In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and John Rotonti Jr discuss:
- Berkshire’s Role in America’s Future and Financial Strength
- Stock Market Returns: Five-Factor Analysis and What Lies Ahead
- Market Mania: Speculation, 0DTE Options, and the Return of 2021 Euphoria
- AI CapEx Boom: Tech Giants’ Spending, Depreciation, and Market Impact
- High-Quality Growth, Cash Allocation, and Infrastructure Focus
- U.S. Housing Market: Underbuilt for a Decade, Expensive, and Stuck – What’s Next?
- The U.S. Housing Shortage: Why Homebuilders Hold the Key to Solving the Crisis
- Some Incredible Numbers Out of Berkshire Hathaway
- Yield Curve Re-Inversion: What It Means for Markets and Investor Sentiment
- Atlanta Fed GDPNow Plunges: Signs of Stagflation or Just Market Jitters
- Balancing Economic Growth: Tech Megaspending vs. Market Uncertainty
- Market Valuations, Cash Strategy, and Navigating a Potential Reset
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:
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Transcript
Tobias: This meeting is being livestreamed. That means its Value: After Hours. I’m Tobias Carlisle. Joined as always by my cohost, Jake Taylor. Our special guest today is John Rotonti. He’s moved firm since we spoke last, so we’re going to be catching with John. How are you?
Jake: Welcome back.
John: Yeah, I’m doing well. Thanks for having me. I think this is the third time on the show. So, always grateful to be on and talk to you, guys.
Jake: Pleasure is all ours.
John: Thank you.
Tobias: So, John, since you were on last, give us a quick update. What’s happened? What’s news?
John: So, I shutdown my podcast, The JRo Show. And in August of 2024, I started working as a portfolio manager at Islamorada Investment Management. We’re going to be changing our name very soon to Bastion Fiduciary. But I’m a portfolio manager there, and I am managing our industrials and infrastructure portfolio.
It’s domestic only, long only about 30 stocks. Right now, nearly 30% cash. I just launched the portfolio on January 23rd of this year. So, I started working August of 2024. I just launched the portfolio little over a month ago. Not completely built out just yet, so sitting on 30% cash. It’s invested in industrials, infrastructure and housing related businesses. Domestic only. But it’s much broader and more diversified than the name would suggest.
Jake: Who’s going to tease out all the little investment process related nuances, and tips and tricks that interviewing the world’s best investors to get those little nuggets out now?
John: Yeah. So, I’ve been on a few podcasts to talk about it, my strategy and my process. And I’m happy to talk about with you guys as well. Yeah, I don’t know who’s going to– Actually I do. So, FinChat has launched a podcast or is about to launch a podcast that is in the same mold of the JRo Show. They’re going to be interviewing portfolio managers specifically about their process and philosophy with a heavy emphasis on process.
Jake: Is Braden doing that one?
John: Braden’s obviously overseeing everything. But I think Ryan is going to be– Ryan Henderson, who’s also– Chit Chat Stocks. He’s the cohost of Chit Chat Stocks. He’s actually going to be hosting the podcast for FinChat.
Jake: Cool.
Tobias: Tell us a little bit about the strategy. You’re going to carry 30% cash or that’s because you’re still getting invested, you’re going to be 100% long?
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High-Quality Growth, Cash Allocation, and Infrastructure Focus
John: Yeah. I don’t want to be 30% cash for long, but I don’t think this is going to be a strategy that’s fully invested at all times. I’ve always been comfortable myself. Just running with 10% to 15% cash most of the time. And so, I think on average over time, it’ll be a 10%, 12%, 15% cash position. Cash is a residual of the process and the strict selection criteria, honestly, what the market is offering me.
Jake: I heard it was trash. That’s the word on the street.
Tobias: You need to know bitcoin treasury strategy where you take that cash, and you stick it into–
John: That’s all the rave these days. Yeah. Yeah. No, so, I launched with 40% cash, because it wasn’t fully built out. So, it’s a quality portfolio, talking about what I’m investing in. Only the most highest quality, most profitable growth businesses I can find, but at reasonable valuations, but I’m not going to sacrifice quality. If you look at the quality group when I launched in January, at least the grouping that I’m looking at the 60 or 70 stocks that I’ve really narrowed down to in my universe, they weren’t cheap. They were sort of fair value. Some of them trading at little discounts, some of them high side of fair. And so, the reason I launched– [crosstalk]
Jake: What are the hallmarks of a high-quality industrial business?
John: Yeah. So, first thing I want to say is they’re not all industrial. In the portfolio, I’ve got Visa and Amazon and Alphabet, just as an example. It’s much wider ranging and diversified than I think [crosstalk] name–
Tobias: What does it exclude?
John: The name of the strategy. It excludes low quality crap.
Tobias: Just in terms of– [crosstalk]
Jake: You’re out, Toby.
[laughter]John: Yeah. Anything that I can’t make a good case is an infrastructure or industrials related business or housing. Let me just give you some quick examples. So, Visa. It’s a fintech or it’s a payments network. Well, it’s got 10 million route miles of telecommunications infrastructure around the world. So, infrastructure in my life, I mean rails. Literally, let’s say it’s digital rails. But that’s actually infrastructure in the ground.
If you look at a company like Amazon, which we have in the portfolio, obviously, the data centers are infrastructure. They also have their vertically integrated, their full stack, so they have their own silicon, their own semiconductors. That’s infrastructure. They’ve got their E-Commerce warehouses, but also the entire fulfillment and supply chain network. All infrastructure. They’ve got robotics working in the factories. They’re working on quantum.
