We Study Billionaires - The Investor’s Podcast Network - TIP513: Warren Buffett's Money Mind

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to The Investors Podcast. I'm your host, Clay Fink, and on today's episode, I'm going to be diving deeper into the money mind of one of our very favorite investors to study here at the Investors Podcast Network, Warren Buffett. Robert Haxstrom has put together some of the very best work I've come across when it comes to studying Warren Buffett, so I decided to give his most recent book a read titled Warren Buffett inside the ultimate money mind.

Starting point is 00:00:28 During this episode, you will learn more about Warren Buffett's core investment philosophies, how his father's libertarian ideas rubbed off on Warren's business mind, how Buffett was able to continually evolve as an investor as the investment landscape changed over his lifetime, how Bill Miller helped value investors realize how value might be found in unexpected places, how Buffett's mindset differs from that of academics, why disregarding short-term price movements is so critical in order to outperform the market and so much more. With that, I really hope you enjoyed today's episode covering the money mind of the world's greatest investor, Warren Buffett.

Starting point is 00:01:06 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. Now, in the intro of his book, Hager-Hatham talks about the experience he had at the 2017 Berkshire Hathaway shareholder meeting, and somebody asked Buffett about Berkshire's successors and how they would allocate capital when Buffett and Munger passed the torch. Warren would be one of the first people to tell you about the tremendous importance of capital allocation, as this is one of the most important skills for the managers of a company to have, especially for a company like Berkshire Hathaway. Buffett described that the company's

Starting point is 00:01:59 successors would need to have what he called a money mind and that there are a lot of really smart people who make really poor investment decisions. Just because somebody is smart and bright doesn't mean they're good capital allocators and have that money mind that Warren is talking about here. So back on episode TIP 487, I talked about one of Hagerm's previous books, which was the Warren Buffett way, and I walked through Warren Buffett's 12 investment tenants that Hagerum lays out in his book. And during this episode, I'm going to be covering his new book, Warren Buffett, inside the ultimate money mind. It covers the mindset of Buffett, which is just as important as his tactical investment approach, I think. Haxstrom stated that he came to understand that

Starting point is 00:02:41 there was a big difference between knowing the path and actually walking the path. Benjamin Graham and Buffett have both emphasized the importance of having the right temperament, so that is why Hagerum went on to write this book as well. Buffett gave us a simple way to characterize how he thinks. He calls it the money mind. This can be used to describe how he thinks about major financial issues such as capital allocation, and as Hagerm puts it, quote, at another level, it summarizes an overall mindset for the business world. At a still deeper level, the profound philosophical and ethical constructs at its core tell us a great deal about the person we call a money mind, a person who is quite likely to be

Starting point is 00:03:23 successful in many aspects of life, including investing. This money mind is a powerful idea, and we should learn more about it, end quote. Buffett, for the most part, is known as being the world's greatest investor, but what is maybe less widely well known is just how brilliant he is at business. At such an early age, such as at age 11, he was already investing in stocks, and by high school, he was running various small business operations. One of Warren's introductions to learning about business was picking up the book 1,000 ways to make $1,000. One of the stories in that book was a story of a man named Harry Larson, who in 1933 had invested in weighing scales to put around town that people would put one penny in just to weigh themselves. He saved up $175 to buy three scales,

Starting point is 00:04:13 which would then start earning him $98 in profit per month, which is quite a good return on investment. But what really intrigued Warren from this story is that he used these profits from the first three machines to end up expanding to 70 machines. And that didn't really intrigued Warren. require him putting any more money into the business. And this is the essence of what made a career for Warren Buffett. It's about taking those profits he would earn to go out and invest in order to make more profits and allow compounding to work its magic. The first step in developing that money mind is to study businesses and know everything there is to know about a business that you're going to invest in. Reading books and annual reports allows you to draw off the experience of others

Starting point is 00:04:56 and understand what the pros and cons are of a particular business from another person's point of view. Learning from others who started a business venture might prevent you from wasting your own time and money to discover it's much different than you might have originally expected. What makes Warren so good at understanding business is that he has read about so many public companies in their annual reports. So he has not only learned what works well and is really profitable, but what tends to not work well and fails? Because he has studied so many businesses, he oftentimes is able to very quickly spot the red flags in the company. The second step, Haxterm mentions in developing a money mind is taking action. When Warren invests today,

Starting point is 00:05:39 he waits for a business he likes that is trading at a really good price, and then he takes advantage of that opportunity. He doesn't consider if we are teetering on the edge of a recession or forecast where interest rates are heading and making his decision to buy a business or not. Early on in Buffett's investing journey in his 20s, people were telling him the market was overvalued and there wasn't much money to be made in stocks, yet Buffett was just obsessed with finding bargains in the market and taking massive action, as he knew that was the only way he could benefit from a stock's rise and is to find those best opportunities he could possibly find and betting accordingly.

