We Study Billionaires - The Investor’s Podcast Network - TIP438: Berkshire Hathaway Masterclass w/ Chris Bloomstran

Starting point is 00:00:00 You're listening to TIP. On today's show, I invited legend investor Chris Broomstrand from Semper Augustus to teach us how to value Berksa Heatherway. Semper Augustus has an outstanding track record with a compounded annual growth rate of 9.2% after fees since exception of the fund in February 1999. This is compared to 8.1% for the S&P 500. There is no one in the space I respect as much as Chris Broomstrand when it comes to valuating Berksie Heatherway.

Starting point is 00:00:29 So, without further ado, here's my conversation with Chris Broomstone. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors podcast. I'm your host, Stick Broderson, and this doesn't get more excited. The Berkshare weekend is coming up, and we have arguably the leading authority on valuing Berksa Hallaway with us here today, Chris Broomston. How are you today, Chris? I'm wonderful. Yeah, really looking forward to after a two-year sabbatical now, seeing everybody

Starting point is 00:01:19 in Omaha, it's been too long, and we're not going to get that many more bites at this apple. So just counting down a few weeks, this will certainly be great. Can't wait. Can't wait for that weekend. But Chris, every year you write these wonderful letters to your clients. And I'm just holding one of those up to the camera here. And you can just see how thick the letter is. And I'm even printing like two pages on one. And in the most recent, you wrote 124 pages plus appendix, if I might add, not only about Berksa Heatherway, but about so much more. And you kick the off the discussion with this really interesting look at the S&P 500 as a portfolio. And in doing so, you have included some key valuation figures.

Starting point is 00:02:04 that stood out to you. Chris, could you please elaborate on this and perhaps relate these valuations to historical figures? Through the lens as though it's a rolled up company, a single entity, and I like to compare that to the market. What you wind up seeing here in the last couple of years as the S&P has been so strong is a lot of measures, and I run this on a common size basis. So I run $100 in sales and calibrate everything to that. It just makes it useful to really visibly see margin structure and for that, then all of your ratio and relationship figures make sense. But we're sitting here now with the market, closing the year at an all-time high,

Starting point is 00:02:45 trading at mid-20s to earnings on a book basis, your five-to-book, your over 300% of sales, your three-times revenues. A lot of those are all-time highs. And what's really interesting is profitability has continued to surge broadly for businesses. So you've got a very high ROE. Again, profit margins are an all-time high, so you've got the S&P earning a high team, let's call it 18 or 19 multiple earnings.

Starting point is 00:03:12 A lot of sectors were very strong. The energy sector is largely recovered, and that's always a big swing factor as the oil and gas prices drive higher and lower, so you've really rebounded smartly and very strongly from the pandemic year. you take the 60% of profits that are not distributed as dividends for the S&P 500, and those retained earnings are not driving growth capex.

Starting point is 00:03:43 They're not driving R&D. What they're doing is buying back shares, and you've seen roughly 3% of market cap repurchased each year, but you're not getting a 3% reduction in the share count, of course, because on the front end, executive compensation is so driven by stock options and restricted shares, performance restricted shares, that you've got a 2% giveaway on the front end and again, nearly a 3% repurchase them. So when you've got a market trading for north of 20 to earnings, your earnings yield is less

Starting point is 00:04:15 than 5%. It's close to 4% at year end. And I would argue that even with the debt cost of capital very low, a portion of those repurchases financed with debt because dividends plus repurchases, you know, I would argue, the repurchases are in excess of the amount of retained earnings. So we've seen a leveraging of the corporate balance sheet. And I'd argue that's not good for shareholders. And it's a huge advantage to say, yeah, you're retaining 60% of profits.

Starting point is 00:04:46 But you're buying back shares at a 5% or a 4% earnings yield. You're not reinvesting at that ROE. And when you take a, you know, through the lens of the Berkshire, the business retains all profit. And over time, they'll make intelligent, redeployments of capital, and they really do earn their ROE and retain capital. And you can see, you know, kind of consistently here for the last 20, 25 years, the return on equity, the business hasn't altered much. There's cyclicality to the profits, and you've got to tease out some of the

Starting point is 00:05:15 short-term distortions. But the ability to reinvest is a huge driver of incremental return and long-term shareholder return. And broadly speaking, these businesses that make up the market do not do that and they've won the war in the short term by driving the share price higher and making themselves rich. If your average CEO is on the job for less than five years, the mission is often to get the stock price up and it's not to reinvest for a 20 year and a 30 year horizon. Warren Buffett is famous to saying that most investors shouldn't pick individual stocks but should rather own the S&P 500 index. Given the current valuation of the index, what are your thoughts on whether most investors should still pursue such a strategy? And could you, in continuation of

Starting point is 00:05:58 This elaborate on the five components you consider to make up the return of the S&P 500. I think he has said that over the years because I don't think he's comfortable in a position to tell people to buy a single security in an undiversified portfolio. I'd take Charlie's view that he said many times. And generally, you know, here in the last, until very recently, the stock has been very undervalued, Berkshire has, it's traded at a deep discount to my appraisal of intrinsic value. And Charlie will say, Berkshire should do better, should do a little better. And I think that's right.

Starting point is 00:06:35 I think the notion and it's correct, and I would have the same advice for the uninitiated investor, the non-professional investor, the 401k saver, the strategy, if you will, of dollar cost averaging from a paycheck every couple weeks, every month, however you do it, and buying shares of a low-cost index fund, eliminating frictional cost, the management fees, is a really intelligent program. You're going to wind up buying some shares when they're expensive. As they are today, you're going to wind up buying some shares when they're fairly priced.

Starting point is 00:07:09 You're going to wind up buying some shares when they're cheap. And at the end of the day, you know, you'll have paid up, you know, probably a reasonably average price. And if you're very long-term returns, because you've paid an average price, mimic the long-term return of the month, which they should. You wind up with a decent return. and you're not trying to jump in and out. You're not trying to chase different market caps.

Starting point is 00:07:32 You're not trying to chase different growth factors. You're not trying to run internationally. You're not trying to outsmart the market. And so for that dollar cost average, it makes sense. For somebody that has serious capital and has saved for the institution that is allocating big chunks to passive, The problem you have is a period like today when the overall stock market is priced so richly that the long-term return, 10 years, 15 years, prospectively, stands to be far lower than the long-term return. You know, high single-digit, call it a 10% return for the broad market. By my math, you're going to maybe get half of that. And so what I did in the letter this year, and it's an interesting exercise, is took the

Starting point is 00:08:23 last 10 years for the S&P and simply broke down the components of where return comes from. And really just five ways. You've got sales growth in dollar terms, which are affected by any increase or decrease in the share count. If companies are net buying back their shares and they've bought back seven-tenths of one percent per year for the last 10 years on average, again, remember, they're giving you. away 2% on the front end, but you've had a share shrink, and that's accretive to the shareholder. You get the real drivers, and certainly in the last 10 years, the real drivers have been

Starting point is 00:08:54 change in the profit margin and change in the multiple earnings and add that to whatever your average dividend yields, it's out your total return. 16.6% for the last 10 years. And if you break down the components, we've only had sales growth in dollar terms of 3% of, a year. I think people are stunned by that. When you ask, you know, how fast do you think the top line has grown for this best index in the world matches nominal GDP? You add to that the shrink in the share count. And so you've got 3.7% growth in sales per share, but you've had an expansion in the profit margin from just over 9% to 13.4% at year end. The PE multiple, which was the real driver, expanded from a 13 multiple at the end of 2011 to 23.6 using operating earnings at the end of the

Starting point is 00:09:51 year. And that added 6.4% to the return. The margin added about 4% to return. You dividend yield 2.4. So here you are trading per your prior question with the market stretched by any fundamental measure. And you've now seen the dividend yield driven down to 1.3%. It's not because companies have cut their payout rates, it's because the price paid for what's now record earnings are so high. So I would conjecture from year end forward, tell me how those five components will progress. And in nominal terms, holding aside any prospects for long-term durable inflation, very high levels of inflation, which would then lead to higher nominal growth in dollar terms, but simply in nominal dollars, if you assume a 3% continued growth in the top line and your share count's going to

Starting point is 00:10:45 shrink by another 7 tenths, five-tenths, what have you, add to that a 1.3% dividend yield and you can get to a 5% return. But from a 13.4% profit margin, which is an all-time record, we got up to almost 9% in 2000. You were a little over 9% in 1929. We'd never been the sign. There are reasons why profit margins are higher. But to grow from 13.4, you know, convince me how you're going to durably drive the number higher. Similarly, on a mid-20s multiple earnings, you've got to have some combination of rising from a 13.4 margin and a 23.6 multiple. If you simply hold those two constant, 10 years from now, you make five. And I would argue between here and there, you're probably looking at some period where prices are far below the average.

