Chris Bloomstran (00:03:04):
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 teens, let’s call it 18 or 19 multiple earnings. A lot of sectors were very strong. The energy sector is largely recovered, and that’s always a big swing factor as oil and gas prices drive higher and lower. So you’ve really rebounded smartly and very strongly from the pandemic year.

Chris Bloomstran (00:03:31):
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. 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 performance restricted shares that you’ve got a 2% giveaway on the front end and again, nearly a 3% repurchase.

Chris Bloomstran (00:04:09):
So when you’ve got a market trading for north of 20 to earnings, your earnings yield is less than 5%, close to 4% at year end. I would argue that even with the debt cost of capital very low, a portion of those are going to be repurchases financed with debt, because dividends plus repurchases, 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, but you’re buying back shares at a 5% or a 4% earnings yield. You’re not reinvesting at that ROE.

Chris Bloomstran (00:04:55):
Through the lens of a Berkshire, the business retains all profit and over time, they’ll make intelligent redeployments of capital, and they really do earn their ROE on retained capital. And you can see, 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 short-term distortions, but the ability to reinvest is a huge driver of incremental return and longterm 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.

Stig Brodersen (00:05:43):
Warren Buffett is famous for 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 this, elaborate on the five components you consider to make up the return of the S&P 500?

Chris Bloomstran (00:06:05):
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, until very recently, the stock has been very undervalued. Berkshire has. It’s traded in a deep discount to my appraisal, intrinsic value. And Charlie will say, Berkshire should do better, should do a little better. And I think that’s right. I think the notion in it’s correct. And I would have the same advice for the uninitiated investor, the non-professional investor, the 401(k) 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.

Chris Bloomstran (00:07:03):
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, you’re going to wind up buying some shares when they’re cheap. And at the end of the day, you’ll have paid probably a reasonably average price at a fewer very longterm returns because you’ve paid an average price, mimicked the longterm return of the month, which they should, then 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. 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.

Chris Bloomstran (00:07:42):
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 longterm return, 10 years, 15 years perspectively stands to be far lower than the longterm return, high single digit, call it a 10% return for the broad market. By my math, you’re going to maybe get half of that.

Chris Bloomstran (00:08:16):
And so what I did in the letter this year, and it’s interesting exercise is took the 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 account. If companies are buying back their shares and they’ve bought back seven tenths of 1% per year for the last 10 years on average, again, remember, they’re giving away 2% on the front end, but you’ve had a share shrink, and that’s a creative to the shareholder. You get the real drivers. And certainly in the last 10 years, the real drivers have been change in the profit margin and change in the multiple to earnings. And add that to whatever your average dividend yields, bits out your total return. 16.6% for the last 10 years.

Chris Bloomstran (00:09:10):
If you break down the components, we’ve only had sales growth in dollar terms of 3% a year. I think people are stunned by that. When you ask, how fast do you think the top line has grown for this best index in the world, it matches nominal GDP. You add to that, the shrink in the share account. 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 year. And that added 6.4% to the return. The margin added about 4% to return. Your 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.

Chris Bloomstran (00:10:17):
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 longterm 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 account’s going to shrink by another seven 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 this high. And there are reasons why profit margins are higher, but to grow from 13.4, convince me how you’re going to durably drive the number higher.

Chris Bloomstran (00:11:16):
Similarly, on a mid 20s multiple to 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. For that, we went back and took the 10 years ended 1999. I wanted to keep decades consistent, sort of run it to the March 24 peak for the S&P and the NASDAQ respectively in 2000. But simply from year end ’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 longterm average of 14.5, but you ended the decade, ended 1999 at 28.4. 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 share repurchases.

Chris Bloomstran (00:12:32):
If you recall, the last four or five years, the tech sector really led the way. And they were very diluted. Microsoft had grown their share account by 40% in the late 90s. They’re giving boatloads of options shares away and they hadn’t gotten around to the repurchases. And so you had an increase in the share account from you using the divisor for the S&P 500 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. We weren’t that far removed from the 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 burdensome level, but you had grown dollar sales by about 6%. And so offsetting those dollar sales growth by the shrink in the share account, you got to a 3.5, 3.6% growth in sales per share, which just matches the decade just ended.

Chris Bloomstran (00:13:32):
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 ’02 on the S&P 500. The NASDAQ fell 80% and that’s really where much of the bubble was, 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 to ’09, you had two bear markets. You’d begun to recover. ’09 was a big recovery year. So I didn’t take the year end period. If you had taken year end 2008, you would’ve had a 3%, 3.5% decline per year, but you lost about 9% cumulatively and just under 1% per year for that decade.