Starting point is 00:06:14 Haxstrom also tells the story of how in the book, 1,000 ways to make $1,000, that Chapter 10 in the book is titled Selling Your Services, and it gave the advice to readers to take personal inventory, figure out what you do better than anyone else, figure out who needs help with that, and how you can best reach them. This sage advice led Warren to starting his very own investment partnership. Warren had built his reputation in Omaha as an investing genius in working for his mentor Benjamin Graham helped further establish that credibility. That first spring in 1956, he had already raised $105,000 to invest money on the behalf of others, while he took 25% of the profits above a 6% hurdle rate, which was quite a generous agreement given how good Warren was at investing.

Starting point is 00:07:04 But above all else, he wanted to do right by his partners. He knew full well that the better he did and the better he could do for his partners, the more money this would attract for him to invest from a larger capital base and make even more money to invest for the long run. From 1957 to 1961, Warren's partnership returned 251% versus the market's average of 74%. At the age of 31, Buffett had accumulated $7.2 million in capital in the partnership, and $1 million of that belonged to him. After 10 years, the partnership had $53 million, 10 million of which was Buffett's. It's pretty clear that despite being fairly young, Warren knew a thing or two about money and had a money mind himself already.

Starting point is 00:07:51 In 1968, Buffett had his best year yet for the partnership with an astounding 59% return relative to the Dow's 8%. And then in 1969, Buffett announced that he would be closing the doors on his partnership. Now, when it was all said and done, the partnership's assets grew from the original $105,000 to $104 million, $25 million of which was Buffett's. Buffett's original goal was to beat the market by 10% per year, and he ended up beating it by 22% per year. Buffett had taken that idea of compounding he had learned as a child and continued to apply it year after year. If owning one pinball machine was good, then he figured that owning 5 or 10 was great. If having one paper route was good,

Starting point is 00:08:38 then maybe having two or three was even better. This continuous compounding, led him to taking ownership of Berkshire Hathaway, a failed textile maker in 1965, that would then become a conglomerate that owned a wide variety of different businesses. In Buffett's 2014 annual letter, he hit on the tremendous benefits of owning a conglomerate. He stated, quote, if the conglomerate form is used judiciously, it is an ideal structure for maximizing long-term capital, end quote. A conglomerate is perfectly positioned to allocate capital rationally and at a minimal cost without incurring much for taxes and other costs.

Starting point is 00:09:16 He's able to move capital from businesses that don't have much opportunity for reinvestment to businesses that show greater promise. So it's clear that Warren, being the learning machine that he is, took these ideas from different people and applied them in a way that really made sense to him. Benjamin Graham's books don't really mention the word compounding, yet Buffett learned from Graham how to buy things at a bargain. So he took that idea of the conglomerate and compounding capital and combined it with investing and finding dollars that were trading for 50 cents that he learned from Benjamin Graham. A key theme you'll find in studying Buffett is that he was constantly reading

Starting point is 00:09:52 and constantly learning and then applying all these different ideas in a way that he saw fit. Buffett took the conglomerate of Berkshire Hathaway and today has turned it into the sixth largest company in the world, not by creating some new innovation or new technology. He simply did it by harnessing the power of long-term compounding. Haxstrom then goes on to discuss more about how Buffett ended up developing the money mind in investment philosophies that he holds. Howard Buffett, Warren's father, was the first person to help shape who Warren would become today. Although Howard served in Congress as a Republican, he was very much remembered politically as a libertarian and a promoter of the private sector's ability to efficiently solve society's problems

Starting point is 00:10:35 rather than having the government do it. At the heart of libertarianism is the celebration of self, putting the individual over the state. Haxstrom then goes on to explain the connection between Ralph Waldo Emerson and Howard Buffett as Emerson was a champion of individual thought and a critic of society's countervailing forces against individual thought. In Emerson's piece titled Self-Reliance published in 1841, it presents three major themes. First, the importance of solitude in taking the time to learn and reflect. Second is nonconformity and the courage to stand up for what one believes is right, regardless of what others think. And third is spirituality and searching for truth rather than relying on others for truth because relying on others

Starting point is 00:11:20 hinders one's ability to continue to grow mentally. And immediately, you can see the similarities in this piece by Emerson in how Buffett invests. He spends a lot of time on his own reflecting on what he is learning. He's a nonconformist and in many ways goes against the theories that are taught in schools. And he really thinks for himself and doesn't rely on others to come up with his own opinions. Being a nonconformist like Buffett can create a lot of displeasure to others because you stand out from the crowd and you make them question their worldview. As Emerson stated, to be great is to be misunderstood.

