In their latest episode of the VALUE: After Hours Podcast, Chris Bloomstran, Jake Taylor, and Tobias Carlisle discuss:
- Why Buffett Loves OXY
- Comprehensive Drill-Down On Berkshire Hathaway
- BH Energy Provides Capital Allocation Training Wheels For The Next Guy
- Lessons From Berkshire’s Proxy Statement
- Investing Lessons From Rats & Bamboo Blooms
- A Keyhole Into The U.S Economy
- Earnings Trajectory From Here
- Brutal Period Ahead For Passive Investors
- SVB – Banking With Unmitigated Assumption Of Duration Risk
- The Future For Energy Stocks
- ESG Has Gone Too Far!
- Investing Lessons From Rats & Bamboo Blooms
- Why We Love The Shiller PE
- We’re Coming Off A Secular Peak
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: This meeting is being live streamed, gentlemen. It’s Value: After Hours. I’m Tobias Carlisle, joined as always by Jake Taylor. Special guest today, the great and powerful Christopher Bloomstran. How are you, sir?
Christopher: Oh, no. [chuckles] Well, how are you, guys? The great and powerful.
Tobias: Better [crosstalk] seeing you.
Jake: Yeah. [laughs] That’s right. The Wizard of St. Louis.
Christopher: Oh, Lordy. Stop.
Tobias: We’ve been debating the status of the American economy and the stock market pretty comprehensively over the last-
Jake: Three years.
Tobias: -four years since we launched the podcast.
Jake: Oh, yeah. [laughs]
Tobias: But particularly with increasing fervor over the few recent months. I guess it’s been an incredibly wild ride. But what does it look like, Chris, from your perspective as someone who– you launched in 2000. Is that right? You launched in around that date?
Christopher: We launched early 1999, very end of 1998.
Christopher: So, we’re into our 25th year, which is hard to believe.
Tobias: So, you’ve been investing, unusually for many people, on social media and doing these sorts of podcasts. You’ve been investing through two cycles that probably look fairly similar. What does it look like from your perch? How do you see the world?
We’re Coming Off A Secular Peak
Christopher: I think we’re coming off another secular peak. It’s hard to believe that we’ve seen as many peaks and troughs in my short lifetime. It feels like I’m still a kid. But you had the late 1990s bubble, which was extraordinary. I never thought we’d see the likes of that again. The big blue chips, the second iteration, if you will, of the Nifty 50 peaked in 1998 with Coke at 50 times earnings, all the big blue chips. GE was really expensive. Then obviously, that morphed into the tech bubble. Those blue chips started declining. Berkshire started declining after they bought Gen Re in 1998. But March 2000 was the mother of all bubble peaks that rivaled 1929, some parallels to 1966. You sold off hard. The market dropped in that 2000 to 2002 decline by about 50%, fully recovered by 2007, and then 2008, obviously, great financial crisis.
You had a low in the fall of 2008, early 2009. Really, as I value the market in my entire career right at the outset coming off the savings alone and banking crisis. Got out of school in 1991. Stocks were arguably fairly priced at that point. Then you went into that 1990s bubble run up and things were extremely expensive. You really were not cheap. By 2002, on three years back-to-back, market was down 9%, 11%, and then 22%. Value guys made money. We made a bunch of money during those three years, which we wouldn’t have expected to do, but the market was extremely bifurcated. But really in 2008, 2009 on the decline that took the S&P back down from having retraced back up to 1,500, back down to 666 at the low.
Tobias: Yeah– [crosstalk]
Christopher: Genuine undervaluation during that period. There was a fear that were going to repeat the Great Depression and the S&P would fall another 300 points, which obviously didn’t happen. Then we ran back up again, and we had a series of years here where the S&P, this last 10 years leading up to the end of 2021 was extraordinary. It looked a lot like the 1920s. I know you guys saw my letter last year. I had a piece in it that suggested that you were at a secular peak. That with stocks trading on record margin of what was then 13.3% trading at almost 23 times earnings, that was a secular peak.
Across all the metrics you’d run as parallels price to sales, market cap to GDP, all of which are nuanced, you have to make adjustments for them. But there was no question that in my mind was a secular peak. Then of course, you had an 18% decline last year, and you cleansed some of that excessive valuation. You had the dual hammering, thanks to inflation, of you took the profit margin down by 200 basis points from 13.3% for the S&P down to 11.3%. So, you lost 15% on return to the decline in the margin, and you took the multiple from 23-ish down to 19. And so, you lost 16% or so percent there. So, between those two measures, you’re down 30%.
What was interesting about the inflationary period that we’re in, and last year, and even into this year, I don’t know if people would believe it, but you had sales growth, which had averaged about 4% a year for the prior 20 years. Top line sales ran 12.5%. You gained one point from continued cherry purchases, but you were 12.8% or 12.9%. You had an absolute outright decline in profitability. Earnings for the S&P were $208 at the end of 2021. I don’t know what the final count was. I had it at 200 in my letter. This year probably going to be like $197 or $198. I think those numbers are probably final on S&P website. But you had an absolute decline in earnings.
If you take the record profitability of energy, which was the energy sector was producing losses in 2020 made up 4% or 5% of profits in 2021, and made up darn near 15% of profits last year. If you take energy out, everything else just got hammered. So, you saw that with the five big tech stocks. I call them the fab five. They were down 36% or 37%. Of course, they’re leading the market this year. Yeah, we’re still from long-winded answer, but broadly speaking, I think we still have an awful lot of excesses to cleanse. The overall market remains expensive. We’re nowhere near what you’d call a secular low. I don’t know what that looks like, but we’re facing a lot of challenges. The Fed doing its thing with interest rates. Famously every bubble throughout time, they’ve popped with big interest rate-
Tobias: And created.
Christopher: [crosstalk] cycles.
Jake: [Laughs] Yeah.
Christopher: You didn’t know who was going to get taken on a stretcher, but the levered borrow short, lend long crowd gets itself killed. When you raise basic interest rates by 500 basis points, somebody’s going to blow themselves up. How much more of that to come? The Fed thinks it’s got to be Paul Volcker. I’m not sure that’s right. So, a lot of interesting nuances, but at the end of the day, we’re stock pickers and you pay attention to everything going on. We always find value, but I think we’re far from out of the woods and a lot of challenges remain would be my view from 40,000ft.
