We Study Billionaires - The Investor’s Podcast Network - TIP662: Building Buffett: The Foundation Of Success w/ Kyle Grieve

Starting point is 00:00:00 You're listening to TIP. Lately, I've been passionate about learning about Warren Buffett's early days. Of course, his current success has many lessons. But I think his past is where I think the average investor can really best relate to him. The reason is simple. He invested much smaller sums of capital and was much more nimble in what he could invest in. And he really used this to his advantage. If you compare the Buffett from the Buffett partnership days with the Buffett from today,

Starting point is 00:00:25 the overarching principles remain the same. However, I think very specific differences are important to key in on and understand at a higher level. The biggest one is his holding periods. He just wasn't a long-term set-it-and-forget-it type of investor at this time. He was focused on lower-quality businesses that were trading well below intrinsic value. He knew that he wouldn't hold on to his ideas for long because there just weren't that many returns from holding once the price and value gap closed.

Starting point is 00:00:50 So on to the next opportunity he would go. In today's episode, we'll go over why he invested differently with smaller sums. the four buckets of investments he chose to invest his capital into, how he aligned himself with shareholders to increase value while taking part in any potential downside, Warren's specific views on performance and how he thought it ought to be measured, and why investing principles should not be thrown away like garbage just because they go through periods of underperformance. You won't want to miss today's episode if you want to learn more about the highest returning portion of Warren Buffett's investing career. Now, let's get right into this week's episode. 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, I'm pleased to share a book on the early days of Warren Buffett. As I've read more books and annual letters by Warren

Starting point is 00:02:04 Buffett, I've become more interested in his early days. One aspect of Buffett's career that I'm trying to understand better is his evolution as an investor. And more importantly, what parts of his career are most relevant to investors today? So different investors will take different teachings from what Buffett has learned. And I think he has lessons to impart at pretty much any stage of his investing career, no matter what kind of investor you specifically are. On a personal note, I've noticed myself gravitating more and more towards the early days of his career for a few key reasons. So the first one being, he still abided at this time by many of Benjamin Graham's timeless principles. It's not like you can just say that his early days don't apply to his later

Starting point is 00:02:51 days, but there's some things that he did in those early days that are, he just can't do now. So we're going to be going over some of that in quite a bit of detail. Another thing that gravitates me towards his early days is in regard to the fact that he invested much smaller sums of money. And I believe this allowed him to use strategies that were just not replicable by a lot of other investing legends or investors that are managing larger sums of money, such as where he is today. Thirdly, in the time of the Buffett partnerships, he was hungrier about finding very specific opportunities at a younger age. And he spoke to this in his letters as he aged that that hunger kind of changed as he got older. Then the kind of the last

Starting point is 00:03:30 one here was that he discussed and detailed the different subtypes of investments that he made and why he was making them. And I really enjoyed the fact that he did this because he was very intentional about the different types of investments he made and he understood them at a really deep level. So I'm really excited just to share all of my learnings with you today. So I've found that I greatly relate specifically to his early days as I personally enjoy looking at a lot of these kind of undiscovered investing opportunities. And this was exactly the type of investing that Warren was doing in those early days. So in the 2024 Berkshire Hathaway annual meeting, Warren mentioned how impressed Charlie was after they met because Warren was aware of some obscure stock based

Starting point is 00:04:12 in California that barely any investor had ever heard of. So, you know, Warren, he wasn't always investing in Apple. If you look back to his early days, he was investing in stocks that literally no one really understood other than Charlie Munger in this example here. So today I'm really, really excited to discuss a book that I just don't see mentioned that often, but found incredibly informative. And that's going to be Warren Buffett's Ground Rules by Jeremy Miller. So the book is about Warren Buffett's Ground Rules, which he learned while operating the Buffett Partnership. So the author did a wonderful job of summarizing a bunch of large lessons from these days in this part of his career. So he made the book practical. He showed how pretty much any investor could take a

Starting point is 00:04:55 very similar approach and why it makes sense. The way the book was kind of structure was that Jeremy would give his thoughts at the beginning of each chapter. And then he would take passages from the Buffett partnership letters and just allow Warren to give the reader his own reasoning on why he did what he did for his partners back in those early days. So let's get started by discussing the basics of Warren Buffett's ground rules. So there were the ground rules, but then he had these primary principles that he followed that he stated, I think, very early in these Buffet Partnership letters. So there's three of them. The first one is just the Mr. Market analogy, which I think everyone's going to be aware of. The second one is the business owner's mindset, and the third one

Starting point is 00:05:34 is dealing with forecasting. So R&TIP listeners are probably going to be very well versed in the first of these two points that Warren learned from his mentor, Benjamin Graham. But for those who aren't, I want to just briefly go over them in a little more detail so that I'm not leaving you hanging. So the Mr. Market analogy uses a theoretical person that's called Mr. Market to basically just discuss how the market tends to act. Mr. Market will try to trade stocks with you every day. Sometimes Mr. Market is euphoric. In those cases, Mr. Market will charge you a lot of money for the stocks that you want. But sometimes Mr. Market will be depressed and beg you to sell a stock to you at rock bottom prices. Much of the time, Mr. Market is in a neutral mood. So the key point is that you should understand

Starting point is 00:06:19 Mr. Markets mood and act accordingly. When Mr. Market is euphoric, it's probably not going to be the best time to buy. Selling might be a better option. And when Mr. Market is depressed, well, buying or adding to current positions is usually going to be the intelligent move. So I just want to make a point here that you have to remember that Mr. Market is just a thinking tool. So just because there are areas of the market that are expensive or cheap does not mean

Starting point is 00:06:45 everything in the market is expensive or cheap. So the second point here is on the business owner's mindset. So the business owner's mindset basically means that you think of stocks as a fractional ownership stake in a real business. So that means you don't trade the business away on things such as interest rate changes, macroeconomic factors, wars and far off countries, market selloffs or price fluctuations. A business owner just focuses on the businesses that they have. So a great example that I really like using when I'm trying to think of this business owner's mindset is just imagining that I personally own a specific business. So let's, you know, I'm in Vancouver, British Columbia. So let's say I own a laundromat in Vancouver,

Starting point is 00:07:28 B.C. Okay. So this laundromat will, just for the simplicity of this example, we'll say it's death free. Let's say I've owned it for five years. And let's say that, you know, I don't actually have to do anything. I just own the business and it just produces cash flow that comes back to me and I get a nice dividend to check, let's say, at the end of each year. So now let's say I've owned this business. And then a couple things happen. Let's say interest rate goes up. Let's say there is a war on the other side of the planet. And let's say that stock market plunges. So then I'm just going to ask myself, okay, would any of these events make me want to sell my business in Vancouver, British Columbia? And realistically, it's doubtful that these events would impact my business at all. Interest rate changes make no difference to my business. People are always going to need to clean their clothes. You know, it's not really a business where you have an option of cleaning your clothes. I mean, you could always go and buy a washing machine. of course, or use the services of a laundromat. So yeah, interest rates just aren't going to make too big of a difference to the business. And like I said, it's also debt-free. So, you know, maybe a war could have an impact on a global economy, but it's probably not going to impact the fact that my

Starting point is 00:08:31 business just doesn't require me to buy things from impacted areas. So I'm still going to be able to run my business. You know, maybe there'll be some short-term pricing issues. But for the sake of this example, we'll just say that it doesn't make any difference in my business. And then obviously the last one there, the fact the stock market goes down makes zero difference to me. The stock market going up, down, sideways, makes no difference to the dividend payments I'm getting paid at the end of each year. So to me, this is kind of the key to investing in public stocks like a business owner. The other key point to remember is that what happens in your business can often have delayed recognition in public markets. So Buffett sums it up really

