Whilst I’m a long-time avid follower of all of the Investment Masters, and I have to say a veritable devourer of their collected wisdom, there is nothing more valuable to me as an investor than actually speaking with these amazing people. Whether it’s a meeting at Berkshire, the odd telephone dialogue or even an interview, all of these interactions deepen my understanding of their unique views on financial and business matters and for that matter, the investment world.
Recently I had a wonderful opportunity to Interview Chris Bloomstran of Semper Augustus. Chris is a veteran of the Investment Fraternity and a recognised Master; The stocks in his portfolio have compounded at 4.7% above the S&P 500 since launching Semper Augustus more than 20 years ago. I’ve always valued what he has to say and our interview was no exception.
We covered many topics in the few hours in which we spoke, and I am incredibly grateful to Chris for being so open in sharing his knowledge and experience. I have collected the gems from our interview below.
Eclectic Value Investor
“For lack of a better nomenclature you’d put us into the value camp. Value is such a broad brush definition. We simply think of growth as part of the value equation. Growth is important. We are pretty eclectic in our process. We own compounders and we also own some out of favor, high-quality cyclicals; we’ll do the long side of merger-arb here and there. You can’t put us in a style box and I think that’s a big advantage.”
Dual Margin of Safety
“We are trying to find outstanding businesses at low prices to give us a dual margin of safety.”
Investment Time Horizon
“Having invested for 20 years at Semper Augustus and run money for thirty years, our process is very eclectic. We have businesses, such as Berkshire Hathaway, that we’ve owned since early 2000. For the duration of our owning it its been undervalued and it’s become an outsized position in a lot of our accounts. We’ve only sold it when mandate or need for diversification compels a sale. We’ve owned Mercury General and Washington Federal even longer, for the better part of twenty years, and have a history trimming companies like this when they’re rich and adding to the positions when they are cheap. We’ve owned things cyclically where we don’t have a long term horizon such as deep water drilling businesses. Today we own Subsea 7. It’s an engineering and construction company in Norway. We’ve also done things very opportunistically.”
“In 2008 we built a big position in the electrical utility Constellation Energy when it was to be acquired by Berkshire Hathaway. Although we ordinarily don’t like electrical utilities because of mediocre regulated returns, no pricing power and limited growth, we know how to price them. Generally they trade rich because investors are attracted to the dividend yield, which usually consists of most of profits. To us, Constellation was an attractive arbitrage opportunity and we traded the position actively as news broke again and again.
Berkshire offered to buy the business for $26.50 to keep Constellation out of bankruptcy. To effect the deal, Berkshire had to put in a billion dollars to shore up the derivative book of a merchant business Constellation owned in Texas. We had a bit of cash and the market volatility meant an attractive deal spread. EDF, who had a JV with Constellation to develop nuclear plants, ultimately made a counteroffer at $37 and Constellation accepted. As EDF was more of an unknown in the middle of the financial crisis, Constellation’s stock price tanked when Berkshire announced they were out. The stock dropped from $24 to $21 to $19 to $17 then $15 and we bought it at every one of those points except the last, when our final limit didn’t fill. It all happened fast. By the end of 2008 it was our second largest holding. We stayed in it until near the close, actually EDF bought the nuclear assets and the utility was ultimately sold to Exelon in Chicago. We exited in the mid $30’s.”
“The businesses at the top of my portfolio are not necessarily going to be the ones that perform the best over the long term but are the ones I know will perform. Generally we’ll start with a 1% or 2% position size. Then as we continue doing our homework, absent some underlying business deterioration, we prefer stock prices to decline which gives us a chance to add to the position size.”
Dealing With Market Turmoil
“Being in the investment business for thirty years and knowing the businesses we own so well, is the best edge to deal with market turmoil. Because we have an anchor in the appraisals of the businesses we own and follow and we’ve done our homework - made accounting adjustments, drilled down to economic earning power and management quality - we don’t have to do a lot of work when price gives us an opportunity. For that reason, we are very non-emotional in times of stress.”
High Quality Companies
“Sustainable returns on equity aligned with very high quality management teams running the businesses is how we define high quality companies. It’s taken a very long time for us to get to that. Leverage is anathema to our thinking. We are running a very unlevered portfolio in terms of the collective balance sheets of the assets we own. Cash largely offsets debt now. Our returns on capital are not far off the underlying returns on equity of the businesses.”
“We don’t run DCF’s. We think long and hard about the inputs [of a DCF] but we think the model lends itself to assumptions where you can get some crazy results.”
