Invest Like the Best with Patrick O'Shaughnessy - Chris Bloomstran - An Update on Public Markets - [Invest Like the Best, EP.171]

Episode Date: April 30, 2020

My guest today for a flash update is Chris Bloomstran, the founder and CIO of Semper Augustus and a popular past guest on the show. We talk about his view on the state of the public equity market, why it will be hard for the market to deliver great returns for the next decade relative to the last, and where opportunities may lie. Please enjoy. This episode is brought to by Koyfin. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Show Notes (1:42) – (First question) – Adjustments to his portfolio in the age of a pandemic             (6:41) – Chris Bloomstran Podcast Episode             (9:36) – The Federal Reserve Act (12:32) – Surprising action in the markets during the crisis             (13:08) – 2020 Investment Letter (15:02) – Why we won’t see the same performance in tech over the future as we’ve seen the last decade (21:00) – The carnage in energy sector and return potential (30:06) – Berkshires activity since the crisis started (35:48) – Where sectors are valued in the current market (41:12) – Expectation for deflation over inflation  (48:54) – Characteristics to look for in businesses to own over the next 10 years (52:05) – Economic factors they are focusing on   Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on Twitter at @patrick_oshag

This episode is brought to you by Coifin. I've become very interested in the best software tools in investing. And when I asked Twitter for the best Bloomberg alternative, the overwhelming winner was an excellent new product called Coifan. It's a web-based platform that lets you analyze stocks, ETFs, mutual funds, and other asset classes in one place. I've been using it every day to track what's going on in the market, and I think if you try it, you will too.

Coifin has a ton of high-quality data, powerful functionality, and a clean interface. The best part is that it's free. You can sign up at www.coiffin.com. A-O-Y-F-I-N.com. Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money.

You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaunicee Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. My guest today for a flash update is Chris Blumstrand, the founder and CIO of Semper Augustus and a popular past guest on the show. We talk about his view on the state of the public equity market, why it will be hard for the

market to deliver great returns for the next decade relative to the last decade, and and where opportunities may lie. Please enjoy our conversation. Talk to me a little bit about how you are thinking about or actually making adjustments to your portfolio in light of what has to be the most bizarre and challenging macro backdrop that we've ever faced as investors in our sort of collective careers. Well, there's no doubt. Nobody's seen anything like this. You can draw parallels to periods like the Great Depression or the World War II period, but I don't think you've ever seen the enormity of entire broad swaths

of the global economy just stopping on a dime. Going into this, and one of the themes of my letters in the last few years has been that we've really built up inordinate levels of debt in society, at all levels, household debt, corporate debt, government debt. And for that, we think that the debt stock relative to the size of the economy is unsustainable. I think given where we are, trying to work out of an over-levered capital stock comes with deflation over time. And because of the dangers of leverage, we've intentionally really pivoted the other way in the last handful of years,

you know, even prior to the crisis. We've gone out of our way to ensure that we own businesses that if they don't have net cash in the balance sheet to the extent they're using any material levels of debt that it was taken on with a purpose, say for an acquisition that makes sense, but with an eye toward running the overall capital level, leverage-wise, at a reasonable level over time. And so we had pivoted, but I tell you, you get these kinds of periods where you get enormous down drafts on a daily basis, and investors can do two things with that. We sat there at the market lows, really, in late fall of 08 and into March of 09, looked at the portfolio and said,

you know, we could flip out of a number of these businesses that we own that we think are really well run with great balance sheets and good management. If we're right and we're at a market low, we would make a hell of a lot more money, liquidating a whole big chunk of this portfolio and buying more levered businesses because you're going to capture a lot more at the upside when you flip into things that wind up surviving the worst part of the down draft,

don't fail and come out. And we refuse to do so. And so the opposite way to approach that is you get a decline like this, or at least like what we had up until a couple weeks ago. And we run around with a working list of businesses that we don't own, but that we'd like to own. And I think the world has caught on to the notion that durable returns on equity, make a lot of sense.

Owning businesses with price and power makes a lot of sense. And so there are some genuinely very outstanding good business. businesses that just typically are very expensive and expensive enough to take a lot of the expected return out of the equation. If you own a business that you've got a sense of reasonable organic growth, just in terms of simple yardsticks, you know, if you think 25 to earnings is a fair number, well, too many of these things have traded at 35 to 40 times. And if you believe a company trading at 40 times, which would be an example of a Costco that we just talked about, I think at some point Costco trades it 25 times. The growth curve is not what it was when we bought the stock for the

first time in 2004. I think it was. They'll open stores at a rate of 25, say, to 30 per year. The net number of new stores per year is not as accretive to the installed base of stores. They're still going to have terrific same store sales growth. It's still a terrific franchise, a great business. But I find a multiple at close to 40 times for the business to be pretty high. You could say, well, sure, but how much of the depreciation of the fixed assets of the business are actually real? And that's a fair point. And so you draw a couple, three points off the valuation. It's just too expensive.

You get these down drafts and you were getting to the point where a lot of the businesses that we'd like to own were getting close enough to buy. And then we almost flipped the switch and launched into this recovery phase when the Treasury and the Federal Reserve got more active in the capital markets. And for that, we're just bewildered where we are today. And we had done some of that. If you want me to talk about some of the things we're thinking about government, the Fed, and Treasury, I can. But we've been very active. We'll go entire years and do very little in the portfolio.

Last year, for example, we simply watched everything go straight up. We added one new business to the portfolio. One, Olin Corporation, which we brought into a small position, and it was the price to climb this year. we've really made it a material position for the firm. We've had the opportunity to liquidate some things in the portfolio that are good businesses, but they're just too expensive. So Dollar General, which we talked about, I think last time, we recorded late last summer.

