Semper Augustus Investments Group letter for the year ended December 2016, titled, “Sympathy For The Dog – Challenging Dogma, Death Of The Profit Margin, And A (Brief) Berkshire Redux”

2016 Hedge Fund Letters


Sympathy For The Dog

Challenging Dogma, Death Of The Profit Margin, And A (Brief) Berkshire Redux

Please allow me to introduce myself; I’m a man of wealth and taste

I’ve been around for a long, long year; Stole many a man’s soul and faith

And I was ’round when Jesus Christ had his moment of doubt and pain

Made damn sure that Pilate washed his hands and sealed his fate

Pleased to meet you; Hope you guess my name

But what’s puzzling you is the nature of my game

I stuck around St. Petersburg when I saw it was a time for a change

Killed the Tsar and his ministers, Anastasia screamed in vain

I rode a tank, held a general’s rank

When the blitzkrieg raged and the bodies stank

Pleased to meet you; Hope you guess my name

Ah, what’s puzzling you is the nature of my game

I watched with glee while your kings and queens

Fought for ten decades for the gods they made

I shouted out, “Who killed the Kennedys?”

When after all it was you and me

Let me please introduce myself; I’m a man of wealth and taste

And I laid traps for troubadours who get killed before they reached Bombay

Pleased to meet you; Hope you guessed my name

But what’s puzzling you is the nature of my game

Pleased to meet you; Hope you guessed my name

But what’s confusing you is just the nature of my game

Just as every cop is a criminal and all the sinners saints

As heads is tails just call me Lucifer

Cause I’m in need of some restraint; So if you meet me

Have some courtesy; Have some sympathy, and some taste

Use all your well-learned politesse, or I’ll lay your soul to waste

Pleased to meet you; Hope you guessed my name

But what’s puzzling you is the nature of my game – Jagger/Richards

Can you guess the name of the protagonist? Many of you would conclude it’s the new occupant of 1600 Pennsylvania Avenue. Some of the verses fit rather well…For others of you, that would have been your guess prior to November 8. Our country has been profoundly divided many times in its history, but we have never observed firsthand such hatred and contempt as today. Of course, the lyrics belong to the Rolling Stones’ Sympathy for the Devil. It seemed a fitting lead.

Semper Augustus

Last year’s letter borrowed its title and the first verse and chorus from Prince’s anthem, Party Like It’s Nineteen Ninety-Nine. Sadly, Prince is once again, and will forever be, The Artist Formerly Known As.

Some observed our timing was forebodingly coincidental. The title and lyrics fit the day as we drew parallels with the market craziness in both 1999 and 2015.

Much of the insanity persisted through 2016, though market breadth vastly improved, and a rising tide lifted the market to all-time highs. Many of the great branded consumer franchises fetch prices rivaling those seen in 1998, the peak of the “new” Nifty Fifty. On insanity, 2016 closed at a political crossroads, with the country divided and many in a manic stupor. Shakespeare would have had a field day if he were alive. However it evolves, we expect the next four years to be jam-packed with entertainment. Tragedy or comedy? Find a safe space, pull up an armchair and behold the tale.

While we sincerely doubt any preternatural correlation with our writing about Prince and his untimely demise last year, we played it safe regardless by awarding this year’s theme to the Stones, because everyone knows they’re going to live forever, especially Keith Richards, the co-author of Sympathy, the epic lead guitar and occasional lead vocalist. With a dedicated effort, I finally finished Keith’s memoir, Life, last year. It was written with James Fox in 2010, and occupied a place among the stack on the nightstand for four years. It’s an incredibly incoherent but interesting history, especially for a lifelong Stones fan. Keith’s remaining brain cells allow him to recount wandering stories while Fox interprets. I found you could only read a few pages and then had to decompress and set it aside for a few days, or weeks, but couldn’t help but come back at times.

This year’s letter begins with a contrast of the things in investing that are within our control and those that are outside our control. We are no more geniuses today for portfolio returns north of 20% last year than we are dolts in years when our portfolio declines in price or underperforms the market. We can control two critical inputs – the quality of the businesses we invest in and the quantity of earnings our businesses produce. By controlling these two essential aspects, satisfactory returns should follow over the long haul. We have no control over stock prices over short periods of time. The stock prices of our businesses will ultimately reflect the earning power of the underlying businesses, thus correlating to things we control. Time is the arbiter of investment outcomes, success comes by controlling the important inputs.

From there, the letter delves into a rare “aha” moment in which a previously sacrosanct investment truth is dispelled. Letting go of long-held biases and convictions, particularly those shared by others, is difficult. After much thinking, we now conclude that profit margins mean reverting to a historically observable range is now an irrelevant concept because the amount of capital required to produce a dollar of revenues has grown. In this case, capital is not capital expenditures, but the combination of equity and debt employed in the business. If a range exists for profit margins, it is now higher than conventionally believed. Many won’t agree (I do) with our conclusion. To support the hypothesis, we compare two companies side by side on a common size basis to demonstrate what really matters in investing, and it’s not the profit margin.

We then wade back into the swamp with a brief follow-up to last year’s dive into Berkshire Hathaway. We’ll answer a couple questions raised in response to the letter, then go off the reservation with a persnickety diatribe about some Berkshire intrinsic value numbers moving around in last year’s Chairman’s letter. Finally, we conclude with a current intrinsic value estimate for Berkshire and an updated ten-year expected return for the shares. An appendix, with updated tables, supports our Berkshire valuation methodologies.

Money Dog

Amazon Claus came early last year, he came often, too, delivering Phil Knight’s recently released memoir, Shoe Dog, on Christmas Eve. The book proved a wonderful holiday read. Unlike the Keith Richards memoir, which took four years to work through, I read Mr. Knight’s over two nights.

Like is widely known as one of the world’s largest athletic apparel companies, but it’s much more than that. It is

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