We Study Billionaires - The Investor’s Podcast Network - TIP573: Berkshire's Beginnings w/ Jacob McDonough

Starting point is 00:00:00 You're listening to TIP. On today's show, I'm joined by Jacob McDunna to cover Berkshire's beginnings. Jacob is the author of the book Capital Allocation, which covers the financials of Berkshire Hathaway from 1955 through 1985. He's also the host of the 10K podcast, where he dives into the annual reports of various companies from decades ago, such as Geico and GM. In 1962, Warren Buffett purchased a stake in Berkshire Hathaway, which at the time was a textile mill in the midst of a decline. By 1965, Buffett took full control of the business and

Starting point is 00:00:35 transformed it into the cash-generating conglomerate that we all know of today. In this episode, we uncover the lessons we can take away from this transformation by looking at the capital allocation decisions Buffett made in the early days. This episode covers why purchasing Berkshire Hathaway stock in the first place was one of Buffett's worst decisions ever. How cheap Berkshire stock was when he started purchasing it, the initial steps Buffett took to turn Berkshire's business around, the pivotal moment in 1967 that changed everything, how insurance float helps supercharge Berkshire's growth, what fueled their 1970s expansion phase, the financials and story of one of Berkshire's best investments ever, sees candy, Jacob's biggest takeaways

Starting point is 00:01:18 from studying the history of Berkshire Hathaway, and much more. Jacob was such an informative of guests for this discussion, and it was such a pleasure putting this one together for the audience. I truly hope you enjoy it as much as I did. 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, Clay Fink, and today I'm joined by Jacob McDonough. Jacob, it's great to have you here. Yeah, thank you for having me. I'm excited to talk to you today.

Starting point is 00:02:03 So today we're going to be covering the early story of Berkshire Hathaway and some of the things we can learn from how Buffett turned this failing textile mill into a powerhouse conglomerate. So it was in 1962 over 60 years ago. Buffett was around 31 years old at the time and he began purchasing shares in Berkshire Hathaway that year. At the time it was a struggling textile maker in the midst of a decline and ironically in hindsight purchasing Berkshire Hathaway in the first place, Buffett has said, was one of his worst decisions ever, which is quite funny given where it's at today. So, Jacob, how about we kick off this discussion just by talking about why Buffett wanted to purchase such a bad business in the first place? Yeah, that's always an interesting

Starting point is 00:02:49 place to start. It's definitely an interesting story and very unique. But basically, Warren Buffett himself had a history of purchasing cheap stocks. So the main answer there, Berkshire was a cheap stock. It had a low valuation. And when Buffett was pretty young, that's how he got his career off the ground, how he started making money early on. He was looking at cheap stocks, those that maybe had a lot of assets. You could liquidate the company for a profit based on what the valuation was. More so hypothetically, I mean, I don't think too many actually liquidated. But he was more of a balance sheet investor and looking at stocks that maybe were selling below liquidation value, or at least had very reasonable expectations of the future or pretty

Starting point is 00:03:31 low expectations of the future for that business. And so Berkshire was one of those cheap stocks. He managed a fund at the time. He called an investment partnership, Buffett Partnership Limited BPL. And so he actually started buying Berkshire just as a stock for his fund. And so I don't think he had any expectations. He'd take it over and manage the company for so many decades. I don't think that was quite part of the plan. So I think it was one of the same story he'd been following for many years, buying a cheap stock and hopefully something happens where eventually he can sell for a little more and, you know, keep running that playbook. And so maybe what might help is a background of Berkshire, why it was so cheap or unloved. So Berkshire had a long history before Buffett got

Starting point is 00:04:11 involved. It was a textile manufacturer, like you mentioned. And one of the products they did, they worked on was they made the inside lining of suit coats. So they didn't make the whole suit coat, but just when you open up like the jacket, the inside lining there was one of the things they made. And so at one time, I know they made half of all suit coat linings in the U.S., at least for men's suit coats. And they were supplier the year one time at least for Sears Roebuck. And so they had good service apparently, at least in one point in time. But even with that being said, Sears was not going to pay them a premium. If Berkshire charged too much, Sears would go find another supplier.

Starting point is 00:04:51 There was nothing special that Berkshire did. Some other textile manufacturers couldn't do. And there was no real brand to Berkshire because, like I said, they didn't make the whole suit coat. So there was no Berkshire brand on the suit coat, really. It was just the inside lining. And not many people really open up that jacket. It really care about what's on the inside there. And then it sold through places like Sears. Berkshire didn't really have their own distribution. And there was no Berkshire type store. So the end consumer wouldn't really be aware of Berkshire too much. And so there's no brand, not too many competitive advantages. So it was pretty much a

Starting point is 00:05:22 commodity business. In a commodity business, the low-cost producer usually wins. And Berkshire and the Randar reports, even back in this time period, would mention that they were not the low-cost producer. In Japan, there were some Japanese competitors that had much lower operating costs. Wages, labor was much cheaper in Japan back in the 50s. I believe the minimum wage in Japan might have been 15 cents an hour versus, I believe, a dollar an hour in the U.S. at the time. So it was a tough, tough business, but the market knew that. So it was a pretty cheap low valuation, which attracted Buffett in the first place. Yeah. How about we tap into the valuation there? because, you know, the business was not a high-quality business. It's a very commoditized product. They,

Starting point is 00:06:02 you know, probably had much higher cost relative to many of the other textile makers. So obviously, the valuation that Buffett was attracted to. So paint some color around that. Yeah. So in terms of valuation, it was selling when Buffett first bought the stock. It was selling for a third of book value about that and below net current assets. So I could define both of those and maybe it helped to give a little more info on how the balance sheet looked for Berkshire since that was a big reason why Buffett wanted to invest in the first place. But book value is the shareholders equity, the equity capital in the business. So it was selling for about a third of that. And net current assets would just be just the current assets minus all

Starting point is 00:06:41 liabilities. And so, yeah, to explain further, the balance sheet for Berkshire looked like it was pretty heavy in inventory, inventory needs. They owned real estate. They had manufacturing facilities. And so they had a lot of PPNE as well, property plant and equipment to operate those plants. And they had a decent amount of receivables as well. But there was not very much in terms of liabilities to offset these assets. So what this means is equity capital basically funded most of the business. And that means it's a pretty capital intensive business. Some companies might have some funding from suppliers in terms of accounts payable or funding

Starting point is 00:07:16 from customers in terms of like deferred revenue. But Berkshire didn't really have too much of that and didn't have too much debt either. And so there wasn't too much leverage. It was mostly funded with equity capital, like I said. And so it took a lot of assets to run the business, and it was pretty capital intensive. And so back to some of those, the metrics I mentioned, net current assets. So that's basically receivables and inventory Berkshire had, even minus all the liabilities, the valuation was below that.

Starting point is 00:07:42 So theoretically, you could think you could liquidate the inventory and collect your receivables and maybe, you know, the valuation would still be below that, assuming the accounting value was accurate for the inventory. and that none of it was obsolete or anything like that. But that's without counting the long-term assets like the real estate and the plants and equipment. So when you factor that in, that's how you get to the book value. And once you add in the real estate and stuff, that's when the valuation was a third of book value. So it was pretty cheap in terms of assets. And yeah, that's really how Buffett got attracted to it in the first place. Yeah. So Buffett, you know, as many in the audience know,

Starting point is 00:08:19 he followed really Benjamin Graham's approach to investing in many ways. You know, he's looking for something that's really cheap, oftentimes trading below book value and then anticipating that eventually the price and the value are going to converge over time. So Buffett, I'm sure, is looking at, you know, what the business is actually doing. Some of the metrics for Berkshire, they were, you know, abysmal. The return on equity was very, very low relative to many other industries. So I'm curious what your take is on what Berkshire was. doing with their business, with their profits, up to the time where he eventually took ownership

Starting point is 00:08:55 of the business? Yeah, it was very unique what Berkshire was doing during this time period. They were buying back a decent amount of stock, which today, plenty of companies buy back stock, but back in the 50s, it was more rare. And especially it was rare for a company like Berkshire to be doing that. So number one, they had some excess capital, but number two, they had some unprofitable plants that management, before Buffett was involved, management decided to close some of those plants, gather up that capital and buy back stock. Like I said, that was unique for that time period. And management wrote about their plans to do that in some of the annual reports back in that time period. So that's clearly something Buffett could see they were doing. And he might have