Dollar General, if you had to pick a business that was going to sail through this crisis, that's the one. Food supply chain is essential to the economy. Dollar General sells into largely rural America, 70% of their stores. All of their stores are open with access to food and necessary household goods. They're terrific, and you have a sense that we're in a recession. I think we're in a very deep recession. My sense is the recession lasts a lot longer than people would probably think coming out the backside.

And Dollar General happens to be a business that historically has done better in recessions than they have during boom times. Some of that is at the margin on increased use of the food stamp program. But the stock has done too well. We had Dollar General. We've added in the portfolio for more than three years. I think we're in it at high 60s per share. We couldn't have bought it any better. We bought it when all the retailers were being chucked out

because Amazon was going to take over the entire swath of the retail economy, which probably is the case for a lot, but it's certainly not the case for a company like Dollar General or Costco with two retailers that we own. And the stock is up for the year, and it's just performed too well, And it's trading at a price where you look at opportunity cost, and we had other names in the portfolio and other businesses that we've kind of been hoping to buy for a long time,

that some of which we've had a chance to buy. And so taking Dollar General down over a series of transactions from 4% of capital to 1% of capital has freed up capital to buy things that are very good businesses, but at much, much better price points that give us a much higher expected return for the duration. So not unlike 2008, we've been very active. And my sense is that with this run-up, leaves us scratching our heads. You know, we talked just a minute before we got on the line. I'm sure you look at your portfolios as well at OSAM. And if you had said to me, Chris, let me paint a scenario for you three months from now, four months from now, we're going to have the entire global economy stop. All the restaurants will be closed. All of the retail in this world will be closed. The airlines will be running 5% of their fleets.

Aircraft manufacturing will have stopped globally. Auto manufacturing will have stopped globally. And you're down 12% for the year. It doesn't reconcile. I mean, there's something wrong with this picture. I think what's wrong with that picture is just an enormous amount of intervention on behalf of government, which we understand. I mean, I get that you don't want to penalize households and you don't want to penalize businesses

for this stoppage in the economy for however long it lasts. And so the folks in Washington are expending every resource times 10 trying to inject liquidity into the system. And for that, I spent too much of my Easter Sunday rereading parts of the Federal Reserve Act, trying to figure out whether what the Federal Reserve is doing is even legal or not. I'm not sure it is, but you can't flaw what's taken place. Right. And doesn't matter as an investor. you have to play the game.

We have to play the game, and then you have to decide, because we're playing the game, A, we like to think we play the game a little bit with our heads in the sand. We like to think you can ignore the macro and just focus on business, business, business, and price, price, price,

and that's what we do. And for that, I think we've got a collection of businesses that will fare well in any economic or monetary environment. Now, that's not to say that Disney is not on its back of the moment. with big swaths of the company, not running, not open. But we would look out in a case like Disney to where they were in 2019.

If you think we're on the back end of this curve, and we're going to put people back to work, at what point does Disney get back to full levels of capacity utilization, or what does that look like? Is there any permanent drawdown to their use of their entire capital stock? And so we're doing a lot of that kind of work. But I think you look at just what's happened with the economy, and you've got projections all over the map.

You've got a couple of the Wall Street houses saying that GDP is going to be down 40% on an annualized basis for the quarter or for a six-month period of time. We've got the Fed president here in St. Louis, James Bullard, who came out three or four weeks ago and said 30-plus down on GDP. So you kind of break down the components of GDP when there are several ways to look at it.

But, I mean, there's no doubt consumption, which is 70% of the economy is going to be down. So I don't know, and I've got the numbers in my letter. I've got the table in the front that kind of showed where we were at year-end versus various secular peaks and troughs throughout time. And our sense was at the end of 2019 that we were at a secular peak on almost any fundamental metric you can use, price to sales, cash flow, dividend yield. Prices were very high. We overlay that with total credit market debt to GDP, which has been 350% since 2007. and again, I go back to there's too much leverage, but GDP is going to be down.

Consumption, if it's 70% of what was going to be a $22 trillion economy, I mean, it's not unreasonable to think that GDP comes in this year. Nominal GDP now, not inflation adjusted, comes in maybe 10% below expectations. I don't think for the year it will be near as bad as some of your pundits have suggested. But if consumption is 70% of that number at $14 trillion, it's going to be weighed out. I look at our own household consumption and my wife, you know, God love her. She's professional shopper. She's not running around to stores, but she's leaning heavily on Amazon. I think if you looked at our house from Google Earth, you would think the Bloomstrands are running a Amazon distribution center right there in St. Louis. You mentioned already the surprise if you were to have been given the setup at the start of the year and to have had a broad portfolio only down 12%. I look today, the NASDAQ is now up on the year, which is,

just kind of remarkable. What else has surprised you most given the setup that we've already discussed? So said differently, looking at the market, what market action in sectors or industries or companies has been most odd to you so far in the COVID market period? Well, I think the five big tech companies that I wrote about in my letter this year, it was remarkable the degree to which they held up. Now, they're outstanding, collectively, they're outstanding businesses. You think about Amazon. Amazon's business being up during a crisis, that's happened. Microsoft's cloud business, Azure, being up during the crisis.