Starting point is 00:09:11 nicely. The course of the stock market will determine to a great degree when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen. So the third point that we talked about here was just kind of dealing with forecasts. Buffett is not a fan of forecasters. He said prophecy reveals far more of the frailties of the profit than it reveals of the future. My favorite case. study on the frailties of market forecasting and trying to profit from it is examining John Maynard Keynes, one of the most influential economists to ever live. So Maynard Keynes, as he liked to go by,

Starting point is 00:09:52 started his investing career by trading and basically attempting to use his superior knowledge of economics to try and forecast what would happen in markets. So for nearly a decade, he to toiled in these types of short-term trades, losing 80% of his capital from peak to trough. So pretty rough. He finally smartened up and settled on a different investing strategy. So no longer would he attempt to prophesize market movements. No, instead, he used the value of a stock as his investment guide, basically, you know, buying when the price was far below value and selling when the price exceeded value, kind of your traditional value investing principles. So next here, I want to move on to Buffett's thoughts on Einstein's eighth one of the world, which is compounding. So Buffett was

Starting point is 00:10:37 very, very smart about compounding from a young age and it's quite impressive. So one of Buffett's first books that he read on businesses was Francis Minnaker's book called 1,000 ways to make $1,000, practical suggestions based on actual experience for starting a business of your own and making money in your spare time. Very long title, I know. So Warren learned an incredible lesson, though, on compounding from one of this book's case studies. So in chapter 10 of 1,000 ways to make $1,000, Minnaker reviews a case study about a man named Harry Larson. So Harry Larson was shopping one day and some curious person, I guess that he met there, asked him what he weighed. And Harry did not know what he weighed.

Starting point is 00:11:16 So he basically went over to a scale machine, threw a penny into it and got his weight. So an interesting thing happened though while he had this experience as he waited in line to buy whatever he went to go shopping for. He basically observed that there were multiple other customers that were just going up to the scale, putting a penny in, finding out what they weighed. And so that just kind of got him interested. So he went over and inquired with the store owner about the weighing machines and just trying to figure out, you know, what are the economics of it? So basically, the store owner made 25% of the machine's profits while doing pretty much nothing.

Starting point is 00:11:50 But the remaining 75% that he was interested went to the owner of the weighing machine. So from there, Harry took some of the savings and just bought three of those weighing machines. From those three machines, he started making about $98 a month in profit. Now, this next part is what really hit Warren. Harry took all the profits from these machines and then plowed the earnings from those three machines into 67 more machines without paying a penny from his bank account. So with 70 machines each earning $33 a month, he would clear about $2,300 a month. So Warren could see that earning something as small as a penny many, many times over could add up to very, very large sums of money over time. And with that, Warren's obsession with compounding was born.

Starting point is 00:12:31 The author points out that Warren's conceptualization of compounding was so good in his mid-20s that he knew he'd be rich if he could just basically continue compounding his capital at his historical rates of return. So he returned to Omaha with a little over $100,000 after working with Benjamin Graham. And according to inflation adjusted numbers, it comes out to about $1.1 million today. At this point in life, Warren basically figured he'd do a couple very simple things. read a lot and maybe attend some university classes. But as Warren's wealth grew, he started spending more and more time trying to figure out what the best uses of his wealth would be. This was especially in regard to his children.

Starting point is 00:13:11 Warren has famously said that Jesse Owens' child's development would not necessarily be helped by allowing them to start a hundred-yard sprint at the 50-yard line. Perhaps you let them start the 10 or 20-yard line to give them a little bit of help, but you don't want your child basically cruising through life. he felt he would be actually doing them a disservice if that was the case. But let's get back to some pretty epic thought experiments that Buffett discussed in his letters regarding compounding. So the first one here was a very popular story about the Indians who own the island of Manhattan.

Starting point is 00:13:42 So essentially in 1627, they sold it for what appears to be a very piddly sum of $24. And Buffett then thinks about, okay, let's say they did sell it. And now let's say they had an investment advisor who was really good with compounding money at not super high rates of return and could do it for decades and centuries. So basically, he came up with this number, 6.5% return from 1627 all the way he wrote this in 1965. And his point was that at that 6.5% return, the $24 would return into $42 billion again in 1965.

Starting point is 00:14:19 So in 1965, the island of Manhattan was reportedly worth $12.5 billion. So even though they'd sold it, if they were able to compound their money, they still are making multiples of their initial investment or multiples of what Manhattan would have actually been worth had they just held it for the entire period of time. So I just think that this is such a good story because it really kind of synergizes with most people's difficulty in really understanding the powers of compounding. So as a bonus to the story, Warren also mentioned that let's say the investor was maybe able to eke out just 0.5% more to get the rate of return.

Starting point is 00:14:53 to an even 7%. So in that case, the value of the initial investment jumps from 42 billion to $205 billion. So that just shows you how a very, very small increase in your rate of return over a long period of time just amplifies your results. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists,

Starting point is 00:15:36 investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses. and building technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about 2,000 extraordinary individuals, dissidents, founders, philanthropists, policymakers, the kind of people you don't just listen to but end up having dinner with.

Starting point is 00:16:10 Over three days, you'll experience powerful mainstage talks, hands-on workshops on freedom tech, and financial sovereignty, immersive art installations, and conversational. conversations that continue long after the sessions end. And it's all happening in Oslo in June. If this sounds like your kind of room, well, you're in luck because you can attend in person. Standard and patron passes are available at Osloof Freedom Forum.com with patron passes offering deep access, private events, and small group time with the speakers. The Oslo Freedom Forum isn't just a conference. It's a place where ideas meet reality and where the future is being built by people living it. If you run a business, you've probably had the same thought lately.

Starting point is 00:16:52 How do we make AI useful in the real world? Because the upside is huge, but guessing your way into it is a risky move. With NetSuite by Oracle, you can put AI to work today. NetSuite is the number one AI cloud ERP, trusted by over 43,000 businesses. It pulls your financials, inventory, commerce, HR, and CRM into one unified system. And that connected data is what makes your AI. smarter. It can automate routine work, surface actionable insights, and help you cut costs while making fast AI-powered decisions with confidence. And now with the NetSuite AI connector,

Starting point is 00:17:29 you can use the AI of your choice to connect directly to your real business data. This isn't some add-on, it's AI built into the system that runs your business. And whether your company does millions or even hundreds of millions, NetSuite helps you stay ahead. If your revenues are at least in the seven figures, get their free business guide, domesticifying AI at netsuite.com slash study. The guide is free to you at net suite.com slash study. NetSuite.com slash study. When I started my own side business, it suddenly felt like I had to become 10 different people overnight wearing many different hats. Starting something from scratch can feel exciting, but also incredibly overwhelming and lonely. That's why having the right tools matter.

