We Study Billionaires - The Investor’s Podcast Network - TIP 042 : Warren Buffett's Berkshire Hathaway Shareholder Letters (Investing Podcast)

Starting point is 00:00:00 We study billionaires, and this is episode 42 of The Investors Podcast. Broadcasting from Bel Air Maryland. This is The Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish, and Sting Broderson. Hey, everybody, how you doing out there?

Starting point is 00:00:30 This is Preston Pish, and I'm your host for The Investors Podcast. And as usual, I'm accompanied by my co-host. Stig Broderson out in Denmark. So Stig really wanted to have a fun episode today. So he decided to read every single shareholder letter that Warren Buffett has written. And that's what we're going to be talking about today. But you know what? A lot of people might hear that and think that they're going to be bored to death as we talk about shareholder letters that were published since 1965. But what we're going to do is we're really going to try to make this fun for you.

Starting point is 00:01:00 So we're going to be talking about some. very interesting concepts. And what we're going to try to do is we're going to try to to extract the really key points out of these shareholder letters that you kind of can have this ability to know kind of what everyone else doesn't know about Berkshire Hathaway and how the company operates and why it's different than any other company out there. So that's what we're going to really try to focus on are those key points. So the first thing that we're going to talk about is the four different types of businesses that Berkshire Hathaway has so you can kind of understand the composition. So before we get into that, I just want to briefly describe

Starting point is 00:01:34 kind of the history with Berkshire Hathaway in the event that you don't know anything about it. So Warren Buffett actually started off with a partnership where people could invest money with him and then he would take that money, he would invest it. And if he had a great year, he would actually get paid. And if it was a bad year, he wasn't making money. He actually didn't take any money at all. Later, as he kind of honed his investing skills, he kind of, he kind of realize that he was handicapped by the people that were giving him the money to invest. Now, he had his partnership kind of structured in a manner that mitigated that a lot, but he still had the people that when the market was booming were giving him more cash,

Starting point is 00:02:14 and then he was trying to invest this money as everything was overvalued. And then when the market would crash, he still had people pulling money away from him whenever he needed it most because that's whenever he could buy undervalued companies. So what he decided to do is he decided to adjust his approach where he wanted to own a public company. And by owning a public company, he could actually take advantage of that behavior. So when the market was really high, he could actually sell more shares to people if he wanted to raise capital. And then when the market would crash, if people were trying to take their money away or sell his company short, he could actually buy those shares back under the company veil. and he would actually do very well for himself.

Starting point is 00:02:55 So he basically took that structure and he flipped it on its head. Now, his biggest mistake, he says, was actually buying Berkshire Hathaway. And I think a lot of people might hear that quote and say, that makes no sense. I don't understand that. But here's the history of why he has made that quote. Whenever he bought Berkshire Hathaway, he had this investing approach that a lot of people refer to as the cigar butt approach. And what that means is he would take the last possible.

Starting point is 00:03:22 out of the cigar. Like if it was a cigar that he found on the side of the street, he could take one free puff out of it before it was done. And so what he's referring to there is he was going around and what he would do is he'd find companies that were trading below on the market. They were trading below the actual value of the assets. If you would liquidate the company, meaning you would sell off all the assets on the balance sheet of the company, those assets would actually be worth more than what it was trading for in the open market. So whenever he had this early on approach, and he learned this from Benjamin Graham, he was reading all these Benjamin Graham books.

Starting point is 00:03:58 And so he was implementing that approach where he'd go around and he'd try to find companies that were trading below the net tangible asset value of the company. So he got in this position where he was buying up shares of Berkshire Hathaway. He was trying to buy a controlling share of Berkshire Hathaway because it was one of these kind of companies. It was this dying business that was a textile business. And what he was trying to do is he was trying to get a controlling share and he was going to liquidate the company. He was going to kill, you know, basically send everybody home after he bought a controlling share. He would sell all the assets and he'd make money on the deal. So this was kind of hard for him. And it was hard

Starting point is 00:04:37 for him because as he was getting ready to liquidate this company and he was showing up, everyone viewed Warren Buffett as being the grim reaper. He was the guy that was coming to kill all of their jobs. And people obviously did not like that. And something that Warren Buffett did not like is he did not like the fact that people didn't like them. He found this to be a very awkward position and something that he never wanted to experience again. And so he kind of got himself in a position where he was in a little over his head with Berkshire Hathaway and the fact that he didn't want to be disliked. But at the same time, he was, how am I going to make money on this deal? Because he was heavily invested. I don't really remember how much of his

Starting point is 00:05:17 his portfolio consisted of owning this Berkshire stock, which was it making money at the time? Do you remember, Stig? No, not really. Yeah, I don't even think it was turning a profit at the time that he was buying it. But remember, his intention of buying it at that time was to liquidate the company and make money that way, which is completely different than the way that we invest now and the way Buffett invests now. So he was basically buying up these shares of Berkshire Hathaway for a very long period of time, And then he was having to adjust his approach because he made a promise to all the employees that I will not liquidate the company.

Starting point is 00:05:53 I will not kill the company. Basically make them rest as sure as he was trying to acquire this controlling share. He stuck to his word that he was not going to liquidate the company. So what he found himself in this unique position was that he started off with one intention, which was to kill the company. And it ended with, I'm going to save this company. and I'm going to figure out ways to, you know, make them profitable and turn everything around. And he did that. He actually did that. But it took him, he lost a decade or more of time because what he could have done is he could have started his own company and then started nesting his picks inside of that. And he would have saved himself a whole lot of friction in the process.