So some of those were to be expected. But going into the year, when I was writing my letter this year, and I don't know, February 11 or 12, collectively, those five businesses together were valued at 20% of the overall S&P 500. And we ran through some fun math in the letter that effectively said, if you're expecting these stocks to compound for the next decade at the same 24% that they had for the last 10 years. If you're expecting their revenues to grow at 19 and a half percent, you're delusional. You're just not going to get it. And I would say for most of the last 10 years,

these stocks generally as a group and even individually were not very expensive. You take the cash out of Google, really cheap at times. Microsoft, we owned for a decade. I wrote about Microsoft in January of 2000 and predicted shareholders would lose money for the next 15 years, which they did. But we bought the stock in the low 20s in 2006, owned it for a decade, trimmed it when it was expensive, bought it when it was cheap, and finally sold the whole thing without a doubt, three or four years too soon. I didn't get that the cloud was going to be as big of a deal for Microsoft, but the stock traded at 38 times earnings. In 2000, it traded at 21 times earnings when we bought it in for the duration of our ownership, most of the duration of our ownership for 10 years,

and traded back into the 30s to earnings. Profit margins had fallen. They were washed out in the low 20s. Now they're back to 30%. So that group really, I don't think, is going to produce even near the same results, not just in terms of share price, but in terms of sales and the margin structures that they've enjoyed. Just real quick to interrupt there. So there's sort of prices if they will. Maybe especially given the backdrop here and the fact that many of them are at or near highs despite the macro environment. Just say a little bit more about what you discussed in the letter as to why you don't think those kind of 19% revenue type compounding experiences are as likely over the next decade for those huge tech companies.

It was the same logic I used 21 years ago now to Microsoft when the market cap was $620 billion and revenues were only 20. It was simply the price was too high. We took a 10-year horizon and a 20-year horizon using market cap, using sales and using net income, and ran scenarios at compound growth rates of on the high end, 25%, 20%, 15%, 10%, and then 4. And we basically said, the S&P 500, if we assume for the next decade or two decades, will grow at 4%. Well, a lot of people would say, well, that's crazy. Except if you look at the last 10 years and consider that sales have only grown three and a half percent a year for the S&P 500, kind of matching nominal GDP growth.

Most people wouldn't believe it, given the performance of the stock market for the last 10. But it's been three and a half percent. And you've got profit margins that peaked, in my opinion, and probably won't return to those levels, perhaps even in my lifetime, in the third quarter of 2018, we saw a net profit margin of a little over 12.1.1. percent on the S&P 500. Most of that during 2018 was on the back of the big tax cut, which took marginal rates from 35 percent to 21 percent through an additional accelerated depreciation. There were a lot of angles, but a lot of that benefit was exhausted over the course of the first three quarters, and so you had the peak.

Making the assumption that sales grow for the next decade at 50 basis points more than they had for the last decade, which I don't believe, but if you assume 4 percent, if you assume no margin increase. So you hold profit margins at year in 2019's levels in the low 11s, and you just extrapolate those out at four, and you assume no more multiple expansion. So we went out with the S&P 500 trading at 23 times trailing earnings on a reported basis of the end of 19.

So at 23 times trailing, we'd make the case that you're not going to get any multiple expansion. Well, let's just hold multiples at 23 and let's hold margins at low 11%. So I think it's reasonable to assume the S&P does 4% by those three yardsticks from the next 10 years or 20 years, starting at year end, 2019. Running the same and then running those various same three yardsticks for those five companies individually and collectively, you simply get to mathematical impossibility by growing at 20%. You grow, if you're starting at a 20% base, if these five components are 20% of the index and they grow at 20% for the next decade or two decades, you start to get to where the five components are more than 100% of the S&P 500. You get to impossible figures. And running those scenarios and kind of working backwards down the growth curve for all three, again, market cap and sales and net income, I kind of got to where I could buy revenues which were,

Stocks were 20%, revenues were 8% of the S&P 500, let's say, a net income was 14%. I could get revenues growing at 10% a year for the next decade and becoming a larger multiple, somewhere south of 20%, but those five companies can't become, in my opinion, more than 20% of the sales of the entire S&P 500. You just have the laws of large numbers, diminishing returns, and I wrote, and I still believe, I don't know what stops it, if it's simply inertia, but regulation comes along. The point where these five gets so big

and they're already having regulation issues in Europe, you just stumble into new competition. Who knows what it's going to wind up being? Who would have known that a company like Google was going to come along and just eviscerate the entire traditional advertising business? I've got a couple of friends in here in town in town here who ran Southwestern Bell's

Yellow Pages of Directory business. And I remember when Google was in its early days had just gone public. These guys swore on a stack of Bibles that it wasn't a threat because locally they had boots on the ground. Well, it wasn't but two or three years before they were done. The advertising agencies that are all inside the big couple conglomerates now, Omnacom, they're all trying to cut costs just to stay alive and they're gone. I don't know what it will be, and that's not a conversation for this COVID crisis, but these are genuinely great businesses.

They have very, very good balance sheets, balance sheets. Collectively, they've got net cash on the balance sheets. We simply found the price is too high and the scale of the businesses in aggregate being too large. But for the last 10 years, if you'd only own those five companies and maybe you throw in a Visa and a MasterCard, so seven businesses, if you'd only own those five or seven, that's all you need it. And then you get to the first quarter here and all of the chaos. If you had just owned those five, you were down maybe 9% a quarter end when the S&P 500 was off. what was it off 19% 20% down 32 or 33% at the low those five businesses held up better than all you take the top 20 companies in the s and p 500 and collectively they've held up better and so i think good businesses tend to keep you out of trouble you just get to the point where if you're thinking beyond what's happened during a crisis and for the next 10 or 15 or 20 years you're just not going to get the same returns but i think the problem is you're probably not going to get very good returns out of the broad stock market either Let's go to the literal opposite story, which I think in this market has been the energy market. So if the Big Five tech have navigated this with sort of amazing resilience, I think on the other end of the spectrum, just like no one could have predicted what we're facing economically, it would have been very hard to predict the action that we've seen in oil markets and therefore in energy equities.

