We Study Billionaires - The Investor’s Podcast Network - TIP621: Warren Buffett’s Wisdom: The Power Of Corporate Governance with Lawrence Cunningham

Starting point is 00:00:00 You're listening to TIP. Horace Cunningham is one of my favorite investing-related authors for a few reasons. One, he's deeply entrenched in quality investing. Two, he's one of the most passionate people regarding social governance I've ever spoken to. Three, he has an in-depth understanding of the characteristics of a quality business. And four, he's broken down one of the most outstanding companies ever, Berkshire Hathaway. I often reread and reference his book The Essays of Warren Buffett. It reminds me of poor Charlie's Almanac, where you are guaranteed.

Starting point is 00:00:30 to get smarter each time you open the book. Not only will you become more intelligent, but you'll also pick up new insights each time you open it. Seeing as the Berkshire Annual Meeting is just around the corner, I thought it would be great to cover some of the details from this book with Lawrence and share them with you. Today, we discuss a wide variety of lessons, including Lawrence's fascination with Warren Buffett and Berkshire Hathaway, why corporate governance is so crucial for shareholders to understand, the power of transparency, accountability, and ethical decision making, how Warren Buffett created his shareholder letters to create a competitive advantage, a list of incredible businesses to research to understand top-notch corporate governance, the makeup of a successful incentive program,

Starting point is 00:01:08 and a whole lot more. If you are as strong of a disciple of Warren Buffett as I am and enjoy learning about what makes Warren Buffett and Berkshire Hathaway so unique, you need to listen to this episode. Now, let's get right into this week's episode with Lawrence Cunningham. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors podcast network. Since 2014, we studied the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Kyle Greve. Welcome to the Investors Podcast. I'm your host, Kyle Greve, and today we bring Lawrence Cunningham onto the show. Lawrence, welcome to the podcast. Great to be here,

Starting point is 00:02:00 Kyle. Thank you. So I had the pleasure of interviewing Lawrence way back in September last year, and it was one of my favorite chats that I've ever had on this podcast, so I'm very, very excited to have Lawrence back today. So since this episode is going to be coming out shortly before the Berkshire Hathaway annual meeting, I figured that we would just go over one of Lawrence's most famous books, which is the essays of Warren Buffett Lessons for Corporate America. So Lawrence, what is it specifically about Warren Buffett and Berkshire Hathaway that made you want to write this book and continue updating it? It was about 1995, and I was a young assistant professor at a university.

Starting point is 00:02:36 put in charge of their corporate governance program, and my job was to conduct high-impact research and highly visible conferences. And I did a couple of things that were reasonably okay, but my beam still wanted more. I had been reading Warren's letters to shareholders, thanks to my mentor, and most people think of his letters as containing investment wisdom and advice, and surely they do, but they contain so much more, including a lot of knowledge about corporate governance, boards of directors, manager of oversight, incentive compensation, accounting, M&A, and on and on. And I thought, there is a high visibility program. And so through a network of friends, I got the proposal on to Warren's desk and for a

Starting point is 00:03:26 symposium for a conference, kind of what I was supposed to be doing. And to my surprise, and I guess the surprise of many others, he said yes. And so we convened the conference in October of 96, a couple hundred people in the auditorium of my university in the middle of New York City. You know, you could never do that today. I mean, you need a rock concert hall for that. But we did it right in my school. And his colleagues, well, his wife Susie was there as son Howard and then colleagues like Charlie Munger, Vice Chair, Ajit Jane, the Insurance Maven, Carol Loomis, who was editor of his letters, and many

Starting point is 00:04:06 others. Lou Simpson, who was the investment manager at GEICO, and on and on, and my colleagues. And we just had a great intellectual debate. You know, I had put onto the conference table selections of his letters rearranged by theme, and so I had panels on each of the different themes. And it was just huge fun. A lot of great ideas, exchange. I published the academic papers in a journal.

Starting point is 00:04:33 And then it got this attention, wider attention in the popular press. I mean, Warren was well known in investment circles then. I mean, he was famous. It wasn't as famous as he is today. But there was interest beyond my symposium in a book. And so, and I think it was Warren's idea to actually do the book. I know it was his idea to do series. So every five years as he writes new letters and as the world changes,

Starting point is 00:04:59 We update the book to weave in the new ideas and eliminate redundancies and stuff like that. And that was his idea. He said, hey, every five years or so you could update the book. So that's what we've done. It's just been a wonderful project. I'm interested in just rewinding a little bit in time and just understanding your interest in governance specifically in corporate America. What got you specifically so interested in that area? I think of corporate governance as the guardrail for investor protection, that you can have a

Starting point is 00:05:31 wonderful business, you know, making an excellent product. People really need want, people pay for, the company produces significant profits. But then, without governance, guardrails, all those profits can be channeled to insiders. Executive compensation and bonuses and payouts and perks and who knows what else. Fees, my interest was to help maintain and support a system that would be owner-oriented, that would be protecting shareholder investments. And it's one of the things that I loved about Warren's letters in this book is that it demonstrates that investors, obviously, you have to conduct fundamental valuation analysis and examine the business case, but you have to have a section in that analysis on governance, on how will the shareholders be protected?

Starting point is 00:06:21 Because I've seen, and I've been involved with companies that were wonderful businesses, but the shareholders didn't receive most of the result of that because of managerial leakage, let's call it. So that was my interest. I think it's a fascinating subject on its own, but the real purpose is to protect investors, protect shareholders. So one thing that I really liked from the intro of your book was that you talked about how Buffett places a very high degree of importance on forthrightness and candor and his communications with shareholders. So you also pointed out how simple he makes the annual reports and how he likes to make sure he uses simple terms, simple language, and numbers that, you know, anybody can

Starting point is 00:06:58 probably understand. So I'm interested in understanding if you think that this structure of his annual report has been some sort of competitive advantage for Berkshire Hathaway. Oh, yes. Absolutely. Most CEOs today and for decades have professionals write their letters and their communications, press releases, some other public speeches. And it's obvious how these things have been produced. They have a sense of scriptedness. They're off the elliptic or foggy or written in PR speak. And it's hard to do what Buffett does, which is to sit down.