Starting point is 00:06:34 But, you know, we could argue that the learning experience and his adjustment to his investing approach changed so dramatically from this experience that he might not be the person. is today if he didn't go through all that. So that's a little bit of the background on Berkshire Hathaway. Berkshire Hathaway is a publicly traded company. It's just like Coca-Cola or Bank of America or whatever. It's a company just like that. And that's another thing that people don't realize. A lot of people think that Warren Buffett has like a hedge fund, but Berkshire Hathaway is not a hedge fund. It is a real company with real businesses underneath of it. So I wanted to give that background because if you didn't know that, I think it's very important for you to know that. As we go through and we discuss the inner workings of this company, the Buffett has been running since

Starting point is 00:07:15 1965. So as we poured through these shareholder letters, we literally started with the year 1965 is very first shareholders letter, which hasn't really changed all that much through the decades. I mean, I found it really amazing that he was already writing to his shareholders in a manner that he's very conversational. He's instructing. He's teaching since the very beginning. And if you have not read these shareholder letters, these are like the book of Genesis for investing.

Starting point is 00:07:47 I think that anybody who has not read these and you're a hardcore investor, you're really missing out because there's some amazing business advice in these letters. So let's go ahead and talk about the four different businesses within Berkshire Hathaway. And Stig's going to go ahead and take that away. Yeah, so if you read the annual letters from Warren Buffett, he will be talking about that he actually looks at Berkshire Hallaway as having four different companies or four different segments.

Starting point is 00:08:16 And I think that's probably a very good way of looking at Berkshire Halleway because Berkshire Hallebeye owns so many businesses. I think that they're probably only around 80 or something like fully owned and then they own like parts or they were owned shares in, you know, multiple other. company. So, now, and really to get an overview on how Berkshire Hallaway looks today, I think the best way is to look at us as four different businesses within Berksa Halloway. And the first business I'd like to talk about, that's insurance. So insurance was actually a way that Warren Buffett really early could get capital to invest in other businesses. And we'll actually return in a later segment to talk about specifically how this work, how this business model work. The second one is regulated capital intensive business. So that would be,

Starting point is 00:09:08 for instance, something like Berksa Heatherway Energy. It used to be called Mid-American, but it's that type of business. So in the energy, for instance. And Buffett owns, isn't it like 80% of all the energy in the state of Nevada? Like his business owns all the power that's basically being provided in Nevada. Is that right, Stig? Yeah, he is close to, to monopoly in a huge region. Yeah, I think it's true. Yeah. And another thing, that's also the railways. So you'll probably know this as BNSF. And so these are somewhat new purchases from Warren Buffett. I mean, this is not how we started because these business are very capital intensive. So that's just something worth mentioning that if you hear about Warren Buffett talking about,

Starting point is 00:09:58 But it's really important not to buy into businesses that acquire a lot of capital. And then you're thinking, he's in energy, and he's in railways, you know, what's happening here? This is basically Warren Buffett's, let's call it, new approach of how to apply capital. He's been saying it himself that is not the most optimal way, but he actually is sitting on so much cash right now that this is still the best way for him to buy into good businesses. And when Stig says that he's sitting on a lot of cash, what's he sitting on right now? $60 billion? Yeah, I think he's, yeah, $60, yeah. That's a lot of cash.

Starting point is 00:10:33 Just a little bit. He's just sitting on a little bit of cash. Yeah. So actually, I think it's rather relevant to speak about because the second one that was regular capital intensive business. And the third one, that is manufacturing, service and retailing operations. And so this was actually some of Warren Buffett's first buy. So that would be some, you know, everything.

Starting point is 00:10:54 from lollipops to, so that would cease candy, for instance, to net jets. But a lot of these companies, especially in the beginning, they were really, really good returns on net tangible assets. And those are really like the core of understanding how we're on Buffett invest. These are really good business because they don't take that much capital to make a decent profit. And again, you might be thinking, so why doesn't he do that? Why don't he buy new cease candy?

Starting point is 00:11:24 Well, there's just not enough out of that. There's not enough Seas Candy out there for Buffett to invest in. Well, and I think you've got to look at it this way too is for him to invest in a company like Seas Candy. Let's say that the company might have a market cap of $50 million. That's not even going to make a dent in his overall portfolio because it is so big. It'd be kind of like, let's say you have a million dollars, your net worth is a million dollars. And somebody comes along when they want you to invest in a company that has a market cap of $3,000. That's not even going to move your needle at all. So why would I spend my time, which is his most

Starting point is 00:12:00 valuable asset, why would I spend my time researching, digging into this, making sure that it's a good buy when it's not even going to make a dent in my portfolio movement? So he's really looking for those big hits. Like you saw him invest in Heinz in the past couple years, things like that that are really going to move his needle. That's the things that he's really trying to pay close attention to. And then the fourth business segment that is financed. and financial products. So just to give you a brand, that might be something like Clayton Homes, for instance. So there would be like rental and trailers and furniture and this sort of business.

