In this episode of The Acquirers Podcast Tobias chats with Christopher Bloomstran of Semper Augustus. During the interview Chris provided some great insights into:
- The Misplaced Criticism Of Berkshire
- Warren Buffett’s $AAPL Trade
- Berkshire’s Share Repurchases At The Right Price
- Berkshire’s Railroad & Energy Businesses
- Berkshire’s Use Of Leverage In A Low Interest Rate Environment
- Berkshire’s Hedge Against Inflation
- The Path From Deflation To Hyperinflation
- Japan’s Stock Market
- Why Is Buffett Borrowing at 30, 40, and 90-Year Maturities?
- Bitcoin – The Cocktail Party Trade
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Full Transcript
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Christopher Bloomstran of Semper Augustus. We’re going to talk Berkshire Hathaway, we’re going to unpack the latest letter and the long history of Berkshire. Chris is an absolute expert on it and it’ll be a fascinating discussion coming up right after this.
Tobias: What did you make of the most recent letter from Warren Buffett and Berkshire Hathaway?
The Misplaced Criticism Of Berkshire
Chris: I thought it was terrific. You’ve had a couple years now of the stock itself not doing very well, 2.4% last year. For the duration of my ownership of Berkshire, which goes back to February 2000, that was the year I attended my first meeting. We bought the stock after had been cut in half, following the Gen Re, I paid on the order of 105% of book. But if you go back for those that weren’t in the room, or who haven’t seen the transcripts, or the CNBC audio of the meetings, even Buffett was getting huge heat for not owning tech stocks and lagging, the NASDAQ was up at 84%, 87% in 1999. In ‘99, the Berkshire stock portfolio was down I believe, because all those Nifty 50, the reiteration of blue chips, Coca-Cola, which was 45%, the stock portfolio peaked. For the duration of my ownership of Berkshire, which is now 21 plus years, there’s just a lot of naysayers and critics.
A lot of it gets misplaced. I think there are a handful of people in the media that I think wrongfully point out the wrong metrics. I wouldn’t measure the stock price, and it’s not in Mr. Buffett’s control. It’s a little bit [crosstalk] formalities gone down the path of buying back shares. In my world, the business over the last couple of years compounded at its return on equity. I had 11% last year, and that’s with a decline a lot of the operating businesses. But the stock portfolio, thanks to Apple, has knocked the cover off the ball.
So, there’s a lot of misapplied negativity toward Berkshire, which I’ve always found terrific because to the extent, we have cash flows in or dividends in, or new clients with deposits, I’ve got to put money to work. I’m the odd bird that would rather have very cheap stocks all the time than expensive stocks. I think my buying over the years has been at very attractive prices. Price to book is the fashionable way it tends to get measured, and that’s not really how we look at it. The stock has generally been very consistently cheap, and it spent the majority of the 1990s very expensive.
The business had compounded at 25% a year for 30 plus years 35, 37 years, got very rich in ‘98. Berkshire bought a bunch of businesses during that decade using the shares as currency. He’d been an active buyer of the stock back in the 1970s and even the late 1960s, when it traded at less than book. Yeah, the 33-year period, we didn’t buy any shares back. With the exception of right at the bottom of the 1987 stock market crash. The stock has been cheap, but I think there’s been enough uses of capital, post the Gen Re deal.
Have they not done that deal, you wouldn’t own the utility operations, you wouldn’t own the railroad. It was that diversion of capital that’s allowed the emphasis on the stock portfolio to shrink materially. The last 12 years have been hell on active stock pickers, as you know. S&P is done 15% a year for the last 12, from the ‘08 low. Hardly an active manager, certainly those that that aren’t loaded into your more growthy businesses have lagged, but the Berkshire stock portfolio’s done 12 and a half over that period. Apple has been a huge save, investing $35-36 billion in it and turning it into $120 plus billion position has driven the bus so the stocks in the last two years of materially outperform the S&P, but you wouldn’t know it because the stock hadn’t done that well.
But that’s okay. If we’re really genuinely in repurchase mode, and I spent a lot of time in my letter this year talking about share repurchases, and the impact on how that works at Berkshire, we’d all rather have very inexpensive stock. Now, clients don’t want to hear that because everybody likes to look at their statements and see that they’re making money, but I’d far rather have the underlying business value compounding and the shares be cheap, which would give the Berkshires of the world opportunities to buy shares back if that’s the best use of capital. In Berkshire’s case, it’s a terrific use of capital.
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Warren Buffett’s $AAPL Trade
Tobias: I’m not entirely sure when I said it, but sometime last year, I started saying that I thought that Apple trade was the greatest trade ever for a number of reasons. One, because he deployed so much capital so rapidly into that position. Secondly, because Apple is such a big company, such an obvious company that everybody knows everybody’s got some device in their house, an Apple device. I just thought it was a great illustration of what a great investor he is that he took that opportunity to just deploy an enormous amount of capital. Then, it’s gratifying to see, it was rewarded so quickly, but it’s funny that he’s had so little kind of credit for that, why do you think that is?
Chris: No, he’s always just been regarded as the anti-tech. It’s very easy when you’re on as big of a public stage as he is, with your portfolio broadcast to the world on a quarterly basis. It’s very easy to nitpick the mistakes. When you’re running $200 plus billion, what’s now pushing $300 billion in an equity portfolio, there are only so many businesses that you can buy. It’s easy to flag the IBMs, it’s easy to flag, what you’d call, I guess the errors of omission, not owning Microsoft with Bill Gates sitting with him for their weekly Bridge game, and all the directors’ meetings on the phone and vacationing constantly.
