Invest Like the Best with Patrick O'Shaughnessy - Chris Bloomstran – What Makes a Quality Company - [Invest Like the Best, EP.141]

Episode Date: August 6, 2019

My guest this week is Chris Bloomstran, the president and chief investment officer of Semper Augustus Investments Group. He became famous in investing circles a few years back for his incredibly detailed investigations of Berkshire Hathaway. While we do cover Berkshire towards the end of the conversation, we spend most of our time talking about what makes for a quality business. I loved some of his angles on the current landscape, including our discussion of companies like Richemont and Disney which are actively taking distribution back in house. Please enjoy our conversation. 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 1:18 - (First Question) – Largest investing error 4:52 – Defining quality investor and their investment strategy 11:48 – Incremental return on capital and other themes that they focus on with investments 15:33 – Importance of unique business models 22:58 – Ownership of the customer relationship 28:06 – Bringing distribution back in house 29:55 – Doing something unique with owned distribution 32:40 – His thoughts on growth and value             32:42 – Chuck Akre podcast episode 37:12 – History of his interest in Berkshire Hathaway and he characterizes the business 53:29 – How is Berkshire protected into the future 59:17 – Most important trends in adjustments 1:08:00 – Which sectors or industries would he focus on 1:10:02 – Most intriguing business he’s unlikely to own 1:11:44 – Kindest thing anyone has done for him   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

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 investorfield guide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy 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 this week is Chris Blumstrand, the president and chief investment officer of Semper Augustus Investments Group. He became famous in investing circles a few years ago for his incredibly detailed investigations of Berkshire Hathaway. While we do cover Berkshire towards the end of the conversation, we spend most of our time talking about what makes for a quality business. I love some of his angles on the current landscape, including our discussion of companies like Richemont and Disney, which are actively taking distribution back in-house. Please enjoy our conversation.

I thought an interesting place to start, which I've really not done before, would be with your biggest mistake, biggest investing mistake. We'll talk a lot about successes and interesting companies over the course of the conversation, but oftentimes we learn most from our biggest screw-ups, and you were talking a little bit about one of those before we hit record, and so let's begin there. What in your now pretty long career investing in equities has been the largest error? Well, 30 years in and 20 years running Semper, you do make a fair share of blunders and mistakes. In this year's letter, I wrote about a handful and probably the one that comes to mind that I would categorize as the worst, which was clearly an error of commission, was having sold Ross stores, having owned it for the prior two and a half years.

We owned at the outset of the firm. We had transitioned a very wealthy family's portfolio away from kind of large blue chip businesses with very low cost basis. A lot of businesses no longer earning their cost of capital. Prices ranging from 30 to 50 times earnings. Very tax efficiently with a foundation and some cruts had liquidated a portfolio. And at the time, all of the value that we were finding was in small midcap names. So we buy Ross stores as an example at maybe 10 times.

earnings. We'd followed Ross for seven or eight years, had never owned it. Terrific retailer. They probably had 350, 375 stores at the time. We love the ramp at which they could continue to open stores. Unit economics were terrific, kind of high teens, low 20s, returns on capital. Balance sheet was great. They used operating leases, but judiciously. So we pay 10 times earnings for Ross. And during that first 50% bare market when the market fell, during 2001, 1 and 02, we made on the order of two and a half times our money on Ross. So the stock at that point was trading kind of high teens, call it 20 times earnings. And we figured, as we did at the time, that you could always sell things and buy them back. Well, the lessons of history

and the great investors all say it's really hard to buy something. You hear Mr. Munger talk about it all the time. Well, we sell the thing. I had this notion, and I still do at some level, that a retail concept or a fast food restaurant type concept, once they get to a certain unit size and I've always thought that number was about 400. A lot of things tend to change. Distribution changes. A lot of times you need new management. And so we thought we could step away from Ross at what we thought was a very full price. It was trading north of our appraisal a fair value. We didn't value anything at 20 times earnings at the time. And so Ross looked expensive, so we trimmed it. In the years having sold it since, the stock's more than a

20 bagger. Just insane. So you look at the unit count, profitability grew, gross margins, If we had done a model and laid out a 20-year projection, we probably could have gotten to the way Ross played out. But we sold it for price. We sold it for price and made the mistake of never circling back and buying it because I think we were anchored at some level in the fact that we paid 10 times earnings for it. And you make two and a half times. Do you circle back and pay 15 or 16 times? Well, it was clearly worth way more than 10. It was worth way more than 20 times.

And so that was just a very painfully expensive lesson because it had grown into a good size position. It was a good size position at the outset. And we forfeited a huge amount of upside on a business and a concept and a theme, really, of finding businesses that can grow units with incrementally growing returns on capital. And we walked away from it. That was a very, very expensive, painful experience. But you learn from those experiences as well. So it's a good excuse to talk about your kind of core investment philosophy.

And again, before we hit record, I mentioned this word quality investor, which I'm hesitant to use that word. too much because so many people say that word and it means 100 different things. So I'm hoping that you can define for us what quality means to you and also answer whether or not you think that it's a good word to describe in very simple terms your investment philosophy and we'll sort of peel it back from there. No, I think quality very much describes what we do. We think about two things. We think about quality and price, but we think about quality way before we think about price. But we like to say we employ a dual margin of safety in the process. We're trying to buy outstanding businesses, run by outstanding managers. I think anybody in the value world talks about the same thing, quality, blah, blah, blah.

But I think 30 years in to doing this and through the mistakes that we've made over time, you get burned enough and you get jaundiced to where your definition of quality, I think, evolves. To the point now, and I wouldn't call us timid investors at all, but if you take our collective business balance sheet today, our businesses are effectively unlevered. And we don't go in with a notion that we're only going on businesses that are net unlevered when you strip the cash out. But that's where we are today and just oddly, there are really outstanding businesses that can be had for good prices despite what we think is a very overall expensive market. But you always talk about management quality and we've owned businesses that didn't have management

quality, but thematically we thought we're in the right place. We own Milan Labs a couple different times on the notion that you had this giant patent cliff with the big branded pharma. Hatch Waxman was passed in 1984, which gave 20-year patent life to drugs. and you knew all these big drugs were going off patent. And so the generics were just in a sweet spot. The management at Mylan was accounting was suspect. They had a revolving door of CFOs. They paid themselves gads of money.

The accounting was terrible. If you think about trying to get drugs knocked off a patent, you spend your life in the courtroom. And so bribes and it was just bad. And finally, we'd made money with it, but walked away from the business quality. And so we've just kind of trended toward, ideally, we're trying to own businesses for a long time. And if you're going to own businesses for a long time, if you're going to start a business with somebody, if you and I, Patrick, want to start a business, we better have a hell of lot of respect for our core sets of values and our morals. And so I think we've just gravitated toward trying to identify these businesses that are run by folks that kind of share our value system.

And it's hard because you don't have access to management the way we would have 20 years ago. I think through longstanding ownership of businesses, management are a lot more comfortable to talking to us because we're never interested in what quarterly earnings are going to be earnings for the year. We're trying to really get a sense of how the business works and where the durable strengths are and where the permanence is and what the business doesn't look like tomorrow or a quarter from now or a year from now, but 10 years out and 15 years out and what the movers are and where's the disruption. So we sit here today with, I think, this business of great CEOs. In our 20 years running Semper, I know that the roster of CEOs that we have on board today are better than we've ever had. A lot of times they're founder owners or they behave that

way, but that's not even the outset. We're turning over rocks. We're looking at businesses, and I just think it's evolved that way. It's evolved into management quality without that being kind of front and center. And so now we talk about all the different things we do research-wise and process-wise. One thing we've started doing recently is we're spending a lot more time in the proxy statement. So every year, with anything we own, you obviously read everything. You read the Ks and the Q's and the proxy once a year. But if we're looking at a business or we're looking at a competitor. For my career, I've always tended to look at a couple three years at a time. So I'll read three Ks and I'll read three proxies. But we've gone back and we've started looking at businesses

and taking a series of 15 years worth of proxy statements. What that does is gives you a sense of where changes have been made. So to the extent the boards of directors want to make sure their CEOs and their CFOs and their managers get paid, they're always moving around these hurdles for incentive comp. And so if straight salary compensation is 10 or 15 or 20% a comp, the majority of how these people get paid is with bonuses and the vesting of their incentive stock options. And the bonuses all have caveats to them. And so we just ran one for a presentation I gave in Zurich. I gave a speech on the imperative of no and spent time talking about management teams that get it. And I use Cummins as a case in point. But then I took the proxy

and talked about what's happened at a company like General Mills. Well, if you think about the nature of branding consumer goods businesses and the threats they have from private label, for example, if we go back 10 years ago, 12 years ago, these guys had in their proxy statement for bonus comp a hurdle of maybe 3% organic sales growth. And in the successive period through this last year, that number had declined from 3 to 2, 2 to 1.5,

one to 1.4. Well, the number today, the hurdle today is a negative 1.4% organic growth rate. And that's stunning. We're going to pay you performance comp to slowly shrink the business. The other overlay to the current comp, and this is evolved in the case of General Mills as well, is we're going to pay you on free cash on a rolling three-year periods. They have an organic sales growth on a rolling three. They have free cash on a rolling three. So I guarantee you these people lay awake at night thinking about what they have to do to the business for the five years they're on watch to how they're going to earn their incentive comp. And so if one of the two metrics is free cash flow, you can cut advertising spending.

