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Berkshire Hathaway Part I

Season 8, Episode 5

Limited Partner Episode

April 20, 2021
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The Complete History & Strategy of Berkshire Hathaway (Part I)


It's time. After 150+ episodes on great companies, we tackle the granddaddy of them all — Berkshire Hathaway. One episode alone isn't nearly enough to do Warren and Poor Charlie justice, so today we present Part I: Warren's story. How did a folksy, middle-class kid from Omaha become the single greatest capitalist of all-time? Why, like Jordan, did he retire (twice!) at the top of his game, only to reinvent himself and come back stronger than ever? As always, we dive in. Let's dance.

If you love Acquired and want more, join our LP Community for access to over 50 LP-only episodes, monthly Zoom calls, and live access for big events like emergency pods and book club discussions with authors. We can't wait to see you there. Join here.

The Warren Buffett Playbook:


1. Money can create more money. (aka "Compounding")

  • Very early in life, Warren figured out something most people never truly grasp: money can be used to generate more money. It's sounds simple, but once you fully internalize this concept, you'll never see the world the same again. A given sum no longer represents what you could buy with it — a coffee, a phone, a car, a house, etc — but rather what it could grow to become over time. At the extreme, people like Warren are "cursed", seeing prices for goods not as whatever the sticker says, but 5x, 10x, 20x higher — because that's what the opportunity cost of parting with the capital represents.
  • If you own an asset that's compounding at a high rate with no obvious reason it will stop... dear lord do not interrupt it!! Most people are tempted to meddle: lock in gains, cover other losses, actively trade, or otherwise "manage" their investments. In the long run these actions are almost assuredly all value-destructive behaviors if you own truly great businesses.

2. Align incentives: be a doctor, not a prescriptionist.

  • Warren likened stockbrokers — who got paid based on volume of trades placed, not investment performance — to "prescriptionist" doctors who were paid by their number and type of pills prescribed, versus actual patient outcomes. Once Warren created his investment partnerships (and then later transformed Berkshire Hathaway into something similar), he not only unlocked hugely better outcomes for his"patients", but allowed created a path to pursue his own dream and become fabulously wealthy in the process.

3. You can't expect to control other people's emotions around money (or anything else).

  • However with the right "ground rules", you can mitigate the impact of others on your business and decision making — and even use them to your advantage.
  • Warren's early partnerships had a few ground rules and norms: partners will not know what securities are held, trading in/out is allowed only 1 day / year, and Warren will consistently set low expectations (leaving himself ample room to over-deliver). These set the stage for nearly complete freedom for Warren to operate as he saw fit — to the immense gain of his limited partners.

4. Sins of omission (selling or passing) nearly always cost more than sins of commission (buying).

  • Warren is almost without doubt the greatest investor of all time. However even he made three incredibly stupid "unforced errors" early in his career that cost hundreds of billions in future gains: selling GEICO, selling American Express, and passing on the opportunity to invest in Intel with Arthur Rock.
  • That said, Warren's fourth great mistake (and in his estimation his greatest) was certainly a sin of commission: buying Berkshire Hathaway itself. Warren estimates this single blunder totaled $200B+ in opportunity cost over his lifetime.


Carve Outs:


Episode Sources
:

Sponsors:

  • Thanks to Tiny for being our presenting sponsor for all of Acquired Season 8. Tiny is building the "Berkshire Hathaway of the internet" — something they're so dedicated to, they even make and sell bronze busts of Warren & Charlie online! if you own a wonderful internet business that you want to sell, or know someone who does, you should get in touch with them. Just like Berkshire, they commit to quick, simple diligence, a 30-day or less process, and will leave your business to do its thing for the long term. You can learn more about Tiny here and find their Berkshire Nerds store here.
  • Thank you as well to Vouch and to Capchase.

We finally did it. After five years and over 100 episodes, we decided to formalize the answer to Acquired’s most frequently asked question: “what are the best acquisitions of all time?” Here it is: The Acquired Top Ten. You can listen to the full episode (above, which includes honorable mentions), or read our quick blog post below.

Note: we ranked the list by our estimate of absolute dollar return to the acquirer. We could have used ROI multiple or annualized return, but we decided the ultimate yardstick of success should be the absolute dollar amount added to the parent company’s enterprise value. Afterall, you can’t eat IRR! For more on our methodology, please see the notes at the end of this post. And for all our trademark Acquired editorial and discussion tune in to the full episode above!

10. Marvel

Purchase Price: $4.2 billion, 2009

Estimated Current Contribution to Market Cap: $20.5 billion

Absolute Dollar Return: $16.3 billion

Back in 2009, Marvel Studios was recently formed, most of its movie rights were leased out, and the prevailing wisdom was that Marvel was just some old comic book IP company that only nerds cared about. Since then, Marvel Cinematic Universe films have grossed $22.5b in total box office receipts (including the single biggest movie of all-time), for an average of $2.2b annually. Disney earns about two dollars in parks and merchandise revenue for every one dollar earned from films (discussed on our Disney, Plus episode). Therefore we estimate Marvel generates about $6.75b in annual revenue for Disney, or nearly 10% of all the company’s revenue. Not bad for a set of nerdy comic book franchises…

Marvel
Season 1, Episode 26
LP Show
1/5/2016

9. Google Maps (Where2, Keyhole, ZipDash)

Total Purchase Price: $70 million (estimated), 2004

Estimated Current Contribution to Market Cap: $16.9 billion

Absolute Dollar Return: $16.8 billion

Morgan Stanley estimated that Google Maps generated $2.95b in revenue in 2019. Although that’s small compared to Google’s overall revenue of $160b+, it still accounts for over $16b in market cap by our calculations. Ironically the majority of Maps’ usage (and presumably revenue) comes from mobile, which grew out of by far the smallest of the 3 acquisitions, ZipDash. Tiny yet mighty!

Google Maps
Season 5, Episode 3
LP Show
8/28/2019

8. ESPN

Total Purchase Price: $188 million (by ABC), 1984

Estimated Current Contribution to Market Cap: $31.2 billion

Absolute Dollar Return: $31.0 billion

ABC’s 1984 acquisition of ESPN is heavyweight champion and still undisputed G.O.A.T. of media acquisitions.With an estimated $10.3B in 2018 revenue, ESPN’s value has compounded annually within ABC/Disney at >15% for an astounding THIRTY-FIVE YEARS. Single-handedly responsible for one of the greatest business model innovations in history with the advent of cable carriage fees, ESPN proves Albert Einstein’s famous statement that “Compound interest is the eighth wonder of the world.”

ESPN
Season 4, Episode 1
LP Show
1/28/2019

7. PayPal

Total Purchase Price: $1.5 billion, 2002

Value Realized at Spinoff: $47.1 billion

Absolute Dollar Return: $45.6 billion

Who would have thought facilitating payments for Beanie Baby trades could be so lucrative? The only acquisition on our list whose value we can precisely measure, eBay spun off PayPal into a stand-alone public company in July 2015. Its value at the time? A cool 31x what eBay paid in 2002.

PayPal
Season 1, Episode 11
LP Show
5/8/2016

6. Booking.com

Total Purchase Price: $135 million, 2005

Estimated Current Contribution to Market Cap: $49.9 billion

Absolute Dollar Return: $49.8 billion

Remember the Priceline Negotiator? Boy did he get himself a screaming deal on this one. This purchase might have ranked even higher if Booking Holdings’ stock (Priceline even renamed the whole company after this acquisition!) weren’t down ~20% due to COVID-19 fears when we did the analysis. We also took a conservative approach, using only the (massive) $10.8b in annual revenue from the company’s “Agency Revenues” segment as Booking.com’s contribution — there is likely more revenue in other segments that’s also attributable to Booking.com, though we can’t be sure how much.

Booking.com (with Jetsetter & Room 77 CEO Drew Patterson)
Season 1, Episode 41
LP Show
6/25/2017

5. NeXT

Total Purchase Price: $429 million, 1997

Estimated Current Contribution to Market Cap: $63.0 billion

Absolute Dollar Return: $62.6 billion

How do you put a value on Steve Jobs? Turns out we didn’t have to! NeXTSTEP, NeXT’s operating system, underpins all of Apple’s modern operating systems today: MacOS, iOS, WatchOS, and beyond. Literally every dollar of Apple’s $260b in annual revenue comes from NeXT roots, and from Steve wiping the product slate clean upon his return. With the acquisition being necessary but not sufficient to create Apple’s $1.4 trillion market cap today, we conservatively attributed 5% of Apple to this purchase.

NeXT
Season 1, Episode 23
LP Show
10/23/2016

4. Android

Total Purchase Price: $50 million, 2005

Estimated Current Contribution to Market Cap: $72 billion

Absolute Dollar Return: $72 billion

Speaking of operating system acquisitions, NeXT was great, but on a pure value basis Android beats it. We took Google Play Store revenues (where Google’s 30% cut is worth about $7.7b) and added the dollar amount we estimate Google saves in Traffic Acquisition Costs by owning default search on Android ($4.8b), to reach an estimated annual revenue contribution to Google of $12.5b from the diminutive robot OS. Android also takes the award for largest ROI multiple: >1400x. Yep, you can’t eat IRR, but that’s a figure VCs only dream of.

Android
Season 1, Episode 20
LP Show
9/16/2016

3. YouTube

Total Purchase Price: $1.65 billion, 2006

Estimated Current Contribution to Market Cap: $86.2 billion

Absolute Dollar Return: $84.5 billion

We admit it, we screwed up on our first episode covering YouTube: there’s no way this deal was a “C”.  With Google recently reporting YouTube revenues for the first time ($15b — almost 10% of Google’s revenue!), it’s clear this acquisition was a juggernaut. It’s past-time for an Acquired revisit.

That said, while YouTube as the world’s second-highest-traffic search engine (second-only to their parent company!) grosses $15b, much of that revenue (over 50%?) gets paid out to creators, and YouTube’s hosting and bandwidth costs are significant. But we’ll leave the debate over the division’s profitability to the podcast.

YouTube
Season 1, Episode 7
LP Show
2/3/2016

2. DoubleClick

Total Purchase Price: $3.1 billion, 2007

Estimated Current Contribution to Market Cap: $126.4 billion

Absolute Dollar Return: $123.3 billion

A dark horse rides into second place! The only acquisition on this list not-yet covered on Acquired (to be remedied very soon), this deal was far, far more important than most people realize. Effectively extending Google’s advertising reach from just its own properties to the entire internet, DoubleClick and its associated products generated over $20b in revenue within Google last year. Given what we now know about the nature of competition in internet advertising services, it’s unlikely governments and antitrust authorities would allow another deal like this again, much like #1 on our list...

1. Instagram

Purchase Price: $1 billion, 2012

Estimated Current Contribution to Market Cap: $153 billion

Absolute Dollar Return: $152 billion

Source: SportsNation

When it comes to G.O.A.T. status, if ESPN is M&A’s Lebron, Insta is its MJ. No offense to ESPN/Lebron, but we’ll probably never see another acquisition that’s so unquestionably dominant across every dimension of the M&A game as Facebook’s 2012 purchase of Instagram. Reported by Bloomberg to be doing $20B of revenue annually now within Facebook (up from ~$0 just eight years ago), Instagram takes the Acquired crown by a mile. And unlike YouTube, Facebook keeps nearly all of that $20b for itself! At risk of stretching the MJ analogy too far, given the circumstances at the time of the deal — Facebook’s “missing” of mobile and existential questions surrounding its ill-fated IPO — buying Instagram was Facebook’s equivalent of Jordan’s Game 6. Whether this deal was ultimately good or bad for the world at-large is another question, but there’s no doubt Instagram goes down in history as the greatest acquisition of all-time.

Instagram
Season 1, Episode 2
LP Show
10/31/2015

The Acquired Top Ten data, in full.

Methodology and Notes:

  • In order to count for our list, acquisitions must be at least a majority stake in the target company (otherwise it’s just an investment). Naspers’ investment in Tencent and Softbank/Yahoo’s investment in Alibaba are disqualified for this reason.
  • We considered all historical acquisitions — not just technology companies — but may have overlooked some in areas that we know less well. If you have any examples you think we missed ping us on Slack or email at: acquiredfm@gmail.com
  • We used revenue multiples to estimate the current value of the acquired company, multiplying its current estimated revenue by the market cap-to-revenue multiple of the parent company’s stock. We recognize this analysis is flawed (cashflow/profit multiples are better, at least for mature companies), but given the opacity of most companies’ business unit reporting, this was the only way to apply a consistent and straightforward approach to each deal.
  • All underlying assumptions are based on public financial disclosures unless stated otherwise. If we made an assumption not disclosed by the parent company, we linked to the source of the reported assumption.
  • This ranking represents a point in time in history, March 2, 2020. It is obviously subject to change going forward from both future and past acquisition performance, as well as fluctuating stock prices.
  • We have five honorable mentions that didn’t make our Top Ten list. Tune into the full episode to hear them!

Sponsor:

  • Thanks to Silicon Valley Bank for being our banner sponsor for Acquired Season 6. You can learn more about SVB here: https://www.svb.com/next
  • Thank you as well to Wilson Sonsini - You can learn more about WSGR at: https://www.wsgr.com/

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Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)

Ben: Welcome to season 8 episode 5 of Acquired, the podcast about great technology companies, and the stories and playbooks behind them. I’m Ben Gilbert, a co-founder and managing director of Seattle-based Pioneer Square Labs and our venture fund, PSL Ventures.

David: And I’m David Rosenthal, an angel investor based in San Francisco.

Ben: And we are your hosts. Let’s talk about the 10 most valuable companies in the world. The first nine are tech companies. There’s the big five in the US, plus Tesla because it’s 2021. And then you have Tencent and Alibaba from China. The ninth, TSMC, the Taiwan semiconductor manufacturer. And the tenth, the only non-tech company, it’s a 182-year-old company that started as a textile mill in New England, Berkshire Hathaway.

As most listeners know, Berkshire is far from a textile mill today. It is a holding company, unique in every way, and by far the most successful in history. A few of the companies that they own outright include Dairy Queen, Duracell, Fruit of the Loom, Geico, NetJets, See’s Candies, and even Brooks Running Shoes.

David: Seattle company, right?

Ben: Oh yeah, and I’m super loyal. I’ve ran up Mt. Si the other morning.

David: Nice.

Ben: They also own large pieces of many of your favorite publicly traded companies including Amazon, Johnson & Johnson, Coca-Cola, American Express, Kraft Heinz, Verizon, GM, Mastercard, Snowflake, and now they even own over $100 billion of Apple stock.

Somehow, the man behind it all—Warren Buffett—has claimed that purchasing Berkshire Hathaway was the biggest investment mistake he had ever made. And for many of you, you’re probably learning that Warren Buffett purchased Berkshire Hathaway and it was not something that he founded, which is the first takeaway from this episode.

David: We will cover this again much later in the episode, but he claims that purchasing Berkshire Hathaway cost him $200 billion in opportunity cost.

Ben: When you compound something over 50 years, you can come up with some large numbers. What the heck is this company? How did it come to be? Why is it that even at an all-time high for the stock, so many analysts think it is underpriced today? To do this right, we are going to need more than one episode, even an Acquired-sized episode. So welcome to our first part of our two-part series on Berkshire Hathaway.

In this first part, most of it won’t even be about Berkshire the company. It’s about the man, Warren Buffett, and his mental iterations and learnings that would shape what Berkshire would come to be.

People always try and reduce what Buffett does to a simple strategy or even a few pithy quotes. In reality, Warren has learned, adapted, and reinvented his strategy at least four distinct times over the decades. In doing the months of research to prepare for these episodes, David and I both learned just how much Warren’s thinking evolved to create the absolutely unreplicatable juggernaut that Berkshire Hathaway is today. In this episode, we bring you the story of Warren Buffett, the learning machine.

Are you an Acquired Slack number? If not, what have you been waiting for? It is a stellar community discussing all things Acquired, recent episodes, but more importantly, it is just a genuine, smart group of people having a thoughtful, nuanced, and respectful discussion about the tech and investing news of the day. You can join at acquired.fm/slack.

Today, for our presenting sponsorship from our friends at Tiny, we have something a little bit different for you. As many of you know, Tiny has been referred to as the Berkshire Hathaway of the Internet. It’s quite a compliment. They have embraced this (and who wouldn’t), and David and I decided that we want to tell you—actually this is with Tiny’s permission, so thanks to the Tiny guys for bearing with us here—about a very different product that they sell at berkshirenerds.store.

This is what I love about these guys. The fact that they would do this really shows you the personality behind who they are, so let’s navigate over to that, David. I’m going to pull up berkshirenerds.store here in my browser. The title is, ‘Warren and Charlie, in bronze at last.’ You can buy a bust of either of them. They’re the same price, which I thought was a very classy decision, $1299 per bust. You can get the complete set there for $2598. It’s a steal.

David: Like Warren, you got to save every dollar.

Ben: Absolutely. Think about what those $2 could be compounded over 50 years. The site is wonderfully designed. They have FAQs, such as will my bust give me investment advice, where do you ship to, can I return my bust, and what is the Charlie Munger, which of course, if you click it, it says, “I’m sorry, but this site isn't for you. Please leave.”

There are some wonderful photography. You can just feel how these busts could look in your office. After listening to this episode, if you’re like, gosh these guys really changed my life, I suggest you head over to berkshirenerds.store and pick up one of these.

David: These things are amazing. berkshirenerds.store is basically like the See’s Candy of Tiny.

Ben: You think this is their cash flow business?

David: It’s esoteric. You wouldn’t think that a little candy store would generate $1.65 billion in pretax profit to be redeployed within the business, but there it is.

Ben: I suppose if Warren can keep a clipping of the Black Friday crash on his wall, then we should all keep a bust of Warren in our office to remind us of sage lessons that we want to remember, too.

David: Or Charlie. Which one of us is which?

Ben: That’s a good question.

David: I think we should each get one.

Ben: Charlie I feel is kind of the color guy, so I would probably get Charlie.

David: I kind of want Charlie. Okay, I’ll be satisfied with Warren.

