Episode #410: Chris Bloomstran, Semper Augustus – Buffett, Berkshire, & Investing During The Energy Transition
Guest: Christopher P. Bloomstran, CFA, is the President and CIO of Semper Augustus Investments Group LLC. Chris has three decades of professional investment experience with a disciplined, value-driven approach to fundamental equity and industry research.
Date Recorded: 4/20/2022 | Run-Time: 1:59:57
Summary: In today’s episode, we touch on a lot. Chris shares why the best investors are those who can pivot, why a good business doesn’t equate to a good stock, and what lessons he learned from buy and sell decisions he’s made over the years.
Then we dive into his thoughts on Berkshire and Warren Buffett to get you prepared for the annual meeting this weekend. He shares his expectations for the company and stock moving forward and why he believes Berkshire is well positioned for the energy transition we’re experiencing today.
And don’t think we could get through the episode without touching on some of Chris’ “Twitter Audits” from the past few years.
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Transcript of Episode 410:
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Meb: What’s up, everybody? Buckle in. We got a really fun show for you today. Our guest is Chris Bloomstran, president/chief investment officer of Semper Augustus. In today’s episode, we touch on a lot. Chris shares why the best investors are those who can pivot, why good business doesn’t equate to a good stock, and what lessons he’s learned from buy and sell decisions he’s made over the years. Then we dive into his thoughts on Berkshire and Warren Buffett to get you prepped for the annual meeting this weekend. He shares his expectations for the company and stock moving forward and why he believes Berkshire is well-positioned for the energy transition we’re experiencing today and just what would cause him to sell Berkshire and at what price. And don’t think we’d get through this episode without touching on some of Chris’s Twitter audits from the past few years. Please enjoy this episode with Semper Augustus chief investing officer, Chris Bloomstran. Chris, welcome to the show.
Chris: Meb, Wonderful to be here. I’ve been a fan of your pod since I started listening to podcasts a handful of years ago. This is a real treat to get a chance to talk to you here.
Meb: We got to cut to the chase and get to the heart of the matter. What is a Denver native doing in St. Louis?
Chris: Kind of in the right place, right time, wrong place, wrong time. Out of school, I did a thing in the commercial paper world, which would occupy too much time for the pod.
Meb: You mean commercial paper like Dunder Mifflin? You’re doing like sales of commercial paper or you’re actually in like finance commercial paper?
Chris: Yeah, I invented this commercial paper synthetic pass through security when Chrysler lost their debt rating as part of an entrepreneurship class and wound up getting Jerry York at Chrysler on board when they were losing their debt rating. The money markets had just been limited to owning no more than 5% of their holdings as anything other than top-rated A1/P1 paper. So, Chrysler finances out of the market and by trying to get other issuers to come in and create a pool, have Chrysler pay for the letters of credit, lower their cost of capital relative to the bank world and top-rated A1/P1 issuers that would come in would not be paying for the insurance backing on the pool.
So, tried to make that work, ran back and forth from New York a bunch and met a bunch of people, and went to work for a bank trust company in Kansas City, Missouri, who had a Denver operation and a St. Louis operation. So, as a young guy, after a few years at the HQ, went to St. Louis to become the first portfolio manager analyst outside of the Kansas City headquarters operation, really with an eye toward winding up back in Denver and wound up being introduced to a family that became my anchor client. I spent a chapter in my letter this year talking about the story. Jim Grant talked to me in December and had an ICS and his newsletter talked about this gentleman being born in 1903, getting out of the stock market in 1928.
Meb: I want to talk about him but I have to interrupt you because it’s more important to me. Do you remain a Denver Broncos fan? You still have an office in Denver, right? Or is that your partner?
Chris: Yeah, my partner’s there. I’ve still got a lot of family there, a lot of friends in Colorado, I spend time there. I was a Bronco fan, grew up with them.
Meb: Good. Now we’ve gotten past that okay, now as long as you’re just not like, “Meb, I’m a huge Chiefs fan.”
Chris: Well, I like the Chiefs as well. I’m not wholly committed to a single franchise.
Meb: Sounds like a hedge fund manager hedging his bets right there.
Chris: Not far from farewell.
Meb: You write some great letters and listeners, Chris has got all these letters on his website. So, you got to go check them out and I’m going to warn you, you’re going to commit the weekend to this because some of these suckers are 100 pages-plus. They’re well worth it, they go back all the way to ’99. But I was laughing as you were talking about…I want to hear the story and I believe the fella you’re going to talk about is named Robert Smith, which is not the private equity Robert Smith, who got into a little bit of trouble for a few years about washing his money in the Caymans or something. Tell me about your Robert Smith?
Chris: Well, this was by far the polar opposite of that Robert Smith. I was running money for the bank trust company and introduced to a gentleman who’s one of his relatives that heard me speak. He was concerned about the stock market and debt levels. This was 1998.
Meb: I want to lay a little more groundwork and I’ll stop interrupting you. When you say managing money, like, was your approach similar then in old Uncle Buffett? Were you inoculated in a certain style? Because mid-90s, everyone I knew was trading the dot-coms, baby.
Chris: I never got into it. We being the bank trust company, the old United Missouri Bank, it was very much a value approach. But it was price-to-earnings, price-to-sales, price-to-cash flow, dividend yield, nobody was looking for a moat. And being too conservative place as banks typically are, we had several hundred stocks in a portfolio, so it was a little bit of a pseudo index fund. The family that ran the bank had dictated durably high levels of cash reserves because the history of being scarred by the depression and by the inflation in the ’70s, by the 1987 stock market crash, which was still a fresh memory when I started working for the shop in 1991. Just persisted throughout the whole bull market with big levels of cash reserves. And I came to Ben Graham only after learning about Berkshire Hathaway for the first time when they issued the B shares in 1966.
My business partner Chad Christensen, who was a good friend, we went to school together, had always theorized we’d run a money management company together. He and my former father-in-law, now passed away, great guy, lived in Omaha, and he said, “You ought to look into this Berkshire Hathaway thing,” which I did. And we didn’t cover it at the bank. We had a research library that was as big as a football field with annual reports going back decades on lots and lots of companies. So, I looked into it and I pitched it and wrote it up, and the pushback from my boss who was a great dyed-in-the-wool value investor was, “Nah, it’s really just a mutual fund in drag,” which it clearly was not, it was very much an insurance operation at the time.
Meb: And did you not just respond, “We’re a mutual fund in drag, by the way?”
Chris: Well, we were a mutual fund in drag. I was running one of the mutual funds in drag that was a balanced fund. And so, it really was a drag, very much cross-dressing. In any event, I wound up in St. Louis and introduced to this gentleman who his story was just phenomenal. By that point, he was in his mid-90s. This was 1998, so 94, 95 years old. But he was initiated into the stock market in an early age. He’d gone to Princeton, played football at Road, did boarding school in the east, prep school, and post-school, his father had passed away and he came into the family’s brokerage firm, which still exists by name in St. Louis in the mid-1920s, call it 1925. And by 1928, he was concerned about the bubble that was brewing in the stock market and in the economy.
And he pulled the plug on stocks and he took all of his family’s money and it was an old St. Louis family, Robert Brookings Smith, so the Brookings and the Brookings Institution, he was Robert S. Brookings nephew. So, the family had some capital, so he got out any clients that would listen to a wet behind the ear kid and followed him out the door. Well, if you know your stock market history, early 1928 was a year and a half before the peak. So, if you go back and look at a chart of the Dow, it would have been at about 200 and didn’t peak until 384 or 387 in the fall of ’29. So, that would have been like getting out of the stock market in 1996 or ’97 and watching the tech bubble rage and the NASDAQ runs from 1000 to 5000.
The pressure on a kid would have been immeasurably high, but obviously then fully vindicated by the 89% decline in the Dow and the stock market and the depression that ensued. And he didn’t dollar cost average in, he waited until literally at the bottom when he could buy things like GE for less than the cash in the business. And then we were in the midst of depression that had taken unemployment from 4% to almost 25%. Businesses were not making money, so we had an enormously underutilization of the capital stock. GE was not making money, but you could buy the business for less than the cash and that would have been Ben Graham’s iteration of the net-net working capital. So, back into the market, he went then over the years picked up things like Merck and later Walmart. Later in the game, the Sun Microsystems. He was a very good investor who, really, after that initial decision, never touched a position unless something was terribly wrong.
Meb: It’s funny because if you look back to that time, there are a handful of examples that are so instructive. Listeners, there’s a great book, we’ll put in the show notes links, called “The Great Depression, A Diary,” where there’s a guy that’s talking about what’s happening during that period. But the similar story also with Templeton buying stocks at that period where people forget, but during a crisis…and down 80 is a lot different than down 50, which, of course, is a lot different than down 8% or whatever we’re at now. And even having assets at that period is like a full candy store because no one does. And you talk to various investors around the world over the last 10 years where they’ve been decimated and in places where the markets have gone down 80%-90%, a lot of people say, “I imagine there’s lots of opportunity but no one has any money, we’ve already lost it all.” So, to even have some ability to buy at that point seems so advantageous, but also so rare.
Chris: That’s a great book. Just anecdotally in it, you have stories about the doctors, the family practitioners, accountants who maintain their practices, they were independent business people, but their clients had no money. Nobody had any money, they didn’t get paid. And so, even if you had an investment capital, you weren’t making any money. Unemployment was, again, sky-high, but even those that were gainfully employed didn’t have the resources, so they had to live through their capital. Very, very few had money on hand. And if you did, you were so scarred by the downturn. That was the beginning of creating an entire generation that never ever trusted the stock market. They thought it was a game that was rigged against them. Ben Graham blew himself up. Keynes blew himself up.
And while Keynes and Graham were writing, when Ben Graham was writing security analysis, Bob Smith was buying companies with family capital and he understood the notion that if you used eventually, the idle capacity inside of GE, that eventually the company would make money. It was just a brilliant investment. And in the letter, I weave the story and I really want it to be well done. I’d never mentioned him in a public setting in my career, guard our client’s privacy. And when Jim wrote that up and I told the story, I did not mention it specifically. And in fact, Jim called me right before he went to press and said, “Hey, would you let me know his name and can I mention him?” And I said, “Jim, I can’t do that. I’ve never done it, the family is still very private and guarded.” And he’s such a good writer, it turned out to be such a good piece. In fact, he’s asked me to speak at his fall conference this year, which will be a highlight.
Meb: We do this quote of the day, which by the way, you’re going to be featured in eventually coming up, because you are very quotable in your writings, by the way, Chris. But we did one from Jim Grant the other day, and often our quote of the day…listeners if you don’t follow me on Twitter, it’s like those old school word of the day calendars. I used to love those back in the day. We did one with Jim Grant, it might have been our most popular to date investing quote of the day, “To suppose that the value of a common stock is determined purely by corporations earnings, discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin, and believed Orson Welles when he told them over the radio that the Martians had landed.” It was such a great quote. Okay, so you’re speaking at his conference. If listeners want to attend, do we know the dates? You said it’s in the fall, do you know where?
Chris: Tuesday, October 18th, I believe at the Plaza Hotel.
Meb: New York City. All right, it’s a good time to be there in the fall time. So, sign up, listeners.
Chris: So, anyhow, I called his daughter on what would have been his 119th birthday. You know, he didn’t have kids until they got back from having volunteered to go fight in World War Two as an old man, not a young man, couldn’t bear to not be in the fight. Talk to his friends in the War Department to letting him in the fight, he captains some training ships on Lake Michigan, the Navy still has a big training facility there, and at a point, he just felt a duty to his country to be in the fight and wound up eventually being second in command on a light carrier, the White Plains. I put a picture of the ship in my letter and he had pictures in his office when I first met him of the Japanese Zeroes that were dropping torpedoes and several of the ships in the fleet were sinking, plumes of water from the bombs hitting the water as high as the office tower that we were at.
And as I got to know him over the years, he would confide a lot in me and he said almost nightly for his entire lifetime, this is now a man in his late 90s, he said, “I can’t shake the nightmares from World War Two.” It was in the Battle of the Philippines. Just a remarkable man. So anyhow, having garnered his privacy and that of his family for years, I called his daughter on his 119th birthday and told her what I wanted to do, I wanted to link his investment history and the decisions that he made over time, particularly at important secular peaks and troughs, and kind of link it to Warren Buffett had done as well at very important seminal lows and highs in the market. And before that, I wanted it to turn out to be a very, very well done piece.