Earnings Trajectory From Here
Tobias: Do you have any view on the likely trajectory of earnings from here? It’s still down, but even before it cracked, there was a piece out of the Man Group where they thought trough earnings on the S&P 500 was, if you took what had occurred in various other recessions and applied that to where earnings stood at that time, and this article was probably early 2022 or possibly even late 2021. They thought trough earnings were in the order of $185 or $186, which seemed a long way down from where they wrote it and that was very much an outlier at the time. How do you feel about that number? Is that reasonable or is it too low, too high?
Christopher: If we were on an operating earnings basis, which is before writeoffs and write-downs, if you were $198 or whatever, $197 last year, you were probably there on a reported earnings basis already for the past year. You tell me how inflation evolves over the next 10 years and I’ll tell you where I think margins are headed. If you have a period like the 1970s rolling inflation, the Burns Fed is argued today to have been behind the curve and they let inflation run too hot. Well, I’ve got a piece in this year’s letter that suggests otherwise. They propped the funds rate in advance of the CPI, which was the metric at the time. It wasn’t the PCE, but they’re very correlated anyway.
You had this series of rolling periods of rising and falling inflation. The Fed was ahead of the curve. They credit Volcker with coming in at the end and hiking rates to 19 and change. But inflation was already in retreat when he did it. I think people forget that the Volcker Fed then cut rates to eight- and three-quarter percent after the first recession and then hiked him straight back up to 19, which was pretty extraordinary. I think if inflation is out of the bag and some of this will prove permanent, you’re not going to get wages back. Price level, some of this is durably higher. Whether that means incrementally on a year over year basis, you’re going to continue to get inflation or not, I don’t know. But if you do have inflation, and I think that could be the sell for the debt bubble that we have.
You just can’t operate a system with 350% on balance sheet credit market debt to GDP. I hypothesize, if we run inflation at an average of 4% or 5% or 6%, which you can do for a decade or two decades, you’re going to see materially lower earnings. Not all businesses can pass through. You’ve got top line growth last year, obviously, which was companies passing through their rising cost of goods sold, and labor costs, and what have you.
Jake: Volumes, when you read transcripts, we’re like, “Hey, we got 11% on price, but we lost 3% on volume.”
Christopher: You look at it in car loadings at Berkshire’s BNSF, you look at the Union Pacific, you look at really industrial America, our second biggest holding is commodity chemical company, headquartered here in St. Louis, Oland. Their volumes are absolutely in the tank. They’re in the deepest recession. These guys running the business have seen in their careers. We’re far from what would be prescribed as these back-to-back quarters of genuine recession. But things under the hood are far weaker, I think, than conventionally believed. Yeah, you’re exactly right on volumes. Things are very, very weak.
Why We Love The Shiller PE
Tobias: I think as much as there are problems with things like the Shiller PE, I like that. I use the Shiller PE just as a shorthand for– You can get the same answer if you go and look at Tobin’s Q, but I just find it’s much harder to calculate from publicly available information or Buffett’s measure that might– [crosstalk]
Jake: Market cap GDP.
Tobias: Total market cap to GNP. It’s GNP, but GDP and GNP, in practical terms, are virtually identical. All of them give you the same answer. They say that we’ve been in this massively expensive period of time that starts somewhere around 1996, and we’ve had periods of time where we’ve gone back to maybe like long run average Shiller PE in this instance. And so, 2009, we got back to the long run average there. We didn’t dip much below it for very long. Since then, we’ve sort of been very, very expensive. Is there just some change in the way that we invest? Everybody’s become aware of the fact that equities are a little bit safer than perhaps they were in the past? I don’t know. Or, a lot of these stocks end up being bond proxies and they just trade on some small premium or discount to the 10-year?
Jake: You have margin are really high, you have rates got really low. You have ROE–[crosstalk] Yeah, ridiculous, seemingly unsustainable. You have effective tax rate way low for corporate America. So, it’s like every lever you could pull has been pulled in one direction, it seems like. Would you agree with that, Chris?
Christopher: Yeah. You go back to Warren Buffett’s Fortune article and interview, I think, in 1999 maybe or 1998 leading up to that bubble.
Christopher: He used the market cap to GDP as a proxy and suggested that profit margins were mean reverting and range bound. Well, he couldn’t have been more wrong on that front, because you didn’t see some of these the reduction in the tax rate. You didn’t see the capital light aspect of some of these tech companies that sit at the top of the market today. So, you had to adjust the profit margin materially higher than where it had been historically. I think you got to 8.9%, 1929, which was a real outlier, but then you were rangebound between 4% and 7% for a long time. You got it up to 7.5% in 2000, rolled back over, but seeing a 13.3% profit margin-
Christopher: -in 2021 took all of these stars aligning. All of those long-term series, like, the market cap to GDP, price to sales, the Tobin’s Q, you’ve got to adjust for this profitability. So, there are two main adjustments you’ve got to make to the market cap to GDP. One, in 1929, when you were 90% or whatever and nosebleed, you had to assess how much of GDP and how much of aggregate corporate profits was attributed to publicly traded companies versus private. Well, you had a hell of a lot more private enterprise and even an agrarian society then than you do today. The other aspect you’ve got to adjust for is the degree to which we trade globally.
If your GDP in 1929 was $103 billion and it fell to $54 billion, trade in 1929 was– we’re a net exporter to the tune of a billion dollars, and it was $5 billion against $4 billion. So, you’re 4% to 5% of GDP. Trade is a much larger component today. And so, profits for the S&P 500 are now half produced abroad and half produced domestically. So, all of those trend lines that you would look at have to be adjusted upward. But you were stretched by any stretch of the imagination a year ago, and you still remain stretched. I think whether it’s Shiller’s PE or all of them, you’re still nowhere near a secular low.
