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- [00:00]
Host 1
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- [00:31]
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- [01:01]
Chris
you get this kind of concentration and it's unprecedented today to have seven companies as big or to have the top 10 be as big. But there's there's no decade or period where the top 10 businesses were all the same top 10 businesses. The businesses have to sustain the returns from their already current operations and they're essentially investing so much money you're doubling the size of your infrastructure and you've not only going to make returns on the old assets, but you've got to make returns on the new assets. And right now the revenues are not there and the revenues that are there in many cases are coming from each other, making capital investments in each other, lending each other money, borrowing against chips. I think the math gets to be skewed against the investor that owns the stock market per se and not a portfolio of stocks.
- [01:52]
Host 1
Chris, welcome to Excess returns.
- [01:55]
Chris
Oh it's good to be with you guys. After trying to get these calendars coordinated, I think for first time we shuffled around was when I wound up with two variants of staph infection following my latest hip replacement.
- [02:10]
Host 1
Yeah, that was kind of a rough patch in there but September of last
- [02:14]
Chris
year so with a lot of moving our dates around here we are fine life.
- [02:19]
Host 1
Well in between that and this know monster of the annual letter that you were, you know, chipping away at, you
- [02:26]
Chris
were busy keeping that I'm thoroughly relieved to be finished with again.
- [02:31]
Host 2
You gave us time to read it.
- [02:34]
Chris
Yeah, it takes a while to write and it's really no easy thing to read either.
- [02:38]
Host 2
I loved it.
- [02:40]
Host 1
So so so Chris, I mean you've built a reputation as a rigorous value driven Long term investor. I think you're known in the investment community and among your peers as this type of investor. But writing these annual letters that have become, you know, almost like must reads in the circles of that, that we run, you know, among serious investors and you know, it, they often cover a very, very wide range of topics. And so what we want to do today is work through a lot of the things that you talked about in the letter talk about or Berkshire Hathaway, where we are on the macro cycle, valuations, investor behavior, and really just try to get, you know, under the surface with some of these ideas and themes that you're, you know, writing about so, you know, in so much detail. And so this isn't a substitute for, you know, reading this letter. So investors can go to your website, semperaugustis.com and they can download the latest letter. It's available for free. You don't have to register or anything like that. So, you know, encourage people to do that. I am joined by a familiar face to many that watch the podcast, Bogomil Baranowski, host of Talking Billions Advisor and long term investor in his own right. Bogomil, thank you for joining. Given your intimacy and knowledge with a lot of these topics, I'm glad we were able to do this together and do this with Chris. So it's going to be a great conversation, guys.
- [04:10]
Host 2
Very grateful. Chris and I had a chance to record at some point and we see each other in Omaha and Zurich now and then. So I got to know Chris and his work. But I'm very excited to dive into this year's Letter together today.
- [04:22]
Host 1
So, so Chris, the, the title of the letter was Both Sides now and you kind of organized it and there's a lot of themes, but it's really three different sort of sections. You have sort of a secular valuation section. You have a section on AI and infrastructure and spending going on there and then you have a section on Berkshire Hathaway. So I mean, to start, what were you trying to kind of capture and get at with that title and how did these all connect in your mind throughout?
- [04:54]
Chris
Well, I'm not, I don't think I'm smart enough to connect all the aspects of the letter to the, the title and the song that I invariably butcher up and change the, change the lyrics to kind of suit whatever, whatever I'm talking about. So I wanted to cover AI this year. And in most of my letters I've got a little bit of a standard format. I talk about our portfolio and I talk about market Valuations, of course, I've got the long Berkshire section each year, which invariably gets longer. But I've done any number of themes. Energy a few years ago, when it was very cheap and interesting, China. And so I wanted to do AI. And I'm far from an expert on AI and I. I struggled with the song. I mean, one year I. I butchered Shakespeare, and nobody even realized what I was doing, except for Liz Clayman, whose mother was a classically trained Shakespearean actress and she loved it. But. So staying in the lane, I usually usually knock off a classic rock song. I through. Through my mental archive of all the songs, I couldn't get anything to fit AI.
- [06:02]
Host 2
So
- [06:05]
Chris
Joni Mitchell wound up landing on one of my playlists last year a bunch. And I'm guessing most of your audience and just the modern investing world being younger, few would even know Joni Mitchell. I mean, she was. She has performed for years. She's still alive. She was kind of a folk singer in the 60s, and so she wrote Both Sides now. And it's a great song. She kind of goes through an evolution of how she perceived clouds, probably when she was a kid. And as you go through life and you get jaundiced, she realized that they blocked the sun and they ran on everyone. And then she essentially, through three verses, switched from clouds to love and then became jaundiced in love and then switched to life. And life happens and tragedy happens. And so if we go back 15 years, any of us, if they said, what is a cloud to you? You'd point to the sky and say, well, what are you talking about? The cloud's bad. It's the white thing in the sky. Right. And then along came Amazon with AWS and Microsoft with Azure. And so you've got the cloud, of course, and the cloud is morphing to essentially be the backbone of AI. And so it kind of fit. And so I took. I took the cloud itself and then chips. Nvidia chips. Different than semis, different than. Well, yeah, just different than semis. And then just a thing on AI and even OpenAI. So I knocked off Joni and. But it wasn't. I wasn't trying together. Trying to tie together Burkshire or anything.
- [07:48]
Host 1
That's.
- [07:48]
Chris
It was too much. But it. It kind of works throughout the letter. Yeah, I've got a couple clients that are older that one. One of whom said, Johnny Mitchell is his favorite singer and this is her sec. His second favorite song of hers. And he really was kidding, but perturbed that I destroyed one of his favorite songs in his mind because now he's going to hear my lyrics versus hers. Everybody should listen to the song. It's great song. And you'll kind of see what I was trying to do.
