24 April 2021

On today’s show, Stig has invited famous investor Chris Bloomstran from Semper Augustus to teach us a masterclass about valuation techniques. It’s no surprise that Chris Bloomstran is heavily followed on Dataroma alongside investors like Warren Buffett and Howard Marks.

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  • How to value a company’s equity portfolio 
  • 4 methods to estimate the intrinsic value of Berkshire Hathaway 
  • Why Berkshire Hathaway, contrary to popular belief, doesn’t have a lot of cash on its balance sheet
  • How to size your position based on your valuation and expected performance 


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Stig Brodersen (00:00:02):
On today’s show, I sit down with famous investor Chris Bloomstran from Semper Augustus. Chris is giving us a masterclass in equity valuation techniques. And since we’re only one week from the Berkshire Weekend, we decided to focus on Berkshire Hathaway. That being said, the timeless principles that Chris explains here to us can be used for all businesses. I regard Chris Bloomstran to be one of the smartest people whenever it comes to valuation of stocks, if not the smartest. It’s no surprise that he’s heavily followed on DATAROMA alongside investors like Warren Buffett and Howard Marks. Make sure to listen to this masterclass. And when you’re done, you should re-listen. Let’s jump to it.

Intro (00:00:43):
You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Stig Brodersen (00:01:03):
I’m your host, Stig Brodersen, and you’re listening to The Investor’s Podcast. And I’ve been looking forward to this interview for months. With us today, ladies and gentlemen, we have Chris Bloomstran from Semper Augustus. Chris, welcome on the show.

Chris Bloomstran (00:01:16):
Stig, great of you to invite me. I’m a big fan of the pod and it’s a genuine honor to be here.

Stig Brodersen (00:01:23):
Well, thank you for saying so. And I just want to say out here right out of the gates that I’m sure our audience will love this interview because the one company that we are talking most about over the past seven years, that’s been Berkshire Hathaway. And today we speak to one of the top people about this company. And I don’t want to embarrass you when I’m saying this, Chris, but I’m going to put Warren up there and I’m going to put Charlie up there and then in my book you are almost up there in terms of your knowledge about Berkshire Hathaway. That’s how great you are in your insights about this company.

Chris Bloomstran (00:01:54):
Well, you’re too kind. I mean, we’ve been shareholders for a long time. I bought the stock for the first time in February, 2000, and it’s been our largest holding for more than two decades. So invariably, we’ve spent a lot of time doing deep fundamental research. As our largest holding, I’ve just accumulated a lot of knowledge of the business. I’ve been lucky and fortunate to have the opportunity to share it with a little bit more of a broad brush of the investment community in recent years, which has been terrific.

Stig Brodersen (00:02:24):
On behalf of the investing community, I want to say thank you because you’re writing these amazing letters and I’m holding up the 2019, 2018 here about Berkshire Hathaway and I know that that doesn’t work too well on the podcast whenever I’m holding something up to a camera because you can’t see that. But what is really amazing in your letters, Chris, is that you are so good at whenever you break down valuation and explain what you’re doing, that’s just outstanding. And in your 2020 letter, you have an extensive discussion about Berkshire Hathaway and the updated valuation. Well, it’s not just in the 2020 letter you have that, but you update that once year.

Stig Brodersen (00:02:59):
And you start out by stating that you estimate the per share intrinsic value has climbed 10.7% in 2020, and later you estimate normalized profitability around $42 billion. We’ll dig into the specific numbers of Berkshire Hathaway and the different valuation techniques in this interview. But perhaps just here right out of the gates, if you can conceptually explain, what do you mean whenever you’re talking about the per share intrinsic value growth, how do you even arrive at such a number and also normalize profitability?

Chris Bloomstran (00:03:30):
Wow. Well, that all gets to the heart really of investing. I’m glad you mentioned it in per share terms because what we saw with Berkshire this year was a sizeable share repurchase. And now you’ve got cash going out the door, which otherwise would have been reinvested in the stock portfolio and businesses and CapEx. And so that’s a change and you’ve really had the better part of the last two decades where Berkshire didn’t use the shares much. They made a couple acquisitions using the shares and we can get into that and only in the last three years have they been repurchasing shares. And so with any business, it’s the per share numbers that really matter, but in the investing world, goodness gracious. And I’ve got a section in one of my former letters maybe it was the 18 letter that really digs into how investors ought to look at profitability, how they ought to look at capitalizing those profits. And there’s really no good answer. It’s a very broad canvas.

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Chris Bloomstran (00:04:27):
And I think it takes a lot of years to finally kind of get through the nuances of how it works, but things like just profitability, you’ve got to determine how fast those profits are growing. And growth can come from organic growth, it can come from acquisition, it can come from the retention of capital and how that capital gets reinvested. There’s just a lot of moving parts. And in my world, what I’m really trying to find are good businesses. And you’ve got to learn how to define what a good business is, the durability of it, the moats around it, quality of management, how they treat the share, how they view the intrinsic value of the share. But I’m really trying to get down to the profitability as measured against the equity and the capital of the business. And really the only difference between those two numbers really is the leverage the companies are willing to take on on the balance sheet.

Chris Bloomstran (00:05:14):
So from there, when you talk about normalization of profit, and there are a lot of moving parts there. We go through a bunch of steps and we’ll go back through as many years as we can and figure out where companies are taking write-offs and write downs. You don’t see those at Berkshire. You saw a $10 billion write down this year for precision Castparts, but you’ve got a 56 year history where there’s very little of that. Well, in the broad S&P 500, for example, if you go back using data to the mid 1980s on the order of 15% of profits on average every year are written off or written down, that’s the difference between operating profit and reporting earnings. And that’ll depress book values and it’ll make it look like returns on equity are higher than they genuinely really are.

Chris Bloomstran (00:06:00):
It allows for the forgiveness of past kind of sins of commission, bad acquisitions, bad capital allocation by management teams. So there’s a lot to that. A lot of acquisition accounting goes into how we kind of normalized profitability. 20 years ago back prior to companies that would pay a premium to net tangible assets would put goodwill on the balance sheet and would write off that goodwill over time. Well, the accounting profession stopped compelling the write off of goodwill and so all of a sudden you saw more intangibles put on the balance sheet, some of which are written off over time, some of which are not. And if you kind of get into the nuances there, there are intangibles that really do lose value over time like patents, there are others like customer lists that don’t. And so the analyst has to make that determination.

Chris Bloomstran (00:06:47):
We’ve always made an adjustment that’s kept us out of a lot of hot water with defined benefit plans. There aren’t a lot of companies anymore that have defined benefit plans, but those that do in cases where they’re material we’ve found for more than the past two decades, actual real assumptions, rate of return assumptions have been fairly aggressive. And so I’ve got a process in place that essentially just in terms of the expected return, I’ve used it for returns have ranged as high as nine to 10, 20 years ago. They’ve come down where the average plan now assumes a little over 7% return, but in a world of low and no interest rates and very expensive stock prices, the defined benefit plans aren’t going to make seven or seven and a half or 8%. And so the process that I use kind of normalizes what will be the cash going out the door from the corporation to fund the pension fund, which would be an excess of the actual real estimate keeps me out of trouble.

Chris Bloomstran (00:07:40):
That essentially says, look, you have a plan that’s underfunded by several billion dollars, we assume we’re going to make eight, I assume you’re going to make four. I have a normalization process that then takes that differential of the return on an annualized basis, runs it through the income statement on a pre-tax after tax basis. And then I’ll take the degree of underfunding, call it $2 billion. And I’ll run that two billion over a 10 year period of time, which is completely from an actual real stand point incorrect but what it does is a company that goes out and borrows $2 billion every five or six or seven years puts it in the plan and tells the investment community, ignore that as a one-time expense. We won’t do it again. No, you should have been readably putting $200 million a year and over the last 10 years. And so I’m creating a charge on the income statement that’s not a cash charge, but it’s going to be cash out for it support.

Chris Bloomstran (00:08:32):
So there’s a lot. And then the price you pay, I like to see cash flows drop to the bottom line that endures for the benefit of the shareholder, there are all kinds of metrics that make sense. And you’ve got to understand the industries that you’re working with. You’ve got to understand how other investors use different metrics. So anything from the top price to sales, bottom line price to earnings, the enterprise value to EBITDA, enterprise value to EBIT, all of that, price to EBIT, they’re just a lot of metrics. And in some cases, some of those are used as an excuse to tolerate higher amounts of leverage. They’re trying to normalize the capital structures of a highly levered business versus a non-levered business, but I’m going to charge you and I’m going to pay a lower price for a highly levered business than I will for otherwise. And so probably a terrible answer to lead off the conversation because there are so many moving parts to it, but we’re really trying to get to the cash that endures for the shareholder and the price you’re willing to pay on a per share basis.

Stig Brodersen (00:09:34):
A lot to unpack there. And I know it was a very tough question asking you the first one, but I just wanted to conceptually talk about what is it we’re trying to do? We are trying to normalize something and whenever you try to normalize accounting, it is going to be subjective one way or the other. And so with that said, Chris, going to the next topic I’d like to talk about is let’s try and put some of those concepts into practice. And let’s do that with Berkshire Hathaway. And let’s talk about the valuation, how you see that and we could talk about valuations in general. I really wanted to talk about Berkshire Hathaway, not just because that’s your biggest holding and you’re so great with it, but also because so many of our listeners to them Berkshire Hathaway is the biggest holding, but they also feel like going into the accounting of the company, it’s just become so complex. So with you, I’d like to see if we together can simplify it.

