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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP764: The Art of Buffett w/ Tobias Carlisle
01:30:53
Stig Brodersen speaks with Tobias Carlisle about Warren Buffett’s timeless approach to risk.
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You're listening to tip.
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Today I'm joined by my friend Tobias Carlisle, the founder and managing director of Acquires Funds. Tobias just released his book Soldier of Warren Buffett, Sung Tzu and the Ancient Art of Risk Taking. In this episode, Tobias and I take you through Buffett's biggest and most misunderstood investments, including the General Redeal and the BNSF railroad acquisition, and draw on the timeless lessons from the art of war. In doing so, we discuss how Buffett truly thinks about risk, why Apple may be his best trade ever, and why Berkshire's culture has its own frequency in the game of business and investing. Let's get to it.
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Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Stig Brodersen.
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Welcome to the Investors Podcast. I'm your host, Stig Brodersen, and today I'm here with my good friend Tobias Carlisle. Toby, what's going on?
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Hey, Stig, good to see you again. Thanks so much for hosting this. I really appreciate it.
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You bet. And we are here to talk about your new book, Soldier of Fortune, Warren Buffett, Sun Tzu and the Ancient Art of Risk Taking. Tobi, I kind of feel like to some extent we're going full circle because back in 2015, this was back on episode 25, this is more than a decade ago, we talked about your book Deep Value. I don't know if you recall, but I kind of feel it's full circle now. We're talking about your most recent book. And I don't know if it means anything to you, Tobi. To me it does because you are the guest we had on the most times here on the podcast. You hold the record. So I don't know if it's just congratulations, but just thank you for being so generous with your time.
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Well, I'm very grateful that you keep on having me on because I love chatting to you guys. Love chatting to you.
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Fantastic. Thank you for saying so. And as the audience can probably hear from this episode, it's very much a conversation between kindred spirits. And I wanted to kick this off by talking about a very iconic deal. This is the $22 billion deal between General Reinsurance Corporation, or Genre as it's known, and then Berkshire Hathaway. So you already know this is between kindred spirits. And we're talking about a deal that happened back in 1998 and still we talk about it today because it was very, very special. And at first glance, for us who follow Buffett, it seemed like a very un Buffett like move. For one thing, you know, Berkshire stock was used as currency, which was something that Buffett long resisted. And he even described the deal as having synergies. And he had previously joked that it's usually code for acquisition. That doesn't really make any sense. That's why you talk about synergies. But what happened, and so often happened whenever Buffett would go into new territory is that it just was a masterstroke. So Toby set the scene for us.
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What happened to put that into context in the book. So the book is look at Buffett's investment strategy. And you need to contextualize this. I make this clear in the book that he's an industrialist rather than an investor. And that's an important for folks to understand what that distinction means. So he doesn't run a pool of money for other people. He owns a company who owns the lion's share. 40% or. I know that he's been diluted down. I don't know if it's exactly 40% anymore, but he hasn't ever sold a share. So he's never made any money out of Berkshire Hathaway other than the salary that he's got, which has been about $100,000 a plus, some security and other things like that. And I wanted to contrast his industrial strategy, his business strategy, with the original work on strategy, which was Sun Tzu's Art of War. It's a book that I have read. I read it first when I was in high school and frankly didn't get it. And I've tried to come back to it every five years or so after high school and never really got it until the pandemic. And I read it and I thought for the first time, I was like, gee, these ideas are very similar to the ideas that I understand from Buffett, and I'll sort of articulate why as we go through this process. But I wanted to find iconic deals of Buffett's that I hadn't previously covered or that I could cover from a slightly different angle. And then to use the principles of strategy, which really haven't changed much since Sun Tzu wrote them down to illustrate why these deals were so clever. For me, genre was one that really stands out because I had just started studying Buffet in the late 1990s. I think that it was 97 or 98. I'd really read every single. All the letters were online. Then I read all the Letters I'd bought Making of American Capitalist. I'd read the 1934 edition of Security Analysis, which is brutal, which is the one that's all railway bonds. And there were newer editions then, but because I'm like a. I like literature, I went and bought the original one, which is a mistake to buy the most recent copy. Don't buy the original when you get started, it was like a reprint of the original. So I was super excited to get it. It wasn't an original document, but it was like a recreation of the original. So when genre happened, I remember it very distinctly because I had just read all of this stuff on Buffett and his process. And I understood in very broad terms, wonderful company at a fair price. That means high return on invested capital, something that can grow while it throws off capital rather than consuming capital all the time, like needing to reinvest in. In large amounts. And also that he didn't like issuing shares because it diluted down the shareholders. And Berkshire Hathaway was a very valuable entity. And anytime you trade it for something, which he did do on. On a few occasions, which. Not in material numbers, although they're, you know, close to material numbers. But then genre came along and it was completely baffling to me why he had done that deal. And it's taken me a long time really, to understand why he did that deal. And part of it was I talked to Chris Bloomstrand, he's a friend of mine, he's a Buffett watcher. He's perhaps one of the most detail oriented investors out there. And he goes through footnotes and all of that sort of thing. And he explained it to me and I really understood it for the first time. And I thought, well, I might not be the only person who doesn't understand this deal. So let me articulate what happens and then put it in the context of strategy and explain why he did what he did. So in one of his iconic deals that everybody will know about is the investment in Coke, and he put a third of Berkshire's assets into Coke. Berkshire was like a $3 billion enterprise at this time. He put a billion dollars into Coke, and Coke looked expensive when he did it. Like, this is one of the. Famously, it was 12 or 14 times earnings when he did it. What he was buying, of course, was all the international expansion and then that delivered in spades. And he got that exactly right, had this massive return out of Coke. Like a few years after he did that deal, it had tripled. And so what had been one third of the Book became almost the. It was 3 billion on a $5 billion enterprise. The other stuff had done well as well. By 1998 or 99, he was up 14 times in that deal in about 10 years. And it was expensive by that point. It was where it had been trading at 14 times earnings. Now it was at like 60 times earnings. Earnings had grown very substantially over that period, too. So it was a massive winner for him. And then Berkshire Hathaway had got recognition for this phenomenal performance. And Berkshire Hathaway was trading at three times its tangible book, which included particularly Coke, which was now super expensive. Buffett's a very conservative, cautious investor, and he needed a way to protect himself from this sort of overvaluation in Coke and overvaluation in Berkshire, with the problem being that you can't sell this stock or you incur tax at a 35% rate. And there's no guarantee that you can ever get back into Coke at a reasonable price, because Coke may just keep on. It might stay expensive. Even if it doesn't stay expensive forever, it might stay expensive for 25 years, which is, in fact, what has happened. It's stayed very expensive. It hasn't got more expensive, like. And it's been an underperformer for Berkshire. And he's been criticized for not selling Coke many, many times. But folks who criticize him have missed the fact that he used that overvaluation in Coke and then the overvaluation in Berkshire on top of that to do this deal with Genre. So General Re is a reinsurer. That's a funny part of the business, but that's the insurance of insurers. If they insure their own clients up to a certain amount, and then they may find that they've got too much concentration in Florida hurricanes or in Los Angeles earthquakes and fires or whatever the case may be, and you want to lay off some of that risk. And the way that you do that is you turn to retrocession or reinsurance. Same funny words for the same thing. Basically, what that means is you find another insurer who'll take some of the risk for some of the fee. And usually Berkshire stands in that role as being a reinsurer, so they take the risk from other insurers. Genre had these sort of problems specific to itself. It was publicly listed, so it was on a quarterly earnings wheel where it had to report. So it was hard for Genry to invest in international business, which. Where it saw its expansion and it had an investment portfolio that was typical of insurers, which was heavily invested into bonds. Berkshire doesn't do that. Berkshire tends to be more heavily invested into equities. But that's because Buffett runs their equity book and he's an investment genius. Everybody else is sort of in bonds and trying to follow the statute. Berkshire's a little bit different. They write a little bit less insurance, but then they put relative to what they could write. But then they put what they do write into equity so they get a little bit more performance out of it that way. And so Buffett saw that if you merged the two together, he could dilute down the risk that he had in the equity portfolio, which is largely Coke and overvalued and everything else, trading at a very high price earnings multiple with the bonds and thereby turn what was a heavily equity portfolio into a better mix of bonds and equity. And if he does it by issuing shares, then he dilutes down the equity risk on Berkshire side to get access to those bonds. So he does that. It's a huge transaction transformative for Berkshire, changes the investment mix of their portfolio, gives them these synergies where Genre could get access to other markets that Berkshire wasn't presently in and allowed Genre to expand internationally. So it works for everybody in this deal. That's the synergies that he's talking about. The true genius of the deal. So it reveals itself, as we all know, what happened after 1999, after the dot com bubble. We all remember it as a dot com bubble and that's how it's sold now. But really it was a large growth market, very similar to the one that we're in now where there were companies that were. They're not.com. it was Walmart and GE. Microsoft also was participating in that. But all of these companies were just very big growthy businesses that were trading at very high multiples. And the dot coms were kind of the blueberries and the blueberry muffins. They were there, but most of the muffin was this overvalued growth stuff. And so then there was a collapse, as we all know, the dot com bust and Berkshire. So Coke halved through that period. And that was a big chunk of Berkshire's portfolio. But because he had the bonds in there, bonds, sometimes when markets fall over, there's a