Brutal Period Ahead For Passive Investors
So, again, back to how we de-lever this economy, whether it’s via inflation or whether it’s a really deep recession where you write off a whole bunch of bad assets, which is the classic Austrian school way you should do it, but-
Jake: We don’t do that anymore.
Christopher: -you’re so far beyond the ability to do it. [Jake laughs] You can’t do it that way and maybe you get hyperinflation. There are a lot of tales to how badly this thing can go. I think if they just go and we list along and you run 350% debt to GDP and run that down to 300% or 250%, you can do that over 20 years, but it’s going to be a pretty brutal period for the passive investor in stocks, brutal period for the owner of credit. I don’t understand why anybody in their right mind would have owned a bond a year ago when interest rates were low or why you would have owned a mortgage. People are learning a lot about duration and convexity risk now.
Jake: Yeah. [laughs]
Christopher: You’re getting paid nothing to take an enormous amount of risk, and then you layer on a bunch of leverage on top of it, like, we do in our classic finance systems, and people are going to get taken out on a stretcher.
Tobias: If this is was something like the US had low but positive interest rates, whereas some enormous– I don’t know what it ended up being at the absolute peak, b ut 20% plus– [crosstalk]
Jake: $17 trillion, I think, something like that of negative yielding debt.
Tobias: It just seemed like that was the trend. That was the trend forever that we would– I think you still find people who think that we’re going at some point to negative rates, even in the US. I guess that’s the reason why.
Jake: Well, people were buying bonds for capital appreciation, not for yield. That’s always a very dangerous game to play, no matter what you’re doing.
Christopher: If you went back 20, 30 years ago, when you had a normal yield curve five or six on the short end, seven or eight on the long end, forget about the high interest rates of the late 1970s and early 1980s, but just running five to seven, where you can’t run five to seven, but there you could have a credit component to an investment portfolio. How in the world your chief investment officers of big pension systems and university endowments could justify credit at all in the allocation. The problem with the bond is you get paid 3%, you got to reinvest the coupon, but you’re going to get only your principal back at maturity regardless of what the inflation rate is. If you own real estate, at least over time, you’ve had appreciation of the underlying asset. You own common stocks and you receive a portion of your return as dividends. You reinvest those dividends. What I like to think of as a control premium, you’re paying the current multiple to earnings for whatever businesses you’re buying. But any portion of reinvested capital in theory is being reinvested intelligently at-
Jake: On time price to book.
Christopher: -mid-teens return. Now, if it’s all chewed up, it happens with broadly for the S&P, where you get 35% or 40% in dividends, and the balance of two thirds of your profit, all goes to share repurchases at 20 times earnings and 5% earnings. That’s not a great use of capital. But that beats the hell out of a credit instrument where you simply get your principal back at maturity. That’s just an insane way to allocate capital, and take duration, and convexity risk on top of it when rates were so low and negative in parts of the world.
Tobias: Speaking of Silicon Valley Bank, can see already bills were taken.
Jake: Oh, were we? [laughs]
Tobias: On Silicon Valley Bank.
Christopher: What about it?
Christopher: Do you have a view on it? What’s your take?
Christopher: My understanding is you don’t even have a credit problem yet. This is just simply banking.
Jake: That’s right.
SVB – Banking With Unmitigated Assumption Of Duration Risk
Christopher: Banking with unmitigated assumption of duration risk in your fixed income portfolio. It’s not a big enough bank to be systemically important. And so, if you get four or five of these, you get more big banks go out, you’re going to get the entire backstop of deposits. You saw our treasury secretary walk that back last week, but you’ll eventually get the– [crosstalk]
Tobias: Which one? How did she end up? Which way did she end up? I saw her go a few different directions. She had an each way better I thought.
Christopher: You’re going to have a lot more pain before you see the full force of the federal government and the federal reserve backstopping. But it took, in 2008, the financial crisis, the suspension of mark to market accounting. You could take the portion of a bank’s bond portfolio that’s available for sell or held to maturity. If you run the entire book on a mark to market basis, which you don’t have to do in bank accounting, you do have these permanently held bond portfolios that you intend to hold to maturity. But if you mark everything in the market, a whole bunch of banks that have no tangible equity capital anymore. You’re an investor in a bank.
You could see in the Berkshire portfolio over the last couple of years, even though B of A is still a big position, but they materially gutted the majority of the bank portion of the stock portfolio. I’ve got to believe that’s an understanding of your spread business when you’re starting at very low absolute yields, it can be toxic. Banking is just classic. You’ve got the left side and the right side of the balance sheet. Well, the asset side of the balance sheet is totally unknown. The liability side, you know with precision who you owe and when you have to pay it to. But the asset side is very assumption based and is the outside investor. You don’t really get a good look at what a loan book looks like, what the assets look like. But you do know– You can read on the portion, you read your footnote and marking all those assets to market. You can see where the exposure was on a quarterly basis in the Q filings and in the K filings. Just way too much risk assumed for a modicum of return.
Tobias: Let me just do a few shoutouts, because I always like to let everybody know where everybody’s dialed in from.
Tobias: We got Dubai. Montréal. Bonjour from Montréal, hello. Bluestone Lane, Manhattan Beach,
Jake: Oh, como sava?
Tobias: Dubai. Loma Linda, California. Tallahassee. Norberg, Sweden. London. Seattle, Washington. Saskatchewan. You have to get me a guide on how to say that. Zurich, Brandon, Tampa, what’s up?
Jake: Should we transition, do a little veggie segment?
Tobias: Let’s do some veggies.
Jake: All right.
Tobias: Are you familiar with the veggie segment, Chris? Whenever you’re having this– [crosstalk]
Jake: This is where I get really pedantic for about 10 minutes, and then [laughs] we go back to the regular show.
Tobias: When you’re having your meat and potatoes and your dessert, you got to eat your veggies. You got to eat the healthy portion of the meal.
Christopher: Well, all I’ve got is coffee. It’ll have to do.