I think his regard as a stock picker has waned, which is ridiculous. Even the naysayers would say– Todd probably, but Todd or Ted, initiated the initial billion-dollar investment in Apple, and only for finding God was he able to buy a tech stock for the first time. It took putting $35 billion into a tech stock, if you look at the way Mr. Buffett buys stocks, he buys earning power. He’s buying well known predictable earning power. Having tested the middle rail, on airlines in the past, and having blown those positions up in a pandemic and being faulted for selling those too early, conceivably, and even Wells Fargo and JP Morgan, taking losses on those positions. I think the sense that he’s not a great stock picker, but if you look at the entire history of the stock-picking, it’s not the ability to find 300 or 400 ideas. It’s the ability to your point, to get a lot of capital in something when it really makes sense and let it grow from there.
You go back to all the big deals, American Express, Washington Post, Coca-Cola, Geico, when it was publicly traded, those things drove the bus. Apple here recently has driven the bus, but he only bought it, it was 12 or 13 times. I think all you had to do, and I didn’t do it, I thought, “Oh, hell, they got to reinvent their product line every year.” At some point, the growth curve is going to slow and the growth curve has been slowing, but get a lot of money into it, or 12 or 13 times. The question for me is, A, you got to give him credit because taking a stock portfolio that was as rich as it was in ‘98, and that pivot away from stocks by buying January and buying bonds was brilliant. His pivots over time have been brilliant. I think even when he closed his partnership, formally in ‘69, but started that process in ‘66, having gotten control of Berkshire in 65, his timing on when overall market levels are cheap or dear, is very good. His individual stock picking is very good. He’s handicapped by running high-class problem with having a whole bunch of money.
Whether he gets credit for the brilliant decision to back up the truck in Apple or not, I don’t care. The game on the position itself represents two years of what I’d call normalized earnings at Berkshire Hathaway. It’s been the stock picking consistently over five and a half decades that is driven the bus on the compounding of capital. Let the bluebirds come at him. I prefer to have Mr. Buffett be yesterday’s washed out and let’s keep the stock cheap. If we’re really in share repurchase mode, it was probably a mistake to be talking to you on the podcast about him, and me writing my letters about it. I’m not sure, the five or six years that my letter has been public, that anybody’s listening to the Semper Augustus letter on Berkshire. It just tends to be undervalued, and it’s hard to value.
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Berkshire’s Share Repurchases At The Right Price
Tobias: There’s a few points in there. One of them is, he spent a little bit of time in this letter defending the conglomerate structure, and he spent a little bit of time discussing buybacks. There are a few articles that I saw afterwards that Buffett defends the buybacks in Berkshire, which I thought was– I didn’t read it that way when I saw it. Then, Elizabeth Warren did a little tour afterwards saying that there was a problem with anonymously buying back shares in the market. Just wondering if you could comment a little bit on perhaps the difficulties of valuing it in a conglomerate structure like that and whether that– I think you spend a little bit more time on Berkshire than Buffett does himself. [laughs] [crosstalk] The function of the buybacks, or what the buybacks achieve?
Chris: When I’m 90, I hope I can write a 15-page letter that the world is willing to read them and there are a lot of people that probably would wish I’d rather write a 15-page letter now, to be honest. I think his criticism of conglomerates is fair. The history of conglomerates is terrible. Capital allocation is terrible, the use of their shares as currency and the promotional aspect, knowing that you’re generally having to overpay for businesses when you’re doing deals as a conglomerator and your need to retain capital and grow, outside of Teledyne and Singleton, there aren’t a lot of great ones. Again, let them be tarred with that. As far as the notion of share repurchases go, we talked about this, I think last time we recorded, and I’ve written about it for years and years. But share repurchases, and he gets into it a little bit in his brief letter this year, are just generally badly done.
They are generally undertaken to offset the dilution that comes on the front end of share issuance with stock options and restricted share units. If we give away 2% of shares per year, and we’re spending 3% of market cap per year to try to shrink the share count by a net one, there’s no price discipline, there’s no sense that price matters. If you’re the CEO, and you’re on the job for five years, you’re going to get rich through the share grants, you’re going to get rich through the options and the RS use. You have every motivation in the world to drive the stock price up in the short term.
Well, the motivation at Berkshire has never been the stock price. The stock has been used as a tool, which is the advantage of a conglomerator doing it correctly. What you don’t have in Berkshire is the dilution on the front end. Find the public business where the leadership– I think it’s to a point, it’s almost silly, the way Mr. Buffett and Mr. Munger are paid. They’ve always made a point that, “Look, we own the thing, and we’re going to get rich by not taking a salary and a cut.” That’s been their fashionable thing to do. You don’t have the gross distortion that nearly every other public company has. You don’t have the delusion, you don’t have the short-term motivation. Thank God, Elizabeth Warren is not treasury secretary or has never been at the Fed.
I think the abuses that take place on share repurchases, have merit, and have a lot of merit. If you look at the broad market for the last 20 years, and you look at the percentage of profits, after dividends are paid, which represent now 40%, 45% of overall corporate profit. You being the market have spent more than the balance of net income buying back shares, and for the last decade, we’ve been buying back shares at north of 20 earnings at 5% or less earnings yields, they may be nominally driving down the share count, but not to the degree to which profits are going out the door. Companies that abuse the repurchases on that front are diverting the capital allocation process to buying back shares at expensive prices, a lot of cases would be north of intrinsic value, and that’s destroying shareholder value. Not the case for Berkshire.