flight, they call it the flight to safety. People rush into bonds and the yield on bonds goes down as people rush into bonds. And if you understand bonds, if the yield goes down, the face value of the bond goes up. And so Berkshire's genre's bonds, which are now part of Berkshire's portfolio rallied through that period, creating this ballast really for Berkshire. And so Berkshire didn't participate in that crash nearly as much as everybody else did. They were protected because they had this bond portfolio. And that bond portfolio gradually rolled off. And then Buffett reinvested that long in equities. And so it was this masterstroke of investment. What sort of confuses folks a little bit. One, he didn't sell the Coke. So everybody remembers that as being a mistake. But the other thing is that genre had this derivatives business where they would write these bespoke contracts. So every single derivatives deal is just two parties standing together and writing a contract between them that describes some index or whatever, however they calculate the profit. And those contracts are complex and they're hard to value, and nobody really knows what they're all. It's hard to. Because there are so many of these contracts, nobody really knew what the exposures of January were. So Buffett sort of instructed these guys in what was a pretty benign market after 2000, after the collapse, it was a pretty good market for getting out of these things. And Buffett was desperately trying to get out of all this stuff as fast as he possibly could, which he did, but they still took hundreds of millions of dollars of losses trying to reverse their way out of it. And that prompted him to then write those letters about weapons of mass destruction, derivatives being financial weapons of mass destruction. And he said that they were in genre and he didn't know that they were there, didn't know the extent of them, didn't know. And they would often have both parties on the contracts to tell you how complex these contracts are. Both parties are claiming that they are making a profit on these contracts where they're zero sum, only one party can be making a profit. So after he had unwound it, he wrote about weapons of mass destruction. So everybody remembers the deal as being the one where he got exposure to financial weapons of mass destruction. And so it was a mistake, which is the way he described it. So he's criticized for Coke, he's criticized for the weapons of mass destruction. And everybody forgets the deal was actually an incredibly profitable deal for Berkshire and it saved them through that crash. And so I was one of the ones that I just wanted to set the record straight and to put that into the context of Sun Tzu, one of the first lines in Sun Tzu is you have to pay attention to. He calls it the art of war, but you might think of it as the art of strategy, because it's a path to Ruin or safety. And so that idea of ruin is important in a. I call it a game in the sense of game theory. In a game with a risk of ruin, ruin is like the end of the game. It means that you can't participate any further. You go to zero. And Buffett talks about this quite a lot, being ruined, and how that all of these great returns that you've put up to the point of becoming ruined are irrelevant when you're ruined, because you go to zero, and you can't compound from zero. And so avoiding ruin is a big part of Sun Tzu, and it's a big part of what Buffett does. And then Sun Tzu says, the way that you avoid ruin is you defend first. And then he goes through all of these ways of defending what to be aware of, hiding what you're doing, being very careful. And Berkshire does exactly the same thing. And I thought that the genry deal was really a great illustration of that principle of defense being so important and then defense turning into offense when the bonds rolled off and turned into cash that he could reinvest long, and then also sort of disguising what he was doing, because everybody remembers it now as he's criticized for Coke, he's criticized for the weapons of mass destruction, when really it was kind of this masterful deal. And he's never really sought to set the record straight. It's just he's happy for people to think of it all as a mistake. So I just think it's just a great illustration of lots of different principles.
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Yeah, I like that you mentioned that, Toby. And I think that a lot of people in business and in life can learn from that. There's this weird tendency with a lot of people that whenever they've done a certain deal, they need to tell everyone how they got the better end of that deal. It's usually a terrible strategy because you want to make the best possible deal, but you also want your opponent to think that they had a great deal, and that says something about delayed gratification. And you can just look at Buffett's track record. So I'm really happy that you say that. And I would imagine that has been his mindset going into it. And, of course, Buffett being Buffett, he does need to praise himself. There are enough people, including the two of us, who would be happy to do that. So that's absolutely wonderful.
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He talks about it as having an internal scorecard rather than external scorecard. And he's got this great line where he says, every day when I tie My tie in the mirror. Then everybody has had their say about what goes on in my life because he only cares about what the guy in the mirror thinks. And then he goes and does his day in the office. He's got an internal scorecard. He doesn't really. He's not worried about what the external is, provided he's doing the right thing. But we'll come to that in a little bit.
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Well, one of the things I really liked about your book, Toby, was that you moved between contemporary events and then Asian writing, whether it was Sun Tzu or some of the other references that you had. And there's this concept called the Lindy effect. And that's the longer something that's non perishable has been around, the more likely it's to stick around. And the most obvious example of that would be the wheel, for example. So in the same way there are a lot of these ancient texts that, well, for obvious reasons been around for a long time, there's also the danger of just assuming that just because something is old, that it has to be true. So whenever you've been doing your research for your book, how did you avoid falling into that trap where this is ancient? I need to find a way why this is applicable to today.
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Well, the art of war, one of the things that I did, and I don't do a great deal of discussion on it, but I do sort of contextualise the art of war a little bit. And it was written in, it's now known as the, the age of the Warring States era. And basically there had been an empire, the Zhao Empire. Apologies for mispronouncing all of these words, this is me reading the English translation. But that empire fell apart. And then there was this 300 year period of warfare where really it was, it started with these little walled city states. So this was in the Bronze Age, this was very common around the entire world. Every little city was sort of its own state and they all had walls around them, they were little walled city states. And this was true in the Middle east and Europe and in Asia and in China. And after these little city states sort of went to war with each other, after a period of time, about 100 years, there were these seven super states that went to war. And then that Warring States era, there's a document that sort of documents this warring states as they fought. And ultimately there was a single winner who the Terracotta army guards his mausoleum. He put together the Great Wall of China. He's a very significant figure in Chinese history. But at the beginning of about 100 years into that Warring States era, this document emerged. And so we don't know a lot about Sun Tzu because Sun is a very common. Su means Mr. Sun is a very common name at that time in the warring States documents. There is some discussion of Sun Tzu and his principles of warfare. And there's a story about one of the kings getting Sun Tzu to instruct his concubines and them sort of laughing and him chopping the head off one. And it's documented at the beginning of the Giles translation, which is the original English translation, which came out in 1910. But Giles says in there that this story can't be true because the dates are wrong, the timing is wrong. So this story is sort of a later fabrication, and it's not related at all to Sun Tzu. But that's something that a lot of people will mention to me, that they've read that book and they know that the Sun Tzu's story. But Giles himself in there says that it can't be. They're not related at all. So I think that one of the reasons that the book the Art of War continues to apply is there are ideas in there that don't. They're very related to the Bronze Age stuff. Like, if you're traversing a salt marsh and you're salt, it'd get you back up against some trees. Clearly, I don't use that as I'm walking the kids to school. I'm not thinking about that kind of stuff. But there are other, much more broader things. One of the ideas is all of the Art of War is written in the negative. It says do not. It's sort of. It's always saying, don't do this. And it very rarely tells you to do something in positive terms. That idea of approaching success from the negative is known as via negativa. Via negativa. It's a very similar idea to Charlie Munger's Invert, always invert. You know, he quotes the mathematician Karl Jacob and he says, invert, always invert. And he says, all I want to know is where I'm going to die, and then I'm not going to go there. So that's the idea. And I like that kind of that principle. And it's true in strategy and it's true in investment. If you think about all of the ways that people have blown up and then you don't do those things, you put yourself in a pretty good position, I think. So one of the ways that people have blown up historically is debt and leverage. Leverage is embedded in many, many different things. So options are a way of getting leverage. Derivatives contracts are a way of getting leverage. Just borrowing is a way of getting leverage. Margin loans are a form of leverage. All of these ways of using leverage. And Buffett makes the point that when the market's going up, you look like a genius, but when the market goes the other way, it cuts both ways and you look like an idiot because you get stopped out. And that's the idea of ruining and avoiding ruin. So I think that there are many ideas in the book that really resonate today and you can find their contemporary analogous examples. And so I think that that means that they are, they have withstood the test of time and there's no reason for this book to continue to be. There are lots of books that have been written in history that we no longer refer to anymore because they're useless, they're a waste of time. So I think that I do believe that the Lindy Effect is a real thing and that things that survive to this point have some merit and are worth checking out. I think Lindy is an idea of Talebs. And Taleb says he doesn't even read a book if it's not 100 years old because he doesn't know if it's going to last, if the idea is not going to last. Beyond that, I'm not quite as strict as that, but I do like ancient literature and I do like reading through these things. And there are some really durable and enduring ideas, and that's one of the ideas that I put in the book, that your objective is to be as durable as possible. Because even though this cycle may not be yours, the very next one might be. And it would be a terrible shame to be stopped out now when a very good cycle for you is coming, which that's just the nature of markets. They call it the law of ever changing cycles. When something works, everybody starts doing it and it stops working and it creates the conditions for the thing that hasn't worked to start working again. I do think that the Art of War is a good example of that sort of understanding cycles. They talk about that a little bit. Understanding cycles and durability. And I think those are good things to remember in your investment life.
