Warren Buffett & Sun Tzu: The Ancient Strategy for Avoiding Ruin with Tobias Carlisle

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2:23And he discusses this idea of ergodicity, which is basically this idea that if you have a game in the context of like a game theory game, where you... Love this podcast because it crushes your dreams and getting rich quick. They actually got me into reading stats for anything. You're tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now. All right, folks. Welcome to Investing for Beginners podcast. Today, we have a lot of fun. We have a great show for you.

3:06We have Toby Carlow, who is the principal at Acquirers Funds, LLC, and serves as their chief investment officer. He hosts one of my favorite podcasts with Jake Taylor, Value After Hours, Must Listen. And finally, he writes books, really good books, such as Acquirers Multiple. And today's topic, The Soldier of Fortune, Warren Buffett, Sun Tzu, and The Ancient Art of Risk-Taking, which we will discuss today. So, Toby, welcome back to the show, and we appreciate you taking time out of your day to come talk to us. My pleasure. Thanks for the very kind introduction. You're welcome. You're welcome. So we probably should forewarn everybody.

3:45None of us are native speakers of the Asian languages. And so we may butcher a word or two here. So just be forewarned as we go forward. That's right. So how, I guess, maybe for those uninitiated, maybe we could talk a little bit about who Sun Tzu was and how you're connecting him to Warren Buffett, of all people. Yeah, it's a funny connection. Sun Tzu is the author of The Art of War and essentially that's all we know Sun Tzu is Mr. Sun or Master Sun there is another group of texts that survive from the same era this is the Warring States era in Bronze Age ancient China So there was a dynasty, the Zhao, that fell after 800 years and they left.

4:43And it was a very big empire. And what remained was independent walled city-states that essentially immediately fell to war, according to these texts. And over a period of about 300 years of basically constant warfare, at the end of that they had coalesced into seven super-states. and the super states found themselves in this uneasy equilibrium where if they attacked one, they left themselves open to attack by another neighbour. And so it was very difficult for anybody to get control the way that the Zhao had previously. Ultimately, there was one, the Yellow Emperor, who was able to defeat all of them and his exploits are, among other sort of fights, are documented in this, the persuasions or the stratagems of the warring states.

5:45That's the name of this document. And in that document, it talks about a general son who had a text with 13 chapters, and it tells a story about him talking to one of the super state rulers, saying that I have this method and then the ruler got his concubines to square off and they were all laughing and joking and then this general had the head concubine's head cut off and then all of the girls stopped laughing and went through and that was discipline. That story is not the Sun Tzu who wrote the book because for a variety of reasons the dates don't line up even though many people remember the Giles translation, which was the original translation that came out in 1910, and it includes that story in it.

6:40And that story, for whatever reason, sticks in people's minds. But if you read that translation, Giles himself says, it's highly unlikely that this is the same person. So we really know nothing about Sun Tzu the man, and it's possible that it's two people over a period of time. it doesn't really matter because the text sort of stands on its own as it looks on its surface, it's this guide to Bronze Age warfare. How is that relevant two and a half thousand years later? You know, on the surface, it's not. And it's a book that I know that, and many people know that, know of the existence of the book, and perhaps many people have like flicked through it.

7:25And I I was one of those people. I read it in high school and honestly, I didn't see the attraction. All that I can remember was that if you were traveling through a salt marsh and you were attacked, you had to get your back up against some trees, which it's just not at all relevant to anything that anybody does. Maybe you can abstract something out of that, but I couldn't. And I went back to it every five or so years to try to see if I could get anything out of it. And I really struggled to find anything. But in 2020, during the pandemic, having read Buffett since I was about 17, having read Buffett's letters, I read The Art of War again.

8:06And it just sort of dawned on me that what they were discussing in the abstract was very similar. And by that, I mean this. Sun Tzu starts off saying the art of war is of vital importance to the state and it's a path to safety or ruin, to life or death. And so it's a subject that you can't ignore. But that idea of ruin sort of permeates the whole thing. And there's some game theory now that exists on this idea. and there's an author who's written a book called Ergodicity, Luca Delana, and he discusses this idea of ergodicity, which is basically this idea that if you have a game in the context of like a game theory game where you have a risk of ruin, all of your strategies have to be dedicated to avoiding ruin rather than trying to succeed in what you're doing.