Ben: Anyway folks, head over to berkshirenerds.store. Thank you to the good people at Tiny for bearing with us when this is the ad read that we wanted to do for this episode today. As always, if you are contemplating a sale or even wonder what it might look like for the future of your wonderful Internet business, you should reach out, tell them that Ben and David from Acquired sent you. You can learn more at tinycapital.com or click the link in the show notes.

Lastly, to keep this short and sweet, if you are not an Acquired LP, you really should just become one. Aside from all the things that we tell you every episode about the LP program, we just did a really cool new thing we called community Q&A with the founder of Levels, Josh Clemente, after we had him on the show. We thought, wouldn’t it be cool to let all the LPs pepper him with questions and interact with him? That was super fun. If you missed it, you can check out the recording in the LP Google Drive. If you are not already a limited partner, you can click the link in the show notes or go to acquired.fm/lp. Cannot wait to see you in there.

David, I think we are ready to do it. Listeners, as always, the show is not investment advice. Like Warren Buffett, we would never profess to give you investment advice. All of our best ideas we will keep a deep dark secret—maybe until long after we’ve executed them—so we can tell the world about our wonderful investments. David and I may have investments in the company that we discuss. The show’s educational, for entertainment purposes only. We hope you enjoy it. Without further ado, David Rosenthal, where are we starting the story?

David: I’ve been a proud Berkshire Hathaway shareholder of the B, not the A, for pretty much my entire life. The greatest thing that my parents and grandparents gave me was a few shares of Berkshire B when I was a little tyke. Never sold them.

Ben: Very smart investment on their part. What’s your sell date on them? Where are you exiting the position?

David: Never.

Ben: As it should be.

David: Before we dive into history and facts, we owe a big, big, big thank you to Alice Schroeder and her wonderful book, The Snowball, which I (at least) used as my main source for this episode. Ben, you read the…

Ben: Buffett: The Making of an American Capitalist, a great book by Roger Lowenstein. I thought this book was awesome. People talk about Snowball all the time as the sort of more popular Buffett biography. I thoroughly enjoyed this book, so I think you can’t go wrong.

David: Yeah. We’ll get to compare and contrast as we go here. Alice’s own story’s pretty amazing. I didn’t realize until looking this up. She was an equity research analyst on Wall Street covering insurance companies, and she wrote to Warren in 1998 asking to talk to him. Warren had never talked to Wall Street research analysts before, but for some reason he takes her call. She was the first research analyst to initiate coverage on Berkshire. Kind of amazing.

Then in 2003, another author approached her about writing a book together on Buffett. She talks to Buffett and he says, well why don’t you just write it instead and I’ll give you full access, like thousands of hours with him. It’s amazing. Amazing story, so definitely go check out both The Snowball and Buffett. Great books, highly, highly recommend.

Ben: And listeners, we’ll have to see how this goes. This is the second time, I think. The New York Times would have been the first one, but David and I both just read separate books. I think we both read them cover-to-cover. Obviously, we’ve got a few dozen other sources that we use for this as well, but we may have stories that one or another does not know about.

David: Yeah, we shall see. I’ll go first and start appropriately enough back in 1867, with a journey from New York to Omaha undertaken by a young gentleman named Sidney Buffett, who was working for his father’s farm in Long Island. He quits because he feels like he’s not getting paid enough. Like so many young men of his generation, he decides to go west to seek his fortune, and he ends up in Omaha, Nebraska.

Ben: He got part of the way west.

David: Part of the way west. I think his maternal grandfather was already there in Omaha, that might have been why he headed there, but the other reason was that Omaha was a boom town at the time. It had existed for a long time. It was kind of a pit stop on the trail west, the Oregon Trail or the California Trail for gold prospectors heading out west.

After the US civil war, Lincoln decrees that Omaha is going to be the headquarters of the new Union Pacific railroad, which is going to connect up the West Coast of the United States with the rest of the country. And the town takes off. Now interestingly, Union Pacific is still around and operating today, ironically as the second largest rail company in America, after Burlington Northern Santa Fe, owned by Berkshire Hathaway. But that wouldn’t come until part two.

Sidney gets to town and decides he does want to be a farmer anymore. He instead wants to sell products from the farm. He opens up the first grocery store in Omaha. He runs it and then effectively passes it on to his son. His son, Ernest Buffett, (I think) actually technically set up a different story, but it’s like the family business, so Ernest is running the legacy of the grocery store in Omaha. As Alice points out in The Snowball, Ernest was very, very aptly named (as we’ll see), under Ernest management of the store, his quote that he likes to use is, “The hours are long, the pay is low, the opinions cast in iron, and the foolishness is zero.”

Ben: Hardcore.

David: Yeah, hardcore. Typical of this new entrepreneurial middle class, Ernest and his wife, Henrietta, were fine with their children working in the store, but they want them to get a good education and become professionals. Most of their children go to the University of Nebraska, including their third son, Howard, who majors in journalism and works at The Daily Nebraskan school newspaper.

While he’s working there, he meets a freshman who comes in and is applying for a job, Leila Stahl, whose father owned a local newspaper in Nebraska. They meet, they hit it off, they marry. Of course, these are Warren’s parents that we’re talking about, and amazingly they meet at the college newspaper. Very fitting. The newspaper business is going to play a large part in young Warren’s life to come.

Howard graduates in 1925, he and Leila marry, and as was typical of the time, unfortunately she drops out of school. By all accounts, she was an incredibly promising student, very good at math. Her professors were very disappointed when she drops out to marry Howard and become a housewife.

Howard wants to go into journalism and eventually politics, but Ernest is having none of it. His son needs a respectable, professional career; the no-nonsense Ernest. He instead suggests that Howard might want to do something more useful, something more like selling insurance. The ironies just continue to mount here.

Ben: We’ve got newspapers already. We’ve got insurance already. Either Berkshire Hathaway basically has an index on the American economy, or the forces that would then shape, bore, and forever are already playing a role in his life.

David: They’re already stacking here.

Ben: Probably some of both.

David: Maybe more the latter because there’s one more chip to stack. Howard—he’s an insurance agent selling insurance, in the late 1920s now, it’s the roaring 20s and its go-go time—after a couple years, decides maybe this insurance stuff is pretty boring. Either my customers here in Omaha don’t want insurance anymore. They want stocks.

He switches careers, two years out of school, and goes from selling insurance to being a stockbroker in Omaha. I didn’t understand this up and have been thinking about this. You hear about stock brokers. What does it mean to be a stockbroker in Omaha in 1927? You got to remember, there’s no Charles Schwab. For one, Schwab was hugely innovative.

Ben: How are you brokering stocks if you’re not on the floor?

David: There’s the New York Stock Exchange in New York, but for the rest of the retail public in America, how did they get stocks, you’ve got a local broker who is your sort of like combination financial advisor plus exchange access. You call your broker, or more often he calls—it was always a he at the time—you and would say, hey I’ve got this great stock that you might want to think about getting into. I know you and your portfolio, your investment objectives. You chat on the phone with him for a while or you go to his office, then you would sign up and you would buy shares. He would then call the exchange back in New York, get a trader on the line, and then buy in your name some shares.

Ben: Oh, so they would get a trader on? It wasn’t like the brokerages bought these big blocks and then they would sort of sub. Your broker would call a trader on the floor to execute your trade?

David: I think it was kind of both if you wanted a specific trade to happen. But more often what would happen was the big banks, financial firms, and trading houses in New York have product that they needed to move. They had issuances that they needed to move. They had trades that they were doing. They needed counterparties to the trades. All these local stockbrokers distributed throughout the country were like the distribution and sales force. There are people who talk about sales and trading back in the day and are part of investment banks. The sales part of it was an effort to educate all these local brokers to then recommend and push stocks to the clients.

Ben: Pretty fascinating, and at this point in history, investing isn’t really like a profession with a lot of science behind it. It’s kind of looked at as gambling, like buying stocks?

David: Totally. Fundamental analysis does not exist yet. Exactly gambling is the right word. It kind of like tickets to bet on a horse, like oh, I like the name of this company or I like what they’re doing, but nobody’s thinking about what’s the capital structure of this company or its revenues, where’s its growth prospects. That’s not how this works.

Later in life as we shall see, Warren would do a brief interlude working for his father at the firm as a stockbroker himself. He called what they did equivalent to being a “prescriptionist” versus being a doctor. It would be like if you were a medical professional and you got paid based on the type and amount of pills that you prescribe to your patients versus the actual outcomes because you’re just getting paid by the commission on every stock that you sell. The incentives are totally misaligned.

Ben: You’re making me pull for my first playbook theme already. Warren’s not even born yet in this story, but this will ultimately be one of his very first realizations. What is the point of me researching the crap out of these companies and picking stocks when all I’m getting paid for is just to move product? Like you said, it’s a total incentive misalignment. But let’s stick on Warren’s father.

David: Okay, so Howard (1927) switches over to becoming a stockbroker. Things are really great, the family is doing great for two years, and then October 29th, 1929. I don’t think we talked about this on the show yet.

Ben: Amazingly no. We’ve made 150+ episodes without talking about Black Friday.

David: Black Tuesday.

Ben: Black Tuesday, oh.

David: Black Friday is a much happier event. A real capitalism-fest. It’s not a capitalism-fest on Black Tuesday.

Ben: America has left its mark on me. All right, so Black Tuesday.

David: Black Tuesday. Of course, we’re talking about the stock market crash on Black Tuesday. I think it actually wasn’t that bad by modern standards. I think the Dow dropped in the low teens maybe percentages on Black Tuesday but it was still shocking to people. The real problem is over the next three years after Black Tuesday. The market loses 90% of its value. Can you imagine that? That’s—

Ben: Unbelievable.

David: I mean in 2008, I think the market lost close to 50%, maybe, but 90% people were just wiped out. It’s carnage.

Ben: The way that it’s described in Lowenstein’s book, what was unique and remarkable about the Great Depression, was that even the smart money got wiped out. The people who realized things are cheap now the crash is over would buy, and even they lost all their money. Of course, that is the thing to fear when everyone’s screaming ‘buy the dip.’ Of course, that hasn’t happened to this level, as you’re saying, since 1929 but just crushed everyone.

David: To grossly oversimplify what at least I think happened and why it hasn’t fortunately happened since is the stock market crashed and that led people to panic. That led to runs on banks. People wanted their cash out of banks. Banks were not nearly as institutionalized as they are now and there was no FDIC insurance. That was put in place after the crash.

When the runs on the banks, that led to bank failures. When all these local banks failed, the Fed had to (I think) raise interest rates because borrowing was so hard now that there’s so much less capital base available to borrow. The interest rates have to go up. You’ve got an economic shock and interest rates are going up.

Ben: You want to be able to lower them.

David: Right. When Coronavirus hitm the Feds slashed it to less than zero, and the same thing in 2008. It’s a double whammy of economic shock plus major interest rate hikes. It was more than a decade really until World War II. The stock market, the Dow wouldn’t return to its high before the crash until 1954. That’s 25 years. That’s a quarter of a century just lost. Crazy.

Okay, so back to Howard and the Buffetts. Howard does something pretty crazy. It’s bad. Warren is born less than a year after Black Tuesday. On August 30th 1930, Warren Edward Buffett is born. The next year—it wasn’t until 1931—Howard was working as a stock broker for Union State Bank and the bank fails. Not only is Howard out of a job, but all the family’s money’s at the bank. They got no money, they got no job, and Howard and Leila now have two kids.

What does Howard do? He does the 100% total contrarian move. First, he does try to go to his father, to Ernest, and get a job at the family grocery store. Ernest was like, I don’t have any money to pay you. I can’t employ you. Howard sets up his own stock brokerage firm. We’re in the middle of the Great Depression after the crash, and he’s just like, well I know how to be a stockbroker. He was not totally crazy because the world is melting down, but for anyone who does still have some wealth left, they need something to do with it. They’re not going to put it in the stocks that they were in before the crash.

Howard has this business plan. He starts going around Omaha to anyone who still has any wealth left, and he advises them on hyper conservative investments that they can use their capital for select utility companies, municipal bonds, that kind of stuff, and it works. There’s actually demand for this kind of service. He’s placing all these hyper conservative securities. He ends up making (I think) pretty quickly way more money than he was making at the old job.

Ben: Wow. I didn’t realize that he broke out on his own there and started his own brokerage.

David: Yes, started his own brokerage. It would eventually come to be known as Buffett and Falk. Even though Warren has no memory of this, of these two years of really hard times, the family actually skates through the depression fairly well off.

Ben: His dad bought the dip.

David: Exactly. Unsurprisingly to anyone who’s heard of him—probably everybody listening to this podcast—Warren turns out to be an extremely mathematical kid. He’s always counting things. He’s counting bottle caps, he’s counting his weight, he’s running all sorts of analysis even as a little kid.

Ben: Did you see he was counting the occurrences of letters in newspaper articles, and then he and his friend would tally them up and make bets on which letters were going to appear more often than others? He was counting completely arbitrary things just to count them.

David: You might say that he has some budding OCD developing in his person.

Ben: He was writing down license plates that went by. It was hardcore.

David: It was hardcore. Famously as the story goes—there’s actually a picture of this—for Christmas when Warren is 6 years old, he receives one of those money coin changers that you wear on your belt, like the old style. I actually had one of these too when I was growing up.

Ben: Me too. I got one from my grandpa.

David: Amazing.

Ben: With the little crank that you push down, the little lever.

David: Yup, and then it spits out one coin at a time. Then there is the separate slot for quarters and dimes, for nickels and pennies. That thing was so cool. Warren gets this and he becomes obsessed with it. This is the culmination of counting, collecting things, analyzing, and money. He wants to get as many coins as he possibly can to stuff into this thing. He starts keeping jars in his drawers. It’s amazing.

He starts to think, how can I get more money? He goes (I assume) to his grandfather to the grocery store, buys packs of gum in bulk, and then he starts going around door to door in the neighborhood and selling individual packs of gum to mothers in the neighborhood for 5¢ a pop. Amazing. He gets this racket going. Then he starts selling soda door to door.

Ben: Didn’t he, on a vacation, goes and buys some Cokes and he’s wandering around the edge of a lake selling Cokes for twice as much as he bought them for?

David: I don’t think this was in The Snowball.

Ben: Yeah, it’s exactly that. And it was Cokes. I remember that. Despite his soon-to-come Pepsi addiction, his earliest childhood sales came from Cokes.

David: Amazing. So he’s starting to accumulate the beginnings of the Warren Buffett wealth. When he’s 10 years old, Howard takes him on one of his trips to New York and to Wall Street. This amazing; you probably have read this, too. Warren actually gets to meet the legendary Sidney Weinberg who was the head of Goldman Sachs at the time. He’s 10 years old. Warren Buffett’s 10 years old and his dad takes him to meet Sidney Weinberg.

Supposedly, Warren’s sitting there starstruck the whole time, and as they’re leaving, Sidney supposedly turns to him and says, what stock do you like, Warren? Unfortunately, The Snowball, Alice doesn’t say what Warren responds. I want to know what the hot pick is. But he’s totally starstruck. This makes a huge impression on him.

Before they come home after the Weinberg meeting, his dad takes him to the New York Stock Exchange, the building for lunch. It was great, amazing lunch in this gilded building. After lunch, a waiter comes up to the table with a tray that has all of these different types of tobacco on it and rolling papers for cigars. Warren realizes that after lunch at the exchange, you get a custom cigar made for you. You choose the tobacco. He has no interest then or ever in smoking a cigar or even in any of these trappings of wealth, but he realizes if this is how they roll at the New York Stock Exchange every day, there must be so much money here. I got to find a way to get me some of this.

Ben: Did you know if he got to see the trading floor as a 10-year-old?

David: I think so.

Ben: Have you ever been?

David: No. Have you?

Ben: Yeah. When I was 16 or something, I went as part of a high school trip. There was someone who had taken a class that I had previously taken who worked at the stock exchange and got us in. We went on the balcony and all that. It leaves a mark. Looking out at this, this would have been 2005 or 2006, something like that, so it was mostly already computers and you don’t have people making every trade live on the floor the way you would’ve in those days. But even that leaves an impression especially as a teenager how much gravitas there is there. That that’s the central clearing house of equities in our nation. That’s an impactful experience.

David: It’s capitalism there incarnate. To this trip and the wealth that he sought at the stock exchange and at Goldman, he says he didn’t have any desire to have any of the fancy stuff, but he says he did want independence. He said, “I realize wealth could make me independent. Then I could do what I wanted with my life. And the biggest thing I wanted was to work for myself. I didn’t want other people directing me. The idea of doing what I wanted to do every day was important to me.”

Ben: That’s certainly happened.

David: It certainly happened. It just resonates so much. I feel exactly the same way. When he gets home, he decides that he’s going to set a goal to amass this wealth that’s going to get him the independence that he wants. He tells all his family and friends that his goal is he’s going to be a millionaire by the age of 35. Being a millionaire in those days would be equivalent to about $15–$20 million in net worth today.

Today, anybody can do it and it’s great. Even our entrepreneurial, startup-friendly ecosystem, it’s probably not totally crazy if a little kid said that they wanted to amass a $20 million fortune by the time they were 35. In Omaha in 1940 this was totally nuts.

Ben: I’ll bet. It reminds me so much too when he would say several times throughout his life—I’m going to paraphrase because I don’t have the exact quote—that he doesn’t want to be rich to be rich. He wants to have a lot of money because it’s fun to have a lot of money and it’s fun to watch it grow. You can sort of already see that in his ambition here is not to make some specific impact or to get to do a certain thing to see his passion for it. It’s, no, I want to be a rich person. It’s fascinating how even so early in his life he’s just unabashed about that.

I think we’re talking to every founder right now that’s going out. Fifty percent wants to be rich and 50% wants to accomplish the mission that they’re on. They’re like, I’m here to accomplish the mission that we’re on because we’ve all had it browbeaten into us. It is not virtuous to want to be and he’s like, no, I want to be a rich person. Later in his life he would also decide, I want to be likable, I want to be an icon for America, I want to be a platform for learning, I want to teach, but at this point he’s like, I want to be a rich person.

