Noahs' Arc 2022 Q2 Newsletter
The Arc has set sail...
Welcome to Noahs’ Arc’s 2022 Q2 newsletter… and what a quarter it’s been! We discuss a healthy way to frame the market downturns, as well as the potential for evolving inflation and grim food shortages on the horizon.
No aspect of this material is intended to provide, or should be construed as providing, any investment, tax or other financial related advice of any kind. You should not consider any content herein or any subsequent services provided to be a substitute for professional financial advice. If you choose to engage in transactions based on the content herein, then such decision and transactions and any consequences flowing therefrom are your sole responsibility. Noahs’ Arc does not provide tailored investment advice to any person directly, indirectly, implicitly, or in any manner whatsoever.
Executive Summary
The Arc Setting Sail, and a Berkshire Letter -Noahs’ Arc entered the market at an interesting time as world markets experienced large swings and heightened volatility. We frame this chaos on an excerpt from a Berkshire Letter about being happy with depressed prices, rather than afraid because of them.
Inflation Bifurcation - Core CPI has been the poster child for inflation since time immemorial… with the disruption in energy and food markets (both discussed below), the non Core CPI may be a more sustained point of pain in regards to rising prices.
Food Shortages - While we can enjoy the relative insulation from calamity granted simply by being in one of the wealthiest countries in the world, many other places on the planet are primed to struggle to feed their populations, possibly damaging supply chains that have yet to be untouched by the chaos.
Personal Note - In line with our reference to the Berkshire Hathaway letter, we were fortunate enough to see Mister’s Buffett and Munger themselves at their annual meeting.
The Arc Setting Sail, and a Berkshire Letter
The Arc has set sail: our investment vehicle officially launched on April 4th! It's been a dream come true for the both of us to see a project we've worked on for years finally take flight.
At the surface, it seems that we couldn’t have picked a more interesting time to start a hedge fund, with wild price swings, often to the downside, the norm. Really, though, we’re actually quite grateful for the opportunity set we’re seeing.
As a frame of reference (and perhaps because of our recent pilgrimage to Omaha), we’ve selected an excerpt from the 1997 letter that’s been making the rounds online:
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
In line with this, since we launched in early April, we’ve kept cash reserves relatively high compared to average fund managers (average is somewhere near 6%, we’re north of 20%), which have given us an opportunity to continue to lower the cost basis on our names. As the old adage goes, if you liked a stock at $50, you’ll love it at $40!
The markets may very well keep going down. Unless our businesses are more than nominally affected in the long run, however, we will continue to welcome the discounts we are receiving.
Limited Partners in our fund will be receiving a more granular discussion of performance separately in a bi-annual shareholder letter; expect it in late July.
Inflation Bifurcation
With inflation staying above 40 year highs, and even being above levels from the late 1970s by one measure, we’d like to discuss the possibility that inflation undergoes an important change. But, to understand where inflation may go next, we need to understand what is causing it.
Most inflation since the end of the COVID has been related to core CPI (Consumer Price Index), which measures inflation related to goods and services where price growth is typically sticky. One example of core CPI is rent. Typically, monthly rent goes up, and generally doesn’t go back down over long periods of time. This causes CPI to become elevated and, usually, to stay elevated.
As COVID subsided, this was the story: consumer stimulus dollars funded the continued purchases of TVs from Target, new homes, and downpayments on automobiles. Demand was growing faster than supply, contributing to rising prices.
Core CPI goods are generally not a commodity. Typically, this means that prices are more stable as individuals can select based on their preferences. People who choose to rent somewhere do not make the decision solely on price. The same generally goes for TVs, homes, cars, plane tickets and more. However, supply lagged in many of these categories due to the myriad of supply chain issues, further contributing to rising prices.
While this was the main inflation story till earlier this year, two things began to change. First, core CPI began to plateau as supply increased for goods like televisions in tandem with pent up demand for these goods being exhausted. But, second (and this is what we think is key), new supply constraints for volatile goods have accelerated the price increases in the non-core CPI category, composed mainly of food and energy.
Because of this, we think that future inflation may very well be much more a function of non-core CPI, and in a longer lasting way than usual. The problem is that, when looking at the causes of this inflation (the war in Ukraine and underinvestment in energy production), this will be much harder to remedy.
Even though, thanks to work from home, the United States is using less gas now (compared to previous averages before COVID), prices are at near all time highs. Why? The US imported 8% of its daily oil supply from Russia before the war in Ukraine started… with a ban on Russian oil, this pricing pressure will not resolve soon.
In the US, supply doesn’t look like it will jump either. While these market prices can certainly support the business case for more drilling, Oil and gas producers are reluctant to do so due to the previous volatility in the market. In addition, 24% of US oil production comes from drilling on federal lands, and while the Biden administration lifted the ban it had on new drilling, they have imposed higher leasing fees on federal lands that make it infeasible to drill here in the long run, reducing the search pool for new sites.
