Hohn and HALO, Untapped Pricing Power and Moat

This has been a year where I have been really drawn towards the ideas of Chris Hohn on pricing power and HALO (Hard Assets Low Obsolescence). I am drilling it in my head that the untapped pricing power Warren always raves about comes down to what happens in an inflationary environment. 

Two companies have $100 in revenue with a 20% profit margin. Inflation ramps up to 10%. Company A can't raise its price and will have its margin drop to $12 as expenses increased to $88 ($80*1.1). Company B is able to raise its price with inflation protecting its margin. It now charges $110 while expenses are $88. It now has $22 in profit that is still 20% profit margin.  

In a third scenario with a company with $10 in margin, if it can increase prices 1% more than inflation, its absolute profit goes up 10%. "If you can price just 1% above inflation and you have a 20% profit margin, your profits will grow 5% faster than your revenue." - Chris Hohn 

The GE investment forms the basis of my investigation towards his ideas. The recurring revenue of the growing installed base led to the allocation of nearly 34% of his portfolio to it. It was protected by its nearly insurmountable lead in making engines through its process that would take a lot of resources to crack. 

Some other ideas that demonstrate the ideas of HALO are increasing volume without increasing the necessary capital to expand the revenue, rising gross margins, being a small portion of the customer's expenses, switching costs, no true substitute, genuine, durable preference, high market concentration, and product scales with customers' success. Essentially, a royalty on the capex of others. 

The following industries with the following busnesses seem to exemplify Hohn's ideas:  

Aerospace: GE, TDG, HEI, 

Industrial Gases: LIN, AI.PA, APD 

Railroads: UNP, CNI, CPKC, CSX, NSC 

Rating Agencies: FICO, MCO, SPGI 

Exchanges: CME, ICE 

Aggregate/Construction Material: MLM, VMC 

Cell Towers: AMT, CMI, SBAC, CLNX 

Midstream: ENB, TRP, KMI, WMB, ET, EPD, PAA, WES, MPLX,

Rubbing Mistakes on Face

2025 Mistakes TEVA: Could not find a buy at $18 despite Druckenmiller presenting the clear thesis of a new business model of innovative drugs (Avojoy, Austedo, and Uzedy) supplementing the strong and stable generic/APIs. That business thrived on scale and it has been deleveraging last few years. WBD: Content was king and at single digits or $10/20billion market cap, it was bound to get a buyout offer despite fcf deteriorating to 4b from 6b. Debt load of >30b slowed me down enough HII: It was never going away with it building so much of USN ships and should have loaded up on drop earlier in the year DK: SRE was not on my radar, but the assets were too cheap even if we are at a low point of the cycle GTX: Hard to buy something at $10 when it was $6 when I first looked at it, but fcf and deleveraging was enough. Maybe some things stay here for longer and cashflows are extended with ICE not going away as quickly. Missed Gas/Electricity boom with AI: gev, vst, ceg; If I was smarter, but nuclear power plants' replacement cost and base load should have been an undervalued asset. EZPW: In July of 2021, it was at $6. It was a microcap at 300-400mm and fcf of 30mm. It is now $26 with market cap of 1.6b and 110mm of fcf. The icky business factor clouded the great business model of lending at a high rate. Counter-cyclical to a point and should have been a buy with diversification. One winner makes up for the rest of the losing portfolio.

Green Lumber Fallacy

I sometimes think of the Green Lumber Fallacy and how the trader thought that the lumber was painted green instead of being freshly cut, yet he traded it as a profession.

So let us call the green lumber fallacy the situation in which one mistakes a source of visible knowledge — the greenness of lumber — for another, less visible from the outside, less tractable, less narratable.

Argus Sour Crude Index was launched in 2009 as it served better than the Cushing's WTI which had deviated from fundamentals of the oil market due to bottlenecks in shipping. Refiners in the Midwest that no doubt Tesoro probably owned a few operated with a spread between the indexes and what they could refine to sell. I remembered that in 2010 era looking at the Brent or WTI prices to drop to allieviate margins as I was invested in Tesoro. I was not looking at the right thing possibly. My knowledge was not as encompassing as it should have been, but maybe the value was the replacement cost and the moat of an irreplaceable asset due to NIMBY. As Kirkegard said, "Life can only be understood backwards, but must be lived forward."

Streaks

I am not sure when do you know doubling down on a decreasing stock price is akin to "Gambler's Fallacy" and I will go broke doing that. I do know that in one study of 6,500 stocks from 1985-2024, the median drawdown was 85% and peak to trough took 2.5 years. Then again half of the stocks never recovered. In order to finish first, you must first survive.

Stories

Everyone likes a good stockstory. Go to any small town in the US and there will be plenty of DG stores. AZO and ORLY also seem prevalent. There are always those TSCO and plenty of ogliogopoly/monopoly lying in their wake. The real question is what is the next story.

Financials

The financial sector is the 2nd biggest sector in the SPX. I am not sure if I am fighting the last war though when trying to avoid it as the circle of competence does not include any of it. I lived through the 2008 and it seems everything can dissappear even if it's not your fault. The leverage is always necessary making the quality of earnings low. Then again, CM's two biggest positions at Daily Journal was BAC and WFC. The sub-categories I would brand financials into are Big banks: BAC, WFC, C, ALLY, Credit Cards/Payment Processsors/Fintech: V, MA, SYF, AXP, COP, DFS, PYPL, FISV, GPN, FOUR, Insurance divided into PC, reinsurance, specialty insurance, diversified into life/annuity, It is too hard to understand all the risks it has with its mismatching of assets/liabilities of borrowing long and lending short, counterparty risks, and unknown unknowns.

Original Sin

One of investing's original sins is summed up perfectly by the phrase: “past performance is not indicative of future results." That remains true in every facet outside of the value vs. growth one too. I lean too much towards "value" even if they are attached to the hip and fail to understand how important ROIC/ROC is vs. FCF. I know the Munger quote:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

But knowing is not understanding. I am finally understanding with a thought bringing the numbers to an understandable limit. If a company has a fcf of 10% and just pays it all out in dividends, the return is 10%. If the company has a fcf yield of 10% and is rebuying stock with the free cashflow, you can compound at 1.1^n. If a company only has a fcf yield of 5%, but it manages to retain 50% while deploying at a ROIC of 30%, the return is 20%. Its fcf will grow .75% a year (30% of 2.5%). Its return is theoretically 5% fcf + .75*20 (.75 growth and 20 is the valuation of the growth) 15% for a total of 20%. Eventually the growth will be exhausted and its fcf yield will have to equal all the return as nothing can grow infinitely. The bond rate is a good rate to discount a company's fcf yield to. Until I actually used numbers to fill in the quote that I knew, I did not understand ROIC is not just a proxy for a durable competitive advantage, but can provide details about the future if its retained earnings can be deployed at the ROIC rate. It is easy to hunt for fcf yield, but combining it with ROIC will be measurably more powerful. I am starting to look at the distributors in the "real asset" space in FERG(plumbing/HVAC), MAS(plubmbing/paint), amd POOL(pool supplies). Their ROIC seem to be good even if their fcf are in the low single digits. I am not sure MAS can deploy their capital in the future as much as FERG or POOL even if its higher fcf yield makes it attractive. UNH might be getting interesting as healthcare is robust and a space that is not going away. NVO always stares at a patent cliff, but its ROIC is high as well. Again, ROIC might not be important though because if there is nowhere to deploy retained earnings, then the future dictates that only fcf matters as ROIC would be a measure of past employed capital.