Kuiper, however you say it, their satellites that are going to launch in 2025. They’re going to launch something in 2025. And so, a lot of infrastructure. But it’s classified as– I think it’s consumer discretionary. It should be classified as tech, if you ask me. But it’s classified as consumer discretionary. So, my point is if it’s high quality enough, Toby and Jake, and it gets cheap enough, I’m going to do a pretty good job of trying to make an argument that it’s industrials or infrastructure housing related to some degree.
Jake: Maybe this is just recency bias. But the technology permeating every company really. A lot of these classifications start getting muddy in my mind. They might hurt more than they help sometimes.
John: Absolutely. Every company to some extent is becoming tech enabled, Jake, like you said.
Jake: What does that even mean though? Like, they use computers there or they–?
Tobias: Or, have a web page.
Jake: Yeah, they have a web page?
Tobias: Dotcom.
John: Well, I thought that to some extent, it’s on a spectrum. It’s on a spectrum, to varying degrees and varying extents. I’m not supposed to name too many names, but I’ve got the Home Depot, housing related, home improvement retailer. If you just think about the housing vertical really quickly, you start with land developers and home builders. So, that’s fair game. But then, there are building products suppliers, building material companies that supply everything from the roofing to the siding, to the flooring to the cabinets to the granite, paint. You’ve got actually third-party installers separate from the builders.
You’ve got companies that actually do off site prefabrication of trusses, or walls or floor joists, doors, custom millwork. They do it all off site at their factories using automation, they ship it, transport it to the site and then they install it. So, it’s these value-added services rather than just selling a company lumber or just selling them siding. You actually perform the service.
So, there’s these third-party servicers. You’ve got companies installing everything from installation to shower doors to gutters, fireproofing, waterproofing, you name it. Then, once the house is built and a household, a family has moved in, you’ve got service companies like pest control, plumbing, pool maintenance, landscaping, home insurance, banks that are providing mortgages and loans. That’s just housing.
Jake: This reminds me of I, Pencil, the write up that Leonard Read did where he talks about like, “No one really knows actually how to make a pencil, because each little ingredient requires some special knowledge that is only in a certain number of heads. By the time you add it all up together, you almost can’t pull apart the connections, because everything is so intertwined.”
John: Absolutely. Absolutely. We’re invested in everything from as far as thematic electric and power generation, electric grid. We can put some numbers around this. It’s pretty mind boggling if you want. But just global infrastructure spend coming from not just grid, but water, roads, bridges, transportation, all those things. Electrification of everything, EVs.
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U.S. Housing Market: Underbuilt for a Decade, Expensive, and Stuck – What’s Next?
John: In my opinion, in housing, we’re underbuilt coming out of the global financial crisis for the last decade plus. I’ve read estimates were anywhere from four million to seven million homes underbuilt. Based on household formation and population growth, that could take 5 years to 10 years or more to catch up.
Tobias: Let’s talk about housing for a little bit, because housing stocks are off pretty significantly laid like 30%
John: Absolutely.
Tobias: And there’s some worries that housing’s expensive, and so we’re at record low levels of transactions. There’s also some argument that Airbnb has taken a whole lot of supply off the market. How do you equalize all of that? Where do you land?
John: So, on the supply thing, Kevin Gordon, who’s Liz Ann Sonders right hand at Charles Schwab, he posted on February 27th, “Pending home sales, existing home sales, all time low.” All time low. Not near the low, just we’re at the all-time low. Supply is really bad. Housing is stuck. I think our treasury secretary said last week, “Housing is stuck.” It is for a variety of reasons.
Jake: Stuck at these prices, right? Isn’t that the– How do you move product? You’ve got to lower the price, right?
John: I think so. There’s very little movement of existing homes, because as you all know, people are locked into their 3% or 4% mortgages. 70% of the country is a 5% mortgage or less. And we’re at 7%, maybe a little now.
Jake: Let’s go.
John: Yeah. 40% of households have a 4% or less mortgage. So, they’re locked into the 3% or 4% mortgages. That’s a big deal.
The other thing is we’ve had a lot of price inflation. So, the combination of expensive houses, the price of the homes have gone up, plus the 7% mortgage rates makes housing really unaffordable. On the new supply side, the home builder side, inflation, input costs and labor have driven up the price of new homes.
This is not political, but tariffs are going to increase the price of lumber, increase the price of other supplies and closing off the borders to undocumented workers. It’s no secret. There’s a lot of undocumented workers in the home building industry. And so, that’s going to reduce the labor supply and drive up the price of labor.
Yeah, homes are expensive right now. They’re particularly expensive for entry level starter homes, because higher end, you can offset the price more. Higher end, there’s almost more pricing power to offset this input cost inflation. But millennials, 35 year-olds, 40-year-olds trying to buy their first house, there’s not a lot of starter inventory and there’s definitely not a lot of starter inventory under the $400,000 mark.
Jake: We have to wait for your parents to kick the bucket or something? What’s the answer?
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The U.S. Housing Shortage: Why Homebuilders Hold the Key to Solving the Crisis
John: I think the answer is to build more homes, particularly entry level starter homes. Like I said, we’re four million to seven million homes short. I think it’ll take us 5 to 10 years, maybe longer to build our way out of this. I think that means that the supply-demand imbalance that we have, which is pretty severe. I will just talk about very little supply. At the same time, demand is very high, because the Millennials are the largest age cohort in US history and they’re in their prime home buying age right now, 35 to 40 right now currently.
And so, a lot of demand, no supply almost. This imbalance creates pricing power for the home builders over time. We need five million new homes. I think this creates an extended cycle, a longer than normal cycle. And so, right now, they’re getting beat up, but I think it’s temporary. I really do. I think that all of the home builders across the board are dramatically better businesses than they were going into the global financial crisis.
