius, Fairfax India and more...

By Travis Johnson, Stock Gumshoe, September 21, 2018

Have you been watching what’s going on with the trendy pot stocks lately?

Holy crap.

This reminds me now of 1999 more than it reminds me of the cryptocurrency bubble of this past winter — these larger marijuana companies, like many of the dot com companies (and unlike most cryptos, of course), are real businesses with real sales…. but they’re being bought with no rational regard to the current or feasible financial performance of those businesses. I fear this is going to end really, really badly for a lot of companies and investors… be careful.

Stocks that can surge overnight by 50% on no news, like Tilray did earlier in the week (it more than doubled in less than a week), can fall 90% just as fast — sometimes faster. If you’re trading these stocks because you love the rush (and I don’t blame you, it can feel absolutely exhilarating), do make sure not to “get married” to these companies… they are obviously wildly priced and completely unsustainable at these valuations even if every beer drinker in Canada switches to marijuana on October 17.

That doesn’t mean they’re bad companies, or that you have to sell, of course. Just that the prices don’t make any sense to me… that doesn’t mean they can’t go up another 500%. No one knows when you’ve hit the tip of that spike in the stock chart until after the fact. Just know that the stock charts here resemble past bubbles, and those generally experience their greatest inflation just before the pop, when everyone’s desperately trying to leap aboard the runaway train.

And yes, I know that Constellation Brands paid $5 billion for a toehold in Canopy Growth, and that other big companies are looking to get into marijuana. That’s a strategic imperative for them, and a hope that they can buy more growth as the beer or soda market softens… big companies and smart CEOs are not immune from catching bubble fever. Yahoo paid $1.2 billion for an online greeting card company in 1999, and bought from Mark Cuban for an insane $7.5 billion that same year. was acquired for about $1,000 per free user, in a world where online advertising did not yet generate any actual money — if I could get that valuation for Stock Gumshoe today I’d sell, too, and buy myself a professional basketball team.

OK, fine, that’s not nearly enough to buy a basketball team, we’re still a small bunch of folks here at Stock Gumshoe… but still, that’s a lotta cabbage. Maybe a professional indoor lacrosse team? All those 1999 numbers are adjusted for inflation, by the way.

When rationality returns to the Canadian marijuana stocks, I’d guess that the strong companies who do have real businesses and sustainable brands or other competitive advantages will survive (like Cisco or Microsoft in 2000) but that they’ll fall in price from these levels by something like 50-75%, while the weak ones (Webvan, fall 90%+ and have their assets bought up by the survivors, or just disappear entirely. Everything is faster now than it was in 2000, so the bubble could also disappear more quickly, I don’t know, but the Nasdaq bubble took almost two years to really inflate crazily and about a year to fully “pop.”

And yes, as far as I’m concerned it is a “when,” not an “if” — some of these are objectively “real” companies with growing operations and supply chains and distribution, particularly the biggies like Canopy, and the underlying marijuana business will obviously grow a lot in Canada with full recreational legalization… but I think that’s more than priced in to every pot stock I’ve looked at. They’re agricultural and consumer products companies, and some of them are just wholesalers… they’re not creating something out of nothing, and they don’t have any magical powers. At some point, they will be valued by investors based on their revenue and profits and the potential and feasible near-term growth of those numbers, so if you’re trading these stocks please make sure you’re ready for that… when you’re trading in a bubble market the adrenaline rush can be fantastic and exciting, but that feedback twists your mind and some people leave rational thinking behind and begin to believe that these are “investments” that are real and sustainable… and that often means that speculators in these kinds of stocks become lemmings — don’t jump off the cliff just because everyone else is doing it.

Tilray (TLRAY) started the month with a $5 billion valuation, entered the week at $10 billion, then hit at a $20 billion valuation on Wednesday morning before coming back down to $12 billion this morning… and it might be valued by the market at $50 billion in a week, I don’t know, but I’ll be surprised if it’s worth $50 a share in a year or two (that would be a $5 billion valuation at this share count, though they’ll almost certainly sell more shares along the way)… that’s not because I know anything particularly about Tilray, but because it’s one of a massive number of companies in what will be a ruthlessly competitive and therefore probably loss-making market that just can’t be that big, that fast.