- [08:18]
Host 1
It's kind of like the markets though. It's like, you know, I don't know, you know, the clouds, sometimes you see this, you know, the, the sun's there, it's making things bright, it's positive. But then clouds come in the market and things kind of get, you know, uncertain or dicey and kind of like where we, to some extent, you know, what investors have been going through this year. I mean, the market came out of the gates super strong. Then, you know, we had, I guess what was like something like a 10% pullback in the S and P after this, you know, war and oil shock that we're kind of going through, that the markets have kind of recovered here. So does any, does this, I mean, you're such a long term investor, so I'm, I'm guessing I know the answer. But, you know, when we go through something like we're going through now in the markets, does it change the way you think about anything or how do
- [09:09]
Chris
you
- [09:12]
Host 1
work through periods like this as an investor and what's important in your mind?
- [09:17]
Chris
Well, if you go Back to my 2021 letter, I wrote that I thought we were at a secular peak. And that looked fairly prescient in that in 2022, the S P declined 18, the Nasdaq declined 35 or whatever it was, valuations were as high in 21 by any yardstick as they'd been at any secular peak historically. And, but then of course you had big recoveries in 23 and 24, kind of back to back 25% years on the S and P. And then last year was up whatever it was, 17 or 18%. And so your valuations had recovered two years after 2022. And then, you know, I argue that you, you're even, even a little more stretched today or at the end of 25. And so instead of sticking to 21 being a secular peak, I borrowed from Irving Fisher's kind of classics and he had a whole bunch of great lines essentially noting that in, at the little, at the very peak in 1929, that we were at a permanently high plateau. And then he stuck to that. And of course the market lost 89%. So I'm calling this a secular plateau which allows for a four year rolling window of prices being high. But for, on a day to day basis, we don't invest in the stock market. I think returns are likely muted for a US cap weighted investor owning the S and P which is so concentrated in a handful of companies. But we buy businesses and we buy businesses regardless of market cap and regardless of geography. And so the, the macro doesn't necessarily affect the way we do things. I, I will say that we're so concerned about leverage broadly and deficits that we don't like leverage and we don't allow much of it onto our corporate balance sheets that we're willing to own in an aggregate. We've got a very debt light in a lot of cases. Half our companies have net cash on the balance sheet. So we're probably even more conscientious about leverage today because of the macro in terms of how much risk we're willing to take in terms of balance sheet capitalizations.
- [11:38]
Host 1
Is there anything to be said for
- [11:41]
Chris
the
- [11:43]
Host 1
companies are more expensive but to your point about leverage, maybe they are healthier in some way. They're higher, higher quality. I'm thinking of you know, like the big tech names, the growth stocks even though you can make the argument that you know, they've now become gone from asset light to asset heavy given the investments in capex. But I'm just curious on your thoughts on sort of that because I was thinking about like the long term to your point about you know, muted returns and cap we indices. You know, a lot of times it's, it's like the bear market that brings those returns down. It's not like, you know, 10 years of like, I don't know, 5% returns per year because that's not the way that you know, equity returns are dispersed. So I'm just curious on the, I guess the quality aspect of the underlying the you know, the companies in the index and sort of how you might just reconcile that.
- [12:39]
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- [12:53]
Host 2
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- [12:55]
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- [13:22]
Chris
well you're right and particularly with the what are now hyperscalers until recently, you know who would have thought Microsoft no longer has net cash on the balance sheet. So this, this AI boom, which is most likely a capital classic capital cycle, you're starting to see some leverage there. But you get beyond the big tech and there is an enormous amount of debt on and off balance sheet, which with very low interest rates until the last few years wasn't a problem. You didn't have a lot of interest burden despite high amounts of debt on the corporate balance sheet. But take an Oracle. I mean, Oracle has no shareholder equity, at least until recently because they've spent so much money buying their shares back to offset a dilution from giving away options and RSUs, but to shrink the share count. But they did it with a ton of debt and now here they are entering the AI arms race, requiring even yet more leverage. And so you really got to take your leverage not so much when you're looking at the aggregate S and P, but company by company and. But there are places where there's an awful lot of debt both on and off balance sheet. And even with the big techs, they appear healthier than they are because you've got. We can get into some of this if you want, but I mean there's a growing amount of off balance sheet leverage as well. And we're pretty good at teasing out where the leverage is and if it's too high to service it, we generally will just pass. And we're willing to take debt. If a company makes an acquisition and they put leverage on the balance sheet, but they're more comfortable at a lower gearing rate, but they work it off over three to four years. It would be easy to tolerate leverage if you've got an accretive good deal that you just did. But we're generally pretty skeptical about the use of too much leverage. And over 35 years investing and 27 years investing at Semper Augustus, I think it keeps us out of trouble.
- [15:30]
Host 2
Chris, reading your letters every year, I know how careful you are with the words that you choose. And in this letter you chose the word plateau, not the peak. It made me pause and think, I want to know more. The reason I want to know more because I wrote a piece years ago how the market usually feels like an escalator on the way up and the elevator went going down. 20, 23 years of gains lost in three weeks. We usually don't enjoy those plateaus, including the one that you're referencing in 1929 that people wrote about. Why a plateau?