Chris Bloomstran (00:14:43):
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%. Your share account was modestly dilutive. You had some share repurchases in the early part of that decade, but then the financial crisis, the banks got in so much trouble, you had enormous recapitalizations. And so your share account actually rose by about 6% cumulatively. So 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 changed to 20. You saw the margin fall from eight to six. And so you lost between those two measures, almost 7% of return. That got you basically a slight loss.

Chris Bloomstran (00:15:37):
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. And here we are. Oddly one of the very strong periods that did not result in a cataclysmic 10-year period was 1958, but 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.

Chris Bloomstran (00:16:50):
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 in dollars and a little bit 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 baton.

Chris Bloomstran (00:17:27):
So I think things are pretty stretched. It was just, again, I think a really useful way. I think if you take that kind of analysis and we think about that in terms of businesses and how they work. In addition to 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’s going to grow and how much you’re going to get as a dividend. Put those five multiplicative factors together and that’s how you get your total return.

Stig Brodersen (00:17:53):
Well said. 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 is overvalued.

Chris Bloomstran (00:18:08):
Well, I would add, at the end of that analysis, it was a little bit digging under the hood to determine kind of how much of that 16.6 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 calculated basis earned 29.8%. It was stunning. And it didn’t come from the factors you would’ve 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 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. 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 five. It’s conceivable they wind up 10, if you kind of put together the moving parts of their business.

Chris Bloomstran (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 billion in revenues with the core of that being Apple and Microsoft at the outset to over 1.4 trillion. You had 17% annual growth in revenues per share, and you had a reduction on the share account. 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 on restricted shares. Apple shrunk 10 billion shares from the share account. They shrunk their share account by 37%. Microsoft shrunk their share account by over 10%.

Chris Bloomstran (00:20:26):
And so as a group, you had a 21% reduction in the share account, but the driver there with 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, Facebook may have seen its high, going to be hard to drive much higher than 30. 37 or 38% for Microsoft. Google’s running high 20s. Apple’s running at a 27 or 28% margin. You’re just not going to get a lot more there out of the multiple and the margin. And where sales had grown at 18% a year, the number’s going to be lower.

Chris Bloomstran (00:21:10):
And I suspect that, who knows what the hammer is, competition with each other, regulation, simply the law of large numbers, but at 70 to earnings for Amazon, for example, I mean that’s baking in, in my opinion, the profit margin will perhaps double from where it is, but if it doubles from five to 10, how much will the multiple shrink from 70? And so that’s the exercise. I think what you’re really going to wind up getting is still healthy sales growth. That group, amazing, was 8.5% of the overall S&P 500 at the beginning of the decade. And they ended at almost 25%. You had that 29.8% return. If you took the 495 companies that weren’t the Fab Five out of the equation, they still earned more than 14%. The remaining 495 companies are in 14.3%, which is still very healthy.

Chris Bloomstran (00:22:12):
But the 13 or 14 X 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 priced 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, not true here. So, that’s the same exercise. But sitting atop of the S&P 500, that group collectively is pretty rich. Albeit it’s going to grow a lot faster. I mean you think about how amazing it is that you 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. They’re larger businesses. Berkshire’s not going to grow as fast as it did in its first 35 years. Apple, Microsoft, Google-

Chris Bloomstran (00:23:03):
…as it did in its first 35 years. Apple, Microsoft, Google, Amazon, and Facebook are not going to grow as fast as they did because they’re much bigger businesses. And typically when growth slows, margins contract, and you can make that case for the market, you can make that case for individual businesses. And it’ll be interesting to see how the 10 years plays out. But 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.

Stig Brodersen (00:23:29):
Definitely, some of the stars would align for that decade and see a similar pattern. But Chris let’s shift gears here. The Securities and Exchange Commission, or the SEC, have this form called a 13F, and it’s a quartered report required to be filled by all institutional investment managers with at least a hundred million in assets under management. That also includes your company, Semper Augustus. And many of our listeners are avid users of Datarama, TIP 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, what can’t the public see in those 13F filings?

Chris Bloomstran (00:24:11):
That’s a really important question. We’ve had folks knock off our portfolio, you know it’s public, we file. And it’s a dangerous thing because they are aspects that are very misleading. We all know that because Berkshire listed in their annual letter, that they’ve got a seven plus billion dollar investment in BYD. Some may know, some may not know they’ve got a small investment, 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 years. But that’s eight plus billion dollars now that you don’t see. So Berkshire’s got, of a $350 billion stock portfolio, 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 as can you see with Daily Journal, obviously Charlie has taken the margin loan and interestingly he’s just resigned as Chairman of the Board of Daily Journal, but will stay on the board. But yeah, he’s got a position in some Chinese companies that had trimmed back his BYD, but I think they’ve probably got an investment in Tencent. They’ve got Alibaba. And neither of those you see on the 13F.