Investing Lessons From Rats & Bamboo Blooms
Jake: [laughs] That’ll work. So, we’re going to be talking about bamboo blooms, and I figured that’s a nice little segue since we have a Bloomstran on the show. This actually comes from– Toby and I were in Palm Springs this last weekend together with some other friends and had a very fun and restorative session there, got some sunshine. But one of our friends told us this story about these bamboo blooms that turn into human catastrophe. And so, I’m going to tell you the backstory of it. Like, I went and did a little bit more research and we’ll see what we can pull from this.
So, it’s 1959 in Northeast India, and humans are desperately seeking food as this famine is stalking the countryside. Mothers are digging up roots to fill their little children’s bellies. Some are hiking hundreds of miles just to find a little bit of rice for their starving children, and thousands of people end up dying of starvation. It’s a natural disaster, but it wasn’t brought on by wind or drought or flood. It came on four legs in the millions, and it’s a plague of rats. What’s happened is, specifically, it’s this dreaded black rat, which actually is the rat that carried the plague throughout medieval Europe. It turns out these black rats are rapid breeders. Their gestation period is only 21 days. The pups are weaned within two weeks after that, and they’re these very opportunistic omnivores that will eat almost anything in sight.
What is weird about this is that 48 years later, in 2007, a similar plague sweeps through northeastern India. The farmers expected to harvest about 4,000 pounds of rice that year and they ended up getting 50. Oddly enough, these rat plagues have been happening at a 48-year cadence with documented cases back to 1911, 1863. We’ve talked a little bit about plagues before on the show. What an interesting fact is that, often, they end up being a prime number, like 13 or 17 years apart. The reason for that is that if there was another organism that was trying to time it to get on with them, you don’t want to be on a repeating number, like, an even number, necessarily, because it’s too easy for the other organism to sync up and then be a predator on you. So, they end up being prime numbers. I don’t know why this came in at 48 for whatever reason.
A little bit more backstory is this area of India is blanketed by 2,400 sq mi of bamboo. Every 48 years, the bamboo blossoms and it fruits, and then it drops all this fruit, and then it dies, and then the next batch grows up. About six months later from the fruiting is when this plague moves out of the forest and into the fields. So, it ends up being that the bamboo produces 10 tons of fruit per acre. It’s just an absolute deluge of fruit and calories that are available. And so, the rats, they get the sensor that like, “Okay, there’s a ton of calories here,” and they go into crazy overdrive to just crank out more baby rats.
A well-fed female rat can start a cycle that results in nearly 200 offspring. So, 50 females can produce within less than six months 10,000 rats. So, just you end up keep like pyramiding this multiplying it up. As long as the calories there, it’s all good, but only when there’s a large enough supply of calories will their bodies trigger this super fertility. So, eventually, all of that fruit rots away and the rats who are desperate for calories now descend out of the forest into the rice fields and they eat everything, and then the humans end up starving.
We’ll tie this back to– This is a little bit of a stretch, but I think of sometimes how Charlie runs Daily Journal’s portfolio is a little bit like this, where he’s just waiting for an absolute feast of calories to come along and he’s doing nothing for long periods of time. And then it dumps and he pulls over on the side of the road, and he puts the whole portfolio into bank of America and Wells Fargo or whatever it was. So, he is very advantageous in that same kind of way and very patient, the way that nature is. That’s the good side of the analogy. Here’s the bad side of the analogy, and this is what our friend was talking about.
Is it possible that humans finding and capturing the energy of hydrocarbons is somewhat akin to the fruit dumping on us? Then we then ramp up our population and then as hydrocarbons get harder and harder to find and then come back down, are we looking at perhaps, a similar fate of too many rats and not enough energy to go around and then, like, what the hell do we do? If you look at the size of the oil fines, they peak in the 1960s, if you look at them, by decade. Is this ramp up? Then it starts to ramp back down, like, both the number of giant fines and the volume of those giant fines. Some people say that we’re having to do increasingly heroic things to get hydrocarbons out of the Earth for our use.
So, Chris, I know that you have oil and gas in your portfolio. I don’t assume, and please correct me if I’m wrong, but that it’s like a long-term, like, 30-year idea for you necessarily. It was more like, “God, how stupid cheap can these be and I have to take advantage of that.” But what do you think about all this? Are we the rats in this analogy?
Tobias: It’s a peak oil type analogy.
Jake: A little bit. Yeah.
Christopher: I’m sitting here worrying about how these rats are going to get from India to St. Louis, first and foremost.[laughter]
Jake: Yeah, they take the boat.
The Future For Energy Stocks
Christopher: We have policy that’s driving us toward net zero by 2050. The cadence at which you go has created opportunities. You’ve created some genuine scarcities and things like refining capacity domestically and abroad. We’ve gone from something like 250 refineries. 20 years ago in the United States down to 127 or so. But until four or five years ago, as you would close refining refiners, the residual refineries would continue to add capacity as population growth and industrial demand growth grew. Well, in the last four or five years, we’ve actually closed net refining capacity either outright, or you take HollyFrontier, HF Sinclair. Valero has got some. But you take your Cheyenne Refinery, you take some of your properties in New Mexico and you convert them to make renewable diesel, which is interesting.
California is starting to mandate over time the use of only renewable diesel in class 8 tractors. Fine. But when you convert that refinery, you go from making millions of barrels of output globally to thousands. You’re doing it on a much smaller scale. The renewable diesel is a biofuel. You take, effectively, food cellulose product. You make what’s chemically identical to diesel. It burns the same, wears on the engine the same, you have the same efficacy, but the problem is you make a smaller amount of it that you would have a conventional refinery that might be doing 30,000 barrels or 300,000 barrels or 800,000 barrels for a bigger one. But out of the stack, that was nothing anymore. You close your conventional refiner, you don’t get jet fuel, you don’t get kerosene, you don’t get gasoline, you don’t get asphalts, waxes, all of the feedstocks for petrochemicals.
So, we have a genuine shortage in the United States of probably a million barrels of refining capacity on 20 million barrels of supply demand. We’re a net importer and exporter depending on the product. We have complex refineries that can make the whole stack. We have access to light, sweet crude. We’ve got to import heavier crude stocks to make some of the heavier components at the bottom of the stack. In any event, we’re on 20 or short a million. The globe is probably 3 million barrels short. We’re just not building refining capacity, certainly not in Europe and the United States. So, places like that, you’ve got Berkshire making its big investment in Oxy and in Chevron. You’ve got a rationality from these businesses.