Starting point is 00:18:15 For millions of businesses, that tool is Shopify. Shopify is the commerce platform behind millions of businesses around the world and 10% of all e-commerce in the U.S. from brands just getting started to household names. It gives you everything you need in one place, from inventory to payments to analytics. So you're not juggling a bunch of different platforms. You can build a beautiful online store with hundreds of ready-to-use templates, and Shopify is packed with helpful AI tools that write product descriptions and even enhance your product photography. Plus, if you ever get stuck, they've got award-winning 24-7 customer support. Start

Starting point is 00:18:52 your business today with the industry's best business partner, Shopify, and start hearing sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So the other point about this story I found interesting was that it does a really good job of showing how important it is to avoid frictional costs. So things like taxes, commissions, fees really just seem trivial on a short-term basis. But as this example shows, a small decrease in your rate of return can have major effects

Starting point is 00:19:34 down the road. This is a good lesson to remember for investors who are paying high. fees, either through their own trades or through fees to their managers. So whenever you look at the little statements that have, you know, the very, very fine writing, it's always going to be very small. It's going to say this really small amount of management fees. And it looks small to the naked eye, but when you look at what the amount of money that they're actually taking from you over a long period of time, it's not a small number. So just be cognizant with that. So another really cool example here that I actually had never seen before was this example that Warren discusses about the sale

Starting point is 00:20:07 of Leonardo da Vinci's Mona Lisa. And he goes back in time here. He's going all the way back to 1540 to Francis I, to France. So he found out that it was sold for 4,000 acres. Warren was kind enough to give us the exchange rate and came to a figure in 1964 of about $20,000. So he pointed out again if Francis I first had a trustee who maybe could have found another investment

Starting point is 00:20:32 that compounded at 6%, that the money that he spent on Mona Lisa would have been worth one quadrillion in 1964. Just because it's not a normal number, it's basically a one followed by 15 zeros. So Warren also noted that this number represented 3,000 times the U.S.'s national debt in the same year. So both examples here just show how an unfathomable amount of money can be made through compounding and through compounding over long, long periods of time.

Starting point is 00:21:03 Now, obviously, you know, we don't all have the luxury of money. being on earth for multiple centuries, but the point still stands, you know, even if you can do it just for a couple decades, it's very, very powerful stuff. So I think the fact that Warren also understood compounding at such a good level was also part of the reason why he just didn't like spending very much money. You know, he understood very well that a few thousand dollars today would be worth a heck of a lot more money, you know, maybe a couple decades into the future if Warren Buffett could basically put that money into his compounding machine. So the primary lessons, I think, from this chapter on compounding is just how important it is to really,

Starting point is 00:21:41 really understand it. Not only can it generate wealth for those who understand compounding, but it can also be used as a sort of break on spending. If you truly feel the pain of buying, let's say you buy a used car and maybe the used car, you know, maybe you have option one and option two, and maybe the second option is $10,000 more expensive. Well, if you understand compounding really well and you have, you know, maybe you can see into the future and you know that you're able to compound money. Well, that $10,000 and $20,000 difference can make a huge difference in 50 years if you can compound it. So I think it's just an interesting kind of thought experiment to use if you need help to rain in your spending just to kind of see the opportunity cost of spending money.

Starting point is 00:22:21 So now I want to take a turn here and kind of look at the other side of frictional costs that I just discussed. So that's namely how individuals and institutions get taken advantage of for being overactive. The problem is kind of hidden in the fact that people who urge you to be active are actually incentivized to increase your rate of transactions. So a broker makes nothing if you hold stocks for decades, but if you decide to day trade, that broker will be your best friend. As every buy and sell that you do will be slowly patting his pockets while unfortunately lightening your own. And I think this concept goes much further than just the world of investing. For business owners, some people will approach you with some magical fix for a problem you never

Starting point is 00:23:06 even knew you had. These frictional costs can add up and they can mean the difference between running a business into the ground versus running a successful business for decades. But Warren's advice to investors is really quite simple. Quote, resulting frictional costs can be huge and for investors in aggregate devoid of benefit. So ignore the chatter, keep your costs minimal, invest in stocks as you would have farm, unquote. So this chapter does a wonderful job of showing why and how Warren developed his disdain, I think, for much of the financial world.

Starting point is 00:23:36 Through his in-depth understanding of compounding and his ability to see how big of a difference fees could make, he explained why he preferred index funds, which did not yet exist at the time of these writings. But here's what Warren said about investment companies in the 1960s. The result of these investment companies in some way resemble the activity of a duck sitting in a pond. When the watermark rises, the duck rises. And when it falls, back down goes the duck.

Starting point is 00:24:02 I think the duck can only take credit or blame for his own activities. The rise and fall of the lake is hardly something for him to quack about. The water level has been of great importance to Buffett Partnerships' performance. However, we have occasionally flapped our wings, unquote. So this final sentence here is so important. We have occasionally flapped our wings. This means that he's essentially added value to his partners through his thoughtful investing skills. The crazy part about all of this is that the fund industry, you know, today is essentially the

Starting point is 00:24:34 same way it was back of the 1960s. Funds are searching for ways to just kind of match the index. Certain people have been able to kind of take advantage of the changing tides and the price just by floating with the market. So I think a really good example of this is ARC funds ran by Kathy Woods. So I think, you know, during COVID, obviously the ARC funds were doing really, really well. So during the height of Arc on February 13th, 2021, it was actually up 737% versus 120% for the S&P 500, an astounding difference. But using Buffett's analogy, investors, I think, thought that Arc had flapped its wings to create this value. But in reality, it was propped up by a mix of factors and largely propped up by a rising tide in all stocks. And when

Starting point is 00:25:19 the pond drained and the ducks floated back down, Arc ended up with lower returns than the the S&P 500 at about 150% versus 231% over the prior 10 years. So what accounts for this lack of performance by institutions versus unmanaged indexes? Is it intelligence? How about integrity? Buffett actually did not attribute the lack of performance to either of these factors. Instead, he attributed it to five things. First, group decision making.

Starting point is 00:25:47 So Buffett, you know, he just did not believe that outstanding management could be the product of a group making decisions. Number two, orthodox thinking, which basically is mindlessly copying what and other people in the industry are doing. Third, the safety of average. If you get the same results as everyone else, you're seen as successful, even if that success was a result of undue risk taking. Four, following standard diversification dogma, and five, inertia.

Starting point is 00:26:17 So he made the statement back in 1965, and I think these points are just as valid today and will probably be valid in another 50 to 100 years from now. So this kind of makes me think about some of the investors, who I won't mention by name, but a lot of them started as really, really successful hedge fund managers, but then things kind of started changing as they scaled up their assets. So here's kind of a narrative for how some of these investors go. So they start as upstarts, right? They're often working on their own or maybe they have a partner and they have a lot of success

Starting point is 00:26:49 and they make very, very high return. But as they start scaling up, they need to bring on more employees and increase the size of the business and maybe get more back-end people involved. And as they get more and more of these employees, the employees who've probably worked at other firms or coming out of school, they mimic the behavior of other people doing things like everyone else's. So because of all this, the returns that the fund once had is just no longer really achievable. you know, the fees just eat into it and it's just hard and you grow. And obviously that has its own problems as well that will be going over in the future. So the returns the fund once had are no longer achievable. And they basically take safety in just being average and tracking the returns of the markets

Starting point is 00:27:34 and even, you know, their competitors. So, you know, they used to have these very concentrated funds, most of them. And then all of a sudden you look 10, 20 years in the future and now they have 100 positions. So it kind of looks like they're just essentially trying to track the industry. And then finally, you know, you can't really go back once you've taken this route. That's kind of where you're stuck. It's hard for you to go from 100 positions to 10 positions. You know, your investors are probably going to be perplexed as to why you're doing that.

Starting point is 00:28:03 So essentially they just kind of stick with it. And that's what everyone else is in the industry is doing. And they probably, you know, they might have billions of dollars under management. And it works. So they just stick with it. Kind of like the Lemmings example that Warren Buffett says that people just like doing whatever, what else is doing. So I think the lesson here is best-dated by the use of one of my favorite metal models, which is inversion. So if we know what accounts for the lack of performance

Starting point is 00:28:29 and if we want to perform really well, well, let's just avoid being guilty of a lot of these mistakes. We know what the mistakes are, so let's invert them. So there's obviously five. So there's five things we want to do. We want to make our own decisions. We want to think like a contrarian, think differently. We don't want to chase average results. We want to chase some sort of result a little bit above. It doesn't have to be super high above, but chase a result that's not average. We want to concentrate our investments on our highest conviction ideas.