Stig Brodersen (00:10:30):
If we can just say that there are three major segments of Berkshire Hathaway, and that might be a stretch. Let’s just say that for the sake of arguments here. We have operating businesses that we’re going to talk about. We have the cash position and we also have the equity portfolio. So let’s try and start with the operating businesses. So you can break down this segment into multiple sub-segments. You have Berkshire Hathaway Energy, BSNF, then you have another group called Manufacturing Service Retail, and now finance is also included in that. And then you can also include insurance. And even each of these business units, they’re all extremely complex in itself. And Berkshire Hathaway doesn’t disclose all the details that we as investors might like for each unit. So if we talk about your approach, how do you estimate the earnings power and intrinsic value for the operating businesses as a group?

Chris Bloomstran (00:11:21):
That’s a good question. I think if you look at the history of Mr. Buffett’s chairman’s letters to the shareholders, he’s given clues to the shareholder base and the investment community over time as to how he and Charlie, if you will, assess the intrinsic value of the company. And if you go back to 95, I think it was, he gave you kind of this dual yard stick of value, where he gave you the operating earnings of the businesses on a per share basis and then he gave you the total value of the marketable securities on a per share basis. And that’s evolved… At a point he augmented what he saw as kind of the main moving parts and segments of the businesses and gave you supplemental information. So for a series of years, you had a very nice summary balance sheet and income statement for what Berkshire calls their manufacturing service and retail businesses. In the last couple of three years, he’s talking about kind of groves in the forest.

Chris Bloomstran (00:12:15):
And I think that’s right. I think as my understanding of Berkshire has evolved, I very much to your point, think about Berkshire in terms of certain segments in businesses. If you take the consolidated financial statements, for example, they have what they call their regulated businesses consolidated into a group. Well, I think about those as two separate groups, you have the energy businesses and you have the railroad. And those each on a standalone basis are very substantial dominant businesses in the respective fields. And the beauty there is each of those businesses files their own SEC filings. They still have bonds outstanding, they’re in regulated businesses. So within the energy business, within BAG, you have the separate financials that are filed and consolidated in BAGs 10K every year for the three electric utilities they own, Nevada Power, Pacific Corporate, MidAmerican, you have subsidiary filings for their pipeline businesses, some of their distribution assets.

Chris Bloomstran (00:13:12):
There’s a lot of information available, but I think looking at breaking up the business into the energy business, the railroad, what’s kind of fashionably called the manufacturing and service and retail businesses, which a few years ago now includes their leasing businesses. And I have a separate bucket for holding company assets, which don’t necessarily fit. And in my annual reconciliation, I’m trying to assign a lot of the big financial statement moving parts to each of the segments. And there are assets that are held in Omaha at the holding company that are not assigned each of the subsidiaries. I mean, the deferred tax liability that exists broadly for the entire company sets as a single line item on the right side of the balance sheet. And I’ve got it then assigned that through the moving parts. Well, I can do that specifically in the case of the energy business and the railroad, because those numbers exists expressly on those financial statements but they don’t expressly present themselves in the insurance operation.

Chris Bloomstran (00:14:07):
So I’ve got those buckets and then you have what’s still the largest 800 pound gorilla in Berkshire, which is the insurance operation. And that’s, as I measure it, probably still 45% of the value of Berkshire. But from the standpoint of the energy business, they and the railroad each do… And when I say the railroad, that’s the Burlington Northern Santa Fe, which was acquired really in the teeth of the great recession. ’09 the deal closed, in 2010, it was bought for a song I thought they overpaid. The economics of that business had changed for the better and railroads were worth a heck of a lot more than they had been in prior decades, because they were capital intensive highly regulated businesses, where there was too much competition and didn’t make a lot of money and that all changed and Mr. Buffett figured it out.

Chris Bloomstran (00:14:54):
I think Bill Gates and his folks at Cascade really figured it out pretty early on. Some of the guys at Allegheny also figured it out pretty early on, but railroads changed. Anyhow, I think it’s fun to note that both of those groves or those segments, the energy business and the railroads each do about $20 billion in revenues. They’re both very capital intensive. They’re a little bit different. The profitability at the energy business is perhaps half of what the railroad produces, but it’s a lot more capital-intensive. Mr. Buffett talked about this year that each of those have spent on the order of kind of twice their depreciation charge for CapEx since acquisition. Well, that’s changing at the railroad a little bit now. And when they bought the Burlington, the company was doing 18 or 19 billion in revenues. I think revenues peaked a couple of years ago before the trade war with China and certainly before the COVID at 23 or 24 billion. They came in a little over 20 billion last year. The profitability on the railroad is down, but they’re basically the same size by revenue, but far different.

Chris Bloomstran (00:15:57):
The railroads case, we have the rail earning kind of low teens, 13, 14% returns on equity capital. They had been spending CapEx at the rate of two to one of depreciation. Now, that changed about four years ago to now where they’re only spending about 50% more. Followers of Berkshire will know that since that acquisition, all of the profits that the railroad has made have been upstreamed as dividends to the parent, which is completely different than the way the utility and energy operations have been treated, where all of the profitability has been retained. So in the regulated utility world and in the pipeline world and in the distribution world with these regulated assets that are allowed to earn, say, 10% returns on equity, if that group of assets in the energy world, BH energy, there’s 20 billion in revenues and earns on the order of $4 billion in what I would call kind of free cash profit, that entire $4 billion is being retained.

Chris Bloomstran (00:16:58):
And in that electric utility world, the regulators like to have a range kind of between 40% of your capital structure and 60% of your capital structure being leaned on as debt. And so Berkshire has fully reinvested those profits. They’ve layered on a little bit more depth in the retained profit. And it’s a growing business. It’s a business where if they’re going to retain $4 billion, they’re going to get a regulated 10% return on that $4 billion. They’re going to layer on an additional four billion rather in debt, but materially grow the operation. The railroad’s not doing that. The railroad’s just not going to get a lot bigger. You can only have so many track miles. So they’ve done things like adding two and three and four tracks in very high dense corridors. They’ve built out tunnels and they’ve allowed for kind of the double stacking of containers and what have you, but a lot of that spending is done and you’re seeing that now.

Chris Bloomstran (00:17:50):
In any event, you’ve got the energy business worth between kind of 60 and 65, maybe $70 billion. If it traded like one of their competitors taking say a Duke or a Southern, Exelon’s probably a bad example because they’ve been struggling a little bit with some of their non-regulated businesses, but in the public markets, my valuation would be conservative. My valuation on the railroad has the rail trading at 17 times what I would call normalized net income. If you look at the valuation of the Union Pacific, which is their primary competitor and sharing a lot of the same geography, but just take the deal that the CP did in buying the Kansas City Southern. The prices there, I mean, these stocks trade for mid 20s to earnings. They trade for six to eight and a half to nine times revenues. My a $110 billion, which would be my midpoint valuation on the railroad, if it traded as a publicly traded comp, you could say the world would value the railroad at $170 billion, which is a big, big number.

Chris Bloomstran (00:18:51):
Then you’ve got this manufacturing service retail group, which is the hodgepodge of all of these businesses they’ve accumulated from way back when they first bought See’s Candies, the very heavy concentration in industrial and manufacturing. They’ve got the retail operations, Borsch items, the jewelry stores, Helzberg. That group of companies does $140 billion. We’ll do probably 155 billion on the V recovery coming out of the COVID. It’ll learn kind of a typical conglomerate profit margin of six or 7%. In my world, the group only earns about 7% return on the equity of the business, which I find insufficient.

Stig Brodersen (00:19:33):
Just one thing to what you said there about manufacturing service retail now also finance, like you said, there were so many things going to that unit. They are heavy in some compared to others, how do you do that? Are you just saying what you mentioned like 7%, so you just do an approximation and say, well, it’s probably better to approximately right than precisely wrong. It’s not the biggest other segments. That’s fine. And then you move on.

Chris Bloomstran (00:19:56):
So Mr. Buffett made it very easy to follow that aggregated group getting in 2003. And I have a table in the appendix of my letter that tracks what had been the summary balance sheet and income statement. Well, for whatever reason, those numbers disappeared from I think it was the 2017 annual and it’s made it a little bit of a bear for an analyst to try to kind of piece together what’s gone on perspectively. I suppose the good news is they haven’t made any material acquisitions post precision. And so by tying out various segment disclosures in the footnote, the struggle I have going back 15, 16, 17 years is you can see the return on equity of that group declining. What’s tough is a lot of these businesses are very mature. They don’t have the opportunity set to retain capital and grow. And I think a lot of the managers that run these companies would defer to Omaha and defer to Mr. Buffet, kind of allow him to drive the capital allocation decisions. So they do send profitability upstream.

