We Study Billionaires - The Investor’s Podcast Network - TIP733: How Warren Buffett Became Warren Buffett

Starting point is 00:00:00 You're listening to TIP. Over the course of six decades while leading Berkshire Hathaway, Warren Buffett has beaten the S&P 500, including dividends, by more than 150 times. It's a record that almost defies belief. But what makes it even more remarkable is just how he did it. He accomplished this by utilizing minimal leverage and avoiding the whims of Wall Street and their pursuits of short-term results, all while conducting business in an admirable, transparent, and really well-aligned manner.

Starting point is 00:00:28 He's one of the best examples in business of patience, discipline, and a razor-sharp focus on intrinsic value. So today, we're going to explore Warren Buffett in more detail through the lens of one of his biographies that was written about him, which is Buffett, the making of an American capitalist by Roger Lowenstein. The book does an exceptional job of sharing the details on some of Buffett's legendary deals, but also showing the more human side of Buffett, highlighting both his good and not-so-good qualities. We'll cover his early first. fascination with numbers, like counting soda bottle caps from a nearby gas station, and how he delivered 500 newspapers a day as a teenager. You'll hear about the profound influence of his father,

Starting point is 00:01:08 Howard Buffett, and how the teaching of Ben Graham transformed Warren Buffett from a precocious entrepreneur into an investor with a winning system. We'll also explore a period that interests me significantly, which was when Buffett achieved his most astounding results, compounding his personal account, at 56% per annum in the early 1950s. We'll also explore a period of the early 1950s. We'll also also analyzed Buffett's journey from investing in low-quality cigar butts to his evolution to investing in high-quality businesses. And we'll highlight why Buffett's philosophy kept him highly concentrated in his highest conviction positions. So if you've ever wondered why Buffett runs a public company while living an intensely private life, or why he's mastered simplicity

Starting point is 00:01:47 in a world that rewards complexity, or just pondered about what truly separates the great investors from the top 0.001%, Buffett's story is an absolute masterclass. Now, let's get right into this week's episode on the book, Buffett, the making of an American capitalist. Since 2014 and through more than 180 million downloads, we've 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 with the investors podcast. I'm your host, Kyle Greve, and today I'm excited to speak about one of my favorite investing biographies. Buffett, The Making of an American capitalist by Roger Lowenstein. I read this book a second time to prepare for this episode, and I must say it's a very,

Starting point is 00:02:47 very well-written biography. Lowenstein does a great job of narrating Buffett's early life and weaving in just some excellent, excellent storytelling along the way. So today, we're going to go into some of the stories that have helped shape Buffett into who he is, as well as some of the stories that have shaped the public's perception of Warren Buffett. But as with all biographies, we're going to start at the beginning and look at how Buffett's childhood shaped him. Now, Buffett was obsessed with a few things at a very young age that I

Starting point is 00:03:13 think are very, very rare. One of his first money-making ventures began just at the age of six years old. Now, during that time, he would do things such as buy a six-pack of Coke for 25 cents, sell them each for five cents, and then pocket a nickel for himself in profit. He did this for his grandfather's grocery store and even took some time from a rare family vacation in Iowa to sell some Coca-Cola bottles. Now, by the age of nine, Buffett was showing an additional affinity for numbers. Buffett would count bottle caps of different drinks from a nearby gas station with his friend. And it's funny to think about it because this was sort of an entrance into Scuttlebutt, which was a type of research that Warren became very well known for. He wasn't just counting all the caps haphazardly. He was

Starting point is 00:03:55 doing it with purpose. He was separating them into specific brands. Therefore, you know, he was really examining the microcosm of the competitive landscape of the soft drink industry. And it's Funny to think he wouldn't start buying Coca-Cola for nearly five more decades. These idiosyncrasies were just one of many. Buffett also enjoyed thinking about things like memorizing city populations, looking at the frequencies at which individual letters appeared in newspapers, looking at lifespans, and how often a ball would bounce off a paddle that he was playing with.

Starting point is 00:04:26 One of Buffett's major influences was his father Howard, whom we'll talk about quite a bit today. One of his first lessons to Warren and his siblings was to understand understand the value of tangible assets. So when Roosevelt was president, Howard believed that he would destroy the dollar. So he gave the children things like gold coins and he purchased items such as crystal chandeliers, silver flatware, Oriental rugs, and even a farm, all things that are obviously tangible, right? And he did this specifically because he felt that these kinds of items provided good protection

Starting point is 00:04:57 against inflation. Now, Howard was a primary influence that sparked warrant interest in the stock market. Howard worked as a stockbroker for a time, and Warren would visit him at work and spend hours just infatuated with stock and bond certificates. Now, near his father's office was another building that had stock quotations that Warren would frequent. As a result of spending time at his father's office and reading, he got the courage to purchase his first stock at the ripe old age of only 11 years old. Now, the first stock that he ever bought was something called City's Preferred Shares.

Starting point is 00:05:29 And just to give you an idea of Warren's incredible memory, at the age of 88, he wrote in one Berkshire letter. The year was 1942. I was 11 and I went all in, investing $114.75 I had began accumulating at age six. What I bought was three shares of city's preferred stock. I had become a capitalist and it felt good. But, you know, his experience with his first stock investment was probably pretty far from good. So Buffett bought three shares for himself and three for his sister at around $38. After purchasing, the share price plummeted to $27, which obviously a lot of concern for both Warren Buffett and his sister, Doris. Warren ended up holding and selling for a small profit when the stock price went back up to $40. Unfortunately, the stock price continued

Starting point is 00:06:13 to rise to about 200, leaving Warren with his first major lesson regarding the mistake of omission, which is to sell too early. Warren was more skewed towards learning about business the old-fashioned way. He had a slew of different money-making activities in his teenage years, helping him understand how business was conducted and run. So a couple of the different ventures he had, you know, he would go around golf courses, find golf balls, then resell them to other

Starting point is 00:06:39 golfers. He built a small paper delivery empire, delivering about 500 newspapers daily and netting himself about $175 a month. He even bought farmland. He rented a car that him and a friend restored and made income that way. And perhaps my favorite story was just

Starting point is 00:06:55 the pinball business. So a friend of Warren's, Donald Danley, bought a pinball machine in the senior year of high school. Now, pictured adolescent Warren and his friend Danley playing pinball in the basement, frustrated that the machine can just continue breaking down. Now, luckily for Warren, Danley had expertise in fixing the device each time that it broke down. This got Warren thinking, what if they put a pinball machine in a local barber shop and rented it out? Dan could handle any of the needed maintenance. So Warren and Donald approached a barber who agreed to have a machine in his shop with a 50-50 split.

Starting point is 00:07:29 And at the end of the first day, Warren and Donald found $14 in the machine. Warren's eyes lit up as he calculated the potential profits from this business venture. That taste of success led him to continue pressing on. Within a month, their pinball machines were in three more stores. That led to continue growth into even more barbershops. They eventually called the business Wilson Coin operated machine company, and they were making about $50 a week. Warren's part of the business was to buy the pinball machines for about $25 to $75 and write regular financial statements.

