We Study Billionaires - The Investor’s Podcast Network - TIP635: Deep Diving Into The Warren Buffett Way w/ Robert Hagstrom

Starting point is 00:00:00 You're listening to TIP. Robert Hagerman is one of the most knowledgeable people on Warren Buffett that I had the pleasure of chatting with. While all of his books on Warren Buffett are must-reads, it's hard to top his most iconic book on the Oracle of Omaha, The Warren Buffett Way. Robert recently released the fourth edition of the book, and he added many great insights into the latest edition. I wanted to break down some of the books most valuable and essential concepts for listeners of the show. So we dove deep into Warren Buffett's first air as an investor and how that has affected him today. We looked at how Warren repeated a mistake on the Dexter shoe acquisition and the consequences

Starting point is 00:00:34 of that mistake. Since Robert has so much knowledge of Berkshire stock, I wanted to find out why other insurance businesses don't leverage their float like Berkshire has. We also touched on some of the outstanding research on outperformance, especially as it relates to portfolio turnover and concentration. Robert brought up one profound point about Warren Buffett. Warren looks at stocks as abstractions. And Robert went into some excellent details about why this is such a decisive advantage

Starting point is 00:00:59 that Warren has deployed over the years. Another aspect of investing that has always fascinated me is how investors can have so much success beating the market while also failing to beat the market 50% of the time. Robert has done some outstanding research into this area using some of the greatest investors from history. And we got into some details about why short-term underperformance can be so powerful as long as we look many years into the future. Another theme of this conversation is how Warren has upended the status quo in the investment

Starting point is 00:01:26 industry to his advantage. The industry at large pays so much attention to things like interest rates, macroeconomics, geopolitical risks, treasury yields, and other factors that Warren's aware of, but doesn't spend too much time thinking about. Robert would say that Warren spends most of his time thinking about the businesses he owns, not the macroeconomic trends out there that may impact his businesses only on short time horizons. So, if you enjoy learning from Warren Buffett and why he thinks so differently from the investing industry, you're going to love this episode. Robert does a wonderful job of breaking down many of Buffett's strengths and weaknesses and provides very useful advice

Starting point is 00:02:01 that any investor, from novice to expert, can use to become a better investor today. Now, let's jump right into this week's episode with Robert Hagstrom. 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 influence 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 on Robert Hagsrom to the show. Robert, welcome to the podcast. Kyle, great to see you. Glad to be back. So I first got the chance to chat with Robert back in October of 23. And we had such a good conversation where we just talked about a bunch of your books, some that

Starting point is 00:02:59 did relate to Warren Buffett, and some others that did it. So I was excited when I got my hands on a copy of the fourth edition of the Warren Buffett Way, which we will be going in depth on today. I want to kick off the conversation by discussing some of the lessons from Buffett's first ever investment, which was City Services Preferred. So this investment taught him the importance of one of his greatest attributes, which is patience. So I think Buffett probably already had the makeup of patience at this time, but he hadn't had the opportunity to express it in the stock market as this was his first experience. So I'm interested in knowing a little bit more about if you think Warren has learned his most valuable lessons from his own mistakes, or if he's

Starting point is 00:03:36 learned them from learning from others? Well, I think it's a combination about Kyle. I think, you know, some of the, you know, you learn from your mistakes, but hopefully you're learning how to be successful from others. I mean, his dad was a stockbroker, you know, and we can fast forward, you know, 10 years and Ben Graham, we'll do that, I'm sure, later in the show. But clearly, I think the lesson that he learned at City Services Preferred was the mistake that he was forced to make because he had pooled his money with his sisters,

Starting point is 00:04:05 Doris and Bernie, and to buy some city services preferred. I think you bought three shares. You know, the stock is 100, 111 bucks or something like that. And it subsequently started to go down in price. And his sisters were just losing their mind. Just, you know, this is terrible. I can't believe you've lost all our money. And they're, you know, like today's equivalent of how the clients treat their financial advisors

Starting point is 00:04:26 from time to die, have just totally lost her mind. Now, never mind that we're in the middle of World War II. And, you know, as Warren said, the front page of the newspapers never had good news. And the market was dealing with, you know, the outcome of the war and stuff like that. But he said he finally just basically had to buy, you know, had to sell the stock because he couldn't take the harassment anymore from his sisters. And he made just a little money, not a lot. But had he held on it to it for, I think, another year or two years, he probably would have tripled his money. And I finally just said to him, you know, I can't live like this.

Starting point is 00:04:58 I can't people either yelling at me and screaming me about it, or, you know, he said, you know, I was a capitalist at a young age. His dad being a libertarian, a congressman, a big believer in the United States of America that, you know, don't bet against America in the long run. It's going to work out. I think that was deeply grained into his psyche, even at that young age. And so I think, you know, patience was something that he learned early in life, even though he didn't have the methods from Graham yet. But he did learn that, you know, just hang in there and eventually everything will be okay. That was kind of the first lesson. One of Warren's biggest mistakes other than buying the original Berkshire Hathaway textile mill

Starting point is 00:05:38 was Dexter's Shoes, a business that he bought in 1993. So when I first researched some of Buffett's mistakes, this one really stood out to me just because not only was it not necessarily a good investment, but he also used Berkshire stock to purchase it. My most significant insight from this one, this mistake was that whenever you buy company, you should be trying to ensure that the business can't be decimated by low-cost competition. But there was an excerpt from your book discussing the Berkshire Textile Mill in the 1980s. And it also talked about how the Berkshire textile mail was actually getting a little bit worse.

Starting point is 00:06:10 And that was also due to foreign low-cost competition. So in some ways, Warren kind of made the same mistake twice with the Dexter shoe acquisition. So I'm just interested in knowing a little bit more about how you think he's fared since then in terms of, you know, not repeating similar mistakes? I'll let you ask for in that question. I don't want to bring it up. But you're right. I mean, the way that which you phrased the question, having that painful lesson of

Starting point is 00:06:35 Berkshire buying the textile mill. And it was very painful for him to, you know, finally shut it down. You know, he said, you know, as long as they can at least earn a modest amount of profit, you know, I won't shut it down. But neither will I fund it from the profits of other businesses at Berkshire to keep them alive. And eventually it just got to be to the point that it was just a money-losing operation. So, yes, he would say the first mistake was buying Berkshire itself.

Starting point is 00:07:00 That was a bad business, as Charlie Munger pointed out, and Warren Bormley wrote about Charlie in this year's annual report and the tribute to Charlie as the architect, like, now that you bought Berkshire Hathaway, never buy a company like this ever again. But you're right. I mean, Kyle, very good observation. You think about Dexter Shoe. And the double pain or the double slash on the back was not. not only did he buy a bad business, but he used Broxcher stock. And that is a double,

Starting point is 00:07:26 painful whammy. I don't know. Kyle, you've asked a very good question. I don't know. Obviously, he must have had pressure from the owners of Dexter Shoes that they didn't want a capital gains transaction, so we'll take the stock in kind, which worked out swimmingly well for them. I mean, they became very rich. Helped Berkshire stock, even though Dexter Shoe went to a zero. But you're right. Good point. I mean, you know, foreign competition for the manufacturing of shoes versus, you know, making shoes. here in the U.S. You would have thought he would have seen that one. I don't have a good answer, but you have a very good observation.

Starting point is 00:07:58 And it's even more when I think back to Berkshire and Warren's talk about this before, he said, instead of rolling the $25 million into Berkshire Hathaway, that then subsequently bought National Indemity, of which, you know, I owned less than 40% of the business. Just think if I would have rolled the $25 million into national indemnity and never owned Berkshire. And I would have had 100% of national indemnity, what kind of world that would have turned into. So very good observations. I wish I had a good answer for your audience, but I don't know. You might just say, you know, he missed on that one. One question I had for you, seeing as you

Starting point is 00:08:31 obviously studied Berkshire in a lot of detail, is on the insurance float area of things and using insurance companies as kind of an investment vehicle is just because, you know, that float in the right hands, like with Warren Buffett, it's just like magic, right? But a question I've had is, why don't more insurance companies take advantage of hiring like a really, really good investor to manage their float? Because it just seems like such a home run. But it kind of seems like a lot of them are just investing in bonds or other assets that are barely beating inflation.