I think, perhaps, when your politicians put a gun to your head and say, “We’re going to put you out of business,” you think twice about the massive overspending that took place from 2011 through 2015. Chevron and Exxon were spending double the rate at which they’re spending Capex today. So, you’ve got a rationality that exists in places that has made some of these things interesting. I’m not sure to your point that they’re 40-year investment assets, but they could be. Depending on where we go with public policy, they very well could be. But two years ago, you had the total energy component of the S&P 500. It was down to something like 1.5%. It had been as high as 12% or 13% 10 years prior. You’re back up to 5% or so today.
We’re paying one times EBITDA for assets. Ollie bought a refinery from Royal Dutch Shell. The European majors had guns to their head saying, “Divest of your dirtiest assets.” Well, they were dumping refineries. Rational buyers wouldn’t bid on those in Europe, because of the political lens. And so, Holly pays $550 million, let’s call it 200 of which was finished. good inventory, feedstock inventory. So, you had probably $350 million is what they paid for the asset that would cost a billion five to replace. Well, that asset had done $250 million in EBITDA on average for the prior five years. So, they paid slightly over one times. I talked to folks in the energy patch who say–
When Armstrong and his team operates that asset, they’re very good operators versus the trader that sits there employed by the European major, that asset is going to do another $50 million in cash flow per year above and beyond what it was doing owned by the European major. So, those opportunities will continue to come along as we barrel down the path of trending toward carbon neutral. You’re going to see displacement in electric vehicles, whether you have the resources available.
So, as an investor, you can be opportunistic when things go too far too quickly in various directions. So, I still treat these cyclicals in the portfolio assets you’ve got to buy at the right price, and then which you’ve got to sell them at the right price. They’re nowhere near as cheap as they were. So, as I’ve been adding to things like Dollar General. I’ve got to put an order in to trim ExxonMobil and trim Valero, for example, simply because I’ve got better opportunities and better assets now that are cheaper and growing versus the cyclicals that really aren’t going to grow.
There’s a rationality for the time being that these guys are minting money. With these profits that the politicians want a tax as surplus profit? Well, you got to account for the fact that they lost money for a whole bunch of years and the returns on capital sucked. If you average the feast and the famine, you get to a mediocre return-
Jake: Normal business.
Tobias: -on capital in these assets, but they’re making so much money. Chevron is making so much money. Exxon is making so much money. Oxy is making so much money.
Look at the balance sheets. Look at the degree to which overlevered balance sheets have been really cleaned up nicely in the last couple of years. They’re better investments than they would have been over much of the past decade.
Jake: Yeah, and if you stay down at a reasonable multiple like Buffett, I’m sure every day– He’s hoping that Oxy goes down a little bit more and their buyback strategy that he’s holding them [laughs] accountable to publicly.
Why Buffett Loves OXY
Tobias: Do you have any thoughts on Buffett in Oxy, Chris?
Christopher: Well, I think he likes the management. They’ve done a great job, Vicky and her team with their assets in the Permian. I think there’s angle, perhaps. They’ve got big investments in carbon capture, which is ridiculous. You’ll take a cement plant capture the carbon, and send it into a depleted hole in the ground. But much like what Berkshire is doing in their solar, in their wind, in their grid investments, these are regulated investments. You’re getting a known rate of return, taxpayer subsidized. The tax rate inside of Berkshire Hathaway energy is negative, almost 50%. The carbon capture is also coming at being financed by the taxpayer. If you can lay out a whole bunch of money, as I think Oxy is starting to demonstrate they can, it could be a place for Berkshire’s capital.
You’re up to 23% or so percent without adjusting for the warrants that they’ve got. They’ve got the $10 billion preferred paying 8%. That’s going to start getting whittled down a little bit here. I could see him continue to buy this thing. That carbon capture aspect of it, where you’ve got a tax subsidized regulated return component is probably what interests Berkshire the most.
Jake: It seems like one of those things he wouldn’t want to own outright though for the same reason that he maybe didn’t buy an attractively priced cigarette company, but he’s willing to hold Walmart that sells cigarettes publicly.
Christopher: Yeah. Who knows? To tender for the rest of the business that Berkshire doesn’t own, you’d have to pay a much higher premium than he’s paying in the open market today.
Jake: Yeah, he’ll just keep chipping away at it.
Christopher: At the end of the day, these are cyclical assets that you don’t necessarily want to own for 30 or 40 or 50 years. Hell of a lot harder to sell the whole thing if you own it entirely than to feed it back out into the marketplace.
Jake: If he’s happy with what they’re doing capital allocation wise, he doesn’t need to get in there and fix that.
Comprehensive Drill-Down On Berkshire Hathaway
Tobias: He pinned their colors to the mask by putting that slide up, and making it public, and talking about that regularly. How do you feel about Berkshire, the entity? Can you walk us through how you think about it?
Christopher: I think about it like it’s a bond to a degree. The predictability of the earning streams, which are coming from all the myriad sources, even the profits you get from the energy business, from the railroad, from their manufacturing service, retail and leasing businesses are very knowable, very durable, very well capitalized. Then you’ve got by far the world’s best assembly of insurers on the planet, which are just massively overcapitalized. I’ve gone through the math with you guys before, but you’ve got $275 or so billion of capital. You can write $3 of auto premium for every dollar of statutory surplus. They probably get $20 billion of capital. The specialty business gets another $20 billion of capital. The balances and the reinsurers.
You just picked up the Allegheny assets, which I think Berkshire just stole. We owned Allegheny, which we bought in the financial crisis or in the pandemic at about half a book. I think it was worth at least 20% more than Berkshire paid. Weston Hicks told me recently that the operating businesses, he heard, they were way more profitable for the last year. They were earning 12 on equity a year ago, not inconceivable that they were into the 2020s returns on equity. And so, given what Berkshire can do with the Allegheny investment portfolio, flipping it from what was largely bonds to largely stocks, retaining more business when it’s written– You’re picking up $5 billion of premium from TransRe of the $7 billion of total reinsurance premium that the Allegheny collective of insurers write.
