MI358: The Essays of Warren Buffett w/ Shawn O'Malley

0:00You're listening to TIP. And so Buffett remains bullish on American dynamism and not wanting to bet against where that innovation can take us. And I just wish more people could appreciate how fortunate we are. It's a lot easier to look at your neighbor's house and be jealous of it than it is to think about the incredible advantages afforded to us by living at this point in history, especially in the United States.

0:25Hey guys, in this week's episode, I had the pleasure of sitting down and talking with my friend and colleague, Sean O'Malley, chief editor of our newsletter, We Study Markets, to discuss what his main takeaways were from doing a deep dive into the essays of Warren Buffett by Lawrence Cunningham. In this episode, you're going to learn how Charlie Munger fits into the story of Berkshire, what allowed for Berkshire's incredible success, how to properly value a company, how Buffett views gold and index funds, the most important aspect of Buffett's character that stood out to Sean, plus a whole lot more.

0:57The essays of Warren Buffett, Lessons for Corporate America, is Cunningham's seminal work. He was a professor of corporate governance for 15 years at George Washington University, and he serves on the board of directors for several public businesses, such as Constellation Software and Markel Group. Buffett has been sharing his thoughts on business and investing to Berkshire Hathaway investors for years. And Cunningham has done a masterful job in distilling these ideas into a book that is comprehensive, non-repetitive, and easily digestible. This is the book that Buffett most frequently recommends to aspiring investors that want to learn how the sage of Omaha sees the world of investing.

1:34Without further delay, let's dive into today's episode with Sean O'Malley to learn about the essays of Warren Buffett.

1:45Celebrating 10 years, you are listening to Millennial Investing by the Investors Podcast Network. Since 2014, we interviewed successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation. Now for your host, Patrick Donnelly.

2:12Hey, everybody. Welcome to the Millennial Investing Podcast. I'm your host today, Patrick Donnelly. And joining me in the studio today is the editor of We Study Markets, Sean O'Malley. Sean, welcome to the show. Hey, Patrick. Thanks for having me. I'm excited to chat. I am too. I think it was about a month ago we had you on. We talked broadly about a lot of different things. We touched on books a little bit. I think you mentioned Nassim Taleb as being an influence, but you have read really widely. And one of the books you've read recently is the essays of Warren Buffett by Lawrence Cunningham.

2:44So I wanted to really do a deep dive into your learnings on that book specifically. And referencing the book, Buffett said that the author, Larry Cunningham, did a fantastic job at capturing Berkshire's philosophy. He even said that if you were to pick one book, that this would be his recommendation of what to learn about Buffett and to learn about Berkshire. What do you think it is about this book that makes it such a unique book that Buffett loves? Well, he's definitely biased. And I'm sure if you ask him, he'd find some witty way to kind of humbly acknowledge that. That's because Buffett essentially wrote the book over 40 plus years of annual letters to Berkshire shareholders, describing the company's operations, his investing philosophy, his big picture views of the American economy, what works in business and what doesn't, and a whole lot more.

3:33Cunningham kind of painstakingly read through these letters, found a number of important themes and edited them together into what we call the essays of Warren Buffett, which is just this really wonderful book to read through. So the book is much bigger than just being a testament to Buffett's track record, though. It's a chance to see the evolution and thinking of one of history's greatest capitalists and a wonderful accounting of what has worked for Buffett and his partner, Charlie Munger, and their very long careers. And I just find it inspiring in kind of our fast-changing world today where new technology promises to upend our lives and middlemen and outside consultants seek to extract fees from us along the way for managing our money.

4:15Buffett and Munger are a beacon of rationality and clarity that have offered wisdom and knowledge to generations of investors hoping to think for themselves. So you mentioned Charlie Munger and most of our audience is probably familiar with him, but it's obvious that the book isn't called The Essays of Buffett and Munger. Munger died, I think, in late 2023, something about a month shy of what would have been his 100th birthday. How does he fit into this book and the entire story of Berkshire Hathaway? Yeah, it's not included in the book, but in Berkshire's latest shareholder letter for 2023, Buffett really doesn't mince his words about Munger's significance.

4:55He calls Munger the architect of today's Berkshire Hathaway with himself just being the general contractor hired to fulfill that vision on Munger's behalf. And I'm quoting here, he says, Charlie never sought to take credit for his role as creator, but instead let me take the battles and receive the accolades. And I think to some extent, that says a lot about their relationship. I'd say with pretty high conviction, that's not just false modesty from Buffett. Munger changed how Buffett thinks about investing. And despite Buffett having already had a pretty fabulous track record, that subtle change allowed Buffett to adopt a new approach that ushered in decades of more success for Berkshire shareholders.

