Reading Roundup: July 2024

This month we read:

• Coal: A Human History by Barbara Freese

• The Selfish Gene by Richard Dawkins

• The World For Sale by by Javier Blas and Jack Farchy

• What I Learned About Investing From Darwin by Pulak Prasad

• The Education of a Value Investor by Guy Spier

• Natural Born Heroes: Mastering the Lost Secrets of Strength and Endurance by Christopher McDougall

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Coal: A Human History by Barbara Freese

Coal is as unglamorous as it gets. Author Barbara Freese, an environmental lawyer, gives an expectedly grim description of coal in the book’s opening chapter:

It is dirty, old-fashioned, domestic, and cheap. Coal suffers particularly when compared to its more dazzling and worldly cousin, oil, which conjures up dramatic images of risk takers, jet-setters, and international conspiracies…

Coal does not make us think of the rich, but of the poor. It evokes bleak images of soot-covered coal miners trudging from the mines, supporting their desperately poor families in grim little company towns.

And yet, despite some obvious downsides, coal is almost single-handedly responsible for the world’s industrial revolution and, by extension, our current living standard.

Humans began using coal 6,000 years ago in northeast China. They valued it for its jet-black luster and ability to be easily carved, not for its energy. Several thousand years later the Romans invaded Britain and were likewise drawn to coal for aesthetic reasons.

Coal wasn’t mined for energy until 1100 AD. By 1600, it was Britain’s dominant fuel. Coal overtook wood because it was plentiful (the forests near cities having been felled), more energy dense, and easy to transport. Seaborne coal built Britain’s merchant marine and shipbuilding industries. The Royal Navy was kept strong to protect the country’s merchants. Merchant ships and shipyards were retooled for war when they arose, allowing the Royal Navy to become the dominant global power for several centuries.

In the late 1700s Britain began to burn coal to make iron. The trick was discovering that you first had to make coke by baking the coal to remove its impurities (volatile matter) before using it to melt iron ore. Previously, iron production required so much wood that facilities had to be relocated as forests were cut down down.

The world took a gargantuan leap forward in the 1700s with invention of the steam engine. The steam engine converted coal’s energy into locomotion. Trains made mining and transporting coal easier, and also increased demand for the fuel.

This is an important lessons seen time and again through the history of energy. It is known as Jevons Paradox. Demand for energy is elastic. As energy costs decrease, demand for energy typically increases even more. On balance, energy demand increases, even as energy consumption becomes more efficient.

Crude oil is even more energy dense than coal. It is also even easier to transport (with modern technology like pipelines). However, crude oil didn’t overtake coal as American’s dominant energy source until the 1940s. And coal is still a non-trivial energy source. This demonstrates the how long energy transitions can take. Abroad, particularly in industrializing nations like China and India, coal remains the dominant source of energy. Worldwide, consumption is growing, not declining.

Pollution has been a problem for coal since the 1600s. Coal’s primary pollutant is Sulfur Dioxide (SO₂). It creates acid rain and is responsible for the hazy air around coal-burning cities. There are two ways to remove sulfur dioxide: using scrubbers to clean a power plant’s exhaust or burning a type of coal that contains less sulfur. Scrubbers can remove 70-90% of the sulfur dioxide, but it is often cheaper to burn low sulfur coal from the get go.

US east coast coals tend to be high in sulfur. Directives under the clean air act encourages many power plants to shift to buying lower sulfur western coals, such as those from Wyoming’s Powder River Basin. The downside is that Powder River Basin coal tends to have less energy than its eastern counterparts. Power plants have to burn more western coal to produce the same energy as eastern coal.

Carbon dioxide, a byproduct from the combustion of coal, is a tougher problem to solve. Coal produces twice as much carbon dioxide as natural gas and a third more than crude oil. This has lead many to declare coal “uninvestable.” Whenever I hear the word “uninvestable” I think about the Howard Mark’s interview where he points out that “uninvestable” assets are usually where bargains lie. The history of tobacco stocks has certainly borne that out.

Sheikh Ahmed Zaki Yamani, a former Saudi Arabian oil minister, once said “The Stone Age didn't end because we ran out of stones.” The stone age ended because better technologies were developed. Likewise, the age of coal won’t end because we run out of coal. It will end because other energy sources are significantly cheaper and as reliable. There are two ways for that to happen: either coal becomes very expensive, or alternative energy sources become much cheaper. If coal becomes expensive, it will only incentivize more mining and make previously uneconomic deposits profitable. So the only real way to kick coal is for the alternatives to become significantly cheaper.