I should be clear: I’m not shorting these stocks, because I could (of course) be just plain wrong, and I’m not crazy (they can stay overvalued for years if I’m wrong about the timing, and bubbles can become dramatically larger than any rational person might imagine — shorting into a bubble is a good way to lose your house), but over the long term, shorting seems far more rational than “buy and hold” for most of these stocks at these valuations. The market capitalization of these companies is absurd, and you probably don’t need me to tell you that, but predicting when it gets “too absurd” is another thing entirely, and a bet that has lost a lot of short sellers a lot of money in just the last week or two.

No, I don’t have strong feelings about marijuana legalization, other than to be a little bummed that I smell more skunks than I used to when I walk the dogs, and a little dismayed that vaping is so hugely popular with kids just as more pot-spiked vaping supplies are hitting the market (a popular platform for students running for high school elections this fall in Massachusetts, I hear, is “I’ll get the vapers out of the bathrooms”).

And yes, I do still have some exposure to medical marijuana — though only through a US marijuana landlord, Innovative Industrial Properties (IIPR). That’s a high-risk investment, too (and leapt over my “buy under” price of $45 to close out the week), but has a pretty solid foundational asset value that should keep losses to 50% or so if the business shifts dramatically and all their US medical marijuana grower tenants go bankrupt, which probably won’t happen quickly and might not happen at all.

And Canada is, of course, a great unknown — I could be entirely wrong, and we could see 30% of Canadians buying weed every week and spending heavily on cannabis-enhanced drinks or brownies or whatever, and hugely profitable marijuana brands could emerge… but I think enthusiasm has gotten firmly out of control and I’ll take the “under.”

Sorry for the sermonizing. I’ve lived through these bubbles in other stocks before, and have sometimes held them through crazy valuations and declines (like Sandstorm Gold when it got out of control following the US listing and the excitement of gold touching $2,000 an ounce, I held some of my shares through that rise and fall and that turned out to be a mistake), so I’m just asking you to please be prepared. Make sure you know what you’re holding and what your exit strategy is — you don’t want a “speculation” that was fun to trade and that you turned into a surprise 400% windfall to turn into an “investment” that drops 90% and makes you want to sell in a panic… and most people do not have the stomach to hold on through a drop like that even if they’re convinced that the stock will eventually become the next Amazon. (Yes, AMZN did fall 90% over a couple years in the dot com crash and aftermath… and if you bought near that 1999 peak and held to today you’d be up 2,000% — but that position would have shown up as a losing “red” in your portfolio for most of the next 10 years before beginning its climb again in earnest in 2009… not many people can be that patient or confident).

These kinds of bubble markets are hard to skip… and I don’t mean that to be flip. It is really hard to watch other people get rich without trying to get a taste for yourself, and for newsletters or money managers it can be professional suicide to avoid these kinds of huge price spikes (just look and see how many newsletter companies quickly released “cryptocurrency” or “cannabis” newsletters to respond to market demand, or how many cryptocurrency hedge funds came out of the woodwork starting a year ago). Missing out on a bubble can also destroy investment managers, particularly in this culture where we’re obsessed with short-term performance — remember how Warren Buffett was pilloried for refusing to buy tech stocks in the late 1990s? The articles about how he had “lost it” and was “too old and should retire” were legion, and he had HORRIBLE performance for a couple years compared to even the broad market averages. Yes, he had the last laugh, but if he had been a hedge fund manager his clients would have all pulled their money out and we would have never known that he was about to grow his company by 1,000% over the next 20 years.

Let’s look at some charts to illustrate that point. This is what Berkshire Hathaway’s stock performance was like from January 1998 to near the March 2000 peak, compared not to just the “bubble” dot com stocks but to the whole S&P 500 and the whole Nasdaq 100 (which, admittedly, were mostly bubble tech stocks):

BRK.A Chart

BRK.A data by YCharts

And yes, by a year later the three had converged again… but it wasn’t easy to watch other people doubling their money (at least on paper) while you saw your portfolio drop 20%.