Starting point is 00:07:38 I mean, it takes him hundreds of hours during the last quarter of the year to produce this, is a difficult art under any circumstances. And here, you're trying to capture and explain performance over a year, and especially in his case, a lot of different businesses, a lot of different engines. And then you try to put it in the context, not only of that particular year, but the arc of the company and its operating environment. So it's painful. It's hard to do what he's done. I can understand why a lot of CEOs just outsource it to the professionals. and they might add their little touch. But to do it yourself and to really put the effort that he does has value because it conveys the real essence of a company, the culture, especially

Starting point is 00:08:24 if it's the founder who's writing these letters. With DNA, that person has injected into the company. So it becomes a very distinctive expression of who the company is. And that will be a distinction. And if it's a positive distinction, it'll be a competitive advantage. And so it certainly is, as Warren, as you said, he tries to explain it in such kuna language. He makes a joke that his audience, any writer has to think for whom am I writing, what's the reception going to be like. He imagines that he's writing his letter to his sister, a smart person, but not an expert. And so, yeah, the accounting concepts are explained in very accessible language.

Starting point is 00:09:06 It's not dumbed down. It's written for smart people, you know, intelligent people, but not a C.P. or an MBA necessarily. And I think that, so yes, he was good at this from the beginning. He took the care and the effort. You know, in his early days, he was writing annual reports to the small number of partners that were in his partnership. I might have been a dozen friends and family, including his sister, where, you know, he had to be very, very personal, very thoughtful, very deliberate, very honest. And he just carried that into the public company and has been doing it now for 50 plus years. And there's no question that it's a competitive advantage. It's also like most

Starting point is 00:09:47 competitive advantages, it's not an easy thing to do, but he does it very well. You're on the board of Markell, Constellation Software, and Kelly Partners Group, all of them, which I noticed have very good social governance. So I'm interested in knowing if you can suggest some other businesses that also have good corporate governance that listeners to the show and probably myself should spend some time learning more about. Yes, well, thank you. I am on the straight boards. I think those companies are wonderful companies led by outstanding executives. And indeed, not coincidentally, I compiled a, I did some research on, I like how you call it, good social governance, you know, that sense that the CEO should be a partner to his or

Starting point is 00:10:29 shareholders and write to them in using, you know, his own time and effort and attention, writing that very carefully. And all of those guys, all the CEOs of those companies do that. And I had done a bunch of research on the quality of shareholder letters using linguistic analytic tools that test for candor versus obfuscation. And I did other research just around rankings of letters and stuff like that. And I did a whole report on that. And then I decided, and I ranked them. And those companies that are at the top of that.

Starting point is 00:11:04 And then I turned around and wrote a, just published a book, a collection of the best shareholder letters from about 15 CEOs. And so it's those companies plus Enwarrant is at the top of that deck. And the others I put in there, just to answer your question of examples, I think I'd cite Fairfax Financial run by the CEO and founders Prem Wazza. Like Markell, it's in the insurance business. In fact, it was actually a part of Markell when Prem Watsa bought it. And like Constellation, It's based in Toronto. Wonderful company. Prim is a very clear, candid writer.

Starting point is 00:11:41 Tells it like it is. Not every year is great. Buy and hold that. Well, if you look back, it's been a very successful business and investment over decades and decades. Another one I featured in that book was called Credit Acceptance Corporation, not a household name, but a very important player in the funding of automobile purchases, is making loans, supporting the market for loans, especially the people who might not otherwise

Starting point is 00:12:08 be able to get a loan. Again, it's interesting business, and the leadership is just clear, candid. I could go on and all. It is a competitive advantage. It's a small number who stand out in this way, but still, it's not 10. It's 30 or 40. And you can check out Deer Shore Horse if you want, or other of my books discuss other examples. Yeah, that book, Dear Shareholders is awesome.

Starting point is 00:12:33 I have it as well. I highly recommend it. It's a really good compilation where you basically just found all the interesting tidbits. And you went back in history, right? Like, I really, really enjoyed what you talked about with Roberto Goyzetta and Coca-Cola. That those, it was really, really well done. Oh, yeah, he was an artist. And went through, again, Coca-Cola is always seen as this wonderful, wonderful company.

Starting point is 00:12:57 Nothing is inevitable about it. I mean, and Inverda did a great job, staring through some challenges, focusing, very focused on owner of interest, on shareholder value. He minted concepts around that idea and wrote clearly about them. That's a real master. So there is an interesting passage in your book about how Warren distinguishes between growth and value. So you wrote, quote, many professionals make another common mistake. Buffett notes by distinguishing between growth investing and value investing.

Starting point is 00:13:29 Growth and value, Buffett says, are not distinct. They're integrally linked since growth must be treated as a component of value, unquote. So the interesting thing here is that Buffett wasn't originally focused much on growth in his investing process at the beginning. He was laser focused on value. So I'm interested. Can you discuss some of the major influences that helped them evolve from being, you know, a very, very value-focused investor to being more of a growthy, quality focus investor that

Starting point is 00:13:57 is today. Yeah, it's an interesting evolution. I think Warren learned. One key thing about Warren is, and about a lot of your listeners, probably they believe in learning. They believe in getting new information, developing new knowledge, adapting as the hand they're playing changes or as the card game changes. And that's what Warren is, I think, trying to get people to appreciate the importance of evolving. And his early phase was mostly, thanks to his professor, his teacher, Ben Graham, the father of call it value investing if you want, but the idea that you should pay a price that is a deep discount from the value you're getting. Ben Graham called that the margin of safety because from the error or so try to be super careful

Starting point is 00:14:47 in what you pay. And Warren took that idea literally in his early decades in an application called cigar butt investing, meaning that, well, you could buy just the last little bit of a cigar. If you get it for cheap, you could make a big buck, you know, from that. And in terms of the influences that evolved him away from that, one was Charlie Munger. I mentioned his business partner, beginning in early 70s, or late 60s. And Charlie thought that's an attractive approach if you're in it for the short term and or if you're just buying a bunch of small things, buy him cheap.