She was thrilled that I sent it to her and it took her two weeks to get back to me and perhaps because the letter is so long, and then her husband had just passed away. She said she was pretty emotional over it and cried and sort of a lot of memories. And so, I was thrilled at the outcome, I hope it turned out well. But when I got to know him, he made his next great pivot. He made the great pivot, obviously, in getting out of the market in ’28, hard to do. Got back in at the absolute low in 1932, hard to do. And then he didn’t really touch anything in the late 1960s, unlike Warren Buffett did in closing down eventually his partnerships. He originally stopped taking capital in ’66, closed them all together in ’69, and wounded up effectively just keeping Berkshire Hathaway.
But he knew the stock market was expensive, it was not his game anymore, and he had bought the textile business and then bought the insurance operation, which gave him fodder and capital to go to war in the 1970s against the bear market that persisted for 17 years, traded in a range-bound cycle and went from very expensive in the late ’60s to seven times the 3% margin at ’82. In any event, they both made an extraordinary pivot in 1998 when Mr. Smith hired me, and as Jim put it, we joined forces, which I thought was just the most perfect way to put it because we really did. Where Warren Buffett had the high-class problem of having had so much success as a stock picker and then the operation where the stock portfolio had compounded at nearly 30% a year for 33 years.
He had Coca-Cola, which was a 13-bagger in the five years that he owned it, it was 40% of the stock portfolio. The stock portfolio inside of Berkshire was 115% of book value. Corporate marginal tax rate was 35%, so he’s never been a fan of paying taxes. And so, by then, buying general reinsurance using Berkshire shares as currency when they traded at twice what you’d call intrinsic value, they were trading at 2.9 to book, he wound up picking up a giant bond portfolio, diversifying Berkshire’s concentrated stock portfolio to where stocks dropped from 115% of book down to 69% of book. GE brought something like 45% of the assets to the combined entity, but only wound up with 18% of the ownership of the entity. It was just a brilliant masterstroke. And it allowed the surplus capital that existed inside Berkshire to be upstream and very quickly buy the first utility operation, Mid American Energy, eventually buy the railroad in 2009.
Well, Mr. Smith, on the other hand, had this high-class problem as well, a very low basis portfolio that had grown, by his favorite expression, benign neglect, and it would have been your coffee can approach. So, GE was half of the family’s portfolio with a basis that was less than the quarterly dividend, if you can imagine. GE had problems by then under Jack Welch. They’d taken two-thirds of the business and bought up all the various reinsurance operations and finance businesses, consumer lending operations. The leverage embedded in GE was extraordinary, they had a lot of off-balance sheet liabilities. So, I thought and he thought GE was, by this point, a problem.
So, we set up a family foundation and some charitable remainder trust that would feed he and his wife’s income during their lifetimes, eventually with all of the assets winding up in the foundation. And over the course of spreading over a couple of years, the contributions to the foundation under the trust was able to take big tax deductions for the charitable gift, these were assets that were headed to charity anyway, and I was able to liquidate the vast majority of that portfolio, 90% of the GE. He said, “Chris, this one holding has been so good to the family, I’ll let you sell 90% of it but I’m just going to keep 10.” Well, that GE position was between…it’s down 80% or 90%, but sold it pre this reverse split that they just did, the one-for-seven split, sold it between $50 and $60 a share.
Meb: That’s a great behavioral psychological hack. We tell a lot of people that struggle with this, always the decision they think has to be all in, all out. And we say it’s less satisfying to many because they want to gamble on either outcome or cheer, cheer for the outcome, “All right, I’ve sold it, now I want it to go down,” or, “I’m still owning it, I want it to go up.” But it’s funny how they said, “Okay, look, I want to at least retain a little bit for this partially sentimental value,” or, “Just because we want to have some of it,” but it’s a good way to help you behave a little bit, I think.
Chris: I’ve learned the lesson over the years and I should have just learned it at that point because I’ve made the mistake many times. In fact, a theme of one of my letters a handful of years ago was the University of Ross and my single biggest investment mistake ever was having sold Ross Stores two and a half years after purchase when the tech bubble was raging, there was a lot of value. And this really was the extension or the continuation of this great pivot that we made by selling GE and selling the commodity, chemical companies. the baby bells, a lot of businesses that were no longer earning their cost of capital if you objectively drilled under the hood into the accounting properly, with no capital gains taxes liquidated.
But instead of doing what he did in 1928, and sitting in cash, waiting for a bottom, the market was so bifurcated, that this is where we really added a ton of value. The average business had been crushed as the tech bubble raged. You had all these small mid-cap businesses, fire truck manufacturers, little banks and thrifts, generic drug companies that were trading at 7, 8, 9, 10 times earnings at the moment that the S&P traded in the high 30s and the Nasdaq at 240 two times. So, one of the positions that I bought was great little retailer Ross Stores.
Meb: What year would this have been for timeline, ballpark?
Chris: ’99 o early 2000. Ross was trading at 10 times earnings, it made no sense. They had about 350 stores. Unit economics were phenomenal, they didn’t have on-balance sheet debt other than capitalization of the operating leases, and the units were earning high teens returns on capital. But because it was in the small-cap bucket, the value bucket, if you’re a small-cap value manager, you were getting redemptions on a daily basis. Walter Schloss was getting fired by his clients, people were apoplectic with Warren Buffett for not having tech in the portfolio. And you had all of these flows, your 401k investor got that quarterly statement and saw the NASDAQ and the tech funds and the Janus funds.
The Invesco growth funds up 70%-80% in 1999 and the world was chasing tech, and to maintain sanity didn’t mean you maintain clients because human nature being what it is, they wanted to chase it. So, you had all of the sell pressure on these real businesses for no operational fundamental reason other than they were in the wrong style bucket. So, I paid 10 times earnings for Ross for a business that was going to grow at store count rapidly and had a very long runway to grow. And as March 10th came and went, everything that I owned, which leading up to March 10th, was down every day, the NASDAQ was up every day, I’m sitting there trembling on my desk on March 10th, actually penned a little note Alan Abelson saying, “This is just crazy.”
Meb: Did you have any pressure from your bosses at that period? Were they getting drawn into this as well because it was really impossible to avoid?
Chris: Yeah. So, when we started the firm in ’98, several of the clients that I had developed at the bank trust company followed me out the door, and almost to a client, the pressure was huge. I was 29 years old, almost 30, when we started the company, and the pressure to not own tech and to party with that rising bubble was immense. In fact, Chad, my business partner had spent years in public accounting, he was an auditor, and we’re out holding clients’ hands who had just come in and the pressure of the meetings that we had to take and the calls that we had to take, he said to me, “Is it going to be this hard? Are these meetings going to be this difficult?” I said, “No,” I said, “When this bubble passes and you get back to a more normal world, no.”
I said, “The next time we’re going to have this kind of pressure will be at whatever the next market low is when nobody wants to own a stock,” and that would have been 1982. But it passed and literally on March 10th, the screen flipped and everything I owned was straight up. The NASDAQ stuff rolled over. It was an evolving bear market, feels and looked a lot like what’s transpired in the last six months, the very high speculative companies, a lot of things that some of your more speculative investors that had so much success in 2020 had had, those are the places where the stocks are down 50%, 60%, 70%, 80%, and they’re still trading at six, seven times sales. The same thing happened in 2000 and it took the full three years to cleanse valuations of the excesses.
Meb: Well, you talked about this in one of your letters, it might have been your most recent or one of your pieces, I can’t remember which, but was talking about…and you can expand on this. But the separation of business, I feel like you were talking about Microsoft, but it could apply to Cisco and many others. And the stock where…I hear all the time on Twitter, people are like, “Meb, this is nothing like 2000 because companies today have revenue and companies back then were only valued in eyeballs.” And I was like, “Well, you know, that’s funny,” because I go up and pull up the top 10 market cap stocks from ’99 and I was like, “Most of them had ten to hundreds of billions of revenue.” Yes, there were the CMGIs of the world because that was me owning that, so I was a little younger and more caught up in this. But there was also very real businesses and many of those businesses, and you can expand on this, not only survive, they thrived, but the stocks in many cases did nothing for a long time.
Chris: Sun Microsystems which we owned and sold. Oracle. America Online, which engineered one of the greatest mergers of all time when they convinced Jerry Levin to sell Time Warner to them and AOL brought 15% or 20% of the cash flows to the party, but these were real businesses. One of my early letters, which is on the website, I know I’ve talked about it on at least one podcast. But as soon as Jim mentioned it in the write-up in his “Interest Rate Observer” in December, I had penned a series of predictions on March 1, 2000, for the millennium, kind of fun, but went through a series of, “I thought interest rates would eventually trade below 3%,” they were north of 6% at the time, market cap to GDP would revert back to some more normal level. But my first prediction was Microsoft shareholders as a proxy for this tech sector, the real businesses with large revenues, in a lot of cases, very large profitability, were simply inflated to bubble levels on a price basis.
Microsoft was doing at that time $20 billion in revenues. It was not a small company, they had compounded their sales, it’s something like 45% a year since their 1986 IPO. They were doing a 38% profit margin, so call it $7.5 billion in net income on $20 billion in revenues. This was an immensely successful, fast-growing, profitable business that had no fundamental flaws other than the fact that they had massively diluted the shareholders on the way up. Silicon Valley really hadn’t caught on to share repurchases but they really had figured out share grants, and options were out of control, companies giving away 4% or 5%, 6%, 7% per year to their key employees, it was insane. Microsoft had diluted the shareholders by 40% since the IPO and had no need for capital, it was the first real great capital-light business. But it traded at a $620 billion cap on $20 billion in revenues, it was 31 times revenues.
And so, I penned that I thought shareholders would lose money for 15 years, which they did. Six, seven years into that 15-year period, I was buying the stock at 15, 12, and then for less than 10 times free cash earnings. The stock had gotten crushed, declined by three quarters, call it two-thirds at least. I mean, it dropped from 60 to 20, so they were down by two-thirds. They had only paid a few modest dividends, they paid a $3.20 special dividend early on, but the stock had just been hammered. But in the meantime, the business was still growing. They were a monopolist. In fact, people wouldn’t remember this, but back in the early ’90s, Apple was failing and Microsoft already had antitrust pressures from the Justice Department and from the European regulators. They needed a competitor. They made an investment in Apple to keep Apple alive. Steve Jobs was done, he was cut, the business was gone.
Meb: It was so unpopular. I remember the announcement and getting booed when the Microsoft came on the video feed.
Chris: It was just an extraordinary time. The parallels are pretty striking to me today. The pushback you get are, “Oh, interest rates are low, interest rates are low, you’ve got to capitalize these things at higher levels.” But I would suggest that where businesses have done well, they’ve been rewarded for it. I’ve got the early piece of this year’s letter on attribution analysis of the 16.6% return that the S&P 500 produced over the last 10 years and how much of that came from sales growth.
Meb: I want to get into that. But before we do, I can’t let you get away with hearing the ending of your Ross stories, by the way. So, tell me the punch line here because this is already making my palms sweat.
Chris: Well, thanks for circling me back. I tend to go off on tangents.
Meb: Well, no, I mean, this is the classic Meb conversation. We tie it all together at the end, of course, but I had to resize the chart. You need a log chart for this because it’s a beauty. So, you’ve held this for 20 years, is that the punch line?
Chris: No, the disaster of disasters was about two and a half years in, we had made about two and a half times our money and the stock would have been trading for mid-20s, low-20s, let’s say, multiple. And the S&P had dropped by 50%, we had made about 30% returns on the portfolio, everything just worked in all of these things that were so cheap. Berkshire Hathaway, which had fallen 50% from the point at which they bought, January, we bought in February of 2000, it was immediately up by the end of March of that year. So, I sold all of the Ross but I still, at that point, hadn’t figured out moats and returns on capital the way I should have. To your point, we’ll circle back and get this thing again, but it’s gone from 10 times earnings to what appeared to be very expensive, so I sold the whole damn thing. And Ross wound up being one of the top-performing stocks post-2004 when I sold it, just the most regrettable decision in my life. It’s been more than a 20-bagger since we sold it. That’s not counting the 2.5x gain that we had on the front end of it.