David: I just want to be rich, yeah. It’s kind of amazing. Even the 50% of people and vendors out there who do just want to be rich would never say that.

Ben: Right. It’s a very Buffett sort of singular focus, and frankly not caring about what other people think of him to just have that out front.

David: Yes, just come out with it. This is pretty amazing. He’s 10 years old, he has this goal, and he figured something out at the age of 10 that just drives the entire rest of his life. I think it’s something that 99.9% of people out there in the world never figure out, which is this concept that money can create more money, which obviously compounding, which we’ll spend most of the rest of the next several hours here and several hours on the next episode talking about, but he figures this out. It just simply reduced to them; money can create more money.

The way he figures it out—the story goes—he had gone to the library and taken out a book called One Thousand Ways to Make $1000. One of those books that could only exist in the 1940s and 1950s. One of the 1000 schemes that it describes in the book is that you could buy a penny weighing machine. These things used to exist. They’re scales in public that would be on street corners, drug stores, and stuff. You would weigh yourself on it.

Ben: I’ve seen these in my grocery stores.

David: Yeah, and you pay a penny. You put a put a penny in the slot and then you’ll get to weigh yourself. The scheme in the book is that you just go buy a penny weighing machine, then you collect the money over time, and eventually you’ll get $1000 out of it.

Warren reads this and he’s like, wait a minute. What if I buy one weighing machine, then once I earn enough money from it I use that money to go buy another weighing machine, put in a different spot, and then I’ve got these two weighing machines both earning pennies every day. Well, the rate at which I’ll earn enough to buy my third weighing machine is going to be half as much time. And by my fourth weighing machine, another third is less time. He figures this out. He apparently literally starts writing out essentially compound interest tables in his bedroom in his notebook, dreaming about all these weighing machines that he’s going to have.

Ben: It’s so crazy.

David: Amazing. Other kids would be thinking about using all this money to buy bubble gum, baseball cards, or something.

Ben: And he’s 10. I knew that later as he gets into his teenage years, he’s got a little pinball servicing business, but he’s 10. That’s crazy.

David: Yeah, so you alluded to. He never does do the weighing machines, but when he’s in high school, yeah he buys—

Ben: Oh, he actually didn’t end up buying. He just does the formulas to see what it would be?

David: No, he just does the formulas, but he does buy used pinball machines in high school. He makes a ton of money off these things. He puts them in barbershops. It’s great.

Ben: Do you know why he got out of that business? The pinball?

David: No. I assume just because he graduated high school.

Ben: No. This is a callback to our Nolan Bushnell episode. Warren found out that this was a business that if you get too powerful in it, then you start having to contend with the mafia for who’s getting a cut of doing that servicing. He basically was like, I don’t want anything to do with that, and he and his friend got out of that business.

David: Wasn’t Nolan saying something about the pinball machines were linked to bootlegging too during prohibition?

Ben: Bootlegging, money laundering. They’ve got sort of a storied history there that would then bleed into arcade games, too, because I think it was an outcropping of the other?

David: That’s right. These are during Warren’s less scrupulous early years.

Ben: He had this whole game too that he was running, where he and his friend would basically pretend that they weren’t the guys in-charge, that they work for some bigger company, so whenever they’d get harassed for something, or they would complain about prices or something like that they would say, look, we’re just the hired hands. We’re not the guys in-charge. We don’t set the prices. That’s such a good bit.

David: So great. The other thing he does when he gets back from the New York trip is that he starts buying stocks. He’s got his dad the stockbroker right there, so he’s got the line and he can go buy stocks. He convinces his big sister Doris to pool all of their money together—they’re about $200–$250 between them—and he decides he’s going to buy preferred shares in a company called Cities Service. He’s the (sort of) managing partner in this partnership.

They buy 6 shares for $38 a share and immediately the stock goes down to $27 a share, so not an auspicious beginning. Doris is freaking out about this and Warren feels horrible; it’s eating him up. The stock does recover at $40 a share and Warren just unloaded. He’s like, great get the money back. Give Doris her money back. But it keeps going. Pretty quickly, the stock goes to over $200 a share, but Warren had already unloaded.

Ben: This is like me and Bitcoin in 2015.

David: This is exactly like 10-year-old Warren. Ben, if only you’d learn these lessons at age 10.

Ben: Blew it.

David: The incident makes an impression on him. He says he learned three lessons from this. I think he actually only learned one, but the first that he says he learns is don’t fixate on the price you paid for something; it’s irrelevant. The second is don’t rush to grab a small profit. Stay focused on the big, long-term wins. The irony is he would violate rules one and two many, many, many times until he was about 40 years old (as we shall see). But the third lesson he does learn, which is that you can’t control other people’s emotions around money. If you’re going to take money from anybody, you need to make sure, (1) that you’re not going to lose it.

Ben: And he’s talking about his sister here.

David: He’s talking about his sister, yeah. And (2) that you need to do something to manage their ability to affect you so that they don’t freak out and cause you to do uneconomic things. Warren might have sold it $40 anyway but certainly that his sister was breathing down his neck to sell. It reminds me of early Sequoia days and Apple. Warren decides it’s best if the clients don’t see how the sausage is made, so to speak.

Ben: Which would absolutely inform his perspective on some of the partnerships he would do in the near future where he would not tell people the stocks he was buying on their behalf. I remember reading those words and being like, what? This is a blind undisclosed pool that he’s running, but it’s so easy to see how these early experiences make him realize, yeah if you want to be the completely independent free thinker that you are doing your own fundamental analysis and not moved not only by the current price that things are trading at but the the emotions of your investors or the demands of your investors for their tax consideration or for whatever reason they want to withdraw funds, then you better figure out how to hold and manage money on your own terms.

David: Totally. Meanwhile, shortly after the New York trip, Howard’s career takes another turn. Pearl Harbor happens and the US enters World War II. Howard is a staunch isolationist.

Ben: Define that for us, like xenophobic, anti-trade, anti…

David: It’s unclear to me if he was xenophobic. He probably was. I wouldn’t imagine he was the kind of person who love foreigners, but he was certainly very against America entering the war. He hated FDR and Roosevelt. He was a diehard Republican, as apparently were many people in Nebraska at the time, because he runs for Congress inspired by the US entry into World War II—which you think is the worst thing that has ever happened—and he wins. The family moves to Washington and Howard becomes a US congressman.

Warren, though, hates it. He wants nothing to do with Washington. He loves Omaha, he wants to go back, so he campaigns his family to let him go live with the grandfather, with Ernest, back in Omaha. Warren’s like, this going to be great, me and gramps are going to become industrialists, were going to be partners, buddy buddy, we’re going to like the Rockefellers and the Morgans, this is going to be great.

He moves back, lives with his grandfather, and Ernest puts him to work in the store as a stock boy. Warren like, wait a minute. I thought we were partners here.

Ben: Yeah. I like the business you’re running. I don’t so much like the work that I have to do inside of it.

David: Yup, so manual labor, stocking the shelves, extremely low pay. Warren’s like, this sucks. I had to get out of here.

Ben: Did you read too that his grandpa was withholding a penny or two each day to simulate social security? To show Warren what it was like to have to pay different levels of taxes?

David: So great. Ironically, somebody else would feel the exact same way about working for Ernest Buffet a few years earlier, though they would not intersect; one Charles Thomas Munger.

Ben: So crazy. How nuts is it that Charlie Munger worked for Warren’s grandfather in the same job that Warren did a few years later, and they never met until their thirties? Something like that.

David: Yeah, until 1959. They never met.

Ben: Wild.

David: Crazy. After this summer that Warren thought would be his future industrialist summer, he’s like take me to Washington. I got to get out of here, get out of the store. He goes with the family to DC where he devises a new way for making money to earn his fortune. He gets a paper route delivering The Washington Post.

Ben: Amazing. Beautiful foreshadowing when he can profess that, I rose all the way from paperboy to chairman, albeit with some leaving, the coming back, and between. It’s an amazing journey.

David: An amazing journey, and he would later become the chairman of The Washington Post and partner to Kay Graham. Was Warren the chairman? I think he was the chairman and Kay was the CEO.

Ben: I think that’s right. He got a board seat commensurate with his investment. I think she gave him the chairman role because she had so much respect for his counsel.

David: We’ll hear more about that in part two to come. He’s got this paper route now. Remember, he was selling gum and soda door-to-door back in Omaha. It’s like, this is great. Now I’ve got literally my foot in the door to all of the housewives in Washington, DC. I deliver them the paper but I can sell them magazine subscriptions. I can sell them calendars. I could sell them all sorts of stuff. He starts an empire in the streets of the suburbs of Washington, DC.

Ben: And he’s doing crazy stuff. He’s ripping off the labels on subscriptions that I think people have put out to throw away. He was basically understanding when subscriptions would expire so he knew who to go sell what subscriptions to at what time. It’s a brilliant strategy.

David: Warren loves digging in the dirt for stuff. By the time he is in high school in Washington, he’s earning $175 bucks a month, which is more than what his high school teachers are making, and almost as much as the average US worker’s salary at that point in time, and Warren’s in high school. Totally crazy. He’s not spending any of it, of course. He’s amassed over $2000 in savings, which is the equivalent of $40,000–$50,000 today? How many highschoolers do you know that have amassed self-made almost a full Bitcoin in savings?

Ben: And how many highschoolers do you know that firmly understand what the value of that is compounded 7% every year for another 80 years? You know that Warren is looking at that stack imagining its future potential.

David: Totally. Now, he’s got some real, actual capital to invest. What does he do? He’s still buying individual stocks, still playing the stock market, but he really wants to be like this industrialist businessman. He decides he’s going to buy an actual business; he’s 15 years old.

He buys a tenant farm in Nebraska back home for $1200. He buys an active farm with a tenant on it that is working the farm because Warren’s not going to work the farm, no way. The deal with the tenant farmer is the tenant farms the land and the profits from the crops get split 50/50 between the tenant and the owner of the farm.

Ben: Half the returns to capital, half the returns to labor.

David: Yup.

Ben: And, of course, the tenant also gets to live there in addition to getting half the profits, right?

Daid: Indeed.

Ben: Warren’s first yielding asset.

David: It’s his first cash flow business. Warren graduates high school in 1947 at age 16. I don’t know, he might have skipped a grade or maybe he was just young?

Ben: It certainly sounded that way.

David: And he goes to the University of Pennsylvania’s Wharton Business School, which has probably now I still think of it as, you want to be an undergrad business major in the US or anywhere in the world? Wharton is the place to go. But it is really his dad who makes him go. He doesn’t want to go to school at all. He’s like, I already know all this stuff. I just want to get to work.

Ben: And he wants to stay in Nebraska. He doesn’t like going east. It’s never been a great experience for him. He’s only comfortable doing it because he’s like, my dad’s in Washington, so I have some family close, I’ll do it.

David: He does it. He doesn’t study, he aces all the tests, it’s sort of ridiculous. After two years, his dad loses his congressional seat and the family moves back to Nebraska. Warren uses this excuse to say, why don’t I transfer to the University of Nebraska at Lincoln? Be back closer to home. He also has something else in mind. He knows if he goes to Nebraska he can take a lot more courses, accelerate and graduate in three years, and just get out of there.

Ben: I don’t think he was loving the social scene of college. He wasn’t a drinker, he wasn’t going on lots of dates, he had his eye on the prize. For him that was making money and he frankly thought he was smarter than all of his college professors at Wharton.

David: And he probably was. With Warren Buffett, he’s not wrong.

David: He was probably pretty obnoxious about it. At Lincoln, he goes to the Lincoln Journal newspaper and he gets a job managing the country circulation, which means he now has 50 paperboys reporting to him all across the countryside in Nebraska. That’s his side hustle. He loads up on courses, he finished his degree a year early.

He’s 19 now, he’s just graduated college. He’s ready to start his business career for real. But unlike when he went to undergrad, he actually does see some value in some further education. He decides there is a graduate school that he wants to go to that would actually be worth it, and that is to go to the prestigious Harvard Business School.

He’s so sure he’s going to get in. He’s like, look, I bought my first business at age 15. I met Sidney Weinberg when I was 10. There’s no doubt I’m going to get in. He writes his application, it’s all about being an investor. He goes to his interview, he’s sure he’s going to get in, and he gets rejected.

Ben: Which Harvard Business School would forever be regretting.

David: Totally. Now, I don’t know exactly what Harvard Business School was looking for in 1947 at the time, but I think either knownst or unbeknownst to Warren, I don’t think he cared either way. I think this idea of being an investor was sort of déclassé because people were still hungover from the depression and it was wartime. I think what he wanted to do is he wanted to be like Mad men. He wanted to work for a big firm, he wanted to climb the ladder, he wanted the stability. This idea of being an investor and on your own was not what was proper at the time.

Ben: And Ben Graham is only really starting to publish The Intelligent Investor. This notion of how to analytically and from fundamentals do investing was still very much looked at as investing equals casino. We’re still not quite in the era of that being respected, and frankly most people that are doing it are pretty much hucksters, are looking to just to make their commissions on the trades.

David: And the people who are not, who are good and professionals, and fantastic at their craft (at this point time), most of them are Jewish. I assume there are probably some Jews at Harvard Business School but not a lot. And it’s kind of viewed as a Jewish profession. This is going to come up in a big way in a minute.

Ben: The anti-semitism that was running rampant at the time kind of help things.

David: Totally. Sidney Weinberg, Jewish. Goldman Sachs, a Jewish firm. They were outsiders; they were not the establishment.

Warren is shocked by his rejection from HBS. He starts looking at the course catalogs for other business schools just to like, oh man what am I going to do? He happens to see in the Columbia Graduate School of Business course catalog that there is a course taught by his heroes, Benjamin Graham and David Dodd. He’s like, holy crap. He would joke later—I assume this is a joke—he said he write a letter to them to plead his case to get into Columbia saying, I thought you guys were dead. I didn’t realize you’re alive and teaching classes.

Ben: Because he had just picked up their book. The Intelligent Investor, I think is the one he probably read and was like, this is incredible.

David: Graham’s book, The Intelligent Investor, had just come out and Warren was obsessed with it. Now, Graham and Dodd together had written and published Security Analysis back in 1934, but that was a textbook. That was an academic. I haven’t read it but it’s super thick, dense. It’s not meant to be readable. The Intelligent Investor is like Danny Kahneman’s Thinking, Fast and Slow version of case studies, distilled down for public consumption.

Ben: And for listeners out there who have read The Intelligent Investor, you’re probably thinking, wait, that was supposed to be the not dense one?

David: Different era. Warren read The Intelligent Investor. He loves it. He’s like, this is amazing. What The Intelligent Investor and Security Analysis—even more dry way before it—what they did was they espouse, hey you should think about investing in stocks systematically, based on the fundamentals of the companies that they represent, and as pieces of a business not like tickets on horse race betting here.

Ben: And they basically introduced the idea of the discounted cash flow. This is the first notion that stocks are the market cap of the company, is a representative of the sum of all future positive cash flows (or I guess all cash flows), discounted at a certain rate back to today. This sort of forcing you to look and say, does the price of the stock today reconcile with what you actually believe the business will yield or produce in its full lifetime? That was frankly novel.

David: It was. Dodd is the chair of the finance department at Columbia. But Graham is an adjunct. He’s a practitioner. Warren is just so gaga here because not only is he a professor, apparently, when he wrote this book, Graham runs essentially the first hedge fund in the world. He runs the Graham-Newman Partnership with Jerry Newman. They are a partnership that invest in stocks on Wall Street. There’s nothing Warren wants to do more than be like these guys.

Ben: I can literally go take a class from a guy who is actively employing a real investment strategy on Wall Street. Mind blown.

David: Totally. The deadline for Columbia has passed by the time he gets to figure this out. He writes a letter to Dodd and Graham, and he’s basically just begging them to let him in. Well, lo and behold, guess who at the time was chairing the admissions committee at Columbia Business School? It was Dodd. Dodd gets this and reads it. He’s like, all right. I’m just going to unilaterally let this kid come in. No interview, no discussion, no formal application. They just send Warren in and like, all right you’re in. You’re starting in the fall.

Ben: Because this is like, hey we basically see ourselves in you. No one is writing us about this thing that we’re doing, and here you are crazy excited about this super dry, relatively unrespected thing that we’re doing in the world. Yes, come join us.

David: Come join us. The fall of 1950, Warren arrives in New York City. At this point, he’s compounded his net worth up to $10,000, which is a lot of money, 5X of what it was in high school 5 years earlier. But he still can’t stand apart with any of his money. Rather than staying in the dorms at Columbia or renting an apartment, he rents a room at the YMCA for $1 a day.

Ben: This guy is truly cursed with having a firm grasp of the future value of his money compounded in the way that he feels he can get a return on it. We can talk all we want about the virtue of compounding and the eighth wonder of the world. Frankly, I feel like I have a new understanding for it based on doing all this research. It’s only now that I’m feeling the heft of what if I just put $1000 in an index fund and accessed it 50–70 years from now? You’re like, oh my god, it turns into a real big amount of money, almost no matter what.

It’s like you won’t notice, but when you’re Warren and you’ve actually done all these calculations, and all you’re thinking about all the time with a singular focus is the future compounded value of this money, how could you ever spend a dime? It truly is cursing to your lifestyle.

David: Yeah, Alice writes about that. Every time he looked at spending money, he would not see the sticker price for things. He would see it times 8, 10, or 20 of what that money would be worth in the future.

Ben: And just to come back and say it so we all have a firm understanding here, if you took that $1000 and you want to invest it for 70 years, say getting at 10% per year return on it—which would be good, that would be a very good return, I think it’s a little bit outpacing public markets—that’s $800,000 70 years from now. Seventy years from now, my money has a lot less utility to me than it does today because I will have not had it my whole life, which is the curse, but if you’re Warren and all you’re seeing all the time is that money in the future, my gosh.

David: I think that’s the difference between Warren and most normal people, too, is that money in the future probably has about the same utility to him because it’s not about what he can buy with the money. It’s just about the stack of money.

