MI305: Exploring the DNA of Quality Businesses w/ Lawrence Cunningham

25:27You'll begin to learn they rely on certain suppliers, certain vendors to deliver their doll or their movie or their products, consumer products. And if you can back up their supply chain, say, well, what role do these little animals furrowing in the forest play? You find that there are some indispensable components of that supply chain that contribute enormous parts of the value to those front big marquee name companies. And I think we give a couple of examples of companies like that in quality investing. And so it is hunting. There's this little animal there. And a lot of those companies appreciate that security and obscurity.

26:07They're very happy to do very, very well for themselves. They don't want to make a fuss. They don't want to be on the front page of the newspaper or on your app. They like making this particular input, whether it's the ingredients in yogurt or the little metal devices on the end of your UBS quartz. Amphenol is that company. And so read a lot and think, you know, what is essential to this visible product that stays quiet and stays obscure? Excellent advice. So I want to move on a little bit more about Berkshire. So Berkshire has only paid a dividend once in its history in 1967. In the book, you mentioned that in 2014, and this book, sorry, I'm mentioning now is Margin of Trust.

26:46You mentioned that shareholders overwhelmingly voted against another dividend when they had a vote. So are these the only two times in Berkshire's history that they voted on dividend payments or has there been other main senses as well. I think that Warren makes a joke about that 1967 dividend that he says, when the board approved that dividend that day, he must have been in the bathroom because he wouldn't have approved it. I think he put two resolutions to shareholders over the years. One was 2014. The other might've been about 10, 15 years before that. But both times he was responding to inquiries from shareholder, Berkshire shareholders who had an appetite for liquidity.

27:23They'd like a dollar a quarter,$10 a quarter, and they wonder, would you be willing to do it? And Warren has long explained that this is a basic capital allocation model is to try to put every corporate dollar to its best use. And in that model, a corporation might reinvest in its existing businesses with that dollar. It might make additional acquisitions of bolt-on or tuck-in businesses, or even add new businesses, or invest that dollar in common for instance, common stocks of other businesses, or it might buy back its own stock if that's trading at a low price to value. And if they run out of uses in those areas that deliver a better return than the stockholders could get themselves, then pay the dividend.

28:07So that's a sort of a basic capital allocation model that Berkshire follows. And his view has always been that we do better holding each dollar than our shareholders could do. We do better reinvesting the business, making acquisitions and buying back our stock when the price is low compared to value. So our stockholders are better off leaving the dollar with us than if we paid it to them. And his second point on that was that the choice between a company buying shares back and paying a dividend, it's better to buy them back if they can be bought at a low price because you're then returning cash to shareholders who would like the liquidity.

28:43They can sell some of their shares and the tax paying recipients will have to pay tax on that. Whereas you pay a dividend, every shareholder has to take it and every taxable shareholder has to pay the tax, even if they'd rather not have the liquidity and would rather not have that tax exposure. So that's how he's thought about it, how he's explained it to his investors. And those two times when the shareholders got a chance to vote, as you say, overwhelmingly, the holders agreed with that policy and they prefer Berkshire to keep it. And so now obviously Berkshire's cash pile is absolutely massive.

29:20I think it's like 150 billion ish, maybe a little bit less. Now I don't talk to a lot of Berkshire shareholders and I know a lot of them probably still trust Warren very much and they probably should, but is he going to be able to reinvest all that money at these high rates? And do you think he's ever going to pay a dividend or do you think it's just, he purely is going to take the option of doing buybacks over dividends into the future, even if the cash keeps piling up? That's an enormous amount of cash, no matter how you look at it on its own. I mean, just in raw terms, it's a staggering sum.

29:51And even within an organization Berkshire's size, maybe$800 billion in market capitalization, I'm not sure of the latest figures, but even for a pretty big company like Berkshire, that's a huge portion of assets and of overall net worth. So it's a burning question. The formula still does apply. What would the holders do with the money? Probably buy an S &P 500 and they'd be receiving that money after tax. And so that return does struggle with even basic return that Berkshire's wonderful businesses and its investees will return. So I think the equation still, the test is met. They're not failing that test.