Meb: Yeah, I’m looking at the chart and like split-adjusted or whatever the chart being, it was like $1 or $2 in 2000, it’s at $108 today. So, listeners, you can do the math, but were you not in any way interested, it had a pretty fat drawdown in the pandemic. Are you totally done with it? You’re like, “You know what? I can never go back to this name, I have too much emotions in this?” Or did it siren song you back in 2020?
Chris: I thought about it. I really did. I had picked up Costco shortly after having sold Ross. And having made a number of decisions and things like that, that I just sold completely out of the portfolio, the lesson I learned that I wish I’d learned or known right at the outset…oh, the GE, in retrospect, it would have been better to sell the whole thing because the stocks 80% below where it was. I mean, you take $1 million in capital down to $200,000 versus the 12, 13, 14x that we’ve made on our stock portfolio since then and the delta there, it’s pretty extraordinary. So, that probably would not have been the lesson in terms of keeping things but Ross scarred me badly in a number of those things that I’ve done. Look at the total return on Costco, I paid 29 bucks a share for Costco in 2004, and Costco, oddly, had about the same number of stores that Ross did.
But Ross had a runway to open a lot more stores per year, Costco has never deviated from the cadence of opening about 20 to 25 stores per year. So, now they’re pushing 850 stores, they’re opening their fourth store in St. Louis here. But between here and there, they’ve paid four special dividends. In fact, when I first bought it, they paid their first regular dividend and they announced a payout that was about 20% of their annual profit. And I thought, “Oh, this is not good because here’s the business that absorbed every dollar of retained earnings and open new stores with it. Is the fact that they’re now paying a dividend reflective of the fact that they don’t have the same opportunity to keep opening stores?” Turns out their model allows them and their real estate team to do 20 to 25 stores per year.
So, as cash would build-up, again, even better balance sheet than Ross, they use very few operating leases, so cash always exceeds the little bit of debt on the balance sheet. They own 80% of their land and their stores, so it’s just all cash-on-cash investment. But between here and there, we’ve earned $29 in special dividends. They paid $7, then $10, then $7, which ironically, absolutely matches my cost basis, my original cost basis on the shares. And I paid 20 times earnings for it but it wasn’t really earning 20 times because on an eight-year maturity schedule until their brand new stores get enough members and enough throughput in the stores, the new stores under-earn on what a mature store would look like on a return-on-capital basis. And so, there was a masking of profitability there.
But we’ve probably picked up, I’m going to guess, 17 to 20 bucks in regular dividends, but the stock is almost $600 today, it’s been another one of those. And over the years, I’ve thought it was expensive. It is expensive, I mean, it’s trading north of 45 times what they’re going to earn this year. So, I’ve sold it back out of almost all of our non-taxable accounts but where I’ve gotten very little basis, I’ve kept it. And so, what I’ve resolved on in the last more than a decade is we do a lot of different things with capital. I mean, I’ve got businesses that I really want to own forever for 30 years. I’ve got big investments in energy and some cyclicals, and those are things where I intend to liquidate the entire position at a point. You’re buying them for a price, you’re selling them for a price, there’s a thesis…there’s a theme to driving profitability higher, but you’re playing with the capital cycle.
In the case of businesses you durably want to own, I’ve learned that by keeping a small position in the portfolio…I’ve made a bunch of money with Nike and I took Nike back a year and a half, two years ago, to a 0.5% position. And a 0.5% position is not going to kill me if it declines or whatever, but it forces me to see it in my portfolios every day and from an opportunity cost standpoint every day, you’re assessing the relative valuations of everything you’ve gotten in the portfolio. And when I’ve got cash and cash flows, cash from dividends, cash from deposits, cash from new clients, cash from transactions proceeds of sales, either trims or outright sales in the portfolio, I’ve always got cash and I’m always assessing against an opportunity cost.
Another lesson is the ability to pay up a much higher price even, in the short term, than you’ve paid recently. I’m buying things that double the price today at which I paid a little more than a year ago on some new positions. And so, I heard later in life that Lou Simpson had adopted that same approach where he always kept at least some portion of a position size on a portfolio. So, I think for those things that you really have done all that work on and you know them like the back of your hand, when the valuation is so high, it compels you to trim it and we do that, I think, really well. That’s one of the things that we do extremely well is manage around the intrinsic value appraisals of the companies in the portfolio and always trying to keep the whole portfolio valuation cheap. But Starbucks, Nike, Costco are durably long-term ownership positions that I will come back into in scale when prices make more sense.
Meb: I think that methodology is thoughtful. And listeners, take a look at your portfolio because what Chris partially is talking about too is you establish a position and we polled our Twitter followers and it’s like 95% or something, when they buy a position, have no general sell criteria. Everyone’s spent so much time on the pie like, “I got to find the perfect investment, is this the right time?” They buy it and they sit back and say, “Okay, let’s see what happens.” And as we all know, that’s a recipe for disaster because what are you going to do if it goes down 50% or 75%? What are you going to do if nothing changes, but the valuation doubles? What are you going to do if the CEO gets into a car wreck?
All these things, but the one you’re talking about, I think, is really thoughtful where you’re like, “Look, I’m probably going to fall in love with this business, we’d love the stock, but at some point, it’s probably worth trimming or selling some.” And so, having the tolerance bands…and we talked about this in markets, like big stock market terms, but also with names, there’s a price where it’s just good risk management and position sizing to trim the security.
Chris: Yeah, if your process centres around the intrinsic value of what you have, on any given day, everything you own is going to trade at some discount or premium to that assessed value. And if you spend the majority of your time thinking about what can go wrong, whether you’ve got high levels of competition coming where you don’t have the moat that you thought or the valuation has changed, I think if you can get your mind around opportunity cost, it’s valuable. And then risk management. I had some energy businesses that went into that post-2015 peak in oil north of $100 and we had this wild cycle of massive CAPEX on exploration, new equipment, service equipment, in the energy patch, absolutely overspent on trying to replace reserves, and they were spending so much money that there was no way to get an economic return on the capital that was spent.
I own a business in Norway that does 3D seismic imaging. So, they’ve got a fleet of vessels, and when you have the downturn…the balance sheet was in pretty good shape, and when you have the downturn, what you realized was, “Good lord, there’s an off-balance-sheet liability for several ships that they have not yet taken possession of but they were fully committed on to complete on a CAPEX basis.” And if this downturn in the oil price persists and we don’t utilize what’s now going to wind up being surplus equipment, we’re going to mothball it, we’re going to idle our old equipment, we’re going to scrap it, which is exactly what happened. But all of a sudden, a balance sheet that looks pretty good, look pretty bad when you had to finance equipment that you weren’t going to use and you didn’t have long-term contracts in place.
So, there, you’re saying, “Okay, we like this asset as a long-term investment, they’re in a good industry.” But there are other things I can do with capital and I could sell that and buy Subsea 7, which has a pristine balance sheet, they’re operating in a little bit different corner of the world, a subsea and engineering construction company. And they’ll take everything that happens with a topside gathering platform that an Equinor, which is the old Statoil, or ExxonMobil or any of the state oil companies would have, and do all of the engineering work that takes place below the surface. So, all of the risers and flowlines and pipelines, everything down to the wellhead, they’ll manage the field. But run by Kristian Siem, the balance sheet runs generally with net cash and you’ve got to be able to survive a downturn like that.
So, even if you like the thing that you had, you don’t want to get taken out on a stretcher. I gave myself just as much upside with a swap of that position into something, not knowing how long that downturn would persist, we needed to live with it, and things like that are a good trade as well. So, there’s a lot of things that happen on the margin but you’re exactly right. To me, I think spending more time assessing not the upside case, but the downside case, and being constantly aware of changes in your industry and changes in the economic landscape serve to keep you out of trouble. You’ve got to live to fight another day. Risk, to me, is not volatility. Risk is permanent loss of capital and you don’t want to have portions of your capital permanently impaired.
Meb: And you guys, just for listener context, you own about 30 names, so a concentrated portfolio, but you guys long-only and is it domestic-only equities? Do you do any bonds? Do you do any derivatives? Do you do any shorting?
Chris: I have one little account where we do some shorting almost as a hobbyist venture.
Meb: If you get ready to admit that there’s the Robinhood account, I’m not sure how to think about you at this point.
Chris: No, no, it’s a real account. It’s a partnership account that I’ve added, it’s about 10% of our assets. I wouldn’t hold myself out to be a very good short seller. Really, if you look at our 13F, we’ve got a bunch of holdings. The residual GE position, for example, some of that still exists in some family accounts, we hold them, waiting for a step up in basis. I have new clients that come in and we get inherited positions that oftentimes we’ll work out of but we keep some things for tax reasons. Of the portfolio, we’ve got about 20% invested in internationally headquartered companies. When somebody goes on to Datarama or pulls our direct SEC filings, my 13F, I only have to disclose per SEC regulation three of the names, they’re on a list of mandated disclosures.
But six of my holdings, Subsea 7, which I just mentioned, we don’t file under 13F, and so I’ve got a fair amount of capital offshore. But it’s a long-only all cap, I’ve never wanted to be in a style box. And consultants have tried to say that over the years, “You’ve got a lot of small mid-cap, we don’t want you owning anything internationally.” I just tried to go where we can find value and durability. It didn’t matter to me whether you’re headquartered in the Netherlands and you’re an analogue semiconductor company, or whether you’re headquartered in Silicon Valley, it matters not, the business itself and the client list that they have and how they run their affairs matters a lot more. Now, that said, I don’t do emerging markets, I won’t go where we don’t think we have rule of law.
I’ve been fairly public in saying I would never ever invest in the Chinese domiciled company but I think the game can get tilted away from you there. So, when I’m invested abroad, I’m in places, mostly in Europe, I’ve owned some Japanese companies over the years, governance there is an issue. But I’ve got Heineken in the portfolio, and I’m getting a lot of emerging market exposure and growth when they build a plant in Sub-Saharan Africa and I’ve seen Heineken in the years that I’ve owned it take a third of their operating cash flows up to two-thirds of their operating cash flows in emerging markets. I’d rather have the exposure coming with a business that’s growing abroad, but you’re not going to lose the assets. Starbucks has, I believe, a very long growth curve to open stores in China.
They own their Chinese stores, they took them back from a Chinese partner. The risk to me there is if you have a Chinese invasion of Taiwan, not off the table with what you’re seeing now with Russia and Ukraine, if we get really sideways in our Chinese relationships, there’s a risk that our Chinese stores are gone and lost forever. You’ve seen businesses write down and sell some assets now because they’re completely out of Russia. Whether that’s durably out of that market forever or not, who knows? It remains to be seen. But you just don’t want to have capital at a place where horrific things can happen. And a lot of that’s knowable in advance.
Alibaba, if you own the ADRs, if you own the US-listed shares, you don’t own the company, it’s a V structure, you own basically a shell company in the Caymans. So, you really do not have a claim against the equity capital of Alibaba and they have proven to change the game midstream against you. I just don’t do it. I have way too many clients and families and family offices where we manage all or a substantial portion of capital and again, I just don’t want to blow it up. And the trade-off is not that we’re sacrificing return. It’s just the risk is permanent loss of capital and it’s not volatility or short-term underperformance, it’s trying to find durable earning power that’s going to grow and that I can buy it at a cheap enough price to make a good long-term return.
Meb: It’s seemingly, reading your letters…let’s see if we can find some of that, there was a quote you had where you said, “The last two years saw a proliferation of speculative excess and charlatan promotion.” I think your most popular tweet, if you search all your tweets…and listeners, if you’re not following Chris, he likes to mix it up with certainly calling out a fund manager, SPAC issuer, I’m not sure what the call Chamath. But also the one curious thing with his letter, which I assume will be dropping next month if he’s still published it, I don’t know that I’ve ever seen an investment manager just publish gross returns. Have you ever seen that before? Is that a thing?
Chris: No, I’ve never seen it.
