Eric Mandelblatt - Investing in the Industrial Economy - [Invest Like the Best, EP. 266]

My guest today is Eric Mandelblatt, founder and CIO of Soroban Capital, a $10 billion investment firm. While many of my conversations focus on technology and emerging industries, Eric has deep roots investing in the industrial economy, which made this conversation a fun change of pace. We discuss why energy and materials represent such a small share of the market today, how the global push towards decarbonization could have massive impacts on the industrial economy moving forward, and how Eric evaluates this dynamic opportunity set. Please enjoy this deep-dive discussion with Eric Mandelblatt. Editor’s note: This conversation was recorded on February 15, before last week's invasion of Ukraine. For the full show notes, transcript, and links to mentioned content, check out the episode page here. ----- Invest Like the Best is a property of Colossus, LLC. For more episodes of Invest Like the Best, visit joincolossus.com/episodes. Past guests include Tobi Lutke, Kevin Systrom, Mike Krieger, John Collison, Kat Cole, Marc Andreessen, Matthew Ball, Bill Gurley, Anu Hariharan, Ben Thompson, and many more. Stay up to date on all our podcasts by signing up to Colossus Weekly, our quick dive every Sunday highlighting the top business and investing concepts from our podcasts and the best of what we read that week. Sign up here. Follow us on Twitter: @patrick_oshag | @JoinColossus Show Notes [00:03:01] - [First question] - Soroban’s history and why Eric is qualified to discuss industrial and commodity sectors [00:04:37] - Overview of what their portfolio looks like today [00:05:49] - How much of the commodity exposed equity sectors are owned by hedge funds [00:08:03] - The key history points that makes industrials more interesting today [00:11:17] - Commodity cycles, what drives them, the role CAPEX plays and how this world works [00:17:38] - Thoughts on natural demand and the societal push towards decarbonization [00:22:32] - How deeply one needs to know commodities in order to hold them [00:23:57] - Big categories to explore as decarbonization becomes more accessible to consumers and the lack of nuclear investing [00:28:50] - The resurgence of industrial production in the US [00:32:21] - Rail networks writ large and if we can expect new ones in the future [00:36:17] - The market gap between rail and technology businesses [00:41:38] - Commodities and the ways they differ from railroads [00:43:47] - Comparing the differences between businesses within the commodity industry [00:46:52] - Walkthrough of Alcoa’s business and how things like a carbon tax might affect an individual business [00:52:55] - What is the portfolio manifestation of the fact it's impossible to forecast commodities historically [00:56:08] - His view of the world in its current state and big things that matter [01:00:25] - Thoughts on inflation as an investor in the commodity space [01:01:42] - Utopian to dystopian takes on what growth looks like for the world [01:04:28] - Juxtaposed positions in big tech against the industrial story [01:08:45] - The kindest thing someone has ever done for him

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

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• 0:42Patrick O'Shaughnessy?

  by pairing best-in-class technology with the highest-quality user-generated content and data. Tegus content is powered by many of the world's leading institutional investors, where their expert calls are recorded, transcribed and uploaded to the shared platform, leading to the highest-quality content and data sets. Tegus also recently acquired BAMSEC, which will allow users to seamlessly toggle between financial data, management commentary and expert interviews as they get up to speed on a company. Any customer who signs up for Tegus before May 31st will receive a free BAMSEC license as part of their subscription. Find out why a majority of top firms are using Tegus on a daily basis. Head to tegus.com/patrick for your free trial. Stay tuned after the episode to hear my interview with Tegus and BAMSEC customer Steve White

• 1:27Patrick O'Shaughnessy?

  from SW Investments. We cover how Steve incorporates both Tegus and BAMSEC across his investment process. This episode is brought to you by lemon.io. The team at lemon.io has built a network of Eastern European developers, ready to pair with fast-growing startups. We have faced challenges hiring engineering talent for various projects, and lemon.io offers developers for one-off projects, developers for full start-to-finish product development, or developers that could be add-ons to an existing team. Check out lemon.io/patrick to learn more.

• 2:01Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at joincolossus.com.

• 2:27Speaker 01

  Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast.

• 2:52Patrick O'Shaughnessy?

  My guest today is Eric Mandelblatt, founder and CIO of Sorbonne Capital, a $10 billion investment firm. While many of my conversations focus on technology and emerging industries, Eric has deep roots investing in the industrial economy, which made this conversation a fun change of pace. We discuss why energy and materials represent such a small share of the market today, how the global push towards decarbonization could have massive impacts on the industrial economy moving forward, and how Eric evaluates this dynamic opportunity set. Please enjoy this deep dive discussion with Eric Mandelblatt.

• 3:25Speaker 02

  Quick editor's note before the episode. This conversation was recorded on February 15th, before last week's invasion of Ukraine.

• 3:33Patrick O'Shaughnessy?

  Eric, since this conversation is going to be in incredible depth about industrials specifically and a huge set of themes that you and the firm have been working on for a long time, I think it is really appropriate to set the stage a little bit. Normally, I'd handle background information in the introductions. I'm the kind of person that skips the childhood section of biographies. But in this particular case, it's a big and fairly new topic for us. So I think the background of where you're coming from is really important. So maybe you can give us the thumbnail sketch of Sorbonne's history and why you are the right person to be talking to about this big theme.

• 4:07Speaker 03

  Sure. Well, first of all, I appreciate you having me on the podcast. Honored to be here, Patrick. Maybe let me take you one step back further, which is where I started my career. I was hired in 1998 at Goldman Sachs as a natural gas analyst. Ironically, the biggest company we covered at the time was Enron. We covered natural gas pipelines, utilities. I learned about the commodity business at Goldman in 1998 to 2002, ultimately transferred into one of the proprietary investing groups at Goldman, and then left to help start a hedge fund by the name of TPG Axon Capital in 2005, and then landed at Sorbonne and launched the firm in 2010. I tell a funny story. When we launched our firm, folks thought

• 4:50Speaker 03

  of our firm as being an energy-focused hedge fund, and we had to kind of wave our hands in the air and say, no, no, no, we're investing in consumer, we're investing in tech, we're investing in business services industries as well. But the core roots of the firm originally were really on the commodities and industrial side, which is just my background, given where I started my career at Goldman.

• 5:10Patrick O'Shaughnessy?

  So maybe walk us through all the way to the end, what the portfolio looks like today at a high level, because people get sick of hearing me use the quote, "Don't tell me what you think, just tell me what's in your portfolio." It's an interesting sort of two-pronged approach to what you own. So just overview for us what that looks like today, so that we can get into the nitty-gritty of everything going on.

• 5:28Speaker 03

  A framing comment. We love to own good structural compounding monopoly oligopoly businesses at good prices, just like everybody else. Our portfolio is actually quite simple today. Over 80% of the firm's risk is in three sectors. One, big tech. Our biggest position by a mile is Microsoft. It's been our biggest position for the last few years, but our big tech positions are about a third of capital. That's Microsoft, Amazon, and Alphabet. We have 25% of the firm's capital in two of the leading Class I railroads in the United States, CSX Corp. and Union Pacific. And then we have about 30% of the firm's capital today in commodity-levered equities in a variety of sub-industries, metals and

• 6:12Speaker 03

  mining, energy, chemicals being the big ones. So you kind of take a third, plus 25, plus 30, and you have the vast majority of our portfolio exposure today.

• 6:22Patrick O'Shaughnessy?

  Maybe we'll come back to the big tech positions if we have time at the end, but that's not where we're going to spend our time and energy today just because I think it's much more unique to talk about those two other places, rails and commodity exposed equities. Maybe walk us through the high level idea here, maybe even opening with some framing you've given me before around just how much of these sectors the competitive hedge fund world owns. You did an interesting investigation here. I couldn't believe the number. Maybe that's good framing so we can dive into why you find this different looking portfolio so interesting.

• 6:53Speaker 03

  Our firm is at peak industrial economy exposure. We've been at it for 12 years. We have 55% of the firm's capital invested in the industrial economy. When I was thinking about our thematic positioning back in 4Q, I just ran a screen and I pulled the 30 largest hedge funds that do what we do, classic longshore concentrated hedge funds. Those 30 funds had $410 billion of invested capital as of the end of the third quarter. I don't have the updated numbers yet. Of the $410 billion of invested capital, less than $1 billion was invested in the energy sector, 20 basis points. 130 basis points was invested in the materials industry, although I would argue that was

• 7:38Speaker 03

  misleading because they were largely specialty chemical businesses that are really not commodity exposed, really cyclical businesses. So our peers had less than 2% of their portfolio allocated to materials and energy. Sorbonne, on the other hand, today has 30% of its portfolio invested in energy and materials. And then we have this big wedge with an additional quarter of our portfolio on the industrial side. It struck me, and there's a lot of indicators of this, that the hedge fund community specifically, which is what you're asking about, Patrick, is really crowded around growth oriented sectors. It's an obvious point to have survived in the last decade. You needed to be levered to growth. You needed to be levered to tech.

