Hello everyone,

Today I’m happy to share a conversation and written Q&A with Will Thomson and Chip Russell of Massif Capital, a long-short fund in real assets, and particularly the “sectors most important to a low carbon economy: Energy, Basic Materials and Industrials.”

I’ve long enjoyed their letters and white papers and used the Q&A to learn more about their process and worldview. With Russia’s invasion of Ukraine I thought it was a good time to also catch up with Will and discuss how they navigate this environment (Will’s baby daughter was also present for the first half of the conversation and happily commented at times😉 ).

A few highlights from the conversation:

* Will is fairly bearish on the current setup of a stable, globalized world. He believes we’re moving from a highly integrated world to a multi-polar one in which “spheres of influence” play a much greater role and affect commodities and trade. Energy and food are examples where nations will increasingly to protect their own interests and create resilience.

* “What comes next is going to be very different from the past 30 years. And it’s going to be very good, I think, for real assets and natural resources.”

* “We're gonna see a fundamental re-working of trade flows along different geopolitical lines.”

* Political acumen will become more important for management teams. (An anecdote from Disney on its philosophy operating abroad: “We always ask, ‘how does it reflect on the Mouse?’”)

* The collapse of the USSR led to a decline in Russia’s industrial capacity but not in its commodity production, leaving global commodity markets well supplied. That stability has come to an end.

* Europe’s decarbonatization efforts could go into overdrive and lead to attractive long-term opportunities among utilities and industrials.

* Will doesn’t believe he can forecast commodity cycles but his best guess is that we’re in the “first third,” meaning quite early still.

For more reading: Will’s SumZero panel on energy, his conversation with Bill Brewster, and Massif’s Q4 letter:

“We believe we may be at the precipice of a global energy crisis” and “waves of sectoral inflation rippling through the economy appear likely.”

I hope you enjoy the conversation and Q&A.

Disclaimer: I write for entertainment purposes only. This is not investment advice. I am not your fiduciary or advisor. Do your own work and seek your own financial, tax, and legal advice before making any investment decisions.

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A few favorite quotes:

* “Roughly 55% of the world’s GDP rests within the vertical value chains of the related companies we focus on. We like the term ecosystem as it captures a flow-based mentality rather than static industry silos. Within ecosystems, resources are continually moving from one use to another use or reuse. Our focus aims to study, value, and capitalize on that flow of material through the economy up until it transitions into the hands of consumer-facing businesses.”

* “We feel like our ability to evaluate a management team’s ability to complete a project is stronger than our ability to predict commodity prices. Importantly, we are not naïve to think that we can completely isolate commodity price exposure, but we think about it as a potential option (do we have headwinds/tailwinds) as opposed to the main drive of an investment thesis in the mining sector.”

* “If we zoom out, we tend to think about return drivers, or opportunities, in basic materials coming from: a) resource to reserve conversions – the ability for a firm to grow production and convert geological promise to reserves and ultimately cash; b) counter cyclical and capital constrained metals – focusing on supply side analysis and industry capital flows to hunt for opportunities in capital starved sectors; and c) asymmetric demand – which ties back to many of the inputs needed for electrification at scale to occur.”

* “For energy investments, we often look for a disconnect between returns on capital and cash flow generation. Cyclical troughs are often characterized by firms with low returns relative to their invested capital. Strong free cash flow generation during these periods can protect a firm’s balance sheet while also providing healthy dividends to investors. As a cycle turns, returns on capital increase, typically followed by a pivot in investor sentiment and an increase in capital flows.”

Q&A With Massif Capital

(Bold highlights by me.)

Q: Will and Chip, thank you so much for agreeing to this Q&A and congratulations on launching your new fund! Tell me a little about your background and the history of Massif Capital.

Certainly. Massif Capital was started in the summer of 2016. Will Thomson, who was working as portfolio manager of credit and political risk insurance products at a Lloyd’s of London syndicate, saw an opportunity to start a public equity investment firm that focused on similar “real asset” businesses. Prior to managing a credit risk portfolio, Will was a strategic and economic adviser to NATO/ISAF in Afghanistan.

I joined Massif full time on January 1, 2018. Prior to Massif, I worked with several startup battery technology firms, building out business development and corporate strategy teams. My background is in energy economics, primarily working in consulting before earning a graduate degree in environmental engineering.