Starting point is 00:09:34 liked that capital allocation strategy. At least, it still didn't make it a, you know, it wasn't going to be a high growth stocker. It wasn't going to get the market too excited. But still, it was, even though it was a bad business, they were doing some interesting things or unique things from a capital allocation standpoint that might have attracted Buffett. And it was a relatively small company, at least in terms of valuation. And so you knew management talked about they're going to buy back stock. So in one sense, you knew there was a large buyer of stock that would want to, you know, continue purchasing stock. So as Buffett accumulated a stake in the company, he's talked about, he might have thought that management will come and want to buy back some of his stock, given he'd be a

Starting point is 00:10:13 major shareholder. He would be someone they could buy from. And so that might have been his plan from the beginning. It didn't really work out that way for him. But it was very unique in that time here, what Berkshire was doing. And then it was in 1965 where Buffett ended up taking full control of the company. I'm curious if you could tell a bit of the backstory of 1962, he's just purchasing it because it's a cheap stock, make a return for his partners and himself through his partnership. So what was the story of why he ended up taking full control of the company in 65? Yeah, so I know in some of the biographies, they do a good job of explaining how he met with the previous management team or the previous CEO, Berkshire, and they agreed on a price. Berkshire was going to buy back Buffett's steak or BPL's stake is fun.

Starting point is 00:10:59 The stake is fund owned at a certain price. And back then, stocks were quoted in eighths, like one eighths of a dollar or a point is how they were quoted back then. And so whatever price they agreed upon, the actual offer that came back was like an eight of a dollar below what they agreed. agreed upon. So apparently Buffett has said he felt a little cheated. And so that's kind of when his decisions changed on what to do there, whether he was going to take the lower price that, you know, was below what they agreed upon or if he was going to continue buying even more of the stock, which is the route he ended up going. And so interesting to think what could have been, but I'm sure glad he went down this path because it's been a lot of fun to study over the years

Starting point is 00:11:35 as he took over this company. And then once he did take full control of it, you know, this is when Berkshire, it really just went through a transformation period where a whole new mindset entered the management team with Buffett now running the company. What were some of the key decisions he made early on once he did take full control in 65 that just really teach us a lot about capital allocation here? What were some of the things he did? Well, what was very key was right away he was able to generate some cash profits, which we could talk about later how he's actually able to do that. But he was able to generate some cash profits. But he was able to generate some cash profits right away. And most people would take that cash and put it back into the business they're

Starting point is 00:12:16 used to what they're currently in. But instead, Buffett took that cash and temporarily put it into a stock portfolio of stocks. That portfolio did really well, more than doubled in a couple years. And I assume he was just looking for an acquisition to make in the meantime. He bought a couple businesses after that. So he bought National Indemnity and Insurance Company. And he bought Illinois National Bank, a bank that was located in Rockford, Illinois. Those two businesses ended up being very good, produce plenty of cash flow and stuff. And so those are some of the early decisions that really kicked off Berkshire on its journey from being this bad business that was doomed to go extinct eventually and kind of helped generate some cash to move in the right direction. Because before Buffett

Starting point is 00:12:53 took over, like I said, they were buying back stocks. So they were really shrinking the business. They were purposely closing down some of the plants, buying back stocks of the capital. And the business was going down. They're shrinking, getting lower and lower sales as some plants close. Obviously, Berkshire's crossed a trillion dollars in assets this last quarter, actually. So they've, the opposite from a shrinking, dying business into what it is today is just incredible. And one of the key things that sort of stuck out to me in what Buffett was doing at this time is he was drastically trying to cut costs because the profit margins in this business were just razor thin. And, you know, it just makes me really think about one of the key takeaways,

Starting point is 00:13:31 I think, from Buffett, in this example of, at least, is how mindful he is of costs. I remember reading Alice Schroeder's book, The Snowball, and just thinking, nobody is as cheap as this guy. He's always looking for ways in his personal life to increase his income, decreases expenses. And I think the takeaway here is that, you know, when you're looking at a management team or a CEO, and you see that they're very mindful of their expenses, and that's just a very admirable quality. You know, it's so easy for management teams and CEOs to just expense these extravagant business trips and put it on the company, go fly first class, et cetera. I think Buffett cutting costs was a really critical decision in this case, you know, because of the razor-thin margins. And then that allowed him to go out and make those acquisitions that you mentioned. Yeah, that's very true. There's some CEOs that, like Buffett, treat shareholders money in a very conservative way and they don't act like it's their own personal bank account to dip into. It helped that Buffett owned a lot of stock himself. So he was one of the shareholders that helps align incentives. But he definitely didn't waste any of the shareholders' monies by any means.

Starting point is 00:14:35 And so, yeah, one thing he was able to do right away, like you said, cut costs. And I didn't really realize this until I was studying this time here for my book. But when he took over Berkshire, Cost of Good Sold dropped by 10%, which might not sound too crazy, but like you said, the margins were very low. So any little bit of cost savings you can achieve would be meaningful. And in his first year, that cost savings, 10% of cost of good sold ended up being about $5 million of cost savings. And so it really flipped from being negative profits to maybe break even.

Starting point is 00:15:04 and then him having that cost savings flipped to them having some solid profits the first couple of years he was in charge. His first year, they had $4 million of profits and $5 million a second year. And so in 1962, when he first invested it, had a $12 million valuation, Berkshire did. And so he got about $9 million of profits his first two years in charge. So he got most of his money back right away. They also had some tax credits, tax loss carry forwards built up from years of losses before he took over, which again was in the annual reports leading up to this time period.

Starting point is 00:15:33 So the profits he made were tax-free. And so this was really $9 million of cash flow in his first two years. After-taxed cash flow, he could actually take out of the business and reinvest. Like I said, he didn't put it back into the textile mill. He didn't throw good money after bad. He put the money into stocks first, which one interesting thing is some of the stock portfolio was some quality companies. They owned American Express, Disney, and Wrigley at the time.

Starting point is 00:16:00 Those were just three of the companies. and 55 years later, those are still quality businesses, so very durable. And even close to the time period he bought him, American Express and Disney, some people considered part of the nifty 50. So these were quality names. He wasn't just only investing in the Berkshire net current asset, cheap stocks. He also had some quality names, even in his younger days that, you know, I feel like I personally didn't know about before researching for my book. So he did have some quality in the portfolio, which is interesting. The other thing I want to mention too, though, with that time period is he did have some really nice profits those first two years. There might be a little luck involved

Starting point is 00:16:35 or at least a little cyclicality involved there because in future years, even when Buffett was in charge in running Berkshire, there's plenty of years of losses or poor returns on capital for the textile mill. It was a cyclical business. So maybe Buffett knew someday soon they would have some profits in the site when the cycle turned good. But I don't think just because his first two years that he took over, they had some solid profits. It didn't mean that he turned around the business for good. I mean, with him in charge and him cutting the cost, they definitely were much more profitable than they would have been with the previous management team. But it still, by any means, wasn't a great business. It was just one way he was able to generate capital. And the previous manager,

Starting point is 00:17:14 some books write that he had a penthouse office and his secretary had a secretary. So that might be the type of CEO where Buffett, if he got to know him or see anything as an investor before he took over the company, maybe he could have spied some ways he could have reduced costs a little bit. In the annual report, they mentioned that overhead was reduced. And so there's not too much more information besides that, but clearly he was able to run a much more lean operation once he was in charge. And then one of the key highlights, it was in 1967 where, you know, it was sort of a pivotal moment in Buffett's investment career.