Starting point is 00:12:35 And it's actually the smallest one of the four. So I mean, they are quite independent. They're quite, you know, for itself. But, you know, these are like the four business segments of Berksa Hellerwe. So now you might be sitting out there thinking, what about investment? Like, we know that he's a great stock pickup, but where are all the investments? And that is actually, I'll put that as a part of the insurance. In general, I would put that as a part in the insurance business.

Starting point is 00:13:02 But we would definitely return to that. So what's, I think the key takeaway here, and this is the thing that people really got to understand. If you're really trying to be a business leader is where in that list that Stig just named the composition of this company, where did he mention textile business? And he didn't. It's not there. Okay. So he bought a company back in 1965 that was a textile company. And now you go 50 years into the future where we're at right now. And the company has had a total transformation. And that's the key here is change. If you're a leader, you have to adapt to change or change will make you change. And that's more of a Jack Welch kind of quote. But It's so vitally important for people out there.

Starting point is 00:13:55 To stay competitive, you have to be adaptable. You have to move with the punches. You have to see what's coming. And you have to be able to really adapt to that quickly. You've got to be the first person. You've got to be that person, but not assume a lot of risk at the same time. And that's hard to do. You've got to be a balanced person in order to conduct that change in that change environment.

Starting point is 00:14:17 So as we go through this, think about that. And think about what Buffett has really done as a business leader, CEO, chairman of the board. He led this organization. And I think that that's one of the key things that a lot of people don't look at. They only look at his stock picking ability. When in all actuality, this guy is a business magnet and tycoon that has led an organization to be, you know, a market cap over $300 billion. Yeah. And, you know, I really would like to talk about Warren Buffett's leadership skills because that was something I really, if I'm profound, whenever I was.

Starting point is 00:14:50 reading the letters because he is so good at delegating and so good at motivating people. And so let me just give you like two short notes on that. The first one is that I found it really interesting that he kept mentioning people by name whenever he's writing these letters. So he would easily be named driving like 20 or 30 different people and saying, well, we should really be thankful to this manager because he has done an amazing job. So you actually have a lot of people. And, you know, this is not like, I don't think he's manipulating or anything, but, you know, it's really like a human thing that, you know, we all like praises.

Starting point is 00:15:29 And Warren Buffett, he's really, really good at praising people. If they're doing a good job, I mean, that's something he always mentioned. So I think you can see when you're talking about his leadership ability, which you really, what you're seeing is how patient he is. whenever he's dealing with his subordinate leaders within his company, which he's got tons, I mean, just the operational subsidiaries, not even talking like the non-operational ones, like Bank of New York Mellon and Wells Fargo and all those, when you're talking about the ones that he owns 100% of, he has like 60 different managers and leaders, business leaders beneath him.

Starting point is 00:16:05 He is insanely patient, like to the point that most people would not be able to do that. If somebody comes in and they have a bad year, there's often my impression is that there's often very little said because people know what that expectation is. And so when do you see leaders that if somebody does something wrong, he doesn't really necessarily say anything. They just know that they've done wrong and they know they better improve because if they don't, then maybe he'll do something about it later. But he's giving him that opportunity to fail. He's charging them with enormous responsibility. And when he does that and he kind of stays out of it, it's amazing that he's actually getting better results than that leader that's really trying to oversee and micromanage things.

Starting point is 00:16:49 And it's just an amazing approach. And he's been so successful at it. You set that precedence of how you should operate and you watch and you monitor. And if people abuse it, well, then you do something about it. But if they have one bad downturn, maybe it wasn't their fault. Maybe it's something that they're, you know, just they had a rough patch and they're going to get back on their game. So I'll go ahead, stick. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:21:01 hearing sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. Yeah. And I think that the best way to think, about this is to think how many people in us were above having his headquarters.

Starting point is 00:21:29 Like, he actually likes to joke about this. I can't remember the exact figure, something like 30 people or something like that. Yeah, that's right. Yeah. I mean, how can you like have the, I think by market cab or is it by revenue is like the fourth biggest company in the listed company in the U.S. You know, I think that if you compare them to the other companies around that, you know, they will have hundreds, if not thousands of people in the headquarters. And he has like 30 people. Well, what he does at the end of each other. shareholder letter is he has a picture of his headquarters. And just to kind of give you an idea of the size, it's a single photograph and you can make

Starting point is 00:22:04 out every single person's face in the photograph very easily. And there's only three rows of people. So they're like 10 wide. So it's like this tiny little photo. You'd think it was like a little family reunion kind of thing. And that's his whole headquarters for his $300 billion company. So for the next segment, I would like to talk about Berksa Hellerway's special. conglomerate structure.

Starting point is 00:22:26 And I think, you know, whenever we talk about conglomerates, you always have very different opinions on whether or not that's a good idea, because can you, like, one of the most told argument is that can you keep focused when you have so many different things to keep track on? And, you know, in my opinion, I think that a conglomerate for a company like Berkshire Holloway, that's really the main secret to their success. I mean, yes, of course, it's fantastic that. Martin Buffett is good at picking stocks.

Starting point is 00:22:57 I mean, no argument there. But I think that the structure where they can actually invest where the money makes more sense, when you are as good as capital allocation as Warren Buffett, that's really the secret to his success. So what he does that's different than any other company whenever they buy a subordinate business is when you typically see that happen, the parent organization will come down and say, these are the new rules, the way that you're going to operate. All your letterhead is now going to have our business's name on it. And they basically take control of that business and they bring them into their architecture

Starting point is 00:23:32 and to their standard operating procedures. Buffett has the exact opposite approach. He will buy a business and he'll look at the manager and he'll say, you know what? You guys obviously know what you're doing a lot better than I know what to do. So just keep doing exactly what it is that you're doing. That's the reason I bought you. and you just report your numbers, show me your accounting at the end of the year.