5:39I think you could just as easily call this book the essays of Warren Buffett and Charlie Munger, but it's sort of a technicality just because the writings are from just Buffett as Berkshire's CEO. But they're definitely hugely shaped by Munger's insights and their shared lessons learned about life and business and investing. So in that 2023 shareholder letter, Buffett mentioned that in 1965, Munger correctly called his decision to buy Berkshire Hathaway dumb, but he offered a solution for fixing it. And he told him to never buy a company like Berkshire again, but since he already owned it, that he should add to it his holdings by owning wonderful businesses at fair prices.

6:21Tell us a little bit more about why buying Berkshire was a dumb decision for Buffett. And then ultimately, how Munger changed how Buffett thinks about investing and then ultimately how he has invested over the years. Yeah, it seems pretty crazy, doesn't it? To say that anything fundamental about Berkshire Hathaway was dumb, given that it essentially has the best track record in history for creating value for shareholders over many decades. Since 1964, Berkshire's compounded market value has grown over 4.3 million percent versus something like 31 ,000 percent total return for the S &P 500 index, which is still pretty good, by the way.

7:00But that's just incredible performance coming from Berkshire. And that wasn't always the case. Berkshire got a second life when Buffett took control of the company, which at the time was this struggling textile business in a dying industry in the US. And I think that decision was a mistake in two key ways. For starters, Buffett's decision to take a majority stake in the company was at least partially fueled by vengefulness. After Buffett had begun accumulating shares in Berkshire, the company's CEO at the time personally gave Buffett his word that the company would buy back shares from him at a price of$11.50 per share using cash from some recently sold textile mills.

7:45So Buffett agreed and was preparing to sell his shares back to the company to make a small profit. The problem was that when the offer arrived on Buffett's desk, Berkshire only offered to buy his shares for about$11.38, which is kind of a famous story now. And driven by emotion and not really any kind of investing logic at all, he took offense over this difference of less than 13 cents per share and completely pivoted toward really aggressively buying shares in Berkshire Hathaway just so that kind of out of spite, he could fire the CEO. And it was actually this great moment in 2014 where Buffett calls this decision monumentally stupid, basically because it was just entirely childish behavior.

8:26And in 2010, he said something similar and basically says that if he hadn't made this blunder of emotion, it wouldn't really be the same company name as it is now. But whatever holding company he ran, if he'd taken that money and invested it into buying wonderful businesses, especially insurance businesses, that holding company would probably be worth twice as much as Berkshire Hathaway is today. And we're talking about hundreds of billions of dollars. So when you think about it that way, you can actually see why he considers this a pretty big mistake. So the decision itself to buy control over Berkshire was obviously flawed.

9:00Where Charlie Munger's wisdom comes in is on that last point about choosing instead to buy great businesses. Buffett's original interest in buying Berkshire shares followed the teachings of his professor, Benjamin Graham, who taught him about cigar bud investing, which I think is another kind a pretty well-known story. But for anyone who doesn't know, it's where you look for cigar butts left on the street with one last puff in them that you can essentially pick up for free. And that's a metaphor for the type of opportunities that Buffett is looking for as an investor at this time. And he's done pretty well doing it.

9:34He's looking for these struggling or dying businesses with shares priced so cheaply that you can get one last puff of profit from them, extracted as an investor. And sometimes these cigar butt stocks would be cheaper than the per share value of their cash and intangible assets. So you could sell off your assets and use cash to buy back shares. And you could essentially buy a dollar's worth of assets for 80 or 90 cents and automatically realize that 10 or 20 % return. And that plan works fine, but it's not scalable. Those sorts of opportunities don't really exist in the same way today. And even 60 years ago, there was a limit to how many you could find and just the amount of due diligence that was needed to kind of dig through those almost like corporate arbitrages and figure out what the assets on those companies' balance sheets were worth.

10:22So Buffett had this problem where he had made a lot of money with cigar butt investing, and he's in the middle of his career. And now he has a huge chunk of wealth concentrated in kind of the ultimate cigar butt company, Berkshire Hathaway, in this industry that he knows nothing about. And so that's when Munger comes into his life and gives him the solution that this is, hey, going forward, focus on just getting wonderful businesses at fair prices instead of fair businesses at wonderful prices. And that's just going to make your life a whole lot easier. Because with truly great businesses, you can hold them forever.

10:56And those keep compounding on your behalf. It's more scalable, but it's also just simpler. You only have to make one or two really great decisions a year and find those really great companies that you can own for a lifetime. And we just look at Buffett, we're thinking companies like Apple, Coca-Cola, American Express that have just been titans of creating value for shareholders across several decades. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable.

