Former hedge fund portfolio manager. Founder of InvestorVantage.com
Chris Bloomstran explains his evolution as an investor, his daily rituals, how he views Berkshire Hathaway as his ...
Chris Bloomstran, CFA, founded Semper Augustus in 1998. Chris employs a value-driven research methodology. He evaluates businesses just as a private investor would do when buying an entire company. Semper Augustus is a fundamental investor managing concentrated equity portfolios of well-run, well-capitalized businesses with share prices trading below their conservative appraisals of intrinsic value. They go where the value is.
Currently, Chris is finding opportunity abroad, with two interesting investment ideas in Norway (Orkla and Subsea 7). He’s also finding value in Berkshire Hathaway. All three companies featured are all exceptionally well capitalized and high quality businesses trading at discounts to their intrinsic values.
Tell us a little about Semper Augustus?
Chris Bloomstran:
We founded Semper Augustus in late 1998. Massive bubbles in portions of the stock market were obvious, to us anyway, and we were acutely aware that launching an investment firm at that time might go down as akin to building golf courses in 1929. Specific to the late 1990's, a replay of the 1972-1973 Nifty Fifty had developed, with the bluest of the blue chips attracting huge capital flows while smaller company shares were being liquidated. The ‘tiering’ within the market was profound. A parallel and longer lasting bubble in TMT names (Technology, Media and Telecom) was underway as well. The era's insanity was ultimately marked by a hyperbolic mania for everything Internet. To subtly announce to the world that we "got it", that we recognized the folly around us, we named the firm after the most highly valued of the tulip bulbs in 1637 Holland. I had read Charles MacKay's Extraordinary Popular Delusions and the Madness of Crowds years earlier and loved the historical and modern day significance of the Tulipomania and other manias over time. It seemed the destined to fail Internet names would go down as the Semper Augustus of the day.
It ultimately turned out to be a great time for our approach. We had clients at the outset who had portfolios of blue chips which had been purchased in the wake of the 1929-1932 stock market crash by a very smart individual. His is a great story in and of itself. This particular client liquidated his family's stock holdings in early 1928, as well as those of his brokerage clients willing listen to a twenty-something investor preaching about a growing stock market bubble. While painful to watch the market nearly double over the next year and a half, he was ultimately right and waded back in in 1932 and 1933 when England and the U.S. went off the gold standard, buying companies like GE for less than their unlevered cash on hand. He managed his family's capital for the next six decades, picking up new companies like Wal-Mart along the way. I had the great pleasure of meeting Mr. Smith; he had heard I had serious reservations about equity valuations and a building debt bubble. We spent lots of time together discussing the markets, our respective thoughts on the businesses we each owned, and our respective approaches to investing capital. We shared such a common outlook and philosophy that he ultimately hired me as the first outside advisor to the family, turning over the reins to help intelligently liquidate the low-basis, very overvalued portfolios and reinvest the proceeds in the shares of smaller, better run businesses that were getting cheaper as the market narrowed. He was getting older and wanted someone who could help preserve and grow his family’s assets as he had done for so many years.
With some tax efficient strategies we were able to cull out businesses that had grown less attractive over the years, many with inferior returns on capital and operating in staid industries. Selling businesses like Kodak and the RBOC's for huge multiples to profits and buying smaller, well-run, well-capitalized and growing companies was a no-brainer. It was a great time for us. We managed to have cash at a time when many managers were facing ongoing redemptions for failing to keep up with the mania. By the market peak in 2000, we pegged fair value on the S&P 500 at just under 600 (market price was over 1500). The rest is history. We, like many value oriented investors, saw our portfolios significantly rise in value over the next couple years while the markets tanked by 50% for the S&P and 80% for the Naz. It was a privilege to spend lots of time with a great man until his passing in 2002. He was a saint of a man and an outstanding investor. Hearing about his experiences navigating a century of financial and world history was a career and life highlight.
I think my view of investing has evolved pretty similarly to that of many value investors. It's funny to read Mr. Buffett's history of his evolution, beginning with things like candlestick charting. I was a "serious" candlestick charter at the tender age of 20. I had switched to the business school from mechanical engineering when I fell in love with reading the Wall Street Journal. Differential equations didn't spark the same interest as the business paper. I really don't even remember why I started reading the Journal but it probably had to do with thinking I better figure out how to invest the billions I would make playing in the NFL, a dream that never panned out thanks to a broken foot. I had a tiny surplus from a scholarship, which seemed like a fortune at the time.
I was heavy into charting and had recently become a devotee of Bill O'Neil's CANSLIM method. I wound up interested in a tip from the Heard on the Street column, did my "primary research", which involved looking at a series of quarterly earnings per share numbers and noting the stock of interest had "broken out" and was at a new high. All signals were go. I walked into a small retail brokerage office, found a broker willing to let me put half of my money in a little Norwegian oil shipping company called Nortankers. He advised against it - but still gladly collected the commission which totaled more than 10% of the purchase price. As it turns out I never had to pay the back end of the commission. Shortly after buying Nortankers, the Iraqi army rolled into Kuwait and commandeered two of the company's four VLCC's (Very Large Crude Carriers). The company quickly failed. It was probably the best thing to happen to me. Instead of blaming the Journal, Saddam Hussein or the sophomoric CANSLIM system, I rolled up my sleeves and dug in for the why. I obtained and read several years of the company's annual reports and other filings and was quick on my way to becoming a fundamental investor. Over the next few years I read every book I could find on investing, working through the CU business library and new releases at the Tattered Cover, Denver's then great independent bookstore. At a point I found Security Analysis and The Intelligent Investor, which ultimately led me to Mr. Buffett.
Ultimately after several years of reading everything about investing I could get my hands on, I developed what I guess you could call a relational perspective. After hours and hours of thinking and reading, a light went on and I realized everything in an economy, in an industry and in a company had to relate to each other and had proportional limits and bounds. It sounds simple and it is. At top, individual country GDP's combined to make up global GDP. But deeper, corporate profits ranged over time and not only had to be some fraction of GDP but had to be a logical proportion. The market value of a country's stock market had to relate to its GDP. Individual industries grew and shrank as a percentage of the broad economy over time. I needed to know why. On a company level, the various expense lines of an income statement had to make sense and tie out to the balance sheet and cash flows. The world's financial components to me all not only needed to fit together but did. I developed a proportional sense of the components of an economy. I became a better company and industry analyst for that and developed a pretty good view of the macro along the way.
Has your view of investing evolved over time?
CB:
I think my view of investing has evolved pretty similarly to that of many value investors. It's funny to read Mr. Buffett's history of his evolution, beginning with things like candlestick charting. I was a "serious" candlestick charter at the tender age of 20. I had switched to the business school from mechanical engineering when I fell in love with reading the Wall Street Journal. Differential equations didn't spark the same interest as the business paper. I really don't even remember why I started reading the Journal but it probably had to do with thinking I better figure out how to invest the billions I would make playing in the NFL, a dream that never panned out thanks to a broken foot. I had a tiny surplus from a scholarship, which seemed like a fortune at the time. I was heavy into charting and had recently become a devotee of Bill O'Neil's CANSLIM method.