BRK.A Chart

BRK.A data by YCharts

Then 20 years later, you get to be called an investing legend and have CNBC breathless to hear your every quip:

BRK.A Chart

BRK.A data by YCharts

But charts always select for some starting point, often chosen to get a reaction — so let’s move it up to show you that THE PRICE YOU PAY MATTERS. See that spike above in the Nasdaq 100 at the dot com peak? What if you had bought then? This is what the comparison looks like from that point:

BRK.A Chart

BRK.A data by YCharts

OK, sorry, that’s the end of the lecturing for today. I promise. Just a reminder: Investing is hard, and it’s mostly hard because we can’t help but become emotionally involved with the excitement (or panic) of crowds even if we think of ourselves as “long term investors” — if something seems irrational to you, maybe it is.

And if you think that riding a bubble and jumping out at the right time is your plan, do be mindful that picking anything close to the “top” is mostly luck — I sold 95% of my cryptocurrency speculations last fall because I had bought them on a lark as I was trying to understand the technology, and couldn’t come up with any rational assessment of what the price should be… but it was indeed depressing to watch them soar and really create much of that crazy bubble after I sold, even though I had no business claiming brilliance or complaining about the 400%+ gains I made on that “lark” — one last chart, this is ethereum and bitcoin, with some notes where I sold most of mine:


OK, that’s my brain dump when it comes to pot stocks and bubble markets for today. What’s actually happening in the Real Money Portfolio this week?

We saw some nice news from Ligand (LGND) partner (and former child) Viking Therapeutics (VKTX) this week — Viking had some good results in a clinical trial for their non-alcoholic fatty liver drug, and the share price instantly doubled as the market opened on Tuesday morning. That’s a disease seen by many biotech speculators as a prime area for the next “blockbuster” drug to emerge, though there are a half dozen drugs in clinical trials that are all competing in the space and I have no idea which, if any, will take home the prize… but as a Ligand shareholder, it’s just more reason to smile and appreciate their low-cost, diversified approach to building a pharmaceutical giant. Instead of developing its own drugs, Ligand spun out several R&D programs to Viking and helped it go public several years ago, aiming to get clinical trials going without Ligand having to foot the bill for them. That was widely seen as a sneaky way to offload costs and inflate the value of those programs at the time, since no one had a lot of hope for those Viking compounds in 2015, but such things wax and wane and it appears that they’re once again in favor.

Ligand owns about 15% of Viking directly now (Viking has raised money to dilute their shares along the way, it used to be a higher percentage), so just that boost on Tuesday morning meant a boost in the value of Ligand’s investment of about $100 million — not hugely meaningful now that Ligand is a $5 billion company, but it sure doesn’t hurt… and thanks to accounting rules that require companies to report gains in the value of investments as “earnings”, that means Ligand will report some much bigger earnings next time around. That might not do all that much for the stock, since they’ve also had the reverse happen from time to time and investors are pretty good at understanding that such gains are not “recurring earnings.”

More importantly, perhaps, it means Ligand’s closer to earning milestone payments from Viking (could total a few hundred million if several of Viking’s drugs eventually make it to commercial release), and perhaps a new royalty on a potentially big-market drug. We’ll see… we’re still pretty early in clinical trials and Ligand shares jumped more than 5% on the news, which might be a bit ambitious, but optimism has been rolling for them anyway over the past week thanks to the SEC’s charge that longtime Ligand short-seller Lemelson is guilty of spreading falsehoods in an attempt to boost his short thesis.

That latest SEC accusation is the first real short-and-distort charge I’ve ever heard of from the SEC, which is pretty impressive… it follows plenty of back-and-forth with Lemelson over the past couple years regarding his accusations of accounting fraud at Ligand. I don’t know how it will all end, of course, when Lemelson first went public with his short I sympathized with some of his sentiment (Ligand leadership is massively overpaid, they were pretty sneaky with the Viking spinout and the valuation boost they took from that, and they were and are a risky investment because of their huge reliance on the Promacta royalty for much of their revenue), but I didn’t think that merited a “short” or a sale of the stock — or even that those things were particularly notable in the biotech world.

