Acquired - Berkshire Hathaway Part II

Episode Date: May 12, 2021

In Part II of our Berkshire Hathaway Trilogy (!), we pick up the story with Warren wandering in the woods of Omaha, searching for his life's next chapter after retiring from the professional investing business at the top of his game at age 39. How does he emerge from those woods anew, transforming from Ben Graham's cigar-butt cocoon into the butterfly collector of Berkshire's wonderful businesses? (Spoiler: Charlie Munger.) And how did one rotten-to-the-core business nearly bring it all down — everything he'd ever worked for — in the span of one terrible week? Tune in! Sponsors:ServiceNow: https://bit.ly/acqsnaiagentsHuntress: https://bit.ly/acqhuntressVanta: https://bit.ly/acquiredvantaMore Acquired!:Get email updates with hints on next episode and follow-ups from recent episodesJoin the SlackSubscribe to ACQ2Merch Store!The Charlie Munger Playbook is available on our website at https://www.acquired.fm/episodes/berkshire-hathaway-part-ii Links:Chuck Rickershauser's corporate flow chart: (left half) (right half) Carve Outs:The Sopranos: https://www.hbo.com/the-sopranosMacklemore on Armchair Expert: https://armchairexpertpod.com/pods/macklemore

Guess how many grams of sugar are in this normal looking size bottle of Cherry Coke? Is that 20 ounce? It is 20 ounce. Yep. 40. Nope. 50. 70.

In a 20 ounce bottle, there's 70 grams of sugar? 70 grams of sugar in one 20 ounce bottle. Wow. I can't believe they still sell this stuff. Welcome to Season 8, Episode 6 of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert, and I am the co-founder and managing director of Seattle-based Pioneer Square Labs and our venture fund, PSL Ventures. And I'm David Rosenthal, and I am an angel investor based in San Francisco. And we are your hosts. On our last episode, we told the story of Warren Buffett in the years of running his own partnerships, those 12 years leading up through

1969 when he shut it down after his best year ever and returned all the money to his investors. Today, we will pick up right where we left off, telling the story of the declining suit liner manufacturer that he bought, Berkshire Hathaway. Today's story is one of an investment style in transition, from a focus on cigar butts to a focus on wonderful businesses, much of which was inspired by the man we've only briefly mentioned so far, Charlie Munger. Now, you may be thinking to yourself, boy, it'll be really great to get the other half of the Berkshire story to understand where they are today. Unfortunately, you should know David and I better than that.

We were foolish to think that we could tell the whole Berkshire story in a mere two episodes. So this episode is our Empire Strikes Back. It will serve as a bridge between the early forces that made Warren and the mature Berkshire that we have today. What made Buffett start investing again after dissolving his partnership? And why on earth did he decide to do that inside of the shell of the declining Berkshire instead of just starting a new fund? And even how did he end up briefly as the chairman of a Wall Street bank with a culture that he had criticized for his whole investing career? So here we are, part two of our Berkshire Hathaway trilogy. This really is the Empire Strikes Back. It's going to get dark at the end.

Truly. Be prepared. There's a little bit of an apt analogy there. It's going to get dark at the end. Truly. Be prepared. There's a little bit of an apt analogy there. It's true. Well, folks, are you an acquired Slack member yet? If not, what on earth have you been waiting for? It is a wonderful community discussing, of course, all things acquired in recent episodes. But more importantly, it is a smart group of people having thoughtful, nuanced, and respectful discussion about tech investing. You can join at acquire.fm slash slack. Okay, listeners, now is a great time to tell you about longtime friend of the show,

ServiceNow. Yes, as you know, ServiceNow is the AI platform for business transformation, and they have some new news to share. ServiceNow is introducing AI agents. So only the ServiceNow platform puts AI agents to work across every corner of your business. Yep. And as you know from listening to us all year, ServiceNow is pretty remarkable about embracing the latest AI developments and building them into products for their customers. AI agents are the next phase of this. So what are AI agents? AI agents can think, learn, solve problems, and make decisions autonomously. They work on behalf of your teams, elevating their productivity and potential. And while you get incredible productivity enhancements,

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So learn how you can put AI agents to work for your people by clicking the link in the show notes or going to servicenow.com slash AI dash agents. Now, lastly, if you aren't an LP, you should become one. Aside from all the things that we tell you every time, we have a brand new LP event coming up that we are super excited about. Our next book club will be with Brad Stone, who famously wrote The Everything Store, The Upstarts. And now, David, what is his new book?

Amazon Unbound. Part two of the Amazon story. Just like this is part two of the Berkshire story. So our new format for the book club will be that David and I are going to interview Brad. And if you're an LP, then you get to join on the Zoom as well. And we'll have time for Q&A. And everybody will hopefully have read the book before we do the interview. So you can join at acquired.fm

slash LP and learn more about that program. All right, David, before you take us in, and listeners, as always, this show is not investment advice. David and I may, and I think we've already told you that we do have investments in the companies that are discussed on this episode. And this show is for educational and entertainment purposes only. All right, let's get to it. We got a lot to get through here. Yep. So last we left our friend Warren Skywalker, Warren Buffett. He was wandering in the woods of Omaha after having closed down the partnership, as you alluded to, Ben,

and trying to figure out what to do with his life and his retirement. So before we pick back up with that story, though, I think we have some unfinished business and a character that we need to introduce here. This is like, so David, even in an episode where we've already told you like a multi-decade history and we're like into part two, somehow you're finding a way to wind the clock back. Indeed. And we go all the way back to New Year's Day on 1924 in Omaha, Nebraska, the very same woods that Warren is wandering in. That sounds like six years before Warren was born. Yep. Six and a half years before Warren was born, where in Omaha, Al and Florence Munger. Florence gives birth to a baby boy whom they name Charles Thomas Munger. After his grandfather, who is a widely respected federal judge in the Nebraska U.S. District Court appointed by Teddy Roosevelt himself, Thomas Charles Munger. So Charles Thomas Munger, name for his grandfather, Thomas Charles Munger.

And he takes after his grandfather in many ways. His grandfather makes a big impression on him. Thomas's mantra in life was concentrate on the task immediately in front of you and control your spending. Sort of sounds similar to Ernest Buffett, similar ideals. And this kind of instills this idea of gaining wealth through controlling your spending and focusing on doing a great job at the task in front of you and young Charlie. And Charlie, much like Warren, decides that he wants to become wealthy so that he can not have lots of fancy toys to play with, but so that he can be independent. He has a quote. He says, I wanted to get rich so I could be independent like Lord John Maynard Keynes. Of course, elementary school-aged Charlie Munger is aspiring to be like John Maynard Keynes.

So this is where he's a little different than Warren. They really have the same aims and goals in life, but their styles around it are very different. Warren is just like, I don't want anybody telling me what to do. Charlie's like, oh, I want to be like Lord Keynes. So as we chronicled in part one, Charlie actually goes to work for Ernest Buffett at the grocery store as a kid. Unbelievable for Warren's grandfather. Just like Warren learns he hates manual labor and being paid a pittance of salary and he thinks there's got to be a better way. He can use his mind to make money rather than his manual labor. And speaking of his mind, he loves to read.

His parents give him and his sisters lots of books. He tears through them. And very early in life, he stumbles across Ben Franklin. And Ben Franklin would become his hero in life. And that's where he develops this idea. I don't know if he stole it from Franklin or if he came up with it himself of making friends of the eminent dead. He decides he enjoys more the company of dead people and learning from them through their books than people who are actually alive. Kind of a one-way conversation, but there's probably a lot of wisdom there. Not to mention like revisionist histories and survivorship bias, yada, yada, yada. I think a lot of conversations with Charlie are one-way conversations, as we shall see. So also like Warren, he's kind of a wise ass as a kid and has a very high opinion of himself.

His neighbor, one Ed Davis, who we discussed in part one, the doctor, is his father Al's best friend. And just as a refresher, the Davises would become one of the first families to invest in Buffett's first partnership, right? Yeah. And I think the first, if I remember right, the family in Omaha that gave him the most money of sort of the initial group, I think they gave him $100,000 because Warren reminded them of Charlie. So he ends up going to Michigan for undergrad. Sorry, Ben.

It's all right. These days, I'm not sure there's much of a rivalry anyway. Ooh, burn, burn. Of course, Ben went to Ohio State. So where at Michigan he majors in math and gets turned on to physics where he becomes really entranced with physics. And then while he's still at Michigan, Pearl Harbor happens and the US enters World War II. Charlie joins the Air Force. And as part of the intake process, they measure his IQ.

And he's literally like one of the top IQ scores that the military and any branch has ever tested. No major surprise there. Yeah, no major surprise there. He's probably the top wise-ass decile as well. That is definitely true. So they send him first to the University of New Mexico to study engineering there. He then goes on to Caltech in Pasadena in Los Angeles and continues his engineering studies there. And then I think he ends up, if I'm remembering this right, I don't have it in my notes. I think he ends up

getting stationed in Alaska as a meteorologist during the war. I remember him being in Alaska too as part of his duty. Yeah. So anyway, after the war, he decides that he really enjoyed learning about engineering and physics and math and all that. But for a career, he more wants to follow in the family footsteps of his beloved grandfather and his father and go into the law. So Charlie being Charlie, he applies to Harvard law, despite the fact that he doesn't have an undergraduate degree. Why should that stop him? Yeah, he didn't actually graduate from any of these institutions. And he gets in and he goes to Harvard law. He does very well there, graduates Phi Beta Kappa. And he decides after graduation, he's thinking about going back to

Omaha, but he decides, well, one, Pasadena was really nice when I was there at Caltech. The weather in LA is hard to beat. But also in typical Charlie fashion, he sort of asked himself a rhetorical question. He's like, where can I be somebody? And Omaha is obviously a rising town, great city, but it's not Los Angeles. And he says, what city is growing and full of opportunity so that I could make a lot of money, but not so big and well-developed that it would be hard to rise into the ranks of the city's most prominent men? Which, of course, Charlie wants to be among those ranks. And you're already seeing a massive departure

in the sort of psychological makeup of Warren and Charlie here, where like that was never a thing Warren cared about. It was like, how much money will I have on the scoreboard when I die? And like, I'm sure no matter where I live, that'll get compared to everyone else. And for Charlie, it was, you know,

where can I be a man about town town and that town should be big enough to be worth being a man about town. And it's also funny to me that at this point, like LA is for him something that he views as like, oh, it's not too big yet. Yeah. Well, it wasn't. I mean, right after World War II, obviously it was a big town and Hollywood had always been there, but I think California, and particularly Southern California, experienced a huge population boom after World War II, of which Charlie was part. So very tragically, after moving to LA, he had gotten married, I think right after the war, when he started at Harvard. And tragically, both his marriages falling apart when he gets to la and much more tragically his son teddy is diagnosed with leukemia and in those days there was no effective treatment for

leukemia yeah just tragic it was totally tragic and teddy would end up passing away in 1955 at age nine, which is unimaginable to lose a child at all, let alone in that way and at that age. Charlie's reaction to this, I think, is very characteristic, very telling of who he is. He's obviously absolutely devastated, but he decides that the thing to do is he needs to set new goals for himself and move forward versus being consumed by grief. So he says after about when reflecting on this time, he says one of his Charlie isms, you should never, when facing some unbelievable tragedy, let one tragedy increase into two or three through your failure of will, which is probably sound advice, not that I can imagine going through that.

That's also some incredible compartmentalization. I mean, imagine going and speaking to a person who's grieving right now and telling them, hey, don't let this turn into two or three cascading, what is it, failures or catastrophes. It's sort of only something you can decide and tell yourself. And I think only if you are a person like Charlie. Like Charlie. So he sets two very specific goals for himself. One, to find a new spouse. And two, to diversify his business activities outside of law. And so on. One, I thought this was so funny. He's really worried. He's now a divorced man in his 30s in California. He doesn't know that many people out there. He goes through all the math of how many women are

there in California, how many would be of a marriageable age, how many are smart enough for me, but not too smart like of course this is charlie so he happens on a foolproof strategy he decides that he's going to do the most rational thing possible he's going to start every day scanning the divorce and obituary notices in the paper looking for widows and recent divorcees. Oh my God. I guess there weren't dating websites back in those days. So that's what you had to do. His friends are kind of alarmed by this. And one of his law partners introduces him to a woman named Nancy Borthwick, who was kind of fit all of his criteria, except maybe the not being too smart. She was quite smart.

She was recently divorced. She was Phi Beta Kappa from Stanford undergrad in economics. She actually had an undergrad degree, unlike Charlie. And most importantly, see, she took nobody's crap, including Charlie's. So each of the two of them have two children, two surviving children from their previous marriages. They get married. They go on to have four more children together for an entire Munger clan of 10 people, eight children and two parents. It's a lot of Mungers. That is a lot of Mungers. And if you see photos of them, of the Munger clan to this day, especially with all the grandchildren, it is is impressive it's like a small city do you know the this is sort of like

the thing that smacks you in the face the thing she had in common with his first wife uh yes her name yeah they're both named nancy like yeah in some ways you're like come on that's pretty lazy like you can't go marry someone again with your same. Someone once made a remark that Charlie was so sort of absent minded and forgetful of names that thank God his second wife was also named Nancy or he would have forgotten her name too. Yeah, very Charlie. He is unique. So on goal number two, he's doing very well as a lawyer in LA. As you can imagine, Charlie is an excellent attorney. But he decides that even though he's having all this success, really the people who seem like they have the good life and who are really the sort of men, and they're all men at

this point, about town are the clients. In particular, one of his clients is the mining magnate Harvey Mudd, who helped build Caltech into what it became and then helped build and found all of the Claremont colleges, including the one that bears his name, Harvey Mudd. He was one of Charlie's clients. So what does Charlie do? He starts buying some stocks himself, but he also starts taking some of his fees from his clients in equity in addition to cash. Yeah, he's like the early Silicon Valley entrepreneurial startup lawyer type that takes some equity in addition to cash for doing the deals. He also ends up getting into real estate, which real estate in Southern California in the post-war era was a great way to make a lot of money. He gets his net worth up to about $1.5 million by the early 60s,

which if you remember from part one, he's like right neck and neck with Warren at this point in time. And that's what, like 10, 15 million today? Yeah. So certainly more than anybody would need to be living the good life of a man about town at this point. Right. And you could imagine someone in their mid-30s, you could kind of just live off that interest forever if you wanted to put it into fixed income and kind of call it. Totally, totally. Which, unlike Warren, Charlie's not necessarily against something like that. He's definitely enjoying himself in LA. But along the way, as we alluded to in part one, the famous summer night in 1959 in Omaha, Charlie is back in town briefly to settle his father's estate. His father, Al, had passed away.

