Introduction

Patrick: [00:00:52] My guest this week is Chris Bloomstran, the president and chief investment officer of Semper Augustus Investments Group. He became famous in investing circles a few years ago for his incredibly detailed investigations of Berkshire Hathaway. But we do cover Berkshire towards the end of the conversation we spend most of our time talking about what makes for a quality business. I love some of his angles in the current landscape, including our discussion of companies like Richemont and Disney, which are actively taking distribution back in-house. Please enjoy our conversation.

Biggest Investing Mistake

An interesting place to start, which I've really not done before, would be with your biggest mistake, biggest investing mistake. We'll talk a lot about successes and interesting companies over the course of the conversation, but oftentimes we learn most from our biggest screw-ups. And you were talking a little bit about one of those before we hit record. And so let's begin there.

Chris: [00:01:36] What, in your now pretty long career investing in equities has been the largest error, 30 years in and 20 years running Semper, you do make a, a fair share of blunders and mistakes. And this year's letter, I wrote about a handful and probably the one that comes to mind that I would categorize as the worst, which was clearly an error of commission. Having sold Ross stores having owned it for the prior two and a half years, we owned at the outset of the firm. We had trained, positioned a very wealthy family's portfolio away from kind of large blue-chip businesses with very low-cost basis. A lot of businesses no longer earning their cost of capital prices ranging from 30 to 50 times earnings. Very tax efficiently with a foundation and some credits that liquidated a portfolio. And at the time, all of the value that we were finding was in small, mid-cap names.

So we buy Ross stores as an example, maybe 10 times earnings. We'd followed Ross for seven or eight years had never owned it. Terrific retailer. They probably had 350 375 stores at the time. We love the ramp at which they could continue to open stores. Unit economics were terrific, kind of high teens, low twenties returns on capital balance sheet was great. They used operating leases, but judiciously. So we pay 10 times earnings for Ross. And during that first 50% bear market, when the market fell. During 2000 Oh one Oh two, we made on the order of two and a half times, our money on Ross. So the stock, at that point, it was trading kind of high teens, call it 20 times earnings. And we figured as we did at the time that you could always sell things and buy them back.

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

In the years having sold it since, the stocks more than a 20 bagger, just insane. So you look at the unit count, profitability grew gross margins expanded. If we had done a model and laid out a 20-year projection, we probably could have gotten to the way Ross played out, but we sold it for price. We sold it for price and made the mistake of never circling back and buying it because I think we were anchored at some level in the fact that we paid 10 times earnings for it. And you make two and a half times, do you circle back and pay 15 or 16 times? Well, it was clearly worth way more than 10. It was worth way more than 20 times. And so that was just a very painfully expensive lesson because it had grown into a good size position. It was a good size position at the outset, and we forfeited a huge amount of upside on a business and a concept and a theme really of finding. Businesses that can grow units with incrementally growing returns on capital. And we walked away from it. That was a very, very expensive, painful experience, but you learn from those experiences as well.

What Makes a Quality Company

Patrick: [00:04:52] So it's a good excuse to talk about your kind of core investment philosophy. And again, before we hit record, I mentioned this word quality investor, which I'm hesitant to use that word too much because so many people say that word and it means a hundred different things. So I'm hoping the, you can define for us what quality means to you and also answer whether or not you think that it's a good word to describe, in very simple terms, your investment philosophy, and we'll sort of peel it back from there.

Chris: [00:05:17] I think quality very much describes what we do. We think about two things. We think about quality and price, but we think about quality way before we think about price, but we like to say we employ a dual margin of safety in the process. We're trying to buy outstanding businesses, run by outstanding managers. I think anybody in the value world talks about the same thing, quality, blah, blah, blah. But I think 30 years into doing this and through the mistakes that we've made over time, you get burned enough and you get jaundiced to where your definition of quality, I think evolves to the point now. And I wouldn't call us timid investors at all but if you take our collective business balance sheet today, our businesses are effectively unlevered. And we don't go in with a notion that we're only going to businesses that are net unlevered when you strip the cash out. But that's where we are today. And it was just oddly, there are really outstanding businesses that can be had for good prices despite what we think is a very overall expensive market. But you always talk about management quality and we've owned businesses that didn't have management quality, but thematically, we thought we're in the right place. We owned Mylan labs a couple of different times on the notion that you had this giant patent cliff with the big branded pharma. Hatch-Waxman was passed in 1984, which gave 20-year patent life to drugs. And you knew all these big drugs coming off patent and so the generics were just in a sweet spot. The management at Mylan was...the accounting was suspect. They had a revolving door of CFOs. They pay themselves gads of money. The accounting was terrible. If you think about trying to get drugs knocked off a patent. You spend your life in the courtroom and so bribes and it was just bad. And finally, we made money with it, but walked away from the business quality. And so we've just kind of trended toward…Ideally, we're trying to own businesses for a long time. And if you're gonna own businesses for a long time, if you're going to start a business with somebody, if you and I, Patrick, we're gonna start a business, we better have a hell of a lot of respect for our core sets of values and our morals. And so I think we've just gravitated toward trying to identify these businesses that are run by folks that kind of share our value system.

Ideally, we're trying to own businesses for a long time. And if you're gonna own businesses for a long time, if you're going to start a business with somebody...we better have a hell of a lot of respect for our core sets of values and our morals. And so I think we've just gravitated toward trying to identify these businesses that are run by folks that kind of share our value system.

And it's hard because you don't have access to management the way we would have 20 years ago. I think through longstanding ownership of businesses, managements are a lot more comfortable to talking to us because we're never interested in what quarterly earnings are going to be, or earnings for the year. We're trying to really get a sense of how the business works and where the durable strengths are and where the permanence is and what the business doesn't look like tomorrow or a quarter from now or a year from now, but 10 years out in 15 years out and what the movers are and where's the disruption. So we sit here today with, I think this business of great CEOs in our 20 years of running Sempra I know that the roster of CEOs that we have onboard today are better than we've ever had. A lot of times they're founder-owners, or they behave that way, but that's not even the outset. We're turning over rocks, we're looking at businesses. And I just think it's evolved that way. It's evolved into management quality without that being kind of front and center.

And so now we talk about all the different things we do research-wise and process-wise, one thing we've started doing recently is we're spending a lot more time on the proxy statement. So every year with anything we own, you know, you obviously read everything, you read the K,s and the Q's and the proxy once a year. But if we're looking at a business or we're looking at a competitor. For my career, I've always tended to look at a couple of three years at a time. So I'll read three K's and I'll read three proxies, but we've gone back and we've started looking at businesses and taking a series of 15 years’ worth of proxy statements. What that does is gives you a sense of where changes have been made. So to the extent the boards of directors want to make sure their CEOs and their CFOs and their managers get paid, they're always moving around these hurdles for incentive comp. And so if straight salary compensation is 10 or 15 or 20% of comp, the majority of how these people get paid is with bonuses and the vesting of their incentive stock options and the bonuses all have caveats to them.

And so we just ran one for a presentation I gave in Zurich. I gave a speech on the imperative of no and spend time talking about management teams that get it. And I use Cummins as a case in point, but then I took the proxy and talked about what's happened at a company like General Mills. Well, if you think about the nature of brand new consumer goods, businesses, and the threats they have from private label, for example. If we go back 10 years ago, 12 years ago, These guys had in their proxy statement for bonus comp or hurdle of maybe 3% organic sales growth and the success of period through this last year, that number have declined from three to two, two to one and a half, one to 1.4. Well, the number today, the hurdle today is a negative 1.4% organic growth rate. And it's stunning. We're going to pay you performance comp to slowly shrink the business. The other overlay to the current comp. And this has evolved in the case of General Mills as well is we're going to pay you on free cash on a rolling three year periods. They have an organic sales growth on a rolling three. They have free cash on a rolling three. So I guarantee you, these people lay awake at night, thinking about what they have to do to the business for the five years they're on watch to how they're going to earn their incentive comp. And so if one of the two metrics is free cash flow, you can cut advertising, spending, you can cut CAPEX, you can kill the brand of the business that you're running, but you can drive the free cash. And so it's crazy. So with one of their hurdles, there's a 50% mix between the organic sales, which they did not hit for a rolling three so they got zero, but then they had 132% of the free cash metric. They paid that pro-rata. So they split the 132% so they paid 66%. They didn't get zero and a hundred for 50. They actually got 66, which is crazy.

