As part of our ‘Best of 2020 Acquirers Podcast Series’, earlier this year Tobias had a great interview with Christopher Bloomstran, President and CIO of Semper Augustus Investments Group, a fundamental, value-driven firm that manages concentrated equity portfolios of well-run, well-capitalized businesses. During the interview Chris provided some great insights into:
- Berkshire – Shrinking It’s Way Back To Significant Profitability
- Some Reasons Why Buffett Was So Somber At This Year’s Meeting
- Detailed Analysis Of Berkshire’s ‘Real’ Cash Reserves
- The Brilliance Of Berkshire’s Gen Re Transaction
- The Market Remains Clearly Overvalued
- What Do Normalized Earnings Look Like At The Back-End Of COVID-19?
- Constructing A Portfolio With 75% Of Capital In Your Top 10 Names
- Find Businesses With Good Returns On Capital And The Ability To Reinvest Capital At High Returns
- Launching A Value Firm In The Teeth Of The Tech Bubble
- If You’re Wrong Pull The Plug On Your Investment
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Full Transcript
Tobias Carlisle:
When you’re ready, sir, let’s get underway.
Chris Bloomstran:
Yeah.
Tobias Carlisle:
Hi. Tobias Carlisle, this is The Acquirers Podcast. My special guest today is Christopher Bloomstran of Semper Augustus. It’s named after a tulip. It’s appropriate for these times. We’re going to talk to him right after this.
Speaker 3:
Tobias Carlisle is the founder and principle of Acquires Funds. For regulatory reasons, we will not discuss any of Acquires Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle:
How are you doing, Chris?
Chris Bloomstran:
Well, Toby. How are you?
Tobias Carlisle:
Well, thank you. So Semper Augustus, I did just look this up because I was looking for the Latin translation. But I realize now that it’s named for a tulip, presumably a reference to Tulip Mania. What’s the derivation of the name?
Chris Bloomstran:
Yeah, precisely. So loosely translated from Latin it would be always majestic. But having read Kendleberger back in my youth-
Tobias Carlisle:
That’s a classic.
Chris Bloomstran:
And all the classic, the Semper Augustus was the most inflated of the tulip bulbs in 1637 Holland. And so at the point in my life that I thought I was going to start a firm, which was years in advance of starting the firm, I harbored the name and hoped nobody would latch onto the name. And so it’s sort of appropriate-
Tobias Carlisle:
Where did you [inaudible 00:01:23]?
Chris Bloomstran:
Pardon?
Tobias Carlisle:
When did you launch?
Chris Bloomstran:
Very end of ’98, early ’99.
Tobias Carlisle:
Oh, so right into the teeth of the year.
Chris Bloomstran:
The name was appropriate. You were heading right into the peak of the old Nifty Fifty, the new iteration of them. But it was really the tech bubble, which was already raging, and so I don’t think it could’ve been a more appropriately named firm because you recognize the bubble and we all know tech. And it was a tough period for the value crowd because NASDAQ was up 84% in 1999, our first year underway. And clients were wondering what’s going on. You guys were making mid 20s.
Launching A Value Firm In The Teeth Of The Tech Bubble
Tobias Carlisle:
What was the idea of launching a value firm right in the teeth of the tech bubble?
Chris Bloomstran:
Well, it wasn’t so much that we decided to do it, it was a grate opportunity presented itself. I had started my career at Bank Trust Company, and actually did a few … I did a thing in the commercial paper world during my last semester of college at The University of Colorado. But really, my first real job was portfolio manager and analyst at a good sized bank trust company headquartered in Kansas City, and spent seven or so years with them. Ultimately moved to Saint Louis and ran their investment office both in Saint Louis and in Colorado with an eye toward ultimately moving back to Colorado where I grew up, and wound up being introduced to a very wealthy family in Saint Louis.
Chris Bloomstran:
The patriarch, and I’ll tell this story for a minute, patriarch of this family, born in 1903, takes over his family’s brokerage firm, which had been founded I think back in the 1860s. So mid 1920s, his father passes away. He comes into the firm as a junior partner in early 1928. And this is appropriate if you watch the Berkshire Hathaway meeting because Mr. Buffett went through this whole history of the ’20s. So my client, then not a client when I met him, we talked for a couple, three months prior to our start in the firm. But in 1928, he takes all of his family’s money and any clients that would listen to a, I guess at that point would’ve been a 25 year old kid that got out of the market, and he thought there was a bubble. And he was right of course, but if you go back in time, that would’ve been about at DOW 200.
Chris Bloomstran:
And in the next year and a half, up to September 1929, the DOW almost doubled. And I think the peak was 384. Mr. Buffett talked about 381, so obviously, the market had doubled, almost doubled, up to 381. The enter day peak was 384, perhaps. Mr. Buffett talked about 381 on Saturday night. But regardless, it would’ve been a brutal period to be sitting on the sidelines. It would’ve been similar to knowing there was a bubble in the late 1990s, sitting out for a year and a half or two years, only to watch the NASDAQ go up 84% in 1999. But obviously, vindicated three years later with the full 89% drop to 41 on the DOW.
Chris Bloomstran:
And during the depths of the Great Depression, this guy sensed that there was more value out there in things like General Electric, which no businesses were making money. I mean, it was nasty depression. Unemployment had risen to 24%. Corporate profits were nonexistent. But you could buy assets for less than network and capital, you know the old Ben Graham [crosstalk 00:04:41]. This guys says, “I can buy GE for less than the cash in the business. Not making any money.”
Chris Bloomstran:
And businesses also then didn’t have the leverage in place that they had today. He gets into the market and picks up over the years things like Walmart and Merck. The basis on the GE purchase was 12 cents per share, bought almost perfectly after all the splits. This guy goes off to World War II, comes back, doesn’t go back to the brokerage business, but eventually gets into banking. Became vice chairman of one of the big two Saint Louis banks. And when I got to know him, he was long retired, had his hand in all kinds of things. He had some tech investments. He had a contactless card, which is really amazing when you think about payment systems now, Visa and MasterCard going contactless. I mean, he had a healthcare card. He was a brilliant guy.
Chris Bloomstran:
In his lifetime, he knew, had these wonderful stories, he knew every single federal reserve governor because as a kid, the fed was set after 1913, he had met them all. His family was well connected. They were in the investment arena. Anyhow, when he got to know me, we shared this mutual sense that there was a bubble, not unlike the late 1920s. And it looked a lot like it in the late 1990’s. And so he said, “Look, but I don’t wan to have a bank managing my capital. I’d love to have you come in and take over my family office investment wise.” And so I’d always harbored this notion of starting a firm, hence the Semper Augustus name. I’d had it in a reserve for years. And I called my business partner, Chad Christianson. We’d gone to school together and always sensed we’d run a firm.
Chris Bloomstran:
Chad had gone off to do public accounting with KPMG and Ernst & Young. And in very late ’98, we made the decision that we’d always wanted to do this, and here’s the opportunity. And so we took over this family’s portfolio. We had several other accounts, our family’s accounts at the time. And you think about that period with the Nifty Fifty, those stocks trading between 40 and 60 times earnings. In this family’s case, there were a lot of low basis positions, but a lot of businesses that really, if you looked at the accounting objectively, they did not earn their cost of capital. You had even then huge pension liabilities, already at that point, underfunded despite what had been an 18 year market, where stocks had averaged high teens. Interest rates were higher than they are today. And companies were assuming eight and a half to nine and a half. There were even some businesses in the S&P 500 assuming 10% pension liabilities.