Starting point is 00:11:56 In terms of the solitude piece, Omaha, Nebraska made for the perfect location for Buffett to act in solitude as it was far away from all the noise in New York City. Now, Warren really greatly admired his father, who really passed along many of these traits that Warren would pick up, one of which would be his love of reading and his sense of patriotism. Warren once said, the best advice I've ever been given is by my father, who told me it took 20 years to build a reputation and 20 minutes to lose it. If you remember that, you'll do things differently. Ralph Waldo Emerson's wisdom and teachings are also found in Buffett's other great mentor, Benjamin Graham. As Graham told us in the intelligent investor, to quote, have the courage of your

Starting point is 00:12:39 knowledge and experience. If you have formed a conclusion from the facts, and if you know your judgment is sound, act on it, even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right, end quote. There are two chapters from Graham's book that Warren highly encourages people to pay attention to. Chapter 8 is titled The Investor in Market Fluctuations, and Chapter 20 is titled Margin of Safety as the central concept of investment. Graham really helps Warren master investing. As he stated, to invest successfully over a lifetime does not require a stratospheric IQ. What is needed is a sound intellectual framework for making decisions in the ability to keep

Starting point is 00:13:24 emotions from corroding that framework." While Howard was largely influenced by Ralph Emerson, Benjamin Graham really admired Marcus Aurelius, who was the Roman Emperor from 161 to 180 AD, and was the last emperor of the Pax Romana, which was an age when Romans lived in peace, stability, and prosperity. Orelius is widely known for his book, Meditation, which is really simply his personal writings that served as fundamental principles for life to help him encounter his daily challenges. Meditations is largely read by those wanting to learn about the philosophy of stoicism, which encourages people to accept unfortunate events outside of one's control and not get overly emotional over such events while putting more focus on what we

Starting point is 00:14:11 can control. Stoicism really directly lines up with Benjamin Graham's description of Mr. Market. As Hagerm puts it, Graham asks us to imagine we own a private business with a partner he calls Mr. Market. Mr. Market is very accommodating. He shows up each day with an offer to either buy your shares in the business or sell you his shares for the same price. But Mr. Market has an acute emotional problem. On certain days, Mr. Market is widely excited and names you a very high price. Other days, he is deeply depressed, seeing nothing but terrible ahead, and quotes you a very low price. Mr. Market is, of course, the stock market. And it is exactly that wild, manic, depressive behavior that causes so many investors to make poor decisions. Unable to distinguish

Starting point is 00:15:00 between price and value, they look at rising prices with greed and envy and falling prices with fear and anxiety, the exact emotions the stoics seek to avoid. So we really have to learn how to detach ourselves from the prices the market is offering, not getting greedy when prices are up or fearful when prices are down. This brings us to a quote from Buffett. If you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. And as they say in poker, if you've been in the game for 30 minutes and you don't know who the patsy is, you're the patsy, end quote. I believe that this is really important for investors to wrap their head around, as I think there's a lot of investors out there that think they know

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Starting point is 00:19:59 Back to the show. So Buffett has a really good understanding of how to value a business and then after he determines what he believes it's worth, he then looks at the price the market is offering before deciding if he wants to buy or sell shares. Talking about disconnecting a stock's price from the value is really simple to understand and sounds really easy in theory, but actually implementing this in the real world is incredibly difficult, especially with how volatile stocks have been in the past few years. This then brings our attention to Buffett's third influence, Charlie Munger. Charlie reminded Warren right off the bat of Benjamin Graham because of his integrity, dedication to objectivity, and realism.