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Let's take a quick break and hear from today's sponsors.
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B
All right, back to the show. That's so well said, Toby. And I should also say, for the record, it was probably like three years ago, five years ago. So it was one of our mastermind discussions and we always chat before and after and I don't know, even though if you remember, Toby, we were actually talking about the Art of War and I was a bit hesitant about reading it and you were like, hey dude, you have to read it. So whenever you were sort of like, you told me, hey, I'm writing a book and it's about Sun Tzu and it's about the Art of Wars. Of course it's leading up to this. So thank you for back then asking me to read the book. It's a fun read.
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Which one did you read? Did you read the Giles translation?
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I actually don't even remember. But I do remember that I took note of this specific one that you mentioned because I said to you at the time that I've tried reading it. And I was like, I don't know what I'm reading. And then you said, you need the right one. And then I went out and got that one. So good enough for Toby, good enough for me. That was my process.
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C
I used two translations in this book. I used the original translation because the guy who. Giles, who, the guy who wrote it was like a military man. And so he puts this into the context of. And he writes in the start, this is a book written by someone who was a practical soldier. And he writes, and he says that all of these ideas are still applicable in contemporary military matters. So that book is valuable from that perspective. But then there are later editions that have been written from different perspectives. Some I'm just trying to reword what Giles had said, but the one that came out in 1998, I'm just blanking on the author a little bit, which is a shame, because I discuss him repeatedly in the book. He takes it slightly different perspective, which he takes it from an Eastern philosophical perspective. And I think his addition is also very, very interesting. And I discuss a little bit in the book in the last third. I don't want to jump ahead just yet, but I think that he's got some very valuable ideas too, that definitely add onto the Giles translation. Do you want to discuss the second deal in the book?
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B
Let's do it.
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C
So the second deal that I discussed, because this was, again, I was fairly early in my journey understanding Buffett. I think this was 2009, 2010. I forget the exact year, but it was around about that period of time when Berkshire announced that it was buying bnsf, Burlington Northern, which was the railway, and again, completely defied everything that we had understood about Buffett's investment strategy up to that point, because he'd been very clear that he wanted these wonderful companies at fair prices, which was high return on invested capital and didn't require a lot of capital to grow. And Burlington Northern was the absolute antithesis of that, because railways are famously capital intensive and requirements very serious maintenance capex just to stay where they are, let alone to grow. The advantage of something like Burlington Northern, though, is that it would be impossible to recreate that network. Today. They're trying to build a railway, a rail line between Los Angeles and San Francisco, and they're years and years and years behind schedule, and they've already overspent by billions and billions of dollars, and there's really nothing there. They haven't built this rail line at all. So it's an incredibly hard thing to do, maybe even impossible in the modern times to replicate that. So there's a definite moat there, and there's no way it can be overbuilt. And it's also a much cheaper method of moving goods than trucks. Trucks are more expensive. Rail is still the cheapest way of doing it. And Burlington Northern in particular has this unusual geographic footprint where it stretches out to the Pacific. And Buffett had it figured out that where previously the US had done most of its business with Europe from the east coast, it was transitioning to an Asian century or millennium. And so that was going to be over the Pacific. And so they were going to need connections throughout the Midwest, to the west, to access the Pacific. And there were some changes to the tax code as well, which meant they could accelerate depreciation of their investments. And it's a regulated business, so the regulator sets what they can earn, and they're trying to make sure that they get a good return out of these investments. So altogether, Buffett had to understand the sort of geographic implications and the shift of geopolitical business. The tax code, it looked externally like Burlington Northern was earning about 6% on its assets, which is pretty low. But in the context of that period of time, that was a zero interest rate. That was during the zero interest rate period. The ZIRP, that started in 2008, and it ran through until maybe 2018, something like that. And so he thought that he could get a 10% regulated return. But then there were some additional things that he worked out that he could take some of the money out from Burlington Northern. So he got a lot of his capital back very quickly, and it's now paying out dividends that are in the order of 12 or 13% on his investment. So he's got all of his capital back from that deal and the rail line as it exists. I've seen some independent analyses that value it between 100 billion and 200 billion. And this is something that he valued in its totality, I think, at 44 billion, and ultimately only spent about 19 taking it over because he owned some of it. And he used shares again. And so I use it to illustrate two ideas. One idea is that Sun Tzu calls this method military method. And then he describes. He goes through this. It's spread throughout the book. So I've sort of collated it all together so it makes some sense. But he talks about going and measuring, conducting this analysis on it, and then making a decision. And then he gives you some rules for making these decisions. And he says, you're looking for this overwhelming advantage. And he says a pound compared to a grain, which is this older measure, but basically it's 6,000 to 1, which is. He's being extreme to illustrate the idea, but he's saying you want this overwhelming advantage, and when you don't have an overwhelming advantage, then you shouldn't do it. But you conduct this method of analysis to determine whether you do have it or not. And you shouldn't do anything until you've conducted this analysis. Which, when I read that, I was like, this sounds exactly like Graham. And I think Benjamin Graham, who was Buffett's teacher and mentor, and probably more at one point, his employer. He talks about this as being businesslike in your investment, going through and conducting the analysis, doing all of these things and sort of ignoring what everybody else says, just doing your own analysis and then working out whether it makes sense or not. And so I transition there, and I use Graham's analysis for valuing a company rather than Sun Tzu's. But then Sun Tzu also says, you do these analyses where you go through and you look at. He calls it heaven and earth and the commander. But heaven is the conditions are the conditions, earth is the territory. And doing these analyses and then looking at the commander, and that's the leader, and making sure that they're honest and good and doing all these things. And it's very Graham, like, in the way that he thinks about these things. And then you make a decision. And there's this idea in the military literature, they call it the coup d', oeil, which is a really. It's a French term. The spelling is absolutely bizarre compared to the pronunciation. You'll see it in the book. It looks like couple, duil, D, O, U, E, I, L, I think. But it means. Literally, it's a French term. It means stroke of the eye. But the idea is that it's a glance, and that they say that the great commanders had this ability to, like, glance at a battlefield or something and make a decision because they understood the process and the. Both parties and the generals and the weather. They understood all of these things so intimately that all they needed was the glance to sort of make their decision. And so they talk about Napoleon having this and Frederick the Great having this, and all of these sort of great commanders had this coup d', oeuil, and Buffett certainly has the kudoy as well. And he used it after he'd conducted this analysis, and he used it to roll up that geographic spread of bnsf, the tax code, the movements of goods, the relative cost advantage of a railway, to identify this as an opportunity. And then when they announced it, the investment world was perplexed completely by this thing because it was such a departure from what he had done previously. And it was criticized that maybe this is him trying to go back to his roots, because the original security analysis, the 34 edition of Security Analysis, is all written about railways. And it had been Graham's bread and butter to trade railway bonds and various other bits and pieces in the capital structure. And I said, is this just a guy trying to buy himself a railway set? Is this a billionaire buying himself a big railway set? But no, there were very good financial reasons and strategic reasons for doing it. And I hope that I sort of explain them a little bit in that book so you can understand why he did it and how that fits into strategy more broadly.
- [35:38]
B
Yeah, it was just one deal after another. And you just see how amazing Buffett is as an investor, how good he has at adapting and learning new tricks. But I also have to ask Toby, and perhaps I'm just finding the hair in the soup here, but I've noticed that you focused mainly on Buffett's big wins and the timeless principles behind them. And like we also talked about here on the show, sometimes it's best to talk about the failures. That's whenever we really learn, at least, unfortunately, the world sometimes isn't that kind, that it just gives us successes and sometimes we learn more from a failure. So how did you think about balancing that in your book and whether you should sprinkle on some failures?