Tobias: Without restricting share buybacks, how do you correct for that?
Chris: I don’t think you will. I don’t think the way our society is constructed that we’re going to motivate management’s broadly speaking properly. I think having skin in the game, which is really the motivation of why you would give share grants, has a lot of merit, but if I was God, and sitting on a lot of boards of directors’ comp committees, I would try to tie a lot more of the hurdle rates, and the required holding periods of the shares to a much longer period of time. You’d never do it, but why not? If you know the CEO is going to be there for an average of four and a half years, why not say, “Sure, we’ll give you a bunch of share grants.” We know your capital allocation decisions may not bear fruit for five or 10 or 15 years, why not make the vesting schedules extend beyond the duration of employment? Would never happen. You just get this asynchronous time horizon, in terms of corporate behavior. I don’t know how you change it. Oddly, it takes a recession or a pandemic to shrink share repurchases.
You have the Great Recession, and nobody bought a share back, stocks were down two-thirds. The banks and various other industries were forced to raise capital because they were in trouble. The very moment that the stock price is cheap, you can’t buy them back. You’re terrified, you need liquidity. It’s just all done in reverse. Berkshire is a very big position of ours, I think I’ve got a bunch of companies in the portfolio, they’re going to do better. The way of Berkshire as a conglomerate utilizes the share, as one of the capital allocation tools has been brilliant, and it’s extremely conservatively done and it’s rarely copied, which I think gives Berkshire an enormous advantage surely over the history of conglomerates, but most public companies, which tend to do it badly.
Tobias: It’s a muddied conversation about share buybacks because when you look at them in aggregate, they do seem to– the greatest number of shares are always bought back at the very peak of the market. There are no shares bought back at the bottom of the market, when sensibly you’d want it to be the other way around. Part of the difficulty is that they all earn most of their profits at the top of their market and at the bottom of the markets like we saw in 2009 because the banks have lost so much money. S&P 500 earnings were not meaningful for that year. They just didn’t have the liquidity to go and do it in many instances. It doesn’t surprise me that the argument’s ongoing that the argument seems to revive once a year. It’s incredibly frustrating because I agree with many of those arguments that the buybacks aren’t done in the right way, but it’s also true that if they’re done in the right way, they’re incredibly powerful.
Chris: Oh, they are materially powerful. You look at the buybacks, $25 billion for the year in the last couple quarters at a rate of $9 billion quarter, spending more than the operating earnings of the business, buying shares back, and buying them back at– you do the math on the average price at which all the shares were retired in 2020, and you’re paying 105% of book value on a company that’s doing 10 return on equity. It’s incredible in a world of zero interest rates.
I’ve got a table in my letter which I’ve always broadcast out this 10 ROE, and growth and market value and various multiples to earnings at which you’d expect to see the market cap of the business a decade hence and that always assumed no share buybacks because you had 33 years where they didn’t buy a share back and they use the capital and the Gen Re deal they use some of the stock to buy the railroad, but they’ve really not been using the stock. For the last decade, the share count was just flat.
They bought a little bit back two years ago, and then $5 billion the prior year, then the $25 billion this past year. But they’re big numbers. If Berkshire’s running operating earnings of mid 20s, to high $20 billions, and if they’re going to be buying back at that $3 billion a month rate, you’re looking at $36 billion on an annualized basis, which is way more than the operating earnings of the business.
I get to $40 plus billion in total Berkshire profitability, but some of that’s not cash capital, that comes to Berkshire. $10 billion of my number is the retained earnings of the stock market investees. You have the dividends coming in a little bit, interest anymore coming in. One aspect of the letter that Mr. Buffett really delved into, and it was discussed at last year’s meeting, and I’ve been writing about for the last six years is, the capital that’s being spent at the railroad and at the energy operations are sizably in excess of depreciation.
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Berkshire’s Railroad & Energy Businesses
Chris: Mr. Buffett pointed out– I’ve got a table in my letter that will show you that in the last– since they bought the railroad, they’ve spent twice as much on CapEx, as they’ve expended on depreciation. A portion of that is growth. There’s a lot of maintenance CapEx than the railroad that exceeds depreciation expense. But in the energy businesses, it’s the same dynamic and they’re spending twice as much CapEx in the energy operations as they are. You’ve got $7 billion, let’s say, north of the $8 billion depreciation charge that’s going out the door in CapEx, a lot of which is getting a regulated return or close to a regulated return of the spending of the energy operation, which never sends dividends or profits back to Omaha, coupled with the debt that’s used to grow that business in concert.
Utility and energy in these regulated pipeline businesses, though, regulated electric utilities are all going to run a blend between 40% and 60% debt to capital. Berkshire is levered this thing up towards running closer to the 60% level. If utility operations are going to retain all of their profit, which three and a half, closer to four and a half billion dollars when you adjust for some of the tax benefits that you don’t see on the gap earnings number, they’ll gear that up with an augment that retained earnings portion with more debt. It’s an enormously growing business on CapEx but that incremental profit that’s not coming back to Omaha is CapEx off the door. You really only have maybe $25 billion, let’s say, available per year in terms of free cash profit, with which to allocate capital in. If all or more of that is going to go to share repurchases, then you can make the assumption that over time that cash balance that also gets lamented so heavily, will get driven down.
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Berkshire’s Use Of Leverage In A Low Interest Rate Environment
Chris: The reality on the cash balance is it’s not that high. If you look at total cash at $130, whatever, billion, you’ve got debt in the business of $125 billion. You’ve got slightly more cash than debt. That’s been the case consistently for the last 20 years. Cash is up a little bit.
