If you missed it, start with Part 1 of this Book Summary.
“Some books should be tasted, some devoured, but only a few should be chewed and digested thoroughly.” — Francis Bacon (The Essays of Francis Bacon, 1696)
If you've ever wanted to read through all of Warren Buffett's shareholder letters, you really have two choices: read every from cover-to-cover letter separately OR read through the best advice from over the years grouped into clear categories ranging from Investing to Acquisitions to Taxation. Having done both I can guarantee you that reading through the best wisdom arranged by category is much more fun and insightful. You don't just get Warren's thoughts on Investing for instance from one shareholder letter — you get his best ideas from every letter.
All the letters are woven together into a fabric that reads as a complete and coherent narrative of a sound business and investment philosophy.
What Lawrence Cunningham has created with The Essays of Warren Buffett: Lessons for Corporate America is remarkable. I'd argue that reading it in its entirety is just as valuable as getting an MBA. It contains all of the best advice that Warren Buffett has shared over the years — all hard fought and won from real-world experience. This isn't a book about theory, it's a book about wisdom gained from decades of practices.
As Lawrence Cunningham sums up in the introduction, "Experienced readers of Warren Buffett's letters to the shareholders of Berkshire Hathaway have gained an enormously valuable informal education."
Buy the Book: The Essays of Warren Buffett by Lawrence Cunningham
Notes & Transcript: Find my full notes and transcript for this episode at outlieracademy.com/warrens-essays.
Charlie Munger on "The Berkshire System"
On Berkshire Hathaway's 50th anniversary, Charlie Munger contributed his reflections on what he called "The Berkshire System." In that essay, he shares his reflections on what they got right and why Berkshire has been so successful. As always, Charlie's reflections are both simple and profound. He wastes no time and dives straight to the point.
Vice Chairman’s Thoughts – Past and Future
To the shareholders of Berkshire Hathaway Inc:
I closely watched the 50-year history of Berkshire’s uncommon success under Warren Buffett. And it now seems appropriate that I independently supplement whatever celebratory comment comes from him. I will try to do five things.
1. (1) Describe the management system and policies that caused a small and unfixably-doomed commodity textile business to morph into the mighty Berkshire that now exists,
2. (2) Explain how the management system and policies came into being,
3. (3) Explain, to some extent, why Berkshire did so well,
4. (4) Predict whether abnormally good results would continue if Buffett were soon to depart, and
5. (5) Consider whether Berkshire’s great results over the last 50 years have implications that may prove useful elsewhere.
The management system and policies of Berkshire under Buffett (herein together called “the Berkshire System”) were fixed early and are described below:
1. Berkshire would be a diffuse conglomerate, averse only to activities about which it could not make useful predictions.
2. Its top company would do almost all business through separately incorporated subsidiaries whose CEOs would operate with very extreme autonomy.
3. There would be almost nothing at conglomerate headquarters except a tiny office suite containing a Chairman, a CFO, and a few assistants who mostly helped the CFO with auditing, internal control, etc.
4. Berkshire subsidiaries would always prominently include casualty insurers. Those insurers as a group would be expected to produce, in due course, dependable underwriting gains while also producing substantial “float” (from unpaid insurance liabilities) for investment.
5. There would be no significant system-wide personnel system, stock option system, other incentive system, retirement system, or the like, because the subsidiaries would have their own systems, often different.
6. Berkshire’s Chairman would reserve only a few activities for himself.
1. He would manage almost all security investments, with these normally residing in Berkshire’s casualty insurers.
2. He would choose all CEOs of important subsidiaries, and he would fix their compensation and obtain from each a private recommendation for a successor in case one was suddenly needed.
3. He would deploy most cash not needed in subsidiaries after they had increased their competitive advantage, with the ideal deployment being the use of that cash to acquire new subsidiaries.
4. He would make himself promptly available for almost any contact wanted by any subsidiary’s CEO, and he would require almost no additional contact.
5. He would write a long, logical, and useful letter for inclusion in his annual report, designed as he would wish it to be if he were only a passive shareholder, and he would be available for hours of answering questions at annual shareholders’ meetings.
6. He would try to be an exemplar in a culture that would work well for customers, shareholders, and other incumbents for a long time, both before and after his departure.
7. His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became; and
8. He would also spend much time in enthusiastically admiring what others were accomplishing.
7. New subsidiaries would usually be bought with cash, not newly issued stock.
8. Berkshire would not pay dividends so long as more than one dollar of market value for shareholders was being created by each dollar of retained earnings.
9. In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the Chairman could pretty well understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters.
10. In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness, skill, energy, and love for the business and circumstances the CEO was in.
11. As an important matter of preferred conduct, Berkshire would almost never sell a subsidiary.
12. Berkshire would almost never transfer a subsidiary’s CEO to another unrelated subsidiary.
13. Berkshire would never force the CEO of a subsidiary to retire on account of mere age.
14. Berkshire would have little debt outstanding as it tried to maintain (i) virtually perfect creditworthiness under all conditions and (ii) easy availability of cash and credit for deployment in times presenting unusual opportunities.
15. Berkshire would always be user-friendly to a prospective seller of a large business. An offer of such a business would get prompt attention. No one but the Chairman and one or two others at Berkshire would ever know about the offer if it did not lead to a transaction. And they would never tell outsiders about it.
Both the elements of the Berkshire system and their collected size are quite unusual. No other large corporation I know of has half of such elements in place.
How did Berkshire happen to get a corporate personality so different from the norm?
Well, Buffett, even when only 34 years old, controlled about 45% of Berkshire’s shares and was completely trusted by all the other big shareholders. He could install whatever system he wanted. And he did so, creating the Berkshire system.
Almost every element was chosen because Buffett believed that, under him, it would help maximize Berkshire’s achievement. He was not trying to create a one-type-fits-all system for other corporations. Indeed, Berkshire’s subsidiaries were not required to use the Berkshire system in their own operations. And some flourished while using different systems.
What was Buffett aiming at as he designed the Berkshire system? Well, over the years I diagnosed several important themes:
1. He particularly wanted continuous maximization of the rationality, skills, and devotion of the most important people in the system, starting with himself.
2. He wanted win/win results everywhere--in gaining loyalty by giving it, for instance.
3. He wanted decisions that maximized long-term results, seeking these from decision makers who usually stayed long enough in place to bear the consequences of decisions.
4. He wanted to minimize the bad effects that would almost inevitably come from a large bureaucracy at headquarters.
5. He wanted to personally contribute, like Professor Ben Graham, to the spread of wisdom attained.
When Buffett developed the Berkshire system, did he foresee all the benefits that followed? No. Buffett stumbled into some benefits through practice evolution. But, when he saw useful consequences, he strengthened their causes.
Why did Berkshire under Buffett do so well? Only four large factors occur to me:
1. The constructive peculiarities of Buffett,
2. The constructive peculiarities of the Berkshire system,
3. Good luck, and
4. The weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press.
I believe all four factors were present and helpful. But the heavy freight was carried by the constructive peculiarities, the weird devotion, and their interactions.
In particular, Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis.
Buffett was, in effect, using the winning method of the famous basketball coach, John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players. That way, opponents always faced his best players, instead of his second best. And, with the extra playing time, the best players improved more than was normal.
And Buffett much out-Woodened Wooden, because in his case the exercise of skill was concentrated in one person, not seven, and his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player does.
Moreover, by concentrating so much power and authority in the often-long-serving CEOs of important subsidiaries, Buffett was also creating strong Wooden-type effects there. And such effects enhanced the skills of the CEOs and the achievements of the subsidiaries.
Then, as the Berkshire system bestowed much-desired autonomy on many subsidiaries and their CEOs, and Berkshire became successful and well known, these outcomes attracted both more and better subsidiaries into Berkshire, and better CEOs as well.
And the better subsidiaries and CEOs then required less attention from headquarters, creating what is often called a “virtuous circle.”
How well did it work out for Berkshire to always include casualty insurers as important subsidiaries?
Marvelously well. Berkshire’s ambitions were unreasonably extreme and, even so, it got what it wanted.
Casualty insurers often invest in common stocks with a value amounting roughly to their shareholders’ equity, as did Berkshire’s insurance subsidiaries. And the S&P 500 Index produced about 10% per annum, pre-tax, during the last 50 years, creating a significant tailwind.
And, in the early decades of the Buffett era, common stocks within Berkshire’s insurance subsidiaries greatly outperformed the index, exactly as Buffett expected. And, later, when both the large size of Berkshire’s stockholdings and income tax considerations caused the index-beating part of returns to fade to insignificance (perhaps not forever), other and better advantage came. Ajit Jain created out of nothing an immense reinsurance business that produced both a huge “float” and a large underwriting gain. And all of GEICO came into Berkshire, followed by a quadrupling of GEICO’s market share. And the rest of Berkshire’s insurance operations hugely improved, largely by dint of reputational advantage, underwriting discipline, finding and staying within good niches, and recruiting and holding outstanding people.
Then, later, as Berkshire’s nearly unique and quite dependable corporate personality and large size became well known, its insurance subsidiaries got and seized many attractive opportunities, not available to others, to buy privately issued securities. Most of these securities had fixed maturities and produced outstanding results.
Berkshire’s marvelous outcome in insurance was not a natural result. Ordinarily, a casualty insurance business is a producer of mediocre results, even when very well managed. And such results are of little use. Berkshire’s better outcome was so astoundingly large that I believe that Buffett would now fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth.
