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You're listening to Teip today's episode, we sit down with author and George Washington University professor of law, Lawrence Cunningham, most known for his wildly successful publication of Warren Buffett essays. Lawrence is the most prolific research and author of Buffett and Berkshire have written over two dozen books on the topics. In this episode, you will learn how to identify a quality investment, how to distinguish good management from bad, and what would happen to Berkshire Hathaway beyond Buffett. Lastly, we will also talk about whether Berkshire Hathaway is currently undervalued.

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This was a fun and Wide-Ranging discussion, so sit back and enjoy our discussion with Lawrence Cunningham.

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You are listening to the Investor's podcast where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast, I'm your host. And then today I'm here with my co-host, Trey Lockerby, and we are so excited to have Lawrence Cunningham with us, who literally wrote the book on Warren Buffett. Thank you so much for taking the time to speak with me and most importantly, our audience here today.

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Very happy to be here. Thanks so much. Dolores, I want to start by talking about Warren Buffett, the man we know a lot about his philosophies, which we're going to get into. But you know him personally. I've met him many times, even hosted the symposium with him back in the nineteen ninety six that kind of led to this compilation or compendium of his essays. And I want to address all of that. But start by kind of what makes Buffett who he is.

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So, for example, some of our listeners may have figured out by now that you can study Warren Buffett to death by actually replicating his performance is highly unlikely. And I just want to know what you attribute that to most. You're right, it's not replicable or at least not likely to be replicated. It's a combination of compelling traits and most people will be happy to have one or two, but it starts with rationality. He tries always to keep his emotions in check and focus on on the facts, on the substance and on the probabilities.

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Second is analytical acuity. He tries to think deeply and hard about any particular problem, whether it's a business and industry or a person. And he's humble. You get tremendous humility, particularly given his strengths and rationality and analytical acuity. He knows his strengths. He knows where he can do well and he knows his limits. Circle of competence as his famous phrase that defines the difference between what he knows and is good at and what he doesn't know and tries to avoid.

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And I think if you're trying to get the secret sauce or maybe surprising things, I think the singular trait or skill that explains most of Warren's success over that long period and in particular settings is his ability to size people up. He knows it's an uncanny ability. I mean, the others we can teach ourselves a little bit. We can we can create our own discipline. We can develop analytical acuity, and we could certainly define our circle of competence.

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But this uncanny ability to size other people up knows who's trustworthy and who is it. You can tell in a minute whether the CEO will be a faithful steward of Berkshire capital. He can tell pretty easily whether this family will be a reliable partner in a long term business, whether the CEO of this publicly traded company is worthy. How can he do that? Or look at what can we get out of that? I'd say that the skill uncanny and it's hard to teach.

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But here's the tip I have or the lessons I've taken from it. Another thing he does at the slightest whiff of lack of trustworthiness, he goes away. So he's ultimately a very skeptical person of human nature, of the incentives that drive us to be selfish or to be emotional, irrational. It's a high hurdle to gain Warren's trust. He runs a trust based organization. He delegates his managers enormous leeway as we'll get into. But he does all that only with a handful of people.

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And that, I think, helps him with the ability to discern. Trustworthiness is very high. He has the need. Tests may be useful to ordinary people thinking about how to do this themselves. He calls them the son in law passed the test. He only wants to go into business with people he'd be happy to have his child marriage or the other version of the test is the executor test that people he'd be happy to have administer his will carry out his wishes after he's not around.

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Those are pretty high hurdles that a lot of people go into business with people they wouldn't want to watch a football game with or trust with their estate, but he's been pretty rigid about that. And so when you look around at his inner circle, let's say the CEOs of the companies, members of his board, top shareholders, the company, CEOs of investors, all very high grade people, very, very not just professionally competent, but ethical. And so there have been a couple mistakes.

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Everybody makes mistakes, including Warren Buffett. So I think you're right. It's hard to replicate the skill set. I think any of us would be happy to have one or two of those four virtues or skills combine them. But I think we can all learn something from each of those. That's really interesting, I've never actually thought about it that way after meeting Buffett and hearing him speak even a short while, you see the high intelligence level, the high IQ, and he's rattling off numbers from memory, from dating back decades.

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He's always citing dates with events. He just really has a mind for numbers. And it's very apparent he has a very high IQ. But what you brought up now almost as a superpower is that he actually has sounds like a high emotional intelligence or IQ, and you don't often find both. I've never actually really considered that with Buffett having both in that department. But that sounds a little bit like how you're describing him. I think you're absolutely right, I should concur, particularly with the high IQ and its mastery of data and history, facts and numbers.

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I'll just add a point where the IQ, the IQ go together in a business setting. I get this question from young CEOs a lot about, well, how much diving into the details do I do versus how much delegation and what's Buffett's approach. And my my impression from Warren as he dives into the details, he knows exactly how many make it up, how many candy bars season sell, what the steel content of Precision Castparts Assembly is. He knows all that stuff you enjoy and remembers it, but it doesn't second guess people.

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He doesn't say, I think you ought to make more candy bars or reduce the steel, raise insurance rates or he stays out of direction, but he knows what's going on. And so it's kind of a nose in body out kind of idea. And why is that useful? It's useful precisely. If your plan is to trust people, you won't know whether they're vindicating that trust, let you know the facts so you know the facts and then leave them alone.

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And then you'll know when the occasional miscreant appears and they don't tell the things they tell you aren't the things you know to be true. And you'll be able to weed out the mistakes so that constitutional IQ on IQ. I think you're exactly right. It's rare, it's extremely valuable. And I think being aware of it can help us ordinary people do better in settings where the combination is particularly useful.

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I'm glad you touched on that, because I don't think Buffett gets enough credit for being an operator to why public thinks of Buffett as a stock picker, and he sure is doing a great job of that. But what you really excels in is running a conglomerate with wholly owned subsidiary and what you just touched upon.

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I think that's really a holy grail of running your business, right, figuring out how to set up a decentralized system where you don't have to be included in every single decision, otherwise you just can't scale.

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But also knowing what's going on in the business so you can incentivize and motivate everyone the right way. And, you know, like you set that Lawrence Buffett does that better than anyone.

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You're absolutely right. I think his investment success is in the long running and well known and 60 years ago was really spectacular for the first 20 of those and then excellent for the next 20. It's been a little more ordinary in the last 10 or 15, mainly because of the massive size of the organization, but also during that recent period, the diversified into ownership of businesses and the balance sheets that you described. But he's been astute in the ability to manage or oversee such a large, diverse group of businesses.

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And I think that his ability to do that is now worth studying. What did he do? How did he do it out as intended? Because I think it's useful for other managers. I think people are increasingly studying Berkshire and it's decentralized, autonomous, acquisitive, trust based culture. And we'll come to rank it as important in in management as value investing has been in securities analysis and investment. In this sense, everybody listening probably has heard of Ben Graham Warren made famous as a theorist or philosopher of valuation, value analysis, security analysis, stock picking and so on as they study Warren's approach to management and organizational structure.

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The famous person who will emerge there is Tom Murphy and Thomas people. Not many people may know he's on the board of directors of Berkshire now and has been for about 20 years. Warren Warren's been a close friend of his 50. Tom built up the Capital Cities communications company, had some relatively small radio and television broadcasting company in the Northeast that Tom built and grew through organic growth and acquisitive growth over a long period of time, eventually acquiring or merging with ABC and then eventually selling that whole thing to Disney and along the way tutoring Mike Bob Iger, who's been a great run, a CEO.

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Disney was a Tom Murphy protege. But Tom did all that using the principles that Warren has adopted, Perquisite Trust based Krugel focused on on high quality businesses and high wanted managers, and then left them alone, even in an autonomous structure, gave managers enormous leeway to run their businesses in a highly decentralized way. So a couple of years ago, I published a book about Berkshire's culture and I asked Warren, who should write the preface, said Murphy. He said, Because Tom Murphy taught me everything that you say I do in this book.

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And so I think as we study Berkshire Hathaway and it's the recent phase, past 20 years of becoming 80 percent owner of subsidiary owned owned companies. We'll learn more and more about Tom Murphy and his approach to business management. So in nineteen seventy two, Buffett, in large part Charlie Munger's influence, started to pivot away from buying what he calls fair companies at a wonderful price to buying wonderful companies at a fair price, mostly exemplified by his purchase of See's Candy.