Chris Bloomstran:
We have a methodology where we have ratcheted those assumptions way back to try to normallize what we think the annual expense in a pension fund would be. But at bottom, there were a number of companies in this portfolio and across the broad stock market with businesses that really weren’t cost competitive, that earn their cost to capital, that had some of these issues. And we were able to, through a series of transactions with a family foundation and some cred accounts that fed income to the patriarch and matriarch. We were able to sell a huge chunk of this portfolio that was trading between 40 and 60 times.
Chris Bloomstran:
And if you remember the bifurcation that had taken place in the market in the late ’90s, not unlike what you’re seeing today, really. I mean, we were talking before we started. The small and mid cap’s down, just getting crushed. International indexes down. And you’ve got the S&P today down 10 for the year, and the Qs, the NASDAQ.
Tobias Carlisle:
Qs are up.
Chris Bloomstran:
The Qs are up for the year. It’s remarkable. It was an opportunistic time for us because the bifurcation was that wide. And it was a great time to start a firm. We found a lot of great small and midcap companies, couple international businesses in Japan that were just washed out and cheap, and build a portfolio of firetruck manufacturers and small banks and thrifts. Bought Berkshire Hathaway for the first time in February 2000 after the stock had been cut in half, after the general reinsurance transaction. We paid the same multiple to book, 108% on our first transaction in February of ’00 to where the stock’s trading today, which is kind of amazing. It’s come full circle.
Tobias Carlisle:
It is amazing.
Chris Bloomstran:
Because two years prior to that, the stock had traded at three times book. Anyhow, we really benefited from that bifurcation and built a portfolio trading in the low teens to earnings at a time when the S&P was trading at 40 times. The NASDAQ, which had been up to 99% in ’99, was trading by March 2000 at over 240 times earnings. And it was a perfect time to launch the firm because we had pivoted away for the family, away from those blue chips. We had bought those small mid caps, and wound up like a lot of good value investors, making good money during that first 50% bear market.
***
Find Businesses With Good Returns On Capital And The Ability To Reinvest Capital At High Returns
Tobias Carlisle:
How would you characterize your investment style? How would you characterize what you’re looking for?
Chris Bloomstran:
I think conventionally, if you looked at us, you’d say these guys are value investors because price is a very important part of the valuation equation for what we do. But we’re eclectic. Our real core mission is to try to find businesses that earn good returns on capital, but that also have reinvestment sets to reinvest capital incrementally at high or accretive returns. But we’ll do this, so we’ve got classic compounders and I’ve got businesses in the portfolio that we’ve owned for a long time. But we’ve also done things cyclically over the years in energy. We’ve owned Deep Water Drillers a couple times. We wouldn’t touch that world today because of the leverage. But we own a couple other energy businesses today, one in Norway. We own Exxon Mobile here domestically.
Chris Bloomstran:
And here and there, if you’ve prepared capital, and you’ve paid attention to how the world works in the capital markets, occasionally you get things that come along that I would look at as being risk free or as risk free as can be, with huge upside. And oftentimes, you find those things during periods of dislocation. We did some of those in 2008. I’ll give you example of one that we did prior to ’08. Appollo Investment Corp, which is Apollo’s … They launched [inaudible 00:11:05] in probably two or three years prior to the ’08 financial crisis. And I’m going to guess they raised $800 million, let’s say. It might’ve been $700 million or $900 million. But it was a BDC, classic business development company structure. Came public at 15 bucks a share. Net of the underwriting discounts that the syndicate would’ve taken to bring it, it had $14.10 in cash.
Chris Bloomstran:
And they raised the money like water. It was oversubscribed. And so we didn’t want to own a mezz fund. Mezzanine loans, then what would’ve been 12%, to 13%, to 14% yields in the interim before they put that money to work. They were going to buy senior secured debt at 6%, to 7%, to 8% yields. Well, I think they wanted to disincentivize the KKRs of the world, who were teeing up their own S1s when they saw how quickly Apollo had raised capital. And so I think Apollo went back to the syndicate that brought it public and said, “Break the IPO price,” so the stock traded initially up, but then it traded down below the $14.10 that would’ve been all cash not a single investment made. But the stock traded down to 13 bucks a share. And so, we looked at that and said, “We’re buying cash for a discount to cash and looked at the business plan that said, once they put that capital to work.” There was North at two bucks in earnings, power in the business.
Chris Bloomstran:
And they hadn’t made the first mezz loan. Early loans don’t go bad on day one, if the business is going to be a bad business, it’s going to take a financial crisis or recession or a problem or simply too much leverage and the business doesn’t earn its cost of capital for there to be a problem. There wasn’t a huge margin of safety to give them a couple of years to lay out the capital and we own it for a couple of years and wound up selling the whole position in the low 20s per shared, eventually traded into the high 20s but again, we had no intention of owning a mezz fund. But that was an opportunity to buy a dollar bill for a discount and wound up being worth more than a dollar bill and things still trade still. I think in the teeth of the recession, it traded down to three or four bucks a share. I haven’t looked at it in a few weeks, but it’s maybe right around their original IPO price. So what we’ll do is we’ll do weird stuff like that too.
***
Constructing A Portfolio With 75% Of Capital In Your Top 10 Names
Tobias Carlisle:
When you’re constructing a portfolio, how many positions do you like to hold? How big is a position at inception and how do you think about your risk limits and your diversification in the portfolio?
Chris Bloomstran:
Yeah, we’ve always been very concentrated at the high end and Berkshire since we bought it has grown. We’ve never bought it more than 20% of capital. But if you look at our 13 filings, you look at our composite minutes, well North of 20%, but we buy it at 20. Historically over the 21 years that we’ve run the firm, we’ve generally had North of 50 today, probably 75% of our capital in our top 10 names when we’re initiating a position. To your question, we typically start small with one or 2% position size. There’s an exception to that. We are very eclectic in terms of how you would define style or style boxes. We don’t fit well. We own across the whole cap structure. We’ve always had a sweet spot for mid cap companies, small cap companies.
Chris Bloomstran:
I don’t think about cap. I don’t think about where companies’ headquartered. We’re trying to find good businesses that have the characteristics of companies that we’re trying to find at low prices. And when we get a chance to do that, but risk management wise, for example, we’ll never make a tiny small cap business or even some of the smaller mid caps as large as a 10 or 15% position. We manage risk and define smaller companies that are often one trick ponies that often don’t have as durable of a moat that don’t have access to capital, that don’t have the longevity, that aren’t as immune from disruption. We intentionally manage position size smaller with the smaller businesses. There are a lot of things we do. What we do, we manage risk really well.
Chris Bloomstran:
We spend probably 80% of our time thinking about what can go wrong as opposed to what can go right. And for that, you miss a lot of big mistakes. And I think the other thing we do well, and this is a valuable construct. I don’t if it’s learned or if it’s simply risk aversion, but when we buy a position, my ideal scenario is that we’ve taken a toehold with a one or 2% position and that position drops in size. Because you may have an earnings miss or whatever. Well, we like to increase position size and clients have a hard time getting their mind around the fact that we’ll wait. You’ll put money at a business and you want it to go down in price. Well, yeah.
Chris Bloomstran:
Now you’ve heard Mr. Buffett’s say for years and he was right. You only need stocks to be at a high price on the day you need to live on your capital, otherwise you want low prices. So we should all be cheering during times like today. Well, one thing we’ve done exceptionally well is, we don’t play stop loss of hoarders. We’re not traders by any stretch. We’ve had 15% annual turnover. When we commit to a position, we intend to own those things for a long time. Unless we’re talking to some of the cyclicals where we have a target price and a target endpoint in mind. The thing we’ve done well is if we’ve taken a position and we think there may be something wrong, not sure, not entirely confident to where you’d want to back the truck up.