You can cut cap X. You can kill the brand of the business that you're running, but you can drive the free cash. And so it's crazy. So with one of their hurdles, there's a 50% mix between the organic sales, which they did not hit for a rolling three. So they got zero. But then they hit 132% of the free cash metric. they paid that pro rata. They split the 132%.

So they paid 66%. They didn't get zero and a hundred for 50. They actually got 66, which is crazy. So the thing that goes missing from a proxy like that, which we see in too many places, Coca-Cola is another example of it. Too many businesses don't have a return on capital. They don't have an asset-based return metric. They don't have an equity-based return metric.

They don't have a capital-based return metric. They're paid for all kinds of nonsistical things like top-line growth. what does the General Mills do in the wake of all that? Well, they're not hitting the portion of comp that's tied to organic growth. So you buy Blue Buffalo. You pay something like $8 billion for $1.2 billion in revenues. It might be a good deal. It might not. So you don't get the calculation for comp in the first year you make an acquisition, but you have a business that's clearly growing the top line and they're going to drive top line growth. Is it profitable? I don't know. Is that too big of a premium for that brand to be a creative on a return on capital basis? It doesn't

matter because that's not part of the metric on how they pay themselves. And I think that's insane. I want to talk about the common attributes that you look for in a business. You've already kind of danced around one, which is this notion of high incremental return on capital. And you also alluded to this idea with some of the stores, Ross stores as an example of sort of unit by unit expansion as being a really simple example of high returns on a new store, let's say. So talk about incremental return on capital, kind of what that means to you, what you look for, and whether or not there are sort of other themes like that, say, store expansion that fall in that bucket that you've looked at over the years.

Yeah, I think return on incrementally invested capital is probably one of my most important jobs to assess how well these management teams and these boards are keeping our portion of profits that we're not receiving as dividends. So I do have a great example of that. So we made the big mistake with Ross. We didn't know it was a mistake at the time, of course. But a couple of years after we sell Ross, I think maybe 2000 and four, we buy Costco for the first time. I was learning and I just said value investors don't pay 20 times for anything.

We sold things at 20 times earnings. 20 times was nosebleed. I paid 20 times earnings for Costco because with it, we had a business that looked similar to a Ross. They were probably running 350 or 375 stores at the time. But we believed Costco had a very long ramp to open. stores. They were just beginning to pay a small portion of their profit as dividends. So you wondered, well, is this thing getting closer to maturity or not? And so the business at the time was earning 11 on capital, which isn't very attractive. Their gross margin, their average markup was

probably 14%. But we looked at the 11 on capital and knew enough about other businesses that we were to search but didn't own over time like Home Depot and Walgreens. If you were building out units and you don't achieve maturity with a unit for a period of time. In Costco's case, a store they would open wouldn't be a mature unit for six or seven years. Mature defined as kind of maximum sales, maximum throughput of inventory, fully achieving unit profitability. In the case of a Costco, a store wouldn't earn 11 on capital right out of the gate.

Their brand new stores were earning kind of mid to high single digit returns on capital, but the mature stores were earning kind of mid-teens returns. And so we figured 11 was the wrong number and as the installed base of Costco, for lack of a better term, grew relative to the number of stores they were opening, you would start to see the improvements in returns on capital. And so fast forward to today, the business has grown the number of units to probably 800, just under 800. There are maybe 150 international stores in the mix. Returns on capital today are 21, 22%. And I think two or three points of that is probably due to the tax code change. When I look at Costco today, we kind of bake in kind of a high teens, call it 18 or a 19,

return on capital business. And I think they'll be one of the first to compete away this newfound free cash profitability that they have. But Costco today has driven the gross margin from 14 down to 11 percent. And think about that. Usually if you're a retailer, if you're a Macy's or a JCPenney or a Sears and you see a declining gross margin, Wall Street's going to kill you because it's generally a sign of something wrong. Well, in the case of Costco, they've taken the scale of the business, of their

purchasing power, and they've passed it through to their customer. So if a net margin was 1.8 or 1.9 percent, it's 2.1 percent today. But the returns on capital of the system are double what they were. And so to me, our ownership of Costco has probably been the best teaching tool that I've had just for the good fortune of sitting there and watching it grow for as long as it had. It really taught me how capital worked. And it really taught me about the importance of reinvested capital and incrementally return and incremental returns on capital. How important is unique features of a business model to you? So Costco, obviously, what jumps to mind is the membership. And that being, I guess, less unique these days. There's a lot more memberships

and subscription models in the economy. But what does a feature like that mean to you? And do you tend to own businesses that have some unique feature like that, that maybe the market doesn't do as good a job of understanding? It's not so much something that's unique, but we want to see managements take initiatives for the good of the shareholder and the good of their customers. And I've got a series of those. So a dollar general, for example, also in the retail world, it's one of the two retailers that we own today. We own them for similar reason, but we own them for very different reasons as well. I mean, if you're going to be in the retail world today, you have to ask the question, how defensible is your business against online retail? How

defensible against Amazon. And we think for different reasons, Costco and Dollar General are two businesses that are uniquely positioned as impenetrable by online commerce. I mean, if Costco may do online commerce, Dollar General is running ads through their online model, but Dollar General is just a unique animal. So we like the management team. We like the way they compensate themselves. The business, if you recall, was taken private by KKR right before the financial crisis and learned all about how private equity works during that episode. Only until we really started following Dollar General three or four years after it came back public in, I think it came out in 2009. You just saw all the egregious things that private equity does with money.

Can you give some examples there? Oh, I mean, just the leverage. So Dollar General was a wonderful looking business when it was taken private. They had no debt on the balance sheet if you didn't capitalize the operating leases and the operating leases were conservatively done. So KKR comes in and pays very high multiple I would even argue that the management team in place was incentivized with immediate investing of their stock options to allow the deal to take place. So in the six months prior to the deal being done, for whatever reason, the store count growth slowed, they missed on some earnings metrics, and the stock got beat up a little bit. And so which gave KKR a chance to come in and buy the stock back for below the all-time high price, which had been set maybe six months prior. But management got rich.

The current management team at the time got rich. The leverage that was employed was probably three or four X to the equity that was put in. The debt that was put in place came from KKR and it came from private equity and some of it came from Goldman Sachs. It was done at coupons of 12 to 13 percent. Dividends are paid out during the course of ownership. They don't open a lot of new stores. And then when it comes back out and it gets IPOed to the public again, they kind of reprice the number of shares outstanding. and did what amounted to a little bit of a split to make it look like it was the same,

but there was about a 10% shave on top of that. And then when it goes public, Goldman and KKR with their own underwriting arm takes the thing private. So they get their underwriting fees, they get their discounts. They do all the secondary offerings. We added it up and I don't remember the numbers, but it was a staggering amount of money that wasn't reinvested in the business in the case of a dollar general or the case of a Costco post the IPO.