Starting point is 00:09:04 So I'm just interested in getting your insights on that. Well, yeah, and you think about Lou Simpson at Geico doing the same thing. My first answer when I thought about the question was, you know, the mismatch between when you have to get a premium and when you have to pay. a claim, sometimes you can't. The time horizon is not such that, you know, you can put money to work in the market for a year or two if you're already paying out claims and so you've got to keep it liquid. But I think maybe the better answer of how Lou Simpson did that at Geico and how Warren has done this is that the cap, the capital ratios at Berkshire were just so phenomenal that

Starting point is 00:09:37 the insurance regulators didn't require them to keep, you know, 90% plus and liquid overnight paper to play claims. The other thing, too, in Berkshire being different than Geico, particularly national indemnity in the sheet is the long-tail super cap policies that don't have to be paid out for three, four, five, six, seven years. So in that situation, obviously a premium income that doesn't have to be paid out for at least five years or more, that would be ideal for the stock market. So then the question then becomes those that are in that business, you know, if their capital ratios are strong enough to allow them to invest for five years, why aren't there more, you know, Warren Buffett-type investors and insurance companies? And that goes to the Charlie Munger quote that, you know, if we're so right, why are so many intimate places so wrong? Why aren't other people doing that?

Starting point is 00:10:26 And that's a phenomenally great question because it's very clear not only the Berkshire approach, Warren's approach, Charlie's approach. It's now called high active share investing. We called it Focus Investing when we wrote the Warren Buffer portfolio in 98, but now the academicians got a hold of it in early 2000. I think it was Martin Kramer's and Pettigusto at Yale University that quantified what focus investing was now called high active share. And high active share investing is a predictor of future performance and that you have to be different than the market to generate returns different from the market. Then they subsequently went on and discovered of the high active share portfolios.

Starting point is 00:11:04 It was the low turnover portfolios that were the very best high active share. So you have the method, you have the architecture, if you will. high active share low turnover portfolios have the highest probability of general random returns and excess of the market. Then how come they're not more high active share, low turnover portfolio managers? And this is a big puzzle. We tried to answer it the best we could. There just weren't that many that were raised under the principles of what Warren was doing

Starting point is 00:11:34 when modern portfolio theory, which was emitted in the 1950s with Markowitz and refined by sharp in the 60s. You can go to Eugene Fahman in the 70s and 80s. Modern portfolio theory was really just academic type thinking until the 73, 74 bear market. And then when everybody blew up the bear market, value investing actually wasn't being taught then at Columbia. There was a void.

Starting point is 00:12:00 And people were really decimated people who had retirement savings. We're wondering if they could retire, we'd market it down 50%. And people were looking at each other going, what do we do? do? And these academicians from the ivory towers raise their hand and said, hey, I've got an idea. What about low price volatility? Lots of diversification. So if anything goes wrong, you don't have all your eggs in one basket. And we'll do quota reporting and that we'll show you exactly what your portfolio is worth every three months. And that took over the money management business in the early 1980s at the beginning of the big bull market. And we created, you know, the standard of investment

Starting point is 00:12:39 management of principles of modern portfolio theory. And that became the edifice, the Leviathan, if you will. And from that, we just didn't germinate a lot of Warren Buffets. They're just, you know, we know a few of them, you know, they're well recognized. We know their firms, but as a percent of the total money managed and money management and the total number of people, the percents are so small, it's baffling why more have not reproduced and had a lot more. It's a wonderful question and even Charlie was mystified by it. But I think, you know, it's kind of quixotic to kind of fight the windmills of modern portfolio theory to say, you guys are crazy. This doesn't work and you guys are losing money. That's why people are indexing and going

Starting point is 00:13:23 to alternatives because you can't beat the market. I think S&P just finally came out with the new data. 93% of all active managers can't outperform over five years. Yep, but they still stay in business. I don't know how they, you don't outperform for five years, but you still stay in business. and they should go away, right? They should shut their doors and go away, but they somehow find ways to stay in business. But the more perplexing part is why we haven't replicated more Warren Buffett's and Charlie Mungers. Answer may be, Kyle, you and I have talked about that is the temperament required

Starting point is 00:13:56 to run these high, active share, low turnover portfolio is a temperament requirement that is beyond the ability of most people to have patience, to suffer through periods of underperformance. When we looked at the high active share managers and the Warren Buffett Way, and this goes back to Sequoia Fund and Lou Simpson and Charlie, you could go back to John Maynard Keynes, who ran the chess fund.

Starting point is 00:14:21 Phenomenal long-term track records, but their batting average was about 50%. You know, they outperformed month to month, quarter to quarter, year to year, only 50% of the time, and the other 50% of the time, the underpreas. And, of course, when I say this, people say, well, how did you beat the market

Starting point is 00:14:36 for five or ten years if you underperform half the time. And the answer is, that's the difference between frequency and magnitude. It's not how many times you beat the market, less how many times you don't beat the market. It's how much money you make when you beat the market, less how much money you give back. And so when you make money as a concentrated big bet portfolio, you make a lot of money. And if your valuations are good when the market is against you, you're just not giving it back wholesale. So the net difference between those, is your excess return. And that seems to be academically proven.

Starting point is 00:15:10 And we know that. But then the psychology of being wrong half the time on a month-to-month quarter-to-quarter basis, as we know from Danny Kahneman and Amos Tversky's prospect theory, that that unit of not beating the market for the quarter of the month is twice as painful as the unit the next month, the quarter, when you do beat the market. And so you're in a constant psychological impaired position running high active share. portfolios, the rational, logical people understand it and move through it, those that don't really have the rationality to their back get whipsawed by it. So it's a combination of a lot

Starting point is 00:15:50 of things, but the proof is in the pudding. It still stuptifies me that they're not a ton more Buffett-like money managers out there. It's funny, too, that you mention, obviously, those tremendous track records of people that I love following, especially John Maynard Keynes, who's very underrated. But it's funny also when you also add the psychological impact of managing other people's money to the fact that when you do have a concentrated portfolio, your long-term results are probably going to be really good, but you also have to deal with the personal aspect of having people that you have to talk to being like, hey, what happened this, what happened this year, what happened this quarter? Yeah, and that alone is, I'm sure, very, very

Starting point is 00:16:30 painful. Yeah, I worked with Bill Miller for 14 years. So if you kind of think about the writings of Warren Buffett, it's kind of like I did my PhD dissertation, you know, kind of went to grad school and wrote a PhD dissertation. The other half of my experience, though, was actually the practicalities, you know, actually being in the hospital with Bill Miller working on patients, right? And here's a guy that had a phenomenal track record. And, you know, when I joined him, I think he would, had beaten the market six years, seven years in a row. And as kind of a newcomer on the team, I acted as a portfolio specialist. So I was running a growth portfolio as a retail fund, but Bill wouldn't let me run it

Starting point is 00:17:08 institutionally until I had a five-year track record at Lake Mason. So most of the time I spent, I was managing the growth mutual fund, but at the same time, I was out on the road helping Bill with his institutional accounts. And these, you know, institutional accounts, consultants, very smart people, go to grad school. stuff like that. And so you got a guy that obviously knows what he's doing. He's brilliant, writes brilliantly, has performed brilliantly. And it seemed like, you know, if he had a bad month, bad quarter, you're sitting there trying to explain why is Bill wrong? Bill's not wrong. You know, the market gravitates for a lot of different reasons other than arbitraging price and value.