Last year, they net issued $14 or so billion in new debt. I think what gets lost under the surface capital allocation is what they’re doing in this very low interest rate environment with a risk, perhaps down the road of high levels of inflation. They have lengthened the maturity structure of the railroad, and of the utilities, and even of the holding company debt and they’re borrowing it incredibly low-interest rates. The utilities and the railroad are borrowing in low fours. The holding company is borrowing at one.
They’re lengthening the maturities out, they’ve net, so cash has gone up. Part of that cash is the net inflows from net retirement of debt, but also, it’s the net new debt being taken on, in some cases to augment the CapEx spending at the utility operations, but they’re borrowing at really attractive rates and if borrowing today– and I don’t know if rates are going to go up anytime soon, I’m more of a deflationist for the time being and then we’ll pivot to hyperinflation. Hopefully, not in my lifetime. Why rush?
Berkshire has got almost $900 billion in total assets, and so you have a little over $100 billion in cash, and half of that cash isn’t going to get spent. There’s $4 or $5 billion that sits as working capital on the railroad and utilities. I think there’s probably $20 billion in cash at the MSR group, which includes now the finance businesses, and then you’ve got some cash of the holding company, but there’s only maybe $70 billion of cash that’s available to spend, and $25 billion went out the door last year, on repurchases at very attractive prices.
What I’d hate to see, again, and I go back to this misnomer about money management is, you don’t want a high stock price, because they’re disciplined enough at Berkshire, unlike most public companies, to cease the share repurchases at unattractive prices. I don’t know what that number is, I know what my intrinsic value number is. But if you look at that table I’ve got in my letter, I’ve basically said they’re going to take half of income, half of my normalized income in buy back shares, which would be in today’s dollars about $22 billion a year.
Book value grows by half of the historic rate, because again, half the profit is not retained in driving book value higher, it’s going out the door to buy back shares. I’ve got scenarios for multiples to book, ranging from an improbable, impossible half a book, stock hasn’t traded there since the 1960s and 70s, all the way up to 200% of book. The realistic range there in the middle of the table is between book value, 120% of book, and 150% of book. I have scenarios for all three of those ranges.
You could pinpoint where you think the average buybacks might take place over time. It would require the stock being cheap enough to get that much cash out the door on the buybacks. But I also assume two ranges for durable return on equity, a worst-case scenario of eight and what I think is still your kind of steady-state case of 10. What you’ll see is, if that winds up being the program, and we are really going to spend about half of my earnings number per year, which is two-thirds or more of operating earnings, again holding aside that cash that’s not really available to Berkshire, but it’s genuine profitability, you’re going to drive the share count down by somewhere between 25% and 40%. Done intelligently, even if the multiple to earnings doesn’t deviate from today’s 13, you’re going to make more than the ROE by driving the share count down at a discount to what you’d call intrinsic value.
If it’s an acknowledgment that we’re such a big entity, that these share repurchases are an attractive use of capital, then, boy, I think they could have gotten there a few years ago, and had a chance to buy the stock back. You had that artificial floor in place originally at 110%, but then they said we won’t buy shares back above 120% a buck. Well, if you take a 10 ROE and you pay 120% of that number, that effectively is earnings yield of 8.33%. I think the hurdle rate at Berkshire has always been 10. I think it’s still close to 10. In the regulated utility operation and these transmission assets that they’re buying from Dominion, Mr. Buffett talked about the enormous sums that are being spent on the grid in the Western United States, the remoteness of solar, and wind operations.
You’ve got to rebuild that grid and to do so, you’ve got to get a regulated return from the regulators. They’ve worked all that out, but that’s all done at 10, but that number might get driven down. If you hold interest rates at zero for a long, long time, which goes to that deflation case, the regulators are going to drive it down a little bit. The reality is Berkshire’s competitors, generally speaking in the electric utility world, don’t earn and they’re allowed rates of return. If the allowed return is 10, most of them earn 8. Then there’s a drag and what an advantage in Berkshire’s case to not pay dividends out to shareholders.
The majority of electric utilities are paying half a profit or more, a lot of them pay 80%, 90%. To the extent they need to refurbish infrastructure, you’ve got to borrow and you’ve got to issue new shares and you see dilution over time. These things trade at 20 plus times earnings. Berkshire doesn’t have that problem. They have the use of all of that capital in places that they’ve identified spending opportunities, and it’s not an insignificant portion of the free cash profitability at Berkshire each year. I think overall, in terms of my grade for the year at Berkshire, A plus. If we’re really going to buy shares back at good prices now with meaningful amounts of capital, that’s very good for the shareholder long term.
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The Path From Deflation To Hyperinflation
Tobias: I need to take you back to the hyperinflation comment. You’ve got a discussion in your letter, let’s perhaps discuss what you see playing out.
Chris: Toby, I don’t know. I’ve been worried about debt for entirety of my career. I got into the business ‘91, debt had been rising since 1981 as interest rates have come down. By the time we got to the market peak in 2000, you had $10 trillion in GDP and $25 trillion in debt. You looked at any chart of historic debt levels and thought, “Oh, my God, total credit market debt is higher now it’s ever been. This is too high.” Well, you have the 50% bear market, you had recession in ’02. Greenspan takes rates down, we ramped up the real estate market in over the next seven years from the 2000 peak, we grew GDP by 4 trillion, and we took on another $25 trillion in debt. We ran debt up to 350% of GDP, and then you thought, “Oh, my God, this is crazy. It’s bad.”