Ben: Yup. For Warren it is a score board game, not a utility of the cash game.

David: Totally. Okay, so he shows up at Columbia in the fall of 1950, signs up right away for Ben Graham’s seminar, which is in the spring semester. He’s already read The Intelligent Investor cover-to-cover, he's wearing out the pages so many times; he knows everything. But he's such a go-getter for this. He really wants to impress Graham in the seminar in the spring.

I guess Moody's and S&P put out stock manuals at that time, that was the main thing that people like Warren, Ben Graham, Newman, and everybody browse through looking for stocks. He sees that the Graham-Newman Partnership owns 55% and Graham is on the board of this little company in Washington, called the Government Employees Insurance Company. Interesting. Sounds familiar?

Ben: I mean, if Ben Graham's the chairman, surely Warren wants to know more.

David: Yeah. Well, certainly he wants to know more, but the Government Employees Insurance Company isn't mentioned anywhere in the Intelligent Investor. The rest of the Intelligent Investor is full of case studies and talking about different stocks, but they don't talk about this company there. Why is that? Warren decides, I want to go investigate. I'm going to find out more about this company, this GEICO, if you will, for short. I'm going to go pay them a visit.

He hops on the train from Penn Station, goes down to Washington on a Saturday morning. He just shows up at the office and he knocks on the door. He persuades a security guard at GEICO to see if anyone's around who could talk to him. Warren presumptuously at this time, although I guess he was signed up for the seminar and says that he's a student of Ben Graham's and Ben Graham is the chairman of the board. You might want to let me in. Somebody talk to me.

Eventually, the company's head of finance, Lorimer Davidson, is there that Saturday morning and he was like, all right kid, come on in my office. He figures, I'm going to do a Good Samaritan deed, give this kid 10 minutes of my time here. Well, it turns out that Lorimer (or Davey, as everyone called him) wasn't just a finance dude at GEICO—not that there's anything wrong with being a finance dude; I guess he was a finance dude in a certain respect. He had been an investor and a bond salesman before joining GEICO. He was a lot more like Ben Graham than just an employee at GEICO.

The story of GEICO, the founders had thought that they could make auto insurance cheaper by having commercials by selling the auto insurance direct to customers without using agents. To be as cheap as possible and have the best underwriting profile as possible, they also needed very responsible drivers. They borrowed an idea from USAA, which targeted military families for insurance. They target government employees for insurance, hence the Government Employees Insurance Company.

Ben: It's also amazing that their hunch that government employees are going to be less prone to accidents than the general public was right, that they could actually underwrite to, we can give these people cheaper premiums because they're going to be less expensive to us. That worked out for them.

David: I mean, I guess seemed like a reasonable assumption, that if you work for the government, you're maybe more conservative, less likely to drive under the influence of alcohol or who knows. Either way it worked. One of the two founders, after a bunch of years, wanted to sell, the family wanted to sell their stake and hired Davey to help find a buyer. Davey brings it to Graham, which is how Graham at the company ends up negotiating a deal to buy at a discount to the asking price, of course.

Ben: Because it was fully privately owned. It was not a public company.

David: He buys up the 55% stake the family owned for a million dollars, and then he turns around and puts Lorimer in charge of managing GEICO's own investments. Warren happened on the motherlode beating this guy. He's a Graham disciple. He runs all the investments at GEICO. Warren just starts peppering him with questions. Lorimer is super impressed. He's like, who is this 19 year old kid? They talked for four hours that Saturday morning. Davey tells Warren all about how GEICO works, how the insurance industry works, tells him about this magical thing called float. Warren has seen the revelation of, God has handed down the 10 commandments on the mountain.

Ben: You mean you have other people's money that they're loaning you for free that you can do stuff with until you need it?

David: Amd you may not even ever need it?

Ben: Well, that's an interesting idea.

David: Yeah. What is this float idea, and how does GEICO and all insurance companies work? The premiums that the customers pay GEICO for their auto insurance, that cash comes in the door on day one. GEICO’s expenses, they have to pay out claims on insurance claims later. You pay the policy premiums up front, but then when there are accidents and stuff, and then they go through court and blah-blah-blah, it could take years before you have to actually pay out any money, if you pay out any money at all.

Ben: Right. Yeah. Supposing you have a good government employee that never wrecks their car, you might just make money.

David: You might just make a lot of money to sit on and you never have to pay it up. If you manage it well, you can make investments with it. That's what Lorimer is doing at GEICO. He's using all this float to make investments. He's doing a pretty damn good job of it.

Ben: There's two things that Warren realizes this, that I never fully put together before about insurance premiums. The first is, this is a loan that someone is making you at 0% interest. You're like, well, that's a pretty good loan. I don't have to service the debt. That means that I basically can make more profits, because I don't have to take a cut of my profits every month to pay down the debt. Awesome. It's an interest-free debt.

The second amazing thing is, it's not one person that loaned me money. It's a gigantic set of thousands, or tens of thousands, or hundreds of thousands of people that are paying me money. Well, then what that means is they're predictable because that's not just somebody wakes up on the wrong side of the bed and says that they want their money back. The worst thing that can happen, save for some hurricanes to foreshadow the future a little bit is that, one person wrecks their car and maybe another person's car, but nobody's wrecking all my customers’ cars at the same time. That's the second thing that's amazing.

The third thing that's amazing, is it's not a collateralized loan. You don't have to have something in your business that warrants you being able to take on this big debt load. It’s just a big uncollateralized, interest-free distributed loan to you that you get to do something with until you need to pay it out.

David: Especially back then, there was much less regulation about capital requirements for insurance companies, and well, all financial institutions. They really didn't have to keep any cash reserves. I mean, they could do whatever they wanted with the money.

Ben: Speaking of doing whatever they want with the money, I think what was happening back then is that, as you would imagine in the early days of insurance, you would want your premiums to basically equal the amount of money that you would need to pay out in the future. What happens now is, it's assumed that you can do interesting things to earn money on the float. I didn't know this until doing the research. When you pay for your car insurance, they're actually collecting less in premiums than in total they will owe out to everyone, so you need to do something interesting with the float in order to make it so that the insurance company doesn't go under. I never realized that. I suppose that probably happens with competition where everybody's just lowering and lowering their premiums until they realize, gosh, we effectively can sell our insurance below cost because we can invest the float.

David: Yup, and GEICO's got the additional advantage which it still has to this day of, they don't employ agents. They just have a fundamentally better cost structure than all of their competitors, which means more money they get to play with.

Ben: I bet if you call these guys by going direct, they can save you some money in 15 minutes or less on your car insurance.

David: How much money do you think they could save you, like 15%?

Ben: I would imagine. I can't imagine what the cost of customer acquisition is through an agent but it seems like they could at least rebate that to you. One final flash-forward here before we go back to the story. Everyone should go to berkshirehathaway.com, one to bask in the full glory of this beautiful website. Secondly, please observe that there is a banner to purchase GEICO Insurance on the Berkshire website. It is the one thing that they do on that website other than a series of blue links to shareholder documents. It is an ad for GEICO. It's the most hilarious use of web real estate ever.

David: Hey, we have our car insurance with GEICO. It's cheap. It's great. All right, enough of this. The next Monday, Warren goes back to New York City and immediately liquidates 75% of his portfolio and loads up on GEICO, 75% concentrated in GEICO. He's in love. He thinks I'm going to show up at Graham's seminar. I will tell him about this. He's just going to go gaga, this is amazing. I'm going to be his boy. It's going to be like his dreams of Ernest back in the day. Well, he shows up at the seminar and he tells Graham what he's done. Graham is not that impressed. He's like, you put 75% of your portfolio into GEICO? What are you, nuts?

Ben: Yeah, because Graham, first of all, is not a one stock guy. He's a distributed portfolio approach guy. Second of all, I'm sure his next question was, yeah, what did you pay for it?

David: What did you pay for it? GEICO was not a typical investment for the Graham-Newman Partnership. They probably only did it because he was able to whittle a deal out of Lorimer and the family. There's a reason why it wasn't in the Intelligent Investor. Graham's whole strategy, his whole mantra, basically, he and Dodd invented discounted cash flow evaluation, fundamental analysis, all that, and what comes to be known as value investing.

But there's a major problem with what they're doing, which, honestly, this conflation that Graham had between fundamentals and value investing persists to this day. It is still why there are religious wars about value versus growth investing. He thought there was a very specific way to practice fundamental investing, what he and others called cigar butt investing

What does he mean by cigar butts? This is crude, but the analogy is that, you could be walking along the street in those days in New York, and you might see smoked cigar butts laying on the street, in the gutter, and some of them might still have a little bit of cigar on it. You could pick it up for free, not pay anything for the cigar, light it up, and maybe still be able to get a puff or two out of these cigar butts for free.

The reason why this analogy is used is that Graham's whole thing that he looked for in companies of stocks that he bought was, he wanted companies that were “worth more dead than alive.” He actually writes an article by this name. What this meant was, he looked for companies where the book value of the assets, the cash on hand, the value of their land, property, buildings, there—

Ben: If you shut the company down today, stop taking money from customers, paid out all your liabilities...

David: Stop the business, and you just sell off in a fire sale everything in the building, would you make more money from what you're selling off than what the market cap of the company is trading? That was what he looked for.

Ben: Which in that era, you could find those because he didn't have tons and tons of people whose eyes were always on the stocks, trying to figure out is anything trading below the book value that it should be trading below? You could find them pretty often.

David: Not only there were far fewer people participating in the market and far less data available, but the people who were participating were mostly handicapping horse races. They weren't thinking like this. Stocks that weren't hot, there were a lot of them out there. Graham had three big insights, he and Dodd that revolutionized investing. One was this concept that a stock is a piece of a business with cash flow profiles and going concerns and you should value it as such. Two, was that price and value are two very different things. The price of a stock at any given day, may or may not reflect the actual value.

Ben: Price is what you pay and value is what you get.

David: Exactly. You can use this to your advantage here, this concept of Mr. Market. Mr. Market comes to you every day and quotes prices for what you own and what you're contemplating owning. But he's schizophrenic, and one day I'll quote high, one day I'll quote low, but the value stays the same.

Ben: Right. It is the notion that he's your business partner in the venture, and every single day he comes to you offering to buy out your stake at a price that is either too high or too low, almost never exactly reflecting the actual intrinsic value. Every single day, you have the option to decide to sell or buy more.

David: Yup, very true. Points one and two, great, I totally agree with. Point three, I also agree with but I disagree with the interpretation. That's this concept of a margin of safety, the famous Ben Graham, Warren Buffett, Charlie Munger margin of safety.

Ben: Of course, the way that Graham wanted to apply that is buy companies that are so cheap, they are literally free of risk.

David: Yup. It makes sense. Investing involves risk as every disclaimer in history has told you and involves uncertainty, you don't know what's going to happen. Ideally, you want enough downside protection built in, that you'll do okay, no matter what. That makes sense, and you do want that. But Graham's way of looking at this, as we said, was I'm only going to buy things if we literally shut down the business and sold off everything on hand. We would get our money back or more.

There are two problems with that, both on the downside and on the upside. On the downside, as we shall see, sometimes the liquidation value of the assets of a corporation aren't worth as much as you think they are. You can try to sell off the property plant and equipment, but if there are no buyers, or no buyers at the price that you want, well, just because it says it's worth something on the books doesn't mean it's actually worth that. That's one problem.

The bigger problem, though, is that this is the ultimate small ball way of making money. Your upside is so fundamentally capped when this is how you're looking at the world. You could go to a hundred of these cigar butts or you could buy one GEICO and just hold it for 20 years, and make way more money.

Ben: Yeah, it's fascinating. The way that I have been thinking about this, I think the closest analogue is basically to gross margin in an operating business, where if you're running a tech business with super high gross margin and high fixed costs, you got to spend on the fixed costs, but then you get that gross margin forever without having to change what business you're in. If you're in the business of selling lattes, then every single time you need to go and pull a new espresso.

David: This is the stock equivalent of that analogy.

Ben: Yeah. He's in a high velocity business of constantly needing to go and buy a new security, sell it for more than it's worth, go buy another one, sell it for more than it's worth. His notion is never count on making a good sale, have the purchase price be so attractive that even a mediocre sale gives good results. But you're going to incur transaction costs every time, you're going to need to pay taxes every time, you're going to have to do the work of actually identifying what you want to buy and sell every time. It's a high COGS business.

David: Yup, and it takes a long time. Sadly, tragically, by the next year, Warren has succumbed to Graham's exhortations here. Warren sells all of his GEICO stock in 1950 to early 1952 for $15,259. He makes over a 50% IRR on it, which is amazing. But if he just held on to the damn thing, he would have made hundreds of times more of his money.

Ben: Of course, the Graham way to analyse that business is like, hey, it's actually—

David: Now trading at a high price.

Ben: Right. Its price is at or above its value, so it's time to get out. It's so interesting. I just want to take a step back for a second here and just reflect on that for a minute because this whole growth versus value thing, if you think about value in this narrowly defined concept of like, let's just keep using the cigar butt analogy, you pick up the cigar butt, you smoke it and it's done, and now you throw it away. There's all the work we talked about of identifying the cigar butt, the transaction cost of picking it up, of puffing it, of paying the tax on your gain of the puff and then discarding it, and having to go through that whole process again.

The whole notion of growth investing is, wouldn't it be nice if that cigar actually got larger and larger and larger faster than you could smoke it? Not only do you have to not incur all those transaction costs there, but if you're willing to take some risk and be smart about analyzing what risks you're going to take, the value of the business could even grow faster than the way that it's being priced in the market. That's this completely novel concept that exists outside the universe of what Ben Graham was willing to consider an investment.

David: Totally. Now, to be fair to Graham, we know he was doing all this through the depression. If you live 25 years, and the stock market is flat to down for 25 years, of course, you're going to think this way.

Ben: Yeah. Of course, we are all a product of our environment, and I think one of the phrases that is a Buffett-ism that applies to this is we've talked about the market weighing machine. If you think about a weighing machine, then it effectively equates value to price. Whatever you are spending is what it's worth. Or is it a voting machine where people are setting price and voting on the price, independent of the weight or the value of the actual underlying security? This is where the realization comes in that in the long run it is a weighing machine, but in the short run, it's a voting machine, the stock market.

David: Totally. Sometimes the short run lasts longer than you would think.

Ben: Yup.

David: All that said, cigar butt investing was still a sound strategy in the 1950s. You're in the land of the blind, the one-eyed person is king or queen or whatever. The Graham approach works and Warren is just lapping it up. He takes the seminar. Warren becomes the first and only student to ever receive an A+, in the class from Graham. Side note, also in that same class with Warren is one Bill Ruane, who was a stockbroker at that time at Kidder Peabody, and was auditing the class. He realizes this Buffett guy is going places. I'm going to become friends with him. That would pay off handsomely as we will see at the end of the episode.

After graduation, Warren wants more Graham. He can't get enough. He goes to Ben and Jerry Newman and says, hey, can I get a job at Graham-Newman? Can I work for you guys? It was a pretty small place. I think there were only six or seven people working there. They talked about it and Graham, though, turns him down and says, I'd love to hire you, you're the best student I've ever had, but Jerry and I have a pretty strict policy here, and that is that we only hire Jews. He would later recant on this and would hire Buffett in a couple of years. But it makes sense, Graham was British, I think.

Ben: This is effectively an affirmative action type comment, where he's saying, we want to make an opportunity here for those who have been persecuted and discriminated against.

David: Exactly, and this is 1952. World War II ended four years ago, and Graham was, I believe, British-European. He was born in Europe. It's a small firm, but they're like, hey, we're pretty committed to giving Jews an opportunity here. Warren is heartbroken, but not deterred. He goes back home to Omaha, decides, okay, well, if I can't join the Graham-Newman Partnership, I'm just going to set up my own partnership. I'm going to do it myself.

Both Graham and Howard—Warren's dad—talked him out of it. They both say hey, you need some experience first working for someone else before you go and do your own thing. The natural thing to do is, why don't you go work for your dad's old brokerage firm, Buffett-Falk. Warren does, and he becomes the dreaded prescriptionist working for his dad, and he just hates it. He's getting paid on commission, selling stocks.

Ben: The whole idea of, there's a roomful of people who are tasked with moving a stock and calling all their customers to say you should buy this thing. It's about the most anti-Warren Buffett thing I can possibly imagine.

David: Totally. It's like organ rejection. He's making his calls, he's doing what he has to do. He's trying to move the product, but he gets on the phone with people. He'll do whatever he’s asked to, but then he's like, hey, but there's this company called GEICO. They are an agentless insurance company, you should really consider buying that as well. People think he's nuts. An insurance company that doesn't have agents. I want to talk to my agent, that's weird. He doesn't have a lot of success.

Ben: D2C baby. They got this great website.

David: Yeah. There are two good things, though, that come out of his two-year interlude.

Ben: Actually, I am curious. How did GEICO work back then? Is it by mail? Is it by phone? Presumably the whole thing's done by phone.

David: That's actually a good question. I assume phone. There might have been some tie-in with the government agencies that, maybe there was marketing that went out to agency employees. I don't know exactly.

Ben: All right. We'll have to do a spin-out GEICO episode at some point.

David: Yeah, we will. Well, it'll come up again in part two. Don't worry. Warren gets another bite at the apple, so to speak. Two good things that come out of this little interlude back in Omaha. One, he reconnects with one Susie Thompson, whose father, Doc Thompson, was a dean at the University of Omaha and had managed Howard's political campaigns. Warren somehow persuaded Susie to marry him, which was shocking given what Warren Buffett's personality and what he was like back then.

Two, he also after dutifully working for a while at the brokerage, persuades his dad to set up the first of the Warren Buffett Partnerships with him, called Buffett and Buffett. Basically, Warren puts some of his money in and his dad put some of the family's money in, and Warren just gets some more capital under management to invest here. It's his first taste of being a principal.