• 8:20Speaker 03

  And that's where largely the dollars are flooding today in terms of when I think about our exposure versus our peers. So we have 55% of our portfolio in the industrial economy, including industrials as a subsector. Our peers have about 10% of their portfolio in the industrial economy.

• 8:36Patrick O'Shaughnessy?

  Maybe give us a bit, it might require a few of these history lessons around how we got to here because I remember early in my career when energy represented whatever it was 12, 13% of the S and P 500. Today it's a pittance, it's a tiny amount, maybe a bit higher than that 20 basis points you quoted in the hedge fund peer group, but it's incredibly low. All of the commodity stuff, oil and other commodities became a non-issue for a long period of time. No one talked about it. No one really wrote about it. Oil went negative at one point. What are the key history lesson timeline points that you think matter to understand why industrials as a broad group have become more interesting today? Is it globalization? Is it de-globalization? Like, what are the big ideas here that you think matter?

• 9:20Speaker 03

  Let me just frame. Energy and materials, which is the two biggest buckets in addition to industrials within the industrial economy. Energy and materials, when we launched our firm, were 17% weight in the S and P 500. Today, they're five. The energy sector weight is down 80% in the last decade, just as a framing comment. So what happened? Why has there been this massive derating? One obvious point, tech growth have massively outperformed. They've grown as a percentage of the index. And then the inverse, energy and materials have massively underperformed in a decade-long, particularly the last five-plus years, decade-long down cycle in commodities that was driven by excess capacity that built up in China

• 10:05Speaker 03

  in industries like steel and aluminum. It was, and we can talk more about it, partly driven by the shale boom in North America, which while an amazing thing for the United States, was massively deflationary for the energy patch. So you had a lot of capacity added in China 10-plus years ago. The metals and mining companies, the energy companies, were adding significant new capacity through CapEx in the first half of the last decade. And basically, we entered a period of relatively slow industrial production growth in the last decade. So all this supply was added. U.S. Shales, the best example of that. All this supply was added in a backdrop where demand was a lot softer in industrial

• 10:50Speaker 03

  production levered industries relative to the prior decade. And the intersection of lots of supply and a weak demand backdrop has meant commodity prices have been substantially depressed, particularly in the last five years. And I think maybe one way to frame it for you is, we launched our firm November 1st, 2010, at Soroban. On a cumulative basis, inception to date over almost 11 and a half years, the Goldman Sachs commodity index is flat in 11 and a half years. During that time period, the NASDAQ 100 index has compounded 20% a year. So we have this massive dichotomy that's built up where on one hand, tech levered industries, growth levered industries have been fabulous performers in the market and largely driven

• 11:34Speaker 03

  by earnings and revenue growth. And then on the other hand, the commodity world's been flattened like a pancake because of excess supply that built up and a relatively weak demand backdrop. And the intersection of those two has led to really depressed commodity prices today.

• 11:48Patrick O'Shaughnessy?

  I'm sure the answer varies by commodity, by different parts of the world, but I think we've become so used to the ability of supply to catch up to demand in the digital world instantly or extremely quickly, whereas in the physical world, there are cycles. There's undersupply, there's building of supply, there's a glut on the other side. Walk us through sort of what cycles look like in commodities. Like what drives them? How long does capex take to get outlaid to start pulling more commodities out of the ground? Give us a tutorial on how this world works because it's not this instant supply-demand matching like we've come to expect in digital economies.

• 12:23Speaker 03

  We're not going to reprogram the software. It's a lot more complicated than that. Let's use numbers to kind of frame. Global oil and gas capex in the middle part of the last decade was running a half a trillion dollars a year. Global metals and mining capex was running $140 billion a year. So these are big capital intensive businesses. Frankly, it's why investors don't like them. They're cyclical and they're capital intensive. But it depends upon the industry. All industries within commodities are not the same. But these tend to be pretty long lead time, long capital cycle commodities. Again, US shale would be an exception to that, but I'll use copper as an example. First of all, three of the largest 10 copper mines in the world today were discovered over 100 years ago.

• 13:07Speaker 03

  And we estimate that from start to completion, if you and I, Patrick, wanted to go build a copper mine in the Andes Mountains today, we estimate, based on the mines that were developed over the last 10 years, that that is a roughly 10 to 15 year investment cycle. Meaning, we're going to take this project to FID and it's going to take us a decade plus in order to bring supply online. So the punchline here is these tend to be relatively long lead time industries. Again, depends upon your sub-industry. It's tough to be too generic. What's different this cycle versus previous cycles is what I would call the relative inelasticity of supply growth.

• 13:51Speaker 03

  This is a key investment theme for us here at Sorbonne. There's a saying in commodity land that the cure to high prices is high prices. What that means is that in a traditional commodity cycle, when the price of the commodity goes up, you've created an economic incentive for producers to drill new wells, build new mines, bring new supply in. When that supply comes into the market, ultimately it creates an equilibrium and the price comes down. And what we're seeing this cycle is something that is very different. Where not only are the big markets we're investing behind, aluminum, copper, nickel, oil as examples,

• 14:34Speaker 03

  in deep structural undersupply today, meaning inventories are drawn. There's already shortages emerging of these commodities, but we're also seeing a lack of a supply response. And why is that? I think there's a few factors that are playing into the inelasticity of supply. One, the most important one is, I think, the decarbonization in ESG backdrop where Governments, politicians, key stakeholders, including shareholders and society at large, is uncomfortable with the notion, particularly in energy, that we're going to add new fossil fuel resources. So shareholders are saying, we don't want to invest in energy companies.

• 15:16Speaker 03

  We want to starve the supply base. That is having real implications. Banks not lending against E and P companies. And therefore, the energy sector is probably the best example of this inelasticity, is it's creating supply tightness, where normally, when the price moves up, everybody, the producers are ready to go spend money. This time around, because of the government interference, because of differing shareholder and societal pressures, we're not seeing the same supply response. So I think that's part of it. Part of it is the fear of carbon taxes. A lot of these industries, steel, aluminum, fertilizers, are large carbon emitters. We could be stepping into a world, and we can talk more about this, where carbon taxes is a critical driver of the profitability of producers. And right

• 16:01Speaker 03

  now, we don't know what the rules of the carbon tax and quota world are going to look like. On one hand, we have the US with no carbon taxes today, and then many industries in Europe are subject to carbon taxes today that are over a hundred dollars a ton in Europe. So producers are hesitant in these carbon intensive, big emitting industries to add new supply, because they don't know how the carbon intensity of their product is going to be taxed. So I think there's an element of it there. I think part of it is just economics. We lived in a major down cycle for the last decade. Use oil as a great example. Less than two years ago, WTI oil was at negative thirty seven dollars a barrel. Today, we're at ninety three. So there's been a hundred thirty dollar move

• 16:43Speaker 03

  in the oil price in less than two years. Now, let's pretend, Patrick, you and I are on the board of ExxonMobil or Chevron. We're debating, should we take the FID? Should we commission a project in the deep water, Nigeria, Angola, Guyana? Well, we're not going to get our capital back on that project for probably ten years. We're going to get no cash flow for five years. So what commodity price should we be budgeting? Should we budget negative thirty seven? We'd be budgeting 93. So part of it is returns on capital were depressed. The commodities themselves are incredibly volatile. And that's creating angst in the shareholder base, in the management teams and in the boards. As they're determining what rate of supply growth, how aggressively do they want to attack supply?

• 17:25Speaker 03

  So the net of all of this is we're in an environment right now where the global economy is booming. We're hopeful China's coming back after a really weak 2021. We have a very favorable demand backdrop. We think for certain commodities, that demand backdrop is going to get exceptionally good. Because of this decarbonization trend, think of the green commodities, the coppers and the nickels, the aluminums that are going to see demand spike. Because we're pushing decarbonization initiatives. But generally, it's a very favorable demand backdrop. And yet we're having major supply challenges here and our view at Sorbonne. Each commodity is different, but we don't think these supply challenges are going to be rectified in the near term. We think these are potentially decade plus supply challenges in front of us.

• 18:11Patrick O'Shaughnessy?

  There's kind of an unlimited amount of stuff to dig in on there, so I'll have to pick and choose carefully. But you mentioned decarbonization as obviously a massive theme here that sits alongside. What I would call natural demand. So I'll define natural demand as like the stuff we would want. If none of this had any negative externalities. If there was no consequence pumping smoke into the air. We would probably be consuming a lot more fossil fuels because we love consuming energy. So talk us through how you think about those two things. That natural demand concept sitting next to this massive societal level push towards decarbonization. You just give us a lesson there because I think that drives what we would use in an unconstrained world. But the constraints that you've mentioned that get put on supply that make this all very murky and uncertain.

