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  • SYMPATHY FOR THE DOG

    2016 LETTER TO CLIENTS

    CHALLENGING DOGMA, DEATH OF THE PROFIT MARGIN, AND A (BRIEF) BERKSHIRE REDUX

    February 12, 2017

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    CONTENTS

    SYMPATHY FOR THE DOG

    CHALLENGING DOGMA, DEATH OF THE PROFIT MARGIN, AND A

    (BRIEF) BERKSHIRE REDUX

    MONEY DOG 6 INTRINSIC VALUE UPDATE – THE CASE FOR ACTIVE MANAGEMENT 7

    The 2000 Report Usefully Projected the Long-Range Result 7

    The 2015 and Current Vintage Reports 7

    On Cash and Intrinsic Value 8 DEATH OF THE PROFIT MARGIN – A NEW PERMANENTLY HIGH PLATEAU 9

    Hold the Pickles, Hold the Lettuce - Profits Your Way 9 Profit Margin Dogma 10 What’s Behind Door Number 1? 13

    The Climb of Capital and the Descent of Returns 18

    What if Write-offs and Write-downs were Disallowed? 23 De-Risking the Banks Masks Growing Leverage Everywhere Else 24 Summarizing Death of Profit Margins 26

    BERKSHIRE HATHAWAY REDUX – BACK TO THE SWAMP 28

    Thoughts on Questions Raised About Berkshire 28 Moving the Goalposts 31

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    Berkshire Hathaway: Ten-Year Expected Return 33

    Berkshire Hathaway Intrinsic Value Update 34 2016 Year-End Intrinsic Value by Methodology 35

    A SIDEBAR ON INTEREST RATES – DON’T MESS WITH JANET 39

    SUMMARY 39 APPENDIX 41

    Appendix A 41

    McLane Financial Information (Company A) 41 Appendix B 43 Key Business Segment Information – Berkshire Hathaway 2016 Expected 43

    Appendix C - Tables 44 Methodologies and Support for Calculating Intrinsic Value for Berkshire Hathaway 44

    Income Statement GAAP Adjustments to Economic Earnings 44 Sum of the Parts Basis – 2016 Expected 44 Net Income Basis – 2016 Expected 44 2016 Estimated Intrinsic Value at Normalized 18x Earnings on TTM and Norm 44 Two-Pronged Basis 45 Simple Per-Share Price to Book Value Basis – “A” Share Data 45

    Appendix D – Down the Rabbit Hole We Go 46

    Moving the Goalposts – What Changed and How it was Presented 46

    Copyright© 2017 By Christopher P. Bloomstran All Rights Reserved

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    February 12, 2017 2016 LETTER TO CLIENTS

    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. 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.

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    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.

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    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. Nike is widely known as one of the world’s largest athletic apparel companies, but it’s much more than that. It is an icon, one of the world’s great consumer brands, and Mr. Knight’s memoir is a wonderful accounting of the firm’s founding and its pre-IPO years. For the investment crowd, the story is a great example of the value of growth. I hadn’t known that Phil Knight was a public accountant for many years, including many of