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14:10And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. All right, back to the show. So with Munger's help, Buffett starts focusing less on these cigar butt, ultra cheap stocks, and instead starts thinking about owning companies that would be worthwhile to hold for decades, maybe even a lifetime. There's obviously a lot more to the story though. What do you think has made Berkshire Hathaway such a special company? Yeah. I mean, it kind of pains me to say this. There's definitely an element of luck involved. That's not meant at all to kind of discount what Charlie and Warren have accomplished.

14:48But I think even they would acknowledge that for them to recreate the kind of success that they've had in their careers and another life, starting from scratch, even with what they already know, it'd just be very difficult. And the odds are sort of stacked against you. Still, there are things that make Berkshire special. Part of that is Buffett's focus on ensuring that Berkshire never incurs a permanent capital loss. It's often said, I'm sure people say this, like they have a fortress balance sheet and that is intentional. That's the DNA of the company is to be structured that way. So while Berkshire could have followed other companies and even juice its returns further by relying more heavily on debt, that would have made Berkshire more vulnerable to downswings in the economy or financial crisis where chances to borrow money dry up and force a dash for cash.

15:37I think you can pretty safely say that there's not many examples in the history of companies that went bankrupt with no debt. It's pretty hard to do. But on the other hand, debt is a form of leverage that can accelerate a business's growth. And that's very addictive. And I think part of it for Buffett is to acknowledge that returns could have been better in theory with debt over time. But that's like saying, my life would be better if I just smoked one cigarette a day. It's just a temptation that you don't want to get into. And even a short absence of credit can bring a company to its knees. And just look at the 2008 financial crisis as evidence of that.

16:12So part of the success is just being able to survive longer than anyone else. And in a given year, if you roll the dice enough, because investing is inherently in the short term, a game of randomness, you could easily outperform Buffett on a year to year basis. But across a lifetime, the odds that you're going to roll the dice in the right way to be able to beat somebody like him over decades, it's just not realistic, but you're eventually going to get wiped out. And really, to me, the difference is that Buffett is not rolling the dice. he knows the risks facing his businesses pretty much as well as anybody possibly could.

16:47And then he keeps this massive cash cushion to basically hedge against what he doesn't know. And the reality that there are a lot of things he doesn't know. And so this sort of opens a whole other can of worms about investing risk and how to think about that. And I think while most business schools and academics teach that risk can be measured by price volatility. Again, this is well-known stuff, but to say that obviously Buffett does not see risk as being just like price swings. Risk to him is that a business's intrinsic value will decline over time, destroying the value of the capital that's invested in it, which is, I keep saying capital impairment and how that is kind of, especially permanent capital impairment, how that is fundamentally what the risks you face as a capital allocator are in investing.

17:32So in terms of what else makes Berkshire special, much of that has to do with, I think, the top-down standard that is set by Buffett and Munger, where they avoid as much as possible these so-called ABCs of business decay, which they talk about in the book. And those ABCs stand for arrogance, bureaucracy, and complacency. So for example, many CEOs and business leaders fall into this trap that Buffett calls the institutional imperative, where it's far easier to maintain the status quo or follow others' lead than it is to make bold changes. If you manage a company with a poor outlook, your options are basically either to reduce the size of this kingdom that you rule over as being a corporate executive by paying out cash to shareholders in the form of dividends, or you can basically reinvest into that bad business and keep growing that bad business.

18:22Or you can try to pivot into an entirely new industry that you're probably not really equipped to tackle. And so I think that's how a lot of CEOs get trapped into just reinvesting in terrible businesses where in hindsight, it's so obvious, why would you keep plowing money into cable or textiles or newspapers when these things are dying? And there's an element of the ego there where you have to say, well, for this CEO to make that decision, they would have to acknowledge business failures of the past, and even a lack of foresight to anticipate some of the risks that were coming. And I think what's special again about Berkshire is that with this conglomerate structure, you can really avoid that altogether.

18:56Buffett can allocate capital towards its most optimal uses without any biases. If any one of Berkshire's businesses cannot effectively reinvest all of its operating earnings, its CEO has this added option of sending the cash flows upstream to Warren and Charlie will happily put it to use and he'll probably find a better use for it based on their track record. And I think that rationality and common sense just permeates Berkshire in ways that are uncommon across the rest of corporate America. And part of the reason is that most major companies aren't run by people who truly have skin in the game, like Berkshire Hathaway's leadership does.

