On The Brink with Castle Island - James Davolos (Horizon Kinetics) on Betting on Inflation (EP.199)

Episode Date: March 29, 2021

James Davolos, VP and portfolio manager at Horizon Kinetics, joins the show to make the case for inflation and to explain their Inflation Beneficiaries ETF, ticker $INFL. In this episode:  How Horizon and Murray Stahl were one of the earliest asset managers to put client assets in GBTC How Horizon's value approach landed them at a Bitcoin allocation James' reaction when Horizon first made the Bitcoin allocation Whether Bitcoin is a growth or a value asset, and how to reason about it from either perspective James' reaction to Jerome Powell's announcement on rates The genesis of the idea to create an inflation beneficiaries ETF James' case for inflation Should the disinflationists be taking victory laps? Why the Fed is calling inflation 'transitory' Why we didn't get inflation from 2010-20 What crystallized the case for inflation for Horizon Kinetics? The importance of the 'taper tantrum' Why historical parallels are so hard to find – and why we have no historical precedent for our current moment How the dollar is the 'least rotten apple' The prospects for a non-dollar monetary system The effect of ESG on commodity cycles How fiscal spending and the political anti-capital movement represents a structural shift The constant battle between capital and labor Why equities may suffer from higher labor costs Why Horizon focuses on asset light companies James' answer to the equity-inflation return puzzle Horizon's specific allocations to benefit from inflation The early success of the Inflation Beneficiaries ETF Why the inflation beneficiaries ETF does not contain Bitcoin How this ETF sets itself apart from other ways to play inflation – and why TIPS aren't the best bet Is the thesis playing out so far? Why the Fed has to remain subtle with their debasement James' pitch to Bitcoiners 

Hello and welcome back to On the Brink with Castle Island. This episode is brought to you by Copper, more about them later in the episode. So today, I'm bringing James DeVolos of Horizon Kinetics on the show. For those of you don't know, Horizon Kinetics is one of the first asset managers to really take a bet on Bitcoin, which was really impressive. They had an amazing amount of foresight. And most interestingly, of all there, known as a value shop. Horizon has recently come out with an inflation beneficiaries ETF, ticker INFL. It's got a very interesting approach to inflation. They've specifically targeted three different types of companies. It's all equities.

There's no Bitcoin in that specific ETF, and James will explain why. And of course, I'm a inflationista, so I love hearing people make the inflation case to me, and I think James does it really, really well. We actually recorded this episode right as Jerome Powell's announcement was coming out, which was super positive for Bitcoin at the time. We talk about Bitcoin. We talk about why we might be entering a structural shift in terms of fundamental inflation dynamics in this country as we have this struggle between capital and labor. And then some really, really interesting analysis of how equities do under conditions of inflation, which

equities stand to benefit. This is one of the most informative conversations I've had in a long time. Really, really fascinating talk. And of course, you know, I love to hear about inflation. Let's dig right into it. Brought down by bad mortgage investments, Lehman, which has 25,000 employees, will be liquidated. The federal government loans American International Group, AIG, $85 billion. This is a different kind of market, and the Fed is asleep. The federal government is stepping it to stabilize Fannie Mae and Freddie Mac, the two mortgage giants that have been threatened by the housing crisis.

The Bank of England has pumped 75 billion pounds more to Britain's ailing economy with a new round of concentrated easing. You print a couple trillion dollars, and all of a sudden, people start to worry. Out of this worry, we have something called the Bitcoin. Bitcoin. So James, you're a portfolio manager at Horizon Kinetics. You manage the, I guess, among other things, the inflation beneficiaries, ETF, which is pretty new. So why don't you introduce yourself and Horizon Kinetics for those that aren't familiar with the firm?

Sure. Yeah, I run the newly launched Horizon Kinetics inflation beneficiary portfolio, which just launched on January 12th of this year. but I've been at the firm for about 15 years, and most of that time has been bottom-up fundamental value equity research. And that's really the genesis of how the firm was created back in 1994, where I really have to credit the founding partners, Marie Stahl, Steve Bregman, Peter Doyle, and their partners with just always having very original thinking

where they're never going to rely on outside sources. They always go directly to the source. document and come to their own conclusions. And it served them very well with a value investing framework for upwards of 25 years now. But I think as it's really interesting and it pertains to you and your world, I would think that Murray is probably the first value guy that arrived at cryptocurrency and then also obviously has some pretty unique views on inflation and how we can invest for inflationary future. Yeah, you know, it's funny because you don't typically think of value investors is buying Bitcoin. But I believe Murray and Horizon, we're the first sort of big name