Did Berkshire suffer from being a diffuse conglomerate? No, its opportunities were usefully enlarged by a widened area for operation. And bad effects, common elsewhere, were prevented by Buffett’s skills.
Why did Berkshire prefer to buy companies with cash, instead of its own stock? Well, it was hard to get anything in exchange for Berkshire stock that was as valuable as what was given up.
Why did Berkshire’s acquisition of companies outside the insurance business work out so well for Berkshire shareholders when the normal result in such acquisitions is bad for shareholders of the acquirer?
Well, Berkshire, by design, had methodological advantages to supplement its better opportunities. It never had the equivalent of a “department of acquisitions” under pressure to buy. And it never relied on advice from “helpers” sure to be prejudiced in favor of transactions. And Buffett held self-delusion at bay as he underclaimed expertise while he knew better than most corporate executives what worked and what didn’t in business, aided by his long experience as a passive investor. And, finally, even when Berkshire was getting much better opportunities than most others, Buffett often displayed almost inhuman patience and seldom bought. For instance, during his first ten years in control of Berkshire, Buffett saw one business (textiles) move close to death and two new businesses come in, for a net gain of one.
What were the big mistakes made by Berkshire under Buffett? Well, while mistakes of commission were common, almost all huge errors were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well. The errors of omission were of much importance. Berkshire’s net worth would now be at least $50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things.
The next to last task on my list was: Predict whether abnormally good results would continue at Berkshire if Buffett were soon to depart.
The answer is yes. Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage.
Moreover, its railroad and utility subsidiaries now provide much desirable opportunity to invest large sums in new fixed assets. And many subsidiaries are now engaged in making wise “bolt-on” acquisitions.
Provided that most of the Berkshire system remains in place, the combined momentum and opportunity now present is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if (1) Buffett left tomorrow, (2) his successors were persons of only moderate ability, and (3) Berkshire never again purchased a large business.
But, under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.” For instance, Ajit Jain and Greg Abel are proven performers who would probably be under-described as “world-class.” “World-leading” would be the description I would choose. In some important ways, each is a better business executive than Buffett.
And I believe neither Jain nor Abel would (1) leave Berkshire, no matter what someone else offered or (2) desire much change in the Berkshire system.
Nor do I think that desirable purchases of new businesses would end with Buffett’s departure. With Berkshire now so large and the age of activism upon us, I think some desirable acquisition opportunities will come and that Berkshire’s $60 billion in cash will constructively decrease.
My final task was to consider whether Berkshire’s great results over the last 50 years have implications that may prove useful elsewhere.
The answer is plainly yes. In its early Buffett years, Berkshire had a big task ahead: turning a tiny stash into a large and useful company. And it solved that problem by avoiding bureaucracy and relying much on one thoughtful leader for a long, long time as he kept improving and brought in more people like himself.
Compare this to a typical big-corporation system with much bureaucracy at headquarters and a long succession of CEOs who come in at about age 59, pause little thereafter for quiet thought, and are soon forced out by a fixed retirement age.
I believe that versions of the Berkshire system should be tried more often elsewhere and that the worst attributes of bureaucracy should much more often be treated like the cancers they so much resemble. A good example of bureaucracy fixing was created by George Marshall when he helped win World War II by getting from Congress the right to ignore seniority in choosing generals.
Charles T. Munger
Glossary of Terms from The Essays of Warren Buffett
The following are terms and phrases that have appeared in Berkshire Hathaway's Annual Letters, written by Warren Buffett, over the years. It’s a sort of mini dictionary that Warren Buffett uses when thinking about business and investing.
Cigar Butt Investing
A foolish method of investing akin to taking the last puff on a cigar. It is the purchase of a stock at a sufficiently low price that there will be some short-term profit, though the business' long-term performance is likely to be terrible.
Circle of Competence
The limits of one's ability to judge the economics of businesses. Intelligent investors draw a thick boundary and stick with companies they can understand.
Retention of earnings is only justified if each dollar retained produces at least a one dollar increase in per share market value.
Double-Barreled Acquisition Style
A sensible acquisition policy of buying either 100% of businesses in negotiated acquisitions or less than 100% of businesses in stock market puchases.
A pervasive force in organizations that leads to irrational business decisions from resistance to change, absorption of corporate funds in suboptimal projects or acquisitions, indulgence of the cravings of senior executives, and mindless imitation of peer companies.
A hard-to-calculate but crucial measure of business value. It is the discounted present value of the cash that can be taken out of a business during its remaining life.
An alternative to GAAP rules governing investments in marketable securities of the investee less than 20%. This measures the investor's economic performance based on its percentage interest of the investee's undistributed earnings (after an incremental reduction for income taxes).
Probably the single most important principle of sound and successful investing. Ben Graham's principle says not to purchase a security unless the price being paid is substantially lower than the value being delivered.
Ben Graham's allegory for the overall stock marketing. Personified as a mood, manic depressive that causes price and value to diverge — making superior intelligent investing possible.
A better measure of economic performance than cash flow or GAAP earnings. Equal to (a) operating earnings *plus* (b) depreciation and other non-cash charges *minus* (c) required reinvestment in the business to maintain present competitive position and unit volume.
For more, including my full notes for this episode visit outlieracademy.com/warrens-essays.
Daniel Scrivner (00:01.162)
Welcome to part two of my summary of the essays of Warren Buffett. Now the version I've been reading to all of you is the fifth edition. I believe we're on the eighth edition now. So this is actually relatively, you know, I don't know, relatively up to date, but it definitely leaves out, I want to guess maybe the last five years of shareholder letters. And in, you know, this is running a lot longer than I thought. So thank you so much for powering through and coming along with me.
I knew this was going to be challenging. I thought it would initially take maybe an hour and a half to two hours. It's definitely going to come in closer to three hours, but it is completely worth it. So just for a quick recap, in part one, we talked about Berkshire Hathaway's culture. It's incredible culture, which I think is maybe the most enduring part of what Warren Buffett and Charlie Munger have built. I think this is why Berkshire Hathaway will be valuable and successful long, long after they are both gone, as sad as that's going to be when that day comes.
Warren Buffett and Berkshire Hathaway's culture, we talked about the 15 owner-related business principles. Now, Warren initially shared this in 1979. He then shared it annually under the title, Owner's Manual from 1988 to 2017. And then we took a look at the template that he uses that he sells to any business owner who's when he's looking to acquire their business, which was just a masterclass in one sales.
But also in understanding of what it's like to be in the shoes of someone that spent a generation potentially generations building a business and having to contemplate the idea of potentially selling that. And you know, it shows I think Warren Buffett's mastery of what's different about Berkshire Hathaway and how they stack up against some of their competition, but also just all of the classic traits that we love. You know, this like, I will give you a list of every business we've acquired. I encourage you to reach out to everyone.
I encourage you especially to reach out to the businesses where things didn't go well to see how we acted in those scenarios. So that was part one. Part two is we're going to focus on three things. So the first is Warren Buffett is obviously known as one of the world's best investors. He has written a number of essays that have appeared throughout his annual letters that I think are special and worth including. We're going to start with this concept of Mr. Market, which was obviously a concept that Warren Buffett learned from Benjamin Graham. So we're going to talk about that.
Daniel Scrivner (02:17.638)
Warren at one point wrote what I thought was just like a wonderful little, you know, diversion from his, from what he normally writes about, which is an essay about investing in farms, real estate and stock. And I think this was written partially from an experience of kind of preparing his son to become an investor. And then we're also going to talk about one essay that I loved is he has one all about how difficult it is to basically have low investment costs.
And that really the best way to beat costs is with indexing and why that's the case. And I think it's a masterclass. And really for anyone who's thinking about investing, you know, we're all going to have to make decisions about how often to invest, how often to sell, what our pace looks like, how long we hold. This is it's just a wonderful meditation on how important costs are and how to get them to be as low as possible and why that's important. We're then going to move over and focus on valuation. And we're going to talk about I'm going to string together a couple of interesting ideas and perspectives that Warren had.
throughout the annual letters. And then we're gonna end with, on Berkshire Hathaway's 50th anniversary, Charlie Munger penned this wonderful essay just called The Berkshire System. And that's how we're going to end. So again, thank you so much for coming along with me. I know this is relatively long, but it is enormously valuable. This is, to be super frank, I'm embarrassed it took me this long to read this book. And I expect to reread it many, many more times. So it's incredibly valuable. Okay.
And just one last reminder before we jump in, you can find the full notes on this book, including all of the excerpts I'm reading from, as well as my transcript of this episode at outlieracademy.com slash Warren's essays. That's outlieracademy.com slash Warren's essays. Okay, with that, let's dive in. This is going to be our first focus on investing and we're going to start with Mr. Market. Whenever Charlie and I buy common stocks for Berkshire's insurance companies, leaving aside arbitrage purchases discussed in the next essay.
we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts, not as market analysts, not as macroeconomic analysts, and not even as security analysts.
Daniel Scrivner (04:39.534)
I think this is really, really important. You know, it's so easy for us all to spend so much time over indexing on the current news cycle, which is typically all about macroeconomic analysis, in part, some like just in time hot take security analysis, and just market analysis overall. And I just, one of the things that I think is incredibly clarifying about studying Warren Buffett and Charlie Munger is their obsession with only focusing on what you can control.