A tip from the Heard on the Street column sounded like easy money. I remember doing "primary research", which involved looking at a series of quarterly earnings per share numbers and noting the stock of interest had "broken out" and was at a new high. All signals were go. I walked into a small retail brokerage office in Boulder, found a broker willing to let me put half of my money in my little Norwegian oil shipping company called Nortankers. He advised against it - but still gladly collected the commission which totaled more than 10% of the purchase price. As it turns out I never had to pay the back end of the commission. Shortly after buying Nortankers, the Iraqi army rolled into Kuwait and commandeered two of the company's four VLCC's (Very Large Crude Carriers). The company quickly failed. It was probably the best thing to happen to me. Instead of blaming the Journal, Saddam Hussein or the sophomoric CANSLIM system, I rolled up my sleeves and dug in for the why.
I obtained and read several years of the company's annual reports and other filings and was quick on my way to becoming a fundamental investor. Over the next few years I read every book I could find on investing, working through the CU business library and new releases at the Tattered Cover, Denver's then great independent bookstore. At a point I found Security Analysis and The Intelligent Investor , which ultimately led me to Mr. Buffett.
Ultimately after several years of reading everything about investing I could get my hands on, I developed what I guess you could call a relational perspective. After hours and hours of thinking and reading, a light went on and it made sense that everything in an economy, in an industry and in a company had to relate to each other and had proportional limits and bounds. It sounds simple and it is. At the top, individual country GDP's combined to make up global GDP. But deeper, corporate profits ranged over time and not only had to be some fraction of GDP but had to be a logical proportion. The market value of a country's stock market had to relate to its GDP. Individual industries grew and shrank as a percentage of the broad economy over time. I needed to know why. On a company level, the various expense lines of an income statement had to make sense and tie out to the balance sheet and cash flows. The world's financial components to me all not only needed to fit together but did. I developed a proportional sense of the components of an economy. I became a better company and industry analyst for that and developed a pretty good view of the macro along the way.
What does your day normally look like (from beginning to end)? Do you have any daily rituals that help you keep your investing edge?
CB:
Every day is different but there are certainly routines. I try not to keep a regimented daily plan but instead keep the research day free to work on whatever makes sense or comes up. It's very much an ADD approach but it gives me the freedom to look at lots of things or to sit and work long hours, or a day, or a week or longer on an industry or an individual business. My process undoubtedly drives Chad crazy. He's cut in the public accountant / auditor cloth and organizes his schedule and that of our staff by what seems the minute. Very task oriented. For that, we run an extremely efficient and thorough back office.
I try to offset the structure of running the firm with an unstructured research process! One thing I've done ritualistically is keep the first part of most mornings free of meetings or calls and read in depth the Journal, the FT, the Times and skim the local sports page. I have a couple news assimilation sites I read every morning as well. Jim Bianco's is terrific. I usually spend a few minutes with Zero Hedge, which is a little out there. From there I'm into my routine of working on whatever makes sense or pops up. Most of my time beyond the newspaper portion of the morning is spent working on companies and industries. My company specific reading runs the gamut from K's and Q's, quarterly earnings call transcripts and presentations. I utilize various industry specific filings and publications. Value Line company pages, both the large cap and small cap weekly editions, are an easy way to keep up on lots of public companies and industries and the competitive landscape of the businesses we own. These rituals build cumulative knowledge that is required when opportunity presents itself.
Are you able to “shut-down” your investing brain or separate it from your normal life on the weekends?
CB: My weekends are completely different today than they were in the BC years, that is before children. We have a high school freshman and a sixth grader. Both are very involved in their respective sports and activities. I spent their younger years coaching a myriad of their teams and have thankfully retired from coaching all but my son's football team. The kids sports are involved enough to allow for the investing brain shutdown you mention. But between games I still spend the majority of most weekends reading.
Over the years I have learned to compartmentalize my reading. I do most of my company research at the office. I spend my weekends reading the candy, the fun publications I love to read but have to set aside for the weekend so as to not distract from the real business research. My weekend reading list hasn't changed much for more than twenty years, though the leisurely Saturday morning reads over coffee and a bagel at the cafe are long gone. Barron's is a great read. The Journal launched a weekend edition many years ago, so I'm now compelled to read that too. The weekday would have been enough, though Peggy Noonan has a column in the weekend edition which is terrific. I skim the FT weekend and the Sunday Times too.
Other general reads are the Economist, which would be better as a monthly, and the National Review. There are a handful of newsletters which I have faithfully read forever and which are indispensable to keeping up. I love Marc Faber's Gloom, Boom and Doom Report, Jim Grant's Interest Rate Observer, Jack Ciesielski's Analyst's Accounting Observer, and Fred Hickey's High Tech Strategist. Joe Koster has a blog he calls Value Investing World which is wonderful. One of my favorite reads, including all of the extras she has every couple weeks, is Kate Welling's Welling on Wall Street. I'm guessing your format is similar to Kate's. Great in-depth interviews with investors worth listening to are worth every cent. I also try to keep up with the periodic writings of various investors and strategists. The best are Van Hoisington and Lacy Hunt's quarterly letter at Hoisington Management, which is an ongoing treatise and refresher on economics and common sense, Jeremy Grantham and his group's work at GMO, Jeff Bronchick and Ben Claremon's letters at Cove Street, as well as John Hussman's letters. Seth Klarman's letters are always great when I see them.
Chad is a voracious reader of business and non fiction books. He reads something like 30 or 40 books a year. I'm lucky in that he sends me his top five or ten so that’s a nice filter there. That's really the bulk of my weekend reading. I never really formally segregated the weekend candy from the weekday company work, but that's the way it needed to evolve, lest the former intrude too much on the latter. I suppose when the progeny head out into the real world I'll get my Saturday mornings back at the cafe...
What’s a little known secret about you that no one knows?
CB:
This has absolutely nothing to do with investing but it's funny, at least now it's funny. The most impressive mascot in college sports is of course Ralphie at the University of Colorado. The famous buffalo leads the football team onto Folsom Field for every home game. She also travels to bowl games, which sadly hasn't happened in years. But back in the day she was on the road every year, including 1989 when we played Brigham Young in the Freedom Bowl in Anaheim. Southern California has a funny kind of grass. Golf broadcasters call it kikuyu grass, known for being thick and spongy.
Well, the end zones had been recently painted with each team's name, and the paint had hardened and was like a shell on top of what must have been kikuyu. We had longer cleats to deal with the thick, spongy grass. You can probably guess where this is headed. With a national TV audience, I made sure I was near the front of the team following Ralphie onto the field. I was of course the idiot who got his cleats caught in the black and gold crust, and not only did I go down, but my epic fall created a huge pileup of at least twenty teammates. Nobody that fell with me thought it was very funny because it was on National TV. We laugh about it today. Thank goodness it was before YouTube!