30:31And what's he doing? Well, what they're doing is waiting for that big opportunity. Well, I guess they're waiting for two things. One is, I should say, one reason Berkshire has had a policy of holding abundant cash. Now, by abundant, I think the last figure he used for this purpose was$30 billion. It may be$40 or$50 now, but it's abundant cash in order to pay insurance claims if the businesses were hit. Berkshire writes a lot of super catastrophic insurance risks for a lot of catastrophic risks, earthquakes, hurricanes, floods, terrorism. And so if we got a huge, I mean, Berkshire has always said, we want to be the Fort Knox in the insurance industry.

31:15And it brags that it claims that it has the strongest balance sheet of all the major property and casualty insurers that if the world was really overwhelmed, multiple disasters and human and natural, many insurance companies might go broke. Berkshire, he says, won't, and we'll pay every claim that comes to us. So to be able to make that commitment at the scale of insurance that they write, you'd need 20, 30, I don't know what the number is today, but for 40, 50 billion. So at least some, a quarter or a third of the cash that's sitting there has to be there. Even if some$100 billion acquisition opportunity came that they'd kind of run out of money.

31:54And that's what they're waiting for, some amazing opportunity like that. Obviously, there aren't many companies in the world that would fit that, but there are few. And you never know when they might come available. It's good to have that capital there. But I do think it's a problem. It's a high-class problem, but it's still a problem. And I think one of the great challenges once Warren leaves the scene will be for the successor board to make that determination. If I was on it or advising them, I'd stick to the knitting. I'd stick to the Buffett philosophy. But you can bet that there will be greater agitation among some shareholders to break that pattern.

32:31So that's, I think, one of the most interesting things about Berkshire in the next 10 or 20 years. Excellent. So trust is an admirable trait that Warren has fostered at Berkshire Hathaway and through its subsidiaries. That trust has been responsible for much of Berkshire's acquisition history, many potential acquiries end up on Buffett's desk because they're referred to by people inside and outside of Berkshire. But in Berkshire's early days, did he resort to using brokers to source acquisitions or did he always have this network of people that he could call on to get them? Yes. It's a great point that trust is the real secret sauce, I think, of Berkshire's business methods and of Warren's own personality, both in vindicating trust, that is when he says something, you can count on him doing it and in discerning trustworthiness in others.

33:19He's a pretty good gauge who's trustworthy and who isn't. And he hears on the side of skepticism. Any whiff of doubt about a person, he says, well, I can't go into business with you. And these traits have been there since the beginning. He has preferred handshake. He has preferred to buy from a friend or a friend of a friend than through an investment banker or other paid advisor. He He knows plenty of bankers and advisors and likes them as human beings. And he's not making a category criticism as such, but appreciates that when people are paid to deliver a particular result, they will try to deliver that particular result.

33:57And so a lot of his, you know, the earliest acquisitions were done through a network of brands. The two most famous were the original, the acquisition of National Indemnity back in 1967, which he bought from a friend of a friend, Jack Ringwald. Maybe by then Warren was a direct friend, and they did it on basically a handshake and a one and a half page agreement. And then the other big famous one from that era was Nebraska. And by the way, National Demi is one of the largest insurance companies in the world today. And the other notable acquisition of that era of that type was Nebraska Furniture Mart, which he purchased from a local Omaha native that was in his circle, Mrs.

34:38Blumpkin, Rose Blumpkin. And again, not quite a napkin, but pretty close. And that is how he's preferred it. Now, as the acquisition, as Berkshires got bigger and is a publicly listed company, the companies that are buying are big public companies. There was always more space and sometimes need for having those advisors. And so some transactions did end up getting there through that more professional route. But always the favorites and the ones he likes to talk most about came through friends and family. And it was just easier to, it is easier to count on when you hear, oh, this is the book value or this is the gross rate or these are the markets we think we can do better in.