And you know, in their from their perspective, macroeconomics is something you're going to spend 0% of their time on. They want to spend absolutely no time there and they want to spend all of their time deeply, deeply understanding a business, how it's run, its managers, its competitive space, which is all both incredibly important, but it's also much more controllable. It's much more controllable at the end of the day. Our approach makes an active trading market useful, since it periodically presents us with mouthwatering opportunities.
But by no means is it essential. A prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer. Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total. I'm gonna stop here because I found this line just incredibly important. So as we talked about before, Berkshire Hathaway has what they call a double barreled style of investing.
And that is they are primarily looking to acquire majority stakes in businesses that they're going to hold forever, but they're also open to, and this is in large part because of all the insurance float that they have, they're also open to buying partial stakes, small stakes in businesses that they will never own in its entirety or are highly unlikely to own in its entirety, which is typically from the stock market. And so just this, like, you know, if we're going to tune out the noise and we're just going to focus on what we can control, it's so just anxiety relieving.
to remember that eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total. Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market, who's your partner in a private business.
Daniel Scrivner (07:01.142)
Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gain.
gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price since he is terrified that you will unload your interest on him. Mr. Market has another endearing characteristic. He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic
But like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice. Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up someday in a particularly foolish mood, you are free to either ignore him or take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game.
As they say in poker, if you've been in the game 30 minutes and you don't know who the Patsy is, you are the Patsy. Just in a couple of paragraphs, it's such an incredible encapsulation of just this idea of market prices and personifying that as this character, Mr. Market, who basically shows up every single day without fail. You can always ignore him and most people will never ignore market prices and market fluctuations, but you can always ignore him. And he has an incurable emotional problem. He is...
He is susceptible to being incredibly optimistic, way more optimistic than he need be. He's also susceptible to being very pessimistic, much more pessimistic than he should be. And this displays the full range of price movements in the market. And it displays, I think it's just a wonderful, just to forget about that it's a stock market with multiple participants and treat it as you're getting your prices from an overly emotional character. I think it's just like a wonderfully, wonderful, realistic lens to view the market through.
Daniel Scrivner (09:29.59)
The Benz Mr. Market allegory may seem out of date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging, and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, which doctor has ever achieved fame and fortune by simply advising, take two aspirins? The value of market esterotica?
To the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs, or signals flashed by the price behavior of stocks and markets. Rather, an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super contagious emotions that swirl about in the marketplace. It's worth rereading. This is so important. Rather, an investor will succeed by coupling good business judgment
with an ability to insulate his thoughts and behavior from the super contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind. That's not for me, this is Warren Buffett talking. This is how powerful this concept is. Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results, not by their daily or even yearly price quotations, whether our investments are successful.
The market may ignore business success for a while, but eventually will confirm it. As Ben said, in the short run, the market is a voting machine, but in the long run, it's a weighing machine. In the short run, the market is a voting machine, but in the long run, it is a weighing machine. The speed at which a business's success is recognized furthermore is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage.
it may give us the chance to buy more of a good thing at a bargain price. Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes also we will sell a security that is fairly valued or even undervalued because we require funds for still more undervalued investment or one we believe we understand better. We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time.
Daniel Scrivner (11:54.39)
of Wall Street, Maxims, the most foolish maybe, you can't go broke taking a profit. We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory. Management is competent and honest, and the market does not overvalue the business. And here's a really important point. You know, Warren Buffett is, he's looking to hold, they're content to hold any security indefinitely.
but they are flexible and this applies to securities. This doesn't apply to the companies. As we talked about in part one, Warren and Charlie have a very hard line point of view that they are acquiring businesses, the majority of businesses to hold forever. And the only two things, I think he ended up elaborating into three things that would cause them to sell a business that they owned is not producing a profit or not having a prospect of a profit. We saw that in the initial textile business that Berkshire Hathaway acquired.
They ran that for 20 years and only saw an endless line of, you know, just a negative profitability, basically just losses, which is why they eventually sold it. It took 20 years. So in the companies that they hold, they are not looking to sell. But in securities, they're open to selling and they are open to selling for a couple of things. Number one, if the security is overvalued. Now, this is really fascinating. You know, as Warren said in a couple sentences above.
In such a case, we will sell our holdings. Sometimes also we will sell a security that is fairly valued or even undervalued. Okay, interesting. Well, what would cause them to sell their securities? Because they require funds for a still more undervalued investment. So this isn't saying we think we have a hot stock that's going to double. This is saying we found something that's even more of a bargain, or it's a business we understand better. So again, a big part of Warren and Charlie's methodology in investing is all about your depth of understanding. And effectively, I think one way to think about it is one way to maybe
translate this to our own investing is focus on depth of understanding and the deeper you understand a business, the more you should trust your instincts and, and what, uh, you know, kind of the math is telling you about how attractive that business is and how attractive the current valuation is. Okay, back to the text. However, our insurance companies own some marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses.
Daniel Scrivner (14:16.83)
a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price. To that I will add one qualifier. These stocks are held by our insurance companies and we would, if absolutely necessary, sell portions of our holdings to pay extraordinary insurance losses. We intend, however, to manage our affairs so that sales are never required. A determination to have and to hold.
which Charlie and I obviously, which was Charlie and I share obviously involves a mixture of personal and financial considerations. To some are stand may seem highly eccentric. Charlie and I have long followed David O. Gilvey's advice, develop your eccentricities while you're young. That way, when you get old, uh, people won't think you're going gaga. Certainly in the transaction fixated wall street of recent years, our posture must seem odd to many in that arena.
Both companies and stocks are seen only as raw material for trades. Our attitude however fits our personalities and the way we want to live our lives. Churchill once said, you shape your houses and then they shape you. We know the manner in which we wish to be shaped. For that reason, we would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones.
And this goes on for quite a bit more, but I think that captures kind of the nut of it. And so again, you know, what, what is powerful here, what is powerful here is if you, number one, it's, I think it's underscoring Warren's long-term time orientation and the, the lenses that he views making investments, which is primarily driven by evaluation, by strength of the business and making sure that the business can actually be profitable and enduring over the long term.
And, you know, also valuation and valuation is not important to him at all. It obviously adds intrinsic value for wholly owned companies or majority owned companies, but valuation matters a lot for their public equities. And the reason is because of this character, Mr. Market, which is just Warren's personification way, maybe, you know, really helpful frame for lensing for viewing the craziness that is the stock market.
Daniel Scrivner (16:33.714)
I don't know anybody who's a professional investor in public equities that doesn't believe that it's just absolutely bonkers what happens in the market. I think everyone believes that there's some wisdom there, but we all, anyone that's spent sufficient time there also knows that there are absolutely extremes and that prices go to extremes on both the high and the low in just this lens that you want to be able to take advantage of those. Incredibly helpful.
I think if you like me, take this character Mr. Market and bring it along with you, I think it'll be very powerful. So now I'm going to read a second piece, which is Warren Buffett. This is a little bit off the beaten path. It's on investing and it's just kind of a meditation on investing in farms, real estate and stock. And I thought it was fascinating.
It helps capture more of the philosophy outside of just investing in businesses. And I think it helps, it helps us spot things that are general, generalizable, um, in more of Warren Buffett's approach to investing. Okay. Enough talking, go ahead and jump in. Farms, real estate and stock. And this was initially published in 2013 in the 2013, um, annual letter.
From 1973 to 1981, the Midwest experienced an explosion in farm prices caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leverage farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble's aftermath than the Great Recession of 2008 and 2009. That's staggering.
In 1986, I purchased a 400 acre farm located 50 miles north of Omaha from the FDIC. It cost me 280,000 considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm, but I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farms would produce and what the operating expenses would be. So, again, you start to see where this is going. You know, Warren's already starting to look at.
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the farm as a mini business and trying to understand what that looks like. From these estimates, I calculated the normalized return from the farm to be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out. I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop and prices would sometimes disappoint, but so what?
there would be someone usually good years too. And I would never be under any pressure to sell the property. Now, three decades later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm. Second visit in 30 years, just an insane level of focus by Warren Buffett. In 1993, I made another small investment. Larry Silverstein, Solomon's landlord,
when I was the company CEO told me about a New York retail property adjacent to NYU that the resolution trust corp was selling. Again, a bubble had popped. This one involving commercial real estate. Also, we're starting to see a trend Warren is, you know, very interested. He's very valuation driven. And he's always you know, I think in real estate, what would he be trying to do? He'd be trying to buy things for below replacement cost.
You know, he's basically applying that. And so this is a second investment that he got out of a bubble bursting. And this one is a retail property. Again, a bubble had popped, this one involving commercial real estate and the RTC had been created to dispose of the asset of failed savings institutions whose optimistic lending practices had fueled the folly. Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10 percent.
But the property had been under-managed by the RTC and its income would increase when several vacant stores were leased. Even more important, the largest tenant who occupied around 20% of the project space was paying rent of about $5 per foot whereas other tenants averaged $70. It's incredible. Was that 10 to 15 something like that? That's incredible. It's a difference of 15x. The expiration of this bargain lease in nine years was certain to provide
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a major boost to earnings. The property's location was also superb. NYU wasn't going anywhere. I joined a small group, including Larry and my friend Fred Rose, that purchased the parcel. Fred was an experienced high-grade real estate investor who, with his family, would manage the property and manage it. They did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our original equity investment.
Moreover, our original mortgage was refinanced in 1996, and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I've yet to view the property. Just an incredible footnote. Just exceptional returns. Warren's never even seen it. Income from both the farm and the NYU real estate will probably increase in the decades to come.