And the Davises say, ah, we're investors with this local guy, Warren. We've told him about you. Three years ago, we met him. He seemed like you. Let's set up a dinner and we'll introduce we'll introduce you you guys can meet both warren and charlie i think are skeptical going into this dinner but the legend goes that they all sit down to dinner and it's like electric warren and charlie hit it off right away which i think is true and then the legend goes that at this dinner charlie starts laughing at one of his own jokes so hard that he actually rolls out of his chair onto the floor and starts rolling around on the floor. Now, that is not true, but it did happen

later that week because Warren and Charlie got dinner together like every night that week. Oh, wow. That they were there. And yes, apparently, Charlie did actually start rolling on the floor of a restaurant at one of his own jokes. Which is the first of many pretty funny quips about Charlie at dinner parties and his eating habits and his mildly self-absorbedness when it comes to these things. There's another good one where he's been known to, as he's telling a story or opining on something, sometimes, of course, he'll need to drink water. So as he sort of takes his glass and puts it up to his mouth, he puts his hand out to

stop anybody else from talking and holds his hands up until he's done taking a sip and then moves his hand out so he can finish telling the story. This is a man that loves to talk. It doesn't come out as much in Berkshire meetings until you sort of get him going. But yes, in social situations, he is the center. It's so funny because if you just watch the annual meetings, you would think that Charlie is the silent partner. Nothing could be farther from the truth. So during this dinner, Warren and Charlie are like enraptured with each other. And as they go along, Charlie's getting more and more

puzzled because all Warren is talking about is businesses, companies, and investing. And Charlie loves this. He thinks this is great, but it wouldn't even cross any normal person's mind that this could be your job at this point in time. We talked, like we talked about in part one, like maybe a couple people in New York, you know, maybe Ben Graham could do this. But the idea that somebody in Omaha, even somebody in LA could do this as their full-time job, only Warren was thinking this way at the time. So eventually Charlie asked Warren, well, what do you do exactly for a living? And Buffett's like, well, I have these various vehicles, these various partnership vehicles, because at this point, he hadn't consolidated them all yet. These are all... He has like seven or eight different partnerships that he invests from.

And mind you, the setup is there's no fees. He's not drawing a salary from any of these. Yep. He's just working out of his spare bedroom at the house in Omaha, living off of his, what was it, $175,000 that he had when he left Graham Newman. So Charlie, though, this strikes him as brilliant. And he's like, he looks at Warren dead serious for once. And he says, do you think I could do something like that out in California. And supposedly Warren, as chronicled, sits there and he thinks for a minute because, you know, Warren is, you know, he's very polite, but like he's also, especially with people he respects, you know, very honest and direct. And, you know, he doesn't think many people can do this, but he thinks and he says, you know, yeah, I'm quite sure you could do this. And Charlie, it changes his life this dinner. He goes back to LA. He keeps practicing law. He's not ready to go all in yet on investing, but he raises some money. He starts a partnership and he starts emulating Warren investing on his

own out in Los Angeles. Susie Buffett, who is at the dinner, although a silent participant, says in a quote in The Snowball, she says, I think Warren felt that Charlie was the smartest person he'd ever met. And Charlie felt that Warren was the smartest person that he'd ever met. And for the two of them, that was quite the high compliment. So Munger goes back to LA. He starts investing. He also leaves the law firm that he was at and starts a new law partnership, which was originally called Munger, Tolles, and Hills, later becomes Munger, Tolles, and Olson, which to this very day does all of Berkshire's legal work and will become very instrumental in the story at the end, as we shall see here. But he doesn't stay there long. He only stays at this new firm that he

starts for three years. And then in 1965, he's doing so well investing that with Warren's encouragement, he actually leaves MTO. And just like Warren, becomes full-time, running his partnerships, investing. And MTO, despite the fact that Charlie was only there three years, is still MTO today, right? Still MTO today. Yep. Amazing. And I know that... Imagine starting a firm, naming it after yourself, and then leaving, and then all of your partners and everyone else who works there asking you, can we still keep it with your name on it? And your name first.

Right. It's wild. Totally wild. So Charlie starts out in his sort of investing style, doing the cigar butts and the like, and he's talking to Buffett all the time. They're always on the phone. He's absorbing all the Ben Graham philosophy. But it quickly becomes clear that he's wired a different way. So he starts saying to Warren and some of their other friends, this line that is sort of puzzling to them. Charlie says, you know, I just like great businesses. And that's like not computing with Warren and the rest of the crew. And Warren's like, you mean mispriced assets? Because that's what we're doing here. We're

buying mispriced assets. And when you say great businesses, what do you mean by that? Right. I mean, even as we talked about last time, Warren, when he gets a great business like a Geico or an Amex, he's still only thinking about them in terms of the value that he can arbitrage out relative to their hard asset net worth or their cash on the balance sheet. Charlie, though, so the story goes that what really gets him down this line of thinking is at one point he invests in a Caterpillar tractor dealership in Southern California. And this becomes a total albatross because the problem was, as the dealership, you got to buy the tractors from Caterpillar up front, which costs a lot of money. And then they don't turn over that fast. They're just sitting on the

lot. And then every time one goes out the door, you got to put more capital up to buy a new one. It's incredibly capital intensive. It's always tying up capital. And if you got to put more capital up to buy a new one. It's incredibly capital intensive. It's always tying up capital. And if you want to grow, you want to add new stores, you got to invest in all the inventory upfront. And so Charlie, ever the rationalist, he realizes that like, hey, wait a minute. The goal of owning a business should actually be one, that the business spits out more cash than it consumes. And ideally, too, that it consumes as little cash as possible. Right. That then when it spits off cash, that you actually can do something with that cash, not have to go buy more caterpillar

pieces of machinery. He's like, I want to give you cash once and very little of it. And then I want you to give me a lot more cash over time with me never giving you any more. This is best paraphrased in the line from Poor Charlie's Almanac, which was an awesome source, which is a better business. And it postulates there are two kinds of businesses. The first earns 12% and you can take the profits out at the end of the year. The second earns 12%, but all the excess cash must get reinvested. There's never any cash. It the end of the year. The second earns 12%, but all the excess cash must get reinvested. There's never any cash. It reminds me of the guy who sells construction equipment. He looks at his used machines, take it in as customers bought the new ones and says,

there's all my profit rusting in my yard. We hate that kind of business. Totally. So, all right, Charlie's starting to think about this and then he starts really going down the rabbit hole. He's like, well, how can you achieve such a state in business? And that leads him to think about this what is competitive advantage? It's almost like a moat. It's like if your business is a castle, you have a moat around your castle so that nobody can attack it. It's a reason why competitors can't come and arbitrage your differential profits away. It kind of sounds like Hamilton Helmer and Powers, right? So Warren and Charlie are spending a lot of time together. Famously, Warren and Susie start vacationing in Southern California just so that Warren and Charlie can talk for hours. And when they come out, Warren's already a millionaire at this point. The family stays in a motel on Santa Monica

Boulevard and then commutes over, drives over to Pasadena. Of course. So one, they're hanging out because they respect each other's intelligence. But two, Alice points out in the snowball, there's actually a second reason why Warren likes Charlie so much. And that's that as Warren's starting to get more and more known in Omaha and on the national scene for his investing track record, nobody's willing to tell him he's wrong anymore. Everybody's super deferential to him. And as Alice puts it, Charlie's deference to Warren was limited by his high opinion of himself. That's awesome. And that is something that we start to see play out here in the late 60s,

where Buffett was famously very shy about ever sharing investment ideas. I think occasionally at that annual group that he would convene of all the Ben Graham disciples, his fellow classmates, which he then started bringing Charlie into, that they would occasionally sort of allude to some investing ideas they were thinking about. Maybe this business is interesting, but they would kind of talk around it. Warren really found in Charlie someone that he could literally present, here's the name that I'm thinking about, and start talking through the business and look for sort of holes in his thinking in a way that he never opened up to anyone else to ever say the name of a company he was thinking about buying. Yep, totally. That brings us back to,

at the same time, Charlie's starting to go down this different path in philosophy. And Munger starts saying, and he says to Buffett, he's like, hey, you're obsessed with this Graham guy. And I'll give it to you that that's a great strategy. It works. He met Graham at several points this time. Graham also lives in Southern California by now. But he's like, hey, he's not God. And there's a flaw in the cigar butt thinking, which is that it was driven by the environment that Graham came of age in and the depression. And the quote from Charlie is that the flaw is that Graham believes that the future is more fraught with hazard than ripe with opportunity.

And here in the post-war era in the US, especially in California, it's super hard to look out at the future and not see opportunity. So Charlie starts haranguing Warren about this. He says, here's a great quote, because Warren is so good at explaining Ben Graham, he's behaving like the old Civil War veteran who, after a few minutes of ordinary conversation, always interjects, that reminds me of the Battle of Gettysburg. In other words, Warren is falling victim to one of the oldest human misjudgment tendencies in the book, the man with a hammer syndrome. And what's that like when you have a hammer, everything looks like a nail? Exactly. So eventually, Charlie does start

breaking through to Warren right around this time as Warren is shutting down the partnership. He's so depressed. He's worried about the market. He doesn't see opportunity ahead. He only sees hazard. But at heart, though, Warren is an optimist. really feeling yourself and feeling your legs under you a little bit, can you start saying, wait a minute, I am a little bit different and I can act as completely my own agent rather than following their playbook. All right. So this leads us to the first big thing that Warren and Charlie do together, which is blue chip stamps. And I remember what I used to hear Warren and Charlie talk about, blue chip stamps company. I thought this was like a quaint stamp collecting store franchise. I assumed that too. Yeah. Exactly. Like a baseball card shop or something. No, that is totally not what this was. This is some wild Americana history.

And when we say the first thing they do together, we should be crystal clear here. They are not Warren and Charlie on a stage the way that you see them today. There is Charlie who is doing Charlie's partnerships and Warren who's doing Warren's partnerships. Yep. So what is blue chip stamps? So around the turn of the century, the turn of the 20th century, department stores used to hand out... This is crazy. They used to hand out stamps as a bonus incentive for customers to pay cash for goods instead of buying on credit. So the idea was, if you bought something with cash, the store then handed you a certain number of stamps, which you could paste into a booklet. And when you filled up the booklet, you could exchange it for like prizes, like redeem it for like a, you know,

I don't know, like furniture or jewelry or like a bike for the kids or something like that. They did want to incentivize paying with cash because cash flow. Exactly. So this was a way to incentivize paying with cash. So somebody had a brilliant idea that it would be better if you actually operated the stamp service as a separate business from anyone's store, so that customers can get stamps from lots of stores, and then aggregate them, get lots of stamps, and then redeem them for more prizes. It sounds so convoluted when you explain it this way. Totally. But this business turned out to have two extremely attractive qualities. One,

it had float. So the stamps companies that were running the stamp operation, the businesses, the stores, they bought stamps in advance from the stamp company. So you're a department store. You're like, I'm going to buy $500,000 worth of stamps that I'm then going to give out to my customers over time to incentivize them. And they buy it at a discount. Wow. So you better keep those in a safe because those are like cash. Yeah, exactly. And then they would give money, give US dollars to the stamp company in exchange for the stamps. And then the customers of the store, they would get the stamps and then they would redeem them. There'd be breakage. It could be years from the time the stamp company sold the

roll of stamps to the store. Sounds like an insurance company. Exactly. Exactly. So there's float. And then two, even better, there's network effects in this business. Two-sided network effect. The more stores that use a given stamp system versus another one, the more consumers are going to be incentivized to buy at those stores because they want those stamps that they can redeem for big prizes, etc. Right. Right. So yeah, consumers want more stores to support it. Stores want more consumers to use it. Yeah, it makes total sense. So by the middle of the century, there is one dominant national player in the stamp business, the S&H Green Stamps,

except in California, where a bunch of stores had banded together and shut out S&H and launched their own stamp, the Blue Chip Stamp Company. Unbelievable. I had no idea about any of this. So in 1963, S&H and the Department of Justice both sue Blue Chip for monopolistic practices. S&H is trying to get into California and recruits the DOJ. Why the DOJ wasn't like, hey, S&H, you're a monopoly too. But anyway, regulatory capture, I guess. Yep. So the stock gets pummeled when these lawsuits happen. But Munger's heard about this in LA, and he tells Buffett and also their friend, Rick Guerin, who's part of the Graham Group, which becomes the Buffett Group. Remember, Munger's like a highly, highly experienced, top-notch lawyer, corporate lawyer. He says, what's going to happen here is blue chip itself is going to be fine, but the government, what they'll do, what the DOJ will

do, they're going to force all of the California store chains that collectively own blue chip to divest it. And who better to buy it than us? So indeed, that is what happens. In 1968, Blue Chip agrees to a consent decree with the DOJ where the stores have to sell off 45% of the company. And boom, combination of Munger, Guerin, and Buffett all snap up 45-ish percent in Bluetooth. And of course, this sounds complicated to me because each of them represent a different shareholder base. They're sort of talking to each other. It feels like something could be fishy there. It could be. It could be. As the line we shall see in a minute is there's got to be an indictment in there somewhere. Okay, so now we're in 1970. Warren has just unwound his partnership and distributed out

shares of Berkshire, diversified retailing, which was a JV essentially that he had with Munger's partnership to invest in department stores, Ill-fated idea. And then blue chip. And remember, Warren told his partners in the letter where he said he announced that he was winding down the partnership that he intended to buy more of all of these companies. Well, he does. And so just to be super crisp here, Warren owns some Berkshire, but Charlie doesn't own any Berkshire at this point. This is 1970. I think none at this point. They've created the JV of Diversified, so they're definitely in that together. And they both sort of share this idea about Blue Chip, so they both are big holders of Blue Chip as well. Yep. So after Warren winds down the partnership,

he buys so much stock in these three companies from his former partners that his ownership of Berkshire doubles from 18% to 36%. His ownership of Diversified doubles from 20% to 39%. And he buys so much blue chip that he goes from 2% to 13% ownership in Blue Chip, just personally. So Susie's like, oh no, second retirement is going to look exactly like the first retirement here. And this really was the case, right? He was like, I'm winding down my partnerships, I'm done. What was the line? Something about his style and sensibilities no longer being suited to the current environment. And yet here he is heavying up on these three stocks. Yep. So Warren isn't the only one buying these stocks. Berkshire itself starts buying Blue Chip. So pretty soon, Berkshire... Warren owns 13% of Blue Chip. Berkshire holds 17% of Blue Chip, Diversified owns 16% of Blue Chip, and Munger's partnership on his own owns 8% and Guerin owns 5%. So 60% of Blue Chip is owned by these six different entities, all of which also own stock in each other. Now, listeners, if you're feeling like this is convoluted and

a little bit messy, and I don't know, maybe even like they might be sort of hiding something with the lack of simplicity here, so does the SEC. Which we will get to in one sec. But ironically, while they're doing all of this buying, they're just so thrilled at the prospects of what they're doing. The actual business of Blue Chip enters a major secular decline. So during the decade of the 1970s, Blue Chip's core business, even though they settled the DOJ suit, the core business declines 90% over the decade because consumers are just not that interested in stamps anymore. Credit cards are becoming a thing. It seems like an

outdated kind of thing. So the business is declining. Then why were they so excited about buying the stock? Just because it was at historical lows and they felt like it was a low multiple of the profits it was generating? I think the other part of it is the float. So just like Berkshire, Blue Chip is declining in its core business, but it's still got this super attractive float dynamic. And if they don't own it outright, why is that attractive? Because they can't use that. They can't take the cash out from the float to use it for something else, right? Right. Right. They can't take the cash out of Blue Chip, but they can redeploy it within Blue Chip. So they say, hey, let's run the Berkshire playbook that Warren, you just did with Berkshire. Let's start looking for other operating businesses to go buy with our float here at Blue Chip. So they tell Blue Chip's

president, a guy named Bill Ramsey, to start looking about for companies to acquire. And one day in 1971, he calls Warren and Charlie and he's like, hey, I've got a pretty interesting acquisition target here. It's a small little family company here in LA called See's Candy. And so Warren and Shelley come in, they start looking at the company and it's actually pretty interesting. So See's, people love it. It becomes wildly popular across California, starts expanding. They develop a slogan that they want to be known for See's quality, which is supposed to be even better than top quality.