9:03So it's better to survive than it is to win. because if winning risks losing or risks ruin, then you can't take that chance. You always have to be making sure that you survive first and then your options that remain in the survival group are the only ones that you can choose. And investing is a similar sort of, the way that Buffett approaches investing, if you're ruined, your capital is gone, you can't keep on compounding, it's the end of compounding. It doesn't matter if you've had a 50-year career of 30 % compound, if the last year of that returns you to zero, your compound growth, your geometric growth is zero, even though your arithmetic average might be pretty impressive.

9:46And there are lots of investors around who've had these sort of trajectories in their investment careers where they've done very well for a period of time and then blown up or disappeared. And so Buffett's whole strategy and philosophy is dedicated to this idea of avoiding ruin. and then if you do that it sort of limits the things that you can it limits how you approach investments limits what you can invest in it limits the sizing and it has all of these other philosophical and practical sort of knock-on effects from that and that's what Sun Tzu is really discussing and he discusses it in this sort of really the Giles translation in particular which is the original I think has these really fun expressions.

10:32And for whatever reason, I find them quite easy to remember and to apply. And so that's, for me, that's the attraction of the work. Yeah, it's cool. And I feel like you, I haven't read it, so I'm just speculating here, but I feel like you sprinkled those throughout the book. Like, We Came, We Saw. I guess what would the third one be? I'd have to flip my table of contents here. That's Caesar Veni-Vidi-Vici, We Came, We Saw, We Conquered. I just used that as the three heading titles. Yeah, I like that. So, We Came, We Saw, We Conquered. What is the, like, can you explain that? Because that seems like a cool structure.

11:12I just wanted to break it into three. And I wanted, the three ideas are, firstly, the first idea, the first part is just literally describing what I have just described. The importance of avoiding ruin and the various ways that you go about doing that. And the first thing is that you have to think defensively first. And Sun Tzu has a lot of great ideas about how you think defensively. And so does Buffett. And the idea is that it's very simple in an investment context. You're looking for things that don't have too much debt, that don't have a business model that compounds and then has this collapse.

11:51So there are lots of business models that do well through the good times. And then consumer credit is a tough one. If there's a very bad down year, then they'll have a big downdraft. Insurance can be like that. Banking can be like that. Financial-type businesses can be like that. So you need to take a great deal of care, which is funny because that's where Buffett has spent. The vast majority of Buffett's wealth comes from in insurance and banking and financial-type investments. So it's not to say that you can't do it. It's that you have to be very careful when you do do it. the second part is this idea that you have to approach these investments with some sort of framework and then you have to go and do diligence or you have to go have some sort of process for conducting an analysis that yields you an answer and then this is this is something that i think i've seen it a lot and i remember that i was like this when i first started investing trying to be a value investor you do a valuation on a stock but then what does that mean you get a valuation and you've got a stock price that's different, or then maybe they're comparable, what does that mean?

12:54And what Sun Tzu points out is that the idea is that you're looking for an overwhelming advantage. You're looking for a stock price that's so far divorced from your valuation. As rough as it might be, your valuation could be very wide. But if the price is even lower, you know, is half of the lowest end of your very wide valuation, then you might have a very good position. And so Sun Tzu has this quite interesting idea about how you conduct this analysis. And he says, you look at the ruler, you look at what, you know, you can interpret that lots of different ways, but that's clearly the manager.

13:32You look at heaven, which are the conditions. You look at earth, which is the territory, and that's the chances of life and death and so on. And looks at method and discipline, that's efficiency or return on invested capital. And Buffett has a similar approach. I'm not saying that you use Sun Tzu's approach, but I do think that Graham has a similar sort of framework. And then he arrives at the same idea that you're looking for this vast advantage before you put these positions on. And that's one of the ways that you protect yourself. And then the third part is it's a little bit more woo. I think it's a little bit harder to kind of grasp, but the idea that the art of war comes from this enlightenment period in ancient China where they had started writing about Taoism.

14:24So Taoism had been this philosophy that had been around for a while, but there are these foundational texts written about that time, and that's the way and its power, which is the Lao Tzu work, and then the Zhuangzi. and The Art of War is considered one of these three foundational works in Taoism. And they talk about this idea of finding the state of wu-wei, which is basically effortless success or hyper-efficiency. But they have some very – it feels wu, but then the way that they explain it in the book is they just say you can be a great farmer and you can have all of the instruments of husbandry, but if you don't plant in the right season and harvest in the right season, then all of your efforts are in vain.

