FRMO Corp. (FRMO, Financial) is headed by Murray Stahl (Trades, Portfolio) and Steven Bregman. These two investors have had a profound influence on the way I go about investing, and I eagerly await each of their annual letter to investors, one of which appeared last week. Here I will highlight the main message it conveys and what the FRMO Corp. people are doing. FRMO Corp. has a market cap of $326 million, and its value was summarized in the letter (emphasis mine):
"At the end of the 2019 fiscal year, FRMO had $126.3 million of shareholders’ equity, $191.6 million of total assets and $53 million of cash. As has been the case for the past two years, we continue to develop businesses that are intended to serve as an alternative to traditional investments. Prior to describing the efforts, it might be useful to explain why an alternative to traditional investments is needed."
In my view, the total assets substantially undervalue the true intrinsic value of the company's assets. This is the case because it holds a number of assets at purchase value or at a value that's otherwise deflated. Examples are the equity interest in the private Horizon Kinetics, a revenue stream on Horizon Kinetics and the purchase value of interests in private ventures (including a number of emerging stock exchanges, among others). After this intro the letter dives into what the authors view as "The Problem With Traditional Investing:"
"... There is a not insignificant and growing amount of negative-yielding sovereign debt. These are investments that are guaranteed by the governments that issue the bonds to result in a loss. Surely, this requires some alternative. Yet, even in the U.S., where the yield on a 10-year Treasury is 1.63% at the time of this writing, it should be self-evident that, after taxes and the perhaps 2% official inflation rate, this investment is certain to experience a decline in purchasing power over the fullness of time."
There is now about $17 trillion of debt that is traded with a negative yield. This is a baffling development and a problem because many investors require an investment return to meet their future needs. Now they are forced to take significant risks in order to obtain those returns.
"One might assert that equities are the obvious alternative; however, equity valuations are powerfully influenced by interest rates. Consequently, with interest rates at all-time historical lows, equities are expensive. The market capitalization of the Russell 3000 stock index is about $29 trillion. This is 1.36x the level of U.S. GDP. It is true that this statistic has been higher. The St. Louis Federal Reserve uses the Wilshire 5000-to-GDP ratio, which is a very close comparable. According to this measure, in September 2018, the ratio was actually 1.44x, and it is presently 1.39x. In February 2016, which was not a uniquely weak period for equity prices, the Wilshire 500-to-U.S. GDP ratio was 0.96x. This latter figure is simply a statistic that one might consider to be roughly a historical average. Obviously, a decline to this level, even without a recession that might reduce GDP, would not be pleasant."
Equities are a particularly risky alternative because valuation indicators suggest they are overvalued as a group. This is not just true for metrics like the Wilshire 5000 Full Cap Price Index to GDP but also for others like the Shiller P/E. In the GuruFocus menu under "market" you can find a number of such indicators. The Wilshire-to-GDP metric suggests a downside of 36% just to get to an average valuation. Institutional investors are gravitating en masse to private equity:
"Another popular alternative is private equity; however, private equity has limited transactional liquidity and is generally associated with much leverage; so much so, in fact, that it might be more aptly termed leveraged equity. Even a slight increase in interest rates from current levels would be challenging for many firms. For example, a normal high yield credit borrower might, in the current environment, pay 4.5% in annual interest charges. Even if this rate were to increase just to 6%, this would imply a 33% higher debt service expense."
Stahl and Bregman do not have a lot of faith in private equity, which they refer to as leveraged equity because it relies heavily on debt. The low cost of debt (i.e., low interest rates) has been juicing returns, but if this changes, that kills returns very quickly because firms will be defaulting and/or less value will flow to the equity portion of the capital structure.
In the final paragraph, they get to the key to their portfolio positioning:
"Our working assumption is that at the current level of interest rates globally, the central banks of the world are reaching the limits of asset inflation via lower interest rates. Ultimately, the past 38 years of debt creation will require higher rates of money supply growth than has been the case for a very long time."
This ultimately gets them to a "prediction:"
"As a consequence, the investors might need to contend with asset deflation. This is only a hypothesis. As such, it might well be erroneous. Consequently, we have tried to undertake measures that might greatly increase shareholder value in this environment. However, we have undertaken everything in measured fashion within the context of our historical structure that could continue unchanged if the hypothesis proves false."
To deal with this environment of asset deflation (i.e., declining equity prices and bonds losing value), they are investing in non-standard assets. They are buying equity in companies outside of the index universe, they are investing in cryptocurrencies, they are investing in emerging stock exchanges and they are investing in tiny companies with low-risk balance sheets and huge potential upside. Their most important publicly traded asset is the Texas Pacific Land Trust (TPL, Financial). Overall at FRMO, they are taking a unique investment approach, writing some of the most interesting annual letters from which important lessons can be drawn and sticking to highly defensive positioning (although achieved in a non-standard way).
Disclosure: Long FRMO.
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