Starting point is 00:17:48 In 1967, Buffett for the first time allocated capital outside of the textile industry for Berkshire. And that was with the purchase of national indemnity out of Omaha, which you mentioned earlier. It was March 1967, Berkshire paid $8.6 million for 99% of shares in National Endemnity and then 100% of shares in National Fire and Marine Insurance Company. So I'd love for you to just walk us through how fundamentally national indemnity was just a much better business than the textile business that Buffett originally got into in 62. Yeah, the insurance business was a better business. And part of the reason is how much capital needed to be invested in the

Starting point is 00:18:26 business and how you could invest that capital, how you could use the assets. So an insurance company doesn't technically require any capital to operate. There's no real inventory needs and you don't really need much equipment or plants or anything like that, not much real estate. But what you do need is some capital to fall back on in case there's losses, case there's tough times and you owe a lot of money on the policies you've promised to policyholders. And so since you need capital to kind of cushion yourself, it can be in cash. The capital can be invested in cash. bonds or stocks or other types of investments. And so it made it for a perfect situation for someone like Buffett who was going to have stocks anyway, it didn't quite matter if the stocks were in his

Starting point is 00:19:06 personal account or in an insurance company. Someone like that could put the capital work in a much better way. I could talk about float in a minute here too, which is a big part of the story. And it definitely changed over the years how he could use float. But an insurance company, again, you have your equity capital, your book value. That's your shareholders funds. And then you have your liabilities, which mostly were policyholders funds, kind of known as float, what you owe policyholders in the future. And so unlike Berkshire, it had a lot of liabilities that leveraged the business, a lot of liabilities that finance those assets at Berkshire of National Endemnity, excuse me, the insurance company. And it made for a very different business than Berkshire.

Starting point is 00:19:46 In a way, though, there is a few similarities. Insurance can be pretty cyclical. It's not many barriers to entry in insurance. So when times are good, more and more firms kind of rush in or maybe lower prices. And then when times are bad, some firms exit and prices can go up. So it is a little cyclical kind of like the textile mail too. So it's not a perfect business by any means, but it was much better than the textile mill. Yes. And it's national indemnity. It's not a cigar butt type business. So could you walk us through maybe a bit of a valuation comparison of how National indemnity looked when he purchased it versus Berkshire Hathaway, which was definitely more of a cigar butt type play.

Starting point is 00:20:24 I mentioned Berkshire was selling for a third of book value when he first invested in that company. And National Indemnity, he actually had some goodwill in the purchase, which means he paid above book value for that company. And so what's really interesting is that he talked about his purchase price in later years that he paid for national indemnity. And one thing that was interesting was he knew that the book value, the equity capital, of national indemnity could be invested in stocks. So just using round numbers, if he made a $10 million

Starting point is 00:20:52 acquisition for paying book value for an insurance company, it didn't really matter if he had $10 million of stocks in his personal account or $10 million in an insurance company. That was kind of a wash. So if he paid book value, he didn't really consider much of a purchase price because, like I said, he was going to have that $10 million invested in stocks either way. But what it could do, it would leverage his stock portfolio into additional income streams, which means he'd have the potential with an insurance company, one, to earn a return on stocks just like you would in his personal account. But then he'd have the opportunity to potentially have underwriting income. You're also taking risk on in terms of maybe having underwriting losses as well.

Starting point is 00:21:29 And then you'd have potential to earn interest income on bonds or a fixed income portfolio if you invest your float, your policyholder's liabilities into bonds. And so the additional income streams would be underwriting profits and interest income on a fixed income portfolio would be two ways he was able to leverage his stock portfolio into additional income streams. So that's pretty interesting. So National indemnity, though, he paid above book value. And some people might wonder why he did that because some insurance companies, I think plenty of insurance companies would sell below book value back then. And even today, I mean, valuations change constantly. Like I said, it's a cyclical business. But even in modern times, there's plenty of

Starting point is 00:22:08 insurance companies that will dip below book value from time to time. And really what it comes down to is Buffett was laser focused on finding a high-quality insurance underwriter. Like I said, he was leveraging additional income streams, but he was taking on risk from potential underwriting losses. So he was willing to pay some goodwill, willing to pay above book value for a insurance underwriter that he could trust that would be a profitable underwriter over time. National indemnity proved to be high quality in that regard. And so he paid a little bit above book value, but still, the goodwill was pretty low. So even under modest assumptions with interest income on bonds, it was still going to be attractive investment, as long as underwriting could

Starting point is 00:22:47 remain break-even or profitable. Even if it was just slightly negative underwriting, it's still the math would work out to be a pretty attractive purchase price. 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. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing

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Starting point is 00:26:54 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. And, you know, a key part of him purchasing national indemnity. I'm sure this really, really attracted him to that business. It's the flow. So policyholders, they purchase an insurance policy with national indemnity. They get to hold the money until they have to pay out claims later. So they have some leeway with some of the things they can do with that

Starting point is 00:27:24 float. And Buffett, of course, is thinking, I'm going to go out and purchase bargains out on the market and use that capital and, you know, grow the company even more through that. So talk about how Buffett used this flow, how much leeway he was given and maybe touch on some of the regulatory pieces that work around this because insurance is definitely a pretty regulated business. Yeah, that's right. Insurance is regulated heavily and it's state by state. So there are state regulators that you have to deal with. And regulators look at a few different things, but mainly how it affects insurance companies, at least from an investor's standpoint, is how aggressive a company can be in terms of its revenue and also how aggressive it can be with the assets that it has.

Starting point is 00:28:03 And so Berkshire today looks very different than it did when he first bought National Indemnity. Berkshires insurance companies today. Berkshire's size is so massive that it has very few limits on what it can do. There's no one who matches Berkshire size in the insurance industry and very few companies that match its size in terms of maybe not sales exactly, but equity capital and its balance sheet and stuff. There's very few companies that have retained as much earnings over the years and just compounded over such a long time. Berkshire is in a league of its own. So due to its size mainly, but also because of some of its diverse earning streams outside of insurance. It has very few, if no limits on what it can do. Even in the 2000s, it bought

Starting point is 00:28:44 Burlington Northern BNSF through the insurance company, through National Indemnity. They acquired a railroad, a private business, which really no one else could really do that. And I think it might have been the 90s, really when this started a change where they got big enough to really maybe not have quite so much limits on what it could do. And again, that was just due to its size. In the early days, though, when Berkshire first bought National Indemnity, it looked much more like a normal insurance company. And if I tried to acquire an insurance company today, I would have to operate much like National Indemone did in the very early days. And in that case, in the first few decades, Berkshire was heavily invested in stocks, but just related to its equity capital. And then

Starting point is 00:29:21 the float was more so invested in bonds. But it was still very attractive for a person like Buffett based on the purchase price he paid. And I mentioned regulators what they look for. One thing in terms of revenue, you could call it underwriting leverage. A way to explain it is, When an insurance company makes a sale, they're taking on risk because it's an insurance policy that they might have to pay out claims on later. And so each sale, you're taking on more and more risk. And so what a regulator usually looks for is how much revenue or premiums written you have compared to your capital, statutory surplus or your equity capital, because your capital's your cushion, you can fall back on in tough time. So you would be considered pretty leveraged

Starting point is 00:30:04 if you had a high amount of revenue compared to that capital, and regulators will limit how high certain companies can go with that. A high quality underwriter that maybe is pretty safe on the balance sheet side of things could maybe in an extreme case, right, four or five times as much revenue, as much premiums as like the capital it has on hand. Geico actually was one who did that before Buffett got involved. But a lot of companies just have one or two times as amount of revenue as their capital. And Berkshire was actually pretty safe over its history. There's plenty of times where they had far less revenue than capital. Their capital might have been even maybe 10 times as much as their revenue in some years of their insurance company. So they are much more

Starting point is 00:30:43 safe in terms of leverage, my underwriting aspect. But that's one thing I didn't realize in the 60s when they first acquired national indemnity. Buffett was much more limited on what he could do with the float. And today, they're just so unique in terms of their size that there's much more, much more things they can do with it in that aspect. I'm also curious if you could talk to some of the advantages that Berkshire has being in the insurance industry. You mentioned insurance being cyclical where companies get excited. They jump into the insurance market and then they jump out when things aren't going as well. So Berkshire is unique in that, you know, it has this insurance operation, but it's a conglomerate.

Starting point is 00:31:21 So it's investing in other things. You mentioned the BNSF that purchase that they made in the 2000s. So talk to the advantages that Berkshire has. Being in the insurance industry, purchasing natural indemnity, and then turning into a conglomerate that has a bit more flexibility and some of the things they can do and the advantages they have there. Yeah, so I'm a big fan of the Berkshire structure itself. I think the media and investors watch Warren Buffett plenty and the stocks he invested, which is deserved. He does a great job.

