We Study Billionaires - The Investor’s Podcast Network - TIP330: Warren Buffett - w/ Lawrence Cunningham

Starting point is 00:00:00 You're listening to TIP. On today's episode, we sit down with author and George Washington University Professor of Law, Lawrence Cunningham. Most known for his wildly successful publication of Warren Buffett essays, Lawrence is the most prolific researcher and author of Buffett and Berkshire, have written over two dozen books on the topics. In this episode, you will learn how to identify a quality investment, how to distinguish good management from bad,

Starting point is 00:00:26 and what would happen to Berkshire Hathaway beyond Buffett? Lastly, we'll also talk about whether Brexit Heatherway is currently undervalued. This was a fun and wide-racing discussion, so sit back and enjoy our discussion with Lawrence Cunningham. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors podcast. I'm your host, Dick Brutters, and then today I'm here with my co-host, Trey Lock. And we are so excited to have Lawrence Cunningham with us who literally wrote the book on Warren Buffett.

Starting point is 00:01:15 Thank you so much for taking the time to speak with Trey, me, and most importantly, our audience here today. Very happy to be here. Thanks so much. So, Lawrence, I want to start by talking about Warren Buffett, the man, right? We know a lot about his philosophies, which we're going to get into, but you know him personally, have met him many times, even hosted this symposium with him back in the 1996 that kind of led to this compilation or compendium of his essays.

Starting point is 00:01:40 And I want to address all of that, but start by kind of what makes Buffett who he is. So, for example, some of our listeners may have figured out by now that you can study Warren Buffett to death, but actually replicating his performance is highly unlikely. And I just want to know what you attribute that to most. You're right. It's not replicable or at least not likely to be replicated. It's a combination of compelling traits. And most people will be happy to have one or two of them. But it starts with rationality. He tries always to keep his emotions and check and focus on the facts, on the substance, on the

Starting point is 00:02:19 probabilities. Second is analytical acuity. He tries to think deeply and hard about any particular problem, whether it's a business, an industry or a person. And he's humble. You've got tremendous humility, particularly given his strengths in rationality and analytical acuity, he knows his strengths. He knows where he can do well, and he knows his limits. The circle of competence is his famous phrase that defines the difference between what he knows and is good at and what he doesn't know and tries to avoid. And I think if you're trying to get the secret sauce or maybe surprising things. I think the singular trait or skill that explains most of Warren's success over that long period and in particular settings is his ability to size people up. He knows it's an uncanny ability.

Starting point is 00:03:09 I mean, the others, we can teach ourselves a little bit. We can grade our own discipline. We can develop analytical acuity and we can certainly define our circle of competence. But this uncanny ability to size other people up, he knows who's trustworthy and who we Listen, he can tell in a minute whether this CEO will be a faithful steward of Berkshire Capital. He can tell pretty easily whether this family will be a reliable partner in a long-term business, whether this CEO of this publicly traded company is worthy. How can he do that? Or what can we get out of that?

Starting point is 00:03:40 I'd say the skill is uncanny and it's hard to teach. But here's the tip I have or the lesson I've taken from it. It's another thing he does. At the slightest whiff of lack of trustworthiness, he goes away. So he's ultimately a very skeptical person of human nature of the incentives that drive us to be selfish or to be emotional, irrational. It's a high hurdle to gain Warren's trust. He runs a trust-based organization. He delegates, gives his managers enormous leeway, as we'll get into. But he does all that only with a handful of people. And that I think helps him with this sort of ability to discern trustworth. His hurdle is very high. He has the neat tests may be useful to ordinary people. people thinking about how to do this themselves. He calls him the son-in-law test or the daughter-in-law test. He only wants to go into business with people. He'd be happy to have his child married,

Starting point is 00:04:31 or the other version of the test is the executor test. People, he'd be happy to have administer his will and carry out his wishes after he's not around. Those are pretty high hurdles that a lot of people go into business with people. They wouldn't want to watch a football game with or trust with their estate. But he's been pretty rigid about that. And so when you look around at his inner circle, let's say, the CEOs of the companies, members of his board, top shareholders of the company, the CEOs of investors, all very high-grade people, very not just professionally competent, but ethical. And so there have been a couple of mistakes. Everyone makes mistakes, including Warren. But so I think you're right. It's hard to replicate the skill set. I think

Starting point is 00:05:14 Any of us would be happy to have one or two of those four virtues or skills combine them. But I think we can all learn something from each of those. That's really interesting. I've never actually thought about it that way. After meeting Buffett and hearing him speak, even in a short while, you see the high intelligence level, the high IQ, and he's rattling off numbers from memory from dating back decades. He's always citing dates with events.

Starting point is 00:05:41 He just really has a mind for numbers, and it's very apparent he has a very high IQ, but what you brought up now almost as a superpower is that he actually has a, sounds like a high emotional intelligence or EQ. And you don't often find both. I've never actually really considered that with Buffett having both in that department, but that sounds a little bit like how you're describing him. I think you're absolutely right. I should concur particularly with the high IQ and his mastery of data and history, facts, and

Starting point is 00:06:07 numbers. I'll just add a point where the IQ and the EQ go together in a business setting. I get this question from young CEOs a lot about, well, how much diving into the details do I do versus how much delegation and which Buffett's approach. And my impression from Warren is he dives into the details. He knows exactly how many, I'll make it up, how many candy bars seize and sell it, what the steel content of precision cast parts assembly is. He knows all that stuff. You enjoy it and remembers it. But it doesn't second guess people on it.

Starting point is 00:06:39 He doesn't say, I think you ought to make more candy bars or reduce the steel, raise insurance rates, or he stays out of direction, but he knows what's going on. And so it's kind of a nose-in, body out kind of idea. And why is that useful? It's useful precisely if your plan is to trust people a lot. You won't know whether they're vindicating that trust unless you know the facts. So you know the facts and then leave them alone. And then you'll know when the occasional miscreant appears. They don't tell. The things they tell you aren't the things you know be true. And you'll be able then to weed out the mistakes.

Starting point is 00:07:14 So that combination of IQ and EQ, I think you're exactly right, Tray. It's rare. It's extremely valuable. And I think being aware of it can help us ordinary people, you know, do better in settings where the combination is particularly useful. I'm glad you touched on that because I don't think Buffett gets enough credit for being an operator. The white public thinks of Buffett as a stock picker and he's surely doing a great job of that.

Starting point is 00:07:37 But what you really excels in is running a conglomerate with wholly owned subsidiaries. And what you just touched upon, I think that's really a holy grail of running a business, right? Figuring out how to set up a decentralized system where you don't have to be included in every single decision, otherwise you just can't scale. But also knowing what's going on in the business so we can incentivize and motivate everyone the right way. And, you know, like you said that, Lawrence, Buffett does that better than anyone. You're absolutely right. And I think his investment success is long-running and well-known, again, 60 years ago,

Starting point is 00:08:12 and was really spectacular for the first 20 of those. And then excellent from the next 20. It's been a little more ordinary in the last 10 or 15, mainly because of the massive size of the organization. But also during that recent period, they've diversified into ownership of businesses and the balance sheet flip that you described. But he's been astute in the ability to manage or oversee such a large, diverse group of businesses. And I think that his ability to do that is now worth study. What did he do? How did he do it? How does he continue to do it?

Starting point is 00:08:43 Because I think it's useful for other managers. I think people are increasingly studying Berkshire and it's decentralized, autonomous, acquisitive, trust-based culture and will come to rank it as important in management as value investing has been in securities analysis and investment. In this sense, everybody listening probably has heard of Ben Graham. Warren made famous as a theorist or philosopher of valuation, value analysis, security analysis, stock picking, and so on. As they study Warren's approach to management and organizational structure, though, the famous person who will emerge there is Tom Murphy. Tom, as people know, many people may know. He's on the board of directors of Berkshire.