You've got like high quality, top quality, and then C's quality. It's so ubiquitous in California that you know the famous I Love Lucy episode where... Already know. Oh, you definitely know this. It's like one of the most famous moments in television. In the 50s where Lucy and Ethel are working in the chocolate factory, and they're on the production line. They're supposed to like wrap the chocolates as they go by and the chocolates start going so fast that they can't keep up and they're like stuffing the chocolate all like in their clothes. Oh, I do know what you're talking about. Yeah. Yeah. It's amazing. It was modeled after a See's candy factory. So the problem with C's though, from Warren and Charlie's perspective,

is it is decidedly not a cigar butt. So the factory and the stores and the hard assets on the books are valued at $5 million. But C's already has an offer on the table for $30 million. So this fails every Ben Graham test in the book. It's so crazy to me, this notion of cigar butts, that you're trying to pay less than literally just the property, plant, and equipment effectively. And we're not even talking about profit multiples here. We're literally just talking about like, well, are they asking you to pay more than the liquid value of all their assets? And like, oh no, six times the property, plant, and equipment. Ah, too far afield for me.

But this is where, remember we were talking about Charlie starting to get this tingling about great businesses and he's influencing Warren. He's like, hey, Warren, let's actually look at the revenue and earning side of the equation here. This company is doing $4 million in annual pre-tax profit. And that's growing at 12% per year without putting any more capital into the business. It might actually be worth paying this price. So then what? That's about 8x trillion 12 months profit multiple. Totally. I mean, imagine that. That's the offer. That's the offer right on the table. So Warren, of course, he hems and haws about it. And he's like, I can't do 30, but we could offer 25 million. And the only reason he justifies it to himself at this point is he thinks, well,

they probably have pricing power because people love the candy so much. So if we raise the prices, maybe I can get comfortable with this. This is sort of the like brand notion that he's learned at this point of, hey, there actually is a thing that doesn't show up on the balance sheet that has value. Yep. He's starting to come around. So they do get the deal done with the family. Blue Chip buys Seas for $25 million. And over the ensuing years, this little candy company delivers over $2 billion in free cash flow to first Blue Chip, and then when it would get absorbed into Berkshire Hathaway for a purchase price of $25 million. This is the first time that this concept of a wonderful business at a fair price versus a fair business at a wonderful price is executed by Warren and

with Charlie's influence. And Warren, after a brief period of time of seeing the C's operating results, becomes a total convert. So he would say later about this idea that it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. He says, Charlie understood this early. I was a slow learner. Love it. Meanwhile, Charlie is also learning from Warren that managing other people's money maybe isn't so great. So Charlie's partnership before 1971-72 had done not quite Buffett levels of performance, but generated 28.3% IRRs for the first decade, which is still fabulous performance. But not as steady as Warren. That's the thing to notice about Charlie. He did lose money some years. He did. He had some real big years and some down years. And then in 73 and 74,

Charlie's partnership falls 31.9% and then 31.5%. And this is super scarring for Charlie. He feels like he's got to... If he can get almost like Warren and his sister been the first stock he bought back in the day. He's like, if I can get the partnership level back to roughly what it was, I'm going to work like hell to do that. But then I'm out. So he does that in 75. He returns 73.2% on the partnership in 75. And then he winds it down. He's out. He says, you know what? Warren's having a good time with this Berkshire model. I'm going to do the same thing here with Bleachip. Yep. And the difference being, Charlie was still running other people's money at that point. And I think he was doing a more traditional model, management fees and effectively carried interest or some kind of promote that he was getting above some certain hurdle. But in that business, when you're losing money, you feel it really hard because you're being judged on that performance. Whereas with Warren,

the only other stakeholders that he had to think about were the other shareholders in those businesses. But Warren had made no promise to them of, I'm going to be effective with your capital. The structure was, look, I'm invested in this company, this C Corp. You're invested in this company, this C Corp. You can get out at any time. I'm not managing your money for you. And so he just has all this. He has the weight off his shoulders. He can only lose his own money. There's no one else to be mad at him. And if he does well, it's just for himself. But he's got a lot of money. So he has the firepower of a lot of capital without it being other people's capital. Yep. And if the stock goes down, great. He might just buy more of the stock. He doesn't need to feel terrible about that. He's not going to put up a negative number at the end of the year for someone. Right. He does want to make sure that Berkshire never goes out of business. That's incredibly

important to him. But yeah, any given year's performance doesn't really matter. That's not how he looks at things anymore. All right. In 1971, back when they were starting to look at C's, Warren and Charlie for Blue Chip. Bill Ruane from the Sequoia Fund calls up Warren and says, hey, next time you're in New York, I want to set you up with one of my classmates from HBS, this guy that I really think you'll enjoy meeting. Why don't you get dinner with him? His name is Tom Murphy. This is probably the fourth episode that Tom Murphy's come up on and acquired. Yes. We've talked a lot about Tom Murphy or Murph as he was known and is known. He's still alive. I think he's 95. Oh, awesome. Yeah. Amazing. And his partner, Dan Burke, who of course ran

Cap Cities, and we talked all about them on the ESPN episode and turned it into this incredible media empire that today is pretty much, what, at least 50% of Disney? More? Yeah, I think that's right. ESPN, ABC, all the television stations. And they do it all with no further capital investment after that one TV station. Unbelievable. With one very large and notable exception that we're going to talk about in a few minutes here. So they get together and Warren is immediately impressed with Murph and with Capital Cities. And he just loves everything about this business. And of course, he's already familiar with the media industry.

He's intimately familiar with the newspaper industry. He knows a little bit about the, if not television, the sort of moving picture aspect of the media business because of maybe the second biggest investing mistake that he made after Intel, which we intentionally skipped over in part one to have the big reveal here. Ben, what is the unbelievable company that in addition to Geico, in addition to Amex, Buffett had briefly owned 5% of during his partnership days? Disney. The freaking guy owned Disney and he sold it like after what, two years or something of owning it when it reached its, you know, what he felt was a good price for him to get out. Unbelievable. So yeah, I think it was one year. So in 1966, Disney had been trading at an $80 million market cap, the Walt Disney Company, at an $80 million market cap. And it's not like Disney was much smaller back then. It was still freaking Walt Disney. And it had the theme parks and everything.

Mary Poppins had just came out and made $30 million at the box office. And the stock went down because Wall Street was like, oh, well, movies, that's a hits-driven business. The next couple of years, comps are going to be real tough after that Mary Poppins. Mary Poppins just made $30 million in revenue, and the whole company is valued at a market cap of $80 million. Yes. Yes. Unbelievable.

Warren, though, being smart, being Warren, he's like, wait a minute. It's Mary Poppins. They're going to be able to generate revenues for years after this. Kids aren't only going to want to see Mary Poppins once and in one year. Every generation of kids is going to want to see this thing. Take it out of the Disney vault. So he values the company in his head just off Mary Poppins. He's like, the theme parks, all the other movies, let's assume all that's zero. That's my margin of safety. He thinks that it's still worth more than $80 million just on Mary Poppins. He puts $4 million of partnership capital into Disney, buys 5% of the company. And then of course, Warren being Warren at the time, within a year,

he's made $2 million on that. He's made a 50% return, and he sells the whole thing. My God. What's the quote, better to be approximately right than precisely wrong? Sure, he was approximately right, but you have to stretch that approximately pretty far to be like it was the right decision for you to get out of that business. I mean, okay, so the principle of that quote is, look, there's no way that you're going to be able to exactly know the intrinsic value of the company. So you will never know exactly what you should pay for it, either on your entry price or your exit price. So, you know, it's the margin of safety idea that you should be approximately

right. So if you can get a big margin of safety, then you're sort of okay on the entrance price, and you're okay on the exit price, even if they're not precisely correct. Well, you were way, way off on what the intrinsic value of this enterprise could be. And sure, you made money, but this is the sin of, I suppose it's omission because it's that he didn't continue to make money. In a way, it's commission because he actually had to act to sell the stock. But gosh, how different his net worth would be and who knows about Berkshire's future, but if he had continued to hold 5% of Disney at that point. Totally. I mean, Geico, Amex, Disney, we're not even talking about Intel. These are all companies that Buffett owned a meaningful percentage of in his very early days and didn't

hang on to him. No. All right. So he knows about the moving picture business from owning a little bit of Disney. So he's sitting down. He's sitting down with Murph. He and Murph are hashing it out and Murph says to him what? Murph says, after the dinner, Murph is so impressed with Warren's management, investing mind. these are two people cut from the same cloth, he decides that he wants Warren to join his board. So he flies out to Omaha, he makes a pilgrimage to go see Warren, and he says, hey, I really want you to join the Capital Cities board. He would have been really impressed with Warren's head office. Yeah, exactly. If you think about how Capital Cities was incredibly

lean, this is the only person who would walk into Warren Buffett's office, look around and be like, awesome. Love it. I think there's some famous story Tim was telling the ESPN episode about how they only painted the fronts of their buildings and not the sides and the backs. That sounds right though. Amazing. So Warren's like, look, Tom, I love you and Dan, but honestly, the only way that I can join your board is if I were to own a large chunk of your company. And this is like an impasse because just like Warren, Tom equally feels like issuing stock is the ultimate sin and he refuses to do it. So they agree that they're just going to be friends. They will turn to each other for advice on their various businesses for the time being, but there's not going to be any formal

relationship. It was also quite convenient of Warren to do this because he knew that the FCC rules were such that they would not let anybody be on the board of multiple different companies that owned television stations around the country. And Warren's got his eye on another company that owns some television stations, the Washington Post Company. Ah, right. I didn't realize. I forgot they had gotten into TV at this point already.

Yep, they had. They had. So his boyhood dream, his paper route. And the reason he's got his eye on the Post is they've just done a public offering. What year is this? This is 1971. 71. Okay. So still only like a year or two after he's wound down the partnership. He's still in retirement mode. Here's a little early carve out too for anyone who wants an unbelievably good sort of dramatic telling of that IPO and the events around it. Go watch The Post with Meryl Streep. The Post. Oh, it's so good. We definitely have to do a whole episode on the Washington Post

company at some point. But suffice to say for now that the story is equally, if not more, amazing than the New York Times company. The short version of it is that heading into the IPO, the Post has been in the Meyer slash Graham family for 40 some odd years at this point. The CEO of the Post, but not the chairman, the CEO is a woman named Catherine Graham, who her story is just probably many folks have heard of her, is just amazing. Watch the Post and we will tell it someday. But she assumes the role of publisher and CEO at age 46 with four children having never worked a job in her life and goes on to become one of the greatest CEOs in American history.

Sees the paper through the Pentagon Papers, through the Watergate scandal grows the value of the company enormously. She was one of the CEOs that Will Thorndike profiles in the Outsiders book. So great. So Warren sees all this from the outside. He's got the attachment to the post. The IPO is happening. This is going to be my opportunity to come back. So he reaches out to her initially with an idea. He wants to tread carefully. He's very respectful of Kay and the Graham family and what they've built. He also knows that it's a dual class share structure. So they have control. No matter how much stock he buys, all the decisions in the company are getting made by the Graham family, just like at the New York Times. So he reaches out with an idea and says, I've heard that the New Yorker, the magazine,

is for sale. Would you be interested in maybe doing a 50-50 bid, JVV to buy it together? And she has no interest in that, right? Yeah, she has no interest. She's like, I'm learning how to be a CEO here. We're taking the company public. The Pentagon Papers are happening. No, very nice to meet you, Mr. Buffett from Omaha, but thanks, but no thanks. But Warren's like, it's okay. I've gotten to know her. I've got my foot in the door. Two years later, the person who was chairman of the Washington Post company, Fritz Beebe, who I believe was a longtime family lawyer of the Myers and the Grahams, he dies and his estate is being liquidated, of which there's a lot of post stock in it. And Warren arranges to buy a 50,000 share block from the estate.

Which has to feel underhanded, right? If you're the Graham family, you're like, sorry, wait, who's buying what? Yeah, who? What? This guy at Omaha? And he'd also been buying on the open market too. he now owns five percent of the company so when he's having dinner with murph he's like he's already got his plans in motion here so he writes k a letter remember they've already met he says this purchase represents a sizable commitment to us being Berkshire and an explicitly quantified compliment to the post as a business enterprise and to you as its chief executive. Writing a check separates conviction from conversation. I recognize that the post is Graham controlled and Graham managed, and that suits me fine. Huh. So you already sort of get this beginning of him wanting to be a wonderful,

sort of an owner of wonderful businesses without controlling them and leaving sort of family owners in control. Exactly. He wants to be a partner to great managers and stewards of generational businesses. Kay, nevertheless, probably rightly is a little spooked. I bet. You get an activist investor who suddenly sends you a letter and says, by the way, I own 5% of your company. Yep. You're just so great. It suits me fine that you control it. It probably also is known at this point the way that he sort of raided the textile mill company of Berkshire Hathaway.

If you go digging on Warren, you can find some skeletons in the closet. Yep. So she agrees to meet with him briefly when she's out in Los Angeles. And Warren's thrilled. She shows up at the meeting famously looking like Kay. She's Kay Graham. She's like one of the most prominent. Stately.

Stately. One of the most prominent people in the Washington social scene. She's probably the most powerful woman in America at this point in time. Hanging out with presidents. Yeah. First name basis with, yes, everybody in Washington. And Warren shows up looking like the bedraggled, wrong size suit guy from know, guy from Omaha from the hills. And she thinks this is just hilarious. They hit it off right away in this second meeting. And she says, you know what? Maybe this Warren guy isn't so bad. Why don't you come back out, meet with me again in Washington? So he comes back out to Washington, shows up right in the middle of the Watergate

proceedings where Kay and her publisher, Ben Bradley, pulled an all-nighter the night before making decisions about what to publish about Watergate. But she still makes time for him. They go out to lunch. And then afterward, Buffett presents her with a contract that he's had drawn up that legally binds him and Berkshire that they will never buy another share of the post without the Graham family's permission. By the way, by that time, Warren already owns 12% of the company because he's kept buying. In exchange for what? Like, why would he say just we voluntarily... Not in exchange for what? Why would he say, just we voluntarily... Not in exchange for anything. He just really wants to be on Kay's good side. And he really, really wants to be on the Washington Post board. And so he's kind of presenting,

I think he uses the term, he invokes Little Red Riding Hood and the wolf. He says, I may look like the big bad wolf, but we're going to take the fangs right out of the wolf. I'm never going to buy another share without your agreement. I've had this contract drawn up. It's kind of funny, but Kay loves it. And they seal the deal. She says, well, okay, then I'll start calling you for advice. And what Warren really wanted her to say was, why don't you join the board then as a 12% owner of the company? But she doesn't. Warren desperately wants to get on the board. And why does he want to get on the board? Is it an emotional thing? We haven't talked about why Warren views a paper like this as such an incredible business. Is it worth taking a moment on that? I think the board thing specifically is probably an emotional thing.

But the paper, yeah, at this point, it's not only the dominant paper in Washington, but it's one of the foremost publications in the country, if not the world, after the Pentagon Papers and the Watergate scandal. So it both has that franchise effect in Washington. I mean, it is the paper for that city, which I think this comes from a little bit of a different story with the Buffalo Evening News, which I don't think we'll get to today. But Buffett famously referred to being the only paper in town or the biggest paper in town as an unregulated toll booth that you have where you basically have pricing power and everybody's going to subscribe to the newspaper.