Starting point is 00:15:27 okay, you'll make some money and move along. But he said to Warren, you know, if you're thinking you're going to be in this enterprise for decades and decades for, you know, half a century, that's not going to work. You're going to want things that will last over decades and decades. You need a whole big giant cigar, maybe a cigar box. You can't just have this butt. And you say, you know, if you're going to do that, you're not going to find lots of those little cheap things running around. So, Marker encouraged Warren to think about growth, to use that

Starting point is 00:16:01 phrase, but it was really about, well, think about the durability of a business, how it can grow, be sustained over very long periods of time. And so he wanted them to focus on the intangibles, the moats of competitive advantages, customer franchise, brand loyalty, and be willing, you know, you still want a margin of safety. He didn't give up on that idea. but be willing to pay a little more for value, for quality. And so that was a primary influence. Charlie sort of sitting there and coaching. And the second influence intellectually was the book by Phil Fisher came out in around

Starting point is 00:16:41 1958, so it was sort of popular as Charlie's given Warren this advice. Phil's book was called Common Stocks and Uncommon Profits. And it had this sense of what we would now probably call quality investing. which was, look, okay, don't overpay for things. Don't violate Ben Graham's margin of safety principle, but don't take it to cigar butt extremes. You can pay up for value. And that's what I call that quality investing. I think so the nickname's growth investing and value investing.

Starting point is 00:17:11 I think they got a little dichotomized, you know, and sort of a false dichotomy. And that's what Warren was just trying to correct these side. Look, they're not really alternatives. Doing value investing, yeah, you want a margin of safety. but when you're making the valuation estimate, you're going to include some, you know, what's the growth prospects? And so I just, I like quality investing as a way to capture that combination. So you wrote, quote, since 1978, Buffett has always written his letters with a specific purpose to attract what he calls quality shareholders. Those who buy large stakes and stick around, neither thoroughly diversified indexers nor short-term traders.

Starting point is 00:17:50 So I'd like to rewind back to March of 2000. At this period, Berkshire Hathaway had reached a multi-year low of $41,000 and $300, down from a high of $80,900, just a few short years earlier. So it would appear that during bubbles, even quality shareholders are willing to dump their quality businesses to chase returns in other stocks. I'm interested in knowing if you think that Warren has been able to improve on his ability to retain quality shareholders since then, or do you think that the right kind of bubble is just going to negate the positive effects of quality shareholders?

Starting point is 00:18:24 No, you're absolutely right about that. Look, being a quality shareholder by which Buffett has defined them, and I've redefined it as a long-term and focused investor. Having those two characteristics is fiendishly difficult. And it was hard in 1978. It was maybe even harder in 2000. I think it's even harder in 24. for, you know, in terms of being long term, even then there was pressure to meet a quarterly

Starting point is 00:18:53 result. There was pressure to just human behavioral pressure to see returns faster rather than slower. So it was hard to be patient then. But then, you know, imagine, take 2000 the internet period, the pace of daily life changed. We started to move into, you know, you could very quickly just click and purchase goods that be delivered the next day from across the world. to look forward into 2020, social media just delivers everything instantaneously. The piece of innovation is extremely rapid.

Starting point is 00:19:27 Social media intensifies this sort of instantaneity of stuff. And that's bound to affect people's patience in investing, too. The idea of let's find this nice little business, and maybe after three, seven, or 12 years, it'll be this wonderful super duper business. So being able to do that, it just, it's gotten harder. I think it was harder now. I think it's harder now. So being patient, okay, that product, quality shareholder, there's going to be fewer people

Starting point is 00:19:56 who were able to do it. And then on the focus side, in 1978, there weren't really any index funds. Jack Bogle had begun talking about it and writing about it a little bit in college around that time, but they were really incubated the next decade or two and then took off, really in the last since around 2000. So now you have gobs and gobs, trillions and trillions of dollars, massive percentages of the total market capital

Starting point is 00:20:24 or deployed through index funds where no one's picking a stock, picking a basket maybe, and then the purchases and sales are simply done as the market basket amounts change. And so no one's picking this one of Berkshire stock. They have to buy the class B because it's in index. So the proportion of investors who are focused has declined. And even the ones who aren't

Starting point is 00:20:50 officially indexed, there's a lot of closet indexing. So they, 80 stocks. So you're right, the percentage of the shareholders of any company that are quality shareholders has declined massively since 1978 as short-termers and indexers have risen. And that's certainly even been true of Berkshire Hathaway. That said, it's been less true of Berkshire Hathaway than any other company. We crunched the numbers on the types of shareholders in Russell 2000 or so. And Berkshire is way at the top in terms of a portion of its overall shareholder base that are long-term in focus compared to the short-termers and the indexors. It has a lot of those, but less than others. And I think Warren's education, his letters, that audience is a big part of. He has consciously cultivated that cohort,

Starting point is 00:21:46 and they have, they've responded. Largson, again, they're a big index, there's on big chunks of Perkshire, but he has, I think, succeeded in attracting a disproportionate share of that shrinking base. And you could see it. You know, you could see it in Omaha at the annual meeting. You can see it on podcasts like Feet 70. He has led a large group of investors who are inclined to be patient and focused and has, I mean, his current letter actually said the shareholder list, he's got three million accounts. And I haven't broken them down this year. But I would say the overwhelming majority of those are quality shareholders.

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Starting point is 00:27:00 results of a low-cost vanguard S&P fund. So none of the five funds came even close to beating the index. I'm interested in knowing why do you think Warren has taken responsibility himself to show investors not buying index funds is a rational choice? And do you think he just does this for his amusement or is it something that's part of his DNA? I think it's part of his DNA. I think you're exactly right about that, Kyle. And the helpers label that, he's got a wonderful essay. One of the essays in the essays of Warren Buffett is about the helpers. It actually features another cool name. He imagines a family, a single family that owns all of corporate America. And he calls those family to got rocks, got rocks, like old-fashioned ways, you know, rich people.