• 18:55Speaker 03

  So to me, the simplest way to package and answer back to you. Is electric vehicles and demand for copper. It's the tip of the sword example here. And frankly, there's almost more exciting examples of this. There's examples where the decarbonization demand could be substantially greater. Nickel cobalt would be examples, but let's stay in copper. So last year, the world. Sold between four and five million pure electric vehicles. And in a normalized year, we underproduced real end demand for automobiles last year. We only produced seventy eight million cars in the world. We probably should have produced ninety. So in a normalized basis, electric vehicles had about five percent penetration in twenty twenty one.

• 19:39Speaker 03

  Now, most of the aggressive decarbonization forecasts have electric vehicle penetration reaching thirty plus percent by the end of this decade. And ultimately plateauing at a number that's sixty, seventy, eighty percent in the twenty forty type time period. So we're going to basically take electric vehicle penetration, the theoretical demand you're outlining. I say the unconstrained demand, and I would argue it's probably even higher than this. But unconstrained demand means we're going from five percent penetration to thirty by the end of the decade to say seventy by the end of twenty forty. Now, what does that mean for copper? To go from five million cars, four or five million cars per year to roughly thirty and then ultimately sixty.

• 20:20Speaker 03

  As just a general rule of thumb, based on our estimates, that demand for copper is going to grow just from electrification by about three million metric tons per decade. That's electric vehicle demand. And what that's driven by is the average electric vehicle consumes five to six times more copper than an ICE vehicle. And that's largely to do with the battery and the electrification within the car. So basically, we're going to have a situation, roll it out to twenty forty, that we estimate about five to six million tons annually of copper are going to go into the development of sixty, seventy million electric vehicles per year. Just to frame it, the global copper market today, I think, is about twenty four million tons.

• 21:04Speaker 03

  So you're talking about a demand spike per decade. That's probably somewhere in the low teens percent of current copper demand. Cumulatively over two decades, you're talking about a twenty, maybe twenty five percent spike in demand, just coming from electric vehicles. Now, we're doing a lot of other electrification, battery stations, the whole grid needs to be rewired. So the real true electrification demand for copper is more than just cars. But cars alone could be consuming a quarter of the world's copper. And then the flip side is, I mentioned this, three of the largest copper mines in the world were developed over 100 years ago. There's been only one of the 10 largest copper mines in the world. It's been developed this century since 2020.

• 21:48Speaker 03

  So you have this situation where supply in the near term is highly inelastic. We're taking a demand equation globally for copper that typically is like 2, maybe 3% a year. We're going to add probably a point, maybe two points on top of that due to decarbonization. So we're going to take a commodity that normally demand grew 2% a year. We're now going to ask demand to grow 3% to 4% a year because of electrification. And then we have a backdrop that we've been underinvesting in copper mines for the last 25 years. The resource base is getting more barren. The regions that we're going to develop new copper mines are largely Africa, Peru, and Chile, which have a lot of geopolitical unrest around them.

• 22:31Speaker 03

  Look at what's happening in Chile right now with their new leftist government. So we have a very, very challenging and largely inelastic supply base. And that's meeting a demand growth that's 2% a year in the base case. I'm not sure that the supply is there to even do that. And now we're going to spike demand because of electrification on top of that. One other data point, Patrick, just using nickel as an example. The numbers are probably 2 to 3x larger than they are in copper. The electrification demand, the spiking, the green spiking, if you will, is substantially larger in nickel than it is in copper.

• 23:04Patrick O'Shaughnessy?

  In this style of investing, do you have to almost verge into like material science research and understanding to know what the potential on streaming substitutes are for things like copper and nickel? Like, is that something that matters? Because you said the cure for high prices is high prices. If this gets out of hand enough, the incentive would start to exist to find an alternative solution or something. Is that something you think about? Like, or is that just too many steps removed from something that's pretty simple and approachable?

• 23:30Speaker 03

  I think you're giving us way too much credit, to be candid. It depends. In copper, I don't think we're finding a substitute for copper. Copper is the base of electrification in the world. Now nickel's a different story because the demand for nickel is coming largely from batteries. And what the ultimate composition of batteries in electric vehicles looks like, that's TBD. What we know is nickel's the best electricity conductor. In other words, the more nickel you have in your battery, the better the range is on your electric vehicle. So it should be the winner. But ultimately, if the price of nickel goes up enough, we might be substituting other commodities like lithium, like phosphate into batteries. So I don't want to lead you to believe we're the world's experts on battery composition.

• 24:15Speaker 03

  We're much more comfortable making the base bet around electrification. And I think copper is probably the best way to play that. But nickel is a really foundational electrical commodity as well, and is likely to be a big winner as part of this theme as well.

• 24:29Patrick O'Shaughnessy?

  Let's talk through the other components of this big trend of decarbonization. EVs is like a great visceral, easy to imagine example. What are the other big chunky ways that this starts to play out as things get closer and closer to the actual customer or consumer of products and services? Is it solar power generation? Is it like, what are the other big important categories to explore?

• 24:52Speaker 03

  The world has determined that the two big methods for decarbonizing are wind and solar generation and electric vehicles. Now, there's other paths we can go down, but I'd say the big two today, the big two tools for decarbonizing the world are really change out the power generation mix and lean heavier on wind and solar. And then let's ramp electric vehicle penetration from the current 5%. On the wind and solar side, what I think investors are misunderstanding, misinterpreting is the ramp capacity in wind and solar and the starting point.

• 25:30Speaker 03

  The stat we like to use around here is the world is consuming 40 times more fossil fuels than they are consuming wind and solar generation. So if I take all the fuel sources in the world and I throw them into a pie, 82% of that pie is fossil fuels today. That's coal, that's gas, and that's oil. Two percent of that pie is wind and solar. Now, the remainder is largely hydro and nuclear. We're not really adding capacity in a big way today. So this notion that we're gonna just all become greenies and start putting solar panels on our roofs and building offshore wind farms, that is going to happen, to be clear.

• 26:14Speaker 03

  And we estimate that wind and solar penetration, in order to hit the type of net zero targets that the IEA and the United Nations are talking about, wind and solar penetration needs to go from 2% today to roughly 25% over the next 30 years. So the penetration levels are gonna go up dramatically. But wind and solar generation are incredibly capital intensive. Putting solar panels on your house, it's like you're prepaying for power for 30 years and you're paying for all that day one and then you don't have a fuel cost. Your marginal costs are basically zero. But what that means is you gotta pay a lot of money upfront to build that generation. It's major capital intensive. Oh, and by the way, mineral intensive. There's a lot of aluminum, nickel, copper in those solar panels.

• 26:57Speaker 03

  So our point of view is, of course, the world is going to see wind and solar penetration rise dramatically from the levels we're at right now. But that's gonna be a really capital intensive exercise. It's gonna be highly inflationary because in a lot of cases, you're taking a coal plant that was productive. You're shutting it down and now you have to spend all this money building a wind plant or a solar plant in this place. So you're not adding to productive capacity of the world. You're just taking down your carbon intensity. So our view is, it's gonna happen. It's gonna take a lot longer. And that base of fossil fuel demand that we're underinvesting in today, that $500 billion a year of capex that recently has been about 300, there's a long tail there.

• 27:39Speaker 03

  We think the plateau for oil is much longer. Gas is gonna continue to grow. Even coal is still growing globally, despite all the decarbonization initiatives. So the world cannot switch on a dime from electric vehicles to ICE vehicles. We cannot go to all renewable power and shut down all our fossil fuel generation because the base of fossil fuels in the global energy mix today is 82%.

• 28:05Patrick O'Shaughnessy?

  How in the world have we not invested more in nuclear as a technology?

• 28:10Speaker 03

  Well, three mile point. I think it was 1979, but the United States got really scared and it froze the US nuclear industry. I think we've had one plant that's attempted to be built and I frankly, lost track of it over time, but Southern was building a plant either in South Carolina or Georgia. I don't even think the thing got built. They spent 10, 15, 20 billion dollars. We don't have nuclear engineers in the United States anymore. I think the odds that we're going to see a nuclear renaissance in the United States. I'm personally a seller of that thesis. I think that there's societal pressure against it. The capital costs are through the roof. It's not clear that we have the technology and the implementation capabilities that we can actually build this

• 28:53Speaker 03

  stuff. Now China, India, it's a different story in the rest of the world. Look at the challenges France is having right now in their nuclear industry. I mean, they are in some ways the world's leader in that vertical and they're really struggling to run their plants right now. It's part of the energy shortage that's occurring in Europe that I'm happy to talk about, but I don't see nuclear coming to the rescue here, at least during this decade. Maybe there's a bull case to be had 10 plus years out, but between now and then, we're going to need a lot of fossil fuels.

