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Yes, how many grams of sugar are in this normal looking size bottle of cherry coke? That 20 ounce it is 20 ounce. Yep 40 nope 50 70 in a 20 ounce bottle. There's 70 grams of sugar 70 grams of sugar in 120 ounce bottle Wow, I can't believe they still sell this stuff Welcome to season eight episode six of acquired the podcast about great technology companies and the stories and Playbooks behind them. I'm Ben Gilbert and I am the co-founder and managing director of Seattle based Pioneer Square Labs and our venture fund PSL ventures and I'm David Rosenthal and I am an angel investor based in San Francisco and We are your hosts on our last episode We told the story of Warren Buffett in the years of running his own partnerships those 12 years leading up through 1969 when he shut it down after his best year ever and returned all the money to his investors Today we will pick up right where we left off telling the story of the declining suit liner manufacturer that he bought Berkshire Hathaway today's story is one of an investment style in transition from a focus on cigar butts to a focus on Wonderful businesses much of which was inspired by the man. We've only briefly mentioned so far Charlie Munger now you may be thinking to yourself boy It'll be really great to get the other half of the Berkshire story to understand where they are today Unfortunately, you should know David and I better than that We were foolish to think that we could tell the whole Berkshire story in a mere two episodes So this episode is our empire strikes back It will serve as a bridge between the early forces that made Warren and the mature Berkshire that we have today What made Buffett start investing again after dissolving his partnership and why on earth did he decide to do that inside of the shell of the declining Berkshire instead of just starting a new fund and even How did he end up briefly as the chairman of a Wall Street bank with a culture that he had criticized for his whole investing career? So here we are part two of our Berkshire Hathaway trilogy This really is the Empire Strikes Back. It's gonna get dark at the end truly be prepared There's a little bit of an apt analogy there. It's true Well folks are you an acquired Slack member yet if not what on earth have you been waiting for it is a wonderful community Discussing of course all things acquired in recent episodes, but more importantly It is a smart group of people having thoughtful nuanced and respectful discussion about tech investing you can join at acquired.fm slash Slack Our presenting sponsor for this episode is not a sponsor, but another podcast that we love and want to recommend called the founders podcast we have seen dozens of tweets that say something like my favorite podcast is acquired and founder So we knew there's a natural fit. We know the host of founders. Well David Senra. Hi David. Hey, Ben. Hey, David Thank you for joining us. Thank you for having me I like how they group us together and then they say it's like the best curriculum for founders and executives It really is we use your show for research a lot I listen to your episode of the story of akyo marita before we did our Sony episodes this incredible primer You know, he's actually a good example of why people listen to founders into acquired because all of history's greatest entrepreneurs and investors they had deep historical knowledge about the work that came before them So like the founder of Sony who did he influence Steve Jobs talked about him over and over again if you do the research to him But I think this is one of the reasons why people love both of our shows and there's such good Compliments is on acquired we focus on company histories You tell the histories of the individual people you're the people version of acquired and where the company version of founders Listeners the other fun thing to note is David will hit a topic from a bunch of different angles So I just listened to an episode on Edwin land from a biography that David did David it was the third fourth time you've done Polaroid I've read five biographies of Edwin land and I think I've made eight episodes of them because in my opinion the greatest Much puner to ever do it my favorite entrepreneur personally is Steve Jobs and if you go back and listen to like a 20 year old Steve Jobs He's talking about Edwin lands my hero So the reason I did that is because I want to find out like I have my heroes who were their heroes and the beauty of this is The people may die, but the ideas never do and so Edwin land had passed away way before The apex of Apple, but Steve was still able to use those ideas and now he's gone and we can use those ideas And so I think what acquired is doing what a founder trying to do as well is find the best ideas in history and push them down their generations Make sure they're not lost history. I love that Well listeners go check out the founders podcast after this episode you can search for it in any podcast player Lots of companies that David covers that we have yet to dive into here on acquired so for more indulgence on companies and founders go check it out Now lastly if you aren't an LP you should become one aside from all the things that we tell you every time we have a Brand new LP event coming up that we are super excited about our next book club will be with Brad Stone Who famously wrote the everything store the upstarts and now David what is his new book? Amazon unbound part two of the Amazon story just like this is part two of the Berkshire story So our new format for the book club will be that David and I are going to interview Brad and if you're an LP Then you get to join on the zoom as well and we'll have time for Q&A and Everybody will hopefully have read the book before we do the interview So you can join at acquired.fm slash LP and learn more about that program All right, David before you take us in and listeners as always this show is not investment advice David and I may and I think we've already told you that we do have investments in the companies that are discussed on this episode in this show is for educational and entertainment purposes only all right, let's get to it We got a lot to get through here. Yep, so last we left our friend Warren Skywalker Warren Buffett he was wandering in the woods of Omaha after having closed down the partnership as you alluded to Ben and trying to figure out what to do with his life and his retirement So before we pick back up with that story though I think we have some unfinished business and a character that we need to introduce here This is like so David even in an episode where we've already told you like a Multi-decade history and we're like in the part two somehow you're finding a way to wind the clock back Indeed and we go all the way back to New Years Day on 1924 In Omaha, Nebraska the very same woods that Warren is wandering in that sounds like six years before Warren was born Yep, six and a half years before Warren was born where in Omaha Al and Florence Munger Florence gives birth to a baby boy whom they name Charles Thomas Munger after his grandfather who is a widely respected federal judge in the Nebraska US District court appointed by Teddy Roosevelt himself Thomas Charles Munger so Charles Thomas Munger named first grandfather Thomas Charles Munger and He takes after his grandfather in many ways his grandfather makes a big impression on him Thomas's mantra in life was concentrate on the task immediately in front of you and Control your spending So it sounds similar to Ernest Buffett Similar ideals and this kind of instills this idea of gaining wealth through controlling your spending and focusing on doing a great job at the task in front of you in young Charlie And Charlie much like Warren Decides that he wants to become wealthy so that he can not have lots of fancy toys to play with but so that he can be Independent he has a quote he says I wanted to get rich so I could be independent like Lord John Maynard Keans Of course elementary school aged Charlie Munger is aspiring to be like John Maynard Keans So this is where he's a little different than Warren they really have the same aims and goals in life But they're sort of their styles around it are very different Warren is just like I don't want anybody telling me what to do Charlie's like oh, I want to be like Lord Keans So as we chronicled in part one Charlie actually goes to work for Ernest Buffett at the grocery store as a kid Unbelievably for Warren's grandfather just like Warren learns he hates manual labor and Being paid a pittance of salary and he thinks there's got to be a better way He can use his mind to make money rather than his manual labor and Speaking of his mind he loves to read his parents give him and his sisters lots of books he tears through them and very early in life he stumbles across Ben Franklin and Ben Franklin would become his hero in life and that's where he develops this idea I don't know if he stole it from Franklin or if he came up with it himself of making friends of the eminent dead He decides he enjoys more the company of dead people learning from them through their books then People who are actually alive kind of a one-way conversation, but there's probably a lot a lot of wisdom there Not to mention like revisionist histories and survivorship bias yada yada I think a lot of conversations with Charlie are one-way conversations As we shall see so also like Warren He's kind of a wise ass as a kid and has a very high opinion of himself His neighbor one ed Davis who we discussed in part one the doctor is his father Al's best friend and just as a refresher The Davis's would become one of the first families to invest in Buffett's first partnership, right? Yeah, and I think the first if I remember right the family in Omaha that gave him the most money of sort of the initial group I think they have a hundred thousand dollars because Warren reminded them of Charlie So he ends up going to Michigan for undergrad. Sorry Ben. It's all right. These days. I'm not sure there's much of a rival or anyway whoo Burn burn of course Ben went to Ohio State so Where at Michigan he majors in math and gets turned on to physics where he becomes really in transfer physics and Then while he's still at Michigan Pearl Harbor happens and the US enters World War two Charlie joins the Air Force and as part of the intake process they measure his IQ And he's literally like one of the top IQ scores that the military like Eddie branch has ever tested No, no major surprise there. Yeah, no major surprise there. He's probably the you know top wise ass Desil as well. That is definitely true So they send him first to the University of New Mexico to study engineering there He then goes on to Caltech in Pasadena in Los Angeles and continues his engineering studies there and then I think he ends up if I remember him this red I don't have it in my notes I think he ends up getting stationed in Alaska as a meteorologist during the war I I remember him being in Alaska too as part of his his duty. Yeah, so anyway after the war He decides that you know He really enjoyed learning about engineering and physics and math and all that but for a career He more wants to follow in the family footsteps of his beloved grandfather and his father and go into the law So Charlie being Charlie he applies to Harvard law Despite the fact that he doesn't have an undergraduate degree. Why should I stop him? Yeah, he didn't actually graduate from any of these institutions And he gets in and he goes to Harvard law. He does very well there graduates Phi Beta Kappa And he decides after