I'd love to get your take on this space, since I know it's one you're interested in and maybe even have a few investments in. And what's your take on what's happened in energy and whether or not the relative carnage there versus the Big Five Tech has created any sort of opportunity for much better long-term returns than what you see in the S&P 500? We've owned oil and gas in various iterations over the entire history of our firm, and we've done them well. We've made cyclical investments early on in a couple of the deepwater drillers. In late 90s, oil was under $10 a barrel, and the world thought it was headed before. We spent a couple weeks in Houston and talked to all of the drillers and wound up owning trans ocean and diamond.

We wound up tripling our money with way too little capital. We did the same thing again with the same two companies. The next time oil traded down to those lows. We've owned Exxon Mobil cyclically. We, I think, have a good history buying it when we thought it was cheap, selling it when it was deer. The problem with oil is, and the world learned this lesson in our hurry here, this course, with OPEC really existing in perpetuity with a sword over the head of the industry. If you take U.S. production of oil and gas, we were a bit player globally 20 years ago.

The United States was producing 4 to 5 million barrels a day. Our net consumption is in the high teens per barrel today. It's 20 million barrels a day before the crisis. It's 20 million barrels, abruptly down for a very short period of time. So we've gone from producing 25% of our crude needs to producing 12 out of 20 barrels. And so at the margin, that incremental 7 million barrels a day over the last decade has really eaten into OPEC and it's really eaten into the international oil community. We stand up and say we're energy of independent.

Well, we're not. We still import a net 8 million barrels a day, but now we're starting to export various crew products. And so you're Saudi Arabia and you see this. And forever, Saudi and most of these nations that participate in OPEC are very dependent upon oil and gas to meet their federal budgets and their spending needs. You know, there's very little middle class in a lot of these countries. They're very wealthy in Saudi Arabia. You have the princes and the sheiks. And then you've got the poor and the poor, the vast, vast majority of the population.

They need and OPEC needs as high over price as possible to run their affairs. and generally they'll go in cycles, but they will typically keep oil off the marketplace and never run full out. Well, here in the United States, we've been running full out. And it's kind of a nutty thing. We saw the lessons this year with the collapse and crude,

but if you follow the cycles, even Exxon Mobil, which we think at least historically had been best of breed, best capital allocators, we own Exxon today. And I think of the last 10 years, the businesses eroded considerable. They used to zig when the industry would zag.

When their competitors were ramping up cap-X and exploration, and they sensed that we were going to get to a oversupply, Exxon had a great history of backing off their cap-X when everybody else was spending money, and then they would go make investments when you were in cyclical downturns. Well, then they bought XTO, and they couldn't have done it in a worse time, really at the peak of the gas market, and over the last 10 years, they've been hitched this dividend policy,

and they've just increased the dividends in perpetuity to the point where in the last couple of years they've not earned the dividend. If you're the CEO of a business that is hitched to a high dividend payout, it's absolute handcuffs. Olin's in that same boat. My recommendation to the folks that run Olin has been during this crisis, you've got to cut the dividend. It's 80 cents a share. They're in the list of the dividend aristocrats, which is one of the stupidest things you can have because you're obligated as a cyclical business to always pay the dumb dividends. Well, in Olin's case, that's $120 million. They ought to be freeing up, but they haven't freed up.

In Exxon's case, they've got a dividend that's going to be $3.48 a share this year, but they didn't even earn that last year. They didn't earn it the year before. They didn't earn it the year before that. They're hitched to a payout rate that's over 100% of their capital. If you're not earning on a free cash basis, your dividend, you're borrowing money. And so Exxon has obliterated their balance sheet. They've gone from $10 billion in debt going into the year,

Here they had about 47, maybe 50 billion in debt. Here in the crisis, they've done what everybody's doing, and they're drawing down revolvers and they're floating debt issuance. They've had two bond issues in the last month where they've collectively raised, I want to say, $18 billion. Now they've got $70 billion in debt. They've got more cash from the proceeds of the issue, but they're burning through capital. They cut the CAPX budget by 30% a couple weeks ago, but they haven't touched the dumb dividend.

So we did a deep dive on a bunch of little independent oil and gas. companies last year because this crisis didn't just start. These businesses and the service sector in particular has been incredibly weak. The small independent producers have been incredibly weak for the last couple, three years. We have some really good investors, really highly regarded, and I won't mention, but companies like Antaro Resources, big institutional ownership from high class investors and these stocks are down, were already down, 95 to 99 percent prior to what transpired in the first quarter. So you get into the depths of the coronavirus and the global economy flat on its back. And we really had an assault from OPEC when they said they were going to pump full out.

Couldn't happen at a worse time. I think intentionally happened. It was couched as the conflict with Russia. Russia was going to produce. So Saudi said we're going to produce and we're going to flood the world with too much crude. Well, that just exacerbated the problem. And so the entire oil and gas patch just got absolutely crushed. Exxon traded at 30 bucks a share, having traded a hundred dollars a share a couple of years ago. There were numbers of businesses that were down already, like I say, 90, 95 percent. And during this deep dive, an order that number of businesses and could not get comfortable with any of them because what you've seen, and I think the world's known this is you have a massive amount of debt that finances this industry. At the end of the day,

this is not a business that generates sustainable free cash profits. They're cyclical profits, but they don't generate returns on capital. They're actually net over long periods of time, capital destroyers. And so there were an enormous amount of debt coming due in late 20 throughout 2021, 2002, and you're going to see an enormous number of bankruptcy. So here we are with ExxonMobil, has made it a bigger position. We look at where they produce, around the globe. And we think they've got pretty reasonable break-evens in various places. The refining operations are running at 65% capacity, but they have fields that break even at $30, $35, $40, a lot of production. So you're not back there on an oil, on a current spot basis or a futures basis.