So the thing that goes missing from a proxy like that, which we see in too many places, Coca Cola is another example of it, too many businesses don't have a return on capital. They don't have an asset-based return metric. They don't have an equity-based return metric. They don't have a capital-based return metric. They're paid for all kinds of nonsensical things like top-line growth. So what does a General Mills do in the wake of all that? Well, they're not hitting the portion of comp that's tied to organic growth. So you buy Blue Buffalo. You pay something like $8 billion for $1.2 billion in revenues, it might be a good deal, it might not. So you don't get the calculation for comp in the first year you make an acquisition, but you have a business that's clearly growing the top line. And they're going to drive top-line growth. Is it profitable? I don't know. Is that too big of a premium for that brand to be accretive on a return on capital basis? It doesn't matter because that's not part of the metric on how they pay themselves. And I think that's insane.

Too many businesses don't have a return on capital. They don't have an asset-based return metric. They don't have an equity-based return metric. They don't have a capital-based return metric. They're paid for all kinds of nonsensical things like top-line growth.

Examples Of Quality Companies

Patrick: [00:11:48] We'll talk about the common attributes that you look for in a business. You've already kind of. Danced around one, which is this notion of high incremental return on capital. And you also alluded to this idea with some of the stores, Ross Stores, as an example of sort of unit by unit expansion as being a really simple example of high returns on a new store, let's say. So talk about incremental return on capital, kind of what that means to you, what you look for and whether or not there are sort of. Other themes like that say store expansion that fall in that bucket that you've looked at over there.

Chris: [00:12:17] Yeah. I think return on incrementally invested capital is probably one of my most important jobs to assess how well these management teams and these boards are keeping our portion of profits that we're not receiving as dividends. So I do have a great example of that. So we made the big mistake with Ross. We didn't know it was a mistake at the time, of course, but a couple of years after we sell Ross, I think maybe 2004 we buy Costco for the first time I was learning and I just said, value investors don't pay 20 times for anything. We sold things at 20 times earnings. 20 times was nosebleed. I paid 20 times earnings for Costco because with it, we had a business that looked similar to a Ross. They were probably running 350 or 375 stores at the time. But we believed Costco had a very long ramp to open stores. They were just beginning to pay a small portion of their profit as dividends. So you wondered, well, is this thing getting closer to maturity or not? And so the business at the time was earning 11 on capital which isn't very attractive. Their gross margin, their average markup was probably 14%, but we looked at the 11 on capital and knew enough about other businesses that we were to search but didn't own over time, like Home Depot and Walgreens, if you are building out units and you don't achieve maturity with a unit for a period of time. And in Costco's case a store they would open, wouldn't be a mature unit for six or seven years - mature defined as kind of maximum sales, maximum throughput of inventory, fully achieving unit profitability. In the case of a Costco, a store wouldn't earn 11 on capital, right out of the gate. Their brand new stores were earning kind of mid to high single-digit returns on capital, but the mature stores were earning kind of mid-teens returns. And so we figured 11 was the wrong number. And as the installed base of Costco, for lack of a better term, grew relative to the number of stores they were opening, you would start to see the improvements on returns on capital.

And so fast forward to today, the business has grown the number of units to probably 800. Just under 800, there are maybe 150 international stores in the mix. Returns on capital today are 21, 22%. And I think two or three points of that is probably due to the tax code change. When I look at Costco to say we kind of bake in kind of a high teens, call it 18 or 19 return on capital business. And I think there'll be one of the first to compete away this newfound free cash profitability that they have. But Costco today has driven the gross margin from 14 down to 11%. And think about that. Usually, if you're a retailer, if you're a Macy's or a JC penny or a Sears, and you see a declining gross margin wall street is going to kill you because it's generally a sign of something wrong. Well, in the case of Costco, they've taken the scale of the business, of their purchasing power and they've passed it through to their customer. So if a net margin was 1.8 or 1.9%, it's 2.1% today. But the returns on capital of the system are double what they were. And so to me, our ownership of Costco is probably been the best teaching tool that I've had just for the good fortune of sitting there and watching it grow for as long as it had, it really taught me how capital worked. And it really taught me about the importance of reinvested capital and incrementally return and incremental returns on capital.

Patrick: [00:15:33] How important is unique features of a business model to you? So Costco, obviously what jumps to mind is the membership and that being, I guess, less unique these days. So there's a lot more memberships and subscription models in the economy, but what does a feature like that mean to you? And do you tend to own businesses that have some unique feature like that, that maybe the market doesn't do as good a job of understanding?

Chris: [00:15:54] It's not so much something that's unique, but we want to see management's take initiatives for the good of the shareholder and the good of their customers. And I've got a series of those. So a Dollar General, for example, also in the retail world, it's one of the two retailers that we own today. We own them for similar reason, but we own them for very different reasons as well. I mean, if you're going to be in the retail world today, you have to ask the question, how defensible is your business against online retail? How defensible against Amazon? And we think for different reasons, Costco and Dollar General are two businesses that are uniquely positioned as impenetrable by online commerce. And if Costco may do online commerce, Dollar General is running ads through their online model. But Dollar General is just a unique animal. So we liked the management team. We liked the way they compensate themselves. The business, if you recall, was taken private by KKR right before the financial crisis. And learned all about how private equity works during that episode. Only until we really started following Dollar General three or four years after it came back public. And I think it came out in '09. You just saw the egregious things that private equity does with money.

Patrick: [00:17:02] And can you give some examples there?

Chris: [00:17:04] Oh, I mean just the leverage. So Dollar General was a wonderful looking business. When it was taken private, they had no debt on the balance sheet if you didn't capitalize the operating leases and the operating leases were conservatively done. So KKR comes in and pays very high multiple. I would even argue that the management team in place. Was incentivized with immediate vesting of their stock options to allow the deal to take place. So in the six months prior to the deal being done, for whatever reason, the store count growth slowed, they missed on some earnings metrics and the stock got beat up a little bit. And so which gave KKR a chance to come in and buy the stock back for below the all-time high price, which had been set maybe six months prior, but management got rich. The current management team at the time got rich. The leverage that was employed was probably 3-4X to the equity that was put in the debt that was put in place, came from KKR and it came from private equity and some of it came from Goldman Sachs. It was done at coupons of 12 to 13%. Dividends are paid out during the course of ownership. They don't open a lot of new stores. And then when it comes back out and it gets IPO to the public, again, they kind of reprice the number of shares outstanding. And did it, what amounted to a little bit of a split to make it look like it was the same, but there was about a 10% shave on top of that.

And then when it goes public, Goldman and KKR with their own underwriting arm takes the thing private. So they get their underwriting fees, they get their discounts, they do all the secondary offerings and we added it up and I don't remember the numbers, but it was a staggering amount of money that wasn't reinvested in the business. In the case of a Dollar General or the case of a Costco post the IPO, but it was just bled from the business right into the pockets of private equity. And I guess that's a great way to make money, but it wasn't for the good of the business. So the business came out with a lot of debt on the balance sheet. It wouldn't have been attractive to us, but produced a lot of free cash flow produced a lot of cashflow and over the next six or seven years, pay down a lot of debt. And to the point where it's more levered than it was, I mean, I think management learn and they get the guy that's the chairman actually was the guy that engineered the deal for KKR, which gives us pause. It also gives us comfort because he knows how to run business, but they cleaned it up enough and the stock had gotten cheap enough that we bought it, oh, geez, two and a half years ago paid kind of a mid-teens multiple and very similar to a Costco though. We liked what management was doing.

We love the unit, economics and management, how to plan to basically double the store, count over the next, call it 10 to 12 years. And I think if they're running 15,000 stores today, at the time we did our original analysis, I think they talked about having 24 or 25 thousand stores. I think they'll probably get there. And so we look at what's happening in their geography. 70% of dollar General's business is done in rural markets, which I think differentiates it from their primary dollar store competitors. I think if you're an Amazon and you're trying to ship a basket of $13 worth of goods to Knob Noster Missouri, it costs you a hell of a lot more than 13 or $14 to ship. So the units don't make any easy, you know, the economics don't make a lot of sense. We have seen the increase in Amazon prime memberships, even in rural go up and up and up, but they're going to figure out they already know they don't make money shipping a small basket of goods. So you'll see over the time, I think with Amazon larger basket sizes, before they're willing to ship to you, you're not gonna be able to get a tube of toothpaste for $2 and have it sent to the middle of nowhere.