• 29:23Patrick O'Shaughnessy?

  If we could try now to start for this specific theme of decarbonization, map this back to investing decisions and equities specifically and the perspective for good returns. We've talked in my favorite way about what's going on in the world. Oftentimes markets are good at pricing stories, right? And market prices accurately reflect what the future might look like. Talk to me a little bit about how companies behind these commodities operate, how they trade, what are the systems of these companies themselves so that we can understand why an investment thesis in this area might make sense or might not?

• 29:56Speaker 03

  Can I take you off on a tangent and start with a plug for US railroads?

• 30:00Patrick O'Shaughnessy?

  Of course.

• 30:00Speaker 03

  And then I'm happy to come back to the commodity side, which is a little bit more exciting and more volatile. But the picks and shovel, the royalty company sitting on top of this resurgence of industrial production, the reshoring of manufacturing in the US, we're building all these semi plants. We have huge decarbonization initiatives. We're going to be building LNG plants, chemical plants, aluminum plants on the Gulf Coast. The picks and shovels way to get leverage to this from our perspective is the US railroads, which oligopoly in the east with CSX and NSC, out west with Burlington and UNP, and then up in Canada with CP and CNI. And the railroads are very industrial production levered businesses.

• 30:41Speaker 03

  US industrial production undergrew US GDP by 20 percentage points over the last decade. I think we're due for a catch up. Look at US housing as a good example of that. We're probably short 5 million homes in the United States. So think of the stuff that's going into a house, cement, steel, aluminum, all that stuff's riding on the railroad's tracks. So we think the railroads are going to see a real, almost volume dividend, a shipment dividend this decade. Their shipments, their carload growth is going to look very differently this decade than it did the last decade. There are also huge beneficiaries of decarbonization trends because a rail consumes a quarter of the fuel of a truck on a per ton mile basis. So if I'm Alcoa and I'm shipping aluminum out of the back end of my smelter,

• 31:23Speaker 03

  and I want to take down my scope three emissions, a good way to do that is less truck, more rail. So I think there's a broader decarbonization shipment benefit that's going to accrue to the rails as we start thinking and talking more about scope three emissions. But the best thing about the rails are they're oligopolies, they price their product up 3% to 4% every year, and the businesses generate tremendous free cash flow. So all that free cash flow comes back to shareholders in the form of dividends and buybacks. Just to kind of frame it, these are companies that historically were growing EBIT without volume growth. We're growing EBIT 8, 9, 10% a year, largely driven by pricing, operating leverage. And now we think not only is that algorithm in place,

• 32:08Speaker 03

  but they're going to get a volume dividend. So the EBIT growth could be faster. And then these are businesses at 5% free cash flow yields. So you get to pay dividends and buy your shares back 5% a year. Plus, you get to releverage all the growth. So you really get six points of capital return per year. We haven't built one in 150 years. They're the definition of a long dated infrastructure asset. They're priced at 5% free cash flow yields and they're about to go into almost like an industrial production super cycle, decarbonization super cycle that creates massive tailwinds for their businesses. So that's a big theme we have here at Sorbonne. We've been investing in these companies back to my prior firm for over 15 years and these are our sleep well at night, earn really good return type businesses.

• 32:54Patrick O'Shaughnessy?

  I'd love to understand a bit more about rail networks. I realize I know literally zero about what they look like, where they are literally, like what the capacity is and whether or not you think we'll be building new rail network systems in the next 20 years or pick your time. They just teach me a little bit about that. I know nothing about railroads.

• 33:13Speaker 03

  Well, let me say this. We're not building freight railroads, which is what we're talking about. Could we build a passenger railroad? Sure.

• 33:20Patrick O'Shaughnessy?

  And those are different tracks, different systems.

• 33:23Speaker 03

  Different systems. Our end markets here are aluminum, steel, lumber, paper and forest products, some degree of the UPS, Amazon stuff that's in containers. Coal used to be a big end market, used to be when I started covering the industry, a quarter of the industry's revenue was shipping coal. Today, that's high single digit percentage of revenue because we've shuttered so much coal fired generation capacity in the United States. So there's not a lot of coal leverage, but it's big, heavy industry is basically what's moving on railroad networks. This is John Rockefeller 101. We've got two in the east, two in the west, two up north. They're all legopolies. The networks today, the Canadian rails are largely at full capacity. So in order to grow, they need to spend money. They need

• 34:08Speaker 03

  to add capacity to their network, expand their plant, expand their tracks, expand their siding. What we like about the US railroads are they're actually shipping less product today than they were 15 years ago. Part of that's driven by coal. Part of that's driven by the fact their service product has been so bad. They've bled customers to trucks, but we look at CSX and UNP as having the most operating leverage. We think that their tracks are running 70 something percent capacity factor. So these are businesses, just to frame it, like our biggest business is Microsoft. It would probably surprise you when I tell you CSX and Union Pacific have higher EBIT margins than Microsoft, which we view as the best gold standard software business in the world.

• 34:51Speaker 03

  These are businesses that are running in kind of a down cycle right now at low to mid 40% EBIT margins. So their EBITDA less CapEx margins are over 40% today. We think as the networks get more loaded and they take more pricing, that the EBIT margins are headed to 50. And EBIT is a rough proxy for EBITDA less CapEx. So these are like world-class businesses. I mean, to have 40-plus percent, 50% EBIT margins, this is like the Microsoft, the Visa's, the Mastercards of the world, that so many of your listeners love these businesses and capitalize them at very high multiples, appropriately so. Railroads are trading at 18 to 20 times this year's earnings with this incredible margin

• 35:33Speaker 03

  structure, where their shipment volumes are actually down over the last 15 years, and I think they have a lot of upside leverage to the resurgence in US industrial production and the decarbonization initiatives we've talked about. And we're definitively not building more of them, given NIMBY issues. You really can't build anything in this country. These tracks were laid 150, 175 years ago.

• 35:56Patrick O'Shaughnessy?

  Can you explain NIMBY issues, just what that means specifically?

• 35:59Speaker 03

  Yeah, yeah, not in my backyard, meaning, given how developed the country is at this point, Union Pacific can't raise their hands and say, hey, we'd love to run a railroad track through downtown Houston. It doesn't work like that. So the tracks are the tracks. We're not laying new tracks here. And at my old firm, we used to talk about, what are the businesses we'd be comfortable buying a 100-year bond from? Because it's almost the definition of incumbency, barriers to entry, longevity. To me, the railroads are my number one. When I think about, what's a business I know 100 years from now, that business is going to be around, it's going to be cash flowing? Very hard to say that, very hard to look 100 years in the future. To me, railroads are the definition of like the 100-year asset.

• 36:42Speaker 03

  And by the way, they're one of the very few 100-year bond issuers in the United States market. They have 100-year bonds that yield 4% today.

• 36:49Patrick O'Shaughnessy?

  I really like that idea. And if you think about what markets are supposed to do when they price a security, it's assigned terminal value, discount cash flows into the future. With something that is so potentially stable, why are markets pricing them at the levels you just quoted relative to technology businesses, let's say, that have way more disruption risk than something like you just described? But what explains that gap?

• 37:12Speaker 03

  I would say that I think it's largely driven by the lack of volumetric shipment growth that they've exhibited over the last 20 years. So the margins went from 10 to 40, even with no shipment volume growth. And that's being driven by pricing and productivity. But the market's fixated with top line. And when you look back and you say, well, wait, they haven't grown. They're growing top line via price, but they haven't grown top line at all via volumes. So they look a little bit tobacco-esque in that sense. I think that's totally the wrong analogy, to be clear, because if you decompose the historical volume algorithm, what you're going to see is basically a lot of the lack of volume growth is driven by coal. And coal production in the United States, I don't know the exact

• 37:55Speaker 03

  numbers, down 70% in the last 15 years. We're at the tail end of coal. And frankly, the coal we're producing here is largely metallurgical coal, which is going into the steelmaking business or being exported. So that base is probably going to stay around. So the rails have fought through three things. One, coal. Two, US industrial production hasn't grown for a decade. That's their end market. So that's created a headwind for them. And then three, candidly, their service product has stunk. They've not been a good partner to their shipment customers. Because this was a country club business, and you were a monopoly oligopoly service provider, and you didn't need to provide good service. Because you knew your base load of volume, the only way that you were

• 38:38Speaker 03

  going to move the coal was via rail. You can't move it versus truck. It's so inefficient. I'm using coal as an example there. So a lot of these heavy industries are heavily reliant on rail. So the rail would show up when it wants to show up, and you'd never know when your product was being delivered. And they burned a lot of goodwill with customers over the last 20 years. And part of our thesis is that that was The last 20 years, the next 10 years are going to look very different because the management teams have changed out. The philosophy on how to run these railroads has changed. This is the Hunter Harrison phenomenon. I don't know if you're familiar with Hunter, but he brought in operating discipline to this industry. He was like the original, I'd say productivity enhancer in the railroad business.