Chris Bloomstran (00:25:31):
Our filing, we have probably… well, we’ve got about 20% of our capital invested in non-US headquartered companies. And I’ve got three that we disclose. So two thirds of our international holdings, which is, decent chunk, probably 15% of our capital are not on our filings. The 13F does not include any cash and other than portfolio implementation, 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.

Chris Bloomstran (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 it 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. And whether that name stays in the portfolio or not, is really a function of that client relationship.

Chris Bloomstran (00:26:54):
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 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 accounts where again, this multi- generational planning, we’re waiting for a tax basis step-up. And the investor that pulls a 13F and sees Semper owning 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 in most cases it captures a lot.

Chris Bloomstran (00:27:53):
But then in the case of a global investor that has a small allocation to US, you look at 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 years ago that would’ve raised the dollar threshold for 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’ve indexed, when the 13F filing was required, to inflation, a lot of those portfolios that you see on platforms like Datarama would not exist there. Unless we were running a billion and a half, or I don’t even know what the next would be down, maybe it’s five billion dollars, 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.

Stig Brodersen (00:28:51):
Thank you for saying so Chris, appreciate it. Berkshire Hathaway has been making moves here in recent weeks, and 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 eight billion dollars. And then the all cash deal, $11.6 billion of Alleghany. And the latter was the biggest deal since 2016, when Berkshire Hathaway bought Precision Castparts for $37 billion, including debt.

Stig Brodersen (00:29:25):
Perhaps, let’s first start talking about Alleghany. The company’s involved in insurance business, they also own small operational businesses, steel market, tire factory, even a funeral service. What are your thoughts on the Alleghany acquisition and to paint some color around this, I could also say it was bought at 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.

Chris Bloomstran (00:29:51):
I’ve owned Alleghany since well, March of 2020. We looked up some names that we wanted to own for years, in the insurance sector when most things got hammered. So I’ve had about 2% of our capital in Alleghany, basis centered of under $500 a share. So seeing it go at 126 a buck, it hasn’t traded to that multiple in a while. I think Berkshire’s getting a really fantastic deal. There’s… to your point, we’ll see what happens. You’ve got another week and get another couple weeks. There’s a shop period where Alleghany management can go out and find another suitor, not pay a breakup fee to Berkshire, if they take another deal. Really the logical acquirer of Alleghany is Berkshire. Berkshire can do things that other insurance companies cannot do. Similar to the Gen Re acquisition in 1998, what you’ll see if they get this deal closed is the combination of insurers, Alleghany that collectively write about seven billion dollars in premium. Five billion dollars of that is TransRe 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 CapSpecialty that’s really not been a great business for the 20 years or so that Alleghany has owned it. But collectively you’re going to pick up seven billion dollars.

Chris Bloomstran (00:31:17):
You’re not going to… Alleghany 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 acquirer could do. Alleghany 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 insurance insurer has, is because of Berkshire’s massive surplus capital, statutory surplus, end off the year at $300 billion.

Chris Bloomstran (00:32:08):
Collectively, Berkshire only writes $70 billion in premium. Forty plus of that is Geico. Auto insurers can write three dollars 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 grants. And that leaves Berkshire’s massive reinsurance operations between National Indemnity and Gen Re, they write about $20 billion. And if you look at their peers, Berkshire’s peers in Europe, Munich Re and Swiss Re, they write a buck in premium in 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.

Chris Bloomstran (00:33:05):
And so they’ve just been really lousy businesses, but they overwrite. Berkshires had 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 that Berkshire can have a $350 billion common stock portfolio, almost all of which is inside the insurance operation. So what Berkshire’s getting in this $11.6 billion acquisition is picking up 13 or so billion dollars 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, and he’s been just a superb CEO. If your listeners aren’t familiar with the Alleghany annual letters, you may not see any more annual letters after this year if they closed this deal. But Weston wrote, in my opinion, 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.

Chris Bloomstran (00:34:15):
Of that 22 plus billion. They had about three and a half billion in stocks. Berkshire’s going to flip the proportion. And if they run Alleghany’s investment portfolio on par with 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 dollars. With the delta from earning, let’s say 4% on bonds to earning a high single digit return conservatively on a common stock portfolio, you’ll pick up 600 million dollars in additional investment income that other insurers can’t run that heavy in common stocks. So I think that’s a massive advantage. And then I think what you’ll see… you mentioned some of the businesses, Jazz Wears they’ve got the steel business.