Starting point is 00:27:44 And he's got them with, you know, just this enormous capital base that they get the hand-down generation to generation, and if they just did that without paying anything out of it, it would be this gargantuan number. But what happens is after the one generation would like to do a little better, so they hire some people to help them do a little better, actually subtracts costs, incurs fees, it actually doesn't make them any better. So the next generation tries to hire some additional people to try to explain why they aren't doing so well. And that doesn't help, but the next generation decides to get some additional helpers to figure out why the help isn't helping and on and on. It's an amusing parable, and you're right, it displays his passion for this was critical,

Starting point is 00:28:28 you know, it's criticism of the asset management or fund industry that he is passionately critical where overall the fees are higher than the value conferred. And so there was a great book. He, by got him Fred Schwed, back in the, 30s. I'm not sure exactly what it's public. It's classic. And the title is, where are the customer's yachts? You know, he's like walking, walking down the yacht. All the bankers, all the helpers are traveling in these wonderful boats and what do the customers have a boat? So why is Warren, you know, I think it is in his day. He is by nature a very rifty person.

Starting point is 00:29:10 You know, he doesn't pay extra for anything. And that would certainly, you know, he's, you know, even a hamburger, but that would certainly include a financial advisor or a merger broker or a consultant. At Berkshire, they don't use, they use very few of those helpers. I mean, they have a law firm to help them with taxes, regulations, and acquisition agreements. They have an accounting firm to audit the books and maintain the internal control. But otherwise, he's extremely reluctant to use to pay fees. And that's just part of his personality. I think, you know, DNA and also being from Omaha, just Nebraska, the middle of America, very thrifty culture. So I think that's a big part of it.

Starting point is 00:29:58 And then the related part is he does care deeply about his investors. And again, they started out as friends and family, partners. And he looked out for, you know, any penny that he paid was a penny come out of their pocket. And he still feels that way about Berkshire Hathaway. This half a trillion dollar company, they pay a 1% fee to this acquisition. He feels like that's coming out of the pockets of all my shareholders, of all the Berkshire shareholders, and he treats his money like theirs, the company's money like it's their money because it really is. So it's DNA and then it's cultural within Berkshire Hathaway.

Starting point is 00:30:38 And I think that basically explains almost all of it. I would also observe that, you know, when he's in that Got Rock's essay, he's talking about the overall industry for sure, but then he singles out a couple of elements of it, including private equity. And that's fine. I've seen them charge for him. He's like, I get that. But the cynic or the counter, the people in that community might say, look, Warren is just being a competitor. So we're trying to buy the same companies he is. And, you know, he wants to to say, look, if you come with me, we're not going to charge your board fees or strategy fees or selling fees.

Starting point is 00:31:18 We're lean and mean and thrifty. Those PE guys are going to charge you money at every step of the way. So there's maybe one small part. You know, Berkshire is a very attractive home for sellers of businesses. And one reason is they don't charge fees. But so I think that there may be some, you know, Warren is, in addition to all the other things we've been talking about, he is a consummate salesman and he's always selling Berkshire Hathaway. in every market that it's in. And one of those markets is competing with private equity for businesses.

Starting point is 00:31:47 And so to emphasize that that's a costly bunch of helpers, you know, is consistent with Berkshire's own own interests. You know, and on just if I can finish your question, Kyle, the attractiveness of index investing, because that's the place in the essays where he's talking, where he's got the got rock story is about, you know, why ordinary investors in America are better off with a cheap index fund with an index fund that doesn't charge any of those fees, what charges is extremely wealthy because they're not doing anything. They're just buying the basket. There's no advice. There's no strategy. There's no consulting. He's explaining why an index fund is good to most people because it's cheap. You know, you get the market return and no real cost. Whereas, you know,

Starting point is 00:32:34 if you're hiring a stock thicker to give you all this help, don't expect much. That's the context in which he's discussing that. And I take him at his word. I think for decades, he has advised ordinary people that are not, that don't have the time or the ability or the inclination to study businesses in order to intelligently select stocks. He's been advising them for decades, just buy an index. And he calls them the rocking chair investor, the armchair investor, just you don't have to do anything quite well because America is a prosperous country and an economy. So he's, and I think he absolutely stands by that advice. At the same time, he has invested enormously in educating people about intelligent stock selection. So he knows people, even if they index a lot

Starting point is 00:33:23 of their portfolio or net worth, they're going to be picking stocks too. And he's fine with that. He encourages that. I mean, he wants people to buy Burchure-Hathaway stock and then wants them to hold it. I think it's an interesting thing about Warren that he is an advocate for, index funds, but at the same time, he's educating people on stock tech on a complete investment philosophy. So one area that you touched on with that response was just paying fees for M&A. So obviously, you know, Berkshire Hathaway is a very acquisitive company. They've done tons of deals for their subsidiaries.

Starting point is 00:33:59 And I think part of his competitive advantage is, you know, he's not, and this kind of just goes into what you just talked about about all these hidden fees and these helpers is that. that when he makes a deal, he doesn't need to have an army of people coming in there that he's paying to help make a deal. A lot of times, he just goes and meets the owner, shakes their hand, bang, it's done. I mean, that has to be a major competitive advantage for him in Berkshire Hathaway. Absolutely. I think the principle of autonomy that Berkshire authors, that offers, that is that managers of the

Starting point is 00:34:32 Berkshire businesses get to call their own operational shots in product mix, price, saying employee policies, retention, bonuses, promotions, expansion, contraction. It's really all up to them. There's some limits on, you know, retirement plan or deploying large amounts of capital. So a manager who likes that independence, that ability, that autonomy prizes Berkshire as a home. And that's really been the path for a lot of the Berkshire acquisitions. Someone who still wanted to run the business and run it their way, but didn't want some of the other anxieties. Either it was a public company, they don't want reporting anymore like Clayton Homes,

Starting point is 00:35:21 or it's a family company, and they're kind of an inflection point with a generational shift or facing that, so they want to secure a home for the next generation. And so that's been a real attraction of sellers to Berkshire. There are other companies who have mimicked that, but it's a real plus. And on the flip side, I'm not against private equity. I think they do a fabulous job, but they do tend to intervene more. You know, and part of what they're offering is the other thing about Berkshire is they don't have anybody that they could send in to actually make those changes if they were meet.