Starting point is 00:31:50 But I think Berkshire as a company and Berkshire as a structure sometimes gets overlooked or maybe overshadowed from Warren Buff the person because he's such a genius. but the Berkshire structure has a lot of advantages. And the National indemnity is a great example of some of those advantages. Number one, Berkshire really retained all their earnings since Buffett got involved. They really haven't paid any dividends. They've repurchased some shares in recent years and stuff like that. But for the most part, for many, many decades, they retained all their earnings and their

Starting point is 00:32:17 capital grows and grows. So in a way, having more capital, you become a safer corporation versus a company that's always paying out all their dividends. If you kind of run into a tough time or hiccup, you might wish. you had some of that capital back that you paid out as a dividend. So that's number one. Number two, they had a diverse earning streams from many different industries. And that's really helped to, in tough times, insurance is cyclical. And if there's ever a difficult period, in one industry, they have some profits coming in from some others. So those are two main ones.

Starting point is 00:32:45 But I think the most important to me is how aggressive subsidiaries could be within Berkshire versus as a standalone company. Maybe one example would be Cease Candy. If it was a standalone company might keep a lot more cash on hand than when it's within Berkshire. And, you know, when COVID hit and a company like C's had to close down for a while, it would really want some cash if it was a standalone company for situations like that, that might be rare. But it really doesn't need any cash or very little if it's within Berkshire because Berkshire, the parent company has plenty of cash and the ability to borrow since it's so large as well that it could help seize candy out when it's within the parent company there. National indemnity,

Starting point is 00:33:25 I talked about underwriting leverage before. I think as a standalone entity, they didn't have too aggressive of leverage, but maybe a little more leverage than someone like Warren Buffett would have if that was the only business he was ever going to own. But once they joined Berkshire, National Indemite could keep being as aggressive as they wanted with their capital as a subsidiary. And maybe it looked slightly aggressive if you only looked at that one subsidiary level. But if you zoom out to all of Berkshire, how much more capital of Burkshire, how much more capital

Starting point is 00:33:55 Berkshire had, it was very, very safe, very conservative from a leverage standpoint. And so each subsidiary maybe could keep less cash on hand, could be more aggressive with their underwriting leverage or their leverage within the Berkshire system than without it. And maybe last but not least, during the period of my book covers, there's tons of examples of overcapitalized firms that have a ton of cash on the balance sheet that just have nowhere to put it. They might be great businesses in a niche or in one geography, but they just ran out of room to. grow, ran out of room to reinvest. And so that's okay within the Berkshire system. They can get rid of that cash, send it to Omaha. Buffett can reinvest it elsewhere. And it's a perfect

Starting point is 00:34:35 home for a Berkshire type company. Yeah, those are all fantastic points. And I'm reminded of when I read the outsiders, they have a chapter there that covers Warren Buffett. And the outsiders, it really talks about all these CEOs and the unconventional things they're doing. And I'm reminded that with the insurance business, with it being so cyclical, Buffett, you know, he wants to be really conservative with the insurance operations, but due to that cyclicality, he'll, like, really take advantage of those periods where he's able to get really attractive risk-reward opportunities within the insurance industry. And then when, you know, people get too excited and they jump in and, you know, rates start going down relative to the amount of risk taken. And then Buffett's willing

Starting point is 00:35:15 to pull back. And I think another point that ties into that is investors can get upset at him because, you know, the operating results can be a bit choppy. But Buffett is all about creating that shareholder value and he's not really worried about what the accounting numbers are going to look like from year to year. He's just really focused on long-term shareholder value and isn't falling prey to what Wall Street wants and what shareholders want. Yeah, they prove time and time again that over the decades there was plenty of periods where insurance revenue in particular dropped by a very large amount and a standalone insurance company, especially one that had to answer to Wall Street and large shareholders, if that was a standalone company, they might take some heat, especially if they didn't have a

Starting point is 00:35:56 large share like Buffett kind of in charge and in running the show. So they had the culture in place to allow revenue to decline when it made sense because in insurance, you have to say no to bad sales, which sounds easy, but it's tough when you have a quota you have to hit for the month or a sales goal and you just talk yourself into maybe lowering your price just a little bit. And the next time you'll lower it a little more, and you can really fall prey to that. And in insurance, you get cash right away and you deal with problems later in terms of claims being paid out later. So it is tempting for some people to kind of make some excuses or talk yourself into lowering your prices to have cash come in the door right away. Berkshire proved it had

Starting point is 00:36:34 the culture to say no to it. Buffett never put pressure on that for companies for sales goals or growth and insurance all the time. But the Berkshire structure was a big reason why the culture was in place, but the structure really made it make sense where they could go through long periods of big decreases in sales and it still was okay from a corporation standpoint. Since we talk about Float and National Indemnity, I'm reminded of Blue Chip Stamps. And I remember reading this Schroeder book on Snowball and they keep mentioning this company Blue Chip Stamps. I'm like, what in the world is this business? So what did you find about Blue Chip Stamps and the way Buffett got into this one and maybe how Float sort of relates into this business?

Starting point is 00:37:14 too. Bluechips are really interesting business. So Buffett and Munger both bought stock of Blue Chip stamps, a publicly traded company back when they were running their fund operations BPL. And Munger ran Wheeler Munger, I believe it was called. He had his own partnership or fund set up. So they each kind of separately were buying stock, although you could say they were collaborating on that position. But basically what Blue Chip was was a rewards program, a loyalty program for retailers. So say grocery stores or something like that would, you know, hand out some trading stamps to customers and they could collect them over time and eventually if they got enough stamps, they could redeem them for merchandise. And so Blue Chip, kind of like insurance float,

Starting point is 00:37:53 they'd get paid right away by sending the stamps out. And then once merchandise was redeemed, then Blue Chip would have some of their costs come in. So much like insurance float, get cash first and pay some claims or expenses later, it was a form of deferred revenue or flow for Blue Chip. It happened to be unregulated because there was no unlike insurance. The trading stamp industry was not really regulated too much. There was a few antitrust issues with some of the big companies. But it was a pretty interesting business. And so what they're able to do with that, really from day one, there was many years in the

Starting point is 00:38:26 early days, even once Buffett and Munger took over where stocks, they were able to use the float to buy stocks right away. They didn't have to wait so they got a massive scale and size. There were plenty of years in the early days where you could see the equity security the investments on the balance sheet far exceeded the book value of the company, the equity, which means that liabilities must have been funding some of those assets, some of those stocks. In this case, it was float. And so Blue Chip actually pretty quickly, the original trading stamp business declined.

Starting point is 00:38:54 And in that period my book covers, my book goes from 195 to 85, 10 years before. Buffett took over Berkshire all the way until 85 when the textile mail closed down. In that same time frame, Blue Chip basically went extinct, the original trading stamp business. By 1982, I believe revenue was down 93%. Almost zero by that point. But it was still a very successful investment in company, Blue Chip that was, because they actually bought Seas Candy through a Blue Chip

Starting point is 00:39:19 and they bought Buffalo Evening News through Blue Chip and some of their stock investments did really well. And eventually Berkshire owned Blue Chip stock and then Blue Chip merged into Berkshire later on. And so even though this business declined and ended up being really well just because of what they did with the float. Another question that comes to mind here. Speaking of a dying business, I think about the textile business again. Buffett took over this

Starting point is 00:39:41 business in 65 and it wasn't until the 1980s where he decided to fully liquidate the textile business, but it was very clear to him that this was not a good place to allocate capital. And he's compounding all this capital in these other areas, insurance and then purchasing securities. So Buffett being the kind of the master capital allocator that he is, I'm curious what your thoughts are on why he didn't just, you know, by the late, say the late 1960s, why he didn't just liquidate the textile business and start, you know, plowing it into other businesses. Yeah, that's definitely an interesting question. And I think, and mostly I assume has to come down to the personal side. It's difficult to not only fire employees, but completely shut down

Starting point is 00:40:25 a business. And maybe my speculation on the very early days before he took it over or maybe the first two years he took over Berkshire, maybe he thought he could turn it around slightly. I don't think he ever thought it'd be a great business by any means, but maybe, especially after the first couple of years, it was pretty profitable. I just wonder if he thought maybe I could turn this around to make it achieve okay returns on capital or decent returns on capital, acceptable levels where they wouldn't have to shut it down potentially. Over time, more and more became clear that that was not going to be the case and it was not going to earn acceptable returns on capital. But the other thing, too, is over time, it became more and more irrelevant in terms of the

Starting point is 00:41:04 size of the operation. Berkshire was growing and growing and growing, but the original text outmailment was kind of shrinking and not, definitely not growing. So over time, it became less and less meaningful as a percentage of earnings or capital invested even. So it was pretty irrelevant. So on one sense for a while, maybe you were thinking, well, it's not dragging us down too much of overtime, like once the years went on. So maybe you could kind of just let it continue on for the sake of some of those employees there. Where it finally became where they had to shut it down was Berkshire allowed it to continue operating, but they did not invest heavy in capital expenditures. They didn't throw more good money at this textile mill, good money after

Starting point is 00:41:43 bat. And by 1985, I believe it would have required some major capital investment to keep it going, a lot more equipment and maybe new factories and stuff like that. Eventually, it was going to need more money plowed into it to keep it going. And at that point, it finally was, they weren't going to put any more capital in. So that's when it finally closed down. Before we transition to talk about the 1970s, what you called the expansion period for Berkshire, let's talk about how Berkshire's shares performed, because Buffett's kind of known for just compounding at crazy rates in his early days. So how did Berkshire stock do throughout the 1960s? And what were some of the key drivers you found in the performance of the stock?