Starting point is 00:17:46 There are a lot of reasons why stock prices move. But you're right, even at the institutional level where you think they are above the individual irrationality level, they still had the same pressure points. We're underperforming. We're behind the benchmark. And I'm like, you guys are just, of course, I couldn't say that, but you just kind of look at them and go, you really are in charge of these multi-billion dollar plans.

Starting point is 00:18:09 And these are the decisions you're making. You just kind of shake your head and go, God, no wonder, this is a mess. It is a mess. I enjoyed how you mentioned more about the history of Buffett's investing philosophy. in this edition. So you wrote, quote, all of these separate components, your view of the market, your methods, and your temperament as an investor reflect the totality of your philosophy of investing, unquote. So we could easily probably spend an entire conversation discussing this one quote,

Starting point is 00:18:35 but we won't. However, I do want to dig into one point, which is your view of the market. Buffett learned a lot about this view of the market from Benjamin Graham in his book, The Intelligent Investor. This approach is obviously much different that is taught in higher education, which you kind of just pointed out. But I'm also interested in learning just a little bit more about what differentiates Warren Buffett versus the majority of people in finance. I think where I think Warren had the benefit that he was able to lever into this long-term track record is that he did two things.

Starting point is 00:19:10 One is that it resonated with him when Ben said stocks were businesses and we're trying to buy businesses at cheap prices. Ben didn't say we're trying to buy great businesses at cheap prices. We're trying to buy this business at a cheap price. And as Warren said, as soon as I figured out that what Ben was saying is, we're going to buy a dollars worth of value for 50 cents, I got it. And I ran with it. And so early on at 19 years old, he said stocks are just businesses. And I think it was Graham that said in the intelligent investor that the moment you buy a common stock,

Starting point is 00:19:45 you have a choice, instantaneous choice. you need to decide to be an owner of that company, which legally you are now an owner of that company, or you just hold a piece of paper that you can trade moment to moment, week to week, month, and you can decide which one you're going to be. Well, Warren chose the formula, which is, you know, I own a business and, you know, I'm going to hang on to it for a while. And I think that was hugely important. Then, let's layer on top of that, the actual experience when he put Brookshire

Starting point is 00:20:13 had the way together of both having privately owned businesses. You know, go back to Brookshire Hathaway, you can then talk about the insurance companies and go to Nebraska Furniture Market and sees candies and Buffalo Evening News and on and on and on. He owned these companies. They didn't have common stock prices. He owned the businesses. And he intellectually thought about those businesses exactly the same way he thought about owning Washington Post or Cap Cities or Geico or, you know, go on down the list, Coca-Cola. for him, the mindset, the telescope of how he thought about it was identical.

Starting point is 00:20:51 So he didn't say, I own these businesses over here, Nebraska Furniture Martin Seas Candy, but I also own Coca-Cola. So I'm going to analyze Coca-Cola differently than I do Nebraska Furniture Martin C's candies. So I think there's a quote that you and I've talked about, that Warren thinks that stocks are really an abstraction. Common stocks in and of themselves are really abstractions. He doesn't think in terms of common stocks, sectors, correlations. He doesn't think about stock market theories.

Starting point is 00:21:20 He doesn't think about macroeconomic concepts. He just thinks about the business. Now compare and contrast that with an institutional money manager. All they do is think about stocks, common stocks. They think about the beta, the variability, and the information ratio, and all this nonsense, right? And they're worried about what sectors they're in, what they're not in, the correlations, you know. They've got all these theories about the stock market, which tells them what they should overweight

Starting point is 00:21:45 and underweight and God, they're all into macroeconomic concepts, predicting what the economy is going to do, is going to tell you what the stock market is going to do, which tells you what sectors can be in and which I, Warren does zero of that, zero. And so at the end of the day, I think his competitive advantage is that he does none of that. He has purposely, purposely divorced himself from everything else that consumes 99% of the people that invest in the market. It's his purposeful detachment from the stock market. that has allowed him to behave so rationally over these last 50, 60 years. And that behavior is the source of his accessory terms.

Starting point is 00:22:24 And so when you think about it in those terms, getting into that mindset early, and then having it perpetuated by both owning private companies, simultaneously with public companies, and decided to treat them exactly the same, that's the golden sauce. That's the golden egg right there. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future.

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Starting point is 00:26:49 All right. Back to the show. Moving on to Warren's father, obviously you mentioned him as being a pretty massive influence on him. One of his biggest lessons, sorry, that Warren learned from his father was that nothing can bring you peace

Starting point is 00:27:04 but the triumph of principles, which I think is a wonderful little quote there. And as we look at Warren's evolution, as an investor, I would say this has definitely held true. But he has obviously had this significant evolution in his investing strategy from when he was younger and he was a grahamite moving from cigar butts to moving more towards the quality end of the spectrum. So I'm just interested in learning your opinions a little bit more about how he made

Starting point is 00:27:29 this transition while also staying true to his overguiding principles. Let's start. There's two pieces to that. If we unpack it, the first part is his dad, Howard Homan, but, as I said, was a libertarian. He was both a teacher, too. I mean, he taught in Sunday school. He volunteered for the school board. You know, he was a teacher by being a congressman.

Starting point is 00:27:49 But he was also deeply influenced by the philosophy of Rao Paulo Emerson. He was an Emersonian. And if you go back and look at Emersonian philosophy, probably the most celebrated essay was self-reliance. So in the book, we kind of walk through self-reliance step by step. And when you do that, you actually see Warren Buffett every step of the way. Independent thinking, right? It's not what the community thinks is what you think, your principles, not with the, you know, it's what he was talking about the community. Warren says it's not the stock market, right? It's your principles, not the stock market's principles. People are going to tell you what you think you should do. Don't listen to them. Do what you think you should do. That was all powered by his dad, Howard Hoan Buffett. And I owe a nod to Roger Lewinstein, who wrote a great book, Buthett, Making American Capitalists, that came out in the spring after Warren Buffett way came out in 94 and was also in New York Times.

Starting point is 00:28:40 a great book. Rogers, a wonderful writer. And it was Roger that basically helped me make that connection because he talked about. It was the sweet philosophy of Emerson, Emerson, that led to Warren's principles of self-reliance, if you will, right, which is the cornerstone of self-confidence, which is what you need to have in the market to operate independent of what the market's doing. So we spent a lot of time going through all of that. And you can see that had you been 10, 11, 12, 13, 14, 14 years old. And every night, remember in the 1940s, there are no video games. There's no cable TV. It wasn't even TV. It was radio, occasional Saturday movie, if you got lucky, but the rest of time you're reading. And when you got to the table, you talked. And so here's his dad, a wonderful

Starting point is 00:29:27 teacher, just pounding his son on Emersonian philosophy and libertarianism. And it's the self. The self is what governs you, not the community. And so that was in bred in him, really, really at a young, young age. And I think that was his backbone that allowed him to make these moves. And then, you know, as you kind of go, the aggravation of owning Berkshire Hathaway and then Dempster Hill manufacturing and the department stores that were all bought under the principles of Ben Graham, low price, low price to book, low price to earnings were cheap businesses, but they were bad economic returning businesses. And it was Charlie, as Warren testified in the to report this year, whose insistence that they buy seeds candies, which violated every single

Starting point is 00:30:14 principle that Ben Graham had ever said. By the Graham principles, Warren should have never bought Seas Candy. But, you know, Charlie Bobby Brown beating down, and he paid three times book value. And it became, I argued in the book, probably became one of the most dollar for dollar, the most profitable investment that he'd ever made. The light bulb then goes on, right? It's like, wait a minute, I bought something here that didn't comport to my mentor's process of methods of buying stocks. And this thing was a home run. And he began to think about, as he looked at his companies, it's the cash that comes out. And, you know, what do you do with that cash?