But if we get oil back to, say, $45 to $50 sustainably, Exxon's in good shape, when they calculate the reserves, they're overstated, using a longer-term higher oil price. but I think they're fine. At today's prices, you'll wind up making a lot of money, but they are not businesses, Patrick. You can own durably for 30 years, because they're just going to destroy capital. It's a shame for a lot of reasons, but they're cheap. And so as long as you get through the capital structure and you get through the capital needs and sources of liquidity and current demands for capital, you find the ones that'll survive and you'll wind up making a lot of money because we'll come out of this thing and we're going to put people back to work

and we will use more oil and gas. We're not going to be topping up our refiners, which can't even take more crude. We're not going to be layering on, crude on tankerships. We'll use it. It was a painful downturn. But the industry ought to learn, you still live at the mercy of OPEC,

and only for their mercy of keeping crude off the marketplace. And for that, these are really terrible businesses. And yet we own a couple of them. Right, right. Well, obviously, ultimately, price is a key variable in all this. Even for, I love the expression from a famous value investor that they made all their money going from very bad to bad in businesses because the price is just

too low. So yet another variable that one must consider in this strange market. I think that's very well put. That's kind of the nature of investing in cyclicals is you can only own them when they're very bad. You can only buy them when they're very bad. You can't have an expectation of good. I think that's a perfect way of putting it. Everyone listening that knows your work will know your deep exploration of Berkshire Hathaway, its model. You've been a big investor there for a very long time. I know the ins and outs of their balance sheet, maybe like nobody else. And so I think it's been a very curious thing to watch Berkshire in the coronavirus market period, sort of doing perhaps the opposite of what many would expect of them, given Buffett's famous

bi-American I-M op-ed in the New York Times in the 2008 crisis when he was aggressively bidding and setting up interesting structures with places like Goldman Sachs and Wells Fargo to sort of act as a backstop and get paid very well for doing that. Whereas in this period, he's really the only notable activity seems to be sales of banks and airlines, no major landmark purchases, at least none announced, and a huge cash pile by absolute standards, if not by relative standards. I'd love you to just talk through your reaction to Berkshire's activity or lack thereof so far in the COVID period. Well, there's very little activity to observe yet because to your point, they've been extremely quiet.

I think the 08 crisis evolved over a longer duration. And so when companies like Goldman and GE needed capital, you didn't have the massive federal intervention immediately like you've had in this crisis. And I was going to say, you know, it's good thing Bersher doesn't own airlines and money center banks. Well, they do and their meaningful positions. You saw them take their Southwest Airlines and their Delta positions below 10%. Just last week, they shrunk their bank in the York. position to 10%, which was really regulatory driven in that case. So it's hard to know what's going on inside the business. I think you've not seen the deals like they did during the crisis yet

because of the noability of this federal money that's coming to the party. You've got the airlines with their hands out to the government, trying to come to terms over whether and how much equity ownership via warrants that the government's going to wind up taking. Well, Berkshire can't get in front of that. The same way they can't get in front of outside of the coronavirus, a bidding war for outright ownership of companies when private equity has so much capital on the sidelines waiting to deploy. I'm not sure they were at the point where they were able to get capital on terms that made sense to Berkshire when there's so much more free money coming from the federal government. But it's interesting. It's hard to know what's going to happen. I think the airlines

are going to get diluted. We own a couple suppliers of parts to airlines. They're good businesses. and we're struggling with what the back-end curve looks like for replacement parts. We're struggling with what the build profile looks like for construction of wide-body jets, the 787 and the Airbus A350, for example, in the case of Hexel, which supplies intermodulus carbon fiber. But it's hard to know what Berkshire has done. It's going to be really interesting to see it. My expectation would be of the $125 billion in cash that they would have bought back a whole bunch of,

bunch of shares. They spent on the order of $7 or $8 billion last year buying stock back average of $202 or $203 on the B shares. Well, the stock traded as low as 160. And I think there have been days and moments where I can spot Berkshire's buys on the open and on the close. I'm probably, I could be wrong, but I presume they've spent a fair amount of capital. It's going be interesting on the equity front to see what they've done. The airlines, we had held off in a big way owning these things. It was obvious coming out of 0809 when they all restructured. It was a different business. They got a lot more religion in terms of cost structure. They got control of their gates. They weren't killing each other on price, but all these actions were gone outside

of a recession. I think the carriers figured out how to sell first class seats for a price that people would actually pay instead of giving those seats away to their frequent flyer, platinum status customers for free because nobody was buying the seat. So instead of selling a first class seat for $3,000, they would sell it for $1,200 or for $900. So there was a lot of good done. We sat on sidelines and said, it's merest to see how this industry fares when you get the next recession and who blinks first. Because you've got a history of blinking and taking fares down to levels below break-even. So when load factors start to get below 85%, you start to get into trouble and obviously nobody could have seen this thing coming where you really shut down global airline

traffic to the degree we have you've got federal money coming and on one hand i wouldn't be surprised to see berkshire having sold out or materially sold down the airline structure knowing that this will not be the same business going forward knowing that demand will not return to 100% of 2019 levels hard to know what's happened in the portfolio i don't know if they've sold down banks the bank's The bank seemed to be in more trouble than the world thought. They had to meet Graham Dodd standards, and they apparently were better capitalized. But outside of the banking structure and in shadow banking, the fact that you've got all these credit funds that look like long-term capital management, leveraging up at obscene multiples to equity capital, 25 to 1, 50 to 1, 100 to 1. I wrote about two years ago the degree of debt in levered loans and the CLO marketplace.