Though the gains won't be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and subsequently for my children and grandchildren. I tell these tales to illustrate certain fundamentals of investing. Okay, so here we're going to get into the really good stuff. Number one, you don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences.
when promised quick profits respond with a quick no. Number two, focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility, but omniscience isn't necessary. You only need to understand the actions you undertake. Number three, if you instead focus on the prospective price change of a contemplated purchase,
you are speculating. Let me say this again. If you instead focus on the prospective price change of a contemplated purchase you are speculating there is nothing improper about that. I know however that I am unable to speculate successfully. And I am skeptical of those who claimed sustained success at doing so. Half of all coin flippers will win their first toss. None of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the past is never a reason to buy it.
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Number four, with my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. I'm going to say this again. It's really important. With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. So what is he caring about here? He's caring about effectively like, he's caring about the bottom line. He's caring about what at the end of the day is actually going to be workable. And valuations, a key part of that.
You know, he referenced things like knowing that the largest tenant in this retail space, which occupied 20% was paying $5 a square foot as opposed to 70. You know, things like that are very helpful. So you're looking at effectively you're trying to look through the asset, look through the purchase price, look through everything else that might catch your attention and really understand the mechanics. Like how much at the end of the day is this thing going to, you know, basically spin off.
And, and, you know, you don't want to care about daily valuation. You're going to hold it for the longterm. You're going to buy it at a price that guarantees you're going to be successful. If you hold over the longterm, then you're going to care about how it performs. Amazing. With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field, not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
Number five, forming macro opinions or listening to the macro or market predictions of others is a waste of time. Instead, it is dangerous because it may blur your vision of the facts that are truly important. When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment. You don't know how easy this game is until you get into that broadcasting booth. Number six, my two purchases were made in 1986 and 1993.
what the economy interest rates or the stock market might do in the years immediately following 1987 and 1994 was of no importance to me in making those investments. I can't remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU. There's one major difference between my two small investments and investment in stocks. Stocks provide you minute to minute valuations for your holdings.
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where I have yet to see a quotation for either my farm or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings. And for some investors it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his, and those prices varied widely over short periods of time depending on his mental state, how in the world could I be other than benefited by his erratic behavior?
If his daily shout out was ridiculously low and I had some spare cash, I'd buy his farm. If the number he yelled out was absurdly high, I could either sell to him or just go on farming. Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there's so much chatter about markets, the economy, interest rates, and the economy,
price behavior of stocks, et cetera, some investors believe it is important to listen to pundits and worse yet important to consider acting upon their comments. Those people who can sit quietly for decades when they own a farm or an apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of don't just sit there, do something.
For these investors, liquidity is transformed from the unqualified benefit it should be to a curse. This is such a good line, because it's true. When you invest and you invest across liquid and illiquid markets, which I've had the benefit of doing, I've mostly invested in illiquid markets, which have many benefits to them. But here, especially if you have this experience of being mostly a liquid, man, do you appreciate liquidity and the fact that quickly, when and if you wanted to,
you'd be able to convert that over to cash or you'd be able to process a transaction to be able to do something with it. And so liquidity should be a blessing in this idea of don't let it become a curse. And the fact that I think actually by default it is a curse for most people. So again, just for these investors, liquidity is transformed from the unqualified benefit it should be to a curse. A flash crash or some other extreme market fluctuation can't hurt an investor any more than an erratic and mouthy neighbor.
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can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with his or her values. A climate of fear is your friend when investing. A euphoric world is your enemy. During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing.
And if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small, that were small participations in wonderful businesses? So why would I have sold my stocks that were small participations in wonderful businesses? Again, I am invested, not for price appreciation. I invested to be a part owner of a wonderful business. That is the right frame.
True, any one of them might eventually disappoint, but as a group, they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America? When Charlie and I buy stocks, which we think of as small portions of businesses, our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more.
If the answer is yes, we will buy the stock or business if it sells at a reasonable price in relation to the bottom boundary of our estimate. If however, we lack the ability to estimate future earnings, which is usually the case, we simply move on to other prospects. This is another huge insight. They start first with predicting earnings. And this is also why I think historically they've stayed away from technology investments outside of Apple and a few others now at a certain very advanced point in their business.
where I think now, when Warren looks at something like Apple, he can believably predict what the cash flows look like four or five years out. He's talked about his investments in Apple as you can tell that he comes at it from downside mitigation, but the ultimate reason of owning it is for appreciation over a very long time horizon. And I think that's powerful. But he's talked about it as he said things about owning Apple, like what is he banking on?
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people that have iPhones, you know, are not going to trade and move to, you know, Samsung or Android phones. And so this is incredibly durable. They buy these on a recurring stream. I mean, I think now when he looks at a business like Apple, he thinks it's incredibly de-risk. But anyways, this idea of like starting with projecting earnings, and if you can't project earnings, you move on, then you're using that to compute a range of earnings.
and which is will give you a valuation range. And then what you're looking at is for a business to be undervalued and you're using the bottom end of your valuation range is that you're not using the midpoint, you're not using the high point, you're using the bottom point of your valuation range. And then you're using that to compute, you know, like affordability and the discount you'd be able to get. And what you're looking for there is, you know, it's I think the best phrase is margin of safety. And then you're getting into the transaction. It's just incredibly helpful to think about it from that process. I think it's really, really helps us grok.
Warren Buffett makes these decisions. In the 54 years we have worked together we have never forgotten an attractive purchase because of the macro or political environment or the views of other people. In fact these subjects never come up when we make decisions. Say that last line one more time it's incredibly important. In fact these subjects never come up they've never come up when we make decisions.
Okay, that was Farms Real Estate and Stock. I think again, just a fascinating example of how Warren, you know, one, it's a lens into other investments that Warren has made, which of course, I think we're all curious and we can all learn from. But then, you know, it goes and breaks down into one, two, three, four, five, six, you know, six very simple fundamentals of investing that are broadly applicable. Okay, and now we're gonna wrap investing by talking a little bit about Warren's essay, Beatings, Costs with Indexing.
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And again, what I found helpful here was in business, you know, if you're in studying businesses, you ultimately come to find out that, you know, costs are incredibly important because at the end of the day, every business is largely two things in the interplay of these two things. And this is like a fundamental financial level. And the interplay is, you know, the amount of revenue you're generating in the profit margin, which tends to vary somewhat wildly over time.
You know, it's I think for anyone that's been a part of a public company you start to see that even in public businesses That are very advanced there You know, they're looking for a margin of safety whenever they're giving up predictions And so even in highly advanced publicly traded companies, they are not able to have a really clear picture of what's going to happen And and you know, so you have that and so if caught is so you have fluctuating revenue and profitability and margins
And that's why having a low cost structure is so important because effectively, you know, what you're always like in order to get end, in order to get bottom line profit, you'd have more revenue coming in than you have costs going out. And so costs, you know, you wanna be, you wanna get those as small as possible. You wanna be absolutely diligent about making sure that as many of those costs are strategic as possible. So there are things that will likely generate revenue.
And then, you know, and so then it's the interplay of these things. And so if it's an, if costs are in a very important part of business, then why wouldn't they be an important part of investing? And yet it's something that outside of this idea that investors should own index funds because they're a low cost way to own the market. I don't think costs get talked about enough. And so what I loved here was Warren's just absolutely scathing breakdown of the costs involved by active trading and what it looks like, uh, why indexing makes sense and why it matters.
So this is Beating Costs with Indexing, and this is a handful of things. It starts with a letter from 2005, and then it includes things from 2016 and 2017. It's been an easy matter for Berkshire and other owners of American equities to prosper over the years, between December 31st, 1899, and December 31st, 1999, to give a really long-term examination. For example, the Dow rose from 66, that's literally six-six, that's two digits,
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to 11,497. Guess what annual growth rate is required to produce this result? The surprising answer is at the end of this essay. This huge rise came about for a simple reason. Over the century, American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well, but now shareholders through a series of self-inflicted wounds are in a major way cutting the returns they will realize from their investments.
The explanation of how this is happening begins with a fundamental truth. With unimportant exceptions such as bankruptcies in which some of a company's losses are borne by creditors, the most that owners in aggregate can earn between now and judgment day is what their businesses in aggregate earn. So again, this goes back to this idea. We covered, I believe in part one, which is this notion that you can take solace in, you know, in a ownership, whether that's partial or whole.
of any business because at the end of the day, your investment success should translate to the success of the business. And so again, this is why Warren and Charlie are extremely business focused because they believe that an investment is like, you know, it's basically your way of purchasing into a business and then enjoying being a part of a wonderful business over a very long time horizon. And so your entry cost, you know, your entry price really matters.
But at the end of the day, so does your holding time. And just this idea that like if the business does well, you will eventually do well as well too. But this is so important. I'm going to say it again. So what is you know, and then we'll break down what Warren's saying here with unimportant exceptions such as bankruptcies in which some of a company's losses are borne by creditors. The most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. So I was going to get into.
You know, the most that any of us can earn. So if we do nothing, we say we bought December 31st the year before, we're not gonna do this, but let's say we sell the following December 31st the following year. So we have a holding period of one year. The most we can earn, if we're looking at it from a fundamental perspective, so we're taking out Mr. Market, is what that business earns. So if that business is able to grow by 10%, rationally, the stock should appreciate by 10%. That doesn't always happen, but that's rationally what should happen.