• 39:20Speaker 03

  Unfortunately, he passed away a number of years ago, but he went in, he took control of Canadian National 20 something years ago when they were privatized and they had a 0% EBIT margin. Today, the business has a 40% EBIT margin and just putting in place principles on how you run your trains, how you interact with customers, how you enhance productivity of your network. And ultimately that accrues to the benefit of the customer because they're getting a better service product. So in order to be right on our thesis, these volumes are really going to start to structurally grow 3% or 4% a year. It's going to require the rails to actually care about their customers and interact with them in a more sensible way than they have historically. Show up when they tell you the train's coming at 10 a.m., show up at 10 a.m.

• 40:04Speaker 03

  Just to kind of conclude, we talked a lot about revenues and EBIT. I just want to mention capital return because I think our view of stock buybacks versus stock issuance is something that investors are not being thoughtful about. In the technology world, there's a lot of excluding stock-based compensation math that's going on. And sorry to bring the bad news, stock-based compensation is an expense. And value in companies ex stock-based compensation to me doesn't make a lot of sense. It's very 1999-esque. The inverse of that is the rails. You're basically buying back, paying dividends at a rate of 5% to 6% of your market cap, maybe 7% per year. So just think about this over a decade.

• 40:45Speaker 03

  Based on our numbers, we estimate CSX will capital return 90% of its current market cap. Directionally, it's a 70 something billion dollar market cap company. 90% of that is coming back to shareholders in the next 10 years via dividends and buybacks. For Union Pacific, the number's probably closer to 80. So think about how that is de-risking your investment here because every year it's almost like a coupon on a bond. You know, you're getting 5, 6, 7 points of capital return per year. And when you compound that out over a decade with growth, you basically are dramatically buying down your capital structure in these companies.

• 41:23Patrick O'Shaughnessy?

  Just to play the other side, just to make sure we're thorough here. If I was the world's biggest bear on these companies, does it mostly just come down to overall economic growth and being bearish on that? Because it seems like, obviously, these things would ride demand growth generally, GDP growth generally. Is that sort of the other side of this story potentially?

• 41:40Speaker 03

  Yeah, I think you would say, one, I'm bearish on industrial production. They're economically levered. Two, a high single-digit percent of revenues are coal. Most people think that's going to zero. I think that's wrong because of met coal and exports, but you'd say coal. And then you'd say, three, I hear you about the shipment growth, but they haven't done it historically. They've historically been poorly run businesses. And therefore, while the theoretical market opportunity is in front of them, the TAM is large. They're not going to be able to attack that TAM because their service product stinks.

• 42:11Patrick O'Shaughnessy?

  All right, so maybe we could shift now into oil, or you pick whichever commodities we want to focus on. And the ways in which those businesses differ from rails is a great useful comparison point.

• 42:20Speaker 03

  Let me start by saying they don't belong in the same sentence. They're different. They're more different than they are similar. Ultimately, they're both economically leveraged, commodities much more so than railroads. But ultimately, they're industrial economy, global economic growth, levered assets. We have to go commodity by commodity. I use the copper example where I think probably the barriers to entry, when I think about commodity markets, are probably highest in copper. It's the hardest to add supply because the mines are really old. It takes 10-plus years. You have all this resource nationalism at play. So we might want to talk about how electric vehicle manufacturers are going to, in my opinion, backward integrate to the mine.

• 43:04Speaker 03

  They're going to need to secure their nickel and copper. Elon Musk can't just wake up and say, I'm going to develop a copper mine, a nickel mine. These are really long lead time projects. Now, on the other hand, you would have US shale, which is the shortest supply response, where the time to drill and spud a well is some number of days to weeks to months. But you can get a pretty quick supply response. Now, US shale in the oil market is only a low teens percent of the global oil market. But that's an example of very short-cycle commodity that probably has a very low barrier to entry. You just need to own the resource base. And then you have stuff in the middle, like I would say aluminum, fertilizers. The markets are very tight and we're not seeing supply being added.

• 43:48Speaker 03

  But ultimately, with enough capital and a three, four-year timeline, new supply can be added into those markets. So on one hand, the coppers, nickels, some of the mined commodities, probably highest barriers to entry, US shale, US natural gas, lowest, and then some of the processed commodities like chemicals, like aluminum, like steel, are somewhere in between where lead times are probably anywhere between two and five years.

• 44:19Patrick O'Shaughnessy?

  If I wanted to compare businesses within commodity industry, how do you do that? Like, how much differentiation is there, both from a stock ownership, shareholder perspective, and also from a customer perspective, producer? Because I think about oil, it's this fungible thing, you're a price taker, like there's some lousy features. In the same way you highlight the great features of the railroads, there's some really lousy features structurally of an oil business. How do you think about Exxon versus Chevron, or the differing nature as you're building a portfolio of individual securities, not just buying like a sector ETF or something? What do you think about that?

• 44:52Speaker 03

  Each commodity is different, but you're correct. These are capital intensive, they're cyclical businesses, and you're price takers. It's not a railroad that you get three to four points of price. So you have to start with understanding the commodity market itself. If you're going to invest in steel equities, you have to have a point of view on the steel cycle and the consolidation that's happening in North America, or fertilizers, aluminum, copper, et cetera. The interesting thing today, this is an overly generic comment, is almost every market we're looking at is in deep structural undersupply, and we have this issue around inelasticity around supply. And then in some commodities, we're seeing spiking demand. It's a backdrop I've never witnessed during my career,

• 45:37Speaker 03

  where you have the starting point today, we could talk individuals, aluminum, copper, nickel, zinc, oil, fertilizers, deep structural undersupply.

• 45:51Speaker 03

  Real tightness in the underlying commodities, inventories drawing significantly to razor tight levels. So that's the starting point. And then let's talk supply and demand. Demand? Global economy is booming. It's booming with China largely having been on its back in 2021. Now, the US is going to slow. So I think there's going to be a bit of a handoff between the US and China. But overall, US nominal GDP is growing, I think grew 12% in 4Q. So we have a pretty strong backdrop of demand. Plus, we're going to get the decarbonization spike in the coppers and the nickels and aluminums. And then on the supply side, we have this inelasticity, the shareholder activism, the resource nationalism, that we're not seeing the supply response.

• 46:36Speaker 03

  So it's this incredible cocktail, again, that I've never seen of deep, deep, undersupplied markets today, lack of immediate supply growth and a demand picture that's actually quite favorable. Oh, and then we can talk about carbon taxes, which is going to throw this whole system in whack because carbon's in everything we consume. And certain end markets that are very carbon intensive, aluminum, cement, fertilizers, as an example. If the world moves to a carbon quota system, if the world becomes Europe, it's going to throw cost curves completely out of whack. And there's going to be certain producers, I'd highlight Alcoa in aluminum as an example of this, that are going to make windfall profits for a decade plus because of the new carbon tax regime.

• 47:21Speaker 03

  So it's an incredible cocktail in front of us right now.

• 47:25Patrick O'Shaughnessy?

  You mentioned Alcoa. It seems like a really interesting opportunity to dig in on one example of how all this stuff might affect a fairly simple and recognizable business. Most people have probably heard of Alcoa. I like the description you gave of Alcoa to me one time, which is that it's the physical manifestation or derivation of energy as a concept placed into a physical product. So walk us through Alcoa's business just at a high level and how these exogenous things like carbon taxes, like the carbon scene that you've just painted, might affect an individual business like this.