So it's a license to print money. So there's definitely his notion of a franchise town newspaper is awesome. This is one of the ones in the most important town in America. And now it has this national international reach, not to mention all of these sort of great characteristics of a media business where you create the content once and then it's infinitely replicatable. And of course, there's delivery costs, but it's a freaking good business that's wonderfully defensible. Yeah. And I think specifically on that defensibility of the newspaper part of the business at the time and the winner-take-all network effect in any given geography is that if you're able to amass enough readers, it's just like the stamps business, then the advertisers want to be where the majority of the readers are. And once you get the ad dollars flowing in from the advertisers, then you can offer deals. It's like the group buying clones

in China. You can offer subscription deals to enough subscribers to grow your subscriber base that you can crowd out all the competition and the market just naturally tips to a single player. And that's happening in Washington, a large city. So this is a fantastic newspaper franchise. All right. So he's built himself a 12% position. He really likes the company. He wants to get on the board, but he's not on the board. He's not on the board. What happens next is like a middle school dance. It's hilarious. So he doesn't have the courage to say to Kay in the meeting, well, hey, I'd really like to join the

board and I presented you with this contract. Instead, he calls up Murph and he says, gosh, Murph, I really want to join the board of the Washington Post, but Kay doesn't seem to be getting the message. Do you think you could go see her and tell her how great a guy I am and that I'm really not so bad? And I really do want to join the board if she would just ask me. Wow. So Murphy, Dom goes to CK and tells her and she's like, oh my, well, yeah. I guess it would be nice to have him on the board. I really respect him. Well, but I can't really just send him a letter and ask him. He should really ask me. So Warren is like, I'm going to invite Kay out to... By this point in time, he and Susie have a

house in Emerald Bay in Laguna Beach in Orange County in California. I'm going to invite Kay out to a weekend at the family house in California, and I'm going to be like, it's going to be perfect. I'm going to host Kay, to socially make it perfect for her. And at the end of the weekend, then I'm going to make the ask to join the board. So he's really putting on a show for Kay. She comes out. She's a little puzzled. The whole weekend goes by. He doesn't ask.

He doesn't ask. And then on Sunday morning, Kay finally turns to Warren and says, so I hear you want to join the board, but I'm not sure. You know, I'm waiting for the right time to do it, to bring it to my other board members. And supposedly Warren, you know, looks at her with longing eyes and says, Kay, when is the right time then? And they fall into each other's arms and she says, join my board. And this is the beginning of a immense friendship between them. They become incredibly close for the rest

of Kay's life. They go to events together. They spend weeks at a time together in each other's houses, in each other's apartments, in various cities. It's never been written whether this relationship was purely platonic or also romantic. Unsure, but it certainly becomes an amazing relationship. Warren would stay on the board of the Post for most of the next 37 years. Oh, I didn't realize it was that long. 12% stake that Buffett bought for Berkshire cost $10 million. And in 2014, to put a bow on the Post investment, Berkshire sells its stake in what is then Graham Holdings, all the rest of the Washington Post businesses after Bezos buys the Post itself. Berkshire sells at stake for $1.1 billion, which is only a 12% IRR from the initial $10 million investment. However, the post had also been paying dividends

all throughout those 40, 50 years. So I don't have the data on how much Berkshire received in cash flow and dividends from the post, but suffice to say it was an excellent investment on Warren's part. So $10 million for $1.2 billion? $1.1. $1.1, wow. By that point, it's funny, it's actually not a big holding for Berkshire relative to everything else they own by the time Bezos buys the post. Yeah. And Bezos ends up buying the Post, I think, for $250 million.

Something like that. When that happens in 2013, 2014, certainly the value of the Post during the heyday of the newspapers of the 90s and 2000s was much, much, much higher than that. And the cash flow that it was spitting off and sending back to Berkshire and other shareholders was significant. Did you hear, by the way, a little Easter egg that in the annual meeting, one of the questions that Becky Quick from CNBC was written in by Don Graham? No, I didn't see that. Yep. Amazing. Don, of course, being Kay's son who would take over. I think he became CEO before her death and then after her death became chairman and CEO. Too funny. All right, so that's the post. So let's reset a little bit on time

frame and sort of Warren's evolution here. Everything's not yet consolidated under Berkshire, right? Who was accumulating the shares of the post? So that was Berkshire. Okay. But he's got this whole blue chip stamp thing going on. Yep. And diversified. And so we've been alluding to the hot water that they get into with the feds. So right as Charlie's closing down his partnership. And this is like 75-ish? 75. Yep. In 75, he and Warren get a call from one of Charlie's former partners at MTO, Chuck Rickerhauser, who had done the seize deal for them. And Chuck says, hey guys, I just got off the phone with the SEC. And they're considering pressing charges against you for securities violations for this Russian doll version of corporate structure that you've got going on here. And he famously tells them Chuck would spend

weeks putting together a corporate flowchart of all these different entities and who owns what. We'll try and link to an image of it in the show notes. It's amazing. There's so many different subsidiaries and sub-entities. And he looks at it and he says, there's got to be an indictment in here somewhere, guys. I don't know what you've been doing. I remember reading this when I was doing the research. And the Buffett image that you know of today, this sort of folksy, near-benevolent multi-billionaire or multi-deca-billionaire, I don't even know the right phrase for it, would be 100 billionaire if he wasn't donating so much to the Bill and

Melinda Gates Foundation, that he was in hot water with the SEC. It's just the last thing that I would have expected as sort of the Buffett novice before I started doing the research. It's still, when I was reading about this, I was picturing Warren and Charlie like Tupac in Picture Me Rolling. The federales want to see him dead. And now David Rosenthal, that is an image I can never unsee. You can never unsee that.

But it's so apt. Literally, the feds are like, I don't know what's going on here, but like, I don't like it. Clue me in. It was something to do with the fact that they ended up paying more for something when

they could have actually paid less. My understanding is I think the feds had sort of been on the tail because Warren especially is now becoming so known. He's high profile, right? He's on the board of the Washington Post. How much more high profile with agencies in Washington can you get? So the investigation comes to center on a company called Wesco Financial that Blue Chip had bought after Seas. They'd kept looking for other great businesses and that they'd bought a stake in Wesco. And this is some kind of bank? It's like a financial services business at this point?

Yeah, it was a financial services business in Southern California. And what happened was there was another company, I think like Santa Barbara Financial Corporation or something like that, Financial Corporation of Santa Barbara, that had a buyout offer for Wesco. And Warren and Charlie thought it was undervalued and had sort of stepped in and scuttled the merger and ended up investing through Blue Chip in Wesco instead. So we're going to come in, we're going to lead another investment round effectively in it or buy some more of it at a higher price to make it so that you're not going to get away with this steal that you're coming in. And so the way it goes down is they, through their work in convincing the board and the family that owned most of Wesco, they convince them to drop the merger. When the merger drops, the Wesco stock falls, of course. And that's when Warren and Charlie invest,

but they feel bad about tanking the stock price. So they decide, they work out a deal with the company and with the family that they'll buy shares and invest. I can't remember if it was at the merger price or maybe even slightly above. And the feds are like, wait a minute. There's got to be something shady going on here. Because A, you scuttled the merger.

B, you then could have just bought the stock for lower, but you paid this artificially high price. What's going on? Every other time we're investigating someone, what they ended up doing was buying the stock as cheap as possible after they precipitated an event that made the stock price fall. So they're very confused. So Warren ends up getting subpoenaed and testifies that they paid the price they did because, quote, it was important how Wesco management feels about it. Now, you can say, well, we own the controlling interest, so it doesn't make any difference. But Lou Vincenti, who is the president of Wesco, he doesn't really need to work for us. If he felt that we were, you know, slobs or something, it just wouldn't work.

And Munger, when he's testifying, he of course invokes who else but Ben Franklin in his testimony. He says, we didn't feel our obligation to the shareholders was inconsistent with leaning over backward to be fair. We have that Ben Franklin idea that the honest policy is the best policy. It had sort of a shoddy mental image to us to try to reduce the price. It's almost like the notion of the VC founder friendly thing where we're saying, hey, look, let's take a super long lens here and say that the way that we're going to maximize value for everyone, including ourselves, way down the line, is by making sure that management likes us as shareholders and feels that we're deferential to them and not capturing every little bit of value we possibly can out of

their company at their expense. Yep. And he's totally right. This is something I'd always wondered. From afar, looking at Berkshire, they buy these companies that are, if not wholly family-owned businesses, many of them are public companies, but have a large family controlling ownership like Wesco, like The Post. They buy these companies and then the family or the current management often stays on and keeps working there. And I'm like, why would they do that? And this is the key why,? Because they're not just trying to... They're playing the long game. What they really want is great managers who've built great companies to stay running them. And the way to do that isn't to negotiate every last dollar out of

them. Or even if it is, I think we're conflating two things here a little bit. I think Berkshire does make sure they get a great deal when they buy a family-owned business outright. They're good at buying low, but they either just believe that the business has so much future upside in it that they're willing to meet in the middle on price, or they are very good at identifying managers who have a splinter in their mind to continue to do the work. Like there's something about, they're very good at this shrewdly evaluating, even if this person no longer holds a single share of their company, are they going to show up for work every day because this is their life's mission and purpose? And I'm not totally, I don't think that's what was going on in the Westco financial situation, but I think when they buy these family-owned businesses, there's a lot of that in the evaluation of the business. And they definitely compensate those managers well for their

continued performance. And I think that was part of it here too, because it's almost like this is part of the upfront compensation is the price that they're going to pay right for the company this whole thing sucks though like they're this is like a multi-year drawn out thing with the sec where like it's hard for them to get on with their business in every other facet because they have this thing going on not to mention it's not great for their reputation when they're going out trying to talk to the K. Grahams of the world and saying, hey, no fangs here when the SEC is investigating them. So they end up sort of coming to this gentleman's agreement with the feds where Blue Chip, which had been the primary player in the West Coast saga, although I think Berkshire and maybe

Diversified were also buying shares too, which was was part of the problem promises not to do it again something like this it's like no admission of guilt but we also won't do it again we didn't we won't admit that we did it but if we did do it we won't do it again and most importantly warren and charlie agree to start taking steps to quote simplify this complicated rat's nest structure of companies that they have. So right off the bat, they finally merge Diversified into Berkshire, which they had wanted to anyway. And by this point, Diversified owns a large chunk of Berkshire shares. chairs charlie gets installed as the chairman of wesco to be sort of more arm's length than warren and they make it a goal to merge blue chip into berkshire as soon as all of the remaining kind of legal suits wind up and settle here that actually takes a while but it finally does happen

in 1983 wow that really took a while then it really really does take a while. Yeah. I'm not sure exactly why, but especially since the SEC wants them to merge it all into one company and Warren and Charlie want to as well. For whatever reason, it takes until 1983. All right. So they're making an effort to clean things up. They've got this SEC thing behind them. It's the late 70s. There's another chapter on the horizon for Berkshire. Oh, yes. Is there ever? And indeed, it is a chapter involving an old flame, the original crush of Warren's. I think this is the thing about Warren. I don't know about his romantic life and situation. It's certainly also complicated. There's a lot mart or it's the soda he drank growing up or it's the newspaper he delivered and like investing in each and every one of those

proves to be like a once in a generation unbelievable business it's almost like um big fish in a way like this man's life is just surrounded with these Six Sigma events of these really crazy... Or Forrest Gump. What are the odds that the smartest guy that the Army ever surveyed or the Air Force ever surveyed in that generation IQ-wise happened to also be born in Omaha and then get introduced to him by a- Work at the grocery store. It's just crazy. Yeah, work for his grandpa.

Yeah. Oh, and it's also funny that Warren and- More Warren here than I think Charlie. He's so smart and so analytical. Charlie Munger thinks Warren is the smartest person he's ever met. That's saying something. At the same time, Warren is also so emotional and nostalgic and has this, I think you said it on the last episode, this sense of like, you know, what he looks for in companies and what he absolutely wants to be himself is like viewed as an artist painting a painting. So of course, we're talking here about Geico. All right, listeners, our next sponsor is a new friend of the show, Huntress. Huntress is one of the fastest growing and most loved cybersecurity companies today.

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employees at price points that make sense for them. In fact, it's pretty wild. There are over 125,000 businesses now using Huntress, and they rave about it from the hilltops. They were voted by customers in the G2 rankings as the industry leader in endpoint detection and response for the eighth consecutive season and the industry leader in managed detection and response again this summer. Yep. So if you want cutting-edge cybersecurity solutions backed by a 24-7 team of experts who monitor, investigate, and respond to threats with unmatched precision, head on over to huntress.com slash acquired or click the link in the show notes. Our huge thanks to Huntress. it was like 20 years or so, two decades, since Buffett had tragically sold his Geico stake, the company grew immensely. It made the acquired growth in its target market when we went from just acquisitions to just telling the story of all great companies. I was like, where are you going here? When it moves beyond just targeting government employees to opening up to anybody,

non-government employees can also get their auto insurance through Geico. And this is huge. The problem, though, was that in chasing this growth in this new market, the tight underwriting and pricing of risk of all of these new customers didn't quite keep pace. If you'll remember, one of the reasons why Geico was such a great business was through the customers that they were targeting as government employees, for whatever reason or another, happened to be much safer drivers than the average population. It's a known data set. It's a pretty homogenous group. And it's a lower risk homogenous group. Totally. So they didn't really update their pricing enough as they broadened out to the rest of the population. And as we talked about last time in insurance, there is never any such thing as a bad risk,

but there is such a thing as a bad price. And the doubly compounding problem for an insurance company when you've been mispricing your risk over many years is that just like you get the amazing benefits of the float business model where you get the money up front, you get to use the money before you need to pay out claims. When you misprice your risk, that whipsaws on you. Once you realize that you're going to be on the hook for a lot more dollars than you have capital available, you're in for a long period of pain because the premiums that you got, they're already in the bank. You can't go get more money from those customers.

But you know that you're now facing years of streams in the future of more money that you're going to have to pay out than you have. Yeah. It's like you just let someone walk into your casino without testing the game. And turns out the game actually pays out the people who are playing at the casino more than it does to the house. Totally. And you're not able to change your odds or the structure of your game for a very long time, where you can only change it for new customers who come in. Yeah. The analogy breaks down somewhere in here, but yeah. It's bad, suffice to say. It's bad and it's not getting better anytime soon.