From day 1, we were cognizant that it was important for us to build a track-record and base of investors that could hopefully grow into a more mature pooled vehicle structure that we could then bring to a wider, institutional, capital base. This drove our decision to manage separately managed accounts for the first five years. Just recently, we have converted over into a fund structure following a seed investment in 2021.

It is worth touching on our core philosophy of our firm. We are striving to be an investment partnership, not a fund business. As we note in our pitch deck, institutionalization has driven growth in overhead, growth in overhead has driven a systemic need to increase AUM. The business of institutionalized hedge funds is not generating a superior investment return, it is generating fee income. At Massif, we are really focused on investment returns, not fee income. This may sound cliché, but many decisions we make tie back directly to this belief. For instance, some of our share classes have a declining management fee structure as the AUM of the business grows.

Q: I enjoyed your recent paper on the Advantages of the Real Asset Ecosystem. Can you outline how you define your universe and why you think it is interesting for investors who may be focused on more exciting sectors like technology or consumer?

We invest in three broad verticals: energy, materials and industrials. We are geographically agnostic, and have a minimum market capitalization requirement of $200 million USD. We typically describe our investable universe as the “Real Asset Ecosystem” because we find it conveys a richer and more substantive picture of our opportunity set. As we note in the paper, there is sometimes confusion around the economic breadth of our addressable universe. It is not a niche portfolio. Roughly 55% of the world’s GDP rests within the vertical value chains of the related companies we focus on. We like the term ecosystem as it captures a flow-based mentality rather than static industry silos. Within ecosystems, resources are continually moving from one use to another use or reuse. Our focus aims to study, value, and capitalize on that flow of material through the economy up until it transitions into the hands of consumer-facing businesses.

We think this space is interesting today for a number of reasons, principally because the global transition to a low-carbon economy is going to create a wide range of asset mispricings that we think is a fruitful stomping ground for active management. These areas of opportunity come from several directions. For example, growth and innovation in capital intensive businesses will surprise to the upside. CATL, the Chinese battery manufacturing company, is likely the fastest growing ten-year-old company ever, at scale. It’s top line is growing twice as fast as any technology company in their equivalent 10th year, off of a revenue base that is only surpassed by Google. We think this data point is a preview of what the next decade may be defined by.

The space also is seeing an unprecedented policy coordination that we think will unfortunately give rise to a significant amount of capital misallocation. That misallocation will manifest itself in both persistent material scarcity (which we are seeing previews of today), which may re-define commodity price characteristics, and also faster cycles of capital formation and destruction.

Q: You mentioned in conversation with Bill Brewster that you’re not looking to make bets on the prices of commodities. What kinds of situations do you look for and how do you think about return drivers in the portfolio?

It depends. With respect to your reference on commodities, we often like to look for pre-production opportunities if we are going to invest in the metals & mining sub-sector. In doing so, the most important question for an investment becomes: can the management team effectively bring production capacity to the market, not, do I think the commodity they produce is undervalued and will appreciate.

There are a couple reasons for this. First, there are plenty of ways to invest to get exposure to broad commodity price movement. If an investor is bullish commodities (or natural resources), it does not make sense for them to pay an active manager a management fee if they have numerous index/ETF products that can capture that viewpoint. There is a broader point here about the portfolio at large and not paying for beta (however an allocator wants to measure that), but that is a slightly different topic.

Second, we feel like our ability to evaluate a management team’s ability to complete a project is stronger than our ability to predict commodity prices. Importantly, we are not naïve to think that we can completely isolate commodity price exposure, but we think about it as a potential option (do we have headwinds/tailwinds) as opposed to the main drive of an investment thesis in the mining sector. Our investment in copper producer Ivanhoe Mines is up close to 300% over the same time period that copper has appreciated ~80%. In part because our investment was made prior to the company bringing close to half a million tonnes of copper into production.

If we zoom out, we tend to think about return drivers, or opportunities, in basic materials coming from: a) resource to reserve conversions – the ability for a firm to grow production and convert geological promise to reserves and ultimately cash; b) counter cyclical and capital constrained metals – focusing on supply side analysis and industry capital flows to hunt for opportunities in capital starved sectors; and c) asymmetric demand – which ties back to many of the inputs needed for electrification at scale to occur.