Ben: Yup, and just to add a little more color to that comment you made on what Buffett was like back then and got Susie to marry him, he was and is a person of singular focus in his life. He's in his old age and started to do more things, but he was never a socialite. He was never someone that was deeply diving into other people's interests and socializing to be social. He was a person that has always wanted to invest and make money. Of course, he did set his eyes on, hey, I want to marry Susie and I'm going to make that happen.

David: Well, they're all these stories about family dinners. Even they'd have friends over, Warren would just wander off upstairs and start go reading annual reports in the middle of a dinner party. He's a wild man. All he did was invest in stocks. However, the flip side of these personality quirks of Warren are he is very singularly focused and he's very persistent. Despite the rejection from Graham-Newman, Warren continues to write letters to Ben and Jerry, constantly talking about his ideas, talking about stocks he’s looking at. He travels to New York frequently just to go see them and drop in.

After two years of this, Jerry finally sits down with Ben and he's like, we've got this anti-Semitism rule here, but maybe we should make an exception and hire this kid. He's pretty special. Ben relents. He calls up Warren. He's like, all right, you really want to come work here? Fine, we can make it happen. You don't need to ask Warren twice, he accepts on the spot.

I don't think he even talks to Susie about it, even though they have their daughter, little Susie at this point. They're living in Omaha. He just accepts on the spot, moves them back to New York at a moment's notice. He literally showed up at the Graham-Newman office a month before his initial start date. He's just like, yeah, you're not paying me this month, that's fine. I'm here, I'm working.

Ben: That's awesome.

David: Once again, he doesn't want to pay New York City housing prices, so he moves the family into a crappy apartment in White Plains, even though he's pretty rich already from everything he's been doing, and he's now working at the most prestigious hedge fund in the world. He's paying, God knows how much, $50 a month for an apartment way outside the city.

Ben: That's crazy. Is it fair to call it a hedge fund? What differentiates a hedge fund versus an institutional money manager?

David: That's a good question. I don't think really.

Ben: I don't think they're taking huge short positions or anything like that at this point in history.

David: I don't think so. I think they would, sometimes short stocks. Warren would actually, famously—I wasn't going to put this in the script—was a real pain in the ass in high school, arguably, a real pain in the ass for his whole life. In high school, he hated his teachers so much that he knew that they all had the teachers' pension mainly invested in AT&T stock. Warren went out and shorted AT&T stock, brought the slips in, and put them on his teacher's desk just to show them he's betting against their retirement funds.

Ben: Oh, and in high school, he was already seen as a savant, so that probably would freak people out. Like, what does he know that I don't?

David: Yeah. He didn't really care about people's feelings, at least when he was in high school. At Graham-Newman, unsurprisingly, he just crushes it pretty quickly within another two years. Ben and Jerry are consulting him on everything that they do. Warren's coming up with most of the investing ideas that they're doing. He's involved in every decision that the firm makes, and he's really hitting his stride.

So much so that Ben is—we're not going to get super into it—a very colorful character, shall we say, had three wives (I think), and then the story goes. I think he started up a relationship after his last marriage with the girlfriend of—this is at the end of his life—his son after his son died. He's a character. He is ready to retire. He wants to move to California and live the good life. Newman is also getting old. Jerry's getting old, he's thinking about the same. They offer to make Warren a general partner at the firm and have him essentially continue Graham-Newman. I assumed they would stay as partner emeritus or something like that. But this time Warren shocks them. He's like, no.

Ben: Remember that whole, on my terms thing that I really care a lot about?

David: Yup. He's like, I don't know. I don't want to run your firm. If I'm going to run a firm, I'm going to run my firm. I'm just here in New York to work with you guys. I don't actually like it in New York. Susie wants to be back in Omaha. I would do it in Omaha. They end up winding down the firm. Warren, Susie and little Susie, their daughter moved back to Omaha in 1956, this time for good.

Here's the plan. Tell me how well you think this is going to work. Warren's net worth is about $175,000 at this point after working at Graham-Newman for two years.

Ben: It's that a few million dollars by today's?

David: Yeah. The average yearly salary for a worker in the United States at that point is $4800, and he has $175,000 saved up in the bank account, and he's 26 years old. They have two kids now, Howie's been born. The plan is he's going to retire. He says, I made my fortune. Susie really wants me to be a father and all that, be involved at home, the small requests. All right, I think I can retire and if I set a budget that we can live on in Omaha, I'm going to enjoy the good life. This is so not Warren. He says, I think we'll set a budget of $12,000 a year. Remember the annual average income...

Ben: That's 3X.

David: Yeah, close to 3X that he will be spending every year. We'll buy a nice house in Omaha, this is huge. We'll live like kings. Also the rest of the money, that'll be compounding. It'll grow, great. It'll all be fine.

Ben: How much does he have in the bank again?

David: $175,000.

Ben: That's what, 6.8%, so that's probably about what he thinks he can generate passively by just leaving in an index fund, and so he's effectively...

David: I'm sure he thinks he can generate more because he's still going to dabble a little. He's going to do a little bit of active management just on his own capital.

Ben: Why do I feel like this didn't happen? I don't remember this part of the book.

David: No, this did not happen. Despite his retirement, he's hanging out with family and friends and stuff. They're talking to him, and all he could talk about is money. Eventually, some of these people are like, well, you want to manage my money? Warren's like, okay, twist my arm. I don't even know if he's [...].

Ben: I got some ideas.

David: Yeah, I got some ideas. He started setting up these little vehicles around Omaha with family first, immediate family, and then a few close friends to manage their money in addition to his own money that he's managing. He structures these things actually. I really like the way he structures these. Remember, these are people he really cares about, in his own Warren way. He structures them as partnerships, where there's a 4% annual return hurdle. Any returns that he generates above 4%, he as the general partner in these partnerships, keeps half of the upside of those returns.

Ben: Half? I thought it was 25%.

David: No, it's half, at least according to The Snowball. That's pretty huge. That's 50% carry effectively. But there's the 4% benchmark return.

Ben: If it underperforms 4%, then he gets no money? There's no fees, right? He's not paying himself a salary at all?

David: There's no management fee. This is why I think it's actually pretty fair and I really like the structure. He personally puts himself on the hook for a quarter of the downside. Any money lost, I think between 0% and 4% return, it's a neutral zone where nothing happens. I think if there's any capital lost, he will personally cover 25% of the losses of his partners, which are pretty good incentives.

Ben: Yeah, he's so good at incentive alignment.

Totally. Totally, and he hadn't even met Charlie yet. He's finally living the dream. He's fully independent. He doesn't work for anyone else. He has a partnership like Graham-Newman, but it's all part time. He has no employees. They're all separate partnerships. It's all friends and family. It's a little over $100,000 total in outside money, so not that much money. He does everything himself, the investing, the accounting, he files all the taxes himself for the partnerships. He has no employees, no outside services. His total expenses for doing all of this in 1956, you ready for this, Ben?

Ben: Lay it on me.

David: Amount to $22.71.

Ben: That's our accounting at Acquired where all the labor is free?

David: Yeah, totally. That's between all of the gains that he generates and taking in some more money. By the end of the year, he's managing over half a million dollars for less than $23 in cost. That's pretty good fee load on that. Word starts going around Omaha that like, hey, Warren's back in town.

Ben: Wait, let me understand real quick here. This 25% of the downside, is that GP commit where he was putting his own money in and that money was just at risk, or was he sort of like, additionally on top of that, saying, I will reimburse you for 25% losses?

David: Reimbursed. At first, I thought this was weird, but then I understood it later. He does not really put in any of his own money. He only puts in $100 into each partnership. He's keeping his own money separate, which at first I was like, well, that's weird. But I think he did that because these are friends and family. The goal is to make returns for friends and family. He's essentially making the same investments separately with his own pool of capital. Later, when he consolidates it all, he puts in all of his family's money as well. I don't think he really thought of it as a fee-generating scheme.

Ben: Right. It's just that each one of these is the pool of capital for my friends.

David: Yup. Word starts going around Omaha that Warren's back in town. He's taken on money if you want to invest with him. He can't help himself. He's loving this. He's going around town, he's meeting with everybody. He can't stop pitching. He's raising money for his retirement activities.

One family he gets introduced to is the Davis family in Omaha, the husband of which is a prominent doctor in town. They decided to invest $100,000, in this venture, after discussing amongst the family while Warren is there. Saying, Warren, you really remind us of a really bright, young man who actually grew up next door to us, now lives out in Los Angeles. You guys are the spitting image of one another. He's a really bright guy. We remember he was the smartest kid we ever knew. He's left Omaha now. He lives out in Los Angeles. We have to introduce you when he's back in town some time. Charlie Munger is his name. More on that to come in the next episode.

Ben: But it was a while. The seed was planted, but they wouldn't meet for years.

David: That was in 1956 and the dinner that the Davis' would organize would not happen until 1959. Yeah, three more years before Warren and Charlie would meet. This all goes pretty well.

Ben: Do you know the one other term that he asked of the Davis', and then he would ask for everyone else going forward after that?

David: No.

Ben: This gets to his desire for doing business his way and not having other people influence when he does distributions or anything like that. He is open for business one day of the year to his clients, and that day is December 31st. On that day, they can either take money out or put money in, but other than that, it is managed by Warren and secret. He does not have to disclose what he is buying or selling it, nor can they take money out.

David: Interesting. He obviously didn't disclose what the holdings of the partnerships were, but I didn't know that it was only that one day that you could take money in or out. Interesting. This goes pretty well.

Pretty quickly, Warren's rounded up nearly a million dollars across seven different partnerships. After the first year or so of running this, his intention with this effectively carried interest that he sets up the half, 50% of the profits above the 4% benchmark threshold. He wants to essentially grow his equity ownership of these pools. He's not going to take that money out in cash.

Ben: Of course, he's not. There are transaction costs, there are taxes. He’s Warren Buffett.

David: He's Warren Buffett. He does so well within the first year or so that his fees are, on paper, $83,000, which is almost half of what his net worth was when he started this thing. Due to that, he owns 9.5% of the combined partnership, starting from essentially zero. His $100 that he put in, he now owns almost 10% of these pools.

Ben: That's, of course, because in that very first year, when the Dow finished the year down 8.5%, Buffett made 10.5% that year for his partners.

David: Pretty good. He now has enough capital with the million dollars at his control that he can start to do the kinds of things that Graham-Newman used to do. We didn't really talk about this but there was another aspect to the cigar butt style of investing. It wasn't just that Ben and Jerry, and then Warren when he joined, would look for companies with book value above trading value. They would then amass big positions in those companies, trying to get themselves on the board, like Graham did with GEICO, although he didn't need to be agitated with GEICO. With the cigar butt companies, they would then agitate actively to get the companies to liquidate assets and distribute the cash out to shareholders.

Ben: It does sound like a hedge fund after all.

David: Yeah, these guys are like Bobby Axelrod. They're corporate raiders. Now, with a million dollars at his disposal, Warren can start to do this. The first of the companies he does this with is a company called Sanborn Map. He puts 35% of the capital of the partnerships into it, gets control of the company, forces it to split itself in two, and makes a quick 50% profit on the spin off. He's shooting fish in a barrel; he can do this all day. By the end of 1960, total capital is up to $2 million, and Warren's share is worth a cool $250,000 or 13% of the partnership. In 1961…

Ben: Let me pause before you go into 1961. Just to recap a few of the returns here year over year. The second year, he made 41%. The third year, he made 26%. The fourth year, 1960, he made 23%. All while the Dow is having some good years, some bad years. It's losing money sometimes, it's making money sometimes. Warren hasn't lost a dollar. He's outperformed every single year, he stayed positive every year. In fact, the partnership results as a whole so far, if you compound over those four years, are 141% compared to the Dow's 43%. Whatever Warren is doing is working.

David: Wow. I don't have the Dow numbers in 1961, so I don't know relatively how good this performance was.

Ben: The Dow numbers in 1961 are 22.4%. A pretty good year.

David: Pretty good. Warren does 46% in 1961, which not only generates a bunch of returns, compounds the capital, the partners are like, please take more of our money. A bunch more money flows in. The partnerships are managing over $7 million in total, which is larger than Graham-Newman ever was.

Ben: Wow. Let me start quoting from some Buffett annual letters here because this is an interesting phenomena. He was a wonderful writer. He had trained himself both in public speaking, taking some classes in that, and in writing. He wrote these, as I'm sure many people would guess, some prolific shareholder letters to his partnership every year. That actually is not something that he did in the early Berkshire years. It took him years to start doing that again, but he really felt it was incumbent upon him to do this when he was running these investment partnerships.

Let me just read from you a few of these. “1962: If my performance is poor, I expect the partners to withdraw. 1963: It is a certainty that we will have years when we deserve the tomatoes. 1964: I believe our margin over the Dow cannot be maintained. 1965: We do not consider it possible on an extended basis to maintain the 16.6% point advantage we had over the Dow.” This goes on and on where Warren continues to caution, I don't think this is sustainable. I don't think we can keep crushing it as hard as we are.

David: Amd he does this to this day every year in the virtual letter. 60 years later, unreal. At this point in 1962, when he's now bigger than Graham-Newman ever was, he finally gets an office. He'd been working out of their spare bedroom, the Omaha house all these years doing everything himself. He gets an office, he hires a couple of people. He consolidates all these various vehicles into just one vehicle, the Buffett Partnership Limited. This is when he puts all of his own money in as well. He's got a single vehicle. I don't know if he ever said he officially unretired but...

Ben: He's in business.

David: He's in business. He also codifies in these letters. He's sending out a few official “ground rules” for the partnership, just like Don Valentine did back in Sequoia in the early days to their limited partners. There are few rules in there. The last one, like you were saying, Ben, hallmark of the Buffett style for years to come. “I cannot promise results to our partners. What I can and do promise is that: (a) our investments will be chosen on the basis of value not popularity, (b) we will attempt to bring risk of permanent capital loss, not short-term quotational loss to an absolute minimum by maintaining a wide margin of safety, and (c) my wife, children, and I have virtually our entire net worth invested in a partnership.”

Pretty good ground rules. By halfway through that year, 1962, when he consolidates everything, Warren is 31 years old, and his net worth crosses the million dollar mark. He's achieved his dream.

Ben: He made it.

David: He made it four years early. The next year in 1963, Buffett finds the second great investment of his lifetime, and also the second great mistake that he would make on the back end of it, the first of course, being GEICO, American Express. This is great. Some listeners probably already know the story here.

Ben: Before we dive into the story, I think the framework that I would use if you're listening to this and hearing a lot of this for the first time, you heard about GEICO, you're hearing these puzzle pieces, where there's a lesson learned from each of these companies, that Buffett was the first to figure out that these businesses are each interesting in a puzzle piece way that fits in with other businesses, that in the sum of its whole could create this unbelievable capital-efficient flywheel.

I don't know if flywheel's the right term. Puzzle pieces put together into a beautiful puzzle or mosaic might be the right term. But it really is him understanding all these unique types of businesses that have these characteristics that he can then use in the future. American Express, I feel is the second big lesson for him after he learns about the insurance business, the first one.

David: I think you're totally right about the puzzle piece fitting together aspect. He learns that in his third great investment, which will be the last one we'll cover on this episode. That's coming up.

Back to American Express. In 1963, Buffett is still under the Graham spell here. He's looking for cigar butts, that's what he's doing, looking for deals.

Ben: As Charlie Munger would later put it, he's looking for fair businesses at good prices.

David: Great prices. Yeah, fair businesses at great prices.

Ben: Not great businesses at fair prices.

David: Yup, exactly, which is the Charlie way of doing things that Buffett would later wisely adopt. AmEx is, at this point, still widely respected today. Back then, American Express is the most trusted financial services company in America. It had been around already for close to 100 years, the traveler's checks business. Many listeners are probably not familiar with traveler's checks, but was just an absolute juggernaut and an amazing business. The idea was if you were travelling, and this is before—

Ben: I did this growing up.

David: Yeah, me too. Even when I was in college, when I studied abroad, my parents got me AmEx traveler's checks. The idea was, you would go to your local American Express office, give them money, cash, they would in return give you traveler's checks, which were essentially a guaranteed paper for that amount of value backed by AmEx. Then you could take those checks anywhere where you traveled and if you lost them, you could go to AmEx. But more importantly, when you're traveling internationally, you could use this as a way to get funds in whatever the local currency was.

Ben: Right, because wherever you're traveling doesn't know about your hometown bank and may not even know about your home country bank, so this is the way to have your credit accepted everywhere.

David: Right. There were no ATMs and credit cards are still early, early days, although AmEx was a pioneer there and had the American Express credit card. Anyway, it's this gilded institution.

In 1963, they have a small subsidiary of the company that operated warehouses and issued warehouse receipts. What does this mean? It’s the equivalent of a traveler's check for warehouses. You would have warehouses full of a commodity, of something, say salad oil, in this case, soybean oil to be exact, and you would get AmEx to come in, inspect the warehouse and issue paper that says like, yes, there are XYZ tons of soybean oil in this warehouse. You could take that paper, and you could collateralize it, you could borrow against it, you could trade against it. You're essentially financializing this product. It was a pretty brilliant business that AmEx was in, but it was small, this was much smaller than their consumer business.

All this is great, until a pretty shady commodities trader named Anthony "Tino" De Angelis in New Jersey—of all places—decides that he's going to pull one over on AmEx. He has his warehouses with them. He decides to fill his tanks, which were supposedly filled with soybean oil with seawater instead, defraud the inspectors, then collateralize it, borrow against it, and run a Ponzi scheme, essentially.

Ben: Didn't he try and bet with it? He then took it and made some risky investment with his check that said, hey, this is worth so many tons of salad oil, and then he ended up basically losing it all?

David: Yeah, there was something that had to do with the futures market. You can't make this stuff up. It was something with Russia and the Soviet Union. Their soybean crop failed that year, and people thought they were going to have to buy US soybean oil, and then they didn't, so the price collapsed. Anyway, ridiculous stuff.

Ben: Anyway, suffice to say, he's now got a piece of paper that someone's coming and saying, okay, give me what that piece of paper's worth. Of course, not only does he not have it, but there's nothing in the warehouse to back it up either.