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but there's a bunch of costs that eat into that. And that's actually all the frictional costs that typically come with investing. And so now we're going to break this down a little bit more. True. By buying and selling. True. By buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. So investor A may say the stock has doubled. That'll be very beneficial for investor A will probably be very
not beneficial, value destructive for investor B, who's the investor buying those shares now. And yes, all investors feel richer when stocks soar, but an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic, no shower of money from outer space that will enable them to extract wealth from their companies beyond that created by the companies themselves. Indeed, owners must earn less than their businesses
These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have. I think this is an incredible story. To understand how this toll is ballooned, imagine for a moment that all American corporations are and always will be owned by a single family. We'll call them the Got Rocks. After paying taxes on dividends, this family, generation after generation, becomes richer by the aggregate amount earned by its companies. Today, that amount is about $700 billion annually.
Naturally, the family spends some of these dollars, but the portion it saves steadily compounds for its benefit. In the Got Rocks household, everyone grows wealthier at the same pace and all is harmonious. But let's now assume that a few fast talking helpers, helpers is this nice word for anyone that wants to basically grift and take part of the transaction and basically destroy value in the process. I love this term. Warren's come up with the helpers.
But let's now assume that a few fast talking helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The helpers, for a fee of course, obligingly agree to handle these transactions. The Got Rocks will own all of corporate America. The trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American businesses minus commissions paid.
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The more the family members trade, the smaller their share of the pie and the larger the slice received by the helpers. So again, activity benefits the helpers, doesn't benefit you, doesn't benefit any equity owners, it benefits all of the facilitators of transactions. This fact is not lost upon these broker helpers. Activity is their friend and in a wide variety of ways, they urge it on. After a while, most of the family members realize that they are not doing so well, so well at this new Beat My Brother game.
Enter another set of helpers. These newcomers explain to each member of the Got Rocks clan that by himself, he'll never outsmart the rest of the family. The suggested Kirk cure, hire a manager, yes us, and get the job done professionally. These manager helpers continue to use the broker helpers to execute trades. So now what are we getting into? We're getting into fee stacking. So you see that not only are you paying fees for executing individual transactions, you're also now paying fees for having someone give you advice. You know, and this is like way too close to home for probably all of us.
listening. These manager helpers continue to use the broker helpers to execute trades. The managers may even increase their activities so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to these two classes of helpers. The family's disappointment grows. Each of its members is now employing professionals, yet overall the group's finances have taken a toll for the worse. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants who weigh in to advise the Got Rocks on selecting manager helpers. So this is amazing. Just keep fee stacking. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock pickers. Why one might ask should they expect success in picking the right consultant? But this question does not occur to the Got Rocks and the consultant helpers certainly don't suggest it to them. The Got Rocks now supporting
Three classes of expensive helpers find that their results get worse and they sink into despair. But just as hope seems lost, a fourth group will call them the hyper helpers of peers. These friendly folk explain to the Got Rocks that their unsatisfactory results are occurring because the existing helpers, the brokers, the managers, the consultants, are not sufficiently motivated and are simply going through the motions. What, the new helpers ask, can you expect from such a bunch of zombies?
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The new arrivals offer a breathtakingly simple solution. Pay more money. Of course, that's the solution. Bremen was self-confidence. The hyper helpers assert that huge contingent payments in addition to staff fixed fees or stiff fixed fees are what each family member must fork over in order to really outmaneuver as relatives. So, I mean, we're going to continue to go on, but you can see where this is headed, which is at most someone can, can earn what the business earns.
And what we're effectively doing is laying on layering on helper after helper after helper, which is way too real. This is what even the top 1% of society does is rather than just have a handful of wonderful businesses that they own forever. They are perpetually looking for outperformance, which effectively means more activity, which means more fees, which works against outperformance. And it's this vicious cycle that nobody sees. It's just such a scathing breakdown of it.
The more observant members of the family see that some of the hyper helpers are really just manager helpers, wearing new uniforms, bearing sewn on sexy names like hedge fund or private equity. The new helpers, however, assure the Got Rocks that this change of clothing is all important. Bestowing on its wearers magical powers similar to those acquired by mild mannered Clark Kent, we changed into a Superman costume. Calm by this explanation, the family decides to pay up. And that's where we are today.
A record portion of the earnings that will go in their entirety to owners if they all just stayed in their rocking chairs is now going to a swelling army of helpers. Particularly expensive is the recent pandemic of profit arrangements under which helpers receive large portions of the winnings when they are smart or lucky and leave family members all the losses and large fixed fees to boot when the helpers are dumb or unlucky or occasionally crooked. A sufficient number of arrangements like this
heads, the helper takes much of the winnings, tails the gut rocks lose and pay dearly for the privilege of doing so, may make it more accurate to call the family the had rocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American businesses. In other words, the burden of paying helpers may cause American equity owners overall to earn 80% or so.
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earn only 80% or so what they would earn if they just sat still and listened to no one. So here is the point and this, you know, we're going to continue on for a couple more paragraphs here because it's just too good. But it just makes such a scathing point that all that we need to do all that you and I need to do is, you know, find businesses that we deeply care about and understand. Ideally the fewer the better.
We then need to understand those businesses and we need to acquire them at reasonable prices and it's not and it's an and it's not an or, and we have to hold them, hold these positions for many, many years, ideally decades, ideally our entire lives. So generational holdings and if we just do that, then we get the benefits of ownership, which is that we actually get to participate in what's happening in the business and we need to do nothing else. We should do no activity.
we should only be focusing on finding these businesses and acquiring them at reasonable prices and holding them. And if we just do that, we will benefit from what's happening in these businesses, but the more we get active, the more we get active, which we get active because we think it's gonna help us get ahead, the more we actually get behind. Because at the end of the day, the math is irrefutable and we are adding expenses and we are actually, so the amount that we can earn is capped, is capped.
by the performance of the business. And yet all we're doing is we're dialing up the expenses. So we're eating more and more of that percentage. It is absolutely ludicrous. And this is exactly what the majority of us are doing today. Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing. He lost a bundle in the South Sea bubble, explaining later, I can calculate the movement of stars, but not the madness of men.
If he had not been traumatized by his loss, Sir Isaac might well have gone on to discover the fourth law of motion. For investors as a whole, returns decrease as motion increases. Here's the answer to the question posed at the beginning of the essay. To get very specific, the Dow increased from 65.73 points to 11,497.12.
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in the 20th century and that amounts to a gain of 5.3% compounded annually. So even that staggering change, again, this happened over a hundred years, only compounds to a gain of 5.3% annually. Investors would also have received dividends, of course, to achieve an equal rate of return in the 21st century. The Dow will have to rise by December 31st, 2099 to brace yourself precisely $2,011,011.23.
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But I'm willing to settle for 2 million. Six years into this century and Dow has gained not at all. After writing the foregoing essay, I publicly offered to wager 500,000 that no investment pro could select a set of at least five hedge funds, wildly popular and high fee investing vehicles that would over an extended period, match their performance of an unmanaged S&P 500 index fund. Charging only token fees, I suggested a 10 year bet and named a low cost Vanguard S&P fund.
as my contender and I won't continue on. I'm going to keep it there. This, this goes on for quite a little bit more, but Warren did end up making this bet and he ended up winning this bet. And so, you know, somebody did exactly what he proposed, which is you go out and hire you find the best hyper helpers, you know, using Warren's terminology that you can find. And all I'm going to do is, is buy into an S and P 500 low fee Vanguard index.
And he acts, he absolutely brutalized the performance of hedge funds. And it's largely because, and he later goes on. So again, I should have, I should say this, you know, every two minutes, highly, highly recommend that you read the book. And a link is in the show notes and a links, you know, on the website, outlieracademy.com slash Warren's essays, where you can, you know, find, find a link to be able to purchase this book. Cause there's tons in here, but just, you know, like
so rational, so helpful, such a helpful way to view the world. And it's, you know, not surprising that Warren has performed so well. He just, he just grocks things at a level and he sees past the veneer of so many things that I think we all get caught up on. So that was the three essays I wanted to talk about around investing. Now let's dive into valuation because obviously, as we can see, valuation is incredibly important to the way that both Warren and Charlie go about making
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some of their thoughts when it comes to valuation.
Where I'm going to start is there is, let me see this really quickly. So in the 2000, the 2000 annual letter, one of the ideas that Warren had there that I thought was just really powerful is this ASOP and the insufficient Bush theory. The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 BC, though he wasn't smart enough to know it was 600 BC.
The oracle was ASOP and is enduring, though somewhat incomplete, investment insight was a bird in the hand is worth two in the bush. To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? And what is the risk-free interest rate, which we consider to be the yield on long-term US bonds? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of birds.
you now possess that should be offered for it. And of course, don't literally think birds, think dollars. Aesop's investment axiom, thus expanded and converted into dollars is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity, nor the creation of the automobile change the formula one iota, nor will the internet.