Starting point is 00:09:28 now has been for about 20 years. Warren's been a close friend to his 50. Tom built up the Capital Cities Communications Company, had some relatively small radio and television broadcasting company in the Northeast that Tom built and grew through organic growth and acquisitive growth over a long period of time, eventually acquiring or merging with ABC and then eventually selling that whole thing to Disney. And along the way tutoring Mike I, Bob Iger, who's been a had a great run of CEO at Disney. He was a Tom Murphy Prodigy. But Tom did all that using the principles that Warren has adopted. Very acquisitive, trust-based, frugal, focused on high-quality businesses and high-wantage managers, and then left them alone, even in an autonomous

Starting point is 00:10:14 structure, gave managers enormously a way to run their businesses in a very highly decentralized way. And so a couple of years ago, I published a book about Berkshire's culture, and I asked Warren, and who should write the preface said, Tom Murphy. He said, because Tom Murphy taught me everything that you say I do in this book. And so I think as we study Berkshire Hathaway, and it's the recent phase of the past 20 years, so becoming 80% of subsidiary owns companies, we'll learn more and more about Tom Murphy and his approach to business management. So in 1972, Buffett, in large part, Charlie Munger's influence, started to pivot away

Starting point is 00:10:51 from buying what he calls fair companies at a wonderful price to buying wonderful companies at a fair price, mostly exemplified by his purchase of Seas Candy. And this brings up the topic of quality investments, which you also wrote the book on. And I find quality to be an elusive muse, right? I'm reminded of one of my favorite books, Zen and the Art of Motorcycle Maintenance, in which the protagonist goes on a motorcycle journey across America solely as a means of discovering the definition of quality. And just a side note, I just cracked open your book this week, and I saw this exact analogy on the first page. I just thought was so funny that we were just really quickly aligned on that. And so through this book, you've achieved

Starting point is 00:11:30 a definition of your own, right, when it comes to what makes a quality investment. So can you describe to our audience how you define quality and how much it factors into your own investment philosophy? Thanks, Trey. I think what quality investing is is wonderful companies at a slightly high price, at a fair plus. It's okay. to pay up for quality. If you're going to buy a significant position in a high-grade company that you expect to be around for a long time, you expect to hold for a long time, and it has quality attributes that I can get into, paying a little extra for that is reasonable. If you're right, and your analysis backs the conclusion that this company will generate high returns on invested

Starting point is 00:12:14 capital for the foreseeable future, 369 plus years, if it's trading at a little bit of a premium, Don't worry about that. And so it's the opposite of deep value. It's the opposite of what Ben Graham did. And it may be a little more generous than what Charlie recommended Warren be willing to do in the Seas Candy pivot. And so by quality, look, that's a realistic appraisal of the current environment. There's just, and I don't mean just sitting here now in December of 2020, but for the last 10 years of 20, It's extremely hard to find those Ben Graham value opportunities or even the Warren Buffett

Starting point is 00:12:51 value opportunities. It's just in the public capital market. But if you sit down and what we did in that book is describe an approach to identifying what we call quality companies and making quality investments. And we start with microeconomic analytical analysis about industry structure and barriers to entry, economies of scale, rationality among competitors, and then look at particular companies to discern their moats, their competitive advantages, what structural protections they have against invasive rivals and technological disruption. And so we give example, the obvious

Starting point is 00:13:28 examples are things like brand strength and network effects. And we give some other more subtle examples such as having a friendly middleman. That is, you're selling eyeglasses, let's say, through optometrists to patients. And if you are able to enlist a loyal cadre of optometrists who recommend your lenses, your products, that gives you a significant mode of competitive advantage. This can happen across a lot of those sorts of industries with middlemen, plumbing, housing, fixtures, and so on. But so we go through and identify through microeconomic analysis and then particular company analysis. Think the kinds of competitive advantages that people listening will recognize. And then we demonstrate through, I think we do 25 different case studies in that

Starting point is 00:14:16 book of mostly European-based international global all-stars, people will recognize, Diageo, Hermes, and many others. And so the conclusion, the idea, and finally answer your question about quality investing, is that it's not highly likely that you'll be able to get Hermes on sale or L'Oreal to take another one, Diageo. But if you've done the homework and identifiable, and identifiable, a company highly likely through competitive advantages to be able to maintain high returns on invested capital over the foreseeable future and beyond, you don't need to get it on sale. You don't want to massively overpay into a euphoric market, but a slightly elevated price shouldn't be a turret. That's the main thesis of that book.

Starting point is 00:15:00 And I want to stick on this for a minute because you talk a lot about quality, quality investments, quality shareholders. It's a pretty important word, I think, in your research and literature. And it's just interesting how hard it can be to define. So going back to Zen, that book, which is the top philosophy book, that top selling philosophy book, it really showcases how elusive it can be as a word. And Phaedrus, the protagonist, as you mentioned in your quality book, you quote him saying, it's hard to define, but you know it what it is when you see it. My takeaway from that book was sort of like quality is getting at least what you put into something out of it and then some, right? As he's tinkering with his motorcycle, he's getting more out of that

Starting point is 00:15:41 machine. I'm just curious, is that beyond predictable cash, beyond high returns on capital, and attractive growth companies, which is how you define it in a bullet point fashion in the book? Is there anything philosophically important or something that's, I guess, even beyond that for you when it comes to the term quality itself? You're right about those points and the elusiveness and so on. But I think the, I'd say that the key and unifying feature of that notion that you do know when you see, that it's almost never accidental. Certainly if we're talking about quality of things that human beings create, diamond high quality and humans didn't have any accident in geology and so on. But if you're

Starting point is 00:16:21 talking about a company or a firm of investors to achieve that kind of stats to be just recognized and worthy of calling high quality, is the result of conscious effort and deliberate concentration and cultivation. And so why is their May's high-quality company? It is because for years, they have devoted themselves to delivering an extremely appealing product with excellent materials, the finest craftsmanship, with deliberate efforts to restrict supply and to cultivate a clientele pay up for what they're selling. So this is a process through which they deliver high-quality products. And they deliver it with very high margins as a result. So it's luxury. shoppers are willing to pay up for their products. And that's a quality business, quality

Starting point is 00:17:10 business model. And it's the result of deliberate conscious effort, usually over a long period of time. And so the same would be true for those other companies that we describe in the book. And so we can talk soon about the other side. This is about a quality business. The other side's about a quality shareholder. What makes for high quality shareholder? It's also going to be a product of a deliberate and conscious and very reflective mental engagement. And so that's maybe the philosophical version of my use of the term in both of those settings. I love that. So, Lawrence, another pivot that Buffett has performed in the last couple of decades

Starting point is 00:17:48 is flipping Berkshire from being primarily a holder of public entities to prominently holding private companies. And one might think that this is so that Buffett would have more control over the management of these companies, but the opposite seems to be the case. He has expertly distributed and delegated oversight in a decentralized fashion. And as an operator of my own business, I know how counterintuitive it can feel to entrust your team to guard themselves effectively. And even more counterintuitively, perhaps, is how much the autonomy can generate accountability.

Starting point is 00:18:20 For example, in your book, Martinot Trust, which you wrote with your wife, Stephanie Cuba, you quote Jim Weber, the CEO of Brook Running Shoes, because he said, I never felt so much autonomy in my career and never felt so accountable. So I absolutely love that quote and you highlight that Buffett's investing principles have been well documented for over 60 years, but the organizational structure could be a newer lesson to learn. In fact, you highlight how giant tech companies like Alphabet had taken interest in developing a similar approach. Could you please outline the pillars of this approach for our listeners? You're right. Warren has developed and perfected it within Berkshire

Starting point is 00:18:59 in the past 20 years, his motivation is what Jim Weber testified to, that surprisingly, perhaps, or counterintuitively perhaps, people who are trusted are actually more likely to do well for you. Trust is often vindicated. There are studies of workplace productivity that show a culture where people are authorized to exercise judgment and discretion when developing a product, selling it, or administering the operation, they're much more productive. They're much more successful. they get better outcomes than one where people have very few degrees of freedom and they're simply directed to follow. Here is the production manual. Here is the Salesforce playbook. And you must just do

Starting point is 00:19:40 these things. And Warren has known that. He learned a lot of this from Tom Murphy, who developed his company using this model. And so most large companies, especially in corporate America, have a bureaucratic, hierarchical command and control-based culture, where reporting structures are clearly delineated, approvals are required for a designated set of things through a given channel, and there are constraints on employee discretion. The effect of that is to limit creativity, limit willingness to reach in very many cases. And so at Berkshire, and most of its subsidiaries, including Jim Weber's running shoe company, the idea is, is to dismantle or just not even have those reporting structures, those approval requirements,

Starting point is 00:20:27 and those manuals and regulation. But instead, I have broad goals. Like, I want you to sell this many running shoes this year or I'd like our running shoe to be ranked. I'd like to have at least three running shoes, three models of our shoe that are worn by the top 50 people in the Boston Marathon. You give them broad, general targets, goals. And then tell how you do that stuff to you. I don't know how to make shoes, how to sell worms. And so, Jim, that's, that's up to you, but this is where I'd like to see. And then you can also set incentive compensation around, around goals like that. And so the reason for this trust-based culture is to realize human potential. People will do better for you when they're given some leeway, when they have autonomy. And so that's an exceptional

Starting point is 00:21:13 cultural feature of Berkshire. Berkshire is not unique. It's not alone. You mentioned Google or Alphabet has consciously tried to replicate that approach as they, when they change their name from Google to Alphabet, they identified 26 different, I think the total will be 26, different business units that are meant to operate in an autonomous manner, giving the leader leeway, whether it's the search or autonomous vehicles to make a pun or the venture capital group, but the leaders of those businesses have carte blanche. It's their P&L, it's their leadership, they get to stake their claim. and we thought we will do better as a company by allowing all of these different groups to march to their own drums. And in the book, Margin of Trust, we give examples of a dozen other companies