Chris Bloomstran (00:21:02):
Collectively, it’s a fairly mature group. You have businesses that are just growing like a weed and killing it in terms of profitability like Clayton Homes. But as a group, you’ve seen the profitability decline from what was a 10 ROE down to call it a seven. And that seven is not very attractive. And if it’s a seven, that tells you there are companies that are earning less than seven in the group, and there are companies like Clayton that are earning returns far, far higher. And so what I would like to see is, and they talked about it at last year’s annual meeting, Greg Abel and Mr. Buffett did, there are some subsidiaries there, coming out of the COVID, that they’re going to look at and perhaps start to either close or sell off. I think the case can be made that a smaller Berkshire in terms of that group is a better group. But to my prior point, it’s a non-levered group.

Chris Bloomstran (00:21:48):
It sits there historically and the way I’ve got it modeled now with as much cash in the group operating as working capital is they would have debt on the balance sheet. And in a world of leverage and low interest rates, there are, without a doubt, some subsidiaries in that group that I think would be better off in the hands of a long-term private equity type owner, but that’s a lot more tolerant of putting larger amounts of leverage in an enterprise than Berkshire would be. And you can take a company that’s earning five or six on unlevered equity, which is pretty typical of most industrial assets. Lever it up to a low teens type return. Berkshire doesn’t do that. But I think the opportunity exists perhaps to exit some businesses over time.

Chris Bloomstran (00:22:29):
And whether that happens on Mr. Buffett’s watch, and I think some of it will and post the Buffett era, I think some of that certainly will. When I hear Greg Abel talk, I think he gets it. And so it’s a group that’s probably the least attractive segment within Berkshire, but it’s 25% of the value of the company. It’s not a big moving part. And it still earns seven on unlevered equity, which is not that unattractive.

Stig Brodersen (00:22:53):
Can we call it the legacy business? It’s probably not completely fair to say so, but you are definitely right, Chris, you know it. And you know as well as I do Buffett made some different promises to people who he acquired these companies from and he feels he has this bond to many of these companies to some of these managers. Actually, I was a bit surprised that you said that some of this might be spun off on his watch. I don’t know. Like whenever I see Buffett today and I’ll try not to digress too much from the actual outline here of the interview but whenever I see him, I hear him talk and I kind of sense there’s more and more legacy coming into, I wouldn’t say some of his decisions, but definitely in terms of one of the things he is saying, and to me, it makes me sound like he’s less likely to make that happen on his watch and it’s something that could happen with a succession.

Stig Brodersen (00:23:41):
We know we’re going to talk later here about succession, someone like Greg who could potentially spin off some of those assets, and then you have the discussion about, well, if you do that Berkshire then be like go-to buyer to buy them in the first place, if you start spinning them off. So there’s just a lot to unpack there. But let me try and build myself back in here towards one of the things you wanted to talk about. Chris, one of the things I really liked whenever I read your letters is how to think about cash. Whenever you follow the financial news, there is always this big focus on Berkshire’s cash. And if you look at the cash balance at the end of the year, it’s roughly $133 billion, and this is excluding the energy division and the railroads.

Stig Brodersen (00:24:22):
And so to a lot of people that looks like Buffett and Munger are leaving a ton of money on the table in opportunity costs, which comes at disadvantage to us as investors. However, if we see it in the context of cash relative to the balance sheet, things start to look a bit different. Cash today’s only 12% of total assets down from 15% a year ago, and 12% as you note in your letter as a percentage of total assets precisely match the average since 1997. And furthermore, you argue that $133 billion is not the correct cash figure to use for deployment, but rather it’s around 70 billion. So I know I perhaps have put a bit of work there in your mouth, but could you please describe how you come up with that number and how you value the cash on Berkshire’s balance sheet?

Chris Bloomstran (00:25:10):
As you see just an awful lot of angst from the Berkshire watching crowd and you put the media squarely in that camp, they lament this, what they perceive to be this giant cash balance sitting there on the balance sheet. And how can you not come up with better use for cash? I mean, earning less than 10 basis points today, aren’t there deals? Aren’t there elephants? Why can’t you buy common stocks? Why can’t you buy businesses? Why can’t you repurchase your shares. And exactly to your point and I’ve got a great, what I think long-term chart in my letter, it will show you cash as a percentage of firm assets, cash as a percentage of equity. And they’re not materially large numbers. I mean, putting wound up being $135 billion in cash outside of the energy businesses and the rail at year end in context, the entire enterprise has almost $900 billion in assets.

Chris Bloomstran (00:26:07):
And so the world knows that Berkshire has long said that they would always have $20 billion of cash on hand. When they first said that, my observation was that number should probably approximate the dollars that Berkshire is going to spend on insurance losses on an annual basis. Well, those insurance losses have now crept up as the insurance operation has gotten larger and larger to a number just shy of $40 billion, call it $37 billion in annual basis. In my mind, that’s the number that’s off the table that will always sit there as cash largely in the insurance operation. Some of them might set up the holding company, but that’s unspendable cash. But then you do have cash needs in the subsidiaries for working capital. There’s on the order of $4 billion in cash between the railroad and the energy operations. I think you’ve probably got mid $20 billion of cash sitting in the MSR group.

Chris Bloomstran (00:27:03):
And so when you back those cash numbers out, you’re left with about $70 billion of cash that I think can be deployed. And that’s not to say that they can’t go spend more than that. I mean, they’ve proven when they’re going to go to a big deal, they can take the cash balance way down. Berkshire can borrow a bunch of money if they want to make a major acquisition. But when I think about cash, what I’m trying to do, Stig, is normalize the profitability of the business. And so I’ve long assumed that Berkshire’s cash, that portion that I deem as spendable, the $70 billion, will be invested in something other in cash at some point, somewhere in the intermediate horizon. And so I still think Berkshire has a hurdle rate of somewhere pretty close to 10%. It was a much higher hurdle rate when Berkshire was smaller, when interest rates were higher, when the opportunity cost set was completely different, but I think it’s still around 10.

Chris Bloomstran (00:28:00):
And I think that’s how they view Cheri purchases. I think that’s how they view acquisitions of common stocks, acquisitions of businesses. I think that’s how they view the deployment of CapEx. And so, as an example, when they announced last year they’re going to spend almost $10 billion buying some distribution, energy assets, pipelines, and LNG terminal from Dominion, four billion of that was going to be cash. And the balance was going to be funded with debt, which kind of gets you into that classic traditional capital structure for those kinds of regulated assets. Well, take that four billion in cash. Today you’ve got cash earning nothing. And so on $4 billion in cash at zero interest when they go out and presumably are going to earn 10% return on that equity balance, that’s $400 million in profitability. What I don’t want to have to do is every time Berkshire buys a stock or buys a business, makes an investment is move up and down my current earning power of the business.

Chris Bloomstran (00:29:01):
And so they’re going to earn 10, but I’ve been modeling 7% minus whatever the T-bill rate is. So if you think about this number broadly, go back two, two and a half years after the FED had raised interest rates nine times and you had T-bills earning two and a half percent. Well, two and a half percent on $130 billion in cash is pushing $3 billion in pre-tax income. Here we find ourselves today with T-bills earning nothing. And so most definitely in terms of current cash flows in from interest income on bills, you have very little, you have $133 million coming in on $133 billion in T-bills versus what would have been closer to $3 billion. Assuming that 70 billion of that will get spent at 7%, that gets you to $4.9 billion minus the 133 million. And so when money goes out the door, I’m not having to make a change in terms of what it’s going to earn.

Chris Bloomstran (00:30:03):
And again, it goes back to what I think the hurdle rate is. Berkshire is not making investments at 7%. You think about the Apple buy, for example, they were able to get $35 billion in Apple, which turned into more than a $100 billion a year gain a year in. Well, that’s a hell of lot more than a 10% rate of return. So you’re going to have some home runs. You’re going to have some businesses where they’ve just offered to invest in some gas fired plants in Texas. Everybody read about the cold snap that hit and pipelines froze and the wind operations didn’t work, Texas needs more natural gas capacity as backup. I think the world is going to need more natural gas as a backup to wind and solar because the wind doesn’t blow a 100% of the time and the sun doesn’t shine a 100% of the time and you’re going to have to have consistency in the grid.

Chris Bloomstran (00:30:57):
And so Berkshire went in and offered for on an eight plus billion dollar contract to make a 9.2% regulated return to build a bunch of gas fired plants, to have capacity in place so next time you get a freeze, that would be the alternative to ERCOT, the Texas grid compelling the private operators that compete on an unregulated basis from having to go and winterize those assets. It’s probably a win-win for all, but if they were to be able to lay out $8 billion at a 9% return, I’m not going to make any adjustment if they win that contract, because I’ve already assumed they’re going to make 7% on the cash balance in the company.

Chris Bloomstran (00:31:33):
So it’s very much a normalization technique. It also presumes they’re not going to leave money laying around when they buy shares back. And you remember when they first came out maybe a decade ago and said, “Okay, we’re going to buy some shares back and we’ll cap the repurchases at 110% of book,” which they then changed to 120% of book value. Well, if you flip the earnings yield and the PE on their heads respectively, paying 120% of book for a company doing 10% return on equity is an 8.33% return.

Chris Bloomstran (00:32:07):
That’s a pretty attractive number. North of that number, I don’t think that it’s going to meet necessarily Berkshire’s opportunity costs set, kind of their hurdle rate. And so I think looking at it through that lens is pretty conservative. I’m not knocking this decline in interest, thanks to the US treasury and thanks to the COVID, thanks to the excessive debt on the government balance sheet. But at the same time, I’m assuming they will spend a decent portion of the cash balance, but there is the permanent cash reserve in the grand scheme of things. And in the grand scheme of things, it’s not that much money relative to what’s almost $900 billion in assets.