Starting point is 00:11:39 And for that, we went back and took the 10 years ended 1999. I wanted to keep decades consistent, could have run it to the March 24 peak for the S&P and the NASDAQ respectively in 2000. But simply from year in 99, you were close enough to the top of the bubble for government. And what you had there was really the best performing decade of all time on record. The S&P 500 did 18.2. Similarly, you started the period from a very low multiple. Really, what many would say would be the long-term average of 14 and a half, but you ended the decade, ended 1999 at 28.4.

Starting point is 00:12:18 So the multiple to earnings almost doubled. The profit margin ran from 5.4, 5.5% up to 8%. And you really hadn't had the big advent of sherry purchases. If you recall that last four or five years, the tech sector really led the way. And they were very diluted. Microsoft had grown their share count by 40% in the late 90s. They're giving boatloads of option shares away, and they hadn't gotten around the repurchases. And so you had an increase in the share count using the divisor for the S&P 500,

Starting point is 00:12:52 from mid-sixes to low eights. And so you were diluted by 20% which shaved a little over 2% from your earnings. dollar growth in sales was higher. You know, we weren't that far removed from late 70s, early 80s inflation. Inflation levels were much higher than for most of the past 15, 20 years. Debt levels had grown to what were already becoming a burdens of level. But you had grown dollar sales by about 6%. And so offsetting those dollar sales growth by the shrink in the share count, you got to a

Starting point is 00:13:26 three and a half, 3.6% growth in sales per share, which just made. matches the decade just ended. So your real drivers again, though, were the multiple expansion, which got you 7.2 points out of the 18% return, and the margin got you a little over four. Then you had the luxury of looking at what happened in the next decade. So there you were again, with the market stretched on all the fundamental measures that we talked about earlier, and the next 10 years were horrible. You had two bear markets. You had the 50% decline from 2000 to 2002 on the S&P 500, the NASDAQ fell 80%. That's really where much of the bubble was.

Starting point is 00:14:05 But the S&P fell by 50%. Recovered by 2007, you had the real estate bubble. But then, of course, fell by two-thirds during the financial crisis in 2008 through early 2009. Not cherry picking, simply running the decade 1999-09, you had two bear markets. you'd begun to recover. 09 was a big recovery year, so I didn't take the year-in period.

Starting point is 00:14:32 If you had taken a year-in 2008, you would have had a 3%, 3.5% decline per year, but you lost about 9% cumulatively and just under 1% per year for that decade. And the drivers, you had reasonable sales growth. You still had higher sales growth for that period in dollar terms than we just experienced for the last decade, almost 5%, 4.8%.

Starting point is 00:14:55 your share count was modestly dilutive. You had some share repurchases in the early part of that decade, but then the financial crisis, the bank's gotten so much trouble. You had enormous recapitalizations, and so your share count actually rose by about 6% cumulatively, so you lost, the shareholder lost seven-tenths of a point. But the drivers were, again, the multiple being very high and the margin being very high at the end of 99. you had a contraction in both of those measures. And you saw the multiple fall from 28 and change to 20. You saw the margin fall from 8 to 6. And so you lost between those two measures, almost 7% of return.

Starting point is 00:15:33 That got you basically a slight loss. I would expect the next 10 years to look something like that period. In fact, if you were to take rolling 10-year decile, so if you were to take rolling 10-year periods over the history of our market, You only had a handful of periods where stocks even resembled the 16.6% we just got or the 18.2% you got. You did the same thing in 1929, and that was, again, driven by margin and multiple largely. You've had only five years coming off those secular peaks, not even the secular peaks, again, just end of calendar years, but you've had only five years where the market had produced a negative return. 1937, 1938, 1939, 2008, 2009.

Starting point is 00:16:29 And here we are. Oddly, one of the very strong periods that did not result in a cataclysmic 10-year period was 1950. You were coming off very depressed levels, kind of post-World War II. But I'd take those three big secular peaks, 29, 2000, and perhaps where we are, today. Again, go back to the chair of an investment committee or go back to those that have broad allocations to passive and say, justify and tell me where you're going to grow the margin and the multiple. If you think you're going to get three on sales and dollars and a little bit

Starting point is 00:17:05 of a share reduction and a very skinny dividend yield, it's a tough case. If you split and assume you're going to get to a 10% return, then you've got to grow the margin from 13.4 to roughly 18. and you've got to grow the multiple from mid-20s to 30 times earnings. I would take the underside of that betton. So I think things are pretty stretched. It was just, again, I think a really useful way. I think you take that kind of analysis and we think about that in terms of businesses and how they work.

Starting point is 00:17:37 In addition, trying to figure out how much cash the business produces, you've got to think about multiples and margins and what they're doing with the share and how fast the top line is going to grow and how much you're going to get as a dividend. Put those five multiple. applicative factors together and that's how you get your total return. Well, that's also one of the reasons why we talk multiple times here on the show, whether or not we really should be investing in a global diversified index instead if you don't have any real opinion on the market and still you might feel that the US stock market

Starting point is 00:18:06 is overvalued. Well, I would add the end of that analysis was a little bit digging under the hood to determine how much of that, how much of that 16 points. came from the big five tech stocks. And so I included the individual stock analysis for those five. And it was a remarkable 10-year period. That five group collectively on a cap-weighted basis earned 29.8%. It was stunning. And it didn't come from the factors you would have thought it came from. Well, I mean, it did. But it did not come from any expansion in the profit margin as a group. The margin actually contracted. That really was, you started off the period,

Starting point is 00:18:49 with Microsoft and Apple being very, very large businesses. Google and Amazon and Facebook were not yet giant businesses. And Facebook and Google became very high profitable on a margin basis. But Amazon started off essentially with losses at the outset of that 10-year period. They were running a margin of just over 1%. They ended at 5. It's conceivable. They wind up at 10 if you kind of put together the moving parts of their business.

Starting point is 00:19:17 But broadly, that almost 30% return really came from an expansion in the multiple. I mean, those stocks were inexpensive. Microsoft traded at less than 10 times earnings and wound up trading at 38. The group saw the multiple expand from 14 to 33. But the real driver was top line growth. I mean, that group collectively grew from just under $300,000. billion dollars in revenues, with the core of that being Apple and Microsoft at the outset, over $1.4 trillion. You had 17% annual growth in revenues per share, and you had a reduction

Starting point is 00:20:02 in the share count. Oddly, I mean, Google and Amazon and Facebook were slight net issuers of shares, insiders cashing in their initial private ownership, still heavy uses of options and restricted shares, but Apple shrunk 10 billion shares from the share count. They shrunk their share count by 37%. Microsoft shrunk their share count by over 10%. And so as a group, you had a 21% reduction in the share count, but the driver there was sales growth. And so again, same analysis. If you've got a group now trading at low 30, multiple to earnings, and earning a very healthy north of 20% margin, if you go through each of those businesses and ask how much better can it get, I think you've kind of pushed the envelope on the multiple margins.

Starting point is 00:20:49 You know, Facebook may have seen it's high. It's going to be hard to drive much higher than 30, so 37 or 38% for Microsoft. Google's running high 20s. Apple's running a 27 or 28% margin. You're just not going to get a lot more there out of the multiple end of the margin. And where sales had grown at 18% a year, the number is going to be lower. And I suspect that who knows what the hell is. hammer is competition with each other, regulation, simply the law of large numbers, but at

Starting point is 00:21:21 70 to earnings for Amazon, for example, I mean, that's baking in, in my opinion, the profit margin will, you know, perhaps double from where it is. But if it doubles from 5 to 10, how much will the multiple shrink from 70? And so that's the exercise. And, you know, I think what you're really going to wind up getting is still healthy sales. growth. That group was amazing, was 8.5% of the overall S&P 500 at the beginning of the decade, and they ended at almost 25%. You had the 29.8% return. If you took the 495 companies that weren't the Fab 5 out of the equation, they still earn more than 14%. The remaining 495 companies earn 14.3%, which is still very healthy. But the

Starting point is 00:22:14 13 or 14x return on compounding at 30% for this group of five, if you were an investor and didn't own these five businesses and some combination of them in scale, you really suffered mightily. And their price to reflect the success of those businesses. They're five of the best businesses the world's ever seen. But again, I think it's going to be tough to grow the margin of the multiples much from here. So that's the same exercise. But that sitting atop the S&P 500, that, group collectively is pretty rich, albeit it's going to grow a lot faster. I mean, you know,

Starting point is 00:22:48 you think about how amazing it is that you've got that kind of return out of the overall stock market when sales grew at 3% a year. They're just going to grow slower. You know, they're larger businesses. Berkshire's not going to grow as fast as it did in its first 35 years. Apple, Microsoft, Google, Amazon, Facebook are not going to grow as fast as they did because they're much bigger businesses. Typically, when growth slows, margins contract and you can make that case for the the market. You can make that case for individual businesses. It'll be interesting to see how the 10 years plays out. My guess would be five would be a best case for the S&P, littered with some downturns like we had for that decade post-1999. Definitely some of the stars would align

Starting point is 00:23:31 for that decade and see a similar pattern. But Chris, let's shift gears here. The Securities and Exchange Commissions or the SEC, have this form called a 13F, and it's a quarterly report required to be filled by all institutional investment managers with at least $100 million in asset under management. That also includes your company, Simba Augustus. And many of our listeners are avid uses of Deceroma, TFP Finance, and other sources where they can see what thoughtful investors like you are buying and selling. So I can't help but ask, what can the public see, and perhaps even more importantly,

Starting point is 00:24:07 What can't the public see in those 13F filings? That's a really important question. We've had folks knock off our portfolio. It's public. We file. And it's a dangerous thing because there are aspects that are very misleading. We all know that because Berkshire listed in their annual letter, they've got a seven plus billion dollar investment in B.YD.