In the short run, the Department of Energy has been able to affect prices (though it may not feel like it) by releasing 1 million barrels of oil per day from the strategic oil reserve. This has been about ~5% of our daily national consumption. The DoE cannot do this forever, though, and has already said they will need to cease these sales in late September.
Similarly, core food prices are up 10% YoY. Much of this is an issue with supply chain shortages (unless you’re bulking like Jacobs, it’s not as if you’re eating more food each day than last year). Rather, Ukraine (which feeds 400 million people via its fields that grow 13% of the world's corn exports and 10% of the world's wheat exports) are either damaged or won't be planted this year due to the ongoing war.
Furthermore, the crops that do exist in Ukraine, and that are available for harvest, are not accessible. Most of Ukraine’s grain exports go through it’s now bombed out or mined ports. Couple this with droughts in India and you have a recipe for long run food supply shortages. It's not as much of a concern here in the United States, but globally, it can be dangerous.
Food Shortages
As food shortages pose a greater inflation risk, it’s starting to affect geopolitical stability, threatening some of the few supply chains that are functioning properly. From history: studies have indicated that increases in food prices in 2011 were a core cause of the Arab spring uprising, not to mention the way in which famine may have contributed to the French Revolution. Furthermore, “a one standard deviation increase in the international food price index significantly reduced Low Income Countries' polity score by about 0.03 standard deviations on average” in studied nations. People literally (to quote the Snickers commercial) get Hangry.
Sri Lanka and its effects on cooking oil supplies is perhaps the best point of reference right now, but there are others. Polymatter has a great video on this. We’ll attach it below:
In essence, rising food prices can be catastrophic. Unfortunately, due to the shortages in Ukraine, it's not a matter of if, but when and where this happens. A recent UN study found that some parts of the world only had 10 weeks of wheat on hand. And, that was 5 weeks ago.
Even if there was a ceasefire in Ukraine to begin exports today, the Ukrainian government believes it would take 4-5 months to remove the naval mines they put in their harbors to protect themselves from Russian forces. That’s not pretty math. Below is a map developed by The Economist that uses a proprietary model to figure which countries are at the highest risk of civil unrest.
It's a dark scenario (and we certainly hope we're being too pessimistic), but without looking at the worst case scenarios, many of which are becoming more and more real, you risk missing some of the most important details for the future.
That’s the so what of this whole ramble: shortages are bad, but here are a couple specific ways they could get/stay worse. How you apply it to your own investing philosophy is up to you.
Maslow’s Hierarchy of needs is a useful touchstone to close the discussion on: when basic needs are fulfilled, we as a species tend to focus on other stuff (democracy, civilization, etc). In many places, this basic need is no longer being fulfilled.
We believe that an appropriate way to invest in this market is defensively. Put your money in companies that can weather societal changes in needs. Often this is in sectors close to core consumer staples and goods. This may not be the most lucrative investment in the long run, but we believe it removes some risk.
Personal Note
The Arc officially set sail this April, albeit into choppy waters, and we couldn’t be more thrilled with the journey so far. Learning, learning, learning.
In other news, after finishing up another successful semester, we joined some friends on a road trip to that oh so sacred mecca for capitalism: the annual Berkshire Hathaway Shareholders meeting (another good reason to include the letter excerpt above, not that it needs another reason for inclusion).
It was quite surreal to see Misters Buffett and Munger sitting up there on stage, with Bill Gates, Tim Cook, and Jamie Dimon all in the front rows to watch their acquaintances speak on the past few years and the next to come.
One of our personal favorite takeaways was Buffett discussing how investment in yourself is the best way to hedge inflation.
In line with that, over the rest of the summer, we’ll continue to learn, run the fund, and develop tools to give us edges wherever possible.
In closing, a quote from Mr. Munger discussing Berkshire’s success: “It’s not brilliance… it’s the avoidance of stupidity.” While we can only ever hope to reach a fraction of their success, we can think of no better way stars on the journey.
Until next time,
Noah & Noah
DISCLAIMER
> The information and opinions contained in this newsletter are for background purposes only and do not purport to be full or complete. The information herein is not personalized investment advice or an investment recommendation on the part of Noahs’ Arc. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
> All investments involve the risk of a loss of capital. Noahs’ Arc believes that its proprietary investment program and research and risk-management techniques moderate this risk through the careful selection of portfolio investments. However, no guarantee or representation is made that our investment program will be successful, and investment results may vary substantially over time.
> Certain information contained in this document constitute “forward- looking statements,” which can be identified by the use of certain terminology, such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof, or other variations thereon or comparable terminology. Any projections or other estimates in this document, including estimates of returns or performance, are “forward- looking statements” and are based upon certain assumptions that may change. Due to various risks and uncertainties, actual events or results, or the actual performance of any investment vehicle, portfolio or product described herein may differ materially from those reflected or contemplated in the forward-looking statements. Actual events are difficult to project and often depend upon factors that are beyond the control of Noahs’ Arc.