Starting point is 00:08:02 Donald Downley would fix them, and that was just the business model. However, since Warren and Donald were only in high school at the time, they had to invent a story that they actually worked for someone else, which they obviously found very, very amusing. Now, I like the story because it's just so easy to relate to. When I was in Omaha this past May to see Warren at his final Berkshire annual general meeting, we got a chance to go to one of his favorite. stores, which is Hollywood Candy. Now, if you want to understand what Hollywood Candy is like, picture your favorite candy store, then could Rupil its size, and you're probably going to be in the right neighborhood. There's even a video floating around on the internet of Warren Buffett and Bill Gates walking through the store. It's very wholesome, and they have a little shrine to it

Starting point is 00:08:41 inside of the store. Now, to tie this back to the pinball story about Buffett, Hollywood Candy has this room that's full of pinball machines that appear to be built probably around the time that Buffett would have been running his pinball business. So while walking around this room, it really made me think about the pinball business, and if any of the machines that were maybe inside Hollywood, maybe once belonged to the Wilson coin operated machine company. One part of the book that I found fascinating and telling of Warren's future abilities as a father and a husband was his relationship with his mother.

Starting point is 00:09:11 It was rocky, to say the least. Warren's mother, Leila, was a sweet-natured woman, but she could turn on a dime. Without any warning, she could become just furious. She'd rage at Warren and his sisters for hours at a time. She would compare them to other children, criticize their every single behavior, and bring up their failings. From the sounds of it, these mood changes were completely unpredictable, which made them all the more shocking to Buffett and his sisters. Concerning this, Lowenstein writes, Once, in more recent years, one of Warren's sons who was home from college, called Layla, to say hello.

Starting point is 00:09:44 She suddenly lit into him with all her fury. She called him a terrible person for not calling and detailed his supposedly innumerable. failings of character. And this went on for about two hours. When Warren's son put down the phone, he was in tears. Warren said softly, Now you know how I felt every day of my life. I think this likely would be considered a pretty traumatic event for Warren.

Starting point is 00:10:06 And it's hard to assume just how much of an impact it's had on him for his entire life. But it's hard to imagine it hasn't had some sort of effect on him, especially as a father. Perhaps his distance from his children was born out of a fear that he would have some of his mother's fury inside of him as well. we'll never know for sure. And then in terms of ambition, perhaps some of his ambition came from wanting to show his mother that he had more value than she was attributing to him. This is all speculation, of course. Warren is an intensely private person, but it's hard not to see how events like this could have shaped him for better or worse into the person that he is today. Let's now chat about another one of Buffett's biggest inspirations, Benjamin Graham. Buffett went to Columbia to take Graham's course

Starting point is 00:10:46 on investing. This was about a year after the intelligent investor, Graham's most well-known book, was released. Buffett already knew that Graham was his guy. His concepts resonated with him more than others because speculative techniques, charts, and hot tips had burned Warren in the past. And Graham was the antithesis of the speculative strategies. What was the core learning that Buffett took from Graham? I think there are three big ones that he used for the entirety of his investing career. The first one is simple. It's the margin of safety concept. The second. The second, The second one is the Mr. Market analogy, and the third one is just treating shares as fractional ownership of a real business.

Starting point is 00:11:23 Let's go over the three of these in a little more detail. So for those who are unfamiliar with the margin of safety, the book has one of the most eloquent definitions of the margin of safety that I've ever read. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his weight. Taking this one step further, we can observe how Buffett applied this exact mental model to a company that he acquired for Berkshire Hathaway. In 2008, while reminiscing about the investment, Buffett said,

Starting point is 00:11:56 I came to the conclusion that PetroChina was worth $100 billion. And then I checked the price, and it was selling for roughly $35 billion. Now, if I thought the company was worth $40 billion and had been selling for $35 billion, then at that point you have to start trying to refine your analysis a little bit more. But there's just no reason to refine your analysis. I mean, I didn't need to know whether it was worth $97 billion or $103 billion if I was buying it at $35 billion. Any further refining of analysis would be a waste of time when what I should be doing is buying the stock. If you have to carry it out to three decimal places, it's just not a good idea.

Starting point is 00:12:34 It's like if somebody walked in the door here and they weighed somewhere between 300 and 350 pounds. I might not know how much they weigh, but I would know that they were fat. That's all I'm looking for, something that's financially fat. And whether PetroChina weighed $95 billion or $105 billion didn't make much difference, it was selling for $35 billion. Now, the second major learning here was a Mr. Market analogy. This one is probably very well known by all of our listeners. But if you missed it, here it is.

Starting point is 00:13:02 Picture the stock market as an ornery, moody neighbor. Each morning, they shout across their friends the stock prices that they're willing to buy and sell to you. On days where they're elated and happy, they might buy stocks. from you at inflated prices. And on days when they're depressed or sad, they'll sell you their shares at a steep discount. The concept is simple. Use the market as a tool to serve you, not the other way around. When the market is feeling exuberant, you're less likely to find attractive deals. In that scenario, holding or selling is often the necessary action that you should take.

Starting point is 00:13:33 But when the market is depressed, there will be opportunities everywhere. And that's when it's time to deploy capital. There are innumerable examples of Buffett using the Mr. Market analogy in his favor. Basically, whenever the stock market has been shocked by an event, which caused mass selling, Buffett licked his lips and got to work. You can look back at events such as, you know, the 1973, 1974 bear market, which happened after he decided to close a partnership because he couldn't find any ideas. So in 1987 after Black Monday, Buffett was in there buying, buying, buying. Just, you know, name your crash and Buffett's probably there making large purchases. Other examples of the dot-com bubble, the great financial crisis, and the 2022-23 market decline.

Starting point is 00:14:14 Buffett was very busy during all of those times. Then the final investing lesson here that Buffett learned was the importance of treating shares as a fractional ownership of a business. When listening to Buffett, he often imagines himself buying the entire company. I think this is a mental model that is in complete alignment with Graham's concept of thinking of shares as a fractional ownership. If you imagine yourself buying an entire company and like those prospects, and chances are you're also going to enjoy the prospects of being a fractional shareholder as well. Now, there's one area of learning that I focused on, which is the share structure of a business. Buffett-like businesses where going forward, if you owned 5% of that business, you'd likely

Starting point is 00:14:55 own 5% or more of that business in the future. Your ownership stake would say the same because the company tended to be light on stock-based compensation or dilution through things like warrants. Instead, Warn looked for companies that had excess cash to reinvest into the business at high returns and then pay a dividend or repurchased shares. Now, I know I personally sometimes overlook this. If you own a business in its entirety and think that the cash flows will increase at, let's say, 20% per year for the next three to five years, you also have to forecast where the outstanding shares will end up. For instance, when I first bought in mode, I didn't really take this into account. I purchased it in about 2020. And during that

Starting point is 00:15:32 period I owned it until early 2023, my ownership was diluted by about 6% compounded annually. If I assume that my returns would approximate the cash flow growth of the entire company, I would have been sorely mistaken. Because of dilution, the cash flow growth per share would have shrunk to about 13% instead of that 20% example that I had before. And even if you owned a private business, you could still end up lowering your ownership stake if you were forced to, let's say, refinance your business in exchange for shares. So, you know, even So, if you use this metal model, which I think all investors definitely should, just don't forget to examine the capital structure and take that into account to ensure that you can live

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Starting point is 00:20:20 All right, back to the show. Now, let's get back to Buffett and Graham. Another key lesson that Buffett learned from Graham while studying with him at Columbia was the importance of cloning ideas. Most Buffett enthusiasts know Warren got Geico from Graham, but did you also know that he cloned plenty of other ideas? These are less well-known ideas, things such as Marshall Wells and timely clothes. But Warren saw the value in using the ideas of other people that you admire

Starting point is 00:20:47 to help get you a lead on new ideas. Now, once Buffett finished the class with Graham, he enthusiastically tried to secure a job with him. And Buffett gave him the best terms possible for a new hire, to work completely for free. But even that wasn't a good enough deal for Graham as there were other forces at play. So during this time, Jews were essentially locked out of Wall Street firms.