Starting point is 00:23:57 You know, you keep your brand name. You keep everything the way it is. And I'm just going to be standing over here. And in fact, if you make profits, you keep those profits down at your level, at your level because you'll know how to employ those a lot better than I would know how to employ them. And I think that that's just an amazing approach. That just no one does that. And you find that these businesses that do start trying to,

Starting point is 00:24:21 to take control these smaller businesses. They come in and they just mess it all up. I mean, it's not always the case, but it's usually the case. I know whenever there's a business that is getting ready to buy a subordinate business, I always get very concerned with that. I get concerned that they're going to overextend themselves. They're going to take on too much debt. They don't understand even that line of business.

Starting point is 00:24:42 And so by getting their hands in there, they basically throw all this drag into the equation and it creates a bad situation. Berkshire Hathaway takes the exact opposite approach. Yeah, and I think that the best way to really understand the true benefit of Berkshire Hathaway is to compare it to, let's call it a normal operating business. So, for instance, let's take a company like X-Mobile. I mean, it could also be Apple or any other business. But if you look at a company like X-Mobile, whenever they make a profit, they have three different

Starting point is 00:25:13 options of how that would benefit the shareholder. And the first one that would be dividend. So they would pay out some of that profit to the shareholders. Now, as a shareholder, this is not a very efficient way of getting that because you have to pay taxes and you might just want to reinvest in that business. But basically, that's one way to do it. But actually, Halloway doesn't do that because they're saying that instead of paying $1 out in dividend, they can create more than $1 in value.

Starting point is 00:25:40 Now, the second thing that a company like X-Mobile can do is that they can invest in the existing business. But the problem is for a lot of listed companies that they're so big, so they can't keep investing in really, you know, profitable projects. I mean, they would be first taking all the 20% a year projects, and then they would invest in all the 15% of year projects and 10% and so on. So a lot of the projects that they can invest in, you know, they will not be good businesses. Bucksie Holloway would take that money at the mayor of profit and buy new businesses or they might be, you know, widening the mode of some of the existence. businesses. Now, for a lot of the really big companies that are listed, they also repurchase the shares. Now, Warren Buffett, he's really, really good at this because he's very, very adamant

Starting point is 00:26:28 about buying shares in his own company when a really good price. But a lot of these big companies, they have these share repurchase programs where it will just be keep repurching shares, you know, every day, every quarter, every year. And I guess, you know, to some extent that's okay, at least it's tax efficient, but they are not. buying the shares back at really good prices. And Warren Buffett is very, very clear on that. So I used to wonder, you know, years ago when I look at Berkshire Hathaway, I would get frustrated when he wouldn't be buying back shares at certain points in time. But the more that I've learned and the more that I've studied him, I think Buffett has an enormous respect for the power of

Starting point is 00:27:10 liquidity. And I think that's one of the main reasons why he does not do share buybacks like you see a lot of companies like IBM, for example, just go and bananas on their share repurchasing. But I think Buffett has such a respect for the power that liquidity demands during stressful times and the deals that he can get, that he actually values that more than maybe buying back his own equity whenever he could maybe Berkshire Hathaway is slightly undervalued compared to the rest of the market. Something else that I wanted to highlight real quickly, back to the previous conversation that we were having about, him buying up all these different businesses and basically leaving them in place and not doing anything. The only way you can really do that successfully is if you're finding managers that are

Starting point is 00:27:56 absolutely incredible. And that's one of his four tenants, one of his four rules that we've talked about in what was it our second or third podcast that we did. One of his rules is that he only invests in companies that have superior management. And so by doing that, by ensuring that he has somebody with a track record, years of experience, that he trusts, that he knows is going to get results and that is always going to tell him the truth. He's putting him in a situation where he can actually employ those techniques. If you're buying a business and you don't really, and you're looking at the management like, they're okay, that's probably not somebody you want to entrust with, you know, just total control. And I think that that's a key point that we got

Starting point is 00:28:38 to highlight if we're bringing that up. So back over to Stig as he kind of runs a the discussion here. So the third segment I'd like to talk about is how float works. And if you don't know exactly what float is, let me just give you an introduction here. So Berksa Hellaway, they are an insurance company, or at least they have a very huge insurance division. And they'll be, whenever they're writing premiums for, say, something like $100, you know, the premiums that they're writing, you know, that is money that they are getting.

Starting point is 00:29:09 I mean, that is liquidity. And of course, they have to repay a lot of that, you know, in the premiums that. claims and they have expenses and so on. But how that actually works if you just think about this in terms of like $100. It works at Hellaway because they are so good at writing insurance, they would keep some like $2 to $3 on average of that $100. So this has like two huge benefits. The first one is that, hey, whenever they are, you know, having revenue of $100, they will have two to three dollars in profit. That's one thing.

Starting point is 00:29:44 But the most important thing is actually in the meantime, they can actually hold onto that money and invest that in, you know, businesses, stocks and bonds. And they will give 100% of the proceeds from that. So this one's huge. I mean, really, this is the bread and butter of Berkshire Hathaway. And this is the reason Buffett has been able to compound at such a high rate is because he's sitting on this enormous amount of money and GEICO's the engine here, okay?