Starting point is 00:42:25 Yeah, it did pretty well in the 60s. The 70s were a little more, there were some tougher times, a little more interesting to talk about, which we could talk about in a minute here, but in the 60s, it did pretty well. And so it had an evaluation around $12 million when he first invested. By the end of 1969, by the end of that period, it was over $40 million, so $12 million to over $40 million in valuation. The stock did a little better, though, because there was some shares being repurchased in the early days before Buffett took over those first couple years, and maybe even a little bit of shares repurchased once you did take over the company there too. And so I believe maybe 27, 28% compound return from 62 when we first invested all the way until 1969. So very good returns.

Starting point is 00:43:08 And the business also was growing at a nice rate, like book value was compounding at a nice rate and was in roughly the same ballpark as how the stock performed. But the company is invested in much better businesses in terms of much better return on capital and much better growth prospects by 1969 and more diverse, definitely than the early period too. So it was a lot of. was growing, but it was getting better and better over that time period as well. And the stock did pretty well through 1969. Turning to the early 1970s, Berkshire, they continued their expansion in the insurance industry. They opened up shop and the reinsurance space and home state insurance segments as well. And then they acquired an urban auto business too. So one of the interesting

Starting point is 00:43:52 pieces that stood out to me in reading this part of your book and studying the 60s and the 70s is looking at Berkshire's unconventional use of debt. I talked about how Buffett was pretty unconventional and being kind of counter cyclical with the insurance segment. And then he kind of applied this unconventional approach to using debt as well. So talk to us about how Buffett utilized debt in expanding the conglomerate of Berkshire. Yeah, one thing I noticed,

Starting point is 00:44:18 it was pretty clear that Buffett and Munger really valued liquidity and flexibility over maybe being debt-free. They felt much more comfortable having a little debt with plenty of liquidity versus maybe drying up some liquidity but being debt free. And so they did have more debt than I would have assumed. They had more debt than just I would have assumed from listening to the more recent annual meetings or reading some of the more recent letters. But it was never too crazy of debt compared to maybe average corporations or some conglomerates out there that maybe get more aggressive with leverage or private equity or leverage by out firms. never quite, you know, they were still pretty conservative overall in terms of their debt, but they just had a little more than I would have assumed just from listening to the more recent

Starting point is 00:45:03 times. But they always structured the debt to be very long term. So usually the debt wasn't due until 10 to 20 years out. So that gave them some flexibility from that aspect. It was very long-term debt. And then also, like I said, they had plenty of liquidity. So maybe like a blue chip stamps when they made an acquisition of Buffalo Evening News, they had enough stocks on hand, stocks and cash to make the acquisition, but they didn't sell those stocks. They didn't, maybe they would have to pay some taxes on the stocks that went up in value, and then they would have had less liquidity. They didn't sell their stocks.

Starting point is 00:45:35 They didn't get rid of their cash to make the acquisition. They'd take out some debt, and either over time they could feel confident, either from cash flow from the businesses, the diverse group of businesses could pay off that debt, or they could sell some stocks over time if they needed to add some flexibility. But they valued the liquidity. They valued, they didn't want to get rid of the stocks they had that were businesses that they like so they were willing to take on a little debt in those early days especially. So as I mentioned, you referred to the 1970s as the expansion phase for Berkshire.

Starting point is 00:46:05 We could probably make this podcast hours long if we talk about all the businesses that Buffet got involved with. But what were some of the high points for the 1970s in their expansion phase? Yeah, I'd say the biggest driver of expansion in the 70s was Seas Candy. Seas Candy itself kept growing, but it also didn't really need any capital even when it was growing. So all that not only was it growing, but the cash it was producing was able to be sent elsewhere to be invested elsewhere. So C's Candy was definitely a very stable, important part of the growth story, especially in the 70s. Besides that, they made some really great stock investments. Some of their legendary investments in equity securities happened in the 70s because there was a tough bear market

Starting point is 00:46:45 that we could talk about too. But two of that came up were Washington Post during that time period and Geico, both during that time period. And so those definitely were major growth drivers. I think they put less than $10 million in cost into Washington Post. By the end of the period, my book covers, that was over $200 million worth over $200 million. They eventually put in $45 million into GEICO, and that was worth almost $600 million by the end of the period. So, I mean, considering Berkshire started with a $12 million valuation when you start approaching a billion dollars in just a couple of stocks, it's just incredible growth to see. And I could talk about GEICO. The GEICO point there, too, I actually did a podcast in my own on recently on Geico in the 70s, and it went over an hour

Starting point is 00:47:24 and a half just on that topic of Geico in the 70s. So I'll try to make my points a little quicker here. But it's definitely an interesting time period. And Geico was very close to bankruptcy in the 70s. They had decades of growth, nonstop growth, decades of profitability. They were an excellent company. But insurance is a tough industry and you have to always execute. And Geico face some struggles and management did not execute at the time. If you're in a great business and a great industry, maybe you can, it's okay to fall asleep at the wheel a little bit there and maybe not always be executing and you can survive and maintain your place. In the insurance industry, if you don't execute, you could risk bankruptcy or at least lose your place in a big way.

Starting point is 00:48:05 And so inflation was a major problem in the 70s. There was a couple years where there was double-digit inflation, double-digit percentage inflation for a couple years straight, while GEICO didn't really increase their prices. They were charging customers. And so insurance is a very low-margin business. And just with a low-margin business, if a, inflation, if a inflation raises your costs by 10% or more for a couple of years straight and you don't raise your prices that you're charging customers, you're going to be in some big trouble. Another issue with insurance businesses, it's delayed when you recognize some issues. You might have an insurance policy that you don't owe on for a couple of years. So in the meantime, you're kind of estimating your

Starting point is 00:48:42 costs, but it might not become apparent those exact costs until years later. And so Geico is definitely slow in recognizing they had an issue and it almost got them into bankruptcy. And another issue, with GEICO is they were very leveraged in terms of underwriting leverage that I was talking about earlier. Their revenue was four to five times higher than their capital. And so that means they had very little room for error. And that's about as high as regulators will allow you to go. And their annual reports at the time they mentioned regulators were okay with the high leverage. Management mentions it is very high leverage. And they said regulators were okay with it because GEICO had a history of underwriting profitability. And then at the time, GEICO was pretty conservative with their

Starting point is 00:49:22 balance sheet in terms of how they invested a lot of safe bonds and some cash and stuff like that before Buffett got involved. And so they had very little room for error in a couple years of poor execution. You know, they had some major, major losses that put them on the brink of bankruptcy. Jack Byrne entered the scene and helped write the ship and he really turned things around. And Buffett was patient investing. I know I was reading the annual reports and they had decades straight of growth and profits and they looked great. They had one bad year of one negative year of underwriting profits and the stock took a major hit. And I'm looking at this and I'm thinking, you know, one bad year out of 20 or 30, you know, maybe that would have been the time to buy.

Starting point is 00:50:00 But Buffett waited a couple more years. He was smart enough to realize that the company was under-reserving on some of their cost reserves. Their pricing was off. He was an expert in the insurance industry. And he was patient, waited a couple more years and really didn't invest until Jack Byrne was involved in the great CEO was there to orchestrate the turnaround. 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 Vantz is a game changer.

