In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Chris Bloomstran discuss:
- Buffett’s Trust Strategy Makes Sense—But Not for Active Capital Allocators
- Neoteny: How Evolutionary Flexibility Applies to Investing
- Mag Seven Drove 88% of Profit Growth—The Rest of the Market Is Stagnant
- Most Investors Sell at the Worst Time—Here’s Why It Hurts Return
- AI Arms Race, Capital Spending Risks, and Market Overvaluation
- Rationality Returns to Markets Amid NASDAQ Disparity
- Market Bifurcation and the Rise of the Magnificent Seven
- Costco at 60x Earnings Is Hard to Justify Despite Its Quality
- Why the S&P 500 May Only Return 5% Annually for the Next Decade
- Dividend Payouts Haven’t Changed—But Yields Have Collapsed
- U.S. Debt at 350% of GDP Is ‘Totally Unsustainable’
- U.S. Economy Growing Below 1% Per Capita
- Opportunistic Investing Means Knowing When to Sell—even Berkshire
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: We are live. This is Value: After Hours. I’m Tobias Carlisle. I’m joined as always by my cohost, Jake Taylor. Our special guest today, repeat offender. He’s back again. [Jake laughs] One of our favorites, the Great Christopher Bloomstran. How are you, Chris? What’s happening?
Christopher: I’m doing great. I’m doing great. How are you, guys?
Jake: Always good to have you on the show, sir.
Christopher: I’m still on the Kombucha. It’s got me– back for another year.
Tobias: Looking fit and tanned. It’s working very well.
Jake: Yeah. How’s your walking program?
Christopher: It’s good. I’ve kept it up a minimum two hours a day.
Tobias: Wow.
Christopher: Even kept it up during the annual letter writing process-
Jake: [chuckles] A little harder though.
Christopher: I did last year. I decamp now to Florida for about eight or nine days as soon as the letter drops. [crosstalk] I do what I do there what I do here. But you’re walking outside where it’s a little nicer. And for whatever reason, we have a bunch of clients. First, don’t go to South Dakota. In the winter, they go to South Florida. So, generally, have dinners every night. It was great.
We had a guy in town here. I think he invented Celebrex. Just brilliant scientist who was out walking, and a tree branch cracked off, and fell on his head and killed him.
Tobias: Oh, my God.
Christopher: [crosstalk] make you think maybe the Charlie Munger approach of fitness, which was do nothing.
Jake: Yeah. [laughs] Avoid all outdoor activities.
Christopher: No, the handful of days when you were in the military. But other than that, avoid everything.
Tobias: Chris, the letter this year was 168 pages. My notes on it are four pages. [Jake laughs] So, I’ve got some questions for you. From the top, what message do you feel has been missed, or what were you trying to say other than– No, I’m not going to say other than. What were you trying to say? What’s the message?
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Rationality Returns to Markets Amid NASDAQ Disparity
Christopher: The message is rationality. I belabored the bifurcation in the market. I think as I’ve done for a couple years now, segregated my five-factor analysis of the S&P 500, the components that just simply go into how you measure total return. But breaking out the Magnificent Seven from the remaining 493 companies was pretty telling. I just think for the last two years, I look at our portfolio on a daily basis. In any day that the NASDAQ is up, we’re invariably down and vice versa. And same thing happened [crosstalk] in 1998– Exact same thing happened in 1998 and 1999. It’s gotten really pronounced a week ago Monday when the NASDAQ was down 4, we were flat to up. We had a lot of our portfolios were up for the day, which is huge disparity. This is just continuing.
We’re up a bunch this year. Last year was mediocre. I think were up 7, we were up 13 or 14 the prior year. But then, we made money in 2022. So, we found ourselves way ahead for. 2022 and 2023, the market essentially S&P was down 18, NASDAQ was down 35 or whatever, but they fully recovered, but we were flat at the end of the second year, at the end of 2023. And then, last year 2024, S&P was up 25 and change and NASDAQ was up a bunch. The degree to which Seven stocks really– and a handful beyond that, but have dominated returns of late. So, we found ourselves ahead and then behind for a three-year period.
I think this three-year period takes us back to 2021, which I still believe in– I think is going to wind up going down as secular peak. That’s going to rival 2000, that’s going to rival the late 1960s, that’s going to rival 1929, 2000.
Tobias: I agree with that. That’s what I think was the peak too.
Christopher: And so, I mark how things are going from that moment in time. It’s interesting. I forgot to tweet it out or X it out or whatever you call it, but I mentally-
Tobias: Xheet.
Christopher: -waiting for [Jake laughs] March 10th of this year, because that was the 25th anniversary of the peak of the NASDAQ. It was literally that moment, that whole two-year period where there was zig and zag. It continued to zig and zag, but we went straight up. I think we were down 10% for the year to date on March 10th of 2000. Market was up 10 plus. And by the end of the month, we were up for the year and the market was down. And then, the next two years, anything in the value world worked really well. The markets healed themselves.
We got back to Ben Graham’s weighing machine versus the voting machine. It feels like that’s starting to happen of late and wanted to get into some of the reasons for why in the letter. And hopefully in 167 pages if that’s what the count was, I got some of that across. [Jake chuckles]
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Tobias: How do you think we get back to 2021 so quickly? I think we’ve gone through the level. But in terms of the behaviors, I feel like everything was– [crosstalk]
Jake: Qualitatively.
Tobias: Qualitatively. Yeah.
Jake: It doesn’t feel quite as insane. There’s still lots of pockets of insanity, but 2021 seemed like just everything was nutso.
Tobias: I think there’s a fair bit of nutso in crypto and AI. I think some of that AI stuff got pretty silly. I’ve got one of Chris’ quotes in here just in relation to the Magnificent Seven. “Magnificent Seven contributed roughly 61% of the S&P 500’s gain in value over the past three years despite being crushed in 2022. The Seven contributed 16% of sales growth and an incredible 88% of profits to the S&P over three years.”
Jake: Profit growth, right?
Tobias: Not according to this quote.
Christopher: Yeah, profit growth.
Tobias: Profit growth.
Jake: I would imagine. Yeah, the marginal earnings came from mostly the Mag Seven.
Christopher: 88% in three years.
Jake: That’s crazy.