Chris Bloomstran (00:35:07):
So as a insurer with some surplus capital, Alleghany has built out this Alleghany 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 effectively paying finders 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 of Alleghany’s total capital. Company’s 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.

Chris Bloomstran (00:36:05):
So you’ll likely see, if Berkshire closes the deal, every dollar of profit not retained. They won’t build out that Alleghany 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 Alleghany capital business in a world of very high control premiums. There were a couple deals that were, I think, bidding wars with Markel and Markel won. Tom and his guys have the same problem of competing with private equity, if you’re going to grow out those private businesses. So it just eliminates the need there.

Chris Bloomstran (00:36:40):
And the other intangible I think what you’re going to get, is in bringing Joe Brandon back to Berkshire. Joe had been at Gen 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 a loan. The government put a lot of pressure on Berkshire and on Mr. Buffett to look into it and do something. And Joe somewhat got thrown under the bus and left Berkshire. I know in the last few years they’ve… TransRe 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 him as a nice succession plan, if you will, perhaps to Ajid. There’s a very real notion, at a point you wind up seeing Greg Abel and Joe Brandon tag teaming and running Berkshire Hathaway. So that’s… perhaps you’re buying a succession plan, but you’re paying a very, very low price.

Chris Bloomstran (00:37:45):
My appraisal on Alleghany 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 a little bit of equity option in the deal. Berkshire could have done that. With Berkshire now trading at 150 of book, it wouldn’t be that dissimilar to the Gen Re deal when they swapped their shares and bought Gen Re using only their stock when it traded almost 300% of book value. But there’s room to do that and accommodate the taxable investor. And I’m a little disappointed in that.

Chris Bloomstran (00:38:24):
So we’ll see if you get a shop. But all in all it’s a great deal for Berkshire and it’s not small. You think about Berkshire’s reinsurance operation, again, National Indemnity and Gen Re; the two write 14 billion in normal premium per year. And so you’re picking up five from TransRe, assuming TransRe 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 TransRe’s business is proportional 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 rough stretch. Well, they’ve taken price and on their property lines, they’ve been getting 20% for the last two years. The January renewals were very strong and then 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 CapSpecialty, both taking price.

Chris Bloomstran (00:39:34):
RSUI is underwritten at a combined 85%. Their underwriting margins been 15% for the 17 or 18 years that Alleghany’s owned them, has just been a phenomenal investment for them. TransRe has generated a 10% return and CapSpecialty again, was suffering a little bit. They sell into small, mid-businesses where Berkshire doesn’t have lot of business. So it’s a nice compliment. And they’re also like getting price. So you’re picking up seven billion dollars of 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 or good transaction, I guess, for Alleghany.

Stig Brodersen (00:40:12):
So let’s continue talking about Buffett. 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, Chris, you follow Berkshire Hathaway, perhaps closer than anyone else in the space. What stood out to you, if anything, in Buffett’s letters to his shareholders?

Chris Bloomstran (00:40:37):
Well, the letter’s gotten shorter, I think it was 11 pages. Thrilled that at 91, Mr. Buffett’s still writing. He’s taken to thanking folks. I love the orangutan comment about teaching. The collection of Berkshire Hathaway letters over the years have been such a valuable teaching tool. 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 letters. 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 then Charlie’s comment about teaching that Mr. Buffett wrote about the orangutan effect, where if you sit 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 articulating your thoughts in a teaching format. I thought that was great.

Chris Bloomstran (00:41:41):
There weren’t a lot of surprises in the letter. The proxy came out after the annual and much has been the case for 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 climate proposals, you’ve got a couple climate proposals on the books this year. One’s an exact repeat. CalPERS is back. And what they’d like have Berkshire do is have each of the subsidiaries, all of the subsidiaries checkbox their ESG and their climate report. And Mr. Buffett in the letter and Greg Abel had a two page in the appendix, that 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.

Chris Bloomstran (00:42:41):
And Berkshire’s leading in both businesses because both of those companies have public debt. They file their own SEC filings, they have their own queues, they have their own case. They have for years, they’ve had very broad, informative climate discussions. Berkshire has massively reduced its reliance on coal. Half of Berkshire Hathaway 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 is just lunacy. 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.

Chris Bloomstran (00:43:25):
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 is no longer serving as CEO, if they take him out in a pine box, if he retires, that role will be separated. 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 management. And they’ve got a terrific board. We just saw Wally Weitz added to the board, which was great. Chris Davis and Susie had been added as well.