- [16:04]
Chris
Well, again, I go back to. I called it a peak in 21 and measuring where we are at year end 25. And even today you had a decline. And then on what this apparent trending toward peace and Iran. We've had a huge rally in the last few days, last, last week, week and a half where your indices are now up for the year, low single digits. But I, I had fun with Irving Fisher and, and the pl. The plateau from then. But you know, you're right. These, the, the old saw that the market can stay irrational longer than you can stay solvent. It takes time to work off secular peaks. The late 60s was pretty obvious, obviously a peak, at least to Warren Buffett in 1966 when he stopped taking money into his partnership. You had a big sell off following that 20% or so, then recovery by 69. Things were expensive again. He shut it down. You had the big decline in 73, 74 of 45%. So that whole late 60s, early 70s was a rolling secular top that wound up over 16 and a half, 17 years, going from a secular peak to a secular trough by the early 1980s. But you wouldn't have known it minute to minute that you were at a peak because you can tolerate a 20% decline. Everybody made so much money in the 50s and 60s that what's a 20% decline? But if you understood fundamental valuations as Warren did, you would have known this is most likely a tough period to be an investor. And I think similarly for a number of years, when you look at the leverage we have in our system, not just corporate leverage, but now an enormous amount of debt on the federal balance sheet, I think the math gets to be skewed against the investor that owns the stock market per se and not a portfolio of stocks which are not. You're going to have correlation to the market for sure. If the market drops 30, 40%, we're most likely going to decline. Historically, invariably we've always declined by less or we've made money in some of your big market declines in the past. We made money in 2022. We were up 1 or 2% when the market was down 18. But these things take time. I mean it's the old and I use the same line now when, as to how we deploy capital for big deposits or new clients. We don't, we don't just fully invest on day one, typically, unless institutions want to be fully invested. And so the old line from Hemingway's sun also rises. Well, Bill, how'd you go bankrupt? Well, gradually at first and then suddenly. Well, secular peaks and troughs don't happen overnight. And I'm not sure the herd identifies them as such when you're at a peak or a trough because your recent experience kind of dictates your expectations. And so in the late 90s, most investors had an expectation they'd make historically past 15 years, 20% a year. Well, no, you had, you had losses for the better part of the next 13, 14 years. And I think that's where we are today. And I'm not sure, I'm not sure there's a universal sentiment that we're that expensive. But I think again for the cap weighted investor, I think when things are
- [19:27]
Host 2
that expensive and speaking of the cap weighted, when people look at the S&P 500 and I'm thinking of a passive index investor, then they think I own 500 companies, I'm well diversified, am I not? And you point out something that I think some of us forget, that seven companies represent a third of the S&P 500. And then you mention how when you look at the share of sales, it's low teens and a quarter of profits. What's going on here? Like historically we had very few moments, I think it's been half a century when you had a handful of companies represent such a big chunk of the s and P500. And these are very peculiar companies that you devote quite a bit of attention to throughout the letter as well. What should we know, what should we pay attention to?
- [20:13]
Chris
Well, I think Mr. Market got these right. When I first ran kind of my five factor analysis a few years ago, I ran a 10 year return for the S&P from 2011 to 2111 was after the financial crisis, prices had recovered. So you weren't, you weren't cyclically depressed. I mean 0809 you were. The market was very undervalued for a period of time. Meta, Facebook didn't go public until the middle of I think 2012. And so I wanted to make sure I could look at what's now the Mag 7 and look at a 10 year series of returns. Well, they were tiny. I mean other than Microsoft and Apple which were sizable, the others were nothing. I mean again Meta had just gone public. Google wasn't big yet, Amazon wasn't big yet. And so that collection of seven businesses were something like 3% of sales and 7 or 8% of profits. Well now to your point, they're 20. I mean those seven companies make up 25% of the profits for the S&P 500. S&P profits are over 2 trillion. Yeah, 2.2 trillion. And they're core of that and they're 12 or 13% of sales. Well, the differential between sales and profits is they're twice as profitable on a net margin basis than rest. Of the 493 companies, they're trading for 35 times where the market's trading for 26 times. But they should, if you reward them for past success, they've grown faster, they're more profitable, and so they trade at a higher multiple. History shows when you get this kind of concentration and it's unprecedented today to have seven companies as big or to have the top 10 be as big. But there's no decade or period where the top 10 businesses were all the same. Top 10 businesses. A decade or two decades on, disruption happens. These happen to be historically some of the best businesses in the world. And so the question becomes what can go wrong? And I think what could go wrong? Don't know. But what could go wrong is the enormity of capital being spent now on AI, on the extension of the cloud. But as big as the businesses are, you get to a point where when growth slows or margins compression, mm returns on equity and capital compress. Mr. Market doesn't like that. And so what's trading for 35 times or 40 times may not trade at 35 or 40 times. But you don't know. I just, what, what I what. I just love large numbers. What you know is over the next 10 or 15 years, these things can't grow as fast as they have grown for the prior 10 or 15 years. I mean, you can't continue to expand margins, you can't continue to grow the top line as fast because they just get so big they're going to grow slower. And if growth slows sufficiently again or margins compress sufficiently, you tend to take it out of the multiple.
- [23:20]
Host 2
We'll come back to AI because it's a whole topic, but I want to pull on another thread that's related to this. So listening to you Magnificent Seven, the market has compensated them proportionately. And anybody listening to it might think, I'm going to go and find the next Magnificent Seven. And you point out that holding stocks forever might be harder than you think and that infinite time horizon might be trickier than we think. Can you talk about that? Because a lot of people have this idea that they'll pick the next five or seven and hold them for the rest of their life. This is a harder exercise than it seems.
- [23:53]
Chris
Yeah. To the value investing world, you listen to Warren Buffett who said his perfect ideal holding period is forever. There's also a sense that you can find hundred baggers and they're worth any price. Go back to the Nifty 50 in 1919, early 1970s. Once a compounder is known as a compounder. And you could take, you know, any number of businesses that trade at 40, 50, 60 times. Costco, which we own and love, we still own a little bit, but had traded over 60 times earnings. You can't expand the margin to the extent they did over the last, since we bought it in 1994 or 2004 at kind of a 20 multiple on understated earnings, understated returns on capital. So you've got an inability to grow the store, count the square footage of the system faster. The thing traded recently at 60 times, it's down to 50 times. I can't get my mind much around 25 times based on how fast it grows, despite it being one of the best businesses in the world. Talk recently on another podcast with Value After Hours with Jake and Toby. I mean, the beverage stocks, um, Brown Foreman traded forever at 40 times, 45 times. Diageo traded at a big multiple. And these things are nominal GDP growers. They're not going to grow much faster. There's no ability to expand margins anymore. Margins have come in, but they were always incredibly expensive. And once you get a little bit disruption and the volume of, of alcohol consumption declines, they just get eviscerated. The stocks just absolutely implode and you'll go from 40 or 50 times to 20 times. And when things really look grim, they'll trade it 10 times and you'll give up 20 years of compounding because something changes in the business. I mean, you just don't. You're not going to find a business that is just compounded for 100 years or for 50 years, they don't exist. Disruption happens. And so there's. You look at the Buffett portfolio, you look at our portfolio, you know, we are very low turnover, 15, 20% a year. But where we do move money around, it's advantageous to the overall portfolio valuation. When I buy something, I'm forcing myself generally to sell something. So I'm always trimming the most expensive corners of the portfolio to buy the cheapest corners of the portfolio. If you had simply taken the Semper portfolio at any point in our history and we just stuck with what we owned when we started the firm in the late 90s, results would have been a disaster. And if you're in a period of high debt and secularly high valuations, I think you better be a lot more active with an understanding of how valuation works and intrinsic value valuation works, to use the value investing term. And so I think, I think those kind of dispel the classic notions of how value investing works. It's a hard game. So understanding business quality, understanding management quality, understanding how to size positions in a portfolio based on how wrong you think you might be, position by position, it's a tough thing, but I don't think Buy and hold now. Buy and hold. If you owned the Mag 7 in any meaningful allocation 2011, you've had a pretty glorious experience. But I don't think but they weren't expensive. I mean Apple traded at 10x, Microsoft traded at a single digit multiple. Google, Google has traded at a at a reasonable valuation. They were all at varying points cheap. So any return series your return dictates the price you pay on the front end and generally paying high prices is inferior to paying low prices.