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Market Bifurcation and the Rise of the Magnificent Seven
Christopher: And a huge chunk of that was Nvidia, of course. I had thought that when I did the math and when I was early working on the letter, those companies don’t report earnings for their fourth quarters toward the end of January and Nvidia is late. So, I’ve still had to assume where Nvidia was going to wind up being, because the letter wasn’t out yet. But I had originally calculated simply using Wall Street’s consensus that more than 100%, 106% of profits were going to come.
Between the lines, there was a huge– the beginnings of earning misses for the hyperscalers, for sure. What you’re going to wind up seeing is big depreciation charges start hitting these P&Ls. They’ve been very cap light businesses. And that’s changed. As you guys know, the CapEx dollars that are being spent are pretty staggering. And with CapEx, despite elongating depreciation schedules from three or four years to now, five or six or even seven years, managers didn’t want– These balance sheets have gotten a lot more capital intensive and you’re going to see it in depreciation.
We’ll see the efficacy of search in AI. There’s a lot of money being spent. I’m not sure the businesses are yet generating revenues. Nvidia is getting the revenues and Broadcom’s getting the revenues, but this is the picks and shovels. We’ll see how efficacious search winds up becoming. This is simply an extension of what’s been going on for 20 years. We’ve had AI, but this reminds me of the laying of broadband fiber, the lighting of dark fiber and the massive CapEx dollars that were sent in telecommunications. So, these businesses have changed.
You talk about what might disrupt. Well, sustaining margins and sustaining top line growth. The market’s gotten it right. Ben Graham’s Mr. Market is pretty good. You look at the growth over 13 years or 3 years, revenue growth, profit growth– The Seven stocks were roughly 35% of the market of the S&P 500 at year end, but their profits were 25%. They’d grown from nothing. Market caps were 8% of the market 13 years ago and they went to 35%. That’s because revenues were growing.
Their share of revenues went from 3% to 12% and share of profits went from almost nothing to 25%. But at a point, they get capitalized at such a premium that when you start to get misses and history will show you get disruption, there’s such a concentration of wealth in Seven and another 30 or 40 companies that they’re priced for perfection. I think that may be what you’re seeing today. Certainly, when you go from thinking those Seven companies are going to be more than 100% of the profit growth to only 88%, there were big misses. It gets spun differently, but we’ll see.
Tobias: That’s one of the things that we’ve discussed a little bit that all of the investment in whatever makes up AI, the computers in the back end. That’s all expensed by– Sorry, that’s all capitalized by– [crosstalk]
Jake: Revenue.
Christopher: They’re capitalized now.
Jake: Yeah.
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AI Arms Race, Capital Spending Risks, and Market Overvaluation
Tobias: Yeah, capitalized by the big tech companies. But then, Nvidia and Broadcom count it as revenue in the year that they earn it. So, there’s a little bit of double counting, and at some point that wave starts coming through of the depreciation. They’re talking about spending $300 billion collectively a year over the next few years. I don’t even know how they can deploy that amount. It seems like an extraordinary amount of capital to deploy, particularly with no obvious revenue on top of that.
Christopher: Yeah. Well, they’ve all said, “We’re not sure we should be doing this, but we have to do it. It’s an arms race, and you don’t want to be last or left out.”
Yeah, the capital cycle being what it is. We’ll see if it turns into profits. My bet would be it winds up not, and that’s probably the spark that really starts to harm the markets. But when I say the markets, again, you’re talking about the cap weighted S&P 500. There’s such a concentration in a handful of companies. Your international markets are doing well this year.
I’m really, frankly shocked that small caps, when you simply look at the small cap indices are down as much as they are. They’ve been weak since last June. It was small cap, mid cap, everything value related when the market broke after March 10th of 2000, that performed well. But the performance is coming from international, gold. Energy is doing fine. There’s some places that are working, helping our portfolio a lot.
Berkshire’s up oddly yesterday. Here today with Berkshire being flat. Yesterday was the first time since we’ve owned the stock over 25 years that the stock traded at and just a percent and a half above my appraisal of intrinsic value. You got there last year, traded in November at its high for the year, above my prior year number, but intrinsic value had grown roughly 10 for the year. So, it was not above today.
Berkshire’s fully valued on my combination of valuation yardsticks that I use. So, there’re big corners of, at least, the things that we follow and own that are really, really cheap. Really, really cheap. But then, there are some businesses that are not cheap at all and fully valued in some places starting to get pretty overvalued. That’s a microcosm of what’s going on in the broad market.
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Costco at 60x Earnings Is Hard to Justify Despite Its Quality
Jake: You own Costco over the years at various points. And now, what do you think when it’s at 60 times earnings?
Christopher: I did my five-factor in the letter. We bought Costco trading at 18 times earnings and change 20 years ago. 2004, it was really not trading at 18 times. They had on the order of 350 stores, warehouses. If you know the business and the system, it takes about seven or eight years for a warehouse to be fully profitable. You need to get enough throughput, you need to get enough members signed up.
And so, opening 25 warehouses a year on a base of what was then 350, you had a third-ish of the units that were not yet fully profitable. And if you simply said, “Well, how profitable are these warehouses?” Ultimately, your earnings were being understated, your returns on capital were being understated. Well, fast forward– This has been a great business. The net margin’s gone from 1.8% to 2.9%. But the multiple’s gone from a misstated 18 and change to almost 60, 56 at its closing for the year. And it traded even higher than that.
Jake: If you’re still only building 25 stores every year, the percentage add is decreasing over time, right?
Christopher: If square footage of the system was growing then 7.5%, today it’s growing at 2.5%. So, when you break down your five factors of dollar sales growth, change in the share count, there’s not a lot of change in Costco share count, change in the margin, change in the multiple and dividends. They do pay big dividends now as a proportion of operating income. Most of it’s special dividends, so, you’ve got to normalize that. But you do your same store sales growth, which will be at a premium to the inflation rate. So, if inflation is two, call it four. If inflation is three, call it six. Add that to 2.5% square footage growth in the system and you can’t get to much more than 7.5% revenue growth.
And then, the stock compounded it almost 20% a year for 20 years. The dumbest thing I ever did in retrospect was ever selling a share. I would trim it to finance purchases of other stuff and never should have sold it. Should have bought it at any price. But who would have known it would trade it 60 times?