And the other thing they do and kind of to the point of your question is they're very initiative driven. So they realized that including produce and milk and soda and beer and bottled water made a lot of sense. And so they've added cooler doors in all of their stores over about a five-year period. We watched the number of cooler doors go from an average of, I think, eight up to 17. Walmart tried this business and I think failed at it. Realized that the small format, 7,500 square foot store is a totally different animal than running Walmart and Sam's, distribution’s completely different. If a Dollar General has a thousand stores, they'll have one distribution center per thousand stores. They are very actively testing, larger store formats, much smaller store formats. They have drilled down. Now if their typical store runs 7,400 square feet, they have drilled down now and their average stores in towns of 20,000 or fewer they're opening stores in towns of 5,000 or fewer. And we watch cannibalization there very closely. Management watches cannibalization very closely. So they're looking at different ways. I mean, they're looking at ways to trim shrinkage. Turnover of your managers is a big deal. It's very high in this retail world. And so they've done a lot more training. They started paying their managers a lot more money at the sacrifice of net margin and operating margin, but they've realized we're a heck of a lot better off retaining our good managers than we are having to retrain somebody every two and a half or three years. And so we think it's a management that gets it. And clearly, anybody in retail is probably thinking about similar things, but we've got a model that I think works and I think very few in retail do work.

Patrick: [00:22:06] So one way of distilling down your definition of quality might be an assessment of the runway for capital reinvestment at high rates of return. You've mentioned stores as kind of the primary examples thus far I'd love one or two other examples that aren't just expansion of stores to sort of hit it, that same principle. So this could be a business or two. As an example that you've owned for a long time, or when you bought more recently, again, just trying to triangulate on other ways that you deploy this quality philosophy beyond just say the more retail-focused type of thing

Chris: [00:22:37] One thing that's so unique. And again, we didn't set out to do this, but I look across the portfolio and some of the businesses that we've bought in the last handful of years and a common theme there on that front is very much control of distribution. We own. So names that we've bought that have taken distribution back in house would be Nike, would be Disney, would be Richemont would be Cummins and examples from each, if you like.

Patrick: [00:23:01] Those are four really interesting businesses. So I'd actually love to take them one by one and maybe starting with Richemont, so a collection of luxury brands. Talk about what was appealing and this idea of taking distribution back in-house. I think that's a really interesting theme is this ownership of the customer relationship. You hear about that a lot these days. So why is that good and important and how has it done well in the case of these businesses?

Chris: [00:23:22] So I've got a couple of friends that are really kind of, high-end kind of watch geeks, their watch collectors. And when I started looking at the business, I presumed. So if you don't know, Richemont they own very high-end luxury brands. The Rupert family had sold their South African tobacco businesses to BAT, I'm going to guess back in the mid-eighties, and took the proceeds and built out this luxury brand, a good business and made a series of acquisitions over the years. They own Cartier and Van Cleef &Arpels and jewelry. They've got nine or 10, very high-end watch brands. They own Peter Malark off shirts. They own Purdey shotguns. So when. I started looking at the business. I presumed that if anybody's going to pay $20,000 for a watch, you're buying the precious metal content you're buying the Juul. And what I learned quickly was it's far from that. I mean, here's a manufacturer that does 65% gross margins. You're not going to find a lot of manufacturers that run 65% gross margins. And as you run up the curve to more and more valuable or higher price point watches as an example, the gross margins can run into the 90%. It's not the value of the Rose gold. It's not the value of the diamonds, it's the brand. And so we spent a lot of time with the business and fell in love with the chairman, Johann Rupert. He has an affinity for hating the sell-side. He was loathe to talk about quarterly earnings. I mean, he really does think in terms of what can I do to develop these brands and maintain the value of this portfolio for generations, not just for the five years that I'm on watch as CEO.

So he thinks differently. And we like that from the outset, the business had really grown on the backs of Asian demand for very high-end luxury branded goods. China's a very homogenous culture. And as you start to achieve wealth, you like things that differentiate yourself and jewelry and watches are one of those. And so jewelry and watches are big in China and throughout Asia. So Richemont had grown out very quickly from maybe 7 billion euros in sales to $11 billion. Almost all of that growth was on the backs of Asian demand. And at the point then where the Chinese government cut down on graft and made it illegal to bribe a party official to get a deal done with a bottle of Martel or with a Vacheron or with a Patek Felipe, very expensive watch. They cut down on graft, well naturally that killed sales. The other thing that happened was they started limiting the number of travel visas they're issue into the very wealthy families who were intent on getting as much of their capital and their wealth out of China as they could. And you saw the property booms throughout the Pacific rim and Vancouver and Sydney and San Francisco. My wife does real estate in St. Louis and there were Chinese buyers paying cash for homes that would never be occupied simply to get money invested in real estate, out of China. So the government of China cracked down on that as well. Well, naturally high-end luxury and watch sales took a hit. High-end Cognac sales took a hit.

And so the stock got cheap and we watched management and their reaction to what I'd call that crisis was not to allow what typically happens in retail to transpire. And that's, if you're a retailer and you've got merchandise that doesn't move, what do you do? You Mark it down? Well, they said we're not, I'm going to allow somebody who just paid $20,000 for a watch to see that same watch show up on the grey market for $15,000 two months after. The purchase was made. So they physically took inventory, bought it back out of the channel from their third-party retail partners and made, in the case of Cartier, public display at a melting down portions of the watches. They would take the movement out, but they would melt down the precious metal content. So they very much said we're going to limit supply. And I listened to Mr. Rupert on a conference call, talk about, the one thing that we can do to kill the Vasher & Constantin brand, which was founded in 1855 would be the cheap and the brand would be to let the merchandise get cheaper. So they severed ties with a lot of those retail partners and said, look, we're not going to make an investment in real estate. We're going to make an investment in people. We're going to permanently sacrifice our operating margin and control our distribution. And even in the wake of that here in the last couple of years, they've bought all of Net-a-Porter and they've bought Watchfinder. They're intent on controlling their distribution.

And for that, we're willing to take a hit on the operating margin line because we think over the next decade, jewelry sales are going to grow at a very high clip. I think watches are different animal. I think you have things like the Apple watch and it's probably not as rapid growing of a category, but it's still going to grow at four or five or 6%. Jewelry is probably going to grow at double that rate. It's interesting, but we like the culture of the people. We like what they've done with capital. I think in terms of margins, the margin structure comes down now that you've gone to some internet distribution, but they wanted to control distribution. I mean, they do not want to allow the product to cheapen for price.

Patrick: [00:28:06] Let's go to the same theme with Disney. So this is a business whose history fascinates me and kind of current landscape is also really interesting with the move towards owning that customer relationship. So talk about the overall business while you find it attractive, maybe the reinvestment story, but also this notion of bringing distribution back in house.

Chris: [00:28:25] What did it for us really was when Disney took their property back from Netflix and said, we're going to go over the top and distribute ourselves. Across the business of Disney with the theme park business, with retail, with the studio business, with the movies, they call it a tent pole franchise. They have so many different ways to monetize their IP. We looked at the economics going over the top. Disney was in the midst of trying to buy Fox. The stock had been really cheap for about four or five years. And the arbitrage community had driven up Fox. They'd driven down Disney, and we just looked at it and said, we think the economics of controlling your distribution will be huge. Look at the limited number of movies that Disney comes out with each year, but they're all blockbusters. These people are very, very good. And they get it, but it's still the theme of controlling distribution. That's really the exclusive reason. I mean, the R community made it cheap forest cheap enough to get on, on a price basis.