Starting point is 00:21:08 And Graham wanted to keep spots open for other Jews, so unfortunately, Buffett was out. But Warren wouldn't be deterred. He returned home and got a job working at his father's brokerage. But, you know, the brokerage business just wasn't really for Warren. And the problem was pretty simple. Warren just didn't enjoy the process of being a stock peddler. Instead of being energized by selling stocks to other people, Warren got his energy by finding new and cheap opportunities. This was the period where Warren was going through the Mooney's manual with the

Starting point is 00:21:36 same fury that a child has opening Christmas gifts. He was finding gems like Kansas City Life, Genesee Valley Gas, and Western Insurance Securities, which were trading at less than three times earnings. Warren figured these stocks ought to be owned by someone, and if his clients weren't going to buy them, then Warren would. And on top of that, he didn't like how the brokerage industry worked. For instance, he'd get an idea, share it with a potential buyer, who would then take a pass. Then he'd later find out that they'd bought it through a different broker who was more experienced than him. And the customer would trust that other broker just because Warren was young and seen as an up-and-comer.

Starting point is 00:22:13 Warren thought the industry was misaligned as well. So getting a commission, whether your client made or lost money, just didn't sit well with Warren. But by 1954, the religious barrier on Wall Street had been dropped. And as a result, Graham offered Buffett a job paying him about $12,000 a year. And while Buffett must have felt like this job was a dream come true, as time passed, he realized the job at Graham Newman wasn't really the best fit for him. For one thing, Buffett felt Graham was overly fearful of another depression.

Starting point is 00:22:41 This made getting ideas that Warren had really hard to get approved. And Warren had tons of ideas at this time. Additionally, the firm had managed very small amounts of capital, approximately $12 million. And much of this capital was tied up in cash, which was presumably because Graham was fearful of deploying this cash in case of another depression. Another problem was Graham's obsession with the company's balance sheet. For instance, Walter Schloss bought Haleid, which owned Xerox to Graham. its current business was worth about $17, but the stock traded for $21. Schlaas concluded that you could

Starting point is 00:23:17 take a flyer on Xerox for $4 and see what would happen with a fair amount of downside protection. But Graham told Schloss it just wasn't cheap enough. To Graham, Haloid was just pure speculation. Now, by 1956, Graham actually shut down Graham Newman, and during this time, Warren had been very busy building his personal account. When Warren talks about the legendary times of compounding over 50% per annum, it was during this exact period that he was referring to. Between 1950 when he finished college and 1956, when Graham Newman was shut down, Buffett compounded his personal account at 56% per atom. And this is where the story of Buffett just really takes off.

Starting point is 00:23:54 In 1956, Buffett began accepting money from family and friends and established partnerships with them. Buffett was 26 years old at this time. And even at this young age, he faced problems that most 26-year-olds today don't spend much time thinking about. And that's the problem of legacy. We know Buffett loved math and the concepts of compounding. You know, he just finished this period of his life where he was compounding at 56%. While he would have known that he probably would not have kept that rate of return up forever,

Starting point is 00:24:22 he knew that even if he made, you know, half that return for another decade or so, he would be worth millions of dollars. Buffett thought this was a foregone conclusion and he worried about what all that money would do for his kids. This is a great example of Warren being rational and wanting to give his kids just a good life while making sure they didn't grow up with a silver spoon. Now, let's get back to how the partnerships were formatted at this time. Buffett has made the 0625 free structure very popular among Buffett clones,

Starting point is 00:24:50 such as Monich-Bri or Gautombayde. But his original format was actually a little bit more favorable for Buffett. So he started actually at 0-425. So this arrangement featured a 0% management fee, with 4% of profits allocated to partners, and then 25% exceeding that threshold would then go to Buffett. Now, I have no idea why it started at 4% and then moved to 6%. I can only guess here.

Starting point is 00:25:13 And my guess is that Buffett might have needed more money when he first started the fund and having that 4% watermark allowed him to make a few extra bucks while still offering a great return to his partners. Once he was more established and had more capital, he probably raised it because his needs changed as a partnership scaled up. By the end of 1957, about two years after leaving Graham and Newman, Buffett had managed five separate accounts. The compying capital was very modest at just $500,000.

Starting point is 00:25:38 And in that year, he posts returns about 10%, compared to the Dow's return of negative 8%. You might be looking at this number and thinking, okay, well, it's not that impressive. But, you know, given the down year in the index, the impressive part about his performance was the 18 percentage points about performance. In Lowenstein's book, it doesn't make too much of a mention of how Warren thought that he should be evaluated by his partners. Instead, we can examine his partnership letters from those days to see how he wanted to be evaluated.

Starting point is 00:26:06 And it's quite simple. He wanted to beat the Dow or more like cream the Dow by 10 percentage points per year. If you want to learn more about Buffett's ground rules for how he managed the partnership during that time, I would recommend listening to TIP 662 where I go in depth into this subject. The point here is that Warren thought a good investor should be able to beat a benchmark. Otherwise, what was the point in putting your money in with that investor? He provided a three to five year timeline which allowed partners to evaluate Buffett through both up and down cycles. Now, back to the partnership. So the partnership years were also a time when Warren remained focused on his lessons from

Starting point is 00:26:42 Ben Graham. If you made 56% returns per atom, I think you'd probably stick to the same strategy as well. So he was looking at just a ton of cheap, cheap companies. One interesting idiosyncrasy about Warren was that he did not like to share his ideas with others. And I think he did this for a few reasons. First, he believed in the independence of thought. And I think if he thought that he should have independence of thought, it was probably

Starting point is 00:27:06 logical that he would think that others should as well. And second, he knew a lot of people who highly respected his opinions on investing and had substantial financial resources. So when you're looking at microcaps, which was what Warren was doing at this time with small floats, low liquidity, the last thing you want is competition for shares. From 1957 and 1961, Buffett had cumulative gains of 251% for the partnership compared to just 74% for the Dow. So his partners were quite happy. However, as he signed up more and more partners, he decided to merge all the partnerships into one. This single partnership allowed him to quadruple the minimum investment to about $100,000. Another significant event occurred during this time. Warren was introduced to

Starting point is 00:27:51 Charlie Munger. And, you know, they hit it off immediately. And Munger helped change some of Warren's thinking about the role of quality in investing. Around the time that Warren met Charlie, he'd invested in a cigar butt called Dempster Mill Manufacturing. It was, you know, You know, your typical Graham play, cheap, tons of assets. But similar to many Graham-type businesses, the actual business was just nothing to brag about. Warren thought the shares were cheap enough to take a controlling interest. But when he went to the mill to see why it just wasn't performing very well, he knew he didn't have the skill set to write that shit.