Starting point is 00:29:00 And then lastly, we want a willingness to improve our previous strategies when we have mistakes that are identified. We don't want to just get stuck doing the same thing over and over again. That doesn't work or isn't giving us the returns that we're looking for. So this ability to think independently and chase out performance is a really good segue I think into the next part of the book that I want to discuss, which is how Warren compared his performance to the index. So when Buffett wrote the Buffett partnership letters, he was competing with the Dow Jones

Starting point is 00:29:28 industrial average or just the Dow. So the Dow is composed of 30 prominent companies listed on U.S. stock exchanges. Many investors, you know, follow this index simply because it's just a good benchmark for determining whether they're adding any value to the investing process. And sadly, most investors, both retail and professional, lag the index. But because of some of the problems that we've just discussed, it is tough to beat the index. And for the few that are beating the index, they're probably following those five tenets that I just mentioned when we inverted them. So let's kind of get into how Warren compared himself to the Dow and some of the specifics about how he thought his partners should evaluate his performance.

Starting point is 00:30:09 So Warren thought that he should be compared to the index on kind of a three to five year basis. So the reason he liked this format was that it would show his portfolio performance both through an up cycle and a down cycle. Warren felt that a good investor should be able to perform well in pretty much any environment. Warren went so far as saying, quote, if any three year or longer period produces poor results, we all should start looking around for other places to have our money, unquote. But we must also keep in mind that the index can do some pretty wild things. Since the market in the short run is a vehicle for the overall mood of the market, one can underperform the market and still be doing a very good job of investing.

Starting point is 00:30:51 And Warren understood this very, very well. So throughout his letters, he constantly mentioned that Buffett Partnerships would probably underperform in bull markets and would often outperform in bear markets. And it was in fact, expected that the performance of Buffett partnerships would fluctuate and it would sometimes underperform. So another interesting point here was that Buffett considered a year in which his fund declined 15% versus a 30% decline for the index to be a superior year where both his fund and the index, let's say, advanced 20%.

Starting point is 00:31:22 And this kind of goes with that duck's analogy that we just talked about. So he has a quote here, over a period of time, there are going to be good and bad years. There is nothing to be gained by getting enthused or depressed about the sequence in which they occur. I think this really speaks to Buffett's ability to think long term. In the appendix of this book, you can see the results of Buffett's partnerships. And even though he never had a down year versus five down years for the Dow, he did have wildly varying results.

Starting point is 00:31:50 So from 1957 and 1969, he only underperformed the Dow on insanely low one time. So I don't even think Buffett would have predicted that going into the partnership. Another point on performance that Buffett really emphasizes was basically how anyone managing money should be able to state two things. So first, they should be able to clearly state the returns that they are attempting to achieve. And second, they should be able to state how the investors should be measured at achieving those returns. So this means that people managing money should not continuously change your yardsticks. You don't want to be looking at a manager and maybe you went back 10 years in time and they were, let's say they were having a really, really good year. And because they had a really good year,

Starting point is 00:32:33 they may over promise their investors in the future saying, okay, you know, we did 50% so, you know, who knows, the sky's the limit for going ahead. And unfortunately, you know, you got to put a break on that kind of thing because that's just thought the way things work. And one of humans' most powerful biases is that we do attribute skill to lucky outcomes very often in a large magnitude. So this is just a point that you should be aware of managers who are changing their yardsticks during the good times because chances are that the good results that they're having over a short period of time will regress back to the mean. And oftentimes, a very large outperformance can be followed by a very large underperformance. Just keep that in mind. If you paid attention to the markets in

Starting point is 00:33:13 2022, you'll see that in 2021. There were some funds that did it incredibly well in 2021 and then went down like 50% or more in 2022. So Buffett's points on not attempting to beat the market during wild market swings is very valuable because I think it helps investors avoid trying to chase higher returns that are often accompanied by higher risk. This is precisely why Warren shut down the partnerships in the late 60s, which we'll be going over in some more detail later. So the author of the book here, Jeremy Miller, does a great job at the end of this chapter, discussing why performance measurements today has been largely corrupted and obfuscated with terms like alpha, beta, sharp ratios, trainer ratios, and so forth. It doesn't have to be all that complicated.

Starting point is 00:33:56 Investors who decide to go the active route simply need to think it through ahead of time and commit to sticking to a measurement plan. Now, I just think this is wonderful advice. And to be honest, I don't have a firm grasp of many of the terms he listed above because I just don't think they matter to my personal investment goals. So just be wary of salespeople that are using, you know, overly complicated terms to try to justify you paying for mediocre results. So I wanted to end this section here to just a case study, I think, on one of my favorite investors. which is Francois Rochon, who Clay interviewed recently. So I would highly recommend reading his shareholder letters regularly. They're very, very much worth it.

Starting point is 00:34:35 One thing that I really like about him is just how simple he makes things. I opened up his latest letter and just searched for all those words, sharp ratios, trainer ratios above. And you can't find them. He doesn't mention them once. Instead, he's basically telling you what returns that he's attempting to achieve. So basically he's trying to achieve 5% of. higher than their benchmark. So because he invests not just in one geography, he's using a hybrid

Starting point is 00:35:01 index. So he's using the S&P TSX composite, the S&P 500, the Russell 2000, and the MSCI-EA-F-E. So he does a really good job of clearly showing the results he's had versus the index since the inception of his fund back in 1993. He's not changing things or blocking numbers out. And I went back 20 years to, I guess, that would have been 2004. And the benchmarks were all there. They were the same. I mean, he, so he wasn't using the MSCI, M-E-A-F-E, but all three other ones were there. He's using the same index throughout. And I think that's really powerful. And I think that I can give you just a really good picture of the type of investor that he is and that he's obviously a very highly skilled investor as well. So now that we have a better understanding of what Buffett used

Starting point is 00:35:46 to benchmark his performance, let's look at the partnership structure that he made in a little more detail. So Warren doesn't talk much about cloning, but his fund clearly was cloned from Benjamin Graham. Graham had kind of pioneered this structure with a general partner, a GP, who managed fund and then took a percentage of profits. And limited partners, LPs, who basically contributed capital and took part in the gains and losses, but had no part in managing the capital. So although Warren is very well known for being incredibly intelligent investing at young age, he wasn't necessarily predestined to manage money. So here's what, said about how the fund was initiated. Quote, by pure accident, seven people, including a few of my

Starting point is 00:36:26 relatives, said to me, hey, you used to sell stocks, and we want you to tell us what to do with our money. I replied, I'm not going to do that again, but I'll form a partnership like Ben and Jerry had, and if you want to join me, you can. My father-in-law, my college roommate, his mother, my aunt Alice, my sister, my brother-in-law, and my lawyer all signed on. I also had my $100. That was the beginning, totally accidental. So the fund was quite simply structured. on this 0625 system that barely any funds followed today. So basically the way it was was that he took a 0% management fee. He took, he had this 6% interest provision, kind of like his watermark that he had to beat.

Starting point is 00:37:06 And then past that provision, he would then take 25% profits. So basically, in essence, he was offering a 6% return to his investors before taking a penny for himself. So I've kind of always wondered where the 6% number came from. And the book's author mentioned that Buffett figured that the market at this time would go up, say, five to seven percent. And he just kind of split the difference with that six percent watermark. An interesting feature in the structure of the fund was that some people planned on investing in the fund and then using the proceeds for income.