Starting point is 00:30:11 He even says that in the shareholder letters. GEICO is my engine of my vehicle. And the reason why is because it's got all this float. He can reinvest that as the market changes, he's adjusting the assets that are sitting on that float that are most optimal, that are giving him the highest return. And then if there's an event that occurs that requires a large amount of capital outlay based on the fact that some type of unprobable event happened, he's got the money sitting there. He can transfer that to the people that would have claims. So that's big. And I don't think people really realize how robust his insurance business is.

Starting point is 00:30:50 When you think Berkshire Hathaway, you should really be thinking insurance company because that's really the engine of the whole thing. Yeah. I know that we're just throwing a lot of numbers on you. And it might be hard to get a grasp on. But he has $84 billion right now as a float. Like he can invest in. And just in comparison, he has $117 billion in different stock investments.

Starting point is 00:31:14 So, I mean, this is really, really something that's important for Berksa Helloway. And, you know, where they really distinguish themselves from other insurance companies because, you know, this is the business model for insurance companies in general. It's simply that Warren Buffett has been really, really good at finding great investments. And he'd be really good at allocating that capital. So something I want to throw out there because we talk about Monish Pabry. a lot. So Monish Pabra is getting ready to start his own holding company. We've heard that that's going to happen this year, that the company's going to be formed this year. And what's

Starting point is 00:31:50 his engine? He's using an insurance company. He's taking the exact same model that Buffett did. So he can invest that float and he can have larger returns. So it's going to be very interesting and really fun to track Monisha's progress as he stands up his new company. Oh yeah. I think that would be really, really interesting. And, you know, just to just to also give people a peace of mind if they think about insurance companies, it's not like insurance companies can just take that float and then invest 100% of that in inequities. So, I mean, I also just were to make that clear. It's actually kind of more like banks and they have like Tier 1 and Tier 2 capital and a lot of that should be fixed, fixed maturity assets, so on. But yeah, I just want to throw that out

Starting point is 00:32:36 before we actually go into the fourth segment. So, Preston, I don't know what you thought when you read through all these letters. I know it's a long time ago for you, but when you realized that he was actually, Warren Buffett and Berks in Hellaway, they were using derivatives. I was actually quite surprised when I read that in the beginning. So I think people hear the word derivative and they immediately think, that's a bad thing. But they don't understand maybe the context and way and how it was being used. So let's talk about futures and let's talk about derivatives for people to maybe understand the advantages and disadvantages. So if I'm a farmer, okay, and I have a plot of land and say I'm a wheat farmer and I can't be susceptible to major price swings in my crop whenever I sell it.

Starting point is 00:33:28 For me, a futures market adds a whole lot of comfort and a lot of value because I can sell the wheat that I'm going to manage. at a price that I know I'm going to get if I entertain this idea of a futures market and selling things based off of a price that I know that I'm going to be able to get. So that adds a lot of value to certain markets. So when you think about like the airline industry, they're heavily reliant on oil prices. If oil prices are all over the place and they want to have some type of stability and be risk adverse to that fluctuation, they can buy their fuel on these futures market. in order to mitigate those risks.

Starting point is 00:34:09 So for some people, it's a total risk mitigation strategy because they know what kind of price they're going to be dealing with and they know what prices they can offer their customers in advance because they've paid for that in advance. Where it gets really risky and where it gets the bad name is traders who are just basically manipulating the market have no interest in a product that they're actually, or a service that they're actually providing to customers

Starting point is 00:34:32 and that they're just basically manipulating these prices because they're taking wild risks by taking on leverage and investing in things that they're just basically making bets. That's where it gets bad. So whenever I look at Warren Buffett and he owns Coca-Cola, he owns a large portion of Coca-Cola, I think, what, 15% or something like that. So when you look at Coca-Cola, he's heavily reliant on sugar prices, just as one example of one ingredient. There's many other things. BNSF. He owns 100% of BNSF.

Starting point is 00:35:03 I mean, that's a railroad company, heavily relying on fuel prices. That stuff is very important. So for me, that makes total sense. But I think for somebody that would be, you know, you know his quote where he talks about how derivatives are weapons of mass destruction, financial weapons of mass destruction. He has that quote. And I think so people would see they'd start reading his shareholder letters and they see that he's involved in this stuff. But in a way, he kind of has to be just because of the inherent nature of his business. Yeah, and let's just take an example, like if you are in stock investor and how that would work actually doing business with Warren Buffett and Berksa Hellerway.

Starting point is 00:35:40 So I might be managing, say, a mutual fund and I would really not like the market to drop. So what I would do is I would buy a put option. So as a put option, I would benefit from a drop in the market. And that might seem a bit contradictory, but this is kind of an insurance for me. because as a mutual fund, I make money with the market go up. So one way to secure that I have someone of a stable profit would be for me to buy a put option. Now, so where could I do that? Well, I could do that using Berksie Hallaway as my counterparty.

Starting point is 00:36:14 So Warren Buffett would be selling put options. So basically what that means is that if the market drops, then he would lose, you know, money, at least in theory. Now, the specifically puts that he had been selling, you know, they're really nicely structured. Because first of all, people would pay him money up front again. So it's actually the kind of insurance, kind of insurance float. He can invest that money. And it's only if the market drops over 10 to 20 years that you have to pay some of that money back. And so he actually makes a few calculations of this.