• 47:55Speaker 03

  That's great. So what do they do? They make aluminum. They make over 2 million tons of aluminum per year. They're roughly 3% supplier into the global market. Now, they were the biggest aluminum supplier in the world 20 years ago. So what happened in aluminum? I think it's an illustrative, a good illustrative market. The Chinese woke up 20 years ago. They said, we have all this cheap coal. Let's turn it into power. What do we do with the power? Well, let's make aluminum. Let's make fertilizers. These are really power-intensive, energy-intensive commodities, and let's export that all over the world. So what happened? 20 years ago, there is essentially no domestic aluminum industry. Today, they're almost 50% of the global aluminum supply. It's amazing. They destroyed the aluminum

• 48:35Speaker 03

  business. They're very cheap, but very dirty and carbon-intensive coal. They turned it into aluminum, and they exported it all over the world. And if you were a developed world producer, if you were Rio Tinto, they own Alcan, if you're Alcoa, they destroyed your business. And we've lived in a 15-year down cycle in the aluminum business. Now, what's different this time? Well, China's woken up, and they've said, wait a second. The world doesn't like us emitting all this carbon. We're destroying our environment. We're making no money making this aluminum. Maybe we should not continue to grow our domestic aluminum supply. And they've created a cap. The global market's 70 million tons of aluminum, and they've created a cap, I think it's at 45 million tons, and they've said, we're just not going to build smelters beyond that. We're

• 49:19Speaker 03

  ultimately going to reduce our reliance on aluminum smelting as a country. The problem is, there's no one taking the handoff, because Alcoa is not building new smelters, Rio Tinto is not building new smelters. And the backdrop, aluminum is one of the highest demand-growth commodities pre-decarbonization, and it's a major decarbonization winner. So we've got a demand backdrop that's going to grow 4% or 5% a year. The Chinese were more than supplying all of that for the last 15 years, and now they've said, well, we're capping out supply. So what's going to happen? In our opinion, you're already seeing the inventory draws. What's going to happen is, the world's going to be short aluminum. So let me give you the Alcoa examples here. Let's put aside carbon taxes. We'll come back to that. Aluminum's

• 49:58Speaker 03

  at $3,200 per ton today. At $3,200 aluminum, Alcoa is generating low-teens EPS per share. No capital allocation. The business has zero debt at the end of the year. So just looking at the EBIT dropping its net income, they're doing 12 bucks, 13 bucks of earnings and free cash flow per share. The stock's at $70. The business is being valued at 6x free cash flow. So that's like a 17% unlevered free cash flow yield at $3,200 aluminum. But two things. Number one, I think prices are going up. So I'll give you the Goldman Sachs. The best commodity forecasters, nobody can do it well. None of us know exactly where commodity prices are going to land. The best commodity forecasters out there are Jeff Currie's group at Goldman Sachs.

• 50:43Speaker 03

  They're carrying 3850 aluminum price forecast for 2022 and ultimately rising to a $5,000 aluminum price. I think it's in 2024. At $5,000 aluminum, Alcoa is doing $27 per share of free cash flow. And by the way, that's before capital allocation. The share count's coming down dramatically because they're sweeping cash now. So you have a business that's being valued at $72 per share that ultimately is probably going to generate somewhere between $10 and $30 a share of earnings and free cash flow in the next few years. You don't need a lot of $20 per share of free cash flow to eat very quickly into what's a $73 stock that has no leverage. In three or four

• 51:26Speaker 03

  years, this company has no market cap if they're paying dividends and buying back stock at the rate that we anticipate. And then on top of that, we have a point of view. It's not happening tomorrow. It might be a 10-plus-year journey, but ultimately, the world's going to move to a carbon quota, a carbon tax system. We're not going to let the Chinese dump dirty steel, dirty aluminum, dirty fertilizers, nitrogen, phosphate in the United States and not tax it for the carbon intensity. If you think about it, the average smelter in China today is emitting 17 metric tons, 16 to 17 metric tons of carbon per ton of aluminum produced. Alcoa's corporate average is 4.3.

• 52:06Speaker 03

  So take 16 minus 4. Alcoa is emitting 12 metric tons less carbon per ton of aluminum produced. So if we taxed carbon at $100 per ton, we're already taxing it higher in Europe. That basically means that the marginal producer is getting priced up by the 12 tons. That's $1,200 lower on the carbon cost curve that Alcoa is versus the Chinese. The Chinese are half the world's aluminum. They are the marginal producer. $1,200 per ton. Of P and L for Alcoa is almost doubling what their P and L was in 2021. Said differently, to make it a per share metric, $100 carbon tax is $8 per share of added earnings

• 52:49Speaker 03

  power at Alcoa. So if I just take, this is the mega bull case. If I just take the Goldman Sachs $5,000 price forecast, that's $27 a share free cash flow. I add an $8 per share from a carbon tax. This is ridiculous to even say, but there's nodes Alcoa is going to earn over 20, maybe over $30 per share before the share count comes down. So all the per share math is going to get better over time as well. So we look at that as a great thematic beneficiary, structural supply, under supply, demands growing strongly driven by decarbonization, and then the cherry on top is the optionality around carbon taxes.

• 53:27Patrick O'Shaughnessy?

  I'd love to hear your take. It's such a fascinating thing to think through on the nature of uncertainty in the world of commodities. I remember reading Twilight in the Desert and being obsessed with oil, all things oil for a long time and reading about peak demand and peak supply and all these things. And it just seems you just literally said it, almost nobody can forecast any of this stuff. Weird technology changes, shale comes online, geopolitical things heat up. There's just all this complex stuff that happens that affects these things. How do you think about that? Is it just something that requires a bigger margin of safety and a lower entry price? Like, what is the portfolio manifestation of the fact that this stuff has been basically impossible to forecast historically?

• 54:09Speaker 03

  I think you nailed it. First of all, we're playing a directional game. Is aluminum going to 5,000? Is it going to four? Is it going at 35? We don't know. There's false precision there. So you're playing a directional game. What do supply and demand balances look like? Directionally, where do you see prices going? But you're absolutely right. You just need a larger margin of safety. We're not making the argument that a commodity producer is Microsoft or Union Pacific. They're not. But I would make the argument, if I own Alcoa here, put aside the upside optionality in prices. If I own the stock for the next five to six years, 100% of my market gap, 100% of my enterprise value is coming back to me in terms of dividends and buybacks, I'm dramatically de-risking the investment. And then we have a point of view that prices are actually going higher.

• 54:54Speaker 03

  So that's a long-winded way of saying it's a directional game. It's about getting your entry point right in the equities and make sure that they're embedding a low price forecast that you think there's a lot of asymmetry. What I happen to like right now is, one, all the producers largely, I'm exaggerating a bit, but all the producers are running with virtually zero leverage on the balance sheet. So what really kills you in a commodity business is when the cycle goes against you and you're really levered. No one's levered because we just lived through a 10-year down cycle. The windfall profits we're realizing today have gone to healing the balance sheets. So there's really no knockout risk, A. B, we got this dramatic enterprise value buy down that's happening via this free cash flow generation.

• 55:36Speaker 03

  The windfall profits that we think are here to stay are basically coming back to you. Their dividends, their buybacks, or their deleveraging. And the other point I would just make about volatility is I think volatility is our friend in these markets from this point forward. Historically, it's our foe because it could knock us out because you're running with a lot of leverage. If the cycle goes against you, you got real problems. And I think it's our friend right now that, use my old example, are negative 37 to positive 93. It's helping create this inelastic supply. The volatility is scaring capital off. It means that investors don't want these companies investing in long lead time projects.

• 56:17Speaker 03

  Look at fossil fuels, the largest private equity firms in the world, even in their energy funds, are not allowed to allocate money to fossil fuels. So the volatility is scarring the investor base, scarring the capital provider and adding to this uncertainty around supply growth, this inelasticity of supply that we've been talking about.

• 56:39Patrick O'Shaughnessy?

  When you study all of this, you don't have to go far before you start digging into geopolitical entanglements and fascinating brinksmanship. You know, we're living through it right now with Russia and the Ukraine. We've seen lots of examples of Western Europe being very reliant on other geographies for their energy supply and production. You've studied this a lot more than anyone I've talked to. What is your view of the world right now? What are the big things maybe that we haven't talked about yet that are interesting to you, that matter to you, not just as an investor, but just as an observer of everything that's going on?

• 57:12Speaker 03

  Right, so framing comment, it's a really risky geopolitical world. Own commodities, it's your friend, it'll squeeze supply. Just a simple example that we've been talking about in the last week. The potash industry, very, very specialized industry, 70 million metric tons globally. Two of the biggest producers of the world are Belarus and Russia. If the Russians invade Ukraine and the Western world is sanctioning these facilities. Ultimately, like, the world's gonna be massively short potash. And then you can own a developed world producer like a mosaic or a nutrient that's gonna benefit from that. But I'd say overall, across the energy, the food supply chain, even in industries like aluminum.

• 57:52Speaker 03

  The geopolitical risk ironically is probably your friend as a developed world producer today. Part two, I would just say, to me, the canary in the coal mine, this is around heavy industry. It's kind of the energy and mining complex is Europe. The lesson that we just learned this winter, that the Europeans push very high renewable penetration. In fact, they're at the 20-plus percent renewable penetration that we talked about the world getting to in 30 years. They're there today, and what did they do? They're trying to shut their domestic gas industry. They shut nuclear reactors down, look at what the Germans are doing. They shuttered coal-fired generation capacity, they leaned very hard on renewables. And then what happened?