Starting point is 00:37:36 Others wanted to just keep their money in the fund to maximize the amount that they had invested. To appease both parties, Warren would allow investors to keep their capital in the fund for those who did not want the income. It would just be reinvested the following year. And for those that did want income, he would basically distribute 0.5% each month, which comes to that 6%. So this is one of my favorite partnership structures, and it's hardly used by the financial industry today. So the norm is a 2 and 20 structure. So in this structure, the manager takes a 2% management fee based on the assets under management, and then they take 20% of any profits.

Starting point is 00:38:10 So the problem with this structure is it does not align the manager, in my opinion, with its investors. So let's go over some of the issues with the 2-20 system. So the manager has zero exposure to the downside. The manager does not lose anything if the fund goes down, say, 10% in a year, but obviously the partners do. Since the managers incentivize on assets under management AUM, they are encouraged to increase AUM rather than increase shareholder returns. So for instance, let's say a manager takes AUM from $1 billion to $2 billion in the same

Starting point is 00:38:44 2% management fee, that means that their fees basically go up from 20 million to 40 million just by increasing AUM. But during this time, they could theoretically have zero returns and basically be offering no actual value to their partners. And yet they're doubling their fees. You know, the alignment there is just, it's off. So the 20% performance fee can also force manage to take undue risk in kind of a short time frame.

Starting point is 00:39:10 Since they have no downside, managers might be looking to invest in. strange products, derivatives, expensive stocks, maybe trying to ride momentum, all while ignoring potential downsides, because like I said, they don't have to, they don't lose anything if the value of the fund goes down. And lastly here, the compounding effects of these fees do really eat into the returns of the shareholders at an alarming rate. I think we covered that pretty well in the section there on compounding. Let's take a quick break and hear from today's sponsors.

Starting point is 00:39:38 No, it's not your imagination. Risk and regulation are ramping up. and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving.

Starting point is 00:40:05 Instead of chasing spreadsheets and screenshots, VANTA gives you continuous automation across more than 35 security and privacy framework. Companies like Ramp and Ryder spend 82% less time on audits with Vanta. That's not just faster compliance, it's more time for growth. If I were running a startup or scaling a team today, this is exactly the type of platform I'd want in place. Get started at Vanta.com slash billionaires. That's Vanta.com slash billionaires.

Starting point is 00:40:37 Ever wanted to explore the world of online trading but haven't dared try? The futures market is more active now than ever before, and plus 500 futures is the perfect place to start. Plus 500 gives you access to a wide range of instruments, the S&P 500, NASDAQ, Bitcoin, gas, and much more. Explore equity indices, energy, metals, 4x, crypto, and beyond. With a simple and intuitive platform, you can trade from anywhere, right from your phone. Deposit with a minimum of $100 and experience the fast, accessible, you can trade from your phone.

Starting point is 00:41:11 futures trading you've been waiting for. See a trading opportunity. You'll be able to trade it in just two clicks once your account is open. Not sure if you're ready, not a problem. Plus 500 gives you an unlimited, risk-free demo account with charts and analytic tools for you to practice on. With over 20 years of experience, Plus 500 is your gateway to the markets. Visit plus500.com to learn more. Trading in futures involves risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus 500, it's trading with a plus. Billion dollar investors don't typically park their cash in high-yield savings accounts. Instead, they often use one of the premier passive income strategies for institutional investors, private credit. Now, the same passive income strategy

Starting point is 00:42:01 is available to investors of all sizes thanks to the Fundrise income fund, which has more than 600 million dollars invested in a 7.97% distribution rate. With traditional savings yields falling, it's no wonder private credit has grown to be a trillion dollar asset class in the last few years. Visit fundrise.com slash WSB to invest in the Fundrise income fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses.

Starting point is 00:42:47 This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. So I personally am always emphasizing the importance of partnering with aligned management teams in the businesses that I personally invest in. And I don't think that advice should change for investors looking for managers to invest with.

Starting point is 00:43:10 Search for managers who are incentivized to make you money, not just collect fees. A good manager should have to face the pain of losing money for the fund just like their investors will feel if money is lost. So even though Buffett mentioned the $100 that he put into the fund, I believe this was just at the very, very beginning. The evidence for this is in his 1960s letter to partners while discussing provisions to the fund. So he actually mentioned that his and his wife's life savings were invested in the Buffett partnerships.

Starting point is 00:43:37 He also said that they were the single largest investor and that they owned about one-sixth of all the partnerships assets. So to me, this is a cherry on top of an already excellent partnership structure. So the next section of this book that I want to cover is going to be about the investing buckets that Warren Buffett thought about for the fund. This book discusses four investment types. one, the generals, two, workouts, three controls, and four asset plays. So we're going to go over all these in a little more detail.

Starting point is 00:44:05 We're not going to talk too much about asset plays. But let's start off here by talking about the generals. So generals made up the largest percentage of the portfolio. He kept their names highly secretive. And I think the simple reason for this was that since many of these businesses were small and illiquid, he didn't want to necessarily have to compete with his partners to acquire shares in these generals. And another potential reason for keeping his investments a secret could have been to help him control biases. So the specific bias I'm referring to is commitment bias.

Starting point is 00:44:35 In the Nomad Investment Partnerships, they wrote, commitment bias occurs when we publicly disclose our positions, which most definitely affects our objectivity towards the position. So in investing, as anyone who has held a losing position knows, we need to be able to let go of an idea when it doesn't fit with our initial hypothesis. So perhaps Warren believed that sharing the names of his generals would bias him into making poor decisions and lower his willingness to part ways with an idea if partners, family members, friends and colleagues knew he was invested in it. After speaking with Annie Duke on TIP 623, I learned how to best handle commitment bias. In her book, quit, she has some great passages on why quitting is so hard.

Starting point is 00:45:15 Whether it is on the level of an individual, an organization, or a government entity, when we're getting bad news, when we are getting strong signals that we're losing, signals that others plainly see, we don't merely refuse to quit. We will double and triple down, making additional decisions to commit more time and money and other resources towards the losing cause. And we will strengthen our belief that we are on the right path. This means that when all the signals say we are wrong, we can often become even more stubborn. My favorite tool she outlined to combat this bias was when,

Starting point is 00:45:50 she called Kill Criteria. So Kill Criteria has two parts. A state and a date. It's very simple. So here's an example from my own portfolio. So I own a business called Eritzia, which I haven't spoken too much on the podcast about. But let's use that business and see what one of my kill criteria might look like. So I've made it a habit now since learning about these kill criteria to make them for every single business that I own. But one of the ones that I noted for Eritzia specifically was to do with gross margins. So, Essentially, the kill criteria is, okay, if Eritzia has gross margins below its 10-year floor of 36% and that's, again, over a 12-month time period, then that's a kill criteria.

Starting point is 00:46:31 So you can see this code criteria has both a state and a date. The state is gross margins below 10-year floor and the date is 12 months. So obviously it's floating. I don't have to say, okay, in the 12 months from now because they just had their latest quarter and the numbers are way higher. So it wouldn't really apply now. So that's kind of why I made it a 12 month period. You know, maybe it needs to be longer, maybe it needs to be shorter.

Starting point is 00:46:54 It's completely dependent on you and what you're comfortable with your businesses. So if this kill criteria was actually hit by the business, I think that's a, it's a really good signal that the fundamentals of the business are maybe falling apart. And, you know, I wish I'd had this framework for some of my businesses in the past because I feel like, you know, if I'd made the kill criteria, a lot of them probably would have been hit and I probably could have sold out a lot earlier and lost less money. so I think that's why Kill Criteria do have so much value. Now, I don't know if Warren Buffett ever actually used Kill Criteria, but given his intelligence and rationality, it would not surprise me one bit if he just wanted to avoid his own biases as much as possible. And I think keeping his idea as a secret might have been a really good technique for avoiding those biases.