35:20You can trust it more than a section 6.75 of the agreement makes a representation that the gap financials have been audited. And it is different. And he's managed to, You asked early on what's different, why, how is Warren different? He has cultivated a phenomenal network of business people. So he must get, I don't know what the figure would be, dozens of acquisition opportunities a week. And so that is a little harder for the rest to receive that volume, but he'll see everything within his potential wheelhouse. And it's easier for him to run his business that way. So advisors are sometimes critical.

35:57But within my footnote, I think if you're a professional engaged in building a business or trying to grow a business in that dimension, having advisors is important. But what's critical is having advisors you can trust. Our book, Margin of Trust, is partly about how you can prove for that. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore. from learning about Bitcoin to embracing a richer, wiser, happier lifestyle.

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39:39All right, back to the show. Yeah. So I got some more questions on the book. So you mentioned in margin of trust that as a business grows in size, centralization begins creeping in. You mentioned Mark Leonard, which is dear to my heart because I'm a big fan of his work. So anyways, you mentioned that he was doing a search for high-performing companies at one point. And he said, and I quote, they eventually caved in to increase centralization. My hunch is that it takes an unusually trusting culture and a long investing horizon to support a multitude of small businesses and their entrepreneurial leaders.

40:11If trust falters, the business units can be choked by bureaucracy. If short-term results are paramount, the siren song of consolidation synergies is powerful. Now, for a business running decentralized systems as part of their model, how can they best maintain trust with their subsidiaries to avoid the creep of centralization. That's beautifully put and poignant because you're absolutely right. As an entrepreneur, you or I or the group of us, we start to develop this product or market this service and we're excited about it and we want everybody to do as well as they can and reach their potential.

40:47So we give them lots of responsibility. This person's in charge of this business. This person's in charge of these accounts and we just have everyone doing their best. And it's a sort of partnership and we all trust each other and we don't have reports. We don't have two people signing off and we sort of just let it roll. And then as you get bigger and bigger, your interest in trying to impose a little control increases too. And so you have some oversight, supervision, reporting hire and things like that. So it is a natural thing to want to do. And you have to have a balance. You certainly can have an organization of a thousand people and each person can just do whatever they want and let us know how it goes.

41:22You have to have some culture, some glue, some shared sense of what an achievement would be, what the goal is. And so you do need to have a balance between autonomy and oversight or control. And I think, you know, though a way to do that will vary with the personalities and the business. But what you mentioned, Constellation, I think it's a neat example of a reference point, certainly, that would be generally useful to people, which is that the business is decentralized. So it's divided into there are 1000 different businesses inside that company, each one with its own P &L, each one managed by its own team, and with enormous autonomy in their sphere of marketing, pricing, product innovation, staffing, even compensation, incentives, work hours, environment.

42:16And they're in 100 different countries. So that is also very important because locales differ in language and religion and geography in just about every way. So it's an extremely decentralized model for really good reasons. And it's very much a system of trust. And then the flip side, the way that the balance is that there are also a set of business expectations that performance metrics that each of these thousand units say should be able to meet. And what's nice about this business is that all of those thousand are in the market, they sell software. And so the economics of software tend to be similar even in different markets and different geographies and so on.

43:00So it's possible, even in a diffuse and sprawling organization like that, to say, this is for a software business, revenue per employee, let's say, should be within this range. Expenses for product development should be within, compared to revenue, should be within this range. Numbers of levels of customer attrition should not be worse than this. And you can go down a whole list. And so the balance is achieved by broadcasting these common expectations and then saying, You can meet them however you want. This will count in a good software business. And so it's wonderful. And as I said, each company does a little differently.