So in 1976, the company announces a $190 million underwriting loss, the largest in its history, maybe even the largest in auto insurance history, period, at that point in time. They eliminate the dividend for the company because they need to conserve all the cash that they can to deal with this. And Wall Street figures out they don't have enough capital to cover future losses. So this is like a crisis situation. Insurance regulators descend on the company. The stock drops from $61 a share to $2 a share. Can you that you know what's that like 90 value destruction you want to get to the exits before anybody else does if you're a shareholder totally so warren fortunately hasn't had all of the cigar but ben graham uh ironically ben graham with geico philosophy

beaten out of him this piques his interest again in geico so he thinks he's found another you know amex type situation where yeah like where's buffett to say that they're going to recover from this then he's not going to you know catch the knife on the way down right so he wants to find out can this actually be turned around but unlike the salad oil thing where it was pretty easy to figure out like yeah this is going to be good like that's not going to be the case here. There is no way to avoid the years of pain ahead that Geico is going to go through. But there is something that Warren sees happening that the rest of the market doesn't quite understand yet, which is that Geico, a good move, fires all of its management team and brings in a new CEO, a grizzled, literally grizzled veteran of the insurance industry

who Warren had heard about named Jack Byrne. And this guy is a legend. And does Warren have anything to do with installing him? No, no no no this is warren's just watching from afar he's waiting to see if there's something that like a glimmer of hope that maybe geico could make it out of this because the stock is like super attractive i mean two bucks a share right so this is their current board like figuring out what to do here yep yep partially at the uh shall we say, request of the regulators. So they're like, yeah, you guys are really getting yourself up a creek here. So Jack

had been one of the top execs at Travelers Insurance before he resigned in a huff when he was passed over for CEO. Wow. That's going to come full circle. Totally. It's absolutely going to come full circle. Listeners, remember traveler's insurance, just so David and I aren't making inside jokes here as we get to the end of the episode. So Jack is the man for the job. He comes in and he engineers a plan to go out to all the other auto insurers in the industry and basically argue to them like, hey, if Geico goes under, yeah, you'll lose a competitor, but it's actually going to be terrible for you. Because if we go bankrupt, all of these underwater policies, the regulators are

going to make you guys absorb them. You don't want that. Oh, man. Was that true? Is that what would happen? Well, I mean, you can't operate a motor vehicle in America without car insurance. So if your insurer goes under, you need insurance. And especially if you've got claims underway, what's going to happen to those if the insurance company behind those claims goes away? Interesting. So this is the argument that Byrne makes to the industry. And it mostly works.

And the deal that he proposes is to get all these other auto insurers not to buy GEICO, but to reinsure GEICO for some of these future losses off of their own balance sheets. And remind us what reinsurance is. Well, so reinsurance is anytime an insurer is selling off some of their risk in their portfolio to another insurance organization. And there are large reinsurers like Kettle that we've talked about on the show, One of My Angel Investments. All they do is they buy risk off of other primary insurers' books. But primary insurers can also buy risk off of other primary insurers books, but primary insurers can also buy a risk off of each other's books. This is like, just to keep bringing it back to Vegas for fun, if a sports book messes up and sets the line in the wrong place, and then they end up like 70-30 on, you know, are the Patriots going to win or the Buccaneers going to win? I can't remember if they ever played in the Super Bowl, but just throwing names out, they will go to another casino and bet the other side to basically make it so that they're sure

they're not going to make as much money on a sort of expected value basis. But now at least they're not overexposed on one side versus the other. Exactly. Exactly. In your example, I mean, Tom Brady is going to win either way. So that's the bet to make. Whichever team currently has Tom Brady is the answer to that game. There's probably a way to make that bet somewhere. I love it. We digress though. We digress. So this plan actually, Buffett is like, that's a good plan. That's like a creative plan. That could work. So he gets Kay. Remember, Geico's in Washington and Kay knows everybody in Washington. So Buffett doesn't actually know Jack. He gets Kay to broker an introduction for them. They meet at Kay's house in Washington. Buffett grills Byrne for hours and he's like, oh yeah, this guy's going to do it. So just like the first time that Buffett met Geico, when he goes, takes the train down, he meets Lorimer Davidson. And the very next day he liquidates 75% of his portfolio to load up on Geico.

To impress Ben Graham. The next day after the dinner with Byrne at Kay's house, he buys $4 million of Geico stock at two bucks a share. So he loads up. He's all in. How much of the company is that? I didn't actually disentangle that versus what he would buy in what's going to happen next. So it's some meaningful percentage. But after what happens next, Buffett's going to end up with a third of the company. Right. So this is like high single digit, low double digit that he just bought at the company. Yeah, probably in the double digits. So now, it goes back by Buffett.

Byrne is the man for the job. Things are looking up, but they still need capital to operate. They're out of money. They're going to sell off some of the risk, but they've got claims that are happening now that they need to pay off. So they need to go raise money. So Buffett tells Byrne to go up to New York and do the rounds with the investment banks and line somebody up to do a secondary equity offering out there. None of the big established banks want to touch this situation, except for one. There's one bank that is willing to take on enough risk and enough risk to their reputation of what could end up being a broken offering here, which all the white shoe banks are like, we don't do broken offerings here.

So I don't actually remember who this was. I'm going to guess by the relationship that gets forged for future events that it's Salomon Brothers. It is Salomon Brothers. Interesting. The Bank of Liars Poker, Michael Lewis Payne, which we will definitely come back to in a sec. They're the only bank that is willing to underwrite what ultimately ends up being a $76 million convertible debt deal, convertible into equity that they underwrite. Buffett flies to New York and tells, and it's not just Solomon Brothers, it's one specific person

at Solomon Brothers, a guy named John Goodfriend, who is a rising star there. Remember that name, folks. So Goodfriend and Solomon underwrite the $76 million deal. Buffett flies up to New York to sit down with Goodfriend and tell him, hey, look, I know this is going to be a tough deal to get through. Even Solomon Brothers' famous sales distribution channels, even your famous prescriptionists out there. If things go sideways, Berkshire, we're willing to underrate the deal and do all of it, but we're going to do it at a much lower price than what you go out with if the deal is broken. So Griffin's like, all right, great. At least I'll go trade on your name then at least and tell all my clients like, hey, Warren Buffett already owns a large percentage of this company

and he's willing to... Okay. So what do you mean trade on his name? What do you mean Buffett will do it all but at a lower price? He would buy the whole offering? If they're trying to sell a whole swath of stock at a certain price, is this the convertible preferred that they're selling? Yeah. This is the convertible... I think it's convertible debt, not convertible preferred. But yeah, essentially what Buffett says is he's like, look, I'm good for the 76 million, but I want you to go out there and try and get this deal done at less dilution, like a higher price on that convert. It's like when an insider in a venture round tells the company, hey, like I'm good for my pro rata in whatever round you raise,

go raise the round, go get a price. If you were to lead an inside round, you know, I'd lead it. Like if you wanted to do an inside round, but it won't be at the price where you could go raise your external. Your external round. Exactly. That's exactly what's going on here. So, Gertrude's like, all right, I can work with that. They go out, Salomon Brothers,

sales and trading, famous, aggressive sales and trading desk. They get the deal done. It ends up being oversubscribed. And Buffett does end up, even though it's oversubscribed and goes out at the price that they wanted, Warren's like, all right, I think this company is going to make it. He ends up buying 25% of the deal, even at full price for Berkshire. The stock, even though they just issued new convertible into equity securities, the stock jumps to $8 a share because people realize, hey, this is good news. This thing could make it out alive. And if it does, damn good business. Yeah, exactly. So Geico has now got two of the three problems solved.

It's capitalized. It's got enough money to make it through. It's laid off a lot of the tail of risk in their current book over the coming years with the reinsurance deals that they do. But it's still not pricing right. So the thing about auto insurance and most consumer insurance is you need licenses to operate in any state. And part of the licensing process is you have a license to sell insurance at a certain price.

You can't just arbitrarily change your price on your customers. The regulators don't allow that. It's a super weird market. It's not like we could change the price of the LP show tomorrow if we want. You're only allowed to make a certain amount of profit too. There's sort of a cap on the profitability of insurance businesses. Exactly. So this is Byrne's time to shine. This this is amazing this is my favorite moment i think of this whole second episode so he goes out to all the states individually he explains the situation be like hey we were mispricing we got to raise prices on consumers and some of the states are okay with it apparently new york right off the bat it's like yeah we get it okay fine but some

of the states are playing hardball and in particular new jersey is playing hardball huh i mean new jersey right like uh burn himself north yeah burn himself is from new jersey so he's like all right you want to you want to do some mafia tactics here i'll do some mafia tactics so i'm just gonna read what happens next from the snowball because i can't do this any better than Alice did here. So Byrne marched into the New Jersey commissioner's office with a copy of the company's license to operate in the state in his pocket and told Sheeran, the commissioner, that Geico must have a rate increase. This is now a quote from Byrne. He had a sour ass little wizened actuary at his side who'd been fired by some insurance company and had a bone to pick. Sheeran said, my numbers didn't

justify a rate increase. I did all the arm waving and stuff that I could, and Mr. Sheeran was intractable. So Byrne pulled the license out of his pocket, threw it on Sheeran's desk saying, I have no choice but to turn in the license or something to that effect with more four letter words. He then drove off to the office with his tire screeching, sent out telegrams to 30,000 policyholders in New Jersey, canceling their insurance that day and fired 2000 New Jersey employees in a single afternoon before Sheeran could go to court and get an injunction to stop him. Byrne says, It showed everybody, all audiences, I was serious about this.

And that I was going to fight for the life of this company no matter what, including walking out of a state which wasn't done back then. Byrne's impalement of New Jersey had exactly that effect. Everybody knew he was serious. And so do they end up actually just vacating New Jersey and just didn't serve policies there? Yeah. They literally vacate New Jersey. They vacate a bunch of other states. And Byrne is like, look, this is war. We got to reprice. So either we're going to burn the house down and vacate these states, or we're going to be allowed to reprice. So Geico, by the end of this, has shrunken down to only seven states. It's like the original Travis Kalanick. I know. I know. It's amazing. He

has shrunken down to only seven states. Byrne has completely swapped out everybody in the company. Famously, a lot of the sort of middle and lower management in the company was from the old days, undisciplined days. Apparently, at one point, the then existing HR director is giving a speech in front of the company and Byrne gets so upset that he storms on stage and fires him on the spot, literally gives him the hook, takes him on stage, points at somebody in the audience and says, you're the new HR director, brings him up on stage. Amazing. Is Lorimer still there at this point in history? Lorimer is long retired at this point in time, but he's cheering on from the sidelines that he's advising

Byrne and Buffett behind the scenes. Wow. Amazing. So they shrink Geico down to only the seven states and DC that let them change the rates. And they right the ship and they price the policies appropriately. The company gets profitable. It stops losing money. It starts growing again and then would go on to become... What did Warren say in the annual meeting this weekend? I think that they have like 20... Second largest insurance company. Yeah. Progressive is slightly larger, but I think they each have about 25% of the US market. Wow. Something like that. Incredible. And he spent $47 million from 1976 to 1980 to buy, is it about half the company?

So yes, by the time the debt offering closes, and then when the share price jumps, I assume the debt converts at that point. Berkshire owns 33% of Geico. But because he's Warren, and because this is now one of his jewels, he runs the playbook that he's also helping Kay Graham run at the Post. Geico starts buying back its own stock. So by the mid-90s, we're fast-forwarding to... We'll get to this later in the next episode. By the mid-90s, Berkshire has 50% of the company without putting in another dollar. And then in 1995, Berkshire buys the rest of Geico that it doesn't own for $2.3 billion. So they get half the company for $47 million and half the company for $2.3 billion. Either way, they get a hell of a deal because estimates are that Geico is worth probably about $50 billion today, maybe more. So that's $25 billion of value, assuming that's 50 on $45 billion and $25 billion billion of value on 2.3 billion. Either way, pretty good.

Either way, pretty good. Warren's like, look at me now, feds. Listeners, even though this is going to be in the final part of the trilogy, we do have to tell you that in 1996, the 2.3 billion that was used to purchase the second half of Geico, you might be saying to yourself, why did it take so long if you really like this business forever? Well, Berkshire had a lot of cash tied up in other stuff for a while. And a thing that happened pretty much immediately before this $2.3 billion transaction for half of Geico was that Warren had a big investment in Capital Cities,

and Disney came in and bought ABC Capital Cities, which then, of course, in that outright sale, all the proceeds went to good old Berkshire, and that was a little bit more capital than $2.3 billion, but about the same amount that suddenly they had to play with to go put to work somewhere else, and Geico was where they decided to go put to work somewhere else. And Geico was where they decided to go put it to work. What better jewel to put that capital into than Geico?

Amazing. So it's funny. I said on the first episode, something that I was totally convinced was right at the time, and now maybe not, where I said that, God, if Warren had just held on to Geico and not sold, imagine what his returns could have been. Who knows what would have happened otherwise? But Geico almost died, right? If he had held on, would he have had this ride anyway and ended up here? He got to buy back in at two bucks a share. Totally. Yeah, that's a good point. He did get it at an extremely low basis, even though he skipped a few decades of compounding and growing in there. It is also worth pointing out that despite the fact that it is a Buffett mantra to hold businesses forever, hold great businesses

that you believe in forever, he can dump a stock just as fast as the next guy. I mean, the way that he dumped all the airline stocks at probably the low point of the COVID stock crash, it was really interesting hearing him on stage last week where he was totally unapologetic for that, thought it was totally the right move. And you could imagine that he easily could have been convinced that that was the right thing to do in the Geico situation too. Totally. And all that matters is the long run. Although as Charlie Munger would say, who is it? I think it's Charlie quoting John Maynard Keynes that in the long run, we're all dead. So, you know, but in the long run, Geico becomes, you know, one of the major jewels,

if not the most important piece of Berkshire, especially given all the float that they generate. I guess that is the big thing that Berkshire and Warren miss over that 20-year period where he's not invested in Geico is using the float. Yep. There is a playbook theme I want to pull forward here, which is, and it's actually two themes, and it's important to know how they're different. The first one is identifying things that have far less risk than the market perceives them to have. And that's things like American Express. That's things like him realizing that brands are more powerful than value investors give them credit for, or the magical thing of a monopoly franchise newspaper. But then there's this second category

of identifying things that, should you act, will have far less risk than the market perceives them to have. And even more importantly, if you uniquely have the capability to act, then you actually can be value creative. Like the thing that he did with Geico in making sure that that financing got done, there's not a lot of people out there whose name can be traded on to get an offering done like that. And Buffett's willingness to both strategize and then put his name on the line, and of course his name wasn't really on the line because otherwise he just would have gotten the screaming deal, but did a thing that he was uniquely suited to do and able to do meant that in a self-fulfilling prophecy way,

the investment was way less risky merely because he was involved. Yep. Oh boy. Is that ever the case? And does Warren ever know it? David, I figured I'd set you for that next story we got coming. Well, you tossed that ball in the air and I cannot wait to slam it. But before we get to Warren getting punch drunk on his own reputation and ability to save businesses. So the Geico situation wraps up around 1980, and it's off to the races. The rest of the beginning of the 80s is just more goodness for Warren and Charlie and Berkshire. So finally, when Paul Volcker becomes chairman of the Fed,

first at the end of the Carter administration, and then under the Reagan administration, he enacts the correct fiscal and monetary policy to reverse the terrible inflation that had been happening. And the 80s just become... We're both children of the 80s, an immense period of prosperity, the 80s and 90s for America. So the 80s are the go-go years. This is Wall Street movie. This is excess. This is everything. And it's a good time for Berkshire in Omaha too. So we won't go into all the details, but they buy the Nebraska furniture mart from Mrs. B. Incredible story. She then gets upset with the way her children who are in their 80s at this point, or 70s, are running the business. She leaves, starts a competitor across the street at age 95 when Berkshire has to buy it back for $5 million and sign a non-compete

with her at age 95. Amazing. There's the Buffalo Evening News in here, sort of the early 80s, which is when Buffett really... Is that the early 80s? Yep. Early 80s. Yep. He gets into a good old-fashioned newspaper war. He's trying to be the franchise newspaper in the city, ends up sinking tons of capital in, gets into not a fight, but a few disagreements and has some words with Charlie about the right things to do. But Buffett's a committed guy. There's a bunch of stuff that happens in here that we could do 10 episodes and wouldn't have time for it all. Totally. He goes to war with the efficient market hypothesis theorists, which is amazing. At Columbia's 50th anniversary event of the publishing of security analysis, he gives this talk where he just calls it the super investors of Graham and Doddville. It gives this long talk

eviscerating the efficient market hypothesis folks, economists, which basically their hypothesis is that all markets are efficient and that changes in price are simply volatility and around the efficient price and that volatility equals risk. And so that is market beta. And that's all there is. If you're investing, there is no such thing as investing acumen. You're just taking volatility risk in the market. Charlie has a one word retort to that, which is bullshit. Warren goes through and eloquently explains why that's wrong. Well, and they just have a lifetime of investment results to prove it.

