Buffett or the Apes ‒ a Tale of Two Investments

Two questions today... Revisiting AMC and Hycroft... Buying high, selling low... Where is the SEC?... Buffett or the apes ‒ a tale of two investments... The greatest business in the world... Two Olympic weightlifters as one...

Two recent deals provide one great investment lesson...

Last week, I (Dan Ferris) discussed AMC Entertainment's (AMC) 22% purchase of Hycroft Mining (HYMC)...

I showed how the deal inappropriately used AMC's capital to attract some naïve, overly enthusiastic shareholders.

I also showed how Hycroft's share price conveniently rose sixfold before the deal was announced... which accommodated an unannounced share offering nearly 10 times the size of AMC's announced investment in Hycroft.

Then, in Tuesday's Digest, Corey McLaughlin treated you to a rundown of Berkshire Hathaway's (BRK-B) recent acquisition of fellow insurance-based conglomerate Alleghany (Y)...

Having these two deals take place within days of one another gives us an opportunity to contrast a great investment with a terrible one...

I'll make the comparison by answering two important questions I raised last week.

The first question is this...

How did each deal treat the shareholders of the companies involved in the transactions?

It's hard to say whether the AMC or Hycroft shareholders were treated worse in last week's two deals.

Remember, besides the announced acquisition of 22% of Hycroft shares, Hycroft management filed a $500 million share offering the same day ‒ but without mentioning the bigger offering in any press release... or by any other means.

So let's recount the series of events.

Based on no public news whatsoever, beginning March 8, Hycroft's share price rises sixfold as share and option volumes explode in four subsequent trading sessions.

On March 15, five trading sessions after Hycroft shares start to rise, AMC announces its purchase of 22% of Hycroft Mining for $28 million, alongside an identical investment by mining veteran Eric Sprott.

The exact same day as the AMC/Sprott announcement, Hycroft quietly files for a $500 million share offering ‒ nearly 10 times the AMC/Sprott investment... and five times Hycroft's market cap.

On the face of it, it appears as if Hycroft did the AMC/Sprott deal to increase Hycroft's share price. Then, enticed by an increased share price, AMC's naïve, overly enthusiastic "ape" shareholders ‒ the name for small investors who use social media to try to outdo big investors ‒ grabbed the newly issued Hycroft shares, creating even more demand for the $500 million offering...

Eventually, when market forces finally get to work, the enormous dilution of Hycroft shareholders will likely send the stock plummeting... Anybody who has been around the mining world for any length of time has seen this happen many times.

A little background for you...

Hycroft's share price fell from around $16 in 2020 to $0.30 by March 4, days before its mysterious rise.

Hycroft shareholders who owned the stock before that mysterious sixfold rise on zero news have had a wonderful chance to dump their shares ‒ perhaps at a large profit ‒ if they bought recently enough. That group of course includes Hycroft executives.

It also includes Mudrick Capital Management, an investment firm that famously sold a $230.5 million investment in AMC on Tuesday, June 1, 2021 ‒ the same day it was disclosed that it had made the purchase to begin with.

Before the AMC/Sprott deal, Mudrick owned 40% of Hycroft...

When filings are announced, it will not be a surprise to find out that Mudrick sold its 40% stake last week.

I'm doing a lot of speculating here... And questioning situations like this is supposed to be the reason why we have the U.S. Securities & Exchange Commission ("SEC")... But so far, the SEC has made no public statements about looking into the AMC/Hycroft deal...

Situations like this are one of the awful consequences of market bubbles... Inflated equity valuations give the slimiest folks an opportunity to unload shares of dubious value onto unsuspecting, inexperienced investors.

And the combination of COVID-19 lockdowns and stimulus checks from the federal government created a whole new army of these inexperienced investors... in fact, more than at any time in the market's history.

That said, AMC shareholders are doing OK so far...

The stock is up 53% since March 15, the day the Hycroft deal was announced. Hycroft shareholders who were on board before March 7 ‒ the day the stock started exploding upward ‒ and stayed – are up more than 300%...

Given that most people come in at the top of any trading frenzy, most folks who bought Hycroft on March 15 are down 30% to 50%...

Except that, if I'm right, and the goal was to entice AMC shareholders to buy Hycroft, then the AMC apes probably bought way too much Hycroft stock near its March 15 peak and may very well have lost even more than they've made on AMC in the last several days.

I expect Hycroft's share price to hit zero at some point...