43:38It depends on the character, personalities, and the types of business. At Berkshire Hathaway, those 82-odd businesses are virtually all in different areas. I mean, there are five jewelers and five furniture stores, but they're making consumer products, industrial goods, selling services of various kinds of insurance. So the metrics of the performance expectations and how to measure than will be different. It's very different to sell candy in a shop than is to build the fuselage for large aircraft. So you can't measure it in the same way. They're going to have different business cycles and all that.

44:11But you can nevertheless have relationships that acknowledge that you can manage the business any way you want, but we do expect results around these metrics, around these areas. So that's, I think, the key is it's trust with accountability. And as Mikhail Gorbachev, I think, Ron Reagan said of Mikhail Gorbachev back in the 80s that they were working on very dangerous balancing of warheads and ballistic missiles and nuclear arms. And Reagan said, I trust, but verify. Okay, you reduce those things. Good. Let me just take a quick inspection. And it's a little like that in a business organization.

44:50It's not carte blanche, full stop. It's autonomy with discipline. I call it intelligent autonomy. I like it. So you also mentioned a wonderful quote in that same book, Margin of Trust, which is, quote, all directors should act as if there is a single absentee owner and do everything reasonably possible to advance that owner's long-term interest. You also mentioned that the CEO not be present during certain parts of board meetings. Why is it so hard for most businesses to adopt this strategy in regards to the board actually trying to look out for the shareholder's best interest rather than maybe necessarily just the CEO's best interest?

45:27It's a great question of the nature of boards. And I should say, yeah, boards vary greatly across companies. And I think some may be more effective and others less effective on that dimension. But the reason it's challenging in any event is that corporations face many different competing claims and have multiple different constituents. And that's always been true. But in the past five years, that reality has been amplified. And boards are now asked to do any number of virtuous things, promoting certain level of worker diversity or environmental protection or employee security or customer economics.

46:10And they face, obviously, the pressures from the senior executives around the table about what their priorities might be. So it's always been difficult for a director to prioritize owner interests, but it has been more difficult in the past three or five years. The answer, I think, has also been the rationale has always also been the same. It's still hard to do, and it's harder now, but to see how what is best for owners will entail doing right by employees, customers, communities, the environment, suppliers, lenders, and everyone else. And so trying to sustain that owner mindset while recognizing the importance of all the other interests is a delicate thing.

46:55Not every director can grasp that, articulate it, or remind the CEOs who need it of that. That's a big framing, Kyle. Now, the second part of your question about the advice that directors should review the CEO's performance without her or him being in the room is a critical point because, you know, ultimately, everything I just said, the board needs to be able to conceptualize that owner interests are derived from other constituent interests. The CEO has to understand, live that too. And that's a real balancing act because we cannot allow the CEO to ignore or diminish owner interest by saying, well, I've got to give the employees this significant raise.

47:34I've got to give them a big raise so my pay doesn't look so bad, or I can't push that price increase through because we're in a recession or we just pulled out of a pandemic. I mean, the CEO's got to balance that matrix as well. And then it has to do other owner-oriented tasks well too, such as a rational capital allocation strategy of the sort we described. So measuring that person's performance is a critical board function. It's hard to do as it is, and it's really hard to do if that person's sitting right there. And, you know, essentially 20 years ago, that was not a common practice. It was not a common practice to ask the CEO to leave, to have an executive session.

48:14But it is now, it has been for probably at least eight or 12 years, really a common practice. And no one objects, no CEO says, I can't have the board talking behind my back. And so that was, I think, one of the more successful governance initiatives or improvements of this generation. We've had a lot of governance changes, some better, others not so good, but I'd say that's probably the most important, most valuable and successful one, or one of the top ones in the past 10 or 20 years. So in quality shareholders, you mentioned that Phil Fisher is one of Buffett's biggest influencers had a great way of comparing companies with restaurants.