David: The piece of paper is worth zero. All in, it comes to over $150 million worth of fraud that happened. Theoretically, AmEx is on the hook for this. Now, legally, it's debatable like Tino defrauded them. Whether they should actually be on the hook or not is debatable, but they're American Express. The CEO says, we're going to settle with the creditors, we're going to cover this. The scandal rocks AmEx’s stock on Wall Street. The share price drops by over 50%. Analysts and people out there think the company's not going to survive.

Buffett, though, thinks otherwise. He sees an opportunity. He and his new employees, they go around Omaha and New York and a bunch of other places. They just started interviewing consumers, talking to the banks, and saying, hey, what do you think of AmEx? Have you heard about the soybean oil scandal? The salad oil scandal? Are you still using the traveler's checks? Are you using the credit card? Consumers are like, I haven't heard of this.

Ben: Scandal? What are you talking about?

David: Of course, I trust the traveler's checks. Buffett figures that AmEx can easily absorb all of these losses, even if they covered the whole thing, out of cash on hand. They have over $200 million of cash on hand, plus over $500 million of float from the traveler's checks business.

Ben. This is a similar lesson that he learns from GEICO, which is all of this debt that the company has, that they owe out to these people with traveler's checks, as long as there's not a scandal, they're not going to have a run on us. They're not going to come at us all at once. It's a portfolio distributed liability. As long as I do my diligence, I assume that consumer confidence hasn't been rocked, and there's not going to be a run on AmEx, then we're actually in good shape.

David: He makes a huge bet on AmEx. At this point in time, the partnership, BPL, Buffett Partnership Limited, has over $17 million in capital. Buffett puts $3 million into AmEx right away, a huge position at this time. Eventually, he puts $13 million in total into AmEx and owns 5% of the company.

AmEx ends up settling the case the next year for $60 million. The stock goes through the roof and they make 2½ times their money on the $13 million invested. Amazing win, when second great investment of his career, and similarly, second incredibly stupid decision, once he gets up 2.5X, he sells it all.

Ben: Brutal.

David: Brutal. He did not listen to our Sequoia Capital part one episode.

Ben: He did not. This is something that he sought, too, that is a departure from Graham and wouldn't really come about until later with Coca-Cola, but this is the first twinkle of it, of Buffett really recognizing the defensibility, the moat that comes from brand. Brand doesn't show up on a balance sheet, but it's a huge asset.

It's one of these things where I think Buffett's starting to flex a little bit and say, hey, I actually can analyze these businesses a little bit beyond the black and white numbers they are showing up on the financial statements by doing a little bit of a different form of diligence and assigning value to things that are a little bit less tangible than previous value investors have in the past.

David: Yeah. Could you imagine talking to Ben Graham about brand and the value of brand? He would kick you out of his office.

Ben: Ben Graham wouldn't even talk to you about product. He's like, if you're talking to me about product, I'm not interested in hearing your opinion on how the company's product blah-blah-blah. Show me that it's underprice relative to book value. I can't imagine taking that to brand.

David: I want to know how many machines they have in the factory and what I can sell them for. Totally. That's the AmEx story. Right around the same time in parallel, Buffett finds another cigar butt that he is just over the moon excited about. This one he hears about from a friend, I think in New York, Dan Cowen. It's a failing due England textile manufacturer, whose stock was selling for well less than the book value of assets.

Ben: I think about 50%.

David: Yeah. I have the numbers here, yes. The book value of all the property, plant, equipment and cash on hand at this company is $20 a share, and the stock is trading at $750. Warren is just like, his eyes get real big. Real, real big here. What is the company we're talking about? We're talking about Berkshire Hathaway. Berkshire, the company was really Hathaway, had its origins, way back in New England, the whaling times like Moby Dick style.

Side note, I tried to read that book once, and I was like, this will be cool. It's a whaling adventure. It's an American classic. That is the most difficult book I've ever tried to read. I got 50 pages in and I was like, no.

Ben: It's your Intelligent Investor.

David: Yeah, totally. It was the security analysis, if I needed the Intelligent Investor version of it.

Ben: There you go. I think the way to think about New Bedford was like they were an industry town and their industry was whaling and whaling oil. Then when they pivoted as a town and needed a second industry, textiles cropped up based on all the competency and talent, labor and stuff that they had in the town.

David: The business leaders in town collectively decided that textiles was going to be a thing. We think about whaling now and it seems barbaric, and it totally was, but it was the biggest industry in America. New Bedford, Massachusetts was the wealthiest town in America during the whaling.

Ben: I did not realize that.

David: Yeah. This was not some little thing. There's a reason why Melville wrote his novel about whaling. In 1888, after the whaling business was in decline—thankfully because it was horrible—Horacio Hathaway and Joseph Knowles found Hathaway manufacturing company, which would then go on to acquire and merge with a bunch of other mills over the years. There's just one problem with this business plan that the elders of New Bedford come up with, which is that building textile mills in New England was a really, really dumb idea. A really dumb idea.

Ben: Why is that?

David: If you think about it, what do textile mills do? They take raw cotton.

Ben: From the south.

David: From the south. They turn it into yarn, finished products, et cetera. Berkshire Hathaway eventually would become (I think) the largest or one of the largest producers of men's suit linings.

Ben: Yup, synthetics, too, like polyester.

David: Yeah, synthetics. You're importing this cotton from the south. That means that the cottons got to get on ships, and come up to New England. Well, if you're going to put a bunch of cotton on ships, you could also send it to places that have a cheaper cost than the former wealthiest town in America.

Ben: Or just not put it on ships.

David: Well, not in the beginning. In the 1880s, you had to put it on ships because the climate in the south, the humidity was such that there were problems with producing the cotton.

Ben: They needed to send it to some cooler climate.

David: You needed to send it to a cooler climate. But you didn't need to send it to New Bedford, Massachusetts. It’s still like, okay, it's not great off the bat. But then in the early 20th century, industrial air conditioning is invented, and now you don't need to put in ships at all. Just build the factories, the textile mills there, which people did. The business is kind of limping along, but it's been operating for a long time.

There's a lot of mills, a lot of plants and equipment. There is a decent amount of cash-on-hand. By this time in the 60s, it's run by a descendant of Knowles named Seabury Stanton. Stanton is like the Don Quixote figure of the New England's textile business industry. He sees himself preserving the legacy, the wonderful institution of great textile manufacturing in New England. He's going to do everything he can to protect and bring the industry back to its glory days.

He is, every year, just spending millions of dollars, outfitting all the mills with all the latest technology, doing everything he can to bring back the glory days.

Ben: Yes. He has not once heard of the Buffett-esque notion of what's your return on invested capital in the business? If we have capital, spend it. Just pour it into the business.

David: He's like a noblesse oblige. Warren hears about this from Cowen and he's just like, this going to be amazing. I'm going to make so much money here. He starts buying the stock. Seabury, once he finds out that Buffett is buying the stock, he started buying the stock himself. He was like, I don't want anybody taking my baby away from me, let alone these guys that have a reputation of being corporate raiders. At first, buffet is happy about this because he doesn't really want to own this company. He’s like, good the price is going up. Once it gets to a certain point, I'll sell.

If I sell to Seabury, all the better. I don't really care. He goes and he meets with Stanton. They discuss the company making a tender offer to buy outstanding shares, in particular, Warren’s shares. They have, according to Warren, a handshake deal at $11.50 a share. Warren says, great, if you want to tender an offer at that price, I will sell my shares. He goes back to Omaha, gets a letter in the mail, tender offer is announced at $11-⅜.

David: $11.37 or $11.38, something like that.

David: 12¢ a share less than what they talked about. I still don’t understand. I've read a lot about this.

David: Nobody, including Warren, can really seem to explain why Warren get so worked up about this because it's not in his personality. He cares a lot about money, but it's not in his personality to get worked up about things or to get emotional about stocks. But he goes off the deep end. He is pissed. The best explanation I've seen is sadly his father, Howard, was dying around this time and passed away right around this time. That must've been affecting Warren.

Ben: And buffet has also built a lifetime reputation on doing right by his word and in dealing in good faith. I’d have to imagine that facing off against someone who is not dealing in good faith and is reneging on an agreement, that can't sit well.

David: Totally. Although, the Munger version of what to do here would be when somebody deals in bad faith, you just don't deal with them. It would have been completely understandable to say, fine, whatever. I was going to sell my stock at $11.375, get out of this, be done with it, still make a lot of money. If you want to fight, it would be also totally rational to just hold the stock and say, I'm not selling.

Instead, Warren says screw you. I'm going to launch a tender offer for your shares, which is so uncharacteristic for him. He starts canvassing the entire shareholder base trying to get anybody to sell him shares. He’s on a mission like a man possessed that he wants to get control of Berkshire Hathaway and kick Stanton out of his company.

Ben: This is like a big-ish company at this point. I think it's something like 15,000 people work in the mills.

David: Yeah. It is not a small company.

Ben: It would become a small company, but it is currently a large company.

David: It's now a non-existing company except in name. By April 1965, Warren gets enough shares to get himself elected to the board. The next month, he stages a boardroom coup essentially, also very uncharacteristic of him. He forces Stanton out and installs himself as chairman. He’s won and his prize is this super crappy company. What's he going to do? He can shut down the mills, but then he’s got to lay off 15,000 people and have the whole town of New Bedford hate him. But then what's going to do with the buildings? Is he going to sell the buildings? To whom? Is he going to sell the equipment? To whom?

Ben: Right. The whaling industry's done, every other textile manufacturers also not doing great at this point. It's a pretty terrible asset to own. If he really could have liquidated it for book value, then awesome. But frankly, he couldn't have. And he’s got this reputational thing, which I think we're seeing come into play here and we'll definitely see more of it in the second episode in the series, which is Buffett deeply cares about his reputation and will ultimately derive a tremendous amount of value from his reputation.

He doesn't want to be seen as this raider who comes in and destroys the local economy and shuts down the mills. He basically doesn't. He makes a deal with himself, with the rest of the company, and I think, you probably know better than I do, but basically not to continue to invest crazy. Only make very smart investments. Eventually, make no additional investments into the company but at least keep it running.

David: Yes. He would say to Alice in The Snowball about this, about Berkshire, “So I bought my cigar butt and I tried to smoke it.” This is amazing. “You walk down the street and you see a cigar butt. It's kind of soggy, disgusting, and repels you, but it's free and there may be one puff left in it. Berkshire didn't have any more puffs. All you had was a soggy cigar butt in your mouth. That was Berkshire Hathaway in 1965. I had a lot of money tied up in that cigar butt. I would have been better off if I'd never heard of it in the first place.

Ben: What did you say at the top of the show? It cost them in terms of compounded opportunity capital?

David: Yeah. In 2010, he did the math and claims that not only was purchasing Berkshire the worst biggest mistake of his investing career, but had he taken the money that he put into Berkshire and instead just invested it directly in an insurance company, by 2010, he figures, he would have made about $200 billion in incremental returns. But like Steve Jobs said, you can only connect the dots looking backwards, not looking forwards.

Ben: And now, there is an energy company that bears its name, a real estate brokerage that bears its name, and on and on and on.

David: Not only that, but I do think if he hadn't bought Berkshire, I don't think he would have made his third great investment or at least wouldn’t have made in the same way and figured out the same lesson from it that really drove the entire rest of his career and what Berkshire Hathaway would become.

The next couple of years, despite all this Berkshire nonsense, things go great. Thanks to American Express at the end of 1965, the partnership has $37 million in assets. Buffett's net worth is about $7 million.

Ben: And that year in 1965, the Dow did at 14%. Of course, Buffet’s partnership did 47%. Still, not only beating the Dow, but positive every year of its existence so far.

David: Crazy. All this success is building up in and weighing on Warren. In January of 1966, thanks to, now knowing from you that on December 31st was the day that partners could take money out or put money in, on December 31st of 1965, partners invest another $6.8 million in the partnership.

Ben: Wouldn't you?

David: Yeah. All in, baby. For the first time, Warren doesn't know what to do with all the money. He starts setting aside some cash reserves. He's never done this before. He's always been 100% invested. He starts to worry that he might not be able to find enough good investments for all the capital he now needs to play.

Ben: As he is cautioning in his letters every year.

David: Yup. He closes the partnership to New Capital at that point. He says, I can't take any more capital, continue invest this and compounding but there's danger in getting too big. I might not be able to perform in the same way.

Ben: This is like a disciplined seed stage venture capitalists saying, no, I don't want to grow my fund size. I don't want to have to change my strategy and invest in different things. I want to stay true to the thing that I'm good at.

David: Yup. Before we get to his third grade investment, I think maybe in part because of this mindset of like I'm going to stay true to do what I'm good at, he makes the biggest missed opportunity ever maybe in history. I was teasing Ben, over the last couple days texting him saying, I've got something in this episode that I don't know if you know but is just the most unbelievable thing that you will never imagine.

Ben: Lay it on me.

David: In 1967, he writes his partners saying that he's introducing a new ground rule to the partnership. This one is quite literally the opposite of Don Valentine. He says, “We will not go into businesses where technology, which is way over my head, is crucial to the investment decision. I know about as much about semiconductors or integrated circuits as I do about the mating habits of this chrząszcz.” It a Polish word. It means beetle in Polish. Typical Warren way with words here. “This is very unfortunate.”

Ben: What was the company?

David: “Very unfortunate decision to make.”

Ben: Let’s see, 1967. It predates Microsoft by seven years, predates Apple. It’s way after IBM. What's around this time, DEC? No, it’s post-DEC.

David: No, you'll get it if you think about it enough. Silicon Valley, or just as we talked about it a lot on the show.

Ben: Is it an early Sequoia investment?

David: Just pre-Sequoia. Sequoia was started in 1972, but this is all the crew that Don Valentine—

Ben: Is it an Arthur Rock investment?

David: It is an Arthur Rock investment.

Ben: Is it Intel?

David: We're talking about Intel here.

Ben: No way.

David: Get this. Buffett, at this point, is on the board of Grinnell College in Iowa. He's a trustee of Grinnell College, which by the way, he was introduced to by Susie. Susie became an incredible civil rights activist and Grinnell College was involved in the civil rights movement. Martin Luther King spoke at Grinnell College six months before he was killed. Susie brings Warren to the college to listen to King speak. Warren is like incredibly moved by Dr. King.

He decides after that to join the board. They were trying to recruit him to join the board, so he does. Do you know who else was on the board? One of Grinnell College's most famous alumni, alongside Warren Buffett?

Ben: Noyce or Moore.

David: Yes, bingo. Robert Noyce.

Ben: Wow.

David: Alumni of Grinnell College, inventor of the integrated circuit, part of the traitorous eight, who left Shockley Semiconductor to start Fairchild, and then co-founder of Intel with Gordon Moore and Andy Grove is on the board of Grinnell with Warren. Not only has that, but Warren chairs the endowment investment committee at Grinnell. Of course, that would make sense. When Noyce leaves to start Intel and Arthur Rock is putting the deal together to finance Intel, Noyce brings it to the investment committee at Grinnell College and says, there's $100,000 piece. I think Grinnell should invest in this company. I think this is really going to be big. I know what I'm doing.

Ben: He saw the deal.

David: Warren approves the investment and Grinnell does invest $100,000 in the Intel seed round effectively. But Warren never goes near it for the partnership, for himself. In fact says, I will never invest in technology companies. Unreal.

Ben: Basically held to that for another 45+ years.

David: Totally. Not until Apple and I think—I haven’t done the research yet—Apple bubbles up within Berkshire from Todd Combs, not from Warren. Talk about sins of omission. This is before Sequoia. Imagine if Warren had financed Intel, Warren Buffett could have been Warren Buffet plus Sequoia Capital.

Ben: Wow. Realistically, what would he have done with it if he did invest in it? First of all, he’s never invested in technology business to this point. He's never invested in something that early. Everything he's bought has been pieces of public companies.

David: Yup. Established on-going cash flow businesses.

Ben: The Buffett Partnership doesn't wholly own any businesses. It doesn't even know anything private. Every single thing is SEC-registered.

David: Well Berkshire is now private at this point.

Ben: Okay. I'm just trying to do a little bit of math on would he have held it. How long would he have held it.

David: All of these things, but here's the thing. Warren always justifies not doing technology investments by his whole circle of competence thing. That really is a Charlie Munger thing, but that Warren had adopted, like I stay within what I know, my circle of competence. I know the boundaries of my competence. It doesn't make any sense to me because he invests in plenty of businesses that he doesn't know anything about at the beginning like textiles, insurance, retail.

Ben: Yeah, and the question is are the dynamics in those businesses more closely related to each other than they are to technology businesses? Are high-growth pre-product/market fit or pre-scale technology businesses just so completely different?

David: Yup. I think that's maybe what Warren thinks. He's got some kind of mental block here, because with Intel, you got Noyce, Moore, and Andy Grove coming from Fairchild. You know what Fairchild is. It's an amazing business. They're like, we're going to basically dethrone… I don't know. Anyway, I just read this and I was like, jaw on the floor.

Ben: It also goes along with his notion of independence of thought. He doesn't really care what other people think about a company that if he doesn't understand it from first principles in a way that he's going to build it up from fundamentals, then it's not his cup of tea and he's not investing. All this sounds like Warren Buffett to be, but it turned out to be a bad decision.

David: It does. That’s Warren for you. Anyway, back to the story. I just thought that was so amazing. Berkshire, meanwhile, unlike Intel, is quickly becoming a major problem. Buffett, of course, stops Stanton’s investing in the business, but once he stops investing, they were already uncompetitive. Now, they're wholly uncompetitive and they're just losing money. He says like, I got to do something. Berkshire is going to burn through all of its millions of dollars cash reserves if I don't do something here. I don't want to shut the business down, as we were saying.

He starts thinking about like, can I just buy something else within Berkshire? Use the money that's sitting there. In a sense, he just kind of transform the business around it. He starts looking around and there's a company right there in Omaha that he's been eyeing for a while called National Indemnity. This is the third grade investment, and where we’re essentially going to leave the investing portion of the story.