And so, I’ve got our five-factor over the next five years that simply allows a 7.5% growth rate in revenues, and takes the multiple back to some more normal level. It’s never traded at 60 times before. It’s a business that does 2.9% profit margin, going to grow a lot slower, maybe it’s worth 25 times, not 60 times. And so, any number of scenarios of revenue growth you can come up with, you really can’t get to a positive return. You break even if the stock still trades at 35 times earnings. And so, that’s an example.
Walmart is another example. There are a bunch of companies like that. They’re big cap businesses that are simply overvalued again, much like you saw in 1998, and then obviously in your tech bubble. That’s the corners of the US Stock market, which is now the largest proportion of the global stock market that it’s ever been over half. But it’s 40 companies, it’s 50 companies, it’s 60 companies. Outside of that, there’s a lot more value and rightfully so.
There are a lot of businesses that are no longer great businesses in the small cap world. Toby, as you probably see in your world, a lot of the better businesses have been bought. And so, you look across Europe– [crosstalk]
Jake: [crosstalk], Toby?
Christopher: Europe has done–
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Tobias: I will say that some of the mid-caps, which are pretty good businesses are now small caps. So, the small cap’s looking better than it has for a while. [chuckles]
Christopher: You never want it going that way. [Jake chuckles] So, yeah, the market gets it right. I think it’s starting to see some cracking with some of the places where you’ve got overvaluation. But it’s never been hard for us to not own things that are outperforming and growing a lot faster. I learned years ago to not screw it up. When I sold Ross Stores, having bought it at the last bubble at 10 times earnings and made two and a half times our money in a couple years between 1999, let’s say and 2002, sold it at 25 times, let’s say all of it. Never bought it back, and it was a 20 plus bagger after I sold it.
So, we still have a few Costco shares laying around, but those are only in taxable accounts and they’ve got 29 per share basis. We’ve made more special dividends once they started paying their five special dividends than we have in cost basis on our original shares. They pay a regular dividend now. So, you’ve got more than half, 60%, let’s call it of operating earnings. It doesn’t take as much money to open 25 stores.
So, the larger proportion of income, they’ve not tried to go out and make acquisitions. They’re not foolish, they’re not buying bitcoin, they’re not doing some of the things that get allocation circles of managements. And so, they rationally say, “Look, the stock is not cheap. It hasn’t been cheap for a long time. Why buy it back?” They don’t buy it back. They buy a little bit back to offset a little bit of the option shares they issue, but they do very little of that. And so, pay it out which makes a lot of sense. But I’m afraid at 60 times, or 56 times or probably down to 52 times now. Very difficult to think you’re going to make money over the next five years or six years or seven years, if the revenues grow at 7.5 the stock seven or eight years ahead of itself.
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Why the S&P 500 May Only Return 5% Annually for the Next Decade
Tobias: How about the index? How do you feel about the index? Do you want to break that down for us?
Christopher: Yeah, the cap weighted.
Tobias: Yeah.
Christopher: [chuckles] S&P 500 closing the year at almost 26 times. Even taking out the Mag Seven at 35 times. Frankly, when I ran the numbers, I was surprised that the residual 493 were still trading at over 21 times. These are historically very expensive levels. My guess would be that the equal weighted– If you could own an equal weighted index as an option in a 401(k), if you were limited to just a handful of funds. But I don’t think it’s much offered and equal weighted.
Again, it’s the Seven plus another 30 or 40 or 50 companies that make the index priced for perfection. I go through my five-factor analysis and look at differing– And you guys talked about it a couple weeks ago when you had John Rotonti on the scenarios in my letter using my factors of taking margins to different levels. If you’re going to get continued high revenue growth, you’re getting high revenue growth in the last three years, because you’ve had inflation.
But you’ve had a decline in the net margin. The profit margin for the S&P was 13.3% at the end of 2021. It’s 11.8% now. It got down to 11.2% after 2022, and then you’ve had a little bit of recovery. But if you strip out the Seven, you’ve had actually a margin decline over the entire three years. But you’ve had a multiple expansion. You’ve got less margin, but you’ve got multiple expansion. That’s how it’s supposed to work, but market went from 22 times to almost 26 times. Historically, that’s a very expensive level particularly if you think what’s still an 11.8% margin.
If we have higher interest rates for longer, there’s a lot of debt that gets refinanced, the interest burden starts to grow. If you have inflation, that will continue to eat on profit margins. For the uninitiated investor that owns the index, I can’t get to making much more than 5% a year for the next 10 years. And more likely than not, this window of 7, 8, 9, 10, 12 years that we’re in, I think is going to look a lot like the 10 years after 1999 when stocks had done 18% a year, the S&P…
6% a year up to 2021, again thinking that’s a secular peak. That number is down to 14. So, your rolling 10 is going to drive down, Jake, to your mean reversion to a lower level. If given the choice between the S&P 500 and a 10-year treasury, give me the 10-year treasury at 4.3, because your best case for the index is about 4.3.
Tobias: Yeah, I think you got to 3,500 on the index. I use Hussman’s method which is Shiller PE mean reverting to long run mean over a decade, and that assumes no compression in the margins. But that gets a fair value today of 2,700 which is– I don’t say that very often because it makes me sound like a lunatic, but it is what it is. It’s tracked pretty well to that number over a long time which means flat on the index or 0.5% annually on the index, plus you get the dividend yield of 1.3%, which is just not a very appetizing return from here. So, well south of treasuries. Well south of the 10-year.
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Dividend Payouts Haven’t Changed—But Yields Have Collapsed
Christopher: Yeah, I think that’s a reasonable way to look at it. Your dividend yield at 1.3% at year end is about as low as it’s been it for a moment at the very-
Jake: Yeah. They can go up.
Christopher: -tip and top 2000, it went to 99 basis points. 99 basis points in 2000 in March. I’ve got a chart and letter of dividend payouts over the last 150 years. The payout rate is still 30% income. It’s not like these companies have gotten chintzy with their dividend payouts. The dividend payouts the same as what it’s been for 40 years, 50 years.
Jake: Capitalizing that is–
Christopher: Capitalize your multiple to earnings as high which makes means your multiple to dividends is high. And so, people crack me up when they say the company is paying a healthy dividend. No, if you take a stock that has a 2% yield, and you cut it in half and you’d maintain the same dollar per share payout, your yield just doubled to four. Well, the company didn’t get more generous. No, you cut the stock in half.