But it was just bled from the business right into the pocket. of private equity. And I guess that's a great way to make money, but it wasn't for the good of the business. So the business came out with a lot of debt on the balance sheet. It wouldn't have been attractive to us, but produce a lot of free cash flow, produced a lot of cash flow, and over the next six or seven years paid down a lot of debt. And to the point where it's more levered than it was. I mean, I think management learned. And the guy that's the chairman actually was the guy that engineered the deal for KKR, which gives us pause. It also gives us comfort because he knows how to run business. But they cleaned it up enough and

the stock had gotten cheap enough that we bought it, oh geez, two and a half years ago, paid kind of a mid-teens multiple. And very similar to a Costco though, we liked what management was doing. We love the unit economics. And management had a plan to basically double the store count over the next, call it, 10 to 12 years. And I think if they're running 15,000 stores today, at the time we did our original analysis, I think they talked about having 24 or 25,000 stores, I think they'll probably get there. And so we look at what's happening in their geography. 70% of Dollar General's business is done in rural markets, which I think differentiates it from their primary dollar store competitors. I think if you're in Amazon and you're trying to ship

a basket of $13 worth of goods to Nob Nostra, Missouri, it costs you a hell of a lot more than $13 or $14 to ship. So the units don't make any easy. The economics don't make a lot of sense. we have seen the increase in Amazon Prime memberships, even in rural, go up and up and up, but they're going to figure out. They already know they don't make money shipping a small basket of goods. So you'll see over the time, I think, with Amazon larger basket sizes before they're willing to ship to, you're not going to be able to get a tube of toothpaste for $2 and have it sent to the middle of nowhere. And the other thing they do, and kind of the point of your question, is they're very initiative driven.

So they realized that including produce and milk and soda and beer and bob, bottled water made a lot of sense. And so they've added cooler doors in all of their stores. Over about a five-year period, we watched the number of cooler doors go from an average of, I think, eight up to 17. Walmart tried this business. And I think failed at it. Realized that the small format 7,500 square foot store is a totally different animal than running Walmart and Sam's. Distribution is completely different. If a dollar general has a thousand stores, they'll have one distribution center per thousand stores. They are very actively testing larger store formats, much smaller store formats.

They have drilled down now. If their typical store runs 7,400 square feet, they have drilled down now. And their average stores in towns of 20,000 are fewer. They're opening stores in towns of 5,000 or fewer. And we watch cannibalization there very closely. Management watches cannibalization very closely. So they're looking at different ways. I mean, they're looking at ways to trim shrinkage.

Turnover of your managers is a big deal. It's very high in this retail world. And so they've done a lot more training. They've started paying their managers a lot more money at the sacrifice of net margin and operating margin. But they've realized we're a heck of a lot better off retaining our good managers than we are having to retrain somebody every two and a half or three years. And so we think it's a management that gets it. And clearly anybody in retail is probably thinking about similar things. But we've got a model that I think works. And I think very few in retail do work. So one way of distilling down your definition of quality might be an assessment of the runway for capital reinvestment at high rates of return. You've mentioned stores as kind of the primary examples thus far. I love one or two other examples that aren't just expansion of stores to sort of hit at that same principle. So this could be a business or two as an example that you've owned for a long time or one you've bought more recently. Again, just trying to triangulate on other ways that you deploy this quality philosophy beyond just say the more retail focus. type of business. One thing that's so unique, and again, we didn't set out to do this, but I look across the portfolio and some of the businesses that we've bought in the last

handful of years. And a common theme there on that front is very much control of distribution. We own some names that we've bought that have taken distribution back in house would be Nike, would be Disney, would be Richemont, would be Cummins, and examples from each, if you like. Those are four really interesting businesses. So I'd actually love to take them one by one. and maybe starting with Richemont. So a collection of luxury brands. Talk about what was appealing and this idea of taking distribution back in house. I think that's a really interesting theme is this ownership of the customer relationship.

You hear about that a lot these days. So why is that good and important? And how is it done well in the case of these businesses? So I've got a couple of friends that are really kind of high-end kind of watch geeks. They're watch collectors. And when I started looking at the business, I presumed, so if you don't know Richmont, they own very high-end luxury brands. The Rupert family had sold their South African tobacco businesses to BAT.

I'm going to guess back in the mid-80s and took the proceeds and built out this luxury-branded good business and made a series of acquisitions over the years. They own Cartier and Van Cleef and Arpels and jewelry. They've got nine or ten very high-end watch brands. They own Peter Malarck off-shirts. They own Purdy shotguns. So when I started looking at the business, I presume that if anybody's going to pay $20,000 for a watch, you're buying the precious metal content.

You're buying the jewels. And what I learned quickly was it's far from that. I mean, here's a manufacturer that does 65% gross margins. You're not going to find a lot of manufacturers that run 65% gross margins. And as you run up the curve to more and more valuable or higher price point watches, as an example, the gross margins can run into the 90%. It's not the value of the rose gold. It's not the value of the diamonds. It's the brand.

And so we spent a lot of time with the business and fell in blood. with the chairman, Johann Rupert. He has an affinity for hating the sell side. It was loath to talk about quarterly earnings. He really does think in terms of what can I do to develop these brands and maintain the value of this portfolio for generations, not just for the five years that I'm on watch as CEO. So he thinks differently, and we like that from the outset. The business had really grown on the backs of Asian demand for very high-end luxury branded goods. China's a very homogenous culture. and as you start to achieve wealth, you like things that differentiate yourself, and jewelry and watches are one of those. And so jewelry and watches are big in China and throughout Asia. So Richemont had grown out very quickly from maybe 7 billion euros in sales to $11 billion. Almost all of that growth was on the backs of Asian demand. And at the point then where the Chinese government cut down on graft and made it illegal to bribe a party official to get a deal done with a bottle of Martel or with a vacharon or with a paddock. Philippe, very expensive watch.

They cut down on graft. Well, naturally, that killed sales. The other thing that happened was they started limiting the number of travel visas they were issuing the very wealthy families who were intent on getting as much of their capital and their wealth out of China as they could. You saw the property booms throughout the Pacific Rim and Vancouver and Sydney and San Francisco. My wife does real estate in St. Louis. And there were Chinese buyers paying cash for homes that would never be occupied simply to get

money invested in real estate out of China. So the government of China cracked down on that as well. Well, naturally high in luxury and watch sales took a hit. High in coniac sales took a hit. And so the stock got cheap and we watched management and their reaction to what I'd call that crisis was not to allow what typically happens in retail to transpire. And that's – if you're a retailer and you've got merchandise that doesn't move, what do you do?

You mark it down. Well, they said we're not going to allow somebody who just paid $20,000 for a watch to see that same watch show up on the gray market for $15,000 two months after the purchase was made. So they physically took inventory, bought it back out of the channel from their third-party retail partners and made in the case of Cartier a public display out of melting down portions of the watches. They would take the movement out, but they would melt down the precious metal content. So they very much said, we're going to limit supply. And I listened to Mr. Rupert on a conference call. Talk about the one thing that we can do to kill the Vacherone-Constantine brand,

which was founded in 1855, would be to cheapen the brand, would be to let the merchandise get cheaper. So they severed ties with a lot of those retail partners and said, look, we're now going to make an investment in real estate, we're going to make an investment in people, we're going to permanently sacrifice our operating margin and control our distribution. And even in the wake of that here in the last couple of years. They've bought all of Netta Porte, and they've bought WatchFinder. Their intent on controlling their distribution, and for that, we're willing to take a hit on the operating margin line because we think over the next decade, jewelry sales are going to grow at a very high clip. I think watches are different animal. I think you have things like the Apple Watch,

and it's probably not as rapid growing of a category, but it's still going to grow at four or five or six percent. Jewelry's probably going to grow at double that rate. It's interesting, but we like the culture of the people. We like what they've done with capital. I think in terms of margins, the margin structure comes down now that you've gone to some internet distribution, but they wanted to control distribution. I mean, they do not want to allow the product to cheapen for price. Let's go to the same theme with Disney. So this is a business whose history fascinates me and kind of current landscape is also really interesting with the move towards owning that customer relationship. So talk about the overall business, why you find it

attractive, maybe the reinvestment story, but also this notion of bringing distribution back in house. Well, what did it for us really was when Disney took their property back from Netflix and said, we're going to go over the top and distribute ourselves. Across the business of Disney, with the theme park business, with the retail, with the studio business, with the movies, they call it a tent pole franchise. They have so many different ways to monetize their IP. We looked at the economics going over the top. Disney was in the midst of trying to buy Fox. The stock had been really cheap for about four or five years. And the arbitrage community, had driven up Fox, they'd driven down Disney.