If You’re Wrong Pull The Plug On Your Investment
Chris Bloomstran:
The mistakes that we’ve made over the years, the majority of the mistakes we’ve made plenty. In this game, you’re going to make a lot of mistakes. We’ve kept them small and we’ve hesitated to take a 2% position that’s dropped by a quarter and is now 1.5% of our capital to rebalance that position or to make it a 3%. Rare are the ones that have been position sizes. We’ve chased capital and chased capital because I think we’ve got a pretty good hunch when there might be something wrong. We’re not quick to pull the plug, but once we know we’re wrong, we’ll pull the plug, we’ll move out of capital. But the times to back the truck up is a huge art and couldn’t be more important to the money management process.
***
Some Reasons Why Buffett Was So Somber At This Year’s Meeting
Tobias Carlisle:
Well, let’s talk about that a little bit and I’m going to tie this into your biggest position which is Berkshire and you’re known as someone who’s has spent a great deal of time researching and writing about it. We’ve just had the general meeting this weekend gone that I think that perhaps shocking might be too strong of a word, but the scary thing for me was really that I had some inkling that this was going to happen before we went in because Munger said beforehand that they hadn’t done a great deal. And we knew that they had sold down Southwest and Delta and it sold down Bank of New York, which has the very unfortunate BK ticker symbol. And then I think it’s the most somber I’ve ever seen a Buffet in a general meeting and perhaps compounded by the fact that he was alone for a lot of it or with only Greg Abel there for part of it in a gigantic auditorium. What were your impressions and how do you feel about Berkshire right now?
Chris Bloomstran:
Yeah, it’s all very interesting. And I couldn’t agree with your perspective anymore. He was extremely dour and somber and you think about where he is at his station in life, he’s run this operation. He’s had this great American tailwind at his back where he’s seen, GDP per capita on a real basis, compound at multiples over a course of a lifetime. And you really haven’t had that in the last 20 years. And we’ve seen leverage levels build throughout the system, went through the financial crisis and took some opportunities and made some very good investments during that period, wound up buying the railroad, in ’09 but had made the investments in GE and in Goldman Sachs. You think about running the operating businesses that they have and seeing the retail operations in the empire.
Chris Bloomstran:
They’ve owned Nebraska Furniture Mart for a long time. They’ve owned Borsch arms for a long time. They’ve owned seas, back to the early 1970s. Those are businesses that closed their doors and they furloughed employees. And that’s something Berkshire has never done. They managed through the ’08 crisis seamlessly. And then on the other hand, you’ve got Bill Gates who’s very close to who couldn’t be more of an authority on what’s going on medically today, resigning from not only his board of directors, but the Microsoft board to focus on what I think Bill knew was going to be a very, very profoundly serious thing, and that it would impact the economy for a long time. And so, we presumed correctly when we saw the sales of the Southwest position and the Delta position to take them down to 10% that it wasn’t because he was teeing up the outright acquisition of an airline.
Chris Bloomstran:
We assume they sold all of them and had probably already sold the other two United continental and American prior to the 10. He rightfully, having grown up in the wake of the great depression and I go back with my own family and both my grandmothers when I was growing up having lived through that period with large families and not a lot of resources and a lot of pain and suffering. On the odd occasion that my grandmothers would be willing to go out to lunch or to dinner because they really just never wanted to spend the money. Both drank hot tea for example with both for their entire adult lives that I knew them. They would wrap up in aluminum foil or a napkin their teabags and take them home from the restaurant. Because why don’t you throw away a perfectly good teabag that you’ve only gotten one use out of. We’ve lost that sense.
Chris Bloomstran:
But Mr. Buffet grew up in that environment and they have every right to be concerned about what’s going on because nobody can know the duration and the magnitude of where we are. We’re seeing the economy start back up and we’re trying to put industries that have been closed back to work, but within that microcosm of Berkshire, they’ve seen this thing up and close and we see it as investors and we’re talking to CEOs and CFOs and people in the medical world and try to get our minds around it. But he’s running businesses and he’s never seen anything like this. I couldn’t share the sentiment anymore. I think he’s logically concerned about what’s going on.
***
Detailed Analysis Of Berkshire’s ‘Real’ Cash Reserves
Tobias Carlisle:
It was shocking that they have been so aggressive in their acquisitions that even December 2019 they took that opportunity to buy some more stock. You were suggesting perhaps hoping for a buyback through this period. Even $20 billion, that’s a very large amount of money, but it’s not a great deal of money really for Berkshire. Were you surprised that the buyback was so small?
Chris Bloomstran:
I was surprised that the buyback was so small. We look at the business at year end and I write my big long letter every year in the stock close 2019 at 70 cents on the dollar of what we think intrinsic value is. And as we go through the big moving parts of the business, three quarters of the business that exists in the insurance operation, which is still probably 45% of the value of the company. And then between the rail and the energy businesses mean that’s three quarters of Berkshire Hathaway. And those three businesses are fortresses and really will not be that materially harmed during this period. And so to see Berkshire’s shares down as much as they are has been surprising. I think the stock is wildly undervalued today given what I think is the durability of a lot of the earning power of the business.
Chris Bloomstran:
And we can talk about some of the pieces of the business inside where you really are going to have some diminution of earning power.
Tobias Carlisle:
Please.
Chris Bloomstran:
Yeah, I was frankly shocked that there was not much of repo, but then to put the cash in perspective, if you think about it and I wrote about this in my letter this year, Berkshire is taken a lot of heat over the last three or four years for sitting on this giant cash pile, that’s now North of $130 billion with the sales of the airlines and incremental profits coming in on some of the businesses, they might have $140 billion in cash today. If you look at the business post, the Gen Re deal, when I think they ran away from the stock market and ran away from Coca Cola when it was trading in the high 40s to earnings by doing the deal with Gen Re and buying the business for their own stock, with their own stock that was trading at three times book and they diversified so beautifully away from stocks, which were 115% of book value down to 69. If you look at the last 20 years, the cash and the business has averaged about 12% of Berkshires total assets.
Chris Bloomstran:
Well at year end it was 16% it’s probably crept up now to where you’re pushing back on $800 billion in assets. It’s not that large. When you think about the insurance operation itself that had statutory capital of 215 or $220 billion at year end, the stock portfolio as big as it was pushing $250 billion got down to 100 and probably 60, 65 at the lows on March 23rd probably back up to $190 billion today. The cash really arguably all of is not available for investment. Mr. Buffett’s always talked about the $20 billion. That would just always be the fortress and would always be a permanent cash reserve. I look at that number really is more likely approximating one year’s worth of insurance losses paid as cash, which on a current run rate would be about $37 billion.
Chris Bloomstran:
And then you’ve got cash throughout the operation in the rail and in the energy businesses and although you can’t tell where it is now, because we’re seeing less transparency of the MSR businesses themselves. And I’ve been critical of this in the last three years, there is cash that’s held in those operations and the cash in the MSR business is probably offsets of the debt, but I think there’s probably call it $60 billion of cash that really is not available for long duration investment in businesses or in common stocks. But I think it’s the permanent cash reserve and the insurance operations plus working capital that’s required in the other businesses. In today’s world, there’s the balance of somewhere between 60 and 140 so, it’s still a good chunk. It’s still $80 billion. And part of our method for valuing Berkshire is we assume that money is going to get put to work. That portion of the cash that we think is available for spend.