Jake: Right. [chuckles] I was surprised that all the buybacks effectively did nothing as far as actual share count. Wasn’t that a shocking realization?
Christopher: Yeah. If you’re a shareholder across the board of the index and you had this period after the tech bubble peaked, you had a big share issuance in the 1990s, because Silicon Valley was very good at giving away shares. They were giving away 4% or 5%, 6%, 7% of their companies per year and they hadn’t figured out. You could offset the dilution with buying shares back. And then, of course–
Jake: Plus, the accounting. They weren’t counting it at that point, right? So, it’s even more–[crosstalk]
Christopher: Yeah, it was two or three years later. And so, it wasn’t an expense. Now, it’s expensed. When the NASDAQ dropped 80%, all those options were out of the money. We talk about the budget being balanced. Well, there was no fiscal prudence really. You had a deal with the Republican House and the Clinton administration, but it wasn’t like you really did austerity and tighten the budget. You had an enormous amount of revenues that flew into Washington’s coffers from simply the exercise of stock options.
And so, after that tech mobile peaked and after you started expensing, they got around to repurchasing shares. And so, even in the 10 years up to 2021, you retired seven 10s of shares per year. Apple has been a huge repurchaser of shares. They’re the preponderance of share repurchases over the last few years.
But if you look at it over 25 years, and this is stunning, using simply the divisor for the index. Companies have spent more than half of cash flow from operations buying back their shares, and they have not reduced the share count. The share count is dead flat for 25 years. That’s stunning. So, if you’re not accreting your ownership with a lower share count and half of your cash from operations is going out the door to buy shares back, who’s getting rich?
Jake: Yeah.
Tobias: [laughs] In SaaS.
Christopher: Washington, intermittently, Lamb-based share repurchases. No, if you want to penalize the egregious issuance of shares to corporate insiders and tax them at a higher rate, if they’re getting money for free. Anyhow, we could spend the rest of our– [crosstalk]
Tobias: Let me do a quick–
Christopher: [crosstalk] share repurchases.
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Tobias: Let me do a quick shoutout and then let’s come back to market level or government debt. Market level debt and leverage for the government.
Santo Domingo. What’s up? Brandon, Mississippi. Boise. Valparaiso. How’s it, Mac? Toronto, Tampa. Toronto. Tomball. Tallahassee. Bendigo, Victoria. What’s up? Early start. London. Edmonton, Canada. Toronto. Kennesaw, Georgia. New London, Minnesota. That’s a place. Castleford, Yorkshire. Fort Wayne. Las Vegas. Gothenburg’s back in the house. Brunei. Jupiter. Nice. Cincinnati, Ohio. Woodlands. Ballynamullan, Ireland. William, the Wizard of Wishaw in Waterloo. Well done. Medellin, Colombia. Mendocino. Royal Oak. Guadalajara. Nokia, Finland. Bremerton. San Diageo. San Diego too.
Jake: German for–
Tobias: Stavanger, Norway. Nice. I got some stats here for you, Chris. Trailing 2024 debt to GDP, 347%. 12/31/24 GDP, $29.7 trillion.
Jake: They’re your stats.
Tobias: Yeah. [Jake laughs]
Christopher: They seem familiar.
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U.S. Debt at 350% of GDP Is ‘Totally Unsustainable’
Tobias: Total credit market debt $102.9 trillion. Is that a lot?
Jake: Winning?
Christopher: Is it a lot? I thought we had debt problems in 2000 when total credit market debt was 250% of GDP. You’ve been 350% since the financial crisis. Maybe it’s not a lot when interest rates are zero. But when interest rates are at a more normal level, it begins to tax things like profitability. Totally unsustainable. Huge problem. The workout of excessive leverage at the extremes, you could get extreme deflation, which is no fun and have a depression like you had in the 1930s. You could have high levels of inflation, either hyperinflation at the very extreme or high levels of inflation like you had in the 1960s, throughout the 1970s. But going into the late 1960s, 1970s, you didn’t have high debt levels.
The government debt got really high in World War II, and that got financed down. But in 1982, total credit market debt was 140%, 130% of GDP. It’s 350%, the interest alone is just a huge tax on the economy. Who knows? You would have said Japanese government debt was really high when it was 100%, and then 200% and now 250%, just the government debt alone. So, can we have more debt? Perhaps. But I’m very apolitical over my lifetime. You get a little disenchanted with what we see in the United States from both parties in Washington. But I’m cautiously optimistic that we’re getting around to austerity. We had to do austerity. We tend to not elect politicians and we don’t appoint central bankers that are into austerity. You usually take the Yogi Berra’s easier fork in the road when you get to it. We’ll see. I think this is going to be tough.
Jake: You don’t think they’re going to all just turn interventionist at the first real panic?
Christopher: Well, you’ll get a recession. Unemployment is likely on the rise. The consumer’s in bad shape. All the free money from the pandemic, the increased SNAP, and increased credits for child tax credits and earned income tax credit, that’s all gone. You take, what’s, a $1.8 trillion pushing $1.9 trillion deficit. You’re running almost 7% peacetime deficit to GDP, which is just out of control. But if the government takes in a little over $4 trillion and spends $6 trillion, the vast majority of expenditures are non-discretionary.
Medicare, Medicaid, Social Security, generally, that’s the third rail that politicians don’t touch. Even the defense spending, half a defense is non-discretionary, half is discretionary, So, DOGE, they say they’ve rounded up $100 billion. That’s a rounding error in terms of what the government spends. You talk about cutting a trillion dollars of expenditures, I’m really appalled.
I think the messaging is critically important. If you’re going to cut fat– There’s a lot of fat in Washington. There are a lot of places where we spend too much. If you’re going to take people out of jobs though, and maybe we have to do it the– Messaging, the optics have to be, “Look, we really don’t want to do this, but we have to do it. We inherited a mess, not just from the previous administration. But we’ve inherited a mess from the last 30 plus years of fiscal imprudence, and we’re going to fall on the sword and do this.”
Austerity is going to come with price, and we might have a bad recession. Unemployment might go up, the stock market might go down. You’re getting that message out of the current treasury secretary. But don’t go on stage with a flipping chainsaw and glow.