Every metric across the board, almost across the homebuilder space, they have much less debt. They own, left land on their balance sheet. So, they’re pursuing to different degrees across the space. I own four of them right now in the strategy. It’s like a basket approach. Small positions across four of them. But I cover eight of them. To varying degrees, they have pursued an option their land, so rather than buy the land, hold it on their balance sheet, they’re just putting down 10%. And if the market turns on them, they can actually get out of these pretty easily without having all this land sitting on their balance sheet.
So, they’re much less capital intensive, less land intensive, hold a lot less debt, have much higher interest coverage, margins are higher, returns on invested capital through cycle I think are higher. I just think that they are just more disciplined, or almost like the oil and gas industry.
Jake: More rational.
John: Yes. More rational in their pricing and their discipline and how they allocate capital. Did I answer the question?
Tobias: Yeah. No, it’s good. I wanted a little bit– [crosstalk]
Jake: [crosstalk] about one then.
John: Yeah. I answered something. I answered something. Yeah.
Tobias: No, I tend to agree. I’m in agreement. I’m just interested. One of the things that I think about is the Airbnb. I don’t know how much of the Airbnb is taking supply off the market that will come back onto the market. There’s this Airbnb and bust supposedly going on. It’s just hard to tease it out and work out what the impact is.
John: If that’s happening, the way I look at it through my lens just means we need more new homes built. If Airbnb is going to take all the supply, we need more homes in particularly to supply the first-time entry-level home buyer.
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Tobias: Let me do a little shout out around the horn and then we’ll come back. Maybe we discuss Buffett’s letter when we come back. Mac in Valparaiso. What’s up? Winter Park, Florida. Lausanne, Switzerland. London. Toronto. Tampa. Bellevue, Boise. Cincinnati. Moncton, Canada. Manchester. Oregon. Istanbul, Turkey. William “The Wizard” of Waterloo from Wales. The UAE. Cardiff, Wales. Bremerton. Andhra Pradesh. Tomball, Texas. Tyler. And–
Jake: Is this where we insert an apology for the tariffs to all of them worldwide?
Tobias: Buffalo. What’s up? Yeah.
Jake: Sorry, mates.
Tobias: Let’s talk Buffett’s letter. Full disclosure, I haven’t read it. [chuckles]
John: There you go.
Jake: [crosstalk], Toby. Get off.
Tobias: I’ve been home over the weekend for a few weeks, so I’ve been traveling. I was in Vegas for the Australian Rugby League.
Jake: Yeah. Tell us the story about that.
Tobias: I’ll save that for later, but it was good. It was fun. Let’s talk about– You guys can talk Buffett’s letter.
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Berkshire’s Role in America’s Future and Financial Strength
John: I’ll just say, I think the messaging was similar to 2023. So, in 2023, he actually said, “Berkshire will remain an asset to the country.” He actually used the word, asset, to the country twice. He said, “Once Berkshire will be an asset to the country and will remain an asset to the country.” And then, another time he said, “Burlington Northern railroad will remain an asset to the country.” But he actually used the word asset to the country. He didn’t use the phrasing asset to the country in 2024, but I think the message was the same, honestly, Toby and Jake.
He said, “We have the railroad. We have the utility. We can ensure climate risk when other insurers can’t, when other insurers are bailing out. We’re the largest taxpayer in the US. We’re not going to go broke on you. We own a lot of treasuries and we are buying.” He says “Our cash position will likely increase. We’re buying even more treasuries.”
Jake: I heard he had more than the Fed, actually.
John: Exactly.
Jake: [laughs] How can that be?
John: Right. So, I think he went out of his way to message the same thing as he did in 2023, which is, “We’re here for the country. We have these massive, massive infrastructure projects with the railroad and the utility.” I think they have the largest natural gas pipeline in the US too, by the way. If not the largest, it’s one or two. So, “We have Berkshire Hathaway Energy. We have Burlington Northern. We’re not going to go broke. We’re going to ensure climate risk when no one else is. Everyone else is bailing on you.”
Jake: [unintelligible 00:20:10]
John: Exactly.
Jake: You can get a [crosstalk] for a dollar still. That’s nice.
John: Yeah. “We own a lot of treasuries and we’re buying more and we’re the biggest taxpayers.” So, I think people want to get on the good side of this administration, I think. They want the administration to know– I know you’re trying to make America great again. You’re trying to rebuild the country, putting a lot of money towards infrastructure, etc., etc. We can help with that. I’m just talking in general. I think companies are going to start messaging that.
Jake: Yeah. I thought it was a classic Buffett letter, fit in nicely with the entire compendium. I thought that it was very clever to include a story about Pete Liegl, who was the founder of Forest River. In telling that story, Buffett was basically laying out what is he looking for in acquisition. He wants basically like a founder, owner, operator to show up with a price. Don’t expect a lot of negotiation. Expect to keep running the business and we’ll make a quick decision for you. He laid it all out in a story format that anyone who read it and had that type of business might pattern match to it,-
John: Absolutely.
Jake: -which is not necessarily for him, but I think also for Greg in the future. I thought that there was a lot of really good reinforcements of culture that will continue to echo for hopefully a long-time, post Buffett and Munger. I thought he did a really good job of just reiterating and re-banging the drum on culture for Berkshire.
John: I agree. Okay.
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Some Incredible Numbers Out of Berkshire Hathaway
Tobias: I was going to say, did he address the cash, the big cash?
John: He says we have a lot of it and we may have more. He said it may increase, I think.
Jake: If I remember, I could be confusing these, because I’m just–
John: I’ve read so many.
Jake: Yeah. But I think it was something like they’d rather have it pile up than do something stupid with it, basically.
John: Yeah.
Tobias: Not moving into cloud anytime soon or anything like that? No big AI play?
John: I don’t think.
Jake: Haven’t seen that.