And we just looked at it and said, we think the economics of controlling your distribution will be huge. Look at the limited number of movies that Disney comes out with each year, but they're all blockbusters. These people are very, very good, and they get it. But it's to the theme of controlling distribution. That's really the exclusive reason. I mean, the community who made it cheap for us, cheap enough to get on on a price basis.

We just like the concept of controlling the distribution. We think now owning all of Hulu, they had 30% of Hulu, Fox had 30%. They've now got the whole thing running. your adult content across that platform, running your sports content across the SPN apps. Disney came out with their investor meeting, what, six months ago, four months ago, whatever it was, with what the app look like and the price points on the app. I think Netflix may be a long-term viable competitor, but I don't know. You talk to kids and folks in their 20s.

I'm not sure that once they've lost all this content, they can do what Disney has done. The library that they own is invaluable. The intangible assets inside of Disney are invaluable. How about something completely different with business you mentioned earlier, which is Cummins, as someone doing something unique with distribution? So, Cummins makes diesel engines. They make diesel engines from Class 8 down to Class 2. So basically, their bread and butter selling into Piccar and Navistar, the big truck manufacturers. So the truck manufacturers always rely on dual source.

So they all have their own engine manufacturing in-house, but they don't want to do themselves. So Cummins has really been a cyclical environmental upgrade story. If you go back 20 years, 25 years, the amount of particulates and nitrogen oxide that have been taken out of emissions because of the environmental standards that have been put in place in the United States and Europe and now even in places like China, the R&D and the high tech that goes into improving the engine have just been extraordinary. So along comes Tesla and Nikola and battery technology. So there's a fear that battery will replace the diesel technology completely. you've got some cities in Europe that are looking to ban diesel engines entirely. We think at a minimum, the Class 8 truck market, which is the big tractor trailers that run over the road, we just don't see that as a threat any time soon.

We look at the weight of a battery. We look at the length of a haul. It's very prohibitive. I mean, if you take a 33,000 pound tractor and a 50,000 pound trailer and say, we're going to run away from diesel and we're going to go to battery. Well, a battery right now weighs about 10,000 pounds. So if you take the diesel engine, you take the fuel, you take the transmission out. You're basically taking out 5,000 pounds.

So you're adding 5,000 pounds. Well, that 5,000 pounds comes immediately off the load capacity of the 50,000 pounds. You're losing 10% of what you can carry. Tesla says they can run a battery that doesn't have to be charged for 500 miles. We think it's more like 300 miles. Typically, your diesel engine, the fuel tanks run from 80 to call it 300 gallons. typically they're 120, 150, 150, you can run a shift and a half without having to stop for fuel. And it's a huge advantage if you're over the road now that the government's come out and said,

you can only run so many hours per day. We have electronic logging for driving. To have to stop downtime and charge a battery in the middle of an over-the-road shift just doesn't make any sense. So the economics don't work. But Cummins has done a lot of things. And one thing that appealed to us is on this theme of controlling distribution. They spent a fair amount of capital, oh, maybe six, seven years ago, buying in what I would call their distribution. They bought in independent service centers, branded them under the Cummins umbrella.

So now if you're running a truck, if you're a car and your driver, and you've got to maintain the vehicle, you've got to maintain the truck. Cummins has stores all over the place. They have stores globally, and it's a huge competitive advantage that they're not just servicing Cummins engines. It was just brilliant. Like a conversation I had with Chuck Akri a few weeks ago, who I would also classify as very much a quality investor that cares about price, but cares about quality a lot for price, sort of reinvestment potential of the businesses. How do you think about those two more extremes? So if you're sort of down the middle with quality, growth has obviously been an incredible story, you know all the famous businesses that have driven that. And value's

been a terrible story. So any thoughts on those two extremes where it seems like you play less? Yeah. So again, I kind of go back to my evolution as an investor where price to me was a low PE early on and you were less interested in finding businesses that could grow. I've kind of thought about the increment of the types of businesses that we've evolved to over 20 years of running Semper. My 30 years is an investor. And I've always said that growth is but one component of the value equation. And it is, but it's a really important equation because if you wind up buying a business

for a price reason and you've got a return to par motivation, Well, if you don't have a catalyst and if you don't have growth to bill you out, you may have yourself a value trap. And we still do things cyclically. I still own business. I wish I could own a portfolio of 25 compounders. And we've never gotten our minds around the fangs. We haven't done them probably to our detriment. We've owned things like Microsoft over the years, though.

I mean, having written about Microsoft in early 2000, predicting that shareholders would lose money for 15 years. Well, that was exclusively an assessment based on price. Microsoft had compounded at 65% a year. The stock since its 1985 IPO, top line had grown at 50%. But there you sat in January 2000 with the stock trading with a $620 billion market cap on $20 billion in sales. And you extrapolate forward for the next 15 years that 65% growth in share price. Your market cap would have been in the quadrillions of dollars. It just didn't make any sense. And so we made that our first prediction in our prediction letter from January 1, 2000. And three, four years later, when the stock had fallen 75%, the

underlying business had continued to compound, we found ourselves owning the business that we predicted shareholders were going to lose money for 15 years on. And we had a series of trimming it when we thought it got deer, adding to it when it got cheaper, trimming it, adding to it, and finally a year and a half ago or so, we sold the thing entirely in retrospect probably too early. But it's a business that had and has in anordinate amount of internal organic growth. It has the ability to price. It has the ability to grow volume. I think Satya's a great CEO. I don't think Balmer gets enough credit for migration to the cloud. But growth is invaluable. And I'm not sure that classical valuation techniques kind of get growth right. So again, because we don't have

25 compounders, we do own some businesses that we've worked apart. And we've been very successful with those things over the years. But we own those for a very specific purpose and for a very specific time period. One of our largest holdings today is subc7. Well, that's not a business we're and own for the next 30 years. It's an oil and gas engineering construction business headquartered in Norway, run by a great capital allocator. We love the management. We love what they do with capital. We love the assets that they own. And we think long term, there's probably a play on deep water drilling again because we think there's an underinvestment taking place. And we think a lot of assets that have been taken out of production will probably never come back into production.

But that's a business that we have a price in mind at which we would sell the business. I think there may be a price in mind at which Christian Seam, who runs the business would sell the business. But it's not a 30-year holder. That is not a business that we expect to make a 10-bagger or a 20-bagger on. We just don't have that many. So we're kind of forced to do other things. We do things opportunistically, but kind of the lens through which we start the research process is generally we're trying to find compounders. We've got a couple kind of retail-ish concepts that we've worked on for a while here that we like a lot. I think the world's grown up a lot and it's got a lot more sophisticated. And some of these things that truly are compounding

businesses are trading for 50 or 60 times earnings today. And maybe that's the right number. But I'm not paying 50 or 60 times. I can only go so far as a value guy. Do you have a fun example of one of those that you think is a great business, but it's just too dear? Oh, I mean, I hate to give them away, but only because it's so wildly expensive and I don't know that we'll ever get to it. It's kind of a funky concept, but five below. Kind of back in that dollar store theme, but a totally different dollar store theme than a dollar general. They sell little knick-knacky stuff for $5 to kids, candy and little toys and games. Small number of units. They're going to be a way bigger concept. The unit economics of that business are as good as any retail concept I've ever seen,

but it trades for 60 times earning. So it's a long way away. So we've got a whole hour without getting to the thing that I actually originally read you for, which is Berkshire Hathaway. Maybe you can begin by telling us your motivation for starting to publicly publish your investor letters again. I think for a long period of time, you didn't. And then you made the decision to start publishing them. And they're awesome. They're fascinating. They're very long, very detailed. and Berkshire was the subject of your, I think, widely distributed a 2015 letter. So I'd love to talk about your take on Berkshire Hathaway because you've gone probably as deep on that business as anyone I've ever encountered.