Starting point is 00:21:59 who do this. A lot of them happen to be in the insurance business, but there are also a lot of other industrial companies that do it too. Danahur comes to mine. Post is a good example. Constellation Software, where I happen to be on the board, is an example. The insurance industry is an interesting specimen because there's so many. Markell, Fairfax, Berkeley, obviously Berkshire itself has a huge insurance business. And I draw from that a couple of points of what does it take to organize and want to lead a trust-based culture as opposed to this command and control culture. One thing is you have to have a long-term view. You have to trust people and give them the leeway and the latitude to build up their businesses

Starting point is 00:22:41 over long periods of time. And insurance business is innately long-term. And so I think that helps explain it. But perhaps the biggest reason is what they sell is trust. The product of the insurance company is a promise to pay money in the future. That's all. It is. And so customers, policyholders will only pay for that if they trust you to pay back to honor the commitment. And so there's a sort of trust in the air in the insurance industry. Some third sort of reason is that the people who lead those companies tend to be value-minded or value-investmented, they focus on capital allocation, they are in the business. In effect, they're receiving premiums and then investing those funds in order to have a capital to pay claims. And so they're long term, they're trust-focused,

Starting point is 00:23:24 and they have to invest in a prudent way for the long term. So I think those ingredients help to explain why trust does seem to percolate in an insurance business, maybe more than industrial companies. But the examples of Dan O'Hur Post and Constellation and others, I think also is a testament to the value of autonomy in corporate America. It's something it would be not, I personally would like to see more of. But you see it too. I'll give you another example that's in the news, not just on this day we're doing this, but this quarter is Pfizer. Pfizer is a trust-based culture. That is it's autonomous, it's decentralized, the scientists who are experimenting in laboratories with all sorts of drugs and treatments have enormous leeway. And they need teams and they need a long time, in most cases,

Starting point is 00:24:10 is to do the research and testing to deliver useful pharmaceuticals. And they've just done it. We're in the middle of doing it, but appears to be a highly successful capability in addressing the coronavirus pandemic with a vaccine. It's doing quite well in the trials. And I think its corporate culture has a lot to do with that. You see it from the CEO.

Starting point is 00:24:31 That's something that the culture believes in. Scientists, they in particular, thrive more when they've got degrees of freedom to run experiments, to learn from prior results, without necessarily having to report up the chain of command and get new authorizations and so on. So I think there's a big lesson in there for corporate America. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future.

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Starting point is 00:29:03 This obviously sounds like a metric to identify quality management. But how does a retail investor, you just mentioned Pfizer and how you see this trust factor from the CEO, where are you seeing that? Are you seeing it in the shareholder letters and interviews? How do you identify that? You can see it in the shareholder letters and interviews. Another book that I've come out with that I know you want to talk about soon is it's called Quality Shareholders.

Starting point is 00:29:28 It focuses on what the most focused and patient shareholders look for in their investments. and how management can offer that menu. It's an iterative relation that end up talking to each other or having their minds meet at a large number of companies. And the way that two come together are first a management team that believes in a certain set of values, long term, high returns on invested capital, stewardship as their primary duty, stewardship of shareholder capital. And then internally, they create structures that achieve results like that, long-term, high returns on invested capital for shareholders over many periods. And so attentive shareholders, ordinary shareholders, as well as professional fund managers who are trying to select outstanding securities for their funds and their clients,

Starting point is 00:30:18 can discern signals and cues from the source you just mentioned, a shareholder letter, our annual meeting, restraint in around quarterly calls. You could have quarterly calls or not not in themselves at problematic, but when managers over-emphasize quarterly results and particularly using quarterly guidance, that creates perverse incentives for the troops to meet short-term bullposts. That would be particularly bad in a case like a pharmaceutical company where products take years to develop or a computer software company where products typically take a long years and years to develop. So worrying about the quarter, fixating on the quarter, is usually a bad signal for a long-term focus in a shareholder and articulation about the thinking around

Starting point is 00:31:06 capital allocation. Capital allocation is in some ways a fundamental idea and certainly is in the value investing world, the quality shareholder world where we wonder how each dollar of corporate wealth is used. And there's every single dollar. And it can be used a variety of ways concurrently, but you go down a list and think about while reinvesting in the current business to deliver increased profit margins. And that's useful to do if you can make that dollar work. Acquisitions is an appealing use of dollars so long as the investment thesis is sound and the internal rate of returns, satisfy, disciplined hurdle rates. Those acquisitions can either be, you know, add-ons or bolt-ons to the existing operation or tuck-ins or they could even be.

Starting point is 00:31:56 go beyond the current business, but in each case, you're thinking analytically about the internal rate of return and your hurdle. If organic growth and acquisitive growth aren't available, or if you've sort of exhausted your current capability to exploit those, then you think about reinvesting in your own shares, buying back stock. If the price value relationship is attractive, your stock is trading it low compared to intrinsic value. There's a good use of corporate cash. It also has the incidental benefit of paying cash to people who will. want to exit and receive a tax event while not inflicting a tax event on others, a dividend. And that's the last typical use is if organic growth, acquisitive growth and buybacks,

Starting point is 00:32:36 you still have extra cash, well, distribution to the holders. I've just gone through a simplistic statement of capital allocation. Quality shareholders look for managers who understand what I'm talking about, who think in those terms. And they're rare, or at least not every CEO thinks that way. Not every member of every board of directors think that way. Why? well, they may have risen through the business ranks in other departments in merchandising or production, sales, administration, what have you, and not been exposed to this particular highly disciplined, investment-oriented way of thinking about management. But savvy investors, certainly the value crowd, quality shareholders, are attracted to managers who think that way

Starting point is 00:33:21 and managers display that thought in the forums you mentioned. Sureholder letter of the annual meeting, reticence around quarterly results. And so there are other ways that managers, CEOs, and boards can signal to ordinary investors or, again, fund managers who care about this. Another thing that drives short-term my OPS compensation, because a lot of CEOs are incentivized by short-term metrics. How are you identifying the alignment between the CEO and the shareholders? I'm sure you know the funny quote or quip, I guess, that is attributed to Charlie Munger that show me how someone's compensated and I'll show you what they're likely to do. Incentive compensation is the term and boards, intelligent boards, set CEO compensation

Starting point is 00:34:07 knowing that it will lead to behaviors and consequences. You know, moments ago, I said what Warren tries to do with his CEOs is identify the targets, the broad, big targets, how many shoes we're going to sell or how many shoes are going to be ranked high in the Boston Marathon or what's the premium volume or underwriting profit, let's say at KICO, and then tie the leader's compensation to that outcome. And in cash, not stock options, not prescribing how they go about it, but having broad, big targets and big high payoffs. And that compensation system will produce certain results.

Starting point is 00:34:45 At least have a tendency to do that. Not every board is able to think that way or to negotiate successfully with their CEO to achieve that kind of result. And so you do have compensation consultants may not always find that the most lucrative advice. It's very simple. It doesn't require lots of consultation. And so you get a proliferation of forms of compensation, many of which do induce shorter term thinking. Stock options may be the best example or certainly a good one. The goal is to meet this quarter and get the stock price up. And they expire and they're accounted for, I think the accounting for stock options continues to be a serious problem. The real cost of options is not recorded on even gap less financial statements.

Starting point is 00:35:28 And so another point to make, this is very important for investors. Not every CEO cares about the long term. Not every CEO is interested in the longevity of his or her company, the durability of the brand. Plenty of CEOs are just interested in making a lot of money as soon as they possibly can, running a wonderful empire, and doing something else. Or being prepared to leave without much concern. The average CEO tenure in America is quite short. I forget the most recent, but it's not longer than seven years. A lot of people, it's shorter. So I think savvy investors should focus on compensation packages, what the likely effects are and what the likely incentives are. And see, in very many cases, the alignment is more towards short term. And I think being careful about that is

Starting point is 00:36:11 important. One interesting thing we try to look at is CEOs who have eliminated their compensation, CEOs would just take $1. It's a funny thing. It's a small group. They're only about $50. We thought when we did it, what we'd say is that these all tended to be longer-term thinkers. They tended to focus on capital allocation. They tended to attract high-quality shareholders.

Starting point is 00:36:32 It turns out it's not a simple story. A lot of them have taken the dollar because the company's actually going bankrupt, they've lost a lot of money. But it's a useful place to zero in because within that group, it's a small group. And if you just do a data quickly, you know, an S&P, or a company. float spec, find your data set, just isolate the CEOs who have been paid $1 a year for, say, in some Cs who just do it for one year and they're back on the $16 million treadmill. But look, CEOs who have taken just a dollar for five or seven or nine years.