- [28:27]
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- [28:58]
Host 2
For the benefit of the audience and you know, reading your letter, I want to highlight how different your portfolio is from the s and P500 and from the Magnificent Seven. Right. So you mentioned 35 times earnings for the Magnificent Magnificent Seven, 25, 26 for the S and P. You fall at half that from what I know. But tell us more. And in terms of returns on capital leverage, you're looking for opportunities in different places than the average average stock of the s and P500.
- [29:27]
Chris
Well, kind of back to back to the earlier couple comments on leverage and our aversion to it. We've classically not allowed much aggregate leverage into our so so for those that that don't read our letter, every year I update our portfolio fundamentals and we use a common size, aggregating all of our holdings by the size of the investment as though they're a single business. And then we do the same thing for the S&P 500. And what you'll see over time is our portfolio generally has very little net leverage. I mean at times we've had nearly as much cash on the balance sheet as debt. And what that means is if our companies earn 19 or 20% on equity, they earn 18 plus on capital, where the S&P 500 in aggregate earn 20% on equity and equity. That's probably understated for varying reasons, which we can talk about inflation, depreciated assets, the repurchase of shares at higher and higher and higher multiples, which shrinks equity write offs and write downs. But at a stated 20% return on equity, the return on capital gets shaved way back because there's as much debt in the capital structure as there is equity and that's not our portfolio. So these things earn the S and P earns 12 or 13 on capital. Given the proportion of money that goes to repurchasing shares for an index investor. Again you're muting the equity balance in aggregate. But if, if, if your retained earnings are being spent buying back shares at high prices, then those businesses are not reinvesting at the return on equity or return on capital. Where we cotton to businesses generally that when they retain earnings have a place to reinvest in the businesses themselves or with bolt on acquisitions at good returns on equity or capital. And that's a huge difference over time. And so with portfolio activity and ongoing earning progression of the companies we own, we've generally had a portfolio that's traded between 10 and 12 or 13 times earnings, which means an earnings yield of kind of 8% to 10%. If we've assessed the earning power of the companies that we own properly, we're going to make the earnings yield. And if as value investors we've bought assets at a discount to what they're worth, we're going to make some accretion to fair value over time. The better way to look at that though is If I've got 18% of our company's profits coming to us as dividends versus a third for the S&P 500. And my businesses are really investing at mid teens, let's say on average returns on equity or high teens returns on equity, but at high teens returns on even on capital. Then I'm starting with my earnings yield of let's say eight and a half at present. But the majority of my earnings are being invested on for, for our benefit as the shareholder at a mid teens return. And so I start with what I view as kind of a control premium. I'm going to get my earnings yield, but my money is being invested at a teens return. If you own a bond, the 4% treasury and you're not living on your coupons your interest payments, you reinvest in the next 10 year Treasury. So whatever your yields average over time plus your starting yield is what you get. Well, if you're, if you're trading at 26 times earnings, you know you've got a 2 and change, you've got a, you know, 2 and change earnings yield. Well, no, you've got 4 and change earnings yield. And they're buying their stock back at high multiples and so you've got a lower earnings yield, higher multiple to earnings 26. The earnings yield is just the inverse of the PE and they're not reinvesting it at mid or high teens. And we've got some business portfolio that really don't have opportunities to reinvest. And then in those cases you either want dividends or rather if the stocks are cheap and you're generating cash that the management knows they can't reinvest. Olin is a really good case. Case in point. There's no reinvestment opportunity that business. And in the last five, six years they've taken the share count down from 165 million shares to 115 million shares and they've bought the stock in at very, very cheap prices. And so that's a great use of capital even though they can't reinvest at the stated return on equity of the business because they're not going to build any more capacity. So it's company by company. But when you roll it up with a portfolio today that's trading at 12 times earnings, up from 10 times earnings over a year ago. I mean at the end of 2024 we were 10 times earnings and we made 42% last year return, we were up, I don't know, the first two months of the year, February 20th we were up 12 or 13% and then for three weeks straight we lost money every day and I were now up 6 or 7 or 8%. But the market, which was negative when we were up 12 or 13, has made a huge recovery and it's up four or five. But I think at 12 times we've got a pretty good handle on the durability of what our companies earn. And so we use that as a baseline expectation for return. And then I think we've got upside Based on again Mr. Market doing his thing or just the long term ownership of companies that reinvested themselves at good returns. And that's then a huge advantage to have that mindset for a third of a century as an investor versus owning an index.
- [35:33]
Host 1
It seems like the market Right now related to this AI Capex spend hundreds of billions. I think in the letter you pointed out that you know, it might be like a few trillion dollars of cumulative capex by 2030. It seems like the market is giving these companies, and I'm talking these companies, you know, broadly speaking the benefit of the doubt that returns or maybe it's growth is going to come from this investment. But how would you approach assessing that, thinking about that, looking at that, do you agree with that statement that the market is giving these companies the benefit of the doubt or how are you kind of thinking about this?