So, that reinsurance operation at Berkshire– and I’ve got a chart in this year’s letter that shows you how much capital the aggregate of the reinsurance industry has globally. Berkshire has more than a third of it, and they write seven cents on the dollar of capital in premium volume. Well, the Swiss and the Germans, Swiss Re and Munich re write at about a buck of premium for a buck of capital, which is insane. The Europeans have never met an insurance policy they didn’t like, an insurance risk, [Jake laughs] and the banking system in Europe never met a loan they didn’t want to make. These have been horrible investments for decades. You look at the stock price charts and they’re just dying a slow death over time.
Berkshire is so massively capitalized with that reinsurance business again writing seven cents on the dollar of statutory capital. You can’t kill it. It allows Berkshire to have largely a common stock portfolio versus a bond portfolio. So, you put it all together– I’ve got $53.9 billion, I think it was this year in total Berkshire earnings. A big slug of that comes from the stock portfolio. You’ve got the retained earnings, obviously, of the investees that is now running close to $17 billion. You’ve got $5.5 billion pushing $6 billion in dividends. Here’s where my number. Some people say, “Well, Chris, you make these adjustments for the railroad and the energy business.” They use accelerated depreciation, and I presume a timing benefit of fully depreciating an asset in year one or year two. That’s about a billion dollars. You can pick at that and throw that assumption away.
The big assumption is, if Berkshire only earns the earnings yield on the portfolio, which now gets you to $17 billion plus $5 billion, the thing had been 19 to 20 times earnings for the prior couple of years. Well, with the stock portfolio down last year, and with Berkshire investing almost $60 billion net back into the stock portfolio, you’ve got a way bigger earnings number coming and it’s trading at a 7% earnings yield. So, if the stock portfolio only makes 7% a year between dividends and retained earnings, that’s the number that exists in my $53.9 billion. But if the $300 plus billion dollar stock portfolio makes another 3% a year and averages 10%, it’s another $10 billion in earning real-
Jake: Starting to talk about real money here.
Christopher: -effectively inures for shareholders benefit, that’s not counted. So, I’ve got a case in the– I’ve always assumed 10 ROE, and Berkshire earns a little more than 10. Well, it’s the delta, really, between the stock portfolio doing better than the earnings yield of the stock portfolio over time.
Jake: One thing you had in the letter that surprised me was that you said that BNSF wasn’t going to be somewhere where he could plow capital back in like he had been able to, and that was closed off, especially relative to BH Energy. Can you explain that a little bit?
Christopher: Yeah. When they bought the Burlington Northern, and the financial crisis in 2009, it closed in 2010, they had the opportunity to put more leverage in the business. They paid, what, $36 or so billion dollars for it, including the piece they already owned. You were able to go add corridor track. You were able to blow out all the tunnels in the west to allow for intermodal, [crosstalk] the double stacking. There was a lot of what you would call capacity improvement of the system that was there for the picking. It was right for the picking. And so, Berkshire was spending in the rail $2 of Capex for every dollar of depreciation. Well, normally it kind of 120%, 130% Capex would be maintenance Capex relative to depreciation. But there was a big delta there where they’re able to really improve.
Now, they didn’t add net track miles. The whole thing has been 36,000 track miles from the get go. But there were a lot of improvements to the system that allowed for ongoing profitability. So, this is a business that earns low to mid-teens returns on capital. That Capex has run its course. And so, you’ve now got Capex at the rail running a little under 150% of depreciation for the last couple of three years. And so, the cadence of that spending has declined. You’re not going to go from 36,000 track miles, 46,000 to 56,000. There’s only so much you can do with the system. But the system is what it is. It’ll continue to throw off abundant cash presuming a lot of profitability.
The energy business, on the other hand, where you’re adding wind capacity, you’re adding solar capacity, you’re building the grid, every dollar of profit that’s earned by the energy operation since they bought MidAmerican has been retained and invested. If you understand accounting and the regulation of regulated utilities, you’re going to augment equity capital with roughly a like amount of debt, capital running between 40% and 60%. If you’re 40% debt, the regulators think you’re not spending enough on maintenance. If you’re running 60%, you’re gorging on leverage. So, you tend to run half and half. But they’re retaining $4 billion-
Jake: Yeah, the dividends.
Christopher: -$5 billion would you consider the joint venture pieces that Berkshire doesn’t own 100% of and augmenting it with debt. So, you’re running Capex, and for the duration of their ownership, retaining all that money and spending $2 of Capex for every dollar of depreciation. That’s genuine growth Capex. It’s a great use of about $5 billion of retained capital every year. The railroad, since they bought it has dividended up almost all of its profits, I think all of its profits to the parent company for use elsewhere. There’s only so much capital that the rail could take, but Berkshire’s appetite for the energy assets is endless for the time being and it’s heavily subsidized by the taxpayer. And so, that energy piece is going to be bigger than the railroad within a couple of three years and will continue to grow. It’s by far going to be the second most important asset to Berkshire next to the insurance operation.
BH Energy Provides Capital Allocation Training Wheels For The Next Guy
Jake: I have a secret hypothesis that the BH Energy represents this awesome capital allocation training wheels for the next guy who comes in, because he can always stick it in there and earn a 10% ROE, let’s call it. Whereas if he has to be real clever about buying, let’s say, like Scott Fetzer. Okay, you don’t keep any money in there, that money is coming out. It has to be redeployed. The decision is so easy to just stick it into BHE, if you don’t have another opportunity set that’s obvious.
Christopher: Yeah, I’ve got a table in the letter, and I took the last five years of cash flow from operations, which totaled about $190 billion, I think, for five years, and then backed off depreciation, which is another $40 something billion dollars. So, you really have had $150 billion or so of deployable Capex. I showed where that’s gone. There were some years, a couple of years, 2020, 2021, I think, where the share repurchases were north of $25 billion a year. Last year, they spent most of their deployable Capex buying stocks in the market for the public common stock portfolio of the insurance operation. They did the same thing in 2018. That growth Capex is linear, but if you’ve got, say, $30 billion a year of operating income, of operating cash flows after depreciation expense to deploy, that’s 15% of the total which will grow.