Starting point is 00:35:56 Warren is sitting in Omaha with a couple dozen mostly financial people. He's got some business geniuses who can troubleshoot, but that's not their preferred approach. They like an existing business. It's run really well and just will be able to continue to perform and maybe even grow as a result of the Berkshire Fugiation. Private Equity, they have tools and people who can diagnose problems and help fix them. And that usually, and very often includes managerial leadership, but could be the product mix and the customer base and everything. else about a business and what they're selling or what they're offering is quite different from what Berkshire is offering.

Starting point is 00:36:36 And so in some ways, they end up sometimes competing for the same business, but ideally, most of the sellers would be at home in one setting and less at home in the other. So Warren Buffett listed a few lessons in one of the essays that you shared in your book that he and Charlie learned over 25 years. So one of them really stood out to me, and this was, quote, after 25 years of buying and supervising a great variety of businesses. Charlie and I have not learned how to solve difficult business problems, unquote. So then he went on to say, you know, they're trying to win by stepping over one foot hurdles rather than seven footers. So I'd love to know some examples of when

Starting point is 00:37:14 Warren has attempted to stray from this strategy and how he came ultimately to this conclusion of jumping over one foot hurdles. It's a great passage. Yeah. And he was reflecting. That's a great essay because it was a couple decades ago, but it was still after 25 years of working of making purchase decisions, both in individual stocks and in whole companies. And, you know, I think overall the record is very strong. They made way more wise capital deployment decisions than stupid ones. But nevertheless, one of the lessons is to learn from the stupid things you did. And he's, in that essay, he's diagnosing, it's like, one of the things we did, and this again, contrast to private equity, Warren, thought, you know, I personally weren't, I'm not good at solving

Starting point is 00:38:01 difficult business problems. Maybe there's some geniuses of private equity or are, but I'm not good at that. It's really hard to do. And so, and neither's Charlie. And so our best strategy, instead of trying to buy those turnarounds and fix them, we're going to try to avoid them and try to just get the simpler ones. And Charlie had a wonderful quote a lawyer. along these lines, too. They thought very much alike. Charlie said when she goes through life, it's more important just to make a few good decisions and avoid making the stupid ones. And it's often harder to avoid making the stupid ones. And stupid in this context is those seven footers. You know, and so, I mean, Warren, he'd have a list. I think there's a list in that

Starting point is 00:38:44 essay of some of the seven footers that had difficult business problems that he couldn't fix. and maybe weren't even fixable. The original classic was his acquisition of the original Berkshire Hathaway business, which was a dying textile business up in Massachusetts at a time when the beginning of globalization and of making fabrics and textiles abroad and shipping them around the world, including to America, so that you just couldn't have the pricing power. So it was a dying industry, and he stuck with it. it, but they also had a union group to deal with.

Starting point is 00:39:23 And so it was just, it was maybe a due business. And he tried to keep it alive for, God, at least a decade. And he realized he couldn't, he finally shut it down. So it was a terrible business. And you learned a big lesson. Another one, though, I mean, but you didn't learn it immediately or permanently because then maybe a decade after that, he bought a shoe company called Dexter Shoe. And actually a similar horizon facing it where you.

Starting point is 00:39:49 Just shoe companies, you could manufacture the same shoe in Asia, bring it back across the oceans for a fraction, a tenth of what it can cost to do in England. So he learned a lesson again. In that one, in that transaction, it wasn't just a big business problem. He couldn't jump over it, but he also used Berkshire-Hathaway stock to buy Dexter. And so just year by year, he saw, as Berkshire stock increased in value in that shoe company he deteriorated and he saw how much he wasted. So another big seven-footer that I think he missed, he didn't really see. I think Charlie did was Jen Ray. One of the biggest acquisitions they've ever

Starting point is 00:40:30 made, even now, I think it was $27 billion, around 1998 or so. So these would be much bigger numbers now. But Warren obviously was attracted to its wonderful book of business and reinsurance. It was a large global carrier, a player in that field, abundant float at appealing cost. Charlie was concerned. He said, but they're also writing all these derivative contracts, these hedging instruments. They look too complicated to me. I can't understand them. I don't see.

Starting point is 00:41:01 And that feels like a risk. It feels like a potential seven-footer. Not positive, it's a seven-footer, but it doesn't look like a one-footer. Warren went forward with it anyway, and Turner Charlie was right. It had extensive derivative products that blew up and cost a fortune. And it took years to unwind every year in Warren's letter during that period. It's about a six-year period. It's classifying the costs in money and brain damage.

Starting point is 00:41:31 And so, again, I mean, you could fix it. It was just a series of bad business decisions and set of business problems. But it took enormous effort. So I think it's a nice out analogy too. It might be fun and exciting to try to hit those seven footers. And some people may be really good at it. Again, the private equity world. You have to know your strengths and fixing businesses just isn't one of his strengths.

Starting point is 00:41:56 And even, you know, he's, there's a little bit of modesty in there because he's certainly owned businesses that had challenges and that through selecting the right managers, they will fix. But he's right. You know, obviously, it is a lot easier if you can find a long footers. So looking at the opposite end of the spectrum is obviously the one footers. So I'm interested in knowing, you know, obviously there's probably tons and tons of one footers that he's crossed.

Starting point is 00:42:19 But in your opinion, what are the investments that just made the most sense to Warren Buffett that have obviously been some of his biggest successes that we know about today? I think, you know, it's the seize candy, chocolate confectioner with deep brand loyalty and therefore some significant pricing power. Geico, the car insurance company that had built out a wonderful underwriting discipline and staff with the very thrifty, very cost-conscious, disciplined group. It maybe wasn't a one-footer because they did face problems. Most insurance companies do, maybe it's a two-footer.

