During their latest episode of the VALUE: After Hours Podcast, Costa, Taylor, and Carlisle discuss Investing Lessons From Earthquakes. Here’s an excerpt from the episode:
Tobias: JT, you want to do your veggies?
Jake: Yes, sir. So, this week’s veggies, we’re going to call this like the big one for fun.
Tobias: Value growth finally happened. The big way.
Jake: No. Inspired by this, actually, a book recommendation from Todd Combs which is called Ubiquity by Mark Buchanan. And so, I’ll set the scene here. It’s November 1990 in St. Louis, Missouri. It’s just a month before Christmas. You’d expect the shops to be crammed with people buying gifts, getting their Christmas decorations. And yet, all the stores are barren, the streets are empty. Where is everybody? It turns out that they’re all at the supermarket, and the hardware store, and they’re cleaning out every shelf preparing for Armageddon. Why is that? So, to understand, we have to rewind the clock a little bit back 179 years actually.
On December 16th, 1811, the strongest earthquake ever recorded east of the Rockies hit about 150 miles southeast of St. Louis in a town called New Madrid. It was upwards of an 8.2 in magnitude quake. This quake was felt all the way up to Canada. It rang church bells 1000 miles away in Boston. It caused the Mississippi River to run backwards for a while, [Tobias laughs] which is pretty freaking incredible. And then there was an aftershock later that day of 7.4 magnitude, and two additional quakes of a similar magnitude early in 1812, so like a month later. Reelfoot Lake in Tennessee didn’t exist in 1810. It was a result of these earthquakes. It created an entire lake.
So, let’s go back to 1990. Dr. Iben Browning is a PhD, business consultant, author, self-proclaimed climatologist, whatever that means, he predicted that there would be a massive quake in the New Madrid zone between December 1st and December 5th of 1990. His theory was like the Sun and the Earth and the Moon in this rare alignment that would create these tidal forces which would stress the rocks in the New Madrid zone past their limits and cause an earthquake. The entire southeastern US sat on a hair trigger, and this planetary gravity was about to unleash hell. So, perhaps because of the PhD after his name, and never mind the fact that his doctorate was in zoology, but the media ran with Browning’s prediction, and they caused this mass hysteria. All across the Mideast US, schools were closed, emergency crews stood on high alert, catastrophe plans were hatched, extra insurance coverage was purchased. And of course, as we all know, there was no earthquake. So, what happened?
Now, the process that drives earthquakes is no mystery. It’s basically, imagine, if the Earth was this big ball of mud, and the outside of it had dried and it was a crust, and it had this dried and cracked crust around it, and these cracks run all over. Some are large, some are microscopic and they’re all connected to each other. And inside this ball remains liquid, which as you know the Earth is liquid inside, and it’s constantly agitating the surface causing these pieces to move around and collide with each other. The frictions build up, and release, and the rocks are smashed together or torn apart. Everything that’s going on in the ground is fully deterministic and predictable in principle. It’s not much more than just rocks pressing against other rocks, right? And yet, we’re unlikely to ever be able to accurately predict a large earthquake.
There have been more than 4,000 earthquakes reported in the New Madrid seismic zone since 1974, and none of them have been newsworthy. There have been 19 earthquakes of above a 1.0 magnitude in California in the last 24 hours. [Tobias laughs] So, earthquakes are happening– The Earth’s surface is constantly moving. We can never tell which of these first tiny little slipping of rocks will cascade into a bigger catastrophe. There’s no way to know. There’s hundreds of millions of places in the Earth’s crust where these slipping events are just about maybe to happen, and cause rocks to be pushed past their limits, and push that stress then to another fault that then cascades, and it gives way, releasing energy into the next.
So, if you think that rocks slipping past each other in a very deterministic manner is difficult to predict. Imagine if those rocks had feelings about the pressures that they were under. Imagine if there was contagion amongst the rocks when it comes to fear and greed driving their behavior. That’s what we face when we’re trying to make predictions about the economy and markets. The sheer number of people with all their own individual ideas, and tastes, and utility curves, and hopes, and apprehensions, and all the companies with their own individual goals and strategies and foibles, and all the well-intentioned officials who are tweaking all the knobs, it’s no wonder that it’s impossible to predict these things.
I believe it’s possible to predict the what of potential financial catastrophes, excessive debt, high valuations, like, mean reverting data series that are pushed at historical extremes. But I think predicting the catalyst and the win of any of these meltdowns is really not that much different than trying to predict the next big earthquake. As Buffett has observed, all of that stuff is important, but it’s unknowable. And so, he doesn’t spend any of his time or brain power trying to really predict the win. He just prepares for it. I think that’s really good advice for all of us. So, there’s your earthquake analogy to financial markets.