Starting point is 00:30:51 And the cash that was coming out of Berkshire Hathaway and Dempster Hill Manufacturing and the retail store, there was no cash coming out. They were broke every year. So there was no money to take out of those bad businesses to go buy other businesses, where C's was gushing cash. And with that money, he could go buy other businesses that were gushing cash that could allow him to go up by other businesses with gushing cash. So that tangible, real experience of owning a company that did that. Then he looked at Coke and he said, this thing is gushing cash. Roberto Gazzietta had showed up, changed the economics of the business after Paul Austin almost drove it into the ground. And he was buying back stock and it was raising the dividend and cash just kept flooding out.

Starting point is 00:31:32 And so, you know, it's been argued, and I think it's true that the lessons he learned from Seas Candy got into Coca-Cola and American Express. And there's some that argue that same cash gushing phenomena at Apple is what turned doing on. Remember, in the last 10 years, Apple's bought back half of its stock. It's reduced its share count by 50% on the way going from $600 billion to $3 trillion. And you bought back half your stock. that's a lot of cash coming out of there. So that always, that goes in my mind all the way back to seize candies. So I want to turn to some of Buffett's learnings on intrinsic value as he evolved.

Starting point is 00:32:12 So when he was a pure grahamite, you know, intrinsic value was essentially just a benchmark to reach that would trigger the sale of an asset. But as Buffett began scaling up capital, he realized that holding businesses where intrinsic value would continue growing were a better option for them than just, you know, finding something that wouldn't grow. It's funny because his success with the Graham approach kind of necessitated him moving on from it, as it was just no longer an effective strategy as his capital grew as well. A lot of these opportunities he was looking at were small, right?

Starting point is 00:32:41 And just it wouldn't work with a lot of capital. So I'm just interested in knowing what were some of Buffett's other well-known aspects of Graham that maybe he had to ditch as he began scaling up his capital? And at Ferranet Graham, he gave him a temperamental foundation, which we could talk about, but also a methodological foundation, which was absent. You know, Buffett actually was a chartist. He was doing technicals and stuff like that until he read the intelligent investor. And finally, that was the epiphany.

Starting point is 00:33:07 And he applied it to the Berkshire, I mean, to the Buffett partnership from 56 to 69, with great success, which, you know, gave him financial independence, financial security for his family. And then obviously gave him the resources that he eventually was able to take control of Berkshire Hathaway. So to say that Graham wasn't a big, huge part of his success, you know, it played a very big role for a period of time. You rightly point out, Kyle, that as the asset base got higher and bigger, moving money around a lot, because in the Graham approach, once you got to fair value, you had to sell and move on. Fair value being you were trading at book value or you were trading near the market multiple. and having bought it at a discount to the market multiple or a discount to book value, you are of that until it got to Graham's definition of fair value, and then you had to move on. You had to sell it and buy something else.

Starting point is 00:34:02 Well, as you're working with bigger and bigger sums of money, this kind of high, this high, not high trading, but often need to buy and sell things was impractical for him at Berkshire Hathaway. And, you know, he finally learned that buying and holding an immediate. company over times gives you mediocre returns. And so if I can't buy and sell them, as I did in my partnership years, and I got to buy and hold. You know, Seas Candy taught him buy and hold good stuff. Of course, National Indemity was teaching that at the same time. The water was dripping down on him. Like buy and hold good things that generate a lot of cash and you'll be in pretty good shape. So then he was definitely moved on from Buffett's methods of

Starting point is 00:34:46 picking stocks. But the two parts that are still today ever present, chapters 8, chapters 20, and the intelligent investor, one is the margin of safety, buy something for less than it's worth, calculate its intrinsic value, buy it at a discount. He goes, today those are the still the right three words, margin of safety. And then in chapter 20, you know, it was the temperament of the market. You know, distancing yourself, a purposeful detachment from the market. The market It is not your boss. It is there to serve you, not guide you. And those two parts are still the cornerstone of its philosophy.

Starting point is 00:35:23 And those are Graham principles. So you could say Graham still carries a very big arc of influence on Warren, but it's now been reduced to buy value at a discount, margin of safety, which was there in 1934, and how to think about the stock market from the temperamental standpoint, which was there in 1949 in the intelligent investor. So it carries a lot of way. Then the question then becomes what happened after that. You and I have talked about the influence of Phil Fisher.

Starting point is 00:35:53 Fisher was not methodologically about the quant side as Ben Graham was. He was looking for great companies run by great managers. So he was more on the fundamental side, things that were not easily quantifiable, but if you bought a great company run by a great manager and held onto it for a long period of time, usually something good happened to you. The compounding and holding of great businesses was Phil Fisher's reward. And so Warren slowly was merging these things together. The quote that I think is misunderstood is in the 1960s, he said,

Starting point is 00:36:29 I'm 85% Graham and 15% Fisher. And that's a quote that has been used often by times, but you've got to put it in context. That was before he bought Seas Candy. You know, if you would have said, what's that quote after he bought seized candy? It might have been 50-50. Today, it might be 50-50, which is business and management matter a lot. The kind of business that you're in, future prospects of the business that you're in,

Starting point is 00:36:53 is it favorable? Do they earn above the cost of capital? Do they increase shareholder value? Those aspects of business that Graham never talked about are important, just as it's important that management rationally allocate the resources in the company, back to the company itself as opposed to themselves or making stupid acquisitions for the sake of enlarging the corporate edifice. So management and the type of business started to write very, very high and the compounding

Starting point is 00:37:21 of this well. So I would argue today, if you would say, I think it's more 50 RAM, 50 Fisher. But even that, you know, where do you put Charlie? And I'd probably put Charlie in the Phil Fisher camp, who was the actual proponent. the actual practicality of the Phil Fisher philosophy. Charlie was probably more akin to Phil Fisher, and the types of stocks that he bought were more like Phil Fisher stocks. Charlie didn't have a lot of Ben Graham stocks.

Starting point is 00:37:47 He didn't have bad businesses that were cheap. He had pretty decent companies, and those that he held, compounded at the high rate. So you've got to put Charlie in that Phil Fisher bucket. And then it tips maybe more than 50-50, buying Charlie and Phil Fisher together. That's a pretty big bucket. It's a big bucket. So you wrote a fascinating point that you kind of actually touched on a little bit earlier about how Buffett looks as stocks is an abstraction, but I just want to say this quote.

Starting point is 00:38:14 So, quote, for Buffett, stocks are an abstraction. He doesn't think in terms of market theories, macroeconomic concepts, or sector trends. He makes investment decisions based only on how a business operates. So you kind of did a really good job of talking about that abstraction and why he thinks of it. But I want to actually just invert the question and ask you if you think there's any potential downsides to looking at a stock the way he does as an abstraction. I'm just interested in knowing your opinion on that.

Starting point is 00:38:41 Only in the short term, because there's still enough people that are still looking at stocks as these abstractions of beta, information ratio, correlations and stuff like that. The game is short term. And there are people that play the short term game. It's embedded in modern portfolio theory. It's practiced largely in the standard approach to investment management, that people want smooth returns, non-quorative returns, conservative returns, but they want consistent returns. All those things are important. You would say, you know, market theories and macroeconomic

Starting point is 00:39:15 concepts, it stuptifies me that people still feel the need to embrace or at least are attracted to these concepts, where we already know scientifically proven, that there is no model, no individual, no model that can predict complex adaptive systems. Because of the Santa Fe Institute, Bill Miller introduced me to add in the 1990s. The Nobel Prize winners out there, they will tell you there is no science on this planet Earth that can predict the behavior of a complex adaptive system, three months out, six months out, nine months out, nine months out, 12 months out, much less you might argue overnight. Still, people are obsessed with talking about it, thinking about it, believing in it.