We just liked the concept of controlling the distribution. We think now owning all of Hulu. They had 30% of Hulu. Fox at 30, and they've now got the whole thing. Running your adult content across that platform. Running your sports content across the ESPN apps. Disney came out with their investor meeting, what six months ago, four months ago, whatever it was with what the app look like and the price points on the app. I think Netflix may be a long-term viable competitor, but I don't know. You talk to kids and folks in their twenties. I'm not sure, but once they've lost all this content, they can do what Disney has done. The library that they own is invaluable. The intangible assets inside of Disney are invaluable.

Patrick: [00:29:54] How about something completely different business you mentioned earlier which is Cummins as someone doing something unique with distribution?

Chris: [00:30:00] So Cummins makes diesel engines. They make diesel engines from class 8 down to class 2. So basically their bread and butter are selling into Paccar and Navistar, the big truck manufacturer. So the truck manufacturers always rely on dual-source. So they all have their own engine manufacturing in house, but they don't wanna do it themselves. So Cummins has really been, has really been a cyclical environmental upgrade story. If you go back 20 years, 25 years, the amount of particulates and nitrogen oxide that have been taken out of emissions because of the environmental standards that have been put in place in the United States and Europe and now even in places like China, the R and D and the high-tech that goes into improving the engine has just been extraordinary. So along comes Tesla and Nicola and battery technology. So there's a fear that battery will replace the diesel technology completely. You've got some cities in Europe that are looking to ban diesel engines entirely. We think at a minimum, the class eight truck market, which is the big tractor-trailers that run over the road. We just don't see that as a threat anytime soon. We look at the weight of a battery, we look at the length of a haul as very prohibitive. I mean, if you take a 33,000-pound tractor and a 50,000-pound trailer and say, we're going to run away from diesel. We're going to go to battery. Well, battery right now weighs about 10,000 pounds. So if you take the diesel engine, you take the fuel, you take the transmission out, you're basically taking out 5,000 pounds. So you're adding 5,000 pounds. Well, that 5,000 pounds comes immediately off the load capacity of the 50,000 pounds. So you're losing 10% of what you can carry.

Tesla says they can run a battery that doesn't have to be charged for 500 miles. We think it's more like 300 miles. Typically your diesel engine, the fuel tanks run from 80 to call it 300 gallons. Typically they're 120, 150. You can run a shift and a half without having to stop for fuel. And it's a huge advantage if you're over the road, now that the government's come out and said, you can only run so many hours per day. We have electronic logging for driving. To have to stop downtime and charge a battery in the middle of a over the road shift just doesn't make any sense. So the economics don't work, but Cum-mins has done a lot of things. And one thing that appealed to us is on this theme of controlling distribution, they spend a fair amount of capital, Oh, maybe six, seven years ago, buying in what I would call their distribution. They bought in independent service centers brought them under the Cummins umbrella. So now if you're running a truck, if your Paccar and your driver, and you've got to maintain the vehicle, you've got to maintain the truck. Cummins has stores all over the place. They have stores globally, and it's a huge, competitive advantage that they're not just servicing Cummins engines. That was just brilliant.

Price Vs Quality

Patrick: [00:32:40] Like a conversation I had with Chuck Akre a few weeks ago, who I would also classify as very much a quality investor, and cares about price, but cares about quality, a lot for price sort of reinvestment potential of the businesses. How do you think about those two more extremes? So if you're sort of down in the middle with quality growth has obviously been an incredible story. You know, all the famous businesses that have driven that and value has been a terrible story. So any thoughts on those two extremes where it seems like you play less?

Chris: [00:33:05] Yeah. So again, I kind of go back to my evolution as an investor where priced to me was a low PE. Early on and you were less interested in finding businesses that could grow. I've kind of thought about the increment of the types of businesses that we've evolved to over 20 years of running Semper my 30 years as an investor. And I've always said that growth is, but one component of the value equation and it is, but it's a really important equation because if you wind up buying a business for a price reason. And you've got a return to par motivation. Well, if you don't have a catalyst and if you don't have growth to bail you out, you may have yourself a value trap. And we still do things. Cyclically. I still own businesses. I wish I could own a portfolio of 25 compounders and we've never gotten our minds around the FAANGs. We haven't done them, probably to our detriment. We've owned things like Microsoft over the years though. I mean, having written about Microsoft and early 2000 predicting that shareholders would lose money for 15 years. Well, that was exclusively an assessment based on price. Microsoft had compounded at 65% a year. The stock, since 1985 IPO, top-line had grown at 50%. But there you sat in January 2000 with a stock trading with a $620 billion market cap on 20 billion in sales and you extrapolate forward for the next 15 years that 65% growth in share price. Your market cap would have been in the quadrillions of dollars. It just didn't make any sense. And so we made that our first prediction in our prediction letter from January one, 2003, four years later, when the stock had fallen 75%, the underlying business had continued to compound. We found ourselves owning the business that we predicted shareholders were going to lose money for 15 years on. And we had a series of trimming it when we thought it got deer adding to it. When it got cheaper, trimming it, adding to it and finally, a year and a half ago or so we sold the thing entirely in retrospect, probably too early, but it's a business that had, and has in an inordinate amount of internal, organic growth. It has the ability to price. It has the ability to grow volume. I think Satya is a great CEO. I don't think Balmar gets enough credit for migration to the cloud, but growth is invaluable and I'm not sure that classical valuation techniques kind of get growth, right?

So again, because we don't have 25 compounders, we do own some businesses that revert to par and we've been very successful with those things over the years, but we own those for a very specific purpose and for a very specific time period. One of our largest holdings today is Subsea 7. Well, that's not a business we're going to own for the next 30 years. It's an oil and gas engineering, construction business, headquartered in Norway, run by a great capital allocator. We love the management. We love what they do with capital. We love the assets that they own, and we think long-term, there's probably a play on deepwater drilling again, because we think there's an underinvestment taking place.

And we think a lot of assets that have been taken out of production will probably never come back into production. But that's a business that we have a price in mind at which we would sell the business. I think there may be a price in mind at which Christensen who runs the business would sell the business, but it's not a 30-year holder. That is not a business that we expect to make a 10 bagger or a 20 bagger on. We just don't have that many. So we're kind of forced to do other things. We do things opportunistically, but kind of the lens through which we start the research process is generally we're trying to find compounders. We've got a couple kind of retail-ish concepts that we've worked on for a while here, that we like a lot. I think the world's grown up a lot and it's got a lot more sophisticated. And some of these things that truly are compounding businesses are trading for 50 or 60 times earnings today. And, and maybe that's the right number, but I'm not paying 50 or 60 times. Well, I can only go so far as a value guy.

Patrick: [00:36:40] Do you have a fun example of one of those that you think is a great business, but it's just too dear?

Chris: [00:00:00] Oh, I mean, I hate to give them away, but only because it's so wildly expensive and I don't know that we'll ever get to it. It's kind of a funky concept, but Five Below kind of back in that dollar store theme, but a totally different dollar store theme than a dollar general. They sell a little knickknack stuff for $5 to kids, candy and little toys and games, small number of units. They're going to be a way bigger concept. The unit economics of that business are as good as any retail concept I've ever seen, but it trades for 60 times earnings. So it's a long way away.

A Deep Dive into Berkshire Hathaway

Patrick: [00:37:12] So we've gone a whole hour without getting to the thing that I actually originally read you for, which is Berkshire Hathaway. Maybe you can begin by telling us your motivation for starting to publicly publish your investor letters again. I think for a long period of time, you didn't, and then you made the decision to start publishing them. And they're awesome. They're fascinating. They're very long, very detailed. And Berkshire was the subject of your...I think widely distributed 2015 letter. So I'd love to talk about your take on Berkshire Hathaway, because you've gone probably as deep on that business as anyone I've ever encountered. Obviously, it's a business that people are fascinated by both because of its success and because of its leadership. So first describe why you started writing again so publicly, and then I'd love to begin with sort of your assessment of Berkshire and its evolution.