For businesses fortunate enough to be endowed with resources that can enable large scale decarbonization, management teams must push towards maximizing environmental sustainability per unit of growth output. Our investment in Altius Minerals (ALS) in the spring of 2020 exhibits many of these traits. ALS is a diversified royalty & streaming company. The firm assembles prospective geological real estate in periods of market stress that they later sell to junior miners in return for equities stacks and underlying royalties. Countercyclical capital allocation is a pillar to their business model, not just a catchphrase. Earnings generated from prospect generation are recirculated into the exploration business to acquire third party royalties that augment the internally generated royalties held by the business. The geological ‘flywheel’ often creates royalties at zero cost for the future benefit of shareholders. The portfolio of royalties is almost exclusively base metals (which differentiates themselves from their listed peers who focus on precious metals). Lastly, the company has created - and now owns a majority stake in - the first ever renewable energy royalty business that was created from recycling coal royalties that were winding down off their books. The business is incredibly capital efficient.

For energy investments, we often look for a disconnect between returns on capital and cash flow generation. Cyclical troughs are often characterized by firms with low returns relative to their invested capital. Strong free cash flow generation during these periods can protect a firm’s balance sheet while also providing healthy dividends to investors. As a cycle turns, returns on capital increase, typically followed by a pivot in investor sentiment and an increase in capital flows. Our investment in Equinor ASA in the summer of 2020 is a good example. Our investment in the business was on the heels of an historic down move in oil prices and extreme economic uncertainty given the volatile COVID19 situation at the time. EQNR was trading at a >15% free cash flow yield, was paying a 6% dividend and was growing production, and earnings at 3% a year. Leading into 2020, EQNR utilized a downturn in oil prices from 2014-2018 to become more efficient, spending 30% less on operating expenses per barrel of oil production. Furthermore, EQNR at the time, and still today, plans to grow their renewable portfolio base by 10x, a ~30% CAGR, over the next six years. Lastly, their large reservoir of oil production off the Norwegian Continental Shelf has some of the lowest energy intensity per barrel of oil anywhere in the world. EQNR is up 160% and we still believe it has room to grow.

For industrial business we often focus on economic scarcity – investing in companies that produce goods that have a very specific purpose and are difficult to duplicate. The industrial complex is where we will often find more of our compounding type opportunities. Here, we focus particularly on a firm’s ability to maintain and grow gross earnings power per share over time. We also are beginning to find divergent market prices, and opportunities, from intra-industry differences in management teams flexibility (or willingness) to engage in strategic reorientation to tackle decarbonization. Some are forced out of necessity, some are pursuing opportunities they see and some are choosing to sit on the sidelines. They won’t all be correct.

We are not investors in the business, but we wrote an article on ArcelorMittal (MT) in 2020, that walked through the ramifications of the costs associated with the European Union’s carbon goal. The article explores not only the ramifications on MT’s unit economics, but also the downstream effects on the cost of steel and the geographic competitiveness of European exports. A strategic reorientation may be possible for a company like MT, but it might cost them 4x their market cap in CAPEX, a 50-80% increase in production costs and € 200 billion in supporting clean energy infrastructure elsewhere in the economy.

Lastly, independent of sector specific sign-posts, we sometimes find opportunities that are market structure related. We are growing increasingly cognizant of the marginal buyer and seller of securities that we are evaluating and, of greater interest, forced buyers and forced sellers. For example, some smaller companies that may be experiencing a rapid change in growth (warranted or otherwise), may find themselves in an index that increases the capital flow into (and out of) their business by an order of magnitude difference.

Q: Do you believe the portfolio will act as an inflation hedge?

We do not build the portfolio to act as an inflation hedge. Insofar as we have built a portfolio that has a collection of businesses that are further upstream of alternative portfolio’s, it’s very possible that we outperform on a relative basis during inflation periods. This argument however is about as loose as the term inflation itself. It’s entirely dependent on the type of inflation, the causes of inflation and the period of time the price pressures may be exerting themselves on businesses and consumers.

Q: What do you think investors misunderstand about your space?

We think there is an underappreciation for the heterogeneity in the space. “Cyclicality” is a good example. Some sub-sectors are cyclical, some are not. Those that are, can be on very different timelines and can impact things like margins and operating leverage in very different ways. Moreover, in industries that are experiencing fundamental change, the predisposition to assert cyclicality, in part relies on some form of mean reverting tendency (observed historically) that may not hold in the future. In fact, one of the ways in which you can define and/or measure “fundamental change” is to test for the breakdown in those historical relationships.

Importantly, there is always a ‘secular’ trend that some cyclical trend may oscillate around. For ‘cyclical’ equities, it is often a function of ‘what trend matters on the margin’. Most ‘cyclical’ equities find themselves on a secular growth trend pattern that is +/- 4%. On a short time horizon, effectively flat. So cyclicality matters. The secular (long term) trend may change though, making the cyclical movements around that trend less impactful.