Obviously, it's a business that people are fascinated by, both because of its success and because of its leadership. So first describe why you started writing again so publicly, and then I'd love to begin with sort of your assessment of Berkshire and its evolution. We've got a good, what I think is a reasonably good track record. Our stocks have done something like 10 and a half, 11, percent for 20 years. If you net out the cash that wealthy family clients have when we're running all of their money, cash has probably been a drag of 190 basis points. But either way,

our stocks are 500 basis points ahead of the market for 20 years. The portfolios are probably 300 basis points ahead. But we had a period 2012, 13, 14, 15, where we'd us underperform badly. We were doing eight and the market was doing 22%. And by the end of 15, I was getting a lot of pressure from longstanding clients who had made lots of money who I think knew us well, understood our process, but four years is four years and we're getting heat. And 15 was a tough year, if you remember. The median stock was down something like 20%. Berkshire was down 12.5% is our largest holding. We were down 8 or 9%. The S&P was up 1. 4 or 5 of that was the fangs though, of course, but nobody wanted to hear that. So I'm getting calls. Chris, what's going on there in St. Louis?

Are you losing it? And what's going on in Omaha? I mean, why is Berkshire down so much? It's down 12 and And you know, the pat answer, of course, is, look, we can't control stock prices for a one-year period of time. I can't control stock prices for a four-year period of time. Mr. Buffett can't control stock prices for one or four years. It's probably more appropriate to talk about what the underlying businesses that we own are doing and even inside of Berkshire. Is the railroad more expensive and more valuable now than it was a year ago or four years ago or the utility is more valuable. And so when you look through to the underlying economics of Berkshire's holdings and the

holdings across the rest of the separate portfolio, our businesses had accreted in value over the year despite the fact that stock prices were down. So I was going to spend two or three pages on our annual letter. And I've always written a long annual letter. But to that point, we'd only send it to our clients and maybe 40 or 50 friends and colleagues and peers in the business. I got three pages in and thought, you know, we've owned Berkshire so long. And I think there are some aspects to the accounting within Berkshire that I think we'd look at probably uniquely.

I think in some, all of the adjustments that we make to gap earnings were so material that I'm not sure many or any had gone through the same process. And so I'd always wanted to write it up. I wanted our clients to see, other than talking to them at annual updates. I wanted to see how we thought about the business and all the different methods that we used to reconcile against each other to come up with our appraisal of intrinsic value. And so I spent probably 45 pages of what was, I think, a 65 page letter dedicated to Berkshire and sent it out to our clients and to our 40 or 50 friends. And Joe Costor, who you know is a good friend. Joe called me and said, Chris, look, I don't mean any disrespect, but you talk about wanting to grow your business institutionally.

He said, you know, you're an idiot. And I said, yeah, but why now? And he said, look, you can't write this up and not get it out into the either. And I said, geez, Joe, I don't know. I mean, all of the guys I really admire don't publish their letters. They keep them in how, Seth Clarmine and Tom Rousseau as an example. And Joe basically said, Chris, are you running as much money as Seth Klarman? I said, Joe, that's a good point.

So he said, look, let me put it on my blog. I'll link it to your website. Put it on the website. And we'll blast it out. He said it'll go viral. And I laughed and said, nobody wants to read about 45 pages of the accounting inside of Berkshire. And so we did it. And true enough, it went viral.

I think that letter has been downloaded something like 40,000 times. I probably had 500 people that first year reach out from all over the world with emails and calls. I was stunned. I was blown away. And so we've gone back to Berkshire. for various reasons. Two years ago, I wasn't going to touch it other than to update our appraisal. But with the tax code change, I thought with all of the moving parts inside of Berkshire, Berkshire was really a great case study for how the changes in the tax code affected

the broad swath of American business. And so we went back to Berkshire and what was really a letter meant to be written out of self-defense, business preservation in what was a brutal period, has now become probably a good marketing document. And for that, I'm kind of cursed to having to write it now each year. So let's talk about Berkshire the business. So if you had to break it down, you've already mentioned some of the key acquisitions that they made in the past, but if you were to just describe it as a business today to an uninitiated but smart investor that doesn't know Berkshire well, how would you describe

the business? Wow. Well, obviously it's a holding company, but unlike any other throughout time. You've got a collection of businesses and a management team in place that have just assembled a very durable permanent, it's probably a terrible word, but permanent business infrastructure that I think has very adeptly pivoted at times throughout the 55-year history that Mr. Buffett has run the business at times to opportunistically take advantage of major, major inflection points in the capital markets.

I mentioned national indemnity, the purchase in 1967. So Mr. Buffett gets controlled the business in 1965. Everybody knows it. I'm sure all of your listeners know. I mean, Berkshire was a textile business. They made liners for suit jackets in New England. It was a terrible business. And they realized quickly that this was not a business that they could own for 30 years.

And this was not the Costco of the future. It was not the Microsoft of the future. So they bought National Indemnity and effectively kind of morphed from textiles to insurance, property casualty insurance and reinsurance. Over the way, picked up a collection of businesses with surplus capital that had been building inside the business. They bought Seas Candy early on by the me. mid-1970s, overall stock market was cheap. Berkshire had compounded at something like 15 or 16% despite the market decline in 73, 74, despite the textile business, which they ultimately closed in

1985 being a lousy business. It had compounded at a great rate. And then you kind of fast forward from that period from 1975 to 1998, Berkshire grew that insurance business and utilized the float in the business to compounded an unbelievable kind of high 20s return on equity for a long time. The business, because it had surplus capital and so much surplus capital eventually, was able to run a much more fully invested equity portfolio for a long time. So everybody kind of looks at Berkshire Hathaway kind of as a pseudo-mutual fund or as a stock portfolio holding. Well, in 1998, Berkshire was very much an insurance company that was very heavily invested

in the stock market. Their stock portfolio had compounded at such a high rate. The purchase of Coca-Cola that they made in 1988 and then a couple successive buys, the stock was up 13x. It was 35, 40% of Berkshire's overall stock portfolio trading at 45 times earnings. They own the Washington Post. They own Gillette. They own Cap Cities ABC, which I think by then was Disney.

They only owned a handful of businesses. But the stock portfolio was insanely expensive in 1998. So if you would have bought Berkshire at the time, you would have owned basically an insurance company, property casualty insurer, reinsurer. 65% I think of all of the assets of Berkshire were publicly traded common stocks. The stock portfolio was over 100% of the book value. I think it was 115% of the book value was represented by the stock portfolio. As I mentioned, stock portfolio trading it, call it 45 times earnings in 98. And so for the second time in Berkshire's history, they pivot and buy general reinsurance.

Oddly, they buy an insurance company for motivation that I believed was to pivot away from insurance. Unlike Berkshire, which had big percentages of its investment capital within the insurance business is invested in common stocks, Jenry was more of a classic reinsurer that had 90% of its invested assets invested in bonds. And so Mr. Buffett had the quandary in 1998. Well, I've got this business that's trading it three times book. It's not worth that much.

We believed, Simper Augustus believed, that the business. was worth probably half that at the time. Call it $40,000 on the A shares, one and a half to book. And could he sell Coca-Cola? When retrospect, he probably should have sold Coca-Cola at mid-40s earnings because post that point, I think Coke's compounded total return at four and a half percent a year. It's been a mediocre lousy business. It's underperforming the S&P 500 by a full percentage point, which in and of itself, the S&P has been no Lollapalooza for the last 20 years. So he buys Gen Re, uses Berkshire as currency, spends,

272,200 shares, I think, with Berkshire trading at three to book, picks up Jenry's bond portfolio. And when you combine what was the result in investment portfolio, the common stocks had dropped from 115% of book down to 69% of book. The overall allocation of all of the assets dropped from 65% in stocks down to 30% in stocks. It's a number that hovers at 25% today. And he pivots away. There's a lot of debate. I've written about why this was such a similarly great transaction.

I wrote about it in my 2015 letter. In Mr. Buffett's 2016 letter, he came out and said, no, I think it was a terrible deal because I spent Berkshire shares that would be worth a lot more money today. Well, here we are today. The $22 billion in Berkshire shares that he spent, which I think were at twice their underlying value. I think he bought Jenree for $11 billion, not $22 billion, when you ratchet back the fair value of Berkshire. It was the allocation away from stocks that allowed him to do everything else with surplus capital for the success of 20 years. So, yeah, in today's terms, would those 272,000 shares be worth $80-something billion?

Yes, they would. But when they did the deal, Genree shareholders brought 35% of the assets to the party and only got 17% of the underlying ownership of Berkshire Hathaway. Think about that. So it's not so much that Jen Re here 20 years post the deal for most of those 20 years hadn't grown its premium volume from $6 billion. They've upstreamed everything they've made to the parent company. And it's the upstreaming of that capital and also the surplus capital that already existed inside of Berkshire that was then more wholly invested in bonds and cash that allowed them to buy the utility in 2000, that allowed them to buy the railroad 2009. Had they not put those bonds and cash on the books, they could not have bought the utility. They were stuck with the stock portfolio.