48:53Quote, just as there are different kinds of restaurants catering to different tastes, there are different kinds of companies catering to different shareholder preferences. You mentioned three major types of shareholders, quality shareholders, which you refer to as cues in your book. So we'll refer to them as that here as well, transients and indexers. So before we jump into some more details, would you outline some of the characteristics of each of these shareholder types to people in the audience who are unfamiliar with these terms? Happy to, Kyle. And thank you so much for reading all of my books so carefully and having such profound questions about them.

49:25And thank you in particular on this quality shareholders matrix. And I confess, as you did for me, that I owe this framework to Phil Fisher, who wrote a great book in 1958 called Common Stocks and Uncommon Profits. And Warren called my attention, called the world's attention to Phil's book in outlining exactly this in his 1978 letter to Berkshire Hathaway shareholders in which Warren said, at Berkshire, we want only quality shareholders. And his definition that I pick up in answering your question now is that quality shareholders have a very long time horizon. So ideally, a holding period forever, and also a high degree of concentration.

50:03That is, they pick stocks and they choose a particular stock because they understand that business, they care about that business, and they want that business as a business to prosper. The two opposites of that are the two you mentioned, the transient shareholder is it's the short-term speculator. You can call them a lot of different things. It's the day trader or nowadays with AI, the artificial intelligence, the nanotrader programs, rapid buys and sells. That is plenty of professional arbitrageurs who simply are buying and selling stocks or options on them in order to take advantage of short-term changes in business or in the perception of the business or in regulations.

50:48I collectively call that whole group transients because they're not planning for whatever reason to hold the stock indefinitely. We've got typically a pretty short sense of getting in and out. So then the opposite of the quality shareholders on the time horizon. Then the other opposite to the quality shareholder is the indexer. These are funds that became famous in the 1990s and now are the dominant players in equity investing. The fund that doesn't pick stocks at all, but simply buys a little bit of every stock in a huge index, like the Fortune, like the S &P 500 or the Russell 2000. And they're not picking stocks at all.

51:24They're picking an index and then buying and selling stocks in proportion to their market cap to hug the index or to replicate the index. There are some funds that try to do a little risk on that and they kick a few out. But by and large, they're not quality shareholder Warren was trying to get who are focused on the economics and character in particular business. They're just looking at the overall market too. And so those are the three primary types of shareholders out there in today's markets. And that book is all about those three categories and why the specific features of the quality shareholder, that long-term focus cohort, and why that's attractive from an investor's point of view and from a company's point of view.

52:06So quality shareholders seem to make up a minority of retail and professional investors. What is it about the investing industry you think that prevents more retail and professional investors from taking advantage of being a quality shareholder? Yeah, I think there may be, it's hard to measure. We tried to measure it inferentially with a lot of different data sets and certainly no more than 25 % of total market cap. Could be even as low as 15. But the reason it's difficult, I mean, one way to just think about it is how easy the other two behaviors are. Indexing is so attractive because you don't have to do any work and you don't have to pay much money and you get the market return.

52:41It's an ingenious invention. Jack Bogle invented it. The late Jack Bogle, who founded Vanguard, had come up with the idea, talking to his professors at Princeton, but he wrote it up in his graduate dissertation and then turned around and opened up a shop. And it's been the most successful form of investing ever. So now the giant funds, there are three huge ones and hundreds of smaller ones, all still pretty big, and they don't have to do anything. They just have to run a model. You've got some back office stuff you got to buy and sell to keep, hug the index or get close, but you don't have to think.

53:15You don't have to think about, is this business going up or down? Is this manager or a superior character or an imposter, you know, they just buy the index, boom. And that's so it's, and it does cost very little money to do. So, and you get the market return that maybe minus 18, as it was a couple of years ago, or it might be, it might be 34 once in a while, but mostly it's around nine and that's great. So it's super easy and tempting. That's why large portions of individuals in America have their retirement savings in an index fund. It's phenomenally intelligent and wonderful. The trader group, the transient group, we talked first or third question today.