graduation. He's thinking about going back to Omaha But he decides Well one Pasadena was It's really nice when I was there at Caltech you know the weather in LA is hard to beat But also in typical Charlie fashion. He sort of asked himself a rhetorical question. He's like Eh, where can I be somebody and you know Omaha's Obviously a right a rising town great city, but but it's not Los Angeles He says what city is is growing and full of opportunity so that I could make a lot of money But not so big and well developed that it would be hard to rise into the ranks of the cities most prominent men Which of course Charlie wants to be among those ranks and it's you're already seeing a massive departure in the sort of psychological makeup of Warren and Charlie here Where like that was never a thing Warren cared about it was like how much money will I have on the scoreboard when I die and Like I'm sure no matter where I live that'll get compared to everyone else and for Charlie It was you know where can I be a man about town and that town should be exactly big enough to be Worth being a man about town and it's also funny to me that at this point like LA is for him something that he views as like Oh, it's not too big yet. Yeah, well, it wasn't I mean right after World War two Obviously was a big town and Hollywood had always been there, but I think California in particularly southern California Experience huge population boom after World War two of which Charlie was part so Very tragically after moving to LA he had gotten married I think right after the war when he started to Harvard and tragically both his marriages falling apart when he gets to LA and much more tragically His son Teddy is diagnosed with leukemia and in those days There was no effective treatment for leukemia, you know, just tragic It was totally tragic and Teddy would end up passing away in 1955 at age nine which is Unimaginable to lose a child at all let alone in that way and at that age Charlie's reaction to this I think is very characteristic very telling of who he is He's obviously absolutely devastated But he decides that the thing to do is he needs to set new goals for himself and move forward versus being consumed by grief So he says after about when reflecting on this time he says one of his charliasms You should never when facing some unbelievable tragedy let one tragedy increase into two or three through your failure of will Which is probably you know sound advice not that I can imagine going through that That's also some incredible compartmentalization. I mean if for Imagine going and speaking to a person who's grieving right now and telling them hey Don't let this turn into two or three cascading. What is it failures or or catastrophes? It's sort of only something you can decide and tell yourself Yeah, I think only if you are a person like Charlie like Charlie So he sets two Very specific goals for himself one to find a new spouse and two to diversify his business activities outside of law And so on one I thought this was so funny. He's really worried. He's now a divorced man in his 30s in California Doesn't know that many people out there he goes through all the math of like how many women are there in California? How many would be of a marriageable age how many are smart enough for me, but not too smart Like of course, this is Charlie. So he happens on a foolproof strategy He decides that he's going to do the most rational thing possible He's going to start every day scanning the divorce and obituary notices in the paper Looking for a widow's and recent divorces Oh my god, I guess I guess there weren't dating websites back in those days So that's what you had to do his friends are kind of alarmed by this and one of his law partners Introduces him to a woman named Nancy Borthwick who was kind of fit all of his criteria except maybe the not being Too smart. She's quite smart. She was recently divorced She was five beta kappa from Stanford undergrad in economics. She actually had an undergrad degree unlike Charlie And most importantly see she took nobody's crap including Charlie's So they each of the two of them have two children two surviving children from their previous marriages They get married they go on to have four more children together for an entire Munger clan of ten people eight children and two parents. It's a lot of mungers That is a lot of mungers and if you see photos of them Uh of the munger clan to this day especially with all the grandchildren. It is impressive. It's like a small city Do you know the This is sort of like the thing that smacks you in the face the thing she had in common with his first wife Uh, yes her name Yeah, they're both named Nancy like yeah, and in some ways you're like come on That's pretty lazy like you can't go marry someone again with your same Ha ha someone once made a remark that Charlie was so sort of absent-minded and and forgetful of names that thank god his Second wife was also named Nancy or who would have forgotten her name too Yeah, very Charlie. He is unique. So on goal number two He's doing very well as a lawyer in LA as you can imagine Charlie is an excellent attorney But he decides that uh, you know, even though he's having all this success Really the people who see blink they have the good life and who are really the sort of you know men and they're all men at this point About town are the clients in particular one of his clients is the mining magnet Harvey mud Who helped build Caltech into what it became and then helped build and found all of the Claremont College is including the one that bears his name Harvey mud He was one of Charlie's clients So what does Charlie do he starts buying some stocks himself But he also starts taking some of his fees from his clients in equity in addition to cash Yeah, he's like a he's like the early, you know, Silicon Valley, you know Entrepreneurial startup lawyer type that takes him takes him equity in addition to cash for doing the deals He also ends up getting into real estate which real estate and Southern California and the postwar era was a great way to make a lot of money He gets his net worth up to about one and a half million dollars by the early 60s Which if you remember from Part one he's like right neck and neck with Warren at this point in time And that's what like 10 15 million today Yeah, so certainly more than Anybody would need to be living the good life of a man about town at this point Right, and you could imagine like someone in their mid 30s like you could kind of just live off that interest forever If you wanted to put it into fixed income and you know kind of call it Totally totally which unlike Warren Charlie's not necessarily against something like that. He's definitely enjoying himself in LA but Along the way as we alluded to in part one The famous summer night in 1959 in Omaha Charlie is back in town Briefly to settle his father's estate his father. I'll head passed away and the Davis's say Ah, we're now we're investors with this local guy Warren we've told him about you three years ago. We met him. He seemed like you Let's sit up at dinner and you guys can we'll introduce you you guys can meet both Warren and Charlie I think are skeptical going into this dinner But the legend goes that they all sit down to dinner and it's like Electric Warren and Charlie hit it off right away, which I think is true And then the legend goes that at this dinner Charlie starts laughing at one of his own jokes so hard that he actually rolls out of his chair onto the floor It starts rolling around on the floor now that is not true But it did happen later that week because Warren and Charlie got dinner together like every night that week Oh, wow that they were there and yes Apparently Charlie did actually start rolling on the floor of a restaurant at one of his own jokes Which is the first of like many like pretty funny quips about Charlie at dinner parties and his eating habits and his mildly self-absorbeness when it comes to these things And there's another good one where he's been known to As he's telling a story or opining on something sometimes of course like he'll need to drink water So as he sort of takes his glass and puts it up to his mouth He puts his hand out to stop anybody else from talking and holds his hands up until he's done taking a sip and then moves his hand out So he can finish telling the story like this is a man that Loves to talk It doesn't come out as much in Berkshire meetings until you sort of get him going But yes in social situations he is the center. It's so funny because if you just watch the In your meetings you would think that Charlie is the silent partner Nothing could be farther from the truth So during this dinner Warren and Charlie are like in raptured with each other and As they go along Charlie's getting more and more puzzled because All Warren is talking about his businesses companies and investing and Charlie loves this. He thinks this is great But it wouldn't even cross any normal person's mind that this could be your job at this point in time You know like we talked about in part one like maybe a couple people in New York, you know Maybe bed and gram could do this but the idea that somebody in Omaha even somebody in LA could do this as their full-time job Only Warren was thinking this way at the time So eventually Charlie asked Warren well What do you do exactly for a living and And buffets like well, you know I have these various Vehicles these various partnership vehicles because at this point he hadn't consolidated them all yet These are all he has like seven or eight different partnerships that he invest from and mind you the setup is There's no fees. He's not drawing a salary from any of these. Yep. He's just working out of his spare bedroom at the house in Omaha Living off of his was at 175,000 dollars that he had when he left Graham Newman So Charlie though this strikes him as brilliant and he's like he looks at Warren dead serious for once and he says Do you think I could do something like that out in California and supposedly Warren as chronicle sits there He thinks for a minute because you know Warren is you know He's very polite, but like he's also especially with people he respects, you know very honest and direct and you know He doesn't think many people can do this, but he thinks and he says You know Yeah, I'm quite sure you could do this and Charlie, you know it changes his life this this dinner. He goes back to LA. He keeps practicing law He's not ready to go all in yet on investing But he raises some money. He starts a partnership and he starts emulating Warren investing on his own out in Los Angeles Susie Buffett who is at the dinner although a silent participant says in a quote in the snowball She says I think Warren felt that Charlie was the smartest person he'd ever met and Charlie felt that Warren was the smartest person that he'd ever met and for the two of them that was quite the high compliment so Munger goes back to LA. He starts investing He also leaves the law firm that he was at and starts a new law partnership Which was originally called Munger Tolls and Hills later becomes Munger Tolls and Olsen which to this very day Does all of Berkshire's legal work and will become very instrumental in the story at the end as we shall see here But he doesn't stay there long He only stays at this new firm that he starts for three years and then in 1965 He's doing so well investing that with Warren's encouragement. He actually leaves MTO and And just like Warren becomes full-time Run in his partnerships investing and MTO despite the fact that Charlie was only there three years is still