Starting point is 00:36:48 And, you know, the market really, really has to drop for him to lose money. And then he's saying, even if he does that, he'll probably have a better return holding on to the premiums he had been getting for these options to begin with anyway. And this really important thing here is that Berksa Hellerweight has no counterparty risk. So, you know, usually at least for some of those derivatives, you know, if your counterparty went broke, you'll be sitting on the risk yourself. And that was some of the problems that happened in the crisis 2008. But since it is Berksa Helloweys that is the insurer that don't have any counterparty risk. So that's just something I found really interesting that he's always protecting his downside, even though it's in derivatives.

Starting point is 00:37:28 Okay, so the next category that we have listed here is how do you value Berkshire Hathaway? And I think this is probably one of the funnest exercises that you can have because this is such a unique company and it has so many different variables. And I think it has a few hidden variables, which I'd also like to discuss. So how would you do this? For us, we think that, you know, Stig and I, we think that the best approach is a discount cash flow model. We look at how stable has the company been for Berkshire Hathaway. It's been extremely stable, very predictable in the movement that it's had. That doesn't necessarily mean that that's how it's going to perform into the future,

Starting point is 00:38:07 but I think that we have a higher probability in expectation that it will perform that way into the future just because of its past record and past performance. But it definitely does not guarantee it. And I think that's really important, whether you're investing in Berkshire Hathaway or any other company, that the future is unknown and you don't know what kind of events are going to occur and you're always assuming risk at an individual level when you invest in an individual stock picks. So I want that to be very clear.

Starting point is 00:38:35 But for me, whenever I would be valuing Berkshire Hathaway, I would look at his past performance. How fast is he growing that cash flow? And if it's somewhat predictable, then I would make some assessments as to what I think that would do into the future. then I would discount that back at an appropriate discount rate. So whenever we look at, and so that's the big question that a lot of people have when you're conducting the intrinsic value of a company, what discount rate do I use? And it's really up to the individual, like how much risk are you willing to assume?

Starting point is 00:39:08 So whenever I look at the current market here in June of 2015, when I look at the S&P 500, based on how it's currently priced, I would estimate that the S&P 500 is going to give me about a 4% return. Whenever I looked at fixed income bonds, like a 10-year bond, they're at about, what, 2.5% in the United States. So those are some pretty low returns, 4% and 2.5%. So when we're talking about a discount rate of how I'm figuring out the intrinsic value of Berkshire Hathaway, I would say I think it'd be very good to first start off by comparing it to what the S&P 500's rate is. So if that rate is 4%, I think I'd probably start off with what will a 4% return give me on intrinsic value of Berkshire Hathaway? Because that way I'm comparing apples to apples.

Starting point is 00:40:00 If the market is going to give me a 4% return, and then I figure out that Berkshire Hathaway is going to give me a 4% return at the current price, which we have calculators at Buffett'sbooks.com that helps you figure this out. We have a video at Buffett'sbooks.com that takes you step by step on how to use the calculator. All this is free. You don't have to pay anything. Just go to our website Buffett'sbooks.com and you can use these calculators. But if I'm getting that same return with the S&P 500 at 4%, and I'm getting the same return with Berkshire Hathaway at the current market price at 4%,

Starting point is 00:40:32 which it's not, just so you guys know. I'm just using this as a comparison. And if those two are giving me the same number, what would I invest in? Would I invest in the S&P 500 or would I invest in Berkshire Hathaway? For me, that's an easy decision. I don't even have to think about that. I'm investing in the S&P 500. And the reason I'm investing in the S&P 500 is because my risk is distributed across

Starting point is 00:40:53 500 companies. Where with Berkshire Hathaway, it's only with one company. And I think some people might be really surprised to hear that. But the reason I say that is because it's based on the current price. If the price is the same as the S&P 500, I don't care how good Warren Buffett is, that selection of buying Berkshire Hathaway at a very high price that's pricing it at a 4% annual return doesn't make any sense to put risk into an individual company that could fail. Now, I think if you would do the actual intrinsic value on Berkshire Hathaway right now, you'd probably get a much better return than what the market is offering at 4%. So when that comes into play, let's say that we did it for Berkshire Hathaway right now, and it was an 8% return, which is probably more realistic as to where it's at. So you're getting double the return, but you're investing in an individual company.

Starting point is 00:41:49 So there's more risk associated with that. That's where it becomes difficult for the individual person to make that decision. Which one do I go with? Because one has a little bit more risk because you're dealing with an individual pick. So that's kind of my thought process as I go through selecting and valuing businesses, is you got to, first of all, you got to consider all the variables. And there are a ton of variables at play here. But I think that you always go back to that benchmark of what's the S&P 500 going to give me,

Starting point is 00:42:22 what's a fixed income bond going to give me, which is impacted by inflation, I will add. So you've got to consider that variable. So those are just some of the thoughts and some of the things that I'm thinking about as I go through it. I want to hear what Stig has to say, though. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:45:42 investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. Yeah, yeah, I think it's really profound what you're saying, in how we are evaluating businesses, because basically we are always discounting,

Starting point is 00:46:08 like the money we expect to receive from that company. But I would like to talk about why you can probably not look at the income statement and Offberg to Hellaway and compare it to other companies because the structure is very, very different because it's a holding company and they own a lot of different investments. So what most investors do is that they will look at the bottom line and they would say like net income, $2 billion. So then they might have this multiple saying, okay, I want to purchase companies less than 15 times earnings.