in sort of the traditional asset management world to actually take a Bitcoin position, maybe even the first firm to publicly own GBDC. Am I right about that? Probably pretty close. It really depends on how you define big name or institutional name where a bunch of the really sharp macro guys, like the Novigrats, John Burbank, Pete Bridger, that crew, those guys were in earlier at the same time. But then we were certainly the first with GBT and the first more conventional value shop. Yeah. And I mean, kind of putting client money in Bitcoin or advising a Bitcoin position to your clients, is that sort of a fair way to put it? Yeah, we put in client portfolios and in certain funds, both long only funds and LP's private funds, we put a very small, arguably a de minimis

amount of crypto in their portfolio saying if one tenth of what we think could come to fruition with this, it's going to serve you well to have that tiny position. And obviously, a lot has gone right. And so now it's a not so tiny position for a lot of people. Yeah, I mean, when I think of the most four-sided asset managers specifically that took a Bitcoin position, I think, of Horizon Kinetics and ArkInvest. And to me, those are the two earliest names. And then, of course, there are other firms exploring Bitcoin, but none of them are really taking the plunge in such a direct way. So I have to give you guys a ton of credit for that. I've actually wanted to have someone from Horizon on the show for a long time to kind of close that gap. I think it's an important conversation

When you guys first got interest in Bitcoin, what was your reaction to that? I mean, you'd been there for a while over a decade, I guess, before that. How did you react to that sort of exploration? I'll be completely honest with you. I was terrified. I showed up to an investment committee that Murray Stahl chairs, and he tells us this story about how he reads this Satoshi white paper. And all I can remember was I was at a wedding a few years.

years ago. Actually, when when Bitcoin first hit 1,000 and there was a guy at my table talking about crypto and I thought the guy was out of his mind. And it turns out he worked at Fortress. So he knew exactly, he knew very well what he was talking about. But it's, it just shows you how important it is to be willing to change your mind and be willing to look at the facts as they evolved. But I thought that guy was out of his mind. I hear Murray talking about this and I'm like, wow, I'm in a value firm. What are we talking about? But he'd been talking about interest rates and how the Fed was influencing to put it delicately risk assets for a long time. And this book he kept referring to, history of interest rates by Sidney Homer. He was advocating everyone to read it, but I ordered it on

Amazon and the thing showed up like a cinder block. It's 800 pages and very dense reading. But he approached it from, he has a mathematics degree. So it's really interesting how he came about this from such a holistic background where he's a math major. He has a variety of majors, but he has the math background. Cryptography is actually a hobby of his. He enjoys it. He finds like solving ciphers and cryptography to be intellectually stimulating. And then he has this value firm where he just sees everybody justifying infinite cash flow multiples based on zero percent rates.

So I was very skeptical and my respect for the people that I work with, I said, you know, I'd be out of my mind not to give this an honest shake and I read everything I could get my hands on. And it took me about a week to be like, you know, I get it. If this is even remotely what it has the potential to be, you're going to want to own some. So it's so interesting because, you know, just contrasting Horizon and Arc, you know, horizon ostensibly, you know, like value focus, as you say, ARC is sort of the quintessential growth firm, really aggressive, betting on, you know, disruptive innovation and so on.

And yet, you know, both firms have this position in Bitcoin. How do you think about Bitcoin? I mean, is it a value investment in a new currency or is it a growth investment? Where does it sit in that kind of taxonomy? I think there's the two frameworks you can use. You can use the Bitcoin as an asset. and then Bitcoin as a network. And if you look at it as an asset where purely supply and demand, that's what all the

macro guys look at. Look at the scarcity. Look at the supply and the demand. And from that fairly simplistic view, you can just see there's a lot more demand than there is supply. But then when you get really technical and look at the network and then look at all the layers, the defy, the applications, it's just I feel like I talk to somebody new every week who thinks of a new application of this network. And somebody in our firm compared it at the time,

somewhat simplistically, to what if you could invest in the HTML protocol in the internet in 1995? And I think that's the growth part where there's this tremendous potential. You don't know how it's going to monetize. But on the other side, you know it's finite. You know their scarcity. And you know the supply and demand is certainly out of whack. So I think that's how you can bridge both spectrums. So it's so funny because this, we scheduled this podcast with the absolute worst timing, I guess, because right as we were hopping on, the news was hitting the tape on, I guess it's Fed Day today, this is the 17th we're recording.

So I actually haven't even seen the news yet, but you were telling me, Jerome has, I guess, said that he's going to hold rates down or is, what is the news actually on sort of the Fed side? I just looked at the summary that flashed, you know, the bold print on the quick flash, and it basically said he's holding fast through 2023. So my interpretation of that and then based on what's happening with interest rates, Bitcoin, growth stocks on the print, I'm guessing that's what he said. So rates are going to be at or near zero through 2023. And everything that is risk on in long duration seems to be very happy. you in the announcement.