Starting point is 00:28:24 So Warren went to Charlie about the problem with Dempster. Charlie had a different thought process on businesses like Dempster than Graham would have offered. Charlie felt that troubled companies like Dempster traded at discounts because the underlying business just wasn't good. And it was also hard to fix these types of businesses. Now luckily for Warren, Charlie introduced him to his friend Harry Bottle. Harry went into the business and just cleaned house. He decreased inventory and staff count.

Starting point is 00:28:51 And it worked wonders from a financial standpoint. One interesting aspect of the dumpster story was how Harry went about decreasing inventory levels. Harry attributes a significant portion of the success of this specifically to Warren and Charlie, and interestingly, they were able to increase a value of inventory by assessing its replacement cost against those of competitors. Here's what Harry said. One idea came from Warren and Charlie. Upon investigating our sales pricing structure, we were evaluating replacement and repair

Starting point is 00:29:19 parts equal to the total of the sum of the completed item. So, lacking of any cost data to determine the correct pricing, they suggested that we simply categorize all parts into three categories. The first one, an item 100% proprietary, not available except from us, increase up to 500%. An item semi-proprietary increased 200 to 300%. Non-proprietary increased 0 to 100%. We turned this inventory with an estimated inventory value of 300,000 into a resale value exceeding $2 million. Incidentally, we had a few, if any, objections to our pricing strategy and continue to sell these parts at higher sales prices with little, if any, sales resistance.

Starting point is 00:30:02 Now, this clearly showed Warren that a business that could increase the price of its products was a very, very powerful business model. And even though Dempster wasn't a great business, it was a crucial lesson that Warren would utilize for future investments. But as I mentioned there previously, Bottle had to lay people off and laying people off did not sit well with Warren and he never wanted to go through that type of experience again. So, you know, Warren wasn't perfect. Despite this crucial lesson that he learned at Dempster, he was about to make arguably

Starting point is 00:30:31 the worst investment decision of his career. And this, of course, was his investment into Berkshire Hathaway. Funny enough, when doing some of the scuttlebutt on this industry, he would have learned that textiles was a really lousy business. Sol Parson, who owned a men's shop in Keywitt Plaza, where Buffett had recently moved his office to where his office was still today, got a visit from Warren one day. So while inquiring about the suit industry, Sol told him, Warren, it stinks. Men are buying suits.

Starting point is 00:31:01 But Warren couldn't help himself. His roots with Graham were still strong at this point. Berkshire Hathaway's shares were trading at about $7.60 and they had $16.50 of working capital. I assume Buffett figured this was what it was worth in a liquidation event. And since they never liquidated, perhaps he believed they could still sell all their linens at or above that price in short order. This was a mistake that he would regret over the next two decades. The business simply was not capital efficient, and therefore Buffett was not interested

Starting point is 00:31:31 in plowing more money into a company that just didn't offer returns that exceeded his hurdle rates. The tech style industry just wasn't a good place to have capital. Basically, the way it worked was that once a competitor upgraded their machinery, everyone in the industry had to follow suit, and that was just to keep even. So there weren't really a lot of ways to get a competitive advantage. And this meant that just having to maintain your business meant you had to spend more and more money on machinery that didn't offer a higher return.

Starting point is 00:32:02 Now, Warren knew that with the cash flows he was getting from Berkshire, he could use that to purchase other private businesses and stocks. And unless Berkshire Hathaway could offer a return above what he was getting elsewhere, he was unwilling to put even a dollar back into the business. I feel I'd be doing our listeners of a disservice if I didn't speak about one of Warren's most contrarian and successful investments, which is American Express. So many Berkshire Hathaway shareholders know that through Berkshire, they've held American Express, which has compounded since 1991.

Starting point is 00:32:32 But this wasn't actually Warren's first rodeo with the business. His first investment into American Express was all the way back in 1963, and it once again top of it, the strength of a brand. Now, I'm not going to go into too much detail on American Express. Express just realized that the share price had dropped nearly 50% over just a few months. Now, the market believed that American Express was on the book for about $150 million of potential fraud from one of its customers. Using Graham's Mr. Market analogy, the market was petrified of holding the stock because

Starting point is 00:33:05 of what could have happened if Amex had to pay back that bill. But Amex was not required to foot that entire bill. They settled on about $58 million payout to settle the case and move on. But during this time, Warren had used more of the scuttlebutt to better understand the strength of American Express's brand. He positioned himself next to the cashier at Ross's Steakhouse in Omaha. He chatted with the owner, and as he watched the cashier sing, he noticed that customers were still using their American Express cards to pay for their dinners. And from this, he deduced that customers would probably continue to use their American Express card to pay for their bills all across America. Warren would eventually get about a triple on this investment in only about three years, making it a significant success for him.

Starting point is 00:33:50 Now, another Warren Buffett Hallmark was his preference for concentrated bets. During the early 1960s, Warren had the lion's share of the fund's assets and only five names. To Warren, his partners were paying him to outperform. And if he couldn't put a hefty concentration on a bet, then you were just investing like the market. And you would get market-like returns. So Warren felt that excessive diversification was an admission that managers just couldn't pick winners. Now, this has been a subject that I spent a lot of time thinking about. And while I'll always be a concentrated investor, I've allowed for a little bit more diversification

Starting point is 00:34:25 than I would have previously been comfortable with. My rationale is pretty simple. Since I now invest a part of my capital into microcaps, which I sometimes consider more venture style bets compared to investing in quality compounders, I allow some of my positions to remain just a little bit smaller to account for downside protection. Warren might find this to be a complete abomination, but, you know, given how many positions I own, I still think I'm fitting well into Buffett's rules. At times, I've only had about eight positions. And today, near my highest amount of diversification, I own around 13 positions. So, I would say I'm still quite concentrated.

Starting point is 00:35:00 I have no problem allowing my compounders, some of which my microcap bets eventually become, to run up higher in concentration levels within my portfolio. But, you know, if an idea, Zia doesn't deliver returns, then it becomes obvious to me because my concentration levels in that bet just won't increase that much. Now, this signals to me that either my thesis was wrong or the market is misunderstanding the opportunity, which then helps to further guide my decision-making. Now, once Buffett tasted the success of American Express and realized that it was an investment that did not trade below liquidation value, but still proved to be a success, he began looking for similar opportunities in other businesses. Disney was one such business. So Lowenstein-Rite,

Starting point is 00:35:39 his definition of value was changing, or rather broadening. To Buffett, the value of Disney's film library, even though imprecise and mostly off the books, was no less real than a tangible asset, such as a factory. In the first 10 years of the Buffett partnership, Buffett continued to just crush the Dow. The partnership's returns were a whopping 1,156% versus 123% for the Dow. After fees, his partner's returns were 704%. However, in 1967, market conditions began to shift. These were the go-go years where the Nifty 50 was first formulated.