Starting point is 00:24:31 Some may know, some may not know. They've got a small investment, you know, just under a billion dollars in Diageo. They own a little Australian insurance operation, IAG. They've got a couple other holdings. They've got the five Japanese trading companies that have been really good investments on, really in an expansion in their multiple over the last couple of years. But that's eight plus billion dollars now that you don't see. So Berkshire's got, of a $350 billion stock portfolio,

Starting point is 00:24:59 there's 15 billion, let's say, that you don't see. So it's not that big of a deal in Berkshire's case, but it's interesting. Can you see with Daily Journal, obviously Charlie has taken the margin loan. Interestingly, he's just resigned as chairman of the board of Daily Journal, but we'll stay on the board. But he's got a position in some Chinese companies that had trimmed back his B.D. But they've got, I think they've probably got an investment in 10 cents. They've got Alibaba, and neither of those you see on the 13F are filing. We have probably, we've got about 20% of our capital investors.

Starting point is 00:25:36 in non-US headquartered companies. And I've got three that we disclose. So two-thirds of our international holdings, which is a decent chunk, probably 15% of our capital, are not on our filings. The 13F does not include any cash. And other than portfolio implementation,

Starting point is 00:25:56 we don't tend to keep a lot of cash laying around, but if a new client comes in that's not an institution, institutions like to be fully invested. But for an individual, a family, We tend to try to only buy when we're buying. And so there's a period of time that we'll have cash on the books for those clients and that gets rolled up into the composite. But it is not disclosed on the 13F.

Starting point is 00:26:16 The other thing is securities that are not in the control of the manager. So we've got a number of clients that have had for years and accounts come in and we get inherited positions. And position meets a size threshold. it's got to be filed on the 13F. So you could infer at times that we're buying things when we're actually not buying those things, but we're inheriting those positions into an account that happens to exist on a quarter-end filing date.

Starting point is 00:26:48 And whether that name stays in the portfolio or not, you know, is really a function of that client relationship. You know, we will keep things for basis reasons, waiting for a tax step up at death, for example. So if you look at our 13F, we really have about 25 kind of core positions in the portfolio, and our 13F has far more names. And a lot of those names are in there for tax reasons, and they're not businesses that we've ever bought. I've never bought a share of General Electric in my life, but we've got a little position. My first anchor client had a huge position in GE when we started the firm, and we sold 90% of it. But there's a trailer there in some taxable

Starting point is 00:27:27 accounts where, again, kind of this multi-generational planning, we're waiting for a tax basis step up. And the investor that pulls a 13F and sees Semperoning GE or Tom Russo has a partner in the firm and they have completely different portfolios. And so you couldn't infer, though, that Tom owns all of those names. They're just dynamics inside of businesses where 13F can be misleading. I think, you know, in most cases, it captures a lot. But then in the case of a global investor that has a small allocation to US, you look at the 13F filing and say, well, this guy only owns one or two stocks. But you're missing the 90% of the portfolio that exists outside the United States that are not on the SEC's required disclosure list. So there was a proposal a couple

Starting point is 00:28:11 years ago that would have raised the dollar threshold disclosure. And I like to see what other investors own and there's some utility to that. But I, from a management standpoint, I'd rather raise the dollar threshold. If you would have indexed when the 13F filing was required to inflation, a lot of those portfolios that you see on platforms like Datorama would not exist there. Unless we were running a billion and a half, or I don't even know what the next one would be down, maybe it's $5 billion. You wouldn't have to disclose your holdings to the public. So there's pros and cons, but buyer beware and observer beware. So I think it's a great question that you asked. Thank you for saying so, Chris. Appreciate it.

Starting point is 00:28:53 The other way has been making moves here in recent weeks. This is recorded March 30th, so who knows what will happen whenever this goes out. But first they were disclosing there are now 14.6% ownership plus warrants, if I might add, of Occidental Petroleum. At today's stock price worth a bit more than $8 billion, and then the all-cash-deal, $11.6 billion of Allegheny. And the latter was the biggest deal since 2016 when Berkshire Heatherway bought precision cost part for $37 billion, including debt. Perhaps let's first start talking about Allegheny.

Starting point is 00:29:28 The company is involved in insurance business. They also own small operational businesses, steel market, toy factory, even a funeral service. What are your thoughts on the Allegheny acquisition? And to paint some color around this, I could also say it was bought a 1.26 book value, at least based on the end of year numbers, and a 16% premium to the stock price at the time it was announced. I've owned Allegheny since well March of 2020. We picked up some names that we wanted to own for years and what insurance sector. Well, most things got hammered. So I've had about 2% of our capital in Allegheny basis center of under $500 a share.

Starting point is 00:30:07 So, you know, seeing it go at $126 a buck, it hasn't traded to that multiple in a while. I think Berkshire is getting a really fantastic deal. There's, to your point, we'll see what happens. You know, you've got another week and, you know, get another couple weeks. There's a shot period where Allegheny's management can go out and find another suitor, not pay a breakup fee to Berkshire, you know, if they take another deal. Really, the logical acquirer of Allegheny is Berkshire. Bersher can do things that other insurance companies cannot do similar to the Gen React

Starting point is 00:30:45 acquisition in 1998. What you'll see if they get this deal closed is the combination of insurers, Allegheny, that collectively write about $7 billion in premium, $5 billion of that is Trans Re. And then another couple billion dollars split between RSUI, which is a really just a gem of a wholesale specialty, underwriting operation, and then a little tiny cap specialty that's really not been a great business for the 20 years or so that Allegheny has owned it. But collectively, you're going to pick up $7 billion.

Starting point is 00:31:16 You're not going to, Allegheny will have to go less to the retrocessional market and lay off insurance risk because of Berkshire's Fortress Balance Sheet and massive surplus capital. They can retain a lot more of that business. And that's something that no other acquire could do. Allegheny has a little bit of debt on the balance sheet. You've already seen the rating agencies move to increase the debt rating. Again, back to the strength of Berkshire's balance sheet. If you take Berkshire's insurance operations, they don't carry debt in the insurers. There's debt held at the parent level and other subsidiaries, but there's no debt in the insurance operation. My guess is Berkshire would pay off the debt. The real advantage, the huge advantage that Berkshire has, that again, no other insurer has, is because of Berkshire's massive surplus capital, statutory surplus, end of the year at $300 billion. Collectively, Berkshire

Starting point is 00:32:09 only writes $70 billion in premium. Forty-plus of that is Geico. Auto insurers can write $3 a premium for every dollar of capital. So even if you give them two to one, you assign $20 billion of the $300 to GEICO. BH primary writes a little over $10 billion. They probably write a buck in premium for every dollar in capital. So give it 20, maybe even give it 40 and just double it for grins. And that leaves Berkshire's massive reinsurance operations between national indemnity and Gen Re that write about $20 billion. dollars. And if you look at their peers, Berkshire's peers in Europe, Munich Re and Swiss

Starting point is 00:32:47 they write a buck in premium. And for every dollar in statutory surplus they have. But they can't invest in stocks. They've got 4%, 3% of their invest portfolios in common stocks. And every time you get a major disaster or financial crisis, they've got to recapitalize. And so they've just been really lousy businesses. But they overwrite. Berkshires have this disciplined underwriting. all the way back to 1967 with national indemnity. They won't write business when it's overpriced. And in being judicious, the surplus capital has built up to such a degree