19:31CEOs and other executives are sort of often hired hands whose incentives really don't perfectly align with shareholders' interests. And that's something Buffett has really talked about at length over the years. And when you look at Berkshire, Buffett, as did Munger, has almost his entire net worth and many of his relatives invested in Berkshire. So he benefits in the same proportion as everyone else who owns the stock in the company. And as your CEO, of course, he acts accordingly. And that stands in really stark contrast to most of the CEOs who get massive compensation packages of both cash and stock options, usually tied to performance goals.

20:08Instead of thinking like long-term owners of a business, they're more likely to focus on what's needed in the short term to hit those targets and unlock more compensation for themselves. But at Brookshare, no one is paid in stock because that dilutes the value of all other shareholders' stakes in the company. And instead of management of subsidiary businesses, instead management of subsidiary businesses are paid cash bonuses based on individual performance. and heavily encouraged to use that cash to buy shares of Berkshire at the same prices available to everybody else in the market. And at the end of the book, there's this essay from Charlie Munger, where he highlights what he thinks has made Buffett and Berkshire so special.

20:51By building up a unique blend of corporate ownership and control, Buffett could craft an equally unique kind of principles-focused corporate culture. And part of that extends simply to just this motto of creating win-wins and treating business managers how he would want to be treated. Buffett does not micromanage any of the management of Berkshire subsidiaries. He doesn't even get set budgets from them. He just shows some trust. And in doing so, he earns theirs. It's really the same thing he's done with shareholders over the years, which is why 40 ,000 people cram into a stadium in Omaha to listen to all day Q &A sessions with Buffett and Munger, because of that transparency, he's offered to shareholders and the trust he's built with them.

21:37Berkshire has probably the highest quality shareholder base of any major US company. One really crazy stat that stood out for me in the book is at one point, Buffett mentions that 98 % of Berkshire shareholders are the same people who own the company at the start, or at the end of the year, 98 % of Berkshire shareholders are the same people who own the company at the start of the year. And for 90 % of those investors, Berkshire is their largest single stock holding. That's just really rare. And you attract the shareholder base you deserve. And I think Berkshire reflects that. A focus on short-term results would attract a very different shareholder base and bring a lot more churn in who owns the company.

22:20And like I said, there's essentially no churn there. And it's a pretty good illustration of how lots of things have compounded favorably for Berkshire beyond just investment results. Goodwill with customers, shareholders, regulators, and the public at large has all compounded to Berkshire's benefit, as well as trust with employees and even trust from CEOs and other business managers who feel comfortable selling their stake in their business to Berkshire and kind of sleep better at night knowing that it's in Buffett's hands rather than in a competitor's or in some Wall Street private equity firm's hands.

22:55You mentioned that Buffett thinks differently about risk than many academics and even many on Wall Street. Talk to us a little bit about what's so unique about how he thinks about investing. If you're to believe modern financial theory, then it's essentially pointless to think about investing at all because in theory, all known information is priced into stocks at all times. There's going to be almost no chance that you can reliably beat the market averages because you have no special advantages working in your favor. Proponents of this idea would pretty much just tell you to buy a broad market index fund and accept mediocre returns by definition, right?

23:34You're going to get the average of what the market delivers over time. And Buffett's track record is sort of fundamentally a rejection of that premise. For those willing and able to think for themselves, Buffett shows that the markets aren't perfectly efficient and it's possible to gain an edge over time. And I think to some extent, that's because markets are driven by humans. Humans are emotional and emotions lead to mistakes, which it's kind of crazy that you even have to say that and point that out. It seems so obvious, but when you're in this academic theoretical setting, that kind of stuff gets overlooked.

24:09And one of my favorite examples for this that really resonated is how conventional financial wisdom gets it wrong when it comes to one of Wall Street's favorite buzzwords, beta. Beta is essentially used to compare how a company's stock trades relative to the broader market averages. Companies with higher betas would, in theory, have more volatile price swings, which most finance aficionados would tell them by definition makes them riskier. And as Buffett points out in many different shareholder letters, this is just the exact wrong way to think about it. If a stock falls dramatically, its price is now much cheaper, making it less risky, not more.

24:50By buying at a lower price, you now have a greater margin of safety if your thesis about the company's quality is wrong. If anything, more volatile stocks give you more opportunities to buy ownership and the company on sale. It just seems so obvious, but that has not been my experience with how a lot of investors think about risk and the opportunities and financial markets. I can remember back to my business school classes where essentially the message was, if something has fallen a lot, it has negative momentum. And therefore, it is riskier to own. And not thinking of it as like, no, this is a piece of merchandise that just went on a 50 % sale that is now significantly cheaper.