- [36:18]
Chris
I'm of the mind. I think this is a classic capital cycle. Canals, railroads, automobiles, auto infrastructure, so the highway system, ultimately the fiber in telecommunications. You didn't have so much a tech bubble, you really had a communications bubble and you had a fiber bubble. In the late 90s the Internet was a thing and the backbone of the Internet was you needed, you needed the capacity to use it. All of those prior cycles had a lot of commonalities and they all involved a changing technology which was apparently an almost obvious to anybody going to change society for the better. Railroads allowed for the movement of freight much more easily. Canals did the same thing. Electricity obvious was obvious to the anybody that it was going to be a big thing. Transportation was going to be a big thing. The automobile and the Internet clear clearly what was going to be and was and is. And so society and investors got it right. And I think AI is a massive game changer for everybody, not just investors, but for any household, any individual corporations, enterprise. This is changing the way information is used and processed. It'll introduce and it already is introducing productivity. So output per hour worked hopefully if we displace labor, which these game changing technologies always did, you know, you've generally society has found a place to replace employees. It's not purely efficient and it's not as easy but, but we've not permanently put big chunks of the population out of work for decades and decades. They they you find new things to do most of the all of those prior booms and the fiber boom looks about as close to what's happening with AI as any. Huge difference though being that that anybody that had rights away so pipeline companies, Williams companies had Williams Communications, the
- [38:47]
Host 1
anybody.
- [38:49]
Chris
It was so obvious that we needed fiber in the ground that everybody did it. And most of the money though came from debt leverage from businesses that had to go raise capital in, in the current iteration. If you take the hyperscalers, Microsoft Matter, Google, Amazon and throwing Oracle into the mix which is a little bit of a hybrid and then, and then the peripheral OpenAI's and anthropics. The source of the capital is largely coming from this collection of wonderful businesses that are hugely profitable, throw off enormous amounts of, of cash flows heretofore have not used leverage on a net basis in, in, in their operations. But the dollars are so big and there's, there's so much redundancy. Again there was redundancy in all of those prior cycles. We wound up not needing the number of track miles, the 260,000 track miles. We've got 140,000 track miles today. A hundred years later we overdid it by that many. We overbuilt fiber so massively that by 1990, by 19 or 2001 or 2002, when all these companies started going out of business, we'd only lit, we were only utilizing 4 or 5% of the fiber that was in the ground. Now it ultimately got used and you couldn't have had YouTube, you couldn't have had streaming video, Netflix without it, but it wasn't used in, in the time necessary to produce a return on it. And I think with the money coming from these giant wonderful businesses that generate cash, the dollars are so large that I don't think that the margin structures of the businesses are sustainable. So if you take Capex last year for that collection of businesses, they spent on the order of $400 billion. Well, there's a debate, there was a debate throughout the year in a lot of corners that when depreciation schedules for data centers and the use of chips moved for the big four big five companies from three or four years to five or six years, there was a, the argument as to whether that was judicious made sense. What was the actual depreciable life of Nvidia's chips? I don't think that's, I don't think that's necessarily the, what's, what's important. What's important is on $400 billion of capex you're introducing depreciation expense, you're introducing maintenance Capex, you're introducing having to replace those chips. And whether it's, if you could repurpose chips not for training but for inference and the life really wasn't three or four years, but it's six or seven or eight years all in. Let's just be more conservative than the conventional depreciation schedules. And on $400 billion of capex, on a 10 year depreciation, linear depreciation, straight line depreciation that's $40 billion of depreciation that you're going to have to replace at some point depending on the depreciation schedule. Well, the revenues in aggregate, depending on who you listen to, are anywhere from 30 billion to $60 billion. The revenues against the depreciation, no profits yet. And so this year the collection of businesses are going to spend $700 billion. So the hyperscalers have gone from in 2023 spending something like 12% of their cash flow earned in operations on CapEx to where they're going to spend about 100% this year. And it happens that that crowds out the ability to buy back shares, the ability to invest in other portions of your operations outside of CapEx, the ability to increase R and D. And so now you're starting to see leverage, you're starting to see debt put into these businesses and it's not just on balance sheet debt to make these things continue to look beautiful. They're using some vehicles that, that we saw in the late 90s. But if you look at CapEx projections through 2030, they're saying $3 trillion will be spent. I mean the whole book value of the s and P500 if you earn 20% on equity profits are 2. I mean the whole book values about $11 trillion of the entire S&P500. And we're going to spend $3 trillion in a four or five year period of time now on $3 trillion at a 10% depreciation schedule. That's $300 billion of depreciation expense which really is presumably maintenance capex. Now maybe once the capital's in the ground, these things become more cap light than is currently believed by some. And it's not quite, it's not quite 300 billion because in your first year's capex you're depreciating 10% of that asset each year. And so two years in you've depreciated 20%, three years in 30%. So it's not quite 300 billion. But by reference if you're going to earn 20% returns on equity and on capital because at the moment they're kind of not net lever but that's trending. If you're going to earn 20% on 3 trillion of CapEx, you need $600 billion of profit, of profit which is going to require $3 trillion of revenue. I mean Microsoft's revenues are $300 billion. Each of the hyperscalers generate over a hundred billion dollars in cash flow from operations. They're all about $150 billion. Meta's a little bit less, Oracle's way smaller, different animal. But we're talking about if we're going to maintain returns on capital and we're going to invest $3 trillion, this is incremental capital. So the business, the businesses have to sustain the returns from their already current operations and they're essentially investing so much money you're doubling the size of your infrastructure and you've not only going to make returns on the old assets, but you've got to make returns on the new assets. And right now the revenues are not there. And the revenues that are there in many cases are coming from each other, making capital investments in each other, lending each other money, borrowing against chips. I'm very much in the camp that the technology is massively game changing for everybody. I'm not sure. Just like with every capital cycle in the past, those that spent the money up front are not the ones that benefited and that made money. These guys can do it because they're not going bankrupt anytime soon because they're already so profitable in the different corners of their operations. But I think the risk to the capital headed investor in the stock market and the risk to investors in the hyperscalers is capital being capital. I mean this is real money. And there's a redundancy of supply. I believe there's a redundancy of supply and they will compete on price. They've all said we probably shouldn't all be spending this much Money, we don't need five LLMs. But they're all terrified of being left out and losing your competitive position against your competitors. But in reality there's a, there's a case to be made. I don't know, I'm not smart enough in this space. There's a case to be made that you've got the same redundancy in, in data centers and in chips that we had in fiber that we had in railroads. And if that's the case and they compete on price and the revenues don't evolve in such dramatic fashion that the profits will inure to justify returns on capital, or if you get to returns on capital, then you get margin compression, you get slowing revenue growth. And when you get margin compression on things that trade at 35 times earnings, kind of. Back to the earlier comments. Mr. Market gets involved and hammers down the valuations. And so where you've got a third of capital in seven companies, I think there's a, I think there's a big risk and this could be the catalyst to, for whatever reason why these seven won't be the same seven 10 years or 20 years from now. I think they could fall on this AI thing. Now streaming Disney plus invites you to go behind the scenes with Taylor Swift in an exclusive six episode docu series.