I stuck with Ligand because of the royalty business model, continuing royalty income increases from Promacta and Kyprolis, and the huge potential of those many early-stage programs in their portfolio… and risk comes with that, but so far it’s working out. Viking is another piece of that working, if the Viking drugs turn out to actually be any good and one or two get approved eventually, that spinout/IPO starts to look a lot less sneaky and a bit more brilliant… and my favorite part is that we don’t have to own Viking itself, which, like most biotechs, is very adept at the “sell high” game in their constant quest for more capital — as we see so often, they announced a huge fundraising ($175 million) just after the stock doubled. If you’re in an industry that burns cash, you have to pull in more cash every chance you get — so if you own biotech stocks that are on the verge of releasing big news, expect them to sell more shares to raise money after that news comes out (assuming it’s relatively good news, that is).

Ligand remains a stock with a bit of hair on it (excessive compensation, high risk from concentrated assets), but growth and growth potential is what the markets want right now, and Ligand genuinely has those things… which, if they work out, can ameliorate some of that risk. Which means, glory be, that the stock hit a new all-time high this week and it remains one of those “I’ll stick with it until a stop loss hits” stocks (that stop loss trigger is now around $190 for LGND, just FYI).

The Lemelson stuff that was most impactful was the first round, which is what the SEC seems to be basing its accusations on — that was in early 2014 when the shares were touching $75 or so, and it was the first negative commentary about Ligand in a while and did bring the shares down by about 30-40%… but the stock was back at $80 within a year and never really looked back. (There was another 20%+ drop in the second half of 2016, but that’s well within the volatility range the stock has “enjoyed” for years.)

And Ligand popped to mind again this week because several folks asked about a Marc Lichtenfeld teaser pitch that was hinting at Ligand in ads for his Lightning Trend Trader — I haven’t written about that particular ad, but it promised “$5.8 billion” in royalty potential and talked up the programs we know quite well, like Promacta and Kyprolis, and the “maybe” potential of the other 200 or so “shots on goal” that Ligand has in the form of funded R&D programs at biotech and pharma firms.

That’s all true, and revenue and earnings are still growing nicely, though the $5.8 billion is some seriously optimistic daydreaming. The risk to those earnings is mostly the same as the reason they’re growing: they’re rising because Promacta sales at Novartis have grown surprisingly fast, and that happens to carry a very high-percentage royalty. That’s still a relatively small drug for a “blockbuster” (just about to hit a billion dollars in sales), and it’s a small and fragmented enough market at the top line that Novartis may be able to hold off generic competition for quite a while even as some early Promacta patents for some applications start to roll off next month… others extend for more than a decade from now, so the late 2020s is when patents for Captisol (their drug delivery technology that underlies a lot of their royalty deals) and Promacta might start to get long in the tooth and be particularly worrisome for Ligand. Perhaps they’ll have other cash cows by then, we’ll see.

Health care as a sector has also hit new highs again this week, though pharmaceuticals lag a little behind the sector as a whole, so you have to be pretty momentum-happy or comfortable with risk to buy a fast-growing stock in one of the fastest growing sectors at all-time highs, but that doesn’t mean the ride is about to end. I’m just holding here, I haven’t added to Ligand in years and don’t want to up my risk exposure to the company, but I’ll happily accept the continuing gains.


Fairfax India Holdings (FIH.U.TO) announced an agreement to take some profits and convert their bonds to equity in Sanmar Chemicals, which is primarily a maker of PVC pipe — the way I read the announcement, they are essentially selling their bonds early (maturity was 2023) and reinvesting half of the proceeds in Sanmar equity.