John: He highlighted, Jake, you mentioned Greg and the culture Abel. I think he tried to weave Greg into the letter more in two ways. One is he said, “Greg will be writing these letters at some point in the future sooner rather than later,” he suggested. And then, the other part was he talked about the five Japanese trading houses-
Jake: Yeah, that was there.
John: -and how Greg was intimately involved, not only with traveling to go meet them and to get to know them, but– I think he implied that he was involved with talking through the investing decision and investing in the companies.
Jake: The other part I like too was he talked about how Pete Liegl took $100,000 salary. So, it’s setting the bar that-
John: Exactly.
Jake: -don’t show up expecting a big salary either.
John: Yeah. Pete suggested it. He’s like, “Well, I read the 10k and I see you only make 100k.”
Jake: I better stay under you.
John: I better stay under you. Right.
Jake: Yeah. 53% of their 189 operating businesses reported a decline in earnings. Yup, I thought that was a little bit interesting. Maybe a slowing US economy. I don’t know what that says. Another calculation I did was operating earnings of $47.4 billion. If you calculate that out, that’s $90,000 per minute non-stop for the entire year. [chuckles] So, that’s pretty good.
John: Yes. He’s also getting float every minute, pretty much. I don’t know it’s every minute, but it’s every day. I remember Tom Gayner from Markel once said that– This was two years ago, he said it. He said that every single day since he’s been at Markel, new float has come in the door. There’s never been a day when float did not come in the door, when insurance premiums did not come in the door. And so, you think about $47 billion in operating earnings, float coming in the door every single day, 180 operating subsidiaries. Some big successful, just incredible story. Incredible story.
Jake: That 5% of corporate US taxes paid was, call it, $27 billion of all corporate US taxes. And then, he gave us the total on the aggregate over the last 60 years at $100 billion. So, a quarter of the lifetime total in taxable income or corporate tax was paid last year, which is a lot of course is the sale of the Apple stake, which is realizing a bunch in one big chunk in a year. But I think it’s still interesting and shows compounding at work. Like, those last few doubles, the last big things that you do, like the numbers, they really matter a lot at the end.
John: At the end. That’s the lesson of compounding. A double at the end is so powerful after 30 years or 40 years or 50 years or 60 years of compounding. That’s how it works. It takes 30 years, you make money very slowly and then all of a sudden, it becomes exponential. The chart really looks like that. Yeah, wonderful lesson.
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Yield Curve Re-Inversion: What It Means for Markets and Investor Sentiment
Tobias: Gents, the inversion, the 10-3 inversion-
Jake: Yes. Let’s get to that.
Tobias: -has re inverted. [Jake laughs] So, we’re normalized and then we reinvested.
Jake: So, if you’re upside down twice, are you back right side up?
Tobias: We’ve going to loop to loop.
Jake: How’s this work?
[laughter]John: Pretty sext. Round trip.
Tobias: That was still inverted. [crosstalk] I went back and had a look the last two times that happened as well. It doesn’t mean that it’s going to continue to normalize. But as it goes over the line, I guess it’s a little bit volatile and it goes over and comes back. The last two times, it inverted was 2020 before the– was 2019 before the pandemic crash and then the time before that was 2008 and did the same thing, unless there’s much you can draw from it. [crosstalk]
Jake: 60% of the time it works every time.
Tobias: 100% of the time it works every time. [Jake laughs] But they’re out that many times.
Jake: Yeah.
John: Related. Yesterday two legends, take what you want from this but you know, Leon Cooperman was interviewed on CNBC and he said, “I don’t like the environment, I don’t like what I see.” And then, Bill Gross posted yesterday and he said, “Frankly, I am frightened every morning to wake up at 05:30 Pacific Standard Time and see what the day brings markets, and otherwise, be defensive.”
So, I don’t know if the two are related, the re-inversion and Leon Cooperman and Bill Gross been around a lot. They’ve seen a lot of markets, seen a lot of cycles, seen a lot of inversions. I don’t know if the two are related. But I found it interesting that they had similar comments on the same day.
Jake: So, Toby, if before you’ve said the term bear steepener. I don’t know what any of these things mean, by the way. I’m just using words that I’ve seen. Is this a bull flattener then? How do these work? [laughs]
Tobias: Yeah, I don’t know. It’s just reinverted. It’s reinverted which means the tens or the threes back over the top of the 10. Who knows? I’ve got no idea.
John: It tends to drop quick. It tend to drop.
Tobias: Yeah. I would say that the normalization is the event that most closely precedes the volatility in the stock market. It seems to be three to six months before it happens. And so, I think we reinverted late last year or we normalized late last year.
Jake: So, everything got reset then basically on the shitometer? [laughs]
Tobias: I don’t know if there’s any–
John: Any rhyme or reason to it?
Tobias: Yeah, I don’t think anybody’s been able to figure out that, because there just aren’t enough instances in the day. There’s eight.
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Atlanta Fed GDPNow Plunges: Signs of Stagflation or Just Market Jitters
John: How much credence do you all give to the Atlanta Fed GDPNow? Have you all looked at these numbers?
Tobias: That it’s been falling over. It’s declined very rapidly.
John: Yeah, it was up positive 2.3% two weeks ago. And then, last week, it surprised to negative 1.5%. And then, yesterday, negative 2.8% in two weeks.
Jake: That’s a lot.
John: It’s a lot.
Jake: Is that what stagflation looks like?
Tobias: I don’t know who publishes it, but that minutes to midnight clock, they’re always saying, “It’s always like 10 seconds to– [crosstalk]
Jake: It’s like 10 seconds until the nuclear Armageddon?
John: So, the ISM manufacturing index is indicating possible early signs of the stagflation thesis, because prices went up, but orders and employment went down in how they measure it. And so, the stag, the price part went up and the growth, the order part went down. I read that yesterday, the day before. I read so much stuff. I can’t remember when, but it’s the most recent reading.