Starting point is 00:43:00 It's hard to find the one-footers even in his case. I mean, you might count Dairy Queen, Justin Boots. Acme, Gricks. I think in Cleaning Homes, maybe that's a two-footer because they face business adversity of various kinds because of the markets that they serve people who at the lower end of the net worth or income matrix, so they encounter challenges in that business. I think the key, if I rephrase his kind of test and say, you need to have good business kind of doesn't have that many problems. Maybe it's a two foot or one foot or then you really

Starting point is 00:43:40 have to have a good manager who is capable of handling adversity when it comes. And I think that's one of the maybe derivative lesson of what he's talking about here is he knows that he personally is not gifted at solving foreign business problem. And so he tries to avoid, that's one of the reasons for the autonomous structure at Berkshire. Warren really knows, you know, he's really not good at pricing insurance, but he knows that his head of insurance, Ajit Jane, is, so he just has Ajit to him and tries not to second guess him. He's really good at picking jockeys, picking jockeys, but not actually riding the horse. And I think that's a big part of what he means when he's when he's reviewing that lesson that he and Charlie Martin. They're really good

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Starting point is 00:47:54 So Buffett had a really good quote on share repurchases, which was this. So, quote, my suggestion, before even discussing repurchases, a CEO and his or her board should stand, join hands, and in unison declare what is smart at one price and stupid at another, unquote. So I'd love to get your input on why this seems like such a hard task for the majority of corporations to execute on. It's troubling because it should be fundamental. That statement there should be. There should be. so well-known, so ingrained, that you don't have to have the standing commitment that he encourages. In this sentence that you quoted, it's in a essay that it's 10 pages on the rationality of share repurchases and the idea that rationality depends on the price. Like any, you could over or underpay for anything, including a company in its own stock. And underpay, that's good for the continuing shareholders. If you overpay, that's bad for them. It's fundamental. Why do we need a seigne to have that gathering? I do think a significant reason, part of the

Starting point is 00:49:07 problem is insufficient appreciation of the basics of capital allocation in American C-sweets and boardroom. Capital allocation is a fundamental concept. I think every business person ought to know it coal, and every director ought to know it cold, so that we don't have to, again, have that scene of unity. But what I'd like to see them do is, well, any director before assuming the board seat, be able to recite the basic ABCs of capital allocation. It's simple. Every dollar in this company ought to be put to its best use.

Starting point is 00:49:46 And there are only three or four uses. One is reinvesting in the existing businesses, another is acquiring new businesses, and then the third or fourth is paying dividends to shareholders and or repurchasing the stock. And that's it. That's the mix. And they're not necessarily exclusive. You can do all of them. And it's not necessarily linear.

Starting point is 00:50:06 But you should evaluate each of these deployment avenues and then determine what's the best allocation mix. And that's whatever, every director ought to think that way, ought to know that. And every executive should too. But not all of them do. A lot of executive capital allocation is a concept that's taught in finance and ingrained in the finance function in a corporation. Investors know a cold, your listeners would. But, you know, not all CEOs come up, majoring in finance or through the finance ranks. They may be great at marketing or product development or management leadership or there may be scientists, good at research and development and get.

Starting point is 00:50:53 getting approvals and stuff like that. And they just haven't encountered this idea of capital allocation. Likewise, with board members, they're chosen for all sorts of skills, the skills I just mentioned. Maybe they're good at marketing or branding or leadership or coaching. They may be good at helping other fellow executives prosper. They may be good at science, or government regulations or shareholder relations or these days, climate science or cybersecurity and may not have given had exposure to.

Starting point is 00:51:23 to finance or capital allocation. I like warrants meeting. Let's have 12 people say, what's good at one price is dumbed another price. I'd also like them to say, before I take the CEO job, I can state the ABCs of capital allocation. Before I join the board, I can state the ABCs of capital allocation. And it shouldn't be terribly hard. And so I'll stop there, Kyle.

Starting point is 00:51:48 But I think, you know, this question of the repurchase, it's a relatively simple, idea and has been obscured. And the simplest idea is the one he's making there. It's good if you, it's a good investment if you can buy it low. Not a good investment if you buy it. So another problem that we run into, especially this happened a lot during the beginning of COVID, was companies basically just borrowing money to buy back shares. So I'm just interested in knowing, you know, if you were to look, if you were, let's say you were on a board of an imaginary company and the company proposed to do a buyback, what would you look at specifically on a balance sheet to make sure that it would make sense and that you're not putting undue risk

Starting point is 00:52:31 just in the sake of doing buybacks? Well, right. I'd think about the buyback decision as analogous to the dividend decision. And they're both deployments of capital back to the shareholders, slightly different route. One is it's optional with the holders. The other is everyone and gets the payment. But I'd think about whether to do it, or the capacity to do it, and for buybacks, the same way I would about dividends. That is, what would happen? After giving effect to this distribution, do we have, you know, and think about my capital allocation matrix, do we have sufficient liquid resources to not only meet our obligations as they come do, but maintain our existing competitive position and sustain it as we wish to do? And

Starting point is 00:53:21 And do we have sufficient capital resources to seize acquisition opportunities that might come our way or we expect to come our way? So if we have sufficient capital to deploy for those two allocation avenues, then one of these allocation avenues, dividends or buybacks, would be prudent. And then I don't really well understand the idea of, well, let's incur it, let's borrow money to effectuate this. I think this is a question of deploying the capital of its own, not incurring debt in order to do it. One of the most powerful quotes from the book on intrinsic value was, quote, the speed at which a business's success is recognized. Furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage. It may give us the chance to buy more of a good thing at a bargain price, unquote.

Starting point is 00:54:17 So as anyone who follows Berkshire knows that he likes using book value to kind of track the intrinsic value of Berkshire Hathaway. But if we look at other companies such as Apple, which is obviously a business that Berkshire owns a lot, it doesn't quite work out the same way. So, you know, I just did some quick math on it. In the last decade, Apple's share price is appreciated at about 17% compound annually. But book value is actually decreased by a compound annual rate of 0.01%, so it basically hasn't moved.