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Starting point is 00:53:52 cigar butt investor, but one of his, you know, he made a lot of his money just buying and holding Geico for so many decades. And it's amazing. Just like how much struggle that business went through throughout the 70s to paint some color on how dire the situation was for them. Geico's shares in, I think it was 1973, 74, that time period, the shares declined by 96%. And I read in 1970s, 36, Berkshire owned 15% of GEICO, and then by the end of 1980, they owned 35% of GEICO. I'm almost curious if, you know, Berkshire being this conglomerate and they're so well capitalized, do you think that, you know, being in the situation they were, they were sort of able to hedge a lot of the bankruptcy risk with GEICO, where if GEICO needed the capital, Berkshire

Starting point is 00:54:39 kind of step in and provide that back stuff for them. So do you think Buffett, you know, was kind of thinking about this, too, when he was purchasing a big stake in them? Yeah, you're right. It was a tough period. And two of Buffett's heroes had a major stake in Geico. Ben Graham made a fortune on the stock. And Lorimer Davidson, someone who he met with and taught Lorimer Davidson taught Buffett a lot about insurance in one faithful meeting. They had a major portion of their net worth in the business. And a decline of 96% after making a fortune in it is tough to swallow. I mean, it was hanging by a threat and almost went into bankruptcy. So it was a tough period. But you're right, there was, in terms of hedging, it is pretty interesting. In some ways, I would say, yeah, Yes, he definitely had some sort of hedge there, but maybe not fully because I think, Gaico had a public offering. They raised capital. And Berkshire did participate in that.

Starting point is 00:55:26 They bought some of their stake through the offering of a convertible preferred stock. And Buffett wanted to buy more. He was willing to purchase the whole offering, I believe, but other investors wanted it too. So he wasn't able to get as much as he wanted in that offering. So in a sense, he had more capital. He wanted to put into GICO. So yes, that does.

Starting point is 00:55:45 I mean, if the company needed more capital, Berkshire Buffett wanted to do that. He also, Berkshire also took some of the reinsurance that Geico needed. So reinsurance is when a separate insurance company takes on some of the insurance policies of another insurance company. Basically, one insurer is taking out a policy from another insurance company. It's a way that Geico, when they're in trouble and don't have enough capital, they can get rid of some of their risk, give it to other firms who have plenty of capital that want to take on some of that risk.

Starting point is 00:56:14 So Berkshire was one of the many, there was many, many firms that did some of the reinsurance deal with Geico at that time. And Berkshire was willing to do some of that as well. So those are two ways where they were willing to help GEICO, put some capital into GEICO or at least help reduce risk. But when I take a look, I don't think Berkshire had enough capital to fully acquire GEICO in this time period, not quite enough capital to take on all the liabilities. Just because one, due to size, but two, due to Berkshire's insurance companies were going through a difficult period as well. the whole insurance industry was going through some struggles then. And so you never know how long that kind of tough period is going to last as well. And maybe if it's going to get worse from there too, maybe like the Great Depression lasted 10 years. And I think that's why it sticks in people's

Starting point is 00:56:56 mind so much compared to maybe there were some tougher periods that people forget about that were just quicker. And, you know, people bounce back a little quicker. So it gets forgotten about in history a little bit there. And when you're living through it, you don't really know if it's going to be something that maybe could bounce back quicker. It's going to be a 10-year, tough period where you got to really buckle in. But with that being said, maybe Buffett's a creative, smart guy. Maybe he could have figured out a way to acquire Geico in terms of maybe he could have raised capital. He never really wanted to dilute his stake in Berkshire and raise capital. But maybe he could have done that for a Geico. Maybe he could have found some creative financing

Starting point is 00:57:30 or a partner to partner with him to buy it or maybe he could have taken on some reinsurance himself too. So maybe there would be a way. But he definitely. had some ways to kind of hedge it, at least in terms he wanted to put more capital in, but I'm not sure at that point in time if they're big enough to acquire Geico quite yet. And as you mentioned, the 70s were just a brutal period for businesses in general. You know, you had high inflation. Stock market was going through a really tough period at that time. Valuations really got compressed, which is of course great for Buffett if he's wanting to be a buyer of stocks. Can you speak to the impact that high inflation had on insurance given

Starting point is 00:58:06 and it played such a critical role in Berkshires conglomerate. And, you know, I think about kind of the regulators too. You know, if there's higher inflation, regulators might be a little bit hesitant to let insurers just jack up their rates. You know, insurers, they have to run a lot of these things by regulators. So talk to the impact of that high inflation had on the insurance business. Yeah, you're exactly right. Seventies were a tough period.

Starting point is 00:58:31 Inflation was a big reason. And there are some tricky ways that relates to the regulatory issue. choose. And so in one sense, well, I don't think I've talked about this yet. Car insurance in particular has a few different types of policies they would take on. So voluntary insurance business is your standard type of business. It's like customers you choose to take on. That's pretty normal in business. But car insurance also had involuntary policies or assigned risk. And that meant regulators would assign policies to your company. And it was spread out to all companies based on how much revenue you had, how much size your company was is kind of how those would get spread out to you.

Starting point is 00:59:07 And basically that meant that bad drivers, drivers where insurance companies would think they're too risky to insure or at least too risky where they would have to charge very, very high rates, too high rates to those kind of drivers. The government or regulators would help out those drivers obtain insurance by kind of forcing insurance companies to take that on through a signed risk or involuntary risk. So for GEICO during this period, I want to say maybe five or six percent of their premiums, their revenue was from this assigned risk, this involuntary portion that regulators just sent to them on a state-by-state basis. Even though it was small, the five or six percent GEICO had was a major

Starting point is 00:59:48 portion of their losses during this time period as well. And so one state in particular, New Jersey, was pretty strict and pretty tough on the fact raising rates and how much assigned risk they spread out. And so one of the first thing Jack Byrne did actually when he took over Geico, he exited the state of New Jersey. They completely left New Jersey. And that got rid of a major portion of their assigned risk policies. It was a tough decision because they spent decades trying to build up that business. They spent a lot on advertising and investments in the state. And just to leave it completely was a tough pill to swallow.

Starting point is 01:00:22 But it really helped them get back to profitability. And it just kind of shows you how much leeway different states had in terms of regulator decisions. But I can see it being difficult from a regulator standpoint of maybe they got surprised or caught flat-footed from inflation. When you're living through it, it's tough to tell if it's like a temporary phenomenon or if inflation is going to keep running rampant for a few more years. It can be tough to forecast that, I guess. And so I can see why maybe regulators would be a little slow sometimes to react to high inflation in terms of the assigned risk because you're dealing with drivers who have no other options really. but some states like New Jersey were slow to approve price increases even for voluntary, normal drivers, which was rare because usually in regulators, I think, were pretty quick to

Starting point is 01:01:08 approve those price increases because those kind of drivers could just leave. If the prices are too high, they could just leave and go to another insurance company. And if companies are price gouging, I mean, that's just an opportunity for a new company to kind of rise up and charge a more fair price. But even I think New Jersey was a little slow to grant price increases even on the normal voluntary policies. And so some of the inner reports of Geico even mentioned regulators were thinking costs would go down some years because of changes in, say, I think they mentioned the 55-mile-an-hour speed limit rule changes in some states and gas shortages during this time period was a major

Starting point is 01:01:43 difficult piece of the economic scene. They thought maybe that'd leave too less driving and therefore less accidents and maybe people would carpool more. So some people were predicting maybe cost dropping lower in insurance, and that was not the case. That didn't end up happening. But kind of highlights how underwriting can be a pretty tricky business, guessing how cost would change over time. I think it's impossible to talk about the beginning of Berkshire Hathaway without talking about Charlie Munger. He oftentimes gets credit for kind of pushing Buffett more on the quality side of looking for higher quality businesses. So tell the story of, you know, Charlie Munger, how him and Buffett sort of interacted and then Munger eventually joining Berkshire

Starting point is 01:02:28 Hathaway. Yeah, so Buffett and Munger met a number of years before this, but they really started collaborating with Blue Chip Stamps and Diversified Retailing. And so I should give a little more background on that. And I'll do that. But Munger didn't really, I don't believe, joined Berkshire officially until 1978, you know, a number of years after Berkshire was already on its way. He became vice president in 1978. And the reason was diversified retail. merged into Berkshire in 78, and Blue Chip didn't merge into Berkshire until 1983. So basically, Munger owned some of diversified retailing along with Buffett and Munger owned some Blue Chip along with Buffett.