Who are the people that inspire you the most? And why?
CB:
Of course you have to appreciate and be thankful for your parents. Growing up I saw little other than work, and learned the importance of outworking everyone. We didn't really do weekends. We did have our sports, but leisure activities weren't part of the Bloomstran household. My step-father to this day runs a successful elevator manufacturing and service company on the west coast and still works all day, every day. He invented 24/7/365. My memories of Christmas Day are opening presents by the tree while my Dad manually wired electric control panels for elevator cabs at the dining room table. I'm also inspired by my wife's compassion and also by the joy with which my kids live life.
But beyond my family I will forever be indebted to a handful of youth and high school football coaches that taught me the game of life. I was fortunate and blessed to have the privilege of learning from a few men not just the game of football, but the values of team, commitment, hard work, overcoming adversity, bravery, honesty, sportsmanship and fun. Everything I learned from those guys carries over to the investment arena. I mentioned that I coach youth football today. Giving back in that way is as gratifying as anything I have done or accomplished in business and in investing. I'd tell any young analyst or investor, anybody driven and hard working for that matter, to at some point in life reflect on who helped mold you, to emulate those mentors and to find a way to give back to the next generations in a way those role models did for you. I try to give back in the investment community for sure, by mentoring a handful of business students. I've been involved with our local CFA Society here in St. Louis for a long time. I particularly love working with college kids.
Security Analysis, The Intelligent Investor and even Margin of Safety are very popular must reads for any investor. What are the top 3 books people don’t talk about, but one’s that you would recommend to an investor?
CB:
Well those are certainly the biggies. If you included Phil Fisher's
Common Stocks and Uncommon Profits
you would have the Big Four! I can't count the number of copies of
The Intelligent Investor
I've given to clients, friends and students. It's the best investing book not only for pros but even more so for the lay. Surely all of the Wiley Investment Classics are worth reading. The best of those are Phil Caret's
The Art of Speculation
, Gerald Loeb's
The Battle for Investment Survival
and Fred Schwed's
Where are the Customer's Yachts?
But all of the Wiley books are great. I mentioned Mackay's book earlier. Another must read in the same vein is Charles Kindleberger's
Manias, Panics and Crashes.
One book that gets little mention outside of Austrian Economic circles, but is one of the best books ever written, is Henry Hazlitt's Economics in One Lesson. It's up there in my opinion with The Intelligent Investor. The book should be required reading for not only anybody charged with shepherding client capital but, perhaps more so, for any appointed Federal Reserve Director, Fed regional bank president, staff employee, janitor, anybody in central banking really, and certainly for any elected official headed to Washington or to a state capital. It's an easy read and is the best book on economics I've ever read. Like Graham's Classic, I've also given away countless copies of this gem. You also can't leave out the compilation of Mr. Buffett's Chairman's letters - required reading in my opinion. I think a series of bound editions can still be ordered on Berkshire's website. They are also on the website as individual PDF's.
A couple of other great business books are Amity Shlaes' The Forgotten Man and Arthur Herman's Freedom's Forge . Both books span the Great Depression through the period leading up to World War II and both are a testament to the necessity of limited government. FDR's control administration is examined for what it was and not as the revisionist's champion of the strong state. Both books are impossible to put down.
What is your philosophy and process to investing? How do you search for investment opportunities and what are your criteria for investment?
CB:
The approach and the philosophy are very much value driven, recognizing that growth is an integral part of the value equation. We place a huge premium on business durability and are extremely price conscious. We say our mantra revolves around a dual margin of safety, that of business quality and that of price. Measuring the intrinsic value of a business or asset is what it's all about. We run concentrated portfolios of generally not more than 30 names. We often concentrate heavily at the top. Berkshire has been our largest holding since our early 2000 initial purchase. Subsequent well-timed purchases at nice discounts to fair value, plus the growth of the business and naturally of the share price make that single holding quite large.
Our turnover averages less than 20 percent annually, though in 2008 it was manic, for us at least, at around 80 percent. We are wary of leverage and the balance sheets of our portfolio companies are in aggregate far superior to that of the broad market. Many of our businesses maintain net cash and are not good clients of the investment bankers. We highly value quality management and look for managers that understand the underlying intrinsic value of their businesses. Free cash returns on capital drive the bus. We read very little sell side research, instead relying on a fundamental, bottom-up process.
The search for investment opportunities is really just the byproduct of years and years of reading. We have an idea of what a great business looks like and have the patience to wait for the right price. The downside of the price discipline is that we often fail to own some businesses we have admired for years, for decades even. I guess those are the errors of omission. We've also sold some businesses just for price reasons that we regret selling and not buying back.
Is there a portion of your investment process or philosophy that you would consider unique?
CB:
I don't know how unique it is but the thing that stands out to me is how uncomplicated we make the research process. I maintain an intrinsic value estimate for each business we own (or close to owning). That's where the heavy lifting and thinking comes in. We normalize free cash returns on capital. It's an involved process. We are very careful about cleaning up GAAP or IFRS earnings for things like aggressive pension accounting, merger accounting, write-offs and write-downs and for non-cash compensation. We think about whether depreciation schedules make sense and try to get a realistic estimate of long-term normalized maintenance capex.
Estimating the rate at which our businesses grow is hugely important. We're trying to get at organic growth and how much growth comes from retained capital and how profitable that retained capital is over time. Share buybacks are measured against our appraisal of the business and go to the quality of management. We reconcile net profits to capital and then operating profits less maintenance capex to enterprise value. It's staggering how many professional investors talk about net income, earnings per share, quarterly earnings misses, profit margins to sales and things like that but have no clue how much real capital is employed in the business or how levered the equity of the business is. It's staggering, shocking, but I think it gives us and our ilk a huge competitive advantage over time.
The process requires hard work and critical thinking to be sure, but it doesn't need to be complicated. It's far from it. We don't maintain financial statement models but we spend countless hours thinking about them. We don't run DCF models but we deeply understand the inputs of valuation. Terminal growth rates ten years out? Give me a break. I've found over the years the modelers adjust the inputs to suit their desired outcome. Go back and look at Alice Schroeder's 1998 report on Berkshire. It was a joke. She had no clue how to value a business. It's the simplicity of the approach but the focus on the right things I think that make the process here unique. It doesn't require an army of analysts or even a committee. It requires tons of reading and thinking about the right things. You have to ask the right questions to get the right answers.
Do you have interest or expertise in a particular industry that you would call your “circle of competence”? Or are you more of a generalist in search of value or market inefficiencies?