Stig Brodersen (00:32:42):
That’s such a great point. Whenever people just read that number, like more than $100 billion, they’re just like, “Oh my God, this is so much.” They’re looking at nominal numbers and they’re not thinking of them attuned to cost. Most people would just put like a 0% on and say, well, it’s not doing anything, it’s just there in T-bills. Buffett said here a few years ago, well, the duration, ever it’s four months. And then people go in to say, well, what’s four months? Well, it’s still a zero. There’s no value. And so I really like the way that you look at this here, Chris. Let’s talk about valuing Berkshire’s equity portfolio. Now one of the frustrating things and I’ve been bashing a lot of the financial media and I’ll continue here in this question for you, because whenever you read about Berkshire Hathaway in the financial news there’s just this excessive focus on reported profits because that’s the easiest to talk about, right?

Stig Brodersen (00:33:31):
And like we talked about here on the show, the way the economy grows is that you are now required to have market to market changes reflected in your income statement. So the earnings are just like all over the place. And Buffett has talked multiple times about you need to focus on operating earnings and even the operating earnings, you also have to adjust for a few things. So going back to the equity’s portfolio, what is the intrinsic value of Berkshire’s equity portfolio also knowing that Avali is close to half of it?

Chris Bloomstran (00:34:00):
I look at the equity portfolio through a couple of different lenses. When you think about insurance and you break out that insurance group that represents 45% of the value of Berkshire, the stock portfolio there at year end was on the order of $270 billion out of what in total was about 208 billion. So there are some stocks that sit at the holding company. BYD was an investment that was made in the energy business, which is very interesting, especially given that Berkshire doesn’t own a 100% of the energy business. Kind of back to the point, one of my analysis is I’m just simply trying to drive the earning power of Berkshire Hathaway. I think too many people that say, well, you have to back off float, you have to adjust for cash and debt, I’m trying to get to the bottom line earning power of each of those segments of the company that we talked about.

Chris Bloomstran (00:34:55):
And when you look at the insurance operation, you look at any insurance operation, profits come from two areas, they come from underwriting and they come from earnings on the invested assets that sit there because of the float. Most insurance companies invest largely in bonds. Berkshire has a huge advantage in being massively overcapitalized to be able to invest the vast majority of its insurance reserves and its invested assets in common stocks. And so Mr. Buffett has long talked about, and we do this with any company that owns common stock portfolio. To your point, the accounting rules changed a couple of years ago and now the changes in the stock portfolio flow through the income statement, which makes the income statement to the lay user completely useless. I will say long-term that changes in stock price as long as they reflect changes in the profitability of the underlying holdings should be accurate. But on a quarter to quarter basis, it’s just going to mask and try to discern what the operating businesses are doing in impossibility unless you really have the wherewithal and the time to dig into the numbers under the hood.

Chris Bloomstran (00:36:05):
So when I think about the profitability that’s earned on the stock portfolio, you simply have the earnings of the underlying companies, some of which come as dividends and some of which are retained by the underlying holdings. And today’s dollars on the portfolio that was pushing $300 billion in size, the retained earnings portion of that number’s about $10 billion. And we’ve got about four and a half billion dollars in profit coming to us. So when I go through my normalization and remove from the income statement, the quarter to quarter changes in the stock portfolio, I’m going to add back on an annual basis $10 billion in the retained earnings. And that’s just another one of these smoothing normalizes techniques. When you think about that though, when I think the local investor in stocks thinks that they’re going to earn, let’s say 10%, which is the long run average back in 1926, well, Berkshire has got 280 or $290 billion stock portfolio, and it earns 10%.

Chris Bloomstran (00:37:00):
You’re going to earn close to $30 billion on that. From a conservatism standpoint, in terms of how much earning power Berkshire really has and how much earning power the stock portfolio has, I’m only getting to 14 or $15 billion in earnings. I’m half of what would be the expectation under 10% return. So when I look at Berkshire’s profitability, I’m trying to go back to the earning power of the utilities, the rail, the MSR businesses, the earnings that are earned at the holding company, but then the earning power of the insurance subsidiary. And so from a pure earnings standpoint, that’s what you get from the stock portfolio, the 10 billion and retain the four and a half billion, let’s say, in dividends plus an underwriting profit. So Berkshire’s aggregate insurance operation underwrites more than $60 billion in premiums.

Chris Bloomstran (00:37:45):
I assume that group earns long-term of 5% underwriting pretax margin. So $3 billion on $60 billion. I’m going to add that $3 billion pre-tax to the profitability from the retained earnings of 10 and the dividends of 14. And then I make a further adjustment to your point about Apple, which I found extremely expensive at year end trading at mid 30 to earnings. When Mr. Buffett was buying it and when Todd or Ted were buying it previously, the stock traded at 12 or 13 times earnings. So you had this huge run up. I find the stock overvalued.

Chris Bloomstran (00:38:21):
Perhaps what, I guess, some would call them nominal sales, but taking $11 billion off the table, I’d kind of hoped that they’d sold some more early in the quarter, the stocks now down 9% or so for the year. Every year, when I make an adjustment to the value of the insurance operation, in some years, I will take to the extent that I think the portfolio is dramatically overvalued or dramatically undervalued and offset the capitalized value of the profitability so I’m capitalizing the underwriting profits at a multiple, and I’m adding to that the earning power.

Chris Bloomstran (00:38:58):
I will back off. So last year I was backing off almost $40 billion from the $270 billion stock portfolio, reflective of the degree to which I think the stocks were overvalued. There’ve been years like the end of 2008, for example, when the stock portfolio was dramatically undervalued and I would then add back a portion of value to that portfolio. But I think normalizing that process alleviates a lot of that bouncing around and volatility. That normalization I go through with underwriting profit, when I’m capitalizing profits at 5%, I’m also removing from the income statement any of the quarterly and annual underwriting profits the businesses earn.

Chris Bloomstran (00:39:37):
Some years, they’re wildly profitable, some years, you have big losses for hurricanes and fire, losses in auto, what have you. But I think long run, the insurance operations will underwrite at 5%, which is a huge advantage because that’s far better than the broad swath of property casualty insurers and reinsurers, but it’s a smoothing technique. It’s a normalization technique that allows me to not have to monkey around with interim giant moves up in stocks and even in underwriting profits.

Stig Brodersen (00:40:09):
Chris, let’s look at the performance of the equity portfolio. You have this interesting stat there in your recent letter that if you look at it since the 31st of December, 1998, you see AGR was 7.6% for Berkshire and 7.2 for the S&P 500. There’s a lot of different things to unpack here, because one thing is that a lot of people, especially if they don’t know Buffett too well, they think of him as like, oh, he’s the greatest stock picker. And that’s not the case. He’s a fantastic business person, but he’s not like the stock picker of the century. In common stock, that’s not how you should look at it, But even with this size, Berkshire has done better than the market. One thing that I like is that you chose 31st of December, 1998 as your starting point for analysis whenever you look at the equity returns. And the stock market matched Berkshire stock portfolio in the sense that at the time it was trading at ridiculously high prices. So keeping that in mind, could you please talk to us about the Gen Re acquisition that Berkshire did and the impact of Berkshire stock portfolio?

Chris Bloomstran (00:41:17):
Well, I think it’s profoundly important. Over the course of Mr. Buffett’s investment career, he’s made some brilliant pivots at these clearly what in retrospect wound up being secular changes in the markets. He closes his investment partnership in the late 1960s. Common stocks had gotten very expensive and he encouraged any of his partners to keep their Berkshire Hathaway shares because he was keeping his. He effectively said, “Let’s get out of stocks.” In 1967, he buys an insurance operation and by the mid 70s, he was buying common stocks in the wake of kind of the Nifty Fifty bear market at the 73, 74 bear market that took stocks down by 50 points. And over the course of 25 years, the investments that were made in Coca Cola and in Gillette and the Washington Post, and then Geico, when it was publicly traded and Mr. Buffett’s stock picking in very, very concentrated fashion was very good.

Chris Bloomstran (00:42:18):
Without the float leverage that you get by owning stocks in an insurance operation, simply on an apples to apples unlevered basis, Mr. Buffett’s stocks trounced the broad stock market. And so you had this wonderful bull market that some date to the early 1980s when the Dow had traded down to 667 from a high of a 1000 back in 1967 sideways for 17 years in years of very high inflation. You can also date the bottom of the bear to 1974. Either way, Berkshire had this glorious run, stocks, average mid 20s in Berkshire’s case. Berkshire’s book value had compounded at 25%. The stock itself had compounded it 28 or 29%. And by 1998, the investment that Mr. Buffett had made in Coca Cola, for example, had grown to 35, 36, 37% of the stock portfolio.