Starting point is 00:37:01 And that will start to, I think, be an appealing place to probe further for integrity, for quality, for high returns on capital allocation. And I do think it's probably the pocket of governance that is least amenable to fix it. Cures for just about everything else, the liability of financial statements, compliance, disclosure around diversity or climate change. There are just enormous mechanisms that seem to be available to channel governance in almost every way. Compensation, executive compensation has eluded any meaningful constraints. We had tax laws that would only permit deductions for incentive-based compensation, and that actually promoted the use of stock options. We had, uh,

Starting point is 00:37:47 S disclosure rules, acquired CEOs, committees to list the peer compensation. So our CEO has earned this and here are the compensation of the peer CEOs. The thought was that this would embarrass people who were overpaid and tamped down on levels. The opposite happened. The theory was jealousy. The lower paid on those graphs complained to their board that they're worth at least as much as this fell on. So there was actually an increase. The latest is the idea of let's require disclosure of the ratio between the highest paid at the company and the median paid. And what you see in that is extremely high ratio at a lot of companies. Average is more than 200 and much higher than that. A lot of places, it has not had the desired effect yet of reducing that ratio,

Starting point is 00:38:34 but certainly not on average. Maybe it has in particular places, but I'm not aware of it. I think as likely, that approach is likely to just create more criticism, anxiety, heat than good results. But I don't have a quick fix, but I do think it's one of the biggest problems. And I would say, just pushing a little harder, one of the most important things I like to look at is the source and level of director ownership in companies. And the reason I think back to, I mean, directors can exert significant influence on a company. if they're properly motivated to do so.

Starting point is 00:39:11 There are others who are incapable of negotiating in a hard-headed way, a compensation package that assures alignment. And these may be wonderful people and even good directors in lots of other ways, but directors I most trust look to are those with significant portions of their own personal net worth in the companies where they're serving. Ideally, that they purchased with cash and that they held for a long time and planned to hold for a long time. The other fashion in corporate governance in the last three or five years is to incurrent institutional

Starting point is 00:39:44 investors and proxy advisors encouraging boards to adopt policies that require their directors to own a certain number or level of shares. And it's typically set at a multiple of their annual retainer three times or five times. I say two cheers for that. I think the motivation is right to focus on the importance and value of having directors with skin in the game. But I look for the director who does it on her own and does it with a lot of money. I'm not that impressed by a board that says, let's all make sure we do it, so we all have to. And then have it three times our little retainer. That's a small amount, even for directors of modest net worth. So I applaud it, but it's just sort of too, I'm not that impressed by a board that says, well, we all have

Starting point is 00:40:30 $600,000 worth of our net worth in our stock because we passed a resolution. saying we must. I look for the Allen Spoons with tens of millions. And so, and you can, you can get that data right off of the proxy statements indicates how many shares everybody owns. And again, I also like to see the director who bought that share with her own money, not by grants that companies give. That's pretty easy. But if you, you believe in the company you're run, you're coaching, you're advising and overseeing, I think you ought to buy stock, meaningful amounts. And Buffett certainly does that.

Starting point is 00:41:04 He has 99% of his net worth in Berkshire Heatherway. And I would like to jump back to Buffett and talk about how he makes acquisitions, because a competitive advantage that sometimes might be overlooked is just that. Could you please walk us through how Buffett approaches acquisition versus other companies or even private equity and how this could be considered to be a part of Berkshares' mode? You're absolutely right that Berkshire's approach to acquisitions is part of its moat and an unappreciated part. And so it's distinctive in just about every respect. And so I'll try to run through it more or less in chronological order. The first is sourcing. Most companies have an

Starting point is 00:41:42 acquisition department, big companies have an acquisition department or an acquisition team, and they're out and about searching for opportunities and then reeling them in. Some of those firms even use brokers to hunt. Berkshire doesn't do any yet. He famously has said, I wait for the phone to rent. He did take an ad out in the Wall Street Journal once about 30 years ago that said, here's what we're looking for if you've got kind of company like this ready for sale, call me. Minimum earnings, management in place, easy to understand. You see the criteria in his letters and in the essays. But beyond that initial vocal pitch, that he now repeats in every letter, they wait for the phone to rip. And so there's no internal pressure to make an acquisition.

Starting point is 00:42:21 It's nice. It means most companies have an acquisition department. It can add value. It can be useful, but it requires enormous discipline. Because if you're not making acquisitions, you may feel like you're not doing your job. But if that's how you feel, then you might start to overpay. And so you've got to have other constraints on that. Hurdle rates would help supervise people making an investment memo that has to be approved by the board or something like that. Buffett does it differently. So I'm not going to go out. I'm not going to go out trying to find acquisitions. I want them to come to me. And the second step in that is I mentioned that many companies have brokers out there kicking the trees. Those people are paid a fee. Therefore,

Starting point is 00:42:56 their incentive is to sell the deal, even if it's a little overpriced or it's not what you're really looking for, but their management that's in place is terrible. Warren doesn't do that. They've almost never hired a broker to make an acquisition. Instead, they rely upon a network of business connections and friends, which is a very large network at this stage, but have relied on that since 1968. He bought national furniture market from a local family friend. He brought national indemnity, largest insurance company in the world from a friend. And that's just discontinued. Now the friend's circle is millions of people. And so then the third thing is that the standard way of making an acquisition is to conduct extensive due diligence, financial

Starting point is 00:43:35 statements, contracts, operations, personnel, site plant visit. It's all very important and useful. And Berkshire does a little bit of that. They don't emphasize it so much. They go a little bit of that. But the main thing that Warren does, he reads the publicly available information, public companies, and private financial statements for others, and has a good sense in his mind about the business based on those things that all of us could gather. And then he sits down and talks to the people. He's got a very high threshold for deciding, I'd like to buy your company. He's got to understand that the financials have, like there is a moat and a sustainable business that he can understand. He's really got to trust that, that manager. That's actually, I think, the most important part of

Starting point is 00:44:14 the Berkshire due diligence. The fourth thing is that what promises Berkshire makes, and this is where the competitive edge really starts to seep in and distinguish itself from most other companies, that when Berkshire buys a company, makes two commitments, permanent ownership and managerial autonomy. We will never sell you. Come hell or high water, thick or thin, so on. Our plan is to hold this business forever. There are two exceptions for labor unrest or just hemorrhage and cash. If we're doing okay, we're not going to sell it. And sellers, who value that commitment are willing to monetize it. They take a discount on a purchase price when on the strength of that commitment. That's a huge competitive advantage. The related is related

Starting point is 00:44:55 promise is autonomy. His pitch is, we don't have management to put in, so any business we buy has to have management in place. And he makes a promise that will keep you in place. You'll continue to run the business the way you've done. As you see fit with no intervention from me. And again, sellers who want to continue to do that, entrepreneurs, family businesses who have a vision, they just need more capital or a better home, value the promise of autonomy as well. So that commitment is an intangible part of the purchase price. And rivals can't match it. So there's a great example when Berkshire bought the furniture store in Utah. It was bidding against Goldman Sachs. And Goldman Sachs bid was 12.5% higher than Berkshires.

Starting point is 00:45:40 And both were cash, all identical, except for that big difference in price. The selling family accepted the Berkshire bid and they explained to me they valued the commitment to permanence and the commitment to autonomy. It was a third generation family business of Mormons with a certain way of doing things and certain outlook. And Goldman was not likely to respect. They would intervene and told them they had to open on Sunday and other things. Warren said, I'll let you guys keep doing this for as long as you want. They valued that to the two and a 12 and a half percent. That's a huge competitive advantage that Berkshire has. And he's done that in scores of acquisitions. And now that's, it's taken years to achieve,

Starting point is 00:46:18 obviously, because he's able to, that promise of permanence, you look at the record. They've only ever sold two or three subsidiaries. And they were odd, strange, weird circumstance. They sold a small insurance company because it was an arch rival to another subsidiary. They were cannibalizing each other. They sold the newspaper subsidiary because, sorry for all the journalists out there, but the local newspaper business is gone. So they've kept businesses that have struggled. Benjamin Moore, paint, net jets, pampered chef, they hold them. O'Henbergh in cash. And the point of autonomy is vindicated with practice, too. Talk to any. The seller of a business can talk to any CEO of Berkshire company and get the same report that, no, I never talk to Warren unless I

Starting point is 00:46:59 call him. Someone will say, I haven't talked to Warren in years. Others say, I talk to him all the time because I can't and I really enjoy doing it. So now, rivals have a hard time monetizing and commit permanent self-time. I've seen it out of the marketplace. Most sellers don't care. Most sellers want the highest cash price or the highest economic price. For them, the promise of permanent autonomy doesn't mean much. But that's fine for Berkshire because they don't want those businesses. They don't want people who have the mindset of the highest immediate cash price because that's not the kind of business they want to acquire. They want to acquire a business that's been run by a guy that really wants something more than immediate cash maximization. So it's

Starting point is 00:47:37 worked for Buffett. It's hard to copy. People can do it to a degree. And I've seen other companies do it a little bit here and there. But it is a little bit harder to do. But I'd say when you join the family of Berkshire, they've burnished such a wonderful image that it's the All-Star Arena. It's major leagues. You're a manager of a certain temperament or a family. Becoming part of the Berkshire enterprise is a special thing. But to get in, it's hard. I mean, they did make a major energy acquisition this year, but the acquisition pace is quite slow right now. And I think with private equity is very different in a lot of these ways. There tend to be interventionists. And they tend to have an idea that really, ideally like to sell as soon as they possibly can.