Starting point is 00:33:24 that Berkshire can have a $350 billion common stock portfolio, almost all of which is inside the insurance operation. So what Berkshire is getting in this $11.6 billion acquisition is picking up $13 or so billion in float, but what they're getting is a $22, plus billion dollar investment portfolio that Weston Hicks had, Weston just retired at year end. He's been just a superb CEO. If your listeners aren't familiar with the Allegheny's annual letters, you may not see any more annual letters after this year if they close this deal,

Starting point is 00:34:01 but Weston wrote, in my opinion, you know, outside of Mr. Buffett's early letters, I think Weston's has been in the last decade, probably the best investment. letter written by a public company CEO. It's just superb. Of that 22 plus billion, they had about three and a half billion in stocks. Berkshire is going to flip the proportion. And, you know, if they run Allegheny's investment portfolio on par with kind of how they run the overall insurance operation, you're going to be able to run the stock portfolio up from three and a half billion eventually to maybe $16 or $17 billion. Well, the delta from earning, let's say, 4% on bond, to earning a high single-digit return conservatively on a common stock portfolio,

Starting point is 00:34:48 you'll pick up $600 million in additional investment income that other insurers can't run that heavy in common stocks. So I think that's a massive advantage. And I think what you'll see, you mentioned some of the businesses, jazz wares, they've got the steel business. So as a insurer with some surplus capital, Allegheny has built out this Allegheny capital, which is a collection of private businesses. I think they've done a great job. Weston bought some phenomenal businesses. I know he had a couple guys that were sourcing deals. And so if you were to look at the ongoing profitability of those companies, for a number of years, it was masked by the fact that they were paying, effectively paying finder's fees to these two brokers. to source businesses. Once those commission tails paid off and once these businesses matured a little bit, you saw the ROE of that collection of businesses, which consumes about $1.3 billion

Starting point is 00:35:48 of Allegheny's total capital, companies earning 12 on equity. Weston would tell you, I think, anybody in the game of trying to find control positions in private businesses will tell you how difficult it is today, given how much money is sloshing around in private equity. So you'll likely see, if Berkshire closes the deal, every dollar of profit, not retain, they won't build out that Allegheny capital business. Berkshire will do that from the Omaha perspective for the holding company, and they'll buy more private businesses. But you don't have to grow that Allegheny capital business in a world of very high control

Starting point is 00:36:26 premiums. I mean, there were a couple deals that were, I think, bidding wars with Markell and Markell all one. Tom and his guys have the same problem of competing with private equity if you're going to grow up those private businesses. So it just eliminates the need there. And the other intangible, I think what you're going to get is in bringing Joe Brandon back to Berkshire, Joe had been at Jen Re, and you had that period where there was a concern that a big insurance deal with AIG was not a conveyance of insurance risk, but alone. The government put a lot of pressure on Berkshire and on Mr. Buffett to look into it or do something.

Starting point is 00:37:05 And Joe somewhat got thrown under the bus and left Berkshire. I know in the last few years, they've trans re where Joe was eventually hired by Weston to come in and run the operation, has done some reinsurance deals with Berkshire, so they've gotten back in good graces. Joe's one of the best insurance executives around, and I see them as a nice succession plan, if you will, perhaps to Ajit. There's a very real notion. At a point, you wind up seeing Greg Abel and Joe Brandon running tag teaming and running Berkshire Hathaway. So, you know, that's, you know, perhaps you're buying a succession plan, but you're paying a very, very low price. My appraisal on

Starting point is 00:37:46 Allegheny was higher than the price at which it's going out, which is not great. We've got a number of taxable clients, and I've got a big gain on that position, albeit only in two years that I'm not thrilled about paying. I would not have minded to see some a little bit of equity option in the deal. Berkshire could have done that with Berkshire now training at 150 of book.

Starting point is 00:38:09 It wouldn't be similar to the Genree deal when they swapped their shares and bought Genree using only their stock when it traded almost 300% of book value. But there was room to do that and accommodate the taxable investor and I'm a little, I'm disappointed in that. So we'll see.

Starting point is 00:38:25 You know, if you get a shop, but all in all, it's a great deal for Berkshire, and it's not small. You know, you think about Berkshire's reinsurance operation, again, National Indemnity and Gen Re. They write, the two write 14 billion kind of in normal premium per year. So you're picking up five from Trans Re. Assuming Trans Re continues to write at that rate. The other thing is, very interestingly, and very beneficial to Berkshire at the bid, is roughly three quarters of Trans Re's businesses purported. Reinsurance. You've had a very strong hard market in the last two years. We had all the hurricanes and weather storms, pandemic costs. And so reinsurance in general had a pretty

Starting point is 00:39:10 rough stretch. Well, they've taken price. And on their property lines, you know, they may get 20% for the last two years. The January renewals were very strong. And in proportionally, you tend to see a lag on profitability. So that book of business that's coming with TransRe is going to be a lot more profitable than it's been in the last two or three years. And similarly, you've got RSUI and you've got CAP specialty both taking price. RSUI is underwritten at a combined 85%. Their underwriting margins been 15% for the 17 or 18 years that Allegheny's own. It's just been a phenomenal investment for them. Trans Re has generated a 10% return. And CAP specialty, again, was suffering a little bit. They sell into small businesses where

Starting point is 00:39:52 Berkshire doesn't have a lot of business. So it's a nice compliment. and they're also like getting price. So you're picking up $7 billion a premium volume and a bunch of investment assets with Berkshire's ability to spend those assets differently. And it's a great transaction for Berkshire and it's an okay, good transaction, I guess, for Allegheny. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:44:11 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right, back to the show. So let's continue talking about Buffett. You know, it's always a pleasure reading his letters, even though as opposed to your letter, it does not include analysis of how much the stock price should be. So, but all joking aside,

Starting point is 00:44:37 Chris, you follow Berks de Hetherway, perhaps closer than anyone else in the space. What stood out to you, if anything, in Buffett's letters to his shareholders? Well, the letters gotten shorter. I think it was 11 pages. Thrilled that at 91, Mr. Buffett's still writing. You know, he's taken to thanking folks. I love the orangutan comment about teaching.

Starting point is 00:45:01 You know, the collection of Berkshire Hathaway letters over the years have been such a valuable teaching tool. You know, when students and young investors ask me for reading recommendations and books they should read, Well, the first thing any investor ought to read is the history of Berkshire's chairman's letter. There's so much there in terms of how business works and I think just an ethical and a moral approach to investing. And so Mr. Buffett's been a teacher, much like his mentor, Ben Graham was a teacher. And Charlie's comment about teaching that Mr. Buffer wrote about the orangutan effect where if you

Starting point is 00:45:35 set and teach an orangutan, your most cherished idea, at the end of the session, you'll have a confused primate, as he said it, but you'll come out of it a lot wiser for, you know, articulating your thoughts in a teaching format. I thought that was great. Now, there weren't a lot of surprises in the letter. The proxy came out after the annual, and, you know, much has been the case for, you know, my two-decade plus ownership of Berkshire going back to February 2000. The proxy and the annual meeting tend to get used by various progressive groups. Last year featured a couple of climate proposals. You've got a couple of climate proposals on the books this year. One's an exact repeat. Calpers is back and what they'd like to have Berkshire do is have each of the subsidiaries,

Starting point is 00:46:23 all of the subsidiaries, checkbox, kind of their ESG and their climate report. And Mr. Buffett in the letter and Greg Abel had a two-page in the appendix, though I thought was terrific, highlighting what Berkshire is doing way above and beyond their competitors. The vast majority, almost all of Berkshire's carbon emissions are in the railroad BNSF and they're in BHE, the collection of electric utilities and distribution assets. And Berkshire is leading in both businesses. Because both of those companies have public debt, they file their own SEC filings, they have their own cues, they have their own K's.

Starting point is 00:47:01 They have, for years, they've had very broad, informative climate discussions. Berkshire has massively reduced its reliance on coal. Half of Berkshire Hapley Energy comes from renewables. There's no other utility in the country that's even close to that. And they articulated that. And Mr. Buffett talked about it in the letter again, Greg did. And with these climate proposals again, it's just lotusy. You've got the most insane proposal I've ever seen, and that's a group that would like to see the chairmanship and the CEO position at Berkshire separated. Now, I'm all for separating that role at a lot of businesses, but you don't do it here until after Mr. Buffett's gone. He has said that once he's no longer serving as CEO, if they take him out in a pine box, if he retires, that role will be separated.

Starting point is 00:47:53 So you've got a guy that owns the voting shares of a massive block of the company. He has run it like a founder since 1965. He's run it more ethically, more morally than any public company you can see. And why the proposal? It just smacks of lunacy to me. So I get frustrated with the proxy as does. I know as does management. And they've got a terrific board.