- [36:21]
C
I think that I needed a deal that was misunderstood but then worked out quite well. And so I think that the main failure that I can always think of is IBM. And I didn't cover IBM because I think that that was pretty well criticized at the time. And perhaps the reasons why it was criticized bore out. And Buffett was. The criticism was probably that IBM wasn't as attractive as he thought it was because it transitioned to a consulting business. Although consulting business is potentially a very good business to be invested in because it doesn't require a lot of capex. But then the main criticism was this was a technology business, that he's not a technology investor and he's misunderstood something about this technology business. And I think that Buffett himself would say that he avoids technology, not because it's not understandable, but the way that he describes being able to understand something is he says, I understand it if I know where it's going to be in 10 years time, if I can work out how it's going to earn its money and defend its economic advantages for a decade or more. And if I can't understand that, I don't understand the business. And it's not really whether it's a technology business or not. But he had done the IBM deal and been criticized and it hadn't worked out when he found Apple. And Apple, I think. I think it's. I just saw this tweet, I didn't include this in the book, but I saw this tweet recently where I think it was John Scully, who was the CEO who came in after Steve Jobs, and he said Steve Jobs idea had been to turn Apple into this consumer products business, which was just lunacy because Apple's not a consumer products business. Apple's a technology business. And it's funny to put that in the context of Buffett saying, I don't think of Apple as a technology business. I think of Apple as a consumer products business. And he gives the example of talking to younger people who he knew, and he would say, would you give up your second car or your iPhone, which is a $2,000, seemingly very expensive, a lot of money to pay for a little consumer gadget. And almost everybody said, or everybody said, I'd give up my second car before I'd give up my iPhone, because it's so important. And so I think he understood then that it was a consumer products franchise. And once you own an iPhone and you probably own a laptop and you might own an iPad or an ipod, you own the ipods. What do they call it? AirPods. AirPods.
- [38:45]
B
I know what you mean. I just bought the new three. It's terrible. Yeah.
- [38:50]
C
How many of them have you bought? How many have you had?
- [38:53]
B
Three, Four? Actually, I have four sets. Yeah, Right.
- [38:58]
C
So I only mentioned IBM very briefly in the context of him sort of shaking off what was probably a mistake and then investing in Apple. And I call Apple the greatest trade ever. And the reason, and I do acknowledge in the book, that it's a little bit in the eye of the beholder. It's like modern art. Like it's not. Everybody thinks it's the greatest trade ever because there are other probably proportionate winners. So I think that the Naspers deal for Tencent is an enormous winner. But then you've got to go to a South African listed equity that put a big chunk of money into a Chinese equity. And nobody would know what Naspers is if they hadn't done that. That's kind of what they're famous for. And that's completely skewed the shape of the South African stock exchange as a result. But you can find these examples of very profitable deals where people put a little bit of money in and had it become wildly successful. But I think that the fact that you've got to go to South Africa to find a Chinese investment sort of tells you that it's a little bit of luck in there. Whereas Buffett Steel's, I've chosen the ones that are very late in his career where he was well known, and I think Apple is a great example of that. But Apple's products were ubiquitous by that point. Everybody knew about the ipod or the iPhone. Or had a laptop or a desktop computer or something like that. They knew about Apple and it was one of the biggest companies in the world. Buffett was very well known. Berkshire was very well known. Anybody could have done that deal. But Buffett put 40% of Berkshire's assets into Apple after Icahn and Ironhorn had had an activist campaign to get it to pay at its cash. So it was already very, very well known and in the news. And then that $40 billion was a material part of Buffett's asset, Berkshire's assets. It was a big chunk of Apple and it went on to return four times in pretty short order, which nobody else in the world could have done that deal. I think there are a lot of private equity firms in the world that wish that they'd done that deal because you could put a lot of capital to work and earn a lot of fees on a great return on a pretty liquid investment. But he did it. And I think that was an illustrate. That was an illustration of pure skill rather than. There's an element of luck in there as well. But identifying it and correctly characterizing it as a consumer products franchise. And his arguments for why it was a good deal, I think not being technology, more consumer franchise. I think that's the only time that I sort of. I mentioned IBM as a loser, but in the context of that giant winner. So it's hard to find deals where Buffett hasn't done well. I think IBM might be the only one that sort of springs to mind at scale. I know that he's done some smaller deals for the shoe businesses, haven't worked out and so on.
- [41:38]
B
Yeah, Dexter Shoes. That's the famous one. But now we also nitpicking. I felt I had to bring it up. And like we mentioned there at the top of the show, you and I have been talking for more than a decade here on this show. And so, at least for me, I wasn't following Buffett in the late 90s, but we had Tip. We had Tobi on the show long before Buffett invested in Apple. And so I remember looking into it 100% having an iPhone. And then it's like, I just don't get it. And I also remember looking into the IBM deal, for that matter, and also sort of getting it. I think I even understood that more. I don't think I invested in IBM. Sorry, calling. But I certainly looked at Apple and I was like, yeah, I couldn't live without my phone. But for whatever reason I could get myself to invest in because it was trading at 14 times earnings or whatever. Or I thought it was tech or whatever kind of thing. And it is kind of like this. It was hiding in plain sight. And I think on that point, Toby, I think you bring up. I think it's such a good observation that you made because it's not like naspers, it's like, no, that's kind of like out of left field. But we all knew Apple, we all knew Buffett, we all knew his track record. And there were so few of us who bought into it, and even those of us who did. And I've spoken with a lot of people, they were like, yes, I got my double. And then I was out. And then hating themselves for not getting like 40x or whatever it's been doing, or probably not since 2016, but it's been hiding in plain sight for a very, very long time. And it's an amazing deal. So I'm really happy that you bring it up.
- [43:11]
C
I think it's an iconic deal. I use it. It's the first one that I mentioned in the book, because I contrast it with. Because in Deep Value, which I'm glad you raised that earlier, because in Deep Value, I talked about the Ironhorn Icahn deal, or at least in Acquirer's Multiple, I talked about that deal because I thought that was a great example of company with one obvious problem, which was just too much cash on its balance sheet, which was not entirely Apple's fault, because all of that cash was overseas. And if they bring it back to the us, they've got to pay tax on it as they bring it back. And so it was sort of trapped overseas a little bit. But Einhorn had an idea for how you could release it, and he called it the iPrefs, which are these funny preference shares that paid out a little dividend attached to that cash holding. And then Icahn said, that's too complicated. Don't do that. Just buy back a whole lot of stock. And I think there was some initial resistance to it because it was just after Jobs had passed away and Tim Cook had stepped into the role, or at least Tim Cook had stepped in the role. And he was fairly new. And I think that he was regarded as being. His experience was all in the manufacturing side. So he was going to streamline the manufacturing site. And this was a little bit out of left field. But I use it as an example of some of the principles of Sun Tzu. One of them is that. And this is this idea that I really love this idea. He calls it Victory without conflict, which is really. There's a lot of different interpretations of what that means. One, like the most direct interpretation is obviously that he means victory without conflict, which Einhorn and Icahn were in conflict with. Tim Cook and Apple now writing letters and running these activist campaigns through the media, saying that it was a mistake to have this sort of cash on the balance sheet. Really, nothing changed. Ultimately, Tim Cook agreed. They did a little bit of a buyback. The stock went up. Ironhorn and Icahn sort of backed off, and it became quiet. And in that intervening period, that's when Buffett bought his big shareholding in it. And I think that what I had sort of taken away from that was that Buffett had obviously here understands Apple, and he had seen Apple out there and. And saw the value in it. But it had this problem with it, which was the one that the two activists had identified. And their idea was, we'll push for this to get changed, and that will result in a sort of catalytic event, and we'll revalue the shares. Buffett's idea is that, why don't you just wait until the opportunity has perfected itself. And it's perfected itself when that cash hold, when they figure out what they're going to do with that cash holding, because then it shows that management's thinking about that. And Apple has famously, consistently bought back stock now through all of that entire period. And so a lot of Berkshire's return is a combination of holding stock while the undervalued shares are bought back, which increases their holding without them having to buy any more stock. But also, it had gone through that. Apple goes through this sort of cycle where before the new iPhone is announced, it gets a little bit cheaper because it looks like the sales are tailing off. And then the new iPhone gets announced, and they make more money and their returns and invested capital leap. And that's what happened. The returns on invested capital leapt as everybody got a stimmy out of COVID and went and bought a new iPhone. Apple was a big beneficiary, became very, very valuable again on a return on invested capital basis. But now it had a much smaller share holding out there, which Berkshire had a big chunk of. And that's how you get a forex on a giant company. I use that to illustrate a few of these ideas. And that's this idea of winning without conflict, and also this idea that Sun Tzu says. And I think this is the biggest difference between good investors and people who are newer to investment. Good investors know how an Investment works out, they know why they're buying this thing and what they're looking for to at least determine whether they're right or wrong on the investment. And so Buffett knows exactly how this thing works. They're going to buy back stock, they're going to go through a cycle of iPhone, they're going to remain a dominant consumer products business and the stock is going to do very well as a result because they earn very high returns and invest in capital. I don't understand IBM as well in that context, but that's good. Investors know how these transactions work out. So one of the things that Sun Tzu says is if you know how you're going to win and then you fight, then it works out. If you start to fight and then you try and work out how you're going to win, that's how you lose. So he's saying, go in and know how you win before you fight. Otherwise, don't fight. That's one of the things that don't put the position on unless you know how the position works out. And at least then it also tells you if it's not going to work out, you know, because it's the thing that you're watching isn't working. And so maybe you can extricate yourself before it all really turns very bad. And so that's one of the I do that. I know how these positions should work out. If they don't work out, there's a reason why we should be able to identify it before it becomes a zero, at least.