15:15You know, you have to be aware of the prevailing conditions and what is likely to transpire as a result of that. And you need to invest in the prevailing conditions. So I think that's a nice thing. That's one of the things that Graham says. You just have some idea where you are in the cycle. Something might look very cheap at the very top of its cycle because it's over-earning. and most investors know that. And as a result, the stock price appears cheap. But most investors understand that it's at the top of its earnings cycle and the next series of earnings are down and then it doesn't look so cheap.

15:53And the reverse is also true, that at the bottom of its earnings cycle, it looks expensive, even though it's quite good value, because the expectation is that the earnings are going to grow rapidly over a period of time. So that's sort of the structure of the book is just this idea of avoiding ruin and being defensive, then doing these analyses and coming up with a decision. And then finally, looking for things that can take advantage of the existing conditions and flourish where really you're just participating in something that's going to happen anyway. And you've got a little tailwind rather than a headwind.

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19:12But I love how you're kind of connecting that. And it definitely, I think Buffett's discipline, long story short here, Buffett's discipline, I think, is underappreciated because he's, through his career, he's had lots of opportunities to be more aggressive and he's chosen not to. You know, the dot-com era, for example, and recently the COVID example. So what are your thoughts on that? I couldn't agree more. I mean, I think when COVID happened and everything got that initial sort of flash crash, and then there was an expectation, I think, that Buffett would have bought quite a lot through that period.

19:56And then I think we were all a little bit shocked maybe to find out that he hadn't. And in particular, what he had done was sold all of these airlines. Because clearly he's had this long documented kind of love-hate relationship with the airlines where he jokes that while it was great for humanity, that the Wright brothers got the planes in the air. If an investor had been there, they would have shot them down. And then he's sort of had all these investments that haven't really worked out. But at some point, they decided a basket of airlines is the right move because there's a finite number of places that you can land and operate.

20:33The slots are hard to get, and that's what gives you the moat. The problem has always been that, you know, an airline's like a building, but you can fly the building to the place where it's needed. So it's – and they've decided that they're moaty enough and they've invested in them. But then, for whatever reason, through COVID, he decided that they weren't worth holding and he sold out of them. But the one that I put in the book that I think really stands out as, you know, the deal that really encapsulates the genius of Buffett, I think, is the Apple investment. And I use that as the, I say that's the greatest trade ever.

21:10And the reason that I say that that's the greatest trade ever, and I say in the book that it's a little bit in the eye of the beholder. It's like modern art. It's a little bit to taste. And many people will say, well, the greatest trade ever is not Buffett's investment. I mean, it's NASPers taking a position in Tencent as a tiny, tiny company and then holding onto that position and growing it into a multi-billion, multi-multi-billion dollar position that basically warps the South African stock market because it's so big. Nothing else sort of matters there. But I say, well, you have to find a South African listed equity with a big Chinese investment.

21:48And, you know, it sounds like it's nothing like Buffett who, when he made that Apple investment, he was already very, very well known and had been tracked by investors for decades and decades. Equally, Apple was very well known. Even if you didn't follow the stock, it's very highly likely that you had either a phone or a laptop or you'd had one of the old computers or an iPod or an iPad or something. You at least knew Apple was a consumer products kind of company. And so then he's taken the position after these two activists, ICANN and Einhorn, have run this very public campaign where they said the problem with Apple is that it has this giant cash holding, which is much, much bigger than the fixed assets that it requires to run the business, and it needs to pay that money out.

22:42but when they did pay that money out and start buying back that stock the two activists got what they wanted and sold out and then shortly thereafter Buffett disclosed that he had a 40 billion dollar position in in Apple and so I think it's one of those things where he could easily have to put that position on when the activists put their position on he was aware of it but there was some imperfection in it which was that they weren't doing the right thing with the cash that they had on the balance sheet with the capital structure wasn't right. And once they perfected that little problem, then all of a sudden it became a Buffett type stock.

23:19So it's a good example of discipline where it's hard for him to deploy lots of money into the market. It's hard to find a big enough company to invest in. And there was clearly, he could see Apple sitting there, but it was imperfect. Even though it was cheap, it was imperfect for his purposes. And he just waited until that imperfection went away, not knowing that it ever would, but when it did go away, then he put the investment on. I think that that's one of the key things that he does better than anybody else, which is that it's either extreme discipline or extreme sort of choosiness, selectivity, just sitting there and waiting for something that is perfect according to your own terms and not swinging before you get that perfection.