“We’ve bought and still buy Berkshire at 15-20% position size, and it’s grown to 35% in some of our taxable accounts. BRK is unique to us and it’s the only business we would concentrate in that kind of size. We almost use BRK as a bond surrogate, really as our opportunity cost of capital, given a very predictable 10% ROE, which in a worst case could be an 8% ROE. To us, it’s a highly predictable, highly knowable business so for that we are willing to own BRK as a lower return business relative to the balance of the portfolio. It’s the most knowable thing we own. At a 10% unlevered ROE its undervalued by a lot, and if it trades closer to intrinsic we’ll earn something north of 10. If it earns 8 (ROE) for the next 10 or 15 years it’s fairly valued and we’ll likely earn 8.”
Company Issues Provide Opportunity
“Usually company specific issues provide opportunities. My experience has been that when the whole market sells off and everything gets cheap, it’s hard to want to make changes because we already like what we own. We’ve also proven unwilling to trade down the quality spectrum during a rout like ‘08, even though you’re going to make way more during the recovery. That won’t change.”
“We’ve had on average about 15% turnover for the last 20 years. Our turnover in 2008 was probably 70%. We had about half of our capital in financials at the end of 2007 which included insurers. None of our holdings failed. In fact, some were rewarded for their conservatism with failed assets more or less given to them at fire sale prices.”
Thinking About Management
“We have learned to think a lot more and spend a lot more time assessing management quality. We are spending a lot more time in the proxy statement than we used to. In our portfolio we only have about 20% of our businesses profits coming back to us in dividends which means management teams are retaining 80% of the profits. It is incumbent on us to work out how those people allocate capital. There are so many levers management can pull and we are very deliberate in assessing how well capital gets invested in the businesses we own.”
The Proxy Statement
“We are spending more time with proxy statements. We try and tie in year to year changes. What we’ve learned by looking at the evolution of proxies over a period of ten or more years, by observing how compensation committees award and incentivise management, is that you can really ferret out underlying changes in the business.
As an example, General Mills’ bonus structure is tied to two yardsticks, none of which are capital related. One is organic sales growth and the other is free cash flow growth. Ten years ago they were using 3-4% organic sales growth as the hurdle for paying half the bonus. Over time that became 3%, then 2%, then 1.4% and in the last couple of years the hurdle has become negative. Think about that! Rev up the acquisition machine. Buy Blue Buffalo. You don’t count a deal in year one but if its a growing business you sure get your organic growth in the out years, regardless of profitability.
Many consumer packaged goods businesses are under-investing in their business and it’s evident in the free cash flow. It’s pretty easy to dial up free cash flow growth by cutting advertising and growth initiatives. I guarantee these people lay awake at night thinking about how to get supremely wealthy in the next five years and not how they are going to grow or protect the business over the next thirty years. If you don’t have a motivation to make decisions based on returns on assets or capital or equity you can get all kinds of nutso behavior. You might as well take a giant pile of money and light it on fire.”
“I wish we didn’t have to think about macro. We spend almost all of our time turning over rocks and looking at businesses, but, in my investing lifetime, we’ve seen aggregate debt levels systemically rise to levels we think are unsustainable. And that does enter our thinking. With on-balance sheet debt alone now at 350% of US GDP and 320% of global GDP, we don’t have room for a term structure of interest rates even remotely similar to where it was prior to the financial crisis. The days of 5-7% interest rates don’t work when debt is 350% of GDP.
The notion that debt levels are unsustainable and we are unlikely to grow our way out of what we think is excess leverage, lends to our thinking that interest rates will probably stay far lower for far longer than would be the case in a more normal, unlevered society. For that, you do allow for higher multiples somewhat than would have been the case historically. By contrast, we also think because the debt numbers are unsustainable we very much worry about long term stability in the financial system. The flip side of low rates driving higher multiples is that low rates are reflective of too much debt which goes hand in hand with disallowing growth. Therefore you can’t justify multiples that purely reflect low rates. Paying high prices for no growth won’t work out. Look at Japan for the past 30 years. We have small positions in two gold companies which are really just hedges against central banks doing bad things. Combined they are a mid to high single digit exposure.”
Anchoring - Mistakes of Commission
“Our single biggest error of commission was Ross Stores. We bought the position when small caps were cheap in 2000 for less than 10x earnings and 50% of sales. We loved the business and we loved the unit economics. We bought it as such a discount that during the 2000-2002 downturn which saw the S&P fall 50% we made about two and a half times our money over that period. When it traded for something like 20x we thought we could sell it at what looked like a full valuation and ease back into the shares at some point when valuations were a lot more attractive. I was probably anchored to having bought the stock at 10x earnings. It never traded at 10x again. It traded in the mid teens. After we sold the stock, it went on to be another twenty bagger. A gravely expensive mistake.”
