The Economics of Different

I grew up in a small town outside of Louisville, Kentucky. I’m not even sure I’d call it a town – more like a zip code. We lived in a subdivision with 5-10 acre lots and gravel roads. Growing up on a gravel road had its challenges. Have you ever fallen off your bike on a gravel road? Ouch! Walking or running on gravel isn’t particularly pleasing either, with rocks consistently finding their way into your shoes. Dust was an issue too, along with bumps and potholes. But there were some benefits.

While waiting for the school bus, the kids on our street played a game that consisted of throwing rocks at a street sign. It was a simple and fun game. How many times could you hit the sign before the bus arrived? The street sign was long, but very narrow – it was a tough shot. Hitting the sign before getting on the bus was always a nice start to the day.

I thought of my old bus stop this morning after driving past a group of kids waiting for their school bus. Instead of playing games and throwing rocks, they were all staring down at their smartphones. No one was moving or saying a word – they were frozen. What were they so focused on? Were they texting each other? Were they reading my blog? I wasn’t sure, but it really made me appreciate my childhood and growing up on that old gravel road.

Whether throwing rocks at signs or gazing into smartphones, kids tend to do what other kids are doing. Little changes as we get older. In past posts, I’ve frequently discussed how career risk and groupthink influences investor behavior. The investment management industry is not alone in its tendency to conform. Look at every industry and you’ll often find companies mimicking and following each other. Whether it relates to management compensation, acquisitions, buybacks, leverage, and general corporate strategy, most companies herd together and think and look alike.

The energy industry is a good example. I’ve been following energy companies closely since 1996. One thing I’ve learned is if I know what one energy company is doing, I’m fairly confident in what the entire industry is doing. For instance, during 2006-2008 natural gas prices were elevated and the shale revolution was picking up steam. The industry was enthusiastically buying and drilling natural gas properties. Although two consecutive cold winters delayed the inevitable, eventually natural gas supply spiked and prices fell. Suddenly spending heavily on natural gas properties no longer looked nearly as attractive.

The price of oil did not follow the decline in natural gas, with oil trading above $90/bl for most of 2011-2014. In response, the energy industry moved together again, sharply curtailing natural gas exploration and production in favor of oil. As natural gas properties were abandoned, the industry rushed into oil rich basins such as the Bakken and Permian. Acquisition and acreage prices soared. Similar to the natural gas boom, the rush to drill for oil eventually caused production and supply to spike, which contributed to a sharp decline in oil prices. The energy industry responded in unison again, slowing production, drilling within cash flows, and selling assets and equity at depressed prices.

Imagine for a moment an energy company that acted differently over the past ten years. I can’t think of one, so imagination is important in this exercise. What if our imaginary energy company didn’t aggressively grow production and buy new properties during the natural gas and oil booms? What if this company didn’t take on considerable debt like its peers? Instead of using its cash flow during the booms to buy new properties and drill aggressively, what if our company let cash flow accumulate on its balance sheet. Instead of selling assets and issuing equity near the industry’s trough, what if our imaginary energy company used its strong balance sheet to opportunistically purchase distressed assets during the bust? In effect, what if our energy company didn’t conform and did the opposite of its peers over the past ten years? I think it would be in pretty good shape right now and would have created tremendous value.

The energy and investment management industries have several things in common. Both industries are highly cyclical, with long histories of extreme booms and busts. Participants in both industries also have a tendency to allocate capital based on unsustainable trends – extrapolation risk is elevated. While the investment management industry has not experienced the same volatility as the energy industry over the past eight years, I don’t believe the degree of cyclicality between industries differs meaningfully. For example, a decline in price to normalized earnings (pick your favorite cyclically adjusted PE) from 30x to 15x wouldn’t be too dissimilar from oil falling from $100 to $50. With all-in costs near $50/bl for many energy producing regions, $50 oil makes a lot more sense to me than $100, just as 15x normalized earnings would for stocks. In my opinion, investors currently paying 30x normalized earnings for equities are no different than a CEO of an energy company buying oil properties in 2011-2014 and extrapolating $100 oil.

Similar to our imaginary energy company we discussed earlier, let’s now imagine an investment management firm that refused to conform and invested differently. What if instead of firing its active managers and replacing them with robots and a passive mindset, the asset management firm encouraged independent and unique thinking? Instead of hugging a benchmark and remaining fully invested, what if the firm invested in a flexible manner that allowed its managers to sidestep future losses and take advantage of future opportunity? What if there was an imaginary investment management firm that was willing to lose assets under management if that’s what was required to remain disciplined? Similar to our imaginary energy company, I believe this asset management company would be in pretty good shape over a full industry cycle.

While positioning a business differently can be very difficult during certain stages of an industry’s cycle, it also can be very rewarding. Given the duration and extremes of the current bull market, I believe the economics of different will be particularly attractive and evident once this cycle inevitably concludes.