CB: I've always said we're generalists and we are. We don't limit our universe by market cap, geographical boundary or industry. At times, like the late 1990's, we owned largely small and mid-cap domestic businesses because that was where the value was. By 2007, we were more large-cap oriented, again, because that was where the value was. We have a sizable investment today in Europe. Are we spreading ourselves too thin, reaching beyond a circle of competence? I'd say definitively no. Businesses are businesses are businesses. The process I just described doesn't apply to companies of specific size or where they happen to conduct business or have their headquarters. Medtronic isn't a different company because they claim a different home office.
I will say that if you look at a pages long history of our transactions or snapshots of our portfolios over time you will see certain industries far more represented than others. We've absolutely had more of our capital invested in property casualty insurers and reinsurers over time than any other. Berkshire is obviously a big part of that but we have maintained significant positions in a number of other very well run insurers over the history of our firm. Most we have owned for years. The accounting and regulatory conventions are very unique and we have spent years trying to master them and staying current. We do so from a user's standpoint but our grasp here is pretty good, I think, particularly for a non-operator. The P/C industry is comprised of a handful of studs and lots of duds. I think we've been fortunate to mostly own the studs. The beautiful thing about the industry is that it is rarely expensive. Because the aggregate winds up only being mediocre at best, valuations across the swath wind up generally being on the cheap side. At times they get dear and we've done a good job trimming our holdings at those times.
Describe your value discipline once you have arrived at an understanding of the Intrinsic Value of the business? Is there a certain discount from intrinsic value when you start to get interested?
CB:
That's a great question, and it really gets to the heart of how we manage capital. Nobody ever asks it. Everything revolves around our appraisal of fair value. I’ve already waxed on about our dual margin of safety approach, and the intrinsic value is really the price piece. Businesses that are more complicated, more levered, more uncertain as to the permanence or durability of their franchise, or even those that we're not as fully up to speed on, simply get a lower intrinsic value until our understanding and comfort level grows. Everything we do is generally on the conservative side.
Once we've established an affinity for a business and have determined our appraisal of fair value, on principle we never pay more than our appraisal. There's no magic discount at which we start buying, but it's seldom more than 90%. At 90% the upside slightly outweighs the downside. We invariably start small, most of the time at one percent, sometimes at two, and, occasionally in special or unique situations, sometimes far greater. Typically at one or two though. Then, and new clients have a hard time grasping this concept, we hope the price declines absent a deterioration in the fundamentals (and in our appraisal).
We always want to make a small position in a high quality business larger and the most intelligent way of getting there is to buy at a bigger discount. The worst way to get there is to have a really attractive small position accrete immediately to fair value or above. Everyone loves a quick buck but huge returns on small positions don't move the needle much.
As a recent example, we had long wanted to own Precision Castparts, a fantastic business, and loved taking a one percent position about two months ago, readied to increase the position size as the price declined below our $205 per share initial purchase. We rued and lamented Berkshire's announced takeout at $235 per share. It was a nice return in a short period of time but way too little, way too soon. We do have certain unwritten guiding principles, (rules are too strict) about keeping positions in smaller businesses or in less liquid securities on the smaller size. In general, however, the higher the quality of the business and the greater the discount the more willing we are to concentrate higher. Berkshire is an extreme case in which we have had on the order of a third of our capital invested in the business. We really use Berkshire as our cost of capital. We measure business quality and upside/downside, effectively the discount to fair value and the expected return over multiple horizons against our long-term expected return in holding Berkshire shares.
Today, at the current price, we expect to earn north of seven and a half percent annually over a long horizon holding Berkshire, so competing investments need to expectedly outpace that threshold. Berkshire's long-term expected return, and that of any business we own, is totally dependent on the current price. As example, Berkshire's shares are down about ten percent this year. The business hasn't seen a ten percent diminution in its intrinsic worth so our expected long-term return is very slightly greater than it was on January 1. Conversely, Berkshire's shares were up 27% last year, yet the fair value of the business grew nowhere near as fast. Thus, our expected return from owning Berkshire over the years was slightly lower at the end of 2014 than at the end of the prior year. Ditto for the two prior years when the stock was up 33% in 2013 and 17% in 2012. If only pension actuaries employed the same approach...
That ephemerally covers sizing on the buy side. On the flip side, we sell or reduce position sizes accordingly based on their intrinsic value, as well as on their expected upside/downside relative to other positions or opportunities. We also sell when we're wrong on the fundamentals. We have classically reduced position sizes as prices approached fair value and were generally gone at intrinsic. With some portfolios we use covered calls to help reduce and scale out of positions approaching fair value, just as we sell puts to initiate or help add to positions. The conservative selling of option premium around our intrinsic value philosophy lowers risk, increases income and allows us to trade around our positions. But our somewhat rigid approach to trimming and selling has necessarily been tempered of late thanks to the Bernank and now the Bank of Yellen.
In the last few years we have allowed some of our positions to trade north of our conservative appraisals. Central bank policies and stimulus measures have thrown a monkey wrench into the valuation engine. ZIRP (Zero Interest Rate Policy) and an unwritten mandate to gear monetary policy to the level of the stock market has not only necessitated a bending of historical valuation yardsticks, but also higher allocation to stocks for otherwise balanced portfolios. Reducing position sizes at, say, 15 or 17 times normalized free cash earnings, or at prices that exceed our adjusted shareholder’s return on capital (if you have a floor rate of return of 6%, then don’t pay more than twice capital for a business earning 12% on capital), has meant bending the boundaries upward. We've allowed our investments in our global, branded consumer businesses in particular to trade at prices above what we consider normalized valuations.
But discipline is discipline and we have been downsizing these otherwise outstanding franchises at prices that make little sense in any environment other than during hyper-inflationary episodes. In fact, and this will get tangential, but the notion that sustained low interest rates warrant higher valuations requires inspection. I'd argue the "terminal multiple", which would be the price paid for the terminal growth rate from the DCF academicians, is lower, way lower, like single digit, in a world that won't and can't grow sans increasing debt levels. But expanding on this tangent would require a conversation into tomorrow at least.
What was the worst investment you've ever made? What happened, and how could you have kept it from happening?
CB: That's a fun question! Really, all of this talk about how wonderful our process is would have you believe we're devoid of mistake — Hardly. This business teaches humility. I mentioned that seventeen years into doing this as Semper Augustus we have pages and pages of transactions, despite pretty low turnover. On those pages you will find a number of mistakes. The number is fortunately a fraction of the "winners", but their existence is the nature of the beast. The great thing is that, I think due to the process and our conservatism, nearly all of our mistakes have been small. The small handful of biggies not only jump out but also have left an indelibly bad taste in the mouth that never goes away. Until the last couple years I would have told you an ill-fated investment in Williams Communications during the unwinding of the tech bubble was far and away the worst investment I ever made. Williams Communications was a fiber network which had been spun out of Williams Companies. Williams had built and was still building a vast fiber network with the advantage of being able to lay the network alongside their vast system of pipelines. Competitors similarly used their railroad rights of way. The energy business had previously sold their telco business, WilTel, to LDDS, which eventually became Worldcom. They retained a small piece of the fiber network which they set to expand and ultimately rebuild the WilTel business after a non-compete ran out. I attended an investors meeting in Tampa with the top brass from both the energy business and the fiber business at the time of the IPO in 1999. We had a position in the energy business and that's really why I was there. In the room were the managers from the Janus Funds, all of them, keenly interested in the fiber business. That was a red flag. The company had amassed something like $7 billion in debt to build out the network, and all of the math I did on the company convinced me they would never, ever produce a return on capital of any kind.