Starting point is 00:48:21 And so, and they use a lot more leverage than Berkshire does. And they're able to pay more. And there's a lot of private equity capital available buying businesses and just active in the acquisition market. So premiums are above Berkshire's toleration. And so the amount of gain you get from permanence on autonomy is maybe just not enough. 12.5% is a good data. That may not be enough right now. Markets change. The environments change.

Starting point is 00:48:48 I think the Berkshire model remains worthy of certainly use at Berkshire and emulation, if you can do it. Well, that kind of begs the question of what happens to Berkshire beyond Buffett, which I've actually surprised that this actually seems to be a topic of discussion for almost over 25 years now. People have been talking about what's going to happen to Berkshire beyond Buffett. And here we are. And you've written extensively about how it might look once Buffett passes on. And I'm just curious how you address the concerns of shareholders who are weighing out the risk of holding Berkshire beyond Buffett.

Starting point is 00:49:22 I'll tell you a quick joke first, speaking of 25 years, when I had that conference that produced the essays, one of the questions during one of the segments from the audience was, what will happen to the stock price if Warren gets hit by a truck? I don't think they put it in that jockey way. I think if he dies tonight, we debated it for a couple minutes, Munger made of quit. Some of us don't like talking about this subject. Warren said, eh, it's okay, Charlie, but my opinion for what it's worth is that it won't be as bad for the stock for the stockholders as it will be for me. They've been thinking about it for 25 years.

Starting point is 00:49:55 And that's what five years ago, I published Berkshire Beyond Buffett to address that question, to ask what will happen? And I did it to address shareholder anxiety. I go to the meeting every year as you do. We usually do 2020 and not in 2021. But that's the most popular topic of conversation around, you know, the informal gatherings at Berkshire meetings. What happens?

Starting point is 00:50:16 So I wrote the book to address that. And my thesis is that the company he's built. is larger than the man who built it. He is infused Berkshire with a set of cultural attributes that give it the very best chance of surviving and prospering long after he is gone. And it includes these points about permanent ownership, about autonomy, about trust, about having a very high hurdle for investments and for people. And others at Berkshire get that. Everybody, not all 400,000 people, but all the leaders, all the management and all the subsidiaries understand these principles of permanence,

Starting point is 00:50:56 autonomy, and trust. And they repeatedly vindicate them and instantiate them every day. And that's especially true of the 18 or 20 people with the highest influence. All the members of the board of directors, the people who help with investments and run the internal audit, they all get this. And in particular, the two fellows who were three years ago put onto the board and named vice chairman, And Ajit Jane, who's been at Berkshire for 25 years, now runs all the insurance operations, and Greg Abel, who has been at Berkshire for 23 years and runs all the energy businesses. Favorite Buffett quote, these guys have Berkshire blood in their veins. They may know more and embrace these values even more deeply than Warren.

Starting point is 00:51:39 That's absolutely true for the board of directors. That board of directors, they've got Berkshire blood in their veins. And I can tell you a story if you want, why I believe that they may even get these values more than Warren does. So these will be the stewards of the legacy. They have every conviction to sustain it and the fortitude and the ownership. The own significant horses that are net worth in Berkshire. All the heads of the CEOs have this view. It's a culture of self-replication, self-selection. People don't fit in. They leave voluntarily or involuntarily. We've had 20 or so CEOs over the last 20 years in that category. And there may be one or two of them left who don't

Starting point is 00:52:19 belong, but there'll be a natural selection. They won't pose any significant problems. So I think the culture will help sustain. Moreover, I think they have designed the best possible succession plan. Warren's job is going to be divided into multiple separate functions. As chairman of the board, the plan is to have the board appoint Howard Buffett, Warren's son, who's been on the board for 20 or 30 years, and has the Buffett legacy. He wants the company to succeed and to prosper. And I think he'll succeed in that job. Notably, this is a job that Warren has never had to do. And so any idea that, well, Howard's not Warren, doesn't matter. Warren had to build a place and develop all these cultural motifs. Howard simply has to enforce them. So it's a very different job. And I think Howard is

Starting point is 00:53:04 well-suited to do it. As CEO, the likely candidate is Greg Abel, hasn't been announced. And he is, not to make a pun, but Abel. He has allocated Apple very successfully for a long time at Berkshire Energy and has proven chops. And I think you will be a very capable capital allocator. And as Jane, will be there to help with play a bit of a Charlie Munger role, a bit of a no, I don't think so. And that's when that's necessary. As investment officers, they've got two there now, Ted Wessler and Todd Coombs, who've been there now for almost 15 years, and each of them manages 10 or 15 or something billion of the portfolio. They had proven records before they joined Berkshire in the philosophy that your audience well knows, very skillful investors,

Starting point is 00:53:52 discipline, focused, long-term, patient, outstanding people, you know, high octane, very ethical. Warren's jobs split those three or four different ways. And then the fifth function, obviously Warren's always played is his controlling shareholder. He's been reducing his ownership state gradually over the past 12 years through gifts, mostly to Gates Foundation and to his kids. And in the 12 years after, State, he's going to gradually sell off a little more of the stock all the way through that tail. And so it will remain controlling shareholder for a while. And his estate will, you know, vote his shares and exert some influence from the grade, as he once put it, but you'll gradually call from a company with a controlling shareholder to

Starting point is 00:54:33 want it isn't. And so during that period, that's when the role of shareholders is going to be vital, and I think they're going to play a positive role. Berkshire has attracted among the greatest densities of long-term focused shareholders in corporate America. They are loyal, faithful, and most of them will stick around and give that team a chance. Give Greg, Ajit, Howard, Todd, Ted, and the board room to run. Not forever. They're not fools. They're not either used to not in love. This is not romance. They want sustained return. I don't know what people have different. thresholds for that, but give them a chance and demonstrate that this model isn't unique for Warren. Warren is right. This culture is self-propagating and that they will be able to make investments,

Starting point is 00:55:19 make acquisitions, and run the overall successfully. And if you're able to do that, Berkshire will survive and thrive and will be operated according to the principles that Warren developed over all these years. If they're not able to do that, the shareholder base will, they'll leave. They'll start selling and deciding it was a special thing, it was a special company. It was a personal company, ego business, and that's not the same, and they'll gradually sell off. And I can tell you what I predict what happened after that. My money is on Greg and the model. I think the model works, and I think Greg knows how to work.

Starting point is 00:55:53 So do you comment about CEOs coming and going voluntarily or involuntarily? We had to mention the David Sokol scandal back from 2011, and David Sogo was seen by many as one of the candidates to become the next CEO of Berkshire. In short, he bought stocks in Luprosol and Lvarez. later presented the idea to Buffett about Berkshire acquiring the company. Clearly an illegal move. As an expert in corporate governance, what is your take on this and how does this tie into this discussion about the succession of Buffett? When David told Warren, oh, I bought some stock in this company and he'd also said, I used a broker. That's how it came up. A broker called Warren to congratulate him and say, I'm glad we were involved, which surprised Mark, because we don't

Starting point is 00:56:34 use brokers. So we called David to say, do you use a broker? I said, oh yeah, did I not tell you that? No, you didn't. Is there anything else you didn't tell me? Oh, yeah, I bought three million dollars worth those stock. I think that finally is our policy. I think you're allowed to do that. I think they decided David had to resign. And Warren wrote his own press release saying, David did this and he's resigning, and then extolling all of the wonderful achievements that David contributed to Berkshire over 20 years, including turning around NetJeds, dealing with John's Manville and running the energy business and growing it. And the shareholders went nuts and the press being worse because Warren had for years been stressing ethics. And the

Starting point is 00:57:08 center of the playing field, not hurting a shred of the reputation of the company. They all said, that's a shred or worse. So this slap on the wrist didn't seem right, didn't seem Berkshire. And this came out 10 days before the annual meeting. So there was a lot of spotlights on this. The board took control of the matter. Ron Olson, who's the chair of the audit committee, along with Susan Decker and Sandy Goddessman, did an internal, you put this in the frame of corporate governance. They executed a perfect corporate governance measure. They investigated what it happened. They interviewed David. They interviewed the folks at the company at Lubrizal. They documented conversations with Warren, the times of his trades, and so on, and concluded

Starting point is 00:57:47 that he had violated Berkshire policy and that under the terms of his employment contract, he was terminated for cause, which meant that he was stripped of all sorts of benefits, mostly economic benefits. And worst of all, this was throwing him under the bus. His reputation is in tatters. The private sort of little resignation, he'd have been immediately rehired and done other great things in the public limelight. But with this repudiation, this review, he couldn't do that. So it was a stinging renunciation of David.