They actually can generate alpha. Otherwise, you have to believe that Buffett has flipped a coin and it's come up heads 100,000 times in a row. You're into these crazy probabilistic scenarios where at some point, it's too many standard deviations away from the mean for you to believe that it's possible. Yeah. And the reason this is important for what's about to come is, so like all this is theory, right? This is like economic theory, but it has a very, very important real world consequence in the 80s, which is that people who use to their advantage the academic thinking behind the efficient market hypothesis that risk equals volatility,

they realized that, well, wait, if risk equals volatility and you can't get alpha, the way you can get more returns if you take something that has a certain degree of volatility and then you lever the crap out of it with debt, you magnify that volatility, and then you can magnify your returns if you arbitrage that. And so this is when the 80s are the debt-fueled decade. Mortgage-backed securities get introduced. All the junk bonds and Michael Milken and DLJ and corporate raiders and corporate takeovers are all happening. Massive leverage buyouts. You get barbarians at the gate. Yep. Argyle and Nabisco, everything. And Buffett and Charlie are sitting and looking at this and they're like, volatility being risk is nonsensical. Risk is risk that you go out of business. And introducing debt into the equation, far from not changing your risk, it massively increases your risk

because what causes you to get game over, it's when you go bankrupt and you can't pay off your debt. So while they're out there espousing this philosophy, in the meantime, well, they do do the capital cities deal finally with Tom and Dan. So Buffett stepped off the board of the Post to be able to do the Cap Cities investment? The Cap Cities deal. So he invests $517 million in Cap Cities to help them buy ABC. $517 million. I mean, that's a big chunk of money, but he can do this at Berkshire now. They're enormous. They're a multi-billion dollar company. He's a billionaire himself already at this point. And so if these guys are anti-leverage

and they're trying not to do the LBO thing where you lever up and then buy something and then have to make debt payments forever out of the profits of the thing that you just bought, how does the Cap Cities transaction work then where Cap Cities is able to be the minnow that swallows the whale? Well, a big part of it is that $517 million in equity from Berkshire coming in to the deal. I see. So they basically have a very large post-money valuation effectively because they're issuing a whole bunch of new primary shares out of CapCities to be able to have enough money on the balance sheet to buy ABC. So I don't have notes on exactly what the structure of the deal was. I believe it was some Cap City stock plus the 500 million

in equity from, I think it was convertible equity from Berkshire. And then they probably did add on some debt as part of it, but you know, like a reasonable amount of debt, like, right. Especially with a predictable cashflow business, you know, that that's reasonable where Warren and Charlie get themselves into not just like trouble on the order of the trouble with the feds earlier in the episodes, or actually the multiple troubles with the feds earlier at the episodes, but real honest to God, like frankly, the worst moments of their lives, trouble, is when they think that their reputation and their ability to save companies and their ability to be this capital partner to companies is so great that they can come in and save Wall Street itself.

Or Wall Street from itself. Or Wall Street from itself with solomon brothers oh boy here we go so remember we told you to remember john goodfriend and solomon brothers who had helped geico do the convert deal that warren backstopped you know warren thinks goodfriend walks on water at this point. They're the only bank that was willing to do this. Warren famously and Charlie, they famously hate Wall Street. They hate banks. But okay, you did be a solid. And we know these guys. So we feel for them a little bit. They don't seem like the enemy.

They're kind of our. We know them. Yep. So we're now in the late 80s. Goodfriend has become the CEO of Salomon Brothers. They've gone through a series of mergers and acquisitions. The firm is much bigger than it was before. It's now publicly traded. And Salomon already was the debt king. But in this environment of the debt-fueled, everything we were just saying about the 80s, Solomon is the king. They sold the first mortgage back security, an inglorious honor if there ever was one. They go deep into junk bonds, derivatives, all kinds of hairy stuff. It gets so extreme at Solomon that in 1980, I think it was 86, a young Princeton graduate and aspiring writer shows up at the firm as a new hire, Michael Lewis, on the Bond sales and trading desk and ends up writing a book about

his experiences, intended to be as a cautionary tale of the wretched excesses of Wall Street, has the exact opposite effect called Liar's Poker. It's inspirational beacon for a generation of Wall Streeters to come. Look, I remember reading the book when I was graduating from Princeton and about to go work on Wall Street myself. It's like the social network 20 years later. This was meant to be, at most, at best, a show all sides of a complicated situation and at worst, a cautionary tale. And instead, a whole generation of young people just look at it and they say, I want me some of that.

Sounds fun. You get rich. Great. I'll just read one quote from the book where Lewis writes about the famous 41st floor home of the bond traders at Solomon. He says, because the 41st floor was the chosen home of the firm's most ambitious people, and because there were no rules governing the pursuit of profit and glory, the men who worked there, including the more bloodthirsty, had a hunted look about them. The place was governed by the simple understanding that the unbridled pursuit of perceived self-interest was healthy, eat or be eaten. The men of 41 worked with one eye cast over their shoulders to see whether someone was trying to do them in, for there was no telling what manner of man had leveled himself

to the rung below you and was now hungry for your job. The limit of acceptable contact within Solomon Brothers was wide indeed. Here was capitalism at its most raw and its most self-destructive. I love Michael Lewis. I could make every single one of his books a carve out at some point. So great. So despite this immense success in the bond market, Solomon and Goodfriend have gotten themselves in kind of a pickle here because it's working too well. All these traders, all these wolves of Wall Street, they are generating so much money, but they're demanding that they're going to get paid all the money. So all of it gets paid out in bonuses to all the traders who are constantly demanding more and threatening to leave for other firms, that the corporation itself, the recently public, now public company, Solomon Brothers,

the profits are actually declining. I was seeing some stat that even in a year, I think it was in a year where they underperformed the S&P 500, there were still over 100 people at the firm that were paid out over a million dollars in their bonus. Oh, totally. Yeah. One year where that happened, famously, one guy, just individual trader, made a $23 million bonus in one year in 1987 or something. Right. Which is, I don't know, 2x, 2.5x by inflation today. Whatever it is, that's a damn lot of money. For a rent seeker. Totally.

Where's the value creation there? Oh, there is only value destruction happening here. There is nothing being created. Or certainly value capture. Absolutely. So because Solomon itself is suffering, they start attracting the attention of corporate raiders, and in particular, Ron Perlman. Revlon, right?

Yeah, Revlon. Yeah. He buys out Solomon's existing largest shareholder, and he starts agitating. He's going to take over Solomon Brothers, which good friend of nobody at the firm because they just want to keep paying themselves the bonuses. They, of course, don't want this. So you've got basically the 100% most anti-Buffett and Munger, at least what they say, situation possible here. A bunch of people at the firm management, quote unquote, there's no management going on, but employees just simply enriching themselves at the cost of shareholders while ratcheting up risk in the economy and creating no value uh what could be better good friend calls buffett he's worried about he doesn't want to get thrown out by pearlman and he says he needs to cash in the favor from the geico deal and warren you know berkshire has such a reputation of being the white knight and

saving companies at this point that and being management friendly and being management friendly exactly it's all going to come back to bite them that good friend says like hey if I can get Warren to join the board I'm going to get Perlman off off my rear end so Warren and Charlie agree to do it and and they both take board seats right they get two And they both take board seats, right? They get two seats. They both take board seats. So here's how it goes down. It's Rosh Hashanah weekend in September 1987.

And Perlman is like an Orthodox Jew. So he's out of commission. He's not doing anything over the weekend. And good friend knows this. And so he times everything. So he gets the deal done in secret with buffett and berkshire over that weekend berkshire buys 700 million dollars of convertible preferred stock in solomon so more than the money than they put into cap cities

with a 15 15 percent interest rate coupon on attached to that convertible preferred stock. So it's like the company's in dire straits and the CEO really doesn't want or really does want to incentivize these particular shareholders to become shareholders. Well, that's what's so disgusting about this situation is like the revenue line essentially of the firm has never been better like these traders you can say what you will about what they're doing but they are raking in money for the top line but then they're paying it all off to themselves in bonuses so the firm is suffering capital's coming in they do this really tough terms deal simply to save you know again quote-unquote management's own skin

it's it's really something that goes on here and i mean it's crazy that warren and charlie and berkshire do this even you know loyalty is super important to them and good friend and solomon having saved gecko anyway they it. Both of them join the board and there's this famous scene where they fly to New York, the two of them over this weekend. Maybe this must be like on the Friday. And they go to the Solomon building to sign the papers and good friend takes them on a tour. They go to the balcony overlooking floor 41. It's like a callback to child Warren overlooking the balcony of the stock exchange and being like, wow, there's so much money here. I want me some of that.

And they're looking down on what's essentially like a seething gladiator pit below. And Charlie looks at Warren and he says, so you really want to invest in this, huh? And Warren supposedly just is kind of like silent for a minute. You can just see him being like, what am I getting myself into? And he finally says, mm-hmm, in like a slow, and then he goes and signs the papers. And credit to Charlie for asking the question, but Charlie follows him into the pit too. Oh, 100%. for asking the question, but Charlie follows him

into the pit too and joins the board as well. Totally. And probably regretted it every day after. So they do the deal. This is September of 1987. October 19th of 1987 is Black Monday when the Dow falls 22.6% in essentially a flash crash. I had this confused in my mind. I thought Black Monday in 87 was the long-term capital management thing. No, that happened much later. This was actually a flash crash. So nobody really knows why this happened. Of course, the market was overheated. Of course, there was way too much leverage in the system, but things recover pretty quickly. That's not what triggers a meltdown. So Solomon, of course, gets crushed like the rest of Wall Street. They lose $75 million

in trading losses on that day. The stock gets crushed, but they're not in any better or worse shape than any other investment bank, But the stock has swayed down. So Buffett and Munger show up to their first board meeting after this happens, which is like the next month, maybe in November. And Goodfriend and Management puts a deal on the table to reprice all employees' stock options because the stock is down. And Buffett and Munger flip they're like wait a minute you guys lost a ton of money for the firm like we as you know as shareholders in the firm like our stock that we just invested our 700 million is now worth less and you guys are saying you want to take advantage of this lower stock price to reprice all of your options that you're then

just going to trade out of immediately as soon as they vest and liquidate the cash. Right. It's like, you know, no one here wants to become bigger owners of this thing. You all just want a quick arbitrage opportunity. Exactly. Exactly. But they acquiesce, you know, they don't really want to fight with management. And they also know that if they get into kind of a public fight with, if this becomes public, that they're fighting with Goodfriend and the board. Stock price drops even further. Stock price is going to drop even further. And they've got $700 million at stake here.

And so they don't really want to do that. So, I mean, we're already pretty far down the slippery slope here. This is when the real slide starts. So not only do the options get repriced, but then in secret behind the board's back, Goodfriend reaches a deal with the head of the best performing trading desk on the floor, the so-called magical ARB desk, the bond arbitrage desk run by John Merriweather, who runs the domestic fixed income arbitrage group, to directly pay them 15% of all the trading profit they make as bonuses. So no longer even just like, hey, management will decide your bonus at the end of the year. It'll be based on the performance of the firm. It's now like you're a prop shop. 15% of all of your profits you're

going to take home with none of your own capital at risk and on the hook for none of the downside when you have losses. Wow. That'll incentivize some bad behavior. Yeah. So things limp along for the next couple of years. Warren and Charlie aren't thrilled about everything that's going on. So then the shoe drops. In August of 1991, Buffett is on vacation in Reno, Nevada, and he gets a call from, not from Goodfriend, from Solomon's president, Tom Strauss, and its general counsel, Don Feuerstein, who behind the scenes at Solomon, Don is referred to as, quote, the prince of darkness for all of the dirty work. Things I never want to be called. Yeah. All of the sticky situations that he gets Solomon out of and all the dirty work he does. This is amazing. You can't make this stuff

up. So Warren's on vacation. He gets a call. This is not a call you want to get. And so Warren's suspicious. They get on the phone and they're like, well, our firm's outside counsel, Solomon's outside counsel has figured out that the head of our government bond trading desk, Paul Moser, who reports to Merriweather, he's apparently been violating some of the Treasury Department's rules when bidding on government bond auctions. The way the Fed controls the money supply, the way that interest rates are set, they bid out bonds, government debt, and then all the big investment banks get to place bids in terms of interest rate, and then the government selects which banks buy the debt. And there's only a few, what is it, 40 banks or something that are even allowed to be involved

in these options, that are allowed to have the privilege of buying debt from the US government. Yeah, this is the way the money supply gets into the economy. To be one of these banks means that you are controlling, you have a direct relationship with the federal government and the treasury controlling the economy. So Moser has been violating the rules. They don't say exactly how or why and that they've suspended him and Solomon is going to notify the regulators about this. And Warren's like, oh, the Prince of Darkness is calling me for this. Like, that doesn't seem that bad. Like, you violate some rules, okay. But like, while this is really important and prestigious,

this is like kind of a sleepy part of the firm. You wouldn't think that the government bond desk is something that could like blow up the firm. You know, you'd be more worried about the ARB desk per se. So he's like, all right, well, you know, call Charlie. He's the lawyer between us you know he'll he'll know what to do just just some rules like how bad could it really be i'm sure it's just some regulatory tape some regulatory stuff so they're like oh yes we've we've already talked

to charlie he's totally cool with it like no worries so i was like okay great i'm gonna go back to vacation well turns out charlie wasn't totally cool with it. And turns out that maybe Moser did a little bit more than just violate the treasury's bidding rules. What he actually did was he submitted fake bids on behalf of clients for the treasury auctions, both fake bids for real clients and fake bids for fake clients. So on behalf of people who weren't even customers of Salomon Brothers. And his goal in doing this was to essentially corner the market in this auction, win all of the auction for these treasury bonds, and put the squeeze on all the other participants who needed the bonds to resell

to their clients so that he could then sell it at a massive profit in the market, which he did. And of course, while it's illegal to bid on behalf of your clients who are not placing orders, and then it's even more illegal to bid on behalf of imaginary clients, it's also illegal to try and quarter the market on a given auction. There are rules in place that say things like you can't try and bid for more than 35% of any given auction because we need it to be able to be spread around because we don't want this big second market for people paying a big premium because someone managed to go get 90% of the allocation. Totally. And the reason they don't want this to have happen is what actually happens as a result of Moser's actions. Three or four small financial firms that couldn't absorb

this price volatility go bankrupt. So this is real, what the dude did. And I think he did this four or five times. And the net of all of it was Solomon made an incremental $4 million in profit. All this for $4 million. So it turns out he did it multiple times. It turns out that Meriwether, who was his boss in the chain of command, and Goodfriend knew about this four months ago. And they knew about it because the SEC started investigating and got in touch with them. And when that happened, the general counsel, the Prince of Darkness, told Goodfriend that what was happening here was criminal, but that technically, they didn't have any technical obligation to report it to anyone. The CEO is sending letters to the general council

without notifying the board. Like, hey, I got this letter from the SEC. They're investigating us, but just our GC needs to know about it. Yep. Not notifying the board, not notifying the shareholders or the public, and equally, if not worse, not notifying the other regulators that this is going on. So the SEC is investigating, but they haven't found any. They just found some irregularities. Internally, Solomon found, oh, no, this is criminal. What's going on here? So they don't tell anybody. And not only that, they don't fire moser they leave him in place running the government bond desk and there's no audits or controls on what he's doing so basically they're like don't do that again wink wink wink wow and then they turn around and look the other way so at this point in time

the sec has like figured out yeah, these aren't just irregularities. They figured out what's going on. Word starts to get out. On Monday after this, August 12th, the Wall Street Journal runs a big piece about how bad this could be and how little is known. Solomon's counterparties, their lenders and their trading partners start getting cold feet about dealing with Solomon and all the markets that they operate in. And Solomon, it turns out, they're the second biggest bank on Wall Street at this point in time. They have 150, 150 billion of capital in the markets. Wow. But they only have $4 billion of equity.