Starting point is 00:39:59 And I, once again, these are one of the things like, why is that psychological need? I think the idea that you are willing to say, I don't know what's going to happen tomorrow, but it's not important to my investment process because I have a good business, right? I don't know if the economy is going to grow fast or slow. I don't know if the stock market's going to go up or down. I don't know what the geopolitical outcome is in the Middle East from Ukraine. Nobody knows. We don't know.

Starting point is 00:40:24 And absent that, you go, well, what are you going to do in the stock market? But I would say, well, whatever happens, I want a good business. So if the economy is accelerating, what do you want? I want a good business. If the economy is going into recession, what do you want? I want a good business. If inflation is going up, what do you want? I want a good business. I don't a bad business. I want a good business. If we get into a geopolitical world, what do you want, I want a good business? Almost in every outcome that you come up with that can be bad, what is the best solution? I want a good business. The only time someone says, I really want to own a bad business is that if you think you can sell it real quick, I buy it now and I sell it pretty

Starting point is 00:41:02 quick. But this psychological need that I can't operate without having some grasp, even though it's obviously bleeding, that what's going to happen tomorrow next week, next month, just people spend 80% 90% of their time on these things they can't predict and on things that have nothing to do with business value? Warren Buffett spent 95, 99% of his time on nothing but business. Just think about that. He does nothing but think about businesses. And hardly ever about the stock market, only glancing at it every once in while to see if it's done something foolish that allows him to take advantage of a misprice

Starting point is 00:41:39 in the market. And we, the majority of we, spend 90-some of our percent, what are we doing, pontificating about the market, pontificating about the economy, pontificating about geopolitics, the presidential politics, who's going to win? Who cares? Does it matter? whatever the outcome, what do I want? I want a good business.

Starting point is 00:41:59 That simplifies your role pretty quick. But as you well know in this business, out of 10 phone calls you get, nine of them are going to ask you those questions. So you're not going to have a long career if you don't at least contribute something to it, even though I say to them, I have no idea, but you might think about it this way or that way. Well, what are you doing, Robert? I'm going, I'm buying good businesses.

Starting point is 00:42:20 That's all I'm trying to do, just buy good businesses. It seems pretty simple to me. So before we go to the next question, you've actually mentioned something, the information ratio twice. So just for listeners who might not know what that is, do you mind just quickly explaining what it is? It's just, yeah, it's a stupid term that came out of modern portfolio theory that basically looks at the volatility, the return of the stock to the actual return of the stock. And if the actual return of the stock is higher than the volatility, then you have an excess return that shows up in the information ratio. the higher the information ratio that you have, it is perceived that you've made a smart calculation that rewarded you beyond the volatility.

Starting point is 00:43:01 You know, efficient market hypothesis would say that, and, you know, there's still people that believe in that nonsense, but basically say, you know, if you bought a high beta stock and you had a high return, it was only because you bought a high beta stock. But information ratio says you bought a high beta stock, but you actually got a return that is even higher than what the volatility would imply that you got from. the return. There are people that actually pay a lot of attention to that. Warren doesn't. I don't even know. I don't even think Warren knows how to define it. Yeah, and we'll actually be covering that question on that in a little bit. So, but yeah, let's get back to it. So you made a really

Starting point is 00:43:35 good point about Buffett and his evolution towards Philip Fisher. So obviously, you know, you've already talked about how a lot of moving on to Philip Fisher was kind of moving on to the qualitative end of investing and, you know, relying less so on the quantitative end. And, you know, relying less so on the quantitative ends. But, you know, if you had to really distill Warren's biggest takeaway from Philip Fisher, you know, what do you think that one thing would have been? Well, actually, you know, the famous term circular competence actually originated from Phil Fisher. And that was in his 16 points. He has 16, if you go to the book, Common Stocks and Uncommoner Profits, he has lists of points. That's his checklist. And one of them is just

Starting point is 00:44:14 stick in your circular competence. And know what you know and know what you don't know and stick with what you know. If you don't know something, you're not going to do a good job analyzing it. And when the price deviates, because you don't know a lot about it, you'll never know if you're right or wrong. And then the game's up,

Starting point is 00:44:27 the gigs up. If you've locked the self-confidence, am I right or my wrong, gigs up? What was the famous quote from Warren Buffett? If you're a poker game for 20 minutes, you don't know who the Patsy is. You're the Patsy, right?

Starting point is 00:44:39 Well, the market's the Patsy and Warren's like, the market's like the market. I know who the Patsy is. The Patsy is the market. It's going to make some dumb bets, right? It's a sucker on the other side of the poker table, right? I'm just waiting for them to make a wrong bet with the cards that they have in their hand. And I've got a pretty good idea what the cards are, and they're going to make a stupid bet.

Starting point is 00:44:59 And then I'm going to bet contrary to that. So I think, you know, circular competence is real good. He did talk about management and channeling the rewards of management back to the company. Phil Fisher was big about compounding. He didn't need the dividends. They'll put it back in the company. You know, that's worn. pay it out into dividend. If I'm earning above the cost of capital, just say your opportunity

Starting point is 00:45:20 cost of capital is 10%, which is what Charlie believed the cost of capital was, not the capital asset pricing model definition of it, but just your opportunity cost of capital. If you're lending money to the stock market, it's perceived that you should generate at least a 10% rate of return, historically speaking. So if I'm lending money at 10%, I should expect back at least 10% if not more. If I'm not getting back 10% or more, then what's the purpose of doing this? If your cost of capital is 10, your company earns 15 or 20, or like Apple earns 100, what do you want them to do? Keep the money. Just keep it all.

Starting point is 00:45:57 Don't pay a dividend. And that's the Amazon store, you know. I don't know, you know, we're on the day here that Andy Chessie wrote the annual report on Amazon. It's just a wonderful end report. But if you look at the operating cash flow of Amazon before it takes it to the bottom line to pay corporate taxes or give out a dividend, they put it back into the company, right? But that operating cash flow before they re-invested about it in the company, it's probably a 3 and 4 percent cash flow yield. That's pretty good, you know, but then they say, well, why don't I want to pay tax on

Starting point is 00:46:31 that when we're growing double digits, earning above the cost of capital, put it back in AWS, put it back in retailing, put it back in advertising, put it back in Amazon prime. So Amazon has been a high-pe stock since 1999, and it's, you know, a $2 trillion business, It's so much for high PE, low PE investing. It has nothing to do with the growth in the intrinsic value. It has every bit to do. Did you earn above the cost of capital? So I deviated a little bit from your original question.

Starting point is 00:46:57 But once again, what are we talking about? Businesses, talking about economic returns of businesses. What are we not talking about PEs? We're not talking about sectors. We're not talking about, you know, is the economy going up or down? What's going on with interest? Oh, it's inflation's up. The Fed's not going to cut interest rates.

Starting point is 00:47:15 Who cares? just by a good business. That's all we have to do. So we've obviously spent a lot of time thrashing portfolio management theory at efficient market hypothesis. But you know what? We're going to keep going with that on that theme. So you pointed out in your book that Harry Markowitz developed his theory

Starting point is 00:47:32 at the very young age of only 25. And he assumed that the unpleasantness of price volatility was the risk that investors should avoid, which is an interesting conclusion. But I'm just interesting. I know that you spoke a little bit about how, you know, security analysis was already out at this time. And he clearly just, you know, obviously he ignored it or I don't know. But I'm just kind of trying to figure out why he completely missed the

Starting point is 00:47:56 point about the underlying value of a business. And I'm just kind of interested in knowing your thoughts on why it came to the conclusion he did. I'm so glad that you brought this up. So when Charlie said, you know, if we're so right, why are so many imminent places not copying us? It goes back to why is modern portfolio of theory the dominant standard management practice. And so we went back to, you know, you go to first movers, right? So how did this whole thing start? So here you have this little kid, 22, 23 years old, right? A well-mannered boy, you know, play the violin, great grades.