Chris Bloomstran:
So if today it’s $80 billion, we assume that that capital, which today is earning zero, a big deal here at the margin. The entirety of their $140 billion a year and a half ago, a little over a year ago, was earning 2.5% interest in T-bills. They’re earning zero today. That’s a huge chunk of earning power that’s gone away. Well, one of the methods that we use for valuing the earning power of the businesses, we normalize what that cash we think will ultimately earn, or at least that portion of cash that’s investible and we assume a 7% return. Now we think Berkshire’s hurdle rate for investing capital is still around 10%. When they did the Oxy deal, they did it at yields they thought would be North of 10%. When they did the GE and they did the Goldman Sachs deals, those were 10% preferred’s.
Chris Bloomstran:
They were callable at a premium over a period of time. Yield on that paper was probably 13% and then they got warrants underneath. And so you do the math on what the warrants wind up being over time. Those were a high teens returns on capital. We don’t think Berkshire is in the business of making investments in businesses that are in seven. The reason I use seven is time value money. We assume it’s all not going to happen on day one. And so it’s whatever point in the future. That’s why I bring it back to 7%. We might have to lower that now with interest rates at zero and Berkshire seemingly on the sidelines for the time being. Because they don’t know how this insurance world is going to evolve. Losses could wind up being as some of this business interruption risk gets litigated through the courts. Event cancellation, you’re going to have an increase in DNO.
Chris Bloomstran:
Sitting on cash during the unknowable, which is the sense that you got. I don’t have a problem with that and correct me here, even though I expected a far larger share repurchase and I think the shares are that undervalued today. I’d rather err on the side of caution and I don’t mind Mr. Buffet erring on the side of caution during a period of this great unknown.
***
The Brilliance Of Berkshire’s Gen Re Transaction
Tobias Carlisle:
Yeah, I couldn’t agree more. That was the first time I’ve ever bought Berkshire was on the 20th of March for my own portfolio. I’ve just never seen it that cheap. I tend to be at the deeper end of the deep value scale, so I think it’s got down cheap enough for someone who likes to pay as little as I do. You touched on it very briefly there, Jake Taylor alerted me to this. I hadn’t appreciated the elegance of the Gen Re deal previously. Could you just repeat what you… just tell that story one more time, just so folks understand what Buffett actually achieved with that acquisition?
Chris Bloomstran:
It was incredible. The success that Berkshire Hathaway had, had from the time they bought National Indemnity in 1967 and got into the insurance game, the success they had investing their surplus capital on their float in common stocks was extraordinary. Post the 1973 bear market that took the S&P and the Dow down by almost 50% from that period, from the mid ’70s through 1998 and you had this phenomenal bull market. You could either mark the low to late 1974 where the Dow had fallen from 1000 to 554 I think it was. Or in 1982 where the Dow had fallen from 1000 again back down to 778.
Chris Bloomstran:
I mean, there were 17 years, 16 years from 1966 when the Dow first traded at 1000 to where it didn’t really break above 1000 you went through these rallies and these sell off. So it was just a long bear market during a period where inflation was very high. Peak to trough from the peak in 1966 to 1982 investors in the Dow or the S&P lost 75% of the purchasing power of their capital. So you were down 25% in price in 1982 from the 1000 peak to the 778, you made some dividends. But stocks were wildly inexpensive. In 1982 profit margins had been wiped out. We were dealing with the inflation margins had fallen from 6.5% of their highs to 3% and stocks traded at seven times earnings. You were paying seven times for a 3% profit margin, which becomes 21% of sales. And so regardless, during the bull market that for Berkshire’s and Berkshire shares and the stocks they invested in ended in 98 didn’t end in 2000. They ended in 98. That’s when Coke peaked.
Chris Bloomstran:
Coke had grown to 45% of Berkshire stock portfolio. Now they’d bought it for the first time in 1988 after the stock market crash. And Berkshire had made something like 13 times their money just on the Coke piece. But everything that they did, I’ve seen studies and I’ve seen a lot of naysayers that criticized the success of Berkshire and even an academic paper by research affiliates that came out a couple of years ago, tried to run a factor analysis of replicating what was important to Berkshire’s portfolio. And I think they got two variables, beta and a price to book maybe it was one.
Tobias Carlisle:
It’s quality. It’s at 1Q 01 and they said it was 1.6 times leveraged and it was to quality.
Chris Bloomstran:
That was a thoughtful paper and well-intentioned. But they also assumed that over the duration of the history of Berkshire, this 55, 56, 57 years that you would have operated your common stock portfolio 70% leverage. Berkshire’s has not operated at 70% leverage. There’s a genuine lack of understanding of how insurance float and surplus capital works. That was not a 70% levered portfolio. And if it was, and you were simply a common stock investor, you couldn’t have survived 73, 74 or you wouldn’t have survived the 87 crash or you wouldn’t have survived the ’08, ’09. A well-intentioned study, but set it aside, Mr. Buffett, when he bought Coca-Cola in 1998 and through ’89 I’m sure it was not thinking about beta or priced to book, he was thinking about the moat that exists around Coca Cola and how many servings of soda these people were going to sell 10 years from now and 20 years from now and how the capital structure of the farm worked and then all of that.
Chris Bloomstran:
Anyhow, Bufffet had a high class problem, Berkshire had a really high class, probably 98 and that’s the history of their success. Berkshire had compounded their book value at about 29% per year from when management took over in 1965 up until the end of 1997. And Berkshire stock reflected that success. Then probably 85% of Berkshire was concentrated in insurance. So they had Cs and they had the shoe business and they had the furniture mart, but they hadn’t really bought some of these big durable assets that have come along in the last 20 years. This was still an insurance operation, high-class insurance operation. By then, they already had all of GEICO of course, and National Indemnity. And so, they had this problem and the stock reflected the success. It was trading at three times a book and it wasn’t worth three times book.
Chris Bloomstran:
When we started following the business, when I got interested in it in ’96 when they issued the B shares, right on the front page at the prospective said, neither Charlie nor I think Berkshire is worthy of buying. But of course they issued the B shares to phase out and keep these guys from running what would be certainly an ETF structure in today’s world.
Tobias Carlisle:
Yeah. Folks might not remember, their shares got so expensive that nobody would have wanted it. I don’t remember where they were, but there might’ve been 20,000 but there were these groups that used to buy the shares and then they would issue their own units. It was like a flow through structure with a fee in it. So you could buy the units in the shares for much lower prices five or 10 bucks.
Chris Bloomstran:
Yeah, they tried to do it. I think the shares were probably closer to 40,000 because they wound up eating it a little over 80,000 in 1998 and I think they doubled during that two year period. But whatever it was, you had a state planning problems if you were gifting to your kids and the gift limits then were $10,000 gifts per person. And so what do you do with your A shares? There were no B shares. So Warren and Charlie didn’t want to see somebody coming in and charging 3% for the right to own Berkshire Hathaway per year. And so they headed that off and issued the B shares. And I think they genuinely felt that the stock at that point was probably override. Now they’re always conservative in terms of talking about how well Berkshire can do, you saw it on the meeting on Saturday night, but it was a genius masterstroke. It created the second class of stock.