Starting point is 00:36:16 It was a time of rapid growth, speculative excess, and then followed by a painful dose of reality. However, the ride-up was just not an environment that Warren was pleased with. It was becoming increasingly difficult to find positions that would meet his benchmarks. One that he did own was associated cotton, a dress shop chain. The founder of this business was named Benjamin Rosner, who was planning to retire. But Buffett knew that this gentleman was integral to making the business run smoothly. So Buffett asked Rosners to stay on for six more months. And since this business was Rosner's baby, Buffett told Munger, that's one problem we don't have.

Starting point is 00:36:55 This guy won't be able to quit. And he didn't. Rosner ended up staying for 20 additional years. And this, I think, shows how introspective Buffett was at just understanding people and the relationship. to their businesses. But as the market began getting hotter and harder, Buffett was finding fewer and fewer opportunities and places to deploy capital.

Starting point is 00:37:16 He realized that perhaps it was time to get out while the going was still good. His decision to close down and how he did it were actually very, very unique. On Wall Street, shutting down a fund that had the success that he had was just absolutely unheard of. No one did it.

Starting point is 00:37:30 So selling the business or changing a strategy would have been the most likely scenarios. But, you know, Buffett, lived by this inner scorecard. And he knew that both of those options were just suboptimal for his partners. I think if he knew that the positions had been reversed and Buffett was a partner, that he wouldn't want someone else managing his money or taking a radically different strategy.

Starting point is 00:37:53 So once the partnerships were closed, he had suggestions for where his partner should invest. He said that they could either invest with his friend, Bill Rewain, who was setting up the Sequoia Fund and obviously had a massive amount of success, or they could invest right alongside Warren Buffett in Berkshire Hathaway, a business where Warren reportedly was a major fan of the CEO. Now let's take a short tangent here to discuss more about Buffett's secrecy, even with those he loved. Not only was he keeping new ideas close to the chest, but he was also keeping the secret that his net worth was growing from his children. Warren lived off of just about $50,000 per year, a salary that he received from Berkshire Hathaway.

Starting point is 00:38:32 He didn't drive fancy cars, his children went to public schools, and his kids lived, you know, a very similar life to that of all their friends. His daughter, Susie, learned of her father's fortune from actually reading a newspaper, not even from her dad himself. To afford fun things, she had to get a job as a salesperson at the young age of 16 years old. Now, Warren was very interested in making sure that his children lived a life without a silver spoon, as I previously mentioned. And while his relationship with his children could be rocky due to his inability to open up, He managed to loosen the purse strings a little bit as he aged. Lowenstein also points out Warren's thoughts on charities, which I thought were very interesting. While Warren wanted to give back to charity to leave the world a better place than when he entered it,

Starting point is 00:39:16 he really struggled to think rationally about how charities were run. As I mentioned, Buffett wouldn't put a dollar into a business if he wasn't going to get a high return on it. And this metal model was the exact same in social projects. So if a charitable initiative was a testing ground or required faith to succeed, Warren was just not interested in donating. It was seen as speculation. Lowenstein writes, the very discipline that made him a good investor crippled what could have been a very powerful inclination to work for societal changes.

Starting point is 00:39:45 He needed a yardstick. Buffett once told a reporter, in investment you can measure results. With some of this other stuff, you don't know in the end whether you've won or lost. Now, getting back to investing, Warren stayed very busy in 1973. This was a period when the nifty 50 was beginning to crack and fund managers were pulling money out of the market as fear crept up. During this time, Buffett made several investments in Berkshire Hathaway. So they were names such as Detroit International Bridge, National Presto Industries,

Starting point is 00:40:17 Dean Whitter, Ford Motor, pick and save, Grand Union, and many other names were being added to Berkshire's public stock portfolio. Conditions were so good for Buffett that he had more ideas than cash at this time. Now, to solve this, he wanted to raise about $20 million in senior notes. The problem was that raising this money was actually pretty tough because lenders knew that Berkshire, the textile mill, was not a good business and wouldn't want to put money into that business. So Solomon, brothers, who was in charge of helping to raise the money, had to actually persuade

Starting point is 00:40:48 the lenders that the money was specifically for Buffett and not to reinvest into Berkshire Hathaway. Lenders also demanded in the terms that they'd be able to demand repayment if Warren Buffett sold stock. Warren eventually secured the $20 million at about an 8% interest rate. Warren made a good point that borrowing money makes the most sense when the money is cheap. This reminds me of debt cycles that Howard Marks has discussed in details in the most important thing. Debt is cheapest when lenders are willing to lend. If you wait to borrow when you need a loan, you're likely going to get worse terms on that debt. This is a good lesson regarding raising capital. Now, in 1974, Warren discovered other business models that he was starting to find

Starting point is 00:41:28 attractive. Media businesses were one of them. He saw media businesses as a cash generating machine due to their ability to generate revenue through advertising. And you know, unlike, say, a Dempster Mill or Berkshire, which just sucked up cash to make profits, and the advertising business required a couple of people, some desks, and a pencil to generate advertising profits. This was the kind of business that Warren really, really liked. Given his success with other media businesses, it's clear that he nailed this business model. I also personally liked this business model, not necessarily in advertising, but just broadly. So bear with me here. So I owned a coal royalty business, and this was a similar business model in my opinion. Now, it seemed a little bit weird, but let me explain. So if we look at

Starting point is 00:42:14 Buffett, he knew that advertisers needed a place to advertise. When Buffett made these investments, the primary means of advertising was through things like TV, newspapers, and radio. So if you owned a business in that industry, that was your key to success. Now, as for the coal royalty business that I owned, the world still needs coal, especially the kind that's used for making steel. There are only certain places where metallurgical coal is located. So if you own the land where that coal sits, you could generate loads of cash without spending very much money as the miner actually takes care of the CAPEX in this case.

Starting point is 00:42:45 And that's what this business does. It's got 50 employees and generates a few hundred million in half. annual revenue. Pretty good. Now, during 1974, the market completely collapsed. The market had been in a bear market for about six years, twice as long as the bear market that was caused by the Great Depression. And at this time, Warren was as happy as he could be. In a rare public interview on Forbes, Buffett was quoted as saying, now is the time to invest and get rich. And since he truly believed this, unlike many other friend managers, he made just an absolute killing. Another business that Warren is very well known for is Blue Chip Stamps.

Starting point is 00:43:19 This business had a float similar to an insurance company. And as we already know, Buffett loved businesses that generated cash that he could invest in opportunities with superior returns. Lowenstein writes, to Buffett, Blue Chip was simply an insurance company that wasn't regulated. Now, here's how it works. So Blue Chip collected a fee from supermarkets that distributed its trading stamps and redeemed these stamps for free items, such as, you know, toasters or lawn chairs. It was selling about $120 million of stamps to retailers each year.