They’ve liked Sanmar for a while, and now they’ll end up with a much larger stake at 43% (the effective equity stake was 30% before, though the equity and bond investments were made as part of the same agreement back in 2016)… so that’s good, assuming they’re right about Sanmar’s prospects in both India and Egypt, where they’re ramping up new capacity. This company looks like a fairly typical “value” investment that you would expect an investor like Fairfax to make: Long time horizon to profitability in a boring and capital intensive business, but very appealing market environment that should generate strong earnings because of the deficit of PVC production in India (they import more than half of their pipe, and are using more PVC in construction).

And on the bookkeeping side, the profits taken and the equity stake, at Fairfax’s updated valuation for the equity (Sanmar is a private company, so we should take that assessment with a bit of skepticism), means that Fairfax will record a big increase in book value per share of $1.62 when they report their next quarter. That’s more than a 10% bump up in book value (which was $13.22 last quarter), so now we can think of Fairfax, assuming that all the other investments are unchanged (they won’t be, but we have to start somewhere), as having a book value per share of $14.88.

Which is about where the stock traded down to after the news, so investors were not instantly delighted — but it sounds appealing to me. I’m investing more on this news, though this is very much a long term “exposure to India” investment for me and I may be more patient with it than you would be — it’s also possible, for example, that if Prime Minister Modi loses his next election the Indian market and this stock could fall by 30% or more (Modi has his detractors, to be sure, but is a symbol of capitalism in India and his fall would worry those who fear that Indians will give up on capitalism after years of bureaucratic malaise and corruption).

So that boost in book value makes the stock a bit more appealing, and I continue to like Fairfax India’s focus on both financial services (with IIFL and Catholic Syrian Bank) and infrastructure (especially their controlling stake in the expanding Bangalore Airport and some associated real estate). Their biggest public holding, IIFL, drove a lot of the value over the winter and has given up some of those gains later in the year (it’s about 5% below where it was when the last quarter ended, for example), so it’s difficult to assess the shifting book value on a quarterly basis with any precision… but I think they’re making the company steadily better, so I’ve increased my allocation to Fairfax India a bit with an add-on buy here just under $15. I expect to hold this for a long time, and if India goes into a long and nasty decline it will not end well, so I’m also keeping an eye on the size of my total allocation… but I’m comfortable with this size position now, about 2% of my equity portfolio.


Speaking of ’emerging’ markets, Naspers (NPSNY), which has come close to hitting a stop loss for me because of the weakness in Tencent’s share price (Naspers owns more than 30% of Tencent, and trades based solely on that asset most of the time), showed one more sign of their continuing effort to shrink the discount at which Naspers shares trade relative to their assets — they announced that they intend to spin off and separately list their South African video entertainment companies. This won’t be a huge deal, but since Naspers shareholders currently value those assets as being worth “less than zero,” it could help to narrow the discount a little bit… and it’s significant in a historical context, since when Naspers was first diversifying away from its core newspaper business pay TV was their first big push — and that’s still the heart of what is mostly the MultiChoice platform of satellite pay-tv across Africa (there’s also a streaming business hiding in there, and they do have a little bit of business outside of Africa). That actually did help a little bit, the discount at which Naspers trades shrunk some — now the whole company trades at about a 23% discount to its Tencent stake, lower than its been in a couple years (assuming no value for Naspers’ other investments, which are worth at least several billion dollars, or substantial net cash position).


And good ol’ Altius (ALS.TO, ATUSF) finally settled with Voisey’s Bay!

Last weekend, Royal Gold and Altius stepped out of the courtroom and made a new deal with Vale to resume royalties on the huge Voisey’s Bay nickel mine, with what will hopefully be a stronger and clearer royalty agreement that effectively applies the partnership’s 3% royalty on that mine to about 50% of the metal concentrate that is produced using their new on-site refining plant. We don’t know the terms, and it doesn’t appear that they’re getting any of those back royalties in a lump-sum payment or anything like that, as they might have if they had proceeded in court, but now they’re back to having a solid multi-metallic royalty on what is still a very large mine that’s expected to be producing key metals, including nickel and cobalt, for close to another 20 years thanks to the underground extension they’re working on now. That’s a win, and it means some cash will be coming in for Altius again — though thanks to Altius’ increasing diversification and cash flow, it’s not as big a deal as it would have been 2+ years ago when Vale started withholding those royalties.