Chris Bloomstran (00:44:15):
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. There’s just a lot of good. And again, I hope at age 91, I hope if Mr Buffett shrinks his letter by one page per year and we can get a one pager 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 going to write a 30, 40 page letter anymore and teach, 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.

Stig Brodersen (00:45:03):
To your point there before, especially the earlier letters, 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. 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 shareholders meaning and his response, which is 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’ll have a different impact on our collection of businesses.” Could you please provide more detail on how inflation will impact Berkshire’s businesses and investments?

Chris Bloomstran (00:45:51):
Yeah, boy, they’re saying it. Everybody’s saying it now. I know how durable it winds up being. I still ultimately shake out in the deflationary camp. I think the…

Chris Bloomstran (00:46:01):
… stationary 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 nose bleed level of 250% in 2000. The remedy for too much 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 on that front. You think about what’s going on with electricity prices broadly, right now the single largest feed stock 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 feed stock costs is largely reliant upon regulators. 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. So inflation there really does harm an electric utility.

Chris Bloomstran (00:47:40):
You think about the capex that’s spent. Berkshire has spent over $70 billion in capex against mid 30 billions 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. They’re getting a regulated return, call it a 10% return on those capex dollars. Again, they’re far ahead on wind and solar. 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, Berkshire’s in the catbird seat, at least for the moment, because the feed stock cost of the wind and the sun does not go up. That is not an inflationary feed stock cost.

Chris Bloomstran (00:48:33):
Now the cost of building at your capex gets exponentially higher, and whether the regulators are going to let you get a regulated return perspectively really becomes a question. Berkshire odes a nice job hedging it’s other feed stock 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. 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.

Chris Bloomstran (00:49:14):
That’s really the first place that you go. You utilities really struggle in the ’70s. These they couldn’t raise prices enough to keep up with inflation. So the returns on equity capital dropped off. The construction costs simply got very high. The railroad is another place where, in the 1970s, it was a terrible industry, extremely capital intensive, maintenance, capex always runs in excessive depreciation costs. It got so bad by the end of the 1970s, that under the Carter administration, we deregulated rail intelligently. The Surface Transportation Board and the government was no longer in a position to set price. That later got modified to where the industry really began using a CAPM approach to pricing and was able to raise prices further.

Chris Bloomstran (00:50:01):
Well, you had an executive order a couple years ago by the Biden administration that’s on the books. There was just a hearing a couple weeks ago that effectively would allow what they call reciprocal switching, allowing a customer and the ag industry loves this, the chemical three 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, 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.

Chris Bloomstran (00:50:58):
So we’re going down the path of price controls, and you’ve got a business that’s working very, very well. The US rail system is the most efficient rail system in the country. 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 kind of low teens 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 feed stock costs there, similar to utility, are rising, it’s tougher to pass them through immediately. Which you’ve got contract escalation provisions.

Chris Bloomstran (00:51:46):
Labor’s 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. Those don’t reset until that contract is up. 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 rail’s in great shape, presuming we can keep the government out of their affairs and let that industry run efficiently.

Chris Bloomstran (00:52:22):
The MSR group is where you could really have a problem. You think about the kinds of businesses that can weather in inflation are those that have higher operating margins and gross margins that are in a position to be able to pass through rising costs. Berkshire’s collection of MSR businesses are largely lower margin businesses and, in some cases, don’t have the immediate ability to pass through to customers, because the customer can’t bear the price increase. So you saw some discussion in the MDNA 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 years.

Chris Bloomstran (00:53:15):
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. 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. They did some restructurings broadly in some of those businesses, and you’ve seen a big improvement in profitability where the group, the MSR group collectively just posted in 2021 it’s best record profit yet, and could very well see a decline in profitability this year for some of this inflationary pressure.

Chris Bloomstran (00:53:56):
Then that leaves you the insurance operation, which thank goodness we’ve got a property casually operation versus life. Berkshire’s 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. That’s what you had in the 1970s. Property casualty runs shorter liabilities than does life. 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 casualty today. Auto claims, they’re very expensive to fix cars. You’ve probably seen chart of… I’ve got the chart in my letter of just used car prices over the last… Well, over time, but they’ve just spiked this year to where on some late model cars you’ve actually got higher used cars prices than the price of the vehicle 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.

Chris Bloomstran (00:55:17):
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. 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.

Chris Bloomstran (00:55:53):
When you get into the third, fourth, fifth year, a lot of that then are your medical claims, the medical portion of an auto policy claim. Those tend to take 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 ditto, your rail industry, ergo your utility industry, as long as your state insurance commissions understand that your profitability is suffering mightily because of the increased cost of paying claims, you’re generally allowed to re-rate. You’ve seen some rate taken 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, a really lousy business to be in. It was a very high underwriting losses, many, many years in the 1970s and early ’80s.