Starting point is 00:20:40 In studying Charlie, there are three distinct things that stick out. The pursuit of worldly wisdom, the study of failure, and the moral imperative to embrace rationality. In analyzing the wisdom of Munger and Graham, Hagerumannes linked the two to two different philosophers and how Munger and Graham had pretty radically different worldviews when it came to. came to investing. How Graham invested consisted of a series of simple steps that were carefully connected and reviewed from beginning to end. His approach was very mathematical. He would come up with his own estimation of value based on what he called prior reasoning and not from actual experience of owning and operating a business. Thus, Graham's investing process led him to look for cheap cigar butts whose value could be based on data that can be collected, data that included tangible items such as the assets on the balance sheet and the company's earnings. Whereas Charlie's

Starting point is 00:21:36 investment style and what he believed was true was based on the observable facts and personal experiences that provide evidence towards knowledge. Charlie preferred to purchase good businesses through a process of observing and analyzing the full scope of the company's operation and not simply buying something at a bargain price. When Charlie was asked what one quality accounts for his success, he gave credit to his rationality. as he stated, people who say they are rational should know how things work, what works in what doesn't, and why. It's a moral duty to be as rational that you can make yourself, and that becoming more rational is a long process. It's something you get slowly with a variable result, but there's

Starting point is 00:22:18 hardly anything more important. Now, in chapter three of his book, Haxstrom outlined Buffett's evolution as a value investor, breaking it down into three phases. The first phase was the classic value investing, which essentially means buying something cheap with a large margin of safety based on the company's current earnings, dividends, and assets. A big emphasis is put on the margin of safety because the larger the margin of safety when purchasing, the lower the potential downside for the investor. Haxstrom states that at the heart of value investing stand two golden rules. Rule number one is don't lose. Rule number two is don't forget rule number one. Benjamin Graham lived through the Great Depression, and he really saw just how much stock prices

Starting point is 00:23:02 could really fall, especially when you don't protect yourself with the margin of safety. The margin of safety concept was brilliant, as most people during this period simply thought the stock market was a place to go and gamble your money. The margin of safety was the ultimate hedge for those wanting to reliably make money in the market. If you were right about the company's intrinsic value, then you would be rewarded handsomely. If you were wrong about the intrinsic value, then your downside was limited because you accounted for some potential margin for error. This method of investing did have its drawbacks, though, as Warren discovered.

Starting point is 00:23:37 It didn't really make sense to purchase bad, wholly owned businesses for Berkshire Hathaway because during his partnership years, he could just hand off the shares to someone else, but now he owned the whole thing and it was more cumbersome to sell. Plus, when you've reached a certain size, your opportunity set to buy cheap businesses continues to shrink as you grow larger and larger. Seas Candy is the perfect example of why buying great businesses pays. In 1972, the asking price to buy Seas was $40 million. The company had $10 million on the balance sheet, $8 million in tangible assets,

Starting point is 00:24:12 and they were earning $4 million per year pre-tax. Munger thought it was a reasonable price, and Warren wasn't really sure, so he offered $25 million, still a bit worried that he was paying too much. In hindsight, they were really lucky to get the business for $25 million, as from 1972 to 1999, the internal rate of return on that purchase was 32% per year. If they had paid double the purchase price, they still would have made 21% per year. In Buffett's 2014 annual report, he stated that Seas Candy returned $1.9 billion in pre-tax earnings to Berkshire, which only required $40 million in additional capital investment.

Starting point is 00:24:54 Warren learned three lessons from purchasing Seas Candy. First, the company's $40 million asking price was not overvalued. In fact, it was undervalued. Second, paying a high multiple for even a slow-growing company is a smart investment if the capital is rationally allocated. Third, Buffett stated, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments. Seas really helped Warren realize the power of purchasing great businesses at a reasonable price,

Starting point is 00:25:27 which led him to make purchases in great companies such as Coca-Cola and Apple, both of which he made a total fortune on. Apple in particular may have been the greatest stock investment of all time. While much of the investment world tries to segment companies as a value or a growth investment, Buffett simply thinks about what he believes the company is worth and if the company is trading well below that intrinsic value. Just because a company has a low P.E., low price to book, or high dividend yield does not make it a good value investment. Similarly, just because a company has a high PE, a high price to book, or no dividend, doesn't make it a ridiculous, overvalued, speculative investment. Buffett says that growth and value are joined at the hip, as the growth is included in the

Starting point is 00:26:13 intrinsic value calculation when you're determining the present value of those future free cash flows that go to the owner. During the 2010s, we did see this drastic outperformance of what people call gross stocks relative to value stocks in the continued transition of many companies making investments in intangible assets rather than tangible assets. Currently in the U.S., the intangible investment rate is twice that of tangible assets. What does this mean for value investors? While due to outdated gap accounting rules, investments in intangible assets must be deducted from their current earnings. This means that if someone is simply looking at the PE ratio of a company, they are looking