I've seen it happen enough times with other little mining stocks over many years. A possible catalyst for such a crash might come when more folks recognize that the company's previous reserve estimates are now considered unreliable.

It's interesting that you don't see the CEO of AMC Adam Aron or Hycroft using the word "reserves" about the gold in the ground. Remember, "reserve" describes the economically mineable part of a resource.

You can have an enormous resource – which Hycroft undoubtedly has – but not have a single ounce of economically mineable reserves. Hycroft seems to be in exactly that condition right now.

The company's most recent technical report summary, filed with the SEC on February 22, 2022, identifies no mineral reserves. The report replaces the company's 2019 report... which identifies 11.9 million ounces of gold reserves and 478.5 million ounces of silver reserves.

Weird thing is... the prospectus for the $500 million share offering filed on March 15, 2022, cites the out-of-date 2019 reserve estimates... even though that report was replaced by the one filed in February, which identifies no reserves whatsoever.

It's sad that AMC's new shareholders – I'm just speculating here – seem unaware that they have turned into liquidity providers, ultimately benefiting big shareholders in AMC and Hycroft, like Mudrick Capital.

Perhaps one day soon, folks from the Wall Street Journal or the Financial Times will sink their teeth into the AMC/Hycroft story and spell it all out in minute detail...

If that happens, it's likely that AMC, GameStop (GME), and any other meme stocks still trading at egregiously overvalued market caps will eventually trade below their early 2021 share prices, before all the meme stock nonsense began.

It's worth mentioning – and ultimately tragic – that the meme stock apes might just get another short squeeze. GME is up 81% since March 15. AMC is up 53%. The apes are excitedly posting all over Twitter about these recent rises...

But that doesn't mean they'll win in the end...

An important lesson, which I've said today and more than once before in the Digest, is well worth repeating... in a bubble or speculative trading frenzy, all the dumb money comes in at the top and gets obliterated in short order.

So even if the apes push AMC and GME "to the moon," as they're constantly harping about on social media, it's more likely that they'll double down at the top than they will sell and reap the rewards... A Twitter user called "Retail Whale" bragged yesterday about nearly doubling his position in AMC, after the recent big move.

This sort of thing characterizes the end of big bull markets... Riding stocks like AMC and Hycroft up to dizzying heights and back down to depressing lows is why people leave the stock market and don't come back for a generation.

On the flip side, I've interviewed several professional investors on the Stansberry Investor Hour podcast who took a drubbing in the dot-com bust and other bear markets and still stuck with it... They eventually became highly competent professionals. Learning is painful, and thousands of apes are about to learn a lot about bull markets and gold mining.

Now let's look at the other end of the spectrum...

Shareholders in Berkshire Hathaway and Alleghany are better off than their AMC and Hycroft counterparts...

On Monday, March 21, Berkshire Hathaway announced that it will acquire fellow insurance-based conglomerate Alleghany for $11.6 billion.

Berkshire will pay Alleghany shareholders $848.02 in cash for each Alleghany share they own. The price is about 25% above where it was before the deal was announced on Monday. It's also the all-time high price for the stock since at least 1980, according to Bloomberg.

Alleghany shareholders have received more value for their shares than they ever could have received at any previous time in the company's history... That's a good thing, to be clear.

How about Berkshire Hathaway shareholders? As we showed you in Tuesday's Digest, they get to own 100% of one of the very best companies in what Stansberry editors Bryan Beach and Mike DiBiase call "the best business in the world"... property and casualty (P&C) insurance.

In fact, Stansberry's Investment Advisory subscribers who bought Alleghany when Bryan and Mike recommended the stock in July 2020, less than two years before Berkshire's acquisition of it, logged a 72% gain.

Digging in a little deeper... Berkshire shareholders get a huge investment portfolio, which will now be in the hands of Berkshire head Warren Buffett, the greatest living investor – still going strong at 91 – and his two top investment lieutenants, Todd Combs and Ted Weschler.

Most folks will cite the amount of float Alleghany has... around $13 billion. Float is the money collected in premiums but not yet paid out in claims.

But that's just the accounting liability. It's not the actual cash amount Berkshire will add to its investments... That amount is about $22 billion, as of its latest balance sheet, dated December 31, 2021.

Berkshire is paying $11.6 billion in cash for one of the best-run insurance businesses on Earth, including its $22 billion investment portfolio. Though the price is a meaningful premium to its last price before the announcement, it's not an egregiously expensive price, at about 1.25 times book value.

That's a long answer to my first question about how the shareholders in these two deals made out. The second question I'd like to ask, which I dealt with extensively, though indirectly, last week, is...

How do we know when a company has made a good investment or acquisition?...

It's largely a matter of fit. For example, a movie-theater company shouldn't buy a gold mine. But I've said enough about AMC and Hycroft.

Right now, I'll focus on why Berkshire Hathaway's Alleghany acquisition is an absolute great investment. Most times, you should take a corporate management's public statements with a heaping grain of salt. But in the press release announcing the Alleghany deal, Warren Buffett summed up why the deal fits Berkshire well...

Berkshire will be the perfect permanent home for Alleghany, a company that I have closely observed for 60 years. Throughout 85 years, the Kirby family has created a business that has many similarities to Berkshire Hathaway. I am particularly delighted that I will once again work together with my long-time friend Joe Brandon.

Alleghany is the same type of business, run very similarly to Berkshire. It's like Exxon buying Mobil.

Buffett has "closely observed" Alleghany for 60 years. He knows the management team well, naming Alleghany president and CEO Joe Brandon, who served as chairman and CEO of General Re, which Berkshire owns, from 2001 to 2008. That tells you that Buffett worked with him closely for several years.

Buffett has studied and invested in the insurance industry since at least 1952, the year he wrote an article about GEICO called, "The Security I Like Best," which appeared in the Commercial and Financial Chronicle. He knows the industry as well as anyone alive.

Besides being in the same industry, both companies focus on consistently profitable insurance underwriting, which many insurers don't do. Berkshire and Alleghany are both among the most consistently profitable, admired, and financially strong insurers in the world.

Also, both companies have embraced a conglomerate model, in which they invest insurance float in other businesses outside the insurance industry. Berkshire owns more than 100 other businesses, everything from electric utilities to Dairy Queen. Alleghany owns eight noninsurance businesses with its three largest in the toy, steel, and biopharmaceutical industries.

When two lousy companies merge, an old Wall Street adage says it's like "two drunks holding each other up." When two companies like Berkshire and Alleghany merge, it's as if two Olympic weightlifters were allowed to compete as one... It's almost unfair to the rest of the insurance industry.

The timing of the deal might be interesting, too...

It looks to me as if Buffett buys himself an insurance company that has a big bond portfolio when he thinks stocks are overvalued. Let me explain...

Roughly 77% of Alleghany's $22 billion investment portfolio is in bonds and short-term securities (probably short-term Treasury securities)... So with the stock market 10% off its most expensive moment in all recorded history, Buffett just spent $11.6 billion in cash and acquired, among other assets, a $17 billion bond portfolio.

This feels familiar if you know a little Berkshire history. Originally a textile firm, Berkshire entered the insurance business with the purchase of National Indemnity in March 1967. Most insurance companies focus their investments in bonds ‒ and National Indemnity was no different, with 87% of its investments in bonds.

Berkshire bought National Indemnity during the most frenzied days of the "go go" market of the 1960s, well-chronicled in John Brooks' must-read The Go-Go Years: The Drama and Crashing Finale of Wall Street's Bullish 60s.

The market saw two large drawdowns over the next several years... down 36% from November 1968 to May 1970 and down 48% from January 1973 to October 1974, according to Bloomberg. Not a bad time to have recently acquired a bond portfolio.

Buffett bought reinsurer General Re for $22 billion in June 1998. Gen Re had $24.7 billion of investments, roughly 74% of which was in bonds and short-term securities. You know what happened to stocks from March 2000 through September 2002... Again, a good time to buy a big bond portfolio.

In his 1997 shareholder letter (published in early 1998), Buffett lamented the paucity of opportunities due to the bull market making everything expensive. He said much the same in his most recent letter...

And here he is again, buying an insurance company with a big bond portfolio with the stock market in spitting distance of its most expensive moment in all recorded history, after complaining of a dearth of opportunities to make large acquisitions.

I imagine building a bond portfolio would get boring for Buffett...

But the insurance business has always excited and interested him. So he gets to buy a great insurance company while simultaneously allocating capital to bonds that he'd like to own.

Alleghany is Berkshire's first acquisition since it paid $37 billion for airplane-parts maker Precision Castparts in 2016. That deal led to an $11 billion write-down in the wake of a travel industry slowdown caused by COVID-19 lockdowns and restrictions. Buffett said the company is "fine" and "the best in the business," but that he just paid too much for it.