Just insert the correct numbers and you can rank the attractiveness of all possible uses of capital throughout the universe. So this immediately goes back to this idea, you know, of, you know, this idea that you can ignore valuation. You don't even need to see something. And that what you really need to be able to do when you're making an acquisition, this goes back to the story that Warren told about buying this commercial real estate property with a few other partners that was near NYU, where, as he said, he only needed to basically look through
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kind of all of the purchase price and purchase details into how the property would actually perform. So he's saying that again, this is where he's starting. This is where it all starts from. You need to start from that perspective. Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs.
in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component, usually a plus, sometimes a negative. It's a negative when it's expensive. It's a negative when it's actually...
you're going to put in more than you're going to take out. Again, one of the ideas, one of the rules of thumb that Warren and Charlie have for managers of companies that they own is that they can retain earnings and they can redeploy those, but they have to be able to prove and they have to have a high degree of confidence. They have to be able to prove, but they have to have a high degree of confidence, have to be able to explain how a dollar that they retain that gets reinvested will produce at least a dollar of additional earnings. And if they can't do that, then it doesn't matter. Well, that gets to the heart of what Warren's saying here.
Growth is simply a component. It's usually a plus. It's a plus when it's actually value additive, but growth can be value destructive when it's too expensive. And this is, you know, and then it's value destructive in the value equation. Alas, though ASOP's proposition and the third variable, that is interest rates are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is in fact foolish. Working with a range of possibilities is the better approach.
Usually the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very attractive estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. Let's call this phenomenon the IBT, inefficient Bush theory. To be sure, an investor needs some general understanding of business economics, as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance.
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nor blinding insights. And I think this line gets exactly to the perspective that Warren and Charlie have that, you know, investing does not require brilliance. It requires extreme rationality. You know, not extreme rationality. It requires a knowledge of all the pitfalls to avoid and including getting swept up in the market, including focusing on macroeconomics, focusing on factors that are not in your control and are not about how the business is actually going to perform. You know, it's just fascinating.
So, you know, the investor does not need brilliance nor blinding insights. Neither of these are required. At the other extreme, there are many times when the most brilliant investors can't much can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when the businesses and rapidly changing industries are under examination, when new businesses and rapidly changing industries are under examination.
In cases of this sort, any capital commitment must be labeled speculative. So again, if you don't have enough understanding of the business and the timing of cash flows that you can't, that you can have a range of outcomes, that you have a reasonable degree of certainty to, then it's speculation, you know, and it's like, it's such a simple perspective because it is, you're, you're speculating. You actually aren't able to do the math. What is speculation when you can't look at the math and be able to justify.
why you're paying the price you're paying or why you expect this will, you know, this business will accrue value in the years to come. Now speculation in which the focus is not on what an asset will produce, but rather on what the next fellow will pay for it is neither illegal immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home? The line separating investment speculation, which is never bright and clear,
becomes blurred still further when most market participants have recently enjoyed triumphs. I thought this next line was incredibly wise. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is continuing to speculate in companies
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relative to the cash they are likely to generate in the future, will eventually bring on pumpkins and mice, but they nevertheless hate to miss a single minute of what is one hell of a party. Therefore, the Getty participants all plan to leave just seconds before midnight. There's a problem though. They are dancing in a room in which the clocks have no hands. Last year, we commented on the exuberance, and yes, it was irrational, that prevailed.
noting that investor expectations. So again, sorry, quick reminder, this was written in 2000. So they're talking about, you know, obviously this is a 2000 bubble. Warren's talking about here and he's referring to the letter in 1999. Last year, we commented on the exuberance. And yes, it was a rational that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Payne Webber Gallup survey of investors conducted in December 1999.
in which the participants were asked their opinion about the annual returns investors could expect to realize over the decades ahead. Their answer averaged 19%. It's absolutely bonkers. That for sure was an irrational expectation for American business as a whole. There couldn't possibly be enough birds in the 2009 Bush, yeah, 2009 Bush to deliver such a return.
Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors mesmerized by storing stock soaring stock prices and ignoring all else piled into these enterprises. It was as if some virus racing wildly among investment professionals as well as amateurs induced hallucinations in which the values of stocks in certain sectors became decoupled from the values
of the businesses that underlay them. This surreal scene was accompanied by much loose talk about value creation. We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created by any business that loses money over its lifetime. This is like literally an irrefutable point.
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value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get. What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses and to those of their friends and associates. The fact is that a market bubble has allowed the
Entities design more with an eye to making money off investors rather than for them. Too often an IPO, not profits was the primary goal of a company's promoters. At bottom, the business model for these companies has been the old fashioned chain letter for which many fee hungry investment bankers acted as an eager postman. Just absolutely savage. Like that's one of the things I love about Warren Buffett. He is, he sees reality and he is scathing.
of what he sees as people doing the wrong things, which they may be unconscious of. I think they're likely conscious of it, but they may be slightly unconscious at times. Okay, this is a very old lesson. I love this. We've got three more paragraphs here. But a pen lies in wait for every bubble. And when the two eventually meet, a new wave of investor learns some very old lessons. First, many in Wall Street, a community in which quality control is not prized, will sell investors anything they will buy.
Second, speculation is most dangerous when it looks easiest. Say that again, I can't talk. Second, speculation is most dangerous when it looks easiest. At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We're not smart enough to do that and we know it. Instead, we try to apply ASOP's 2600 year old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush.
and when they will emerge, a formulation that my grandsons would probably update to, a girl in a convertible is worth five in the phone book. Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try therefore to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes. I'm the fellow, remember, who thought he understands.
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We thought he understood the future economics of trading stamps, textiles, shoes, and second tier department stores. So one of the things I love about Warren Buffett, he is he owns all of his mistakes and he proudly proclaims them. And he's obviously learned from them, which is, I think, why he's able to do that. Lately, the most promising bushes have been negotiated transactions for entire businesses, and that pleases us. You should clearly understand, however, that these acquisitions will at best provide us only reasonable returns.
really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point. So again, that was all about ASAP's fable. It was written and shared originally in the year 2000 annual letter. And you know, like what are the points that Warren is making there? And again, just goes back to this idea that when it comes to a business, but also a farm, also an oil field, you know, it's, it's
anytime it's a, you know, I think the best term is probably a productive asset. Anytime you're investing in a productive asset, you always want to start from a clear, a clear, realistic, conservative understanding of what that asset will produce. And then you want to start to work back into evaluation and determination of price and determination if you're willing to pay a given price for what you are going to get and what you are getting.
is whatever the productivity of this asset is. It could be cash flows, it could be profitability, it could be royalties, it could be price appreciation, it could be annual harvest if it's a farm. It's a very, very simple formula. And I think that's why I wanted to share these ideas around valuation, is I just think it's so powerful. Okay, I'm gonna read maybe one or two more. Let me look here really quickly.
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I'm going to jump ahead and actually look at look through earnings because I think this is a very, is a very powerful concept and Warren Buffett has now talked multiple times about this idea of look through earnings. I've definitely heard it as a term before, but I don't know of anyone that seems to use it as a tool as often as Warren Buffett does when investing and trying to understand businesses. So clearly it's important. So let's read a little bit about look through earnings. This actually started.
with the 1980 annual letter, it then has excerpts from 1990, 1982, 1991, 1979. Again, this is the benefit of this book. Okay, look through earnings. When one company owns part of another company, appropriate accounting procedures pertaining to that ownership interest must be selected from one of three major categories. The percentage of voting stock that is owned in large part determines which category of accounting principles should be utilized. Pretty boring.
But again, Warren clearly understands every level of business, including, uh, you know, accounting with a lot of nuance, generally accepted accounting principles require subject to exceptions, naturally full consolidation of sales, expenses, taxes, and earnings of business holdings more than 50% owned. This is again, why majority ownership is so important is, uh, they get to consolidate sales, expenses, taxes, and earnings only if they own more than 50%.
Bluechip Stamps, 60% owned by Berkshire Hathaway Inc, falls into this category. Therefore, all Bluechip income and expense items are included in full in Berkshire's consolidated statement of earnings. With the 40% earning interest of others in Bluechip's net earnings reflected in the statement as a deduction for minority interest. Full inclusion of underlying earnings from another class of holdings. Companies owned 20 to 50%, usually called investees, also normally incurs.
earnings from such companies, for example, Westco Financial, controlled by Berkshire, but only 48% owned, are included via a one-line entry in the owner's statement of earnings. Unlike the over 50% category, all items of revenue and expenses are omitted, just a proportional share of net income is included. Thus, if Corporation A owns one-third of Corporation B, one-third of B's earnings, whether or not distributed by B, will end up in A's earnings.
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There are some modifications both in this and the over 50% category for inter-corporate taxes and purchase price adjustments, the explanation of which we will save for a later day. We know you can hardly wait. No, no one's, no one's waiting for that. Okay. So it's a lot that I promise it's worth it. Finally come, finally come holdings representing less than 20%. So he's laying out the three kind of tiers here. It's companies that the majority own where they get actually consolidate and they get to show all of this in their financial statements.
It's companies that they own that are between where they own between 20% and 50%. This is the second category. And here again, this is one thing that Warren references here is this idea of the owner's statement of earnings. So one of the things that Warren, sorry, Berkshire Hathaway shared for a very long period of time is this concept of an owner's statement of earnings, which was effectively to try to give everyone a sense of look through what they, what the businesses that they are owned some portion of earned.
And so here in this category, again, they own 20 to 50 percent of these companies. They don't get to consolidate it, but they do get to share what that looks like with shareholders. They just do that in a way that's not in their financial statements. So it's in a separate thing called owner's statement of earnings. Now he's talking about a third category, which is for companies that they own less than 20 percent of. Finally, come holdings representing less than 20 percent ownership of another corporation's voting securities.