Chris Bloomstran (00:56:54):
You think about the retroactive business that Berkshire writes, these long-tail asbestos policies 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 durably 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 by far on that platform.

Chris Bloomstran (00:57:34):
So then you go back to the bond portfolio Berkshire doesn’t have. They’ve got $20 billion in bonds on 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. 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 duration risk there. If we get durably higher interest rates, Berkshire does not lose on that front. 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.

Chris Bloomstran (00:58:17):
Randomly, the top five are all up this year. So Berkshire’s going to show an accretion on book value and earnings from stocks, even though the S&P 500 is still modestly negative. The NASDAQ is down by more. Apple was up for the year, as of yesterday, the other big four or five positions. Kraft, which has carried as an equity method investment, is up for the year or so. But if you get a period where stocks don’t do well, and they did not do well in the 1970s, 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.

Chris Bloomstran (00:58:59):
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 a 1,000 to 7,778. I think it was. Next to inflation, that averaged high single digit, the investor lost 75% of their money. So we’ll see. 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. The fact that you don’t have duration risk in the bond portfolio, it was 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’s going to suffer. 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.

Stig Brodersen (01:00:08):
We can’t talk about inflation without talking about the interest rate, because as a result of this inflation, the fed has already hiked rates and will continue to do so. As many of six rate hikes of different magnitudes have been signaled in 2022 alone. What is the impact on the interest rate increases on Berkshire Hathaway?

Chris Bloomstran (01:00:27):
Well, from a reported profitability standpoint, because you’ve got over $140 billion in cash in the business that, post 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%, two and a half percent, Berkshire’s going to wind up making two or $3 billion in interest income on its cash reserves, which is great. 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’s higher, and 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.

Chris Bloomstran (01:01:33):
I think they’re probably going to own cash matching one year’s worth of losses actually paid as cash. 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. I’ve long presumed some optionality on Berkshire’s cash reserves. 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 that can be invested. From that hypothetical 7% return, I subtract whatever the bill rate happens to be. So if that at year end, we wind up with a series of rate increases and we’re at 2% on T-bills, I’m only going to assume that Berkshire’s going to earn 5%, the 7% minus the 2% on the cash reserves.

Chris Bloomstran (01:02:48):
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, wind up at 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. 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 11 six, now do you have one or one and a half billion dollars 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.

Chris Bloomstran (01:03:57):
Do you then capitalize that new $14 billion at whatever multiple you’d capitalize Berkshire’s income at? Is it worth 18 times that new $14 billion? I’d say, no. I’d say my method has captured. So when Berkshire invests in Oxy or [inaudible 01:04:16], the new investment in Oxycom and 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. So know the fed raising rates will not harm Berkshire in the same way as it will, again, insurers where you’ve got a rising yield curve on the front end and the back back end. We’ll see where the curve inverts, where it flattens.

Chris Bloomstran (01:04:43):
I just saw some are now calling for a 10% or a 4% 10-year by the end of the year. I don’t know that you can get that high. 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 ago at a 5% short end of the curve and 7% long into the curve. 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. They’re simply not net adding to the balance sheet. So 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 to 2018.

Chris Bloomstran (01:05:40):
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. 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. 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. We’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.

Chris Bloomstran (01:06:41):
So to the extent there is inflation, our central banks globally have had a hand in introducing it. Then at the same time, we have these scarcities, we’ve got these scarcities 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 feed stocks for plastics. So we’ve genuinely got a shortage of supply, and that’s not easily remedied.

Chris Bloomstran (01:07:24):
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, 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. 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 $ 100 or more per barrel for a persistent period of time. If we get a peace on this Ukraine situation, you’re going to get oil run back to, but it’s not going to drop much lower than $90, which is kind of where it was before this latest crisis.

Chris Bloomstran (01:08:14):
Until you see a lot of spending on supply, things are going to stay pretty tight. So there are places where you’re going to have some inflation for a period of time, but I just think Berkshire’s in a better position than most businesses to weather it because of it’s fortress balance sheet and durable earning power. 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 can’t bear it, we’ll blow something up in the meantime.

Stig Brodersen (01:08:41):
We’ve gone through Berkshire Hathaway, the business model, and in greater detail than I think we’ve ever had any guest come on to show and talk about. So let’s now talk about valuation and expected 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,”-

Stig Brodersen (01:09:03):
… depression or a hyperinflation. I’d be surprised if Berkshire compounds all the next 10 years at less than 10% per anum. So having said that, could I please ask you to elaborate on that statement and talk a bit about normalized earnings estimates?