Starting point is 00:46:42 Okay, so that company would be 50 times two. That would be $30 billion. Now, I definitely see why you would do that. And for a lot of companies, at least if you do it for like multiple years, it makes some kind of sense just to give you an idea of how profitable the business is. But for a company like Berkshire Hallaway, I think that you should probably look elsewhere. From Buffett, he talks a lot about look through earnings. I mean, that's one thing.

Starting point is 00:47:10 And look through earnings is actually a very simple, simple concept. It's really because they would own shares in, say, Coca-Cola. Now, because they don't own like a big share of Coca-Cola, they're only less than 20% of the company. What's happening is that they're only recording the dividend that they received from that company. So say that Coca-Cola would be making, I don't know how much money, but say that Berksa-Halloway's part of that earnings would be $1 billion,

Starting point is 00:47:40 then they might only be recording $300 million because the rest is not dividend. So I really like this idea of look through earnings. And I think that it's a concept that very, very few people understand. And I think it's a concept that very few people actually discuss when they talk about Berkshire Hathaway. Buffett in his shareholder letters really only talks about look through earnings a few times throughout the document. But when he does, it's very profound. And I think a lot of people could miss the boat on what he's talking about. So let me just kind of describe this from my own experience.

Starting point is 00:48:15 of, so Stig and I both own our own companies. So inside of our company, we have different assets that we've created. So, for example, one of our books, the Warren Buffett accounting book, that's one of our assets. So that brings in a certain amount of money every single month, but that is an asset that we have to report all of that income onto our income statement. So now is that one asset, let's just say that book is producing a flow of revenue and a flow of earnings. some of that is retained within each of our companies. So what do we do with that money that's retained from that asset? Well, we invest in other assets.

Starting point is 00:48:54 So we have the option to create, let's say we wanted to write another book. Okay. We could invest in that or we could invest in something that's non-operational, meaning I could invest in a share of General Electric. Okay, so that's an example. So if I invest in that share of General Electric, all inside of my company, Vail, okay? that would be another asset that would be added to my balance sheet that one share of General Electric.

Starting point is 00:49:21 Now, what's interesting is if I do that, General Electric, let's say that that one share of General Electric produces $3 of earnings. So do I list $3 of earnings on my company's income statement? No, I don't. I don't do that. But if General Electric pays me a dividend, I will list that revenue stream onto my income statement. statement. Now, what people don't realize is that that dividend is only a small portion, typically around, I would guess, 33% to 50% of what the company actually earned, that one share. Okay. So I'm only really reporting a portion of the earnings that that one share,

Starting point is 00:50:04 that one asset actually made for the year. So what Buffett is saying in his shareholders letters, and this is really important, what he's saying is that, hey, I, own $100 billion worth of non-operational stock. Okay. The only thing that I'm reporting on my Berkshire Hathaway shareholder or my Berkshire income statement is the dividends that I'm actually receiving from that $100 billion worth of stock. There is more earnings that are being produced from owning those companies, but I don't

Starting point is 00:50:38 have to report that. That's being retained within those companies. But don't forget, that is real. value. That is real earnings, even though I'm not reporting it. And so whenever the stocks grow, these stocks grow in value over time as he continues to hold him and continues to hold them, that's actually materializing into market value and increased market value over time. And that's what he's talking about whenever he says, look through earnings. If you want to study something out of the shareholder letters, one thing, I would argue that that's the one

Starting point is 00:51:13 thing you need to study. Because if you're trying to value Berkshire Hathaway appropriately, I think you've got to include the value of look-through earnings into your calculation. And I think very few people actually do that. So this is probably, in my opinion, the most important thing we've discussed in this entire podcast episode is this idea of look-through earnings. Yeah, I definitely agree with that, Preston. And I also think that that's one of the reasons why so many people have troubles valuating Berksa Hellerway because either they would be looking at net income or they would be looking at the comprehensive income.

Starting point is 00:51:50 But the problem with the comprehensive income then is that it includes all the unrealized gains that they have acquired through that year. So, you know, if the stock market roars, you know, that would be reflected in the comprehensive income or, you know, if the opposite happens, it's really, really hard to evaluate a business that operates like that.

Starting point is 00:52:07 And the key to do that, the solution to do that is really to look beneath the earnings and say, what is the underlying value of this stream? How much has the underlying value of all these businesses really increased during that year? So I said that that was the solution, but it's really real hard because they own so many businesses. Yeah. As a rule of thumb, my personal experience as I've done this calculation in the past is that when you add in and you account for the look-through earnings, I think that you really do add about 20 to 30% more to the cash flow of the business. So if you're saying the cash flow is 100, I would say that the cash flow is actually like 120 or 130 just because of this

Starting point is 00:52:51 look through earnings piece that people do not account for. And that's obviously a rule of thumb. You'd want to actually do the calculation if you're strongly considering putting in a large chunk of your portfolio in the Berkshire. So there's a lot of other things that we want to talk about. We actually had a very long list of different items here, but we're actually getting pretty long on the podcast here. And I'm sure all this accounting talk is probably boring some people. Other people might be eating it up. One of the things that I really wanted to talk about, but we don't have time to talk about, is this idea of intangible assets being protected from inflation. So if you have time to do a little research, look that idea up and maybe type in Warren Buffett, Intangible Asset.