And so kind of my conclusion on the Gen. Re deal was if they had run the status quo and they had not bought Gen Re and not sold common stocks and paid taxes of what was then a 35% corporate tax rate, I would argue that instead of compounding the underlying book value of the business at 9% from that point, 10 and a half you go back to the prior year. It's really compounded at about 10, which we think has been the ROE for the last two decades. We think they would have compounded at about six. So the combined value today of Berkshire taking its book value of $30-something billion, $35 billion, let's call it when they did the deal, would probably have compounded maybe $110 billion today. Well, Berkshire's book value is $350 billion today.

So the $80 billion that they've given up in terms of today's pro rata share of Berkshire is the wrong way to look at it. It's what they did with the capital. So it's not a single variable assessment of whether it was a good deal or not. Genri is not today worth 17% of Berkshire, certainly not worth the 35% of Berkshire that it was going in when they brought the assets to the party. But those assets were taken out of Genree to do other things. And I think most people that look at this thing don't look at it through that lens. So back to your point, what is Berkshire today?

So now it's really morphed from what was. I mean, it was almost entirely insurance and reinsurance in 98. They obviously picked up all of Geico along the way. Now you've got a business that probably 45% of the overall value is still tethered to property, casualty, insurance and reinsurance. But stripping that capital away from insurance at the point where their overall stock portfolio was that expensive and the overall stock market was that expensive has allowed them to buy all these other things.

So I mentioned the railroad. In 2009, they bought Burlington, Northern Santa Fe. At the time, we hadn't figured it out. We didn't understand that the whole railroad business had changed. If you looked at the history of railroads, they were crappy businesses. They didn't earn their cost of capital. And here comes kind of in the wake of the financial crisis in the middle of recession. Berkshire buys the railroad, Burlington, Northern Santa Fe for, I think, $34-37 billion.

I fell out of my chair and said, what are they doing? I mean, here's a business that in its best year, 2007 prior to the financial crisis, earned, I'm going to say they earned nine on capital. And he paid two times capital for it. And so that nine becomes a four and a half. And if you would have adjusted for what was a very large underfunded pension plan inside the railroad, I thought Berkshire's economic return was going to be 4.5%. What I missed was the competitive nature of change within the railroad business. The business was going to start running on more of a weighted average cost to capital basis in terms of allowed returns. It was going to be less regulated. The market was going to do more of the regulation in terms of their ability to set pricing. So the service transportation board was no longer as overrun. arching as it had been prior to that moment. I think Bill Gates's guy at Cascade figured it out first. And we certainly hadn't figured it out, but Buffett figured it out. And so on a deal that we thought was outrageous at $34 billion, you know, we think that business today is worth

about $100 billion. And they've taken the profits of the business out of it. They've properly employed large amounts of leverage in it. That leverage is not hypothesated to the parent, but it's just a vastly more valuable business today than it was when we got. And that's really been the history of my following Berkshire Hathaway is there's always an aha moment to a lot of the deals they do, whether it's Johns Manville shredding their asbestos liabilities and the tax benefit from that. There's always a nuance to what they've done. You don't quite get it at the outset, but most of what they've done have made sense. And so now you've got this business that's the railroad. You've got a series of electric utilities that they own and distribution assets in Canada

and a power business in the UK that's collectively worth probably $50 billion. You've got a whole hodgepodge collection of manufacturing businesses, service and retail-oriented businesses that do $140 billion in sales that are probably worth about one-time sales, about $140 billion. Then you've got the insurance operations. You've got a little leasing finance business as well, Clayton Holmes. So you've got this extraordinary number, maybe 100 operating businesses inside this structure that's just uniquely diversified.

I mentioned the debt at the railroad not being apothecated to the parent. The debt within the utility businesses are not hypothesated to the parent. And that's really, you know, outside of a nominal amount, the majority of where the on-balance sheet debt sends. And it's not an obligation of the parent. It's an obligation of the underlying subsidiary. So you've got a business that's running with $110 billion in cash that offset by the debt that sits in the railroad and the utilities that's very liquid. So on a net capital basis, the equity is the equity. I think it's absurd that we're going to no long. longer consider equity equity with the business, and that's a knock I have on a nominal pivot that's going to be made next year in terms of disclosures. We're going to go away from reporting change in book value per share, which is insane for a business that still is 45% insurance, for a business that retains 100% of its profits, it doesn't pay a dividend. I mean, book value is a very real thing inside of Berkshire, and to say that it's not is mystifying to me. I mean, if the business continues to earn 10 on equity, 10 years from now, 60% of Berkshire's book

value is going to be driven by what they've done with retained capital. And those are all new investments that aren't done at the historical cost that you guys talked about here a couple weeks ago. These are brand new assets and brand new investments done at today's dollars in a non-low inflationary world. So thinking about your ownership of Berkshire now prospectively, and it's obvious history where a lot of its value has come from masterful capital allocation at the top. I'm curious how much you think that matters in the future. Kind of think about that Buffett quote of a company being run by an idiot because at some point it will be. How protected is Berkshire from things like succession and just poor management in the future

that it gives you the confidence to still have such a high average weight in your client's portfolios? I think a lot of that reallocation of capital that's taken place in the last 20 years of idiot proof is probably the wrong way to say it. But you think about the collection of electric utilities that they own, they are arguably the best set of utilities in the business. They're in places within the country with higher population growth. They've already got a much lower reliance on nuclear and coal than most of their competitors.

They're making a lot of great investments at tax advantaged returns. That's a business that has a good management team, great management team in place right now that's just very durable. Electrics are easy. I mean, we hate investing in electric utilities. I don't like them. I don't like them because they're retail investments. If you think about the way an electric utility works or regulated electric utility works, not wholesale, but your pricing is set by a regulatory board.

So they let you make an allowed decent return on the equity capital investor in the business. And so you're allowed to make 9% or 10% used to be 11 or 12 when interest rates were higher. But they're, you know, say they're allowed to make 9. They pay out typically a large chunk of their profits as dividends. And so for that it kind of attracts the investor that needs income. And so these things get bet up to two times their book value. So if it's earning 9 on book, kind of the same math that I used on Berkshire's railroad, that 9 gets driven down to a 4.5% return when you pay twice book for a number

9% return and the dividend winds up being a 4% yield. And so for that, these things traded twice. Well, if I'm going to buy the shares today at twice book, I'm not going to make much more than the dividend yield plus a little bit of reinvested capital because these things don't grow. There's no unit growth. There's no population growth. They're just sleepy little things. And so you're stuck at kind of 4 to 5% returns. That doesn't make any sense. And that's what they're doing retail wise. But within a Berkshire, they've had the opportunity to invest capital within competitors, but also they've invested a heck of a lot more cap-ex. and growth type initiatives where they've improved the underlying assets in the markets

that they're in and they're allowed to make kind of these nine to 10 to 11 percent returns on large amounts of reinvested capital. Well, I don't see that going away anytime soon. And those reinvestments are made at very tax advantage reasons. They've forever had the use of accelerated depreciation which lowers the amount of cash taxes that they pay. So they're okay businesses, but he bought them at very good prices and they've run them very well. So there's durability there.

I think the railroad, it is what it is. I mean, it exists within an oligopoly. Rational or not, I think more rational here in the last decade. But it's kind of hard to scrub a railroad. It's kind of hard to believe that we're going to displace. I think it's a lot more likely to believe that a Cummins diesel engine gets displaced than an entire railroad network within the United States or globally. And so there's permanence to some of those businesses that they've bought.

One question we sure have on the succession planning front. And as I've gotten to know a good number of the CEs. of a number of the subsidiaries inside of Berkshire. One question I had at the outset was, look, you've got all these old guys that have sold their business to Berkshire. And they like to say they're independently wealthy now. They're rich. They've got money.

Why do they need to work? Well, it's nice to be able to pal around with Warren Buffett. Jump on his plane. I don't think they do it anymore, but fly down to Augusta and play golf. Take them on the phone during your bridge game at the club. And oh, I got to take this call. It's from Warren Buffett. And so they've stuck around.