Yeah, so I'm looking at Bitcoin. Before the announcement, it was about 55, 5, and now we're at 6, 56, 7. So Bitcoin traders seem to like the news. Maybe this is a little bit of a segue into your ETF that you manage. So tell us about the genesis of the inflation beneficiaries ETF. Full disclosure, I actually owned some of this ETF. So I thought it was cool enough to buy some. Although, to be clear, we wanted to do the show before I had actually owned the ETF, but I do own some of it.

So tell me about the genesis of the idea, how that sort of came about. Sure. We as a firm have, in some way, shape, or form focused on what we call hard asset companies for decades. And the beauty of these hard asset companies is that the economics, meaning the margins and the profitability and the cash flow profile, can improve very dramatically as a function of those underlying hard assets appreciating in value. And we've done very well in these companies through multiple cycles, both interest rate, equity, economic cycles. And so we have a very good understanding of these businesses as a firm. But then we also noticed that we were getting more and more concerned about inflation, call it five years ago, just by virtue of.

It seemed as though there was a complete inability to ever break out of the zero lower bound. Deficits are going up. Fed balance, or excuse me, the government balance sheet is expanding. This is all pre-COVID, by the way. Obviously, everything's gotten dramatically extended since then. But we had this appreciation for these business models and this view that inflation was definitely going to be a risk at some point in the future. So I sat down and there was actually a lot of false.

starts where at first I was looking at doing something that was purely royalty oriented with energy royalties and precious metal and base metal royalties. And then we looked at other businesses that could really benefit with scale and operating leverage that had similar business characteristics. And it turns out there's actually a very large, robust universe of these types of companies that we think can thrive under a variety of inflation scenarios. But you're not making that one way binary bet on inflation. So I put the portfolio together. I reviewed it with the investment committee, the partners at the firm, refined some things. And everybody was really excited about it. We've got, and then we basically looked at the way that the world is going. It's moving away from 40-act

mutual funds. Not many people are lining up to pay people 2 and 20 for hedge funds anymore. And the tax efficiency and simplicity and ease of an ETF wrapper just was a fairly obvious. evolution as well. So I guess let's talk first about the case for inflation. So it's so funny. I mean, we've had this inflation debate forever now. And it's almost like the inflationistas, you know, because they were wrong in the first decade after the financial crisis, you know, you see the disinflationistas, I guess,

or really just the mainstream commentators taking like endless victory laps because, you know, the inflation that we all expected to materialize, didn't materialize. with the first few rounds of QE. Now actually inflation expectations are ticking up. So I think maybe those victory laps are a little premature, but now that we hear inflation is going to be transitory or that it has to do with sort of supply side constraints and it'll be just sort of a transient phenomenon.

And then I'm sure when inflation actually hits, all the mainstream commentators are going to say something like, oh, yeah, no, inflation is actually good. You know, it's good to reduce inequality and it's good to reset our fiscal position and stuff. What do you make of the first decade after the financial crisis when a lot of us, including myself, thought we would get inflation, but we didn't. Did that kind of take you by surprise?

It did, but it's fairly obvious what happened in hindsight where there's so little history that can be relied upon for inflation because even going back to the 70s and 80s, the nature of the global economy is just so different. The currencies, the rates, the interconnectedness of the global. economy. So you really can't rely on data in a statistically significant manners. But all else equal, people look at, okay, we have rising money supply, all else, and zero percent rates, all else equal, there's going to be inflation. They were right. It was just financial asset inflation. So you've seen equities and growth equities and speculative equities inflate to these crazy

numbers and anything with a dividend yield, whether it's a staple stock or if it's, it's a bond or if it's a bank loan and then, you know, equities that are yield oriented. So real estate, global listed infrastructure at these crazy low cap rates. So all of the money that was printed did go into more productive end uses. It was just financial assets by by virtue of recapitalizing the banking system with these banking reserves. CPI is a very, very different animal. And I think that you're starting to see the beginning stages of CPI where these consumer prices are going to creep up. But again, we might go down a wormhole here, but then you have to look

into how they calculate CPI with these quality adjustments and then substitutions. So CPI is an imperfect measure at best, but ultimately, I think one thing that's missing for CPI to really explode is the psychological component. So if you go back to the 70s, the seeds were sown years earlier between they started Medicare and Medicaid entitlements. You had Vietnam War spending. You had the removal of the gold standard. And then you have the OPEC oil embargo. And it's almost like it required the average person to go to the gas pump and wait in line for three hours to pay 10 times the price of the pump to realize that they'd been debased for a decade.