All the rest of it is like short-term paper and debt and leverage and like everything that has been building up in the 80s. So they're like, what's that? 60 times levered on their capital. And all of a sudden their counterparties start getting cold feet about trading their paper. And 50 billion, 5-0 billion of $150 billion rolls over every single day. That's really short-term paper.

So if there's a problem, it's going to be instantaneous and the firm is dead. So also on that same day, on that Monday, this is probably the worst thing that happens. So the Federal Reserve sends a letter to Goodfriend and Solomon saying, I think only Goodfriend and the general counsel see this, saying that it is quote, deeply troubled by both the firm's actions and lack of actions. And it is questioning whether it can continue to have a business relationship with Solomon Brothers. This is the Federal Reserve. Unless the firm responds to this letter and significantly changes its business practices within the next 10 days. Now, if the Fed ends its business relationship with Solomon, game over. It's dead. All the counterparties are going to stop trading with Solomon.

Wow. It's literally game over instantaneously. Good friend and the GC just sit on the letter. They don't tell the board. They don't tell anyone else. They don't tell the shareholder. Nobody knows about the letter except the two of them. The feds assume that the board knows about the letter

that like Solomon is doing something. But good friend and the GC cover it up. Buffett, by this point in time, he gets in touch with Charlie and Charlie's like, yeah, you should be concerned about this. So the board convenes, they issue a press release saying that they're looking into this and figuring out what happened. The firm's stock drops 30% that day. The Fed, meanwhile, is like, you guys aren't responding to our letter. They're just getting angrier and angrier every day that goes by. On Friday of that week, the New York Times runs a headline, Wall Street sees a serious

threat to Salomon Brothers. And the Fed finally has had enough. The lead investigator running the case at the Federal Reserve calls Goodfriend and says, you need to resign today. And you need to install new management or else. When Goodfriend gets that call, he calls Buffett, who's still in Omaha, and he essentially just tosses him the keys to the firm. And he's like, I'm going to resign. Somebody has to step in and run the place and deal's like i'm gonna resign somebody has to step in and run the place and deal with this and it's probably got to be you so good luck with that wow not quite in that language but uh but that's essentially how it goes down pretty intense stuff warren and charlie are legitimately frightened at this point and the argument argument there is like, hey, I have to be out.

We don't have any ideas for who's next. Yep. There's no plan. There's no management. Whoever steps in has to have the reputation to be able to save this firm. And nobody wants their investment to go to zero. So I pick you as the person who seems like you might be able to save this thing. Well, at this point, the fiduciarily responsible people are the board and who are the most prominent people on the board, Warren and Charlie and Warren specifically. So like, you know, good friends already out as CEO. So there's nobody left except Warren to come in and deal with this.

So Warren immediately gets on a plane to New York and he goes and meets with the Federal Reserve and tries to understand and sweet talk them. This is amazing to me. The Fed, I think, assumes that Warren knows about their letter, but he doesn't. And that wires still get crossed in this meeting. So Warren doesn't understand what that wires still get crossed in this meeting. So Warren

doesn't understand what the worst case scenario really is. And cryptically at the end of the meeting, Buffett's trying to sweet talk them and buy more time. The Fed tells Warren that to quote, prepare for all eventualities, i.e. that they're going to yank the right to participate in the treasury auctions and Solomon's going to go down the tubes. So now it's Friday night into Saturday morning and Warren has to make a choice. He can walk away from Solomon, say I'm resigning. And $700 million goes up in flames. But he can walk away.

Or the other option is he can take the reins of the company and try and steer this thing through as he's thinking about and talking with charlie he realized he actually doesn't have a choice because if he walks away his reputation is toast if he walks away a hundred percent his reputation is toast and like he loses 700 million like that'll be fine. But what company is going to do a deal with Berkshire Hathaway ever again after this? And if he stays, probably there's a good chance he's not going to be able to navigate through this, in which case his reputation is also toast. Which this brings up that George Bernard Shaw quote that I think it's Charlie who likes to quote it, never wrestle with a pig. You just get dirty, but the pig enjoys it. Exactly. And you can imagine that moment where they're standing out looking over the trading floor,

knowing that they're about to wrestle with a pig. And then this is the eventuality of what happened with that. Yep. And this is where, as he's realizing this, so Alice writes in The Snowball, quote, at some point during that long, horrible Friday, he recognized with a sickening jolt that investing in Solomon, a business with problems over which he had essentially no control had put it all at risk. And by all,

she means everything, not just the 700 million in Solomon, like everything that Warren and Charlie together have built. They're both on the board. So he decides he has to take the job. He decides he's going to become interim chairman of the company. And he installs the head of the investment banking division, a guy named Derek Maughan as the CEO. That's just kind of like a... I mean, the investment bank, that was the one thing that Solomon was not good at was the investment banking advisory at business. So he gets installed simply because he's just far away from all the toxicity. And then on Sunday, the board, Warren and Charlie

and the whole board is at the office in New York. They're trying to figure out what to do. When a letter arrives from both the federal reserve and the treasury department they haven't heard any response to their deadline of things have got to happen yeah and thus far nothing has been announced from solomon so they say they've had enough it's the end like no more negotiating they're pulling the plug that afternoon and by by the time the market opens in Tokyo, which is like, I think late afternoon, New York time, this is Sunday afternoon. So Monday morning, Tokyo time, it's going to be announced that the Fed has revoked Solomon's licenses and it's over. So Warren directs the board and the lawyers to start preparing a bankruptcy filing.

And in the meantime, he desperately starts trying to call anybody he knows in the government, using all of his Washington connections to try and stay the execution here. And he finally reaches the Treasury Secretary, Nick Brady, which is the Treasury and the Fed jointly made this decision. And Warren literally breaks down on the phone crying and begs him, says, this is the most important day of my entire life, begs him to stay the execution and just give them a little more time and figure things out. And so Brady is moved by this. Literally If I literally Warren Buffett, you know, if there's anybody in the world who could get the government to change its mind and he says like,

okay, let me go talk to, let me go talk to Greenspan, the head of the fed and figure out what we're going to do. So hours go by, it's all in limbo and they're just sitting in just sitting in the Solomon office drafting up a bankruptcy filing. And then a call comes in from the assistant treasury secretary. Do you know who that was at the time? Call comes in for Buffett. No. One Jerome Powell.

Oh my God. Then assistant secretary of the treasury. Incredible. Incredible. And he says, look, this is bad. We're not going to allow Solomon to bid itself in treasury auctions anymore. So we are going to, we need our pound of flesh. We will, however, because of you, Warren, because you're stepping in and you're committing to making changes, we will allow Solomon to continue to place bids on behalf of its clients. And he says, will that work? And Warren is like, that'll do. Whoa. Yeah. So he literally gets the government to reverse their decision. Unbelievable. That's insane. So now they have to deal with the aftermath.

Also, it's incredible that Goodfriend never showed the letter because I assume he was a shareholder too. And of course, it's going to come out that there was a letter sent at some point. So it's not like he's saving himself any legal liability by not disclosing it. Well, I think what happened, I don't know how far in advance he had gamed this out. What ends up happening, I'll tell the story in a minute

of how this all wraps up, but as this is going down concurrently that weekend, Goodfriend and his lawyer, they end up, because Warren still, he doesn't know the extent of good friend's you know deception here and cover up and he doesn't know about the letter he doesn't find out about the letter until later and so they go out to dinner and uh good friend and his lawyer uh

personal lawyer try and get warren and charlie to sign a severance package for him leaving the company. They want a $35 million payout. Your reaction is priceless there. That's wild. Isn't that wild? So they're trying to get the money as always. And fortunately, you know, they're dealing with Charlie Munger here.

So Charlie basically stonewalls them. He, this is amazing. I don't have the quote written down here, but this would later get arbitrated. And Charlie would testify in the arbitration under oath that Charlie's natural way of being with other people is he turns his brain off when he's not interested in things and he wasn't interested in what they had to say. And so he was just muttering and not saying anything. It is amazing. In the negotiation. Yeah. The negotiation. So they don't agree to anything. They don't sign anything.

And ends up after years of fighting this in arbitration, get $0 as he should. Anyway. So they get the save, the stay of execution from the government and then they have to deal with the aftermath so warren has no interest or ability in actually running day-to-day solomon brothers but what he can do is he can deal with the government and the public so he instructs mon the new CEO, to clean up the firm inside. You handle everything inside the building. And his instructions are, get it right, get it fast,

get it out in terms of dealing with all the corruption in Solomon. And basically, the first thing that happens that week is Warren gets summoned before Congress to go testify in front of Congress. And this is brilliant. So they bring in MTO, Munger, Tolson, and Olson, of course, to represent them in all this. And Roy Olson comes in. And Roy suggests this brilliant step that goes a long way, I think, towards saving Warren and Solomon. He suggests that they proactively go to the government and say, we will waive our attorney-client privilege. So everything, which is, this is like extraordinary. This never happens. So they're going to the government and they're saying, all of our communications and anything that MTO finds at Solomon, we will share with you.

Wow. And it makes sense to do that because they're the new guard. So there's no way it can reflect poorly on Warren, Charlie, MTO. It's only going to be negative for all the people that Warren wants to fire anyway. Exactly. So Alice writes in the Snowball about how perfect this was. The more evidence that MTO found on employees that were guilty, the more proof it would show the government that Solomon was cooperating and that Buffett was cleaning everything up. And the employees, meanwhile, must cooperate or be fired since none of anything that they would say would be protected by attorney-client privilege with MTO. So the employee's options were get fired or answer MTO's questions. And anything you say to MTO is going directly to the government. Yeah. So Warren's not there to protect anyone.

He's there to... This is a win-win for him. Exactly. Exactly. This has Charlie's finger prints all over it. So Warren goes in front of Congress, probably one of the most famous statements that Buffett's ever made. And certainly corporate history, where he's being grilled by senators about what he's going to do at Solomon and how he's going to turn it around. And he says, the way that Solomon's going to operate going forward is lose money for the firm and I will be understanding, lose a shred of reputation for the firm and I will be ruthless. Fascinating. And he kind of puts on a show and he wows Congress. And Solomon ends up getting out of this thing with they settle in the next few months with the government for a $190 million fine plus a $100 million restitution fund, which I assume is maybe to go to the other financial institutions that were hurt by the cornering of the market in the treasury auction.

Restitution's got to be it. Yeah. Certainly, that's a lot of money. But this is amazing. He pulls this out. The firm survives. And so obviously Solomon is damaged, but over the next few years, they recover and they end up a few years later. When's he able to actually step out of day-to-day?

As soon as possible. Basically, as soon as the settlement hits, he's like, and I'm out as chairman. He stays on the board, though. He keeps the investment in, but he's no longer day to day. So this happens in 92. Six years later, in 98, Solomon gets acquired by Citigroup, the former Travelers Insurance, as you put a pin in, for $9 billion, which means that Berkshire gets a return of $1.7 billion on their $700 million investment, plus the 15% cash coupon that they've been getting. So, unbelievably,

I mean, it literally takes Warren and Berkshire to the brink. But this ends up being a really good investment for them. Wow. It makes so much sense why Buffett then had the quote, it takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently. I bet he sort of imagines looking out on the trading floor when reflecting on how he might do things differently. Totally. I do wonder if he looks back on this and thinks, was it worth it for that investment return? Probably not.

100% not. Yeah. 100% not. You know, the irony is like, yeah, 100% not. But this only kind of adds to the myth of Warren and Berkshire. Right. Now he's the guy, he can save even the cesspool of Solomon brothers. What can't he do? What can't he do? So this is where we're going to leave part two, but there's one coda before we do. Ben, you may know, you probably know, but listeners, I will ask, do you know what other organization after this whole debacle that John Merriweather, the head of fixed income trading at Salomon Brothers, would go on to found two years later in 1994. David, is it something that had a crisis where you mentioned it earlier in this episode?

Yes, it would be. My God, this is just crazy. Is he part of the group that was the former Solomon Brothers people that went to do long-term capital management? Not only was he part of that group, he was the leader of that group. Literally John Merriweather, founder and CEO of long-term capital management. Wow. And he was the guy between Goodfriend, who was the CEO, and the guy directly underneath him was the guy doing the auction violations. Wow. Yep. How crazy is that? Did any of these guys ever go to jail? The only guy who went to jail was Paul Moser, the guy who did the auction violations and he went to jail for four months. Isn't that unreal? Wow. Like literally, I mean, the thing that we didn't talk about in this history you know

certainly the government was influenced by warren's reputation and his pleading but they were also scared too like nobody knew what would happen if you just took the second largest investment bank in the world out back and shot it like it for sure would have created a financial meltdown and then of course you know 16 years later we got to that was this was the dress rehearsal for what we got to see actually happen in 2008 wow which of course berkshire also uh was an active participant in yeah mostly mostly in buying the dip yeah but uh, we'll save that story. It's funny, we've got for part three, we'll have the whole tech bubble, we'll have 2008, we'll have the tech

bull run of the last however many years and kind of the future of where do we think Berkshire goes from here. But this feels like a good place to leave this part. Yeah. I mean, we intended this to be one episode on Berkshire originally, and it's like the deeper we go into it as we were doing the research. I mean, this Solomon episode, I knew that this had happened. I didn't know that this had happened. No. I mean, the only thing that I really knew was that Warren Buffett was called on to act as the head of Solomon Brothers when they were under duress, and his reputation alone was what saved it. But that is really true. That alone, it's not just that he was acting as the head of the bank in a riskless way. He risked the whole future of Berkshire to make this happen. Yeah.

In fact, when you think about the return, turning $700 million into $1.7 billion over how many years was that? Like six or seven? I think he made it. It was a billion. So I think it was $700 million in and then $1.7 out. But he got the coupon payments also. So it's maybe like a 200% return over six, seven years. So good, but not for this risk.

Yeah, definitely not for this risk. Wild. We want to thank our longtime friend of the show, Vanta, the leading trust management platform. Vanta, of course, automates your security reviews and compliance efforts. So frameworks like SOC 2, ISO 27001, GDPR, and HIPAA compliance and monitoring. Vanta takes care of these otherwise incredibly time and resource draining efforts for your organization and

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all acquired listeners get $1,000 of free free credit vanta.com slash acquired well i think before we talk about power we should do a quick review of the businesses that they had owned outright during this part of their history because i think people have a general sense of the stuff that they own now both through the businesses that they own wholly and through their ownership of big public companies like you you know, Kraft Heinz or of Coca-Cola. But let's review the things they bought in the 70s and 80s and owned outright. See's Candy, Wesco Financial, The Buffalo News, Precision Steel Warehouse, Nebraska Furniture Mart, thanks for this B, Scott Fetzer, Feckheimer Brothers, Borsheim's Jewelry, H.H. Brown, Central States Indemnity.