Starting point is 00:48:27 David Hume, the Scottish philosopher was his favorite philosopher. Goes to University of Chicago decides he wants to stick around, spent some time at the Coles Commission, which had done, that came over from Yale, had done a lot of work on forecasting markets, got intrigued about the stock market, decides he wants to get his Ph.D. in economics and decides one day that he's going to write his PhD on the stock market and kind of gets because, you know, it's more than economics thing, gets into, you know, risk and return. So I went back to the original paper. It's a very unimpressive paper. I mean, for a PhD dissertation, I think it's 14 pages. Most of it's

Starting point is 00:49:03 graphs and tables. There was only three citations, one of them, which was John Burle Williams, which we'll talk about the second. But he writes in there. So he kind of says, it's just like in the first sentence. We consider the rule that the investor does or should consider expected return is a desirable thing, right? Your return is desirable. I get that. And then he writes, and the variance of the return as an undesirable thing. Okay, so he's saying variance.

Starting point is 00:49:28 Price volatility is undesirable. I let him slide on that. Since they both have sound points, blah, blah, blah. Then he says the term yield and risk frequently appear in financial writings but are not always used in precision. Even Graham said, you know, sometimes investing is not precisely defined. But then he says this, this is where the slope gets slippery. He says if the term yield, which is expected return, was replaced with expected return, and risk, now he's defining risk right here by the variance of returns, little change in the apparent meaning would result.

Starting point is 00:50:03 Okay. So right there, here's this 25-year-old boy who's never invested in the stock market, never owned a company. never been in business, anything, and he's all of a sudden going to define risk as variance, volatility. Okay. If I'm writing a PhD dissertation, and I have a dissertation committee, much less a dissertation thesis advisor, and I make a statement like that, it has to be defended. Better yet, you have to look at the counterfactual. What do other people say about risk? Is there somebody else that has a different definition about risk? And so to your... point, this was 1952 that the paper was published. So go back. Well, in 1934, security analysis

Starting point is 00:50:47 published. And right there, margin of safety is defined as risk. If you're operating with the margin of safety, it's low risk. If you're operating above intrinsic value, that's bad. Then go to 1938, theory of investment value is published. He cites the book in defense of his thesis. If you go to John Pro Williams, he says this, investment value defined as the present value of future dividends and future coupons and principle is a practical importance to every investor because it is the critical value above, which you cannot go in buying and holding without added risk. John pro William saying, it's if you buy something above its intrinsic value, that is risk. Okay, there's a different opinion about risk.

Starting point is 00:51:29 And then 1940, security analysis, second edition, 1949, the intelligent investor, Benjamin Graham, writes it all down. difference between short-term quotation loss, permanent capital loss, margin of safety. Then 1951, the year before his thesis is published, the third edition of security analysis. Columbia University and Security Analysis owned the finance academia. Here he is at University of Chicago, Marshall Ketchum, who was the dean of the economics department and his PhD advisor and on his PhD dissertation, had a brand new academic journal. that had just been launched called the Journal of Finance.

Starting point is 00:52:09 It's only just a couple of years old, kind of fledging, didn't know what to do with it. Markowitz's paper ends up in the Journal of Finance. And no one on the dissertation committee ever said, you know, there's some other people that have a different definition of risk. Never mentioned. So nothing happens. He goes off and works with the Rand Corporation in the 1950s. He's doing it.

Starting point is 00:52:29 And then Bill Sharp shows up and he's looking for a thesis of his people. He was at UCLA. And they said, oh, track down Markowitz. He goes to see Markowitz. Instead of doing all the non-collegist strategies or doing the tabulations of non-correlations, he says, why don't we just do a, find one thing to measure everything against what has the most influence on the market is beta. I mean, it's the market price itself. You gave it a name called beta.

Starting point is 00:52:53 If your price bounced higher than the market, you had a beta greater than 1.0, if it bounced less in the market. So any portfolio, the weighted average of its betas in a portfolio, if it was above 1.0, you were riskier than the market. And it was less than 1.0, you were less risking the market. Okay, that's 1963. Nobody gave you down. Nobody on Wall Street paid attention to it. Nobody cared. It was never mentioned much of anything ever again until the 73, 74 bear market.

Starting point is 00:53:21 And as we talked about early, you wiped out half of people's money because people were into the nifty 50 stocks, the go-go stocks. They weren't doing valuation work. It was all momentum trades. It was Jerry Zai at the Manhattan Fund. And it was the Go-Go Year's great book by John Brooks, one of Warren's favorite books talks about it. The important part was that value investing had gone away at Columbia University. So Graham retires in 1956.

Starting point is 00:53:47 There was a guy named Roger Murray that took over his spring seminar class. David Dodd retired in 61, 62. Roger Murray then taught the fall investment management class that David Dodd taught, and then the spring class. And he was the guy. He was the guy from the 1950s. and he retired in 1977, and the attendance of the value investing classes continued to go down through the late 60s into the early 70s because everybody was into nifty 50. Those weren't low PE, low price to book value stocks.

Starting point is 00:54:18 So there wasn't a lot of people attending value investing classes. In 1977, Roger Murray retired. That was the end of the security analysis course. There was no security enough. There was no value investing being taught at Columbia University. The ashes of the 73, 74 bear market, you know, or their portfolios are in rubble. Everything is down. But as what typically happens, time passes and people begin to return to the stock market

Starting point is 00:54:47 and they were returning. And as we got to the early 80s, interest rates were being cut. That was the beginning of the big bull market. And firms were being organized again. People were starting investment management firms. And they kept saying, well, what are we going to do? How should we do this? and a couple of these guys that were disciples of Markowitz and Sharp, and they were still in

Starting point is 00:55:06 the business teaching and stuff like that, said, hey, you know that 73, 74? Yeah, what if we did non-correlation and wide diversification and stay away from high beta stocks and we do conservative returns and we think price volatility is the evil that must be slain? What do you think about that as a money management practice? And they went, yeah, this will sell. This is what we got to do. We've got something for you that's going to prevent what happened in 73 and 74. And so it took off. Now, Buffett shows up back at Columbia in 1984 for the 50th anniversary of security analysis. And the very famous speech that he gave, the superinvestor of Graham and Dodsville,

Starting point is 00:55:49 kind of lit a spark back into Columbia. David Dodd's family endowed professorship, guy named Robert Hellbrum, got involved. and they started to resuscitate value investing. But it wasn't until 1991 that, yeah, it was Bruce Greenwald, 1991 that became a professor. And he himself then was probably the most responsible for rejuvenating security analysis. Of course, came back. Value investing became a harbinger of Colombia, but it was too late. By then, you were 10 years into the bull market and Money, modern portfolio theory was ubiquitous everywhere.

Starting point is 00:56:27 And so I think that period between 77 and 82, 83, almost seven years where the value investors were absent and weren't there to offer a counter, you know, a counter argument, allowed modern portfolio theory to get a lead. It took off and, you know, created a leviathan that is still the dominant theory today. And that's kind of how we think about it. So then the question is, well, if in fact the Berkshire Hathaway is the irrational way of what you do it and all this other stuff doesn't meet markets over the time, why don't we change? And then you go to Thomas Coon's theories of scientific revolutions and talk about paradigm shifts. Go ahead and tell a couple of professors that have their PhD in modern portfolio theory.

Starting point is 00:57:14 It's a bunch of bunk and see if they agree with you. They're out of a job. They don't have a class to teach. Go tell guys that have billions of dollars in modern portfolio theory. Oh, you know what? That money management practice is making you millions of dollars a year that gets you all the luxuries and everything that you want. You need to shut that down. It doesn't make any sense anymore.

Starting point is 00:57:35 Well, no, they're not going to do that. They're going to defend that to hell freezes over. So we're now, you know, we have these two paradigms, right? And that's kind of where we are now. And so one of Charlie's favorite quotes, I think was Max Planck, the German physicist, said, you know, science advances one fuel at a time. You just got to wait for these guys to die off and hopefully are going to be repopulated with, you know, the Berkshireist. They're going to rise up.