You had the Great Recession, which really could have just wiped out the entire financial system of the globe. Thanks to our central bankers here and abroad, we introduced all these iterations of QE. We’re running big budget deficits, the majority of which sit on the balance sheets of the central banks. We’ve spent from the ‘07 to 2019, we kind of maintained that 350% total credit market debt to GDP. The government component of total debt has been on the rise, of course, with the QE. Government debt’s never been higher. We’re now north of where we were in World War II.
The reality is, government spending is not generally stimulative. It’s really not stimulative at high levels of debt. We have a lot more transfer payments in place now, mandatory spending. The majority of what took place during the pandemic was just wealth transfer. We were going to run a trillion-dollar deficit in 2020, which was going to be on what was a $22 trillion economy, that was going to be high 4%, maybe 4.7%, 4.8% deficit, we’re at a $3.1 trillion deficit. Tax revenues, which were going to be, I don’t know, 4 trillion, were lower, were less. Outlays, we’re going to be $5 trillion, we’re higher by a lot. You wind up running a $3.1 trillion deficit. We’re now into our third stimulus program. We’re giving money to people that are working, you have a job. Why they couldn’t figure out– This is a sidebar comment, which will get me into trouble. Why could they not figure out and identify the people in need? Why not take people that are out of work and administer the stimulus, administer the aid through the state unemployment offices? They’re all good at it. They know who’s not working. But we’re giving lots and lots of money to people that actually have jobs, which is insanity. So, we’re going to do another $1.9 trillion stimulus.
Zero Interest Rates Forever
This is not a political comment. I’ve watched 40 years of these buffoons in Washington. Nobody has a governor on spending. Republicans have spent, Democrats have spent. Find the electorate official that is willing to not spend. Now, we know debt levels are really high. Now, we’re total credit market debt when you include the portion of government debt that sits on the balance sheet at the Fed, now we’re over 400% debt to GDP. When Jay Powell says, “We’re going to keep interest rates at zero for the foreseeable future,” they’re going to keep them at zero forever. You can’t go back to a normal term structure at all. What I don’t know is, you can take the increase in debt.
Everybody says, “Well, goodness gracious, M2 was up 25% year over year.” What they miss is the fact that monetary base was up 50%. So, you have a lot of cash, a lot of bank capital sitting on the balance sheet at the Fed, which is a liability for the Federal Reserve. You have the total assets of the Federal Reserve, which were $850 billion before the Great Recession. They ran that up to four and a half trillion, tried to run it off, they couldn’t run it off, got to do a liquidity crisis of 19. Then you have the pandemic. Now you’re $7.4, $7.5 trillion, which you’re on more than a third of GDP.
Well, Japan’s, JGB, the central bank of Japan’s balance sheet is 100% of GDP. They own stocks, they own ETFs. We have a lot of room still to run QE from here to infinity. I don’t know what that transmission is, but the velocity of money is not up, it’s down. I’ve watched it go down for the majority of my career. Money is not circulating in the economy. You have this cash sitting, earning 10 basis points at the Fed reserves. We don’t even have required reserves anymore. We suspended those early in the pandemic but there’s no loan demand. You have this whole other non-fiat money, fractional lending system capital that sits in levered finance, CLOs and what have you, back to the long-term capital management in 1994. You’ve got enormous amounts of leverage that exists outside of the banking system. You couple in then, on non-balance sheet, off balance sheet liabilities, for Social Security, Medicare, Medicaid, and all of our social contracts. There’s an enormous amount of leverage.
Two Tails To The Distribution Curve
To me, I guess, I’ve always said you’ve got two tails of the distribution curve. One is, when you have extreme levels of debt, the natural tendency is to work off that debt in a deflation. You restructure the over-levered. You go bankrupt, the debtholders become the equity holders and you clean up debt that way. You can also grow very slowly, by running inflation at 2% a year, and slowly shrink debt. To do that, you’ve got to live within your means. You’ve got to quit running debt levels up at the same rate as economic output. You can’t keep debt at 350% of GDP.
The most expedient thing to do when you’re on an electoral cycle of two years, or four years or six years to get yourself reelected, you’ve got constituents. Nobody requires these idiots to read Henry Hazlitt’s Economics in One Lesson. There are no Austrian economists in Washington. The easiest thing to do is just keep spending and replace debt with debt. If you can fund it all in the Treasury market at 0%, there’s no cost, so you can have an unlimited amount of debt on the balance sheet. Ultimately, whether you get a very long, protracted deflation, which would be my bet, at least for now, perhaps for a long time, if that transitions into hyperinflation, if the Federal Reserve and the central banks directly pay the bills of the government, without financing in the treasury market and running deficit spending, but we just take our exogenous circumstances, and we just give money directly to people, which is what we’ve done, but not really. Then that transmission mechanism works.
I wrote a little bit about digital currency. We’ve had digital currency forever. I can’t tell you the last time I went to the bank and used cash. I don’t go to the ATM, but digital fed dollars are an entirely different animal. If we really can take the physical currency that’s in existence, again the monetary base, which is about $5 trillion, is currency in circulation, and its bank reserves on deposit at the Fed, and it’s cash in bank vaults. That’s $5.5 trillion, let’s say. If we go down the path of eliminating the physical currency, and the Fed gives money- if we do our stimulus program, not the way we’re going to do it and run it through Treasury deficit.