Starting point is 00:58:17 The board also reported the matter to the federal securities authorities at the Securities Exchange Commission because it probably, there was a case to be made that buying the stock before encouraging its acquisition violated federal securities laws. also, they referred it to the SEC. Now, it turns out the SEC conducted its own investigation and decided not to enforce. It didn't mean he was exonerated and vindicated or anything like that. There are many reasons why the SEC might not bring a case. But what it certainly meant was they didn't think it was so obvious that they should do it.

Starting point is 00:58:46 So the read I get from that is that the board took the ethics and the playing in the center of the field and not a shred of reputation much more seriously and warned it. They got that set of values and ethics fully and firmly. I mean, Warren's famous phrase that he first uttered a congressional testimony when he took over the scandal-ridden Solomon Brothers Bank was lose money for the firm and I'll be understanding, lose reputation for the firm, even a shred of reputation, I'll be ruthless. What happened in this case was that he personally was not willing to be ruthless. David did lose a shredder reputation, and Warren was not ruthless.

Starting point is 00:59:22 The board was. And so what I take that to me is that board, and they'll be, you know, if something happens to Warren, I mean, Ron, Susan, saying he's getting a little older, but, That board, its audit committee, believes in these ideas. They acted decisively. So to me, what it says, it's a data point in my argument that the company's bigger than the man. He incubated it and put all sorts of values and culture in there. And it's part of the institution now.

Starting point is 00:59:48 And the institution acted in a much more effective way than Warren hit. Yeah, I think that's an important point, right? It definitely showcases how the company can operate or is operating even beyond Buffett already. And it's almost like David was a sacrificial lamb of sorts to solidify that company culture and to prove it out. It's really quite fascinating. Let's take a quick break and hear from today's sponsors. No, it's not your imagination.

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Starting point is 01:03:20 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. So I want to just touch on a question that I'm curious about. And it surrounds this idea of conglomerates that have fallen out of fashion, right?

Starting point is 01:03:39 But Berkshire is a massive, massive conglomerate, maybe obviously one of the biggest in the world, if not the biggest. So Berkshire itself is this massive conglomerate. And back in the 80s and 90s, conglomerates were falling. out of fashion, they were getting taken over by corporate raiders like Carl Icon or buyout firms that would break them up and sell them off. But Berkshire avoided all of that. And I actually have this impression. I don't know if you agree, but Berkshire almost has this halo effect of being somewhat of like a benevolent conglomerate, if you could use that word, right? Whereas

Starting point is 01:04:09 Amazon, for example, has a totally different distinction or perspective on it. And Amazon, my take on it is the sum of Amazon's parts make up a monopoly. Whereas Berkshire, that's not quite the case. It's subsidiaries across multiple industries that don't quite create a synergy for each other. It's a profoundly deep insight and avenue for investigations. It's an excellent thesis. I think that sort of halo, the halo effect benevolent conglomerate, I think those are apt descriptions for Berkshire. And a big part of that is how Warren positioned himself in the company. And as a member of the sensible center, he's a capitalist with heart, you know, it's a money-making machine, but they care about their customers and their

Starting point is 01:04:56 employees, even in the scrapes that some of the subsidiaries have gotten into, and they've gotten into them. They've managed to work through them. The energy company sometimes accused of not handling customers well. The Clayton Homebuilding Company was attacked for predatory lending and manipulating relatively poor people into buying things and taking loans that they really couldn't afford the insurance companies, some of them being slow pay and not acting in good faith. So they get pockets of heat, but they survived those, and I think for good reasons, I think most of the arguments I've written about this were not correct or credible. But Berkshire itself has managed to be like Halo, benevolence, and also a little bit of a Teflon. They get hit.

Starting point is 01:05:39 You know, the so-called episode is a good example in the papers and big deal, but everyone's soldiered on. It's managed to do that. And your thesis is a series. might be right. It is, it's not a juggernaut like Amazon. Amazon, it's a very different animal, as you say. It's in your face, for one thing, that the whole operation is very consumer-facing, boxes and all uniform. A lot of employees are low on the employment totem pole. And when they're, when they have grievances, they get aired and magnified in ways that Berkshire is much more diffuse and operating through all these different units. So it's a, it is a completely different I think you're absolutely right about that.

Starting point is 01:06:18 The other thing I'd say just about the house, why does Berkshire get to be a conglomerate, so many others have been attacked? But one obvious thing is that Warren has basically the golden share. If Carl Icon wanted to attack, wanted to take a shot at Berkshire, he'd almost certainly lose immediately, partly because Warren's got the block at equally because he's got seven, the other shareholders would absolutely agree with him. It's not a crowd that's likely to accept Carl's argument over Warren's. I think the other thing, and maybe it's a part of that.

Starting point is 01:06:47 I think those activists assaults on the compromises at the beginning of the 80s and 90s, including with Carl and Nelson Peltz and others, and they continue today, United Technologies, or DuPont. Part of the argument is about how it's invisible. It's hard to identify the separate units and to appraise the value of the units and sum of them and that you need to break these up so that we have visibility, so that we can see exactly what this one is worth and exactly what this one is worth. And then the added argument is that when you do it that way, you will unlock value.

Starting point is 01:07:20 People will be able to say you're actually worth six instead of five. So let's unlock the value. These conceptions are not at home at Berkshire Hathaway. There's no thought that we need to unlock value or that you need to have a valuation on these units. Those ideas are very much of what's the market price and how high can you make it today? This alien Berkshire Hathaway. It's not about getting a market valuation on these units.

Starting point is 01:07:45 That's not important at all. It's not even important to have a market valuation for first year as a whole. And it's certainly not interesting to find out what it is today compared to what it is tomorrow. This crew's looking out forever in a practical way, at least three, six or nine years. Then Warren uses 10 or 20. So the philosophical attack, you're trying to break up DuPont. And Nelson tells you, you know, you've got to separate paints and the pharma and bio and life sciences so we can see what each one's worth. You know, that attack, which only barely succeeded, the holder is actually, I think voted the other way, but there were so much momentum behind it. So that attack, it just wouldn't

Starting point is 01:08:19 work philosophically at Berkshire. And I'll just say one final thing is that there are other conglomerates. I agree with you that most have disappeared. But there are quite a few, and they survive, thrive. And I'm talking about Danahir and ITW, that's Illinois Tool Works, even United Technologies. So all three of those have been targeted by activists campaigning for spin-offs, investors, breakups, de-combrammerization. And all three of them did a little bit, but all three of them maintained significant parts of their culture and their philosophy. Danahar, in particular, it's done, I think, two major spinoffs so that it's shrunk, created a little greater visibility and added value market capitalization through doing that.

Starting point is 01:09:07 But it remains, Daner herself, acquisitive, decentralized, autonomous, trust-based. it's going to build and build and build and it's still a conglomer. Illinois Toolworks, similar story, 100-year-old Chicago-based manufacturer of industrial parts and products. And at one point, I think it had 800 different business units, 800 different separate P&Ls that results of acquisitions that were managed by independent managers who ran their own businesses. Now, they did it at the ITWA, which is a certain sort of entrepreneurial, innovative, customer-facing. There's sort of an ethos around the company that you take customers first. But it was a huge diverse conglomerate, enormously deep, vastly decentralized. And I think it was relational, went after them.

Starting point is 01:09:52 And but Scott Santee, CEO, they did some trimming. They went through a divestiture process. They sold a bunch of things. They combined some things. They listened to what the showered activists thought was ideal. But they didn't destroy the company. They didn't just break it all up, sell it all off, 800 little different companies. I did not be still acquisitive, decentralized,

Starting point is 01:10:13 autonomous, living by values that have published for 100 years. And so even in this world, this anti-glamarate world, and this agitation by activists who opposed global, the important parts of the model remain valued and remain durable. And so done right, it's still possible. Well, Pitt. So, Lawrence, I would like to talk about the concept of quality shareholders because you said that one of the biggest concerns in today's market is the rise of investors just owning an index and how that indirectly contributes to the deterioration of quality shareholders.