- [48:03]
B
Yeah. And as I was reading that, I couldn't help but think of the famous net nets. So in case you're not as much of a Berkshire nerd, perhaps as we are, we are talking about companies that have. You can think about it as just net cash, cash that's trading at a very attractive price on the stock exchange. So you almost can't lose. Mathematically you can't lose. And so if you talk about very old school value investing, that was very much what you'd be looking at. And so that is at least what my brain would go to whenever you talk about winning without conflict. But of course the world isn't that kind, at least not today. And a lot of those opportunities are probably not there anymore. And if they are, it would be very, very low amount of money you can put into it. And so I want to use the segue into talking a bit about risk and return, because it all sounds great. Like, let's buy some net nets, let's have no risk and then just pure upside. Who wouldn't want that? But then I can't help but ask, so how do you think about risk and return? Because if I can add something to it, I would say if by definition you would say, oh, you need to take risks to get return, well, and you know you're going to get that return. There's no risk in the first place. And so how should we think about risk and return in that relationship? In the game of investing?
- [49:29]
C
In modern portfolio theory, in the way that investment is taught at university level, the idea is that risk and return related in the sense that the only way you can generate more return is by adding more risk. And under modern portfolio theory, the definition of risk is volatility or volatility relative to the market volatility. So more volatility means more, it's covariance to the market portfolio. But basically that means volatility. And so the only way you get more return is by taking on more volatility. And you can also then lever your return, which adds risk but also adds return. And there's no escaping that matrix. Anytime you're earning more return, it's because you're taking on more risk. And so the fama French, the two gentlemen who sort of came up with this pricing model, the way that they think about it is any like a value stock generates these, this sort of excess return over the market, which shouldn't exist other than the fact that there's this uncompensated. Sorry, not uncompensated, there's a risk there, so they're riskier. That's the only way it works. There's another competing idea, which is this behavioral finance idea, which is the one that I subscribe to, which says that people overreact to the market. So when they see the earnings are going up or the stock price is going up, they just extrapolate that forever. And in literature those guys are known as naive extrapolation investors. And then there are the people who invest counter to that. And so they are mean reverting investors. Basically they say that this excess growth in share prices or earnings or whatever will reverse course. And the other way around as well. The stocks that are going down or earnings that are going down will also reverse course, or at least you'll be across a basket, you'll be compensated for holding these things because when they do reverse course, they're so wildly misvalued that the price will go up. So that's the idea of risk and reward, sort of as it's taught at a university level. When you start investing in the market, it's pretty clear that the behavioral thing is much more prevalent. And you can see it, for example, now. There's clearly, there's a little mania going on, particularly in relation to AI stocks and quantum stocks and some other little hot areas of the market. And then on the other side, there's a whole lot of stuff that's not participating. Energy's as cheap as it's been relative to the index since 2020, when oil was negative $37. So oil's at $60 now. So the idea of risk and reward being sort of combined together in that way, that's part of it. That's part of the literature. But the way that Buffett thinks about it is slightly different. He says that you can find a valuation for these businesses. So a net net valuation is the most extreme valuation, which says that if we were to end this business now and liquidate this business not as a going concern, but for scrap, basically, what could we get out of it? And you get 100 cents on the dollar for the cash. You get some amount of money for the receivables. You get some amount of money for the inventory. You discount the inventory because you got to go and sell it. You discount the receivables because you might not collect it all. And you discount the assets outside of that because they're harder to sell as well. That gives you a net current asset value, because that's what we're talking about, looking at all the net current assets, looking at all the current assets minus all the liabilities. And then you're trying to find something that's trading at two thirds of that number because that gives you a 50% return if it all works out. That's the most extreme valuation. There are other valuations that you might say, let's look at this on a going concern basis, if it continues on as a business, and think about how much we could earn into perpetuity. That's a hard thing to do because you've got to estimate growth. How long is this thing going to earn excess returns? Those are difficult assessments to make, but I prefer this method. So I use the acquirer's multiple as my way of thinking about these things, which is basically looking at what an acquirer would pay for this business in its entirety and then looking at where it's trading now. And so I look at, I want a cashy balance sheet or at least a. A balance sheet that is not in any immediate risk of financial distress or bankruptcy. And then that's sort of downside risk. If it doesn't work out, you've got some downside protection. And then your upside is what somebody will pay for this business in a negotiated transaction, which assumes that you get fair value, which in the market that doesn't always work out. There are plenty of take unders, as they call them. Rather than a takeover, you get sold for less than it's worth. That happens quite regularly, but you sort of relying then on the management team being sensible. And if the management team is buying back stock, I think that's a very strong signal. If you think it's undervalued and they're buying back stock, they probably agree with you, they're doing the right thing by the other shareholders. So there's your pretty strong estimate for value and the stock being undervalued. And then your risk is that you get taken under, but your risk is mostly that you can see that the value is discounted. So there's a lower risk, the bigger the discount because the return is also greater than. So it sort of breaks that modern portfolio theory idea of risk in the sense that the more undervalued it is, the less risky it is, but also the greater the return that is available. And that's the way Buffett thinks about it. So that's his conception of risk in return. Risk is overpaying for something, or risk is paying for something that has a heavily indebted balance sheet, or it's got some off balance sheet liabilities, or it's got some event that could occur that could make the business a zero, or it's got a business that doesn't earn enough money to justify its assets, or it's got a business that's vulnerable to competition. Those are his ideas of risk rather than the volatility of the stock. And then the cheaper that the business is relative to your estimate of value, the less risky it is and the greater your return. That instance, lower risk means higher return. And so that breaks the modern portfolio idea. But I think Buffett's success, and as a sort of matter of logic, it makes complete sense to me that that's the better way of investing. So that's Buffett's conception of risk and reward.
- [55:53]
B
Let's take a quick break and hear from today's sponsors.
- [55:56]
E
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- [59:15]
B
All right, back to the show. I think if I can add something to that, Toby, whenever you're talking about liquidation value, especially if you tend to be very quant focused, and I would say that especially whenever I started out reading about Buffett, that process made complete sense. You read Security Analysis and at least in my case, I didn't understand most of it, but I did understand the idea of net nets and how to read a balance sheet. And it seemed like such an obvious thing to do. And so one of the things that you might go out and do is you would buy a lot of businesses that trade at a low price to book. And then you realize that time is a bit of your enemy. Like you buy things that in theory if they were liquidated, they would hand you cash. But then you realize the management have no incentive to liquidate that business. They're just going to burn cash and then keep their job and do whatever. Why would they liquidate the company and give it to you? And so whenever you hear about Buffett doing that in the early days, that was because he was in control. And whenever you are in control, you can do other things. You can, for example, liquidate a company. And one of the things he also learned, he probably should have read the Art of War first, is that, I don't know, perhaps he did. But is that whenever you're doing that kind of business, you are going to be facing a lot of hostility, which some people, I think Kyle Ocahn would forgive me for saying that he doesn't really care too much about it, perhaps he even revels in that. So that's the way he's wired and that's what he's doing. And that's perfectly fine with him. Whereas Buffett tried doing it and he was just like, no, let me just.