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And this brings up the topic of quality investments, which you also wrote the book on. And I find quality to be an elusive muse. I'm reminded of one of my favorite books, Zen and The Art of Motorcycle Maintenance, in which the protagonist goes on a motorcycle journey across America solely as a means of discovering the definition of quality. And just a side note, I just cracked open your book this week and I saw this exact analogy on the first page I just thought was so funny that we were just really quickly aligned on that.

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And so through this book, you've achieved a definition of your own right, when it comes to what makes a quality investment. So can you describe to our audience how you define quality and how much it factors into your own investment philosophy? That is true. I think what quality investing is, is wonderful companies that have at a slightly higher price at a fair. Plus, it's OK to pay up for quality if you're going to buy a significant position in a high grade company that you expect to be around for a long time, you expect to hold for a long time and has quality attributes that I get into paying a little extra for.

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That is is reasonable. If you're right and your analysis backs the conclusion that this company will generate high returns on invested capital for the foreseeable future, three, six, nine plus years if it's trading at a little bit of a premium. Don't worry about that. And so it's the opposite of deep that opposite of what Ben Graham did. And it may be a little more generous than what Charley recommended, more I'd be willing to do Scandi pivot. And so by quality, look, that's a realistic appraisal of the current environment.

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There's just and I don't mean just sitting here now in December of twenty twenty, but for the last 10 years, it's extremely hard to find those Ben Graham's opportunities or even the Warren Buffett value opportunities. It's just in the public capital market. But if you sit down and what we did in the book is describe an approach to identifying what we call quality companies and making quality investments. And we start with micro economic analytical analysis about industry structure and barriers, entry, economies of scale, rationality among competitors, and then looking at particular companies to discern their most, their competitive advantages, what structural protections they have against invasive rivals and technological disruption.

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And so we give example. The obvious examples are things like brand strength and network effects. And we give some other more subtle examples, such as having a friendly middleman, that is that you're selling eyeglasses, let's say, through optometrist's to patients. And if you are able to enlist a loyal cadre of optometrists who recommend your lenses, your products, that gives you a significant competitive advantage. This can happen across a lot of those sorts of industries with metal, with plumbing, housing, fixtures and so on.

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But so we go through and identify through micro economic analysis and then particular company analysis think the kinds of competitive advantages that people listening will will recognize. And then we demonstrate through. We do. Twenty five different case studies in that book of mostly European based international global all stars. People will recognize the Ozio or many others. And so the conclusion, that idea. Finally, to your question about quality investing is that it's not highly likely that you'll be able to get Airmen's on sale or L'Oreal another one.

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Biaggio But if you've done the homework and identified a company highly likely through competitive advantages to be able to maintain high returns on invested capital over the foreseeable future and beyond, you don't need to get it on sale. Going to massively overpay for a market, but a slightly elevated price shouldn't be a trick. That's the main thesis of that book. And I want to stick on this for a minute, because you talk a lot about quality, quality investments, quality shareholders, it's a pretty important word, I think, in your research and literature.

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And it's just interesting how hard it can be to define. So going back to ZENN, that book, which is the top philosophy book, the top selling philosophy book, it's it really showcases how elusive it can be as a word. And Phaedrus, the protagonist, as you mentioned in your quality book, you quote him saying it's hard to define, but you know what it is when you see it might take away from that book was sort of like quality is getting at least what you put into something out of it.

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And then some write as he's tinkering with his motorcycle, he's getting more out of that machine. I'm just curious, is that beyond predictable cash, beyond high returns on capital and attractive growth companies, which is how you define it and a bullet point fashion in the book, is there anything philosophically important or something that's I guess even beyond that for you when it comes to the term quality itself? You're right about those points and the elusiveness and so on, but I think the I'd say the key in unifying feature of that notion that you do know when when you see that it's almost never actually that certainly if we're talking about quality of things that human beings create, high quality in humans didn't have any accident geology.

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So but if you're talking about a company or a firm of investors to achieve that kind of stats, to be recognized and worthy of calling it high quality is the result of conscious effort and deliberate concentration and cultivation. And so why is there is a high quality company is because for years they have devoted themselves to delivering an extremely appealing product with excellent materials, the finest craftsmanship, with deliberate efforts to restrict supply and to cultivate a clientele, pay up for what they're selling.

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So this is a process through which they deliver high quality products and they deliver it with very high margins as a result, as luxury shoppers are willing to pay up their products. And that's a quality business quality business model and it's the result of deliberate conscious effort usually over a long period of time. And so the same would be true for those other companies that we describe in the book. And so we can talk soon about the other side of this is about a quality business that the other side is about a quality shareholder.

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What makes for high quality shareholder? It's also going to be the product of a deliberate and conscious and very reflective mental engagement. And so that's maybe the philosophical version of my use of the term and both of those settings.

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I love that.

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So, Laurence, another pivot that Buffett has performed in the last couple of decades is flipping burgers from being primarily a hold a public entities to prominently holding private companies. And one might think that this is so that Buffett would have more control over the management of these companies. But the opposite seems to be the case. He has expertly distributed and delegated oversight in a centralized fashion. And as an upgrade of my own business, I know how counter-intuitive it can feel to trust your team, to guard themselves effectively.

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And even more counterintuitively, perhaps, is how much the autonomy can generate accountability. For example, in your book Making a Trust, which you wrote with your wife, Stephanie Cuba, you quote Jim Weber, the CEO of Brook Run Shoes, because he said, I never felt so much autonomy in my career and never felt so accountable. So I absolutely love that quote. And you highlight that Buffett's investing principles have been well documented for 60 years, but the organisational structure could be a new lesson to learn.

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In fact, you highlight how gigantic companies like Alphabet have taken interest in developing a similar approach. Could you please outline the pillars of this approach? Formlessness. You're right. Warren has developed and perfected it within Berkshire in the past 20 years. His motivation is what Jim Webber testified to, that surprisingly, perhaps counterintuitively, perhaps people who are trusted are actually more likely to do well for you. Trust is often vindicate. There are studies of workplace productivity that show a culture where people are authorized to exercise judgment and discretion when developing a product, selling it or administering the operation.

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They're much more productive then, much more successful. They get better outcomes then one where people have very few degrees of freedom and they're simply directed to follow. Here is the production manual. Here's the Salesforce playbook. And you must just do the and and Warren has known that he learned a lot of this from Tom Murphy, who developed his company using this model. And so most large companies, especially in corporate America, have a bureaucratic hierarchical command and control based culture where reporting structures are clearly delineated, approvals are required for a designated set of things through a given channel, and there are constraints on employee discretion.

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The effect of that is to limit creativity, limit willingness to reach in very many cases. And so to Berkshire and most of its subsidiaries, including Jim Webers running shoe company. The idea is to dismantle or just not even have those reporting structures, those approval requirements in those manuals and regulations, but instead have broad goals like I want you to sell this many running shoes this year or I'd like our running shoe to be ranked. I'd like to have at least three running shoes, three models of our shoe that are worn by the top 50 people in the Boston Marathon.

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You give them broad, general targets, goals, and then tell how you do that stuff. I don't know how to make shoes, how to sell works. And so, Jim, that's that's up to you. But this is where I'd like to see. And then you can also set incentive compensation around around goals like that. And so the reason for this trust based culture is to realize human potential. People will do better for you when they're given some leeway, when they have autonomy.

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And so that's an exceptional cultural feature of Berkshire. Berkshire is not unique. It's not a wall. You mentioned Google or Alphabet has consciously tried to replicate that approach as they when they changed their name from Google Alphabet, they identified twenty six different. I think the total will be twenty six different business units that are meant to operate in an autonomous manner, giving the leader leeway, whether it's the search or autonomous vehicles to make a pun or the venture capital group.

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But the leaders of those businesses have carte blanche. It's there, it's their leadership. They get to stake their claim and thought we will do better as a company by allowing all of these different groups to march to their own drums. And in the book Margin of Trust, we give examples of a dozen other companies who do this. A lot of them happen to be in the insurance business, but they're also a lot of other industrial companies that do to Danaher comes to mind.

