Searching For Safe Havens 

Three Capital Efficient Leaders To Put At The Top Of Your Watchlist

Finding Shelter From The Current Economic Storm

This is Porter & Co.’s The Big Secret on Wall Street, which we publish every Thursday at 4 pm ET. Once a month, we provide our paid-up subscribers with a full report on a stock recommendation, and also a monthly extensive review of the current portfolio… At the end of this week’s issue, paid-up subscribers can find our Top 3 “Best Buys,” three current portfolio picks that are at an attractive buy price. You can go here to see the full portfolio of The Big Secret.

The punishing market declines so far this year have left few asset classes unscathed. 

In prior financial panics, investors would typically flood into the U.S. dollar and U.S. Treasury bonds, pushing up their value and providing positive returns as stock prices and other risky assets collapsed. 

During the height of the Global Financial Crisis from mid-2008 through early 2009, while prices of stocks, commodities, and corporate bonds collapsed, the Bloomberg U.S. Dollar Index (an index measuring the value of the dollar against a basket of global currencies) gained 25%, and long-term Treasuries – represented by the iShares 20+ Year Treasury Bond ETF – gained 35%.  

Likewise, during the short-lived panic in the wake of the COVID-19 outbreak in early 2020, Treasuries gained 35% in the three months from January through March, while the U.S. dollar rallied 7%. 

This year, however, the dollar and Treasuries have failed to serve their usual role as a safe haven against financial market chaos. Since global stock markets peaked in late February and entered into a vicious decline, these traditional portfolio stabilizers have only added to the pain, with Treasuries losing 6% of their value while the U.S. dollar has dropped 7%. 

Instead, global investors are turning to gold as their port in the storm, with the precious metal gaining 14% since late February. These gains come on top of an already-impressive rally that’s capped off a nearly 70% gain in the price of gold over the last two years. And this is all happening with the U.S. holding interest rates at over 4%. When the Federal Reserve inevitably cuts interest rates as the fallout from a collapsing stock market spreads into the real economy, further lessening the appeal of U.S. government bonds and currency, all bets are off as to how far this trend could go. 

We believe this is just the beginning of a trend that America hasn’t faced since the 1970s: a prolonged period of loss in confidence in U.S. assets across the board. Like the 1970s, this environment will likely bring a period of prolonged, sticky inflation and stagnant economic growth known as stagflation, which Marty Fridson recently wrote about in the Daily Journal. And any investors that recall the lessons of the 1970s know that gold was the best-performer by a wide margin during that decade. 

Thus, it’s no surprise that gold stocks have become one of the few sectors with positive returns this year, with VenEck Gold Miners exchange traded fund (GDX) up 46% year-to-date. 

However, as we’ve written about previously, companies involved with pulling commodities out of the ground have one major problem: They require huge amounts of capital to grow. And during inflationary periods, those capital costs rise along with the value of the commodities they produce. And they must continuously sink ever-higher piles of capital into the ground, because they are constantly liquidating their balance sheets by depleting their existing reserve base. 

As Warren Buffett’s longtime right-hand man Charlie Munger once explained:

“There are two kinds of businesses. The first earns 12%, and you can take it as cash. The other earns 12%, but all must be reinvested. It reminds me of the guy who looks at his equipment and says, ‘There’s all of my profit.’ We hate that business.”

That’s why we prefer to simply own the rights to these commodities, via royalty companies. We’ll leave the hard and expensive work of digging commodities out of the ground to others. That’s the royalty business model in a nutshell: these businesses own the rights to the metal in the ground, and they lease these rights to mining companies who do the digging in exchange for a percentage of the production.

During inflationary environments, the best businesses to own are those that can grow their earnings without escalating capital investments… In other words, businesses with high capital efficiency.

One simple measure for capital efficiency is the free cash flow margin, or percentage of every dollar in revenue converted to free cash flow. Whereas most gold mining companies generate single-digit free cash flow margins, the streaming company we hold in The Big Secret portfolio is in a league of its own with free cash flow margins averaging 46% over the last three years. 

Along the same line of thinking, another source of safe havens this year have been found in tobacco stocks. 

These stocks are also incredibly capital efficient, thanks to their brand power that allows them to consistently raise prices without any incremental investment into new plant or equipment, leading to free cash flow margins exceeding 25%. And as we’ll describe below, these businesses are in a unique position to grow their earnings despite the economic turbulence we see ahead. Plus, they offer a natural hedge against the demise of the U.S. dollar thanks to their significant earnings from overseas countries denominated in foreign currencies that are strengthening while the dollar declines. 

In today’s portfolio update, we’re reviewing the latest fundamental developments and earnings outlooks for three of our favorite Big Secret businesses in these industries. We believe they offer the most resilience against the current economic environment, and the greatest opportunity for higher earnings and share-price appreciation regardless of what happens next. Thus, we recommend investors put these names at the top of their watchlist to monitor and buy on any short-term price declines caused by overall market volatility. 

Presented by Jim Rickards

战 神 无 脸 | The War God Has No Face

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