• 58:37Speaker 03

  The wind didn't blow. They didn't get the generation from the renewables, and they're shutting down their nukes right now. So, at the end of the day, they've had to increase their imports from Russia. Putin's not giving them the gas, and we've seen prices skyrocket, really spiral out of control. We, in December, had over $50 per MMBTU natural gas prices in Europe, when in the US, the corresponding price was four. So think about the competitive disadvantage heavy industries have in Europe. And then this has the knock-on effect of what are the big industries that consume a lot of power? It's aluminum smelters, it's nitrogen plants, it's zinc smelters.

• 59:19Speaker 03

  So we've seen those mine commodities, chemical industries have to shut down because they don't have enough power in Europe. And that's kind of created a cycle in the mine commodities, in chemicals, this is all circular. So my big takeaway is Europe was the canary in the coal mine. They were the grand experiment around renewables. They were the, by far, the deepest into the renewables penetration curve. And literally, the wind didn't blow and it all came unraveling. So to me, if I was a policymaker, I would be trying to learn lessons from Europe. And I think the key lesson is that the amount of time and effort and capital it takes to wean yourself off fossil fuels is just a lot greater than probably the world anticipates. We're not going

• 1:00:00Speaker 03

  to flick a light switch here and be able to wean ourselves off of gas, coal, and oil. It's a much longer and more capital-intensive process than I think folks realize. And let me just give you one stat behind that. There's been a number of studies, B of A, Goldman, McKinsey just came out with one, that estimate that the trend to net zero, the decarbonization initiatives are a roughly 100 to 150 trillion dollar capital need for the world over the next 30 years. We're talking about three, four, five trillion dollars per year. I think that shows you, one, it takes a lot of money, it's inflationary, but two, it takes a lot

• 1:00:43Speaker 03

  of time as well. And it's just not clear to me that the world has the natural resource base, ironically, the aluminum, the copper, the nickels of the world, to actually do the pivot at the speed and intensity that the IEA and the United Nations are talking about.

• 1:00:58Patrick O'Shaughnessy?

  How do you think about inflation as an investor in this space? I'll keep the question very simple there.

• 1:01:04Speaker 03

  To me, I look at our commodity exposure almost as an inflationary hedge across our portfolio. Most of the businesses, to be clear, that we're investing in, I think have a lot of pricing power, and their nominal profit dollars are going to go up in a higher inflationary world. So I'm not overly concerned about the impact inflation has, at least in earnings power. The multiples may come down, but commodities are one of the few sectors that are positively correlated to rising inflation. Higher inflation is a good thing for their businesses. And that's part of the reason why their businesses didn't do so well over the last 10-plus years. But inflation is our friend here. The best example I give is You're a steel producer, you would think, oh no, scrap prices are going up, iron ore prices are going up, met coal prices, these are the input into your process.

• 1:01:49Speaker 03

  If the prices of those inputs are going up, that's a bad thing for me. It turns out that steel prices are highly correlated. The spreads, the margins these companies generate is highly correlated to steel pricing and input cost. So the more iron ore goes up, more money a US steel ultimately is going to make over time, clearly in oil. Yeah, there's going to be some cost inflation, but ultimately you're pulling for higher inflation, you're pulling for higher prices over time.

• 1:02:15Patrick O'Shaughnessy?

  So much of what we talked about is economic linkage between these securities and what happens in real growth around the world. Maybe, again, with your unique set of perspectives and insight in the companies that you're positioned in. Walk me through a spectrum from utopian to dystopian, so go to two extremes. And describe what a utopian version of growth looks like for the world, and then maybe we'll start with dystopian, so we can end on a higher note. What is the dystopian version? And then we'll talk about utopian.

• 1:02:41Speaker 03

  Ultimately, these commodities are levered to industrial production. And I would just double click on that and say, certain commodities, aluminum steel are the best example of this. Are particularly levered to Chinese industrial production. The property market, the infrastructure market. The scale of the infrastructure build out in China over the last 20 years is mind boggling. China's consuming almost 10 times the amount of steel the United States is consuming today. Our GDP is bigger than China. So at the end of the day, there's a big industrial production bet. And there's a particularly big bet that the Chinese industrial production, the property market, the infrastructure market are going to hold in there.

• 1:03:23Speaker 03

  So what is, last year looked like a good year in terms of global demand growth ex China, China was on its back. I'm sure you've read a lot about the property market there. One of the things that makes us excited about this year is we think we're going to have like a US to China handoff. The US is going to slow, China's going to accelerate. But particularly in commodities like aluminum steel, there's a huge China overlay bet. When we talk about global industrial production, we have to be like global industrial production plus China. Because China is just such a big part of the mix. Now, it's something like oil. China's consuming a teens, low teens percent of global oil demand. So they have less of an impact there. That's the 50% in steel is the 10 to 15% in oil. So it depends on the commodity.

• 1:04:07Speaker 03

  But at the end of the day, higher growth, higher inflation, those are things you're rooting for as a commodity investor.

• 1:04:13Patrick O'Shaughnessy?

  We might just say, whatever promotes, generally speaking, industrial production in those key two couple of areas is good. Anything that massively impairs it is bad. We don't know what those things are going to be. We can't forecast it, but that's sort of the driver.

• 1:04:28Speaker 03

  Agree. And my one added cherry on top is decarbonization. Because decarbonization isn't adding, in a lot of cases, productivity capacity. But we're literally shutting down the old, replacing it with the new and not adding productivity. That's a phenomenon we've never seen before. Normally, when you have a productive asset, you don't shut it down and build a new one. Because of the decarbonization trends, we are doing that. And that's creating what we expect to be a multi-decade decarbonization kicker to global industrial production.

• 1:05:00Patrick O'Shaughnessy?

  Just because it is a 30-year portfolio and it's so different. Juxtapose for us the positions you do have in big tech against this industrial story. Sorry for like the 180 switcheroo, but like I'm sort of fascinated by, we talked about, I'll call it two thirds of the portfolio or so in great detail. Everyone knows the four names you've mentioned that represent big tech that you already referenced earlier in the conversation. Switch mental models for me and bring us through the logic that the same investing team in mind leads to this conclusion that's own big tech alongside this other stuff.

• 1:05:32Speaker 03

  We own Microsoft, Amazon, Alphabet. To me, the Microsoft and Alphabet piece is actually pretty simple. Which is we, whether it's Google search or whether it's almost every part of Microsoft, like these incredible incumbency, massive barrier to entry, high margin, high growth businesses. We're paying some version of a market multiple for it. It's a head scratcher to me. It's kind of the gift that keeps giving. In some ways, we wish the stocks massively rerated. But the fact that they haven't means we just stay here and we're allowed to get the 20% rolls every year. We look at an alphabet and you make just very small adjustments. The 150 billion of cash they have, maybe some adjustments on their other bet losses like Waymo,

• 1:06:17Speaker 03

  maybe some adjustments on GCP. Like you're buying the core of their search and YouTube business for maybe slightly above a mid teens multiple, 16, 17 times earnings, 23. This is like, if it's not the best business in the world, it's got to be in the top five. So to me, it's almost easy. Why would we not be there? Why would we not have a big position? The world loves software, but on our numbers, Cal 23, Microsoft's trading at 22 times earnings. It's the best software business in the world. To us, that has to be a big part of what we're doing. Those two positions combined are over 20% of our capital base today, 20 to 25%. I think Amazon's more complicated in some ways, but it's probably got more right tail gearing. In the sense, our view is AWS is downside bounding us.

• 1:07:02Speaker 03

  We run 10 year DCF models on AWS. We think that business is worth some version of a trillion and a half dollars. And Amazon's market cap is slightly above that today. Enterprise value slightly above that. And then we got to pick through the retail business. And what I say to our investors, and they look at me like I have four eyes is the single most misunderstood business in our portfolio today is Amazon retail. And I would just frame it this way. The street consensus is underwriting businesses doing 600 plus billion dollars a GMV. And if you look at the EBIT that the street and investors are largely anticipating, it implies that this is like a 1% EBIT to GMV margin business. That's like what's embedded in consensus forecast.