Meb: I mean, I’ve seen gross and net. That’s very standard. You and I adhere to the gold standard of our industry, which is the GIPS performance, and most of my funds are public, so it doesn’t even matter. But I don’t know that I’ve ever seen that in my entire life.
Chris: No, I’ve never seen it. And comparing a series of, I guess, venture cap funds one-off and aggregating them as though they’re a single composite entity without disclosing the performance of each and before you have liquidity events where you can game whatever your marks are over time…I think, ultimately, did the underlying investors make money? Who knows? But when you net it out what amounted to…I think it was a 3% and something like 30% performance fee, what appeared to be a low 30s return was more like an 18 return. And to not disclose the net is pretty remarkable.
Meb: What triggered you the most? Was it that or the front page comparison to the GOAT, Buffett? Not only you’re going to do gross returns and all these other things, you’re now going to take and say, “All right, I’m going to compare it to Warren and Charlie?” I feel like that’d be like the final straw.
Chris: Well, I never would have read the letters. I had clients interested in SPACs years ago and determined that the structure was pretty sleazy, great for the promoter, not so great for the retail investor. I never would have read the letter had I not seen that comparison table, only for the fact that I run…when Mr. Buffett dropped the book value per share column in the first page of his Chairman’s letter, I run the whole 57-year history of Berkshire Hathaway’s returns in the same format that they’ve run them. But I run them by year and I run also a year-by-year compound annual growth series, both forward and backward-looking. So, you can now see what the year-to-date return is, what the one-year return is, three-year return, and I run it for both book value per share and market value per share.
When Chamath compared his return series to Mr. Buffett’s, the number that leapt off the page was, “I think the Buffett return was 12% compound.” There was only one moment in the compound series forward or backward where the Berkshire return was 12.5% and that was using the stock price ending 1975. I think it was down 49.5% in 1974. The bear market was ’73-’74 but Berkshire rolled over later in that series. In any event, returns have always been in the 20s forward and backward and then you had a big recovery two years later. So, that number leapt off the page and you wondered, “Well, how did you get to that number?” And then he had labeled his time series as 9 years and it wasn’t even 9 years in his case and Berkshire was actually 10 years to get to that number, so he miscounted whether it was a 9 or 10.
Having now read the letter, where are the auditors? Where are the internal compliance? Where is the SEC outside counsel? Because you’re in the business now of raising money from retail. And I regret, at some level, being on Twitter but the places where I’ve knocked heads with folks are 100% exclusively where I think the retail investor is just getting shellacked and abused. If Goldman Sachs wants to go fleece a hedge fund, everybody in that world are big boys and big girls and know what you’re getting and know what you’re buying. You’re professionals and you’re trained to ferret out the good, the bad, and the evil. But when you’re fleecing the retail platforms like Robinhood at the time of their IPO, I would never have commented on Cathie had she not put up a Tesla report a year ago with a $3,000 stock price target which was riddled with inconsistencies and impossibilities about some of the business lines they’d be at.
I happen to know a little bit about insurance and auto insurance in particular, to suggest that they were going to be the number two or number three underwriter in auto within a five-year period of time was insane. And then to now come out in the last fall and then more recently, a couple of weeks ago to suggest you’re going to make 40% a year and then what’s now 50% a year, to use legal terms, may or could be criminally negligent, you’re just promoting. And I find the behavior appalling. We saw a lot of examples like that in the late ’90s. We haven’t seen it until this latest iteration. And so, I’ve simply tried to raise awareness and a lot of people don’t like me for it but it is what it is.
Meb: It’s a challenge because I, in general, consider myself a very optimistic person. I don’t like being critical, it’s easy to be on social media. But at the same time, as mentioned, there’s a lot of garbage that goes on in our industry. And I don’t think either of us trying to be holier than thou, it’s just we’ve seen this before and this bad behavior eventually gives us a bad name too and it’s not just the money management industry, but it’s all of, to me, free markets and capitalism and everything surrounding it. And so, I think it’s important to have people willing to speak up. I was tweeting back in 2020 and I said, “Look at a lot of the historical research on SPAC, this entire series may be different, but historically, post-IPO, Leuthold had it at minus 70%.” I was like, “I don’t even know of a greater cash incinerator than that, that I can think of from a structure and incentives, etc., and say maybe these will be different.”
Anyone who’s existed long enough in the investment industry, looking at your first example talking about Ross, has a degree of humility and understanding, like, what’s happened in the past and what’s possible. We all have the scars and we’re all proud of the scars. We’ve all had losers and we’ll continue to have losers and make dumb mistakes. But to say some of the things that get said like the 50% thing…we did a tweet last year where I said, “Well, I just want to see how many times this has actually happened in history in sectors or industries.” And then Morningstar has done some reports where they talked about how many times has an active manager achieved these numbers and the answer essentially rounds to never.
So, it’s hard to hear, it’s like nails on the chalkboard. What ends up happening in this cycle is probably the likely thing that happens in the cycle, which you talked about in the quote that kind of led into this entire discussion was, “Proliferation of speculative access and a lot of promotion going on.” But here we find ourselves less than 10% down on the S&P, I think, give us a little review. You talked a lot about this in your letter of decomposing returns, would love to hear you talk a little bit more about that, and if you have any more thoughts on what we just grazed over, feel free to continue to.
Chris: My only last comment, very tongue in cheek, but maybe you and I could join forces as co-expert witnesses and some of the class actions that are inevitably coming.
Meb: I have reported a couple and I don’t like doing this at all, but there are so egregious where these marketing guys send me emails, and they send these emails and I’m like, “Do you realize who you’re sending this to? First of all, you just spam me, so you lose all opt-out ability, you spam me.” And then you sent me this and I’m like, “Just to be clear, is this true, like, exactly what you’re claiming to be true? You’ve never had a down year and you beat the market by two percentage points, but you charge 3%?” On and on and on. And they’re like, “Yeah, it’s amazing, right?” And twice I reported it where I can never say with 100% certainty, but probably 98% certainty that the track record is totally fictitious. But in both cases, these are shops that are managing over $1 billion publicly. But to my knowledge, the SEC has decided to not look into either, so I wash my hands of it and so be it, but it’s hard to watch sometimes. But if you’re listening and you’re running something shady, listeners, whatever you do, don’t email me your pitch if it’s sketchy.
Chris: I’ve done some expert witness stuff and, Good lord, I won’t tell the whole story. But there was a law firm that got sued for misplacing some securities but they’ve been pledged as collateral in big real estate buy. And it turns out the securities that had been pledged was a complete pump-and-dump pink sheet business that had no essential assets run, oddly, out of South Florida.
Meb: Is that Salt Lake or Vancouver? I feel like half are out of those two locales.
Chris: No, it was Salt Lake but…I’ll tell you the name of the company. It was Vertigo Theme Parks was the security, that we’re going to build these theme parks kind of in the mountains outside of Bogota. And then you did the demographics, there was not enough population to support it, wound up pledging that they had capital raised from various entities around the globe and we’re talking about collateral and fixed income but they were using all the wrong nomenclature. Well, the thing was a total fraud. This thing wound up actually going to a lawsuit, did not get settled.
And I won’t say who it was but the expert retained on the other side was the gentleman… and you can read about the story in Maggie Mahar’s “Bull” book about the late 1990s, the bubble, she’d been a Barron’s writer. But the Merrill Lynch guy who ran whatever their science and tech fund, who got on the bullhorn right at the top and said, “Let’s get ready to rumble,” kind of yelled that to the troops to fire them up, and the fund was down 90% and blew up and he lost his job. But he was retained as the expert on the other side and he premised that even though this thing was an absolute pump and dump fraud, it could have worked anyhow, and I think we’ll see some of that. You don’t get it until people are totally blown up but it’s coming.
Meb: You hit on part and I was tweeting this, “This feels like someone who has been through the late ’90s and 2000s on the wrong side as a university graduate right at that point, but experienced it, it feels awfully similar.” And I tweeted last year, I was like, “This feels like one of those times when you look around and a lot of these high flyers are down 50%-70%,” and many of them are, but you still have the broad market generally holding up, you have a lot of the names despite being down, still very expensive. Give us a lay of the land because you had a huge chapter on this. Listeners, you got to go download the report at semperaugustus.com, download it, grab a cup of coffee or wine or a whole bottle because it’s going to take a while, it’s 100 pages. But there’s a whole section on decomposing returns. You going to talk a little bit about that?
Chris: Knowing the degree to which margins had expanded, Warren Buffett had a piece in “Fortune” magazine back in, I think, the late ’90s, maybe ’99, when he talked about market cap-to-GDP and talked about reversion of margins. And what wound up happening is you have more and more of these capitalized businesses and you’ve had a decline in interest rates, so the interest burden are lower even though the leverage on balance sheets are high to where the profit margin has durably pushed higher. It reached I think 8.9% in 1929 at the market peak, having averaged between 3% and 6% most of that time, you just have this bubble in profitability and a lot of aggressive accounting at the same time. In the market peak in 2000, the margin got to 7.5%.
And at that point, kind of what Mr. Buffett had written, 3% to 6% was the normal range for profitability, it would revert back. Well, it really has not reverted back, it’s proven durably higher, you have more of these big bellwether tech companies sitting at the top of the market that generate very high levels of profitability, very high returns on capital, capital-lightened businesses. And so, you have businesses like Microsoft, which had a 38% margin back in 2000. Their business slowed a little bit and before they figured out the cloud and developed Azure, the margin dropped to 23%. Well, now it’s back to 37%. So, you have a lot of big businesses at the top. Apple, very profitable. So, that Fab Five has really driven the bus.
But broadly speaking, the overall market, the S&P did 16.6% a year for the 10 years ended 1999. So, I dissected the components that drive value, it’s a pretty simple formula. You have sales growth in dollar terms, any change in the share count, you have any expansion or contraction in the multiple earnings, you have any expansion or contraction in the profit margin, and you have the dividend yield, which is added to that. So, the first four are multiplicative series, the last is a plus whatever the dividend yield averages over that period. And what you had was just an enormous expansion, you had the initial multiple at 13 or 14 times earnings that ended at 23.6 times. So, of 80-plus per cent, you had the margin expand from 9, which would have been the upper bound of that mean-reverting series, wound up at 13.4%.
So, between those two series, you got over 6 percentage points of that 16.6 out of the multiple expansion and you got 4% of it out of the margin. Most investors that I’ve asked the question of, “How fast do you think sales for the S&P 500 have grown on average per year for the last decade or even the last two decades?” And usually, you get, “Well, I don’t know, it’s got to be 6%-7%.” No, it’s only 3%, you’ve had a 3% growth in sales. And because we’ve had repurchases now in place that have consumed massive amounts of corporate profitability, we’ve driven the share count down over that 10-year period by about 7%. But as you know, and something I’ve been very active and vocal about my entire career is the dilution that comes from giving away. I mentioned the big tech giveaways in the late ’90s and throughout the ’90s.
But on average, S&P 500 public companies give away 2% of their shares each year to executives and key insiders. That was done largely through stock options in the early iteration. We’ve kind of changed the rules and they’re less attractive now, and so we do more restricted stock shares, either performance shares or RSUs, but it’s still a 2% giveaway. Now, you’ve got companies to the extent they’re retaining earnings beyond what they pay in dividends, the dividend payout has averaged about 40% for the last decade. So, the 60% of profits that are retained are not going into R&D, they’re not going into growth CAPEX, they’re not going into expansion of the internal business, they’re going to buy back shares. To the extent we’ve loaded up the collective balance sheet with debt, we’ve actually spent more than dividends and retained earnings buying back shares.
So, leverage relative to capital, leverage relative to assets for corporate America is at an all-time high. We’ve done it to drive stock prices higher because if you’re a CEO is on the job for four or four and a half years and they’re getting a mountain of shares on the front end, their motivation often is to get the stock price up in the short term and not to think about 10- and 20- and 30-year investments you can make for the better the business. So, you had the share crowd during that 10-year period come in by about seven-tenths of 1% per year. So, you added up to 3% growth in sales, you add up those seven-tenths…and I had several questions from the letter and I tried to make it clear in the letter, I don’t think I did a very good job of it.