Chris: [00:37:56] We've got a good. What I think is a reasonably good track record. Our stocks have done something like 10 and a half 11% for 20 years. If you net out the cash that wealthy family clients have when we're running all of their money, cash has probably been a drag of 190 basis points, but either way, our stocks are 500 basis points ahead of the market. For 20 years, the portfolios are probably 300 basis points ahead, but we had a period 2012, 13, 14, 15 where we just underperformed badly. We were doing eight and the market was doing 22%. And by the end of 15, I was getting a lot of pressure from longstanding clients who had made lots of money, who I think newest well understood our process. But four years is four years and we're getting heat in 15 was a tough year. If you remember, The median stock was down. Something like 20% Berkshire was down 12 and a half percent as our largest holding. We were down eight or 9%. The S&P was up one, four or five of that was FAANGs though, of course, but nobody wanted to hear that.

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

And so when you look through to the underlying economics of Berkshire's holdings and the holdings across the rest of the separate portfolio, our businesses had accreted in value over the year, despite the fact that stock prices were down. So I was going to spend two or three pages on our annual letter, and I've always written a long annual letter, but to that point. We'd only sent it to our clients and maybe 40 or 50 friends and colleagues and peers in the business. I got three pages then and thought, you know, we've owned Berkshire so long. And I think there are some aspects to the accounting within Berkshire that I think we look at probably uniquely, I think in some, all of the adjustments that we make, the GAAP earnings were so material that I'm not sure many or any had gone through the same process.

And so I'd always wanted to write it up. I wanted our clients to see other than talking to them at annual updates. I want them to see how we thought about the business and all the different methods that we use to reconcile against each other, to come up with our appraisal of intrinsic value. And so I spent probably 45 pages of what was, I think, a 65-page letter dedicated to Berkshire and sent it out to our clients and to our 40 or 50 friends and Joe Koster, who, you know, is a good friend, Joe called me and said, Chris, look, I don't mean any disrespect, but you talk about wanting to grow your business institutionally. You said, you know, you're an idiot. And I said, yeah, but why now? And he said, look, you can't write this up and not get it out into the ether. And I said, geez, Joe, I don't know. I mean, all of the guys I really admire don't publish their letters. They keep them in-house., Seth Klarman and Tom Russo, as an example, and Joe basically said, Chris, are you running as much money as Seth Klarman? I said, Joe, that's a good point. So he said, look, let me put it on my blog. I'll link it to your website, put it on the website and we'll blast it out. He said, it'll go viral. And I laughed and said, no-body wants to read about 45 pages of the accounting inside of Berkshire. And so we did it and true enough, it went viral. I think that letter has been downloaded something like 40,000 times. I probably had 500 people that first year reach out from all over the world with emails and calls. I was stunned. I was blown away.

And so we've gone back to Berkshire for various reasons. Two years ago, I wasn't going to touch it other than to update our appraisal. But with the tax code change, I thought with all of the moving parts inside of Berkshire, Berkshire was really a great case study for how the changes in the tax code effect-ed. The broad swath of American business. And so we went back to Berkshire and what was really a letter meant to be written out of self-defense business preservation in what was a brutal period has now become probably a good marketing document. And for that, I'm kind of cursed to having to write it now each year.

Patrick: [00:41:46] So let's talk about Berkshire the business. So if you had to break it down, you've already mentioned some of the key acquisitions that they made in the past, but if you were to just describe it as a business today to an uninitiated but smart investor that doesn't know Berkshire. Well, how would you describe the business?

Chris: [00:42:02] Wow. Well, obviously it's a holding company, but unlike any other throughout time, you've got a collection of businesses and a management team in place that have just assembled a very durable, permanent is probably a terrible word, but permanent business infrastructure that I think has very adeptly pivoted at times throughout the 55-year history that Mr. Buffett has run the business by at times to opportunistically take advantage of major, major inflection points in the capital markets. I mentioned national indemnity, the purchase 1967. So Mr. Buffett gets control of the business in 1965. Everybody knows that I'm sure all of your listeners know, I mean, Berkshire was a textile business. They made liners for suit jackets in new England, and it was a terrible business. And they realized quickly that this was not a business that they could own for 30 years. I mean, this was not the Costco or the future. It was not the Microsoft of the future. So they bought national indemnity and effectively kind of morphed from textiles to insurance, property, casualty insurance, and reinsurance, over the way, picked up a collection of businesses with surplus capital that had been building inside the business. They bought See's Candies early on.

By the mid 1970s, the overall stock market was cheap. Berkshire had compounded at something like 15 or 16%, despite the market decline in 73, 74. Despite the textile business, which they ultimately closed in 1985 being a lousy business. It had compounded at a great rate. And then you kind of fast forward. From that period from 1975 to 1998, Berkshire grew that insurance business and utilized the float in the business to compound it at an unbelievable kind of high twenties return on equity for a long time, the business, because it had surplus capital and so much surplus capital eventually was able to run a much more fully invested equity portfolio for a long time. So everybody kind of looks at Berkshire Hathaway kind of as a pseudo mutual fund or as a stock portfolio holding. Well In 1998, Berkshire was very much an insurance company that was very heavily invested in the stock market. Their stock portfolio had compounded at such a higher rate. The purchase of Coca Cola that they made in 1988 and then a couple of successive buys. The stock was up 13 X. It was 35, 40% of Berkshire's overall stock portfolio trading at 45 times earnings. They owned the Washington post. They owned Gillette. They owned cap city's ABC, which I think by then was Disney. They only own a handful of businesses, but the stock portfolio was insanely expensive in 1990s. So if you would about Berkshire at the time, you would have owned basically an insurance company, property-casualty insurer, reinsurer. 65% I think of all of the assets of Berkshire were publicly traded common stocks.

The stock portfolio was over a hundred percent of the book value. I think it was 115% of the book value was represented by the stock portfolio. As I mentioned, stock portfolio trading at call it 45 times earnings in 98. And so for the second time in Berkshire's history, they pivot. And buy general reinsurance, oddly, they buy an insurance company for motivation that I believed was to pivot away from insurance, unlike Berkshire, which had big percentages of its investment capital within the insurance businesses invested in common stocks Gen Re was more of a classic reinsurer that had 90% of its invested assets invested in bonds. And so Mr. Buffett had the quandary in 1998 while I've got this business. That's. Trading at three times book, it's not worth that much. We believed, Semper Augustus believed, that the business was worth probably half that at the time, call it $40,000 on the eight shares one and a half to book. And could he sell Coca-Cola? In retrospect, he probably should have sold Coca-Cola at mid-forties to earnings because post that point, I think Coke's compounded total return at four and a half percent a year. It's been a mediocre lousy business. It's underperformed the S&P 500 by a full percentage point which in and of itself, the S&P has been no Lollapalooza for the last 20 years. So he buys Gen Re, uses Berkshire as currency, spends 272,200 shares. I think with Berkshire trading at three to book, picks up Gen Re's bond portfolio and when you combine, what was the result of an investment portfolio? The common stocks had dropped from 115% of book down to 69% of book. The overall allocation of all of the assets dropped from 65% in stocks down to 30% in stocks. It's a number that hovers at 25% today, any pivots away. There's a lot of debate I've written about why this was such a similarly great transaction.

I wrote about it in my 2015 letter. In Mr. Buffett's 2016 letter, he came out said, no, I think it was a terrible deal because I spent Berkshire shares. That would be worth a lot more money today. Well, we are today, the $22 billion in Berkshire shares that he spent, which I think we're at twice their underly-ing value. I think he bought Gen Re for $11 billion, not $22 billion. When you ratchet back the fair value of Berkshire. It was the allocation away from stocks that allowed him to do everything else with sur-plus capital for the successive of 20 years. So, yeah, in today's terms with those 272,000 shares be worth 80 something billion dollars. Yes they would. But when they did the deal, Gen Re shareholders brought 35% of the assets to the party and only got 17% of the underlying ownership of Berkshire Hathaway. Think about that.

So it's not so much that Gen Re here 20 years post the deal for most of those 20 years, hadn't grown its premium volume from $6 billion. They've, upstreamed everything they've made to the parent company. And it's the upstreaming of that capital. And also the surplus capital that already existed inside of Berkshire that was then more wholly invested in bonds and cash, cash that allowed them to buy the utility in 2000 that allowed them to buy the railroad 2009. Had they not put those bonds and cash on the books, they could not have bought the utility. They were stuck with the stock portfolio. And so kind of inclusion on the Gen Re deal was if they had run the status quo and they had not bought Gen Re and not sold common stocks and paid taxes at what was then a 35% corporate tax rate, I would argue that instead of. Compounding the underlying book value of the business at 9% from that point 10 and a half, you go back to the prior year, it's really compounded at about 10, which we think has been the ROE for the last two decades. We think they would have compounded at about six.