MTO today, right Still MTO today. Yep, amazing and I know that like Like a match in starting a firm naming it after yourself and then leaving and then all of your partners and everyone else who works there Asking you hey can we still keep it with your name on it and your name first right? Wild Totally wild so Charlie starts out in his sort of investing style Doing the cigar butts and the like and he's talking to Buffett all the time. They're always on the phone He's absorbing all the Ben Graham philosophy But it quickly becomes clear that he's wired a different way So he starts saying to Warren and some of their other friends This line that is sort of puzzling to them Charlie says, you know, I really you know, I just like great businesses and That's like not computing with with Warren and the rest of the group And Warren's like you mean mispriced assets or because that's what we're doing here. We're buying mispriced assets And when you say great businesses, you know, what do you mean by that? Right, I mean even you know as we talked about last time Warren when he gets a great business like a guy co or you know an MX He's still the only thinking about them in terms of like the value that he can arbitrage out relative to their Hard asset net worth or their cash on the balance sheet Charlie though So the story goes that what really gets him down this line of thinking is at one point he invests in a A caterpillar tractor dealership in southern California Hmm, and this becomes a total albatross because the problem was as the dealership you got to buy the tractors from Caterpillar upfront which cost a lot of money and then they don't turn over that fast They're just sitting on the lot and then every time one goes out the door You got to put more capital up to buy a new one. It's like incredibly capital intensive It's always tying tying up capital and if you want to grow you want to add new stores You got to invest in all the inventory upfront and so Charlie ever the rationalist he realizes that like hey wait a minute The goal of owning a business should actually be one that the business spits out more cash than it consumes And ideally too that it consumes as little cash as possible Right that then when it spits off cash that you actually can do something with that cash not have to go buy more Caterpillar pieces of machinery He's like I want to give you cash once and very little of it And then I want you to give me a lot more cash over time with me never giving you anymore This is best paraphrased in the line from poor Charlie's all-man-ack Which was an awesome source which is a better business and that postulates There are two kinds of businesses the first earns 12% and you can take the profits out at the end of the year The second earns 12% but all the excess cash must get reinvested. There's never any cash It reminds me the guy who sells construction equipment He looks at his used machines Take it in as customers bought the new ones and says there's all my profit rusting in my yard We hate that kind of business Totally So All right, Charlie starting to think about this and he starts really going down the rabbit hoist Well, what how can you like achieve such a state in business And that leads him to think about this idea of competitive advantage like this is all like probably seeming like done Normal stuff to everyone now, but like nobody is thinking this way at the time and what is competitive advantage? It's almost like a moat. It's like if your business is a castle You have a moat around your castle so that nobody can attack it It's a it's a reason why competitors can't come and arbitrage your differential profits. Oh, it kind of sounds like Hamilton Helmer empowers right So Warren and Charlie are spending a lot of time together famously Warren and Susie start vacationing in Southern California Just so that Warren and Charlie can talk for hours and when they come out Warren's already a millionaire at this point the family stays in a motel on Santa Monica Boulevard And then commute over dry so to pass the deed up. Of course So When they're hanging out because they respect each other's intelligence But to Alice points out in the snowball there's there's actually a second reason why Warren likes Charlie so much And that's that as Warren starting to get more and more known In Omaha and on the national scene for his investing track record Nobody's willing to tell him he's wrong anymore. Everybody's super differential to him And as Alice puts it Charlie's deference to Warren was limited by his high opinion of himself That's awesome And that is something that we start to see play out here in the late 60s where You know, Buffett was famously very shy about ever sharing investment ideas I think like occasionally at that annual group that he would convene of all the Ben Graham disciples this fellow classmates which he then started bringing Charlie into That they would occasionally sort of Allude to some investing ideas they were thinking about you know, maybe this business is interesting But they would kind of talk around it Warren really found in Charlie someone that he could literally present Here's the name that I'm thinking about and start talking through the business and look for sort of holes in his thinking In a way that he never opened up to anyone else to ever say the name of a company He was thinking about buying Yep, totally that brings us back to at the same time Charlie starting to go down this different path in philosophy and Munger starts saying he says to Buffett He's like hey, you're like obsessed with this Graham guy and like I'll give it to you that that's a great strategy It works He met Graham at several points this time Graham also lives in Southern California by now But he's like hey, he's not god and there's a flaw in the cigar butt thinking Which is that it you know, it was driven by the environment that Graham came of agent in the depression and the quote from Charlie is That the flaw is that Graham believes that the future is more fraught with hazard than ripe with opportunity And you know here in the postwar era in the US especially in California It's super hard to look out at the future and not see opportunity So Charlie starts harringing Warren about this he says Is a great quote because Warren is so good at explaining Ben Graham He's behaving like the old civil war veteran who after a few minutes of ordinary conversation always interjects That reminds me of the battle of Gettysburg In other words Warren is falling victim to one of the oldest human misjudgment tendencies in the book The man with a hammer syndrome And what's that like when you have a hammer or everything looks like a nail Exactly So eventually Charlie does start breaking through to Warren Right around this time as Warren is shutting down the partnership. He's so you know, he's so depressed He's worried about the market. He doesn't see opportunity ahead. He only sees hazard But at heart though Warren is an optimist Yeah, it's interesting when you're 95% aligned with your teacher It's easy to just try and do things exclusively their way and it's only when you start really feeling yourself and feeling your Your legs under you a little bit can you start saying wait a minute I am a little bit different and I connect you know as Completely my own agent rather than following their playbook All right, so this leads us to the first big thing that Warren and Charlie do together Which is blue chip stamps and I remember I used to what I used to hear Warren and Charlie talk about blue chip stamps company I thought this was like a quaint Like stamp collecting store franchise, you know, I assume that too. Yeah exactly like a baseball card shop or something No, it's totally not what this was So this is some like Wild Americana history and when we say the first thing they do together We should be crystal clear here They are not Warren and Charlie on a stage the way that you see them today There is Charlie who is doing Charlie's partnerships and Warren who's doing Warren's partnerships. Yep so What is blue chip stamps so Around the turn of the century the turn of the 20th century Department stores used to hand out this is crazy. These to hand out stamps as like a bonus incentive for Customers to pay cash for goods instead of buying on credit So the ideal was if you bought something with cash The store then handed you a certain number of stamps Which you could paste into a booklet and when you fill up the booklet you could exchange it for like prizes Like redeem it for like a you know, I don't know like furniture or jewelry or like a bike for the kids or something like that They did want to incentivize paying with cash because cash flow exactly So this was a way to incentivize paying with cash So somebody had a brilliant idea that it would be better if you actually Operated the stamps service as a separate Business from anyone store so that customers can get stamps from lots of stores And then like aggregate them get lots of stamps and then redeem them for you know more prizes It sounds so convoluted when you sort of explain it this way totally but This business turned out to have two extremely attractive qualities one it had float so The stamps companies that were running the stamp operation The business is the stores they bought stamps in advance from the stamp company. So like you're a department store you're like I'm gonna buy 500,000 dollars worth of stamps that I'm then gonna give out to my customers over time to incentivize them And they they buy to do this you better keep those in a safe because those are like cash Yeah, exactly and then the they would give money give us dollars to the stamp company in exchange for the stamps And then the customers you know they would of the store they get the stamps and then they would redeem them They'd be breakage you know it could be years from the time The stamp company sold the roll of stamps to the store sounds like an insurance company Exactly exactly so there's float And then to even better There's network effects in this business two sided network effect right the more stores that use a given stamp system versus a Another one the more consumers are gonna be incentivized To buy at those stores because they want those stamps that they can redeem for big prizes etc Uh, right right. So yeah consumers want more stores to support it stores want more consumers to use it Yeah, it makes total sense. So By the middle of this entry There is one dominant national player in the stamp business the SNH green stamps Except in California Where a bunch of stores had banded together and shut out SNH and launched their own stamp The blue chip stamp company amazing unbelievable. I had no idea about any of this So in 1963 SNH and the Department of Justice Both sue blue chip for monopolistic practices SNH is trying to get into California and Recruits the DOJ why the DOJ wasn't like hey SNH year monopoly too, but anyway Ha ha regulatory capture I guess yep. So the stock gets pummeled when these lawsuits happen but Mungers heard about this in LA and he tells Buffett and also their friend Rick Garen who's part of the Graham group Which becomes the Buffett group? Remember mungers like a highly highly experienced top notch lawyer corporate lawyer He says what's gonna happen here is blue chip itself is gonna be fine But the government what they'll do with the DOJ will do they're gonna force all of the California store chains that collectively own blue chip to divest it And who better to buy it than us huh? So indeed that is what happens in 1968 Blue chip agrees to a consent decree with the DOJ where the stores have to sell