But that change in the share count…when I talk about all of these factors being multiplicative, if your sales are growing by 3% a year, that’s a positive growth. If it’s 30% over three years, it’s a positive attribution factor. When your share count goes up as it did in the decade that end in ’99, and I can jump forward to that, it’s not additive. If you owned 100% of a company and you increase your share count, you have a partner come in and the share count runs from 100 to 125, you now own 80% of the business. So, it’s not 25% growth that’s positive and added to the return, it’s a 20% dilution over whatever period of years.
If you’ve increased the share count like we did in the late ’90s, it’s dilutive to the owner even though it looks like it’s a positive. That’s way deep into the weeds on the math. So, I said, “Okay, 16.6.” So, here you are with stocks having had one of their best 10-year periods of all time, only rivaled really by the 10 years ended in 1999, then you have to ask, “What’s next?” You pull the typical investor, they’re going to mark that 16.6 return that they just earned for the last 10 years and that’s now the expectation of future return. You saw the exact same thing in the polls taken in the late 90s, people thought they were going to get 20%.
Meb: It’s true. You mentioned the polls in late ’90s. The polls over the last couple of years…who was it? Schroeder’s was one, we’ll put him in the show notes links because we tweeted them out. But as the market kept going up, the polls just kept going up and up and up and top ticked, I think, around the 17% rate recently. Like, you’re an expert witness, there’s a chance, but it’s an extremely slim one.
Chris: So, here we are, with a profit margin at 13.4, a multiple at the mid-20s to earnings and sales that have grown at three and hindered by too much debt, really. I mean, we’ve not grown real GDP per capita by much in the last 20 years. We peaked on that measure in 2000. Forget about inflation, we have high inflation now. And I think if you get durably high inflation, nominal sales number can grow. So, everything I’m going through here is in nominal terms and you could get an adjustment up, so you really ought to be thinking about it in real terms. Inflation hasn’t been much of a thing for the last 20-30 years, and so my mind still thinks in nominal terms. But regardless, whatever you think you’re going to get in sales growth, adjusted by any increase or decrease in the share count, recognizing that when we have recessions and downturns, the share count balloons.
We had the financial crisis and the banks had to recapitalize, and so the share count for that decade ended the period 2008 was just brutal because the share count was off the charts. You recapitalize the entire financial system, effectively. But you’ve really got to say, “Okay, now we’re here with the dividend yield that’s down to 1.3%, it’s almost as low as it was in March 2000.” So, sales growth of maybe 3%, 3.5%, offset by whatever the share cap, 1.3 on the dividend, you can get to 5% between those two measures, between top-line growth and the dividend that you’re going to get paid. And then you have to come back to the remaining two measures, and that’s the profit margin and that’s the multiple, and you’re starting at 13.4. I have a hard time believing we’re going to durably drive profits much higher than they are today.
So, we can talk about the five big companies that have really driven the margin high at the top end. But I would say you’re not going to get much more and I would say you’re not going to get much more than a mid-20s to earnings. Okay, interest rates being low, they’re going to rise this year until we cripple the economy and have a recession and then we’re going to be back at zero at a point. But I don’t think you’re going to get much out of those two measures. And if you do, then you’ve got to say, “Well, how high and how much? So, if you’re going to run a 3% sales growth, if you’re going to run it a skinny dividend yield to get to a 10% return, you’ve got to take the margin up to a high teens profit margin, or you’ve got to take the multiple north of mid-20s up to 30 or 31, or 32, to get to 10.
So, find me the chief investment officer of a pension fund endowment, find me the investment committee that oversees a family of mutual funds. And if you’re in that seat allocating capital and you’ve got a bunch of money invested in passive or in broadly diversified funds that are going to look and act like the duck that is the S&P 500, you’ve got to answer that question. It’s tough to get much higher. I would conjecture that we’re more likely to have a period like what you saw after the 10-year run-up where stocks peaked in March of 2000. But I ran…just to keep decades consistent, I ran that 10-year period ended 12/31/99, and you got a higher return, you had 18.2% return out of that decade but you had a very similar experience.
You had expansion in the multiple for 14 or 15 times doubled to 28 or 29, you had an expansion in the margin from mid-5s to 8 at that point, and you had sales growth in dollars that were higher but inflation was higher. I mean, sales growth and dollars were closer to six. But there again, to my point about the tech bubble, they hadn’t figured out the share repurchases, you were getting pretty diluted. The share count grew, using the divisor for the S&P, by about 25%. So, you have that 20% dilution that I talked about, so that shaved two percentage points from the return of the shareholder. But you got seven-plus points on the multiple expansion, you got four on the margin, put it all together on a sales per share basis when you adjusted for the dilution, you were the same, you were 3.5%.
So, even though you had higher inflation, sales per share, which is you adjust the share count for the dollar sales, you can eliminate one of those measures, and you got to 18.2. So, there you were almost at a bubble peak, things continued rising until March of that year, the S&P really didn’t fully start rolling over until September of 2000. But the decade that followed was abysmal. You had a loss of 10%, you lost almost 1% per year. And that’s not cherry-picking the market low and you can say, “Oh, well, you started off in January 1 of 2000.” You ran it through two big market downturns, you had the S&P 500 off 50% between 2000 and ’02, then it recovered back to 1500, then it fell, obviously, in the financial crisis down to 666.66, oddly and kind of eerily, at the market low in February of ’09.
But if you ran it through ’09, you were off by one. If you ran it through the end of ’08, you were off by more like three percentage points per year. So, you had contraction in the multiple, of course, from the high-20s to 20. You had contraction in the margin from 8 to 6 or 8 to 6.5, so you lost four-plus points to the multiple contraction, you lost almost three points to the margin contraction. You had good healthy sales and sales growth per share. You started off with a dividend yield that was 1.1% in March of 2000, again, on a very high payout rate, but again, prices were so high that the dividend yield and the earnings yield, earnings yield minus the dividend yield is retained earnings yield was so low, so you couldn’t have anything but a bad downturn. You had two nasty bear markets. By the end of ’09, which was a big recovery year, stocks were up a bunch.
Meb: The funny thing, though, if you talk to people…we did a tweet, it was all facts, it wasn’t even opinion, but we mentioned the dividend yield as being almost as low as 2000. Wasn’t quite there yet. I think you said, what, 1.1?
Chris: Actually, I think you are under 1%. I think you’ve got down to literally 0.9.
Meb: Okay, under one, we’ll use one. But man, did people get ornery about that? You got to put on your hat, your blinders, your clown hat, maybe those old school beer drinking hats with the tubes. And I said, “Chris, 10 years out, you have to come up with a scenario where not only a returns 5%, but they’re 10% for the next decade. What is that scenario? What has to happen for this thing to keep cranking for another 10 years? What could it be?” As remote as that might be, as a good analyst, you have to think about what’s the possibility. We used to joke that Elon Musk finds the moon is made of diamonds and there are wells of free energy. What could happen that actually is the opposite of what is most likely?
Chris: To my point on inflation, you’re running nine on the CPI right now. I’m in the camp that says we’re more likely to get long term deflation as we work off that over-levered credit stuff. You can’t have 400 balance sheet total credit market debt to GDP and expect a healthy economy. We’ve absolutely put the brakes on the ability to grow the real economy. But if we have durably high inflation or hyperinflation, I mean, hell, the Venezuelan stock market for the last few years has been the best performing stock market in the world. But holding inflation aside, you can adjust these numbers for whatever you think the inflation rate is, you have to expand beyond all-time high record profit margins or a very robust multiple to earnings. Most of the time, the market is pretty efficient when you have that somewhat of a mean-reverting series.
And there is a mean-reverting aspect to capital and there is a mean-reverting aspect of margins, you would drive it higher because of the nature of the capital-light businesses that exist today. But if we have high inflation, we’re going to reset a lot of interest burden at a higher level. Still an awful lot of commercial paper, there’s an awful lot of borrow short, lend long structure out there, a lot of financing at the very short end of the curve. Japan, again, unlimited amounts of treasuries but there’s a lot of leverage and the system is financed at the short end of the Japanese curve. Between here and there, if we have persistent inflation for a few years and the Fed executes on a massive program of raising interest rates, their intent is to do so pretty heavy.
Bullard just came out, our St. Louis Fed head here yesterday, I think, and said, “Now we’re talking about conceivably 75 basis points on the pot.” At a point, the Feds got a perfect record of blowing up bubbles. They did it in ’29, they did it in the late ’60s, they did it in 2000. We’re trending toward that, especially if they shrink the balance sheet like they tried to do from 2016 to ’18. So, put all that aside, to get more than a mid-single-digit durable return over, let’s say, a 10-year period, you got to have margin or multiple expansion under on that from an overall stock market standpoint. And if again, you’re chairing the Investment Committee, you’re responsible for capital, and you can’t answer the question as to why profit margin should move higher…
Now, I would say if you look at the market through the lens of the amazing evolution of these big five companies that sit atop the market now. So, I then wanted to apply how much of that 16.6% return came from the big five companies at the top of the market, Apple, Microsoft, Google, Facebook, and Amazon. You had that group that was about 8.5% of the market at the outset that finished at almost 25% over the course of a 10-year period of time. Microsoft and Apple were already big players, Google and Amazon and Facebook were not very big yet. But the total return of those five stocks was almost 30%, I think it was 29.8%.
And you roll through the attribution of each, you got what you expected in terms of multiple expansion. You multiple, the stocks were cheap for the majority of the last 20 years or 10 years. Microsoft was cheap, Apple was cheap, Mr. Buffett got his big Apple position, got $36 billion into it at 12 times earnings. I got my basis into Microsoft, having sold it three or four years ago too soon, at 10 times earnings. So, with that collective group, you had a multiple expansion from mid-teens, 14 and change. But after 33, you’ve had just enormous growth in the business, assuming sales were a little over 100 billion, they’re pushing 400 billion now, they’ve bought back something like 40% of their shares outstanding, just generating mountains of cash.
But the stock trading from 11 to 30, margins didn’t really budge, they were mid-20s 10 years ago, they’re mid-20s today, but where you had growth in sales of 17% a year, sales were up 200%, they grew 3X in dollars, you’ve got a law of large numbers now. You cannot repeat sales growth for an Apple to the extent…and I don’t think you can get the same sales growth out of that group of five. So, for the Fab Five, for these big five companies, you had a 10% return out of the multiple expansion. The real driver was sales growth, 18% of your annual return came from what was almost 400% cumulative growth in sales and dollars. You can go through them one by one, you’re starting at very robust now levels of profitability, you’re starting at a very high multiple, and you don’t have that price margin of safety. And whether it comes from competition with each other, outside competition, regulation, simply your end of product cycle, who knows what it is? But you’re not going to get the same sales growth.
You take an Amazon. Amazon was a smallish business, they were doing $50 billion in sales, now they’re doing $500 billion in sales. So, labor-to-revenue is by 10X over the decade. They really weren’t making any money, they had a margin of maybe 1%, 1.5% on the outside, now it’s 5%. I’m operating under the assumption that the margin there will probably be 10, based on the mix of AWS and their first-party and their third-party marketing, so perhaps doubling from where it is. But the stock trading at 70 times and now it’s a mature business. So, you’ve got 70 multiple, you’ve got a margin that’s likely to double, and I would say in that case, as that business evolves over the next 10 years, as you get ongoing continued growth, it is not going to trade at 70 times earnings. As the margin grows into its mature margin structure, the multiple is going to come back. And so, if you double the margin but cut the multiple in half from 70 to 35 or lower and probably terminally much lower, you have a lot of headwinds in that group.
Meb: What do you mean 30? What about 50? Come on, Chris, you’re being so despondent and bearish. I’m looking for 50. There’s an old great post we’ll link to in the show notes for listeners by our friend, Wes Gray at Alpha Architect, called, “Even God would get fired as an active investor,” that just shows even if you had the perfect portfolio, you even did it long/short, you still experienced these nauseating drawdowns and volatility and everything else. But we’re set up for nothing good, probably, less than average. What’s your estimate? So, it’s not 50%, what do you think the broad market does? Vogle would call this forecasting, but let’s just call it expectations. I’m all about with my wife and everyone I know, “Set a low bar so we can exceed it.” What do you think broad U.S. stock market does next, take your pick, 5-10 years?