Matt

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The Selfish Gene by Richard Dawkins

The Selfish Gene is easily a top ten book I’ve ever read. There are a handful of books ( How The World Really Works, Guns Germs and Steel, Factfulness, Sapiens, and all of Taleb’s books to name a few) that really impact the way I’ve viewed and understood the world and I’m adding this one to the list.

I was inspired to read this after reading What I Learned About Investing From Darwin (more on that one below) and in addition to learning about how life came to be as it is today, the book is actually quite applicable to investing.

The book is all about evolution/natural selection and how animals evolved from a “primordial soup” beginning billions of years ago. Each section is filled with a plethora of examples of Darwin’s theory of natural selection, much of which is directly applicable to understanding various business models and what works over the long run.

One idea that is particularly interesting is the fact that seemingly small variations can make a massive difference in evolving organisms. Dawkins elaborates:

“As an analogy, think of the influence of a fertilizer, say nitrate, on the growth of wheat. Everybody knows that wheat plants grow bigger in the presence of nitrate than in its absence. But nobody would be so foolish as to claim that, on its own, nitrate can make a wheat plant. Seed, soil, sun, water, and various minerals are obviously all necessary as well. But if all these other factors are held constant…the addition of nitrate will make the wheat plants grow bigger. So it is with single genes in the development of an embryo…All parts of a baby have a near infinite number of antecedent causes. But a difference between one baby and another…might be traced to one or a few simple antecedent differences…it is differences that matter in the competitive struggle to survive”

Similarly, when assessing businesses against one another, there is usually only a few differences that really matter and determine a winner and a loser, and it’s the investors job to make those judgements. We are looking for the nitrate.

Another takeaway is the masterful job Dawkins does at inverting, which would make Munger proud. Before presenting compelling evidence of one of his conclusions, Dawkins rattles off all the logical counterpoints and reasons to doubt what he is about to say.

Inverting is an essential habit for investors to practice. Before making an investment, you ought to be able to understand the other side of the argument - i.e. why something is cheap - before becoming comfortable with the upside arguments.

Dan

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The World For Sale by by Javier Blas and Jack Farchy

Javier Blas is a Bloomberg columnist covering energy and commodities. I always enjoy his pieces, so I picked up his book and was not disappointed.

Blas writes: “Most of us take for granted the ease with which we can fill up our cars, buy a new smartphone or order a cup of Colombian coffee. But underpinning almost all of our consumption is a frenetic international trade in natural resources. And underpinning that trade, from their offices in sleepy towns in Switzerland or New England, are the commodity traders.”

The answer are the big, secretive commodity trading houses. “The five largest oil trading houses handle 24 million barrels a day of crude and refined products, such as gasoline and jet fuel, equivalent to almost a quarter of the world’s petroleum demand. The seven leading agricultural traders handle just under half of the world’s grains and oilseeds. Glencore, the largest metals trader, accounts for a third of the world’s supply of cobalt, a crucial raw material for electric vehicles. But even those numbers understate the traders’ role: as the fastest and most aggressive participants in the market, it is often their trades that set the price.”

These middlemen exist because the “supply and demand of commodities often don’t match. Most mines, farms and oilfields aren’t located in the same place as the buyers of their goods. And not every copper miner or soybean farmer can afford to have a network of offices around the world to sell their products.”

‘It’s not for the faint of heart,’ says David MacLennan, chief executive of Cargill. ‘The history of Cargill has been to go into places where other people won’t. That’s where opportunity is. Whether there’s crisis, or threat, or things that are high risk, that means there’s opportunity.’

The book is structured around four big developments in the global commodities trade.

The first was the opening up of markets that had previously been tightly controlled – above all, oil. The dominance of the large oil companies, known as the ‘Seven Sisters’, was loosened by the wave of nationalisations that swept the countries of the Middle East in the 1970s. Suddenly, oil that had been locked into a single company’s supply chain from well to refinery to petrol station was freely tradable, and prices that had been fixed began to move. Middle Eastern and Latin American leaders alike now had oil to sell, and the commodity traders dealt with them indiscriminately. In the process they helped to create a new form of global power, the petrostate.

The second was the collapse of the Soviet Union in 1991, which, at a stroke, redrew a global network of economic relationships and political allegiances. Again, the commodity traders dived in, bringing the law of the market to what had previously been planned economies. Amidst the chaos, they became key lifelines for struggling mines and factories, even propping up entire governments. In exchange, they were able to secure access to natural resources at extremely favourable terms.

The third was the spectacular economic growth of China in the first decade of this century. As the Chinese economy industrialised, it created enormous new demand for commodities. In 1990, for example, China consumed the same amount of copper as Italy did; today, every other tonne of copper on earth goes to a Chinese factory.27 And the shift of China’s rural populations to the cities created new demand for imports of food and fuel. The result was another step up in the international trade in commodities, followed by a huge spike in prices. As the commodity traders scoured the world for commodities to feed the insatiable demand, they helped to forge new economic relationships between China and resource-rich countries in Latin America, Asia and Africa.

The fourth was the financialisation of the global economy and the growth of the banking sector, beginning in the 1980s. Where their predecessors would need to have enough capital to pay for each shipment of metal or grain they bought, suddenly the modern traders could use borrowed money and bank guarantees, enabling them to trade in much larger quantities and to marshal much larger sums of money.

The book has lots of good ancedotes about specific trades people or companies put on. Often these were make or break not just for their companies and careers, but also for the nation states on the other side of them. The world of physical commodity trading, especially back in the day, felt like the intersection of James Bond and Warren Buffett.

Matt

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What I Learned About Investing From Darwin by Pulak Prasad

Continuing with the evolution-as-an-analogy-to-investing from above, this is another great read.

Prasad has run a highly successful India-focused hedge fund for more than a decade and has modeled his process after the principles laid out in Richard Dawkins’ book. Every chapter is great, but here is one of my favorite ideas:

One Metric to Rule them All

Certain single genetic traits in plants and animals are indicators of a plethora of other traits or genes that benefit the species and ensure long term survival. Prasad uses the evolutionary example of foxes that were bread to behave like dogs. Breeding based on a single genetic marker which indicated and influenced the presence of a number of other traits that made wild foxes behave like dogs allowed wild foxes to become domesticated after just a few generations.

Similarly, Prasad has identified the single metric (a financial genetic marker if you will) as a starting point to find good investments: Return on Capital Employed (ROCE).

That ROCE is important is no secret to anyone familiar with investing. Buffett, Greenblatt, and countless others have explained the importance of investing in companies who earn high returns on capital, but I love the way Prasad frames things. Everyone who claims to follow the Buffett style of investing is basically looking for good businesses with competitive advantages, barriers to entry, and whose businesses are run by capable management teams. Prasad contends that, instead of searching for each of these characteristics one by one, it’s more efficient to first find the one measure that is indicative of the potential existence of the rest of these characteristics. ROCE fits the bill well.

For example, assessing the quality of a management team can be very hard. They all sound smart and are optimistic when discussing their businesses. Evaluating their results is easier. Sustaining a high ROCE in any business in any industry is difficult (though some industries are certainly harder than others). A management team with a track record of sustaining unusually high returns on capital is, at the very least, competent and worthy of further investigation.

In capitalism a business that earns outsized returns is certain to draw competitors who hope to earn the same returns. Normally, those high returns are competed down to average or worse returns. When a business sustains outsized returns on capital, it often means there is some microeconomic reason for this. In other words, it’s a great clue that a competitive advantage or barrier to entry exists (in addition to good management), otherwise the high returns would be unlikely to persist for so long.

Finally, a sustained high ROCE might also be indicative of intelligent capital allocation. Management teams who earn high returns are productively investing their businesses resources, otherwise the returns on capital would dwindle over time.

There are other examples of traits a high ROCE is indicative of, but you get the idea; a sustained high ROCE is a great indicator - but far from a guarantee - of a number of desirable traits in a business and can help efficiently narrow down the universe of investable stocks.

There are a few other very important ideas, such as understanding Type I vs. Type II errors that warrant an entire blog post, which I intend to get to at some in the coming weeks.

Dan

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The Education of a Value Investor by Guy Spier

Guy Spier’s book has long been one I’ve had on my list and finally got around to reading it. I very much respect Guy Spier both for the way he invests but also the way he views life and how results should be achieved. He is a very authentic person which is a helpful trait to have in investing, not to mention in life.

To that end, Spier does a great job explaining the importance of finding an investing strategy that fits your personality. You can read all you want about successful investors and their different styles, but you can’t expect to adopt a style that has worked for someone else if it doesn’t fit your personality; you’ll never stick to it when the going gets tough, which it will.

Morgan Housel is a master at this idea as well; having a successful outcome in financial markets is not about maximizing every cent you can make, it’s about maximizing the time you can stick with a strategy that will work well enough to get you where you want to go. There is a critically important difference between trying to absolutely maximize your returns and finding what will do well enough for an extremely long period of time, and the sooner investors figure out what works for them to achieve this goal, the better.