off 45% of the company and boom Ha ha combination of Munger Garen and Buffett all snap up 45% in blue chip And of course like this sounds complicated to me because each of them represent a different shareholder base They're sort of talking to each other feels like something could be fishy there Yeah, it could be it could be Uh as uh the line we shall see in a minute is there's got to be an indictment in there somewhere Okay, so now we're in 1970 Warren has just unwound his partnership and distributed out shares of Berkshire diversified retailing which was a JV essentially that he had with mungers partnership to invest in department stores ill-fated idea and then blue chip and Remember Warren told his partners in the letter where he said he announced that he was winding down the partnership That he intended to buy more of all of these companies well he does And so just to be super crisp here Warren owns some Berkshire, but Charlie doesn't own any Berkshire at this point This is 1970. I think none at this point. They've created the JV of diversifies They're definitely in that together and they both sort of share this idea about blue chip So they both are big holders of blue chip as well. Yep So After Warren winds down the partnership he buys so much Stock in these three companies from his former partners that his ownership of Berkshire doubles from 18% to 36% His ownership of diversified doubles from 20% to 39% and he buys so much blue chip that he goes from 2% to 13% Ownership can blue chip just personally. So Susie's like oh no Second retirement is gonna look exactly like the first retirement here And this really was the case right he was like I'm winding down my partnerships what I'm done What was the line something about his style and sensibilities no longer being suited to the current environment and yet here He is heavying up on these three stocks. Yep, so Warren isn't the only one buying these stocks Berkshire itself starts buying blue chip so pretty soon Berkshire Warren owns 13% of blue chip Berkshire holds 17% of blue chip diversified Own 16% of blue chip And mongers partnership on his own owns 8% and garen owns 5% so 60% of blue chip is owned by these six different entities All of which also own stock in each other now listeners if you're feeling like this is convoluted and you know a little bit messy and I don't know maybe even like they might be sort of hiding something with the lack of simplicity here So does the SEC which we will get to in one sec, but Ironically while they're doing all of this buying they're just so like thrilled at the prospects of what they're doing The actual business of blue chip enters a major Secular decline so during the decade of the 1970s Blue chips core business even though they settled the DOJ suit the core business declines 90% over the decade Because consumers are just not that interested in stamps anymore credit cards are becoming a thing Seems like an outdated kind of thing So the business is declining then why were the why were they so excited about buying the stock just because it was in historical lows And they felt like it was a low multiple of the profits. It was generating I think the other part of it is the float So just like Berkshire Blue chip is Declining in its core business, but it's still got this super attractive float dynamic And if they don't own it outright like why is that attractive because they can't use that they can't take the cash out from the float to use it for something else right Right, right they can't take the cash out of blue chip, but they can redeploy it within blue chip so They say hey, let's run the Berkshire Playbook that Warren you just did with Berkshire Let's start looking for other Operating businesses to go by with our float here at blue chip So they tell blue chips president a guy named Bill Ramsey to start looking about for for companies to acquire And one day in 1971 he calls Warren and Charlie and he's like hey I've got a I've got a pretty interesting acquisition target here. It's a small little family company here in LA Called C's candy And so Warren and Charlie come in they start looking at the company and It's actually pretty interesting so C's people love it becomes wildly popular across California starts expanding they develop a slogan that they want to be known for C's quality Which is supposed to be even better than top quality you've got like high quality top quality and in C's quality It's so ubiquitous in California that you know the famous. I love Lucy episode where already know Oh, you definitely know this. It's like one of the most famous moments in television In the 50s where Lucy and Ethel are working in the chocolate factory and they're on the production line They're supposed to like wrap the chocolates as they go by and the chocolates start going so fast that they can't keep up And they're like stuffing the chocolate all like in their clothes. Oh, I do know what you're talking about. Yeah. Yeah It's it's amazing. It was modeled after a C's candy factory So the problem with C's though From Warren and Charlie's perspective is it is decidedly not a cigar bud So the factory and the stores and the hard assets on the books are valued at five million dollars But C's already has an offer on the table for 30 million dollars So this like fails every Ben Graham test in the book It's so crazy to me this like notion of cigar but that like you're trying to pay Less than literally just the property plan and equipment effectively and like we're not even talking about You know profit multiples here. We're literally just talking about like well Are they asking you to pay more than the liquid value of other assets and like oh? No six times the property plan equipment. Ah too far afield for me. Yeah, but this is where Remember we were talking about Charlie starting to get this tingling about great businesses and he's influencing Warren He's like hey Warren Let's actually look at the revenue and like earning side of the equation here This company is doing four million dollars in annual pre-tax profit and that's growing at 12% per year Without putting any more capital into the business like this is it might actually be worth paying this price So then what that's about 8x Trilling 12 months profit multiple totally. I mean imagine that like that's the offer. Yeah, that's the offer right on the table So Warren of course he hemson haws about it and he's like ah, I can't do 30 but we could offer 25 million And he the only reason he justifies it to himself at this point is he thinks well They probably have pricing power because people love the candy so much. So if we raise the prices Maybe I can get comfortable This is sort of the like brand notion that he's learned at this point of hey, there actually is a thing That doesn't show up on the balance sheet that has value. Yeah, he's starting to cover on so they do get the deal done with the family Blue chip buys sees for 25 million dollars and Over the ensuing years This little candy company delivers over two billion dollars in free cash flow to first blue chip and then when it would get absorbed into Berkshire Hathaway for a purchase price of 25 million This is the first time that this concept of a a wonderful business at a fair price versus a Fair business at a wonderful price is executed by Warren and and with Charlie's influence and Warren After a brief period of time of seeing the seas operating results becomes a total comfort So he would say later about this idea that it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price He says Charlie understood this early. I was a slow learner Love it meanwhile Charlie is also learning from Warren that managing other people's money maybe isn't so great So Charlie's partnership before 1971-72 had done not quite buffet levels of performance, but generated 28.3% IRRs for the first decade, which is still fabulous performance But not as steady as Warren that's the thing to notice about Charlie. He did lose money some years He did so he had some real big years and some down years and then in 73 and 74 Charlie's partnership falls 31.9% and then 31.5% and This is super scarring for Charlie He feels like he's got to like if he can get Almost like Warren and his sister been the first stocky bought back in the days like if I can get the partnership level back to roughly what it was I'm gonna work like hell to do that, but then I'm out. So he does that in 75 he returns 73.2% on the partnership in 75 and then he winds it down He's out he says you know what Warren's having a good time with this uh this Berkshire model I'm gonna do the same thing here with Lee chip Yep, and the difference being you know Charlie was still running other people's money at that point And I think he was doing a more traditional model management fees and Effectively carried interest or some kind of promote that he was getting above some certain hurdle But you know in that business when you're losing money you feel it really hard because you're being judged on that performance where I was with Warren The only other stakeholders that he had to think about were the the other shareholders in those businesses But Warren had made no promise to them of I'm going to be effective with your capital It was you know the structure was look I'm invested in this Company this C corp you're invested in this company this C corp like You can get out at any time. I'm not managing your money for you. Yeah, and so he just has all this He is the weight office shoulders. He can only lose his own money There's no one else to be mad at him and uh, you know if he does well It's just for himself, but he's got a lot of money So he can he has the firepower of a lot of capital without it being other people's capital. Yep And if the sack goes down Great he might just buy more of the stock like he doesn't need to feel terrible about he's not gonna put up a negative number at the end of the year for someone Right he does want to make sure that Berkshire never goes out of business. That's incredibly important to him But yeah any given years performance Doesn't really matter. That's not how he looks at things anymore All right in 71 back when they were starting to look at C's Warren and Charlie for Blue Chip Bill Ruin from the scoy of fund calls up Warren and says Hey next time you're in New York I want to set you up with one of my classmates from HBS This guy that I really think you'll enjoy meeting Why don't you get dinner with him his name is Tom Murphy Probably the fourth episode that Tom Murphy's come up on and acquired. Yes We've talked a lot about Tom Murphy or Murph as he was known and uh is known. He's still alive I think he's 95 oh awesome Yeah, amazing and his partner Dan Burke who of course ran cap cities and we talked all about them on the spn episode and turned it into this incredible media empire that today is like pretty much What at least 50% of Disney more uh, yeah, I think that's right ESPN. Yep ABC all the television stations and they do it all with no further capital investment after that one TV station on one very large and notable exception That we're gonna talk about in a few minutes here So they get together and Warren is Immediately impressed with Murphy and with capital cities and he just loves everything about this business And of course he's already familiar with the media industries intimately familiar with the newspaper industry He knows a little bit about the if not Television the sort of moving picture aspect of the media business because of Maybe the second biggest investing mistake that he made after Intel Which we intentionally skipped over in part one To have the big reveal