Starting point is 00:26:54 at a distorted view of whether the company is under or overvalued. This means that if someone is simply looking at the PE ratio of a company, they are looking at a distorted view of whether it's under or overvalued because they aren't looking at it through the lens of a business owner like Buffett is. Buffett will be the very first to tell you that he isn't in search of a high PE or a low PE business. He says that the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

Starting point is 00:27:25 Haxstrom states that in Warren's money mind, it is always about the compounding. More importantly, it is about the value-creating compounding companies. As I mentioned during my episode covering Buffett's story in episode TIP 482, Buffett also learned a great deal from Phil Fisher, and Fisher really admired Buffett as well. Fisher described how most investors learned one craft and one approach to investing, for example, only buying stocks with low PEs, and then they continue to build their craft, but most of them never change. In contrast, Buffett would continue to evolve decade after decade. Haxstrom points out that no one would have predicted that Buffett, with his original training

Starting point is 00:28:07 and value investing, would invest in franchise media stocks in the 1970s, yet he added a number of them to Berkshire's portfolio. Warren began to understand the value that wasn't stated on the balance sheet that traditional value investors would overlook, such as the value of Coca-Cola's brand. Warren had largely learned how to identify these businesses with above-average economic potential and capable management from Phil Fisher himself. Fisher famously wrote the book Common Stocks and Uncommoder, Common Profits, and it was released in 1958. Fischer was impressed with businesses that had the ability to grow sales and profits over the years at rates higher than others in their industry. He was also attracted to companies that could grow into the future without requiring additional financing.

Starting point is 00:28:54 This is something that Buffett also mentions he looks for in businesses time and time again. Fisher is also a proponent of only investing in companies that are understood by the investor, or what Buffett calls investing within your circle of competence. Since it's required that the business is well understood, it also leads him to not over-stress diversification because if you own too many businesses, then this may actually increase your risk in your portfolio because you may not have sufficient knowledge about the business. If you owned a portfolio of, say, 50 companies rather than 10, it makes it really difficult to monitor how each position is performing and whether each of them are creating or destroying

Starting point is 00:29:33 shareholder value. There is a direct correlation between the number of stocks that an investor owns and the level of understanding the investor has about each business. Tom Gainer did a really good job describing the difference between what Haxstrom called stage one and stage two of the value investing landscape. Stage one was the classical value investing methods of simply looking at a snapshot of a company at one specific moment. This method of purchasing mathematically cheap stocks worked great after the Great Depression, it became more and more and more people found out about it and started utilizing this strategy, it became more and more and more people found out about it and started utilizing this method. Stage two of value investing is to value

Starting point is 00:30:18 a business rather than a stock. Rather than looking at a snapshot of the company's current assets and earnings, stage two unfolds over time like a movie. This method is more difficult because you have to uncover and understand the intangible value of a business. There isn't a number that tells you how much the value of Coca-Cola's brand is. You need to have an understanding of the business, its management, and the industry to come up with that sort of estimate yourself. Haxstrom then went on to discuss stage three of modern-day value investing, which is what he called the value of network economics, which really boils down to companies with strong network effects. Haxstrom states that, quote, in stage three, the cost of the physical input to business

Starting point is 00:31:01 models has gone down while the value output has grown exponentially. In stage three, billions of dollars in market value are being created by companies generating hundreds of millions of dollars in earnings, all made possible by fractions of the capital employed compared to the Industrial Revolution, end quote. The internet and its capabilities have really allowed companies to bring tremendous value to customers at a substantially lower cost than what was ever believed possible. For many brick-and-mortar-type businesses, they reach a point where there is diminishing returns on their investments, meaning that eventually the returns and profits that are generated are less than the money that is invested. However, many modern-day technology companies actually experience

Starting point is 00:31:46 increasing economic returns because of the network effects that are in place in building a successful business in today's economy. A network effect is the phenomenon in which a product or service increases in value for all users with each incremental user that is added to the network. This includes social networks like Facebook and Twitter, tech companies like Amazon, Google, these are all massive beneficiaries of network effects. Network effects are why Google holds 92% of the search market in 2022. Each person who uses Google search is in turn making the Google search algorithm smarter and better, which encourages more people to use it. Industries in which these network effects-type businesses are common are going to trend towards

Starting point is 00:32:30 a winner-take-all-type environment. Haxstrom then goes on to talk about Bill Miller's transition to understanding the new-age economy as a value investor and understanding the psychological reasons why network effects are just so powerful. For example, when someone has a positive experience with technology, they want to relive it. In the fact that human beings are very habitual, it can make it sometimes very difficult to get that person to change their behavior. So in order for the current monopoly in an industry to be disrupted, the new entrant can't just be a little bit better. They need to be significantly better to overcome the friction to enable people to switch products. What really makes these network effects so powerful is the high switching

Starting point is 00:33:11 costs because customers really get locked into these networks and it's really difficult for any competitor to disrupt that. This type of transition in understanding the new network New Age economy allowed Bill Miller to greatly excel and see what other traditional value investors weren't able to see. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vanta automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving.