So, I think there’s a concern out there of stagflation. I think that’s why people are buying treasuries, and treasury yields are falling. There’s some fear out there. And that reading suggests maybe there’s something to the stagflation thesis. I’m not saying that, but it’s what the early reading is suggesting.
Tobias: I don’t know whether the administration actually cuts government spending or not, but– Let’s say that that’s what they’re trying to do. If you cut government spending, then GDP goes down because it’s counted in GDP, which seems to me like a silly way of doing it, but that’s the way we do it. And then, you introduce pretty chunky tariffs. It seems to me like it’s likely that we have a little slowdown somewhere here.
John: I would agree. It wouldn’t surprise me. It wouldn’t surprise me if growth slows from tariffs, if growth slows from less immigration and if growth slows from the way that they measure GDP with government spending included in that, then yeah, maybe we could have some slowdown that registers.
Tobias: Do you know how the Atlanta Fed is making that calculation? Is it feelings or there’s some data that backs it-
Jake: Vibes. Just a vibe session.
Tobias: -sentiment?
John: It’s not sentiment. No, it’s an algorithm that incorporates the different components of GDP. It also incorporates imports, which are declining right now as the trade war accelerates. And so, I think that decline in imports is what’s weighing most heavily on the Atlanta Fed GDPNow, but it’s not sentiment. It’s the components of GDP. And they just run it through this algorithm.
Jake: I think if that one starts looking, the numbers get too bad, they’ll just shut it down like they did to the–
John: Reset it.
Jake: What was it? Was it shadow stocks or something like that, or that had the inflation that seemed to be running quite a bit hotter than– [crosstalk]
Tobias: The billion price project.
Jake: Yeah, billion price project. Yeah, that one was interesting, and then died unceremoniously. [chuckles]
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Balancing Economic Growth: Tech Megaspending vs. Market Uncertainty
John: Yeah. These things are so nuanced though. I think the Wall Street term is puts and takes, because we just talked about what could potentially, negatively impact GDP growth. But then, on the other side, you’ve got all these announcements. You got Apple announces $500 billion in five years domestic investment. Stargate announces $500 billion in four years. That’s OpenAI–
Tobias: Is that new spending? Is that new investment, or is that investment that was going to happen anyway?
Jake: Where’s that coming from anyway, by the way? These are huge numbers. Just because you say it, it doesn’t mean you actually have the money to put out there.
John: Look, Oracle’s a great company. Great. I think Oracle gets a bad rap. I actually think it’s a great company. I think they have a great cloud. I actually spent a lot of time reading about their cloud and their AI. But how they’re going to come up with their portion of $500 billion, it’s hard to see.
Apple could conceivably do it through borrowing, through debt. But yeah, Apple $500 billion over five years. Stargate, OpenAI, SoftBank and Oracle $500 billion for four years. Zuckerberg mentions that they’re going to build a data center, one of several. But they’re going to build a data center in my home state, by the way, that is so large, it would cover a significant part of Manhattan. That’s a quote. [Tobias laughs] So large–
Tobias: We can see it from space.
John: Yeah, it would cover a significant part of Manhattan. These are big, big numbers. It’s nuance. There’s puts and takes to how the economy is going to progress.
Jake: Couldn’t you argue that any complex adaptive system that did not have some period of time where it had some culling to it would be sclerotic and unhealthy?
John: Absolutely. I talk to my best friend about this all the time. He’s a deep thinker. He’s an investor, but not– By profession, he’s a corporate attorney. But he’s a serious investor, very intuitive. All the time, he’s talking about complex adaptive systems, a controlled burn, controlled fire to prevent larger burns to get rid of call some of the dangerous stuff at the bottom that can prevent a bigger blow up down the road. Yeah, absolutely. I think so, Jake, I think so.
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Stock Market Returns: Five-Factor Analysis and What Lies Ahead
Tobias: JT, you want to do-
John: Veggies.
Tobias -veggies?
Jake: Veggies time. Absolutely.
Tobias: Market boys, six minutes past the hour.
Jake: [laughs] All right. So, a few years back, we explored the ingredients behind stock market returns with the help of our friend of the show, Christopher Bloomstran of Semper Augustus and his five-factor analysis. His letter came out weekend before last. Clocking in, I think 160 pages. Wasn’t light reading necessarily, but it’s always good. I made it through it.
So, I wanted to update a little bit on pulling some of the numbers from the most recent that he did and giving everyone an update on it, because I think it’s interesting. So, if you remember, those five factors are sales growth, change in profit margin, change in share count, change in the multiple and then dividend yield. Four of those five factors depend on the business’s results, which are largely maths, and understanding and maybe more science, let’s call it. And then, the last is psychology, market psychology, which is how excited do investors get about the business’s future.
I can’t help but wonder actually if that how you should spend your time might be roughly correlated to that 4:1 ratio. Should you be thinking about the businesses, four times to the one time that you’re spending, like messing around with the market and worrying about where it’s going.
However, let’s keep going. In our previous analysis, we unpacked how there was a really, really strong decade from 2011 to 2021. It produced a 16.6% annual return, to be specific. And that came from the attribution of this was 3.4% from sales growth, 0.7% from share reduction, 3.8% from margin improvement, 5.8% from multiple expansion and then 2.3% from dividend yield. You add all that up and it’s 16.6. Okay.
Fast forward today, we’re going to be using Chris’ numbers for these things to give us a new recipe. This is what did the returns look like over the last couple of years using this analysis. So, 2022 was a reality check for everyone. The S&P fell 18.1%. The business results were actually not that bad. Sales per share grew at a robust 11.9% for that year. But that didn’t save you. The index plunged, because profit margins slipped from their peak and the PE multiple dropped pretty considerably.