So maybe the fiscal orientation and the stimulus checks and then what might happen as they, get more fiscal bills passed worldwide, that's then going to basically crystallize with the average consumer and you're going to see it in consumer prices, not just you're seeing it in PPI's and you're seeing it in financial assets. But you haven't really seen it in those core CPI consumer numbers just yet. You know, it's so funny is that if you said this on Twitter and Joe Wisenthal read it, he would call you like an inflation truth or whatever because you're quite, questioning the CPI metric and its validity. But, I mean, it's undeniable.

We see signs of inflation everywhere. Obviously, financial asset inflation has occurred. Now we're starting to see it in commodities, and I'm sure it'll trickle down into consumer prices. Was there a moment in the last, you know, let's say three years when you realize that things were changing in terms of the aggressiveness of deficit spending? Like, obviously, COVID was a Catholic moment. I would say maybe even before that.

things seem to be changing dramatically. Was there a shift that you noticed at all in, you know, monetary fiscal cooperation in the aggressiveness of deficit spending? Or was it a more gradual thing that makes you think that we're looking at an inflation every environment here? It was honestly a really slow burn and COVID turned dumped gasoline on that slow burn. But one thing that really crystallized and we realized there was really no way out other than to debate to debase the dollar was the fact that every time that we hinted or took steps to normalizing policy in terms of deficit spending or interest rates markets just seem to freak out and the federal reserve now is obviously sensitive to risk asset prices and sure there's correlations with that

in the underlying economy i think you can't be completely complete. completely ignorant to it. But in hindsight, once we crossed that point of no return with supporting risk assets, it's almost like you can't go back. And that coupled with the inability to normalize every chance that we had and every chance that we took, both in the U.S. and then other OECD countries, it's just, it's been a nightmare as we've tried to normalize policy. That's when we realized that we were probably past the point of no return. And then you really look at the three scenarios a government has. You can default, you can institute austerity measures, or you can debase. Let's assume default is completely off the table. Politicians tend to like

to get reelected, so austerity's off the table. So here you go with the basement. So you tell me, you know, you guys tend to take a bit of a historical perspective. I'm definitely going to order that book on interest rates. But are there historical analogs at all that you look to? It doesn't even have to be the U.S. Are there any parallels you find in history? I mean, maybe not in the last 50 years, but what is helpful in terms of reasoning about our current situation? It's really unprecedented. It's so hard to look at anything that you can directly compare to what's going on right now, because there's really two things that I think have completely changed with no historical precedent. The most important of which is this blurring.

And Russell Napier is just brilliant man. And this is what changed him from deflation to inflation after many years of, excuse me, I should clarify, disinflation. People tend to lump those two words together, but very different things. Is this blurring of the lines between the independence of the Fed and the Treasury? So if the Treasury can just use the Fed to basically buy whatever bonds that they want to issue to spend whatever they want to spend, you've crossed a tipping point where there is no independence and is there any obligation or any intention to ever repay these bonds whatsoever. I think the other thing that makes the historical perspectives so difficult, and you're seeing

this with Bitcoin, is the fungibility of currencies and assets and rates worldwide. where you don't live in a microcosm anymore where you basically just have one interest rate, one currency, one market. So the old saying, history doesn't repeat itself, but it rhymes. You can take inferences and you can take indications from history, but this world is so, everybody in this world tries to basically model things with precision, but obviously it's completely impossible right now. So I think you can make an educated guess with a huge behavioral finance overall.

You need to look at human behavior and this behavioral variable that is so important in trying to understand where you think things are going to go short, intermediate, long term. Totally. And I find it so interesting that people will reason about the dollar in kind of a vacuum. You know, they won't include Bitcoin into that analysis. But in my view, Bitcoin changes the reality on the ground. It gives you this like highly liquid alternative non-state asset that is technologically nays. and trades 24-7 and you can sort of immediately offload your dollars for Bitcoin.

And it's this sort of this substrate which competes with sovereign currencies. And in my view, that changes the game a little bit, changes the odds. Just its real presence in that equation. When you think about, you know, you have an inflationary outlook, people tend to conflate that with, okay, this assumption that you think that, you know, the dollar system is going to collapse or withdraw, you know, that maybe the dollar isn't going to denominate international trade or it's not going to be the main currency that commodities are traded against. Is that part of your thesis, the withdrawal of the U.S. from the international system, the decline in terms of the

dollar's prevalence in denominating international trade and in foreign exchange reserves, is that part of it? Or is that not a necessary? sort of condition for your thesis to play out? It's definitely not a necessary condition. And I think that it's really complicated and hard to forecast what's going to happen because the dollar is probably the least rotten apple of all of the global established currencies. No one's going to be doing global commodity trading and global interbank settlements in

ruble or yuan. And then you look at the pound, the yen, the euro. not a lot of room there. And then, you know, obviously the Swiss franc is far too small. So it's, I don't see what could possibly displace it. I mean, people talk about this global basket. I've heard you guys talk about it. But how do you get, you can't even get neighbors in the EU to cooperate and agree on things. And how are you going to get the entire world to agree on a monetary policy and a currency convention? So I think the bigger variable here is basically just going to be the propensity to consume. And you mentioned when we started the conversation is the supply side is dramatically different from past cycles.