Starting point is 00:43:50 And since the owners of the stamps wouldn't redeem them immediately, it meant that there was ample amounts of cash in the business that could be redeployed elsewhere. Now, even though Blue Chip Stamps was a good business, it ended up being a pretty big headache for both Buffett and Munger. So there was some complicated ownership structure that would end up biting them both in the butt. So Buffett owned blue chip stamps through three separate vehicles. He and his wife owned it personally, Berkshire Hathaway owned it, and diversified retailing, a partnership with Charlie Munger, owned a slice as well.

Starting point is 00:44:20 Then with Blue Chip stamps, also investing into public businesses, regulators just saw this as a massive conflict of interest. So the problem really arose due to a business called Wesco. So Westco was a savings and loan business that was undervalued, trading at around half its book value. So Blue Chip quickly bought up about 8% of the company. Eventually, Westco announced a plan to merge with another savings and loan business called Santa Barbara. But this merger just didn't sit well with either Buffett or Munger because they saw it as Westcoe shareholders exchanging their undervalued shares for expensive shares of Santa Barbara. As a side note, I don't mind these types of transactions if you own the more expensive business. And the reason is simple. So there is an arbitrage opportunity

Starting point is 00:45:03 when an expensive company acquires a cheap one. For instance, if your company trades at 30 times earnings and you buy a company at five times earnings, it re-rates once it becomes part of that parent company to 30 times. So if you buy it for $5 million, meaning it has $1 million in earnings, once you own it, it's now worth $30 million based on the multiple. 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.

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Starting point is 00:48:28 carefully consider the investment material before investing, including objectives, risks, charges, and expenses. 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. The key is understanding the value of the parent co. And I think in this Westco example, Buffett believed the premium evaluation of the parent company was just unsustainable and that's why he wasn't comfortable with it. But I digress. So Warren wanted to buy more Westco stock to counter the merger that he believed was unfair to Westco's shareholders.

Starting point is 00:49:04 Eventually, he accumulated about a 20% position. Discussions with Westco's presidents unfortunately went nowhere. So they turned to Elizabeth Peters, who was Westco's largest shareholder. She was tough to convince, as she knew Wesco needed a push to bring in some new energy into the company. But Buffett and Munger convinced her that they could be that catalyst. Once they knew that Peters was on board, they bought the stock. The problem was that once the merger was blown up, as any investor knows, lots of investors

Starting point is 00:49:31 just drop out creating a drop in the share price. Buffett and Munger bought shares that they intentionally purchased at higher prices than they could have, as they felt like they were the reasons for the merger's failure. This action specifically caught the SEC's attention. The case was eventually settled for a very modest fee of $150,000. But during the case, it was made pretty obvious to lawyers that Buffett and Munger had not tried to kill the deal at the expense of others intentionally. They wanted Westco's shareholders to receive value. As a result of the investigation, Buffett just had to simplify things. He merged

Starting point is 00:50:03 diversify with Berkshire, which netted Munger a 2% position in Berkshire Hathaway, and he built a majority stake in Blue Chip Stamps and Wesco. Now, turning here to Munger, I think Munger's biggest value to Buffett was in his preference for good businesses. Even though Buffett had been highly successful in his years managing the partnership by buying these low-quality businesses at a low price, Munger taught him that this approach only works really for so long. Once Buffett had acquired the Berkshire Hathaway vehicle and bought businesses like Seas Candy, American Express, and Disney, he began to understand the power of intangible assets. This was where Buffett's affinity for franchise businesses came from. To Buffett, a franchise business has six attractive characteristics.

Starting point is 00:50:47 One, a durable competitive advantage. He liked brands and low-cost providers. Two, a product that is desired or needed. When it came to brands, customers wanted a specific product over others because of the trust and reputation it had built. So a company here that fits this to a T is C's C candies. I didn't really get a chance to speak too much about it just because there's so many things to talk about in this episode.

Starting point is 00:51:11 But C's Ccandy is just a chocolate brand. If you've gone to the Berkshire Athaway AGM, you're going to see a lot of people carrying bags with Case Candy. And the reason that this business was so attractive was that the product was desired. People loved it. And people wanted specifically C's over an alternate because they had this feeling, this brand strength that they got when they bought C's candy or gave Case C candies to other people. So the third one is that there's no close substitutes.

Starting point is 00:51:42 Excess supply in any single market, unfortunately, erodes pricing power. A franchise can raise prices if the substitutes are inferior or even non-existent. Number four, a capacity to increase the prices without losing customers. So Buffett had a very simple test here. He would just ask if you raise the prices by 10% would you lose customers, yes or no. The fifth one is low reinvestment needs. If a business is just gushing cash and doesn't require to be reinvested, Buffett would get that cash to then reinvest elsewhere, which was basically how he built Brookshire Hathaway into what it is today. And the sixth one here is just predictability. You know, Buffett sought businesses with predictable earning streams and durable high returns

Starting point is 00:52:24 on equity. This meant that the business could continue producing more and more cash over the years, providing Buffett with liquidity to buy other private and public businesses. So Munger has said, you know, that he thinks that Buffett would have come around to this whole concept of quality on his own, but I think he helped nudge Buffett in the right direction, given all the conversations that two of them had about different ideas over many, many decades. So we've already discussed how Buffett likes media businesses with low CAPX needs that can generate revenue from advertising. And Buffett had a few businesses in media that he's very well known for. I want to cover two here. The Washington Post and the evening news with an honorable mention for Cap Cities.

Starting point is 00:53:03 So let's start here with the Washington Post. So the Washington Post is well known for its continued circulation today and its very rich history. Kay Graham took over as a leader of the business when her husband, who was a leader, committed suicide. The business wasn't amazing when Buffett began buying shares. You know, the profit margins were around 10%, but these were being dragged down by some of the television stations and other parts of the business. The area of the business that Warren really liked was a newspaper, which just dominated

Starting point is 00:53:32 its market. So he started buying a pretty hefty sum, and he quickly approached 10%. Now, Kay Graham, seeing this, was a little fearful that Buffett was attempting a takeover bid, even though he had the B shares, which didn't have the same voting rights as the A shares that were owned by the Graham family. To ease Kay's mind, he even signed his proxy over to Don Graham, which was Kay's son. Once Warren assured her that he wasn't trying to take over the business, he was invited onto the board. And once Warren was on the board, he helped share his wisdom with Kay about the world of business. He shared his thoughts on topics such as, you know, capital allocation.

Starting point is 00:54:07 spending and dealing with unions. Kay really depended on Warren, but he eventually trusted her enough to make great decisions on her own, which she did. The book mentions that Kay was very frugal with her spending, which she probably learned from Warren. It was easy as a media business to acquire other media business, as that's what a lot of people were doing in that industry during that time.