Jake: The glee of it all is, I find quite distasteful as well.
Christopher: It’s abominable. It’s abominable. We have to do this. I’m skeptical that we’ll be able to do what needs to be done, and we’ll be able to suffer the pain. Because when you get to a legit recession, you’re going to turn on the spigot. The Fed can again take rates back to zero. They’ve been tightening the balance sheet by almost $3 trillion, but that was largely offset. I got a little section in the letter.
Yellen was pretty creative in terms of leaning on– financing a lot of this most recent years. Deficits at the short end of the curve and increasing treasury bill issuance. And so, hence, a lot of supply of bills pushed up the yields of treasury bills and all that money.
There was over $2 trillion sitting in reverse repo that all drained out happened to be an election year. But that went from $2.2 trillion down to what’s almost nothing today. But that was offsetting the shrink in the balance sheet. When you go back to 2018 and 2019 and we shrunk the balance sheet, which if you go back even further, the Fed balance sheet was $850 billion before the financial crisis, and wound up at $4.2 trillion–
Jake: Seems quiet, doesn’t it?
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U.S. Economy Growing Below 1% Per Capita
Christopher: They got it down to $3.7 trillion, but you had a liquidity crisis when they got it down to $3.7 trillion. Well, you got it up to $9 trillion, now you’ve run it off by $2.5 trillion. But that completely got offset by all that money that was in repo finding its way into a higher yielding treasury bill market. So, that completely offsetting. Well, now, there’s no more repo. And so, any continuance of shrinking the Fed balance sheet is tightening. So, it all tilts toward more likelihood of recession.
But to your question about debt, it’s been a huge problem. And at some point, you pay the piper. I always thought, if you got the extremes of the tail of very bad deflation or very high inflation, it might be not on my watch, but after my lifetime. Here I sit at 56 years old, and I think we’re going to deal with the vagaries and the problems that come with excessive leverage probably sooner rather than later.
Tobias: Reinhart and Rogoff wrote that paper that said that it was 90% was the tipping point. And then, somebody found a hard coded cell in the– Do you remember this? In their research and said that invalidated it all and it made it– I don’t know where we’ve ever landed on 90% being– I don’t know if that completely demolished the entire paper, or they were able to talk their way through it, but it muddied what was a pretty good argument at the time. But it seems to have– You remember that, Chris?
Jake: Yeah, there was critical threshold of 100% [crosstalk] GDP.
Christopher: I think that work and there’s a lot of other academic work that supports something around 90%. But that’s the publicly held portion of the debt. So, that would exclude the portion held by the central bank. And so, you’re not at 125%. You’re at 100% of debt that’s simply held by the public today. But you’re at the point.
I go back to that point where I thought debt in 2000, when you had a $10 trillion economy and $25 trillion of debt. That was really the moment where I thought total credit market debt was excessive. Federal debt wasn’t at that 90% yet, but total credit market debt was. But I think all this academic work that suggests that at a point when government debt gets to a level that the next dollar of debt is decremental to the economy, that the law of diminishing returns kicks in. I think there’s a lot of validity to that.
You’ve seen it for the last quarter century in far less growth in real GDP per capita. When you adjust GDP growth for population growth and you adjust it for inflation, you’re growing at less than 1% for the last 25 years, where Warren Buffett talks about the great economic tailwind. Well, he enjoyed a huge economic tailwind in his lifetime.
You go back to the Industrial Revolution in 1870. But by the time you got in to the post-depression, you got through World War II, we grew real GDP per capita at over 2%. We’re growing it at less than half the rate. So, I think you’ve seen a slowdown in the economy. This translates, if you think about it, into the price you’re willing to pay for financial assets. You had a lot more growth. You adjust for population. You adjust for inflation. If 15.5% or whatever the number is for the long term, normal multiple, well, the multiple is partly derived from how much growth you’re going to get out of the underlying asset. And if we’re going to have less growth in aggregate, you don’t pay as much for it.
So, that to me becomes more of a headwind against markets. It becomes a big headwind against markets when they’re priced at the very high end whether you’re using the Shiller or whether you’re using simply stated operating or reported earnings. Things are pretty priced for perfection, and leverage is a problem.
Tobias: Unfortunately, AI bails us out. I just–
Jake: Maybe.
Tobias: AI bails us out, Chris.
Christopher: Yeah, probably. Just like the dotcoms did.
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Mag Seven Drove 88% of Profit Growth—The Rest of the Market Is Stagnant
Tobias: Yeah. If that’s the backdrop, what do you think about the earnings growth in those largest companies?
Christopher: Well, you talk about the Mag Seven making up 88% of profit growth for last three years, you haven’t had a lot of earnings growth in aggregate. Again, you had a margin decline for the non-Mag Seven. But earnings on the S&P 500 were 208 and change in 2021. I don’t know, they’re 230 something today. You’ve had 25 plus percent sales growth, but your profit growth has been half that. That’s a byproduct of inflation, and it’s also a byproduct of– You don’t have the share repurchases that you did. When the companies that are generating cash are now spending way more money on CapEx, you don’t have as much money to do other stuff. And if you’ve got inflation, that is a tax on profitability.
You’ve seen it in a lot of industries. Manufacturing here and abroad has been weak. Retail especially at the lower end of the consumer. We own a bunch of retail, because we find the stocks really cheap, Dollar General and Dollar Tree. Even a Starbucks being case is in point. It’s just the broad market. Again, I find the cap weighted US stock market price for perfection. That’s the last place I think you’d want to allocate capital.
It’s not just me. I mentioned Vanguard. I did the whole section, and I attributed it to Jack Bogle. But Vanguard’s own analyst team, put out a couple papers at year end and essentially said, for the next 10 years, your S&P 500, your cap weighted S&P 500, they’re the Vanguard 500 Index Fund and all the iterations of it is going to do 2.8% to 4.8% a year. And over 30 years it’s going to do an average of 4.7% to 6.7%. So, call it 5.7%.
Well, you survey the typical 401(k) investor, or you survey the typical endowment fund manager or pension fund manager, nobody thinks stocks are going to do 3.8% for the next 10 years. But Vanguard said it. Toby, it goes back to your math. However you skin it, it’s really hard to make a case that the US cap weighted stock market is the place to be. There are places to be, but that to me is not it.