Starting point is 00:47:37 As with all Buffett investments, the generals were acquired at a discount to intrinsic value. He took this notion even further and actually sought to look for discounts to private market value in public markets. this was a pretty incredible undertaking. After all, many private companies go public specifically because they want to increase the value of their holdings of their shares. So generally speaking, public evaluations are just higher than private markets. So Buffett knew that if he could find these generals trading below private market prices, the multiple rating alone could deliver very impressive returns to Buffett and his partners. With his generals, he also knew that he could heavily invest in a single idea. For instance, Buffett invested 10 to 20 percent of the

Starting point is 00:48:18 partnerships assets into Commonwealth Trustco in 1959. He calculated the intrinsic value of Commonwealth to be around $125. The price of the time was $50 on earnings of $10 a share. So he was getting a 20% earnings yield on the business. In a 1964 letter to partners, he further discussed the advantages of the general segment. He wrote, there is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price, that is an overall valuation on the enterprise substantially below what careful analysis indicates its value to a private owner to be. In typical Buffett fashion, he displayed his trademark contrarianism that has helped fuel

Starting point is 00:49:00 his investing career. Now, I want to touch on this concept of market sponsorship because it's an area that I've noticed more and more over the past year. So when I first started investing, market sponsors were a completely foreign concept to me. I don't think I spent a second ever actually thinking about it. But back then I was also investing in larger businesses and I don't think that market sponsors were necessarily needed because so many people in the market just knew about the business and their

Starting point is 00:49:25 products. But once I started investing in some of these small cap businesses, then I started realized, okay, this sponsorship idea is actually really, really powerful. So there's one that I own a small cap that I won't mention its name. But it's a business that has an incredible product, but the problem with it is that the product is not very well known by anyone, including their customers. So they actually literally have to go out to their customers, say, hey, look at our product. It's really good. Here's what it'll do for you. Here's how much money it'll save you.

Starting point is 00:49:57 You know, a business like Amazon, they don't have to do that. You know, everyone listening to this probably used Amazon once or twice and knows that they know what Amazon does. So just understanding this difference here between small caps and larger caps. and the different types of products and services that they sell is just really showed me how important having that sponsor is because, you know, if you have the right person or, you know, company or whatever that does a sponsor work for other business, it could just be really powerful, right? Because not only can it bring that idea to other potential investors, but it can also help just spread the word on their products, which kind of has this second

Starting point is 00:50:36 order effect of also maybe even helping the business find more actual business partners to sell their product to. And so one of the big problems is that a lot of these smaller businesses just kind of flounder in obscurity for long periods of time because investors don't know who they are and they just, a lot of people just don't know what their products are. So I think a market sponsor, especially in these smaller businesses, can really help solve this problem by just getting exposure to the business, both in terms of finding other investors, but also maybe even finding customers for its products. So the last point here that I want to make on generals is that Buffett was looking at very, very boring businesses. So as the Buffett quote I just referenced

Starting point is 00:51:13 points out, they tend to lack glamour. And I think this risk really plays to Buffett's avoidance of technology, but also more importantly to his avoidance of overpaying for stocks and for assets. So the next type of investing bucket, the book covers here, are workouts. Another really easy way to think of workouts is just as arbitrage. For instance, if you can find, let's say, the same stock trading on two different exchanges at different prices. You just buy it on the cheaper exchange and then sell it on the more expensive exchange. And there you go. There's your arbitrage. So one of Buffett's best known arbitrage deals from his past was in Rockwood & Co. So this was a business that really seemed like a very lousy business with very minuscule profits. But they were

Starting point is 00:51:54 a chocolate business. And because they were making chocolate, they also owned large amounts of cocoa and they had cocoa sitting in their inventory. And Buffett had found out that this cocoa that they were sitting on in their inventory was acquired at about five cents per pound. So in 1954, there was a shortage in cocoa. And this was causing a major supply demand imbalance. And because of the imbalance, it was shooting the price of cocoa up to over 60 cents per pound. So Rockwood was pretty intelligent about it, actually.

Starting point is 00:52:24 They decided basically they wanted to sell their inventory of cocoa to take advantage of this temporary cocoa bubble. But there was a problem. They couldn't just sell the cocoa by itself, because if they did that, they would have had about a 50% tax on the proceeds, which was very high, and they didn't want to deal with that. But the tax code came to the rescue. So there was a provision in the tax code that last in first out profits of inventory could actually be distributed to shareholders as part of a restructuring plan for the business. So basically, Rockwood had to terminate one of its businesses to satisfy this restructuring, and then the sale of 13 million pounds of cocoa bean inventory was part of that downsizing.

Starting point is 00:53:05 So in order to return valued shareholders, they basically would buy back their shares in exchange for cocoa beans, paying 80 pounds of beans per share. So Buffett said here, for several weeks, I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good, and my only expense was subway tokens. So Buffett basically would buy the Rockwood shares of $34. then exchange the beans worth $36. So there, his arbitrage was just $2.

Starting point is 00:53:34 And, you know, obviously you keep doing that over and over again. And it's a decent little deal. The only thing that was really needed in order to make sure that this arbitrage continued to work was that the price of cocoa beans had to remain elevated. Obviously, if cocoa beans kind of went back down to its normal price, then the arbitrage would no longer work. And you probably actually, you might end up losing money. So you can see how this type of arbitrage can create some interesting short-term profits

Starting point is 00:53:59 but, you know, there's not really much compounding available because the ARB deal eventually is going to be found out by people and the arbitrage between, you know, the buy and the sell price closes and it doesn't last for very long. So, you know, merger arbitrage just doesn't really necessarily seem like a very scalable strategy, but Buffett still employs it, you know, as recently as 2023 when he was part of the Activision and Microsoft merger. So Buffett saw Activision shares trading for $73 a share. And then the proposed, his acquisition price by Microsoft was actually $95 per share. So although Warren would end up selling 70% of his initial investment for the merger, he was still able to eke out a $1.4 billion

Starting point is 00:54:40 profit on the merger arb. So pretty good. So even though workouts require a lot of work, and I think it's probably the opposite of sit on your butt investing that Charlie Munger was such a proponent of, it really did have great results for Buffett. So as the book's author Jeremy Miller outlined. Using the record of Graham Newman, Buffett Partnerships and Berkshire Hathaway in the 65 years through 1988, Buffett figured the average unleveraged returns in the arbitrage business was about 20% per year. In the annual report that year, he said, give a man a fish and you feed him for a day. Teach a man to arbitrage and you feed them forever. Indeed, we know what 65 years of 20% average annual compounding does. It turns $100 into $14 million.

Starting point is 00:55:20 So another investment bucket that Warren used here is what he called controls. So the simple way of thinking about controls is just as activist investing. You know, think of investing legends such as Carl Icon or Bill Ackman and I think you're going to be on the right track here. Controls require that the investor kind of have to get their hands dirty and often do things that might upset the traditional way of doing things inside of a business. So let's jump into the Sanborn Maps case study that's outlined in the book. Sammore Maps was a business which required a jolt to a system in order to unlock its full value. And Buffett basically would be that jolt. So what did Buffett see in this business in the first place?

Starting point is 00:55:59 The business was quite simple. It had two value lovers. First, it basically just sold maps to insurance companies. So revenue had declined in the previous 20 years. But even though it had declined, it basically was unlikely, very, very unlikely to go to zero because the product had a very, very high replacement cost. So these insurance companies would just keep on shelling out money to Sanborn Maps specifically for the maps. And then the second value lever was just that it held an equity portfolio, which distributed dividends. So this is the important part.