Chris: Let’s do 10 just because I’ve been playing with decades here in the work I did at year-end. I would say if inflation average is two, you’ll get five, best case. And with iterations of market drawdowns not unlike we had from 2000 to ’02 and ’08-’09. So, where are you in precisely 10 years from today? I don’t know, but you’re going to have periods where the return is negative, it’s negative today by whatever, 8%-9%, it stands to be negative.
Meb: You’re the optimist on this call. I tell you, it depends if you’re a New Yorker, I don’t know who eats the most doughnuts. I was going to say bagel or a doughnut. In LA, what would we be having? I don’t even know what a good analogy would be. But zero, I’m going zero real is my expectation. But somewhere between you the optimist and me the pessimist, it’s certainly not 50. That’s my guess.
Chris: No, that’s my high side. I think you layer in some margin contraction, so you run back to 9 or 10 from 13.4. I thought we traded at the peak in the third quarter of 2018. Here we are running record profits but a lot of that is just a pull-forward of demand from the pandemic and the low-interest burden and companies have learned to live with less labor for the moment. But inflation is going to take a wicked hammer to corporate profitability. If it persists for another 12 months or 18 months, you’re going to see much, much lower levels of profitability. I’m the under on a 13.4 profit margin and I’m absolutely an under on a 24 multiple to peak earnings. So, you dial those back and it easily get to zero.
Meb: It’s funny because most people would hear that and say, “Okay, Meb, Chris, you guys are bearish, you think the sky is falling.” But you’re talking to two people who run…my largest fund is a long-only U.S. equity fund, you, for the most part, are long-only U.S. equity for the most part. You finding opportunity, though, it sounds like. Tell me what looks good to you today.
Chris: Oddly, quite a bit. I’m doing a lot of buying with cash flows and cash on hand and deposits. We’ve got new clients coming in the door. I’ve got a portfolio trading a little over 12 times, so half the market multiple, largely unlevered balance sheets. So, for that, we’ve got returns on capital of the businesses that we own, which are very lightly levered. Our return on equity of our portfolio holdings is almost the same as the return on capital. That’s how averse we are to debt in the capital structure. Things are cheap. As you know, Berkshire, with a meeting coming up next week, sits at the top of the portfolio. It was trading at 13 to earnings and change as I jumped through all of my earnings assumptions. And Mr. Buffett just takes it on the chin from the media and the naysayers, you’ve seen charts that always underperformed for 20 years.
So, I just ran…with the stock up 17% this year and 29% last year, I ran my forward and backward CAGR, so updated through the end of the quarter. And just for all of the Bluebirds and Berkshire Hathaway land, Berkshire’s stock has now outperformed the S&P…I’m updating the quarter, I haven’t run exactly four quarters, but I’ve got my annual numbers for each year back over the last 23 years. Berkshire is now ahead for one year because we’re up 17 and the market is down, so the S&P was down 4.6% for the quarter. It’s down more than that today. Berkshire was up 29.6% Last year, so it beat the market by a point or two. So, the one year is now ahead. The two-year is now ahead. The 6th year is ahead, the 7th, 8th, 9th, 10th are ahead of the S&P 500. The 12 years ahead, and everything from 15 years on going backwards is ahead. And it’s still cheap.
Meb: Which is amazing because the S&P hasn’t really reverted. It’s still near all-time highs.
Chris: Berkshire should beat the market by 3% to 5%, I would guess, per year from year-end. One of Mr. Buffett’s big critics and I won’t name names, but I offered up a bet on Twitter bracketed by whatever the guy wanted to take, anywhere from a steak dinner, a nice bottle of Bordeaux, up to a two comma that, and I didn’t get a response on it. My wife was not thrilled when I made that in the public forum but I could structure it like Ted Seides, Berkshire would have to be the pony. I mean, you have to just agree, we’re just going to put our money in Berkshire in an escrow account and run it at a 10% discount rate. And so, put up a little over a third of the money, 40% of the money.
Meb: This is going to depress you because I did a tweet because I love to do tweet polls, and they always trigger me because I already know the answer and what it’s going to be but I hold out hope. But I said, “What stretch of underperformance by a portfolio manager would you be willing to tolerate before selling the allocation?” Over half said less than three years, which is just everything wrong in our world. Another third said three to six years. And the example I gave was this Berkshire situation but I said, “Look, he’s crushed the market by plenty forever.”
But in this example I wrote, which was a year or two ago, I said, “There’s periods where he underperformed on a year over year basis,” just looking at years 11 out of 17 years, which if you go back, there’s a bunch of Vanguard research on active managers, if you outperform, all of us go through periods where it’s multiple years in a row or periods where it underperformed. That’s just the noise and the statistics. And I was like, “You can single-handedly buy Berkshire or buy the stocks and beat 98%-99% of mutual funds,” but the disconnect is this fact that people were unwilling to hold something even a couple of years when it’s underperforming, which is the entire price of admission. That’s the whole point is you have to sustain these periods and which is why I drive so much bad behavior on and on. Anyway, end of rant.
Chris: No, you’re spot on. From a personal standpoint, we had navigated that bear market in 2000 to ’02 well, I mentioned we’ve made something like 30% and lost almost as much as the market in ’02. So, the first two years now we made just a bunch of money in 2001, the S&P fell by half and we made money. In ’08, we were down by half as the market declined, 20 against 40. Beat the market in ’09, ’10 was behind by a couple of points, and then ’11, we were up like seven against two.
So, at the end of ’11, you would have said we were genius because our one-year, two-year, three-year, four-year, five-year when we’re so far ahead of the market, our compound return at that point was 11.8% on our stocks. No cash, we have clients that have different cash levels. But our stocks had averaged 11.8 and the market had done something like 1.8% or 1.9%. We then had a four-year period starting in 2012, ’12, ’13, ’14, we averaged about 10 but the S&P was doing 22% a year for that three years.
And so, all of a sudden, even some of my long-standing clients were wondering, “What’s going on? This is three years, this is kind of crazy.” They said, “Are you losing your touch?” And then in 2015, the fourth year in a row, we were down 10, Berkshire, my largest holding was down 12, and I really had some restless natives. People were genuinely concerned that we didn’t know what we were doing, that Berkshire didn’t know what they were doing, that Mr. Buffett had lost it.
And yet, at the end of that, what was now a 16-year period, we’d still crushed the market by a whole bunch, but that four years was trailing badly. And then because we were down that 10, we’ve made 4%, let’s call it, on average for four years when the market did like 15%. That was when I wrote up Berkshire for the first time because I wanted our clients to see how we analyze the business beyond talking to them just generally about valuations and I wanted them to see the thought that went into how we analyze the companies that we own.
So, I wrote it up and went through all the valuation yardsticks and some of the parts and all the ways that I get to what I think the business is worth. And a friend of mine, Joe Pastor, convinced me to put the letter out in the public sphere. We decided at that point, we’d love to raise some institutional money, we were never in the databases. We wound up doing our GIPS composites, took several years to do it. But our portfolio was absolutely being given away, Berkshire was absolutely nearly as cheap at the end of ’15 as it had been in a long time.
And since then, the letter is out and we’ve gotten some notoriety for it. We’re so far ahead of the market. Even at the end of last year, we were up…I don’t know, stocks were up 25%, 26%, 27%, so we were a couple of points behind the S&P. A couple of guys on Twitter had just said, you know, we were idiots, just terrible money managers. So, if you like my whole return history, we’ve now made about 12% a year on our stocks. Our stocks have done 12.2, the S&P’s average 7.8.
Even if you throw in what’s been probably 15% cash, say I’ve got foundation accounts that are given away money 5% every year, we’re still two points ahead even with all the cash in the portfolio and net of fees of the market. But endpoint, sensitivity matters. The reason I was willing to go throw up those Berkshire numbers is they’ve just crushed it in the last one or two years. But if you take a year when you’re way behind or two years when you’re way behind, it’s going to make some durable portion of your backwards-looking returns look pretty poor.
So, my 10-year was no good, my 12-year was no good, 5 and 6, that was fine because after ’15, we had beat the market by a bunch. Berkshire started recovering and outperforming again, but they look really bad for 10 years. We’re up 12% for the year or something like that, or 11% for the year that market is down, Berkshire is up 17. I’ve got some energy stocks that have really moved things ahead and are still very cheap.
Meb: I was going to make you sing your intro, the brown sugar rendition you have and put that as your Christmas karaoke intro to the episode. Listeners, to get the joke, you got to download his letter. But energy is a fun example and you can talk about the thesis there but tying a bow on what we’re just talking about, so many investors…and you and I were joking about CalPERS leading into this. And so, I’m not just talking about retail, this is equally as important for institutions.
And we see this all the time and all the academic research shows that many of the people heading up a lot of these institutions are as bad, if not worse, at this process, which is chasing managers, piling in after they’ve had a hot return, and then selling them after they do poorly. And one of my favorite things I tell investors over and over that they hate to hear, I’m like, “Look, if you’re going to allocate to an active manager, could be quant, could be discretionary, or an asset class or anything, like, 10 years to me is the minimum to even get any statistical interesting output.”
And honestly, in many cases, it’s actually only going to be evident in the fullness of even longer than that, 15 years, perhaps even 20. And then no one wants to believe that, they want the Robinhood returns now, they want them to be certain, and that’s just not how any of this works, in my opinion. So, a lot of the market-beating returns is being in the investments when they’re out of favor as well and that’s a hard part. And energy. I think it may have been one of my favorite examples of my career, but even the last decade, when it ticked, what, like 2% of the S&P or something a couple of years ago? Just astonishing.
Chris: Less, just north of 1%, maybe 1.5% in October of 2020.
Meb: All right, take your pick. You can take this in any direction you want in your portfolio. We’re on the topic of Berkshire, or we can talk about energy or anything else. Any of these other gems you got hiding in there?
Chris: Energy is so fascinating today, broadly speaking. I’ve got the brown sugar section, which is energy, it was also a tribute to Charlie Watts who had passed away. I’ve been a Stones fan since I was knee-high to a grasshopper, my absolute favorite band of all time. Even though the oldest, he was not the first I thought would pass but we lost Charlie last year, so I want to do something with a tribute to the Stones. We have seen in energy and in some of its peripheral industries, so I’ve got a big holding in Olin, which is a commodity chemical company here.
Meb: Disclosure, we own it too, listeners, but keep going.
Chris: The capital cycle just creates enormous wealth and then it destroys it. You have a period where things are washed out and nobody’s making any money, capital disappears from the space, you go through restructurings, the creditors become the equity owners, it’s hard to form capital, nobody wants to build, expand, and all of a sudden, you get a shortage. And then somebody starts making money and that draws more capital and more capital and then you overbill.
The chemical industries are famous for doing that. We earlier in the conversation talked about the period leading up to 2015 when Chevron and Exxon were spending $40 billion on exploration and CAPEX and today, they’re spending half that. You’ve got a discipline now in place and you’ve got a scarcity in place that’s really, in my mind, being driven by ESG, being driven by the European greens toward essentially eliminating fossil fuels. I think there’s a not small corner of the world that thinks we can do that and we cannot do that.
But rightly, we are doing what we had started doing under the Carter administration that we should have done more, and that is figure out a way to get cheaper wind and cheaper solar and to do it in scale. Now we’re doing it on massive scale, Berkshire Hathaway’s three utility operations, MidAmerican, PacifiCorp, and Nevada Power have 50% of their electrical output is now originated by wind, solar hydro, some geothermal, way ahead of anybody else in the field.
But we’re creating scarcities by making the notion of exploring for oil and refining it. A dirty concept and Europe has led on this front. We’re seeing divestitures of invested capital, we’re seeing divestitures of refineries. We’ve seen the number of refineries in Europe over the last 20-30 years cut by 40%, the productive capacity of their refineries cut. I mean, in the United States, we’ve gone from 250, let’s call it, down to about 127 refineries.
But in the U.S., we’ve at least taken the remaining refinery stock and added capacity over the last 30 years commensurate with population growth. You can’t not have refined crude. When you think about what happens to a barrel of unrefined oil, of course, we make gasoline, almost 50% of which gets refined as gas. So, we still have an enormous isolate. We can talk about the rate at which we’ll have EV penetration. It’s going to be way longer than people think and I’m not sure we even have the resources to do it.