The IPO came at something like $40 per share, and the business had revenues of about $2 billion and cash of $1 billion to go with the $7 billion in debt. We seriously laughed at the fools destined to lose their money — and they did. Later the next year the stock had dropped to $4 a share, a 90 percent haircut. That's when we decided to make a quick buck on a dead cat bounce in the wake of the bursting of the tech bubble and joined with the fools. We looked at the cash in the bank, $1 billion, next to the cost of building out the network, and decided we had plenty of time to catch an upward spike and make a quick buck. I won't bore you with what I think was a massive fraud perpetrated at the hands of management.
Needless to say, we endured a permanent loss of capital, selling our stake for a small fraction of our cost. It's important to recognize that $4 to zero is the same as $40 to zero in percentage terms. As a footnote to the story, Berkshire actually entered the picture later on behalf of the energy business which had gotten upside down. Berkshire extended credit to keep Williams Companies afloat at the usury rate of 34%, and as a kicker picked up the Kern River Pipeline, now a crown jewel in Berkshire's regulated utility business. As a second footnote, Leucadia purchased the assets of Williams Communications out of bankruptcy, and with the deal inherited the company's vast tax loss carry forwards. I take some solace, little really, in having owned both Berkshire and Leucadia and thus ultimately redeeming some value from the experience. The pain still stings, however.
But as I mentioned, the too long tale of the Williams Communications speculation is probably not the worst. A gold position over the past three or four years has been very expensive and, at least for now, is a real black eye. I started buying gold mining shares in the late 1990's at favorable prices as gold was reaching its nadir near $250 an ounce. We made money and sold two of our three positions, Barrick and Kinross almost perfectly in early 2008. We kept a position in Newmont. As the globe's central banks have gone back and forth with rounds and rounds of QE, we built a position back into Kinross, added to the position in Newmont, and more recently initiated a position in Goldcorp. We have owned the miners as a proxy for gold. The gold position serves as a presumed hedge against central bankers gone wild. All the while we never believed gold mining to be a great business.
To justify owning the businesses you have to do mental gymnastics to justify paying for unknowable cash flows. That's the nature of commodity businesses. Ore grades are lower every year. The low hanging fruit is long gone. The cost of production is never fixed, but rises at times faster than the price of the underlying commodity. Management teams are anything but superior. Add it up and it becomes tough to justify a losing position over what seems an eternity to clients. I really do believe there is no positive endgame to the Keynesian experiment underway. Debt levels remain unserviceable under any normalized yield curve. Weimar seems closer by the day.
If we were running just our families' money I wouldn't sweat the losses in gold to date. But the percentage losses are large enough, especially with Kinross, to wonder if there remains enough upside to even see break even. We're not throwing in the towel at all, but with the position size greater as a percent of capital than with the Williams fiasco, it's fair to say that investing in gold miners over the past few years has cost some real and reputational capital. That said, even though they are down, the systemic risk we are trying to partially hedge remains front and center. We maintain the position and think it's the right thing to do. In retrospect, the common thread between the permanent loss of capital in Williams Communications and the not permanent but not insignificant unrealized loss in the golds is a deviation from the processes we just talked about. We jumped the rails away from buying great businesses at good prices, in one case trying to make a quick buck on a wasting asset, and in the other compromising business quality and even price for what we believe to be a rational and necessary hedge. I guess the upshot is we know we're going to make mistakes, but not only should we learn from those mistakes, but should use those mistakes to remind us to stay within our circle of competence.
What was the best investment you’ve ever made? What happened?
CB: Thanks for changing the subject! A too easy answer would be a follow-on to your earlier question about great books. I think Mr. Buffett said something similar already, but the return on investment from my original purchase of The Intelligent Investor is nearly infinite and is still compounding. A second lay-up would certainly be our original purchase of a large position in Berkshire in early 2000 at an average cost of $43,750 per A share. But you're probably looking for something more glamorous and sexy. A couple come to mind because they have similar characteristics to the purchase of the book and to the 2000 purchase of Berkshire - the best investments are those with no downside risk and huge upside reward. It's a combination that does exist from time to time and throws the classic risk reward efficient frontier curve as well as the efficient market hypothesis squarely on their respective academic pointy heads.
You may remember when several of the big private equity guys launched mezzanine funds. Leon Black's Apollo Management was the first to bring a fund to market. Apollo Investment Corporation raised something like $900 million in an IPO in early 2004. The fund priced at $15 per share, which after underwriting fees netted $14.10 to the fund. Well, when the KKR's of the world saw how easily Apollo raised nearly a billion, they and several others quickly filed registration statements to bring their own mezz funds. With substantial immediate competition potentially coming, I think the syndicate that brought AINV public tried to dissuade the competition from going public by allowing the price to not only trade below the IPO price but below the netted value. We looked at the price below $14.10, which obviously was all cash early on, and saw a virtually risk free opportunity. Apollo's plan was to build a two-to-one levered mezz portfolio over time, and to generate early returns by parking cash in senior secured paper. We had no interest in being in the mezzanine lending business long term, but given the timeline of reasonably putting the money to work, the notion that new loans don't generally fail right away, and the overarching fact that the $14.10 was all cash at the start, a short-to-intermediate investment made sense. The stock traded into the low $13's per share. I called Chad and asked him how much cash we had. After explaining that I meant ALL cash in ALL client accounts, we quickly added it up and put most of that cash to work at about $13.10, almost 90 cents on the dollar of the cash in the bank at the fund. It was reasonable to assume that given the anticipated leverage and yields at the time that the earning power was at least $2.00 per share, 90 percent of which would come as dividend. We figured the stock would conservatively trade at least at ten times. The risk free trade played out as expected. We sold all of our shares in less than two years in the low 20's and didn't regret selling early and leaving money on the table as the stock briefly continued higher. In the 20's the longer term risks, namely underperforming loans, outweighed any further upside, and time works against high-yield leverage. The stock was around $6 the last time I looked.
The second low risk, high returner that comes to mind were a series of investments made both on the coattails of Mr. Buffett but also on the other side of Mr. Buffett during the financial crisis. We've never done much with utilities outside of Berkshire's investments in the industry. When Berkshire, through their MidAmerican business, offered to bail out Constellation Energy in 2008 by agreeing to acquire them, we did some quick digging and determined that Berkshire, as has often been the case, was getting a deal far below fair value. Constellation had an unregulated wholesale merchant business in Texas that had gotten upside down in their derivative book. Berkshire's offer to buy all of Constellation, which was the big Baltimore electric, included an immediate $1 billion dollar preferred investment in the unregulated Texas business to shore up the book and wind down the exposure. The work we did on the company had Berkshire buying Constellation for $26.50 per share, and our hastily put together fair value work up had fair value closer to $40. In any event, with the wholesale book now backed by Berkshire, we used a portion of our cash on hand to buy Constellation shares at $24 to just long arb the upside to $26.50. Utility acquisitions can take a long time to close but there was plenty of spread given overall market volatility during the unfolding crisis.