So, margins fell about 15%, which is 13.3% going to 11.2%. And then, the PE went from 22.9% to 19.5%. So, that double hit the company’s earning a bit less on each dollar of sales and investors paying less for each dollar of those earnings drove the bulk of 2022’s loss. So, then came 2023 and 2024, which together were a big rebound. The index surged 26.3% in 2023 and then 25% last year. So, what caused this sharp recovery?
Well, largely, it was just a resurgence of investor enthusiasm. Over those two years, more than half of the total return was just PE multiple expansion. We closed the year at 25.2% at the end of 2024. In other words, basically, prices rose faster than earnings did. To be fair, the business fundamentals were decent. From the start of 2022 to the end of 24, sales grew at a total of 13.8% cumulatively, which is a 6.7% per year. And margins recovered a little bit from the 2022 drop, and they went back up to 11.8% for the yen. But we’re still below that 13.3% high water mark of 2021.
So, surprisingly in all this, the overall share count of the S&P 500 rose modestly over those two years. The companies, by the way, were spending billions of dollars on buybacks that whole time, and yet the net share count increased by 1.2%. This is due to the stock issuance, outpacing the purchases. So, all that stock-based comp that people are worried about, it actually does matter to you as an owner over time. Those buybacks that were done in the 2010s, those were relatively accretive, but we just barely kept up to keep share count in check. So, most of the market’s gains came from PE expansion, and it wasn’t really necessarily earnings or economic output.
So, what I would say that kind of driver of returns like market expansion can be fickle, like what Mr. Market giveth he can taketh away as well. So, where does that leave us for the remainder of the decade? This is where you should probably start to get interesting. In 2021, stocks were priced for perfection. And after a round trip in 2024, they’re again priced at close to perfection, like pretty high levels. Unless these business fundamentals somehow continue to surprise to the upside, it’s hard to see the index delivering anything close to that very juicy 16.6% that we had that decade before.
So, Chris has a few 10-year forecasts that we’ll run through real quick and plugging in various assumptions into this five factor model. You can do your own work on what do you think is reasonable and come at your own conclusions. So, in Chris’ call it a rosy scenario, he assumes that margins and multiples return to that 2021 level. You get 3.4% from sales growth, which is just call it GDP. You see a bit of share count reduction and some dividend yield. And you add it all up and you get a 5.7% per annum return, if you go out to 2034. Okay.
He has another one that’s call it like a reversion to the mean scenario. It’s not that far-fetched, I don’t think. But assume that you go back down to an 8% profit margin profile, which by the way, is still a couple points higher than the long term 6% as put forth by Buffett and Grantham.
Tobias: A bit lower than we’ve seen for quite a few years now.
Jake: Yes, it is a bit lower than we’ve seen for quite a few years, which may have been goosed by trillion-dollar deficits, but I digress. And then, plug in a 15x market multiple which is more like the long-term average. So, we’re just reverting towards the mean a little bit on some of these things.
You still get credit for 6% sales growth, which I think personally might end up being a little high. You still get a 1.7% dividend yield and assume no change in share count, which may or may not be true. But that result is then in 2034, you’re sitting 14.2% lower than you are today on the index 10 years from today, which is a minus 1.5% annualized, a lost decade similar to the 2000s.
In the last scenario, which is imagining that at some point in the history of the world, you have to spend some time under the mean, which I know is totally unrealistic. So, just throw this in the garbage. But let’s say you get that same 6% sales growth and an even higher 2.2% dividend yield, and you assume that the margin is going to that 8% again, which you know, we could even take that lower. But then, assume that the PE multiple goes to 10x which I know no one can imagine that when you’re sitting at 2025 today. There’s been lots of times in history when you’ve been at a 10x multiple for the market.
In this very sobering assumption set, you’re 42.5% lower a decade hence, which is a 5.4% loss per year over the next decade. I’d say that this might not even be the worst-case scenario. If we imagine that stagflation that we were talking about before, you don’t get 6% sales growth, but you do get the even worse margin compression as businesses can’t raise their prices on an already ailing consumer despite their input costs levitating. I would make the argument, like maybe we’re $150 oil away from this becoming a very realistic scenario.
So, then, imagine that these companies might also have to issue equity at some point and dilute you in order to survive, maybe as part of some government bailout scheme. We’ve seen that before. One does not need a particularly fertile imagination to paint a quite oblique picture from here.
So, anyway, you’re free to plug in your own numbers into all of this, and maybe you end up with a better expected outcome. But what you probably shouldn’t do is just draw a linear extrapolation off of the last decade and line up– which was a line that just went up and to the right. I think it’d be wise for all of us. Munger said this continuously was, “You should temper your expectations. The next stretch of the track might be a bit muddy. Maybe the easy money of the last decade likely won’t repeat this coming decade.”
As always, we’re talking about the overall market here. Within it, there will be individual opportunities, individual intelligent things to do if you’re disciplined and patient and selective in what you’re doing. But that’s it for today’s veggies. Perhaps, a little bit bitter in the aftertaste, but that’s how proper medicine often is. There’s a little [Tobias laughs] bitterness to it.
Tobias: What do you think, John?
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Market Valuations, Cash Strategy, and Navigating a Potential Reset
John: I always love my veggies. When you were going through the scenarios, two things I was thinking about were, I feel good having my 26% cash right now. [Jake laughs] And then, the second thought was, I hope I have a lot of cash if I ever do get to see a 10 times market multiple. Because I don’t want anyone to get hurt on the way, but a 10 times market multiple would be nice for a change. I’d like to be investing in that, [crosstalk] into the market.