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Starting point is 00:36:49 All right. Back to the show. Miller famously purchased Amazon on his IPO day in May of 1997, and then he actually quickly sold it after the stock had doubled. He then re-entered the position at $88 per share, while many of his value-investing colleagues mocked or chuckled at him for owning Amazon, as it then declined 90% after the tech bust. And Miller today actually holds over 40% of his net worth in Amazon stock, and that's at the time of his conversation with William Green on the Richer Wiser Happier Podcast. What Miller really saw

Starting point is 00:37:23 on Amazon is that they had a direct-to-consumer model and recognized revenue immediately while paying suppliers later. Like any other value purchase, Miller wants to own a company with high returns on invested capital. And he actually estimated that Amazon's return on capital was in excess of 100%. Haxstrom states that Miller is universally considered to be one of the first investors to successfully tackle the value conundrum of technology companies. Then I just love this quote from Bill Miller, Hagerardstrom included here, quote. With money managers turning their portfolios north of 100% per year and a frenetic chase to find something that works, order glacial R11% turnover is rare. Finding good businesses at cheap prices, taking a big position, and then hold

Starting point is 00:38:11 holding for years used to be sensible investing. We are delighted when people use simple-minded accounting-based metrics and then align them on a linear scale and then use that to make buy and sell decisions. It's much easier than actually doing the work to figure out what a business is worth and it enables us to generate better returns for our clients by doing more thorough analysis, end quote. While many value investors still use basic accounting metrics like PE, Miller, with his philosophy background, was able to perform second-level thinking and think really pragmatically. Because of his philosophy background, Miller states that he was able to smell a bad argument from miles away. During Berkshire's 2019 annual shareholder meeting, Warren gave much praise

Starting point is 00:38:57 to Jeff Bezos for creating one of the largest companies in the world from the ground up, and he said that he was an idiot for not buying into Amazon much earlier, as today they have a relatively small position relative to their portfolio size. Charlie, on the other hand, acknowledged that his age led him to being a bit less flexible with these new age companies, but Charlie mentioned he's really kicking himself for not buying shares in Google. Then Warren, of course, did come around to stage three of benefiting from technology network effects as he started a substantial position in Apple in 2016. Making this sort of transition as a value investor is critical to stay ahead of the curve in order to see what others aren't seeing and develop a superior

Starting point is 00:39:39 money mind. Moving along to Chapter 4, Haxstrom titled this chapter, Business Driven Investing. He kicks it off with what Buffett called the nine most important words about investing, and it's from a Benjamin Graham quote, investment is most intelligent when it's most businesslike. And this really drills down to how Buffett thinks of stocks as real companies in real businesses. Graham stated that investors purchase shares in a company, they can view themselves in two ways. The first being that you're a minority shareholder in a business whose value is dependent on the profits that enterprise produces or how the assets on the balance sheet change over time. Or you can view what you own as a piece of paper which can be sold in a matter of minutes

Starting point is 00:40:23 at a price that varies from moment to moment. And sometimes those prices are far removed from the true underlying value of the company. So when you purchase any stock, you have to decide whether you are a business owner or a stock speculator. Graham noticed that those who speculated in the market would get caught up in the day-to-day news and headlines that were fairly irrelevant to the factors that were actually important to the company's long-term success or failure. Graham stated that, quote, The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage in the company.

Starting point is 00:41:00 into a basic disadvantage. That man would be better off if his stocks had no quotation at all, for he would then be spared the mental anguish caused him by other person's mistakes of judgment, end quote. Buffett adopted this business owner mindset from Graham, as he stated, as far as I'm concerned, the stock market doesn't exist. It is only there to see if anybody is offering to do something foolish. While most people are caught up in the day-to-day activity, two of the world's greatest investors say they pay very little to no attention to the day-to-day price movements. Haxstrom then goes on to talk about how it's impossible to overstate this. The bedrock to forming a money mind is a purposeful detachment from the stock market.