- [47:44]
Host 2
I wanted to give something to the fans that they didn't expect.
- [47:47]
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- [47:49]
Chris
the book the end of an era and don't miss Taylor Swift. The Eras Tour the final show featuring for the first time The Tortured Poets
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- [48:02]
Chris
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- [48:22]
Host 2
So. So what hits me listening to you, is this an existential crisis because we're talking about companies that not long ago had so much cash, they were generating so much cash. They had even activists put pressure on them to do something with that cash. Do buybacks, special dividends, anything. Give. Give the money back. Because you guys ran out of ideas what to do with that money. It's the same companies that today have this pile of massive capex going into places that clearly is not showing immediate returns or profits. Is it an existential crisis for them that they have to be a part of it to remain relevant and related to that? I think you're pointing in that with every innovation it's very hard to figure out who's going to capture the value because there's definitely a huge value in all of us having AI in our pockets on a personal level, on a business level, I think it's creating huge opportunities. I know particular case studies where people close deals and have meaningful clients on board because of how quickly they were able to present something with AI's help. I know that. So for them they spend $10, they brought in $100,000 client. The returns are out of this world for them, but not for the companies that are spending those trillions. Is it an existential crisis?
- [49:35]
Chris
Could be. I don't. I think it could be. I think, I think it's an existential crisis because I don't think there's any way. Are you not going to harm your margins?
- [49:46]
Host 2
Yeah.
- [49:47]
Chris
And I, I just can't see a Runway to the hundreds of billions and ultimately the trillions of new incremental revenues that are required to support the capex that's being spent. Again, Google is determined to win this thing and they're so profitable and supported by their advertising platforms that they can outspend everybody. I mean, OpenAI is hat in hand doing funding round after funding round to be able to spend the $1.4 trillion that Sam, a Sam Altman insists that he's going to spend. Microsoft was an investor in the couple of the early funding rounds. They're in for $13 billion or whatever. And if OpenAI doesn't make it to the finish line, Microsoft owns their ip. So they're, they're, they've all done things to position themselves to, to win. I just, at the moment the revenues are not there. The enterprise users, if you're a freight forwarding company, if you're a logistics business, you're using this and you're paying, you're paying anthropic for Claude and you're benefiting from it. Now that's back to the capital cycle in each industry that is an early adopter and then an adopter, the early adopter is going to wind up having an advantage on productivity and profitability. But ultimately, what I've seen over all these years and study history is once everybody adopts it, industries compete on a return on capital, unless you're an oligopoly or a monopoly. And so once everybody adopts it, the, the, the, the benefit kind of goes away to the early adopter and you're back to competing on margins relative to the capital invested in each of these businesses. And when you've got five, when you've got $3 trillion and you've built five or seven of these things, they're going to compete on price because they want the logistics customer paying them. I mean, we as individual users are going to wind up paying a lot more than free or the token amounts that you're being charged for the use. But the $3 trillion, $700 billion in a single year is such a vast amount of money. I don't think many appreciate the magnitude of those dollars and how difficult it's going to wind up being to generate sufficient returns on the capital spend. So I, Is it an existential crisis? Tbd? We'll see. I mean, it's going to be fascinating to see. We just, but we've got companies in the portfolio that benefit from it. We own some Cummins, which I haven't bought in a while. The stock's just gone straight up. But there's a constraint on the ability to build data centers fast enough and so turbines, ges, which we don't own, with the exception of some legacy accounts that have low basis Shares, we're waiting for a basis step up. I mean, the turbine business is, is four years behind. I mean, the, they, they can't, they can't keep up production fast enough to keep up with demand. So this is fascinating. It's, it's an absolute arms race. This is a gold rush. It's a fiber boom. And you're going to have winners and losers. And I don't think you would have predicted who the winners were in 1999. Much like I'm not sure, you know, who's going to win this thing today, except that some of these guys have. The resources are so vast they can't kill themselves. And even if the stocks decline. Right. If you're still rebuying shares and Microsoft gets cut in half.
- [53:40]
Host 2
Yeah.
- [53:41]
Chris
And they're spending some portion of cash from operations buying the stock, that's actually a benefit to the shareholder. So it's not. It's not. It's. I don't know. No, I was going to say something about the too hard pile. I don't know if it's too hard. P. I don't have any clarity. What's interesting about it is I don't think that many people knew what was going on in 99 or 2000. In the investing world, the stock market had done so well for the prior 16, 17 years that everybody just simply dismissed the NASDAQ bubble, the NASDAQ going from a thousand to five thousand, and they just presumed that party would continue. And there was not a lot of debate over whether fiber made sense and whether it was going to get used. Everybody's had this conversation. That was my. That was what. That was the pause in trying to tackle AI in the letter. I'm not the world's authority on AI I'm simply observing this thing as a, as a investor from the sidelines, trying to figure out what might happen. And I have the luxury of not owning on a cap weighted basis, the Mag 7 or I have the luxury of not owning them at all. And that's okay. I've got plenty of things to do with money where we've made pretty good returns over time, not having to play the momentum game with everybody else.