Your rate base continues to grow as you add assets to the system. It’s just getting larger and larger, and it’s earning a regulated 10-ish return on invested capital. It’s a no brainer. For $5 billion is not chump change. As long as the opportunity set is there from a tax standpoint and from an economic return standpoint, it’s a great use of capital. But other utilities don’t get to enjoy it, because you have these publicly traded electrics that have dividend policies. You’re distributing two thirds of your profit as dividends.
Jake: All the compounding goes up–
Christopher: Even if you wanted to go spend the Capex, now, you’ve got to go raise new equity capital to run it back up. Berkshire is not saddled with that. There is no dividend policy. The parent gets nothing from the energy. You want that being reinvested at what is an acceptable and predictable return.
Jake: Yeah, imagine having a savings account with a 10% yield. It’s just keep– [laughs]
Christopher: Well, that’s how I look at Berkshire. If you buy the stock intelligently, and the thing earns 10.5 or 11 or 12 on equity, depending on what the stock portfolio does over time, how much better is that than buying a two-year treasury at 4%?
Lessons From Berkshire’s Proxy Statement
Tobias: Before we jumped on, Chris, you said that you had taken a look at the Berkshire proxy. Do you want to let us know what you’ve gleaned from that?
Christopher: Well, since I’ve gone to the annual meeting and you guys have gone a long time as well, we’ll talking about that. I don’t know, I went for the first time in 2000. The business part of the annual meeting, every year you’ve got these proxy proposals by various– Now, ESG-oriented, climate-oriented groups that use Berkshire as a soapbox. You’ve only got to own a share, $2,000 worth of a stock for three years or $25,000 for a single year to have a proxy initiative introduced onto a proxy statement. Mr. Buffett gives those groups time at the annual meeting. Last year’s meeting was a little slow. I think we got through three questions in the morning session.
Jake: [laughs] Yeah.
Christopher: He’s determined to speed up the annual meeting this year and field at least four questions in the morning– [crosstalk]
Jake: It’s like the pitch clock in the MLB. [laughs]
Christopher: But you’ve got CalPERS, and you’ve got the Québec Canadian pension system, they’re back with an identical proposal to last year that wants Berkshire’s parent, the holding company, and then each of its subsidiaries to file their own climate reports. Berkshire’s response is, “I don’t think you people even read our 10k, let alone [Jake laughs] where the energy operation has publicly traded debt. And so, I spent a bunch of time every year with the Qs and the Ks of Berkshire Hathaway Energy. They’ve got deep disclosures on what they’re doing on the carbon front and on greenhouse gas emissions.
Greg Gable had a long section in the 2021 letter that addressed climate, but here these guys are again. You’ve got the Québec system. They invested in failed crypto. They had investments in SBF. Maybe you ought to pay attention to your own investments instead of [Jake laughs] preaching to Berkshire how to run their affairs. If you’re CalPERS, good Lord. They managed to hire a card-carrying member of the CCP, who took the hedge book off just as the stock market was melting down when the pandemic broke out. Literally, look it up. Honest to God, card-carrying member of the CCP that they finally had to fire. Clean up your own house and quit using the Berkshire meeting as a proxy. You got the one lunatic, a lawyer, that’s got a little foundation that wants to separate the role of chairman and CEO. I’m sure you guys are, as well, generally a fan of separation of that role. But this is Berkshire Hathaway.
Warren Buffett still has 35% or 36% of the voting control of the company. It’s his baby. Berkshire has already said when he’s not running the show anymore, those roles will be separated. You’ll have an independent director. But in the time being, you’re going to dare to tell Warren Buffett. So, the guy that runs this proposal, you can look up his 990, his tax return, and he’s got something like $25 million in– I take that back. $2.5 million in revenues of the foundation gifts or grants per year, and they’ve got a whopping million dollars investment assets. Well, this dude pays himself-
Jake: Where is all going?
Christopher: -$250,000 salary. As far as I can tell, he is the chairman and the CEO of this thing.[laughter]
Jake: Oh, oh, irony.
Christopher: So, it’ll be interesting. I encourage anybody that either is at the meeting or listens in to hang around for the business meeting part, because that’s when Warren last year came out of his chair and really got animated, because it pisses him off. You won’t find better governance at any company in the world better than you have it at Berkshire. You have the chairman, and the CEO, and the vice chairman making $100,000 salaries forever. They’ve never given away a single stock option or restricted share unit. You don’t abuse accounting. You don’t have write off, write down year after year after year. They did write down $10 billion of precision, but that was very much as one-off.
It’s as clean of a place as you can get. The charge of the board is to keep these lunatics away from Berkshire for as long as possible and allow the culture of the place to persist for as long as possible. It’s really going to be interesting when he is gone, because these climate nut jobs and these ESG nut jobs are not going to go away and they’ll continue to come with full force and fury. It’s just maddening. Yeah, it’s the same proposal. Did you guys go to the Chuck E. Cheese when you were kids, that whack a mole?
Christopher: Well, it’s like your rats. They keep coming at you every cycle. They come at you every year. They come at Berkshire. You hammer them back down into the peg, and they crop up the next year with the same damn proposal.
Jake: I like when they– because they used to do that part, the vote part earlier at the beginning of the meeting. The crowd would just cheer when it would announce that it was voted down. [laughs]
Christopher: Yeah. Well, hopefully, more stick around and cheer this year. These things have never come close to being passed.
Christopher: Berkshire has just got such a unique culture. You do have so many individuals and families that own the shares that really think about governance through a proper lens, rather than CalPERS dictating to you that, “You’ve got to fill out some checkbox form to make them all feel good and sing Kumbaya.”
Jake: I don’t know if we’re getting our $100,000 worth out of the guy at the top. I don’t think he’s working that hard every day.
ESG Has Gone Too Far!