We run around talking to university endowments and their CIOs and pension CIOs. I bet you that nobody runs cash in fixed income by simply owning individual credits. So Berkshire goes into the year with $125 billion in cash. But what's their cash investor then, T-bills? Nobody does that. It's a crazy time for such an interesting company. I can't wait to see the buyback activity looking back now once we get the data, but it has been somewhat surprising. And perhaps their method for capturing value created by COVID is simply in their own stock. I'm curious, you've mentioned

energy on one end, the top end of the tech ecosystem on the other end as contrasting examples. Are there other areas that you see as sort of wildly cheap or what seems to be wildly expensive? in this market today on April 14th, 2020? The places where you still have enormous upside, if you believe the durability of Federal Reserve and Treasury intervention in the marketplace are businesses that were destined to fail, lousy retailers that were already going out. Macy's is just in a slow bleed. They were going to go from 900 stores to 800 stores coming out of this downturn.

if they don't file a Chapter 11 very quickly, which may not be the case now that you've got access to capital here for the time being, I think they'll still accelerate their number of stores that'll close. The mall retailers, even Mr. Buffett is invested in, at least he was investing in Saratage, Simon Property, all of the big malls, just long-term businesses that are probably going to zero in a lot of cases, are still cheap, even though they're up 50% to 100% off their lows, they're still down 60, 70% off their high.

So if you're willing to swim in that pond and go find the most over-leverage businesses, even though you've had an enormous recovery, there's a whole bunch of them that are still down 70, 80, 90%, we're not doing that. The things that we own today, I mean, there are a lot of businesses that are really cheap and still down materially for the year, not as cheap as two weeks ago. But I would contend that coming out the backside of this, that we'll have deflation for an in an ordinately long period of time. I think a better way to think about what to do with capital today is think about how capital's going to work for the next 10 or 20 years, certainly for the next 10 years.

And if you bake in short-term interest rates, which are already at the zero bound, if you bake in a Federal Reserve that will be determined to try to compress long-term treasury rates as close to the zero-bound as possible, and you go back to the Fed Treasury Accord that existed during the latter part of World War II and into the period immediately after the war that allowed them to run enormous federal deficits. increased the household savings rate to the point where we actually managed to finance the deficit from household savings. We rationed a lot of what was consumed at the household level. I think coming out the backside of this, you can bake on deflation. And if corporate credit levels were at all-time highs, and if government debt levels on balance sheet debt levels, which were already at the point where you get a diminishing returns out of the next incremental dollar of death that's taken on, this all smacks of deflation. And so we're in a period where none of these things are going to fail.

I mean, if you figure this out and realize they're not going to let businesses fail, we're going to probably violate the Federal Reserve Act and buy secondary corporate bonds, both investment grade and now high yield as of last Thursday's announcement. We're going to buy ETS. We're going to buy high yield. ATFs, which I think is way beyond the Fed charter, well, they've put a stake in the ground and said, we're going to get enough liquidity into this system, and we've got the firepower to do it. Well, yes, they have the firepower to do it.

But it's going to take a four-plus trillion dollar deficit this year, which is going to add an enormous amount of debt to the Fed balance sheet. We're going to take total credit market debt from $76 trillion to somewhere north of $80 trillion. Debt to GDP, which has been 350 percent, is going to be at least 400 percent of GDP. The only way to deal with these kinds of debt levels is deflation, which comes with austerity, which comes with things like lower wages versus higher wages. Well, we're not mentally set up for that. We haven't seen this since the 1930s.

And so if I'm right and we have deflation for the next 10 years, let's say, then finding businesses that have pricing power, because very few are going to have it, that also have rock-solid balance sheets, is the way that, to survive and make decent returns for the next 10 years. If you survive this COVID crisis, because you happen to have access to capital, because the Treasury has allowed the Fed to lever up its balance sheet at 10 to 1 for high grade corporates and for the securities that they're allowed to own treasuries and agencies, maybe munis, but not high yield, not ETS, not CLOs, not commercial mortgage-backed securities. This is all crazy. They're all going to live, but, you're

you're going to come out of this thing with even more leverage than you had. Even good businesses like Disney is going to come out with more debt on the balance sheet. And they already had debt on the balance sheet because they financed the Fox deal last year. We're introducing more leverage into the capital structure of business than existed prior to 2019. And if we have deflation, then these companies are going to bleed badly. And I think you've got a decade of restructurings. You have to be vigilant. And so, yeah, I think the companies that we own are the right businesses. And to the extent we've been able to add to those, it's been the right thing to do. Can you say a bit more about this deflation versus inflation concept?

I think your viewpoint on deflation is a bit against the grain where maybe the simple argument would be with as much money being pumped into the system, the expansion of M2, of the money supply, of everything the Fed has done to introduce liquidity, that the naive expectation would be inflation, not deflation, and that the way to get rid of that debt would be to inflate your way out of it. So can you just maybe draw a little bit more detail around why you expect deflation versus inflation? Yeah, the problem is the same problem that the Japanese have had for the last 30 years going back at their peak in 1989. And that's, you can run up the money supply, but an increase in the money supply, if you want to call M2 money, money,

M2 is really your monetary base times little M, which is the money multiplier. But let's just say M2 is the right number. Well, if your GDP was going to be, let's say, $22 trillion going into the year, probably $20 by year end, I mean, M2 at last week's print was $16.5, maybe $16,7 trillion off top of my head, which means the velocity of money, which is what nobody thinks about, isn't working. So none of this federal money, none of the $2 trillion. spending, none of the leverage that's incorporated in the special purpose vehicles, the commercial paper deal, the various credit funds, the various term asset backed facilities,

none of these are stimulative. And I think it's been proven academically that at higher and higher levels of on-balance cheap federal debt, the incremental use of debt starts to produce diminishing returns where it's not effective. And so that's deflationary. So the answer then becomes, and I think you're right, the endgame, the end game is inflation. The end game is probably hyperinflation, given where we are. Because here and abroad, there's simply too much unbalance cheap debt.