- [60:50]
C
Discuss very quickly the last third of the book, the last part, which is when he made the investment in the Japanese conglomerates. I always mess this up, but I think they're called Shogo Sour or Sogo Shower. I always get those two confused. But they were set up during the Meiji era because Japan is Resource poor. And so they needed some connection to the rest of the world to develop to find some resources, basic materials, energy and so on. And then they vertically integrated, so they got the processing facilities and they've built these sprawling conglomerates that really touch all these different parts of. I forget exactly how I discussed it in the book, but they've got grain elevators in Australia and they've got oil and gas fields and processing facilities in the Middle east and this all throughout the world, wherever these resources might be found. And the complexity of the business combined with the complexity of their shareholdings in these businesses, because they often had cross shareholdings, very hard to figure out what was going on in them. They've traded at a big discount too, probably what they're worth for a long period of time. And they're very hostile to outside investors. They really run for management. It's not a criticism of the Japanese method of doing business is one that I have a great deal of respect for because they look after their employees and their partners possibly to the exclusion of their shareholders. Whereas that's sort of anathema in the US The US is probably shareholders first and then employees and customers somewhere else down that path. It's meant that they're very survival focused, they're very durable, they've been around for a long time and they plan to be around for a long time. And I think that there's been some recognition in Japan that they're too shareholder unfriendly. And so they've had these reforms that started a little while ago under Prime Minister. I think it was Abe, I think I said that in the book. And those reforms have gathered steam. And Japanese stock exchange is trying to implement these reforms in various different ways, trying to make them more shareholder friendly and more responsive to shareholders and to get rid of the cross shareholdings and do pay out a little bit more of what they earn so that shareholders are getting a reasonable return on investment as all of this is going on. Buffett has sort of recognized this opportunity hiding in plain sight where these things are paying out. They're trading at single digit multiples of earnings and then they're paying out half of what they earn as dividends. So the dividend yields are 6, 7, 8%, 9% on these shareholdings. And at the same time government debt in Japan is a negative number or very low number. And corporate debt is very, very low as well. So Berkshire itself is able to borrow in Japan for 0% interest rates, which is crazy. It doesn't really make a Lot of sense, but they're able to do it. And so he puts on this deal where he buys five of these big trading houses and he finances it with 0% interest rates debt denominated in yen. So he eliminates any of his currency issues. So if the yen weakens against the dollar or strengthens against the dollar, it doesn't matter at all because the yen denominated assets are supported by yen denominated debt. And then he's getting a carry on top of that. So the dividends get paid out and he receives dividends to the tune of 7 or $800 million a year on this virtually costless debt. So he's able to. It's called a positive free carry. He's positively carried in this position, earning 7 or $800 million every year. While these positions appreciate at the same time against 0% debt, I think it's one of the most incredible transactions ever done. And it's non recourse to Berkshire. So if it falls over, it doesn't impact Berkshire, it might impact their holdings in Japan. But as it happens, it's been an incredible performer and it's returned a great deal to Berkshire. But I use it as an example of two things. One is that there's this idea in Sun Tzu called following the moral law. Although sometimes they call it the way, which is this sort of slightly woo sounding term. But the idea is that if you behave in this sort of honest and forthright way, then you'll be recognized for that and your partners will respond in kind. And they forged these quite deep ties with these Japanese trading conglomerates and they're doing. Berkshire does deals now with these guys. So Berkshire's able to use its balance sheet and its excess capital and cash to do deals with the Japanese businesses. I think Greg Abel has been sort of further deepening ties with them. So Berkshire's reputation, Buffett's reputation, Berkshire's reputation, which has developed over a lifetime of doing this, is this sort of strategic. And this has been quite well known for a long time. But it's this strategic benefit where people want to do business with Berkshire and they'll do it at a. They'll give Berkshire better terms than they'll give anybody else because they want to be associated with Berkshire. And that's a very powerful idea. And the other idea is that this is the most woo version of it. But basically that there is this idea in that the Art of War is one of these foundational documents that comes out of daoism, which is this philosophy of written down in several books. Dao De Jing, the Zhuangzi, the Art of War is one of them. And it sort of explains these principles in they tell these little Lao Tse, which literally translates as Old Master. So he may be not a mythical or legendary rather than a real person, we don't know. But he gets these little discussions, these little sort of poems about how to think about the right way to behave, like being cautious and careful and respectful and then letting things follow the sort of natural path, the natural way that they're going to play out. And I think that Buffett's investments in Apple is a good example of that, where there's just a way that these things will play out. And he just aligns himself with the natural flow. So, again, just avoiding conflict and trying to find the way that these things will play out, aligning himself with these conglomerates that were very similar to Berkshire in many ways, conducting business with a very, very long that's famously the Japanese think in terms of decades and centuries and millennia in their investments, which is why they subjugate the shareholders to the employees and to their business partners, because they're thinking very, very long term in terms of durability, that they'll support their business partners if they get in trouble. And there's an expectation that their business partners would support them if they got in trouble. And so I think Berkshire is a great example of putting these positions on trying to do the right thing and then aligning yourself with probably the way it's going to play out anyway and just making sure that you're not sort of in conflict and you're allowing it to play out without sort of interfering all the time. And I think if there's anybody who sort of Buffett says his favorite holding period is forever. And so there's this sort of philosophical alignment with those Japanese firms. And I think that that's what I try to illustrate in that part of the book, which is a little bit more. It's a little bit more woo, I get. It's a little bit less concrete, it's a little bit harder to understand. But I think equally, it's a very powerful idea. And it's one that I really have and I'm trying to sort of use in my own life a little bit.
- [68:14]
B
I really, really like that chapter. And again, this is something that I would say in the grand arc of Berkshire Hathaway happened somewhat recently. And I remember reading about the deals whenever they came out, and I was like, I was just thinking, this can't be right. So they're borrowing at 0% and they're getting at least what, 6, 8% back plus capital gains. This is not supposed to happen. Of course, you study what's going on in Japan, yield curve control, and you're sort of like, it sort of makes sense, but it doesn't really make any sense, which is amazing in itself.
- [68:47]
C
And.
- [68:49]
B
I never invested in Japan. I find it to be very challenging to invest in. And I think I have this US filter where I understand what it means. Whenever you are optimizing for shareholder value, it sort of makes me comfortable in its own way. It's like, oh, so this is what you're supposed to do and you can see when someone's deviant from the norm. And I always had this fear, even though to your point, you see some changes going on in Japan where they're just building up a bunch of cash on the balance sheet and there's. I'm speaking with my American investor friends and everyone's like, oh, that is unethical and yada yada, yada, and we all agree on that. And then they talk about their jobs and then they basically all want to work for Japanese companies, but they're not saying that so themselves, right? They're like, oh, we should have this and then we should do that and the company should do this and think so we all want to invest in shareholder friendly companies, but few of us actually want to work in those companies because they do things a certain way, because they optimize for shareholder value. So anyways, it was just one of those life small ironies that I'm susceptible to myself.
- [69:53]
C
I think writing the book, A lot of the ideas in the book will be very familiar to people who've studied Buffett. Or just as you go through life, you will encounter these ideas over and over again. And I think really a lot of it is common sense. But I liked using Sun Tzu and Buffett to illustrate these ideas because I think that it makes it a little bit more concrete. And often I've thought something and then I've seen Buffett articulate it. And I think, yeah, that's. That's exactly what I. That's how I think about it too. That's the right way of doing it. And I found the same thing with surprising with Sun Tzu because it feels like it's this really military aggressive book. But that's not really what it is. It's this. It really is about. It's quite a humane book. And it's about seeking peace through largely conflict avoidance. But if conflict becomes unavoidable, then he's got these ways of doing it with the minimizing the harm, which I think is, you know, they're great ideas, but that's in a military context. And then Buffett, I think, turns it into a business and life philosophy where he talks about it using these. And they're all things that you would want in business partners, things that you would want to show that you possess as well, and which is just, you know, being honest, being forthright, conducting yourself in this fair manner. And then ultimately that is a. You know, the reasons why you might do that is because that's the right thing to do. But I also make the point that it's strategically smart to do these things. And ultimately, I think people who don't follow those rules get found out just through a pattern of behavior, of doing it to enough people somewhat. It catches up with them eventually. So there are good strategic reasons for behaving well, aside from the morality of it, which is just that you should do the right thing, which is the point I make in the book.
- [71:41]
B
Yeah, it's just good business morality. Yes. But if that doesn't work for you, it's just good business to do it that way.
- [71:49]
C
That's the point I make. Exactly right.
- [71:52]
B
So, Toby, in your book, you emphasize Buffett's ability to continue to adapt to the changing times. He was moving out of textiles. We've talked about embracing railroads. Who talks about investing in Japanese trading houses. How do you think that we as value investors can stay true to our core philosophy, but then also still have the flexibility to adopt whatever kind of circumstances that are changing?