- [55:04]
Host 1
Speaking of the too hard pile, you spent considerable time in the letter writing about Berkshire Hathaway, doing your intrinsic value estimate on Berkshire. And I think the company has, you know, roughly $370 billion in cash and it's been a net seller of stock over the past few years. I was just thinking, you know, like Apple, one of the greatest trades, maybe Ever on a dollar basis. You know, that is the one company that maybe of these large tech companies that isn't going nuts with this capital expenditure, which I think Buffett would have liked. But anyway, so but I'm more wondering, like, what do you think the that level of cash at Berkshire? What does it signal to you? What does it kind of tell you about the market and what the way he's. Even though he's not CEO anymore, Greg Abel is. But you know, just in general, that cash balance.
- [55:59]
Chris
If you go back to the genre deal in 98, when, when Berkshire kind of diversified its stock market holdings in its Coca Cola and essentially cut the stock portfolio in half without selling anything and paying capital gains taxes, Berkshire's cash as a percentage of firm assets has averaged 13 or 14%. It's double that today. It's 25 or 26%, whatever it is, 372 or whatever billion. The cash is largely there as a byproduct of the Apple sales. Warren acknowledged that by not selling Coca Cola, he had made a mistake in the earlier iteration. If you go back to when Berkshire bought Coke, when Warren bought Coke after the stock market crash in 1987, accumulated most of his position in 1988 and 89. He bought a little bit a couple years later, rounded it up when the stock actually got back to traded back down to split, adjusted, whatever, four bucks a share. But he ultimately got $1.3 billion invested. And in the first 10 years, nine and a half or 10 years going into 98 Coca Cola, the stock compounded at 36% a year or something like that, revenues were growing at 9% a year. They took the margin from 12% to something like 19%. And Warren paid 15 times earnings for it. And I'm not sure he would have known that the margins were going to go up that much. And he certainly would not have known that the multiple was going to go from 15x to 58x. And so Coke was a 17, $18 billion position on a cost basis of 1.3 billion. It was a way bigger and better investment relative to the size of Berkshire at the time than Apple, even though the Apple was a home run as well. And so the corporate tax rate was 35% then, which would have applied to capital gains versus 21% today. And so against a cost basis, that was almost nothing. I get not wanting to send 35% of the majority of your position to the government. So he buys Jenry uses Berkshire stock as currency, trading at almost three times book when it was worth Half that. Jenry brings 45% of the combined assets to the merger, excluding the goodwill that was paid, which was the majority of the purchase price. And like I say, you bring in that giant bond portfolio and you cut Coke from 30% of firm assets down to 14% of firm assets in the ensuing 27 and a half, 28 years. Now, Coca Cola has compounded at 4.5% a year. Sales no longer grew at 9, they grew at 3, 3 and a half. Margins didn't continue to balloon highward. Higher. And you had to bring the multiple back from 58x to a more pedestrian mid-20s multiple. And so that market cap of Berkshire's position On its original $1.3 billion, he's never sold a share. Berkshire's never sold a share. It's now a $28 billion holding. That's compounding it at four and a half percent. And two thirds of your four and a half percent came from the dividend. They're paying out two thirds of what they make because Coke does not have a massive ability to reinvest in the business. They have bought a whole bunch of stock back. But even with the reduction in the share count as one of the ways you make money in stocks, it's four and a half percent, it should have been sold. So, vowing to not repeat the same mistake, I think the economics of Apple are not dissimilar from the economics of where Coca Cola was. Warren bought it at 10 times earnings and he's been selling it at 35 times earnings. And it's a business that I don't think can grow its top line much more than 6 or 7%. And I don't think it's got a, an ability to expand its margins much above the current level. And so at that level of growth, with an inability to expand your margins much, you don't pay 35 times earnings for those. And with the tax rate, the corporate tax rate now at 21%, you sell it down. So still Berkshire's largest holding, but he's taken 100 plus billion off the table. And that now sits in cash. Of the $372 billion of cash, 100, roughly a hundred is required as insurance reserves to support the underwriting operations. But there's over $100 billion of cash that has been taken out of the insurance operation because they don't need it to write at Geico. You don't need it to write in the primary business, you don't need it to write in reinsurance. And in fact, in a lot of those insurance lines that Berkshire has. There's so much competing capital and you're so late in the economic cycle that Berkshire is writing and they're going to write materially less business in reinsurance. They're going to write way less business than some of their primary lines. And so in the last two years they've dividended almost $100 billion up to the parent company. Two years ago they sent 65, let's call it billion and last year they sent $30 billion. So Greg needs to invest $300 billion at some point, 100, you know, we'll call it 270 of the current and then an ongoing, call it $40 billion that Berkshire earns in its various operations that comes into Omaha for reinvestment. And so I, I think Greg will do the right thing and lean in. I just started buying the stock back at a price that I think made sense. It was essentially at a valuation level. When Warren stopped buying it two years ago, we were buying at the same prices. I was buying B shares at 460 in August. We've been buying them in the last few weeks. We started buying them for clients that didn't own enough. Berkshire at the point where Greg announced that he was started buying so he can do it earnestly with sheer repurchases. When Berkshire's cheap enough, maybe you get an 800 pound gorilla, maybe you get an elephant that crosses your path and they can buy an entire business. But there's an opportunity in the stock market which in Berkshire's universe, it's a much limited universe because when you're trying to put $300 billion to work, there aren't that many things you can buy. But there are, there are of the top 100, 150 companies in our stock market and a few companies abroad that are big enough where you could get a whole bunch of money put in at. But you've got to do it at great valuations. And so it's going to take a recession or a financial crisis of some sort or another Covid whatever comes along that just makes assets across the board cheap. That cash will get whittled down to where you know, at a hundred billion dollars you're, you're, you're less than 10% of Berkshire's current assets. So if he takes the cash down to 12% of firm assets and firm assets are over $1.2 trillion, you do the math. I mean, he can spend a couple hundred billion dollars and just do it the right way. If he proves incapable of doing it or if enough time passes that they can't do it, then you either want cherry purchases even at an increasingly marginally higher valuation. The last thing I want is a regular dividend. I would take a special dividend. But we own Berkshire in our taxable accounts. And I don't want to pay dividend taxes on my investment. I mean my shares that I own in my taxable accounts. I'm banking on the government not changing the tax code and I'm banking on getting a cost basis step up at my death. And I'm banking on never paying a dime of tax because they don't pay me a dividend. But they've got to be able to reinvest at some hurdle rate, which is probably still 10. They can do it in the US stock market. Greg can do it. He can't do it today on the US Stock market, but he'll be able to do it in the US Stock market. And if this whole thing with AI evolves and you do get margin compression and decline in returns on capital, Mr. Market does his thing. This may be the catalyst for the next big stock market decline for the cap weighted US investor. And so it was a long winded answer as to Berkshire's cash. But I'm very confident that Greg will do more with it than Warren did. Warren said he screwed up 0809. I mean they bought, they got five and three billion dollars invested in GE and Coke. They did some of the Dow preferreds, few other things. They later did the bank of America preferreds warrants. But if you look at what Berkshire did in the stock market, they didn't do anything in the stock market. They were a little bit of a net buyer I think in 2007 when things started to get cheap in the fall. But then there was not much done and Warren said he really screwed it up because he should have, should have leaned in way more and done way more in U.S. stocks. And everything I've seen about Greg is he, he, he understands that and I think he'll do it. But we'll, but we'll see. Tbd.