Starting point is 00:48:19 We just saw Wally Wheats added to the board, which was great. Chris Davis and Susie had been added as well. Interestingly, that was not mentioned in the annual, but you saw it in the proxy. Wally's going to be a great steward. He owns a big block of the stock. He's owned it for years. He's there in Omaha.

Starting point is 00:48:35 There's just a lot of good. And again, I hope at age 91, I hope, you know, if Mr. Buffett shrinks his letter by one page per year, and we can get a one pager

Starting point is 00:48:46 when he turns a hundred, that'd be super. I'd love to see him in that seat for as long as possible. And just seeing any, he's not, he's not going to write a 30, 40 page letter anymore and teach.

Starting point is 00:48:56 His teaching has been done. The wisdom is there if you want to go get it. And I think anybody that goes back and reads the archive is going to wind up being a far better investor for it. And just seeing the 2021 letter added to the collection of the others, it's just icing on the cake for me. To your point there before, especially the earlier letters, so much, so much wisdom. And it's different now. The letters are different. Perhaps legacy also plays a role in terms of how he's considering what to write and how to write it.

Starting point is 00:49:28 But let's transition into the next question here, Chris. Inflation has been a hot topic for quite some time. And Buffett was even asked about this during the last annual shareholder's meeting. And his response was much longer than what I'm going to say here, but I'm just going to paraphrase here. He said something along the lines of, well, inflation won't be good for Berkshire, we'll manage it. And he also said it will have a different impact on our collection of businesses.

Starting point is 00:49:54 Could you please provide more detail on how inflation will. impact Broxia's businesses and investments? Yeah, boy, they're seeing it. Everybody's seeing it now. I don't know how durable it winds up being. I still ultimately shake out in the deflationary camp. I think the notion that we're running on balance sheet credit market debt at almost 400% of GDP up from what was already a nosebleed level of 250% in 2000, the remedy for too much

Starting point is 00:50:27 debt really should be austerity and deflation, recession, you work off credit by restructuring to where the creditors become the equity owners. I'm not sure our elected officials or our central bankers have the tolerance for it. So here we are in the meantime, on the backside of the pandemic. Everybody knows we've got massive supply chain issues. We have scarcities in energy. we have gone toward this renewables world trying to get to net zero carbon by 2050. The world is spending a lot of money introducing solar and wind. Berkshire leads there. Again, 50% of their energy operation is wind and solar.

Starting point is 00:51:09 On that front, you think about what's going on with electricity prices broadly. You know, right now the single largest feedstock for power production is natural gas. Well, domestically natural gas prices have doubled. In Europe, they've been up as much as 15x. And the rate at which utilities can pass through their feedstock costs is largely reliant upon regulators. And when the household or the business electric bill gets so high that it's tough to live paycheck to paycheck, you start to get regulatory pushback.

Starting point is 00:51:46 And so inflation there really does harm an electric utility. You think about the CAP-X that's spent. You know, Berkshire has spent over $70 billion in CAP-X against, you know, mid-30 billion in depreciation expense since they've owned their collection of utility operations. That Delta is driving the wind and the solar. It's driving the build out of the grid. And they're getting a regulated return, you know, call it a 10% return on those CAP-X dollars. Again, they're far ahead on wind and solar.

Starting point is 00:52:19 And so if you've got the conventional utility that's still very heavily reliant upon coal and coal prices have skyrocketed because we have a shortage of power productive capacity, natural gas prices have risen. Well, you know, Berkshire is in the catbird seat, at least for the moment, because the feedstock cost of the wind and the sun does not go up. That is not an inflationary feedstock cost. Now, the cost of building at your cap X gets exponentially higher. And whether the regulators are going to let you get a regulated return prospectively really becomes a question. Bersher does a nice job hedging. It's other feedstock costs. They're not going to be out of coal for a couple decades, but they've already cut their number of coal plants in half.

Starting point is 00:53:06 You've got long-term contracts that are all written with price escalators. Some utilities will have better price escalation clauses than others. But the utility operation in Berkshire's case sits in a far better position, I think, than the collection of other utilities. And that's really the first place that you go. You saw utilities really struggle in the 70s. They couldn't raise prices enough to keep up with inflation. And so the returns on equity capital dropped off. The construction costs simply got very high.

Starting point is 00:53:37 The railroad is another place where in the 1970s, it was a terrible industry, extremely capital-intensive, maintenance, CAP-X always runs in excess of depreciation costs. And it got so bad by the end of the 1970s that under the Carter administration, we deregulated rail intelligently. And the Surface Transportation Board and the government was no longer in a position to set price. and that later got modified to where the industry was really began using a CAP-M approach to pricing and was able to raise prices further. Well, you have, you had an executive order a couple of years ago by the Biden administration that's on the books. There was just a hearing a couple of weeks ago that effectively would allow what they call

Starting point is 00:54:24 reciprocal switching, allowing a customer and the ag industry loves this, the chemical industry loves it, the ability to go shop for competing railroad to come supply. Well, if you've got a single line running past your farm, your silo by your chemical plant, you're in. If you're in Burlington Northern's territory, you know, that's the single source provider. Well, insanity to let CSX or the Union Pacific come in and bid to carry freight and use your rail. It'd be like going to General Motors and saying, you guys are going to need to let Tesla build cars in your plants and subsidize Tesla in that fashion. So we're going down the path of price controls. And you've got a business that's working very, very well.

Starting point is 00:55:14 The U.S. rail system is the most efficient rail system in the country. And to see a pivot towards re-regulation of an industry that's working just fine, it is not absurdly profitable. If you look at Berkshire's returns on capital in the group, it earns, you know, kind of low teams returns. They are not price gouging. They're running it very efficiently. With all of the variable cost in a rail, the ability to quickly raise price is not as immediate. So if your feedstock costs there, similar to utility or rising, it's tougher to pass them through immediately. But you've got contract escalation provisions.

Starting point is 00:55:56 Labor is an interesting thing. because the household is being squeezed by the rising cost of living big time today. But you've got a fairly substantial union workforce, and you've got union wage contracts that are long-term in nature, and those don't reset until that contract is up. And so in an inflationary period, you don't really have the immediate variable nature of labor prices rising as quickly as they perhaps should in an inflationary environment. So I think the rails in great shape, presuming we can keep the government. out of their affairs and let that industry run efficiently. The MSR group is where you could really have a problem. You think about the kinds of businesses that can weather and inflation are those that have higher operating margins and gross margins that are in a position to be able to pass

Starting point is 00:56:49 through rising costs. Berkshire's collection of MSR businesses are largely lower margin businesses. in some cases don't have the immediate ability to pass through to customers because the customer can't bear the price increase. And so you saw some discussion in the MD&A this year about inflationary pressures impacting some of those businesses inside MR. I think that's going to be worth keeping an eye on as to how that group navigates if this inflation proves persistent beyond perhaps the next six to 12 months and you get high inflation for a couple of years. you had a really terrific recovery. That group, I'd lamented, A, my inability to fully reconcile where the equity was in each of the subsidiaries. And after a lot of years of trying to put the pieces together, I think I've got a pretty good grasp on how much equity is in that MSR group now. They've had a big improvement in profitability.

Starting point is 00:57:45 They did some restructurings broadly in some of those businesses, and you've seen a big improvement in profitability. We're the group, the MSR group, collectively, just posted in 2021, its best record profit yet. And they could very well see a decline in profitability this year for some of this inflationary pressure. Then that leaves you the insurance operation, which, you know, thank goodness we've got a property casualty operation versus life. Berkshires in such a unique position for the stock portfolio that we just talked about. You think about this run up in interest rates and credit spreads, your longer dated long duration bond portfolios are underwater this year. And that's what you had in the 1970s.