On a daily basis it seemed the market was reacting to news and rumor and fact checking later. Not long after we bought our Constellation position a German news wire announced Constellation was considering filing for bankruptcy due to insolvency in a Texas merchant subsidiary. It was old news that somehow was just being mistakenly released. The stock started tanking. The Constellation sub already had Berkshire's $1 billion. The story was old and wrong. I called Chad and asked how much cash we had. No explanation needed this time. We put the majority of our cash to work in a matter minutes at prices as low as $18, even using the balance sheet of a partnership we managed to buy more shares. We had a big order out at $15 when the stock logically quickly recovered. We reduced the position way back in a matter of hours. Time then passed and our plan was to allow the arb to run its course or until something more attractive came along. That something came from within Constellation. The utility had engaged in a 50/50 joint venture with EDF, the huge French electric, to develop some nuclear plants in Maryland and Virginia. EDF entered the mix with an offer to buy just under half of Constellation which valued the business well above MidAmerican's agreed price and closer to our $40 appraisal. Constellation's board claimed a fiduciary responsibility to consider the higher offer, I suppose goading Mr. Buffett to bid higher. Anyone who knows or has studied Mr. Buffett knows how much he values a handshake. Constellation's contemplation of the EDF bid certainly infuriated him. The upside to Berkshire was a termination clause which gave them 10% ownership of Constellation, plus a conversion of the $1 billion from the merchant business to a 14% secured note, plus a several hundred million dollars as a termination fee.
The Constellation stock sold off again by about 20 percent on the news of the EDF offer, and of Berkshire’s exit, giving us an opportunity to pick up some additional shares. It quickly recovered and we trimmed the position. After all, it was 2008 and there were lots of things going on and places to intelligently move money around. But then the trade gets even better. Either because he needed liquidity, which he did, or out of petulance, which may be correct, Mr. Buffett began liquidating his now 10% position in Constellation. The stock sold off again. We bought again. EDF had provided liquidity to replace Berkshire's $1 billion so we reasoned a permanent loss of capital was nonexistent and the upside to the EDF bid was substantial. So back we plowed into a bigger position. We closed 2008 with Constellation as one of our largest holdings and ultimately sold our entire position in the mid-30's. Oddly, Constellation ultimately merged with Exelon after the EDF joint venture failed to move ahead with the nuclear developments as originally planned and the joint venture partners scrapped the merger.
In both the case of Apollo Investment and that of Constellation, a cumulative body of knowledge, a proper definition of risk, and a willingness and ability to decisively move capital around allowed the marriage of low or no risk to come together with outsized upside reward. If only these situations came along every day…
We see you’re interested in a couple of Norwegian companies. Can you describe your investment thesis in Orkla ASA (ORKLY)?
CB: Orkla ASA is what I'd call a disaggregating conglomerate unlocking asset value. With it you get a company narrowing its focus on four core branded consumer goods (BCG) businesses, an improving margin structure and an attractive, undervalued currency. The company is headquartered in Olso, Norway, trades on the Oslo Børs as ORK and has a US ADR trading OTC as ORKLY. Shares total just over one billion so at the current price of NOK 60 the market cap is NOK 60 billion. The Norwegian Krone has been crushed over the past year, falling from 6 to the dollar to 8.3 to the dollar. The currency should provide a huge prospective tailwind for US investors and gives you a call option of sorts on a higher oil price over time. 710 million shares float, with investor Chairman Stein Erik Hagen, through a family holding company and other related parties, owning about 25% of the company. At the current price the dividend yield is north of 4%. Orkla reports in the Norwegian Krone using IAS/IFRS. The Krone is really cheap and should be a wonderful currency long-term. Norwegian debt to GDP is only 30%, but net government debt is actually negative. GDP is $500 billion and the country's has a sovereign wealth fund worth around $800 billion. Per capita GDP is the third highest in the world.
Orkla was founded in 1654 as a pyrite miner. They went public in 1929 (great timing), started a separate investments portfolio in 1941, and had shed the mining operations by 1987. They have been a conglomerate for a handful of decades now, but are intelligently moving away from that structure. They bought newspapers and magazines in the 1980's and early 1990's and sold those businesses to Mecom in 2006. They bought pulp and paper businesses, merged them with Borregaard in 1986 and spun that business on the Oslo exchange in 2012.
Orkla found religion in 1995 and began investing in food and consumer staples. They acquired Abba Seafood and Procardia Food, then acquired Swedish brewer Pripps with Volvo. They also bought Baltic Beverage Holdings. They merged subs Norwegian Ringnes and Pripps with Carlsberg in 2000, retaining 40%. They sold Carlsberg in 2004 at a great price. Since then they have added numerous additional staples businesses. They don't overpay and have a great track record integrating new businesses. They bought Norwegian material company Elkem and Swedish Sapa group in 2005.
The four branded consumer goods today consist of four segments - Orkla Foods, Orkla Confectionery and Snacks, Orkla Home and Personal and Orkla Food Ingredients. Those businesses will do about NOK 30 billion in sales, which converts to about 3.6 billion.
To give you an idea about how strong the dollar has been, at last year's exchange rate of NOK 6 to the USD, dollar sales would be $5 billion. The company's core business is largely conducted in Scandinavian currencies so when I think and talk about Orkla's business I use Krone. Profit margins at the BCG businesses normalize at 10.4%, and were 9.1% at year-end. Return on capital for 2014 was 15.2% for 2014 and normalize closer to 17%.
At current margins the consumer businesses will net NOK 3 billion on their NOK 30 billion in sales. The current market cap of Orkla is NOK 60 billion, which is about 20 times. Net debt is a very modest NOK 6 billion.
How did you arrive at the valuation of the business?
CB: On top of the BCG businesses, Orkla has noncore, hidden value assets with a carrying value of NOK 16.4 billion. I peg fair value on those of NOK 25-28 billion. The BCG's alone are worth somewhere between NOK 46 and 61 billion. With barely over 1 billion shares out the math is easy. Orkla's total intrinsic value is somewhere between NOK 70 and 87 per share. Said differently, you are paying about fair value for the BCG businesses and you get everything else for free.
Management has done a great job unlocking value and with ongoing restructuring of their noncore operations, joint ventures and associates. These noncore subs are profitable, but due to a series of write-down and restructuring charges their normalized profitability hasn't flowed through IAS/IFRS numbers.
What would make you sell your position?