And when you look at some of these inflationary end markets, whether it's precious metals, energy, industrial metals, forget the fact that all of these industries have been blown up financially. at some point over the past 15 years. Copper ran up going into the bricks spilled out, going into 0-607, blew up, gold peaked in 11, oil peaked in 2008, 2009. They've all basically been doing triage on themselves, these companies for a decade, no growth cap-ex. So there isn't the supply to basically turn that back on with a switch the way that people think there is. But I think there's a more interesting factor that nobody's talking about today is I was looking at Glencore and it doesn't really matter any of these global integrated mining companies first six pages on their slide deck is ESG so think about the amount of capital as being withdrawn from these

all of these companies which are going to be absolutely critical to society and the well-being of everybody on earth. Not to mention a lot of these are requisites in building out a lot of green initiatives, but within ESG's not only defunding and restricting capital to these businesses, but what government in an OECD country is just going to let you start digging at will for copper or iron or gold with diesel powered equipment and then you need to smelt it and all of these things. So it's almost like this movement has been the best thing that could ever happened to these end markets, which are already supply constraint to begin with. That's fascinating. So what you're saying is that ESG is actually sort of an artificial

constraint on capital inflows into this sector, meaning that there's a real scarcity. And so the established companies have been kind of deprived of capital. And if, you know, if there's a rotation back into commodities, precious metals, that the net impact of those flows would be greater. Is that kind of a fair statement? It would be greater on their equities, but more so fundamentally that you're not just borrowing money at 5% to do a $3 billion mine expansion the way that you could in prior cycles. For shale companies, no one's giving them growth capital anymore on the equity or the debt side. And you have the European multinationals, BP, the leader, but no different for Total, Royal Dutch Shell, E&I, divesting basically all of the, of their deep water and all of their growth cap-x and hydrocarbons.

So it's setting up for we're not, we are firmly in belief that there's going to be transitions and there's going to be peak oil at some point in the future. But based on what markets are dictating today, there's probably going to be peak supply a heck of a lot earlier. Right. So I don't want to commit you to anything, but you know, decade ahead outlook and you can be as general as you want here, you know, what do you expect in terms of you? of kind of CPI inflation or is it impossible to even commit to to anything precise there?

You know, I'd be kidding myself to commit to anything even ambiguously, directionally. But I think that it is all but certain that prices are going to rise once you start getting money into the median household and fiscal these stimulus checks and then these fiscal objectives. And then there's also a political shift now where the wealth inequality movement is not just in the U.S. It's worldwide, and politicians are running on platforms to empower the lower and middle class. So in a sense, you've seen almost 30 years of policy worldwide favoring capital. I think there's going to have to be a shift here where there is a rebalancing of the dynamics

between capital and labor. And that's where consumption comes from, is those households that have the discretionary capital and they consume it. But I think the more interesting future outlook, I think, is that a lot of the companies that people think are going to benefit might not benefit. And equities might not benefit because if there is wage growth and there is an empowerment of labor and you see all of these input cost rising, a lot of companies are going to struggle with or without higher interest rates because they're going to have margin compression. they're going to have lower returns on incremental invested capital because everything is more expensive and everything is more competitive. So that's why we really focus on these asset-like companies where they don't have the working capital

requirements, they don't have the balance sheet, and they don't have the reinvestment cap-x needs. So they can weather a down cycle, but then also compound through an advantageous cycle. This episode is brought to you by Copper. Copper is the global provider of blockchain infrastructure solutions for institutional investors who are actively trading digital assets. Its award-winning custody application is connected to 25 of the largest exchanges in the world, ensuring safe storage and movement of assets for the biggest crypto hedge funds, market makers,

family offices, and high-net worth individuals. Their clear loop product is the first off-exchange settlement network for digital assets. It's the safest way to trade balances and custody across multiple exchanges without requiring on-distance. chain settlements. Their unique custodial solution and exchange integrations allow it to remove counterparty risk from the equation, enabling funds to raise and deploy more capital and trade higher volumes quickly and securely. And now back to the episode. So I wanted to ask you about this, and you kind of hinted at that actually, which is that inflation isn't necessarily good for equity returns. This is something I've been puzzling over a lot recently. Because in theory, you know,