Starting point is 00:58:32 Property casualty runs shorter, shorter liabilities than does life. And so the typical duration of a property casualty bond portfolio is something like four or five years. It's more like seven or eight years in the life business. you think about the nature of where inflation is rearing its head in property casually today auto claims are very expensive to fix cars you've probably seen chart of i've got the chart in my letter of the just used car prices over the last well over time but they've just spiked this year on some late model cars you've actually got higher use cars prices than the price of the vehicle

Starting point is 00:59:14 when it was new. There's such a scarcity of chips that auto manufacturers, deliveries are way down. The cost of getting parts, the cost of labor are very high. The good news about writing shorter tail property lines, about your auto lines being short tail in nature. You think about an auto policy, typically by the time you have an accident and a claim reported, it's almost all paid out at the end of five years. Most of it gets paid in the first year. You know, say two-thirds gets paid because you wreck your car, you've got to fix the car. You file the claim, you fix the car, you take it to a body shop, and you're in and out in a month, you're in and out in a few weeks. So another 20% winds up getting paid in the second year. When you get into the third, fourth, fifth year, a lot of

Starting point is 01:00:06 that then are your medical claims, the medical portion of an auto policy claim. And those tend to longer to work their way through the courts. You've got legal inflation. But the good news there is, as long as you've got an accommodative regulatory environment, ergo, you know, ditto your rail industry and ergo your utility industry, as long as your state insurance commissions understand that your profitability is suffering mightily because of the increased costs of paying claims, you're generally allowed to re-rate. You've seen some rate-taking this. year that should offset. But if you get a durably high inflation, the 1970s were just as they were with utilities and just as they were with the rails, a really lousy environment,

Starting point is 01:00:55 a really lousy business to be in. It was a very high underwriting losses for many, many years in the 1970s and early 80s. You think about the retroactive business that Berkshire writes, these long-tail asbestos policies, that. that are capped at a price level? Well, again, if legislation and the cost of claims becomes inflationary, you wind up paying your losses that are capped over a shorter duration period of time, which means Berkshire gets the use of the float for a shorter period of time. So that's a place where durability high inflation would harm the business. I think the business is probably better off in terms of reserves against statutory surplus, Berkshire's the winner,

Starting point is 01:01:42 by far on that platform. So you go back to the bond portfolio, that Berkshire doesn't have me. They've got $20 billion in bonds in the $350 billion stock portfolio. They really don't have a bond portfolio. To the extent they've got fixed income plus cash sitting there as insurance reserves,

Starting point is 01:02:00 you know, they had $90 billion in cash in the insurance operation alone year-end and only maybe $16 of the $20 billion in fixed income. So you do not have to-raevales. risk there. If we get durability higher interest rates, Berkshire does not lose on that front. And I think where you could lose on that front is the stock market doesn't do well. You get top five or six businesses make up almost all of Berkshire's stock portfolio.

Starting point is 01:02:28 And randomly, I mean, the top five are all up this year. And so Berkshire is going to show an accretion on book value and earnings from stocks, even though the S&P 500 are still modestly negative and the NASDAQ is down by more. Apple was up for the year as of yesterday. The other big, you know, big four or five positions, Kraft, which has carried as an equity method investment is up for the year. But if you can period where stocks don't do well, and they did not do well in the 1970s,

Starting point is 01:02:55 that stagflation was not good for the stock market. It was good for a stock picker. It was good for somebody that was able to trade and pick up businesses when they were cheap, the ability to buy the Washington Post and Geico, General Foods, the investments that Berkshire made during that period that were just home runs were done during a period where start to finish, late 60s through 1982. The Dow declined from 1,000 to 778, I think it was. And next to inflation that averaged high single digit, the investor lost 75% of their money. So we'll see.

Starting point is 01:03:31 You know, Berkshire loses there if the stock market does poorly and their stocks do poorly. But again, that's coming from surplus capital. Most of that stock portfolio is money that Berkshire does not need to have in the insurance operation and the fact that you don't have duration risk in the bond portfolio is a huge win. So net net, as is the case in almost any affair in any situation, Berkshire wins on the insurance front because it's got the Fort Knox balance sheet. You put it all together. and Berkshire is going to suffer.

Starting point is 01:04:03 Most businesses will suffer during a period of high inflation, but relatively to their peers in their various industries. And as a whole, they should suffer far less and I think fair better than the average business in the stock market for that. And we can't talk about inflation without talking about the interest rate. Because as a result of this inflation, the Fed has already high rates and will continue to do so, as many as six rate hikes of different magnitudes have been signaled in 2022 alone. What is the impact on the interest rate increases on Berksa Heatherway?

Starting point is 01:04:38 Well, from a reported profitability standpoint, because you've got over $140 billion in cash in the business that host the Fed intervention at the outset of the pandemic in March of 20, when we took short-term rates back down to zero, you had almost no interest income on your bond portfolio. At 2%, 2.5%, % Berkshire is going to wind up making $2 or $3 billion in interest income on its cash reserves, which is great.

Starting point is 01:05:12 I treat that differently, as you know. And of Berkshire's cash, you see Mr. Buffett talk about, he's now raised the number from $10 to $20, now $30 billion. He says of the cash, we'll never go below $30 billion. I think that number is higher than I segregate the overall 30. I also presume in the insurance operation because they don't own a long-dated bond portfolio, and they're going to use cash effectively as the highest mark on capital.

Starting point is 01:05:44 I think they're probably going to own cash matching one year's worth of losses actually paid as cash and, you know, that number is about $42 billion. So if you take the 30 plus 42, that gets you to $72 billion, which randomly is half of Berkshire's cash at year end. So I presume there's about $70 billion, low $70 billion, available for investment in longer dated, longer duration investments, investments like Allegheny. And I've long presumed some optionality on Berkshire's cash reserves. And what I do there is presume that the hurdle rate for investment is still at least 10%. But because they're not going to make investments today on a time value of money basis, I presume they'll make 7% returns on that portion of cash

Starting point is 01:06:36 that can be invested. From that hypothetical, 7% return, I subtract whatever the bill rate happens to be. So if at year end, we wind up with a series of rate income. increases and we're at 2% on T-bills, I'm only going to assume that Berkshire is going to earn 5%, the 7% minus the 2% on the cash reserves. And I'd pose the question this way to those that would look at optionality in a different lens. The minute the Fed raises interest rates, is Berkshire immediately more valuable? If the Fed were to raise in the next three meetings, 50 basis points at a clip, it wind up

Starting point is 01:07:15 but 175 on Fed funds, call it 2%. Is that incremental $3 billion that Berkshire earns immediately worth some multiple to that current earnings number? Take the $11.6 billion, presuming it closes in the Allegheny deal. I mean, that's going to earn more than 10% based on the price that Berkshire's paying for. And again, the ability to flip the investment reserves to more of a common stock approach. but on 116 now do you have one or one and a half billion dollars

Starting point is 01:07:51 of now immediate earning power that needs to be capitalized at some number if Berkshire took all of its cash $144 billion and invested it at 10%. Now you've got an additional $14 billion in actual earnings in the business. Do you then capitalize that new $14 billion

Starting point is 01:08:11 at whatever multiple you'd capital? personalize Berkshire's income at, I mean, is it worth 18 times that new $14 billion? I'd say no. I'd say my method has captured. And so when Berkshire invests in Oxy referred, the new investment in Oxycommon, the investment in Allegheny, the increase in interest rates, I don't change a thing because I've assumed this time value of money optionality on Berkshire's cash. And so, you know, the Fed raising rates will not arm Berkshire in the same way as it well, again, insurers where you've got a rising yield curve on the front end, the back end. We'll see where the curve inverts, where it flattens, I just saw. Some are now calling for

Starting point is 01:08:56 a 10% or 4% tenure by the end of the year. I don't know that you can get that. I mean, frankly, in my opinion, we don't have a system with debt levels as high as they are, $23, $24 billion GDP, and on-balance sheet debt at $90 billion. We can't go back to where we were 20 years. We can't go back to where we were 20 years ago at a 5% short into the curve and 7% long into the curve. So the market being forward looking, this latest rally in stocks is interesting. It almost seems as though now we're telegraphing a recession and we finish the taper. So now the Federal Reserve is not in the game of buying treasuries and mortgages on a net basis, but they're not at the same time shrinking the balance sheet.

Starting point is 01:09:38 They're simply not net adding to the balance sheet. Now, when a treasury matures, they're going to replace that treasury with a new treasury, but they're not going to shrink the balance sheet like they tried to do for a few years leading up 2018. Broadly speaking, if you get three or four or five years of inflation and they've got to continue to defend the currency and raise rates, and every year when you get a CPI adjustment factor on Social Security, the boomers just started retiring. And now, we've got that demographic time bomb. If the Fed were to raise rates to 4% or 5% on the short end of the curve, we would blow up the economy.

Starting point is 01:10:16 You're going to have a very, very, very bad recession. So my guess is in the short term, yeah, they're going to run because they've kept monetary policy too loose for too long. Doing what they did in the pandemic, I suppose, for a period of time needed to be done. You've had this white-hot housing market. What business have they had up until just last month continuing to buy mortgages, mortgage-backed securities? That's absolute insanity. You've had housing prices rising by 10 plus percent, a shortage of homes, and the Fed is facilitating the mortgage market, just absolute craziness. So, you know, to the extent there's inflation, our central banks globally have had a hand in introducing it. And then at the same

Starting point is 01:10:58 time, we have these scarcity. We've got these scarcity in energy because this transition to wind and solar requires so much more productive capacity because those are intermittent sources of power that we don't have enough conventional power. We've flipped a lot of our refining capacity to renewable diesel. Well, a renewable diesel plant only makes synthetic diesel, does not make gasoline, does not make asphalt, does not make the feedstocks for plastics. And so we've genuinely got a shortage of supply, and that's not easily remedied. You know, if the energy industry wanted to flip a switch and ramp up production. And they've been drilling all these wells that are ducts drilled but uncompleted.