So the combined value today of Berkshire taking its book value of 30 something billion dollars, $35 billion. Let's call it when they did the deal would probably have compounded to maybe $110 billion today. Well, Berkshire's book value is $350 billion today. So the $80 billion that they've given up in terms of today's pro-rata share Berkshire is the wrong way to look at it. It's what they did with the capital. So it's not a single variable assessment of whether it was a good deal or not. Gen Re is not today worth 17% of Berkshire. Certainly not worth the 35% of Berkshire that it was going in when they brought the assets to the party, but those assets were taken out of Gen Re to do other things. And I think most people that look at this thing, don't look at it through that lens.

Source: 2015 Semper Augustus Client Letter

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

So I mentioned the railroad in 2009, they bought Burlington Northern Santa Fe. At the time we hadn't figured it out. We didn't understand that the whole railroad business had changed. And if you looked at the history of railroads, they were crappy businesses, they didn't earn their cost of capital. And here comes. Kind of in the wake of the financial crisis in the middle of the recession, Berkshire buys the railroad Burlington Northern Santa Fe for, I think $34, $37 billion. I fell out of my chair and said, what are they doing? I mean, here's a business that in its best year, 2007, prior to the financial crisis earned, I'm going to say they earned nine on Capital and he paid two times capital for it. And so that nine becomes a four and a half. And if you would have adjusted for what was a very large underfunded pension plan inside the railroad, I thought Berkshire's economic return was going to be four and a half percent.

What I missed was the competitive nature of change within the railroad business, the business was going to start running on more of a weighted average cost of capital basis in terms of allowed returns, it was going to be less regulated. The market was going to do more of the regulation in terms of their ability to set pricing. So the Surface Transportation Board was no longer as overarching as it had been prior to that moment. I think Bill Gates's guy at Cascade figured it out first and we certainly hadn't figured it out, but Buffet figured it out. And so on a deal that we thought was outrageous that $34 billion. Yeah, we think that business today is worth about a hundred billion dollars and they've taken the profits of the business out of it. They've properly employed large amounts of leverage in it that leverage is not hypothecated to the parent, but it's just a vastly more valuable business today than it was when he got it.

And that's really been the history of my following Berkshire Hathaway is there's always an aha moment to a lot of the deals they do. Whether it's Johns Manville shredding their asbestos liabilities and the tax benefit from that, there's always a nuance to what they've done. You don't quite get it at the outset, but most of what they've done have made sense. And so now you've got this business, that's the railroad, you've got a series of electric utilities that they own and distribution assets in Canada and the power business in the UK, that's collectively worth probably $50 billion. You've got a whole hodge-podge collection of manufacturing, businesses, service, and retail-oriented businesses that do $140 billion in sales that are probably worth about one-time sales, about $140 billion. And then you've got the insurance operations. You've got a little leasing finance business as well, Clayton homes. So you've got this extraordinary number, maybe a hundred operating businesses inside this structure. That's just uniquely diversified.

That's really been the history of my following Berkshire Hathaway is there's always an aha moment to a lot of the deals they do. Whether it's Johns Manville shredding their asbestos liabilities and the tax benefit from that, there's always a nuance to what they've done. You don't quite get it at the outset, but most of what they've done have made sense

I mentioned the data, the railroad, not being propagated to the parent, the debt with them, the utility businesses are not hypothecated to the parent. And that's really, you know, outside of a nominal amount, the majority of where the on-balance-sheet debt sits. And it's not an obligation of the parent. It's an obligation of the underlying subsidiary. So you've got a business that's running with $110 billion in cash. That offset by the debt that sits on the railroad and the utilities. That's very liquid. So on a net capital basis, the equity is the equity. I think it's absurd that we're going to no longer consider equity, equity with the business. And that's a knack I have on a nominal pivot. That's going to be made next year in terms of disclosures. We're going to go away from reporting change in book value, per share, which is insane. For a business that still is 45% insurance for a business that retains a hundred percent of its profits. It doesn't pay a dividend.I mean, book value is a very real thing inside of Berkshire. And to say that it's not as mystifying to me. I mean, if the business continues to earn 10 on equity, 10 years from now, 60% of Berkshire's book value is going to be driven by what they've done with retained capital. And those are all new investments that aren't done at the historical costs that you guys talked about here a couple of weeks ago, these are brand new assets and brand new investments done at today's dollars in a non-low inflationary world

Patrick: [00:53:28] So thinking about your ownership of Berkshire now, prospectively, and it's obvious history where a lot of its value has come from masterful capital allocation at the top. I'm curious, how much do you think that matters in the future? Kind of think about that buffet, quote, a company being run by an idiot 'cause at some point it will be. How protected is Berkshire from things like succession and just poor management in the future that it gives you the confidence to still have such a high average weight in your clients' portfolios?

Chris: [00:53:55] I think a lot of that reallocation of capital that's taken place in the last 20 years of idiot-proof is probably the wrong way to say it. But you know, you think about the collection of electric utilities that they own. They are arguably the best set of utilities in the business. They're in places within the country with higher population growth, they've already got a much lower reliance on nuclear and coal than most of their competitors, they're making a lot of great investments at tax-advantaged returns. That's a business that has good management team, great management team in place right now. That's just very durable. Electrics are easy. I mean, we hate investing in electric utility that I don't like them. I don't like them because they're retail investments. If you think about the way an electric utility works, a regulated electric utility works not wholesale, but…your pricing is set by regulatory board.

And so they let you make an allowed decent return on the equity capital invested in the business. And so you're allowed to make 9% or 10%. It used to be 11 or 12 when interest rates were higher, but then you say they're allowed to make nine. They pay out typically a large chunk of their profits as dividends. And so for that, it kind of attracts the investor that needs income. And so these things get bet up to two times their book value. So if it's earning nine on book, kind of the same math that I used on Berkshire's railroad, that nine gets driven down to a four and a half percent return when you pay twice book for a 9% return and the dividend winds up being a 4% yield. And so for that, these things traded twice. Well, if I'm going to buy the shares today at twice book, I'm not going to make much more than the dividend yield, plus a little bit of reinvested capital because these things don't grow. There's no unit growth. There's no population growth. They're just sleepy little things.

And so you're stuck at kind of four to 5% returns that doesn't make any sense. And that's what they do in retail wise. But within a Berkshire, they've had the opportunity to invest capital within competitors, but also they've invested a heck of a lot more CAPEX and growth type initiatives where they've improved the underlying assets in the markets that they're in and they're allowed to make kind of these 9 to 10 to 11% returns on large amounts of reinvested capital. Well, I don't see that going away any-time soon. And those reinvestments are made at very tax-advantaged reasons. They've forever had the use of accelerated depreciation, which lowers the amount of cash taxes that they pay. So they're okay businesses, but he bought them at very good prices and they've run them very well. So there's durability there. I think the railroad. It is what it is. I mean, it exists within an oligopoly, rational or not, I think more rational here in the last decade, but it's kind of hard to scrub a railroad. It's kind of hard to believe that we're going to displace. I think it's a lot more likely to believe that a Cummins diesel engine gets dis-placed than an entire railroad network within the United States or globally. And so there's permanence to some of those businesses that they've bought.