Tobias: The Signal and the Noise, in Nate Silver’s book that came out after he got that first election right. He got one election right in a row and got the book out, which is the way to do it.
Tobias: He said that as much as they’re not predictable, if you have a certain level of seismic activity in an area, then it’s more predictive of the next level. So, if you have a lot of 3 on the Richter scale, then 4 becomes more likely. If you have a 4 on the Richter scale, then 5 and so on.
Tobias: They used that to analyze the Bay of Japan, and they said there’s so much activity there, there should be these 8 or 9 gigantic earthquakes there, and there hadn’t been one. And so, they said is it because the floor of the Bay of Japan is sandy, and all these other things. And then, of course, Fukushima– the earthquake that caused the Fukushima meltdown came along and they said, “Oh, no, it just turns out you need a long enough period of time.” They didn’t have enough time to capture the possibility of that outcome. So, now it happened and now it’s in the history books.
Jake: 1970s Japan, they were incredibly worried about earthquakes, because they had a long history, obviously, of devastating quakes throughout their history. Like, 1970s, there was a huge push to be ready for the next big one. And then, of course, it just took quite a bit longer to happen. I think you let your guard down eventually. Everything seems like it’s hunky dory and an entire generation, nothing happens, which geologic scale is a blink of an eye.
Tobias: You guys are permabears.
Jake: Yeah, exactly. You’re a permabear if you’re worried-
Tobias: No earthquake.
Jake: -about the 1970s earthquake.
Tobias: I had a friend who told me this story, but he said that when he was in high school, there was some space junk that was expected to crash into Australia somewhere. And so, he sold this insurance policy where he had this dunce cap essentially, that you had to wear that advertised his insurance policy. If you were struck by space junk while you were wearing this dunce cap that he made, he would pay a million dollars out to anybody. And of course, everybody wanted to wear one, because they saw them being advertised and the chance of winning a million dollars. So, that’s a pretty entrepreneurial kid.
Jake: Wow, what a play.
Tobias: Pretty smart.
Tobias: It didn’t happen.
Jake: [laughs] How much money do you make from that?
Tobias: I don’t know.
Jake: What premium did he charge?
Tobias: Much money. Anything really, it’s all good.
Jake: That kid grew up to be a [unintelligible [00:39:10]. [laughs]
Tobias: That guy has a law degree, a medical degree. He’s got a PhD in something as well. He’s a smart guy. Anyway, now we just got to segue on from that.
Tobias: Is the lack of the lower grades and just the reduced supply? Is that we’re just getting to the end of what we can find? Because I think that technology is so much better now for finding deposits. It doesn’t seem to be yielding much more. What’s going on there?
Jake: Coders and not geologists.
Jake: No, I’m just kidding.
Tavi: AI has helped in some senses, actually. Especially, I’ve seen some companies that have tried to apply that. I know some other businesses actually provide a service for that. It certainly helps, but I don’t think we’re yet in a place where the exploration endeavor is as easy as it may sound. It’s extremely difficult. When I hear people talking about bringing gold and other things from Mars, and I’m like, “We can’t even get it stuff out of Idaho, how are we going to get stuff out of Mars?” And so, maybe it will happen in the future. I’m not saying it won’t, but I think it will require a lot of understanding.
A great example of this is lithium, for instance. Lithium is incredibly difficult to extract. There is this new understanding of or lack of understanding really of, I think, it became a popular view. It’s a question we get the most from institutional investors. We love what you’re doing, why you’re not investing heavily on lithium?
To me, it’s attractive in a sense. But the valuation of the same deposit that has nickel, cobalt, and other things that will be just as useful as lithium are trading peanuts relative to lithium projects. And so, as a value investor, those are things that are interesting. To me, it was very difficult to start really investing in the space, because I also like cash flow, I also like bottom line improvements and so forth.
When you buy in an exploration business, you get nothing of that. Essentially buying a business or investing in a company that is going to be continuing to dilute themselves over the years, that capital is used in the ground. The beauty of it is that it’s very different than the energy space. It requires $5 million, $10 million. You can create a very, I would say, a very successful, potentially drill program for a season relative to energy where you have to spend $150 million just to try to work on something. This is really because of how deep you have to go for energy projects usually relative to metals and mining as a whole, where I think it became more, I guess, a lot easier to understand the space was how takeout prices happen in the space.
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