Starting point is 01:10:48 So perhaps first, if you can define what makes up a high quality shareholder, and then why an investor should pay close attention to the risk of so-called low-quality shareholders. Yes, thanks. I took this term quality shareholder from Warren in his 1978 letter, and then again, more fully in his 1983 letter. So that's early days from Berkshire. he explained that he wanted to attract to Berkshire a certain kind of shareholder. And that kind of shareholder was the long-term focused shareholder. And he called them a high-quality sharehold. And he made

Starting point is 01:11:24 a joke about how hard it is to turn a corporation into a club like that. He made a joke about Lady Astor being able to choose which 400 people she'd have in her home or in the social register. The Berkshire is a publicly traded company. Anybody can buy a share. So he can't simply admit you, and not admit you. He said, there's a certain kind of person I want. It's the long term, I need people, patient. I don't want a lot of day trading in this. And I want them focused. I want them to put significant portions of net worth in Berkshire. I want them to pay attention. I want to be able to talk to them, teach them, and I want them to understand and stick around. Come to my meeting. Let's read my letter. So he said that early on, and he said, and how am I going to

Starting point is 01:12:04 do that? Well, I'm going to have a set of policies and practices that cater to that crap, and only do that And so those policies are stressing the long term, stressing capital allocation, stressing trust, autonomy, decentralization, the playbook. And so he consciously cultivated that group. And what I've come to realize over the past five years, studying Berkshire this whole time, looking at all the reasons for its success, we started this conversation identifying the personal characteristics of Warren that have contributed this. Well, there are many factors that contributed to Berkshire success. Warren personally, Charlie Munger's role as number two, trust-based culture, the commitment to permanence, autonomy, the rationality, and so on, the network and all of that. I came to eventually

Starting point is 01:12:54 realize that all that's important. The crucial thing, you couldn't have done any of that without the shareholders. Warren was right that he needed to have. What do you call it high-quality shareholders? He defined them as long-term and focused because they helped him. They gave him him a runway, they stuck with him through the thin, and there were a bunch of thins. They're thin now, the tough periods. They stuck with it. They gave him the strength, the fortitude, to prevail, to be a CEO. He couldn't have done all it. Whatever, his brain, his EQ, his IQ, his brain trust and all that, wouldn't it be able to achieve what he achieved without those long-term patient holders? And so that's what I came to realize. So five, four years ago,

Starting point is 01:13:36 I started focusing on them on books about their role in Berkshire. And then I realized that's probably true at a lot of other companies, too. So I broke down the prevailing shareholder demographic into four quadrants based on time horizon and concentration. And you've got basically four quadrants. You've got the indexers who are long term. They basically hold forever unless the stock gets out of an index, but never concentrate. They own small bits of every company.

Starting point is 01:14:03 And so they can't be focused. I mean, the staffs of the big index are minuscule compared to the investees. BlackRock just increased its staff, the stewardship staff, as it called it, to about 48 or 45 people, which doubled. It's a lot more people. They're invested in 4,000 U.S. equities and 12,000 all the world. They simply can't consider it. They can't know.

Starting point is 01:14:25 And the business model isn't too no. They just buy everything, every single stock. That's the business model, and they don't need to pay attention. And they shouldn't really be expected to pay attention. Their business models just by the market. So that's one crop, the indexors. They're long term, but they're not folks. They can't be.

Starting point is 01:14:41 And the next quadrant is sort of the opposite of that, the traders, the transients. The arbitrageurs, the robotics, the artificial intelligence, just the happy day traders, or just a lot of funds that are active, that move a lot and do a lot of buying and selling. So average holding periods are a year, maybe two. And so they're short term, and they might have high levels of ownership at certain times, and they might concentrate but never hold for long. You know, and incidentally, those two quadrants make up the vast majority of ownership of public equity today.

Starting point is 01:15:13 The indexing segment is at least 30%. And if you look at the publicly stated indexors, BlackRock, Vanguard, State Street, Northern Trust, that's 20% right there. And then the smaller quadrant next is another five or eight. or 10%. And then there are just a lot of investors, institutions, who are closet indexers. Well, they advertise themselves as picking stocks, but they really own 200, basically the index, more than 200. So at least a third of the public equity is owned by indexers. And then another third is owned by transients. The average holding periods of a third of the equity is less than two years. Those are

Starting point is 01:15:54 enormous, enormously powerful influences in public equity today. And they're both useful in different ways. Indexers deliver the market return for millions of ordinary people at virtually no, very low cost and just the market risk. It's a wonderful thing. And so they add enormous value to society. And traders add value too. They do price discovery. They provide deep liquid markets when people do have to sell. Long-term people have to sell for bequests or. or deaths, they provide the deep liquid capital markets that the United States has long been famous for. So it's not a condemnation of these cohorts, but they do, they play those roles. They do not play the role of a focused long-term shareholder understands the business,

Starting point is 01:16:39 gives managers the benefit of the doubt and a little leeway and he's willing to engage constructively with managers. And that's the quality cohort. That's the kind of holder Warren long ago said he wanted to have. So the quality group is, in some ways, the group, these all three of the others do very important things, but the important thing that the quality group adds is an informed, incentivized focus on, that very often help management, certainly elongate the time horizon and so on. But they're not fools. They're not sycophants or cheerleaders. They're in it for returns as well. And so managers are failing. They'll sell, they'll leave, join an activist campaign, for that matter. When Warren, it's sort of interesting, when Warren wrote those letters

Starting point is 01:17:24 in 1970, 1983, indexing was in its infancy. I think he was mostly concerned about day traders, and activism had a different texture. It was more rival companies doing hostile tender offers. They were occasional activists, but the real era hadn't begun. So his statement was addressing a slightly different demographic. But what's happened is you get way more of the two things that he said he wasn't really interested in track way more. And the pressures on investors to index or to trade rapidly are huge. You know, indexers, it's safe. You just delivered the market return? Well, at least you didn't lag. That's why you get a lot of closet indexers. And if you're really hungry, you're really eager or your clients are urging you. It's tempting to design

Starting point is 01:18:12 trading strategies that end up looking like you're turning, just doing a lot of shorter-term trading. So the pressure is on the quality shareholder to join the others. And so I think, nevertheless, I also think that the quality cohort knows that they are not only playing a valuable role, but through doing it can outperform the market and certainly the day traders. And incidentally, the evidence, there's a huge debate as you know, about value versus the index or stock picking versus the index. Significant studies that have often shown that there's no systemic strategy that will beat a passive index. Warren even did a famous bet with Ted Seidies over the past decade where Warren bought the S&P and Ted was able to assemble any group of hedge funds he wanted stock pickers

Starting point is 01:19:02 and see who would win. And now it was a funny bet. It was over a 10-year period. The stock pickers actually won in a couple of years, but the index won overall after fees. case in distress. The reason Warren made that bet and highlighted so much was to emphasize that the funds extract enormous fees from their clients so that they may have outperformed. Stockport picking may actually be possible. Individual may be able to discern quality to get returns, but if you have to pay for it, managers, head fund managers take high fees. That was his real critique. But nevertheless, it China's spotlight. How difficult it is to pick stocks and outperform the average. And so it is. And so that said,

Starting point is 01:19:41 An important strand of that empirical research led by the dean of the University of Notre Dame Business School, Martine Kramer's and others, an important strand has demonstrated that the strategy I'm talking about, the quality shareholder strategy, being patient and focused, has a tendency to outperform. Now, you've got to do other things. You've got, you know, it's not magic. You just don't pick 30 stocks and hold them for five years. You've got to conduct the kind of homework and analysis that Warren's famous for, that value

Starting point is 01:20:12 investors do, and my quality shareholder and cohort does. But the research indicates that long-holding periods of concentration going together contributes to the possibility of systemic outperformance. That's a very important strand of research. Now, it too is controversial. I'm sure your listeners know as well as I do, but some of the quant firms attack the research. And there's a great debate about it, but there's no question that it is a genuine, reliable contribution to the literature so that any idea that, well, you cannot outperform or value is dead or quality shareholder is wrongheaded is just wrong. And so I think the quality cohort know that they add a lot and they gain a lot from being who they are. And, you know, there's a philosophy here too,

Starting point is 01:21:00 and even a personality. You know, different individual human beings and fund managers will have a greater or lesser affinity for merely indexing or being a day trader or sticking with quality or being an activist. It really depends on your appetite, your willingness to do work, your toleration for risk, your level of willingness to be an agitator versus being a more of a diplomat. And so people will self-select into these styles of strategies in ways that suit themselves. So I think it is, it's harder to be a quality sure. So anyone who's familiar with Berkshire probably is aware that they have a prominent insurance business unit and that they use the float to allocate and grow other business units within

Starting point is 01:21:44 the company. It's part of the fuel that's been driving the growth of Berkshire overall for many years. I'm just curious because we're in such an interesting economic environment where interest rates are lower than ever. And there's no real sign of them being able to increase anytime soon. There's even pressure to potentially go negative as they've done. so in other parts of the world. There's on top of that even devastation caused by this global pandemic that will have consequences for insurance companies, generally speaking. And we saw that

Starting point is 01:22:12 in Berkshire's insurance earnings, they decreased about 60% in the last quarter. And I'm just curious, given that insurance is greatly affected by these interest rates and that insurance makes up 27% of Berkshire overall, not to mention it produces the float used for capital allocation. In your opinion, is Berkshire at risk as we enter this new economic environment and how do you see it affecting the insurance portion? Great question, Trey. You've really outlined a set of challenges that the industry generally faces, and Berkshire in particular, because of its heavy, I wouldn't say concentration, but big portion of its operations and strategy. It's hard to know.