One question we sure have on the succession planning front, and as I've gotten to know a good number of the CEOs of a number of the subsidiaries inside of Berkshire. One question I had at the outset was look, you've got all these old guys that have sold their business to Berkshire. And they like to say, they're independently wealthy. Now they're rich. They've got money. Why do they need to work? Well, it's nice to be able to pal around with Warren buffet, jump on his plane. I don't think they do it anymore, but fly down to Augusta and play golf. Take them on the phone during your bridge game at the club. And Oh, I got to take this call. It's from Warren buffet. And so they've stuck around, but these were good managers when they sold the businesses, they stayed on as good managers. And the question was, have they developed their own benches inside of those, those companies? And I'm satisfied with what I've seen and all kinds of the digging that we've done, that they really have thought long and hard within each of those myriad operating subs about succession planning. Ajit does, you know now heads the insurance operations. Greg Abel runs the balance of the operating businesses. There's a question as to Ajit succession. We've heard Mr. Buffet for years and years talk about how important he is to Berkshire. And there's no doubt he's that important to the national indemnity piece of the business. But my understanding is his ability to price businesses is like no other. And my presumption would be that they've developed a bench underneath a sheet. As you know, he spends a lot of time on the phone with Mr. Buffett and they talk about deals. And Warren talks about him being that much more brilliant than anybody that he's encountered, if anything happens to Ajit and there's no bench underneath them, does that imply then that some portion of the business that they've written needs to be in runoff and that we can't write that type of business. Some of these odd one-off policies they've written. I don't know. That's a question that probably should have been asked at the meeting this year. I think deserves an answer at some point in the near future.

Um, I think Mr. Buffett at 88 and Mr. Munger at 95, as brilliant as they both are. I applaud them for bringing Greg Abel and Ajit in this year to answer some of the questions I'd like to see a more involved in kind of front and center as the face of the business for the folks that are going to be running, kind of post the current executive team that runs it. They're trending that direction. I'd like to see more of it immediately, not so much because we have to get the granular data about how each of the operating businesses are doing inside the company. But there's a reputation that goes with being Warren buffet. And for that, there needs to be a confidence factor that the whole bench, the entire bench under-neath is equipped to run the business. I'm convinced they are. But I think just the general shareholder base probably deserves to see more of them

On Adjustment to Financial Statements

Patrick: [00:59:07] One of the things that I think maybe quants do not as well though, some do it very well, as say a fundamental analyst would do on a company is adjustments to income statements and balance sheets. And so I'd love to close with a section on this, which is, you actually mentioned the paper that we had put out, which got very deep into the impact that depreciation has on earnings and mentioned...this precisely why we put this stuff out because very smart people like you read it and tell us areas to study further. So I'd love to hear your take on kind of the most important trends in adjustments, you mentioned earlier that you make to businesses when doing your initial analysis and ongoing maintenance, kind of what those areas are, what you suggest people focus on and we'll close with this kind of very practical, hopefully, useful section.

Chris: [00:59:50] Okay. Running is probably one place where I think we differentiate what we do among even a lot of our active competitors. We like to say we live in the financial statements of the companies that we own. We really only begin with GAAP and IFRS reported numbers and dig a lot deeper. And I don't think anything we do is uniquely, is purely unique to Semper, but we are very rigorous about kind of looking through to sustained, free cash is the wrong word, but true economic profitability. The reason I say free cash can be a misnomer or you take back to my Costco example. When you have a growing business that can reinvest retained earnings at high incremental returns, the CAPEX that's being spent masks underlying economic profitability. I mentioned, you know, the 11 return on capital, which was really a lot higher, but it made sense for them to spend money as rapidly as they did. And if you would have just tried to capitalize what looked like free cash free cash was way understated because they were spending CAPEX very well, kind of to your paper and ties into one of the key themes of our letter this year was, we asked, why is it that if a shareholder that owns the broad stock market, hasn't earned the underlying return on equity of the stock market over a very long period of time.

And you guys kind of got to the same numbers that we did ROEs over very long periods of time have been about 13%. They didn't fully adjust as they should have during the high inflation years of the 1970s. They're probably aberrantly high today in a world of very low interest rates, but kind of that 13 ish number has been well that doesn't correlate to the long-term returns from the stock market, which have been about 300 basis points lower. So we've always had a process in place, of under the hood and below the line kind of looking at write-offs and write-downs that take place over time, which is probably the initial biggie that we use. And look at with any individual business with it, we're studying. We want to see the extent to which companies have taken, write-offs and write-downs of their assets and their equity over time. We want to see the extent to which a serial acquirer tells us to not include acquisition expenses and its assessment. We want to see the extent to which a company like a mile and labs lives in the courtroom ignores litigation expenses because there are a lot of very real operating expenses that companies bear that were told by management that like to see returns on equity higher and stayed at equity lower we always make those adjustments.

And so if you go back and take from an index standpoint, kind of from top-down, if you go back to early eighties, we've calculated that almost 15 of annual profits every year, you can get these numbers right off S&P is website 15% of the operating net income numbers, which are before write off some write-downs have been written off. The numbers are obscenely higher during economic slowdowns, you get the kitchen saying, so you get the big baths. They tend to be lower during boom times. I think in the last couple of three years, they probably average 10%, not a full 15, but over a long period of time, you're losing 15% of your profits. Well, that's a big number.

And so if you're a business that does 13 on equity and you shave 15% of that 13, you're losing almost 2% to write off some write-downs. And so we're now understating equity. And in turn overstating the ROE. It's interesting when you're setting an index with a macro, but it's critically important when you're studying an individual business, because at bottom, we're trying to determine returns on equity and capital and just stated equity and capital aren't always, as they seem, they've been monkeyed with over time. They've been monkeyed with, by inflation over time, in some cases for businesses that have very old assets, we've got to get to the right number.

The other big adjustment for an index that we've made over time that's less important to the businesses that we own, but only for, we tend to not own those businesses, tends to be in the area of defined benefit plans. Back in some of our early letters that are now on our website, we've written about all these accounting adjustment we make so defined benefit plans. If you go back 20 years, there were maybe 350 companies just in the S&P 500 that had defined benefit plans today there, I think 320. So you've shed by probably 30. You've had new tech businesses that have IPO that don't have DB plans. They tend to use defined comp and 401k plans.

But we've had a method for the duration of our firm. That's been blanketed on kind of back to your question about macro themes, we have found the overall stock market generally to be. On the over-valued side, during the history of our business, 1991, the market was cheap, but we weren't in business in 1991, clearly in '08ish, early '09. The market was very cheap, but broadly, at least as far as historical metrics go, the market's been very expensive. So we have just long assumed that a business that has a defined benefit plan. We've assumed its investments would on average earn a 4% rate of return. We'd make adjustments to different businesses based on different allocations and what they've owned, but generally, we've assumed a 4% return. So we'll take fair value of plan assets and run a 4% return on those assets. Well back 25 years ago, the typical corporate defined benefit plan on the S and P was assuming a 9% rate of return. Well, this is after 17 years of bull market where stocks had done high teens returns, bonds, which were coming off mid-teens levels of rates bolstered by falling interest rates, increasing prices, and trailing larger absolute returns. 9% was an unobtainable number. In the late nineties, early 2000 for a long-term return. If you have to go back to that stock market low, I talked about when stocks traded at seven times, the 3% profit margin, long-term interest rates are 15%. Short-term rates are 20 stocks are trading at 21% of sales and the typical defined benefit plan assumed a six and a half percent rate of return.

Well, it was crazy, but the experience for the prior 17 years had been stocks had gone down. These are terrible. Bonds have crushed us because interest rates have risen and our principle values have been eroded. And so that was insane, but then you get the subsequent 17-year experience of rising asset values and voila you're at 9% for the typical defined bond plans. So we would run that 5% differential, 4%, our return assumption versus what was a nine. And we take that 5% difference and run it through the P&L through the income statement on a pretax and an after-tax basis. To the extent a plan was underfunded, we would take the underfunded status and assume full funding over a period of time. Our method changed to 10 years versus what had been five years, a number of years ago, which would be less conservative, but I think winds up being a lot more actuarially correct. So we would advertise that on a pre-tax and after-tax basis. And then to the extent OPAB basically healthcare liabilities, which tend to be not funded at all. We'd also assume those would be funded and run those through, but kind of the biggies were the return differential.

And so what that's done for us is kept us out of businesses where the defined benefit plan is large compared to the business itself. It's kept us out of the auto manufacturers. It's kept us out of some of the heavy equipment businesses, where the plan is as large as the business itself. And so what happens with those plans is. Take a forward. I mean, take any of those, take a General Dynamics. You know, some of these have been still good investments because they've had tailwinds in terms of their underlying industries, but you get the one-off call it $2 billion one-off. We borrowed money, $2 billion in the bond market, threw it into the plan and told wall street to ignore that as a one-time expense. But the plan's in great shape today. Well, no, you should have, readably been funding $200 million per year, over a 10 year period of time. And I'm not getting north of $2 billion because that's my capital as a shareholder that just went into the pension plan.