I’m sure they didn’t get everything they wanted, but Altius CEO Brian Dalton said the value of those future royalties is “consistent” with what they would have expected the future for Voisey’s Bay to bring them a few years ago… so they gave something up (hopes were much lower at Voisey’s Bay a few years ago than they are now), but they get the return of steady cash flow and this royalty paid for itself years ago, so to some degree it’s all gravy. Royal Gold is the senior partner in the royalty-owning partnership (they own 90%, Altius owns 10%), and they indicated that the first check to the partnership, covering the second quarter, should come within a month or so and be about $2.2 million, which would mean (you can do the math!) $220,000 to Altius.

So that annualizes to less than $1 million a year, but production should increase over time and that will, of course, be sensitive to commodity prices — if nickel, copper and cobalt rise, the payouts will rise… and vice versa. Either way, Altius won’t be spending any more on this royalty, either for lawyers or for capital expenses (Vale’s spending close to $2 billion to expand the mine underground, and Altius and Royal Gold get their royalty on all of that new production that will follow without spending anything), so this is worth a smile if not quite a cheer. It didn’t really do anything to the Altius stock price immediately, it was up less than 1% on Monday, and that’s probably just about right — Royal Gold did have a nice day on Monday following the news, up almost 5% at one point, but gold was also up so part of that was probably just “relief” (Franco-Nevada was up close to 3%, and they have nothing to do with Voisey’s Bay). As the week progressed, Altius actually surged ahead more than the gold guys and finished up about 8%, though that’s probably more about predicting what happens with the China trade disputes and how that impacts base metals (copper is Altius’ biggest royalty driver right now, and copper prices were up almost 10% this week after falling 20%+ since June).


Disney (DIS) is starting to show some early traction in its “over the top” subscriptions for cord cutters — they reported this week that the new ESPN+ service has hit a million subscribers, which is not huge but does indicate that it’s possible to scale this sports content pretty quickly… and that there is an appetite for more sports, particularly from those who are getting rid of conventional cable subscriptions (“cord cutters,” as folks call them). ESPN+ is not a replacement for ESPN, it’s a toehold that makes future replacement possible if and when the affiliate fees for ESPN really start to deteriorate — it doesn’t have the same content, it’s basically just niche sports and an occasional baseball or hockey game, none of ESPN’s core shows (SportsCenter) or most popular sports (NFL or NBA), so getting to a million subscribers is impressive. ESPN+ is what I’ll be using to watch college hockey this year, I expect, if that gives you some idea of what’s available.

More importantly, Disney’s now-controlling stake in Hulu (following the Fox acquisition) will mean that they now control one of the powerful three services for cord cutters (the others being Amazon Prime video and Netflix), and it’s also the only one of the three that provides a “live TV” option for folks who don’t want to give up live television entirely. There are plenty of competing services, of course, both from the traditional providers (DISHNow) and from online upstarts (Sling, etc.), but I think Disney has a good chance to put together an incredible suite of streaming services with their incredible world-leading library of quality content, and to get more love from investors as that happens.

The new Disney will become the biggest “content” spender in the world, spending about twice as much on “content” as even the hard-charging and budget-busting Netflix programming folks, and is in a far stronger financial position and trades at a much cheaper valuation… and I continue to think that Disney’s better content will turn streaming into a two-horse race: Netflix and some combination of Disney/ESPN services will meet most of the needs of most people, at least in the US (Netflix is way ahead internationally, but perhaps not forever and Disney’s brand is plenty strong overseas).

And I also think we’re going to start seeing more advertising in streaming TV — Netflix et al can’t just keep throwing money at content production without raising prices, and I think we’ll see a strong demand for ad-supported “free or cheap” options… which will play into the hands of The Trade Desk (TTD), too, if they can keep building a strong market share in streaming video analytics and logistics for big advertisers. I don’t think we’ll see people paying dramatically more or less for at-home video entertainment than they have for years, on average, it will just move to different companies.