But we will go through various iterations of what the Japanese have done. We did the first iteration of quantitative easing during the financial crisis, and we had to do that because we were going to a 1930s style downturn. But then we had the three iterations of quantitative easing, one, two, and three. And that didn't push up GDP. I talked about earlier that sales for the S&P 500 have grown at 3.5%. Nominal GDP has barely grown. If you go back at the beginning of my career, in my investing career, total credit market debt to GDP was about 200%. Up from 158% during the middle of Reagan's first administration.

Well, interest rates were sky high. It took the 30 years coming out of World War II, 40 years to utilize the capital stock that was overbuilt in 1930s. glorious growth in real GDP per capita at an enormous level. Well, in the subsequent 20 years, in 2000, when the tech bubble peaked and the nifty 50, the new iteration of the nifty 50, the big caps peaked at 40 to 60 times earnings, the NASDAQ traded at 240 times. We had taken on an enormous amount of debt to that point, and debt was 250% of the economy. And we were stunned to that number. It was just crazy. GDP was 10 trillion, and debt was $25 trillion. So, We had the downturn.

The stock market broke. S&P dropped 50%. NASDAQ dropped 80 plus percent. We had a mini recession in 2002 and then recovered. And we really put credit to work in things like the mortgage stock. We did the household finance and covenant light, no covenant loans. And it was a stunning seven years from 2007 in that GDP grew from $10 trillion to $14 trillion. but the debt stock, total credit market debt, doubled from $25 to $50 trillion.

We took an incremental $25 trillion in debt to grow the economy by four. Think about that. And so we had the great financial crisis. We've then taken the Fed's balance sheet from $850 billion. The first thing they did was took up that first bailout with the various SPVs, the various facilities they had, the conduits. And we added a trillion or a trillion and a half dollars to the Fed balance sheet. That had to be done to avoid going to a 1930s.

I'm not sure they needed to do the QEs, but in the subsequent years, we've taken the Fed balance sheet from what was $850 billion. It got up to $4.5 trillion a couple of years ago. And then we tried quantitative tightening, where we were going to run it down. I remember the president of the Fed in San Francisco saying, well, we're going to get this balance sheet about halfway to where it was. So you would have said $2.5 trillion. And what they proved was you can't do it.

We had nine increases in the Fed funds rate, and you started to really weaken the economy, weaken the global economy. We got into a trade war. Well, China was already weak. In the last five years, even though profits for the S&P 500 rose, profits more broadly under NEPA, national income product accounts, have been in decline. And last year, we had the S&P up 31.5%. Profits were flat, and it looked for most of the year, like profits were going to be down year over year. So the tax debt benefit was gone. So here we are. We came out of 07, 08, 09 at 350% debt to GDP. Now we're sitting here at 350% again. So for the last 10 years, we've taken on $3.50 in debt to grow GDP by a dollar. So from 07, GDP has grown from $14 to $21 trillion. We've added $7. But now we've gone to $76 trillion in debt.

there's an inefficacy of the ability to get money into the economy and have it work, and that gets back to this velocity of money. So velocity, I remember 20 years ago when we started the firm, I always had it in my head that M2 times velocity is GDP, M2 is always about half of the size of the economy. So back when we had a $10 trillion economy, M2 would have been $5 trillion, and the velocity of money was two. Well, now the velocity of money is down to about 1.3 in the claim. there's no way to get this money working because we've already got an overbuilt capital stock.

That applies whether capital is property plant equipment or whether it's services. We simply have too much stuff. We have too much retail square footage. We have too much restaurant square footage. We have too much manufacturing capacity globally. And so we're in big decline. And you can't simply introduce more debt on top of debt and call that the solution. So yes, I fear that.

that hyperinflation is the endgame, but we're not there yet. I think everybody thinks that all these QEs is absolutely creating inflation, and it's not. Only when the Fed really turns the liability side of the balance sheet into notes, currency, instead of going through the Treasury,

when the Fed directly monetizes the debt, buys treasuries that are not issued first by the Treasury Department to finance deficit spending, then you probably get it. But until then, it's just deflation deflation. And so we'll do numerous iterations of ongoing QE to try to get inflation up. You know, we're going to try to get inflation up to that Fed target of 2%. I just don't see it.

We fast forwarded by a decade over the matter of three months in terms of how much debt the system could really bear. And now it's beyond kind of that tipping point where there's no ability to take new debt and grow the economy. And I think that's problematic. And so my bet would be deflation, deflation, deflation, and hopefully. and hopefully we don't get hyperinflation. In my lifetime, I'd always hope we can get it through my kids' lifetimes.

My grandkids, all bets are off. You can't control that much from the grades. So it's coming. I just don't think it's coming yet. I'd love to review the characteristic profile. You mentioned one or two already, which is this notion of pricing power, maybe capital efficiency, in contrast to the very capital inefficient growth, which is how I would characterize the increasing debt load to produce the same amount

of GDP as a sort of capital inefficiency. What other characteristics do you think are most important to look for in businesses to own prospectively over the next, say, 10 years alongside pricing power? Well, I think you better sell things that are essential that households need. If you go back to the Great Depression, when GDP fell by half, nominal GDP got cut in half, the consumption was similar to where we are today. It was 70% of the economy when GDP was $103 billion in 1929. We cut the economy in half. The consumption grew to 90%. So everybody now knows unemployment went from 3% or 4% up to 24.9, is always the headline number.