Chris Bloomstran:
By 98 though, the stock had doubled or whatever it had done from 96 was that expensive. It was three to book. And so the problem was the stock portfolio had grown so large. Like I said earlier, it was about 115% of Berkshire’s total book value, which is amazing. Instead of paying what were then 35% capital gains taxes, corporate tax rate, and selling Coca Cola down and selling Gillette and selling the Washington post, he buys General Reinsurance, which as a classic reinsurance operator business, had the vast majority of its capital invested in bonds. The size of Gen Re, which is where this is really interesting, where it was such a brilliant transaction, picking up Gen Re tripled Berkshire’s float and immediately diversified the stock portfolio from 115% down to I think it was 69%.
Chris Bloomstran:
Berkshire has lamented over the last handful of years, the fact that he gave away Berkshire shares and looked at what was spending, I think it was $20 billion, let’s say for what would have grown to $80 billion 4X growth over a period of time. And I look at it differently. I look at the percentage of the company that Berkshire gave away which was about 17% and they wound up, Gen Re was really a third of the business. They used the stock at three to book when it was worth half that in my opinion. And it was a brilliant transaction. I would contend here, lo these many years later that had they not done that deal, that Berkshire could not have started buying the utility businesses, would not have bought the Railroad in 2009 because the capital was trapped in common stocks that were trading at 45 to 50 times earnings. And if he wasn’t going to pay the capital gains taxes to sell them, he couldn’t have upstreamed enough capital out of the overcapitalized insurance operation to do the deals. And yeah, it was perfect.
***
The Market Remains Clearly Overvalued
Tobias Carlisle:
It’s a really clever transaction that I’d never heard explained before until Jake recounted you describing that to him. I appreciate it. I think it’s absolutely fascinating. Can you contrast the market when you started investing in the late 1990s to the market that we’re currently in. How do you see the current opportunity set and where do you see the risks and so on?
Chris Bloomstran:
Well, I started investing in the early ’90s and had the run during my ’20s with the bank. I saw this great bull market. The first part of my career was a straight up bull. In fact, if you look at what I would call fair value for the overall S&P 500 of the market, probably the only time during my career that it was undervalued was 1991. We had a big recession in 1990 stocks had sold off pretty hard. Really, not until you got. So you had the bull and we started the firm in 99, 2000 was the mother of all peaks on all fronts. You had the 50% decline in 2000 or 2002, but at the bottom and at the lows in 2002, the market was not cheap.
Chris Bloomstran:
It had sold off from a crazy high level, but on any fundamental yardstick, and you can look at the table I do in the last couple of three years in the front of my client letter, I’ve got the historical peaks and troughs that we think are the seminal major secular highs and lows over time. And I wouldn’t put 2002 in that bucket, even though the market had fallen by 50%. 2007 peak yeah. Because the S&P had recovered all of that decline had traded right back up to the mid 15 hunters, which is where it was in 2000 and then you have the 60 plus percent decline by late ’08 and in November of ’08 and then in ultimately in February 2009, maybe it was March, stocks were genuinely undervalued.
Tobias Carlisle:
It was 666 bottom.
Chris Bloomstran:
666 bottom. That marked the cheapest my portfolio had ever been. And we fell by half of the market decline. We navigated that bear market using a lot more activity than we typically do really well. But then obviously, the Fed came in and put a put underneath the market and levered up the Fed’s balance sheet from $850 billion to about 1.5 trillion. And then in the success of decade layered on three more rounds of QE, ignited financial asset prices, kept the Fed funds rate at zero for a long time. Finally, thought well heck, we’ve probably created an asset bubble and we need to slow this down. So they went through a series of nine rate increases. They tried to run off the Fed balance sheet which eventually got up to $4.5 trillion dollars in size, ran it down to 3.7 but you had this glorious bull market in stocks that really wasn’t predicated or supported by fundamentals.
Chris Bloomstran:
If you take the last decade, sales for the index have grown at about 3.5% a year and people wouldn’t realize that when stocks are doing, double digit returns, but you had 3.5% top line growth and that’s from the end of 2009 which allowed a full year of recovery. When you do the math, we found at the end of 2019 and I said it in the letter this year, stocks were at a secular high that rivaled and in some cases exceeded the big ones. The 1929 that Mr. Buffet talked about on Saturday, the 2000 peak were really the other two major secular marks. You call it 1966 a peak as well. It deserves merit. But in all four of those occasions, there are a lot of parallels between the current 2000 and in 2019. And so taking the S&P down 31 or 32% to me didn’t even get the market remotely close to fair value. We got down to 2200 on the S&P.
Tobias Carlisle:
Yeah, I agree. It was only a little bit South of where it was in 2007 at the peak only just.
Chris Bloomstran:
Yeah, earnings peaked on a profit margin basis in the third quarter of 2018 at 12.1% that was at the point of maximum benefit from the tax cuts at the end of 2017 you were still North of 11% of the end in 2019 even though profits were flat and the market went up 31.5%. I’ve got fair value on earnings, normalized earnings that are somewhere around 100 bucks a unit on the S&P 500, maybe 110. Fair value is somewhere between 1516.50 that’s a long way to go.
Tobias Carlisle:
Yeah, I said 1800 is my estimate for fair value on the S&P 500 probably a little bit more optimistic in here Chris.
Chris Bloomstran:
Yeah. Well, what’s the famous better to be roughly right than precisely wrong. It’s [inaudible 00:43:12]. In fact, when we first put out our first intrinsic value report, this is a funny story, in March 2000 because we were under a lot of pressure because we were only up 20% in 25% whatever. In 1999 like I said, the NASDAQ had done 84 all of our clients including my anchor family office client with whom I was sharing office space. They had the second and third generation in there. Everybody wanted to know why didn’t you own tech stocks? It was a brutal period. We were under a lot of pressure. In that period you were new to the firm. I started the firm when I was 29 years old. We didn’t own any tech and every client wanted to know why don’t we own some tech?
Chris Bloomstran:
Mr. Buffett in that first meeting in 2000 that I had gone to he was getting a lot of pressure. I remember distinctly questions and seeing them on the wonderful archive that CNBC has. He had one guy that came out of his chair and really screamed at him for not owning any tech stocks. And the pressure was that intense. I needed a tool to demonstrate the fact that we own high quality businesses. What I thought they were worth, what I thought their normalized earning power was. I built this intrinsic value report that showed you that we had a portfolio of stocks that was trading at about 15 and a half times earnings.
Chris Bloomstran:
The S&P was trading at 40 times, and so our stocks then were roughly 75 cents on the dollar, a fair value. They gave us 33% upside on top of our earnings yield, which was then 6.4%. The S&P 500 by contrast, when I did all the math and ran normalized earnings and current gap earnings, we had fair value at 590. The S&P at the end of March 2000 was 1499 it was 21 points below. It’s March 10 higher, it’s March 24 high.We put together the report and Chad, my business partner, who’s the Eagle scout, public auditor, conservative accountant said, “Chris, we’re already under a lot of pressure from these people.” Because here in March, during March we were going straight down every day until March 10 the market was going straight up.
Chris Bloomstran:
A lot of parallels with what’s happened in the last handful of months and a couple of years. He said, “Do you really want to tell people that you think the market is worth precisely 590 when it’s 1500? Shouldn’t we just say it’s really overvalued?” I’m not going to quibble with your 1800 or 1500, it’s overvalued. I don’t think there’s any reason, a rhyme or reason to put a precise calculation.
Tobias Carlisle:
We’re like 3000 that writes something like that, roughly just for people of the future who come back to hear us talking about these levels when it’s 3000. It makes really no difference whether it’s 1500 or 1800 that’s just …
Chris Bloomstran:
From these levels down is 30 to 50% and that’s just to get a fair value. That gets you to a 15 multiple the what you would call normalized earnings. And there’s a whole camp that would say, well but Chris and Toby, you have to consider the interest rates are zero and the tenure for future generations, the 10 year treasury is less than 1%. It’s something like 70 basis points. The 30 year treasury is 140, all of those have been below 1% for the better part of the last two months when the Fed took rates back to zero. And so-
Tobias Carlisle:
It looks like it’s about to go negative today. [crosstalk 00:46:41]. It’s dropping like… something that drops really fast.
Chris Bloomstran:
Well, you’ll plop these very low interest rates into your DCF and you can spit out a value higher but you have to ask yourself the question, should you be running DCFs on zero interest rates or on a 70 basis point 10 year when in fact, the reason the interest rates are low is because there’s no growth in the economy and we’re saddled with 350% credit market debt to GDP going into the year, which is probably going to be 400% coming out of the year. The Fed was going to run a trillion dollar deficit this year. They’re going to run a $4 trillion deficit GDP, nominal GDP is going to be down somewhere between five and 10% at least. I would argue that I don’t think running a DCF at zero or at 50 basis points or 70 based ones makes a heck of a lot of sense.
Chris Bloomstran:
In 1982 there were academic studies. Arthur Laffer had a paper that suggested that in 1982 when I talked about stocks trading at seven times at 3% profit margin, that stocks were overvalued. As you would have been discounting based on-
Tobias Carlisle:
The interest rate yeah.
Chris Bloomstran:
While the longterm treasury traded at 1571 I think, or 1578 in the fall of 1981 short-term rates were 20%, mortgage rates were 20% and so you run those discounts so you got to look to the whole duration. And throw out at the extremes in fiscal and monetary policy, consider that debt levels are at a point that to me introduce deflation for a long time. We either need to have a very long period of austerity to try to grow our way out of this mess. The problem is politicians don’t really like austerity households, businesses don’t like austerity.
Tobias Carlisle:
You get it one way or the other. You get it voluntarily or involuntarily. We may be getting it in involuntarily.
Chris Bloomstran:
Yeah. My guess is we hold interest rates low like we did for most of the last 10 years, for the next 10 years. The federal run through various iterations of QE will continue to balloon the balance sheet, it’s going to wind up more than doubling in size. We went into the crisis beginning of the fall when the repo crisis evolved. We had the Fed balance sheet at 3.7 trillion. My guess is we’re going to be at least double the 4.5 trillion where it was a year and a half ago will be nine, maybe $10 trillion. My concern is as an investor, empathy goes to Mr. Buffett on Saturday night.
Chris Bloomstran:
Jerome Powell did the right thing and we put a put again underneath the market. We introduced all of these liquidity programs because I think they said we’re not going to let families and businesses fail during this crisis. They couldn’t control and had no business being a part of. And so, we’re layering on more debt. Boeing’s taking on debt, Exxon Mobil’s taking on debt. The debt issuance is pretty staggering. The Fed compressing the credit spreads with the notion that they can come in and buy corporates and they can buy high yield corporates and even ETFs is astonishing. But they compress spreads. They allowed companies to borrow at reasonable rates. You know what rates where Berkshire would not be a lender of capital or an investor, but the problem is what are you doing on the backside?
Chris Bloomstran:
Once we’ve put people back to work, we’re not going back to 3.5% unemployment. We will have structural unemployment in a whole bunch of industries. We’ve taken corporate debt levels that were already high, especially if you take the debt that exists in the financial system. If you take non-finance debt out, corporate debt levels were at an all time high and now they’re at an all time, all time high. None of this new debt that’s been taken on beyond drawing down the revolvers, but absolute issuance of credit. None of this is stimulative. None of these federal reserve programs are stimulative. None of the household bailouts, the PPP and what have you are stimulated. This is just getting liquidity into a system, but it comes at a huge cost because these are enormous programs. The federal government’s already teed up three plus trillion dollars.
***
What Do Normalized Earnings Look Like At The Back-End Of COVID-19?
Chris Bloomstran:
What does the economy look like on the back end? And you can go through industry by industry. We can do it inside of Berkshire Hathaway or we can do it through our portfolio. But we’ve taken a machete to a number of our portfolio holdings. We’ve taken a machete inside of Berkshire to a number of the moving parts inside of Berkshire. Berkshire sold the airlines of course, and we know that Boeing and Airbus are going to be weak. Well, we have an investment in a company called Hexcel that we made probably five years ago, introduced to the business by a couple of friends of mine. Really smart investors. I run a host a small conference every year for about 20, 25 good value investors. And we do idea pitches. 10 of us or 12 of us will present an ideal for an hour each over three days.
Chris Bloomstran:
And we eviscerate each other on how well you live in the footnotes. But I knew this business that was pitched and I’ve looked at it over the years, but I hadn’t gotten into the nuances. And so when I talked earlier about one of the most important things when you’re trying to find attractive businesses is, is how does a business invest incremental capital? Well, Hexcel is a business that makes and sells inner modulates carbon fiber. You think about who buys fiber, aircraft’s manufacturers, Boeing and Airbus, or 70% of their business. So they’ll make the prepregs for the wing assemblies that will go on an airline. As airlines and aircraft manufacturers are trying to improve fuel efficiency, carbon is much lighter rather than aluminum and steel.
Chris Bloomstran:
And so you’ve seen an integration of more carbon fiber and homogenous carbon fiber into aircraft. Well Hexcel lives in an oligopoly. It’s a great business. But what made it interesting was I think people that screen on free cash, oftentimes when you talk about free cash being the metric on investing, well a lot of times if a business is investing for the future to build capacity, you take your operating cash minus your CapEx to get free cash CapEx or free cash during that period where somebody is spending money intelligently, it can be really understated. Hexcel went through a period of three or four years to build capacity to build polyacrylonitrile capacity for their wide body programs with Boeing and Airbus. The 787 that Boeing manufacturers, fairly new aircraft we think has a 20 year life to grow units.
Chris Bloomstran:
Hexcel sells about 1,000,004, 1000,005 per aircraft into the 787. The Airbus A350 is their bread and butter and that’s a $5 million ticket per plane. And so, we owned the business for four or five years. They were spending about $300 million in CapEx. We knew that CapEx cycle was going to run off and they were probably going to spend $150 million, which would be what they’ve been spending on the trailing last couple of year run rate. All of a sudden the free cash is ballooned. These aircraft programs are rolling, they have carbon fiber and a bunch of the other aircraft, they’ve got a business that does the propellors for wind energy. They’ve got some side businesses as well outside of aircraft. Their defense business inside a carbon fiber is strong. But here we are and the stock had reflected this program.
Chris Bloomstran:
And so we made a lot of money. We doubled our money in Hexcel over a three or four year period of time and the stock was trading at about 80 bucks at year end. And then they announced a merger with Woodward. But Woodward is another aircraft supplier manufacturer with more aftermarket business. And so, I had Hexcel, Hey this is going to wind up being another one of my bad mistakes so far. Absolutely. We had Hexcel trading fairly close to our intrinsic value number. It was fully valued and we looked at the deal and thought if aircraft manufacturer slows for whatever reason it will be good to have Woodward’s aftermarket business. And so this merger probably makes sense. They talk about synergies but there really were a lot of shared costs they would be taken out of the equation.
Chris Bloomstran:
We looked at whether the deal was fair in terms of how much Hexcel got and how much Woodward got. We liked the management of both companies so we decided to hold the business. Well, along comes the Coronavirus and lays this aircraft manufacturer industry flat on its back. Boeing closes all of its plants, Airbus closes all of its plants and the stock just got decimated. It’s down 65% from its high and they’ve got a good balance sheet. They had a little over a billion dollars in debt. They’ve taken down the revolver they have plenty of resources to survive. They’re still operating a lot of their capacity. It’s a good management team. And we’re sitting here with a stock wondering what does on the backside of this virus once the government stops printing money and we get people back to work, are we really going to sell as many A350s and 787s?
Chris Bloomstran:
And the answer is no. And so, I had the business doing four bucks per share in earnings and at 80 bucks a share, it was 20 times, but they were still going to grow for another 15 years on that wide body program. And there was a call option in it to for penetration of carbon to the auto industry. There was a lot that was likable and I really liked the management team, but we’ve had to take a machete because this business is not going to earn four bucks next year. It’s not going to earn four bucks the year after that. It’s not going to earn four bucks the year after that. So the earning power of the operation is permanently diminished and harmed. And the question is, what does normal output look like once we get on the back end of this thing? You have to go through that analysis for-
Tobias Carlisle:
What’s your rough impression of the impact to your portfolio?
Chris Bloomstran:
It’s not bad because it’s really not that bad. So in a case of a Hexcel where we took a machete to it, the earning power of most of the companies that we own is incredibly durable. I look at where our big pieces of capital, and I can swing back and talk about Berkshire, but Costco is a top five holding and dollar general we actually trimmed it back for price reasons, but our two retailers are sailing through this downturn. Dollar general is a better business in a bad economy and that their median household income customer, $30,000 per family, they lean on dollar general more during a downturn than they do in normal times. The food stamp program will go from 1% of their revenues to eight or 9% of the revenues. It’s a better business essential during the downturn, but better business.
***
Berkshire – Shrinking It’s Way Back To Significant Profitability
Chris Bloomstran:
We really haven’t had to whack the machete that much a lot of it is more of a scalpel. If you take Berkshire, there’s this anchor cornerstone of our business go through the big moving parts. The insurance operation, 45% of the business, highly invested in common stocks. Well, you take the insurance industry and the investment capital insurers is largely, again, like what January looked like in the late 90s. It’s bonds and cash. Well, we’re back to a 0% climate on short rates. The government does a lot. The federal do a lot to compress longterm interest rates as close to zero as possible. Credit spreads will thus necessarily have to be higher than they were at year in ’19 where they were really tight. In Berkshire’s case, because they’ve got so much surplus capital in the insurance operation, GEICO writes more than half of Berkshire’s premiums in auto insurance, which is written on an admitted basis, meaning the insurance commissioners in each state.
Chris Bloomstran:
Bless your rate filings. GEICO and all the auto insurers are allowed to write $3 a premium for each dollar of statutory capital. We think GEICO has always written at about two to one. If they’re going to write $37 billion, they only need 13, 14, 15, $16 billion. Well, Berkshire’s statutory capital in the insurance operation was over $200 billion a year end. It’s probably 185 or $190 billion today. The rest of the insurers, National Indemnity, Gen Re, the specialty business, the home state business, all of them put together, they write call it $30 billion, not even $30 billion, probably 27 or $28 billion. Find another insurance company that writes $27 billion. Let’s say on almost $200 billion of statutory capital. What that tells you is there’s so much surplus capital in the insurance companies alone. And then you take the businesses that are held outside of the insurance operations and the profitability there and the lack of leverage there.
Chris Bloomstran:
And there’s an enormous amount of capital inside Berkshire where if this pandemic winds up being really bad, Berkshire’s not going to be out having to raise capital. Losses may develop a lot worse than they think. There’s a sense that they’re going to have some losses and they’ve taken some business that was really badly written in Europe. Lloyd’s is probably in big trouble today. There are a couple of others, but there’s no permanent impairment. They’ve already sold the airlines. I think there’s some lousy businesses, honestly, in the stock portfolio. But the portfolio went in trading a decent number to earnings. If $40 billion, let’s say as the normal earning power of Berkshire Hathaway, and I had $42 billion a year end, and that assumes that they’re going to earn that 7% on the residual cash.
Chris Bloomstran:
If you take that out and make that a more conservative number, call it $40 billion. And so today, Berkshire is trading at $420 billion market cap on what I still think is close to normalized $40 billion earning part. The earning power of the insurers are not diminished. They will underwrite profitably. They’re worth every bit of the invested assets of the firm. And with the stocks being down as much as they are, if we have a depression, the stocks are going to get cheaper, but Berkshire will never have to reach into its pocket to liquidate securities to pay losses on the insurance operation. It’s just not going to happen. That piece of the business, which is 45% is as durable as can be. It will fluctuate with the capital markets. But it’s a fortress. It truly is a Fort Knox.
Chris Bloomstran:
Then you move onto the other two biggies. The rail and the energy operations. You heard Greg Abel talk about the energy businesses and it was music to my ears. Part of our analysis of the earning power of the utility and the rails is hitched on the fact that they pay less in cash taxes every year than they report in gap earnings. And that stems from the use of accelerated depreciation for the fixed asset and investments that are made. So because the rails at some level, but certainly regulated utilities, electric utilities exist in part for the public good. They’re allowed to use for tax purposes, accelerate depreciation. The whole world is on accelerated depreciation on steroids today, thanks to the tax code change in 2017. But the use of that method was limited more narrowly to businesses like those two within Berkshire.
Chris Bloomstran:
So you have a 40 year asset and you depreciate it on a straight line basis, over 40 years for gap purposes, you take 2.5% depreciation charge per year. While for accelerated appreciation you may be allowed to write down 50% in year one. And so what that means is your cash taxes are less than your one. They’re going to be later in the out years. But as long as you’re spending more CapEx incrementally over a long period of time, there’s always a tax benefit. The energy business has been paying at a very low rate. You lay in the use of accelerated depreciation. Now with the tax credits they get for all of the investments they make in wind and solar, and effectively the government is writing Berkshire Hathaway energy a cheque. And so here we are with industrial production down pick a number, 20% 30% unemployment, wherever we think it is.
Chris Bloomstran:
There are another 3 million this morning, 15% let’s say arguably headed higher depending on how long we shut the economy down, we’re still using power. We still have some portion of the manufacturing base that’s up. You and I are online here using a lot of broadband. That’s getting sucked out of some natural gas plant somewhere, we’re using power. Their revenues were down maybe 4%, and there’s a lot of variable costs in electric utility. In the deepest of declines, you’ll see very little diminution of the earning power of the regulated utility and it earns 10 on equity. And if we have a period where we go through a deep, deep, deep decline, they will be allowed to adjust their pricing to reflect a return on the invested capital to the business.
Chris Bloomstran:
If everybody was paying attention to you heard Greg talk about the $30 billion in the 100 billion dollars that Berkshire could spend over time on CapEx. As I’ve taken heat over my assumption that there’s probably a billion for in earning power for the benefit of, again, the Berkshire pays less than cash taxes. People have always said, well, Warren has always said that with CapEx exceeding depreciation that CapEx really doesn’t equal depreciation, that a lot of that is required investment, that they’re not going to return. And I’ve always said, no, no, no, you may be right. But they’re getting a regulated return on every dollar of capital that they’re spending. They’re earning 10% on every dollar of capital and they talk about all of these investments they’re making in transmission assets. Pipelines if you like.