If the Fed just gives money to those people that the IRS applies a social security number for, and we just give people money, that then could conceivably turn into hyperinflation. Hyperinflation effectively to me is when you’ve observed it throughout history, you’ve observed it more recently in Venezuela, you’ve got perhaps the beginnings of in Argentina. We certainly saw it in Zimbabwe, but you go back to the Weimar Republic, you look at Hungary, post World War II, the Chinese had hyperinflation for 15 years in the 1930s and through the mid 40s. On all cases, the citizenry does not want to own the currency. They lose the currency, so now we have bitcoin and all this, but we’re not there yet.
But if we have digital dollars, and we don’t have cash in the bank earning zero, but if we really have a deflationary period, the central Banks are fighting like hell. If we really are going to have deflation, which can be a 1%, 2%, 3%, 4% decline in the price level decline in wages, decline in housing prices, we’re not set up for that in a levered society, you see what happens to businesses that are levered when their revenues decline and they have operational leverage, you go bankrupt. We have now digital dollars on deposit earning zero. Well, if you can’t take your cash out and put it under the mattress and keep it at zero. At zero, you win if the deflation rate is two. But if they charge you a penalty rate of 3%, or 4%, or 5% to trying to get money out of the currency, I don’t know what that transmission mechanism is, but with today’s debt levels that are unsustainable, I don’t know how it plays out. I lamented for 10 or 15 pages of the letter.
This concern about the tales of deflation on one end and hyperinflation on the other end having fattened, and I never thought that we’d see this in my lifetime to actually have to deal with. I frankly believe that we’re going to have to deal with it now. How do you survive that as a steward of capital, what do you do? I find circling back to Berkshire, for example, what are enormous benefit Berkshire has the way they’ve capitalized the business and the way it is capitalized? The last thing you’d want to own in a hyperinflation, if we go down that path, and they’re trying to take us down the inflationary path, the last thing you want to own is cash, the last thing you want to own is bonds, you want to own long duration, durable assets. In the business world, you want to own businesses that have pricing power. Well, who happens to be among the largest owners of bonds in the world? Insurance companies. The vast majority of insurers are required, either statutorily by insurance commissioners or by regulators or by customers to have large percentages of their invested capital in fixed income and cash. That’s a function of reserves required to pay losses.
Well, if you take Berkshires reinsurance– well, let’s just take, I’ll get on this path. Take all of Berkshire’s insurance operations, which is insurance is almost half, it’s 45%, let’s say, of the entire value of Berkshire Hathaway. Take Geico, which writes two-thirds of Berkshire’s insurance premiums. Well, in auto insurance, you’re allowed to write $3 a premium for every dollar of capital, and so on premium volume that declined because of the pandemic and the rebates they were giving away, Berkshire’s Geico is going to wind up doing $40 billion, let’s say over the next 12, 14, 15 months on an annualized basis. That’s two-thirds of their $60 plus billion in premium volume. They only need $15 billion in capital to write that amount of business. They probably have $20 billion. Well, all of Berkshire’s statutory capital in insurance is about $240 billion, so 20 of that goes to Geico.
Then, you’ve got the Berkshire primary group, the new specialty business that they seeded a couple, three years ago, all the home state businesses, all the med-mal businesses, that group does about $10 billion in premium volume, would require probably a dollar and capital for every dollar of premium volume written there. On the order of $10 billion, but even let’s say it’s $20 billion, give it 20, so now you’ve got Geico with $20 billion in capital, you’ve got the primary businesses with $20 billion in capital, that leaves $200 billion for the reinsurance operations. National Indemnity and Gen Re. Combined, the reinsurance businesses, $20 billion in premiums, let’s say. They’ve got $200 billion in capital. They’re writing, what has averaged probably 12, 13, 14 cents in premiums for every dollar of capital. Take all the rest of the insurance operators, Munich Re writes a dollar in capital for every dollar in premium. The big European reinsurers just have never really found a policy they didn’t want to write. You don’t see them pull back when prices are not healthy. There’s a very thin layer of capital there.
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Berkshire’s Hedge Against Inflation
Chris: Well, Berkshire with their $200 billion. Berkshire writes– on $20 billion in premium, they write less than 10% of all of the premium volume for all of the reinsurers globally, maybe 7%. They have a third of the capital. There’s $600 billion in total reinsurance capital globally. If you throw in some of the exotic capital, like insurance-linked securities and CAT bonds and all that. It’s maybe $700 billion, but Berkshire has $200 billion of the $600 or $700 billion, a third of the capital, the 7% of the premium. When things like COVID comes along, and the global reinsurance industry now has losses so far that total $30 billion, 5% of capital, Berkshire’s COVID loss is just over a billion dollars. The advantage there in this hyperinflationary context is, it’s the only insurance operation on the planet that has the vast majority of its reserves invested in common stocks. If the asset class you don’t want to own is bonds– Berkshire doesn’t own bonds. They’ve got $20 billion in bonds. $65 billion in cash in the insurance operations. The stock portfolio inside of Berkshire is largely held at the insurance operations, and it’s over $250 billion. Historically, stocks have proved somewhat of a hedge against very high levels of inflation and hyperinflation. If you look at the Caracas stock market last–
Tobias: I do all the time. [laughs]
Chris: The currency goes to nothing, stock market goes up, it’s the best performing stock market in the world in local terms. You’ve got to own the right kind of businesses. You think about a Verizon purchase, that’s an earning power business. They get the pipe coming into the house, they have pricing power. The contracts roll fairly regularly, they can raise prices. It’s a balance sheet that can withstand, high levels of inflation, you look across the portfolio. I’d rather own the stock portfolio than I would a bond portfolio. That just gives Berkshire an immense hedged protection if we go down the path of high levels of inflation.