24:01I like to use the little story. There's the Book of Five Rings, which is a Musashi Miyamoto who was this, I think, 15th or 16th century AD. But you can read the book and it's clearly that it comes from a Taoist philosophy and he's also borrowing quite a lot of ideas from Sun Tzu. Although those ideas were out there and he's parallel. He writes it in Japan. And the idea is that he talks about this. He was a sword duelist and he fought 62 sword duels sort of famously. And he talks about, he calls it hitting from the void or the no design, no conception cut, where basically you just sit and wait for the opponent to make a mistake or wait for the opportunity to sort of appear like the sun coming through the clouds.

24:52And so the opportunity appears and then you deal your strike. And that's what I think of with Buffett. He sits there 100 % ready to go, just waiting for that opportunity. And the moment that he sees it, he delivers the strike and then moves on. Yeah, I love that. That's a great example of how he has performed and behaved over the years. So a couple of questions that I have. number one is what are your thoughts on you hear this you see this all the time on the internet you know the x machine talk people talk about how charlie changed buffett and how he's you know evolved or whatnot but then i've also seen studies that shown that he hasn't paid more than a certain multiple for any of these companies including apple so how i guess how do you you know how do i how do I connect the two, if you will?

25:52It seems that Buffett has this genius for analyzing businesses and everything that I have learned about investing, and I think that everything that a lot of people have learned about investing, they've learned from him and from those letters where he describes high returns and invested capital as being the attractive thing and moats protecting the high returns and invested capital and then buying at a price that allows you to have a margin of safety and participate. It feels like there's a great deal of thought and work on that side. But he clearly, we know that he'd taken a lot of positions in control situations and sub-liquidation type companies and then he made the investment in American Express.

26:35And similarly, it was a special situation where it had that weird fraud with the salad oil scandal. Which, his concern when that was happening was that merchants wouldn't accept the credit cards. And so, he or his man, Harry Bottle or whoever it was, went and sat, or whoever did the scuttlebutt kind of research, went and sat in restaurants just to see if they were still taking the cards. But most people, I don't think, had even thought about the connection. And so, he thought, well, that this is going to survive and it's going to be a good business. And so he put a lot of the fund in it, he got the bounce, held onto it, and then he sold it.

27:16And then he revisited it years later and he realised that it had been such a great business and it had compounded away into, when he reinitiated the position for Berkshire years later, it was a much, much bigger position. But, you know, he could have sort of got there just by holding on and compounding through that period of time and that sort of transitioned him across. he says that Munger pointed out that you're better off having these sort of the companies that have that kind of woo-way quality to them that effortless success quality to them and it's so much easier in something like that than these other things that are in your face a little bit a little bit of a headwind the whole way through but he he Buffett says in in his sort of dedications to Charlie that Charlie was the architect who gave him the blueprint and he was the general contractor.

28:02And so I think you have to take some of that at face value that there were discussions going on and that Munger said something to him and that triggered something inside of him and that moved him on a little bit. I do think he maintains the discipline of buying these probably very good companies. When he says fair prices, I think what he's saying is that if you were to buy this in a steady state, we're paying about a full price. We're paying a fair price for this at steady estate, but the growth you're getting on top of that for free and the growth is near certain. So the likelihood is that these positions work very well.

28:36And the example of that that I would give is Coke, where Coke was optically expensive in terms of earnings. And that was probably a fair representation of where it was at the time, but those earnings were mostly derived from the US. And there was this expansion to the rest of the world. And it looked like it was a product that should travel very well because it's full of sugar, it's got caffeine in it, which is a little bit addictive. It doesn't have alcohol in it. There are a lot of countries that can't drink alcohol, but it wouldn't have any of those problems. And it had been around for so long that it had good brand awareness globally.

29:10And so I guess he was just betting on the fact that it would get this growth and that the growth would be very valuable to the company. It's not always very valuable. In this instance, it would be because it would be marginal to the company. and marginally profitable to the company. So it worked out very well, but I still think that he was paying a fair price for the existing business and then getting the growth, which he felt was almost certain for free. So does that kind of lead to the first part you were talking about, about playing these games where you're not going to go to ruin? And I'm reminded of Manish Prabhai, heads I win tails I don't lose much we talk about all the successes of Buffett but it was that risk tolerance so you mentioned