Costco & Growth
“I learnt a lot about the growth component of the value equation by watching Ross Stores. A couple of years after we sold Ross we bought Costco, which has provided an invaluable education about how capital really works. Costco is the same deal as Ross Stores. We love the unit economics, we love the management. Costco had a similar number of stores to Ross when we first bought it. They’d just started paying a dividend. We bought Costco when their gross margin was about 14% and they were earning 11% on capital. We understood, having followed high quality businesses like Walgreens, Walmart and Home Depot for a lot of years, the embedded unit economics of Costco where lots of stores that have been opened recently and don’t reach maturity for six or seven years. Therefore the 11% return on capital was very much understated by the relative installed base compared to new stores that had been opened.
I paid 20x earnings. I was still a classic value guy and value guys don’t pay 20x for things. Fast forward today and Costco trades for over 30x, so you’ve made over 50% on the multiple expansion, but we’ve made over 10x our money on Costco because they’ve grown the store base profitably.
The gross margin has been driven down by from 14% to 11%. Wall Street typically kills a company for shaving gross margin, however Costco has taken the scale and purchasing power of the business and they’ve passed their cost savings through to their customers. Returns on capital have gravitated upward towards to the high teens or higher if you account for the cut in tax rates [Costco will likely be one of the first companies to compete away the tax cuts]. Our returns over owning the business for a long time have gravitated toward the underlying return on capital of the business.”
Most Valuable Lesson
“I look at the amount of money we made on Costco and we could have paid 35-40x earnings at the time. Everything they do as a retailer is best in class. You just can’t get anchored to classic valuation pricing methods even if you call yourself a value investor. This is probably the most valuable thing I’ve learned. The extension of that is, if you own a business that really is a true genuine compounder where you have a ramp to grow and particularly for re-investment at high rates of return, don’t sell it, and definitely don’t sell it all. I get cute with a lot of other things that aren’t your classic compounders but any time I’ve sold shares in one of the handful of businesses that I think we can own forever it has proven to be a mistake. ”
When Compounders Mature
“The durability of compounders is really only obvious in arrears. There are very few that are knowable. The risk is when you own a compounder and it matures and starts to face its own competition. Walmart for example, having killed retailers in small towns started facing competition. First from Costco and the like and then internet retailing. Look at Coke for the last 20 years. The core business weakened at the same time it traded for a nosebleed valuation that was awarded because of a glorious past.”
“A great business at the wrong price can be a disaster.”
Long Term Focus
“We have stocks that have some common threads. They have all suffered in one form or another. We’ve been able to look through the short term suffering which is just that, it’s short term. Richemont is a great example. We’ve owned it for a handful of years. Richemont owns Cartier and Van Cleef & Arpels in jewelry. They have ten or so very high end watch brands including Vacheron Constantin, IWC and Jaeger-LeCoultre. Then they own some one-off brands like Peter Millar and Purdey shotguns. The Ruperts, the family that founded the firm had South African tobacco holdings which they sold to BAT probably 30 years ago. Within a holding company structure, they started buying up luxury brands. They’ve done a marvellous job preserving the brands and building them out and growing them intelligently.
Richemont’s watch business, when you count watches sold by Cartier, comprise about half the revenue, experienced a huge growth curve on the back of Asian demand. Richemont grew their distribution by using the store inside a store concept. Retail outlets were located in the best zip codes in Hong Kong, Macau and the rest of the high end world. A few years ago two things happened - the Chinese cracked down on graft and travel visas which really put a dent in high-end watch sales. It gave us the opportunity to buy the stock.
We watched how the CEO, Mr Johann Rupert and the management thought about the long-term viability of the brands they own. Mr Rupert talks about being a temporary steward of Vacheron which was founded in 1855. When sales declined, management recognised an excess of inventory in the retail partner channel. The first thing retailers do when sales slow and they have excess inventory is mark it down. The last thing you want to see happen if your customer just paid $20,000 for a watch is to see it sell six months later on on the grey market for $15,000. Richemont approached their retail partners and bought back a whole bunch of inventory and in some cases physically melted down the precious metal content of the watches.
Richemont is a 65% gross margin manufacturer. Initially I presumed the value of a $20,000 or $200,000 watch was largely in the precious metal or jewel content. Far from it. The higher up the price point, the higher the gross margin. On a $200,000 watch the gross margin can be ninety percent plus. It’s the brand. So to preserve brand they destroyed watches.
They also didn’t want to be in a situation where retail partners could kill the brands so they built out more of their own distribution. They spent a lot of money building out their own bricks and mortar. They sacrificed operating margins for the durability of the brand. The watch business is a good business but will likely only grow 4-6% organically, above nominal GDP, but it’s the fashion jewellery business where the upside lies. Fashion jewellery is very early, it’s maybe 10% of all the jewellery sold and there is a long curve to teach wealthy families about the appeal of high end jewellery lines. Once you’re into a line you’re kind of hooked on it. They’ve now fully bought into the internet. Control of distribution is a common theme across several names in our portfolio.”
Disruption & Change
“Disruption is happening at a much faster pace which makes investing that much harder. What looked to be a durable brand or franchise can get dislocated in a hurry. Things like cutting out wholesalers and middlemen and going direct to consumers, I think we are in the early innings of it.”
“If you get fundamental change on a compounder and you bought it at a high price, the combination of the fundamentals deteriorating and then the multiple revaluation downward can be lethal.”
“There are reasons we will stop the investment process. We start with either unknowability of industries or industries we don’t like because the economics don’t work for us. They would be the easiest decisions (e.g. Electric utilities without growth and the complexity of pharmaceuticals).
When I think back to the branded pharma companies we’ve owned, despite making a bunch of money, we really didn’t know what we were doing. It’s the unknowability. We’re not scientists and I’m not sure the scientists inside those companies know what’s going to go through the FDA or the EMEA. We don’t have an edge. Being lucky is not a replacement for understanding.”
“Once we get past knowability, it’s onto the blocking and tackling which is the business fundamentals, management quality and how they’re compensated, price & volume, the durability of product lines and all the myriad accounting adjustments we make.
If we have an edge it’s adjusting every business’ GAAP numbers. Most businesses overstate what they earn. We are very good at getting to economic earnings from GAAP or IFRS which is just the starting point.”
Waiting for Price
“We’ve built a working list over the years of c450 companies that we track peripherally. We try and update our thinking on them through the course of the year. We maintain a rough intrinsic value target. When we get a stock trading south of that number we might get interested. It’s a function of sitting around and waiting for price. In the meantime thinking about where you are wrong on the valuation or the fundamentals. Price is then kind of the last thing we look at. When we have done work for 20 years on a business and the price now makes sense it’s very easy for us to put 1-2% to work. To the extent we’ll have to do more work we’ll do it. If we get comfortable we’ll make the position size even larger.”
Circle of Competence
“I would tell my younger self, ‘your circle of competence is way more narrow than you think it is’.”
Independence of Thought
“From a psychological perspective, you need independence of thought, but not to a fault. You need an understanding that the crowd at the extremes is wrong, but for a long time they can be right.”
“Client expectations are never aligned. Clients expect results and if you’re not racing ahead when markets are, nobody likes to get richer slower. We spend a fair amount of time with process over the years, and telling the same story. It still doesn’t make it any easier. Human nature doesn’t make it any easier. Most people wrongly view the stock market as a casino, and it’s not. It’s a joy and refreshing to find clients who get it, who think about the long term, that are realistic about expected returns and think about what can go wrong and right. It makes way more sense to focus on long-term business performance and not short-term stock price performance, but that’s really hard for most people. It’s easy to see the stock price. You have to work to understand the business.”
Free Cash Flow
“We’re looking for businesses that have an opportunity to invest and build out capacity. We are looking for retail concepts that can grow units over time on an accretive basis and expand returns on capital. Can I build a plant or distribution facility and earn high returns on the investment? Free cash flow in that setting is a terrible concept. It’s a great yardstick if you are in a business that is mature and isn’t going to grow. There are all kinds of flaws with various pricing metrics. It would be easier if maintenance capex was a disclosed number. It’s not. So you’ve got to talk to management and get a sense of what it really takes to replace your capital stock.”
Listen to Transcripts
“We read the transcripts but we might also listen to the transcript to see the nuances, to hear how something is said. The value might be in the Q&A and listening to what was asked and how management has answered the questions.”
Value Line vs Broker Research
“We read and see very little sell side research. We do read Value Line, both the large cap and the small and mid cap editions every week. It allows me to cover the gamut of a lot of companies and industries very efficiently. Thirteen editions. It’s not in-depth but you see each company and industry four times per year.”
“We don’t want to talk to management about quarterly earnings. We are trying to get to the durability of the business franchise. I want to understand why an insurance company can raise prices by 6.9% but not 7%. That answer is meaningful for me. It’s not something discussed in a SEC filing. But there’s value in knowing that stuff.”
Chris also suggested some book titles he has read and recommended to others. These include: Sol Price, Merger Masters by Kate Welling, Economics in One Lesson, Freedom’s Forge, The Forgotten Man, Shoe Dog, Railroader, and The Bare Essentials. He gives copies of The Richest Man in Babylon and The Intelligent Investor to lots of students. All of these tomes include fascinating and valuable insights into both business and investment worlds.
Chris is a Master. Even with more than twenty years of my own in investing, Chris still manages to teach me things that add value to my own thinking. He is humble and was very generous with his time, and I am grateful for the opportunity to have spoken with him.
Chris Bloomstran: The New Super Investors - Investment Masters Class
Chris Bloomstran - Annual Letter [Part II] - Investment Masters Class
Chris Bloomstran – What Makes a Quality Company – Invest Like the Best - Podcast
Semper Augustus - Investor Letters
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