Chris Bloomstran (01:09:15):
Well, it’s fairly straightforward in that Berkshire’s never paid a dividend. Actually, they paid it 10 cent dividend in 1967, but outside of that, they’ve never paid a dividend. So if you drill down to what I’d call economic, normalized economic earnings at the business, Berkshire’s 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 buy back shares north of book value. You have old assets on the books that in a high inflation period are carried at a lower cost. So book value is going to be less important as a proxy for value perspectively, 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. 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 900 billion and change.

Chris Bloomstran (01:10:33):
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 great detail 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 just the main adjustments that an investor would make from a macro perspective at Berkshire 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. When 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% owned and of the [LNG 01:11:32] Cove Point property, Berkshire only owns 25% of that asset. So we all know that in Berkshire Hathaway 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.

Chris Bloomstran (01:11:48):
His estate is still open. He and his wife’s foundation will wind up picking up the 7.9% interest in Berkshire Hathaway Energy that he owns. That’s not insubstantial. That’s $80 billion. You’re looking at six plus billion dollars. Greg Abel owns 1% of BHE. 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 four billion dollars in assets and $400 million, oddly, a 10% ROE. You’ve got a non-controlled interest that Dominion and other investors have retained. 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. Yeah, 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.

Chris Bloomstran (01:13:08):
I carried 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. So where during the early years of Berkshire’s ownership of that railroad, they were spending two dollars of CapEx for every dollar of capital. The cadences dropped off in the last three, four years to where they’re spending about 150% now. But I think that number, again, if Mr. Market as a guy is fairly conservative. The MSR businesses were just on fire last year. The group does 150 billion in revenues. They’ve got the margin backup to 7% and healthy now, having lagged a bit. Precision Castparts’ investment has been a bit of a disaster, but they’ve made some real strides with some of these businesses. The group is now earning almost 10% of equity again, which is terrific. Again, we’ll see what happens with inflation this year, but on multiple of high teens, multiple earnings, that group is worth a couple hundred billion dollars.

Chris Bloomstran (01:14:20):
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’s undervalued. There are moments where it’s overvalued, but I’m charging $50 against it. Then you’ve got some assets at the holding company. So you’ve got almost $30 billion of net assets there and your investments in craft and the other equity method investments, Pilot Flying J, TTI, [Berkadia 01:15:01] 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 get to your number. I would say from a conservatism standpoint, when you add up the profitability of each of those groups, I get to about $48 billion in normalized Berkshire economic earning power and at 18 times earnings, that’s how I get to my intrinsic.

Chris Bloomstran (01:15:32):
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 overvalued, 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 and realized gains flowing through the income statement, as opposed to simply realized gains flowing through the income statement, both are obviously flowing through the balance sheet, of course, you’ve got to back those out. So we all know to then assume that on top of the five billion dollars 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, we’ll call it $12 billion of retained earnings on the common stock portfolio, the portion of profits that Apple retains that they don’t pay as dividends. There’s $12 billion there.

Chris Bloomstran (01:16:38):
Well, you add up the five billion in dividends and call it the $12 billion in retained earnings, and you’ve got a portfolio that was trading a little under 20 times earnings at year end. 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 Berkshire’s going to earn the retained earnings, then you’re assuming that the stock portfolio averages a 5% return over time. 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 and my. In our earnings yield has ranged at the end of each year for the 23 years we’ve run the firm, between seven, six-and-a-half and 9%, but our stocks have averaged just right at 12% a year. You’re buying stocks for less than what they’re worth, they accrue, but also the retained earnings, back to the earlier discussion, the retained earnings are being invested at the ROE of the businesses.

Chris Bloomstran (01:17:51):
So an investor should earn more than the earnings yield over time. So there’s a conservatism to that $48 billion that is underappreciated, again, because it’s only an earnings yield number. 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 then simply the retained earnings of the portfolio. I further strip out whatever your underwriting results are in the short term and I add back in, I presume 5% pre-tax underwriting margins. So on 70 billion in premium, Berkshire would earn three-and-a-half billion dollars 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 invested assets on their pension funds. If Berkshire assumes a 6.4 or 6.5% return, there’s about a $400,000 adjustment there.

Chris Bloomstran (01:19:08):
Mr. Buffet has talked about, and this would be correct, and I’m not sure I’m fully on board with, but 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. That’s 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. We changed the accounting there. So goodwill is no longer amortized. 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 a nuance. I’m not sure 100% if intangible should be added back, and I don’t add 100. Mr. Buffet suggests that you should. So you run all that together and you wind up essentially with the same $48 billion in earning power for the business.