53:51It's fun to buy and sell stocks, right? It's neat to try to get in there and see if you can time something, see if you can get ahead of AMC or what is the next big thing. And then you say, well, gee, I'm pretty sure this is now at the peak. Let's sell it. Or the more sophisticated, making bets on whether this new merger is going to go through or whether the antitrust authorities are going to block it. It's fun to do that kind of stuff. And less exuberantly, it's a lot of people are just, they want to try to get things done within a year or two or three. And as soon as they're going to take a big position and then sell it, they're not here.

54:28They're not sticking around for five or 10 or 15 years. They're not thinking that way. They're not thinking about their retirement or their college, their kids' college education or grandkids. So those are two reasons why quality shareholding is less popular. Indexing and trading are one's lucrative for doing nothing. The other is fun for doing a lot. And then just on the other side, quality shareholding, to have the patience and the conviction requires a mental investment in order to decide, okay, I'm not going to sell quickly. You have to be able to stick it out. You have to be able to ride through those bear markets and avoid being too optimistic and bull.

55:06So that's just hard mentally to do. And to focus, you have to be able to have at least some confidence that your analysis and your judgment of a relatively small number of picks is defensible, is fair and right, and you won't lose sleep and you won't lose your spouse or your house. So it's hard, these activities. It's hard to be disciplined, but I hope you'll ask me what's the good side, what's the upside? Absolutely. Let's talk about that to close it off with what's the upside of being a quality shareholder? Thank you. Because I think it pays off. Obviously, compared to the indexer, the trap is you underperform.

55:44You make bad decisions and just can't get it right and you underperform. The real upside is being able to discern high-quality businesses run by high-quality people and making investments in them at least a fair price and then holding it for a really long time. And you can perform exceedingly well. And there are lots of examples of individual human beings who've done that. Famous examples. We list a whole bunch of in-quality shareholders. We've got a whole appendix of some of the famous people and then funds that they've gone on to create. So I think there's a lot of upside for the investor. And the related upside is especially as maybe not for individual stock pickers with a relatively small nest egg, but for larger individuals who come to have significant positions in companies, They have a voice.

56:36They have an influence. They can help companies. Most shareholders don't help companies. Those indexers, they don't know. Even those giant money managers, the trillion-dollar money managers like Larry Fink at BlackRock, he can't help Warren Buffett. He can't help Steve Jobs. He can't help Procter & Gamble. He can't help the board at Cummins Engine. He doesn't have the first idea about any of their business. He doesn't have any clue what he's good at at thinking about big time policy things like emissions disclosures and diversity. That's not going to help Berkshire deploy that$150 billion. It's not going to help Navida innovate in AI.

57:13It's not going to help Cisco close that acquisition in cyber. He doesn't know the first thing about any of those things. Quality shareholders of those companies, those funds and individuals who spend their careers studying companies and then zeroing in on, say, some of those investments, they're a RainTrust. I mean, Warren has great shareholders and he'll call them and say, or he'll get those calls from them saying, here's an opportunity. Here's a$30 billion acquisition for you. Or Steve Jobs will get to call you. We have the chip that you need. Or here's a way to get that chip, to fix that chip.

57:47Or here's your famous quality shareholders who have educated CEOs on capital allocation. Quality shareholders tend to be good at thinking fundamentally about how to use every corporate dollar. And there are examples in that book of shareholders who helped CEOs learn about how to deploy capital. And that has helped the company, helped build a better business, helped the employees, helped the customers, helped the holders. And the indexers can't do that, and the traders don't even care to try. So there's a real social value in the quality shareholder cohort. They really help corporate America succeed in ways the transients of indexers simply don't.

58:24Well, Lawrence, thank you so much for joining me today. Before we say goodbye, where can the audience connect with you and learn more about you and your books? LinkedIn is my favorite. Please do visit me there. DM me, check out. And I want to thank you again, Kyle, for having me and for having read all those books and asked such excellent questions about them. I can't thank you enough. Okay, folks, that's it for today's episode. I hope you enjoyed the show and I'll see you back here very soon. Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor's Podcast Network.

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