Tobias: The index weighted towards the biggest end of town in the index.
Christopher: Yeah.
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Neoteny: How Evolutionary Flexibility Applies to Investing
Tobias: JT, do you want to do veggies? You got veggies?
Jake: Of course. Always have veggies. All right. So, this week we are exploring this biological concept called neoteny. I don’t know if you guys have ever heard of this before, but it’s–
Tobias: [crosstalk]
Jake: It’s sort of. Yeah, it’s N-E-O-T-E-N-Y. I know sometimes the veggies feel like monotony, but that’s not [Tobias laughs] what I said. I said neoteny. And it comes from the Greek meaning extended youth. It’s when a species retains juvenile characteristics into adulthood instead of fully maturing. This can often help an organism avoid competition and keep a flexibility.
So, basically, mother nature came up with a way to have more cards in the deck of evolutionary development by allowing certain environmental inputs to change how much development occurs.
So, there’s a classic example of this. I don’t know if I’m saying this right, but it’s the axolotl, it’s Aztec sounding word, A-X-O-L-O-T-L. They’re the native to the lakes around Mexico City. They’re these little amphibian looking– They almost look like tadpoles basically. They’re famous for staying in this juvenile state. Unlike typical salamanders, they never undergo metamorphosis. So, instead, they remain in their larval form, they keep their external feathery gills, they have an aquatic lifestyle and this youthful appearance throughout their whole lives. But they could still procreate as these little tadpoles.
So, however, they thrive when the aquatic environment is stable. But they have this hidden genetic switch inside them that for whatever reason when iodine is added to their water, which I don’t quite understand the linkage there, but it activates their thyroid gland and then they basically go the complete rest of the way in development, and they turn into effectively like mature land-dwelling looking salamanders and then they can procreate as a salamander as well. And so, they lose their gills, they get lungs, they grow limbs to move around on land. This dramatic transformation is like this built in evolutionary flexibility.
And so, it’s not just salamanders in Mexico. Actually, humans, we have neotenous traits as well. Our flat faces, larger heads relative to our bodies, less hair, extended learning phases compared to other primates. This author, John Gribbin, who actually Munger’s recommended several of his books over the years. He takes it a step further and he argues that humans became distinctly neotenous around four million years ago when we split off from the chimpanzees and gorillas. We basically kept these flexible brain structures that allowed us to adapt better to a rapidly changing environment.
He talks about it in this book called Ice Age, which we actually did a segment on that Season 5 Episode 10, if you want to double click on that. But essentially, our ancestors had these juvenile like monkey characteristics. We stayed flexible for longer in earlier development, and it gave us this evolutionary advantage for a shifting climate that was uncertain around that time period.
And so, basically, we move back and forth between the plains and the trees and probably the oceans. The chimps basically stayed in the forest and developed into full blown monkeys and we didn’t. And so, there’s this complicated phrase that biologists like to use which is ontogeny recapitulates phylogeny. Let me explain, you could just forget about those words. It doesn’t matter.
Tobias: It means that the development from a zygote to a baby mimics evolution, but it’s been debunked.
Jake: Oh, really? It’s been debunked, huh?
Tobias: Yeah.
Jake: Well, then how do they explain then like humans having gill like structures similar to fish or tails, similar to our reptilian ancestors?
Tobias: It just looks like it.
Jake: Okay. Well, thanks for blowing the hole on that one.
Tobias: Ontogeny recapitulates phylogeny.
Jake: Yeah. Well, good job, Toby, you’re way ahead.
Tobias: I’m so sorry, JT.
Jake: No, no. That’s good.
Tobias: It was on my grade 11 biology test. I remember it well.
Jake: Oh.
Christopher: Jake, I read Ice Age. My wife and my kids, they would tell you that I’ve maintained juvenile characteristics far into my own adulthood, deep into adulthood.
Jake: Yeah. Now, that’s what keeps youthful, right?
Tobias: JT, the reason I remember it is because it was on my grade 11 biology test. The textbook that we used was old. When I went and looked it up on Wikipedia, Wikipedia told me that it had been debunked before I took the test. But I didn’t know it at the time.
Jake: All right. Well, fair play. Everything that I say should be taken with a big dose of salt that it might have been updated. That’s just science, right? Okay. So, let’s see if we can torture this into an investing analogy.
As everybody knows, early in his career, Buffet followed Ben Graham’s deep value, net-net approach. He’s buying undervalued stocks for less than the working capital. Did quite well with that. But over time, markets changed. Buffett adapted. He evolved from net-nets to more Fisher and Mungerian quality companies like Coke, See’s Candy, etc., emphasizing durable moats. But all along, he retained this juvenile deep value method and returned to his roots when opportunities appeared, like, let’s say filling up his PA with Korean stocks, Korean net-nets in the early 2000s. So, he was able to revisit these foundational strategies whenever conditions called for it, which is really the essence of neoteny.
So, I think lessons for investors there would might be maintain flexibility to shift strategies with the opportunities. Never fully abandon a proven basic method. Continuous improvement and learning is the name of this game. Finance is full of cycles. So, know when old strategies become relevant again, and whether you’re a tadpole or a salamander or a human thriving by staying young at heart or an investor cycling back to foundational strategies. Sometimes the best move evolution ever made was refusing to grow up.
I’d say that Chris has demonstrated over his 25 years career a pretty broad toolkit of different businesses and valuation ranges that you’re comfortable with from quality names like Nike and Starbucks in the portfolio, or Costco like we talked about, or cyclicals in a rationalizing industry like Olin, for instance. So, that’s why I thought this would be a good fit for Chris, since he has a pretty broad range compared to a lot of investors.
Tobias: I like that one.
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Buffett’s Trust Strategy Makes Sense—But Not for Active Capital Allocators
Christopher: Yeah. There’s an eclecticism to capital. You need to be opportunistic. Yeah, pigeonholing yourself doesn’t make a lot of sense. You’re always trying to make money and you’ve always got cash, you’ve always got dividends, you’ve always occasionally proceeds from security sales, you’ve got deposits from clients, you’ve got your own personal net savings, ideally.