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Japan’s Stock Market
Tobias: Well, let’s talk about the stock market a little bit because you spent some time discussing peaks and troughs in the stock market. It’s one of my favorite topics too, was speaking earlier about Buffett winding up the partnership in ‘66, which is a historic peak on a cyclically adjusted P/E basis and then ‘82 is about that historic low. You spent some time going through peaks and troughs in your letter, and just perhaps in that comment on, if we do in fact go the way of Japan, what’s Japan’s stock market been like the last 30 years or so, I think it’s been reasonably favorable for value guys, funnily enough.
Chris: Well, Berkshire, they got $6.5 billion put out in the five trading companies. The TOCHU made it into the top list of holdings, but I did the math on them and they were valued at on the order of $7.7 billion a year, and he’s buying earning power at 7 or 8 times earnings. Stock market’s negative from 1989, negative. The Nikkei peaked at 39,000 and change. It’s negative. Japanese nominal GDP was about $5 trillion. Our GDP was $10 trillion in 2000. The Japanese economy was the second biggest economy in the world in 1989, 10 years before the US economy in my mind peaked in terms of being able to grow in inflation adjusted and population-adjusted terms, but in nominal terms, they were $5 trillion GDP and it’s still about $5 trillion. That economy has not grown in 30 years, which is incredible, incredible, and the stock market’s negative for that fact.
But the stock market was way ahead of itself. The Japanese economy had boomed. I’ve got a great chart in my letter on the long tail growth and real GDP per capita globally. You can see post World War II– Japan hadn’t entered the trading world, prior to World War Two. China hadn’t come in until about 60 years ago. We had the Marshall Plan, and we helped finance the Japanese recovery, we rebuilt the economy. Japan had a horrible war with China, that was really the– until we had Pearl Harbor, Japanese were fighting the Chinese and they were just killing each other. Millions and millions died. The Japanese mere miraculous recovery post World War II was incredible. They became a major, major global trading power, and they export other technologies. They were not a net importer. They were an exporter. They started off as a very low-cost producer. They brought lower and middle class into middle and upper class in a hurry. The Japanese economy was the wonder of the world in 1989.
When I went to college 1987 at the Air Force Academy for my first six months, I hadn’t taken foreign language, I thought I better study Japanese, which was one of the reasons I didn’t stay at the Air Force Academy, I couldn’t handle it. The market traded at 80 to 100 times earnings. The Japanese bought Pebble Beach, they bought Rockefeller Center, and they paid top dollar. They had a very strong currency at the time. Who would have known that they were going to go sideways for the next three decades? Who knew that the stock market was going to go down? But it took three decades to work that down. The parallel there is, Japan has been fighting deflation now for 30 years. Their central bank has had dozens of iterations of QE.
Tobias: They invented the term, didn’t they?
Chris: They invented QE, they invented negative interest rates, they invented a lot of things that the Europeans are now adopting, and that we’re the latest of the party and adopting. The Japanese have been there. They’ve had, despite this massive attempt to introduce inflation into their insular economy, they’ve had no success. I think there’s a lesson there. The difference is, the United States is the reserve currency of the world. When you go back and talk about all those hyperinflations that I mentioned, they were all insulated, they were all one-off. If you were in Argentina, or Brazil, who have had myriad, multiple different currencies over the years, and you know it’s coming and you’re among the wealthy, well, the first thing you do is just get your money out of the country. You get to the United States, you get to Switzerland, and you come back once you’ve had the hyperinflation. There’s a reason why Argentinians and Brazilians own a whole bunch of land, arable farmland, they own ranch land, and cattle, because they’ve seen their currencies destroyed.
Well, before long, the government’s-imposed currency, controls and you can’t get your money out. You light the currency on fire, and you’re introducing a new one and o do it again, and it’s isolated. Well, now we’ve got our problems. The Europeans have their problems. the Japanese have their problems. The Chinese have their problems. We’ve all gorged on debt, and we’re all on a race to the bottom in terms of devaluation of currency. You can’t really leave and maybe that’s the notion of bitcoin, and I’m not sure that’s the right answer. We’re on a global stage now in terms of the problem. The reality is given debt levels that have to be worked out, if we apply what Japan has done on an insulated basis where almost all Japanese government debt is owned internally by the Japanese. We still have a lot of our debt that’s externally owned by our foreign creditors, because we’ve been running trade deficits for a long time. If you take the net trade out of the mix and you just say the entire global economy is now what was a Japanese island, then we’re probably all looking at deflation for a long time. We’re now all resolved to try to introduce inflation.
Again, I don’t know what that transmission mechanism or where you flip the switch, which makes what we do, what you and I have to do as stewards of capital, it’s so damn difficult today, because we’re dealing with things that I’d rather not have to deal with. When Mr. Buffett talks about the wonderful growth and invest in America, he’d come onto the stage in the depths of the depression, had this output boom, here and abroad post World War II, that was just a massive tailwind. Real GDP per capita was growing at 2.5%, to 3.5%.
We’re done with those days. Real GDP per capita is growing at less than one, and to work down the level of debt that we have to work off, I think there’s a real case to be made that if we look out 30 years and kind of paint ourselves into the Japanese corner, we have very little growth in real GDP per capita. United States happens to be in a little bit better shape. We have marginally better demographics. We have some population growth, it’s slower than it’s been in the history of our country. It’s been less than 1% for a handful of years, but we benefit from immigration of both high skilled and non-skilled laborers. We need to get people to come into this country, onto our payrolls and into our tax paying system. You win this thing through population growth.