Electrification may be a good example. Annual rates of growth in electric demand are quite muted, given their close tie to productive labor rates and demographics. Over the last 15+ years, total electric demand has actually fallen due to energy efficiency measures and hardware in many developed nations. Looking ahead, electrification (as a broader strategy for decarbonization), may lead to a 50% increase in power demand by 2030, moving from 20% of primary energy consumption today to 50% of primary energy consumption. That rate of change has potentially profound implications on both what electrification is replacing as a primary energy source and the industrial complex that needs to scale to allow for electrification to scale to that degree.

Q: You’ve written extensively about the transition to a low-carbon economy and the massive investment required. In your latest letter you wrote that we “may be at the precipice of a global energy crisis” and that the “structural undertones that are defining this energy crisis will persist.” Can you explain how this transition is different from historical ones? What kind of opportunities do you think it creates for investors in public markets?

With regards to the differences, we outline three big ones in our 4th quarter letter:

* The current transition is both a replacement transition and an additive transition. Historically, energy transitions have been primarily additive.

* It is the first transition to move down the energy density ladder rather than up. This also means it is the first transition to move from lower capital intensity energy processes to higher capital-intensive processes.

* Lastly, it is a timed transition. It is a transition we have chosen to undertake now and a transition we have decided needs to be completed within a particular time horizon. All previous transitions have been untimed, organic, and unplanned.

The best way to perhaps summarize the potential opportunity set is to point out the (perhaps simple) observation that this is having (and will continue to have) profound implications on industries that most investors have never seen change. The implications for public equity investing is interesting. For example: an industrial company might be worth the free cash flow it can produce, discounted back to the present at some rate, with a terminal value that is pretty closely tied to say GDP. Granted, an unknown number, but a pretty tight band around say 0-4%. Almost no option value in the future – demographics and labor productivity do not have fast changing expectations. The unit economics have effectively zero expectation to change, and the pricing multiple on earnings is both low and not going to deviate too far from its sub-industry and competitors. It’s not terribly interesting, and the whole “game” is really just a function of, can I get it for a decent price

In this hypothetical example, what happens if the market for the product is expected to 10x in a decade? What happens if there is an expectation for a carbon price? All of a sudden, an investor has an entirely different set of questions now to ask. First, do I really think the product is going to see a 10x increase in a decade? It doesn't matter what the number is, the point is the range of expectation of future market size is dramatically higher than when it was tied to GDP/demographics. Second, if I do, clearly there is a new buyer in the market – at scale – do they have different specifications for the product based on their need? If yes, are we going to see new competitive advantages take hold? Do the unit economics of the business change if my feedstock is suddenly 3x the cost from a policy driven mandate? If the business has the flexibility and balance sheet, can it change geographies to alter its energy cost? If the end market for my product is new, can I provide new services to my buyers? If my buyers are in a different industry, with different unit economics, has my pricing power now changed? What type of company does the public equity market think I am now considering I may be selling to new customers, growing at different rates, have changed my unit economics and the range of possible outcomes for my addressable market in a decade from now has tripled?

To echo sentiments made in previous questions, we find the space to be rich with optionality. Disruption is quite literally the stated goal of policy makers.

Q: What would be an example of a company or industry in which the market is suddenly expanding? And if this is driven by public policy, won’t the market either quickly reflect this new expectation or will capital compete away any excess return?

Lithium is a good example. Prior to 2014, Lithium was primarily used in the pharmaceutical industry. From 2014-2019, demand for Lithium doubled, with EV penetration growing to only ~2% of the market. Lithium supply needs to roughly triple to meet mid-century forecasted demand. The rationale to bring new lithium supply to market, at scale, prior to 2014 was probably not a great investment thesis. Two years ago, we made an investment in a pre-production mining firm, Lithium Americas (LAC), that we think is going to be a top tiered producer by the end of the decade with annual production on par with Albermarle Corp (ALB), a company that, at the time, had a market capitalization 15x that of LAC.

On this issue of public policy and forward expectations, yes, it is possible that new expectations are priced in immediately. It does not suggest that the new expectations are correct. There is a wide range of future outcomes here, and the notion that capital intensive industries are getting differing sets of future expectations more frequently, lends itself to more (efficient or inefficient) price discovery as policy, new technologies and/or the consumer zeitgeist of the day changes. That pace of changing expectations is not something the resource industry, for instance, is accustomed to.