Lots of uncertainty in the future, of course, but Disney has the world’s best content and is playing the long game — and they don’t need to count on constant capital raises or massive spending increases to sustain their content creation budget. Who knows, they could even pull out of Hulu and sell that streaming service to Comcast — if it got a Netflix-like valuation it would presumably be worth at least $15-20 billion. I don’t think that’s likely, but it is a little unclear how much Disney will spend on Hulu while Comcast, its biggest rival, is reaping 30% of the rewards (Disney/Fox will own 60% of Hulu, Time Warner 10%, Comcast the other 30%).


For those following the Apple (AAPL) or Apple supplier story closely, the first iPhones went up for sale today… which means that the first teardowns of the new designs happened (Apple doesn’t disclose its suppliers and swears them to secrecy, so taking the phones apart is the only way to find out what’s in them — though Apple has also diversified its sourcing over the years, so each phone might not be identical).

That sometimes leads to surprises when new suppliers emerge or favorites are removed, but not so much recently — as it pertains to my portfolio the teardown confirmed that yes, Qualcomm (QCOM) is out of the new iPhones in favor of Intel (INTC) modems, but Skyworks Solutions (SWKS) does still have several chips on the communications board of the new iPhones — I never know what this means in a dollars and cents way, the iPhone X had five SWKS amplifier chips and these new iPhones have three, apparently, but Skyworks also guided us to expect that their “content” to Apple would increase substantially over last year, up to 25-30%, so either the number of chips doesn’t give us an “apples to apples” comparison or Apple’s telling its suppliers that they’ll sell more than last year.

Either way, I’m comfortable with all these positions in my portfolio. Qualcomm’s Snapdragon was expected to be out of the iPhone as the fight over royalties continues, Skyworks still has that big volume customer so should have a strong end of year if iPhone sales volumes are good, and Intel’s getting some meaningful business despite not having as robust a chip as Qualcomm. And, of course, Apple can pressure them all on prices, still raise prices on its phones despite the tendency of technology to be deflationary, and is among the easiest stocks to hold. I wonder who will get the lead on early part orders for the first 5G-enabled phones over the next couple years…


Remember that hurricane we had last week? Hurricane Florence was widely feared to be the most damaging hurricane to hit the East Coast in decades, depending on where exactly it hit… and it was indeed a huge storm, particularly to the folks along the coast in the Carolinas, where dozens died in those first days and where power plants and dams were in huge trouble almost immediately, but also those inland who saw an almost unimaginable amount of water (I spoke to someone in Chapel Hill, and she said one of their shopping centers was under five feet of water… despite being more than 150 miles from the Wilmington area where the storm came ashore). It even brought a good amount of rain and flash flooding up here to the Northeast.

But did the hundreds of millions of dollars in damages scare people out of insurance stocks? Sadly, no — the narrative has finally evolved to meet reality, and people don’t generally sell insurance stocks in advance of (or during) a natural disaster anymore — mostly because disasters tend to do as much good as they do bad for the well-run insurance companies, who have their exposure hedged through reinsurance and who are, at least theoretically, able to raise rates and sell more insurance at those higher rates once the storm (fire, tornado, ice storm, etc.) has passed. I continue to hold out hope that there will be knee-jerk selling in insurance stocks that I like when these things happen, but that’s almost never the case anymore… oh, well.

The media might not have noticed, by the way — so you probably saw plenty of articles about how insurance stocks were depressed or cratering going into the Florence landfall… just remember, don’t pay too much attention to headlines.

And we got a reader question about insurance this week too, so let’s get into that — here’s the question:

“Does an effective 15% allocation to insurance (Berkshire, Fairfax, Markel) make sense in a cheap money environment?

“Historically these insurance structures have had negative cost float (ie they earned underwriting profits in addition to investment gains), but with the flood of cheap money into insurance, particularly reinsurance, I wonder if float will begin to have a cost (ie underwriting profits get competed away). That seems to have been the recent trend, although its also complicated by recent weather events. Or perhaps these three insurers have established their brands to an extent where they can continue to earn underwriting profit even amid fierce competition? I’m not sure of the answer, just something I’ve been pondering. I think it comes down to ‘how important/valuable is brand in various types of insurance’ and to what extent is it simply a price driven commodity. I fear it is the latter, which is what has kept me away from Fairfax Financial, despite a plausible valuation.”