Japanese part of the problem is they’ve had no population growth. It’s a very old society. The Chinese economy, which has been this booming miracle for 60 years. They’ve gone from nothing to a massive number two now in the world economy in a shorter period of time than it’s ever been done. They’ve had at their own doing, the dumbest demographic policies you can imagine from their one child policy back in the 70s, which they finally suspended four or five years ago. They are running into not a slow drop off in a demographic problem, but they’re running into an explosionary problem where they’re going to have a very, very old population now going forward. They’ve entered the world of the middle class, and we’ve got this global population problem as well. We have these enormous social contracts. Well, the easiest thing to do is eliminate the contracts through devaluation of the currency, which, again, is makes our lives so much more complicated than they have to be because Mr. Buffett, for the majority of his career had these enormous tailwinds, which have been slowing since 2000.
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Why Is Buffett Borrowing at 30, 40, and 90-Year Maturities?
Chris: To your point, he got the pivot. He got out of the stock market effectively in the late 1960s. He effectively got out of the stock market in 1998 with the Gen Re deal, he took the stock portion of Berkshire Hathaway, which was 115% of book value, and 65 or so percent of total firm assets, and cut stocks down to 69% or 70% and cut the stock portfolio as a percentage of total assets, down to about 30%. He cut it in half, so that allowed all of that debt capital that he bought from Gen Re to go do everything else that he’s done. He’s gotten the timing of these things right. Why is he net borrowing $14 billion at 30- and 40- and 90-year maturities? It’s one of those things, watch what he does not what he says. I’m confused. I’m as confused as I’ve been in a long time, because I can see the path that’s coming. I just don’t know, how we evolve.
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Bitcoin – The Cocktail Party Trade
Chris: I think this excess today in bitcoin, it’s trading for a fraction of where it’s going to trade? I don’t think that’s the answer.
I say it because housing prices are up 10%, but that’s a supply and demand thing. Loaf of bread hasn’t really changed by much. I think if you were in Weimar, Germany, and you knew what was coming, you got your money out of the country, if you could, you went to the United States. At a point, part of the reason why the wealthy leave their various respective countries is, for personal safety as well, it’s not just preservation of wealth, but it’s personal safety, you don’t go to the United States, because you’re going to get rich in a hurry. You don’t leave Venezuela, because you’re expecting to get really wealthy. Watching this bitcoin go from 10,000 to 50,000 in a short period of time, I don’t believe that the Winklevoss twins are going to be the richest people in the world. Next to the guy we’ve never seen who invented bitcoin and limited the supply at 21 billion or 21 million units, or whatever it is. You’re not supposed to get rich, you’re supposed to be preserving wealth.
My objective with me and my clients is to maintain and nominally grow the purchasing power of our capital, and all these young investors that have jumped into this bitcoin, and now you’ve got a couple institutions that have jumped into bitcoin. It’s not a mindset, it should be a mindset of, we’re concerned about hyperinflation, we’re just trying to preserve our standing in life. You shouldn’t be able to go make five times your money and come back in, and if you had a million-dollar house that you just bought six months ago, now you can afford a $5 million house.
That’s not what removing yourself from fiat currency is supposed to be. I’m very jaded that it’s not much more than a greater fool theory, asset class. Hell, it could get very institutionalized, you can see a lot of flows and with limited supply, you could really run it up in price. It’s a disservice, I think, to these real concerns about hyperinflation. I don’t think the government’s going to go for it. I mean, they have the printing presses. We have our fiat monetary system. We have our fractional lending system, which is how monetary transmission tends to take place.
I just don’t believe the Federal Reserve is going to allow bitcoin to usurp fiat currency. They’ve got to control on it, and I don’t see them giving that up. How do you do that? I don’t know, they tax it at 90% or 100%, then they make it illegal. I don’t know how they deal with it. I’m very, very suspicious, at least so far, and I’ve tried to read some and stay up a little bit and I don’t know as much as some of the very smart guys who have gotten into it, but it doesn’t remove my concerns about what could be the tales of deflation to inflation.
Tobias: That’s just about coming up on time for us. If folks want to follow along with what you’re doing or get in contact with you, what’s the best way of doing then?
Chris: Oh, our website probably, semperaugustus.com has a whole host of my old letters back to the late 1990s, would have been 22 years in business. All my contact information is on the website. I’m on Twitter, I shouldn’t be on Twitter.
Tobias: [laughs] None of us should be.
Chris: I’ve had some– I’ve never talked publicly about bitcoin until this moment. I’ve never tweeted. I tweeted about Twitter a couple times. We actually put on a little short position late last year. I was blown away at the response of the Twitter crowd. Entertaining. I spent half a day with the feedback of a couple of my early big tweets that got a lot of response and just spent a few hours on a Sunday laughing about the response. It’s very similar to the cocktail crowd back in the late 1990s. The doctors and the lawyers that were convinced in the tech bubble, in the internet bubble, and they all lost 80% or 90%. That group of investors is not back in this current iteration because they blew themselves up in 2002, they blew themselves up in ‘08, and they’re not doing it again. They touched the rail. But I am on Twitter, but I wouldn’t listen to my tweets, those are fun and personal. If you want to know what I’m thinking, you can read through the archives of my client letters on the website.
Tobias: I highly recommend everybody does that. Christopher Bloomstran, Semper Augustus. Thank you very much for your time, sir.
Chris: Thanks, Toby. Always fun.
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