Starting point is 00:58:02 I don't think we have to wait that long. And I have some ideas maybe how we can try to light a spark under it. But it gave me a great deal of satisfaction, personal satisfaction, to understand how to answer Charlie's question, which is what we do makes a lot of sense, makes a lot of money. How come it's not taught? I think I got to the bottom of why that happened. Yes, I agree. And thank you for that excellent historical breakdown. So I wanted to discuss now Buffett's points on risk and how it obviously differs a lot from the portfolio management

Starting point is 00:58:35 theory. So Warren's view on risk is the possibility of injury or harm to the intrinsic value of the business. It has nothing to do with the fluctuations in stock prices that are taught in portfolio theory. You wrote, quote, in Buffett's view, harm or injury comes from misjudging the primary factors that determine the future profits of your business. One, the certainty with which the long-term economic characteristics of the business can be evaluated. Two, the certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows. Three, the certainty with which management can be counted on to channel the rewards from

Starting point is 00:59:11 the business to the shareholders rather than to itself, and for the purchase price of the business, unquote. So what really stood out to me on this incredible list is the word certainty, obviously, it's mentioned in three out of four of the points. So I'm interested in knowing just kind of more, this is more of a question to you than what Buffett would say, but you can obviously inject anything that you think Buffett would say. But obviously, the market loves certainty, but the problem with certainty is you pay for it. So I'm trying to be interested in knowing how can investors best balance being certain about investment and coming up with a purchase price, that makes sense. Well, I mean, you know, it's long been said that Warren's investment approach is to buy certainties at a discount.

Starting point is 00:59:50 about your point, or at least your observation would be oftentimes certainties are priced at a premium. And that's probably true, but not always true. As Wharton says, the market is frequently efficient, not always efficient. And there are times when the market's got it wrong. So go back to Coca-Cola. Coca-Cola was trading at a high, you know, price earnings multiple was above the market, high price to book value, low average dividend yield, by every metric you could think about in 1988. Cola was no screaming bargain whatsoever. Warren invested $1 billion, a $1,000. A third, third of his portfolio and what he believed was a certainty of all those things that you just said. Good business, good long-term outlook, good management, going to allocate the capital rationally,

Starting point is 01:00:31 and I got it at a good price. In 10 years, that billion went to 10 billion. A billion in the S&P went to $3 billion. Did he buy a certainty at a discount? Yes. Was it perceived to be above its intrinsic value? Yes. But the way in what you think about value sometimes is different in the market,

Starting point is 01:00:48 thinks about that. You know, and we go back to the dividend discount model. It's a different way to think about value than price earnings ratios. So we're kind of continued to elaborate on this. So if we kind of think about three certainties that we're trying to get right, which is what are the economics of the business and the persistence of the company to continue to generate attractive economic returns. That's one certainty bucket I'm trying to figure out. The second certainty is who are the people running the company? Are they going to rationally allocate the capital and in doing so, will they do it to enrich shareholders themselves? And third is purchase price.

Starting point is 01:01:24 He goes, of all those three things, I rarely have gotten the purchase price wrong and I've rarely gotten management. The mistakes I've made is miscalculating the persistence of the company to generate high returns of capital over time. That which was generating attractive returns just didn't do it for as long as possible. And so that's why he spends so much time on moats. Motes are the ability, you know, if a company has a big moat, which is nothing more than it has the ability, a competitive advantage period that's going to last for a long period of time, people that have competitive advantage period that last a long time. And Warren's metaphor, have big moats that people can't attack the castle and take their business away.

Starting point is 01:02:08 So the mistakes that he has made, the biggest mistakes that he has made is that a company that he thought had a moat, and a long competitive advantage period did not. Now, you could argue that was probably that you didn't buy something as cheap as you thought it did. It wasn't as worth as much as you thought it was, and there's some rationale to that. But really, it gets down to when you're a long-term investor and you're compounding something. You own something that generates good returns on capital that can be reinvested back in the company, to compound, compound, to compound. it's your thinking on who are the competitors,

Starting point is 01:02:45 how quickly are they coming over the moat, quickly are they going to take your business away, or how quickly do your customers decide they want something else? That's the problem. And so much of the thinking today for, I think, value investors that are compounding money, is basically trying to answer that question, whether it's MasterCard or Visa or Petticard processors

Starting point is 01:03:10 and in my case, we own a lot of technology. So it's how long does Amazon keep doing this or Google, the cloud service providers, how long can they keep doing this? When is somebody going to come over the wall, attack the castle, and do what they do cheaper and better and what they're doing? So we spend a lot, a lot of time thinking about that competitive threat because that's the one certainty that Warren has gotten wrong, which could be then argued that that's been the biggest biggest,

Starting point is 01:03:40 biggest risk in this portfolio is misjudging the certainty of a company to do that for a long period of time. Does that make sense? Yes, that makes perfect sense. And that actually leads kind of really well into the next question I had, kind of about Buffett's franchise definition. You know, a big takeaway I had from your book on the Geico and Coca-Cola case studies was, you know, his variant perception of these robust franchise characteristics. So just for people not familiar with those characteristics, basically it's an economic franchise arises from a product or service that is, one, needed or desired, two, thought by customers to have no close substitutes, and three, is not subject to price regulations, unquote.

Starting point is 01:04:20 I just want to learn a little bit more about how Buffett's success is kind of interplayed with these franchise characteristics in terms of, you know, do you think his biggest wins have come from franchise type businesses, or do you think he's been able to find success in other areas as well. Yeah, I think the franchises are a huge part. You know, let's just think about Coca-Cola. Warren said, this was 20 years ago. He goes, he says, I gave you $10 billion right now. You couldn't unseat Coca-Cola. It's the number one manufacturer of concentrate syrup that combines with carbonation, makes soda pot. You couldn't do it. There's no chance. Okay. That's pretty interesting to think about it, right? And then think about GEICO. Who's going to take their business away?

Starting point is 01:05:01 For a long time, being an agentless direct provider of insurance products was taking market share from all state to Prudential and on and on-debt. Until Progressive, it came in and done a phenomenal job. Now, Geico would progressive and going at pretty hard. So you kind of look at like, who is going to, you know, who's going to come take your business away or who could potentially come take your business away? So then let's look just, you know, Warren doesn't own cloud, but I think cloud's pretty interesting. these hyperscalers, right? You think about these huge data centers, AWS, Azure at Microsoft or Google,

Starting point is 01:05:38 and you say to me, okay, who's going to take this business away? If I gave you $10,000, $20 billion, $30 billion, could you go take out AWS? No. No. You know, there's not enough money for you to go again. Now, will there be more?

Starting point is 01:05:53 Oracle's coming into the game, IBM's coming into the game. But you look at how the market shares are changing, A little market share is changing and adjusting a little bit, but they're not going to go away. I mean, they are, you know, is anybody going to disrupt Amazon as a world's leading online retailer? Can anybody do it cheaper and better? How much money do I have to give you to you to become the world's best at this? It's kind of like, really?

Starting point is 01:06:19 You know, Google search, with all the angst about Google search and everything that's going on, and we have, you know, Bing at Microsoft and we have Yahoo and we have Duck. duck and all that. Google's still 93% market share. It's kind of like, okay, who else you're going to throw at me? So you kind of begin to think about who can take my business away. And I would have to say, Kyle, I probably spend more than half of my time reading and thinking about that. I mean, I read the balance sheets. I read the income statements. I read the quarterly. I listen to the management, you know, just to make sure that they're doing what I think they should be doing or what they said they would be doing. You can understand balance sheets and

Starting point is 01:06:56 income statements relatively quickly and easily to see, you know, where the levers are moving left or right. But I spend more time thinking about competitive threat and, you know, who can take me out. And for a compounder, which owns a business that earns about the cost of capital, that is thought to be able to do that for a long period of time, that's what I spend most of my time thinking about. Let's take a quick break and hear from today's sponsors. No, it's not your imagination, risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC

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Starting point is 01:10:41 All right. Back to the show. I discovered the rule of one from reading the third edition of your book a couple years ago, and I've really, really enjoyed using it. But I have had quite a bit of pushback on it that I'd love to get your opinion on. I just want to give some background onto what the rule of one is in case people don't understand. So basically, it's the rule that for each dollar that a business retains, it should earn at least a dollar of market value.