- [64:58]
Host 2
I'm, I'm very excited to see where he takes it and what he does with the cash and what if, what kind of opportunities they'll find along the way. I have a question about something you mentioned in the letter that has lost less to do directly with investing. It's a more personal story that you bring up. You know, Charlie Munger had this anecdote that if life was all about buying securities, putting them in a safe, waiting for Them for it to appreciate it wouldn't be enough of a life. Something along those lines. You bring up our mutual friend, Guy Spier, and I'm curious about the fragility of life that you bring up in the letter. You know, we're investing, we have a certain discipline, and then there's a certain wake up call. You mentioned I have a friend who's retiring. Can you bring that up? You mentioned it in the letter, and I feel like it belongs in this conversation, too.
- [65:41]
Chris
Yeah. The guy's situation breaks my heart. He's got a pretty aggressive cancer. He just sent me a really beautiful kind of a video note. We're gonna see him in Omaha. He is gonna host his event. But he made the decision for those that don't know Guy or of his current situation. He said, look, I've. I'm fighting this cancer that's come back. Loves what he does for a living. Wouldn't in a million years, I think, have ever contemplated walking away from it. But he's got to take care of his health, and he's got to spend the time requisite with his family. So he made a decision to close his firm. That's br. I mean, that's just brutal. That takes your breath away. My working assumption, knock wood, is I'll do what I do. We're never going to sell a simper that. In a perfect world, I can go out like as Charlie did 34 days shy of his 100th birthday in a pine box. Or I get to the point where I'm 95 and it's difficult to read. And so you decide to retire as Warren did last year. I mean, I just had our folks start sending me a lot more paper copies of annual reports. I find myself reading too much digitally on the iPad, on my screens, here at the desktop, and even on my phone and kind of terrified of, you know, I having played football for a lot of years, kind of abused the body. I hope I get a long run. But there is a fragility to life. And as every year we get older, I'm 57 years old. I like to think when we bought Berkshire for the first time in 2000, Warren was 69 years old. I mean, I've got 12 years to go till I'm the age that Warren was when we bought Berkshire more than a quarter century ago. So. But you. But that's not how life works. I mean, that goes back to the letter. I mean, you look at clouds one way, and I don't look at clouds the same way. Joni. Didn't look at love the same way or life the same way. There is a fragility to it. It's just life being life.
- [67:51]
Host 2
Yeah.
- [67:52]
Chris
And you, you just don't want to be at the end of it and have any regrets that you could have done something different with your family. So it's tough, it's tough to see something like that because you're taking, you're taking the joy away from somebody who absolutely loved going to the office all day and working on behalf of his clients.
- [68:16]
Host 1
Well, we certainly wish him the best. And yeah. Chris. We like to ask our guests all one standard closing question, and the one for you is based on your experience in the markets, what's the one lesson you would teach the average investor?
- [68:35]
Chris
I would say this will be probably more than one thing. I would say read everything. That's the advice you got from Warren and Charlie. And it's absolutely true. We just read everything you can. But, but, but when you process information, whether it comes from your reading or from an AI query, confirm, investigate, treat anything that you read or that you hear with skepticism, that's probably the, the one unhealthy aspect of being an investor is you learn that everybody's trying to tell you something to their benefit and they'll sugarcoat listening to earnings calls that are just Pollyanna to an extreme. Do your own work, read the footnotes, understand what you're. Understand. But what you're reading would probably be that, probably be, Be a contrarian, but not to a fault. I mean, there, there are times to invest with the masses in the herd, but there are times to step back. And I could be totally wrong on the, on the risks and what I think may evolve with this whole AI capital cycle. I could be totally wrong, but I'm going to come to my own conclusions by, by not spending. I'm, I'm going to spend sufficient time, I'm to understand it. Anytime we buy a business, you've got to have done an enormous amount of homework. And it's cumulative. And so the reading winds up being cumulative. The learning we all get from our experiences and the successes that you have, and even perhaps more importantly, the failures that you have, learn from those. But I think it's not only read all the time, but learn how to process what you're reading and be able to think for yourself and which makes the whole AI thing even that much more interesting because it's making us all more efficient. But you don't want to make yourself so efficient that you don't learn that you don't accumulate the ability to think for yourself and to have judgment. So advice would be learn how to incorporate judgment into your thinking. That was probably. That was way more than one thing.
- [70:56]
Host 1
That's awesome. Thank you very much, Chris. We really enjoyed this discussion. Appreciate it.
- [71:00]
Chris
Well, thanks for having me on. Good. Good to talk to you guys and see you in less than two weeks now. Yeah.
- [71:08]
Host 2
Thank you.
- [71:08]
Host 1
Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@xcessreturnspod.com if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on this podcast
- [71:28]
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should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.