Chris Bloomstran (00:43:18):
The stock portfolio was trading for mid 40s to earnings, almost 50 times earnings. Stocks had grown. Berkshire then was much more concentrated in insurance. They hadn’t yet bought the railroad. They hadn’t yet bought the utility operations. It was very much an insurance company. They had some of the operating subs and Mr. Buffett used what had become a very expensive stock throughout that decade of the 1980s buying a bunch of businesses, not using cash, but using the stock either entirely or in part in deals. Man, they bought Dexter and Helzberg and FlightSafety. Then along came 98. Well, Berkshire was trading at almost three to book Berkshire’s common stock. The stock portfolio, as I mentioned, was ridiculously expensive and Mr. Buffett knew it. He knew, I think, that book value could not compound at 25% perspectively. And he had this problem, if you will, from a highly appreciated stock portfolio that was 115% of Berkshire’s book value, it was two thirds of Berkshire’s assets concentrated in these companies.

Chris Bloomstran (00:44:20):
And if you know Mr. Buffett you know that he doesn’t have a high affection for writing large checks to the US government. Well, the corporate tax rate was 35% and capital gains taxes for corporations isn’t treated as though it’s taxed at the individual level. It’s taxed at the corporate tax rate. So had he sold down the big position in Coca Cola, for example, he would have paid 35% tax. Well, that’s hard to do. So he winds up doing what I think was the most brilliant stroke, arguably one of the two or maybe three most brilliant strokes in the history of Berkshire and that was to walk away from insurance and the stock market, he buys an insurance company, he buys general re-insurance.

Chris Bloomstran (00:45:01):
And in doing so, materially diversified the investment portfolio within what now became a combined insurance operation, much more heavily weighted in bonds, and didn’t pay a dime of capital gains taxes to do it. If you think about it, Berkshire paid $22 billion for Gen Re. And as I mentioned, the stock was trading for almost three times as book. It wasn’t worth that. It was worth half of that. So they really paid $11 billion when you adjust the stock back to fair value. And in doing so, picked up, wound up tripling their float. Berkshire had about seven and a half billion dollars I think on the order of float. At the end of 1997, Gen Re had twice that, call it $15 billion.

Chris Bloomstran (00:45:44):
So they wind up putting those together and Berkshire’s combined float winds up being $22.7 billion. And Berkshire’s stock portfolio was 35 or $36 billion at the end of 97. And as I said, it was really expensive. They buy Gen Re and pick up $25 billion of investment assets. And I remember Gen Re’s investment portfolio was largely bonds, call it 90% bonds. After they cut the deal, that stock portfolio was liquidated prior to the closing of the transaction, so effectively Berkshire took in $25 billion bond and cash portfolio. And in doing so, you could take the combined… I mean, they took the stock component of Berkshire’s book value down from, as I mentioned, 115% down to about 65% and assets from two thirds down to about 30%.

Chris Bloomstran (00:46:34):
So by using the shares even though they paid two and a half or 2.6 times book for Gen Re, a company that was doing six billion in premiums, Berkshire increases their shares outstanding by 22 or 23%. They increased their firm assets by 75%. Think about that. Of the combined entity, Gen Re shareholders got about 18% of the combined entity and they bring almost 45% of the combined assets to the party. I mean, it was a brilliant master stroke. And in the wake of that, Mr. Buffett has said that the Gen Re transaction was not a very good deal. And everybody knows that follows Berkshire that they had to run off a derivative book at great expense for the better part of the next 15 years until about two or three years ago, they really hadn’t grown premium volume.

Chris Bloomstran (00:47:26):
But what gets lost is the profits inside Gen Re have been dividends up to the parent. They didn’t grow the reinsurance book. You had about a decade and a half for the reinsurance market and Gen Re’s world, abroad and here in the States was too much capital chasing, too little business. Pricing wasn’t very good. And so Mr. Buffett would say, okay, I spent 272,000, maybe 270,200 shares at what was a little over $80,000 on the A share. So that’s my $22 billion. Today, I don’t know, that position would be worth over $100 billion.

Chris Bloomstran (00:48:01):
So five X growth in the Berkshire share from the 98 price when they used them as currency in the deal to what it is today. So some would say I gave away 80 plus billion dollars in today’s dollars. I look at that completely differently and say to your point about Berkshire stock portfolio return, it took time to work off the overvaluation of Coca Cola and Gillette, and the Washington Post and Berkshire stocks have compounded at 7.6% a year through year end 2020. The S&P 500 has compounded at 7.2 points over that same period of time. Berkshire’s common stock compounded at seven and a half percent. Remember, Berkshire was trading at 2.9 to book, closed the year on the order of 120% of book, it’s trading at probably 125 ish percent today.

Chris Bloomstran (00:48:48):
So what it did was allowed Berkshire to take that fixed income portion of capital on what was even then an overcapitalized insurance operation, not paying any taxes and upstream capital to the parent, and then buy in a handful of years MidAmerican Energy. It allowed them to take the capital and buy the railroad in 2009. And if Berkshire’s stock portfolio was compounded in the mid sevens, I would say Berkshire itself probably would have compounded not much better than that, but the reality is book value per share, book value even because there hadn’t been a lot of change in the share count, but book value has grown at almost 10% a year. So you’ve got more than a 2% differential in terms of the growth in book value and in terms of the growth in the stock portfolio. And I would say with the high concentration of assets back then in 97 going into that Gen Re deal, Berkshire’s book value would have compounded a hell of a lot closer to the mid sevens than it did 10.

Chris Bloomstran (00:49:53):
And so for that, if you’ve got 385,000 on the A shares today, market caps a little under $600 billion, I mean, to me, there’s at least $200 billion in additional value that was created because Berkshire itself was able to compound. Itself being the business, not the stock. The stock had become down a work off excess valuation as well. I mean, I bought the stock two years after the Gen Re deal in the low 40 thousands per share, at 43,700. I mean, it was not worth three to book, it was worth less than that. So this diversion of capital from insurance, this diversion of capital from the stock market into operating businesses, added more than 2% of compounding over the next 23 years that gets you to a couple hundred billion dollars in surplus value that I don’t think would have been created had Mr. Buffett not known that his stock and the stock market was expensive back then. So it was a Seminole transaction.

Stig Brodersen (00:50:52):
That’s absolutely fabulous, the way that you outlined Chris and understanding that you need to have a deep understanding of what you’re measuring stock is. Like you can’t just look at those numbers and be like, well, yeah, that sounds higher, it sounds low, but in comparison to what? And it’s so interesting when I think you say, well, Berkshire shares or Berkshire’s equity portfolio perform better by 0.4% since 1998, but it was also from an extremely high level and what was the stock market trading at but if it has also the same high level like you, you always need to take things in comparison and I absolutely love the way that you talk about that. So Chris with all of that said, I think it’s important to understand that the flip side of repurchasing shares, that’s issuing shares and again, the other way around. So it’s very interesting how we can use your shares as your own currency.

Stig Brodersen (00:51:44):
Buffett has done a great job of always knowing what the business is worth and knowing what other businesses are worth. And there’s been a lot of chatter about Buffett not bringing out the elephant gun. Some people would say that he did last year, he bought Berkshire Hathaway. He retired 5.7% of the stock and it’s $25 billion that’s more than the operating earnings for the same period. And so whenever we look at that, and we look at your intrinsic value estimate between 325 to 365 per B share, at the time we’re recording here, I think, just bring this up the B shares are trading at 257. And we will talk more about the different valuation techniques later, but how should we as investors in Berkshire Hathaway measure the buybacks value creation in 2020? And then perhaps to make this a long-winded question, can you relate that back to using Berkshire’s own stock as a currency all the way around?

Chris Bloomstran (00:52:38):
Well, it’s early in being able to really determine the degree to which the Cheri purchases may represent another of Mr. Buffett’s brilliant pivots, but I think they might for a lot of reasons. We do have this cash balance and even though we’ve now put it in the context that it’s not as materials, I think the world thinks it is… I think in the world of private equity with an awful lot of capital to invest, a lot of committed capital to invest, with control premiums being what they are, they learn their lesson at precision by paying a controlled premium that really on the surface at the time even seemed high. I think the use of the shares with the stock being as undervalued relative to what I’d call intrinsic value may represent a material pivot. And the pivot there may be an acknowledgement that the overall stock market is expensive and Berkshire was a net seller of common stocks out of the insurance portfolio last year, even though the portfolio earns such a high return.

Chris Bloomstran (00:53:41):
Yeah. To your point, if you go through time and you kind of observe Mr. Buffett’s use of the shares, I talked about the deals that were done in the 1990s for the acquisitions that were made with the Gen Re being the biggie, they even used the shares and parked by the railroad in 09. And I found the stock not as very expensive rather. I mean, kind of inexpensive to me is the buyer, that they were a little more fully valued when he used the shares at that moment on the rail. But if you go back when Mr. Buffett got control of the company in 1965, you think about how he got into Berkshire. I don’t know that all of your listeners would know this story, but there were a period of years where this pre Buffett iteration of the textile operation of Berkshire Hathaway had a bunch of the textile mills in New England.

Chris Bloomstran (00:54:27):
And textiles were in decline. A lot of the labor had moved to the South. They weren’t as competitive. Returns on capital were horrible so they would sell off a mill or two mills. And with the proceeds, they would buy back the stock, which was trading it on the order of 50%, 60% of book value. But the company was not earning high returns on equity, but you’d get this pop because they’d sell off a mill, buy the stock and you get a run-up in the stocks. So Mr. Buffett’s in there buying the A shares at the time at an average of $7.50. And he wound up with an offer from the CEO at the time, Seabury Stanton, to buy the stock back from the shareholders and a big tender offer. And they were going to tender for at least a third of the shares at… And I should know this off the top of my head. I think it was 12 and five eighths per share. And the offer wound up coming in, let’s say, at 12 and three quarters.