know, if you're doing a discounted cash flow analysis, if the numerous air changes, you know, the dollar is debase and it's worthless in real terms, that doesn't strictly matter that much because corporations just adjust prices. But that's obviously a highly simplistic model, and it sort of depends, you know, how much of that corporate values in the near term, as opposed to discounted far out into the future. And as you say, like input costs, like labor and so on, there's this puzzle. Are you familiar with this puzzle? I'm sure you are the sort of equity inflation return puzzle. Have you come across this concept? I've seen it, yep. And I think I'm trying not to butcher it, something like stocks should do well under

inflation, but they actually tend to underperform under sort of moderate and higher inflation. Not to put you on the spot, but can you explain that puzzle a little bit? No, there's definitely a Goldilocks scenario of, quote, healthy inflation, where we've seen mostly benign inflation ever since Volker came in and kind of broke the back of aggressive inflation and that's been highly accommodative towards risk assets because modestly rising prices is generally good for the economy, for commerce, for asset prices, but it's when rising prices get out of whack with real growth rates and with interest rates. So everything really needs to be taken within the context of where rates are.

where growth is and where inflation slash prices are. So there's a lot of complicated factors that are going into how sensitized equities are going to be and how much cost they're going to be able to push on. But I think that there's even some deeper level concerns, like how many Americans can retire with a 10 year at 1.5%? Even with the Federal Reserve telling you our long-term target is two, not only that, we're going to actually let it run hot so our average can be 2%. There's going to be consequences to that, but you think of the individual saver, the median household with a couple hundred thousand dollars of savings to retire on, but then look at pensions and endowments where they have obligatory funding requirements every year that just

can't be funded at where interest rates are. Worse yet is you look at insurance companies where they can't invest their float. You need to invest your insurance premium in low risk, short duration assets to earn a return. The banking system needs net interest margin and a yield spread. So again, I think I keep going back to this. My cop out is it's complicated. But the fact that we have such a low interest rate environment right now, I think healthy inflation or benign inflation is much lower than people think.

because a real 10 year and a real negative yield on a 10 year, you're taxing savers. And at a certain point, that's going to have, that's going to be a problem. So, okay, so you have this idea that, look, we're going into a structurally more inflationary decade or a couple decades, you know, the trend we've been on since the 70s of disinflation is going to turn. How do you actually allocate to play that? I looked at the allocations. There's a lot of, energy companies, minerals, and so on. What's the justification for those, you know, in terms of the whole universe you could have selected from? So the biggest variable in everything that we own in this fund is asset light.

And, you know, I mentioned earlier, we do have fundamental driven views on supply and demand within these underlying commodity markets. But asset light is really the most important part. And I can kind of break it out into three categories. One is what we call the direct inflation beneficiaries, where they have a direct asset light exposure to an underlying inflationary asset. So hard to imagine high, high inflation without energy price is really moving. We have a structural view that we've formulated on a bottom up basis as well. But we don't necessarily want to take the risk of an upstream producer.

or let's just throw out a name, just Exxon, for example. They have billions of dollars of debt. They have a massive dividend. They need to fund. They have huge operating expenses. And then they're reinvesting a lot of their capital into growth. Some of it's in renewable. Some of it's in other types of conventional stuff.

So really tough to make money full cycle in that, even in an accommodative cycle. So we focus on asset light, which is a royalty. So companies in the portfolio, might own a completely cost-free interest in wells that Chevron and Exxon drill. So they spend their hundreds of millions of dollars to drill the well. These guys cash the check. And basically they can have a 90% operating margin, in some cases, over a 70% net margin. And some of the better companies have 30 to 60 years of reserves.

You don't worry about reinvestment risk. So they can weather the downturn. Most of these companies stayed completely. profitable every quarter of 2020, which was amongst the worst in history for energy. Similar plays in gold and iron ore and other types of metals. But I think really interesting is the second basket, which we call the indirect beneficiaries, where they have an indirect exposure to these inflationary end markets, asset light, high operating leverage. And this is one which I also eventually want to bring back to the crypto discussion is financial exchanges.

Think about the intercontinental exchange. It's really not much more than a supercomputer matching buyers and sellers and creating tremendous amounts of data and transactions. So in an inflationary environment, to the extent that you have volatility and interest rates, hard commodities, soft commodities, currencies, currencies, they do have some crypto contracts. The best friend of an exchange is volatility because volatility creates volume. volume, it all flow to the bottom line. So their incremental costs for another trillion dollars of volume is maybe a new mainframe computer and a couple staff. So these actually have a counter-siclicality because of their exposure to these end markets that might not be correlated with equity. The last basket is really what we call opportunistic beneficiaries where

they have exposure to really interesting end markets. And it's not asset-like. but a lot of the costs are fixed. So think of a grain processor where you're buying farmers, wheat and corn and soybeans and oil seeds, and then refining that and processing it into flour, starches, and seed oils. To the extent that there is an inflationary ag market or cycle, tricky to own the fertilizer companies, the underlying commodities, or farmland, these companies are basically just a spread-based business, the more that goes through the machine, the higher the margin on the higher number going through the top line. So those are really the three areas that we focus on. And you can really

touch, I mentioned a variety of different exposures already, but we've identified businesses that have exposure to everything from land to these other types of more conventional commodities to real estate, commercial real estate, the health care system, financial services. There's really a lot of different ways to get exposure to these inflationary in markets. So that's fascinating. I actually, the royalties argument makes a ton of sense in terms of being asset light, but still having exposure to real, you know, real resources, I guess, at the end of the day.