Tobias: Yeah. I think about it in terms of Shiller PE, long run PE is about 16, it might have bumped up to 17, because we’ve been above it for a long time, but say it’s 16. And long run total return on the market is about 9%, 9.1%, something like that. We’re currently sitting at 37 or so times on the Shiller PE. There’s lots of problems with the Shiller PE, but I don’t mind it as a rough guide to where you are. Clearly, it doesn’t apply to things like Google and Microsoft. They’re not going to trade on Shiller PE.
Jake: There’s no rule written in the universe or in our DNA that says, that we can’t see 1989 Japan at 99 times CAPE.
Tobias: That’s right.
Jake: That could happen. And if so, you don’t want to be out.
John: And you want to be fully invested– [crosstalk]
Jake: 35% cash as Buffett’s currently positioned. If you look at call it $350 billion on $1.1 trillion balance sheet. That’s a lot of cash to be sitting to go from a 4x from here on just multiple expansion.
Tobias: If you assume Shiller PE reversion over a decade and you get the underlying growth and you get to keep the dividend. So, the dividend yield is about 1.3% probably at the moment, something like that on the whole S&P500. And so, the numbers that I got, if you get mean revert back to a 16 Shiller PE, which is a 16-market multiple, you get a negative return on the index but only it’s like 0.3 negative.
Jake: You get Michael Jordan crying sad face.
Tobias: And you get to clip out a dividend, you get your one point– [crosstalk]
Jake: That’s going to be higher though. That’ll go up.
Tobias: It’ll go up, but the index is going to go down.
Jake: Yeah. [laughs]
Tobias: And so, you’ve roughly flat over the decade as like a midpoint.
John: I think about– Go ahead.
Tobias: Well, I was just going to say that clearly there’s a big chunk of the market that hasn’t participated. So, there’s a big chunk of the market that I think is reasonably valued. You’re not overpaying. You probably get reasonable market returns from the deep value, the small value. I’m talking my book– [crosstalk]
Jake: Wouldn’t it be annoying though if you’re– You didn’t get the multiple up that everyone else got, but you get the panic multiple down that everyone else is going to get.
Tobias: I guarantee that we catch down with the market, or they say correlations go to one and unfortunately that includes the value stocks.
Jake: Yeah.
Tobias: But you probably recover first and you recover faster. But I would say, that’s going to be a nasty period here, potentially.
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Buffett’s Cash Strategy, PE Contraction, and Targeting 12% Returns
John: That’s what Cooperman and Gross were suggesting, I think. Buffett is clearly cautious with the 35% cash. Didn’t buy back any stock in Q3 or Q4, 2024. But I’m running through these equations in my head all the time or just quickly, back of the envelope math. So, I’m trying to underwrite the portfolio to a minimum, trying. Based on my analysis, I could be wrong. This is what I think based on my analysis and my valuations, I’m trying to underwrite it to a minimum of 12% annualized return.
So, if the starting PE is 30, I try to think out 10 years. I really want to encourage my clients to think long-term as well. So, starting PE is 30. If that drops to 20, which is the average market multiple, I think Bloomstran said 21. Well, over 10 years, that’s a 4% annualized headwind to returns.
Jake: Yeah, it’s big.
John: Yeah, it’s big. 4% annualized. So, if I want 12%, that means I need to find a company that I think can grow earnings per share at 16%. Now, this is assuming no dividends. 16% EPS growth minus the 4% headwind from PE multiple contraction gets you to 12% annualized. If the PE goes from 25% to 20% over 10 years, that’s still a 2% headwind to return. I need to find a company I think can grow EPS 14% annualized. 14% growth minus the 2% headwind gets me to my 12% annualized.
The opposite is also true, if I can find a company that is trading at 15 times earnings, but I believe, for whatever reason, it’s justified PE is 20, and I end up being right. 10 years down the road, the PE goes from 15 to 20, that’s a 3% tailwind. So, now, I only need to find a company that can grow earnings per share 9% per year. 9% plus 3% tailwind from PE expansion gets me to 12%.
So, Toby, the calculation you just did with the Shiller and the calculations that Jake just ran through from Bloomstran, I’m thinking about those all the time, and how do I get to 12, how do I get to 12, how do I Get to 12? Minimum of 12. Minimum of 12. And so, yeah, I like that train of thought.
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Market Mania: Speculation, 0DTE Options, and the Return of 2021 Euphoria
John: Let me ask, y’all, what do y’all think is the biggest story in the market right now? Do you think it’s policy– [crosstalk]
Tobias: I think the biggest story that nobody’s talking about, because I think the biggest story, like I almost don’t care because it’s– that you just get hammered by Trump tariff, like whatever’s going on.
John: Yeah.
Tobias: Ukraine, whatever’s going on. There’s an extraordinary amount of gamble this market. 0DTE options, crypto, all of the techie part of the market, that’s all recovered from– It’s back to where it was in 2021.
John: Yeah.
Jake: The leverage loan side of things too, which is supposed to be a little bit more buttoned up is like– I know I read in the Wall Street Journal that that conference that was lampooned in the big short where– [crosstalk] Well, it was the biggest it had ever been, there was 10,000 people there over the last weekend.
John: So, it’s back. It’s back.
Jake: We’re back, baby.
John: Yeah. Those enterprise value to sales multiples on the SaaS companies are back to 20.
[laughter]Tobias: Housing is stretched. Everything’s stretched.
John: Yeah. There’s a lot of gamut. It’s ranked speculation. In parts of the market, it’s ranked. It’s purely speculative.
Tobias: I went and checked out the–
Jake: Even outside of the market too. I mean, the sports betting.
Tobias: Yeah.
Jake: What’s the [unintelligible 00:51:56] or how do you say it? Like, it’s just prop betting on anything– [crosstalk].
Tobias: Poly market.