I have to wonder... why he waited so long. If Buffett has been following Alleghany for 60 years, couldn't he have acquired it sooner and spent less?

I accept that I'm probably reading more into this than is really there, but it's worth pointing out that Buffett doesn't just know the trees very well. He knows his way around the whole forest better than he lets on.

This exercise of comparing these two deals was too irresistible after I noticed they happened within days of each other. It was like the market was begging us to point out the difference.

If you own Berkshire, your company just grew a little bit, like it has been doing since Buffett got into the insurance game in 1967... If you own AMC, good luck getting out of it with your capital intact... and maybe go back and read today's and last Friday's Digest all over again.

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New 52-week highs (as of 3/23/22): Alcoa (AA), Bunge (BG), Bristol-Myers Squibb (BMY), Continental Resources (CLR), Cheniere Energy (LNG), Mosaic (MOS), Nucor (NUE), Palo Alto Networks (PANW), Royal Gold (RGLD), Sprott (SII), Suncor Energy (SU), SPDR S&P Oil & Gas Exploration & Production Fund (XOP), and Alleghany (Y).

In today's mailbag, a pair of conversation-starters about inflation, stemming from our Tuesday Digest... What do you think? Please, jump into the discussion. All ideas are welcome... Let us know with an e-mail to feedback@stansberryresearch.com.

"So, here's a thought on the interest rate hike-fest we're headed into. I offer it to, maybe, stir some thoughts for publication. Certainly not looking for any kind of investment recommendations.

"Raising interest rates is supposed to have the effect of slowing down a heated economy. Slow the supply chain down by forcing a pull back on too many orders... rebalance the supply-demand equation.

"Currently (seems to me), the source of inflation is supply-chain problems being unable to get everything to market that is needed to get back to 'normal.' Yes, demand is outstripping supply but it is the supply side being unable to recover from the shutdown. I don't think the world demand for staples is going to reduce as a result of higher interest rates. I know for sure I will not use any less toilet paper, even if the cost quadruples from here.

"And wages have been rising. Way past due. That means it costs more for companies on their biggest (most often) operating cost, putting pressure on prices.

"I am no economist but, it seems under these circumstances, pressing hard on interest rates will have the wrong impact. As has been said, no-win situation." – Paid-up subscriber Bill K.

Corey McLaughlin comment: Thanks for the thoughts, Bill. You might not be an economist (neither am I), but that "outside thinking" can be an advantage, if we say so ourselves.

I happen to agree with you... These aren't exactly the most typical conditions for a rising-interest-rate run to start. And, as you point out and we've said too, the Fed can also only do so much with relatively small rate hikes to seriously cut into the "real" inflation rate anyway.

What the stock market will have to say about this, though, we can't know for sure.

"Not sure what 'alternate universe' I'm now living in, but here in Canada one of our provincial governments has literally gone berserk. (A province in Canada is like a state in the U.S.).

"Basically, the government of Quebec is giving $500 to every taxpayer who earns less than $100k per year 'to help offset the effect of inflation.'

"Obviously there are no economists in the Quebec Ministry of Finance. Here's the article from the Montreal Gazette. Terrifying stuff from your Northern neighbor. All the best from Canada." – Paid-up subscriber Dave J.

McLaughlin comment: As a naturally sarcastic American, I'm trying to think of a witty Canadian reference to make, but all I keep thinking about is poutine, the deliciously unhealthy dish of French fries and cheese curds covered in gravy... that originated in your province of Quebec.

More seriously, thanks for the note, Dave. Unfortunately, the government handouts – and the ideas about them as a way to fight inflation, the future be damned – aren't limited to Canada. The "alternate universe" is basically most of North America, it seems...

Last week, a few politicians "down here" in the U.S. House of Representatives proposed a similar idea... "stimulus checks" – $100 per month for those making less than $75,000 per year – every month that the nation's average gas price is above $4 a gallon. In another way to address high gas prices, Maryland, our state, last Friday also suspended our gas tax through at least April 16.

I don't know when all this ends. Obviously, the folks proposing the "gas checks" don't think the stimulus checks of the past two years have anything to do with our current inflation situation, or if they do, they're choosing to ignore the consequences in favor of another short-term "fix."

Good investing,

Dan Ferris
Eagle Point, Oregon
March 24, 2022