Starting point is 00:41:44 Mentally, you must put on blinders so that the stock market does not absorb your attention during every waking moment. Then he covers Buffett's 12 investment principles, which I covered during episode TIP 487, if you'd like to check out. The primary things Buffett looks for in a business. Here's a quick rundown on those 12 tenants or principles. One, the business must be simple and understandable. It must have a consistent operating history. It must have favorable long-term prospects. Management must be rational. Management must act candid with shareholders. Managers must resist the institutional imperative. It must have an adequate return on equity. You need to

Starting point is 00:42:24 calculate owner's earnings, you want a business with high profit margins, the business must create at least $1 of market value for each dollar retained, we must determine the value of the business, and number 12, we want to purchase at a favorable price. Again, I do a deep dive on each of these points in TIP 487 if you'd like to learn more about Buffett's investment checklist from a high level. Now, I really liked how Haxstrom linked a research paper titled the new theory of firm, equilibrium short horizons of investors and firms. Now, this paper looked at investment returns over varying time horizons and looked into investment returns for the S&P 500 from 1970 through 2012. During this 43-year period, the average number of stocks in the S&P 500 that

Starting point is 00:43:13 doubled in one year averaged around 1.8%, or about 9 out of 500 companies. Over a three-year rolling period, 15.3% of stocks doubled, or about 77 out of 500. In over a five-year rolling period, 29.9% of stocks doubled or about 150 out of 500. Despite the data showing that long-term investors have the greatest probability of success, the data shows that since the beginning of the 1970s, the average holding period has actually consistently declined. Haxstrom then describes that the stock market does not often efficiently price long-term sustainable growth. And that's because there are so few companies that are able to achieve sustainable growth over a multi-year period. Perhaps the market skepticism is understandable, though, but this much is certain. For those companies with favorable

Starting point is 00:44:06 long-term prospects that generate positive economics and drive above-average future value creation, many of their stocks are likely mispriced. The key, though, in achieving good investment returns lies in the robustness of the individual's ability to pick the right companies and having an effective portfolio management strategy. Haxstrom states that, quote, there can be no doubt that those who follow the investment tenants outlined by Warren Buffett stand a good chance of isolating a fair number of outperforming companies. However, if you can't effectively select stocks that have a good chance of outperforming the market over time, then it is probably best to simply own a broadly diversified portfolio like a passive index fund. Haxstrom also wrote extensively on the difference

Starting point is 00:44:52 between the way Buffett views risk and the way academia views risk. Academia famously defines risk as volatility. The more volatile in investment is the higher level of risk that is present. From Buffett's point of view, this definition of risk is ridiculous because it doesn't even consider the company itself, the company's assets, the company's earnings, their competitive position in the marketplace, etc. Benjamin Graham made the important point that there is a difference between short-term quotational loss and permanent capital loss. So a difference between the stock price trading down and you actually losing money in the long run. He believes that risk isn't volatility of the investment, but risk is the chance that you end up losing money in your

Starting point is 00:45:36 investment. Buffett doesn't view volatility as risk and something that should be guarded against. He actually viewed volatility as opportunity. In 1974, Buffett made the Washington Post his largest equity position with a $10.6 million investment. By the end of the year, the overall market had fallen by 50%, bringing his portfolio down with it during the worst bear market since the Great Depression. In the 1975 annual report, Buffett stated that stock market fluctuations are of little importance to us, except as they may provide buying opportunities.

Starting point is 00:46:11 but business performance is of major importance. On this score, we have been delighted with the progress made by practically all of the companies in which we now have significant investments. When a business is trading at a good margin of safety relative to the company's intrinsic value, Warren welcomes lower share prices as lower prices reduce his risk and give him a wider margin of safety. Warren believes that the risk that is present when buying stocks or businesses is when you misjudge the prior factors that determine the future profits of your investment, or in other words, misjudging the intrinsic value. In Warren's own words, the risk present breaks down first into the certainty with which the long-term economic characteristics of the business can be evaluated.

Starting point is 00:46:57 Second, the certainty with which management can be evaluated, both as its ability to realize the potential of the business and to employ its cash flows wisely. And third, the certainty with which management can be counted on to channel the rewards from the business to the shareholder rather than to themselves. And then fourth, the purchase price of the business. Furthermore, Warren tells us that risk is inextrably linked to an investor's time horizon. If you buy a stock today with the intention of selling it tomorrow, this is a really risky transaction as it's essentially a coin toss whether the value of that stock is higher or lower. But if you extend that time horizon out to a few years, then you're odds.