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Post is a good example. Constellation software will have to be on board is an example. The insurance industry is an interesting specimen because there's so many Marquel, Fairfax, Berkely, obviously Berkshire itself has a huge insurance business and I draw from that the a couple of points of what does it take to organize and want to lead a trust based culture as opposed to this command and control culture. A lot of thing is you have to have a long term view.

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You have to trust people and give them the leeway in the latter to build up their businesses over long periods of time. And insurance business is innately long term. And so I think that helps explain it. But perhaps the biggest reason is, is what they sell is trust. The product of the insurance company is a promise to pay money in the future. That's all it is. And so customers, policy holders will only pay for that if they trust you to pay back to honor the commitment.

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And so there's a sort of a trust in the air in the insurance industry. I'm sure the reason is that the people who lead those companies tend to be value minded or value investor minded. They focus on capital allocation. They are in the business in effect. They're receiving premiums and then investing those those funds in order to have a capital to pay claims. And so their their long term, their their trust focused and they have to invest in a prudent, prudent way for the long term.

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So I think those ingredients help to explain why why trust does seem to percolate in an insurance business, maybe more than industrial companies. But the examples of Denver Post and others, I think also is a testament to the value of autonomy in corporate America. It's not something that would be nice I personally would like to see more of, but you see it, too. I'll give you another example that's in the news, not just on this day we're doing this, but this.

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This quarter is Pfizer, Pfizer is is a trust based culture that is it's autonomous, it's decentralized. Scientists are experimenting in laboratories with all sorts of drugs and treatments have enormous leeway. And they need teams and they need a long time in most cases to do the research and testing to deliver useful pharmaceuticals. And they've just done it. We are in the middle of doing it. What appears to be a highly successful capability in addressing the coronavirus pandemic with a vaccine doing doing quite well in the trials.

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And I think its corporate culture has a lot to do with the see it from the CEO. That's something that the culture believes scientists or they in particular thrive more when they've got degrees of freedom to run, experiments to learn from prior results without necessarily having to report up the chain of command, get the new authorizations and so on. So I think there's a big lesson in there for corporate America. So for the retail investor, this obviously sounds like a metric to identify quality management, but how does a retail investor you just mentioned, Pfizer and how you see this trust factor from the CEO?

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Where are you seeing that? Are you seeing it in the shareholder letters and interviews?

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How do you identify that? You could see it in the shareholder letters and interviews, another book that I've come out with that I know you want to talk about soon is called Quality Shareholders focuses on what the most focused and Asian shareholders look for in their investments and how management can offer that menu. It's a iterative relationship that end up talking to each other, having their minds meet at a large number of companies. And the way to come together are, first, a management team that believes in a certain set of values long term, high returns on invested capital stewardship as their primary duty, stewardship of shareholder capital.

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And then internally they create structures that that achieve results like that long term high returns on invested capital for shareholders over over many period. And so attentive shareholders, ordinary shareholders, as well as professional fund managers who are trying to select outstanding securities for their funds and their clients can discern signals and cues from the source. You just mentioned a shareholder letter, our annual meeting restraint in around quarterly calls you can have corporate quarterly calls are not not in in themselves that are problematic.

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But when when managers over emphasize quarterly results and particularly using quarterly guidance, that creates perverse incentives for the troops to to meet short term goal posts. That would be particularly bad case. A pharmaceutical company where products take years to develop or a computer software company or products typically take a long years and years to develop. So worrying about about the quarter fixating on the quarter is usually bad for a long term focused shareholder and articulation about the thinking around capital allocation, capital allocation.

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In some ways, the fundamental idea and certainly is in the in the value investing world, the quality shareholder world where we wonder how each dollar of corporate wealth is is used and there's every single dollar and it can be used on a variety of ways concurrently. But you go down a list and think about, well, reinvesting in the current business to to deliver increased profit margins or and that's useful to do if you can make that dollar work. Acquisitions is an appealing use of dollars.

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So long as the investment thesis is sound and the internal rate of returns satisfy a disciplined hurdle rates, those acquisitions can either be add ons or bolt ons to the existing operation or tuck ins, or they could even go beyond the current business. But in each case, you're thinking analytically about the internal rate of return in your in your hurdle. If organic growth and acquisition growth are available or you've sort of exhausted your current capability to exploit those, then you think about reinvesting in your own shares, buying back stock.

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If the price value relationship is attractive, your stock is trading at low compared to intrinsic value. There's a good use of corporate cash. It also has the incidental benefit of paying cash to people who want to exit and receive a tax event while not inflicting attacks on others. That dividend. And that's the last typical uses. If organic growth, positive growth, buybacks, you still have extra cash? Well, distribution to the holders. I've just gone through a simplistic statement of capital allocation quality.

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Shareholders look for managers who understand what I'm talking about, who think in those terms and they're rare, or at least not every CEO thinks that what not every member of the board of directors think that what why they have risen through the business ranks in other departments in merchandising or production, sales administration. What have you not been exposed to this particular highly disciplined, investment oriented way of thinking about management, but savvy investors? Certainly the value crowd quality shareholders are attracted to managers who think that way.

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And managers display that thought in the forums. You mention shareholder letter at the annual meeting, reticence around quarterly results. And so there are other other ways that managers, CEOs and boards can signal to ordinary investors or again, fund managers who care about this.

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Another thing that drives short my compensation because a lot of CEOs. So it's it's obvious by short term metrics how you identifying the alignment between the CEO and the shareholders. I'm sure you know the funny quote or quip, I guess that is a tribute to Charlie Munger said, show me how someone's compensated and I'll show you what they're likely to do. Incentive compensation is the term. And Ford's intelligent boards set CEO compensation knowing that it will lead to behaviors and consequences.

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Moments ago, I said what Warren tries to do with his CEOs is identify the targets, the broad, big targets, how many shoes we're going to sell or how many shoes are going to be Ranchi in Boston Marathon or what's the premium volume or underwriting profit, let's say if Geico and then tie the leaders compensation to that outcome and in cash, not stock options, not prescribing what how they go about it, but having broad, big targets and big payoffs.

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And that compensation system will produce certain results, have a tendency to do that. Not every board is able to think that way or to negotiate successfully with their CEO to achieve that kind of result. And so you do have compensation. Consultants may not always find that the most lucrative advice is very simple. It doesn't require lots of consultation. And so you get a proliferation of forms of compensation, many of which do induce shorter term thinking stock options. Maybe the best example or certainly a good one.

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The goal is to meet this this quarter and get this get the stock price up and they expire and and they're accounted for. I think be accounting for stock options continues to be a serious problem. The real cost of options is not reported on even less financial statements. And so another point to make, this is very important for investors. Not every CEO cares about the long term. Not every CEO is interested in the longevity of his or her company, the durability of the brand.

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Plenty of CEOs are just interested in making a lot of money as soon as they possibly can, running a wonderful empire and doing something else or being prepared to leave without much concern. The average CEO tenure in America is quite short read the most recent, but it's not longer than seven years. A lot of people and shorter. So I think savvy investors should focus on compensation packages. What the likely effects are, the likely incentives are. You see, in very many cases the alignment is more towards short term and I think being careful about that is important.

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One interesting thing we try to look at is CEOs who have eliminated their compensation, CEOs who just make one dollar. It's a funny thing. It's a small group, only 50. We thought we did it. What we'd say is that these all tend to be longer term thinkers. They tended to focus on capital allocation. They tended to attract high quality shareholders. It turns out it's not a simple story. A lot of them have taken the dollar because the company is actually going bankrupt, lost a lot of money, but it's a useful place to zero in because within that group, it's a small group.

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And if you just do a data quickly, S&P or back, find your data set. Just isolate the CEOs who pay one dollar a year for some CEOs, just do it for one year and they're back on the 16 billion dollar treadmill. But CEOs have taken just a dollar, five or seven or nine years. And that will start to, I think, be an appealing place to probe further for integrity, for quality, for high returns on capital allocation.

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And I do think it's it's probably the pocket of governance that is least amenable to fix it. Cures for just about everything else, the liability of financial statements, compliance, disclosure around diversity or climate change. They're just enormous mechanisms that seem to be available to channel governance in almost every way. Compensation, executive compensation has included any meaningful constraints. We had tax laws that would only permit deductions for incentive based compensation and then actually promoted the use of stock options.