Starting point is 00:54:47 So obviously in the case of Apple, looking at earnings per share or free cash per share is going to be a better proxy for tracking that intrinsic value of the business. So my question for you is, how does Warren differentiate between which quantitative metrics he's going to use to track the intrinsic value of a company other than, of course, Berkshire athaway? I think he says often in the essays that the ultimate valuation is intrinsic value, which is, it's easy to state. It's the discounted cash flows that the business or the investment will generate from now to the end of time. So, okay, that's easy to say. It's very difficult to map out what those

Starting point is 00:55:26 cash flows are and then to determine the right discount rate. So intrinsic value is the thing, but it can't be, it's unlikely even to people would agree on any given investment that this is the intrinsic value. And so all we have are indirect approximations or tools that can help prove or test one's estimate. And book value is one. You mentioned earnings per share, free cash flow per share or others. We can tinker with all those, make an adjusted book value or adjusted earnings per share or free cash flow defined in different ways or just cash flow.

Starting point is 00:56:04 We could look at market price and could be there at the moment or over a period. And this Munger always talked about having the right tool for the job. He imagined that we all have a toolkit. We have a toolbox with lots of different tools in it and that we need to pick the right one. And so these are valuation tools. And what will be most useful and reliable in an estimation will vary with the business. He had a wonderful joke. He said he must have thousands of times in his life. He said to the man or to the person with a hammer, every problem looks like a nail. And he said, that's a really stupid way to solve a problem. So I think it will be incorrect to think, well, I will always use book value as my tracker or always use free cash flow. Or we'll even say something like, I'll use book value for an old fashioned industrial company and free cash flow for, you know, a modern tech company with no tangible assets. You know, it might be directionally okay, but still you're not quite finding the best tool

Starting point is 00:57:08 for the job. And I think what, you know, with Warren and book value, you know, even for Berkshire, I mean, He still, I think, uses it for lots of purposes, but a few years ago, when it was, and in the essays, he talks about how, you know, look up and telling you like Kyle just did for decades that I'm going to, the first sentence in every annual reports going back to the 70s was our gain and book value or our loss was X. And he stopped doing that. I'm not sure when, maybe five years ago. And he said, don't book value. It'll be useful for a lot of things.

Starting point is 00:57:42 But it's, yes, less useful than it used to be. year because our mix of owned businesses and equities has changed a lot, the accounting that goes into determining book value for those two different buckets are different. And also, we've been doing lots of buybacks, and that's going to actually increase insurance insurance value per share, but decrease the book value per share. So for all these reasons, he said, I'm not going to use that as the primary tracker anymore. It's still useful for lots of purposes. But that tool, you know, So he had to adjust for what purpose that tool is still useful. And so, you know, we can probably go through sort of company by company or investment by

Starting point is 00:58:21 investment and think, well, what is the best tool or how will Buffett determine the best tool for the job? But it is, I think that's probably the key thing, right? I don't think he thinks there is some universal metric for every context, you know. And my own thinking on this is that it's most useful to approach the valuation estimate in a few different ways and then draw some sort of an implicit consensus among them. And then rely on things like, okay, I need to have a margin of safety. Or, okay, I have some reasonable grounds to estimate that there's growth, there's high quality, that there's good corporate governance, and therefore I can pay up.

Starting point is 00:59:02 So I think it is an excellent question. And I think, It takes that whole toolbox. I really loved how you dedicated a lot of pages in the book to retained earnings. So I think retained earnings are one of the most underutilized line items on a company's balance sheet. And that one number tells you just so much about what management is done with the money of shareholders and their ability to create value with that money. So Buffett said many years ago that, quote, the five-year test should be one during the period did our book value gain exceed the performance of the S&P? and two, did our stock consistently sell at a premium to book, meaning that every dollar of retained earnings was always worth more than a dollar. If these tests are met, retaining

Starting point is 00:59:42 earnings has made sense, unquote. So I'm just interested in knowing if you can discuss how Warren has used retained earnings, and he hasn't talked about it in quite a few years. So I'm just interested in knowing, kind of like you just said, with book value. Is he still using that kind of internally in his own mind, but not necessarily sharing it with shareholders? It's a great question. And that passage instantly appears. It's on page 23 of the essays. And it comes from the owner's manual, the Berkshire Pathway Owners Manual that he published

Starting point is 01:00:12 in around 1998, which contains 14, 15, owner-related business principles. It's very short, sweet. It's sort of like a constitution, you know, for a country. So here in the essays, it's just six pages. and it's essentially the first six pages of the book. So that happens, that's number nine. And so I would say to take your last question first, that yes, he still believes this approach or this perspective as a way to test the value of the decision to retain a dollar, I think

Starting point is 01:00:47 my answer would be yes, because I think if he changed it, he'd very, very explicit to change it in here. In fact, he also says in that same passage that, hey, I've been saying, you know, I've been saying, this for decades, but I realized in 2009, it has to be, as you just said, a rolling five-year average. It can't be static because you might miss it, but you should be looking at this over five years. What is getting that? It's a real fun. It's a fundamental thing, like you say, okay, retained earnings or an overlooked feature business because it's inherent compounding, right? The manager is keeping that dollar and it's redeployed, it's not being paid out,

Starting point is 01:01:26 is being redeployed in that business. And so you're going to automatically, you should automatically get some compounding out of that. And so what Warren is saying is the only way I'm going to keep, it's only rap, it's only fair for me to keep that dollar is if I can do more with it, then you can. And that's what he's trying to get out. And then, you know, how do you figure that out? But that's the intuition is we will, and look, he's also defending Berkshire's historical

Starting point is 01:01:54 policy of not paying dividends. It has done a lot of repurchases, and we've discussed that a little bit, but it's never paid, it paid one dividend once 50-plus years ago. So it's got this policy of retaining its earnings. And so in this passage, you know, he's trying, in this constitution, he's trying to say, you know, and I'm only going to do that, I'm only going to keep doing that, is if the company can do better with the dollar than you can. And then he tries to give this two-part test that you'll explain, that compares the, and he's very explicit that he's saying when he measures what I can do with it versus what you can do with it, it's whether you shareholders get at least a dollar of market value, right? And so he compares out of book value to the market premium to our book value,

Starting point is 01:02:44 and he compares it or change in book value to the return on the S&P. So he's trying to have a market reference for his own performance. And to me, just going back to your very first question, the candor here, right on the opening pages, is here's our policy and here's our break point. And what's wonderful about that or what's special about that is not everyone explains that. You open lots of CEO letters and you're not going to have a test at all. I mean, the better ones will at least say, look, there are four different things we can do with the capital. Well, one of them is dividends or buy back the stock and here's how we think. You get some very good companies who do that, but tons of them do not.