So the method is important. It's less of a drag today, simply because return assumptions now that we're 20 years into the S&P averaging five and a half percent and interest rates that are near zero or have been near zero for the better part of the last decade, return assumptions have come down to about six and a half percent. They're no longer nine they're, six and a half, which is less onerous requires on using our 4% number, which I still think is right. I think that ties to the paper you guys did. You guys are assuming four, three to four percent, maybe 5% for the next 20, you guys were using 10. I use kind of four to five for the next 15 to 20 years. I think the next 15 years may look a lot like the last 15, which is very modest returns out of the overall stock market. So we've not come off our 4% return assumption, but it's not as much of a charge. And then there are fewer plans on the overall market too, but...

Investing for The Future

Patrick: [01:08:00] So I've got three kind of fun closing questions for you. The first is if for the next 10 years or next five years, you were only allowed. To buy stocks within a certain industry or sector, what sector or industry would you choose?

Chris:[01:08:14] Wow, we are so sector...agnostic. In fact, until we started putting market-ing sheets together, I didn't know. There were four sectors in the S&P that we didn't even have investments. Oh, if you look at what we've owned over time and even stripped Berkshire out, this is going to be wrong, but we've had so much success owning well-run property, casualty, insurers, and reinsurers. And the reason I think they work is.as long as we're allowed to do the investing. And I don't have to just own the sector. I'm good because I think there are some outstanding insurance people. And I think there are a lot of mediocre insurance people. I mean, it's a business that everybody kind of knows is, kind of produced disastrous results over time. Underwriting margins that are lousy under reserving, too much competition. You've seen way too much competition in the last decade. But I still think because collectively it's such a mediocre industry that the stocks themselves, the individual components of the various sectors never tend to be expensive. And so you're able to invest in good businesses where you can find the good ones at very modest prices.

And for that, if I was limited to doing that, I've got one in particular. I'm not going to talk about, but my appraisal of fair value on the business 20 years ago is the same number that we're using today. So we thought a business that could grow is just prove that it couldn't grow because insurance is so hard. They got outside of the main state, they underwrite business in and they got their heads handed to them. So they reverted back inside their state line and for that though, it's a good insurer within their niche. They make good, not great underwriting results, but because it's a stock, we almost treated as a bond that trades plus, or minus 30% around the price. So it's way more volatile over a period of time as we've been able to buy it when it was cheaper than our appraisal and trim it when it was expensive. But for the industry being perpetually undervalued, it's worked.

Patrick: [01:10:02] What is the business, you mentioned 500 before, this is sort of inspired by that. What is the business that you're most intrigued by that you think you're unlikely to own anytime soon if it's something other than Five Below?

Chris: [01:10:14] Probably MasterCard or visa...we've understood them and we've just never owned them for price. And in the back of our minds today, we kind of justify that lack of ownership, really that total error of omission to perceived regulatory threat. I think you'd make the same case for in varying degrees, kind of the big FAANGs today. Some of these have been so obvious and we don't know, obviously, they've been in the rearview mirror, they've been terrific, but for the next 10 years, the regulatory threat is there, but I've also learned I can pay more than 20 times earnings for something and be okay with it. We're not hitched to some firm set of kind of classic value metrics. So we understand growth. We're willing to pay a heck of a lot more for it than we ever were but...

Patrick: [01:10:59] So these businesses came up in my episode with Chuck Akre as well. And obviously the notoriously incredibly high return. Businesses. So you say you understand them. Why do you think they're able to maintain such incredibly high returns?

Chris: [01:11:11] Well, they don't take a lot of capital. They live in very much an oligopoly structure and we still have an awful lot of cash deals that are done transaction-wise around the globe. There's still an awful lot of market share to go get the growth curve is long. I equate it to a Costco. The concern would be that that model doesn't work outside of the United States where they've got 150 stores or whatever the number is that have proven in places like Korea, where the unit economics really do work. So that curve is still along. I think visa, MasterCard, absent being crushed by a regulatory body will be much bigger much more profitable businesses, 10 years out.

Patrick: [01:11:44] So my closing question for everybody is for the kindest thing that anyone's ever done for you, okay.

Chris: [01:11:48] I'm only getting into podcasts now. And so obviously prepping for this Joe even called me and said, I'll bring you to the podcast, better dig into this question. And so, you know, outside of you inviting me to the podcast, of course, and parents would think, which I think everybody kind of acknowledges, I have thought about this and I would say, so I played football for a long time from eight years old up through college. And I had a series of men kind of molded me to be driven with work ethic. My father was very hard on me, very tough. And for that, I think that was one of the kindest of things he could do as well. He was an old Marine and one summer I'd move a pile of river rock out of the driveway. One summer, I, by hand with a pickaxe and the shovel, dug the foundation for an addition to the house. We didn't get a backhoe. I was the backhoe that summer. On a corner lot. We did a brick fence and we had to be 24 inches deep and 12 inches square. By the time he got home from work every day. So I spent a whole summer with summers in a row with pickaxe and a shovel loading up the pickup truck.

But it was these football guys. I'm kind of going backward. Really learned the benefits. Yeah. Out-working everybody, and kind of working backward with bill McCartney and at college and Brian McGregor and high school. See if I can remember all these guys I'm Joe Studenka, John Walker, Bob Jordan. But my first coach, gentlemen named Ken Aker, had me when I was eight years old and nine years old. He was a terrific man. He didn't have kids that had played. I think about it now. He was probably my age and I thought he was a fossil. I was eight and he was an old, old guy with grey hair. And now I'm an old, old guy with gray hair and I've been coaching football for the last six, seven years, eight years. So I'm sure these kids look at me through a similar lens and he took us at eight and sat us down in his living room the whole team go to the 20 of us, I think, asked who at that time knew. But in-between offense and defense, I'll never forget. Nobody knew because we didn't have Madden and we were eight. We hadn't played football. You weren't watching a lot of football on TV. And so he explained all that. And so he was just a great mentor and a teacher, and I'll never forget, it was a terrible football player at the age of eight.

I improved on that. I was more interested in watching planes fly overhead during games. And when I kind of figured it out as an offensive lineman that year, it was easier to go try to block the safety than it was the big kid standing in front of me. Well, that's not exactly how football is supposed to work. By the time I got to nine, for whatever reason, I was a lot more highly motivated and I was very driven by the game and I was inspired by this man because he was fair. He was hard on us, but he was fair. And I was so desperate to get back under his tutelage. This is between eight and nine, right. I'm still a kid. So we work hard. We had a good football team and I'll never forget. We lost a game to Columbine. This is in Colorado, Jefferson County and we lost this game. And I was crushed. So we had our team meeting at the end. All the parents are standing around. The kids are standing around and I was just crying. I was bawling my eyes out, but I'll never forget. He came over in the middle of the meeting. He put his arm around me and he said some of the kindest things that anybody could have ever said.

He talked about my evolution from the prior year and the work ethic and that moment really inspired me to just be the best football player I could. And for the rest of my years playing the game, nobody outworked me in the weight room, nobody ran more sprints. I did everything I could to be a great player and I attributed it to him.

And so we had my 30th, high school reunion a couple of years ago. And somebody on social media put a picture of our nine-year-old football team out. And I hadn't thought about some of these guys in years. A lot of them didn't wind up going to the high school. A lot of them did. There were some very good football players on that team, but I thought about coach Aker for the first time in a long time. And I thought, well, geez, you know, I've gotten to be really great friends with my high school coach, Brian McGregor. He and I are very close. I thought I should go try to find coach Aker. And I hadn't thought about how old he was when he coached me, but he had passed away. I learned by digging up and I spent a week trying to find him.

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

Patrick: [01:16:18] And, yeah, fantastic. Well, the amount of these answers, they keep morphing and changing and some of my favorites are around mentorship and shaping younger people. When they're kind of most malleable and that's one of my all-time favorite answers. So thanks so much for that. And just the awesome conversation.

Chris: [01:16:23] Well, Patrick, thanks. This is awesome. I love the podcast and it's been a lot of fun to get, you know, here in the last few years.

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