- [72:17]
C
I used this in the last chapter, and I only touch on it very briefly, but I talk about it as a. When you think about Berkshire Hathaway taking over, or when you think about Buffett taking over Berkshire Hathaway, when it was originally it was a textile manufacturer, and it was facing competition from domestic textiles, but also from international textiles, and was basically unable to earn its cost of capital. And Buffett contrasted it with another competitor that continued to reinvest in that business. And they did become increasingly efficient. But every efficiency gain was canceled out by the international. Competition could just do it more cheaply still. And so that competition, every dollar that they reinvested, continued to earn subpar returns. And at some point, Buffett says it's better to be in a boat. I'm slightly messing up that term, but he says, you want to be in the boat where you're not having to bail out, just switch Boats don't be in the boat with holes in it. So that's what he did. He got out of this textile business and then got into insurance and seized candies and all of these businesses that had tailwinds, as he calls them, rather than headwinds. And I think that that's a good idea as an investor to be looking for businesses that have the tailwinds rather than the headwinds. It's hard sometimes to separate out cyclical headwinds from secular headwinds. And that's the real art of investing, is to find things that it's got some, it's had some very near term stumble that's affected the share price and it's made it available for a price that means the forward returns are better than they should be for a business of this quality. And so that's the way I think about it. You're looking for businesses that have tailwinds, or at least that whatever little niche in the economy that they occupy, they're going to continue to occupy that niche into the future. And there's tariffs or higher interest rates or something that is impacting it in a cyclical sense that you can, you know, eventually that's, that's going to go away or that problem's going to be solved. It's just that right now, and most investors don't want to look ahead two or three quarters, let alone a year or so. Energy might be another one. Energy companies are trading very, very cheaply right now. This is, you know, I've written the book so that it can be. I'm trying to write a timeless book. But I do think that those principles all apply in the immediate moment. One of them is you're looking for businesses with tailwinds and they have some. And energy is something that we're going to continue to use energy. The economy is as energy intensive or more so as it has been over the entire since the Industrial Revolution. We're becoming increasingly energy intensive and oil and gas is a big part of that. Any substitutes for oil and gas become additions, they're not trading away oil and gas. Energy is going to be a part of business going forward and now's an opportunity to buy it reasonably cheaply. So I think that's an example of it's a cyclical business. It's not a secular headwind. It's a cyclical headwind which would at some point could easily turn into a cyclical tailwind. And if you read any of the literature on any of the industry literature on energy, it's clear that it's going to be consumed more so in the future than it is now. We're having a little demand. There's a demand issue because I think there's a little global recession going on and you can see that outside of the AI CapEx beneficiaries. Yeah, the 497 of the what is 493 of the S&P 500 and the S and P mid caps and the, the small caps are all in this little earnings recession started in 22 but that will work its way out and you're getting this opportunity to buy these things cheaply right now and they'll return to their long run trends at some point. So that's, I think that's an example of getting these big long term trends working for you rather than trying to, you know, maybe trying to buy the liquidation. You can make money in liquidations as well and then you can do very well in that. I'm not saying that you shouldn't do that and maybe that idea doesn't apply there. But in terms of the business, that idea of aligning with the tailwinds I think is a strong one.
- [76:22]
B
So thank you for teeing it up for the next question here, Toby. Talking about all the companies in the S&P 500 that are not doing so well. Perhaps whenever you compare a lot of different funds, individual portfolios for most long equities investors, they don't beat the S&P 500, which is perfectly fine, perfectly respectable. That's not my point at all. Many investors would say that they take on less risk than the S&P 500. I don't think I've met anyone who said they take on more risk and deliver lower returns than the S&P 500. Funny enough, but they would say, yes, we don't outperform the S&P 500, but we also take less risk because for example, in The S&P 500 you have bad companies, you have 500 companies. Some of them are going to be poor and we don't want them. Some of them are going to be overvalued. Even if they're good companies, we also don't want them. And so it's a tricky situation. Whenever you talk about risk, you mentioned before that in academia you think about risk as what's the volatility. And like you also said, that's not the way to think about risk. And so in reality it's very difficult to say exactly how risky a portfolio is, whereas it's a lot easier to say, well, what's your returns? Because we can then all say, well, we don't take as much risk because it's really difficult to point that out. And so I'm going to put you on the spot and ask you a ridiculous question that is really difficult to put your finger on. Because with that in mind, some people would call Berkshire Hathaway like a super powered etf, considering the structure of the company. But do you think Berkshire as a standalone company is less or more risky than The S&P 500?
- [78:06]
C
Yeah, that's a great question. That's a hard question to answer because in a sense Berkshire has become like a diversified. It's a diversified conglomerate, it's like a diversified etf because they've got this exposure to every facet of the economy. Probably what they are is a little bit underweight tech relative to spy, because that's where all the returns in SPY have come from. I do think that the philosophy in Berkshire is the right one, and I don't know that the philosophy throughout all of The S&P 500 is the right one in the sense that they'll buy back stock when it's cheap. Whereas if you look at the S&P 500, they tend to buy back stock to goose the share price. So they wouldn't be buying back stock when it's cheap. They're buying back stock either to push the share price up when it's already expensive, or because they're trying to mop up the option issuance, which in some of these companies runs at 15% a year, which is an extraordinary amount of dilution too. That's a big dilution headwind to get over every year. So the metrics are a little bit harder to trust for some of those businesses. Whereas I think Berkshire, they buy back the stock when it's cheap. They really only issue stock when it's expensive, like the genre example where there was a specific reason for doing that share issuance. So I think that the philosophy is very important and that's really. You're riding the jockey on. The horse is important, the horse is important and the jockey is important too. And the jockey in Berkshire. I think Greg Abel is unproven at this point, but philosophically he sounds like he's aligned with, with Buffett. And I think that there's enough of a community of people who have expectations about the way that Berkshire will be run that it will continue to operate. I think that I always think of Berkshire as the example that you could hold up and say, how does Something compare to Berkshire in terms of the way that they run the business, its returns on invested capital. I think that it couldn't be run more efficiently. I do think that most of the businesses in the S&P 500, efficiency is not really the problem. I think that to your point, and I think that the pandemic did reveal this a little bit, that probably the fault of us business has been trying for efficiency over or optimization over endurance and durability and all of that. The efficiency is the way forward most of the time. But then you run into periods of time like the pandemic or like 2008, 9, global financial crisis. And inevitably we'll have something like that again in the future, probably sooner than we think when those things manifest. Efficiency doesn't help you. You need to be durable. And that would mean maybe what you would call a lazy balance sheet, not as much debt as you could possibly borrow, maybe you carry a little bit of cash so you can take advantage of opportunities when they arrive in a distressed form. So I think that Berkshire is really best of breed in the S&P 500, even though now it's very, very big. I think durability and endurance are undervalued as qualities in businesses. And that's why Japan is a much better example of they may be undervaluing efficiency there. You need to strike the right balance between efficiency and durability. And that's a very messy, hard question to answer. And it's got to only be, can only be answered on a business by business basis. But I think that Berkshire is really durable. Berkshire is really built for endurance. A lot of the S&P 500 businesses, they're carrying too much debt, there's too much share issuance, they turn over their CEOs way too often. So they don't really have that. They get a big payday, they get their restricted stock units or their options, and then they pull the levers that you can pull, take on more debt, buy some assets, buy back some stock that will make the stock price go up, but it doesn't make the business itself better. It makes the business more fragile. And then that fragility gets revealed only when there's a big crash. And so if you're only there for four years as a CEO and you pull those levers and you jump out with your 100 million or $200 million paycheck, then you've done fine, stock price has gone up, but the business is more fragile at the end of your tenure then you failed the shareholders of that business, whereas you couldn't say that at Berkshire.
- [82:25]
B
It's.