Starting point is 01:03:05 So his blue chip stock became Berkshire stock, same with diversified. And so through those mergers, that's how he obtained his holding in Berkshire. And that's when once those merged together officially, that's when he was officially like vice president or, you know, on the board of Berkshire. They were very intertwined for a number of years, though, and that's kind of why they had to merge eventually. They were a little too intertwined and overlapping in terms of Berkshire owning Blue Chip stock and diversified owning Berkshire stock and all that kind of thing. But all this story started from three failed businesses, basically.

Starting point is 01:03:37 Diversified retailing, blue chip stamps in Berkshire, and they all kind of failed in this time period my book cover. So I already mentioned Blue Chip trading stamps failed in this time period. The Texelmail mill closed in 85. And then diversified retailing was actually a company that Munger Buffett and a man named Sandy Goddessman formed a private business. They just formed those three. And they bought Hotschild Cone, a Baltimore area department store. And that one actually went out of business in the 80s as well. They actually realized it was a bad business and sold it a couple years later. Blue Chip and

Starting point is 01:04:07 Berkshire they never sold. But Hotschild, within diversified retailing, they did sell and get out of there. So Buffett and Munger and Sandy Gossman formed diversified retailing. Their plan was to acquire a bunch of retailers. Eventually, it got down to they only owned one retailer called Associated cotton shops, and then they owned a couple stocks, Blue Chip stamp stocks and Berkshire stock. So it wasn't very diversified. It wasn't very much in retailing. They kind of were flexible with their original plan and changed their mind once they realized they made a mistake.

Starting point is 01:04:33 But that's how Munger got involved. He first, they met maybe when they were in their 30s or so. Munger at least was in his 30s. They became friends. They started collaborating on Blue Chip and Diversified. And then eventually that all got merged into Berkshire. You mentioned that probably the biggest winner for Berkshire was purchasing Seas Candy. And I wanted to highlight some of what was going on and that that purchase was

Starting point is 01:04:56 C's. They acquired 99% of that company in 1973, very stable business, consistent cash flows. They paid $35 million and they got $2.3 million in net income, which was growing over time. They had $9.9 million in cash on the balance sheet, zero debt. And the return on equity in this business was over 35% after you take the cash out of the balance sheet there. And And I think this business, in my opinion, it was price as if it wasn't going to grow at all. The earnings yield you were getting was 9%. The 10-year treasury at the time was 6%. But seize candy's revenue over the decade that followed that purchase, their revenue grew

Starting point is 01:05:36 by 15%. And then their operating profits compounded at 19%. So it just looks to me like they got the best of both worlds where they got a wonderful company at a wonderful price, given that the PE on it was trading around 11 when they purchased. So talk to us about how Seas Candy was such a success for them, how this business grew so much over time. You know, it's just a candy company. So talk to us about this.

Starting point is 01:06:02 Yeah, you're right. To me, it doesn't look like that high of evaluation. You know, like you said, 11 times earnings and it had a lot of cash. And it was a very strong growing business. So I know Buffett said it taught him to pay up for quality. But at the same time, especially compared to some valuations today, it doesn't seem like that lofty of evaluation. You're right.

Starting point is 01:06:20 And what's interesting is C's struggled to grow. They were very, very strong on the west coast of the U.S., but they struggled to grow elsewhere. I don't know exactly why, but candy and chocolate seems to be one that different brands dominate different geographies in different countries, as opposed to maybe Coca-Cola or some other brands that Coca-Cola seems to do pretty well in a lot of different countries and geographies and all that. So, Seas was unable to really grow locations geographically. But on the flip side, that meant that their West Coast position was pretty protected and pretty strong because if Seas can't grow elsewhere, their competitors can't really grow into the West Coast too.

Starting point is 01:07:00 So it had a very strong competitive advantage and a strong brand known for quality on the West Coast. And they didn't take much capital to operate the business. And it had a ton of cash on the balance sheet. I think over half, I think half their assets on the balance sheet were cash. And each year they're just spitting out more and more cash. So it was a perfect situation for a Berkshire structure company where that cash could move to Omaha, Buffett could reinvest it elsewhere.

Starting point is 01:07:23 And they didn't have to physically grow locations of candy stores to really grow. And so I believe in the decade plus 10, 12 years that followed the acquisition, Cs grew the revenue by about 13% per year. While their volume of candy sold only grew maybe 3%. And so that difference 3 versus 13, the real difference there is price increases on the candy. Buffett and Munger maybe thought there was untapped pricing power. And when inflation hits, they could kind of raise prices, pass along, cost increases to customers as well. And so a big reason they grew was through price increases. And like I said, that really powered their growth for

Starting point is 01:08:00 Berkshire in the 70s, really gave them consistent cash flow to go along with some of their cyclical insurance kind of businesses. And it was perfect for the Berkshire structure. I think when we're looking at a lot of these businesses that Berkshire purchased throughout the 60s and 70s, I think it's easy to believe that Buffett, you know, he only got into things. He thought were obvious bargains. But one purchase that somewhat took me by surprise was the purchase of Buffalo Evening News. He paid $35 million in 1977 for a business that was only earning $860,000. So what do you think Buffett was seeing in this one that other people were missing?

Starting point is 01:08:37 You're absolutely right that this was unique and outlier kind of valuation. And I think it's a good lesson that you can pay high prices. You can pay high valuations. But you have to, your confidence in the quality and durability of that business has to match that. So the higher price you pay, the more you better be sure that actually is a quality business and a durable business. There's plenty of businesses that seem strong but die out pretty quick. Or maybe you realize it really wasn't quite as strong as you thought. Or maybe maybe some that you just kind of judge wrong. So the higher price you pay, the less margin of safety you have of whether you get that right or wrong. In this case, Buffett was, I think,

Starting point is 01:09:16 another expert in the newspaper business. He'd owned newspaper stocks for a while. But also, Berkshire itself acquired a small newspaper in Omaha, the Sun News, Sun newspaper. It always was a pretty minor piece of Berkshire from an earning standpoint and a capital amount of capital that took up standpoint. Even in the very early days, it was a minor. And then as Berkshire grew, the Sun newspaper didn't grow. So it very quickly was pretty irrelevant economically. But I think it's interesting that Buffett had experience as a business owner of a newspaper. I'm sure that helps in your knowledge as an investor there. So when Buffalo Evening News came along, he was an expert in the newspaper business. And a few things. Number one, Buffett being a business owner of newspapers

Starting point is 01:09:56 and kind of being an expert, he quickly realized that Buffalo Evening News was a private business for many, many decades, family-run business. And he noticed they were paying too high of prices on newsprint, a raw material. Apparently, they were sourcing it from a ton of different suppliers to make sure they always had it on hand in case if a supplier went down on a strike or something. They wanted to make sure they're always safe. Buffett and Munger, I guess they weren't worried about that. So they took all their newsprint from one supplier and got a big discount on that. That was pretty standard how the business industry operated back then. So they were able to save some money on that right away. Still, it was still a high purchase price even factoring that cost savings in. That was kind of minor. It was still a high purchase price besides that. But Buffalo Evening News was the leading newspaper in Buffalo at the time, but they did not have a Sunday paper. And Sunday was the time most people read newspapers. So it was a unique circumstance where just historically there was two newspapers in the town, weekdays, Buffalo Evening News dominated. And then on Sunday they didn't have a paper. So another paper kind of gained a large readership on Sunday.

Starting point is 01:10:58 And so the first thing they did, they launched a Sunday paper when they bought the newspaper. And unfortunately, they had a couple tough years of losses because there were legal troubles, some lawsuits, some antitrust things about them opening a Sunday paper. And some people worried that they're going to drive out the competition in town and maybe being a monopoly in town. But basically all across America, that's what was happening. Every town, most towns were going down to like one newspaper. Some towns historically in the early days of the newspaper industry had two or multiple

Starting point is 01:11:28 newspapers in a town. But over time, more and more, it kept converging to a winner take all in each city, each small town at least. And so it was their theory that there was going to be one winner in Buffalo, and they thought they picked the one that would win and end up being the dominant paper. For a couple of years, they almost gave up. They almost said they didn't want to deal with the legal issues and the losses. And they thought they made a mistake. Eventually, they succeeded and became the dominant paper in Buffalo. And it was an excellent, excellent business all the way until the internet really hurt newspaper businesses when, yeah, when the internet came around it, it was no longer quite such a dominant business.