here Then what is the Unbelievable company that in addition to Geico in addition to Amax Buffett had briefly owned 5% of during his partnership days Disney the freaking guy owned Disney and he sold it like after what two years or something of owning it when it reached its You know what what he felt was a good price for him to get out Unbelievable so Yeah, I think it was I think it was one year so in 1966 Disney had been trading at an 80 million dollar market cap the Walt Disney company and an 80 billion dollar market cap And it's not like Disney was much smaller back then like it was still freaking Walt Disney and It had the theme parks and everything And Mary Poppins had just came out and made 30 million dollars at the box office And the stock went down because Wall Street was like oh well Movies that's a hit-striven business, you know the next couple years comps are gonna be real tough after that Mary Poppins Like Mary Poppins just made 30 million dollars in revenue and the whole company is Valueed at a market cap of 80 million. Yes. Yes, unbelievable. Warren though being smart being Warren He's like wait a minute. It's Mary Poppins They're gonna be able to generate revenues for years after this like kids aren't only gonna want to see Mary Poppins Once and in one year Every generation of kids is gonna want to see this thing haven't taken out of the Disney vault So he values the company in his head just off Mary Poppins He's like the theme parks all the other movies. Let's assume all that's zero. That's my margin of safety He thinks that it's still worth more than 80 million dollars just on Mary Poppins He puts four million dollars of partnership capital into Disney buys five percent of the company And then of course Warren being Warren at the time within a year He's made two million bucks on that. He's made a 50% return and he sells the whole thing My god What's the quote quote better to be approximately the right than precisely wrong? Like sure he was approximately right But you have to stretch that approximately pretty far to be like it was the right decision for you to get out of that business I mean it okay, so the principle of that quote is Look, there's no way that you're gonna be able to exactly know the intrinsic value of the company So you you will never know exactly what you should pay for it either on your entry price or your exit price So you know, it's the margin of safety idea that you should be approximately right So if you can get a big margin of safety then you're sort of okay on the entrance price and you're okay on the exit price Even if they're not precisely correct well like You were way way off on what the intrinsic value of this enterprise could be and like sure you made money But this is the sin of I suppose it's omission Because it's that he didn't continue to make money in a way It's commissioned because he actually had to act to sell the stock But gosh how how different his net worth would be and who knows about Berkshire's future But if he had continued to hold 5% of Disney at that point Totally I mean Geico Amix Disney. We're not even talking about Intel. These are all companies That buffet owned like a meaningful percentage of in his very early days And uh didn't hang on to him No, all right. So he knows about the moving picture business from a little bit of Disney. So he's sitting down He's sitting down with Murf He and Murf are passionate out and Murf says to him what? Murf says after the dinner Murf is so impressed with Warren's you know sort of like management investing mind like these are Two people cut from the same cloth. He decides that he wants Warren to join his board So he flies out to Omaha. He makes a pilgrimage to go see Warren and he says hey I really want you to join the capital cities board He would have been really impressed with Warren's head office Yeah exactly like if you think about how capital cities was like Incredibly lean. This is like the only person who would walk into Warren Buffett's office look around and be like awesome Love it. I think there's some famous story Then we tell on the espn episode about how they only painted the fronts of their buildings And not the sides in the back. That sounds right though. Uh Amazing So Warren's like look Tom I love you in Dan, but Honestly the the only way that I can join your board is if I were to own a large chunk of your company And this is like an impasse because just like Warren Tom equally feels like issuing stock is the ultimate sin and he refuses to do it So they agree that they're just gonna be friends They will turn to each other for advice on their various businesses for the time being but there's not gonna be any any formal relationship It was also quite convenient of Warren to do this because he knew That the FCC rules were such that they would not let anybody be on the board of Multiple different companies that owned television stations around the country and Warren's got his eye on another company That owns some television stations The Washington Post Company Ah right. I didn't realize I forgot they they had gotten into TV at this point already Yep, they had they had so And his boyhood dream is paper route and the reason he's got his eye on the post is they've just done a public offering What what year is this? This is 1971 71 okay, so still only like a year or two after he's wound down the partnership He's still in retirement mode Here's a little early carve out too for anyone who who wants an unbelievably good sort of dramatic telling of that IPO and the events around it Go watch the post with with Merrill Street post. Oh, it's so good We definitely have to do a whole episode on the Washington Post Company at some point But suffice to say for now that the story is equally if not more amazing than the New York Times company The short version of it is that heading into the IPO the post has been in the Meyer slash Graham family for 40 some odd years at this point The CEO of the post but not the chairman the CEO is a woman named Catherine Graham who her story is just Probably many folks have heard of her is just amazing Watch the post and and we will tell it someday but she Assumes the role of publisher and CEO at age 46 with four children having never worked a job in her life And goes on to become one of the greatest CEOs in American history You know sees the paper through the Pentagon papers through the Watergate scandal grows the value of the company enormously She was one of the CEOs that will Thorndeck profiles it in the out there's book Yeah, so great. So Warren Seize all this from the outside. He's got the attachment to the post the IPO is happening. He says This is going to be my my opportunity to come back So he reaches out to her initially with an idea he wants to tread carefully He's very respectful of came and the Graham family and what they've built he also Knows that it's a dual-class share structure. So they have control like there's no No matter how much stock he buys like there's no all the decisions in the company are getting made by the Graham family Just like at the New York Times. So he reaches out with an idea and says I've heard that the New Yorker the magazine is for sale Would you be interested in maybe doing a 50 50 bid JV to buy it together and she has no interest in that right like yes. Yeah, she's like I'm learning that'll be a CEO here We're taking the company public the Pentagon papers are happening Uh, no very nice to meet you mr. Buffett from Omaha, but thanks but no thanks But Warren's like that's like I've gotten to know her. I've got my foot in the door two years later The person who was chairman of the Washington Post Company Fritz BB who I believe was a long time family lawyer Of the Myers and the Graham's he dies and his estate is being liquided of which there's a lot of post stock it and Warren arranges to buy a 50,000 share block from the estate And uh, you know has to has to feel underhanded right like if you're the Graham family you're like sorry Who's buying what yeah, who what this guy at Omaha and he'd also been buying on the open market too And he now owns 5% of the company so when he's having dinner with Murf he's like He's already got his plans in motion here So he writes kale letter Remember they've already met and he says this purchase represents a sizeable commitment to us being Berkshire and an explicitly quantified complement to the post as a business enterprise and to you as its chief executive Reading a check separates conviction from conversation. I recognize that the post is Graham controlled and Graham managed and that suits me fine Ha so you already sort of get this beginning of him Wanting to be a wonderful sort of an owner of wonderful businesses without controlling them and leaving sort of family owners in control exactly he wants to be a Partner to great managers and stewards of generational businesses K nevertheless probably rightly is a little spooked. I bet you get an activist and investor Who suddenly sends you a letter and says by the way on 5% of your company? Yep, and you're just so great It suits me fine that you control it It probably also is known at this point the way that he sort of rated the textile mill company of Berkshire Hathaway If you go digging on Warren you can find Some skeletons in the closet. Yep So she agrees to meet with him briefly when she's out in Los Angeles and Warren's Thrilled she shows up at the meeting famously looking like K she's you know K Graham. She's like one of the most prominent state Lee state Lee one of the most prominent people in the Washington social scene She's probably the most powerful woman in America at this point in time hanging out with presidents Yeah first name basis with yes everybody in Washington And Warren shows up looking like you know the bedraggle the wrong size suit You know guy from Omaha from the hills And she thinks this is just hilarious. They hit it off right away in this second meeting And she says you know what maybe this Warren guy isn't so bad. Why don't you come back out meet with me again in Washington So he comes back out to Washington Show stuff right in the middle of the watergate proceedings where K and I published her been Bradley and pulled an all-nighter the night before Making decisions about what to publish about watergate But she still makes time for him they go out to lunch and then afterward Buffett presents her with a contract that he's had drawn up That legally binds him in Berkshire that they will never buy another share of the post without The Graham families permission And by the way by that time Warren Ardeo and 12% of the company because he's kept buying In exchange for what like why why would he say just we voluntarily not in exchange for any he just he just really wants to be on Case good side and he really really wants to be on the Washington post board And so he's kind of presenting I think he uses the term the he invokes little red riding hood and the the wolf he says you know I may look like the big bad wolf, but we're gonna take the fangs right out of the wolf I've never gonna buy another share without your agreement. I've had this contract drawn up It's kind of funny, but Kay loves it and They sealed the deal she says well, okay then, you know, I'll start calling you for advice And what Warren really wanted her to say was Why don't you join the board then as a 12% owner of the company, but she doesn't Warren desperately wants to get on the board and and why is he want to get on the is it an emotional thing or is it we haven't talked about why Warren views a paper like this as such an incredible business is it worth taking a moment on