But these were good managers when they sold the businesses. They stayed on as good managers. And the question was, have they developed their own benches inside of those, those companies? And I'm satisfied with what I've seen and all kind of the digging that we've done, that they really have fought long and hard within each of those myriad operating subs about succession planning. Ajit, as you know, now heads the insurance operations. Greg Abel runs the balance of the operating businesses. There's a question as to Ajit's succession.

We've heard Mr. Buffett for years and years talk about how important he is to Berkshire. And there's no doubt he's that important to the national indemnity piece of the business. But my understanding is his ability to price businesses like no other. And my presumption would be that they've developed a bench underneath Ajit. As you know, he spends a lot of time on the phone with Mr. Buffett. And they talk about deals and Warren talks about him being that much more brilliant than anybody that he's encountered. If anything happens to Ajit and there's no bench underneath him, does that imply then that some portion of the business that they've written needs to be in runoff and that we can't write that type of business.

Some of these odd one-off policies they've written. I don't know. That's a question that probably should have been asked at the meeting this year, I think deserves an answer at some point in the near future. I think Mr. Buffett at 88 and Mr. Munger at 95 as brilliant as they both are. I applaud them for bringing Greg Abel and Ajit in this year to answer some of the questions. I'd like to see him more involved in kind of front and center as the face of the business for the folks that are going to be running it kind of post the current

executive team that runs it. They're trending in that direction. I'd like to see more of it immediately. Not so much because we have to get the granular data about how each of the operating businesses are doing inside the company. But there's a reputation that goes with being Warren Buffett. And for that, there needs to be a confidence factor that the whole bench, the entire bench underneath is equipped to run the business. I'm convinced they are. But I think just the general shareholder base probably deserves to see more of them. One of the things that I think maybe quants do not as well, although some do it very well as, say, a fundamental analyst would do on a company is adjustments to income statements and balance sheets. And so I'd love to close with a section on this, which is you actually mentioned the paper that we had put out, which got very deep into the impact that depreciation has on earnings and mentioned this is precisely why we put this stuff out because very smart people like you read it and tell us areas to study further.

So I'd love to hear your take on kind of the most important trends in adjustments you mentioned earlier that you make to businesses when doing your initial analysis and ongoing maintenance. Kind of what those areas are, what you suggest people focus on and we'll close with this kind of very practical, hopefully useful section. Accounting is probably one place where I think we differentiate what we do among even a lot of our active competitors. We like to say we live in the financial statements of the companies that we own. And we really only begin with GAAP and IFRS reported numbers and dig a lot deeper. And I don't think anything we do is uniquely, is purely unique to Semper. But we are very rigorous about kind of looking through to sustained free cash is the wrong word. But true economic profitability.

And the reason I say free cash can be a misnomer, you take back to my Costco example, when you have a growing business that can reinvest retained earnings at high incremental returns, the CAP-X that's being spent masks underlying economic profitability. I mentioned, you know, the 11 return on capital, which was really a lot higher, but it made sense for them to spend money as rapidly as they did. And if you would have just tried to capitalize what looked like free cash, free cash was way understated because they were spending CAP-X very well. Kind of to your paper and ties into one of the key themes of our letter this year was,

we asked, why is it that if a shareholder that owns the broad stock, market hasn't earned the underlying return on equity of the stock market over a very long period of time. And you guys kind of got to the same numbers that we did. REOs over very long periods of time have been about 13%. They didn't fully adjust as they should have during the high inflation years of the 1970s. They're probably aberrantly high today in a world of very low interest rates. But kind of that 13ish number has been, well, that doesn't correlate to the long-term returns

from the stock market, which have been about 300 basis points lower. So we've always had a process in place of under the hood and below the line kind of looking at write-offs and write-downs that take place over time, which is probably the initial biggie that we use and look at with any individual business that we're studying. We want to see the extent to which companies have taken write-offs and write-downs of their assets and their equity over time. We want to see the extent to which a serial acquirer tells us to not include acquisition expenses in its assessment.

We want to see the extent to which a company like a Milan Labs lives in the courtroom. ignores litigation expenses because there are a lot of very real operating expenses that companies bear that were told by management that like to see returns on equity higher and stated equity lower. We always make those adjustments. And so if you go back and take from an index standpoint, kind of from top down, if you go back to early 80s, we've calculated that almost 15% of annual profits every year. You can get these numbers right off S&P's website. 15% of the operating net income numbers, which are before write-offs and write-downs have been written off. The numbers are obscenely higher during economic slowdowns. You get the kitchen sinks.

You get the big baths. They tend to be lower during boom times. I think in the last couple of three years, they probably average 10%, not the full 15. But over a very long period of time, you're losing 15% of your profits. Well, that's a big number. And so if you're a business that does 13 on equity and you shave 15% of that 13, you're losing almost 2%. to write off and write downs. And so we're now understating equity and in turn overstating the ROE. It's interesting when you're studying an index or the macro, but it's critically important when

you're studying an individual business because at bottom, we're trying to determine returns on equity and capital and just stated equity and capital aren't always as they seem. They've been monkeyed with overtime. They've been monkeyed with by inflation over time in some cases for businesses that have very old assets. We've got to get to the right number. The other big adjustment for an index that we've made over time that's less important to the businesses that we own, but only for we tend to not own those businesses, tends to be in the area of defined benefit plans. Back in some of our early letters that are now on our website, we've written about all these accounting adjustments we make. So define benefit plans, if you go back 20 years, there were maybe

350 companies just in the S&P 500 that had defined benefit plans. Today, they're, I think, 320, so you've shed by probably 30. You've had new tech businesses that have IPO that don't have DB plans, they tend to use Define Comp and 401K plans. But we've had a method for the duration of our firm that's been blanketed on kind of back to your question about macro themes. We have found the overall stock market generally to be on the overvalued side during the history of our business. 1991, the market was cheap, but we weren't in business in 1991.

Clearly in 08-8-ish, early 2009, the market was very cheap. But broadly, at least as far as historical metrics go, the market's been very expensive. So we have just long assumed that a business that has a defined benefit plan, we've assumed its investments would on average earn a 4% rate of return. We'd make adjustments to different businesses based on different allocations and what they've owned. But generally we've assumed a 4% return. So we'll take fair value of plan assets and run a 4% return on those assets.

Well, back 25 years ago, the typical corporate defined benefit plan on the S&P was assuming a 9% rate of return. Well, this is after 17 years of bull market. where stocks had done high teens returns, bonds which were coming off mid-teens levels of rates, bolstered by falling interest rates, increasing prices, and trailing larger absolute returns, 9% was an unobtainable number in the late 90s, early 2000 for a long-term return. If you go back to that stock market low I talked about when stocks traded at seven times a 3% profit margin, long-term interest rates are 15%, short-term rates are 20.

Stocks are trading at 21% of sales and the typical defined benefit plan assumed a 6.5% rate of return. That was crazy. But the experience for the prior 17 years had been stocks had gone down. These are terrible. Bonds have crushed us because interest rates have risen and our principal values have been eroded. And so that was insane. But then you get the subsequent 17 year experience of rising asset values and voila, you're 9% for the typical defined benefit plan. So we would run that 5% differential, 4%.

our return assumption versus what was a nine and we take that 5% difference and run it through the P&L through the income statement on a pre-tax and an after-tax basis. To the extent a plan was underfunded, we would take the underfunded status and assume full funding over a period of time. Our method changed to 10 years versus what had been five years a number of years ago, which would be less conservative but I think winds up being a lot more actually really correct. So we would advertise that on a pre-tax and after-tax basis. And then to the extent OPEB, basically health care liabilities, which tend to be not funded at all, we'd also assume those would be funded and run those through.

But kind of the biggies were the return differential. And so what that's done for us is kept us out of businesses where the defined benefit plan is large compared to the business itself. It's kept us out of the auto manufacturers. It's kept us out of some of the heavy equipment businesses where the plan is as large as the business itself. And so what happens with those plans is take a Ford. I mean, take any of those.