Meb: I don’t know, man. We’re doing this during Tesla’s call, I’m sure their projections are happening as we speak.
Chris: The ARK got them doing 20 million vehicles, I think, in five years and it would be matching Volkswagen and Toyota has combined market share, which is pretty spectacular. In any event, we’re not going to build another refinery in this country. We’re not going to build another refinery in Europe. And not only that…so I own Holly Frontier and Valero. We bought them for the first time in March of 2004 of what amounted to between one and two times kind of normalized mid-cycle cash flow. Nobody wanted to own these assets.
And what’s happened, even in both those cases…and they’re both low-cost refiners for different reasons. Holly, which just acquired Sinclair, so now they’ve got some downstream operations, which is great, it gives them some diversity. But their core refineries are inland refineries, proximity to places like Cushing. So, they have very low-cost supply of light, sweet crude pipeline system to have delivery, they’re marketing in the West, which is a growing region.
But even there, two of the refineries just converted Cheyenne to renewable diesel, they’re converting portion of their New Mexico properties to renewable. Valero is doing the same thing. California is phasing out the ability for Class A tractor to run on conventional diesel. So, now we have this renewable diesel, which is essentially taking agricultural byproducts and running it through a unique refinery that creates the chemical equivalent, if you will, of regular diesel fuel. Runs the same, does not wear on the engine any differently, it gives you the same output.
But unlike a conventional refiner that makes kerosene and gasoline and all of the distillate, so diesel, jet fuel, asphalt, all the feedstocks for the chemical industry, propylene, ethylene, all of that. Tar, waxes, lubricants, everything we use and everything we need comes from refined oil, so you’re not going to have it…but now we have a scarcity. So, here we are today, with a very high oil price. Even prior to the Russian invasion of Ukraine, we were pushing $90 on oil and we’ve got shortages.
So, usually, if you’re a refiner…and I guess we’ve gone down the path of refineries, if you’re a refiner and you have a very rapidly rising front end feedstock cost, if the price of an unrefined barrel of oil rises rapidly, typically, the prices of your end product, finished goods, or just the various asphalt that comes out, the various distillate that come out, typically, those don’t rise as fast in price. And so, a refiner typically has compressed margins spreads and refining is a spread business, price you pay for your feedstock versus the price at which you can refine and sell your end product for.
That’s not the case, we have a shortage on the back end because we’ve closed three refineries in California. California is like Germany, they’ve lost their absolute minds on the energy front, they think we can actually not have energy or at least we’re not going to make it in their state. So, all of this refined diesel is flowing into California but it’s shrinking the refining capacity of everything else we need as a society and we’re not going to build it. It’s just absolutely insane.
And so, last year, Holly bought a refinery from Shell because the European majors are dumping assets because they’ve got a gun to their head from a policy perspective to shed their dirtiest of assets. Nobody in Europe wants to own a refinery. So, they sold their Puget Sound Refinery, which is in Anacortes, Washington, halfway between Seattle and Vancouver, to Holly Frontier for about $550 million dollars.
But when you net out the inventory, both the unrefined crude and all of the finished product that sits in their various storage facilities in their pipelines, when you net it out, they paid $350 million for an asset that averages about $250 million in cash flow per year. So, not much more than one-time cash flow.
Breakevens are not very long when you’re paying one-time cash flow and now you own a scarce asset and now you’ve got proximity to bring in unrefined crude from Canada by rail and also by ship and take care of the California marketplace, which has lost its mind. You’ve got those scarcities across energy…Olin is a special case, which I’d be happy to drill into if you want to a little bit since you own it as well.
Meb: We own Valero too and it’s interesting because it feels like an entire decade of narrative in just the last two months and has had a massive shift. It’ll be curious to me to see the repercussions on how policies do or don’t change, there certainly seems to be a shift on nuclear but the European continent is certainly feeling a lot of the effects of what’s going on and who knows how this is all going to play out, eventually. But I had to ask you, did Rockefeller end up investing, because they didn’t like your energy focus? Did you, like, respond to them this year and been like, “So, do you want to revisit?”
Chris: Maybe I should figure it out and call her back. You can read about it in Jim’s thing but I had a call from Rockefeller Foundation, curious about investing perhaps with us. But the mandate would have been that we would have had to sell all of our energy investments, simply not only for their portfolio but across the board. And I thought, “Geez, won’t you guys the old Standard Oil? This is kind of a crazy ask.” But I tell you, we have some folks that are very climate-sensitive, very interested, I think, in hiring us.
They would have been the last group on the planet I ever would have thought would be interested in hiring us, but they thought the comments and grants and they thought my letter was interesting. And these are really kind of diehard for years and years, they said, “No fossil fuel, no fossil fuel.” And I think perhaps for my letter and some of the conversations, they’ve realized that we need to do all this thing in harmony and in concert.
And yes, we’re going to go down the path of more renewables and we should, but you’ve got to do it in a way that’s still helpful to the citizenry in the planet. I mean, you can’t create scarcities that drive the price up of trying to live. If you’re Germany, you can’t go from 17 nuclear plants to 3 at the moment. They closed three on January, one they’re supposed to close and another three, we’ll see.
But the political machine there, Schroeder was, I believe on the Gazprom board. Politicians going to office poor as dirt and they come out rich as titans, and we have to stop that. So, we still have political motivation. It’ll be interesting. What’s happened is we’ve exposed how absolutely reliant upon Russia Europe and particularly Germany is, it’ll be interesting what happens with the second Gazprom, the Nord Stream 2 pipeline, which was gas ready to go, a lot of politics involved.
We’ve got politics with some of our leadership and some of the folks in the energy patch and Ukraine. Who knows why we go to war and who knows why we do what we do, but there was a lot of pushback on essentially doubling the capacity of gas that flows out of Russia into Europe bypassing Ukraine and Poland. Ukraine gets a tax of about $3 billion a year where if you run gas directly under the Baltic into Germany, they’re not collecting that tax on that toll.
But they’ve spent something like $10 billion, they being the Germans, closing their nuclear capacity and nuclear is the most efficient source of power on the planet. It’s stunning to me that as we transition to renewables, where you have to create and build so much more productive capacity with wind and solar because they’re intermittent sources of power. The wind does not blow and the sun does not shine 24 hours a day. When the sun is in the southern hemisphere and you’re in northern Germany, what are you doing with solar? I mean, that’s just crazy.
And the cost of replacing all of our coal, all of our natural gas, which you can’t do, with going to a wind and solar and hydro grid but not have nuclear, it doesn’t work. The cost of replacing just our fossil fuel or just replacing coal is something like $4 to $8 trillion just in the U.S., you run that at a factor of six to try to do it worldwide and you can’t do it. The replacement of wind and solar against a nuclear plant, for example, you’ve got to have four the…let’s call it, at least double, if not four extra productive capacity, again, because it’s an intermittent source of power.
And because the grid has to be constantly fired, you either have to have industrial-scale battery backup, which we do not yet have, or you’ve got to have not only a peat- or natural gas-fired plant that can plan for seasonally periods where you need power where you know you’re not going to get it from the sun. But on days when it’s too cloudy, you have to have constantly fired grid, and so you need natural gas always on hand under every single solar and gas field.
And I’ve got a section on how carbon-intensive it is to build solar panels and to build the big industrial wind turbine, both on and offshore, and how much steel and how much cement and how much quartz and all of your mined minerals go into that and where those exist and how dirty they are. Ninety per cent of our solar panels are built in China because you can’t do it without running coal, you need the heat. You’ve got to have rare earth metals.
And so, the Greens have totally lost their minds and they’re pushing us down the path and I think maybe they’d be okay if we go back to horse and buggies. But if you want to actually live and fly and drive and do it in a reasonably quick period of time but not do it so fast that you create dangerous scarcities, then there’s a middle ground. And for that, Valero and Holly are good corporate citizens. Berkshire is the best corporate citizen. Exton, again, they lead on the renewable front and they’re getting paid for it.
I mean, you wouldn’t do it if you weren’t going to get paid for it. So, getting enormous tax credits to build out wind, they’re going to build a lot more wind through 2024. In Olin’s world, again, you can’t not have the two components that come out of the chloralkali process. You’ve got chlorine and caustic soda on both sides of the molecule, Olin is the lowest cost on both sides, they’re vertically integrated.
When they picked up a bunch of assets from Dow when Dow and DuPont merged six or seven years ago, they loaded up…the balance sheet was in debt, but they got the epoxy business, they got the vinyl’s business. So, they’re vertically integrated. And so, everything from pulp and paper on the caustic soda side of the equation to paints and marine coatings on the epoxy side. Wind turbines are going to have epoxy at the interior part of a wind blade. You’ve got carbon fiber because it’s lighter on the outside of the blade.
You want purified water, you want bleaches, you got to have all of these commodity chemicals and Olin and their competitors, Westlake, Huntsman, are not building more capacity. These competitors are not going to build more capacity. They’ve played the commodity cycle too long that they don’t want to go through another downturn where you jeopardize the health of the corporate balance sheet and the durability of ownership.
So, they’ve been collectively taking their lowest margin product off the market and closing supply even in a hard market where prices are recovered. So, when Olin traded down to 10 bucks a share on 160 million shares outstanding, our base centered is in the low teens. So, I was paying a market cap of $2 billion for a company that this year is doing over $2.6 billion in EBITDA and will do so durably.
So, the stock is now trading at $60 this morning so we’ve made a big gain, but I’m buying Olin at a few points below where we are today because I think a portion…and I hate to say it and I’ll be on the record for time immemorial, but a portion of the capital cycle has been repealed because we generally have capacity constraints in place and we have some level of rationality. So, they’ve cleaned up the balance sheet, they’ve paid down a billion and a half of their debt, and they’re just minting money.
At the current bid on their current share repurchase, if they reauthorize it every year, they can take the company private at four to five years. The stocks are that cheap but still trading at such a low price. Again, a rationality in places that you have not seen rationalities. You can very much apply that to different pockets in the energy world. The luxury that we have is a lot of people don’t want to own this stuff. The university endowments, sovereign wealth funds, if they’re going to force big institutions to sell their energy holdings, great. I mean, bring them on.
Meb: Music to my ears. Chris, we’ve held you for a long time but I can’t let you go without at least talking about Berkshire, the meeting is coming up. You mentioned they’re having a nice fat run. Listeners, download Chris’s letter to get a really deep dive on all things Berkshire, but a couple of quick questions on it. These guys are about to crossover into the hundo club in age. Charlie just doing laps with everyone and his recent trading at “The Daily Journal” has been, still at his spry old age, causing waves everywhere. Give me a fair value. Berkshire is having a big year, what do you think the stock should be at? And then I want to get to a harder question for you, which is circling back to the beginning of the discussion. when would you ever sell it? What would be the criteria for you to kick this sucker out of your portfolio?
Chris: Broadly speaking…and you’ve read my letter, so I use a some of the parts analysis where I value each of the main sectors in the business, the utility operation, the railroad, the manufacturing service, retail, and what’s now finance business, a few assets to the holding company, and then the juggernaut, which is the insurance operation. Run that number, I run an income statement adjusted, GAAP adjusted financials for a lot of accounting hoops you’ve got to jump through to normalize the profitability of the business, and then the more conventional price-to-book and the ol’ Mr. Buffett’s two-prong valuation method. If you kind of put them all together, fair values, a little over $900 billion market value, which makes the math easy on the A shares, you’re just over 600,000, and on the B shares, just over 400. I hate it when it’s between…you got to do that difference on the 1,500 share differential.
Easy math when it’s 900 billion, 600,000 and 400 bucks a share, a little bit north of those numbers. On valuation, we’re probably going to shake out similar to what you’re going to wind up seeing on the repurchase front, having bought back something like $60 billion in Berkshire shares over the last two and a half, three years, $27 and $24 billion per year. As the stock has run up late last year and early this year, you see the cadence of repurchases slowing, you’re trading at about 150% of book value, a little under 150% of book value now, which is as expensive as the stock has been over the last year and a half. I think it’s worth more but again, it’s opportunity cost.