that I think the board things specifically is probably an emotional thing But the paper Yeah, at this point it's not only the dominant paper in Washington But it's the you know one of the foremost publications in the country if not the world after depending on papers and the watergate scandal So it both has that franchise effect in Washington. I mean it is the paper for that city Which I think this comes from a little bit of a different story with the Buffalo evening news Which I don't think we'll get to today, but Buffett famously referred to Being the only paper in town or the biggest paper in town as an unregulated toll booth that you have where you basically have pricing power And everybody's going to subscribe to the newspaper. So you know, it's a it's a licensed to print money So there's definitely his notion of a franchise town newspaper is awesome This is one of the ones in the most important town in America and now it has this national international reach Not to mention all of these sort of great characteristics of a media business where you create the content once and then it's infinitely replicatable And of course there's delivery costs, but freaking good business. That's wonderfully defensible Yeah, and I think specifically On that defensibility of the newspaper part of the business at the time And the the winner take all network effect in any given geography is that If you're able to amass enough readers, it's just like the stamps business Then the advertisers want to be where the majority of the readers are And once you get the ad dollars flowing in from the advertisers Then you can offer Deals it's like it's like the group buying clones in in in China You can offer subscription deals to enough subscribers to grow your subscriber base That you can crowd out all the competition and the market Just naturally tips to a single player and that's happening in Washington in a large city So this is a fantastic newspaper franchise All right, so he's built himself a 12% position He really likes the company he wants to get on the board, but he's not on the board He's down on the board. What happens next is like a middle school dance. It's hilarious so he doesn't have the courage to say to K In the meeting You know, hey, I'd really like to join the board and I presented you with this contract Instead he calls up Murf and he says You know gosh Murphy I really want to want to join the the board of the Washington Post But K doesn't seem to be getting the message Do you think you could go see her and you know tell her what how great a guy I am and you know that That I'm really not so bad and and I really do want to join the board if she would just ask me Wow, so Murphy dom goes to see Kay and tells her and she's like oh my well Yeah, um, I guess that would be nice to have him on the board. I really respect him well But I can't really just send him a letter and ask him like he should really ask me So worried is like I'm gonna invite Kay out to by this point in time he and Susie have a house in Emerald Bay in Laguna Beach in orange county in California I'm gonna invite Kay out to a weekend at the the family house in in California And I'm gonna be like it's gonna be perfect on the host K the socialite Make it perfect for her and you know at the end of the weekend then I'm gonna make the ask To join the board So he's really putting on a show for Kay. She comes out. She's a little puzzled the whole weekend goes by He doesn't ask he doesn't ask and then on Sunday morning Kay finally turns to Warren and says So I hear you want to join the board But I'm not sure you know, I'm waiting for the right time to do it to bring it to my other board members And supposedly Warren you know looks at her with longing eyes and says Kay when is the right time then And they fall into each other's arms and she says I would join my board and this is the beginning of a immense friendship between them They become incredibly close for the rest of Kay's life. They go to events together They spend weeks at a time together in each other's houses in each other's apartments in various cities It's never been written whether this relationship was purely patonic or also romantic Unshur, but it certainly becomes a you know amazing relationship Warren would stay on the board of the post for most of the next 37 years. Oh, I didn't realize it was that long Yep, so the 12% stake that Buffett buck for Berkshire cost 10 million dollars and in 2014 to put a bow on the post investment Berkshire sells its stake in what is then Graham holdings all the rest of the Washington Post businesses after Basas buys the post itself Berkshire sells its stake for 1.1 billion dollars Which is only a 12% IRR from the initial 10 million dollar investment However, the post had also been paying dividends all throughout those oh wow 40-50 years so I don't have the data on total dividend return Berkshire received in cash flow and dividends from the post But suffice to say it was an excellent investment on Warren's part So 10 million for 1.2 billion 1.1 1.1 wow By that point, it's funny. It's actually not a big holding for Berkshire relative to everything else they owned by the time they they Bezos buys the post yeah, and you know, Bezos ends up buying the post. I think for 250 million something like that when that happens in 2014 2013 2014 Certainly the value of the post during the heyday of the newspapers of the 90s and 2000s was Much much much higher than that and the cash flow that it was spitting off that and sending back to Berkshire Another shareholders was significant Did you hear by the way a little Easter egg that in the in the annual meeting one of the the questions that Becky quick from CNBC Was written in by Don Graham. No, I didn't see that. Yep. Amazing Don of course being case son who would take over I think he became CEO before her death and then and then after her death became chairman and CEO Too funny All right, so that's the post So let's reset a little bit on time frame and sort of Warren's evolution here Everything's not yet consolidated under Berkshire, right? Like who was accumulating the shares of the post So that was Berkshire Okay, but he's got this whole blue chip stamp thing going on yep and diversified And so we've been alluding to The hot water that they get into with the feds So right as Charlie's Closing down his partnership and this is like 75 75 yep in 75 He and Warren get a call from one of Charlie's former partners at MTO check Rikker Houser who had done the seized deal for them And Chuck says hey guys. I just got off the phone with the SEC And they're considering pressing charges against you for securities violations for this Russian doll You know version of Corporate structure that you've got going on here and he famously tells them check would spend like weeks putting together a corporate flow chart of all these different entities And who owns what we'll try and link to an image of it in the show notes. It's amazing There's so many different subsidiaries and sub entities and he looks at it and he says There's got to be an indictment in here somewhere guys I don't know what you've been doing but I remember reading this when when I was doing the research and The Buffett image that you know of today the sort of folksy near benevolent Multi billionaire or multi-deca billionaire. I don't even know the right phrase for it would be 100 billionaire If it wasn't donating so much to the Bill and Melinda Gates foundation That he Was in hot water with the SEC like it's just the last thing that I would have expected Uh as sort of the Buffett novice before I started doing the research It's still what I was reading about this. I was picturing word and Charlie like two pocket and uh Picture me rolling and the the federal allies want to see him dead And now David Rosenthal that is an image I can never unsee you can never unsee that But it's so apt literally the feds are like I don't know what's going on here, but like I don't like it Clumian it was something to do with the fact that they ended up paying more Yeah for something when they could have actually paid less my understanding is I think the feds had sort of Been on the tail because Warren especially is you know now becoming so known. He's he's he's high profile Like he's on the board of the Washington Post like how much more high profile with agencies in Washington? Didn't you get so the investigation comes to center on a company called westgo financial That blue chip had bought after C's they'd kept looking for other great businesses And that they'd bought a stake in westgo and this some kind of bank. It's like a financial services business at this point Yeah, it was it was a financial services business in southern California and What happened was there was another company? I think like Santa Barbara financial corporation or something like that financial Corporation of Santa Barbara that had a buyout offer for westgo and Warren and Charlie thought it was undervalued and Head sort of stepped in and scuttled the merger and ended up Investing through blue chip in westgo instead. So there was still a stub kind of public basically backstop the price Because they're like look we already we hold a bunch of this already We're not gonna let you buy it for this really cheap per share price So we're gonna come in we're gonna lead another investment round effectively and it or buy some more of it at a higher price To make it so that like you're not gonna get away with this steel that you're you're coming in and so the way it goes down is They Through their working convincing, you know the board and the family that owned most of westgo they convinced them to drop the merger when the merger drops this the westgo stock falls of course Mm-hmm, and that's when Warren and Charlie invest but they feel bad about Tanking the stock price so they decide they they work out a deal with the company and with the family that they'll buy shares and Invest I can't remember if it was at the merger price or maybe even slightly above and the feds are like wait a minute There's got to be something shady going on here because like a you scuttled the merger b you then Could have just bought the stock for Lower but you paid this artificially high price. What's going on every other time we're investigating someone what they ended up doing was buying the stock as cheap as possible after they Presipitated an event that made the stock price fall So they're very confused so Warren ends up getting subpoenaed and Testifies that they paid the price they did because quote it was important how westgo management feels about it Now you can say well we own the controlling interest so it doesn't make any difference But Lou Vincenti who is the president of westgo he doesn't really need to work for us if he felt that we were you know Slabs or something it just wouldn't work And monger when he's testifying He of course invokes who else but Ben Franklin In his testimony he says we didn't feel our obligation to the shareholders was inconsistent with leaning over backward to be fair We have that Ben Franklin idea that the honest policy is the best policy It had sort of a shoddy mental image to us to try to reduce the price So it's almost like the notion of like the VC founder friendly thing where we're saying hey look like Let's take a super long lens here and say that the way that we're going to maximize value for everyone Including ourselves with way down the line is by making sure that management likes us as shareholders and feels that we're You know differential to them and not not capturing every little bit of value We possibly can out of their company