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We have disclosure rules that require CEOs committees to list the higher compensation. So our CEO has earned this and here the compensation of the CEOs. The thought was that this would embarrass people who were overpaid and tamp down on levels the opposite. The theory was jealousy. The lower paid on those graphs complained to their board that their worth at least as much as this felt. So there was actually increase. The latest is the the idea of let's require disclosure of the ratio between the highest paid at the company and immediate paid.

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And what you see, and that is extremely high ratio. And a lot of companies average is more than two hundred and much higher than a lot of places that it has not had a the desired effect yet does say that ratio, but certainly not our average. Maybe it has a particular places, but I'm not aware of it. I think as likely that approach is likely to just create more criticism, anxiety, heat than than good results. But I don't have a quick fix, but I do think it's one of the biggest problems.

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And I would say just pushing a little harder, one of the most important things I like to look at is the source and level of director ownership in companies. And the reason I think back to directors can exert significant influence on a company if they're properly motivated to do so. There are others who are incapable of negotiating in a hard headed way, a compensation package that assures a lion. And these may be wonderful people and even good directors and lots of other ways, but directors I most trust look to are those with significant portions of their own personal net worth in the companies where they're serving.

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Ideally, that they purchased with cash and that they held for a long time and planned for a long time. The other fashion in corporate governance in the last three or five years is to encourage institutional investors and proxy advisers encouraging boards to adopt policies that require their directors to own a certain number or level of shares. And it's typically set at a multiple of their annual retainer three times or five times. I say to cheers for that. I think the motivation is right to focus on the importance and value of having directors with skin in the game.

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But I look for the director who does it on her own and does with a lot of money. I'm not that impressed by board decision is let's all make sure we do it so we'll have to and then have it three times our little retainer. That's a small amount even for directors of modest net worth. So I applaud it. But it's just too I'm not that impressed by a board that says, well, we all have six hundred thousand dollars worth of our net worth in our stock because we passed a resolution saying we must look for the balance fund with tens of millions.

[00:36:27]

And so and you can you can get that data right off of the proxy statements, how many shares everybody owns. And again, I also like that. See, the director bought that share with our own money, not by grants that companies give. That's pretty easy. But if you you believe in the company or your adviser coaching or advising and overseeing, I think you ought to buy stock meaningful amounts. And Buffett certainly does that he is ninety nine percent of his net worth in to Hathaway, and I would like to jump back to Buffett and talk more about how he makes acquisitions because a competitive advantage that sometimes might be, although it's just that.

[00:37:06]

Could you please walk us through how Buffett approaches acquisitions versus other companies or even private equity and how this could be considered to be a part of purchase note?

[00:37:16]

You're absolutely right that Berkshire's approach to acquisitions is part of its most underappreciated part. And so it's distinctive in just about every respect. And so I'll try to run through it more or less in chronological order. The first is sourcing. Most companies have an acquisition department. Big companies have an acquisition department or an acquisition team. And they're out and about searching for opportunities and then reeling them in. Some of those firms even use brokers to cut back on doing it.

[00:37:43]

He famously has said, I wait for the phone to ring. He did take an ad out in the Wall Street Journal once, about 30 years ago that said, here's what we're looking for. If you've got a company like this ready for sale, call minimum earnings management in place. Easy to understand. You see the criteria in these letters and in the essays. But beyond that initial vocal pitch that you now repeats in every letter, they wait for the phone to ring.

[00:38:07]

And so there's no internal pressure to make an acquisition. It's nice. It mean most companies have an acquisition part where it can add value. It can be useful, but it requires enormous discipline because if you're not making acquisitions, you may feel like you're not doing your job. But if that's how you feel, then you might start to overpay. So you've got to have other constraints on that. Hurdle rates would help supervise people making investment memo that it has to be approved by the board or something like that, but it does differently.

[00:38:34]

So I'm not going to go out. I'm not going to go out trying to find acquisitions. I want them to come to me. And the second step in that is I mentioned that many companies have brokers out there picking traits. Those people are paid a fee for their incentives to sell the deal, even if it's a little overpriced or it's not what you're really looking for. But the management is the place is terrible. Warren doesn't do that. They've almost never hired a broker to make an acquisition.

[00:38:57]

Instead, they rely upon a network of business connections and friends, which is a very large network at this stage, but have relied on that since nineteen sixty eight. He bought national furniture market from a from a local family friend. He brought national indemnity largest insurance company in the world from a friend and that just this continued. Now the friend circle is millions of people. And so then the third thing is that does other the standard way of making that position is to conduct extensive due diligence, financial statements, contracts, operations, personnel site, plant visits, all very important and useful at Berkshire does a little bit of that.

[00:39:31]

They don't emphasize so much. They go a little bit of that. But the main thing that Warren does, he reads the publicly available information, public companies and private financial statements for others and has a good sense in his mind about the business based on those things that all of us could get together. And then he sits down and talks to the people. He's got a very high threshold for deciding. I'd like to buy your company. He's got to understand that just like there is a moat and a sustainable business that he can understand, he's really got to trust that that manager, I think the most important part of the Berkshire due diligence.

[00:40:06]

The fourth thing is that what promises Berkshire makes and this is where the competitive that really starts to seep in and distinguish itself from most other companies, that when Berkshire buys a company makes two commitments, permanent ownership and manager autonomy, we will never sell you come hell or high water thicker then so on. Our plan is to hold this business forever. There are two exceptions for labor unrest or just hemorrhaging cash. If we're doing OK, we're not going to sell.

[00:40:33]

And sellers who value that commitment are willing to monetize. They take a discount on a purchase price when on the strength of that commitment, that's a huge competitive bet. The related is related promises, autonomy. His pitch is we don't have management to put in so any business we buy has to have that place. And he makes a promise that we'll keep you in place. You'll continue to run the business the way you've done as you see fit with no intervention from me.

[00:41:00]

And again, sellers who want to continue to do that, entrepreneur's family businesses who have a have a vision, they just need more capital or better home value, the promise of autonomy as well. So that commitment, it's an intangible part of the purchase price and rivals can't match. So there is a great example. When Berkshire bought the furniture store and in Utah it was bidding against Goldman Sachs and Goldman Sachs bid was twelve and a half percent higher than Berkshire's and both were cash, all identical except for that big difference in price.

[00:41:33]

The selling family accepted the Berkshire bid and they explained to me they value the commitment, the permanence and the commitment to autonomy as a third generation family business of Mormons with a certain way of doing things, a certain outlook. And Goldman was not likely that they would intervene and told them they had to. Open on Sunday, another thing Warren said, I'll let you guys keep doing this as you want. They value that to the tune of twelve and a half percent.

[00:41:58]

That's a huge competitive advantage that Berkshire has. And he's done that in scores of acquisitions. And now that it's taken years to achieve, obviously he's able to keep that promise of permanence. You look at the record, have only ever sold two or three subsidiaries. And there were odd, strange, weird circumstances. They sold a small insurance company because it was an arch rival to another subsidiary that they were cannibalizing each other. They sold the newspaper subsidiary because sorry for all the journalists out there, but the local newspaper business is gone.

[00:42:29]

So the businesses that have struggled. Benjamin Moore paint NetJets pampered chef. They hold the owner not hemorrhaging cash and the point of all time is vindicated with practice. To talk to any, the seller of a business can talk to any CEO of your company and get the same report that I never talk to or unless I call him. Some will say I have to warn others. I talk to them all the time because I can't really enjoy doing it.

[00:42:54]

So now rivals have a hard time monetizing the permanence of the marketplace. Most sellers don't care. Most sellers with the highest cash price, the highest economic price for them. The promise of permanence autonomy doesn't doesn't mean much. But that's that's fine for Berkshire because they don't want those businesses. They don't want people who have the mindset of the highest immediate cash price, because that's not the kind of business they want to acquire. They want to acquire a business that's been run by a guy that really wants something more than immediate cash maximization.

[00:43:26]

So it's worked for Buffett. It's hard to copy. People can do it to a degree. And I've seen other companies do it a little bit here and there. But it is it is a little bit harder to do. But I'd say when you join the family of Berkshire, the Bernie, such a wonderful image that it's the all star arena, the major leagues, you're a manager of a certain temperament or a family becoming part of the Berkshire Enterprises is is a special thing.