A good example is hydrogen. From 2018-2020, public company’s use of the phrase “green hydrogen” (in all public filings), increased 400%. We wrote a blog about this in June of 2020, which can be found here. The issue at hand here is that while hydrogen will play a role in decarbonization, it will not be a solution for every problem people have claimed it might solve. Knowing where the gap is between the two requires an understanding of hydrogen. For a period of time in 2020 and 2021, companies that had a hydrogen segment saw immediate re-ratings. The effect was so strong that companies that had zero hydrogen in their business models began talking about their hydrogen plans as a response function to what they saw in the market.

You could argue that expectations were priced in. You could also argue that a majority of the pricing was based on inaccurate market size assumptions, market fit assumptions, time to build scenarios and completely unknown unit economics. Insofar as there are companies that develop the technical competence and market demand for their product, capital will indeed likely be competed away with excess returns, but with a significant time lag.

Q: Can you talk about a couple of ideas that recently made it into the portfolio and why you think they are compelling?

Certainly. We initiated a position in RWE in 2021, a full investment report can be found here. In short, RWE just completed a major asset swap with E.ON that cemented the firm’s transition from a carbon intensive, fully integrated utility, to a top three renewable power producer in Europe. Pre-swap, RWE used Innogy’s dividends to pay for loss-making nuclear and coal mines. Any excess FCF from the core business, when it occurred, was paid out as dividends. This business model was based on a free cash flow maximization strategy that depended on the firm running existing thermal coal assets as efficiently as possible and with the lowest possible maintenance CapEx. Capital appreciation potential was limited; growth potential was tied to European electricity demand. Via the asset swap, RWE traded Innogy sourced financial cash flows for renewables generated operating cash flows. We believe the swap primed RWE for further growth inside and outside core markets, an equity driver not previously present. We do not believe this transition is being reflected in the equity price of the firm.

Q: What has been your experience running your own firm so far? What does a typical day look like? What takes up most of your time?

It has been humbling and rewarding. The dynamism in markets is, in part, what makes it so fascinating to be a part of; an ever-evolving system that you’re trying to wrestle with. Building a business feels similar – the freedom and responsibility of your own decision making is a double-edged sword.

We have had a slightly abnormal few weeks leading up to our fund close, but typical days are almost exclusively focused on studying businesses. I would say 50% of our time is spent reading and writing, 25% spent talking to companies, industry contacts, market participants and 25% building out new models and processes; either coding or internal processes by which we review research and edit internal databases.

Q: How do you think about gaining an edge as a small shop in a complex and global market?

I’m reminded of an interview of Steve Martin by Charlie Rose (15+ years ago I believe), where he said something to the effect of: “be so good they can’t ignore you”.

I think that’s an important point for young/aspiring asset managers to be cognizant of. This is a very competitive industry, and one where absent some strand of that unrelenting, almost unbashful, drive to be very, very good at what you do, it will be hard to persist.

“So good” of course can come in, and perhaps needs to come in, lots of different flavors. Maximizing returns is certainly one of the optimization functions, but we think a lot about how we can be better at communication with our investors, how we can build a business that inspires people to want to work here, how we can contribute more thoughtfully to research efforts in our fields of study.

It’s an excellent question. I would say the most important thing is to recognize that edge is both one of the most important things to figure out and that it is likely to be an ever elusive, moving target. Persistence in the pursuit of edge, wherever that may be, is our job.

Q: Which CEOs, investors, or publications do you follow closely in your space?

For those interested in studying energy transitions, we would recommend consulting the work of Thunder Said Energy. It is highly pragmatic and breaks down the world of complex energy systems into bite size research pieces. It is an excellent launching pad for those constantly returning to the question of: “how does this technology work?” or “can I get a straight answer on the physical, unit economics, of this energy process?”. It is a research solution set to the problem of industrial literacy that we contend is a major problem in society today. As a motivation to dive into the work of Thunder Said Energy, we would encourage readers to browse the Roots of Progress platform which outlines this theory nicely.

Q: What is your vision for Massif? What would you like your firm to look like in the long-term?

Our goal over the next several years is to diversify our fund offerings in an effort to reach a broader and more diverse investor base. This may include an extension into private markets for earlier stage technology investments, as well as public equity retail product.

Thank you so much for taking the time! Where can investors learn more about you?

Our website is a good repository of all of our published material. We also have a small, but increasingly active presence on Twitter at @MassifCap.

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