CB:
The best outcome for us would to see the shares sell off precipitously. I'd like our position to be larger with a lower basis! Once we are full it would be great to see the shares accrete to and above our appraisal of fair value where we could sell our holdings and move on to another dollar trading for less than a buck. But I don't think that's what you are asking. You want to know what could go wrong with the fundamentals, and that's something we spend lots of time thinking about with any investment we make.
Probably the greatest concern I have with Orkla over an intermediate horizon would be execution risk in selling off the investment portfolio. Their largest investment is in Sapa, a 50% equity method joint venture with Norsk Hydro. The business is the largest global manufacturer of extruded aluminum profiles. CAFE and emissions standards drive demand. The company has been restructuring for about three years, masking substantial profitability and readying for what I think will be a preliminary IPO as early as next September 1 in which Orkla and Norsk Hydro would each retain a third of the company at first. The company recently did this with a smaller sub called Gränges. They did an IPO in Sweden and a secondary just this spring. Any severe economic downturn, think about what happened to auto sales in 2008-09, could derail the timing or success of a potential sale. Orkla's share of Sapa is carried at NOK 7.8 billion and I peg fair value at 1.5 book, 50 percent of sales and 7x EBITDA, which gets you NOK 11.5 billion. Another longer-term concern is simply the aging and slow growing population in Scandinavia. Norway has been in better shape. They have grown at 1.3% for the past decade due to immigration. Their fertility rate is only 1.8%. Sweden and Finland's population growth has been closer to 1% for a long time, but even there it's been on an upswing due to immigration. Trump probably has something to say about that. At the end of the day, Orkla's markets are mature. You'd rather have booming populations, more mouths to feed. The good news is Orkla's brands dominate in their respective categories.
Also, I would have said oil at $100 was a big risk. Norway's GDP is 25% dependent on energy. Hence the decline in the currency. But oil in the $40's and the Krone at 8.3 really become tailwinds in my opinion. Consumer health sensitivities are a real concern. Look at McDonalds and Kraft Foods. Orkla is heavy into processed foods — the company gets it. They are running fast to improve the health component across their food businesses. The CEO talks about things like lowering the sodium content across the portfolio but can also quantify the cost savings of doing so. Smaller and focused in today's case is better. We'd really like to see the shares sell off a bunch. It's only a decent sized position and I think the quality of the BCG businesses is high enough to be a big position at the right price. But that's the story of my life today...
I see you’re interested another Norwegian business, energy company Subsea 7 (SUBCY). Can you describe your investment thesis here?
CB:
We started buying it about a year ago at a price well off its highs, but at a price well above current prices. Everyone in the energy patch has just been crushed. We had a small position initially, but, as is usually the case, we’ve added to the position as the stock has gotten cheaper. We have a really nice average cost right now and we believe it’s a very interesting story. I think it has some insulation relative to many of the other more levered players to the underlying commodity. They are a very interesting oil service company.
In conducting our research we learned that the Chairman is almost a Warren Buffettesque type guy named Kristian Siem. He’s an excellent investor and he’s been on the board of Transocean Offshore (RIG). He’s spent his entire career in the energy world. Much like the Chairman at Orkla, he has his family’s holding company largely invested in this business. This is the crown jewel of his family’s empire. And it’s a great business that trolls around in the subsea energy space.
Subsea really does seabed-to-surface EPIC (Engineering, Procurement, Installation, and Commissioning) work. They’re an engineering and construction firm that effectively hooks up the subsea infrastructure of deep water wells to topside production and gathering platforms. They have some shallow water assets and projects as well. They have a fleet of 39 vessels with five more under construction. Their vessels are the most modern and technically advanced in the industry, where its enablers – pipelay and heavy construction vessels are superior. They have the largest high-spec fleet in the industry. They also have 175 remote operated vessels. Their equipment allows them to contract on both a day rate and a lump-sum basis with the big integrateds and with national oil companies. The largest part of their business is called SURF (Subsea, Umbilical, Risers, and Flow Lines). When you think about where their projects are located, it can be very harsh environments. So they’ll also contract to go in and manage the infrastructure over the life of the fields – make sure the flow lines are working, regular maintenance, etc.
How are you looking at valuation?
CB: Subsea has 350M shares outstanding. The current market cap is about $2.8B. The ADR is trading around $8.50. The primary shares trade as SUBC on the Oslo at the multiple of the currency conversion. With Subsea you need to think about everything in normalized terms because of cyclicality and certainly with everything going on today in the oil patch. The entire sector has been disrupted by the decline in crude and the precipitous drop-off in tendering (front-end bid process to contract with the integrated and national energy companies). Overall, business is just slower and all the margins will be off. So if you have a view that oil prices will stabilize (not necessarily recover to $100), and if we resume a normalized exploration cycle for oil and gas, Subsea is one of three companies that is best in its class. However, there’s no one else in the subsea industry that really competes in earnest with the three biggest players. Subsea 7, Technip and and Saipem are the top three businesses in the sector and each have about equal market share.
Let me start with the balance sheet because I think that’s where you get a margin of safety. You have total assets of $8.5B. The company wrote-off half of their goodwill last year. Goodwill was about $2.6B, now it’s about $1.3B. The goodwill is largely on the books from a big merger between Subsea and Acergy back in 2011. They have current assets now of ~$2B out of the ~$8.5B with cash at $373M and the company is almost running at net-cash, or at least neutral. The only outstanding term debt is converts ~$550. You get total equity of ~$5.5B. Only ~$1.3B of which is now goodwill.
What you have now with the assets on the books are some incredibly attractive vessels, as well as onshore infrastructure (spoolbases and fabrication plants around the world, etc.). The asset value is very tangible and real. The company has been in front of the downturn, quick to identify and sell or scrap several of their older and less technically advanced vessels. There are nine to ten vessels slated for decommissioning right now. They recently reduced headcount by 1,000, from 14,000 to 13,000, but have retained all 2,000 of their engineers. Their engineers, along with their equipment and assets, give them their moat. And once we get through this downturn we have a company with best in class assets that will earn excellent returns on the carried value of the assets on the balance sheet because of recent fleet upgrades (even with the allowance for another $1B write-off). So on a balance sheet with $5.5B ($4.5B of which is very firm), they have maintenance capex of ~200M per year and depreciation runs around ~$400-450M per year. This gives a little more free cash since the fleet is so new. As far as income statement margin structure, I would normalize gross margins at 23%, 18% operating, 12% earnings before taxes, and 8-8.5% on a net basis. We probably won’t come anywhere close to those numbers this year, but I believe they are viable over a 10-15 year time horizon.