[00:43:52]

But to get in, it's hard. I mean, he's they didn't make a major energy acquisition this year, but the acquisition basis is quite slow right now. And I think with private equity is very different than a lot of these ways tend to be interventionists. They tend to have an idea that really ideally like to sell as soon as they possibly can. And so they use a lot more leverage than Berkshire does and they're able to pay more. And there's a lot of private equity capital available buying businesses just active in the acquisition market.

[00:44:21]

So premiums are above toleration. And so the amount of gain you get from permanence, autonomy is maybe just not enough. Go to a half percent is good data. That may not be enough right now. Markets change, environments change. I think the Berkshire model remains worthy of certainly use at Berkshire and emulation, if you can do it. Well, that kind of begs the question of what happens to Berkshire beyond Buffett, which I'm actually surprised that this is actually seems to be a topic of discussion.

[00:44:54]

For almost over twenty five years now, people have been talking about what's going to happen to Berkshire Buffett. And here we are. And you've written extensively about how it might look once Buffett passes on. And I'm just curious how you address the concerns of shareholders who are weighing out the risk of holding Berkshire beyond Buffett. I'll tell you a quick joke first, speaking of twenty five years, when I had that conference that produced the essays, one of the questions during one of the segments from the audience was what will happen to the stock price if Warren gets hit by a truck?

[00:45:25]

I don't think they put it in that the way I think if he dies tonight, we debated it for a couple of minutes longer. So some of us don't like talking about the subject. Warren said. OK, Charlie, but my opinion, for what it's worth, is that it won't be as bad as the stock for the stockholders is. It will be for me to be thinking about it for twenty five years. And that's what five years ago I published Berkshire Beyond Buffett to address that question, to ask what what will happen.

[00:45:50]

And I did it to address shareholder anxiety. I go to the meeting every year, as you do. We usually go twenty twenty nine, twenty twenty one. But that's the most popular topic of conversation around the informal gatherings of Berkshire meetings. What happens? So I wrote the book for to address that. And my thesis is that the company he's built is larger than the man who built it. He is infused Berkshire with a set of cultural attributes that give it the very best chance of surviving and prosper long after he is gone, and includes these points about permanent ownership, about autonomy, about trust, about having a very high hurdle for investments and for people and others at Berkshire.

[00:46:36]

Get that everybody, not all four hundred thousand people, but all the leadership, all the management and all the subsidiaries understand these principles of permanence, autonomy and trust. And they repeatedly vindicate them and instantiate them every day. And that's especially true of the 18 or 20 people with the highest influence, all the members of the board of directors, the people who help with investments and run the the internal audit, they all get this. And in particular, the two fellows who were four years ago put onto the board and named vice chairman Jane, who's been a Berkshire for twenty five years, now, runs all the insurance operations.

[00:47:15]

And Greg Abel, who is been a person for twenty three years and runs all the energy businesses, favorite Buffett quote, These guys have Berkshire blood in their veins. They may know more and embrace these values even more deeply than Warren. That's absolutely true for the board of directors, that board of directors, they've got Berkshire blood in their veins. And I can tell you a story if you want. Why I believe they may even get these values more than Warren does.

[00:47:41]

So this will be the stewards of the legacy. They have every conviction to sustain it and the fortitude and the ownership, the significant forces are net worth in Berkshire. All the heads of the CEOs have this view. It's a culture of self replication, self selection. People don't fit in. They leave voluntarily or to that 20 or so CEOs over the last twenty years in that category. And there may be one or two of them left who don't belong.

[00:48:09]

There will be a natural selection. They won't pose any significant problems. So I think the culture will help sustain. Moreover, I think they have designed the best possible succession plan. Warren's job is going to be divided into multiple separate functions as chairman of the board. The plan is to have the board appoint Howard Buffett, Warren's son, who's been on the board for twenty or thirty years and has the Buffett legacy. He wants the company to succeed and to prosper, and I think he'll he'll succeed in that job.

[00:48:40]

Notably, this is a job that Warren has never had to do. And so any idea that Howard's not Warren doesn't matter. Warren had to build the place and develop all these cultural motifs. Howard simply has to enforce them. So it's a very different job and I think ours will do it. A CEO, the likely candidates, Greg Abel, hasn't been announced, but and he has to make a pun but able he has allocated capital very successfully for a long time at Berkshire Energy and has proven chops.

[00:49:08]

And I think it will be a very capable capital allocator energy. Jane will be there to help with play a bit of a Charlie Munger role, bit of a of a no, I don't think so. And that's when that's necessary. As investment officers, they've got to there now. Ted Weschler and Todd Combs, who've been there now for almost fifty years, and each of them manages ten or fifteen or something, billion of the portfolio. They proven records before they joined Berkshire in this in the philosophy that your audience well knows, very skillful investors, disciplined, focused, long term patient, outstanding people, high octane, very ethical, that jobs split those three or four different ways.

[00:49:51]

Then the fifth function, obviously words always played is is controlling shareholder. He's been producing his ownership stake gradually over the past twelve years through mostly the Gates Foundation and Whiz Kids. And in the twelve years after that, it's going to gradually sell off a little more of the stock all the way through that tail. And so it will remain a controlling shareholder. For a while and his estate will vote his shares and exert some influence from the grave, as he once put it, but it will gradually, gradually go from a company controlling shareholder to one.

[00:50:23]

It is. And so during that period, that's when the role the shareholders is going to be vital. And I think they're going to play a positive role. Berkshire has attracted among the greatest densities of long term focused shareholders in corporate America. They are loyal, faithful, and most of them will stick around and give that team a chance. Give Greg a Howard Todd, Ted and the board room, but not forever. They're not fools. They're not easy to use.

[00:50:53]

And this is not romance, but it wants to stand firm. I don't know what people have different thresholds for that, but give them a chance and demonstrate that this model isn't unique or is right. This culture is self-propagating and that they will be able to make investments and make acquisitions and run the overall successfully. And if we're able to do that, Berkshire will survive and thrive and will be operated according to the principles that Warren developed over all these years.

[00:51:19]

If they're not able to do that, the shareholder base will believe they'll start selling and deciding. It was a special thing, a special company, and it was a personal business. And that's not the same. And they'll gradually sell off. And I can tell you what I what happened after that. My money is all great. And the model, I think model works and I think Greg knows how to work. So to your comment about CEOs coming, going voluntarily or involuntarily, we have to mention the David Sokol scandal back from 2011 and David Sokol was seen by many as one of the candidates to become the next CEO of Berkshire.

[00:51:55]

In short, he bought stocks in Lubrizol and later presented the idea to Buffett about Berkshire, acquired the company. Clearly an illegal move as an expert in corporate governance. What is your take on this? And how does this tie into this discussion about the succession of Buffett?

[00:52:11]

When David told Laura, Oh, I bought some stock in this company and it also said I used a broker, that's how it came up, a broker called Warren congratulate him and say, I'm glad we were involved. Which surprised more because we don't use brokers, so-called David, to say he's a broker. I said, oh, yeah. Did I not tell you that? No. You didn't do anything else. You didn't tell me. Oh, yeah.

[00:52:30]

But I think that violates our policy. I think you're allowed to do that. I think they decided David had to resign and Warren wrote his own press release saying David did this and he's resigning and then extolling all of the wonderful achievements that they've contributed over 20 years, including turning around NetJets, dealing with John's Manville and running the energy business and growing it. And the shareholders went nuts and the press even worse because Warren had for years been stressing ethics and the center of the playing field, not hurting a shred of the reputation of the company.

[00:53:02]

They all said that's a shred or worse. So this is like a slap on the wrist. Didn't seem right. Didn't seem Berkshire when this came out 10 days before the annual meeting. So there was a lot of spotlights on this.

[00:53:13]

The board took control of the matter. Ron also is the chair of the audit committee, along with Susan Decker and Sandy Gottesman. An internal you put this in the frame of corporate governance. They executed a perfect corporate governance measure. They investigated what had happened. They interviewed David. They interviewed the folks at the company Lubrizol. They documented conversations with Warren that the times of his trades and so on, and concluded that he had violated Berkshire policy under the terms of his employment contract.

[00:53:41]

He was terminated for cause, which meant that he was stripped of all sorts of benefits, mostly economic benefits. And worst of all, this was throwing them under the bus. His reputation is in tatters, the private sort of little resignation. He'd have been immediately rehired and none other great things in the public limelight with this repudiation, this rebuke. He couldn't do that. So it was a stinging enunciation of David. The board also reported the matter to the federal securities authorities that the Securities Exchange Commission, because it probably was a case to be made buying the stock before encouraging its acquisition, violating federal securities law.

[00:54:20]

So they referred it to the SEC. Now, it turns out the SEC conducted its own investigation and decided not to enforce it. Didn't mean he was exonerated, vindicated or anything like that. There are many reasons why the SEC might bring a case, but would it certainly was.

[00:54:34]

They didn't think it was so obvious that they should do it. So the read I get from that is that the board took the ethics and the play in the center of the field and not a shred of reputation, much more seriously than Warren did. They got that set of values and ethics fully and firmly. I mean, Warren's famous phrase that he first uttered in congressional testimony when he took over the scandal ridden Salomon Brothers bank was lose money for the firm.

[00:54:59]

And I'll be understanding Lew's reputation for the firm. Even a shred of reputation will be ruthless. What happened in this case was that he personally was not willing to be ruthless. David did lose a shred of reputation and Warren was not ruthless. The board was. And so I think that means that that board and they'll be if something happens, Warren and Ron, Susan is getting a little older, but the board, its audit committee believes in these ideas.

[00:55:24]

They acted decisively. So to me, what it says is that it's a data point in my argument that the companies bigger than the man, he incubated it and put all sorts of values and culture in there. And it's part of the institution. And the institution acted. They acted much more effective way than Warren. Yeah, I think that's an important point. Definitely showcases how the company can operate or is operating even beyond Buffet already, and it's almost like David was a sacrificial lamb of sorts to solidify that company culture and to and to prove it out.

[00:55:57]

It's really quite fascinating. So I want to just touch on a question that I'm curious about, and it surrounds this idea of conglomerates that have fallen out of fashion. Right. But Berkshire is a massive, massive conglomerate, maybe obviously one of the biggest in the world, if not the biggest. So Berkshire itself is this massive conglomerate. And back in the 80s and 90s, conglomerates were falling out of fashion. They were getting taken over by corporate raiders like Carl Icahn or buyout firms that would break them up and sell them off.

[00:56:25]

But Berkshire avoided all of that. And I actually have this impression. I don't know if you agree, but at Berkshire almost has this halo effect of being somewhat of a benevolent conglomerate, if you could use that word right. Whereas Amazon, for example, has a totally different distinction or perspective on it and Amazon might take on it. Is the sum of Amazon's parts make up a monopoly, whereas Berkshire, that's not quite the case. Its subsidiaries across multiple industries that don't quite create a center for each other.

[00:56:56]

It's a profoundly deep insight and avenue for investigation. It's an excellent thesis. I think that sort of halo halo effect benevolent conglomerate, I think those are are descriptions for Berkshire. And a big part of that is how Warren positioned himself in the company as a member of the sensible center. He's a capitalist with heart. It's a money making machine, but they care about their customers and employees, even in the scrapes that some of the subsidiaries have gotten into and they've gotten into them.

[00:57:28]

They've managed to work through them at the energy company, sometimes accused of not handling customers. Well, if Clayton Home-building company was was was attacked for predatory lending, manipulating relatively poor people into buying things, taking loans they really couldn't afford, the insurance companies, some of them being slow and not acting in good faith. They said they had pockets of heat, but they survived those. And I think for good reasons. I think most of the arguments I've written about this were not correct or credible, but Berkshire itself has managed to be pretty low, benevolent and also a little bit of a Teflon.

[00:58:04]

They get hit. So-called episode is a good example in the papers and big deal. But so everyone sold it on. It's managed to do that. And your thesis might be right. And it is it's not a juggernaut like Amazon, Amazon. It's a very different animal, as you say. It's in your face. For one thing, the whole operation is very consumer facing boxes, all uniform. But a lot of employees are low on the employment totem pole.

[00:58:33]

And when they're when they have grievances, they get aired and magnified in ways that is much more diffuse and not free through all these different units. So it is a completely different I think you're absolutely right about that. The other thing I'd say just about the how else why does Berkshire get to be so many others have been attacked. But one obvious thing is that Warren has basically the gold chair. If Carl Icahn wanted to attack, want to take a shot at Berkshire, he'd almost certainly lose immediately, partly because Warren's got the block at equally because he's got the other shareholders would absolutely agree with him.

[00:59:08]

It's not a crowd that's likely to accept Corales argument over Warren's. I think the other thing and maybe it's a part of that, I think those activist assaults on the conglomerates that began in the 80s and 90s, including with Carl Nelson, Peltz and others and the continue today nanotechnology's Dupont, part of the argument is about how it's invisible. It's hard to identify the separate units, to appraise the value of the units some and that you need to break these up so that we have visibility so that we can see exactly what this one is worth and exactly what this one is worth.

[00:59:42]

And then the added argument is that when you do it that way, you will unlock value so people will be able to say you're actually worth six instead of five. So let's unlock the value. These conceptions are not not at home at Berkshire. So there's no thought that we need to unlock value or that you need to have a valuation on these units. Those ideas are very much what's the market price and how high can you make it to this elite Berkshire Hathaway?

[01:00:08]

It's not about getting a market valuation on on these units. That's not important at all. It's not even important a market valuation as a whole. And it's certainly not interesting to find out what it is today compared to where it is tomorrow. This crew's looking out forever, practically at least three, six or nine years. Then Warren uses ten or twenty. So the philosophical attack you're trying to break up Dupont and Nelson tells you you've got two separate patents and the pharma bio life sciences.

[01:00:36]

So we could see what each one's worth. That attack, which only barely succeeded, is actually the. Way, but there was so much momentum behind so that Tiger just wouldn't win more philosophically at Berkshire. I'll just say one final thing is that there are other glamorous. I agree with you that most have disappeared, but there are quite a few and they survive, thrive. And I'm talking about Danaher and it w that's Illinois Tool Works, even United Technologies.

[01:01:04]

All three of those have been targeted by activists campaigning for spin offs, investors, breakup's, Deek bombers, and all three of them did a little bit, but all three of them maintain significant parts of their their culture and their philosophy. Denner articulate it done, I think, two major spin offs so that its trunk created greater visibility and added value, market capitalization. So we're doing that. But it remains Danaher herself, acquisitive, decentralized, autonomous trust base.

[01:01:40]

It's going to build and build and build. And it's still a conglomerate. Illinois Tool Works, similar story. One hundred year old Chicago based manufacturer of industrial parts and products. And at one point, I think it had eight eight hundred different business units, a hundred different separate panels that the results of acquisitions that were managed by independent managers who ran their own businesses. Now, they didn't think it the way, which is sort of entrepreneurial, innovative customer facing.

[01:02:06]

There's sort of an ethos around the company that you treat customers first when it was a huge, diverse conglomerate, enormously, vastly decentralized. And I think it was relational went after them. And but Scott Santae, CEO, they did some trimming that. They went through a divestiture process. They sold a bunch of things. They combined some things. They listened to what the activists thought was ideal. But they didn't destroy the company. They didn't just break it all up, sell it all off.

[01:02:35]

Eight hundred little different companies idea, ideally still acquisitive, decentralized, autonomous living by values that publish for one hundred years. And so even in this world, this entire world, in this this agitation by activists who oppose conglomerates, the important parts of the model, the remain value and remain durable and so done right. It's still possible. Well, Pat, so Lawrence, I would like to talk about the concept of quality shareholders, because you said that one of the biggest concerns in today's market is the rise of investors just owning an index and how that indirectly contributes to the deterioration of quality shareholder.

[01:03:15]

So perhaps first, if you can define what makes up a high quality shareholder and then why an investor should pay close attention to the risk of so-called low quality shareholders. Yes, thanks. I took this term quality shareholder from Warren in his nineteen seventy eight letter and then again more fully in his nineteen eighty three letter. So that's early days for Berkshire. He explained that he wanted to attract Berkshire, a certain kind of share, and that kind of shareholder was the long term focused shareholder and he called them a high quality show and he made a joke about how hard it is to turn a corporation into a club like that.

[01:03:56]

He made a joke about Lady Astor being able to choose which which four hundred people she'd have in her home or the social register as a publicly traded company. Anybody can buy a share, so he can't simply admit you and not admit you. He said there's a certain kind of person I want in the long term. I need people patient. I don't want a lot of big trading and I want them focused. I want them to put significant portions of the net worth of Berkshire.

[01:04:20]

I want them to pay attention. I want to be able to talk to them, teach them, and I want them to understand that. Stick around, come to my meeting, read my letters. So he said that early on and he said, And how am I going to do that? Well, I'm going to have a set of policies and practices that cater to that crowd and all of that. And so those policies are stressing the long term, stressing capital allocation, stressing trust, autonomy, decentralization, the playbook.

[01:04:47]

And so he consciously cultivated that group. And what I've come to realize over the past five years studying Berkshire this whole time, looking at all the reasons for his success, we started this conversation identifying the personal characteristics of Warren that contribute to this. Well, there are many factors that contributed to Berkshire success. Warren personally, Charlie Munger, as well as a as number two trust based culture, the commitment to permanence, autonomy, the rationality and so on, the network and all of that.

[01:05:20]

I came to eventually realize that all that's important, the crucial thing, you couldn't have done any of that without the Sheryl Warren. What was right that he needed to have, what do you call it, high quality show. You define long term focus because they helped him. They gave him a runway. They stuck with him through the thin. And there were a bunch of things. There's been now the tough periods they stuck with. They they gave him the strength, the fortitude to prevail, to be a CEO.

[01:05:49]

He couldn't have done all whatever his his brain, his IQ, whose IQ, whose brains, his his brain trust and all that wanted to achieve what he achieved without those long term patient holders. And that's what I came to realize five, four years ago. I started focusing on them books about their role in Berkshire. And then I realized that's probably true in a lot of other companies, too. So I broke down the prevailing shareholder demographic into four quadrants based on time horizon and concentration.

[01:06:19]

And you've got basically four quadrants. You've got the indexers who are long term. They basically hold forever. The stock gets out of an index but never concentrated on small bits of every company. And so they can't be focused. I mean, the staffs of the big indexers or minuscule compared to the investor's BlackRock just increased its staff, the stewardship staff, as they call it, to about forty eight or forty five people, which double it's a lot more people, but they're invested in four thousand US equities and twelve thousand all over the world.

[01:06:49]

They simply can't consider it. They can't know. And the business model is isn't to know. They just buy everything, every single stock. That's the business model and they don't need it and they shouldn't really be expecting their business models just by the market. So that's one one called the indexers. They're there long term, but they're not folks they can't be. And the next quarter is sort of the opposite of that. The traders, the trans arbitragers, the robotics, the artificial intelligence, just the happy day traders are just a lot of funds that are active that that move a lot and do a lot of buying and selling.

[01:07:22]

So average holding periods or a year, maybe two. And so they're short term and they might have high levels of ownership at certain times and they might concentrate, but then for hold for long in those two quadrants, make up vast majority of ownership public equity. Today, the indexing segment is is at least 30 percent. And then if you do look at the publicly stated index or BlackRock, Vanguard, State Street or Trust, that's 20 percent right there.

[01:07:52]

And then the smaller quadrant next is another five or eight or 10 percent. And then there are just a lot of investors, institutions who are closeted. Well, we know where they advertise themselves picking stocks, but they really own two hundred, basically the index, more than two hundred. So at least a third of the public equity is owned by index and then another third is owned by transients. So the average holding periods of a third of the equity is less than two years.

[01:08:20]

Those are enormous, enormously powerful influences in public equity today. And they're both you. So in different ways, indexers deliver the market return for millions of ordinary people at virtually no very low cost and just the market risk, it's a wonderful thing. And so that's a they add enormous value to society and traders add value to they do price discovery. They provide deep liquid markets. When people do have to sell long term people have to sell for bequests or deaths.

[01:08:52]

They provide the deep liquid capital markets the United States has long been famous for is not a condemnation of these these cohorts, but they do. They play those roles. They do not play the role of a focused long term shareholder, understands the business, gives the managers the benefit of the doubt and a little leeway, and is willing to engage constructively with managers. And that's the quality cohort. That's the kind of Hoder Warren long ago said he wanted to have to.

[01:09:19]

The quality group is in some ways the group these all three of the others do very important things. But the important thing that the quality group adds is an informed, incentivized focus on that very often help management certainly elongate the time horizon and so on. But they're not fools. They're not sycophants or cheerleaders. They're in it for returns as well. And so managers are failing. They'll sell, they'll leave, join this campaign, for that matter, when worry is sort of interesting.

[01:09:50]

When one wrote those letters, nineteen seventy three indexing was in its infancy. I think he was mostly concerned about day traders and activism had a different texture. It was more rival companies doing hostile tender offers, the occasional activist. But the real era had begun. So his statement was addressing a slightly different demographic. But what's happened is you get you get way more of the two things that he said he wasn't really interested in track more. And the pressures on investors to index or to trade rapidly are huge indexers.

[01:10:24]

It's Insaaf. You just delivered the market return. Wow. We shouldn't lag that way. You get a lot of closet indexers and if you're really hungry, you're really eager. Your clients are urging it. It's tempting to to design trading strategies that end up looking like you're turning just doing a lot of shorter term trading. So the pressure is on the quality shareholder to join the others. And so I think nevertheless, I also think that the quality cohort knows that they are not only playing a valuable role, but through doing it and outperform the market.

[01:11:02]

The day traders and incidentally, the evidence have the huge debate, as you know, about value versus the index or stock picking versus the index. Significant studies that have often shown that there's no systemic strategy that will be a passive index. Warren even did a famous bet with Airside over the past decade where Warren bought the S&P and Ted was able to assemble any group of hedge funds. He wanted stock pickers and see who would win. And it was a funny Beddows over a ten year period.

[01:11:33]

The stock picker actually one of a couple of years, but the index won overall after fees to stress. The reason Warren made that bet so much was to emphasize that that the funds extract enormous fees from the clients so they may have outperformed stock picking may actually be possible. That individual may be able to discern quality, get returns. But if you have to pay for it, managers, managers take high fees. That was pretty. But nevertheless, it shine a spotlight on how difficult it is to pick stocks and outperform the average.

[01:12:05]

And so it is. And so that said, an important strand of that empirical research led by the the dean of the University of Notre Dame Business School, Martine Kramers and others, an important strand has demonstrated that the strategy I'm talking about, the quality shareholder strategy, be patient and focus has a tendency to outperform. You've got to do other things that magic. You just don't pick thirty stocks. And over five years you've got to conduct the kind of homework and analysis that Warren's famous for that investors do like quality or work does.

[01:12:42]

But the research indicates that long holding periods of concentration going together contributes to the possibility of systemic outperformance. That's a very important strand of research. Now, it, too, is controversial. I'm sure your listeners know as well as I do, some of the firms attack the research and there's there's a great debate about it. But there's there's no question that it is a genuine, reliable contribution to the literature so that any idea that, well, you cannot outperform values that all shareholders edit is just wrong.

[01:13:17]

And so so I think the quality cohorts know that they add a lot and they they gain a lot from being who they are. And there's a there's a. Philosophy to any of the person out at different individual human beings and fund managers will have a greater or lesser affinity for merely indexing or being a trader or sticking sticking with quality or being it depends on your appetite or your willingness to do work, your toleration for risk, your level of willingness to be an agitator versus being more of a diplomat.

[01:13:51]

And so people will self select into these styles of strategies selves. So I think it is it's harder to be sure.

[01:14:00]

So anyone who's familiar with Brookshire probably is aware that they have a prominent insurance business unit and that they use the float to allocate and grow other business units within the company. It's part of the fuel that's been driving the growth of Berkshire overall for many years. I'm just curious because we're in such an interesting economic environment where interest rates are lower than ever and there's no real sign of them being able to increase any time soon, there's even pressure to potentially go negative as they've done so in other parts of the world.

[01:14:30]

There's on top of that even devastation caused by this global pandemic that will have consequences for insurance companies. And generally speaking, and we saw that in Berkshire's insurance earnings, they decrease about 60 percent in the last quarter. And I'm just curious, given that insurance is greatly affected by these interest rates and that insurance makes up twenty seven percent of Berkshire overall, not to mention it produces the float used for capital allocation, in your opinion, is Berkshire at risk as we enter this new economic environment?

[01:15:00]

And how do you see it affecting the insurance portion? Great question. You've really outlined a set of challenges that the industry generally faces, and in particular because of its heavy, I wouldn't say concentration, but big, big portion of its operations and strategy, it's hard to know. I don't have anything to pinpoint in your articulation, but it added a dimension in thinking about bursar's insurance position. It's less gloomy in some ways. I think that what Warren worries about most is catastrophic risk and the massive claims that his companies and many others will face.

[01:15:40]

No one can predict what the Black Swan or whatever we like to call it is it could be cybersecurity. It could be different aspects of pandemic business interruption. There's a good bet that there's going to be continued bad effects from climate change, hurricanes, floods, tornadoes, fires and whatnot. And so this set of risks may well have been magnified, not likely to change direction. And so I think he might be expecting I think insurance pricing shows some of this huge claims in the near term.

[01:16:14]

Little dwarf, Hurricane Andrew and 9/11, hundreds and hundreds of billions. And it'll wipe out a lot of many insurance companies will become insolvent. State funds will have to take over, and Berkshire will remain a fortress. And because it has the strongest claims capacity, it's got enormous capital gushers of cash flow. I think when it comes to insurance, that's the thing I worry about the most for the industry and for society. But it's going to actually be extremely beneficial for you because it will be able to pay all its claims.

[01:16:46]

It'll be able to take over portions of the market or industry and thrive as a result. It struck me at the annual meeting in May, Warren certainly looked very gloomy and it may have just been for the pandemic. And he sounded or at least, you know, he's usually, as you know, happy and fun, optimistic, realistic, but generally seem discerning. The positive trend in America has had all those essays about Americans still with. You do not see any of that that day.

[01:17:16]

And maybe it was a pandemic, probably not there on the stage with him and no one is there. Your cousin may have been there, but not many other people. One hundred people, not forty thousand. So there were all kinds of reasons for it. I just have had a strong sense that I think it was in the comments that there are seismic catastrophic risks and that a lot of insurance companies will be wiped out and at more amounts of money and will be able to.

[01:17:42]

And that's what you read the letters. One of the most important things in Berkshire is that claims capacity calls it a fortress in Fort Knox. That's good advertising slogan for big insurance, commercial property casualty insurance to say we'll weeder your policy. Not only can you trust us, but we've got enormous we've got so much capital, there's nothing no tsunami is going to starve us. And that made me think Berkshire's got this enormous cash balance and Treasury one hundred and thirty forty fifty billion.

[01:18:10]

I can't keep track. Warren's got that old joke. One microphone, one billion. Two billion. Three billion. When. Now this cash is one forty one one forty two. Is that a lot of money. Everyone thinks it is. He's always said we're always going to have at least twenty billion of cash said that I forget the last time he said he said it more than once. It's been a policy. You know, I just wonder if that's way too low.

[01:18:32]

He hasn't update maybe seventy five times better. That would explain half of the cash. Why you just we're not going to buy another Precision Castparts right now. So I think you're right in your analytics around the data earnings for the income stay part of the church operation and even the investment part. I think it's a balance sheet. It's going to matter. And I think Berkshire is going to be proven prescient once again. Sadly, I shouldn't be laughing, but because it's it would be awful if those things did happen.

[01:19:02]

But some of the trends seem to point it more in that direction that the lower risk for. I love that's a great point, that it's going to come to the balance sheet, it's a great way to say it. I know we shouldn't really focus on the daily share price of Berkshire, but something I read in your book, I just can't really help myself but ask you this question. So you've mentioned that Buffett likes to see the stock trade around its intrinsic value, but we've seen recently this year he's been buying back some shares.

[01:19:28]

And if we look at Berkshire the way Buffett does, he breaks out the business units as what he calls into these groves. Right. That are kind of harvesting their own cash flow. And so you did this breakdown. It's very back of the envelope math, but you mentioned there one hundred fifteen billion or so a float, which we don't actually factor in because it's paid out. But there's beyond that, the three hundred billion of subsidiaries, two hundred billion worth of stock holdings, about 15 billion between his partnerships with private equity groups and then this one hundred billion dollars or so of treasuries.

[01:19:59]

And so you add all that up and you divide it by the shares outstanding, which is about one point three, seven billion shares. And you come up with this value of around four hundred dollars a share, given that the stock price right now is in the low to hundreds. I'm just curious, do you currently see Berkshire as undervalued and and that way and buy that much? You're right that I laid it out kind of a high level way, but I think it is roughly right and if it is, then it's a little undervalued.

[01:20:29]

And I guess two things make me two checks, make me feel more confident that one is the person buying its own stock in significant levels for Berkshire. And the others just understand that enormous capital has flowed into the fangs and the the unicorns. And just in there's a significant elevation in the overall stock market. You see Snowflake, which I think is one of Berkshire's recent investments and is priced at two hundred times revenue, some stratospheric figures. So there's enormous fascination, glamour and excitement.

[01:21:04]

Companies are going to change the world and with Facebook and Apple and Netflix and Google, Alphabet and so Berkshire looks very old and simple and tired. So it's not the glamour stock, in my view. That's good for Berkshire. One advantage, Berkshire buying back its own stock right now is that those who are among most of the sellers are probably not going to be the quality shareholders that I've been bragging about. They're going to be people who bought it on spec for the short term, a very famous one, as is Bill Ackman, apparently, whose firm Pershing acquired a substantial stake around the onset of the pandemic and last month or so sold it.

[01:21:44]

I think Bill went on television somewhere saying I lost. I don't know how much he lost over hundreds of billions or large amounts of money in Berkshire, that the headlines of Blackwood's one of the rare people who lost a lot of money were. But, Bill, explain that. I bought the stock, Bill said, because I assumed that Warren would deploy enormous amounts of capital at the depths of the pandemic and exploit the opportunity and so on. He didn't do all that.

[01:22:09]

So I'm going to sell well, that's not quality shareholder thinking. That's day trading and it's it's arbitrage. It's opportunism. Again, there's nothing wrong with good for Bill. I like Bill. I think if that's the kind of person that is selling well, Berkshire's buying back that improves the average quality of the shareholder base measure in the terms that I've described. So I think that's probably another advantage, a slight advantage that you're going to see Warren retired or left to borrow those quality shares are more important than ever.

[01:22:39]

Lawrence, this has been absolutely amazing, him a chance to speak with you today, and I couldn't be more grateful for your time. I'm sure the audience feel the same way. I would like to give you the opportunity to talk a bit more about your publications initiatives. Could you please give a hand off to where the audience can learn more about you?

[01:22:55]

The best place to get my books is our old friend, the juggernaut Amazon.com. Go to that site and type my name. You'll get a list of 20 to 30 books. If you don't like Amazon, you can go to my university's website by Quality Shareholders Initiative. Website contains, I think, interesting information about my latest book and latest research about this quadrant, the long term focus shareholder. So I think we just do a Google Search Quality Shareholders Initiative will come right up.

[01:23:23]

And we'll be sure to provide links in the show notes to all the books we mentioned on this during this discussion for our listeners to check out. So, Lawrence, I so greatly appreciate you coming on to the show you. And I could probably sit here and talk all day about Burke. Sure. I know that we could. I hope we can do it again sometime soon. I really enjoyed having you on the show. Thank you.

[01:23:42]

Oh, thank you very much. Likewise. All right.

[01:23:45]

That was all the train I have for you for this week's episode of the Masters podcast. We'll be back next week. As always, Preston and his Wednesday releases with Bitcoin and then with a regular episodes next weekend. Have a wonderful week at. Thank you for listening to TI IP to access our show notes, courses or forums, go to the Investors podcast Dotcom. This show is for entertainment purposes only before making any decisions, consult a professional. The show is copyrighted by the Investors Podcast Network written permission must be granted before syndication or forecasting.