- [82:26]
C
It's as strong now as it's ever been. And if anything it's optimized for a crash. It's the other way around. He's got $300 billion in cash. He's waiting for something to happen. He could deploy that cash long into suboptimal opportunities and do better now, but he would ultimately do worse because there wouldn't be that opportunity to deploy at lower prices, which they will manifest at some point. It's a little bit hard looking at because we've gone through a very, very long period, started in about 2015, which has been much like the late 1990s. It's been a very big growthy market. And the bigger you are and the growth you are, the better you've done. You can look, there's a hundred years of stock market history going back to 1926. And you can look at the performance of the largest 100 stocks in the S&P 500 versus the S&P 500 itself. And clearly the smaller stocks have outperformed the largest stocks to the tune of about 0.8% a year, compounded over a hundred years. So it's a very, very big margin of outperformance. But during booms, the s and P100, the biggest stocks have outperformed the S&P 500. And you can see it in 2000. From 1991 to 2000, it was very much a big growth market. And since 2015 it's been very much a big growth market. And so now we're at these levels of extreme outperformance of the 100. And these things have happened many times before. The Nifty 50. Exactly the same idea. That was just the biggest 50 companies outperforming everything else. And even though they were exceptional businesses, they had this very long period of underperformance because they just got too expensive. Same thing happened in 2000. Microsoft, Walmart, Costco, all of these businesses were big and exceptional businesses and continued to be exceptional businesses for 15 years after 2000. But the stock prices went down because they just got too expensive for their businesses. And I think the same thing has happened now. There's a handful of these businesses, it's a magnificent seven, and then it's the 50, and then it's the 100 have outperformed by virtue of the fact that they're big. And so Michael Green says it's flows to those businesses. But it's not the first time that it's happened. It's happened repeatedly throughout the the data. And so it's been this big growth market which makes anybody who's equal weight or value oriented or a fundamental investor or not expressing their or international has sort of suffered in comparison to these things. But it is cyclical, it's not secular. The secular bet is for smaller value, potentially international over these more concentrated big growth us. So I think that my bet is that in the long term we go back to the way that it was. And so I think that that will benefit Berkshire probably more than it benefits the rest of the S&P 500 even though they've done pretty well over the last 10 or 15 years too.
- [85:27]
B
Yeah, it's an interesting point to bring up because it also depends on what is the long term. And so let me try to paint some color around that because I think my knee jerk reaction if you ask me that question like what is most risky? I would say oh, The S&P 500 is certainly more risky. But then we were looking at frothy evaluations and crazy we are looking at the balance sheet of Berkshire Hathaway looks very, very solid and like okay, the risk is really an S&P 500. But then if I then turned the question a little bit differently and then said well what about in 200 years? How long is the long term? Well Berkshire, how do we be here in 200 years? I don't know. The balance sheet right now looks good. I don't know how it would look in 200 years. The S&P 500 is that going to it's very powerful the idea of having a self selection of the 500 biggest companies. So I don't know if we're going to have Nvidia 200 years, probably not. But then it's going to be replaced by another company that's been it's going to be big and powerful and important in 200 years. And so if I look at through that lens and you're forcing me to keep it for quote unquote the long term but I'm saying the long term is actually 200 years. Perhaps I would prefer the S&P 500 even at the crazy valuation that we have right now. And so I'm thinking a lot about and I think we have all kinds of bias. I sure have a lot of biases here and I think I'd like to think that I understand Berkshire really, really well because of following it for such a long and as opposed to all the other shares or stocks I hold my portfolio I don't actually go to the shareholders meeting, so I don't even know if they're there. But a lot of us, we would go to Omaha. But then at the same time, it also gives us all the biases you can probably think of, like, how good do we know Greg Abel is? Well, a part of my brain is like, Warren Buffett says he's good, so he must be good. Is that really my full analysis of how good Greg Abel is? And so it's incredibly difficult even if you know something really, really well, because that's to some extent also where you have the most blind spots, ironically. And so then you look at a company like Nvidia crossing $4 trillion and you're like, that just looks ridiculously overvalued. I thought Nvidia looked ridiculously overvalued 10x ago whenever it was like 400 billion. And I should say for the record, I hold Berkshire Hathaway in my portfolio. I don't hold the S&P 500, but if I had the S&P 500, yes, I would be holding on to some really bad companies. But I also would have owned Nvidia and I would never have bought Nvidia on my own. So this is not me saying that I know the answer to what is most risky. I just find it to be an interesting premise to say, just remember the long term is true in the years. I know that's not how people invest or necessarily how you should invest. But anyways, I just wanted to add that dimension.
- [88:20]
C
It's very true. But I would say that if that is the thought process, then you need the international version of the S&P 500, whatever that is, ACWI or VT or whatever the international version of that is, because there's no guarantee that it's a US dominated world 200 years from now either. You need exposure to probably you need exposure to China, you need exposure to Europe, you need exposure to these other places. Probably the way that it looks now is it looks like it probably will be America for another long period of time, but that's not guaranteed. And I think you're already expressing that bet. If you buy ACWI or you buy one of the international market capitalization weighted float adjusted ETFs, because there's a huge concentration in the US beyond its GDP contribution to the world. So I think the market capitalization weighting for the US might be 60% globally at the moment, whereas the GDP contribution might be a quarter or something like that might be 25%. So the same thing happened to Japan in the 1990s, where it was 40% of global market capitalization, but it was only 20% of global GDP. So in a funny way, you're already getting that bet on that you think that it's going to be an American century or two centuries, even though you're having an international bet. And I think that's probably the better one because that's a bias that most people have. They only invest in their home country, they don't invest internationally. And for America, that's been. For Americans, that's been the right bet for the last ten years or so. But that could easily reverse and it could be an international decade or two from here. It's sort of set up to be an international decade because the international portion is undervalued, the American portion is overvalued. The American portion has really got to do something extraordinary to sustain its market capitalization, waiting for the next 20 years, whereas the rest of the world just kind of has to keep on muddling through. And it'll do pretty well because the valuations are so much better. So there's a lot of different ways to think about it, but I think that thinking about it from a via negativa worst case scenario is not a bad approach either. That's a good way of doing it, thinking about the ways that you could go wrong and then avoiding those ways of going wrong. So as you point out, Greg Abel's untested, but additionally, America's had a very good run. So the international bet might be the good one, might be the best one.
- [90:44]
B
Yeah. There is this reference in Dalio's book the Changing World Order, where he's saying that if you just bet on the 10 biggest economies in the year 1900, you would have gone broke in seven out of the 10. So he would say at some point in time, all of them had blown up and then they recovered. But whatever you multiply with zero is going to be zero. And I found that to be very interesting. And he said that in hindsight, it was very easy to see that the US would take over the world. But he was like, that was not really how people would say it looked in the year 1900. And so I think you bring up a very good point whenever you're talking about what kind of ETF should you buy? And so the way the thing about the Vanguard, the blackrocks, and they say, oh, it's going to be global. I'm going to own a little of everything. And that's good, and that's Fine. I think you're right. If you're thinking 200 years out, that's probably the way to think about it. But you do have that overweight because the way that they're calculated, the way they're constructed, is that they're doing it on free float. And there is an overweight just structurally in the US the way they're doing free throat, for example, compared to some countries in Asia that might have very big markets, but it's just not a free float. So it's not the same type of market cap waiting. So there are all kinds of structural biases in there, for better or for worse. So it's just really important to understand even if you buy a so called passive index, which statistically is very good bet, and they come at very low ratio, expense ratio, you are still making a somewhat active decision to how you want to weigh that.
- [92:16]
C
I make the point in one of my other books, Quantitative Value, or maybe it was deep Value, that if you took two stock markets, I think this is from 1900 and this is from the Triumph of the Optimist study, which is an Elroy Dempsey Marsh book they updated every year. And I think they said in 1900, if you'd looked at England versus China, you looked at the rate of growth in China was off the charts and England was basically stagnant. And you would therefore have thought, well, I'll invest in China rather than England. And turned out that it was an English century relative to China. In any case, they did much, much better. And who knows the reasons for that. Maybe it's the rule of law or focus on shareholder return, who knows. But it wasn't, it wasn't clear that it was going to be that way because China grew its economy hugely over that period, whereas England didn't grow much at all. But the stock market did better in England than it did in China. That's what makes investing so hard that it's not a first order game, it's a second order handicapping. It's not just what you think, it's what you're getting, what price you're getting for what you think. And that's what makes it hard, that you have to make your decision on a risk adjusted or opportunity adjusted basis. And I talk about that a little bit in the book too, that how you calculate that risk adjusted weighting, how you think about finding the bet that you want to put on. And it involves that second order of thinking.
- [93:42]
B
Toby, you've been very generous with your time as always. As I started out by saying so thank you so much for making time for the TIP community. The name of the book is Soldier of Fortune. Warren Buffett, Sun Tzu and the Art of Risk Taking. Where can people find it?
- [94:00]
C
It's on Amazon. Only Amazon at the moment, I think so The Kindle version is released on October 14th and the hardcover and paperback are currently available. This is a hardcover of this is the first hardcover book I've produced and I'm very proud of that cover. I think it's a good looking cover. It'll look good in your bookshelf.
- [94:20]
B
It looks fantastic. All right, Toby, again, thank you so much. It's always a pleasure speaking with you. So thank you and thank you for your contribution to the value investing community.
- [94:31]
C
Likewise. Stig, thanks so much for having me on. I always love chatting to you and I can't tell you how grateful I am for you continuing to host me and have me on. I really appreciate it. So thank you very much and thanks to everybody for listening in.
- [94:44]
A
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