Well, you still have to eat and drink. So businesses that sell things that you need, food, food products, drink, consumer goods companies should be in terrific shape unless they've just layered on too much debt. Because what's going to wind up happening is if the price level starts falling by 2% a year, it's problematic for everybody. I go back to portfolio companies like Dollar General, which I think is perfectly weathered for a deflationary environment, except that if the overall cost level, cost of goods sold, declined by 2%, you're going to be pushing back on wages by 2%, to try to maintain margins. But if you're a levered business, if you've got an enormous amount of debt in the capital structure, even nominal declines in your top line can have profoundly bad impacts on the backside. So I would make sure you own staple companies. I regret now having owned and sold PepsiCo a few years ago because a company like that is perfectly situated. Their beverage franchise, but also their salty snacks.

PepsiCo still is a business that has pricing power. Now, they may have to adjust the price level to the overall inflation level, but they're in a command position in terms of distribution. They're in great shape. Companies like that, businesses that are going to have a permanent, a long-tail falloff in demand. Again, I go back to these things that I struggle with that we own. the supply chain to the airline industry. My experience had always been when you had a deep recession that the backlogs at Boeing and the backlogs at Airbus would disappear. And that was the case.

I have vivid memories over the last 30 years during recessions where we would park airplanes in the desert. But the thing that happened during those downturns was even though the backlog disappeared, production never really stopped because there was still enough order for. flow. Well, if we're going to wind up with 85% of capacity utilization two or three years from now, all of these new aircraft that have been built is a game changer. So that really impacts companies that sell into the supply chain, that sell into the parts business for replacement. It's very disruptive. I think this three-month period is going to wind up being incredibly disruptive for the economy. Any closing thoughts, Chris, as you look forward, things that you are

most heated on rates of change that you're paying closest attention to, whether it's in your businesses or in the economy, things that you would leave people with to consider? I've watched the economy for the 30 years that I've managed money. Move production to the lowest cost of production. So Nike moved production to Vietnam. And then as Vietnam grew, they move production to China. I think our relationship with China is irreparably harmed from this episode. And so we all know that the Chinese held the supply chain for our pharmaceutical industry kind of over our heads at the most inopportune moment. But I think about if I'm running a manufacturing company and I need to grow capacity and my

decision now is am I going to locate a plant in Dothan, Alabama, or in Wuhan, Hubei province, I'm going to Dothan Alabama. The southeast cadaverie surges as we bring manufacturing back home. I think about companies like Starbucks. We've always said we would never directly own a Chinese business. And so Luckin, a couple weeks ago, had a lot of people laughing unless you own the company. But we own Starbucks. Starbucks is a top five holding of ours. And the premise on the growth curve at Starbucks is very heavily dependent upon opening new stores in places like China. And if we really have genuinely irrepably gone the other direction, and you've seen Japan now introduce federal money to try to help industry take supply and manufacture out of China, if we go down that

path, which we very well may, and perhaps we even should, then you get to where we've seen governments around the globe commandeer assets. Well, Starbucks has a whole bunch of stores already on the ground in China. They ended their East China joint venture, which was done on a license basis, a franchise basis. So now the company owns those stores. I think on the table, my biggest concern prior to this crisis had been that at some point the Chinese commandeer Starbucks stores and kick them out of the country. Something that gets very much on the table. And if that's the case, then Starbucks is not worth mid-20s to earnings. If they have 16,000, let's have 16,000. Let's have, let's say company-owned stores and another 16,000 franchised and licensed stores,

we think the number of stores will grow high single digits over the next 10 years, but they have to grow in China. And so, yeah, I think everybody's going to do a lot of thinking about what the whole landscape looks like on the backside of this. And if we're a more insular economy, if globe becomes more insular, that absolutely has a bearing on world trade. We have seen in the last three years getting back into that GDP discussion, this year will probably be accretive because we're probably, so the total number of exports and

imports are both declining precipitously, just like the 2008. During most recessions, the aggregate numbers don't decline to where they're negative. Well, they're both going to be negative this year, but if you think about the equation, exports minus imports, exports are probably declining less abruptly than imports. So that differential will be accretive to GDP. But the absolute number is going to be down 30% from where it was, the absolute level of trade. So if you go back to the 1930s, the absolute level of trade was only exports and imports were only three or four percent of GDP. And we were a net exporter. So if we were 103 billion, we were exporting four billion and importing three billion. And I'm kind of rounding up the, I don't know exactly what they were.

Well, now those numbers are more like 13 and 18 percent of GDP and we're in that importers. Global trade and global supply chains are much more of fabric. of the global economy. And I wouldn't be surprised to see a retrenching, both here and abroad. And that has very profound implications for a whole lot of businesses. So you really didn't understand your cost structure, but you really, I think, I think we win this because we were ahead of the curve. I kind of feel like the patsy at the poker game because in the last two weeks,

we've lost because everything else that has too much leverage are the things that are getting bailed out by all this federal action. But if I'm right, we have deflation, then you have to be a lot more careful with debt and balance sheets than I think the world has grown accustomed to over the last 30 years. I love it. It's such a fascinating place to close. So many interesting topics covered here today. What a crazy time. And it's always fun talking to you about what's happening in markets.

Chris, I appreciate your time yet again. Well, Patrick, I look forward to maybe a month out, two months out, and seeing you in New York City when we're all declared to travel. We'll have a cocktail and look back on what hopefully is the COVID. Or three or four. Or three or four. But hopefully this thing's in the rearview mirror before long. Chris, have a great day. Thanks, Patrick.

Take care. Hey, everyone. Patrick here again. To find more episodes of Invest like the best, go to investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter

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