Chris Bloomstran (00:55:20):
And so Mr. Buffett felt slighted and instead of taking the lesser eighth, he went to war and said, “You know what? I’ll just buy the whole company.” And he wound up buying enough shares to win a proxy battle and get control of all of Berkshire Hathaway. Mr. Stanton got the boot, Mr. Buffett came in as chairman and they ran the textile operation. And he realized right away he was like the dog that had caught the car. What the hell do you do with this thing that’s really not even in retrospect? But they knew it right away that it was a bad business and they wound up ultimately closing it 20 years later, but made the first brilliant pivot.

Chris Bloomstran (00:55:53):
I talked about taking his partnership and closing it and getting his partners and himself out of the stock market. He effectively then said, “I’m going to go buy an insurance operation.” And he bought National Indemnity in 1967. And at the time the stock was trading for maybe 60% of book value. So he knew enough to not use the stock as currency, because it was kind of at those prices at which he was a fan of the stock prior to him getting control of the company. So he pays cash for National Indemnity, but at the same time, during the same year, that stock continued to fall. And it traded at half of book later in 1967.

Chris Bloomstran (00:56:27):
They got control of the company in the spring of that year and they bought back a bunch of stock in 1967. And then it traded at half of book again I think in 1969. And they bought the shares back in 1969. Bought a few back in the ’70s and then had a 33 year period of time where they did not buy a share back, save one occasion, the stock market 40% crash in 1987, the stock traded down to a discount, not below book, but it traded down to enough of discount where they bought the shares back.

Chris Bloomstran (00:56:55):
But they had 33 years, think about that, where he had known the stock was cheap in the 60s and early 70s, went on sabbatical, doesn’t buy a share, buy some in the stock market crash, then you get to the 90s and he spins the shares and acquisitions Allah, the Singleton model, and buys a bunch of businesses, buys Gen Re and then the stock app posts the Gen Re deal trades down to, I bought it at 105% of book, they started buying it three years ago and they bought a billion for… I think it was in 2018 and they bought almost $5 billion in 19. And then to your point, they spent almost $25 billion last year, which was a big, big number in excess of the operating earnings of Berkshire. And when you take out the 10 billion of retained earnings in the stock market investees, and the $7 billion of what I would call kind of growth CapEx and access of the $8 million depreciation charge, the stock has been cheap. And this may now signal an acknowledgement that the capital markets are too rich.

Chris Bloomstran (00:57:52):
There’s too much competition for elephants and for elephant hunting, which makes the share at very modest premiums to book value, but certainly at discounts to intrinsic value, material discounts, as I measure intrinsic value, a wonderful use of capital. And it may signal a much smaller Berkshire Hathaway perspectively, but when you’re buying at a modest premium to book a business that in my world earns 10 on equity, then that’s down near a 10% return, you’re shrinking the share count and that’s very creative. So book value grew by four and a half percent last year. Book value per share grew by closer to 11, intrinsic value grew by closer to 11. As long as the share price stays cheap enough, Stig, I think it’s a wonderful use of capital. Again, I don’t mind Berkshire being a smaller entity. I don’t need it to be a three or four, two or $3 trillion market cap. It doesn’t need to be bigger than Apple. Smaller and profitable is better than larger and less profitable.

Stig Brodersen (00:58:49):
Well said. There’s much talk there is about Berkshire should pay out a dividend, which has been put to a vote. No, Berkshire shareholders does not want to get a dividend. I think they’re being quite a few of us. And I don’t know if I can include you here whenever I’m saying this, Chris, but I think quite a few of us investors have felt like with that cash as much as it’s not a huge pile compared to the total assets, but it’s been trading at levels where we felt that Buffett could be a bit more aggressive. And we’ve seen him buy a bit back and I would say 1.7 and then close to five year after.

Stig Brodersen (00:59:21):
So whenever I was saying that it was 2018, 2019, it didn’t seem like a lot whenever you considered everything. And now with… I don’t know if the deciding factor for Mr. Buffett has been that with all that extra money playing that has happened, he’s like, “Hey, we just need to go where we can get that value.” And to your point about the 10% hurdle rate, that’s the easiest way to do it. It’s just now the stock. And that elephant target we’ve been looking for, we still have cash, but it’s not going to materialize.

Chris Bloomstran (00:59:54):
He took a lot of flack. And even from me to a degree, I mean, in the teeth of the decline last year in late March when everything was down 30 plus percent, I expected Berkshire would have bought back more of their shares or had bought back some of their shares. During that decline, they didn’t buy any and I thought they’d probably buy some common stocks. The opportunity didn’t come along to buy a private business. Downturn didn’t last long enough and nobody was going to sell on the teeth of a downturn when people were closing factories and suspending retail operations. But if you think about… If you put yourself in his shoes at that moment, and you look at the retail operations that simply closed, and you look at the manufacturing operations that simply closed, Bill Gates, who he’s close to resigns from his board of directors, you didn’t know how deep the downturn was going to be.

Chris Bloomstran (01:00:48):
We’d never seen in the history of the industrial economy as rapid of a decline. We’ve never seen the majority of the economy simply come to a halt. And back to the original point about the size of the cash balance, 130 plus billion dollars on what’s now almost 900 billion in assets is not that much money. And the thing that Mr. Buffett will not do is compromise the permanence of Berkshire. And you never know how much of that cash was going to be needed in the insurance operations. You did not know how long it was going to take to restart the economy. We were stress testing every business that we own for an unimaginable scenario of how long are we going to burn cash at Disney? How long are the theme parks going to be closed? He went through the same process and he’s got a front and center view on what happened.

Chris Bloomstran (01:01:38):
And so I don’t fault the lack of purchase there at all. I think the outcome was unnoble. You did not know that you’d have this V-shaped recovery at least as far as the capital markets go, thanks to the central banks of the world. And then I think to your point about dividends, I don’t want to dividend, I’ve got taxable clients. I own taxable shares. I don’t want to pay taxes because then I’ve got to turn around and reinvest those shares at what’s invariably a control premium to me as a shareholder. If Berkshire closed the year at 12.8 earnings, I don’t want to pay tax and then come back in and have to pay 13 times when Berkshire can keep the capital and at some point, make investments at 10, which I discount back to a present value of seven as we discussed. That proves that the share gets expensive and these repurchases drive it up, or the world thinks Berkshire is worth more than it is and the shares become unattractive as an investment.

Chris Bloomstran (01:02:33):
And you’re not finding opportunities in common stocks, and you’re not finding opportunities to buy control positions in businesses, then a dividend perhaps maybe introduced and should be introduced, but I wouldn’t make it an ordinary dividend where you’re committed to the ongoing payment of a portion of profit. I think you’d maybe do what Costco has done when they kind of grew into the point where they were only going to open 20 or 25 stores per year. You build up a bunch of surplus cash and once there’s enough cash that you know you’re never going to need it, you send it out to the shareholders. When I think that very well may be on the table, there are a lot of investors that clamor and say, Berkshire has so much cash, they got to pay a regular dividend and I couldn’t disagree anymore.

Chris Bloomstran (01:03:10):
I think that would be a terrible protocol that businesses wind up being stuck with when you’re Berkshire Hathaway and you live in the world of deployment of capital, your capital allocator, why do you want to commit to a policy that commits you to pay profit out when there are better opportunities than paying a dividend? So I disagree with that aspect.

Stig Brodersen (01:03:34):
So some of our listeners might be sitting out there thinking, well, Chris is really, really smart. I’m sure everyone out there is thinking Chris is really, really smart. And they’re thinking like the way that he adds things and subtracts them again, he’s just normalizing it, it’s hard. Like it’s too hard to figure that out. And they might be ask themselves, is there an easier way to calculate the intrinsic value or at least to give like a rough rule of thumb. And one of the things I really liked that you put out there is that you estimate the fair value to be around 1.75 multiple to book value.

Stig Brodersen (01:04:08):
And so if you look at the book value at 31st of December, 2020, it was $195.31 and that would give us approximately an estimated fair value of $335 per B share. So that might be a good number for us to have, but it’s also important to note that not only is the $335, not a static number. If you’re looking at the 1.75, that’s also a dynamic number that we can expect to increase over the years. Could you please elaborate, Chris, on why that 1.75 is expected to go up as an estimate of the fair value?

Chris Bloomstran (01:04:47):
Yeah, it should go up. And Mr. Buffett has acknowledged and noted that he’d expect, I wouldn’t say so much the multiple to book, but I think book value as less useful of proxy of value. And if you look at drug companies, older businesses that have legacy assets, you have a lot of assets on balance sheets that are carried at historic costs that gets offset when companies do deals and pay control premiums, and you wind up with goodwill and other intangibles. So you’re kind of resetting the cost basis, but there are a lot of legacy assets. I talked earlier about the 15% of operating profits that are written off per year for companies. Reported earnings being 15% less over time. During downturns like last year, I mean, earnings for the S&P dropped from 150 bucks, soon we’ll call it 158 or 59 down to almost a 100. It fell by more than a third.