In these cases, accounting rules dictate that the owning companies include in their earnings only dividends received from such holdings. So they don't get any look through the finances. They only get to include dividends, which is which is pretty remarkable. It's not at all a true read on the performance of the business. Undistributed earnings are ignored. Thus, should we own 10 percent of Corporation X with earnings of 10 million in 1980, we would report in our earnings ignoring relatively minor taxes on
either a 1 million if X declared the full 10 million in dividends, B 500,000 if X paid out 50% or 5 million in dividends or zero if X reinvested all earnings. So here what he's saying is what's critically important is are they paying out or all their earnings? So most companies, the majority of companies do not pay out all of their earnings and dividends. It's not it's not generally a safe or smart or practical thing to do unless you know, you don't need to reinvest in the asset.
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Typically you're keeping some portion of that for reinvestment as a little bit of a buffer potentially as a you know cash on your balance sheet. And so what he's saying here is in this 20% or less category all they get to include are dividends. What's critically important is are you know what percentage what amount of total earnings are getting paid out in dividends. We impose this short and oversimplified course in accounting upon you because Berkshire's concentration of resources in the insurance field produces a corresponding
concentration of its assets and companies in that third, less than 20% owned category. Many of these companies pay out relatively small portions of their earnings and dividends. This means that only a small portion of their current earning power is recorded in our current operating earnings. But while our reported operating earnings reflect only the dividends received from such companies, our economic well-being is determined by their earnings, not by their dividends. So what he's saying here is there's kind of two things. There's a cash flow from this asset and there's the value of this asset.
And the value of this asset, what he refers to here as economic well-being, is obviously, it's not just earnings, it's what they're retaining. It's effectively, you know, these are kind of divorced. Effectively, you're taking all of the earnings, you're subtracting a percentage, which you're paying out in dividends. And that's typically being, you know, being paid out in cash. You can obviously do, you know, share repurchase agreement, something like that. That's sometimes common. Typically, you're getting cash.
But for anything that's retained within the company, you're going to get economic well-being and that's typically in excess of what you're going to get from cash because any retainings that are earned within a business are going to obviously roll up into the valuation of the business, which is going to be a multiple on earnings. I'll stop my additional commentary. Our holdings in this third category of companies have increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly
opportunities in the common stock area. The large increase in such holdings plus the growth of earnings experienced by those partially owned companies has produced an unusual result. The part of our earnings that these companies retained last year, the part not paid to us in dividends, exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings
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iceberg to appear above the surface in plain view. Within the corporate world, such a result is quite rare. In our case, it is likely to be recurring. So what he's saying here is, you know, what we're effectively able to tell you and what you're able to know about these businesses is, you know, pales in comparison to the true valuation of these holdings because we can only share the dividends that we're getting paid out. You know, it's much more difficult to be able to share the rest.
Our own analysis and earnings reality differ somewhat from generally accepted accounting principles, particularly when those principles must be applied in a world of high and uncertain rates of inflation. But it's much easier to criticize than to improve such accounting rules. The inherent problems are monumental. We have owned 100% of businesses whose reported earnings were not worth close to 100 cents on the dollar to us, even though in an accounting sense, we totally controlled the disposition.
The control was theoretical. Unless we reinvested all earnings, massive deterioration in the value of assets already in place would occur, but those reinvested earnings had no prospect of earning anything close to a market return on capital. We have also owned small fractions of businesses with extraordinary reinvestment possibilities whose retained earnings had an economic value to us far in excess of 100 cents on the dollar. So what he's waiting into here a little bit is part of the problem of not being able to actually
show in their accounting and their financial statements the true power of the business that they say own 15% of. You know, again, what can they show? They can show the dividends that are paid out. But you know, again, if we go back to some of their rules around capital allocation, if that business can actually redeploy and earn a acceptable rate of return, so this idea of at least for every dollar employed or sorry redeployed.
you want to be able to have an additional dollar of earnings. If that's the case, then they don't want the business paying out any dividends because that's effectually effectively from their perspective, value destructive. You can earn a higher rate of return rather not have cash. We'd rather have that reinvested in the business. And so he's getting here is this nuance of, okay, if we own 15% of a business, it's not paying any dividends. It's actually a wonderful thing.
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What's happening is the asset that we own is actually appreciating in value. Unfortunately, we can't actually tell you that. We can't communicate that. That's an add up into Berkshire's overarching value. The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage. So it's again, this idea that, you know,
If growth can be profitable, can be value, you know, creative or value destructive, then the same thing with retaining earnings and how you decide to deploy those earnings, whether you're paying those out in a dividend or whether you're reinvesting those in the business. This is true whether we determine the usage or whether managers we did not hire, but did elect to join, determine that usage. It's the act that counts, not the actors. And the value is in no way affected by the inclusion or non-inclusion of those retained earnings.
in our own reported operating earnings. If a tree grows in a forest partially owned by us, we don't record the growth in our financial statement, we still own part of the tree. Really important. Our view, we warn you is non-conventional, but we would rather have earnings for which we did not get accounting credit put to good use in a 10% owned company by a management we did not personally hire than have earnings for which we did get credit put into projects of more dubious potential by another manager, even if we are that management.
So again, that one was a little bit more in the weeds, a little bit more nuanced, but the reason that I wanted to share it was one, I think to give you a sense of the range of what Warren's talked about. He's gone from the incredibly technical, like in this last section, getting into particularly accounting rules and how that affects them and helping us all as shareholders be able to understand how those impact how we should think about the valuation of our holdings. But he's also just, you know, it's again, I think another way, like it's incredibly clear reading this book.
so much of it is done to reinforce how they make decisions and to reinforce all the things that they've said previously about why people should invest and about how they approach. So again, if I was to try to distill this down into just a couple of sentences, what is this all about? Well, the point that they're making is at this point in their business, they actually had a substantial number of companies where they own 20% or less. And so the conundrum that they had was helping shareholders understand...
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the value of this business. And I think this line was incredibly important. If a tree grows in a forest partially owned by us, but we don't record the growth in our financial statement, we still own part of the tree. So again, as a shareholder, if you're using these look through earnings, well, for things that they own 20% or less of, you don't get to see look through earnings. You only get to see dividends that are paid out. And dividends are only getting paid out typically when a certain amount of, basically that's capital, ideally from their perspective.
that can't be redeployed into the company profitably. And so they're paying out dividends. So what they're saying is, hey, we have a lot of these holdings. We actually can't show the earnings or we're showing a minuscule portion of the earnings of these businesses in our financial statement. And those are only as dividends. And so you need to understand that we own these, that these are very valuable and that that's not a bad thing that these businesses are not showing up on our income statement because they're growing in value. And in fact, by redeploying, by reinvesting capital.
they could be growing at an exceptional rate, a faster rate. Okay, so I wanna end now, this is gonna be a little bit of a departure with, you know, we've covered a ton of ground, it's difficult to decide where to end. My decision was to end with something that Charlie Munger wrote. So, you know, Berkshire Hathaway's about to turn 60 in just a couple of years. And for the 50th anniversary, both Warren and Charlie wrote somewhat special essays for the 50th anniversary.
This is Charlie's essay and in it, it's simply, you know, it's a, it's a, it's a analysis. I think there's probably no better word. It's an analysis from Charlie's perspective of why Berkshire pathway has succeeded and the things that have contributed to that over that time. And so again, this is Charlie Munger on the Berkshire system, the management system and policies and policies of Berkshire under Buffett.
also called the Berkshire system, were fixed early. Berkshire would be a diffuse conglomerate, averse only to activities about which it could not make useful predictions. The parent company would do almost all business through separately incorporated subsidiaries whose CEOs would operate with extreme autonomy. There would be almost nothing at conglomerate headquarters except a tiny office suite containing a chairman, a CFO, and a few assistants.
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Berkshire subsidiaries would always predominantly include casualty insurers, which as a group would be expected to produce dependable underwriting gains while also producing substantial float for investment. There would be no significant system-wide personnel system, stock option system or other incentive system, retirement system or the like, because the subsidiaries would have their own systems, often different. Berkshire's chairman would reserve only a few activities for himself.
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with those normally residing in Berkshire's casualty insurers. Number two, choose all CEOs of important subsidiaries and fix their compensation and obtain from each a private recommendation for a successor. Number three, deploy most cash not needed in subsidiaries after they had increased their competitive advantage with the ideal deployment being to acquire new subsidiaries. Four, make himself promptly available for almost any contact wanted by any subsidiary CEO
and require almost no additional contact. Number five, write a long, logical, and useful letter for inclusion in his annual report, designed as he would wish it to be if he were only a passive shareholder and be available for hours of answering questions at annual shareholders' meetings. Number six, try to be an exemplar in a culture that would work well for customers, shareholders, and other constituents for a long time, both before and after his departure. Number seven,
reserve much time for quiet reading and thinking, particularly that which might advance his determined learning. No matter how old he became, and number eight, spend much time in enthusiastically admiring what others were accomplishing. So again, just in this last paragraph and in just these last two paragraphs, Charlie Munger has broken down a lot of the magic of Berkshire Hathaway. He talked about all the ways that it's different and some of the unique choices that made it pretty singular in the first paragraph.
And then he broke down effectively the qualities of Berkshire's chairman. And I think this not only applies to Warren Buffett, it obviously applies to Charlie Munger. I am thrilled to record many episodes about Charlie Munger. And this number seven reserved much time for quiet reading and thinking, particularly that Mitch, which might advance his determined learning. This is Charlie Munger written all over it. And obviously Warren Buffett does this as well, but this is Charlie's no exception here as well too.