Starting point is 01:12:05 As I was reading through your book, it kind of occurred to me that different return metrics are probably more applicable to certain types of businesses. For example, the return on equity seemed to be pretty important for insurance. And then you have return on assets. That was highlighted when talking about the purchase of C's candy. Then we have other metrics such as return on Invested Capital. I'm curious when you're analyzing a business, how do you think investors should think about these different return metrics and what sort of things should be considered when looking at these here? The return on assets was a very unique situation for maybe three, at least three of the businesses I studied. Seas Candy, Detroit International Bridge Company,

Starting point is 01:12:49 which was a toll bridge in Detroit, Michigan, Detroit to Canada, that they tried to acquire. They bought the stock of it and they tried to fully own it, which would have made for a great story in the Berkshire history. But someone outbid them and did really well with that asset over time. And then Pinkerton's, a detective agency that gained a lot of infamy throughout the decades and going back even more than a century. And there was a lot of fictional detective novels written about the Pinkerton detectives and security guards and stuff like that. So those are three businesses I studied that just had really unique, very high return on assets. And that's just pretty rare to see that.

Starting point is 01:13:25 So what that tells you is without any leverage, without any debt, without any benefits from accounts payable, again, from suppliers or deferred revenue from customers, without any of that leverage, they still would earn really good returns on assets. And these businesses had a lot of cash on hand because I already mentioned C's, but the bridge is another good example. They weren't able to go build another bridge. They just had all this cash piling up, nowhere to put it. It would have made for a great situation to join the Berkshire family.

Starting point is 01:13:56 But still, even with all this cash piling up for all three of these businesses, their capitalite cash piling up and the return on assets was still great. So it just shows how good the economics were for these three businesses. And it just shows you how unique they were. Return on assets, a lot of people talk about for banks. But for a bank, like one to two percent return on asset is pretty good because a bank has to rely on leverage through deposits. an insurance company has to rely on leverage through float like policyholder liabilities

Starting point is 01:14:25 or else they wouldn't be good businesses. They'd probably be worse than the textile operation if they didn't have leverage in liabilities. I mentioned earlier in the textile operation didn't really have much liability. So their return on assets was pretty close to their return on equity, which is also kind of rare. And so it's a business by business situation. I don't really go around too often like really paying much attention to return on assets,

Starting point is 01:14:46 but it just really caught my eye like, wow, double digit return on assets. or some of these cases, more than 20% return on assets for this company that's got way too much cash on hand. It was very impressive or unique. Now, it's very clear. You've studied all Berkshires and your reports, studied their history, studied, you know, the amazing capital allocation decisions that Warren Buffett has made over his investment career. What are some of the biggest takeaways that you've found in studying capital allocation and studying Warren Buffett's life? Yeah, I really learned a lot. I learned a lot about specific industries like insurance and banking. Just forcing yourself to write or talk about, it helps you learn a lot too. Even if you don't write a book, just even note taking and forcing yourself to sit and think about what you're reading. I know me personally, sometimes I get in a groove of more passively reading things and not note taking. And then later, realize you don't retain quite as much. So doing the book helped me become a lot more active with my reading and note taking and all that coming

Starting point is 01:15:48 on here helps as well being active with information. But the biggest thing I learned, I already talked about a little bit, but I'm going to repeat it just because for me it was a major change of perspective. It might sound kind of simple, but the National Indemnity purchase price, just how Buffett kind of threw, ignored the book value in terms of its purchase price. Because again, just using round numbers, if he was going to have $10 million in a personal account of stocks or $10 million with an insurance company, that was a wash. It didn't matter. So that was basically like not really part of his purchase price, just the goodwill, even if it was maybe $100,000 a goodwill he paid, that's all he really considered as purchase price in the acquisition. Just call it $100,000. It wasn't exactly that,

Starting point is 01:16:26 but close. On that $100,000, you just got to make sure you earn an attractive return on that $100,000 from either bonds or from underwriting profits. And so that really changed my perspective on how to think as an investor. You know, if you're a minority investor, a passive investor, You don't have a chance to really grab those assets like Buffett did, but you can see what management does with it. And really, it made me think more from a business owner perspective, what are you actually buying? What is the capital of this business?

Starting point is 01:16:54 How is it invested in? What is management going to do with it? Do they tell you what they're going to do or you can see their track record of what they've done? And it really changed my perspective. And I think that's what I learned the most about it. Maybe one more thing is reading history, studying history really hammers home, how crazy things can happen in the market for sure. I mentioned the stock did really well in the 60s. In the 70s,

Starting point is 01:17:16 73 and 74, the stock market went down in a major way. I think, I think like the Dow Jones was down 45%. It was a major hit. And Berkshire stock and Blue Chip stock were no exceptions. They went down quite a bit too. So from 1969 to 1974, five-year period, Berkshire stock went nowhere. In the meantime, it went up and then it crashed back down. But when the dust settled in 1974, it was at the same level as five years earlier. And Buffett's someone who's used to compounding money at high rate. So, I mean, five years of no stock price changes a long time. And when you do read history, you might gloss over five years.

Starting point is 01:17:50 But when you're sitting every single day, if you're checking your stock prices every day or maybe even minute by minute or something, I mean, five years is a long time, especially if you have investors an answer to. The business of Berkshire itself did really well over the time period. I mean, some of their stocks went down to value in the portfolio. But the businesses were earning money and, and compounding and stuff. Blue Chip stamp itself, though, their stock price went down 77%, I believe, more than 75%. And it was a really tough period. And the valuation of Blue Chip got close

Starting point is 01:18:19 to a third of book value and close to three times earnings, which is incredible because Blue Chip's book value is mostly made up of a stock portfolio controlled by Buffett and Munger in their prime. And then their earnings came from Seas Candy, which we talked about how great a business that is. So if you were sitting in 1974 and if you happen to have some excess cash on hand, you could have bought blue chip stock. You could have got a discount on Buffett and Mugger managing your portfolio for you without having to pay any management fees or performance fees. Could have to own C's candy at a reasonable valuation.

Starting point is 01:18:49 So you can pay high prices, but you have to be, you have to know that sometimes even these excellent businesses that are going to have great results in the future temporarily could go down quite a bit. So studying history kind of helps emotionally put that into perspective when it actually's happening to you. Yeah, I totally agree that studying history can be just so, so humbling. You mentioned earlier that the first three businesses that Berkshire was in, he ended up going bankrupt, but you look at some of these other businesses and they just went up like crazy. So you just never know what can happen with businesses. Capitalism is brutal. We need to learn from our mistakes and, you know, like adopt what Buffett and Munger do where they're just learning machines and they're always

Starting point is 01:19:30 learning new things and studying their businesses. So Jacob, thank you so much for joining me. This was really fun. Really glad you joined me to cover Berkshire's beginnings. This was a really fun chat for me, and I hope the audience really enjoyed it as well. So as always, I want to give a handoff to you. Tell the audience where they can learn more about you and please feel free to share your book. Where the audience can learn more about that and any other resources you'd like to share. Yeah, thank you. It's been a lot of fun. Thanks for having me on here. The easiest place people can find me is on Twitter at MCD underscore investments. I'm on Twitter there. I recently started doing a podcast myself, the 10K podcast where I try to cover some of the early annual reports of businesses so far I've done. Geico, some of the very early reports of General Motors and National Cash Register. Next, I'm going to try working on Teladine. I'm in the middle of putting together some stuff on their reports of them. So that's on most places you can. can find your podcast, Spotify and Apple, but Twitter is probably the best place. But again, this was a lot of fun. It's an honor to be on your guys' podcast. This is a legendary one in the

Starting point is 01:20:36 value investing community. Awesome. Thanks so much, Jacob. This is fun. Thank you for listening to TIP. 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 the Investorspodcast.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.

We Study Billionaires - The Investor’s Podcast Network - TIP573: Berkshire's Beginnings w/ Jacob McDonough

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