In recent years, the company generated 19% gross, 13% operating, 8% pre-tax, and 5.5% after tax. That gives us an idea of where they are right now. The company did $6.9B in sales last year, which was a record and will be peak for some time. They’ll probably generate $5-6B this year with the downturn. On the low end of the range, I could see them generating $4.5-5B. At the $4.5-5B in sales, they’ll still produce decent economic returns. I could see net profits getting down to $200-300M, depending on the utilization of their active fleet. With a market cap today of $2.8B it looks really cheap on depressed numbers (potentially trough earnings). However, if you normalize the cycle, a 10% ROE on $5B in fixed assets gives us $500M in earnings power. The stock today is trading less than 6x normalized earnings and it has a great balance sheet. It is far better capitalized than their two biggest competitors. So they’ll have staying power with the best fleet and engineers in the industry.
At today’s price, you’re paying half book for a business that would produce an ROE of 9-10% on a normalized basis. On $500M in normalized profits with 350M shares outstanding, you get $1.42 in free cash flow profitability per share. With the current stock trading at only ~$8.50 per share. A 10x multiple on $1.42 gives you a stock trading at ~$14 per share and a 15x multiple gives us a stock trading at ~21.00. If you’re constructive on your long-term outlook for oil, you can make a lot of money in Subsea 7. You also get the huge currency tailwind prospectively that you have with Orkla. We have a 3% position in the business right now.
From what I understand you’ve been buying some Berkshire recently. It’s been a big position for you for quite some time now. Can you describe your investment thesis here?
CB: Yes, it is our biggest position by far. We had our original 5% position which we talked about in early 2000 and it obviously worked out very well. We’ve done a very good job of adding to that position absolutely and both for new clients and with new cash flows at, what we believe, are attractive discounts to fair or intrinsic value. With that said, we’ve also trimmed the position over the last few years with prices approaching fair value. The last time the stock traded above fair value was back in 1998, since then it’s consistently traded at a discount. Now it’s, depending on the client, ~20-30% of our capital. For newer clients in the last couple of years, we’ve only recently been buying shares on this recent downturn. We had trimmed it for longer-term clients because it had become such a large position and the shares were closer to fair value than they had been in some time. Almost all of our clients have at least a 5% allocation to Berkshire now and we’re close to making it a 10% position for new clients.
Mr. Buffett certainly lays out how to value Berkshire very well. It’s a conglomerate and there are a lot of moving parts, but if you do just a little bit of work he tells you exactly how he looks at it. We do individual work on as many of the operating subsidiaries as we can get information on. Many file with various regulators and there is a lot of information available not found in the SEC filings. In fact, we wish there was more transparency as far as the operating subsidiaries go. As an example, we’d love to have a P&L, Balance Sheet and Cash Flow Statement for each sub once a year. Mr. Buffett gets them monthly. Send a set down to St. Louis once a year! It’s not easy to determine how much capital each sub carries year-to-year, for example, and we only get topside data on the larger of the businesses within the company. Mr. Buffett does breakout limited summary financial data for what he considers the four key segments of Berkshire, the groupings of the key insurance businesses, the regulated rail and utility businesses, all of the businesses in manufacturing, service and retail, and a groping of a of finance and leasing companies. It’s a very useful way of segregating and valuing the moving parts. But the detailed information we gather and long for isn’t required to get a handle on how much the whole is worth – it really serves to satisfy our analytical need.
Mr. Buffett simply assumes there are two pieces of the business: insurance operations and everything else. (1) The insurance side has its own insurance accounting and regulatory characteristics, and each insurance company within Berkshire is markedly different from the others. But at the end of the day, what you have in an insurance operation are premiums coming in which are used to run the business, the surplus of which are invested in various investment assets that are used to pay current and future losses and liabilities. To the extent you have the ability to underwrite on a profitable basis over time, you’ll have the combination of what the investments will make over time with the underwriting profits. That’s essentially it on the insurance side of the business. (2) Then Mr. Buffett gives you the pre-tax earnings on the businesses not insurance related. You apply whatever multiple you want to those pre-tax earnings and add the valuation of the insurance operations. You can make a determination as to long-term underwriting profitability and the degree to which insurance float is really an asset, but beyond that it’s really that simple.
The reason we’ve made Berkshire such a big position, is that we believe Berkshire is our opportunity cost of capital. We won’t put money in something else unless; you have great business quality, the price is right, and your expected return is at least what Berkshire is expected to return. Buffett says it himself, if you don’t want to be an active investor, just invest in the S&P 500. Go buy a low-cost index fund to save yourself all the frictional cost and expense. The cost savings and the lack of turnover will serve you well.
We always compare the earnings yield in our businesses to that of the overall market. Today, the earnings yield on the S&P is somewhere between 3.7% and 5.8%, depending on the degree to which you think profits are overstated on an accounting basis and due to cyclicality. The earnings yield should be your expected return (unless you get further multiple and or margin expansion). We don’t use the S&P as our opportunity cost, because we wouldn’t own the S&P. In terms of deploying capital, we use Berkshire.
And we use Berkshire because within it you have a supremely diversified portfolio of high quality businesses – far better than the aggregate of the S&P. Within Berkshire, you generally have businesses that earn their cost of capital on a free cash basis. Overall, there isn’t a great deal of leverage with Berkshire either. I have no problem paying more for a free cash flow stream that’s not levered versus what I would pay for the same but levered stream. That’s a valuation and investing principle that’s lost on the vast majority of investors. It’s the combination of the diversification and the nature of the free cash flow generating businesses within Berkshire that are largely unlevered, which allows us to concentrate far more than what academicians or consultants would say is prudent. And we’re not giving up the fact that we’re active managers. We’re not throwing in the towel and handing over the capital management reigns to Warren Buffett – not at all. Our expected return on Berkshire changes every day the current price of Berkshire changes. It’s always a moving target. Your opportunity set changes and we’ve resolved to the fact that we’re really comfortable with Berkshire at current prices. It gives us a very satisfactory expected rate of return over time with relatively low risk. We try to buy it cheap and sell it dear.
At the current price the stock is trading at 13x ballpark normalized earnings of $25B. That’s a 7.7% earnings yield at current prices. Today, Berkshire has a market cap of $325B and you have Mr. Buffett waiting to buy back shares at 120% of book, which is at $300B. That’s essentially only 8% down to where you have a known buyer with lots of cash willing to purchase shares on behalf of the shareholders at a published price and at a return in excess of 8%. So you can buy one of the best businesses (if not the best) in the world at a market cap of $325B with an implied put option underneath it and we think it’s worth $450-500B right now. Book value is certainly a moving target - it can go down. However, the risk-reward trade-off for this quality of business is amazing. So why wouldn’t you use it as your opportunity cost of capital.
What are The 3 Things an investor should focus on the most to keep their edge or advantage over the market?
#1 -
If you're not focused on what could go wrong then your focus is wrong. Manage risk – all risk!
#2 - You're buying return on capital, which means properly understanding return and properly understanding capital.
#3 - Patience and a willingness to run away from the herd allow you to own businesses, not pieces of paper.
Bonus - The financial markets are highly leveraged here in the short-term to the notion that the Federal Reserve has efficacy. I think Ben Graham would have likened Ben Bernanke and Janet Yellen to the voting machine...
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