On the financial asset side, it's interesting because where the financial exchanges, we've been in a somewhat low volatility environment, I would say, as far as I can tell. And yet speculation and basically trading is completely rampant and the economy has become highly financialized. How does that fit into your thesis the fact that even though we're not currently in a inflationary environment or maybe we're entering one, we're still seeing huge volumes, especially in more speculative asset classes like options and things like that? Do you still, despite that high, you know, established level of financialization in the economy, expect with volatility these exchanges to still look good from a revenue perspective? Yeah, I think that the, right now you're going through a secular trend of higher transactional volume. That's really a byproduct of technological innovation. So these companies have basically been on a tear ever since you had algorithmic trading, high frequency

trading. Everybody could get quotes on their desk. And now you've taken it full circle where high school and grade school kids have Robinhood apps on their phones and are playing with buying and selling stocks at recess. But that's somewhat of a joke. But taking a step back and looking at where the real velocity of money is, these algo funds, these quant funds, these market makers, it's all a function of technology that I don't think is slowing down. It could plateau, but the real way that these institutions make money is the spread. And these spreads blow out during periods of volatility when they can make so much more money. And this is across every single product. So I think that under a volatile environment, you'll see trades.

trading begets trading. The more volume that there is, the more volatility there is, the more people that can step in. And we've seen it in our fund where we originally had a great lead market maker that stepped in and basically took us to market. And not many people were interested in taking this small ETF out there and onto their books, but then we've done, we're up to over $100 million in a couple months here. And now all of a sudden, you're seeing new market makers wanting to jump into the marketplace. And so, So I feel like that's emblematic of how it can be a virtuous cycle, specifically within the niche asset classes that different exchanges that we own in the fund have.

So one thing I wanted to ask you was, so as we've been talking for the last 40 minutes, Bitcoin's up $2,000. So I suppose that's the market reacting positively to Powell. Obviously, you don't have Bitcoin or any Bitcoin proxies in this portfolio. How does Bitcoin fit into this story? I mean, do you see it as an inflation beneficiary or is it something else entirely? Without a doubt, I do. And I really wanted to remain ideologically sound with asset light.

And something that I alluded to, but it wasn't explicit about, is that everything in this portfolio and firm wide is value on a bottom-up fundamental basis. So you really need to justify the valuation today off of some reasonable assessment of the future discounted back to fair. value. So there are some varying degrees of asset like, quote, pure plays in Bitcoin in the marketplace, but some of these mining companies and some of the conglomerates that have a bunch of different things going on are tricky from a valuation standpoint and then also from an asset light standpoint. You know, we'll see obviously gone through the Coinbase S1 and gone through Baxx S1 and to the extent that they get spacked where and then we'll see what happens with Crackin. Just I think that the universe is going to be there. It just hasn't gotten there just yet. Yeah, that's a very fair

point. All the public market proxies for Bitcoin have been firms that just happen to hold Bitcoin on the balance sheet, but might be doing something else or miners. And mining is not an asset light business, although it looks like we're going to have some sort of high quality public market names in the next few years that will have exposure to Bitcoin. and to financial sort of exchange. So who knows, maybe your allocation will have to change when those come to market. In terms of the traction so far, as you said,

you're over 100 million in AUM for this fund. Is that sort of in line with what you expected? What were you hoping for when you launched the fund? I was hoping for, and this is talking to some people that were experts in the industry, that launching a brand new fund from a somewhat smaller organizations such as Horizon, we were hoping blue sky scenario to be at about 30 million by year end. It's really tough to get a following and it's really tough to get people to buy into something that's

this new. But I think it really shows the intellectual power that Horizon has and the fact that a lot of really respected people follow what we do. And this is such an actionable idea that is on people's minds. People are concerned about it. And most people understand the limitations of tips and other types of equity oriented strategies. So credit to everyone on my team, both the guys that are the product managers, the partners at the firm, the sales staff. It's really been a team effort, but they're wildly successful and happy with where we're out already. So in the universe of inflation hedges, what are the other options? And then what distinguishes the CTF from those other ways to get exposure if you have a high inflate view, you know,

positive view on inflation? Most people default to tips. And there's some big problems with tips. We'd already talked about CPI, but they're CPI driven. But more importantly, as of a day or two ago, the 10-year tip had a gross yield of about negative 65, negative 70 basis points. And so what that means is if inflation is 2%, call it, you net a yield of 130 basis points. So you're 70 basis points underwater, but let's say inflation blows out to five. You're still going to yield for 30.