New subsidiaries would usually be bought with cash, not newly issued stock. Berkshire would not pay dividends so long as more than $1 of market value for shareholders was being created by each dollar of returned earnings. In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the chairman could understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters. In choosing CEOs of subsidiaries,
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Berkshire would try to secure trustworthiness, skill, energy, and love for the business in circumstances the CEO was in. So again, what lens do they use when picking CEOs? This is pretty incredible. In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness. That's number one. It's incredible. Skill, energy, and love for the business in circumstances the CEO was in. As an important matter of preferred conduct, Berkshire would almost never sell us with
Berkshire would almost never transfer a subsidiary CEO to another unrelated subsidiary. Berkshire would never force the CEO of a subsidiary to retire on account of mere age. Berkshire would have little debt outstanding as it tried to maintain virtually perfect credit worthiness under all conditions and easy availability of cash and credit for deployment in times presenting unusual opportunities. And Berkshire would always be user-friendly to a prospective seller of a large business.
An offer of such a business would get prompt attention. No one but the chairman and one or two others at Berkshire would ever know about the offer if it did not lead to a transaction and they would never tell outsiders about it. Both the elements of the Berkshire system and their collected size are quite unusual. No other large corporation I know of has half of such elements in place. How did Berkshire happen to get a corporate personality so different from the norm?
Buffett, even when 34 years old, controlled about 45% of Berkshire shares and was completely trusted by all the other major shareholders. He could install whatever system he wanted and he did so creating the Berkshire system. Almost every element was chosen because Buffett believed that under him it would help maximize Berkshire's achievement. He was not trying to create a one-type-fits-all system for other corporations.
Indeed, Berkshire subsidiaries were not required to use the Berkshire system in their own operations, and some flourished while using different systems. What was Buffett aiming at as he designed the Berkshire system? Over the years, I diagnosed several important themes. He wanted continuous maximization of the rationality skills and devotion of the most important people in the system, starting with himself. Win-win results everywhere, in gaining loyalty by giving it, for instance,
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decisions that maximize long-term results, seeking these from decision-makers who usually stayed long enough in place to bear the consequences of decisions. He wanted to minimize the bad effects that would almost inevitably come from a large bureaucracy at headquarters. He wanted to personally contribute, like Professor Ben Graham, to the spread of wisdom attained. When Buffett developed the Berkshire system, did he foresee all the benefits that followed? No. Buffett stumbled into some benefits through practiced evolution.
But when he saw useful consequences, he strengthened their causes. Why did Berkshire under Buffett do so well? Only four large factors occur to me. The constructive peculiarities of Buffett, the constructive peculiarities of the Berkshire system, good luck, and the weirdly intense, contagious devotion of some shareholders and other admirers, including some of the press. I believe all four factors were present and helpful.
But the heavy freight was carried by the constructive peculiarities, the weird devotion in their interactions. Buffett's decision to limit his activities to a few kinds and to maximize his attention to them and to keep doing so for 50 years was a lala-palooza. Buffett was, in effect, using the winning method of the famous basketball coach John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players.
That way opponents always faced his best players instead of his second best. And with the extra playing time, the best players improved more than was normal. Buffett much out wooded. Buffett much out wooded and wooden because in his case, the exercise of skill was concentrated in one person, not seven. And his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player.
Moreover, by concentrating so much power and authority in the often long-serving CEOs of important subsidiaries, Buffalo was also creating strong wooden type effects there. In such effects, enhanced the skills of the CEOs and the achievements of the subsidiaries. Then as the Berkshire system bestowed much desired autonomy on many subsidiaries and their CEOs, and Berkshire became successful and well-known, these outcomes attracted both more and better subsidiaries into Berkshire, and better CEOs as well too.
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and the better subsidiaries and CEOs than required less attention from headquarters, creating what is often called a virtuous cycle. I guess this is the perfect description of a flywheel effect in how Warren Buffett designed and built Berkshire Hathaway. How well did it work out for Berkshire to always include casualty insurers as important subsidiaries? Marvelously well. Berkshire's ambitions were unreasonably extreme, and even so it got what it wanted. Casualty insurers often invest in common stocks,
with the value amounting roughly to their shareholders' equity, as did Berkshire's insurance subsidiaries. And the S&P 500 index produced about 10% per annum per tax during the last 50 years, creating a significant tailwind. In the early decades of the Buffett era, common stocks within Berkshire's insurance subsidiaries greatly outperformed the index, exactly as Buffett expected.
Later, when both the large size of Berkshire stock holdings and income tax considerations caused the index beating part of returns to fade to insignificance, perhaps not forever, other and better advantages came. Ajit Jain created one of the created out of nothing an immense reinsurance business that produced both a huge float and a large underwriting gain. All of Geico came into Berkshire, followed by a quadrupling of Geico's market share. The rest of Berkshire's insurance.
operations hugely improved, largely by dent of reputational advantage, underwriting discipline, finding and staying within good niches, and recruiting and holding outstanding people. Later, as Berkshire's nearly unique and quite dependable corporate personality and large size became well known, its insurance subsidiaries got and seized many attractive opportunities not available to others to buy privately issued securities. Most of these
Daniel Scrivner (01:24:31.49)
Berkshire's marvelous outcome in insurance was not a natural result. Ordinarily a casualty insurance business is a producer of mediocre results. If you're, you know, a little bit of commentary for me, uh, I've studied a lot of these, um, it is very hard to find, uh, you know, insurers that actually have durable and sustainable underwriting profits and have done this over a very long period of time. One of the most impressive companies I've studied, it's publicly traded. You can get it on its own as progressive. And I think progressive has a phenomenal track record here.
on par with Geico. But outside of progressive Geico and a handful of others, it's generally a very mediocre business, even when managed very well. Back to the text. And such results are of little use. Berkshire's better outcome was so astoundingly large that I believe that Buffett would now fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth. So this is a warning to anyone that wants to go build a similar business.
Charlie is effectively saying here that, you know, Buffett would now fail to recreate it. This was a window of opportunity that's now seemingly closed from Charlie's perspective. Did Berkshire suffer from being a diffuse conglomerate? No. Its opportunities were usefully enlarged by a widened area for operation. In bad effects, common elsewhere were prevented by Buffett's skill. Why did Berkshire prefer to buy companies with cash instead of its own stock? It was hard to get anything in exchange for Berkshire stock that was as valuable as what was given.
Why did Berkshire's acquisition of companies outside the insurance business work out so well for Berkshire shareholders when the normal result in such acquisitions is bad for shareholders of the acquirer? Berkshire by design had methodological advantages to supplement its better opportunities. It never had the equivalent of a department of acquisitions under pressure to buy. And it never relied on advice from helpers, sure to be prejudiced in favor of transactions. And Buffett held self-delusion at bay as he...
underclaimed expertise while he knew better than most corporate executives what worked and what didn't in business, aided by his long experience as a passive investor. And finally, even when Berkshire was getting much better opportunities than most others, Buffett often displayed almost inhuman patience and seldom bought. For instance, during his first 10 years in control of Berkshire, Buffett saw one business, Textiles, move close to death and two new businesses come in for a net gain of one.
Daniel Scrivner (01:26:54.458)
Incredible. So for 10 years, only only, you know, oversaw and effectively acquired or, you know, moved out of, well, not quite at this point. So just you saw it move close to death. It's just three businesses for a net gain of one. It's incredible. 10 years. What were the big mistakes made by Berkshire under Buffett? While mistakes of commission were common, almost all huge errors were not, were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well.
the errors of omission were of much importance. So again, I think this is really important. So, you know, what Charlie's saying here is Berkshire was actually incredibly well managed, not only on the insurance front, but on the acquisition front. And, you know, he didn't, the errors weren't things that were done, the errors were things that were not done. And yes, those are bad, but I think it's, you know, this is preferable. You know, obviously it's terrible to miss out on something like buying Walmart at such a low valuation, but you know, net-net, that's the lesser evil.
Berkshire's net worth would now be at least 50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things. Would abnormally good results continue at Berkshire if Buffett were soon to depart? The answer is yes. Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage. Moreover, its railroad and utility subsidiaries now provide much desirable opportunity to invest large sums in new fixed assets.
and many subsidiaries are now engaged in making wise bolt-on acquisitions. Provided that most of the Berkshire system remains in place, the combined momentum and opportunity now present is so great that Berkshire will almost surely remain a better-than-normal company for a very long time. Finally, consider whether Berkshire's great results over the last 50 years have implications that may prove useful elsewhere. The answer is plainly yes. In its early Buffett years,
Berkshire had a big task ahead, turning a tiny stash into a large, useful company. And it solved that problem by avoiding bureaucracy and relying much on one thoughtful leader for a long, long time, as he kept improving and brought in more people like himself. Compare this to a typical big corporation system with much bureaucracy at headquarters and a long succession of CEOs who come in at about age 59, pause little thereafter for quiet thought.
Daniel Scrivner (01:29:20.958)
and are soon forced out by fixed retirement age. I believe that version of Berkshire system should be tried. I believe that versions of the Berkshire system should be tried more often elsewhere in that the worst attributes of bureaucracy should much more often be treated like the cancers they so much resemble. So it was Charlie's Reflections published on the 50th anniversary of Berkshire Hathaway. With that, I...
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