Chris Bloomstran (01:05:36):
Well, there were big write-offs last year. Right offs were about 30%. When you have boom times, you don’t see a lot of write-offs. So there are distortions to book value. Well, a material distortion to book value, if you look at most companies, is the repurchase of shares in the open market at a premium to book value. So for most combinations you have this enormous dilution that’s going on on the front end, giving away shares to employees via stock options and restricted share units, that dilution in the last 20 years has averaged about 2% per year. And so companies are out there on the other end buying their shares back in the open market at what consultants will tell you is a return of capital for shareholders. Well, if you’re paying a big premium, not only to book value, which in a lot of cases is now an immaterial really worthless number in a lot of businesses, but if you’re paying 20 times in a 5% earnings yield or you’re paying 30 times in 3.33% earnings yield, 33 times earnings, if you’re overpaying for your shares, you’re destroying shareholder value.

Chris Bloomstran (01:06:42):
And so in the world of a Berkshire… Berkshire, they back all of their 24.7 billion last year. They bought at an average of 105% of book value, which is remarkable, again, with the business that earns 10% in a world of zero or very low interest rates. But if we can presume that Berkshire is going to be in the business now of buying back shares, and the shares are trading at sufficient discounts to fair value and that 175% of book is one of my reconciling methods that I use to kind of reconcile to my more appropriate measures of how I get to intrinsic, the larger the premium that you pay, the more decline you’re going to see, not only in book value, but also in book value per share. I’ve got a table in my letter that you may have seen, this year I introduced the concept of Berkshire spending 50% of its profits, which would be more than two thirds of their operating income buying back shares.

Chris Bloomstran (01:07:37):
And I’ve got an illustration of five different scenarios at prices at which they would pay anywhere from half of book to book, to 120%, to 150%, to 200%. The top and the bottom of those cases are outliers and I wouldn’t even bake them in as realistic, but I wanted to illustrate the degree in which by paying low prices allows you to retire more shares obviously than by paying high prices. And in a world where Berkshire can buy their shares back between 100% of book and 150% of book, they’re going to retire somewhere between 25 and 40% of their outstanding shares over the next 10 years. If those repurchases take place at sufficient discounts to intrinsic value, but are made at premiums to book value, then the book value per share of Berkshire will not grow as fast.

Chris Bloomstran (01:08:29):
The book value… So if Berkshire is going to earn $44 billion, let’s say, in profit and spends $22 billion, book value in dollar terms only grows by $22 billion. Book value per share will decline by more because you’re paying a premium to book value. So Berkshire is going to wind up having less equity capital 10 years out than it would have had if they don’t durably prove to be in the reinsurance game. But that will have a distortive effect on book value. And then if we wind up having high degrees of inflation, all of these capital investments that have been made in places like the railroad and the utility operations, those don’t get immediately reset.

Chris Bloomstran (01:09:08):
And if the cost of replacing depreciated assets rises, you’ll have an understated book value relative to modern replacement costs. So there are a lot of things that should, and probably will work against book value, which means that as a reconciling tool, if 175% kind of ties into some of the parts and some of the other tools that I use to value Berkshire, then you would expect it to go up and shareholders will just have to make that adjustment over time.

Stig Brodersen (01:09:37):
And I wanted to talk about that. And I wanted to talk about the other valuation methods that you have for Berkshire Hathaway. Specifically, you listed four but some of the parts that we just talked about, we had the simple price to GAAP book value that we just talked about. You have something called the GAAP adjusted financials, and you have the two pronged approach. And if you look at those four approaches and we estimate the value of a class B share, we’ll be getting an interval between 325 and 365. Now, which method do you think best estimates the intrinsic value of Berkshire Hathaway, and how do you think about margin of safety when buying the stock?

Chris Bloomstran (01:10:15):
So earlier in the conversation I kind of addressed that what I call the two-prong approach, and that was Mr. Buffett’s giving you the marketable securities per share, and then the operating earnings on a per share basis, you could capitalize the operating earnings at some number, you can make any discounts or add any premiums to the securities to the degree to which you thought they were over undervalued. But that’s been a pretty good back of the envelope proxy and that’s all that was, was a very shorthand, useful tool that shareholders could use to come up with value. I use my two-prong approach and there are nuances there that have evolved over time, and I’ve addressed them in the letter and I won’t bore you with the TDM of them. Some of those things like how they treat operating or underwriting profit rather has changed over time.

Chris Bloomstran (01:10:58):
There was a period where underwriting profits were excluded and then they were not disclosed, but then they were included. And so I make adjustments in my model and you can find that in the appendix of my letter. What I call some of the parts and this GAAP adjusted financials are essentially going to get you to the same place, but they’re going to get you there in two completely separate ways. And both are, to me, essential to understanding Berkshire. One is very much an earning power of the subsidiaries, an earning power of the segment based approach that would be trying to discern what you think the value of the energy businesses are, the railroad, the MSR businesses, net assets at the holding company, and then the value of the insurance operation. That’s my some of the parts. I think if you have years and years of data and you understand the economics of each of those respective businesses and the industries in which they compete, it’s a very reliable method.

Chris Bloomstran (01:11:59):
I mentioned my appraisal of the railroad at $110 billion. Well, if it traded publicly today as a Canadian Pacific buying the KSU or traded as a Union Pacific, it would be worth in today’s market a hell of lot more than my very conservative appraised number. So I find my some of the parts appraisals are very inexpensive. Again, the earnings power from the stock portfolio, which I alluded to is 10 billion from retained earnings plus four and a half billion in dividends. If you thought the stock portfolio could earn 10, you’d make almost $30 billion a year. And so I’m half that number on just the retained earnings basis, which simply means that the price of the portfolio was high relative to the current earning power of the businesses that are invested in the common stock and publicly traded stock portfolio. My GAAP adjusted financials approach allows you to offset the effect that you talked about. And that’s the volatility that you get on the current financial statements, the income statement, the volatility of quarterly changes in stock prices distorting everything else.

Chris Bloomstran (01:13:10):
What I find are quarterly distortions and even annual distortions from underwriting profits being much higher than my normalized 5% number much lower than my 5% number. I mean, I think taking my GAAP adjusted financials approach is probably one of the most worthwhile case studies that can be used with young investors or students that are learning how to work with financial statements and valuation. I’ve got a series of eight or nine adjustments that I go through, so I can take GAAP earnings, or if this were an international business take IFRS earnings and make my series of adjustments and ultimately get to what I would get to by capitalizing properly in my some of the parts approach.

Chris Bloomstran (01:13:54):
And so again, you’re going to take out the what are now unrealized gains in the stock portfolio. You’ve always had the unrealized gains flowing through the balance sheet and through the book value, but not through the income statement. Well, now they’re in the income statement, you’ve always had realized gains flowing through the P&L and also through the book value. So strip both realized gains and unrealized gains out and put in on an annualized basis $10 billion representing the retained earnings of the investees. Take out all of the underwriting profits of the insurance operations on a short-term basis. And in my world put in a 5% pre-tax normalized underwriting profit. You’re going to take the degree to which other intangibles are being amortized that don’t reflect economic decay and add those numbers back into profitability. You’re going to take the cash, what I call the optionality premium of that 7% kind of normalized present value earning power on the cash, the portion of the cash balance that I deem as investible and back out whatever the business is earning on its T-bills today.

Chris Bloomstran (01:15:11):
I’m going to add that to my normalized profitability. And again, when they buy assets from Dominion or they buy Apple, I’m not saying, well, all of a sudden the earning power went up from 10 basis points to whatever the earnings yield is on the actual investment being made, my normalization at 7% has already done that. I’m going to take even Berkshire’s very conservatively assumed pension fund, which I can leave out of this exercise. I mean, the aggregate defined benefit plans in the US and abroad at Berkshire are small compared to the whole. But my method here is, I think, such a valuable teaching tool, I’d leave it in. If I were analyzing a business and the pension plan we’re rounding here inside of a company, I would just ignore it in terms of an adjustment, but I’m going to whack $400 million off of Berkshire’s 44 and a half billion dollars in profitability to make the pension adjustment that we talked about.

Chris Bloomstran (01:16:03):
And so you go through those series of adjustments and in 2020 terms, I’m adding a net almost $18 billion back into whatever the GAAP earnings are having backed out realized unrealized gains and having removed whatever the underwriting profit and loss is. And it’s weird because some years you’ll have big underwriting losses. And yet I’m saying, ignore the underwriting loss and add in a 5%. In some years you’ll have underwriting profits that are in excess of 5%. I’m saying, whoa, whoa, they’re not as profitable because I’m smoothing that number over time. And then you occasionally have these one-off that you also have to adjust for. And so the two largest recent examples of that would be TCJ, tax code change at the end of 2017, that was monster. You had this giant deferred tax liability sitting on the balance sheet that was valued at a 3,500 tax rate.

Chris Bloomstran (01:17:02):
When you revalued that net liability at a 21% tax rate, there was a big one time net effect on the income statement that you had to zero out. More recently when a company writes down or writes off an investment reflecting a past investment, so in Berkshire’s case for 2020, the $10.6 billion right off of precision Castparts on a pretax basis 10.4 on an after tax basis, I’m going to ignore that from the earning adjustment calculation, I’m going to take it out, but I’m mentally now going to go put $10 billion back into the balance sheet. And when I’m calculating return on equity, I’ll never forget that Berkshire paid that extra $10 billion for precision. I will always carry that number as what in my mind is a higher book value. It’s not like I’m trying… I’m not trying to get book value higher, I’m trying to normalize it.