Starting point is 01:11:03 And this is Buffett's rule. So just to give an example in the Warren Buffett way, you mentioned that Coca-Cola created about $1.2 cents in market value per dollar retained between 1974 and 1980. But when Roberto Goyzetta took over, he elevated that to $4.66. between 1980 and 1987, which is incredible. Just getting back to the pushback, a lot of what I get is that the market obviously is kind of in charge of assigning prices to a business. Let's say that there is a business that is retaining a lot of earnings, but maybe it's

Starting point is 01:11:34 not growing the earnings at a super high rate. It can still technically pass a rule of one if, let's say, the market's really euphoric and they're just driving up the price of that business. I just kind of would love to hear your opinion on the rule of one as a tool for investors. And if you think it's still valid and kind of how you would kind of hit back against that common complaint that I've got. I've heard that criticism before. I think it's legitimate criticism.

Starting point is 01:12:00 I think what you have to do is to put it in the right context. It was not meant to say that a dollar today in two years or three years or four years is worth more than a dollar if you're in the middle of a bull market. It would straight up. That'll kind of skew the numbers. I think it was kind of meant over a decade type longer where you've gotten the fluff out of the market and maybe even been in a bear. People would say, well, you know, if you go into a bear market, however, you know, are you being unjustly punished because stock prices are down far worse than what the economic return. So let's just go back to first principles.

Starting point is 01:12:30 The idea is that if you earn above the cost of capital, you're increasing intrinsic value. You can earn below the cost of capital. You're destroying intrinsic value. If you do either one of those things over a multi-year period of time, it should show up. in the market value of the intrinsic value of the business. So if I'm consistently earning above the cost of capital by reinvesting above the cost of capital, every time I put a dollar in the business, it should earn me at least a dollar, if not more, and vice versa.

Starting point is 01:12:56 I think the criticism is let it play out over a lengthy period of time. What I would say is that it really shines a very, very bright light on bad businesses. If you're a bad business, high reinvestment, low margin capital intensive business, and you're struggling to earn returns on capital that are below the business, or own cost of capital, you can add up all the money that they've spent over 10 years. And if it doesn't show up in a market, dollars worth of market value, there's something really bad going on there. And I'll give you a perfect example.

Starting point is 01:13:33 I was with Tom Russo, great value investor, a great purchasist, super investor. And we were visiting Peter Kahn at the Wall Street Journal in the mid-1990s. And we happened to be in his office in New York. And Peter had done a great job running the business, but the economic returns just weren't that good. And he flipped open the end report and looked at the back and actually was a line that's a capital investment for 10 years. And the Wall Street Journal was investing in a lot of crazy things. The Internet was coming on and money was just flying out the door because newspapers generate a ton of cash. I mean, they're not capital intensive, but he was finding a way to reinvest it in a lot of things.

Starting point is 01:14:14 And Tom just very gently said, you know, when I add up this line of capital investment that you've spent and I look for the return of that capital investment, I can't find it in the price. And it was so illuminating. It was kind of like, yeah, where did the money go? What was the return on that money? And it's not in the price. There's a problem here. I get the argument that when you're in a roaring bull,

Starting point is 01:14:38 market, it might be a false positive, right, that you're getting more for the bang of the buck because the market's going up multiples. But more often than not, it's a huge tell on a bad business. You just add up money of bad businesses that either put it into existing operations or bought other things in hopes of getting something better. If that doesn't show up in price meaningfully over 10 years, then that should be alarm bell, alarm bill. stay away, stay away. So that's kind of how an answer. Final question.

Starting point is 01:15:13 There was a great excerpt from your book, and this is from Warren Buffett. Quote, so why do smart people do things that interfere with getting the output that they're entitled to? It gets into habits and character and temperament and behaving in a rational manner, not getting in your own way. As I have said, everybody here has the ability to absolutely do anything I do and much beyond. Some of you will and some of you won't. For those who won't, it'll be because you get in your own way.

Starting point is 01:15:38 not because the world doesn't allow you. So I think Warren is a very humble guy. I think he's a genius. I'm sure you probably agree with me there. So even though many of his attributes, I do think are replicable by other people, maybe some areas of his temperament are, some aren't. But I kind of want to get your opinion on

Starting point is 01:15:56 what do you think is the most critical attribute that Warren Buffett has that if taken away would have drastically changed his outcome? I like that way to finish up. I would say, Warren said, what I do is not beyond the competence of other people to do the same thing. And that was really kind of the objective writing the Warren. By the way, Warren says, what I do is not beyond the confidence of other people to do it. And we laid out all the methods and said, look, you probably these methods, generally something good is going to happen to you.

Starting point is 01:16:23 Then years later, he said, investing is easier than you think harder than it looks. And I went, okay, there's a positive right? Well, easier than you think was, when we talked about this earlier, you don't have to spend all the time worrying about the stock market and forecasting the economy. which nobody in the last three years, nobody's been able to forecast this economy at all. You don't have to do that. You don't have to worry about the stock market. You don't have to worry about who's going to be present.

Starting point is 01:16:45 Take that off. Take that off. You don't have to do it. It's so much easier. But the harder part than it looks is you own something whose price doesn't always walk lock step in the stock market when it goes up. Or sometimes it goes down in price. And there's the divide, right?

Starting point is 01:17:05 that you get to the river and people go, I just can't cross it. So when I wrote the Warren Buck away and we were managing money, I've said this many times. I have never met anybody that I sat down with and said, this is how we think about investing. This is how Warren Bucket thinks about investing. Stocks and businesses, this is what we're going to do. Do you think this would work for you? Do you think this is something you would like to do? 90% of the people said, yeah, I'm in.

Starting point is 01:17:29 In about three months, three quarters of those people have already lost their mind. What else going up, Robert? How can we don't own oil stocks? Oh, my God. You know, you need to sell this over here. It's not doing it. You know, it's the cycle. The harder part is the temperament part, right?

Starting point is 01:17:44 The harder part is the sound-mindedness. The harder part is disassociating yourself from the stock market. If you said to me, what is the one single one characteristic that has made Warren Buffett successful? It's been his purposeful detachment from all things that are in stock. Just divorced himself, emotionally, mentally. whatever. The cap, it's not there. It is, it might as well be up at Jupiter and Mars. It's not there. He owns a business. That's all he thinks about. The rest of us, that's all we do, is think about it.

Starting point is 01:18:18 And we don't think enough about the business that we own. And when you look at it in that glaring light, that's probably the single biggest reason. What Warren doesn't think about, we're all consumed with. What he does think about, there's not We don't spend enough time. Robert, I just want to say thank you so much for coming back on the show, had an amazing time as usual. Where can the audience learn more about you and your books? Well, the book is preordered on Amazon. I think PubDate is April 23rd.

Starting point is 01:18:49 You can pre-order it now. It is, I think, it is a compidium of everything that I've written about more in these last 30 years, studying in the last 40 years. So, one, thank you, as always, for your wonderful invitation. and thank you for a great conversation. You do a great job prepping and your questions are always very thoughtful. So thank you.

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We Study Billionaires - The Investor’s Podcast Network - TIP635: Deep Diving Into The Warren Buffett Way w/ Robert Hagstrom

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