Ben: National Indemnity, David, to me sounds like an insurance company, would that be right?

David: That would be right. It is run by Jack Ringwalt.

Ben: All right. I'm going to leave us on a cliffhanger here for a moment and talk about another insurance company that we would like to thank as a wonderful sponsor of all of season eight.

Vouch. Listeners, do you like that? Was that a smooth, seamless transition? See how well I can do. Much like these very storied insurance companies of years past who disrupted in their own way, Vouch is disrupting in the technology industry, providing great insurance for startups. You all know the story, Vouch insures Acquired. With our business insurance we know the founders, their listeners, they're members of our community.

My experience getting insurance for the business was extremely good, especially versus having to deal with some of these other insurance companies that we are talking about not directly on the show but of that ilk. It is a very old business and Vouch brings a very, very new, modern, flexible, fast way to get insurance for your business.

They're the fastest in the industry. They have next day coverage. Their digital app takes 10 minutes. They provide proprietary coverages engineered specifically for startups. They're backed by Munich Re. I think after this episode you will know what Re Insurance is. After this next story that David's going to tell you, that'll provide a little insight there. You get the benefit of that great Vouch user experience in the product and the stability and backing of a large and well-known insurance company.

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David, tell us about other insurance companies.

David: None as good as Vouch. They are truly the…

Ben: Seriously awesome.

David: They are awesome.

Ben: I honestly want to go start a company just to use it again.

David: So great. I can't imagine going back to traditional insurance after how easy that was. Okay, so back to National Indemnity and Jack Ringwalt. What National Indemnity does, they're very different than GEICO. Indemnity National insure super esoteric risks. GEICO wants the boring safe driver, low-risk, wide aggregate insurance.

Ben: These guys want like the hole in one policies, right? Like what we were talking about on the Virgin Galactic episode with the XPRIZE?

David: They would be insuring the XPRIZE. They want the riskiest, craziest, wildest stuff out there as Jet Jack was famous for saying, “there's no such thing as a bad risk, only bad rates.” Of course, he's right. You could price anything as long as the price it right. They were very good at pricing risks and Jack famously would personally go dig into… there's some story about they're once insuring a settlement on a murder case or something like that.

It was a murder case or maybe it was something. He went personally and did a bunch of detective work to figure out how likely it was that the case was going to go one way or the other and then he priced the risk. They happen to be right down the street from Warren's office in Omaha.

Ben: I feel like half of the Berkshire orbit companies are Warren happened upon them in Omaha and they happen to be these best in class businesses. This is an unbelievable little nexus.

David: It’s so folksy. It's hilarious. And differently in how they did this than GEICO but similar to GEICO, National got to use its float for a super long time because most of the policies they're writing never cashed in. They were the type of things they were ensuring where it was long-tail stuff, stuff that was very unlikely to happen. They just got used to the money for a long, long time. Jack, though, is getting older. He's considering selling the business but it's his baby. He's super fickle about it. He wants to sell, but does he really want to sell? He makes noises about it every now and then.

Warren knows all this. In February 1967, he catches him in a dour mood. They were having lunch or something. It’s [...], Warren’s courting him. They work out a deal in 15 minutes; 15 minutes or less to sell your company. Warren is like, I'm going to buy this company for Berkshire, not the partnership. This is it. I'm going to transform Berkshire into an insurance company.

He hammers out a one page deal at the price Ringwalt wanted. No audited financials, promised to keep the company in Omaha, promised not to fire any employees. He literally gives Jet Jack everything he wanted, no reason to say no, and they do it. Jack even sticks around and continues running the business because he can't disengage. He’s obsessed which Warren wanted anyway, so it's great.

Ben: Puzzle piece. That's a little learning Warren's going to employ later.

David: Yup. He's just adding to his quiver of tricks of the trade here. It becomes part of Berkshire. It's unclear how much Warren thought about this ahead of time or more like he was looking for something to buy for Berkshire. This is probably the single, greatest insight that Buffett has across his entire career of marrying an insurance business with first one in Berkshire but then many operating companies.

He already knows going back to GEICO that with the insurance business, you have float. You can invest the float, that's great. Then you can compound your capital for free essentially. The problem, though, not that it's a problem, but the limiter on this is that you do need to keep some cash on hand as an insurance company because you got to pay out some policies. At any given month, you might need to pay some stuff out. You can't just go invest all of your capital into other things. But if you actually combine an insurance operation with other non-insurance operating businesses, you can invest all your capital, all of your float.

Ben: Because an operating business both consumes capital but also spits off cash.

David: Also produces the capital. You can keep the capital from the float tied up in the operations of operating businesses and then buying more operating businesses to attach. Then if you ever need to pay off claims, you just pull a little capital over from the cash flow every month that's coming out of, say, a rail road or anything that's very predictable, like a candy store, or a Dairy Queen or what have you.

This is brilliant because this now enables Warren, through this insight, to start building up a two-sided fly wheel of more and more insurance businesses and operations that generate more and more float, that he can then invest that capital in more operating businesses, which generate more monthly cash flow, which enables him to take on more and more float. You can start to see how this ping-pongs back and forth.

He actually writes a paper after the National acquisition where he talks about the capital requirements for insurance companies. In his insight, he says, “By most standards, National Indemnity is pushing its capital quite hard. It is the availability of additional resources in Berkshire Hathaway that enables us to follow the policy of aggressively using our capital, which, on a long range basis, should result in the greatest profitability within National Indemnity. Berkshire could put additional capital into National should underwriting turned sour.” Berkshire is still a dog but the inside was huge. He can go out and just run this playbook all day long. It's amazing.

Ben: Right, so this is the beginning of Berkshire morphing from a series of textile mills into a holding company that has all these incredible cash flow flywheels happening inside of it.

David: Yup, and it's not just a holding company. Unlike the Nifty Fifty conglomerates of the 1960s which were just holding companies for the sake of being holding companies. It's a holding company with a purpose.

Ben: Right, like these companies actually benefit each other rather than just, hey we have a whole bunch of capital, so we’re going to roll up companies that never really interact at all.

David: Yup. It’s brilliant.

Ben: I should say it's not like the products interact. It’s not like the managers meaningfully interact. This is a little foreshadowing here, but the way that Berkshire will eventually run is capital is managed by the central head office and when a business you know needs cash or produces cash, it goes to the head office. The capital allocation is done there. But all of the actual operations of the businesses are done inside the business. It's insight that the synergies, or the flywheels, or the connectivity, whatever you want to call it don't have to happen from the managers of the businesses actually dealing with each other. It can happen at the capital allocation level.

David: Yup. Warren is already a once-in-a-generation talent when it comes to capital allocation, but it gives them this huge margin of safety because, back to the Ben Graham concept, he doesn't have to chase the cigar butts anymore because his cost of capital is way lower than anybody else out there.

Ben: He's got all these policyholders lending him money for free in a non-dilutive way. It's not really debt. It's not really equity. It's just free cash that he gets to play with.

David: Yup so he can go buy businesses and graft them on this flywheel. He does make great investments and great purchases, but even when he doesn't he’s still benefiting from it because he's adding on to this capital flywheel.

Ben: Yup. National Indemnity is such a good pickup for Buffett, too, because he's the master of probability. If we go back and look at AmEx, the market was scared off because there could have been a run on AmEx. But Warren look at probabilistically, figure out the probability of it actually happening was low, assess the expected value, multiplying the probability by the potential outcome, and was like this is an expected value positive bet with a margin of safety. He's just a genius probabilistic thinker.

When you apply someone like that to owning an insurance company, not only is he a brilliant probabilistic thinker, an individualistic decision maker who doesn't need third parties to give him social proof that something is a good idea, now there's this third leg of the stool also which is this master capital allocator. The capital allocation, the probabilistic thinking, and the individualistic decision making, he's now got these three crazy tools at his disposal, and owning an insurance company is awesome for someone like that.

David: And he's playing with a stacked deck here. He can't lose. No wonder he becomes the best investor of all time.

Ben: We're about to see some pretty excellent returns here through 1967 and 1968. The Dow does well in 1967. It's at 19% return that year. We're starting to see some go-go action going on in the market. 1968 is a little cooler but it's 7.7%. Across those years, Warren did 36% in the Buffett Partnerships in 1967, then had its best year ever with a 59% return in 1968. He's untouchable.

David: He's like Steph Curry. He’s just draining threes here.

Ben: I mean if we look all the way from 1957 through 1969, the compounded results of the Dow were 153%. The compounded results of the partnership were 2795%. It’s a 28X that Warren did over the 12 years of the Buffett Partnership.

David: He’s just playing out of his mind.

Ben: Yeah.

David: Unreal. But hopefully, as we painted on this episode, there’s probably the best quote—I don't think we said this at the top of the episode—about Buffett, most apt quote that has ever been said about him. It was in a Forbes piece that came out (I think) right around this time. It says, “Buffett is not a simple person, but he has simple tastes.” Hopefully, we painted a picture here. He's a really complex dude. He comes across folksy. He drinks his Coke, he eats his peanut brittle.

Ben: He doesn't use a computer for his analysis, but there is deep, deep analysis.

David: Yeah, and there's a lot of psychology going on in his head. This insight, this whole thing about insurance, the float, the flywheel, and the operating businesses, this insight should have and did drive the entire rest of his career. The next five decades is this, but he doesn't see it. He's really worried at this time what started a few years ago of, I don't know that I can invest all this capital in the partnership. I don't know that I can keep generating these returns, close the partnership to new capital.

Ben: I'd have to go buy really big businesses or buy businesses outright to deploy this much capital and I don't have access to that. These are the types of businesses we can buy and we buy smaller shares of them.

David: Yup, so in 1967, he writes a letter to the partners saying, “I am out of step with present conditions. On one point however, I'm clear. I will not abandon a previous approach, the cigar butt investing strategy, whose logic I understand, although I find it difficult to apply in the current environment, even though it may mean foregoing large and apparently easy profits to embrace an approach which I don't fully understand, have not practiced successfully, and which possibly could lead to substantial permanent loss of capital.” He’s mentally struggling here. Times have never been better and he's never been more worried.

Ben: He is Ben Graham through and through at this point in his life. It's rule number one, don't lose money. Rule number two, see rule number one. Then you also have this thing going on where because everything is so tied to the purchase price rather than the betting that you'll be able to generate a positive outcome, his mood is tied to purchase prices. Even though everything's going up, he's looking at it like this sucks. I can't find anything attractive to buy. His mood is very much inverse of the market.

David: He's feeling (I think) like, I've got so much to lose now. I've got all these gains. He's not playing like he's got nothing to lose anymore. He's playing like he's got everything to lose. He's in such a bad place that even after this brilliant National Indemnity pickup for Berkshire, in 1968, he tries to unload Berkshire. He tries to wholesale sell it to Munger and David Gottesman, who is an investor in the partnership.

Fortunately for Warren, they're either too smart or too dumb to take him up on it. In difficult Charlie fashion, Charlie's looks at it like, you're telling me you want to sell this thing and you want me to buy it, knowing that you want to sell. Why on earth would I buy something knowing that you want to sell?

Ben: The mutual admiration and respect there is so telling.

David: So telling. By mid-1969, Warren is done. He starts making plans to wind down the partnership. He's dejected. He's going to hang up his spurs.

Ben: After his greatest year ever.

David: Definitely there was some tension with Susie as well or Susie was like, we’re worth like many, many millions of dollars. What are you doing?

Ben: Interestingly many millions of dollars, but he still kind of an unknown person. Wall Street doesn't yet know the name Warren Buffett the way that they would in the next couple of decades. He's not being called on. He's not a celebrity investor. He's not informing the public on investing. This is very much just about staying private and making money.

David: Yup. On Memorial Day, 1969, he writes a letter to the partners and says, “If I am going to participate in the investment business publicly, I can't help being competitive. I know I don't want to be totally occupied without pacing an investment rabbit all my life. The only way to slow down is to stop.”

Then he says he's giving notice of his formal retirement at the end of the year. He's going to wind up the partnership, distribute out all the securities to the partners in the beginning in 1970. That's it. He's done. He's walking away. He’s like Jordan. He’s going to play minor league baseball.

Ben: That’s a very apt analogy.

David: It's exact. This is the last dance, except it's not really the last. The partners are shocked. They rightly never thought Warren could give up the game. Of course, he can't give up the game as we'll see next time. They ask Warren what to do. He thinks about recommending them to Charlie, but Charlie at this point is like, I don't want a bunch of new investors either. I'm worried about the market, too.

He sends the big investors to David Gottesman at First Manhattan Bank in New York, his big firm can manage big clients. The small investors, he ships ever to Bill Ruane who had back from his class with Ben Graham. Bill had just left Kidder Peabody and was setting up his own fund, the Sequoia fund, not to be confused with Sequoia Capital but equally incredible performance over the last 60 years, and that's where he leaves it. January 1970, he liquidated all the public securities. He unwinds the partnership. At this point, he owns 26% of the partnership. He gets $16 million in cash, 18% of Berkshire, 20% of Diversified Retail Company which is a joint venture he had with Charlie owning department stores, an ill-advised place to invest.

Ben: We keep mentioning Charlie here. Do not worry. Stay tuned. We'll have the full Munger story in part two.

David: In part two, and 2% of Blue Chip Stamps which is another Charlie JV, and that's it. He also owns the Omaha Sun which was a vanity purchase to get back to his newspaper roots. The partners have to decide with these private companies, Berkshire, Diversified, Blue Chip and the Sun whether they want to sell their stake and Buffett says he's happy to buy their stakes from them if they want to sell or they want to keep them.

He writes long FAQ to the partners including, should I hold my stock in the private companies? To which he writes, all I can say is that I'm going to do so, hold the stock, and I plan to buy more. With that cryptic statement, he drops the mic. He's out of the game.

Ben: He owns how much of Berkshire Hathaway at this point?

David: 18% as he rides into the sunset.

Ben: I think that little cliffhanger is probably a great place to leave it on history and facts for this first half of Berkshire Hathaway.

David: I don’t know. We’re at about three hours. Do you think that’s enough? Should we go another hour?

Ben: We could talk about the part after this where he tries to figure out what to do with his life while the market is doing crazy things, or the little bit of warm water that he gets into with Charlie and the Feds. But maybe let’s hold on that and we’ll start part two off with some of that wandering pre, going all in on Berkshire Hathaway.

David: Back like Jordan, we’re in the 4-5.

Ben: Yup. Boy do we have some fun playbook things to dive into this episode.

The first one that I have, I actually decided to leave Berkshire land for a moment to illustrate the point. The point that I wanted to make is, sure Warren Buffett is really into compounding. I think that would be an understatement, and that everyone in the audience is probably chuckling if they’ve made it with us that far.

Another fascinating thing is, David, you just mentioned, he took this distribution in cash at the end of the wind down. What I’m thinking is, that’s got to kill him, to have to take these transaction costs, these taxes. He must have really wanted to wind down the partnership to make that happen. To illustrate the point of how much transaction costs and taxes can interrupt the beautiful thing that is compounding, I went to a paper that was written in May of 2020 from the Yale School of Management by AJ Wasserstein, Mark Agnew, and Brian O’Connor who are collaborators with someone that we have had on the LP show. David, do you know who that person is?

David: Hamilton?

Ben: Will Thorndike.

David: Will Thorndike. I should have gotten that.

Ben: Author of The Outsiders who came on our book club.

David: Of course. Will is awesome.

Ben: They did some great analysis in this paper called, On the Nature of Long-term Holds, where they basically ran a little simulation and showed what would happen if you held something that’s had continuous compounding for 25 years and you paid taxes once in your 25, or if you had continuous compounding happening where you paid taxes every five years. Basically, if you withdrew in cash and then reinvest it in the exact same or an equally producing asset.

David: Is this assuming taxes are all long-term capital gains?

Ben: Yes. They are assuming a tax rate of 25%, so some federal capital gains and some state taxes.

Ben: So if you invested $1 and just let compounding do it’s thing for 25 years, you would end up with $24.90 at the end. This is assuming a compounding rate of 15%. You take your dollar, 25 years later it’s worth $25.

If you pay taxes every 5 years, that same $1 is worth $16.8. It’s a 50% increase in the amount that you are left with at the end if you just don’t interrupt compounding, by doing the thing all humans want to do which is manage the money, do stuff, be active. I think that it’s this brilliant insight that Warren has sort of begun to have here. I think of the Buffett Partnership, he moves stuff around much more than he later would in Berkshire Hathaway. This uninterrupted power of compounding—taxes, transaction costs, whatever the things are—if you can find yourself betting on a winner and just let it ride, that is the very best strategy you can possibly employ. It feels to me, at the end of this story, he’s really starting to grasp that.

David: We go way out there in left field, but we’re three hours into this episode so who knows how many people are still listening. There’s this great book called Transitions by William Bridges, and it’s wonderful. It’s about psychologically dealing with transitions in your life, even if it’s a good transition like getting married or having a kid, and bad transitions, too, like big changes in your life. The whole theme of it is that when you have a transition, the old you needs to die before the new you can arise.

I kept thinking about this, to this story here in this part one. Warren was so successful. He was the most successful Ben Graham disciple that there was—more successful than Ben himself—but that wasn’t going to work anymore. He needed to start to understand these things that you’re talking about, and he needed to symbolically die—the old Warren—to have the new Warren arrive. I think that’s what happened here with the closing down of the partnership. Whether he knew it or not—almost assuredly he did not—he needed to close the chapter on that part of his life to start to embrace some of these very different philosophies.

Ben: Yeah, fascinating. That’s a really good point. I’ve never thought about that, literal “let the old you die” think that way.

David: It’s a really good book, recommend it to anyone.

Ben: Speaking of Ben Graham, this notion of independence of thought, there’s a Ben Graham quote that, “The stock investor is neither right nor wrong because others agreed or disagreed with him. He is right because his facts and analysis are right.” This is something that I think as a venture investor is so difficult because so much of the success of a company when you’re investing in it depends on its ability to, in the near-term, raise future capital from someone who is not you. It encourages this herd mentality of, do other people perceive this to be a hot company in the way?