Stig Brodersen (01:20:14):
Yeah. I certainly agree with that. 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 how I felt whenever I picked up your letter and I found page 96 and I looked at the intrinsic value assessments you have made there through your different approaches. I would just like to give a handoff to the last time we had you on the show. We’ll make sure to link to that in the show notes, where you go through each your approaches and specifically emphasize the two prong approach.

Stig Brodersen (01:20:45):
At year end numbers, you come up with a valuation of $949 billion or equivalent to a B share price of 429. Of course, whether I said 46 or 26 or 29 there at the end, we are 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 are describing evaluation approach, what’s the simplest way for a new intermediate investor to assess Berkshire’s value?

Chris Bloomstran (01:21:23):
That two prong method Mr. Buffet introduced, I think it was in the 1995 letter and it was in for five years, and then it was out for a period of time, 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. Then you take the marketable securities, and those are worth what you think they’re worth. You could charge against them for float. You could charge against them for the fact that you think the portfolio is $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 Gen Re. You had a couple years of really nasty underwriting results. All of a sudden, the underwriting results were so bad in the late nineties that it dwarfed the operating earnings of the business. Now back then, Berkshire was largely insurance. They hadn’t bought the railroad, they hadn’t bought the utility operations.

Chris Bloomstran (01:22:28):
The majority of the earning power of Berkshire came from the insurance operations. 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. So Berkshire had a 13, 14 year now longer period of time where they underwrote profitably. We’ve long assumed that Berkshire’s going to underwrite, to my earlier point, at a 5% pretax operating number. So again, on 70 billion in premium, my final addition to my two prong approach is backing out whatever they actually make on an underwriting basis and adding in 5% pretax and capitalizing that a conservative number. 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 four billion dollars, 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.

Chris Bloomstran (01:23:40):
So 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 the 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, [TCGAA 01:24:10] at the end of ’17, I was multiplying, I was using a 13F cap factor against earnings to get to my 18 to earnings. 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 at a different number to get to 18 times. I don’t think Wall Street investors really caught onto 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.

Chris Bloomstran (01:24:44):
So I flip the cap factor to 15.4 multiple to pretax earnings, but that gets you to that portion of the number and then I simply take the marketable securities, make any adjustment to the degree securities are over or undervalued, and add back in a little bit of margin for underwriting. 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 and pretty straightforward. So it eventually was taken out. It just got too cumbersome as moving parts changed here and there. 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. You can see that progression. All of the methods, my adjustments to gap earnings, sum of the parts are normalization factors.

Chris Bloomstran (01:25:54):
There is an additional, not even in some 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. So you’ve got this big deferred tax liability that now in cumulative sums to about 90 something billion dollars. Some of that is the offset for unrealized gains in the stock portfolio, which you’ve got a good chunk of it that simply represents the fact that we’re accelerating CapEx immediately for tax purposes and those taxes are eventually paid. Well, there’s an absolute time value of money to 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. For conservatism’s sake, you would, perhaps, exclude that by the same token for those that would jump on the optionality of cash.

Chris Bloomstran (01:27:01):
Again, if you’re going to exclude the optionality of the cash, then when you’re running the ROE of the business, you better take the cash out of the business and only apply the operating 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 over time, 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 conflated about three moving parts there to really make things not straightforward for the listeners. But yeah, I think that two prong is still pretty useful and I’ll keep it in the letter.

Stig Brodersen (01:27:37):
I just want to highly recommend your letters, just like I did last year. It’s absolutely fantastic. If you’re like me and like Chris or avid followers of Berkshire Hathaway, this is definitely the letter to read. But with that said, Chris, where can the audience know more about you and Sempra Augustus?

Chris Bloomstran (01:27:55):
Yeah. We have a history of letters on the website, Sempraaugustus.com. I’ve got a tab for letters and there’s another tab for podcasts and interviews. When this is published, we’ll post it immediately to the website. So our interview, our talk from last year is up there, handful of others. 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 @chrisbloomstran. I don’t think that’s cap sensitive. Website’s probably the best place to find us.

Stig Brodersen (01:28:34):
Perfect. Chris, I can just say, like you also mentioned in 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 of this 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.

Chris Bloomstran (01:28:57):
Yeah, I count on it and I’ll count on seeing you in Omaha in 2023. 2023 or bust.

Stig Brodersen (01:29:04):
Challenge accepted, Chris. Thank you so much for your time. Have a good one.

Chris Bloomstran (01:29:08):
Thanks, Stig. Appreciate having me on. Been a lot of fun.

Outro (01:29:11):
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