Starting point is 00:53:37 assets, inflation proof, or something like that, and you can maybe read up some of that on your own. But what we're going to do is we're going to transition into the, take a question from our audience. And this question comes from Dylan Richardson. Hi, guys. My name is Dylan, and I'm a new listener to your show and love what you guys are doing. Earlier this year, I bought Ben Graham's Intelligent Investor book, the one with Jason Weig's commentary giving updates to some of his principles. And I've studied it as if it were textbook. I'm in the process of rebalancing my stock portfolio in accordance to his defensive investor guidelines and have a question for you guys. I have most of my portfolio

Starting point is 00:54:16 invested into individual stocks as well as an S&P 500 index fund. I'm reducing my individual stock concentration while trying to increase my exposure to international stocks. I'm looking at ETFs as the way to gain international. national exposure, specifically some of Vanguard's low-cost ETFs. My question to you is this. How would Ben Graham analyze an index fund or an ETF? He laid out very clear steps in Chapter 14 of his book for analyzing individual companies, but nothing for analyzing larger groups of stocks such as index funds. How can a Ben Graham defensive investor analyze an index fund? Thank you for taking taking time to listen and answer my question and keep up the great work.

Starting point is 00:55:08 Hey, Dylan, love this question, and it really pertains to the discussion we were previously having in the episode where we were talking about the return that you got on the S&P 500. So I made the comment that I thought that the return would be 4%. So this is so simple, and it's not anything that really takes a lot of effort when I'm coming up with that figure. All I'm doing is I'm taking the overall PE ratio of the market. So for the S&P 500, you could take, you know, I like to use the Schiller PE. So right now the Schiller P is around like a 27.

Starting point is 00:55:42 So all I'm doing is I'm taking one divided by 27. You're always going to take one divided by whatever the P.E. And by doing that, you're basically flipping the P.E. ratio upside down and you're inverting it. So it's an E.P. ratio. When you do that, what you're doing is you're actually taking the earnings, the profit of the overall S&P 500 and you're dividing it by the price that everyone's willing to pay to own the S&P 500. When you do that, you come up with a percent.

Starting point is 00:56:10 So one divided by 27 is giving you that rough number that I keep throwing around of 4%. So Graham, when you reference, I love the fact that you reference Chapter 14 in the intelligent investor because that's exactly where Graham passively talks about this idea. Graham talks about that if you would take the earnings to price ratio, and he actually calls it that, which is the same thing that I just quoted to you, taking one divided by the P.E. He says that if you take the earnings to price ratio, you should be at least as high as the current high grade bond rate. And that was the exact discussion we were having earlier in the show. So Graham doesn't come out and say, hey, this is how you value an index because indexes during his time really weren't anything like what it is now.

Starting point is 00:56:54 But this is how ahead of his time that he actually was working, he was already really talking about this concept. He was just kind of doing it passively. So that's how he values an index. There's really not too much more to it than that. Whenever you're evaluating an individual company, you've got a lot more risk to be concerned with because that risk isn't distributed across 500 different companies. So whenever I'm valuing an index, it's really just that simple. I'm just taking the P.E. ratio. I'm inverting it.

Starting point is 00:57:21 And that's really the end of my analysis. I know that might sound really simple and simplistic, but that's really all it is. Yeah, and just one thing really quickly to say about Bingham Graham is that I think that he would have a very quantitative approach. I know that we're talking a lot about Warren Buffett and we're talking about how he values companies, but his mentor and his old professor, Benjamin Graham, he was a lot more quantitative than Warren Buffett. So I actually think that, first of all, Benham would really like ETFs and indexes. And I think that he would really emphasize that, you know, the cost was low and also that has some very strict measures to looking at.

Starting point is 00:58:01 So he wouldn't like personal judgment in those funds. He would have like investing in companies that had the lowest book value, investing in the companies that had the lowest price to sales or, you know, such metrics. So if you find ETFs like that, I'm pretty sure that Benjamin Graham would like that. All right, Dylan, so awesome to have you part of our community. We're going to send you a free signed copy of our book, the Warren Buffett Accounting book. And for anybody else out there, if you have a question like Dylan and you want to try to get

Starting point is 00:58:32 it played on the show, go ahead and go to AsktheInvesters.com. You can record your question there. And if we really like it and we think that it fits with the episode, we will definitely play that and try to give you a good response. So everybody out there, thank you so much for everything that you do. You're helping us out tremendously by going to iTunes, leaving you. reviews, sending us emails, and we just appreciate it so much. It's just so much fun to interact with our audience. So we really appreciate that. We hope that you guys really got a lot of value out

Starting point is 00:59:01 of this discussion of Berkshire Hathaway's shareholder letters, and we'll see you guys next week. Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.Theinvesterspodcast.com. Submit your questions or request a guest appearance to the Investors Podcast by Goh. going to www. www. asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy

Starting point is 00:59:28 of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before a commercial application. TIP! TIP! TIP!

We Study Billionaires - The Investor’s Podcast Network - TIP 042 : Warren Buffett's Berkshire Hathaway Shareholder Letters (Investing Podcast)

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