Whereas what Ben Graham is looking at is the complete opposite side of the spectrum, no growth at all, exclusively looking at cigar butts. It’s like you have to hang your hat exclusively on your independent analysis which is way easier to do when you have a book value staring you in the face and you’re only going to do, basically, a one-time transaction on it.

It is, I think a thing, this independence of thought and something that we can all bring a little bit of Ben Graham into our lives. It’s funny because the positive and the negative hit you in different ways. When other people are telling you you are right, it’s very easy to accept the idea that you are right. When other people are telling you you are wrong, you know that, hey, maybe what I’m supposed to do is be contrary and trust my gut. It’s funny how you want to say, look, just because other people are telling me I’m wrong, it doesn’t mean I’m wrong, but if other people are telling me I’m right, I’m definitely right.

David: Totally. I think you raised a really good point in there, too. Two good points. We could all use a little more Ben Graham in our lives, but people talk about value investing in venture and blah-blah-blah, and some people try to do it. Other people bemoan why it doesn’t happen. You raise a really, really good point which is that it kind of can’t because you’d need other people to believe, too. Unless you’re going to be willing to just wholly finance a company yourself, but even then, that’s (a) a slippery slope, but (b) the company needs to recruit employees, it needs to recruit partners, it needs to recruit customers. You got to be bringing people into the fold. You got to be a missionary to succeed in the startup world.

Ben: It’s funny how basically, in a growth company—and in a very small growth company especially—you cannot be the only believer. Otherwise, it won’t work.

David: Which maybe is a reason why, as painful as it is to go back and talk about it, maybe is why Buffett investing in Intel and technology would have never worked in the first place. He just wasn’t in a mindset to be able to think like that.

Ben: It is a completely different way of thinking. Speaking of not being in the right mindset, Buffett’s spinning down the partnership after it’s very best year ever. This is like there’s a boom time going on and that’s a terrible time for Warren to be buying. I think that the classic Warren Buffett aphorism, “Be fearful when others are greedy, and greedy when others are fearful,” springs to mind, where it’s easy to say this guy shut down his investment partnership when everyone else was being greedy.

David: When he returned 50% plus that year.

Ben: Right? It’s crazy. Most people would say, let’s go raise so much more capital to deploy. It is really adherent to principles approach. If you truly do believe the fearful when others are greedy and vice versa comment, there is better illustration than that.

David: Interestingly, though, I bet he would probably also say it was the wrong decision. I mean, the right decision in the long run because it enabled Berkshire, but in a vacuum, he’s crazy. He should have kept going.

Ben: Maybe. That’s the whole Bill Gurley enjoy every last minute of the upside, you never know when the downturns are going to happen so you have to invest through all cycles. That’s true unless you’re Warren Buffett and you can actually pick the cycles. So far, he has proven and we will see in future years, too, he is remarkably good at having a lot of cash when he needs a lot of cash and being fully invested when he needs to be fully invested.

David: Yup, that is true.

Ben: Don’t time the market unless you’re the oracle of Omaha, I think is the second part of that phrase.

David: He does have a saying that I actually first heard from Chamath, of all people, very different approach than Warren, although great in his own way, but the quote from him, “It’s not timing the market, it’s time in market,” which [...] would be like do as I say and not as I do. He also says, invest in index funds and goes out and is incredibly concentrated himself.

Ben: It’s funny listening. I’m going to flash forward here a little bit. I was watching the first recorded annual meeting, the 1994 annual meeting with him and Charlie, and he’s remarking on, “Well, sure. If you have no conviction, then you’re any better than any fool at picking stocks, you should go own as many stocks as possible. You got to be diversified. You got to be covered in case of downturns. If you feel like you’re investing in managers who are excellent and have fortified their businesses so that they’ll be excellent through all cycles, then you should own as few businesses as you possibly can. I own one. I trust the managers implicitly,” which is a very Warren Buffett quip. But for all of us who are taught diversification, that’s another way of saying that we should all be reverting to the mean and if you believe you actually have a gift or have an edge, then bet on your ability to perform superiorly, which he has done.

David: Incredibly well, yeah.

Ben: A couple of others here that I think are worth highlighting, and I’ll save a lot of these that are better illustrated in part two. I think the one that I really want to harp on here is Buffett’s singular life focus and obsession is getting as much money as possible and watching it grow and doing it in the most ethical, stand-up way possible, on his own terms. What we’re witnessing is just the result of that singular focus, of that complete, maniacal, singular focus when applied by someone who is a genius savant at that and also has trained himself to be a master communicator.

I think there’s just very few examples in the world where someone truly is world-class at something and is singularly focused on it. I think when you have that, that is when you have these 10 sigma events, or I don’t know how many standard deviations from the mean this is, but this performance is remarkable and enduring. We’ll talk about this in grading, but this is a 29.5% compounded return every year for 12 years.

David: Partnerships, yeah.

Ben: You mentioned Michael Jordan. I don’t think that’s a ridiculous analogy. I think Jordan’s singular focus on winning is a very reasonable comparison. He’s naturally the best in the world, he is the hardest working, and he’s singularly focused on it, so I think that’s very apt.

David: Totally. There’s a—I just pulled up—a wonderful quote from Mike Moritz that I love, that was in the book, Leading, that he wrote with Sir Alex Furgeson. It says, “The great ones eliminate all distractions and focus only on what matters. Shut out the things that don’t matter, and don’t let their time get stolen away. People forget how few hours there are in a year. You must focus on what’s important and not do what’s not.”

We haven’t talked about his work habits, but Warren is the singular embodiment of that. He sits in his office all day and he reads annual reports. Period. Six plus hours a day, he’s just reading and the other hours, he’s talking to Charlie.

Ben: Right, and there’s massive life trade-offs to that. If you’ve decided that that’s the thing you want to do and that’s what makes you happy, great. But do not pretend that it doesn’t come without trade-offs because for someone who wants a well-rounded life—

David: That’s not it.

Ben: You’re not going to get it.

David: Totally.

Ben: The last one that I’ll highlight here, and then I’ll save the rest for part two because there’s so many other things here worth discussing, but I think they’ll be better illustrated by the full embodiment of Berkshire Hathaway as it is today, is the secrecy of his ideas. Not to get too much into power, but I think he was actually counterpostion to every other stock picker who got paid to look smart in the short-term.

Warren did not care about looking smart in the short-term. His business was not that. He wanted to make the most money long-term so he stayed quiet about his ideas—to a religious extent—and he never ever wanted to move the market or cannibalize that rare, really good idea that he had by showing his hand too early and trying to appear smart. He didn’t have that national brand, he was never paid on commission or transactions, he aligned the business model with his long-term goal, and that was totally counterposition to the market.

David: Yup. Totally agree in aligning the business model. Huge. Only one I throw in there which will probably also come up in part two, but I think it really came out here in part one is—I say this all the time—it’s the Sequoia Capital. Let your winners run. Selling GEICO, selling AmEx, those were massive mistakes. As brilliant as all the things that Warren did and as brilliant as his performance was in this first part of his career, it’s just impossible for me to look at it not think, man, it could have been 10 times better had he not made 2 very simple mistakes.

Ben: When you’re saying just like Sequoia you’re talking about the hard-learned lesson of selling Apple and making a $6 million profit on it.

David: Yup.

Ben: So true. We’ll have some fun here in grading, but before we get to that, we’d like to thank Capchase, the official sponsor of grading of season eight of Acquired. What better episode to talk about a new form of financial product than a Warren Buffett episode? This is perfect. And about cash flow dynamics.

David: We couldn’t have picked three better sponsors for this season.

Ben: Right? The Berkshire Hathaway of the Internet, a brand new awesome insurance company, and a revolutionary form of cash flow financing.

David: It’s like the stars were aligning for all of this.

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David: It’s literally like if you hadn’t been thinking from hearing about Capchase all season long that this is a great idea, if you’re like, ah, you know, it’s finance or whatever, look at what you can do with float. Capchase is going to turn your contracts into float dollars for your business. The dynamics of this are incredible.

Ben: As a little precursor grading here, let’s do a quick value creation, value capture. On these episodes, we always compare. How does the value that they create compared to the value that they actually capture? Is it very little like Wikipedia? Do they capture a lot like Google does? And then of course, the second part, how does the value created for the world, not just for shareholders, compare to any value destruction, so talking from an ethical, moral perspective.

On the first one, David, you might say Warren Buffett is a pure play investor, so that, by default, means he’s just capturing as much value as he’s creating. He’s not out there innovating and creating a new product for the world. That’s not a value creation type person. I’m curious on your thoughts on that. On part two, that will definitely not be true. I think Berkshire Hathaway from this point forward will have lots of value creation to talk about, but what about up to this point to 1970? What companies created value for the world that otherwise wouldn’t have created new value because Warren was involved?

David: In even stepping back and looking at the whole Ben Graham entourage and cigar butt investing, you could make a super real argument that is value destructive investing. Coming after companies and breaking them up and liquidating them?

Ben: There was a going concern providing value to customers that is no longer going.

David: Not employing people. There is definitely some value destruction here. Now, I think you could also argue about the cigar butt investing and Ben Graham, that before him and them, there was just rampant speculation that was happening, and that’s ultimately value destructive for everybody too. He did lay the groundwork for fundamental investing, value-based investing in the pure sense of the word. Value not as anti-growth but as true investing in value as opposed to speculating. That’s all great for the world.

Ben: If you think about all the pensions that invested from the Graham era through today that generated money for the people whose pensions they support, that’s awesome to the extent that they had access to public equities that were no longer just treated as lotteries.

David: Warren, I don’t know, was probably neutral to Berkshire Hathaway, his involvement. He stopped investing in the business, but the business was going to die anyway.

Ben: Die any faster. That’s a good question. It is interesting because the least charitable view that you can take on pure investors is that you’re just reallocating piles of money. You’re not creating new value for the world, and that’s the least charitable in lots of ways. If you think about the ways that great venture investors are value add, yes there’s something there to bringing a lot more than capital.

Some of the things we’ll talk about in part two where someone with a really strong reputation can come in and save a business who is in the midst of blowing up like the Salomon Brothers or something like that, that is much more than reallocating money from one pile to another, so you are legitimately creating new value for the world.

It’s interesting, though. Up to 1970 where we’ve covered here, I’m not really sure that you could make an argument that what the Buffett Partnerships were doing was in any type of value creation.

David: I don’t really think so. It laid the groundwork for a lot of value creation but yeah.

Ben: It’s actually very interesting to examine in the financial sector, pure play investors, what else is value creative? If you increase liquidity in markets, that’s value creative. If you come up with more innovative instruments that allow for… again, companies get funded faster or companies get funded with fewer fees, that provides value.

David: Warren’s not really doing any of these at this point, though.

Ben: No, not at all. It’s just coming at it from the other side because normally, when we’re talking about a new tech product that’s created, we start from a place of, they created all this value. Did they capture it? With pure investing and pure finance, you're starting from this place of, well, they definitely were moving value from one place to another but where did they grow the pie?

David: I don’t think they really did at this point.

Ben: Nope. Okay, so grading. The Buffett Partnerships returned 30% for 12 years, compounded. That’s a 28X. David, how do you think about that? Is that an A? Is that a C?

David: It’s interesting. We were talking before the show about how we’re going to approach this question. I think it depends, everything, the lens through which you look at it. If you look at the Buffett Partnerships like a fund—which they essentially are, it’s essentially a hedge fund—any fund that returns 28X over a 12-year standard-ish lifetime of a fund, that’s incredible. That’s one of the greatest of all time. There may be some Sequoia and benchmark funds that are approaching that, but I don’t think any of them hit that number.

Ben: No, I think the super fantastic, recent benchmark fund was a 25X.

David: Even that and that had what? Uber, WeWork, and Snap in the same fund, I think. From a fund, grading it through that lens, A+, no doubt. Interestingly though, if you were to look at it relative to an individual company investment—which I think would be a stretch, I think it is much more like a fund, it is a fund—it’s not that impressive these days, that you would return 28X on an individual investment over 12 years. There are individual investments in Crypto these days that are returning 28X in 6 months.

Ben: It’s been 12 years since Bitcoin was invented and it’s returned 6.2X million. Crypto’s a whole different…

David: Right. That just blows it out of the water. It’s really interesting, though. Back in these times, there probably wasn’t anything returning on this level, an individual style. Intel, for sure, but the concepts of venture investing or investing in private companies, we’re talking about maybe 15 people in the world that did that.

Ben: That’s a great point. I hadn’t thought about normalizing for the time period because when I looked at this, the numbers jumped out at me and I was like, oh, I have an IRR number on a 12-year fund. Cool. Let’s compare it to venture. Oh, I have a cash-on-cash? A 28X on a 10-year fund with a 2-year extension, this is a top 0.1% venture fund. People say, I want to be top decile investor, I want a 3X, I want a 5X. Funds don’t 28X, especially with the inflation-adjusted millions that Buffet was investing then. It’s a crazy, impressive feat.

Just to assign a letter, this is an A+ and frankly, the fact that they never lost money. They not only beat the Dow, but they had a positive return every single year, is crazy impressive. A positive return with the option to take your money out, there’s not an illiquidity premium unlike venture. It’s just crazy. Now granted, Berkshire Hathaway’s been around a lot longer today, and they’re managing way more money than the Buffett Partnerships ever were, but this 30% or 29.5% definitely beats the pants off of Berkshire’s returns ever since Warren went full-time which we’ll talk about in the next episode.

David: What is full-time?

Ben: What is full-time?

David: I think Warren was just a man ahead of his time.

Ben: Certainly was.

David: A+. We’re dancing around trying to figure it out but yeah, it’s an A+ no doubt.

Ben: All right, carve outs?

David: Carve outs. Mine is a very, very, very different way of thinking, investing, looking at the world but fascinating. Balaji Srinivasan on the Tim Ferriss Show, another three-hour podcast that came out a few weeks ago, wildly fascinating. Balaji is a very interesting character that many people in tech know. He was a partner at Andreessen Horowitz for a while. He founded Counsyl. He was founder of a company Earn.com that Coinbase acquired, then he became the CTO of Coinbase. He’s a Crypto Evangelist, Transhuman Evangelist, Transnational. Anyway, very interesting podcast, lots of seemingly out there ideas to discuss but always considering these things. I really enjoyed it.

Ben: It’s next on my queue to check out. It’s right after all the stuff that I was listening to to do the Berkshire research.

David: Yeah, we haven’t had a lot of time for other carve outs recently.

Ben: I will say, this is the first time I’ve started research months in advance, giddied to do this episode.

David: I know. This was so fun.

Ben: Mine is also something that I listen to via audio. You can read it via text as well, but since I’m such a big audio consumer, I chose to listen. Hearing it straight from the horse’s mouth, I much prefer it to reading especially in this case. Packy McCormick wrote a wonderful piece called Not Boring, One Year In.

I can’t recommend reading it, especially the narration and hearing it in his voice enough. I don’t know if it particularly resonated with me because we’re friends with Packy and we’ve been watching his journey or if his journey is just remarkably similar to Acquired. Just reading it, I’m just screaming in my car while listening to it, yes! I get certain moments, but it is the most awesome open book, cathartic telling of his first year. I can’t believe it’s only been a year. What a crazy, a crazy thing he’s accomplished.

The biggest thing that resonated with me is there is both a process and not a process. He’s like, “I have certain things that I do because I need to get the content out once a week or twice a week. I have a set schedule that I need to follow, but I never actually know what the content’s going to be and I need these lightning bolts of creativity.”

I would say that David and I aren’t quite as wide in the gamut that we run where the A Not Boring piece can look quite different than what the Acquired’s mold is. Although recently, who knows. But I definitely know that thing of, there’s a set of activities that I need to do to go generate ideas. At some point, I need to narrow and pick on, and then I need to run with one of those ideas.

For a person who is creating on any sort of regular schedule, be it creating in products you’re making, creating in the blog stuff you’re writing, creating podcast, whatever it is, that is such a real emotion to identify with, and Packy did such a great job writing about it. I think anyone who makes stuff should go read Not Boring, One Year In.

David: Yeah, it was so good. I love that piece.

Ben: Packy my friend, you are gifted.

David: Indeed.

Ben: As we wind down here, we should say there is a Berkshire Hathaway 2021 annual shareholder meeting that will be coming up on May 1st.

Ben: So if you’re like David and I are becoming sort of a converted Buffet-head, that is a great thing to tune into and watch on that lovely Saturday on Yahoo Finance. We will have part two coming out here in the near future. Haven’t yet decided if we’re going to do it before or after the annual meeting, but we definitely look forward to talking about all things Berkshire with you, both past as we’ve covered on this show up to the present as we’ll do in part two, and looking into the future with the Berkshire annual meeting. Tune into that if it sounds interesting. It’s Warren and Charlie on the stage just fielding questions for hours and hours and hours on end. It should be pretty good.

David: We should totally, in post-Covid times, (a) go next year, (b) be like them and just do the same thing. We should totally do this. We should just get up on stage and we’ll probably have three people show up, but get up on stage and we should have all of our sponsors, all of our partners—

Ben: Oh my gosh, out in the concourse.

David: Out in the concourse. We’ll have bronze busts of Warren and Charlie.

Ben: Thank you to our good friends at Tiny.

David: Yeah, thank you. And we’ll have a big Acquired-fest.

Ben: I’m in. Let’s do it. All right, I’m going to keep the wind down brief, everyone. If you liked this episode, share it with your friends. If you have a friend who’s a value investor, or not a value investor, or you talk about this stuff with, share it. Feel free to share it from social media. If you’re getting excited about the annual meeting coming up for Berkshire, feel free to point people to this as a resource. It’s definitely one of the things that inspired David and I to do it.

Become an LP. We love our LPs. We love everyone but we love our LPs the most. Join the Slack. It’s a great conversation there and I’m sure there’ll be much discussion of this episode there. I think that’s all I got. Listeners, thank you so much and we will see you next time.

David: We’ll see you next time.

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