Starting point is 00:56:29 So when Buffett found it, the map business was being evaluated at minus $20, with the stock owners unwilling to pay more than 70 cents on the dollar for the investment portfolio. So he put money into the idea, a lot of money, in fact. He put in 35% of the partnerships assets just in this one bet. So he knew that the equity portfolio loan was worth more than the entire business's market cap. So we bought up shares from unhappy shareholders and established a board seat for himself. Though he had to go through some pushback, he eventually got the business to basically sell off its stock portfolio and distribute it back to shareholders.

Starting point is 00:57:02 Buffett ended up making about a 50% profit on this investment in less than two years, which is somewhere around a 22.5% compound annual gain. It wasn't exactly sure on the date. So if the date was shorter than two years, that compound annual gain is going to go up. So now let's look in how Warren valued these controls because he obviously is conservative and everything else. He's probably going to be conservative in the controls as well. So Warren wouldn't use an appraisal of what he thought the control would be worth in the

Starting point is 00:57:30 future. Basically, it wasn't a number that he hoped it would be worth or even a number that, say, an over-eager buyer would pay him for it. Instead, he basically would use a number that he felt was realistic to sell under current market conditions in a very short period of time. Another interesting point on valuation is how Buffett would use assets a business own to calculate its value, the more traditional type of value investing. On this subject, Jeremy Miller made a great point.

Starting point is 00:57:55 Quote, when you do your valuation work, the assets are always worth what they can be sold for and the liabilities are always assumed to be due in full. That's the difference between accounting value and economic or intrinsic value, unquote. So his point is that valuing in business based on asset value requires making adjustments to those assets. Assets for lower quality businesses tend to not trade at par value. So adjusting them downwards at a conservative increment would probably yield the most conservative type of valuation. Benjamin Graham had some very rough rules of thumb here. He would ascribe 100 cents on the dollar for cash, 80 cents on the dollar for receivables, 67 cents on the dollar for inventory, and 15

Starting point is 00:58:35 cents on the dollar for fixed assets. Buffett stopped investing in controls a few years before closing the partnership down. In a 1968 partnership letter, he discussed the importance of doing business with people that he liked. He also pointed out that although controls might offer higher returns, it got to a point where it just was not pursuing for war and personally due to the aggravation of dealing with people who did not want to do business with them. So he said, it seems foolish to rush from situation to situation to earn a few more percentage points. It also does not seem sensible to me to trade known pleasant personal relationships with high-grade people at a decent rate of return for possible irritation, aggravation, or worse, at a potentially higher

Starting point is 00:59:12 return. So the final point on controls I'd like to touch on here are why he had this segment in the partnership in the first place. So as previously noted, he eventually grew tired of investing controls. But before he reached that point of peak aggravation, there was a reason that controls actually existed. So they were actually a hedge to his larger allocation and to generals. because controls would eventually be valued fairly in a reasonably short period of time, they could prop up the returns of the portfolio during times where the generals were lagging a little bit. Additionally, controls had asymmetric upside. There were really only two outcomes. One, the market prices the business closer to intrinsic value and then Buffett would sell out

Starting point is 00:59:52 a profit or two, the market continues to underpriced the asset, in which case Buffett just buys more until the market comes to its senses. So the next section of this book that I found fascinating was on the chapter called conservative versus conventional. Now, this chapter does an exceptional job explaining some more of the details on why Buffett plays such a high value on contrarian views and why other investors should place very little emphasis on conventional views. Warren's views on the opinions of others was largely molded by, I think, his relationship with his father.

Starting point is 01:00:23 So his father was a fan of some of Ralph Waldo Emerson's greatest philosophical concepts, self-reliance being one of them. Now, this is why Buffett did not take solace and whether or not the market agrees with them. It also meant that he was ambivalent towards the thoughts and opinions of those with high levels of influence and authority. Another great concept he learned from his father about conservatism was that conventionally speaking, once the consensus was in agreement, a thought or opinion was considered conservative. So if you go through all of Buffett's investments, most of them were not bought when the consensus viewed that stock in a positive light. So a great example of this straight from Warren Buffett is just Apple, right? He started buying Apple back in 2016.

Starting point is 01:01:04 But when he started buying it, it was at a very, very low P.E multiples at the time. I think he got it somewhere between 10, 11, 12 times earnings. So compare that now it's cheap. So he bought it at very low double digit P.E. multiples, say around 10 to 12. Now, a stock trading at a P.E. of 10 to 12, especially in kind of the tech area, it is definitely does not scream consensus to me. And another interesting point here is that since 2021, Apple has never sold for a price earnings ratio of less than 20 times.

Starting point is 01:01:35 So he's done really well on this investment, you know, both because obviously his return has been very good, but he obviously bought it when it was out of favor, knowing that it would, at some point, I'm sure he had no idea when it would be back in favor, which it's been now for quite a long time. The odd thing about Apple is that many hedge fund managers probably saw it as a very conservative investment at 20 times earnings. because the consensus view was somewhat similar. So in the 1965 letter to partners, Buffett wrote,

Starting point is 01:02:03 we derive no comfort because important people, vocal people, or a great number of people, agree with us. Nor do we derive comfort if they don't. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear. In the course of action obvious,

Starting point is 01:02:25 in that case, whether conventional or, or unconventional, whether others agree or disagree, we feel we are progressing in a conservative manner. Now, Warren's propensity towards concentration is pretty well documented. As I've already outlined, Warren liked to invest large portions of the partnership's assets into a single opportunity if the risk and reward was right. From the 1990s, Warren gave a speech to a group of students. In it, he outlined the following diversification criteria. He's basically said, six wonderful businesses is all the diversification that you need. Investing money into your seventh best idea is probably going to be inferior to investing in your

Starting point is 01:03:02 best idea. He made a point that very few people have gotten rich investing on their seventh idea, but many people have gotten rich off of their first idea. And then his final point here was that for anyone working with normal capital, six positions is great, and he would actually put half of his capital into his most loved idea. So Warren is known for well over 50 years that Orthodox views on diversification are just plain silly. In his 1964 letter to partners, he wrote, if good performance of the fund is even a minor objective,

Starting point is 01:03:29 any portfolio encompassing 100 stocks, whether the manager is handling $1,000 or $1 billion, is not being operated logically. The addition of 100th stock simply can't reduce the potential variance in portfolio performance, sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectations. So I just loved this point here.

Starting point is 01:03:52 He's definitely been quoted about it a lot in regards to diversification. But the thing that's always kind of confused me about being diversified is just trying to come to grips with understanding 100 business as well. I think that's maybe part of the reason for the fund industry, right? A lot of these funds will have, you know, many, many analysts, right? So if you have a team of 20 people, then sure, maybe, you know, each person gets five businesses and they can understand them at a high level. And that's kind of how they justify it themselves.

Starting point is 01:04:22 as an individual, you know, six businesses. I think, yeah, you could definitely understand that. Maybe you could go take that up to 10, 15, whatever. Depends how much time you have in your day. But it's just, it doesn't make a lot of sense to try to have 100 businesses because you're just not going to understand it at a very deep level. You know, maybe you can do things where you're only looking at the business, you know, just just reading their, let's say reading their annuals and their quarterlies

Starting point is 01:04:47 and maybe listening in that that's probably all the work that you're going to be able to do if you have a ton of businesses. but that means that you're also disregarding a lot of other work that could be really helpful, such as looking at competitors, looking at the industry, you know, talking with people involved in the business or maybe customers or suppliers, you know, all these other things. All these things take time, right? And there's only a certain amount of time in the day. So if you have a lot of ideas, it basically means that you're spreading yourself thin

Starting point is 01:05:11 and you're probably not going to understand your businesses as well as if you are a more concentrated investor. So I guess, you know, if you have no edge in the business that you own or you don't have the desire to, then you are best off diversifying. But the beautiful thing about that is you can just buy an index fund and not actually have to spend a second of time looking into the individual stocks that you own and you can probably just do really well. So the final point from this chapter I want to discuss is on time horizons and performance. So Warren was perfectly content with having a high variance of returns from year to year.