at their expense. Yep And he's totally right. This is something I always wondered You know from afar looking at Berkshire they buy these companies that are If not wholly family owned businesses many of them are public companies But have a large family controlling ownership like westgo like the like the post They buy these companies and then the family or the current management often stays on and keeps working there I'm like why would why would they do that? And this is the key why because they're not just trying to like they're playing the long game You know, they what they really want is great managers who built great companies to stay running them And the way to do that isn't to You know negotiate every last dollar out of them Or even if it is like I think some of I think we're conflating two things here a little bit I think Berkshire does make sure they get a great deal when they buy a family owned business outright You know they they they're good at buying low But They either just believe that the business has so much future upside in it that they're willing to you know meet in the middle on price or They are very good at identifying managers who have a splinter in their mind to continue to do the work Like there's something about they're very good at this Shrewdly evaluating even if this person no longer holds a single share of their company Are they going to show it for work every day because this is their life's mission and purpose and You know, I'm not totally I don't think that's what was going on in the the West Go financial situation But I think when they buy these family owned businesses There's a lot of that in the evaluation of the business and they They definitely compensate those managers Well, yeah for their continued performance And I think that was like part of it here too because it's almost like this is part of the upfront compensation Is the price that they're going to pay right for the company this whole thing sucks though Like they're this is like a multi-year Drawing out thing with the SEC where like it's hard for them to get on with their business And every other facet because they have this thing going on not to mention it's not Great for their reputation when they're going out trying to talk to the K grams of the world and saying hey No fangs here when the SEC is investigating them So they end up sort of coming to this gentleman's agreement with the feds where Blue chip which had which had been the primary player in the West Go saga Although I think Berkshire and maybe diversified were also buying shares too of course was part of the problem Promises not to do it again something like this It's like no admission of guilt, but we also won't do it again But we didn't we want to admit that we did it, but if we did do it we won't do it again and Most importantly Warren and Charlie agreed to start taking steps to quote simplify this complicated Rats nest structure of companies that they have so Right off the bat the finally merged diversified into Berkshire which they had wanted to anyway and by this point diversified owns a large chunk of Berkshire shares Charlie gets installed as the chairman of West Go to be sort of more arms length than Warren And they make it a gold emerge blue chip into Berkshire as soon as all of the remaining kind of legal suits Wind up and and settle here that actually takes a while, but it finally does happen in 1983 Why that really took a while then it really does take a while. Yeah, I'm not sure exactly why But especially since DCC wants them to merge it all into one company. Yeah, and Warren and Charlie want to as well For whatever reason it takes until 1983. All right, so They're making an effort to clean things up. They've got this SEC thing behind them. It's the late 70s There's another chapter on the horizon for Berkshire. Oh, oh yes. Is there ever and indeed Is a chapter involving an old flame the original Crash of Warren's this is like I think this is the thing about Warren You know, I don't know about his romantic life and situation It's it's certainly also complicated There's a lot about that in the snowball and elsewhere Not the scope of our show to get into But he certainly has like a serial love affairs with companies Well, and somehow there's all these businesses that he has like a romantic flame for from his childhood And from various parts of his life that just so happened to be these like unbelievable businesses Where like it's a furniture mart or it's the soda he drank growing up or it's the newspaper he delivered and like investing in each and every one of those proves to be like a once in a generation Unbelievable business. It's almost like big fish in a way like this man's life is just surrounded with these Like six sigma events of like really crazy It or forest gump or like what are the odds that the smartest guy that the army ever surveyed or the Air Force ever surveyed in that generation iq Wise happened to also be born in Omaha and then get introduced to him by work at the grocery store It's just crazy work out work for his grandpa Yeah, oh, and it's also funny that like Warren and Tim are more Warren here than I think Charlie He's so smart and so analytical like you know, Charlie Munger thinks he's the smartest part Warren is the smartest person he's ever met that's saying something At the same time Warren is also so Emotional and nostalgic and has this I think you said it on the last episode this sense of like you know What he looks for in companies and what he absolutely wants to be himself is like viewed as an artist painting a painting Mm-hmm. So of course We're talking here about gaggo in the intervening at this point it's like 20 years or so two decades Since Buffett had tragically sold his gaggo steak The company grew immensely it made the acquired like Growth in its Target market when we went from just acquisitions to just to telling the story of all great companies like where you going there When it moves Beyond just targeting government employees to opening up to anybody Non-government employees can also get their auto insurance through gaggo Mm-hmm and this is huge The problem though was that in chasing this growth in this new market the tight Underwriting and pricing of risk of all of these new customers Didn't quite keep pace Bydona Done it. I if you don't remember one of the reasons why gaggo was such a great business was Through the Customers that they were targeting as government employees for whatever reason or another Happened to be much you know safer drivers than the average population It's a known data set. It's a pre-homogenous group and you know, it's a lower risk homogenous group totally so they didn't really Update their pricing enough as they've broadened out to the rest of the population and As we talked about last time in insurance There is never any such thing as a bad risk, but there is such a thing as a bad price and the doubly compounding problem For an insurance company when you've been mispricing your risk over many years is that Just like you get the amazing benefits of the float business model where you get the money up front You get to use the money before you need to pay out claims When you misprice your risk that whipsaw is on you once you realize that You're going to be on the hook for a lot more dollars than you have capital available You're in for a long period of pain because The premiums that you got they're already in the bank you can't go get more money than those customers But you know that you're now facing years of streams in the future of More money that you're going to have to pay out than you have Yeah, it's like you just let someone walk into your casino without testing the game and Turns out the game actually pays out the people who are playing at the casino more than it does to the house Totally and You're not able to change your odds or the structure of your game for a very long time where you can only change it for like new customers You come in the analogy breaks down somewhere in here, but yeah, it's bad It's bad and it's not getting better anytime soon So in 1976 the company announces a hundred and ninety million dollar underwriting loss the largest in its history Maybe even the largest in like auto insurance history period at that point in time They eliminate the dividend for the company because they need to conserve all the cash that they can to deal with this And Wall Street figures out they don't have enough capital to cover future losses This is like a crisis situation Insurance regulators descend on the company the stock drops from $61 a share to two dollars a share Like if you imagine that you know, what's that like 90% value destruction you want to get to the exits before anybody else does if you're a shareholder totally So more unfortunately hasn't had all of the cigar but Ben Graham I radically Ben Graham with Geico philosophy beaten out of him this peeks is interest again in Geico So he thinks he's found another you know, MX type situation where yeah, like what where's Buffett to say that they're gonna recover from this Then he's not gonna you know catch the knife on the way down Right So he wants to find out can this actually be turned around but unlike the salad oil thing Where it was pretty easy to figure out like yeah, this is gonna be good like that's not gonna be the case here There is no way to avoid the years of paying ahead. The Geico is gonna go through but There is Something that Warren See's happening that the rest of the market doesn't quite understand yet Which is that Geico you know, it a good move fires all of its management team and brings in a new CEO He grizzled literally grizzled veteran of the insurance industry who warranted heard about Name Jack burn and this guy is a legend and does Warren have anything to do with installing him or have no no no This is just watching from afar. He's waiting to see if there's something that like A glimmer of hope that maybe Geico could make it out of this because the stock is like super attractive in two bucks Sure, right. So this is their current board like figuring out what to do here. Yep. Yep. Yep partially at the Shall we say request of the regulators so they'll like yeah you guys have really gotten yourself Up a creek here So Jack had been one of the top execs travelers insurance Before he resigned in like a huff when he was passed over for CEO. Wow. That's gonna come full circle Totally. It's absolutely gonna come full circle Listeners remember remember travelers insurance just so David and I aren't like making inside jokes here Like as we get to the end of the episode So Jack is like he's the man for the job He comes in the engineers a plan to go out to all the other Auto insurers in the industry and Basically argue to them like hey if Geico goes under Yeah, you'll lose a competitor But it's actually gonna be terrible for you because like if we go bankrupt all of these underwater policies The regulators are gonna make you guys absorb them like you don't want that. Oh, man. Was that true? Is that what would happen? Well, I mean you can't operate a motor vehicle in America without car insurance Like so if you're insurer goes under You need insurance and especially if you got claims underway Hmm, like what's gonna happen to those like if the insurance company behind those claims goes away Interesting. So this is the argument that burn makes to the industry and It mostly works and the deal that he proposes is to get all these other auto insurers Not to buy Geico but to reinsure Geico for some of these future losses off of their own balance sheets They remind us what reinsurance is Well, so reinsurance is