And then in 95, the finishing touch on Geico, they bought Helzberg Diamonds and R.C. Wiley Home Furnishings. So there's a lot of Berkshire that you think about today that they don't own yet. Yeah. On the public equity side, the main positions we talked about, the Post, Cap Cities, Salomon Brothers, and one that we didn't talk about that we'll talk about more next time in Coca-Cola, I think those represented significant parts of the value. But again, as we've seen, they're taking a hands-off approach here. As we analyze the power, we think about them as sort of two different business lines, because it does feel like the business activities day-to-day are very different

between those two things, which actually you see reflected in the management structure of the business. Flashing all the way forward to 2020, you have Ted and Todd on the sort of investment management side buying publicly traded companies or investing in publicly traded companies. And you've got Greg and Ajit on the wholly owned subsidiary side. The insurance and Ajit running the insurance businesses and Greg running all the non-insurance businesses. Non-insurance, which is funny because it's like so diverse that you don't have a way to label it. So it's just insurance and non-insurance. So, okay, let's talk first about the wholly owned businesses. So the business activities there are prospecting, identifying the whole landscapes of businesses

you could buy, evaluating those businesses on their fundamentals, making the decision to invest or not invest, and then making sure that you leave or install the correct management in place to make those businesses hum over a long period of time. And then, of course, capital allocation, where you're making sure that you're deciding if that business is one that you like consuming capital and you want to funnel more capital to that business so it can reinvest in growth, or if that's a capital producer and you maybe like your jacket linings business or your stamps business, you don't want that business consuming any more capital. And that should just spit off capital that gets sent to the head office for reallocation.

So with that preamble, those are sort of the business activities of the wholly owned subsidiary side of the business. Now, of the Hamilton-Helmer powers, which basically enable you to, in a long-term way, get a durable, sustainable, differential profits above your nearest competitors. So here, I think we should think other conglomerates. We should think private equity firms. Definitely private equity firms. Yeah. Think about these companies going public. SPACs weren't really a thing yet, so that wasn't an option on the table. Strategic acquirers, I think, were though.

The question is, which of the seven powers sort of applies to Berkshire? Yeah, this is going to be fun. Because it's not network economies. It's not our usual favorite. It is definitely not. I'll make a first run at it and say counter-positioning, and certainly counter-positioning versus anybody that's running money. And I think to more finely articulate that, I opened this episode by talking about the fact that Warren chose a very unique structure in choosing not to have a fund or a partnership, but instead to have this operating business, Berkshire, that he uses the capital from to invest off the balance sheet. And it's very interesting when you have that structure and you're not generating fees and

you're not thinking about raising another fund and you're not getting a carry or a promote, you have just as much downside risk as upside benefit. And so your incentives are pure in a way. You only want to make financial decisions that buy low, sell high, or buy low, hold forever. And there's no other way that you make money. Well, your only focus is long-term value creation because nothing that you're going to do is it going to increase your fees or increase your value in any set you know fund life period of time or anything like that right so that makes you counter position to private equity firms and so then the question becomes, is that actually power in a positive way? Or is it somehow negative?

Is it just a disadvantage? Are they counterpositioned to you? Because let me put it this way. There's certainly deals that a PE firm would do that Warren wouldn't do because the price is too high. But is the opposite true? Can Warren get deals done because the PE firms have an opposite business model? Well, it's interesting, right? Because this is so obviously

not a tech company in so many ways. And this market that Berkshire operates in, the market of acquiring and investing in other companies is not a winner take all market so what's interesting is like to succeed they need a niche and they certainly carve out their niche exceedingly well with counter positioning versus other players the best you know we didn't talk about this on the episode i'm gonna say because we didn't have time but like what is time on an acquired episode anymore but uh this is how they win the mrs b deal the furniture mart deal you know buffett sits down with mrs b and says to her because she has other offers to buy the furniture mart for more money and says you know, you can certainly take those offers, and I'm not going to pay what the private equity firms and others will pay. But at the end of the day, those firms are,

what's motivating them is selling your business for more money. And they may say lots of things to you and be aligned and love you and want to keep you and your family in place running it. But at the end of the day, they're going to do anything to maximize them selling the business for more money within a set period of time so that they can make their fees. I'm not going to do that. I'm genuinely going to leave you and your family to run this. Right. It's like having a longer lens is actually the counter-positioning here. Yeah. And simultaneously holding true the belief that, or holding it to be true,

that keeping the family in place to manage it is the long-term value-maximizing decision. Yeah. Both of which are true. Both of which can be true, depending on if you acquire the right business. It gets back to the fight with the efficient market hypothesis theorists and the nature of debt, which all of the private equity firms are using to buy these companies,

to lower up the companies and buy them. If the goal is to have the companies operate sustainably the longest and generate the most cash flow over truly the longest period of time, you don't want to use debt because debt is going to increase the chance that the company goes bankrupt. And so if as a seller, if you care about the legacy of the company, either for whatever your family working in the business, them making money, you retain a part of it, or just for the legacy of the business, your interests are aligned with Warren's then because he wants the cash flows over the

longest period, which means he's going to avoid debt. Such a good point. Okay. So yeah, I agree. Counter-positioning for sure. Definitely branding. Definitely. I mean, like that's probably actually the place where you start. The Warren Buffett brand just enables you to do things that... Literally the Solomon thing. Anyone else crying on the phone to the federal government probably wouldn't have impacted them, but because it was Warren's brand crying on the phone... Totally. It's trite, but I'm trying to use the

Seven Powers language here a hundred percent i think the seven powers actually apply a lot yeah counter-positioning applied but yeah branding 100 like warren buffett and berkshire hathaway's money is worth more than the equal amount of money from somebody else yep absolutely okay so i don't think there's necessarily scale economies i mean maybe you could argue a little bit that the scale of the insurance businesses and the float enables more investing, which enables more operating businesses, which maybe I think that's a little bit of a stretch. During this phase, so it's interesting.

Today, I think they actually have diseconomies of scale because they just have too much capital that they need to put to work, but we'll save that for the next episode i do think uh this period was the one for the first time where they did realize some economies of scale where there is this like nice middle ground where like if you're really small then you can't invest enough money to have sharp elbows on a board but if you have too much money then all you can buy is apple and you know nothing else moves the needle for you enough but during this period in the 80s they they had the perfect amount of money where they could be activist investors on boards and throw their weight around, and that would deliver enough return for them to be needle moving. Yeah. Yeah. Actually, that's a really good point. That's a good point. It's

a power right now, but it's not a sustainable power. Yeah. Oh, that's interesting to think about. Okay. I don't think they're switching costs. No. Oh, that's interesting to think about. Okay. I don't think they're switching costs. No. And that's all I've got for this so far. The question is, which of those apply to the public investing side of the house? Ooh. Well, the one I was going to talk about, I always have such a hard time thinking about this power. And as Hamilton says, it is the trickiest of the seven powers. But is there process power here at berkshire i mean it's funny it's like thinking about process power in a super small

organization feels like a de facto no because they always uses the example the toyota production system that like the system was so complex it couldn't be written down to be retaught to someone else because it's held in so many heads and the decisions are all made by one person so like is there process power in warren's head well he calls charlie but warren ultimately makes the decision i think there's a liberal interpretation of process here to make that the case it's funny because i was for public market investing i was thinking like that might be the only really arguable one. You freaking efficient market hypothesis to you.

Well, no, I'm definitely not an efficient market hypothesis disciple, but I do. I think there are definitely market inefficiencies as this episode shows, but I don't know that Berkshire had any sort of unique, any defensible ability versus others to see and then act on them. They acted on the ones that they saw. Other people could act on the ones that they see. Right. But getting back to that point that I made earlier around identifying things in the market that not only have less risk, but actually exclusively have less risk than the market perceives them to have when you act. I think I was sort of foreshadowing power there, where there are things where Berkshire uniquely could have acted, and therefore saved the company, gotten the deal that they did,

were able to join the board, whatever the thing is. And so I'm trying to figure out how to quantify that. So WAPO, Salomon Brothers, these were things that Buffett could uniquely do in an advantaged way versus their competitors, their competitors being all other capital. And why? Well, WAPO was kind of... Buffett had to fight his why well wapo was kind of buffett had to fight his way in it was sort of like maybe that was like part of developing this power because you know k was sort of like scared of him at first and certainly reluctant and then buffett fights his way in i don't know that like that a power, but then once he was on the Washington Post board and the mystique of Warren Buffett had started to grow, then I think maybe it becomes

something defensible. Yeah. That's a great point. Well, normally here I would move us on to playbook. I literally think we had discussed every playbook theme during the narrative, during history and facts that I possibly could have brought up here. So I have nothing to add in the playbook section this episode. Yes. As Charlie would say, no. Nothing to add. Value creation versus value capture. Let's do it. So Buffett definitely created more value in this chapter than in the previous one.

100%. The previous one, you're buying and selling. You're buying at low prices. You're selling at high prices. Here, you're doing things like they legitimately created value for Solomon's shareholders. Yes, they created $ billion dollars worth of value the question is what other situations in the 70s and 80s did they create value certainly for berkshire shareholders by marrying the insurance businesses and the operating businesses for berkshire shareholders

to be able to sort of realize the incredible benefits of those two things operating in tandem. I think they also created value for Geico in the saving Geico. Now, Jack Byrne did all the legwork himself, but no question having Warren there, both with the regulators and the government of like, hey, Berkshire Hathaway is behind us now, we're going to be okay. But then also specifically with the financing and with Salomon Brothers and with Wall Street, you know, backstopping the deal. Yep.

Is there value destruction for the American consumer by making it so all those people who had Geico in the states that they decided to pull out of lost their car insurance? That's a good question. it so all those people who had Geico in the states that they decided to pull out of lost their car insurance? That's a good question. I don't think so. I mean, how hard is it to go get different insurance?

Right. And if Geico wasn't going to make it if they didn't make those changes. Right. It's not like they corporate raidered it and went in and it was going to go perfectly fine, but then they destroyed it Toys R Us style. Now, what was interesting in that story, though, was, you know, I think Geico and Byrne were the first to actually pull out of states. Like, nobody had ever done that before.

So they did sort of cross a Rubicon. So yeah, I don't know. It's a good question. Now, certainly Solomon Brothers, you could debate a lot of value destruction there in aggregate. Oh, from the entire time they were shareholders, certainly. Yeah. Now, did Buffett and Berkshire meaningfully contribute to that? No, probably not. Unlikely. Other than they did prop up corrupt management yeah like value capture to move on to that and

hit it real quick it's berkshire it's buffett they always do a damn good job of capturing the value they create no qualms there yeah interestingly especially over this period in the life of the company probably because of the long-term focus on not selling investments with regard to tax liabilities. Berkshire and its shareholders pay... If you don't sell, you pay no tax. Right. Massive tax deferrals. Massive tax deferrals. Yep. All right. Grading. I want to grade this the same way that we graded the last one, which is we are going to look at their pure performance versus the S&P 500 during that same time frame.

And you may recall that in the Buffett Partnership years, the annualized return was a 29.5% annual return over those 12 years. Historic, legendary. And I think what did we determine that was? Something like a 28X. And you actually, that 12 12 years you could comp nicely against a venture fund and say uh if anyone could 28x the money then they'd be a top decile fund for sure and uh the buffett partnership had the increased benefit of you could take all your

money out or put all your money in in any given year you didn't even have to lock it up for the entire life of the fund the way that a venture Fund does. So slam dunk, I think we call that an A or an A plus. This set of years, we're going to look at 1970, so the year immediately following the liquidation of the partnership, to 1992. And we're going to look at just Berkshire Hathaway over that stretch of time. their rate of return pretty similar 27.4 percent dang like i don't know how you like the buffett partnership years and don't like these i think this is like yeah this is the golden years of berkshire hathaway totally wow i didn't realize that that's what the number was i mean it literally is it's just like michael like Michael Jordan. He went out at the top of his game. He came back and he won three more championships. And then he went to

play for the Washington Wizards. And actually, maybe we will see that last part here in a little bit of foreshadowing. In the next chapter. Yeah. But truly, I think there's this scary thing where you sort of look at this and you're like, maybe Buffett does know how to time the market. No one can. And yet, the guy liquidated his partnership in 69, bought back in big in 71, 72, had this run all the way through the early 90s, started piling up cash in the 90s. And as we'll talk about, wrote a very famous article in 99, you know, the year before the dotcom bubble burst, articulating exactly how overheated everything was as he was piling up his cash. So he is acting on his thoughts here. Maybe he can time the market. Maybe. Although, well, we'll save this for part three, but I would say track record on market timing has not been great of late. No. But just to put some numbers around this 27.4%

rate of return, if you had bought Berkshire in 1970 on January 1st, which is the day that Buffett distributed it out to everyone when he closed down the partnership. It was 45 bucks a share. And at the end of 1992, and of course, these are what we now call the A shares, in 1992, that was $11,750 a share. Wow. That's bonkers bonkers and today it's over 400 000 is that right yes it is a record high as of last thursday and maybe up again again this week wow my hat is off what more can you say all right what more can you say except like the comparison is michael jordan yeah well listeners we will know more in part three. And thank you for listening to the Empire Strikes Back episode of the Berkshire

Trilogy. David, do you want to do quick carve outs? Yeah, let's do it. So my carve out is a great podcast episode on the Armchair Expert podcast, which so good so good dax and monica do such a good job so many good episodes recently but seattle love the mclemore episode was amazing have you listened to this no i haven't oh you gotta listen to it it's so great lots of seattle talk dax loves seattle he recently was in was in Seattle. They spent a lot of time talking about it. But Macklemore was so great. They just get into so much great stuff. Lots of discussion about that. Just go listen to the episode. It's fantastic. All right. Just added it to my queue. Literally pulled out my phone and added it to my Overcast queue. Mine has its roots in something that you said earlier this episode. You mentioned the mafia.

You mentioned the state of New Jersey. I, for the first time, am watching The Sopranos, and it is excellent. And I totally see how it kicked off this, like, modern golden era of TV that we have going on. And I think it was lost on me. I mean, I was, what, nine when it first came out or ten when it first came out. But it was lost on me all these years where I've loved shows like Mad Men and Billions and Succession and going back and watching The Wire. The Sopranos really did sort of kick it all off, and it's violent. It's horrifying in many ways, but God is the writing great. So great. So can't recommend it

enough. I am in season six a, so I am nearing the finish line. So nobody spoil it for me. Amazing. What year did the Sopranos start? I want to say it was like 97, 98. It was like right around the time the matrix came out. Wow. Oh man actors between the matrix and that which is it's it's old enough where you see people who you know from things later in their career and you're like oh my god it's a young so-and-so and i'm i'm feeling quickly like my parents like when i was a kid i remember watching things with my parents and they would say oh my gosh this movie has young so-and-so in it and that's now me that's amazing that's amazing well we're hitting that time of life we are well listeners if you want to talk about all things acquired this episode things we missed things we caught little notions that you have that we may

not have seen in the research. This is a three-parter, so it is not too late to tell us, and we can insert these great tidbits into the final part of the trilogy. Join us in the Slack, acquire.fm slash Slack. You can talk to lots of other people. There's 7,000 people plus David and I, and it's always a great time in there, so you should join us if you love acquired i want to be a deeper part of what we do here become a limited partner acquired.fm slash lp you'll get access to our library of over 50 interviews and deep dives on company building topics monthly zoom calls and our upcoming next book club with brad stone which we're super super

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