Chris Bloomstran:
I’ve got a table in my letter of the last 20 years of CapEx and depreciation across the railroad, the utility and the rest of Berkshire. And they’ve been spending 40% more, let’s say on CapEx, the depreciation. These are all at a creatively high returns on invested capital. Of all of the businesses inside of Berkshire, the utilities are an absolute fortress and they’re worth probably somewhere between 50 and $60 billion. Then you have the rail, we see have rails on one hand and everybody says, well transportation’s terrible because there’s freight traffic is down, car loading has been down for the last two years. It wasn’t just the Coronavirus, we’ve had less trade with China. So really every type of goods that trains will move with the exception of grains have already been in decline, a very steep decline and now they’re down a whole bunch.
Chris Bloomstran:
Let’s say they’re going to be down 25% almost every expense inside of the railroad is variable. If you go back to ’08, ’09 when industrial production was down 25% and look at Union Pacific and the Burlington Northern and the Canadian rails revenues were down 25%, earnings were down 25% so that business, the rail is going to be off, but it’s not going to bleed red ink. These three businesses are going to produce cash and that’s 75% of the value of Berkshire Hathaway. The problem you have is in the MSR businesses, which we’ve been struggling with for a long time because there are some genuinely mediocre businesses in the portfolio and there are a lot of reasons that some of those are mediocre. Part of the problem is Berkshire’s had to pay such large control premiums for businesses. Precision Castparts being the largest, most recent big deal.
Chris Bloomstran:
Well they paid, Oh, I don’t know. 37 billion, I think it was for the whole business, might’ve been low 40s with debt. And we own precision when they bought it. Berkshire bought it at a price that we never would have paid. The business was already in trouble. They bought it and I think late 2015 the energy business, oil and gas oil especially had already rolled over. And so the turbine business was already in trouble. Don again, and his guys had built that business up through acquisition. It was very much a roll up and I’ve always thought, if you’re going to buy a roll up, who’s got more information in the sale of that business? The seller or the buyer. I think Berkshire made a mistake with precision, but who would have known that the airline side of their business, the commercial airline side of the business would be weak.
Chris Bloomstran:
And that’s really where precision is bread and butter is. Forgings and what have you that go into the manufacturing of jet engines and the fuselage. This downturn is going to be a huge problem for that business. If you look at the evolution since 2003 of the MSR businesses, they’re run on an unlevered basis. If you look at the disclosures that used to exist in the chairman’s letter, you can see where cash would net out any little bit of debt that existed. But these were unlevered. And over the course of 15, 16 years, you would see a decline from high nines return on unlevered equity down to after the precision deal for a couple of years, about 6.5%. Well, I’m not in the business of owning anything that is going to earn six and a half on equity, even if it’s on lever. That’s just not our game. That’s not our deal.
Chris Bloomstran:
And so what’s happened is between the control premiums and this culture of Berkshire Hathaway, Toby, you sell your business to Berkshire and you’ve got a home for your employees and you’re going to get a good price. How are you going to run that business? I mean you admire this guy in Omaha, he’s a God and you know everybody sends profits upstream to Omaha. And part of the problem with this decline in profitability, and I was thinking about this over the weekend and the wake of watching the meeting, my suspicion is that some of these businesses probably have required more what you would call maintenance CapEx or investment in growth than has taken place. I think if you know that the culture is, Hey, we’re going to make the money and send it to Omaha and let this genius reinvest it because this is how this thing works.
Chris Bloomstran:
You may have under invested in your business, but regardless, if you now have a group that has benefited immensely from the changes in the tax code, I mean, that MSR business that does about a 50 billion in revenues generates 10 billion in profits, which is 25% of Berkshire Hathaway. The other businesses I talked about are three quarters. This group, that’s a quarter of the business in aggregate is not profitable enough. You heard Mr. Munger talk about the notion that coming out of this thing, there would be some businesses that probably did not reopen. Greg talked about a food business inside of Marmon that probably wouldn’t open. And so the ones that are not going to reopen are going to be small. But there are enough businesses in that group without getting into specifics that just donor their cost of capital.
Chris Bloomstran:
And you saw, they did the deal with the newspapers, sold them to Lee, but they actually made a larger investment in the newspapers. I wrote about it in the letter this year. Now they’re in a creditor position and they own the real estate of Lee. I suppose the machete that we’ve had to take to Berkshire has been exclusively in the MSR group. I’m not going to give you a number with any precision because I don’t know what that number is. But the earning power of that business is not $10 billion. As I had assumed that year end, which wasn’t a high enough return on their 125 billion in capital to begin with. And now that we’re on the Coronavirus program and a diminished level of economic output, that group in aggregate is a struggling group.
Chris Bloomstran:
And I think over time it’s going to make sense to sell some of those businesses where they can because there’s this giant amount of liquidity sitting on the sideline and private equity that needs to go somewhere. And whether these guys can do it or not, they’ll tell you they can take a five ROE and lever it up properly and turn a business into a 15 or a 20. Now, whether they can do it or not, or whether it’s smoke and mirrors and magic on leverage, so be it. But I’d rather give them a shot than leave some of these things unlevered inside of Berkshire, earning inadequate returns on capital. There’s a lot to be said for owning a business that shrinks its way by eliminating places that are not profitable. I’d rather own a smaller Berkshire Hathaway that’s more profitable than a larger Berkshire Hathaway that’s not.
Tobias Carlisle:
Shrink your way to profitability. Absolutely. Fascinating insights Chris. Thanks very much for that very detailed explanation of Berkshire. I really do appreciate the amount of research that you’ve put into that. If folks are looking to follow along with what you’re doing or to get in contact with you, how do they go about doing that?
***
Chris Bloomstran:
Well, we have a good amount of our old client letters on our website, semperaugustus.com. I write this crazy long letter and it’s only been a public document. I’ve told that story before and I won’t burden you with it here, but now I write this letter, it was 123 pages last year. We try to get it out before the Berkshire letter is out because in the last five years I’ve talked a little bit about Berkshire but we’ve got a good history of some of those going all the way back to 1999. That’s a good resource.
Tobias Carlisle:
And you’re on Twitter too. You should mention your Twitter account.
Chris Bloomstran:
Well, I am now on Twitter as our buddy O’Shaughnessy after I did my first podcast with him in the fall admonished me to be on Twitter. In fact, he emailed me on the Saturday after he released the podcast and he said, “Shouldn’t you be on Twitter?” And I said, “I don’t know. I don’t know if I can manage it.” He said, “You need to be on Twitter.” He said, “You’re going to meet a lot of good people. There are a lot of allocators out there.” He said, “The downside is if you do it right, it’s going to consume way too much of your time and you’re going to meet some idiots, but those guys are few and far between.” And so I’m hemming and hawing like I do. I overthink everything and he sends me this note that says check your Twitter account.
Chris Bloomstran:
And he basically said, Chris is now on Twitter and I was sitting with my daughter at a golf tournament in Florida. I said, “Oh Jesus, what do I do with this?” And she said, “Well, you better send a tweet out.” And so I sent a tweet. I look at it occasionally, I should probably do more because I’ve learned, I know you’re on there. It is a good resource. There are some really thoughtful people that not only have good insights and thoughts I’ll be at and however many limited characters that you can have, but they linked to good stuff. I have a hard time tweeting out because if I’m a guy that writes 123 page client letter, I try to come up with any kind of a thought inside of X number of characters. It doesn’t really work for me.
Tobias Carlisle:
Well, I’ll make sure to link to all of that in the show notes. Chris Bloomstran of Semper Augustus. Thank you very much.
Chris Bloomstran:
I hope to see you soon in Redondo beach Toby.
Tobias Carlisle:
Thanks Chris. Yes indeed.
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