Take a general dynamics. Some of these have been still good investments because they've had tail wins in terms of their underlying industries. But you get the one-off, call it $2 billion, one-off. We borrowed money, $2 billion in the bond market, threw it into the plan and told Wall Street to ignore that as a one-time expense. But the plan's in great shape today. Well, no, you should have ratably been funding $200 million per year over a 10-year

period of time. And I'm not going to ignore the $2 billion because that's my capital as a shareholder that just went into the pension. plan. And so the method is important. It's less of a drag today simply because return assumptions, now that we're 20 years into the S&P averaging 5.5% and interest rates that are near zero or have been near zero for the better part of the last decade, return assumptions have come down to about 6.5%. So they're no longer 9. There's 6 and 1⁄2, which is less onerous, requires on using our 4% number, which I still think is right. I think that ties to the paper you guys did. You guys are

assuming for three to four percent, maybe five percent for the next 20. You guys were using 10. I use kind of four to five for the next 15 to 20 years. I think the next 15 years may look a lot like the last 15, which is very modest returns out of the overall stock market. So we've not come off our 4% return assumption, but it's not as much of a charge. And then there are fewer plans on the overall market too. So I've got three kind of fun closing questions for you. The first is if for the next 10 years or next five years, you were only allowed to buy stocks within a certain industry or What sector or industry would you choose? Wow.

We are so sector. I know. That's why I'm agnostic. In fact, until we started putting marketing sheets together, I didn't know there were four sectors in the S&P that we didn't even have investments. Oh. If you look at what we've owned over time and even stripped Berkshire out, this is going to be wrong.

But we've had so much success owning well run property casualty insurers and reinsurers. And the reason I think they work is as long as we're allowed to do the investing and I don't have to just own the sector. I'm good because I think there are some outstanding insurance people. And I think there are a lot of mediocre insurance people. I mean, it's a business that everybody kind of knows is kind of produce disastrous results over time, underwriting margins that are lousy, under reserving, too much competition. You've seen way too much competition in the last decade.

But I still think because collectively it's such a mediocre industry that the stocks themselves, the individual components of the various sectors, never tend to be expensive. So you're able to invest in good businesses where you can find the good ones at very modest prices. And for that, if I was limited to doing that, I've got one in particular I'm not going to talk about, but my appraisal of fair value on the business 20 years ago is the same number that we're using today. So we thought a business that could grow is just prove that it couldn't grow because insurance is so hard. They got outside of the main state they underwrite business in and they got their heads handed to them. So they reverted back inside

their state line. And for that, though, it's a good insurer within their niche. They make good, not great underwriting results. But because it's a stock, we almost treat it as a bond that trades plus or minus 30% around the price. So it's way more volatile over a period of time. So we've been able to buy it when it was cheaper than our appraisal and trim it when it was expensive. But for the industry being perpetually undervalued, it's worked. What is the business, you mentioned 500 before. This is sort of inspired by that. What is the business that you're most intrigued by that you think you're unlikely to own anytime soon, if it's something other than five under?

Probably Master Carter visa. Oh, interesting. Okay. We've understood them and we've just never owned them for price. And in the back of our minds, today we kind of justify that lack of ownership, really that total error of omission to perceived regulatory threat. I think you'd make the same case for, in varying degrees, kind of the big fangs today. Some of these have been so obvious.

And we don't know, obviously they've been in the rear of your mirror. They've been terrific. But for the next 10 years, the regulatory threat is there. But I've also learned I can pay more than 20 times earnings for something and be okay with it. We're not hitched to some firm set of kind of classic value metric. So we understand growth. We're willing to pay a heck of a lot more for it than we ever were. So these businesses came up in my episode with Chuck Akria as well.

And obviously the notoriously incredibly high return businesses. So you say you understand them. Why do you think they're able to maintain such incredibly high returns? Well, they don't take a lot of capital. They live in very much an oligopoly structure, and we still have an awful lot of cash deals that are done transaction-wise around the globe. There's still an awful lot of market share to go get. The growth curve is long.

I equate it to a Costco. The concern would be that that model doesn't work outside the United States. Well, they've got 150 stores or whatever the number is that have proven in places like Korea where the unit economics really do work. So that curve is still long. Because I think Visa and MasterCard, absent being crushed by a regulatory body, will be much bigger, much more profitable businesses 10 years out. So my closing question for everybody is for the kindest thing that anyone's ever done for you. I'm only getting into podcasts now.

And so obviously prepping for this, Joe even called me and said out of you to the podcast, better dig into this question. And so, you know, outside of you invited me to the podcast, of course, and parents, which I think everybody kind of acknowledges. I have thought about this. And I would say, so I played football for a long time from. from eight years old up through college. And I had a series of men kind of molded me to be driven with work ethic. My father was very hard on me, very tough. And for that, I think that was one of the kindest things he could do as well.

He was an old Marine. And one summer I'd move a pile of river rock to the side of the driveway. One summer, I'd by hand with a pickaxe and a shovel dug the foundation for an addition to the house. We didn't get a backhoe. I was the backhoe the next summer. On a corner lot, we did a brick fence and we had to be 24 inches deep and 12 inches square by the time he'd go home and work every day. So I spent a whole summer with summers in a row

with pickaxe and a shovel loading up the pickup truck. But it was these football guys and kind of going backwards really learned the benefit of outworking everybody and kind of working backwards with Bill McCartney at college and Brian McGregor in high school. See if I can remember all these guys. I'm Joe Studenka, John Walker, Bob Jordan. But my first coach, a gentleman named Ken Acker, had me when I was eight years old and nine years old. He was a terrific man. He didn't have kids that had played. I think about it now.

He was probably my age, and I thought he was a fossil. I was eight, and he was an old, old guy with gray hair. And now I'm an old old guy with gray hair, and I've been coaching football for the last six, seven years, eight years. So I'm sure these kids look at me through a similar lens. He took us at eight and sat us down in his living room. The whole team, there were 20 of us, I think, asked who at that time knew the difference between offense and defense. I'll never forget. Nobody knew because we didn't have Madden.

We were eight. We hadn't played football. You weren't watching a lot of football on TV. And so he explained all that. And so he was just a great mentor and a teacher. And I'll never forget. I was a terrible football player at the age of eight. I improved on that. I was more interested in watching planes fly overhead during games. And when I kind of figured it out as an offensive lineman that year, it was easier to go try to block the safety than it was the big kid standing in front of me. Well, that's not exactly how football is supposed to work. By the time I got to nine, for whatever reason, I was a lot more highly motivated. And I was very very much. very driven by the game. And I was inspired by this man because he was fair. He was hard on us, but he was fair. And I was so desperate to get back under his tutelage. This is between eight and nine, right? I'm still a kid. So we work hard. We had a good football team. And I'll never forget, we lost a game to Columbine. This is in Colorado, Jefferson County. And we lost this game. And I was crushed. So we had our team meeting at the end. All the parents are standing around. The kids are standing around. And I was just crying. I was bawling my eyes out. But I'll never forget.

And he came over in the middle of the meeting, put his arm around me, and he said some of the kindest things that anybody could have ever said. He talked about my evolution from the prior year and the work ethic. And that moment really inspired me to just be the best football player I could. And for the rest of my years playing the game, nobody outworked me in the wait room. Nobody ran more sprints. I did everything I could to be a great player. And I attributed it to him. And so we had my 30th high school reunion a couple years ago.

And somebody on social media put a picture of our. nine-year-old football team out. And I hadn't thought about some of these guys in years. A lot of them didn't wind up going to the high school. A lot of them did. There were some very good football players on that team. But I thought about Coach Acker for the first time in a long time. And I thought, I've gotten to be really great friends with my high school coach, Brian McGregor. He and I are very close. I thought I should go try to find Coach Acker. And I hadn't thought about how old he was when he coached me, but he had passed away. I learned by digging up and I spent a week trying to find him. But I found his kids.

I found his three sons. Gosh, even his two assistant coaches had passed away. But I found his kids who ultimately, after those years in the late 1970s, also got into coaching with him. And I sent him a note about what he meant to me. And I wouldn't be who I am today without the nice things he said to me during the game, but what he had done for me for the two years. And they in turn, so his wife was still away. And they then passed along my note to her.

and they sent me a really nice note back about how it made kind of her decade post having lost him. Fantastic. Well, the amount of these answers, they keep morphing and changing. Some of my favorites are around mentorship and shaping younger people when they're kind of most malleable. And that's one of my all-time favorite answers. So thanks so much for that and just the awesome conversation. Well, Patrick, thanks. This is awesome.

I love the podcast. And it's been a lot of fun to get you know here in the last few years. Awesome. Thanks, great. 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 investorfield guide.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.

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