That’s a good question. The insurance sector has suffered, generally speaking, from a “soft” market for many, many years now (that just means “premiums aren’t going up fast”) — there have been ups and downs, but no real strong pricing power for the insurers despite a big disaster year last year.

That seemed to be caused by a few things: Cheap reinsurance has had an impact lately, because more money flooded into the sector as it began to be considered a “non-correlated asset class”, buying up things like catastrophe bonds and forming new reinsurance pools. (Markel has gotten more into that “managing outside capital that floods into insurance” business with recent acquisitions, and I hope that will offset some of the weakness we might see in reinsurance.)

But the bigger impact until recently, I think, has been falling interest rates and rising stock markets. That has brought more capital gains to the investment portfolios of insurance companies (their bonds became more valuable as interest rates fell), and if they make more money on investments they can afford to compete more on underwriting. That can’t last forever, and indeed started to end a couple years ago, I think, with interest rates approaching zero — because they do still have to invest each year, and with the majority of their investments going into corporate bonds the income received has also been dropping.

What’s going to happen now? Interest rates are rising, which means that portfolios will be reset in value if the bonds they hold are therefore worth a little less than they were last year… but behind that they’ll also begin to see investment returns increase from rising bond yields, and that’s really what they say they price their policies on — the risk they’re taking, and expectation of what that money will make in their portfolio while they’re holding the risk.

I think good underwriters will always do well, in pretty much any market — they might not grow, but they tend to have very large portfolios to fall back on and they can be disciplined in not cutting prices too much. That’s what made Markel so successful in their earlier decades, they were focused on areas of the market where there wasn’t any real competition — insurance for buses and summer camps and hair salons where specific and personal underwriting could give them an advantage. They’re still a specialty insurance company, though there is more competition everywhere now… and they’re still growing and compounding the earnings in their large investment portfolio, just not as fast as they did five or ten years ago.

So to shorten that answer a bit: Yes, with rising rates I think underwriting profits could shrink a bit over the next couple years — but there’s balance to most things, and that might actually help the reinsurers, too (all of those companies write at least some reinsurance).

It’s also possible that a couple big catastrophes that wipe out some outside reinsurance or catastrophe bond investors could help to harden the rate environment. Usually insurers get a little pricing boost after big catastrophes, both because they need to raise prices to help rebuild their cushion after paying out all those claims and because, I expect, that’s when customers are most appreciative of their insurance coverage and least inclined to “push back” on pricing. And I trust the generally consistent and conservative underwriting success at Fairfax, Berkshire and Markel will continue… and that, more importantly, those companies will all have the potential to compound earnings at an above-average pace thanks to their investing acumen (Fairfax and Markel have investment portfolios that are massively larger than their market capitalization, Berkshire is another beast entirely but is also much less driven by insurance than it used to be)…

… so I’m quite comfortable with about 20% of my individual equity portfolio being in those companies, as is the case now, but, of course, everyone has to make their own decisions about their own allocations. I wouldn’t buy Markel today, not at 1.8X book value, but Fairfax is very decently valued here and I think Berkshire is an easy buy if it gets back down near $200. I expect they’ll all be much higher in 20 years than they are today, though they could certainly go through periods when they trail the market for a long period of time.

Actually, he had a second question as well, so in case anyone else is interested in the answer I’ll cover that:

Hi Travis, I’m a recent member, and just wanted to compliment you on what a nice job you’ve done with the real money portfolio, both in terms of its performance as well as presenting your holdings and trades in a way that’s easy to navigate. I’m extremely impressed.
I tried the service years back, but don’t know if you had the real money portfolio in place at that time in its current format – if you did, I somehow missed it.
One thing you don’t disclose (I don’t think), is how much $ you are allocating to your options trades (I