Starting point is 00:54:30 But it's also important not to try and emulate poor business, which was exactly what Buffett had been known for. So, you know, just to give an example, the Post was receiving numerous deals in cellular and TV sectors. But Buffett didn't really like those deals because those specific businesses just sucked up cash. Instead, Buffett and Kay Graham focused on shareholder returns. Buffett helped establish a buyback program that ultimately retired 40% of its shares outstanding. And Buffett definitely chose the right business. So during the 11 years from 1974 and 1985, the Washington Post had exceptional growth in its fundamentals. So get that. So net profits grew

Starting point is 00:55:06 seven times. Now, because of that massive buybacks, EPS actually grew 10 times. It maintained a average ROE of about 23%. And because of all this, the shareholder return was about 37% compounded annual during that 11 year time period. And this resulted in war in netting a 20-bagger, which was just incredible returns. Now, shortly after joining the board of the post, Buffett's interest in GEICO was reignited. The share price had gone from $42 to $2.00. The business had made a few mistakes. GEICO had basically loosened its underwriting standards, which did result in a short-term increase in profits, but unfortunately, they failed to reserve for losses.

Starting point is 00:55:50 And then they were hit with a pretty significant drop in earnings, which was the reason the share price cratered. Buffett was part of an investor group led by Solomon's John Goodfriend that helped save GEICO. They injected about $76 million of capital into the business, and, you know, and 23 million of that was from Berkshire. The capital infusion was successful, and within six months, the stock quadrupled from its lows. The evening news, which didn't have the, when Warren bought it, was an interesting business

Starting point is 00:56:15 because when Warren bought it, it actually wasn't a monopoly, but it was a duopoly. So this was a newspaper, and in its town of Buffalo, it had a competing newspaper, which was the Courier Express. Warren liked that the evening news didn't print on Sundays due to an unwritten rule between Courier and the evening news's previous owners. But Buffett knew that this would actually be a great growth lever for the evening news. So Warren and Charlie purchased this business pre-tax multiple of about 19 times, which seems very expensive.

Starting point is 00:56:47 However, I believe they probably assumed that they could put the right personnel in place to increase the margins. So they used a gentleman named Stan Lipsy, but they actually ended up struggling to turn a profit even with him in charge. They were actually turning a loss. but luckily, the courier was turning in an even greater loss. And eventually, they went bankrupt leaving the Evening News as a sole survivor in the Buffalo market.

Starting point is 00:57:10 In its first year without competition, Evening News earned $19 million in pre-tax income. The book mentioned an interesting talking point that Warren discussed in his annual letters, which I want to discuss a little bit. And this was how, now that the Evening News was a monopoly, it no longer had an economic incentive to maintain its high quality. I had a note in the margin of this book that reminded me a lot. of what happened with TCI. So TCI, a business I covered in a lot of detail in TIP 619, had monopolies and cable in certain

Starting point is 00:57:39 markets. However, they encounter difficulties because they really allowed the quality of their product and service to deteriorate, which caused them numerous amounts of headaches. Buffett pledged to keep the evening news a good newspaper, regardless of its monopoly status. Now, this kind of problem of monopoly businesses reminds me a lot of a company that's actually in my province that many people in my province of British Columbia very, very much dislike. And that's an auto insurance company called ICBC. So ICBC is a fully owned Crown Corporation, which means the government of BC owns it. And as many government entities go, it's not

Starting point is 00:58:17 very efficiently run. So they also maintain a complete monopoly on car insurance, meaning I have to pay whatever premium they offer just to drive my car. And because they can charge whatever they want, we have among the highest auto insurance premiums in all of Canada. Now, I've never had to claim with them, but I know others who have, and they've had absolutely miserable experiences. And at one time, the government of BC actually used ICBC's capital reserves basically as an ATM for their own financial purposes, which ended up punishing ICBC's users by just increasing their premiums.

Starting point is 00:58:49 My wife has made a claim with them, and they're excruciatingly slow. Additionally, each year, they adjust my premium, and it's almost as if they're They're just drawing a lottery ball to see what they're going to charge me. One year, it's up 20%, another it's down 10%. Despite the fact I've never made an insurance claim. All this to say, I totally agree with what Mr. Buffett is saying here. And monopolistic businesses need to be held to higher standards for the good of its customers. Now, getting back to Buffett here, one interesting paradox about Warren has been the interplay

Starting point is 00:59:19 between being a very private person and also having, you know, his public persona. Charlie Munger said that it was an accident that Warren was even running a public company. He could have easily just run a private company from his home base in Omaha and would have been probably wildly successful, even maybe just as successful as he is now doing so. But as Lowenstein points out, in his letters, he found his stage. He would seize an aspect of Berkshire, a wrinkle in his accounting, a problem in insurance, and veer off into a topical essay. Now, when you look at his lifestyle and family life, there wasn't anything to read about

Starting point is 00:59:52 in the mainstream media. Buffett lived by the inner scorecard, so he wasn't trying to do anything that would be worth putting on the front page of the news anyways. But he still did a lot of things different than other high net worth individuals. I got five here. So the first one here is that he lived in Omaha, which was a place that is, you know, as far away as possible as being known as a financial hub. The second one was that he gave very, very few interviews. Sure, he gave them, but they were quite rare and they were always very, very insightful. He didn't use them as a platform to be overly promotional and spread his name.

Starting point is 01:00:23 And third, he had very transparent shareholder letters and he used them as kind of this vehicle to help the average investor just to understand exactly what Warren was doing. And he also shared how he thought corporations should be run in America. The fourth one is that despite being known as someone of a recluse, he still had a massive investor network and lists of business superstars, people like Kay Graham, Bill Ruehain, and Tom Murphy. And lastly, you know, the fifth one, Buffett just didn't need self-promotion. He just allowed his results to speak for themselves. This final point is just so important.

Starting point is 01:00:57 With the popularity of social media, there's no shortage of people just yelling from the rooftops about how good they are. But those are the types of people you should probably mute. Because if someone is so good at the investing game, you'll end up knowing who they are simply because their track record is just so exceptional. I've skipped over a few important parts of Buffett's life, such as his acquisition of Nebraska Furniture Mart and his deal with Cap Cities and Scott Fetzer. But it's in the interest of time.

Starting point is 01:01:21 So let's fast forward here to 1987, specifically on October 19th when the Dow dropped 22.6% in one day. Berkshire stock could drop 25% during the course of a week during Black Monday. But Buffett was unfazed. Given his deep understanding of value, he had a very good idea of what all of his businesses were worth. To help discuss some of the reasoning behind the crash, Lowenstein goes over the efficient market hypothesis, or EMH. To put it simply, EMH believes that. that the risk and investment comes from the volatility of a stock's price. If a stock moves in

Starting point is 01:01:55 lockstep with the market, it is said to be a less risky investment. Buffett vehemently disagrees with this. For Buffett, risk is a permanent loss of capital. This risk, as he pointed out, often arises when you just don't know what you're doing. This perfectly explains why a circle of competence is so important. If you don't know what you're doing, it's unlikely you'll understand the signals of a business and how they affect the fundamentals of a business and its stock price. EMH believes that volatility is risk, but Warren pretty much crushed that theory very simply. When thinking about the Washington Post, he noted that the market was valuing the business

Starting point is 01:02:29 at about $80 million. If that price dropped in half, then according to the efficient market hypothesis, that business was now considered riskier. Buffett said, I have never been able to figure out why it's riskier to buy something at $40 million than $80 million. EMH essentially just eliminates the concept of value from the investing equation. And since Buffett's entire investing framework is based on value, you can see why the hypothesis doesn't make sense to him.

