We mentioned in our last investor letter that volatility on the scale of the first quarter is destructive not only to investors’ accounts, but to the very important role of public markets in capitalism. Volatility in the first quarter increased dramatically over the fourth quarter of 2017—intraday swings of 1,000 points in the Dow remind investors of the gut-wrenching days of 2000 and 2008, and with good reason. Branzan’s portfolios are structured with the intention of reducing volatility.
Overvaluation of Traditional Financial Assets:
The correlation between publicly-traded securities and commodities such as oil and gold is negative, and we are at one of those unusual points in time when the prices of financial assets, primarily publicly-traded equities and debt, are extremely overvalued relative to the prices of real, non-financial assets. At the risk of over-exposure of this chart, here is the situation in graphic form. It does a good job of making our point.
While Branzan has always preferred real assets to financial assets, at times like this the preference is compelling.
Investor angst is driving more money into safer investments. We believe that will continue. Returns on cash are negligible—negative, in fact—after inflation and taxes. Current returns on select real assets are still attractive. For Branzan, those select real assets include real estate, precious metals and mineral interests.
We are still finding attractive commercial real estate investments, but the risk of higher interest rates and overvaluation in some markets has tempered our enthusiasm. For those investments we are considering, we are focused on locations that have high barriers to entry and have moderate, long-term leverage which reduces the interest rate risk. We also prefer real estate investments that produce current cash flow which provides a buffer on the downside. We have always avoided investments in single-family residences—management is an expensive and unrewarding chore and the extreme leverage (nothing down, no-doc loans) makes the single-family residence market too risky for us.
Our precious metals are less of an investment and more of an insurance policy. Over the long haul, gold has performed well in that role. The U.S. dollar has lost about 97% of its purchasing power in the last 105 years after the Federal Reserve was given the task of preserving the dollar. We would be much better off had we not abandoned the gold standard in 1971. All evidence is that the gold standard constrained government spending.
If, like most, you are skeptical of the value of gold as insurance, spend some time at the Priced in Gold website. In terms of the U.S. dollar, a barrel of crude oil is about 30 times more expensive than it was in 1950; in gold terms, it is around 30% less expensive. Gold, of course, doesn’t produce any income and current income is necessary to pay for current expenses and a current return tends to cushion the downside of investments.
Mineral Interests and Oil and Gas Royalties:
For current income, we believe minerals, particularly those that produce crude oil, are the best option. We set out our argument for crude oil prices in our last investor letter. It bears repeating in an abbreviated form.
Based on reading and our personal experience, we believe the current supply of shale oil in the U.S. may be only temporary. Horizontal wells decline precipitously in the first year or two. This means a continuous stream of new horizontal wells is required to maintain current production. The sweet spots in the Bakken and Eagle Ford have been drilled up, leaving only the Permian to take up the slack. A number of the shale wells completed in 2017, particularly in the Bakken, were drilled in earlier years and left uncompleted, waiting for higher prices. That increase in supply will not be repeated. We conclude that shale production in the U.S. will not be sustained as long as most believe.
Having said that, many of the minerals in the Branzan Energy Income Fund are in areas of horizontal shale oil production. We manage the risk of higher depletion by concentrating our investments where minerals are less expensive to purchase—for example, the Denver-Julesburg Basin instead of the Permian, refusing to overpay for acquisitions and selling when we believe the market is overheated.
The urbanization of India will follow the paths of China and South Korea. More highways will be built (India has about 1,100 miles of paved highways today), mopeds and small automobiles will replace vehicles powered by humans and animals, and more Indians will move from the country to the city (city dwellers use more energy than rural ones). So far, India’s top-heavy, bureaucratic democracy has moved slower than China’s command economy to encourage modernization. We believe that is changing.
With this in mind, we are putting the finishing touches on the Branzan Energy Income Fund II to invest in minerals–primarily in Texas, Oklahoma, Colorado, Wyoming and North Dakota. As in our first energy fund, we will own and lease minerals in place and will not drill or operate wells, thereby avoiding liability and overhead associated with drilling and leasing.
One point that bears repeating: Branzan employees and their families are the largest investors in all of our Funds, and we will make a material investment in the new energy fund. Every investment decision affects us personally and proportionately with our investors. That distinguishes us from most, or perhaps all, of your other investments. We think that’s meaningful.
Very truly yours,
Branzan Investment Advisors, Inc.
THIS LETTER CONTAINS FORWARD-LOOKING STATEMENTS WHICH MAY OR MAY NOT PROVE TO BE TRUE. PAST PERFORMANCE IS NO ASSURANCE OF FUTURE RESULTS.