Starting point is 00:47:38 of making money on your purchase are much greater than if you would sell it tomorrow. Hacksstrom states that the cornerstone of the money mind is understanding how to value a business and how to think about market prices. To help us better understand why stock price movements oftentimes seem pretty random, he also compares the stock market to a game of chess. In chess, you're making your own moves while the other person is making their own moves as well. You have to try and figure out why they're making the moves that they are. So in the stock market, you can try and speculate why a stock is moving higher or lower, except nobody truly knows exactly why stocks move the way they do in the short term. We might have a rough idea, but for the most part, nobody really

Starting point is 00:48:22 knows. This is because the market has millions of people constantly making buy and sell decisions. All at the same time, you have all the following types of investors constantly making changes to their portfolio. You have momentum investors who exploit the tendency for a stock's prior return to predict future returns. You have technical traders who trade based on the charts they're seeing. You have asset allocation decisions, which is an investment strategy that divides and continually reallocates between asset classes. You have index investors that are just generally buying no matter what the price is. They're just consistently, month after month, putting more more money into index funds. You have hedging strategies, you have tax loss selling or people

Starting point is 00:49:06 gifting shares to other people. Then you have things like ESG, macro investors, high frequency traders, and then just pure speculators. You have all these different players and all of these people are making buy and sell decisions in the market. Oftentimes these decisions have very little to do with the value proposition of the company. This is why Warren emphasizes the economics of a business rather than obsessing over the short-term price movements in the stock. The majority of people trading these shares might not even consider the underlying value. They might have their own strategy that really is nothing related to yours, and they might have a time horizon that is much shorter than yours.

Starting point is 00:49:45 The final chapter in Hagstrom's book is Chapter 6 titled The Money Mind Sportsman, Teacher, Artist, and he makes the comparison of investing in sports. In both sports and investing, most people are focused on. on the end result. Did the team win or did the team lose? Did the stock go up or did the stock go down? He describes how sports psychologists divide athletes into two groups, the product-oriented and the process-oriented. The product-oriented athlete is singularly focused on winning, while the process-oriented athlete sees the sports in a much broader view and finds the reward in working with others, striving for something outside of themselves, seeking personal excellence,

Starting point is 00:50:26 and many other life lessons. Meanwhile, investing is also a game of process and outcomes just like sports are. And like sports fans, many participating in the stock market don't give much thought to the process. And as Hagerstrom puts it, quote, that's a shame because they will never grasp the beauty of the internal goods that come from the activity of thoughtful, involved investing. And as I'm reading this, I can't help but think of my colleague William Green's podcast episodes and interviews that dive into the deeper parts of investing like psychology and morality,

Starting point is 00:51:01 understanding and appreciating the process is critical to being successful in sports and in investing. When you look at the grades in investing or in sports, you see the highlight rails on ESPN or the documentary talking about Warren Buffett's $100 billion fortune, but you don't see the countless hours of discipline and basic, repetitive, boring tasks that it took to get to that point. To expand on that, true investing is more so in art than a science. Just like how a painting can be too complex to be fully understood with a quick glance, it's a similar thing with a company. And the game of investing isn't all about winning to warrant, as he lives a virtuous life. He has pledged to give away 99% of his net worth to charitable organizations and foundations,

Starting point is 00:51:48 and in 2020 alone, he donated $2.9 billion in Berkshire Hathaway B shares. Hagerm states that if virtues are isolated to one activity, such as investing, then they aren't genuine virtues. One Scottish philosopher stated that, quote, the beauty of virtue as the real prize of competition, is that it benefits not just the victor, but also the community at large. I just love that quote that Hagerm mentioned and really enjoyed reading more about how Buffett lives his life, not only to make substantial sums of money, but to ultimately leave the world a better place and continue to help others and teach them who are willing to listen.

Starting point is 00:52:27 All right, that wraps up my biggest takeaways from Inside the Ultimate Money Mind by Robert Hagstrom. If you'd like to pick up the book yourself to read it, I'll be sure to link that in the show notes. If you guys would like to give me any feedback, I would truly love to hear from you. Whether you liked the episode, didn't like it, I'm always open to feedback. so we can provide the best show possible for you guys. You can reach me by email at clay at the Investorspodcast.com or on Twitter at Clay underscore Fink, that's C-L-A-Y-U-S-I-N-C-K. Again, positive or negative feedback.

Starting point is 00:53:04 I'm more than happy to hear what you have to say about our show. Thank you so much for tuning into today's episode, and I hope to see you again next week. Thank you for listening to T-I-P. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

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