Starting point is 01:22:52 And so I don't have anything to pinpoint in your articulation, but I'd add a dimension in thinking about Berkshire's insurance position that's less gloomy. in some ways. I think that what Warren worries about most is catastrophic risk and the massive claims that his companies and many others will face. No one can predict what the Black Swan or whatever you like to call it is. It could be cybersecurity. It could be different aspects of pandemic, business interruption. There's a good bet that there's going to be continued that effects from climate change, hurricanes, floods, tornadoes, fires, and whatnot. And so this center risks may well have been magnifying, not likely to change direction.

Starting point is 01:23:39 And so I think he might be expecting, I think insurance pricing shows some of this, huge claims in the near term, it'll dwarf Hurricane Andrew and 9-11, hundreds and hundreds of billions. And it'll wipe out a lot of companies. Many insurance companies will become insolvent. State funds will have to take over. and Berkshire will remain a fortress. And because it has the strongest claims capacity, it's got enormous capital, gushers of cash flow. I think when it comes to insurance, that's the thing I worry about the most for the industry and for society, but it's going to actually be

Starting point is 01:24:15 extremely beneficial for Berkshire because it will be able to pay all its claim. It'll be able to take over portions of the market or industry and thrive as a result. It struck me at the annual meeting in May, you know, Warren certainly looked very gloomy, and it may have just been for the pandemic. And he sounded dour. I mean, it was the least, you know, he's usually, as you know, he's happy and fun, optimistic, realistic, but generally seeing, you know, discerning the positive trends in America's had all those essays about America's tailwinds and all. You did not see any of that that day. And maybe it was a pandemic. Charlie's not there on the state with him. And no one is there. Your cousin may have been there, but not many other people.

Starting point is 01:24:57 100 people and not 40,000. So there are all kinds of reasons for it. I just had a strong sense that, and I think he adverted to this in the comments, that there are seismic, catastrophic risks, and that a lot of insurance companies will be wiped out. And Berkshire will have to pay enormous amounts of money, but it'll be able to. And, you know, that's what you read the letters. One of the most important things in Berkshire is that claims capacity. It calls it a fortress in Fort Knox. That's a good advertising slogan for big reinsurance commercial property, casualty insurance to say, we will be here. Your policy, not only can you trust us, but we've got enormous, we've got so much capital. There's nothing, no tsunami is going to starve us.

Starting point is 01:25:37 And that made me think, Berkshire's got this enormous cash balance and treasuries, 130, 40, 50 billion, I can't keep track. Warren's got that old joke when these microphones, one billion, two billion, three billion. Well, now this cash is 141, 142. Is that a lot of money everyone thinks it is? He's said we're always going to have at least $20 billion in cash. He said that, I forget the last time he said it. He said it more than once. It's been a policy. I just wonder if that's way too low. He hasn't updated. Maybe 75 is better. That would explain half of the cash, why you just were not going to buy another precision cast parts right now. So I think you're right in your Uri-analytics around the data, the earnings, sort of income statement, part of the insurance operation and even

Starting point is 01:26:23 the investment part. I think it's a balance sheet that's going to matter. And I, I think, I think Berkshire is going to be proven prescient once again. Sadly, I shouldn't be laughing because it would be awful if those things did happen. But some of the trends seem to point more in that direction than the lower risk one. I love that. It's a great point that it's going to come to the balance sheet. It's a great way to say it. I know we shouldn't really focus on the daily share price of Berkshire, but something I read

Starting point is 01:26:50 in your book, I just can't really help myself but ask you this question. So you've mentioned that Buffett likes to see the stock trade around its intrinsic value. But, you know, we've seen recently this year he's been buying back some shares. And if we look at Berkshire, the way Buffett does, he breaks out the business units as what he calls into these groves, right, that are kind of harvesting their own cash flow. And so you did this breakdown. It's very back of the envelope math. But you mentioned there's $115 billion or so afloat, which we don't actually factor in because it's paid out. But there's beyond that the $300 billion of subsidiaries.

Starting point is 01:27:23 200 billion worth of stock holdings, about 15 billion between his partnerships with private equity groups, and then this $100 billion or so of treasuries. And so you add all that up and you divide it by the shares outstanding, which is about 1.37 billion shares. And you come up with this value of around $400 of a share. Given that the stock price right now is in the low 200s, I'm just curious. Do you currently see Berkshire as undervalued in that way and by that much? right that I laid it out in kind of a high level way, but I think it is roughly right. And if it is, then it's a little undervalued. And I guess two things make me, two checks make me feel more confident in that. One is that Berkshers buying its own stock in significant levels for Berkshire.

Starting point is 01:28:11 And yeah, I just understand that enormous capital has flowed into the fangs and the unicorns. and just in, there's a significant elevation in the overall stock market. You know, you see Snowflake, which I think is one of Berkshire's recent investments, Edertanto, is priced at 200 times revenue, some stratospheric figure. So there's enormous fascination, glamour, and excitement, companies are going to change the world and with Facebook and Apple and Netflix and Google, Alphabet. And so, you know, Berkshire looks very old and simple and tired. So it's not the glamour stock.

Starting point is 01:28:51 In my view, that's good for Berkshire. One advantage of Berkshire buying back its own stock right now is that those who are most the sellers are probably not going to be the quality shareholders that I've been bragging about. They're going to be people who bought it on spec for the short term. A very famous one is Bill Atman. Apparently, his firm, Pershing acquired a substantial state around the onset of the pandemic and last month or so sold it.

Starting point is 01:29:17 I think Bill went on television somewhere saying, you know, I lost, I don't know how much he lost, a very large, you know, hundreds of millions or something, large amounts of money. In Berkshire, the headlines also said, Bill Ackwood's one of the rare people who lost a lot of money with Warren. But Bill explained that I bought the stock, Bill said, because I assumed that Warren would deploy enormous amounts of capital at the depths of the pandemic and exploit the opportunity and so on. He didn't do all that, so I'm going to sell.

Starting point is 01:29:43 Well, that's not quality shareholder thinking. That's day trading thinking. It's arbitrage, it's opportunism. Again, there's nothing wrong with it. Good for Bill. I like Bill. I think if that's the kind of person that is selling while Berkshire's buying back, that improves the average quality of the shareholder base,

Starting point is 01:30:00 measured in the terms that I've described. So I think that's probably another advantage, a slight advantage that you're going to see. Warren retired or left tomorrow, those quality shareholders are going to be more important than ever. Lawrence, this has been absolutely amazing having a chance to speak with you. Trey and I couldn't be more grateful for your time. And I'm sure the audience feel the same way.

Starting point is 01:30:20 We'd like to give you the opportunity to talk a bit more about your publications, your initiatives. Could you please give a handoff to where the audience can learn more about you? The best place to get my books is our old friend the juggernaut, Amazon.com. Go to that site and type my name. You'll get a list of 20 to 30 books. If you don't like Amazon, you can go to my university's website. My Quality Shareholders Initiative website contains, I think, interesting. information about my latest book and latest research about this quadrant, the long-term

Starting point is 01:30:50 focused shareholders. So I think if you just do Google search quality shareholders initiative, it'll come right up. And we'll be sure to provide links in the show notes to all the books we mentioned during this discussion for our listeners to check out. So, Lawrence, I so greatly appreciate you coming on to the show. You and I could probably sit here and talk all day about Berkshire. I know that we could.

Starting point is 01:31:12 I hope we can do it again sometime soon. I really enjoyed having you on the show. you. Thank you very much. Likewise. All right. That was all the train I had for you for this week's episode of The Investors podcast. We'll be back next week as always. Preston on his Wednesday releases with Bitcoin and then with our regular episodes next weekend. Have a wonderful week ahead. Thank you for listening to TIP. To access our show notes, courses or forums, go to the investorspodcast.com. This show is for entertainment purposes only. Before making any decisions

Starting point is 01:31:45 consult a professional. This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP330: Warren Buffett - w/ Lawrence Cunningham

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