Starting point is 01:05:43 Between 1957 and 1969, Buffett Partnerships maintained its margin versus Dow ranging from a low of 2.4% to over 30%. So this meant that the partners had to make due with a wide variance. Now, many investors might be unwilling to have such large swings in portfolio returns, and that's okay. But Warren used the fact that he was chasing long-term returns to his advantage. Warren knew that he would have been able to smooth out his variance if he wanted to and accommodate maybe shorter-term partners if he wanted to, but doing so would have sacrificed

Starting point is 01:06:16 overall performance of the fund in the long term. Now, one of the aspects of Buffett's early days I find most enticing is how the role of size affected as a performance. So his funds started in 1958. But by 1966, he was actually no longer taking on outside capital as his capital was growing too quickly for him to continue using the strategy that had been working so well. So Buffett Partnerships, AUM was $43 million in 1966. And he said at this time that as circumstances presently appear, I feel substantially greater size is more likely to harm future results. than to help them. This might not be true for my own personal results, but it is likely to be true for your results. So the point on size and performance is profound, and I think worth

Starting point is 01:06:59 digging into a little deeper. Why would scaling up lead to decrease performance in Buffett partnerships? There are two primary reasons. The first is an inability to invest in obscure businesses with inefficient prices. As you grow larger and larger, you have to find larger and larger businesses to invest in. And I think, while yes, you can find inefficient pricing in those, it's just a much lower frequency. And the second one is just market cap problems. If let's say he wanted to stick with these smaller ones, he could theoretically do it, right? But the position sizes would be small, right? And sure, maybe he could find something that could double in the next year. But if he could only put 0.5% of his funds assets into that one idea, well, it wouldn't make too big of a

Starting point is 01:07:43 difference to the overall returns. So if we look at Buffett Partnerships performance through its lifecycle, it returned 29.5% compounded annually before fees. So it's too bad that Buffett didn't track intrinsic value at this time, but it probably just didn't really make sense, given the sense of the structure of the fund. But if you look at the book value of Berkshire Hathaway, which Warren has said is a good proxy for long-term returns, you can actually see that the book value is growing at a decreasing pace. So I went back and looked in 2000 and the kegger of book value at that point was 24%. And in 2024, that's dropped to 20%. And my assumption is in 20 more years, it's probably going to be some number or less than 20% as well. Now, if we look back at just the

Starting point is 01:08:22 past 10 years, book value is grown at a compound annual growth rate of only 9.8%. And market cap has grown at a compound annual growth rate of 9.6%. So the point is obviously that Berkshire Athaway has slowed down its growth as it has scaled. And unfortunately, that's kind of just an inevitable consequence of scaling. It can't go on forever. So the important takeaway here is that, that if you are working with modest sums of money, you do not need to follow in the footsteps of money managers who are investing large sums of money. Avoiding businesses with small market caps does you a disservice to your ability to compound your money. Now touching again on the point about position size constraints. So Warren noted one additional reason for closing the fund.

Starting point is 01:09:01 Due to AUM, he could basically not invest in positions where he could invest less than $3 million in a single position. So this obviously limited his investable universe even more. So let's transition to talking more about the go-go years in the 1960s. So Warren realized that his strategy, which allowed him to beat the Dow by such a wide margin all these years, would basically no longer work as it once had. In 1969, he ended up closing the partnership down, stating, I would continue to operate the partnership in 1970 or even 1971 if I had some really first-class ideas, not because I wanted to, but simply because I would so much rather end with a good year than a poor one.

Starting point is 01:09:37 However, I just don't see anything available that gives any reasonable hope of delivering such a good year, and I have no desire to grope around hoping to get lucky with other people's money. I am not attuned to this market environment, and I don't want to spoil a decent record by trying to play a game I don't understand just so that I can go out a hero. And with that, Buffett ended the partnerships and returned monies to his partners or suggested they invest with him in Berkshire Hathaway or invest with his friend Bill Ruehawain in Sequoifax. Interestingly, Warren could have actually sold his partnership to someone else, generating himself additional money, but he decided not to go that route because of his business philosophies. The partnership was originally built to make money along with his partners. It wasn't created to make money from his partners.

Starting point is 01:10:24 This big distinction, I think, is why he refused to sell it despite actually fielding offers for it. There is a vital lesson from Buffett's reasoning for closing the partnerships that applies to investing principles. Namely, you should not drastically alter your investing principles just to make a quick buck while not understanding the risks involved with such an adjustment. Buffett understood that the market at this time was favoring more speculative investments that did not appear to have a good risk return profile. The fact that more and more money was coming into the market was making his smaller and more obscure ideas harder and harder to find and justify investing in. So here's a wonderful

Starting point is 01:10:58 quote Warren wrote about the high returns on speculative investments. My mentor, Benjamin Graham, used to say speculation is neither illegal, immoral, nor fattening financially. During the past year, it was possible to become fiscally flabby through a steady diet of speculative bonbons. We continue to eat oatmeal, but if indigestion should sit in generally, it is unrealistic to expect that we won't have some discomfort. Now, Warren noted that in the years leading up to the closure of the partnership, he was only able to find two to three ideas per year. I wasn't able to find a reference point about what an average year look like for him in the 50s or 60s, but since he specified that number, say, two to three, I can only assume that it was much smaller number than he was

Starting point is 01:11:39 accustomed to. So I've now covered the bulk of Warren's ground rules, but there was a very interesting point of emphasis in the book about how Warren looked as stocks as bonds that I want to share with you. So part of the reason Buffett closed the partnership was because he saw returns for the Dow being lower than 10-year bonds. So at this time, tax-free municipal bonds were yielding six and a half to seven percent. Buffett thought stocks were unlikely to rise by more than, say, 6% per annum and pay 3% dividends.

Starting point is 01:12:07 This gets you a 9% return, but remember, this is pre-tax. So to make the two comparable, Buffett reduced the 6% return from stocks to 4.75% and the dividend yield from 3% to 1.75%. When we add these together, you get 6.5%, which approximates the yield on tax rebonds. For this reason, he assumed that the vast majority of money managers would underperform the market, due to elevated prices and additional frictional fees, I think this is part of the reason that he was so reluctant in trying to name other managers he trusted to provide similar results to the Buffett Partnerships after it was shut down.

Starting point is 01:12:39 Now, I want to conclude this episode by going over six of my biggest takeaways. Number one, a good investing track record requires three to five years of experience going through a full market cycle. Number two, an investing track record does not mean your returns are always going to be positive. In fact, beating your benchmark in down years, even with a negative return, is still a sign about performance. Number three, any stock pickers should be able to state their investment goals and not move the goalpost if performance suffers. If a money manager constantly moves a goalpost, that is a glaring red flag. Number four, make your own decisions and don't rely on validation from other people or the market to impact your decision making.

Starting point is 01:13:19 Number five, if you think like everyone else, expect the same results as everyone else, which is underperformance. And number six, don't destroy timeless principles to warrant unnecessary risk taking. Thank you so much for tuning into my episodes today. If you want to connect on X, feel free to follow me at a rational MRKTS or add me on LinkedIn if you'd like. I'm always striving to increase the quality and value of each episode that I release. So please feel free to provide me with any feedback you have, both of the positive and negative variety so I can enrich your listening experience.

Starting point is 01:13:50 Have a good one. 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 theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP662: Building Buffett: The Foundation Of Success w/ Kyle Grieve

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.