Christopher: Well, here we are talking about him. So, he’s getting some play. I think the whole ESG thing has gone too far. The CFA institute really got behind it. If you look at their website, all they talk about the CEO. It’s all she tweets about. When the war in Russia broke out last year, and it really exposed the folly of Germany, for example, in their nuclear policy closing all, but three of their nuclear plants, Post Fukushima, they wind up having to keep some open. They wind up having to reinvest in coal. They really got lucky with a mild winter. Ditto in New England this year got very lucky with a mild winter. You got natural gas prices back down. I think as well intentioned as ESG is, this formulaic prescription method of applying it is insane.
You’ve got people assessing boards of directors for all the wrong reasons. You ought to be sitting around thinking about capital allocation and ensuring you have the right management team in place, and not whether your board is being trained properly on climate and ESG, especially when you’ve got a place like Berkshire that’s making such huge investments in renewable energy, unparalleled investments in renewables. You’d think that would suffice it for these crowd, but it’s not sufficient for this crowd. It’s just absolute insanity.
Tobias: Chris, we’re coming up on time. So, it’s probably not really fair to ask you this question now, but I’m going to do it anyway.
Tobias: I track the 10:3 inversion as a reasonable proxy for just what the shorter-term looks like in the economy. I think it’s been a reasonably good predictor of recessions before they occur. Not that you need to follow those for any particular reason, but the 10:3 inversion as of today is as steep as it has ever been. So, the data only goes back to 1980, something like that. We’re at 1.38 today and it’s been inverted since October 25-ish last year. It’s typically been a precursor to recession. Do you see having– paying it–? I think Berkshire is a pretty broad slice of the global, but particularly, the US economy. Do you have any thoughts on–?
Jake: Keyhole into the US economy?
A Keyhole Into The U.S Economy
Christopher: I would guess we’re probably, if we’re not already in a recession trending, I think we’ve probably been in one, technically. I think you actually had two quarters in a row of the conventional definition, which is no longer the way it’s-
Tobias: Change the [crosstalk] of the definition.
Christopher: -properly defined. You look at industry, every business we own, things are just slower. Things are just slower. Our prior discussion on units being very weakened down, that’s not changing. My guess is that it’s probably been fairly predictive and it probably is. telegraphing. The Feds again, Feds got a perfect record of popping bubbles, and blowing up the stock market, and blowing up levered lenders, and the borrow-short-lend-long crowd. This last 25 basis point hike, now you’ve got our man, Bullard, here in St louis. I think he’s at five Ace. 5.625 is now his longer-term target.
Again, I don’t think Volcker needed to do what Volcker did. Inflation was already under control and these guys think they need to be Volcker. I’m not suggesting we ought to jam rates back down to zero and run more QE from here to eternity, but that’s where we’re headed. So, they’ll break something and they’re already breaking some things. They’ll break a little bit more. Economy be very weak and you’ll be back at zero and you’ll be back at QE, and the Fed’s balance sheet will blow through $9 trillion and it’ll wind up at $18 trillion. If you look at the Japanese central bank’s balance sheet, we have a lot of room to layer on more and more QE. I think that’s what the market wants. I think they like that monetary support and the free money, but it’s just creating such enormous moral hazard that it’s something we’re all going to have to contend with.
Here is the leverage crisis, the overlevered system that we have resolves itself in some way, shape, or form. Shame on these people for allowing it to happen in the first place and not letting garden variety recession run its course. So, with the volatility, comes opportunity, but I don’t think it’s going to be a lot of fun for a lot of people for the next 10 or 20 years.
Jake: I saw that the little bit of tightening that they did in the last, whatever, six months or a year or something like trying to bring the balance sheet down. Two thirds of it was undone in two weeks with just two– [crosstalk]
Tobias: [crosstalk] over a weekend.
Jake: Yeah, over a weekend, basically, from a couple of very inconsequential banks failing. We’re just going to go back to QE basically.
Christopher: Yeah, they’re leaning on the discount window and accessing the home loan bank. Banks need capital. But again, if it gets bad enough, you’ll just suspend mark to market accounting and we’ll just backstop all deposits, all $18 trillion of bank deposits, which is insane. I will say, I’ve got clients who were terrified. You run a business, and you’ve got millions of dollars of payroll, and you can’t help but be in the banking system. To try to manage FDIC minimums is insane. So, we had a bunch of money roll into a handful of our client accounts, which is really just cash-cash where we’re just buying T bills on behalf of our client, because they really were scared about having money in the banking system.
I think what Schwab and all the– we use Schwab heavily, but I think what the brokers all did in the financial crisis was criminal. Criminal is hard, harsh, but you used to be able to sweep your cash either from deposits or dividends or security sales into a money market fund. Well, when rates were zero and money market funds had 50 basis point fees and you couldn’t earn 50 basis points on cash instruments, they all said, “Oh, better off instead of subsidizing our money funds.” You can’t send a negative yield on cash to a customer. They said, “Well, let’s just create banks.” And so, they all now sweep to a bank. And so, Schwab pays you, whatever, half a percent on cash and they’re running a spread business and own a bunch of mortgages, and half the portfolio is marked to market. Half, it’s not marked to market.
They’ve created a lot of systemic risk there on the Schwab platform. The brokers have all done the same. I think Vanguard is the only one that doesn’t sweep to a bank now. I think Vanguard still sweeps to money funds. But you can go buy a money fund if you’re on any of the broker dealer platforms. But you have to manually do it. We never leave FDIC balances north to the extent any of our clients have cash, even when interest rates were zero and we’re getting five basis points on a T bill, we’ll take five basis points on the T bill versus earning nothing in the Schwab bank. Why? I don’t want the credit risk. Why would you take the credit risk? You have no credit risk with the T bill. You have a damn large amount of credit risk when you leave money into a bank suite and you get a period like this where the Feds jacked up rates by 500 basis points.
Jake: A lot of people learning some lessons that have been around for a long time.
Tobias: Some old lessons.
Jake: Yeah. [laughs]
Tobias: Chris, thanks so much for joining us. Hope you’ll come back again soon and do it again. It was great to learn from you.
Christopher: Yeah, it’s always fun to be with you guys and we’ll get together in Omaha in a couple of weeks if you– [crosstalk]
Tobias: Sounds good.
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple: