Double, Double Toil and Trouble
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DOUBLE, DOUBLE TOIL AND TROUBLE WICKED VALUATIONS, BUBBLES IN MONETARY POLICY AND PASSIVE INVESTING PLUS: BERKSHIRE – CHARMED BY THE TAX DEED 2017 LETTER TO CLIENTS February 11, 2018 CONTENTS DOUBLE, DOUBLE TOIL AND TROUBLE WICKED VALUATIONS, BUBBLES IN MONETARY POLICY AND PASSIVE INVESTING PLUS: BERKSHIRE – CHARMED BY THE TAX DEED IN THE LETTER – INTRODUCTION 6 MARKET VALUATION FLASHES DANGER 7 They Say You Only Know it was a Bubble After the Fact…Hmmm… 7 THE GREAT MONETARY POLICY UNWIND 10 QE to QT – Gimme Back My Bullets 10 Fiscal Policy Joins the Tightening Race; Will Foreign Central Bankers Leap In? 13 STREAM OF UNCONSCIOUSNESS 14 Bitcoin 14 The 17-Year Cycle Theory 14 INTRINSIC VALUE UPDATE – THE ONGOING CASE FOR ACTIVE MANAGEMENT 15 The 2000 Report Usefully Projected the Long-Range Result 15 Robbing a Little from Peter, But Paul Will be Fine 18 On Cash and Intrinsic Value 20 Fundamentally Different: The Semper Portfolio and the S&P 500, Side by Side 21 Why We Don’t Own the Index 28 ACTIVITY V. PASSIVITY – THE COMING PASSIVE INVESTING UNWIND 29 The Argument for Passive Investing 29 Superinvestors 31 Go with the Flow 32 The Nail in the Passive Investing Coffin – Price Doesn’t Matter…Until it Does 37 Active Shouldn’t Mean Activity: Common Threads Among the New Superinvestors 40 2 BERKSHIRE HATHAWAY: CHARMED BY THE TAX DEED AND OTHER RUMINATIONS 45 Tax Code Mini-Primer; The Tax Bill Formerly Known as… 46 The Impact of the Tax Bill at Berkshire 49 Cash Taxes 52 Operating Segments 53 Berkshire Hathaway: Ten-Year Expected Return 61 Berkshire Hathaway Intrinsic Value Update 63 2017 Year-End Intrinsic Value by Methodology 64 Berkshire’s Dual Yardsticks of Intrinsic Value: “Removing” the Goalposts 70 Summary on Berkshire and Intrinsic Value 72 SUMMARY 73 APPENDIX 75 Appendix A – Key Business Segment Information – Berkshire 2017 Expected 75 Appendix B - Tables 76 Methodologies and Support for Calculating Intrinsic Value for Berkshire 76 Income Statement GAAP Adjustments to Economic Earnings 76 Sum of the Parts Basis – 2017 Expected 76 Net Income Basis – 2017 Expected 76 2017 Est IV at Normalized 18x TTM Net Income Before and After Tax Change 76 Two-Pronged Basis 77 Simple Per-Share Price to Book Value Basis – “A” Share Data 77 Appendix C – Capital Expenditures and Depreciation; Deferred Tax Liabilities 78 Appendix D – Down the Rabbit Hole We Go 79 Moving the Goalposts at Berkshire – What Changed and How it was Presented 79 (Reprinted From 2016 Year-End Letter) Copyright© 2018 By Christopher P. Bloomstran All Rights Reserved 3 February 11, 2018 2017 LETTER TO CLIENTS DOUBLE, DOUBLE TOIL AND TROUBLE WICKED VALUATIONS, BUBBLES IN MONETARY POLICY AND PASSIVE INVESTING PLUS: BERKSHIRE – CHARMED BY THE TAX DEED SCENE I. The Federal Reserve. March the Third, 2009. In the middle, a boiling cauldron. Thunder. Enter the three Witches, Alan, Ben and Janet First Witch Alan Thrice the brinded cat hath mew'd. Second Witch Ben Thrice and once the hedge(fund)-pig whined. Third Witch Janet Keynes cries 'Tis time, 'tis time. First Witch Alan Round about the cauldron go; In the poison'd entrails throw. Toad, that under cold stone Days and nights has thirty-one Swelter'd venom sleeping got, Boil thou first i' the charmed pot. ALL Double, double toil and trouble; Fire burn, and cauldron bubble. Second Witch Ben The Illustrated Library Shakespeare Cool it with a baboon's blood, Then the charm is firm and good. Enter BROOM-HILLDARY to the other three Witches BROOM-HILLDARY O well done! I commend your pains; And every one shall share i' the gains; And now about the cauldron sing, Live elves and fairies in a ring, Enchanting all that you put in. Music and a song: 'Black spirits’ BROOM-HILLDARY retires 4 Second Witch Ben By the pricking of my thumbs, Something wicked this way comes. Open, locks, Whoever knocks! Enter MACTRUMP How now, you secret, black, and midnight hags! What is't you do? ALL A deed without a name. Albrecht Dürer A deed without a name, indeed… Not yet invented, the cauldron of poison’d monetary entrails came to be known as Quantitative Easing, QE for short. The witches’ elixir produced its desired effect. From the nadir of the financial crisis, at the devilish 666 on 03/06/09, the Standard & Poor’s 500 has since doubled. And doubled again. The index went out 2017 at 2674. Toil and trouble… “No one may buy or sell save one who has the mark, or name of the beast, or the number of his name. That number is 666.” – Revelation 13:17-18 Is it too much concocting to blend The Bard’s “The Scottish Play” with the Book of Revelation and the wizards at the Federal Reserve to explain the last nine years’ “buying and selling”? More buying than selling, really… The sum of the digits 666 is 18. The sum of the digits at the date of the low is 18. Here we are in the year 18. Hmmm…Lest we get ourselves marked with an obsession with the underworld (last year’s letter invoked the Rolling Stones’ Sympathy for the Devil), let’s quickly broom off to what’s brewing. Next year, we vow to do something saintlier, perhaps blessing the letter, “Holy S_ _ t! The Market was Up Another 20%!” Come to think of it, if that comes to pass, we’re more likely to seal our fate with something appropriate like Van Halen’s Running with the Devil… 5 IN THE LETTER - INTRODUCTION Berkshire Hathaway, our largest investment holding by far, wields enormous “hidden” earning power and value. Our most recent two year-end letters discussed why. The situation got even better with the passage of tax reform in December. We think Berkshire may be the single largest beneficiary of the tax bill, so we dig into the company yet again. Included are updates to our ten-year expected returns and our appraisal methodologies for estimating intrinsic value, followed by an overview of how the tax code materially improves the moving parts within the holding company. We make several ongoing upward and downward adjustments to Berkshire’s reported income each year to reflect economic earning power. The adjustment results in adding nearly $10 billion to net income today. Thanks to tax reform, an additional increase of more than $3 billion in after-tax earning power is created by the tax changes applied across the moving parts that constitute Berkshire. Combining our GAAP adjustments with new earning power derived from tax reform, Berkshire is thus worth at least $200 billion more than would be determined by simple use of reported earnings and former tax rates. I know the prospect of diving right into taxes sounds exciting, but we’ll save the best for last. Instead, the letter begins by comparing current stock market conditions with those at past market peaks and troughs. Valuations are at extremes only seen at major market tops, with some measures at records. From there we examine a reversal underway in monetary policy, shifting from accommodative to tight. Easy money helped drive asset prices higher. Conditions are heading the other direction. Quantitative Easing has become Quantitative Tightening, and policy interest rates are on the rise. Combined with what is now a tightening fiscal climate from tax cuts, potential ramifications for the economy and the stock market are foreboding. When valuations are overlaid, the climate is hostile. Next, the intrinsic value approach used in our investment process is updated. The portfolio is embedded with critical fundamental and valuation advantages. A side by side common size comparison with the S&P 500 is used to illustrate disparities of quality and value. That discussion on intrinsic value moves to a thematic look at passive versus active investing. Passive flows are distorting valuations across much of the domestic and global stock market. A great deal of risk is building. Included are the results of a flow analysis that is distorting returns, prices and index weightings. A mind-blowing chart summarizes the point that passive investing, despite the logic and seeming efficiency of its use, has run so far that a terrible prospective outcome is likely. Finally, we conclude the letter with the jump back into Berkshire. A ten-year forecast of expected returns, its improved tax position, and an update to our intrinsic value methods and estimate of intrinsic value are discussed. Despite the shares climbing more than 50% over the last two years, considerable value remains and prospective returns versus the “market” look particularly rewarding. We considered including a comparison between General Electric and one of our favorite holdings, the Norwegian branded consumer goods company, Orkla. Both are involved in de-conglomeratizing (new word), one doing it well, the other, er, not so well. We had this penciled in as a topic early last year, but given GE’s header of late, decided against what would look either like cherry picking or kicking a down dog. Thus, How to Shrink a Conglomerate is saved for another day. Perhaps the subject company will be a certain small Omaha-based enterprise. It’s too bad we moved on. The GE/Orkla contrast would have mixed riveting topics like accounting quality, capital allocation, acquisition treatment, pension issues, compensation, and intrigue. Something wicked this way comes… 6 MARKET VALUATION FLASHES DANGER They Say You Only Know it was a Bubble After the Fact…Hmmm… Terror reigned when the S&P 500 touched 666 in 2009. The index had lost nearly 60% of its value. Many stocks had declined by far more.