Starting point is 01:02:56 Put another way, imagine if someone were selling $10 bills. Let's say this person has just lost her marbles and they're willing to sell it to you for five $1 coins. Now, let's say he's having an especially erratic day and he only wants to sell it to you for three $1 coins for that same $10 bill. EMH states that buying it for $3 is riskier than buying it for $5. It just doesn't make any sense. So attempting to use EMH's concepts to justify what happened during Black Monday is also a pretty weak argument.

Starting point is 01:03:26 You were saying that the market was rational before Black Monday, on Black Monday, then right after Black Monday when the market rebounded pretty quickly. So according to some research by Robert Schiller regarding Black Monday, he noted that investors check stock prices on average 35 times. This selling wasn't due to the fundamentals. There was no sudden downgrade in future corporate profits. So if investors weren't selling based on relevant, knowable information about the stock, then why were they selling? And the answer was that it was purely emotional. This adds strength to Ben Graham's Mr. Market analogy,

Starting point is 01:04:00 which states that the market often does just silly things. Whether that's due to sadness or relation, the market simply cannot be explained in a measurable way. The measurement that EMH depends on is something called beta, which measures the volatility of a stock. So if the beta was 1.0 on a stock, it meant that the stock price moved and stepped with the market. If it was above one, it was more volatile on the market. And if it was less than one, it was less volatile in the market.

Starting point is 01:04:24 The problem with this number is that it doesn't really have any actual use. There was literally a study that was out that showed that beta had no relation to a stock's return. So I've always found this funny because if you're trying to use a number to justify the riskiness of an investment, shouldn't it have some sort of bearing on returns? To me, figures like beta are used in investing field to make an investment manager or consultants just seem smarter than they are to justify their high fees. Buffett and the majority of other value investors don't use it and they get along just completely fine. The key to dealing with market corrections that I've learned from Buffett is to focus on value. During a correction, expensive stocks often get cheaper and, you know, very, very quickly.

Starting point is 01:05:06 Cheaper stocks might also get cheaper, but the argument is that they're low. less likely to drop as fast as an expensive business. No matter whether you buy cheap cigar butts or high quality, high price to earnings businesses, if you have a view on value, you should know that when a business is trading below at or above intrinsic value. When a correction happens, you're best off basing your decision making off of that and not trying to succumb to the mood of the market. When you sell because the market is selling, you'll end up selling potential winners too. The final prominent theme of this book was a Solomon Brothers incident. So Buffett owned a large stake in Solomon since he purchased about $700 million of preferred convertible shares

Starting point is 01:05:44 to keep Solomon out of the hands of an unfriendly takeover bid. But in 1990, he was kind of at odds with the business over their compensation package. The business had lost about $118 million that year, and CEO John Goodfriend was asking for board approval for about $120 million compensation package. Buffett, as a director in the business, voted against the deal. He believed that people should be compensated for creating shareholder value, which clearly had not happened that Buffett doesn't really like businesses that treat the business as a piggy bank. There is no doubt that Solomon employees worked hard in long hours. But if they weren't producing value for shareholders, then why did they deserve additional

Starting point is 01:06:21 compensation? It really just misaligns management and shareholders, which is a major no-no for Buffett. So during this time, Paul Moser, a treasury bond trader, was engaging in some nefarious trading to make money for Solomon and himself. Solomon was a mainstay in buying U.S. government bonds. But Moser bid on more of these bonds than what was allowed. He even bought more on behalf of some of Solomon's investors without their knowledge. Because he was buying in such large quantities, he was able to drive up prices, essentially squeezing

Starting point is 01:06:49 the market. But regulars took quick note and gave him ample time to cease his actions, which he blatantly ignored. John Goodfriend was aware of the situation, but unfortunately made a significant mistake. He just wasn't transparent with people like his lawyers, his shareholders, or even the board. And eventually Solomon was banned from treasury auctions, which was catastrophic for Solomon's business, as that was actually the core part of the business. As a result of this opaqueness, Good Friend was forced to step down. Buffett took his place and promised the Treasury Secretary Nicholas Brady that he would go in and clean house inside of Solomon. And clean house he did.

Starting point is 01:07:24 While Buffett was initially viewed positively for his leadership in keeping the company afloat, resentment began to build due to some of the changes that he sought to implement in the business. For one thing, Buffett wouldn't partake in buying loyalty. He was unwilling to give raises to top performers, and as a result, many people left for other opportunities. Buffett also went in with new CEO Derek Mowon on a new incentive program based on linking bonuses to the group's return on capital. As part of the cleaning house initiative, Buffett was leading, he said one of his most famous quotes. I want employees to ask themselves whether they are willing to have any contemplated act appear on the front, page of their local paper the next day to be read by their spouses, children, and friends. If they follow this test, they need not fear my other messages to them. Lose money for the firm,

Starting point is 01:08:14 and I will be understanding. Lose a shredder reputation for the firm, and I will be ruthless. Now, even though Solomon investors had plenty of good ideas, they'd take them to Buffett to see if Buffett approved. And Buffett actually had to deny many of the investments because he felt they were too close to the line that regulators might not want to see. Buffett also brought in a new lawyer and replaced the old team that was led by Goodfriend. He eventually handed over his duties to Bob Denham and moved past the event, even adding shares to Berkshire Hathaway's holdings. Although Buffett said the Solomon Escapade was interesting and worthwhile, he also added that it was very far from fun. Now, the book ends around 1995, so the last three decades aren't mentioned.

Starting point is 01:08:54 Hopefully, you know, Loewenstein or someone else will write another biography about that period. But there was one more nugget I wanted to share from the book before I let you go. And this was the afterward. So Lowenstein wrote that he was often asked if there is anything that he would change about the portrait of Buffett in his book. And he mentions that Bill Ruehain told him that he wasn't sure he really captured just how tough Warren is. Now, this concept of toughness is interesting, because it's not like Buffett was tough in the typical, you know, macho way. He was tough as a businessman. He was tough because he was able to dodge deals thrown his way that were likely to blow up. He was tough because he said no so often in an industry that loves to pay croupiers, such as consultants.

Starting point is 01:09:34 He was tough because he didn't follow common Wall Street dog on many things, such as compensation, efficient market hypothesis, transparency, honesty, and integrity. And I think that's part of what makes Warren Buffett Warren Buffett. His ability to do things his own way, which makes so much sense, even when the industry seems to be diametrically opposed to his views. And instead of following the herd, he created his own path that clearly, worked for him and all of Berkshire's shareholders. So if there's one big takeaway from today's episode,

Starting point is 01:10:03 it's to have an excellent understanding that you can succeed in the business world while being someone full of kindness and integrity. That's all I have for you today. If you'd like to interact with me on Twitter, please follow me at a rational MRKTS or on LinkedIn under Kyle Grieve. If you enjoy my episodes, please don't hesitate to let me know how I can improve your listening experience. Thanks again for tuning in.

Starting point is 01:10:24 Bye-bye. 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 - TIP733: How Warren Buffett Became Warren Buffett

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