• 1:07:46Speaker 03

  And we just think there's massive high margin revenue streams here at the ads business, the subscription business, that ultimately we think that Amazon retail, they're massively, massively investing. You've probably seen the stats on the square footage growth, all the logistics capacity. They have more logistics capacity today than UPS and FedEx have. The scale of what they're doing is absolutely incredible, but it's really burdening the P and L. And we kind of look out a few years and we say, where do we think margins are going to be on this business? And our personal view is we're heading into the mid singles. And ultimately, this is a business that should have the capacity to generate at scale 10%

• 1:08:26Speaker 03

  EBIT margins. It's at 1% today. And we just think that the runway of growth around the retail business and the ultimate profitability is dramatically greater than probably the average investor. And if you believe that and you start looking at the look through profitability of the business at higher margin structures, Amazon's a very inexpensive stock on our numbers. The stock's at mid twenties times Cal 23 earnings, and we're underwriting about a 4% EBIT margin. We don't think that's the ultimate landing point. So we think there's a lot of look through profitability on the retail business that's going to be unleashed in coming years. And the dominance this company has in retail, we think they're going to destroy the Walmarts, the Targets

• 1:09:07Speaker 03

  of the world, the logistics capacity, the infrastructure they built. We love the mode around the business, and we think it's going to be one of the great five to 10 year compounders in our portfolio.

• 1:09:17Patrick O'Shaughnessy?

  When we started this, we'd said before hitting record, it'd be fun to make this conversation basically zeroed out on frameworks and philosophy and all in on detail and nuance and even individual companies. This has been so much fun to structure the conversation just this way. I've learned a ton. And I think the theme itself of industrials, industrial production commodities has been one that is fascinating, but just largely ignored by investment dollars, by commentary as positions in portfolios. So this has been a totally different and really fun episode. I always ask everybody the same traditional closing question. What is the kindest thing that anyone's ever done for you?

• 1:09:53Speaker 03

  Before I answer, let me just thank you again, Patrick. Really enjoyed the conversation. Specific to your question, the guy that gave me the shot in this business. So we didn't get into this, but I grew up in South Florida. I went to the University of Florida and never thought I'd get a shot on Wall Street. I sent out 400 resumes in the fall of 1997, hoping somebody would call me back. I got two callbacks. Both were from Goldman Sachs on the investment banking side and the equity research side. And I ended up interviewing with the lead Gas analyst and MD at Goldman Sachs, David Fleischer, and he took a liking to me. He mentored me. He hired me. Most importantly, I believe I was the first analyst hired in my class, the 1998 analyst class. And it was really David saw something in me. He gave me a shot.

• 1:10:38Speaker 03

  I didn't think I'd have the opportunity to be at Goldman coming from the public school background, but David really leaned in. He took a liking to me. He mentored me. And I'm forever grateful for that. Unfortunately, he passed away about two years ago, but David was just a huge inspiration to me and he gave me my shot and all I can do is say thank you.

• 1:10:59Patrick O'Shaughnessy?

  What did he do well that could serve as almost advice for others that want to do that same function for people entering this world today? Like, what are the good parts of that feel like to be mentored, have someone take you under their wing like that?

• 1:11:13Speaker 03

  It was a painful exercise. I'll be candid. David was tough. He was tough, but fair. He was always very transparent with me, very candid with me. And I remember he used to have a sofa in his office. I'd get the phone call like, come see me. And I was like, I got a problem here. And he would basically sit down next to me. And frankly, I'm not a good writer. And that was something I struggled with. And he would just sit down and he would literally edit line by line with me and explain to me the logic, the thought process on why he didn't like the way I was writing. And he was persistent with it. So I think the combination of a true rooted desire to make me better. He invested his time, his effort, his mentorship in me. And he was very

• 1:11:58Speaker 03

  consistent and persistent in doing that. I'm still not a good writer, but I think he kind of got me over the hump and allowed me to excel in areas, thankfully, outside of writing that I was probably stronger with.

• 1:12:10Patrick O'Shaughnessy?

  Love that. What a cool place to close. I hope everyone listening can do this for somebody else out there. It's the single most consistent answer we get is someone that took a chance early on, played that mentorship role early on when they didn't need to, is pretty powerful. So really great closing advice. Eric, thanks so much for your time.

• 1:12:27Speaker 03

  Thank you, Patrick.

• 1:12:31Patrick O'Shaughnessy?

  Next, you'll hear my conversation with Steve White from SW Investments. We cover how Steve incorporates Tegus and BAMSEC from sourcing to monitoring his portfolio. Maybe you could talk us through the specifics of how you use Tegus and BAMSEC, which are now under one umbrella, one company, but very different tools. What are the ways that you use those things actively in the process?

• 1:12:50Speaker 04

  I use these tools every day. So I first came across BAMSEC through, I think somebody mentioned it on Value Investors Club on a message board. And I went and checked it out, got a free trial. And I think within the first five or 10 minutes of using it, it was like the biggest no brainer to me. I think it was something like $30 a month. And I was like, you gotta be kidding me. This is the easiest 30 bucks I'll ever spend. And I absolutely love it. You know, everybody in our business has Edgar bookmarked and that browser window open. Basically, it's like the first browser window you go to in the morning. And Edgar's fine and all, we've all been there. We all used it for many years, but I just love anything that takes sort of a clunky or cumbersome or not perfect process and just makes it easy.

• 1:13:35Speaker 04

  And that's what I immediately discovered with BAMSEC, where they just had this great interface and this great organization around this publicly available information that we all see every single day. And then they were able to add some higher value services on top of it, like quarterly call transcripts and some other things like insider buying and these other things. So what I found is that it had replaced Edgar for me. It was open, it was one of the first browser windows I opened in the morning. It was one of the last browser windows I closed when I shut down my computer at night. And I just sort of love that it could make it easy. Anything that made my life easy, I'm happy to plunk that money, especially because as you know, like with the one man band, I'm a little bit time constrained. I'm conscious of how I spend my time and where I spend it.

• 1:14:20Speaker 04

  And I don't want to be spending my time. Copying and pasting a million things from an SEC filing into some sort of separate note taking tool like Word or Excel or OneNote or whatever it happens to be. So I've been a huge fan of BAMSEC for a long time. In fact, I was always happy to give them feedback on product improvements. And I was involved with them when they were rolling out some beta features and I've loved it all. All they've done is made that site much more robust as they've added more features, including things like global search functions, which I find myself using all the time. So I was really impressed with the product and the thought that they put behind it and how they were rolling out new features. It's been a part of my daily process since I've used it.

• 1:15:05Patrick O'Shaughnessy?

  How about Tegus itself? I mean, obviously I like the Edgar first have open, last have closed concept. It's sort of the primary material. And now this is a BAMSEC, a tool on top that lets you parse through it much faster and easier. Tegus itself is something much different, but adjacent, obviously really important. How does that get used in the process relative to BAMSEC? Let's say.

• 1:15:25Speaker 04

  Yeah, it's funny. A friend of mine had told me about Tegus a few years ago and he strongly recommended it. And I didn't quite understand the concept of what he was talking about until I went to the site and spoke to somebody who got a free trial. And I instantly understood what it was that they were doing and I thought it was brilliant. And one of the reasons why I think I kind of quickly picked up on the value add was because the things that Tegus does, I used to do all myself. So I used to do, in the hunt for fundamental research in Scuttlebutt, I would be on LinkedIn, searching for former employees of companies or searching for employees and competitors that might have something interesting to say. I'd be going to their company websites

• 1:16:08Speaker 04

  and I would look at things like white papers that they would publish and you'd find the author or people that were quoted in it because you would assume, oh gee, well, they probably might be a little bit more willing to share some insights as to this company. And so it was actually funny. I was living in Chicago. Tegus is a Chicago company. I had been reaching out to them just casually and they invited me to come over to the office and I was sitting down with some of the team and the founders and I was sort of laughing about them. I was like, you know, I know exactly what you guys are doing, only you guys are having a thousand times more success with it than I ever had because I found myself increasingly running into non-responses. Reaching out to somebody with a cold, direct message

• 1:16:48Speaker 04

  on LinkedIn has gotten, had gotten worse and worse over the years. And so Tegus had really kind of cracked the code as acting as a credible middleman between the buy side and some of these experts. And so they took, almost like BAMSEC, they took a process that was very clunky and they made it almost seamless. In Tegus's case, they were taking a process that had become almost impossible for me, and they had made it very easy. So, once I realized what they were doing, it just became a no-brainer for me, and it became ingrained in part of my daily process. I get their morning emails where they say what all the new transcripts are.

• 1:17:30Speaker 04

  I like doing that. I've actually started using Tegus as sometimes a screening tool, actually a starting point for the research process, because I get very interested, for example, in companies where if I see it's a new transcript, and it might be the only transcript that's ever been done on a particular company, rather than the 50th transcript that you see coming in and, you know, you go, "Well, I don't know if this is going to be that helpful." When I see a new one, I start thinking, "Oh, this is interesting. Maybe there's some hidden gem company that somebody else is doing some work on," and I get to piggyback on that a little bit.

• 1:18:04Patrick O'Shaughnessy?

  If you enjoyed this episode, check out joincolossus.com. There you'll find every episode of this podcast, complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.