Starting point is 01:11:43 We don't have a lot of exploration spending going on right. In this tight world where there's a demand for energy, there's some rationality to what they're doing, but there's also an inability to do much. You know, bringing labor back, the jobs just aren't there. The workers that are willing to come work are just not there. You can't get steel casing for pipe. So there are pockets there where we're likely to have far. higher energy prices. I wouldn't be surprised if oil averages, you know, $100 or more per barrel

Starting point is 01:12:13 for a persistent period of time. If we get a piece on this Ukraine situation, you're going to get oil run back to, but it's not going to drop much low than $90, which is kind of where it was before this latest crisis. And until you see a lot of spending on supply, things are going to stay pretty tight. And so there are places where you're going to have some inflation for a period of time. I just think Berkshire is in better position than most businesses to weather it because if it's fortress balance sheet and durable earning power and we'll see where regulation takes us. But we're not going to go to where we were in terms of the yield curve because the system

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Starting point is 01:16:12 All right. Back to the show. We've gone through Berksa Hallaway, the business model, and in greater detail than I think we ever had any guests come on to show and talk about. So let's now talk about valuation and expect return. So in your 2021 letter, you have this quote and it says, bearing a deep depression or a hyperinflation, I'd be surprised if Berkshire compounds over the next 10 years at less than 10% per annum. So having said that, could I please ask you to elaborate on that statement and talk a bit about normalized earnings estimates? Well, it's fairly straightforward in that brochures never paid a dividend. Actually, they paid a 10 cent dividend in 1967. But outside of that,

Starting point is 01:16:57 they've never paid a dividend. And so if you drill down to what I'd call economic, kind of normalized economic earnings at the business, Berkshire is going to earn effectively an ROE return on equity capital of whatever the profitability is relative to the equity capital. And book value is going to get more distorted to the extent Berkshire continues to buyback shares north of book value. You have old assets on the books that are in a high inflation period

Starting point is 01:17:27 or carried at a lower cost. So book value is going to be less important as a proxy for value, respectively. But still, it's a very real thing in the energy operation. It's a very real thing in the railroad. It's very much a real thing in the insurance operation. And those are the main drivers of Berkshire.

Starting point is 01:17:49 So retained equity and what happens with retained equity is very important. I get to an intrinsic of about little, over $600,000 on the A shares and a little over $400 on the B shares. So, you know, $900 billion in change. I think the best, I think of all the ways that I measure Berkshire, and you've read this in the letter and those that haven't seen the letter, I go into kind of grade to tail most years about how I break it out. I think the two methods that I use to offset each other, some of the parts of the main subsidiary components, and then I offset that against kind of just the main adjustments that an investor would make from a macro perspective at Berkshire

Starting point is 01:18:34 from an adjustment to gap earnings. The energy operation is going to earn a regulated return, three and a half billion in profits to Berkshire, you just picked up these Dominion assets. I think fair value there is probably $80 billion. I had a mistake in my letter this year on that front, because in the closure of the Dominion assets, of the pipeline systems that they have, two of them are only 50% own. And of the LNG cove point property, Berkshire only owns 25% of that asset. So we all know that in Berkshire-Athaway Energy, you've got a non-controlled interest. For Walter Scott's, what's now, sadly, we lost Mr. Scott last year in the fall. his estate is still open. He and his wife's foundation will wind up picking up the 7.9% interest

Starting point is 01:19:29 in Berkshire Hathaway energy that he owns. And that's not insubstantial. That's, you know, at, you know, $80 billion. You know, you're looking at, you know, six plus billion dollars. Greg Abel owns 1% of BHA. So you've got this non-controlled interest. Berkshire has a non-controlled interest of that 7.9 plus that 1% piece. Well, within the Dominion assets, you've got $4 billion in assets and $400 million. Huh. Oddly, a 10% ROE, you've got a non-controlled interest that Dominion and other investors have retained. And so I was a little high on my earnings estimate, but you take the energy business worth maybe $75 or $80 billion, the railroad earns low-teens returns on equity and capital.

Starting point is 01:20:18 I carry it at a range of $115 to $135 billion. If you marked it to market, it's a very similar business in terms of track miles, in terms of assets, in terms of profitability to the Union Pacific. Mr. Market values the Union Pacific last I looked at about $170 billion. So my number there's pretty conservative. I carry it at a range of 17 to 20 to earnings. They don't retain capital. a lot of the spending that's taken place on building out parallel track, blowing out bridges for intermodal, being able to dual stack containers. A lot of that's been done. And so where,

Starting point is 01:21:00 during the early years of Berkshire's ownership of that railroad, they were spending $2 a KAPX for every dollar of capital. The cadences dropped off in the last three, four years to where they're spending about 150 percent now. But, you know, I think that number, again, if Mr. Market as a guy is fairly conservative. The MSR businesses were just, we're just on fire. Last year, the group does 150 billion in revenues. They've got the margin back up to 7% and healthy now. Having lagged a bit, the precision cast parts investment has been a bit of a disaster. But they've made some real strides with some of these businesses, and the group is now earning almost 10% on equity again, which is terrific. Again, we'll see.

Starting point is 01:21:45 see what happens with inflation this year, but multiple of a high teens, multiple earnings, that group is worth a couple hundred billion dollars. And then you've got the insurance operation that can be valued multiple ways, earnings power, or simply marketable securities. I take the stock portfolio and I charge $50 billion against the stock portfolio for what you would call overvaluation. There are moments where the stock portfolio is undervalued. There are moments where it's overvalued, but I'm charging $50 billion against it. And then you've got some assets at the holding company. And so you've got almost $30 billion of net assets there.

Starting point is 01:22:26 And your investments in Kraft and the other equity method investments, pilot flying J, TTI, Burkadia are held at the holding company. You've got some cash at the holding company. You've got some liabilities at the holding company. But there are assets there as well. You put it all together and you kind of get to your, number. I would say from a conservative conservatism standpoint, when you, when you add up the profitability of each of those groups, I get to about $48 billion in kind of normalized Berkshire economic earning

Starting point is 01:23:00 power. And at 18 times earnings, that's how I get to my intrinsic, no more complicated than that. I would say when you are analyzing the stock portfolio, it's easy to take the market value, make an adjustment for Apple being overvalued or some portion of the stock portfolio being more valued. But when I'm running through the earning power of that subsidiary, I think most Berkshire watchers know, now that we've got unrealized gains

Starting point is 01:23:31 and realized gains flowing through the income statement as opposed to simply realize gains flowing through the income statement. Both are obviously flowing through the balance sheet, of course. You've got to back those out. And so, you know, we all know to then assume that on top of the $5 billion in dividends that Berkshire earns, which is a portion of the $48 billion, there's another $16 or so billion collectively. So 11 to $12, so we'll call it $12 billion of retained earnings on the common

Starting point is 01:24:05 stock portfolio, the portion of profits that Apple retains, that they don't pay as dividends, there's $12 billion there. When you add up the $5 billion in dividends and call it the $12 billion and retained earnings, and you've got a portfolio that was trading a little under 20 times earnings at year-in. So you've got a 5% earnings yield. If you're adding back the retained earnings, and that's it, and you only presume that that Berkshire is going to earn the retained earnings, then you're assuming that the stock portfolio averages a 5% return over time.

Starting point is 01:24:38 Maybe that's right, but if the stock portfolio earns 10% a year, then you've got a much, much higher earnings number that will actually accrue through Berkshire's income statement, balance sheet, book value, so on and so forth, by only assuming the earnings yield. In our simple, our earnings yield has ranged at the end of each year for the 23 years we've run the firm between seven, you know, six and a half, let's say, in nine percent. So, but our stocks have averaged just right at 12 percent a year. You're buying stocks for less than what they're worth, they accrue, but also the retained

Starting point is 01:25:18 earnings, back to the earlier discussion, the retained earnings are being invested at the ROE of the businesses. And so, you know, an investor should earn more than the earnings yield over time. So there's a conservatism to that $48 billion that is underappreciation. again, because it's only an earnings yield numb. The reconciling method that would be used against the sum of the parts, the largest adjustment there is exactly what I just said. It's pulling out the realized and unrealized gains and substituting than simply the retained earnings of the portfolio.