I want to segue thought about something, and it ties back to what we were talking about earlier about the cap weighted S&P 500 and you get into Buffett. I think people should consider– I get this question all the time, because Warren would sit there at the deus and talk about– When asked about Berkshire, when he would proffer advice on investing, he’d always say, “The S&P 500 is a marvelous tool, because it’s low cost, low turnover, tax efficient, very hard to actively pick stocks. You’ve really got to know what you’re doing. And even there, a lot of people don’t do well with it.” Charlie would always say, “Yes, but Warren, I think Berkshire will do better.” Anytime Charlie said, “Yes, but Warren, Berkshire would do better,” Berkshire did better. But of late with Warren’s second wife, he’d said a few years ago that Astrid would have a trust set up for her benefit, and it was going to own the S&P 500, I think 90% S&P and 10% T-bills.
At last year’s annual meeting, somebody asked the question about cap weighted S&P versus market cap weighted S&P. He never answered that question. But what he said was, “Look, there’s so much money that’s going to be in this trust for her benefit that she doesn’t care about beating the S&P 500. It doesn’t matter. She’ll never spend enough money that’s being produced just by the dividends being distributed. So, it really doesn’t matter.” But then he said what I’m glad he said, because I’ve been saying this for a long time and that was, “And there’s this little thing, because you don’t want to get the trustee to get sued.”
Jake: Yeah. [crosstalk] man argument.
Christopher: This will be an irrevocable trust distributing income. And from a fiduciary standpoint, Prudent Investor Rule, now Prudent Investor Act in every state, you cannot hold a single concentrated position in the security. I was an expert witness in a lawsuit. An heiress of the Procter & Gamble family had a charitable trust, and I wound up defending the bank, because they had a document that expressly allowed the retention of Procter & Gamble, which was a blue chip. If you read the Prudent Investor Rule and Act, it allowed for concentrated positions. But they come up with a game plan to slowly diversify.
Well, they made the mistake they being the bank manager of buying tech stocks with the proceeds, but they were two or three months in and P&G had earnings miss and the stock got cut in half. And in turn, because the portfolio got cut in half, the income distribution to the donor got cut and there was a lawsuit. And the attorney general in Ohio got involved and the bank lost. They wound up settling it. But it was a crazy loss, because the document actually allowed for a fully concentrated position in P&G. No, you’ve got to diversify. So, there’s a requirement.
I think it’s similar to Warren’s just having bought the energy business from Walter Scott’s estate or in part from the kids, but ultimately in the foundation, wherever it was at that iteration, I presume that was going to be a very big position. Walter ran [unintelligible 00:49:45] and he certainly had assets outside of Berkshire, but that Berkshire Hathaway energy position was huge, and I think it required diversification. So, I think there’s a lot more to Warren saying the S&P makes sense.
To me, the S&P makes sense for the family that’s going to sit down and dollar cost average over a lifetime. Occasionally, you’re going to buy some stock when it’s cheap, sometimes it’s going to be fairly priced, sometimes expensive, but you’re going to save a lot of fees, you’re going to save a lot of frictional costs. It makes sense if you’re uninitiated. It’s terrible advice at a moment where you’re sitting at a secular peak where you’re 26 times earnings, where the deck is stacked against return, when there are way more favorably priced attractive things to do with capital.
If you’re a pension fund or you’re somebody that has capital today, owning the cap weighted S&P is a terrible, terrible thing. He never made that caveat. Charlie was more prone to make that caveat than Warren would have been or would be today.
===
Most Investors Sell at the Worst Time—Here’s Why It Hurts Return
Jake: The unfortunate thing, is there’s a catch too there where in order to fully believe in why you should expect to get a 6% over 30 years, let’s say, you have to do a lot of work to understand why that would be, and what’s the argument for and against that. Chances are, if you haven’t done that work when it does, if you do buy at a secular top, you’re going to get spooked out of it at the worst time. That’s Just how everyone handles securities, unfortunately, unless you’re a little bit weird, really.
And so, unfortunately, I think there’s going to be a lot of people who probably make the bad decision in the tough time when they really should be adding, they’re going to be punching out, because it’s too painful to watch everything going down. I don’t know how to save people from that, but I think that’s unfortunately what history shows is the path that is probably the most likely.
Christopher: Yeah. You think about what the asset gatherers, the old brokers, now wealth managers– I would say if at two or three of these seminal moments in time where you’re at a washed out panic low, where you’re in a financial crisis in 2008, 2009, when you’re in a pandemic of 2020, if you’re charged with the allocation and the investment of your customers capital, if you can walk those people off the ledge from making a terrible decision by selling everything at a low or chasing into a tech bubble [crosstalk] at the wrong time, the advice there at the margin just saves–
If it saves 1% or 2% or 3% a year, that’s enormous. Because when you cement a loss in 2002, because you owned a bunch of tech or you cement a loss in 2008 or 2009, you’ll never recover that capital. You’ll never get it back. Hugely important.
Tobias: Compounding that is that value just tends to recover first and recover fastest. A big portion of value’s returns come from that early stage of the recovery. We tend to lag at the end of the cycle when everybody else is having their party. We started selling off in this most recent sort of little drawdown. My portfolio peaked in-
Jake: 2015? [laughs]
Tobias: -on Thanksgiving. And it plummeted like a stone for Thanksgiving.
Christopher: Yeah, I was down, I don’t know, 7% or 8% just in the month of December. But we’re up 7% or 8% or 9% or 10% or whatever it is this year.
Tobias: Recover first.
===
Opportunistic Investing Means Knowing When to Sell—even Berkshire
Christopher: I think to your point though, Jake, back to your veggies and opportunistically investing and being willing to do different things, to me, one of the key advantages we have and I think active investors that do it well have, is opportunistically when you’re trading, when you’re buying a new position, you’ve got to finance it. Once I’m fully invested, I like to stay invested. I’ve written about the hazards of owning too much cash over time.
I owned a bunch of Dollar General, bought it really cheap in 2016 or 2017, made a bunch of money. They were a beneficiary of the pandemic. They’re typically beneficiaries of bad economies. The use of food stamps, SNAP goes up. Well, the stock traded from the 60s into the mid-200s. I was buying energy, I was buying two refiners in 2020, the fall of 2020. And to finance those purchases, I took Dollar General from 4% down to 1%.