Starting point is 01:03:26 And even among those who do, that the breakpoint test that he's giving is far more informative, you know, what you see. But it's a fabulous question. One of my favorite points of emphasis that Buffett talks about when assessing a manager's performance is to look at their achievements, not necessarily in terms of total shareholder return, but in terms of return on equity. When you pair a business that doesn't require much leverage with a manager of a business who has a track record of having a high and sustainable ROE, I mean, that's a pretty clear indication that they're skilled, that capital allocation, which you obviously discussed a lot this episode. So there are businesses that do exist that incentivize managers on capital efficiency metrics,

Starting point is 01:04:08 but it seems pretty rare. I'm interested in knowing, you know, why do you think businesses utilize some of these weaker incentives, such as revenue growth or appreciation and total shareholder value for incentives, which can often misalign, you know, the managers with shareholders? I mean, you might have just hit it that, you know, it takes an owner oriented person or a shareholder oriented person to measure themselves based on the return to the holders. And so I'd like to see more of it. I agree with you, there are own wonderful companies that do pay based on return on equity. or return on investment capital or other metrics that are shareholder level defined. Whereas growth in revenue, I mean, there are shrinkers out there, but many companies will tend to grow without the manager lifting a finger.

Starting point is 01:04:55 And some growth will actually not result in good margins and good returns for the holder. So I think you should be extremely careful about incentivizing growth to growth sake, a combination of a bonus of the growth and a bonus for return on equity might be optimal. Some mix. It depends on the business, depends on its market and its propensity to grow or the desireability of shrinking. So some mix.

Starting point is 01:05:24 But as for why, I think it's an insufficient focus on the shareholder. You know, along the lines we've been talking about, the managers and directors, you know, haven't all come up through the lens of the show. And I think that's gotten even more out of whack in the past five or ten years where lots of other interests are asserting a priority. And I am worried that this problem will get worse rather than better. But I do applaud those who focus on, as you do, on return on equity and like to see more of that.

Starting point is 01:05:59 Lawrence, I want to say thank you so much for coming back onto the show today. I want to hand it off to you, let the audience know, What can they learn more about you, your book? And I also, please feel free to share any public talks that maybe the audience can sign up for for Berkshire, because there's going to be a lot of members, including myself, who are going to be attending that event. Oh, yeah, well, thanks, Kyle. Well, I think the best, this way to get in touch with me is on LinkedIn. I'm present there.

Starting point is 01:06:23 I don't post prolifically every day, but I put ideas up there and have conversations and followers. And so that's probably the easiest way. And there are some of my stuff for the book. So here, here's a picture of it. I've got my dog ear, too. So you want a dog ear, and for that, you can buy it anywhere, and I don't need to single out a particular retailer. But Amazon has this book and has other books, including Dear Shareholder that Kyle mentioned.

Starting point is 01:06:51 So feel free. Connect with me on LinkedIn, visit the books. I was on a show. Another interviewer recently said, Larry, it looks like he's written, what, five books. And I said, well, I've written 20, but five of them are good. And so this is the best one. And it's because it's mostly not me. It's mostly Warren.

Starting point is 01:07:13 And I just rearrange it. So, and visit Amazon to pick it up. I will be at the Berkshire Hathaway annual meeting in early May, 2024. I've been to most of them for past since 1996 or seven when I first went. It's gotten bigger every year, more interesting. The first one was, I think, when I first went, six thousand people in a basketball stadium. Last year, I mean, 35-ish thousand in a rock arena. And all the related activities have also blossomed.

Starting point is 01:07:46 So back then, I was the first person to sell a book at the Berkshire Hathaway in your meeting. It was the essays. It was Warren's idea. He invited me to come with my nephew. And he said, you should bring some books. You can set them off outside the jewelry store where shareholders gather and sell them. I did. And now lots of things are sold at the first year-hand-way annual meeting from cowboy boots to Coca-Cola's and lots of books.

Starting point is 01:08:14 And so I will be at the good place to say hi to me if you'd like. I will be at the bookworm. That's the bookstore that it has a concession inside the annual meeting. It will be open Friday and Saturday, and I'll be there almost all day. Saturday in and out of the meeting. So please, please say hi. I'd be happy to, he sells books in a discounted price. I'll be there signing copies of this one. For those who are coming, if you got another minute, for those who are coming a long distance, you're out of town and get into Omaha on Thursday, which will be a lot of Australian guests and from the east.

Starting point is 01:08:50 There is a wonderful annual event called the Berkshire Summit that's hosted by Bob Miles, a friend of Berkshire author, great guy, and he's the empressario of this gathering where there's a different theme each year. This year, the theme is going to be Charlie Munger, who passed away in November, so tribute to his life, his contributions to Berkshire. So I'll be speaking at that on Thursday morning, get in touch with Bob. I'm in a lot of other events over the weekend, so I'll be around. So feel free to say hi if you've been with Kyle and are inclined to say hi. I'd be happy to Speak with you. Okay, folks, that's it for today's episode.

Starting point is 01:09:33 I hope you enjoyed the show, and I'll see you back here very soon. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. 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.

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We Study Billionaires - The Investor’s Podcast Network - TIP621: Warren Buffett’s Wisdom: The Power Of Corporate Governance with Lawrence Cunningham

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