Starting point is 01:25:57 I further strip out whatever your underwriting results are in the short term, and I add back in a presumed 5% pre-tax underwriting margins. So on 70 billion in premium, Berkshire would earn $3.5 billion in a normal year. On an after-tax basis, maybe $2.7 billion of after-tax profit that the insurance operation would earn as a portion of that $48 billion. You would also, I make a small charge for the extent that I just assume companies are only going to earn 4% on their investment assets on their pension funds. And if Berkshire assumes a 6.4 or 65% return, there's about $400,000 adjustment there. You know, Mr. Buffett has talked about, and this would be correct.

Starting point is 01:26:43 And I'm not sure I'm fully on board with. To the extent other intangibles, not goodwill, but intangibles are being amortized, you've got to add back a portion of those intangibles to net income. And that's, you know, about a billion dollars. customer lists is a portion of any premium on an acquisition. Back in the day, up until 2002, you'd put a lot of Goodwill on the balance sheet, and Goodwill tended to be amortized over a period of 40 years. And we changed the accounting there, and so Goodwill is no longer amortized.

Starting point is 01:27:19 So you see the accountants put more into other intangibles. And there are certainly intangibles that lose value patents expire, for example. And so you've got to play in nuance. I'm not sure 100% of intangible should be added back and I don't add 100. Mr. Buffett suggests that you should. And so you run all that together and you wind up essentially with the same $48 billion in earning power for the business. Yeah, I certainly agree with that.

Starting point is 01:27:49 And if you're the kind of person who whenever you read a crime novel, you always read the last page to figure out what's going to happen, that's sort of like how I felt whenever I picked up your letter, and I found PADs 96, and I looked at the intrinsic value assessments you have made there through your different approaches. And I would just like to give a handoff to the last time we had on your show. We'll make sure to link to that in the show notes where you go through each of your approaches and specifically emphasize the two-prong approach. And at year-end numbers, you come up with a valuation of $949 billion or equivalent to a B-share price of 429. And of course, whether I said 46,

Starting point is 01:28:29 or 26 or 29 there at the end, we're talking about approximate numbers. So please don't take this at face value with two decimal points whenever we talk about intrinsic value. For the listener out there who might be a bit overwhelmed with all the numbers and the detail of which you're describing your valuation approach, what's the simplest way for a new intermediate investor to assess Berksia's value? That two-prong method, Mr. Buffett introduced, I think he was in the 1995 letter. And it was in for five years and then it was out for a period of time.

Starting point is 01:29:08 And it came out for five years. And then it was back in. And the methods changed. But essentially, all you're doing is taking the operating earnings of the subsidiaries on a per share basis. And you capitalize those at some number. And then you take the marketable securities. and those are worth what you think they're worth. You could charge against them for float.

Starting point is 01:29:31 You could charge against them for the fact that you think the portfolio was $50 billion overvalued, but essentially you have that in a nutshell. In the early iteration of doing this, underwriting profits were included using the Berkshire method for five years. Berkshire bought Genree. You had a couple of years of really nasty underwriting results, and all of a sudden, the underwriting results were so bad in the late 90s that it dwarfed the operating earnings of the business.

Starting point is 01:29:55 Now, back then, Berkshire was largely insurance. They hadn't bought the railroad. They hadn't bought the utility operations. The majority of the earning power of Berkshire came from the insurance operations. And so when your underwriting profitability was negative and you lost money on a combined basis, those numbers were pulled from the return. When they made a reappearance, they were excluded. And so Berkshire had a 13, 14 year, now a longer period of time where they underwrote profitably,

Starting point is 01:30:22 We've long assumed that Berkshire is going to underwrite, to my earlier point, at a 5% pre-tax operating number. And so, again, on 70 billion in premium, you know, my final addition to my two-prong approach is backing out whatever they actually make on an underwriting basis and adding in 5% pre-tax and capitalizing that a conservative number. The also at a point, cash within the subsidiaries was excluded using the Berkshire method. it wouldn't count the little bit of cash held within the railroad and the energy operations, which today is only about $4 billion, but it would exclude the cash held within the finance businesses that's more meaningful. All of the cash got rolled up and included, and I think that's probably fine. And you're really talking about rounding errors and using the difference.

Starting point is 01:31:14 So, you know, if you take the operating earnings of the subs, you get to about $27 billion in earning power now. And from that, you have to exclude any earnings on the marketable securities, on the stock portfolio, the cash, and bonds. Otherwise, you wind up double counting, right? Because you're going to count the value of the assets over there as opposed to the earning power on the assets. So on $27 billion, let's call it north of 27. Before the change in the tax code, TCJA at the end of 17, I was multiplying, I was using a 13F cap factor. against earnings to get to my 18 to earnings.

Starting point is 01:31:54 Well, all of a sudden, when the tax rate changed from 35% to 21%, if those profits were durably retained, you got to capitalize them with a different number to get to 18 times. And I don't think Wall Street investors really caught on to that notion immediately that all of a sudden, because you've now got more, because the world's obsessed with EBITDA and not net income, but net income and free cash are a real thing. and so I flip the cap factor to 15.4 multiple the pre-tax earnings.

Starting point is 01:32:23 But that gets you to that portion of the number, and then I simply take the marketable securities, make any adjustment to the degree of securities are over undervalued, and add back in a little bit of margin for underwriting. It could be more conservative and assume break-even underwriting over time. Could be more conservative and back out the cash. But I think for the investor, it's pretty easy to get your mind around. operating earnings from the subs because they're still broken out in the MDNA and whatever you think the marketable securities are worth.

Starting point is 01:32:56 And pretty straightforward. So it eventually was taken out. It just got too cumbersome as moving parts changed here and there. And I was critical about it at the time. In retrospect, it really didn't matter. But it hasn't been in the letter for several years. But I've got it in my letter and I've got the history of it back to 2005 or 2006. and you can kind of see that progression.

Starting point is 01:33:20 All of the methods, my adjustments to gap earnings, my sum of the parts, or normalization factors, there is an additional, not even in the sum of the parts, but in my gap adjustments to earnings that I didn't mention. Berkshire's utilities and railroad immensely benefit from the use of accelerated depreciation for tax purposes. Berkshire pays way, way less, far, far less in cash taxes than it reports as gap. And so you've got this big deferred tax liability that now in cumulative sums to about, you know, $90 something billion. Some of that is the offset for unrealized gains in the stock portfolio. But you've got a good chunk of it that simply represents the fact that we're accelerating

Starting point is 01:34:06 cap X immediately for tax purposes and those taxes are eventually paid. Well, there's an absolute time value of money. the fact that you're physically writing a far smaller check to the government and you're going to pay them 10 years from now, 20 years from now, 30 years from now. So I pick up a little bit of that differential as well in my normalized number. And for conservatism's sake, you would perhaps exclude that by the same token for those that would jump on that, you know, the optionality of cash, again, if you're going to exclude the optionality of the cash, then when you're running the ROI of the business, you better take the cash out of the business and only apply the operating

Starting point is 01:34:42 earnings against the assets that are employed in the production of that portion of the profitability, and then do whatever you want with, whatever you think cash is going to earn overtime. But you can't assume it's zero. If you assume cash was worth zero, then you have $150 billion less of Berkshire value than you have. That seems silly to me. So I just, I conflated about three moving parts there to really make things not straightforward for the listeners. But I think that two prong is still pretty useful. And I'll keep it in the letter. I just want to highly recommend your letters, just like I did last year. It's absolutely fantastic. If you like me and like Chris or avid followers of Berksa Hathaway, this is definitely the letter to read. But with that said, Chris, where can the audience learn more about you and Simper Augustus? Yeah, we have a history of letters on the website, Semperagustus.com. I've got a tab for letters, and there's another tab for podcast and interviews.

Starting point is 01:35:40 interviews when this is published, we'll post it immediately to the website. So our interview, our talk from last year is up there, a handful of others. And there's enough between the letters going back to 1999. There's a lot of literature there. I'm on Twitter. I still regret maybe that I'm on Twitter, but I think I'm at Chris Blumstrand. I don't think that's cap sensitive. Website is probably the best place to find us.

Starting point is 01:36:07 Perfect. And Chris, I can just say, like you also mentioned, the introduction. It's just impossible to find a better person to talk about Berkshire than you. I'm sorry I can't meet up with you and your crew for this meeting. I would highly encourage everyone who are going to the meeting. I know a lot of your listeners, the podcast would be going. It's been absolutely a pleasure speaking with you here today, Chris. I hope we can do this again next year. Yeah, I count on it and I'll count on seeing you in Omaha in 2023, 2023 or bust. Challenge accepted, Chris. Thank you so much for your time. Have a good one. Thanks, Dick. Appreciate having me on. It's been a lot of fun. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional. This show is called. Copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP438: Berkshire Hathaway Masterclass w/ Chris Bloomstran

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