So no matter what, you're, I mean, the 10 year would get destroyed, the straight 10 year, but your tip is just going to be less bad. You're still losing money in real terms. And there's ways to try to bet against that with rate steepeners and things like that. But options markets tend to be pretty smart and price things like that in. Then you look at the equity market. I mean, obviously there's the commodity market, but rolling spot commodities and playing CTAs and stuff like that is tricky and inefficient. Within the equity market, there's really two strategies. One is these yield-driven strategies I talked about,

which are primarily commercial real estate and global listed infrastructure. And some great businesses, some great durable cash flows, but at a four or three percent cap rate, pretty tough to make money, even if you do have inflation. In fact, even if you can grow your revenues or rents more than inflation, your discount rate could blow out even more and you could lose money. The last one would be the upstream commodity producers, and they have been really difficult investments to own other than just for a trade because of that capital intensity, the balance sheet risk, the reinvestment risk. And who knows, this cycle might be different because of what's going on with ESG and capital markets. But every other time you've seen a peak in base metal, precious metal, energy, kind of everything in the ag spectrum, everybody just goes nuts and expands capacity at the same time and then the bottom falls out. So we're really the only product that we're aware of that focuses on these asset light businesses that we really intend to compound over many business cycles. You don't have to view inflation as a trade. You can view it as saying, this is a differentiator to what I own, my beta, my bonds, my whatever else, my alts.

And so it's going to be something pretty different than I'm comfortable holding through a full cycle. So a couple more questions before we hop. So one, is there anything that you want to see from the Fed specifically like an acknowledgement that we're doing yield curve control or anything specifically a political catalyst from Congress, for instance, which will, you know, make you think, okay, yeah, my view on inflation is correct. Are there any conditions for this thesis to sort of play out, or as far as you're concerned, is it sort of already playing out? I think today was a pretty good affirmation moment

with the PAL statement as we started this conversation. I need to read into exactly what was stated. But as you mentioned, kind of the asset class reaction is somewhat of a confirmation indication. But I don't think that they can be explicit here because go back to my earlier argument that they basically have to very subtly debase. Because if they go out there and basically tell the world what they're doing to you,

they're going to do things to go around you. So they basically... Like what we're doing right now. Exactly. You can't be that explicit with what you're doing. You need to be very... They're going to say it's transitory. They're going to say inflation is healthy.

But at the end of the day, you can't pay. your debts in real terms when they roll. So you basically need to debase the currency with which you're repaying your debts. And, you know, it's going to be a tricky proposition. But I really, I think that the more fiscal orientation you see might just confirm more and more data points, but it's going to be bumpy. But I think that everything's kind of lining up. And to be fair, catalyst pulled forward what might have been a five to 10 year event into this year. Yeah. So James, a lot of the listeners of this show, not all of them, actually. Surprising amount are not Bitcoiners, but a lot of our listeners are Bitcoiners.

And of course, Bitcoiners tend to think that they found the magical inflation hedge. And to their credit, I guess they've been right. Or they've, at the very least, you know, done well over the last few years as fears of inflation have grown. What would be your pitch to Bitcoiners who, you know, have a 100% allocation in Bitcoin? And why should they own, you know, some equities that stand to benefit if we get inflation, too? I think any intellectually honest crypto analyst or crypto holder realizes that there are still a lot of known unknowns. And the merits of diversifying into other companies and other assets that have complementary attributes to crypto, it makes a lot of sense. And within a broader crypto portfolio to have some of these more tangible attributes,

tangible businesses with cash flows where you can basically look at it as ideologically very similar to your crypto thesis, but expressed in a more conventional way. Totally. Well, James, this has been really great. I was an inflationista before, but I'm an inflationista squared now after listen to this listen to your case here. How should people follow your work and where can they learn more about the ETF itself? Great. Well, thanks. And this has really been a great time for me as well. I enjoyed the conversation. You know, best resource is horizon kinetics.com. We have a Twitter account.

We have some social media. We're not all that active on there. So I think our website, we offer a tremendous amount of free research. A lot of this is very high subscription for a lot of institutional buyers, but we offer some on our website. We offer a lot of thought pieces. You can see all the media that we've done. So if you dig around on our website, you can get a tremendous amount of information on some more of our thinking and more things that we've done. And if you want to learn about the inflation beneficiaries, ETF, that is, INFL is the ticker. James thanks again for coming on it's been great thank you