Jake: Yeah, these betting markets out there on just whatever you want to punt on, like where technology is making it so easy to just gamble on every goddamn thing. It’s troubling for– [crosstalk]
John: And to not only to gamble on everything, but to do it easily and quickly– [crosstalk]
Jake: From the toilet.
John: Yeah, from the toilet.
Tobias: And you know, they know that when people wake up at 03:00 or 04:00 in the morning and use those apps.
John: They’re addicted.
Tobias: They’ve got some little elements to those that they hack a bit of dopamine at 03:00 AM or 04:00 AM in the morning.
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AI CapEx Boom: Tech Giants’ Spending, Depreciation, and Market Impact
John: Yeah. That’s definitely not getting enough coverage. I think the other story is the– I hate to call it this, but the AI trade has reversed dramatically and quickly ever since January 27th, I think.
Tobias: Is that DeepSeek?
John: Yeah, DeepSeek on January 27th. And now, the narrative is that hyperscale CapEx is going to– either the rate of growth is going to decline. So, it’ll still be growing, but it will grow slower. Or, absolute levels of CapEx will just decline from really, really, really high levels. I think they’re expecting $320 billion or $330 billion in CapEx just this year from the Mag 7 or the Mag-10, whatever it is.
Tobias: It’s a big number.
John: It’s a big number. But here’s what’s interesting, and this only take a second. Hyperscale mega CapEx almost never goes down from year to year. It very rarely goes down. Microsoft did $800 million in CapEx in 2005. It’s doing $80 billion [Jake laughs] this year. That’s a 100x. So, in 20 years, 2005 to 2025, a 100x. Google $800 million in CapEx in 2025. It’s doing $75 billion this year. So, the exact same story. Roughly 100x in CapEx increase in 20 years. One more for you. Amazon CapEx in 2005, $204 million. $204 million. It’s going to do a $104–
Jake: $20 trillion.
John: -$104 billion this year. That’s a 500x increase in CapEx from Amazon.
Jake: I thought these were cap-lite businesses. What are you talking about?
John: Exactly. Yeah. That was, I think always misunderstood.
Jake: Well, wait till you run all that through that depreciation through the income statement in a couple years and [Tobias laughs] what do earnings look like?
John: So, that’s really interesting. So, my first point, is these numbers don’t go down often. And if they do go down, they don’t go down a whole lot. Historically, at least, they don’t go down a whole lot. And over a 20-year period at Microsoft and Google they’re up 100x and at Amazon it’s up 500x on the depreciation.
So, these companies are depreciating these assets at five years, roughly. Some, four. Some, six. But they’re depreciating these servers at five years. So, like you said, it’s going to hit the P&L in a few years. It’s going to hit hard I think. There could be offsets to some degree. So, if revenue growth accelerate—
Jake: Write it all down in one year and then–
John: Well, you could do that. [Jake laughs] Yeah, right. If revenue growth accelerates, it actually has to accelerate. That’s one offset. So, revenue growth grows faster than the depreciation line on the income statement.
The other potential offset is, if these companies, and this is what I think is going to happen to a large degree, maybe not offset all of it, is if these companies find internal efficiencies from all of this AI. Google mentioned AI is writing a quarter of all code across the company right now. I think the efficiencies that they could potentially find from their own AI, it’s almost unimaginable at this point. It’s just as new. This is new. And so, I do think in the next few years they’re going to surprise us with efficiencies. Labor cut.
Jake: OpEx down basically from-
John: Yeah. Depreciation up–
Jake: -substituting man with machine.
John: Exactly. Exactly. So, depreciation up big. I think revenue growth is stable-ish, low double digits at some of these companies. Not Apple, but some of the others. So, if revenue growth can be stable and depreciation runs its way through, it’s going to be a big hit. But if they can offset it with efficiencies, then maybe the margin hit, and the earnings hit and the hit to ROIC too won’t be as big as expected. But that’s just one scenario. The other scenario is what Jake said, which is that it just flushes everything out and earnings growth dramatically slows for a period of time.
Tobias: It did look like Microsoft was pulling back. I saw some tweets– [crosstalk]
Jake: Canceled some leases or something. Is that what the– I saw a tweet about that, I think.
Tobias: [crosstalk]
John: It was a lot of verbiage. I think they pulled back on some leases, but then they reiterated $80 billion for the year and they said they’re just rearranging stuff around the world, because they’ve got, as you know, data centers everywhere. It’s just a little confusing from Satya, I think. And then, he put the IR team on it, and they did a conference in Australia and then they put out a press release saying that it’s still going to be $80 billion for the year. So, it was a little confusing.
Jake: Is that what investors want? Are they cheering on they want Satya to spend $80 billion on CapEx?
John: It’s really confusing. If he spends all this 80 billion, then it props up the AI trade elsewhere, all those electrical component companies, the power companies, the servers, the chips, Nvidia-
Jake: All the revenue-
John: -prop up that. Yeah.
Jake: -it comes from few customers, right?
John: Exactly. So, it props up that supply chain into the data center which the market wants. But if you want to see higher free cash flows at the mega cap tech, then you want less CapEx, that’s the other thing. If these companies cut back on CapEx, then they’re going to be printing more free cash flow. It’s nuanced and it’s confusing. But I don’t think CapEx is going down dramatically over time.
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Tobias: Hey, John, we’re coming up on time. If folks want to follow along with what you’re doing or catch up or get in contact, what’d they do?
John: Yeah. Thank you. I’m at @jrogrow on Twitter, but the main place to find me is lastbastion.com. You can sign up for my newsletter. I’ve been sending one out a week, and I like writing it for my readers. And so, yeah, lastbastion.com.
Tobias: Good one. JT, any final words?
Jake: No. Even if we get market meltdown, be good to each other. That too shall pass.
Tobias: Good words. All right, folks, see you everybody.
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