So, whether it be in the separate portfolio or whether it’s Mr. Buffett sitting in the captain’s chair and thinking about how to allocate Berkshire’s $28-$29 billion in cash coming in the door each year, Berkshire at the present bid relative to the acquisition offer they just made for Allegheny at 11.6 billion, relative to the 8 billion they just added to the Oxy position, now in common where they had the preferred position. I think if you ran what you can earn on Berkshire shares at the current bid versus those two deals against repurchasing the stock, then those were better deals. So, that’s the place for $20 billion. They’ll continue the pace at which they’re spending CAPEX in the energy operation in particular since they’ve owned MidAmerican and then the other utilities and distribution assets here in the UK and in Canada. They’re spending $2 in CAPEX for every dollar in depreciation and that cadence won’t slow anytime soon.
The wind build-out on some of that has run its course, they’ve been very heavy. The state of Iowa now has more of its power produced by wind versus any other state in the country, and that’s Berkshire MidAmerican leading there, they’re spending a lot in the Northwest with PacifiCorp. The solar investments are going to come for tax policy starting after about 2024. Unless they change the tax incentives, solar is going to be more favorable in a couple of years. So, Berkshire has really been focusing on the wind side of that equation.
But that’s the ability to retain $4 billion in profit and lever it up with $4 billion in debt, which is kind of how utilities are appropriately structured, kind of even mixed between equity and debt capital, there’s a lot of growth CAPEX there. So, if you’re Mr. Buffett, you’ve got to figure out what to do with $25 to $30 billion per year without eating into the cash in the business. They’re out of the game of trying to elephant hunt for the time being, control positions in big businesses. Nobody is going to sell their company to Berkshire today at a price that makes sense to Berkshire. Private equity will pay far richer sums because they’re not trying to own assets for 30 years, they’re trying to arbitrage multiples, and d what private equity does.
Venture cap, I think it’s going to get re-rated pretty spectacularly thanks to declines and things like the ARK portfolio and the level of valuation trenches, I think some of your investors in venture cap are in for a surprise. So, I’ve got a foundation that gives away 5% of their capital. And earlier, just a couple of months ago, we gave away some Berkshire shares on a tax-advantaged basis. It was at the point where it had run up in size and there’s an account that wants to limit the Berkshire position itself and because Berkshire does pay a dividend and it earns at least 10 on equity…probably more when you objectively account for the stock portfolio more appropriately, Berkshire really earns more than the 10 that I conservatively get to in my letter. So, I have trimmed it back but I’m actively buying it.
Meb: Let me give you a scenario. This is the price based scenario. All right, value has its moment, like, plenty of us are expecting it too, the expensive stuff continues to get whacked like it has been, the cheap stuff continues to do well like it has been. We have a similar situation where you have a flight to quality. And so, Berkshire goes from where it is called a price book 1.5 or whatever, let’s say it goes up to 750k a share. Is that a sell point? Or $1 million? Because those are totally within the realm of possibility this cycle alone just from this value trade. Berkshire has traded at these multiples before, sometimes not really since the ’90s but certainly, there’s been periods where it’s hit around 200 price-to-book as an example. But 750, a million, what would cause you to clean house on the entire position?
Chris: A 750, very near term time horizon-wise, it will be a smaller position in the separate portfolio. At a million in the very near term, it would be a much smaller position. But I’ve got different constituents as clients and a much more readily willing to shrink and overvalued or even a fairly valued Berkshire in a non-taxable setting than I am in a taxable setting. Taxable investors, as long as we don’t get a change in the tax code, you’re always looking for the basis step-up at death and … lens through which to think about things.
Meb: Simple answers, Chris, we just got to get you to launch an ETF. There we go.
Chris: It’s on the table for tax reasons. It’s on the table.
Meb: S-T-A-N, we could do that ticker T-U-L-P, Tulip.
Chris: Yeah, we can do the tulip thing.
Meb: As the MPR. I’ll start reserving some of these for you.
Chris: There are those on Twitter that would maybe want it to be FOOL, F-O-O-L, JERK, J-E-R-K.
Meb: This is what I tell people and it’s the beauty of being a public fund manager, we get all the haters on Twitter and elsewhere. And I love them, I embrace them because I say, “You know what? Do you think I’m an idiot?” We have 12 funds, so something is always not working. People love to post charts over whatever period and say, “Look how much you really are,” and I just love to say, “I hope you were short, please short my funds because it increases the volume and liquidity and I’m totally happy if you think I’m an idiot that you should short all my funds. Because I’m on the other side of that trade, and God bless you if you make money from it and you get to play it out.”
See, you can’t short a lot of the hedge fund managers out there, you can’t short certain mutual funds. ETFs, you can. So, that’s the beauty. I’ll take it. All right, we got to do like two more questions and then wrap this up. This has been a blast. This is going to take the record for longest conversation but also one of my very favorites. Outside of the price target, what would cause you to sell Berkshire? To me, I’m trying to think of anything and it’s a tough argument because a lot of the criteria, but as an analyst, you got to think about these sorts of things, PM, what would cause that to be a sell for you?
Chris: From an operational standpoint, there have been some businesses bought in the manufacturing service retail group where prices paid were so sufficiently high and you didn’t have any growth margin of safety in those businesses, that you really began to wonder whether the acquisition machine of buying control positions in large businesses…Precision Castparts being a great case in point. I own a little bit of Precision, had bought it at a lower price, would not have paid the price that Mr. Buffett paid for it. And the energy rule had rolled over, so you knew the turbine business was already in trouble. You would not have predicted what was going to happen with aircraft manufacturer and that side of Precision’s business but…and I’ve gone back and forth.
But I’ve highlighted in my letter, there was, for a long period, really, back to 20-plus years ago, an aggregated balance sheet and income statement summary of both for that group, you had seen a decline in the return on unlevered equity of that group down to about 6.5% a few years ago. The Precision deal coming in was almost too much. There were some businesses that really would be candidates for leverage and for private equity and doing some things. But the Berkshire method is typically to try to let things work out and if they become small enough to we’re the rounding errors, you try to keep people on the books and on board, you’re not rash with shedding assets.
The good news is, I think, with an acknowledgement that at 90, now 91 years old, Mr. Buffett didn’t have the energy to do everything he had done. So, the most logical thing they did three years ago was bring and elevate Greg and Ajit to effectively be co-operational heads of the business. And so, Greg has spent an enormous amount of time now outside of MidAmerican, but getting his arms around all of the operating subs. And you can see the post-pandemic last year, a real improvement in the two and three-year progression of profitability. Part of it is I got my balance sheet to finally reconcile to a number or I got a pretty good sense of where the equity than most of the subs within Berkshire are. But they’ve made some operational improvements and it’s not just the $10.5 billion write-down of Precision, but those businesses are operating at a better level.
If you’re an old guy and you sold your business to Mr. Buffett, it was a lot of fun to be able to report to him back when he was flying down to Augusta. He’d fly down to St. Louis and pick up Gene Toombs and they’d go play at Augusta National. Gene sold MiTek here in St. Louis to him. But at a point, some of these guys really didn’t have the energy to run the businesses and I worried that there was not a lot of good succession planning underneath. I think enough time has passed and Mr. Buffett’s no longer in the day to day that that’s as much of an issue. The culture of the place, what happens post- Buffett is important. I spend time with a proxy statement and you’ve got these “Looney Tunes” four proxy proposals this year. The news has been CalPERS is now going to vote for separation of the chairmanship and the CEO role. That makes sense in perhaps most businesses, but give me a break.
It’s a gadfly that’s done this thing. In fact, I wrote this down in case we got to it. The National Legal and Policy Center. This guy’s kind of an anti-corruption activist dude and they think we should separate the role and Mr. Buffett should not be both chairman and CEO. So, find, from a governance standpoint…we talk about ESG, find a business that’s been non-abusive to the shareholder that treats all of its constituents better than Berkshire Hathaway. Zero stock options, zero restricted shares, no history of write-offs and write-downs other than this recent 10 billion Precision and other little knickknacks here and there, the treatment of the employees. It’s the model of how to govern and run a place and the guy that’s run it since 1965, his primary concern, now that he’s stepped aside from the day to day operational role, really is preserving the culture of Berkshire. That’s his role. And as long as he’s lucid and functioning, the longer he sits in both chairs, find a better company on the governance front. I mean, that’s just insane.
Meb: The huge irony of this is, obviously, CalPERS talking about governance, it’s like the most preposterous situation. Longtime listeners know that I humorously applied for the new CalPERS CIO job and they refused to interview me probably because of me continually poking them on Twitter. But I promised them that I would fire everyone and invest in a basket of ETFs that will likely beat their portfolio and save hundreds of millions of dollars in fees and political headache and drama. And they said, “Sorry, Mr. Faber, you will not be interviewed for this role.”
Chris: Well, that’s not it. The reason you didn’t get the job, you’re not a card-carrying member of the CCP.
Meb: I can apply, though.
Chris: Because they did manage to pull that rabbit out of the hat.
Meb: Chris, we got to go, mainly because I’ve been sitting for two hours and have to go the bathroom. I’ve had too much tea and soda water. We have to do with our closing question, and you can’t say Ross now because we’ve already checked that box. Most memorable investment in your career, good, bad, in between, ex-Ross, what you got for me?
Chris: Well, in that section on Ross that I put in the letter, I highlighted some of my doozies. my worst investments. I mean, there’s no doubt that the very first stock I bought…and I was a senior in college and I had a little bit of scholarship money leftover from no longer playing football, put all my money in a Norwegian very large crude carrier company that I read about and I heard on the street, and the business was bankrupt within six months of my acquisition.
Meb: Wow, that is some velocity. How did they manage that?
Chris: So, in arrears, once I actually read the financial statements and I had to write over to Norway to get them, there are these four VLCCs, these crude carriers, they were old equipment, it was a self-liquidating structure, you’re going to get a bunch of cash flow as they ran the vessels. I like to blame Saddam Hussein because who wouldn’t? But when Iraq rolled into Kuwait, they had two of their carriers in port there, they were commandeered for a time by the Iraqis, by Saddam’s army, but they eventually got it back and the thing was absolutely going to go to zero anyway.
For that, it was my single worst investment because I had like $7,000, all the money I had saved from my high school job, slinging tacos, and delivering office furniture in college in the summer one year, and that little bit of scholarship money. That was all the money I had and I blew up all $7,000 and then I had zero. And I was pretty despondent, as you can imagine, and either I needed to figure it out if I wanted to be an investor because I’d fall in love with the stock market but it’s easy to get jaded when you lose all your money. So, it was either going to go figure out something else, maybe dance ballet, or figure out how to invest. And I chose the latter, fortunately, but those are definitely impactful.
Meb: It’s funny because you and I can sit here and joke, having been through it, being experienced and older and having the scars. But like looking back and saying, “Look, that was in so many ways a blessing, how great of a lesson do you have that early in the career?” It didn’t feel that way at the time, having to eat ramen and losing all your money, like, that sucks. But in retrospect, what an awesome thing to have happened when you were young and could afford it in the sense that you had your whole life in front of you, as opposed to leveraging it all and losing it all later in life.
Chris: Yeah, probably better to do those things vicariously. I don’t think you can do them vicariously, you have to do some harm to yourself and hopefully at a young age to where you take the time and have the wisdom at least to learn a little bit from the mistakes that you make. The mistake you make is repeating the same mistakes and that is Einstein’s definition of insanity.
Meb: Yeah, and going with it, my favorite investing quote, “Every investment makes you richer or wiser, never both.” On that, Chris, I’ve had an absolute blast chatting with you today. We’ll definitely have to get you back to see if we get 50% returns or zero in the coming years. You mentioned it before, but the best place for people to find you, where do they go?
Chris: You mentioned the website, semperaugustus.com, the archive of all the letters, and as soon as this discussion is up, we’ll post the audio and the video link. So, I’ve got most of our letters historically on the web, and then podcasts and various interviews. And then you can find me on Twitter.
Meb: There you go, ChrisBloomstran on Twitter, we’ll link to it as well. Chris, thanks so much for joining us today.
Chris: Thanks, Meb, a lot of fun.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.