Company made the mistake of buying back a bunch of stock and even using debt to buy the stock back at a very full valuation. But here we are today in the stocks trading. I’ve got my 10-year or 5-year expected on where I think Dollar General heads over the next five years. And using my five factors, it’s really cheap. Berkshire, here we sit, we talked about it is trading at my number of intrinsic. I’m in no rush to go sell it. I think if the stock trades at intrinsic 10 years from now, we’ll make the return on equity of the business.
Jake: 10% maybe. Yeah. 8 to 10% maybe.
Christopher: But if the stock trades at a discount to intrinsic and the business is going to earn, let’s say, 11% on equity, might make 8 or 9%, whatever it is, but there’s no urgency to go sell it all immediately. But the next purchase I make, Berkshire has moved up to where that may be my source of capital. I’m more inclined to use it as a source of capital in a non-taxable environment for a foundation, or for a retirement account or for international investors that aren’t taxed the same way that US investors are. I’m not going to go sell it in a taxable account, where you’ve got an older client and a very low-cost basis, because I’m a buyer, a big buyer at the tax differential.
If I’m paying 20% and a 3.8% healthcare Obama tax and any state tax, your marginal capital gains rate for some investors gets up to 30%. At the net of the tax that I would pay, I’m a buyer, I’m a big buyer of Berkshire. But any position in the portfolio, when I put in a buy order to buy something, I’ve got to sell something. If we have cash in a portfolio, because the deposit has just come in or we’re building a portfolio, we’ll use the cash first, but I’ve got to give our traders a one, two, three list of what I want to sell to be able to finance the purchase.
For the first time really ever, Berkshire has risen up to the level of, it becomes a potential source of capital. But that keeps an actively managed portfolio cheap, because you’re always buying the things that are the cheapest and you’re selling the things that are the most dear. In a taxable account world, you need to do that intelligently. And so, we’ll use wash sales and we’ll try to offset realized gains. We’ve done I think a really fine job of that over the years keeping the tax bill low, because taxes are a big drag and attacks the world if you’re an active trader.
But I thought it was worth saying, because I do all this work on Berkshire and I get asked a lot, “Well, would you ever sell it?” Well, the answer is yes, not urgently, but it’s risen to where it’s a sell candidate. Ajit sold some last year. I think Ajit sale didn’t have anything to do with thinking that Berkshire was going to tank overnight, but you had legitimate proposals, campaign proposals and a tax proposal that was going to tax individuals with over $100 million of net worth on their unrealized gains. Well, Ajit had, I don’t know, $350 million worth of Berkshire that he paid for out of pocket. Berkshire’s never given away a single share of stock to an employee.
Warren bought all of his, Charlie bought all of his, Greg has bought a bunch of it recently, Ajit bought all of his. Nobody was ever giving it to him. But Ajit was staring at, I would guess, a $75 million tax hit if the election had gone differently and something, a crazy proposal like that made its way into the tax code. And so, when he sold it, close to its high for the year last year, why not? It got reported that that was a sign that Berkshire was about ready to tank. No, it wasn’t. But Ajit’s a risk manager. He runs an insurance operation. And if there’s a potential risk that next year, I’ve got to pay a tax on a $300 plus million gain.
Jake: He had an asset liability mismatch.
Christopher: And you don’t have a lot of cash laying around. Who has $75 billion of cash, except for Berkshire itself laying around? So, they trim the position. There are just times when it makes sense to sell some things. That’s the luxury of being an active manager and leaning on the discipline of asset valuation.
Jake: Warren could have loaned him the money at a 15% interest rate. [laughs]
===
Tobias: Hey, Chris, we’re coming up on time. If folks want to follow along with what you’re doing or get in touch with you, what’s the best way of doing that?
Christopher: The website, semperaugustus.com. We have the archive of a bunch of our letters. My overly verbose letters are on there.
Tobias: Don’t contact Chris until you’ve read all of his letters. [Jake laughs]
Christopher: Right. Right. That’s the homework. It’d be stunned how many people do read all those things, and then reach out and they wind up becoming clients. This recording when it hits next week, we’ll put it on. We’ve got a bunch of the old podcasts. I think each of the ones that we’ve done have been on, so the website. And then, I intermittently am out on whatever we call Twitter these days.
Mike Sailor, he’s out going to raise $500 million in a perpetual preferred that’s going to actually pay 10% cash [Tobias laughs] and I had some choice words. I had some choice words about that this morning.
Jake: Yeah, where’s [crosstalk] cash come from?
Christopher: So, I’m on Twitter not very often anymore, but I’d say the website.
Tobias: High impact when you are.
Jake: Yeah. It’s like a seagull- [crosstalk]
Tobias: You’re a fun follow.
Jake: -and then, shared and then fly off.
[laughter]Christopher: I think I’ve been. I’m not political. But last year when you had the– The Biden White House was pushing on convenience stores about bringing gasoline prices down. Well, that was one of the most absurd things you’ve ever heard. If you understand how gasoline is sold, it’s sold downstream by retailers. There’s no money. The margins are just teeny, tiny, tiny.
Tobias: Huge margins. Huge margins.
Christopher: You make all your money in the store. And so, I said, “Mr. President, bring down the big gold.” When I said bring down the big gold but not bring down gas prices, that got shadow banned. So, now, when I talk about Tesla, and its wild valuation and some of the behaviors out of its chairman– I think I’ve been shadow banned by both sides of the X Twitter spectrum.
Jake: That’s how you know you’re on the right side of history.
[laughter]Christopher: I guess. I guess. So, go to my website.
Tobias: JT, any final words?
Jake: Well, we should tell people we’re going to be gone for the next couple weeks.
Tobias: Oh, that’s a good point. Yes. Jake and I are traveling through Tokyo, and then Shanghai one week in each. So, there’s no podcast for the next two weeks. Maybe we’ll try-
Jake: Run a [crosstalk] stuff or something– [crosstalk]
Tobias: -get together and record something. Maybe we’ll try if we have some downtime.
Jake: All right. We’ll see.
Tobias: Comment on the trip maybe. But I don’t know. We’ll see how we go. Chris Bloomstran, thank you very much. Always a pleasure. Thanks for joining us.
Christopher: Thanks, guys.
Jake: Thanks, Bloomy.
Tobias: Folks, we’ll be back in three weeks’ time, same bat time, same bat channel. I’ll send out a tweet. I’ll see everybody then. Thanks so much, everybody.
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