Chris Bloomstran (01:17:57):
So I think at the end of the day, those two numbers will get you to approximately the same intrinsic value. They’re going to get you to the same level of profitability. And then to just touch briefly on your question about margin of safety as it ties into these approaches, there are definitely times where some of the approaches are going to overstate or understate what I would call intrinsic value, and that’s really the drawback of the two prong method or even the book value method. When you have a period where stocks have done very well, Berkshire’s portfolio of common stocks as they’ve done in the last two years, when I find the stock portfolio to be overvalued, well, your book value is going to be overstated. Your value of the market value of securities on a per share basis is going to be overstated relative to what I would call my normalized kind of more properly valued number for the stock market.

Chris Bloomstran (01:18:51):
Those two can only be reconciling tools. The other two are pretty conservative. And I would say in using them during a year like 2020, we’ve been two or three years into a trade war with China. We had a COVID and so profitability at some of those subsidiaries is presently depressed. And so I’ve got to make a further cyclical adjustment now upward for businesses like the railroad and the MSR group. I mean, the railroad is under earning to the tune of maybe a billion dollars. The MSR group is under earning to the tune of about $2 billion, just given the degree to which a lot of those businesses were closed and idled for a portion of 2020. So I’m going to add back perhaps two and a half billion dollars on a net basis for the value. But I would also say, again, back to my point about the railroad, the public markets would deem if we broke up Berkshire Hathaway and we just spot them off like the Canadian rails did, there’s materially more value.

Chris Bloomstran (01:19:51):
And that’s how I get to my intrinsic value being so much greater than the current market value of Berkshire. The railroad would be valued at 160 or $170 billion in today’s market. I’ve got it valued at 110. I mean, this is not an Ark Cathie worth $3,000 per share. There are merits to all the different ways that an analyst would come up with intrinsic value, but I find mine to be conservative. But as she would tell you in her model, you can poke holes in any of my assumptions for my 5% underwriting normalized profitability, make it a zero. I mean, there are places to make it conservative, but I think when you get into the nuances of each of the subsidiaries, you’ll find, I think the numbers that I use are pretty darn conservative.

Stig Brodersen (01:20:33):
So Chris, the final question that I’m going to ask you here today is that, as I’ve said many times before, we have so many passionate followers of Warren Buffett here in the audience and many of them have been going into CNBC and they’re gone through the Q&A’s with the annual shareholder meeting since 1994, because it’s available in there. It’s an amazing resource. And if they have, they will have noticed that Buffett and Munger have increasingly been asked about the succession plan and how well Berkshire Hathaway will do after they’re gone. And Buffett and Munger have repeatedly said that they think that the company would do very well. Of course, you can also argue that it’s very hard to say otherwise, but how do you expect Berkshire’s normalized earnings power to develop in the years after Buffett and Munger and what would you pay special attention to?

Chris Bloomstran (01:21:19):
Yeah, I think the succession issue has been one of the most belabored points. And I think Berkshire has satisfied it for most of its kind of long-term core shareholders. And the team they have in place are terrific. I’ve come to understand that Ajit has some very good people working with him. They’ve always said that he’s irreplaceable and he’s irreplaceable for what he does, but they’re not going to run off a bunch of business when Ajit gets hit by the proverbial bus. I think for those that have gotten to hear Greg Abel answer some questions… When I talk to folks inside the Berkshire world, they hold them in the highest regard.

Chris Bloomstran (01:21:50):
I have every bit of confidence in Greg and they’ve turned over the reins to those two guys as the operating heads of the businesses. And so when I’ve come to know some of the folks at various of the operating subsidiaries, one of my early concerns was succession planning to get these geezers who have sold their businesses to Buffett and they like kind of palling around with them, but perhaps their eyes has been taken off the ball and they don’t have a bench.

Chris Bloomstran (01:22:12):
And I’ve come to really appreciate the bench and get to know some of the folks that are running some of the businesses and I’m impressed. I think they have an outstanding group that will hue to the core principles of Berkshire as designed when each of those businesses were acquired. In terms of the things that you’d watch over time, you’ve got kind of this regulated kind of known earning power business, but I would watch what’s going on in renewable energy and alternatives. And Berkshire’s ahead of the pack by far in wind and solar. They’re getting regulated returns. You heard Mr. Buffett talk about the $18 billion or so that’s being spent to build out the grid in the West. Solar and wind are dislocated. They’re not set and close to urban settings. And so there’s not a grid there in place, and you’ve got to move power, which can’t be stored presently over large areas.

Chris Bloomstran (01:23:06):
And so working with regulators and working with local officials to get rights of way and get regulated returns on all that capital has been a big feat, but it’s certainly a place where they can spend a lot of money. The thing that gives you pause is politically here and abroad a lot of these energy assets are now perceived as dirty. And if you go back to the late 70s through the 80s, nuclear investments that were made a big issue in electric utility world were stranded costs. You make these 40 and 50 and 60 year investments in coal fired plants and in natural gas fired plants and if we move the political center point so far in one direction that the regulatory officials and our elected officials begin to disallow returns on what has been enormous past investments, that gets to be problematic and so you’d watch.

Chris Bloomstran (01:23:56):
To me it’s not inconceivable when government seize power. And when debt levels are as high as they are today, governments tend to seize power. So you have to bake in some nominal notion that perhaps you wind up with some swath of the regulated energy business that winds up being nationalized here and abroad. Data on the railroad, you go back to the previous decades to 20 years ago, the railroad industry was a terrible industry, highly regulated, highly competitive, and they all have kind of modified the way they rate price and they’re allowed to make good returns on capital. I wouldn’t say they’re cozy, but they understand a need for profit. The customers understand a need for profit. They’ve consolidated the business quite a bit, but if you were to get a regulatory change and we go back to a more regulated structure in terms of pricing and allowed returns, then perhaps competition heats up more than it is today.

Chris Bloomstran (01:24:47):
So you kind of want to watch where you have what now is a big wide moat. You want to watch where these moats can be attacked. I don’t think they’ll be as attacked as much by competition as they would on the regulatory front. For now, Berkshire’s reputation in those businesses is pristine. I think they’ve got wonderful relationship with the regulators, but a lot of this policy stuff is coming down from higher levels. And I think that’s probably what I would watch over time.

Stig Brodersen (01:25:13):
Chris, this has been absolutely amazing speaking with you. I don’t think I just speak for myself but for everyone in the audience whenever I say that. We’d love to speak to you another time. This has been so profound hearing your insights on Berkshire Hathaway and valuation in general, where can the audience learn more about you and Semper Augustus?

Chris Bloomstran (01:25:31):
Well, probably our website would be the best, semperaugustus.com. We have a pretty decent archive of a lot of my old letters. The annuals are all there. So I’d start with the website. The great thing about that is I think enough institutions be they family offices, or what have you are finding us now much more familiar with what we do than would have been the case 10 or 20 years ago. And they’ve read the letters and they’ve heard some podcasts, but to me, if you’ve taken the time to read through what are brutally long letters, North of a 100 pages and the thought process that is laid out resonates, those are the people that are finding us today. And it’s pretty terrific. We don’t have to do as much screening of clients that are coming at us because we publish our numbers in the consultant databases and our three month return or our three-year return, or what’s now our five-year return is white hot.

Chris Bloomstran (01:26:27):
When those people hire you because your returns are white hot, they’re going to fire you because they’re not white. And the folks that are willing to dig in and kind of read what I’ve written and if it makes sense, it’s a pretty good mesh. And so that’s all on the website. I’m also on Twitter. I shouldn’t be on Twitter, I’ve kind of gotten into the Tesla valuation world here of late and learned a lot about human nature and behavior that resembled kind of what the tech bulls were going through in the late 90s. And I’ve made the contrary case that valuations in a lot of places are stretched. A lot of people don’t want to hear that. And probably social media is not the right place to vet that. I’ve got an article from one of my letters from January of 2000 that got into Microsoft’s valuation being extended. And I wrote that applied broadly to a lot of the tech companies at the time. That is probably a better lens into kind of our long term thinking then trying to fit thoughts into a 288 character Twitter thread.

Stig Brodersen (01:27:24):
Well said, Chris. Definitely, well said. Chris, thank you so much for taking time out of your busy schedule to be speaking with me here today. We really appreciate it.

Chris Bloomstran (01:27:33):
Thanks Stig, it’s been great.

Stig Brodersen (01:27:35):
All right. Two quick things before we run off the show, make sure to subscribe to our podcast on Apple Podcast, Spotify, or wherever you listen to this. Also, remember that we have a raffle. We give away William Green’s outstanding investing book, Richer, Wiser, Happier to the 10 listeners who have the best story from the Berkshire Hathaway annual shareholders meeting. Make sure to send your story to contact@theinvestorspodcast, that is contact@theinvestorspodcast. That’s all I have for you, ladies and gentlemen. Make sure to tune in next weekend where I’m speaking with Mohnish Pabrai.

Outro (01:28:07):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision, consult a professional. This show is copyrighted by The Investors Podcast Network, written permission must be granted before syndication or rebroadcasting.


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