Spier also hammers home the idea of guarding against psychological biases. His contention, which I very much agree with, is that nobody is truly able to overcome human biases just because they know that they exist. Instead, it’s better to create processes and guardrails (such as checklists, habits, environments, etc.) to counteract the biases to which we know we will fall victim.

Spier outlines some of the critical items on his checklist which are all helpful reminders.

Finally, hearing about the lunch he had with Buffett and Mohnish Pabrai is highly entertaining and, if you only read one section of the book, that should be it.

Dan

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Natural Born Heroes: Mastering the Lost Secrets of Strength and Endurance by Christopher McDougall

On May 20, 1941, thousands of German paratroopers descended on Crete. It was Hitler’s first time using his elite paratroopers (Fallschirmjäger) and he expected an easy victory. The Cretan operation was supposed to be a tune up for an eventual invastion of the British Isles.

It wasn’t quite the picnic Hitler expected. The paratroopers suffered 6,000 casualties on their descent and heavy fighting for days after. After nearly two weeks of fighting, Hitler shouted at his generals, “France fell in 8 days. Why is Crete free?''

Although Crete would eventually fall after 11 days, the local civilian population continued to wage a guerrilla war for the next three years until the Nazi’s surrendered.

From the moment Nazi paratroopers appeared in the sky, the Cretans took up arms and resist. Similar unground resistance networks took a year or more to form in the other occupied European countries.

Everyone participated in the resistance — young boys, old men, priests, and women. German soldiers would tear the shoulder of suspected women’s dresses looking for bruises from the recoil of the rifle. The penalty was death.

The Cretan resistance changed the tides of war. Hitler diverted troops from elsewhere to Crete and delayed the invasion of the USSR. The delay forced the Nazi’s to face the Russian winter, which prevented them from seizing Moscow or St. Petersburg. The paratroop regiment’s devastating losses signified the end of large-scale airborne assaults.

Christopher McDougall explores how and why Crete resisted the Germans for so long in this book. The book follows the story of a band of Cretans who team up with British misfits to capture, but not kill, a top Nazi general in Crete. It is an amazing and thrilling story of bravery and heroism.

McDougall takes lengthy tangents off of the main story to explore the nuts and bolts of how the Cretans physically accomplished these heroic feats. He touches on fueling with fat instead of glucose, harnessing the natural elasticity of our body’s fascia to run and jump more efficiently, and why humans can throw a baseball much faster than a chimp even though chimps are much stronger than us.

McDougall initially wanted to write a book about human performance, but, when he discovered the lesser-known story of Cretans kidnapping a German general, couldn’t decide which book to write first. Eventually he concluded that they were one in the same and could be combined. The result is a unique book, and one that could easily have been two distinct books. At times it’s hard to understand why McDougall is plunging down a rabbit hole, but it was always interesting.

This book’s style reminds me of Michael Easter’s book The Comfort Crisis. If you liked that book, or McDougall’s other book, Born To Run, you should read Natural Born Heros.

Matt

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The Best Of The Rest

• John Huber: Walter Schloss, Nifty Fifty, Current Market Valuations and Opportunities. “It’s worth studying successful investors who achieved their success in a manner that’s different from the current conventional wisdom (buy and hold great compounders forever). It’s not that this conventional wisdom is wrong, but when it’s practiced at the extreme, it could lead to results that disappoint the practitioner.”

• Howard Marks: The Folly Of Certainty. Profitable investing demands intellectual humility, which means leaving a margin of safety to account for the fact that your analysis might not be right. As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

• Tidefall Capital pitches British American Tobacco at the YYX Stock Pitch Competition.

• Real-Estate Meltdown Strains Even the Safest Office Bonds (WSJ): “The losses are particularly jarring for investors because credit-rating firms initially gave many of the bonds triple-A ratings—higher than even U.S. Treasury bonds. The financial models behind the ratings never forecast property prices falling below the value of the debt.”

• Alexa Is in Millions of Households—and Amazon Is Losing Billions. “A decade later, the payoff for Echo hasn’t arrived. While hundreds of millions of customers have Alexa-enabled devices, the idea that people would spend meaningful amounts of money to buy goods on Amazon by talking to the iconic voice assistant on the underpriced speakers didn’t take off.”

• Do stocks outperform Treasury bills? All of the wealth creation can be attributed to the thousand top-performing stocks, while the remaining 96 percent of stocks collectively matched one-month T-bills. See also: Which U.S. Stocks Generated the Highest Long-Term Returns? (h/t to Phil Orway for the links).

• Stock Spinoff Investing: Dividend As A Catalyst.

• WSJ: QXO’s rally violated the Law of One Price.

• WSJ: Stock’s Are Crashing, That’s a Great Reason to Sit Tight

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