anytime Uninsure Is selling off some of their risk in their portfolio to another Insurance organization and there are large reinsures like kettle that we've talked about in the show What am I angel investments all they do is they buy Risk off of other primary insurers books, but primary insurers can also buy a risk off of each others books This is like just to keep bringing it back to Vegas for fun if a sports book messes up and sets the line in the wrong place And then they end up like 70 30 on You know or the Patriots gonna win or the Buckingeers gonna win I can't remember if they were played in the Super Bowl But just throw names out they will go to another casino and bet the other side to basically make it so that they're sure They're not gonna make as much money on a sort of expected value basis But now at least they're not overexposed on one side versus the other Exactly exactly when your example. I mean Tom Brady's gonna win the other way so That's the bet to make but whichever team currently has Tom Brady is the answer to that game There's probably a way to make that bet somewhere I love it we digress though we digress So this plan actually buff it is like that's a good plan. That's like a creative plan that that could work So he gets K Remember GaiKo's in Washington and K knows everybody in Washington So he buff it doesn't actually know Jack he gets K to broker an introduction for them They meet at K's house in Washington Buffett grills burn for hours and he's like oh yeah This guy's gonna do it So just like The first time that Buffett met GaiKo when he goes Takes the train down he meets Laura Mrdavitson and the very next day He'll equate 75% of his portfolio to load up on GaiKo. Jim press Ben Graham the next day After the dinner with burn at K's house He buys four million dollars of GaiKo stock at two bucks a share So he he loads up. He's all in So now I didn't actually disentangle that versus what he would Buy in what's gonna happen next So it's some meaningful percentage but after what happens next Buffett's gonna end up with a third of the company Right, so this is like high single digit low double digit that he just bought in the company Yeah, probably in the double digits So now GaiKo's back by Buffett Burn is the man for the job things are looking up but they still need Capital to operate like they're they're out of money. They're gonna sell off some of the risk But they've got claims that are happening now that they need to pay off So they need to go raise money So Buffett tells burn to go up to New York and do the rounds with the investment banks and Line somebody up to do a secondary equity offering Not there None of the biggest stylish banks want to touch This situation except for one there's one bank that is willing to take on enough risk And enough risk to their reputation of what could end up being a broken offering here Which all the you know white shoe banks are like? We don't do broken offerings here So I don't actually remember who this was. I'm gonna guess by the relationship that gets forged for future events that it's Solomon brothers It is Solomon brothers The Bank of Liars poker Michael Lewis Bayon which we will definitely come back to in a sec They're the only bank that is willing to Underrate what ultimately ends up being a $76 million convertible debt deal convertible in equity That they underrate Buffett flies to New York and tells us not just Solomon brothers It's one specific person at Solomon brothers guy named John good friend who is a rising star there Remember that name folks So good friend and Solomon underrate the $76 million dollar deal Buffett flies up to New York to sit down with good friend and tell him Hey, look, I know this is gonna be a tough deal to get through Even Solomon brothers famous sales distribution channels even your famous prescriptionists out there If things go sideways and Berkshire We're willing to underrate the deal and do all of it But we're gonna do it at a much lower price than what you go out with if the deal is broken Secret friends like yeah All right great at least 12 I'll go trade on your name then at least and say tell all the all my clients like Hey, Warren Buffett already owns a large percentage of this company and he's willing to okay So what do you mean trade on his name like what do you mean Buffett will do it all but at a lower price like he would Buy the whole offering like if they're trying to sell a whole swath of stock at a certain price Is this the convertible preferred that they're selling yeah, this is the convertible I think it's convertible debt not convertible prefer okay, but yeah, essentially what what Buffett says is he's like look I'm good for the 76 million But I want you to go out there and try and get this deal done at like less delusion It's such like a higher price on the convert It's like when an insider In a venture round tells the company hey like I'm good for my pro rata uh In whatever round you raise go raise the round go get a price if you were to lead an inside round you know I'd lead it like if you wanted to do an inside round But it won't be at the price where you could go raise your extra to like your extra round exactly That's exactly what's going on here So good friends like all right. I can work with that You go out solve them brothers sales and trading famous Aggressive sales and trading desk they get the deal done it ends up being oversubscribed And Buffett does end up even though it's oversubscribed and goes out at the price that they wanted Warren's like all right. I think this company's gonna make it he ends up buying 25% of the deal even at full price Hmm for a broker the stock Even though they just issued new convertible into equity you know securities The stock jumps to eight bucks a share because people realize hey, this is This is good news This thing could make it out alive and if it does damn good business. Yeah exactly. So Geico is now Got two of the three problems solved. It's got it's capitalized. It's got enough money to make it through It's laid off a lot of the tale of of risk in their current book over the coming years with the reinsurance deals that they do But it's still not pricing right so the thing about auto insurance and most consumer insurance is You need licenses to operate in any state and part of the licensing process is you have like a license to Sell insurance at a certain price. You can't just like arbitrarily change your price on your customers That's the regulators don't allow that Hmm. It's a super weird market. It's not like uh, you know We could change the price of the LP show tomorrow if we were only allowed to make a certain amount of profit to There's sort of a cap on the profitability of insurance businesses Exactly. So this is Burns time to shine and this is amazing. This is my favorite moment. I think of this whole second episode So he goes out to all the states individually he explains the situation and be like hey, we were mispricing We got to raise prices on consumers And some of the states are okay, but then apparently New York right off the bat is like yeah, we get it Okay, fine, but some of the states are playing hardball and in particular New Jersey is playing hardball. Huh? I mean New Jersey, right like uh burn and sell north Yeah, burn himself is from New Jersey. So he's like all right You want to you want to do some mafia tactics here. I'll do some mafia tactics So I'm just gonna read what happens next from the snowball because I can't do this any better than than Alice Please So Burn marched into the New Jersey commissioner's office with a copy of the company's license stop rate in the state in his pocket and told Sheeran the commissioner that Geico must have a rate increase This is now a quote from burn. He had a sour ass little wise and actuary at his side who'd been fired by some insurance company and had a bone to pick Sheeran said my numbers didn't justify a rate increase I did all the arm waving and stuff that I could and mr. Sheeran was intractable So burn pulled the license out of his pocket through it on Sheeran's desk saying I have no choice But to turn in the license or something to that effect with more four letter words He then drove off to the office with his tires screeching sent out telegrams to 30,000 policy holders in New Jersey Canceling their insurance that day and fired 2000 New Jersey employees in a single afternoon Before Sheeran could go to court and get an injunction to stop him It says it showed everybody all audiences. I was serious about this and then I was gonna fight for the life of this company No matter what including walking out of a state which wasn't done back then Burn's impalement of New Jersey had exactly that effect Everybody knew he was serious And so do they end up actually just vacating New Jersey and just didn't serve policy there They literally vacate New Jersey they vacate a bunch of other states and burn is like you by name He's like look this is war like we're either gonna we got a reprice so either we're gonna Burn the house down You know and vacate these states or we're gonna be allowed to reprise so Geico by the end of this has shrunken down to only seven states the original Travis Kalanick. I know I know It's amazing He has shrunken down to only seven states Burn has completely swapped out everybody in the company famously It is a lot of the sort of middle and lower management in the in the company it was from the you know the old days Undiscipline days Apparently at one point the then existing HR director is giving a speech in front of the company and burn gets so upset That he storms on stage and fires him on the spot literally like gives him the hook takes it on the stage points It's somebody in the audience and says you're the new HR director It brings him up on stage amazing is Laura more still there at this point in history? Laura more is longer tired at this point in time But he's like cheering on from the sidelines that he's advising burn and buff it behind the scenes wow Amazing, so they shrink guy go down to only the seven states and DC that let them change the rates And they write the ship and they price the policies appropriately the company gets profitable It stops losing money it starts growing again and then would go on to become what it wants Say in the annual meeting this weekend. I think that they have like 20 Insurance company. Yeah progressive is slightly larger, but I think they each have about 25% of the US market Something like that Incredible and he spent $47 million from 1976 to 1980 to buy is it about half the company? So yes by the time the debt offering closes And then when the share price jumps I assume the debt converts at that point Berkshire owns 33% of guy co But because he's Warren and because this is now like what of his jewels He runs the playbook that he's also helping K gram run at the post Geico starts buying back its own stock so by the mid 90s were fast forwarding to What we'll get to this later in the next episode by the mid 90s Berkshire has 50% of the company without putting in another dollar and Then in 1995 Berkshire buys the rest of Geico that it doesn't own For 2.3 billion dollars They can have the company for 40 47 million and half the company for 2.3 billion either way they get a hell of a deal Because estimates are that Geico's worth probably about 50 billion dollars today maybe more So that's 25 billion of value assuming that's 50 on 45 billion and 25 billion of value on 2.3 billion Either way pretty good either way pretty good Warren's like look at me now feds listeners even though this is going to be in the final Part of the trilogy we do have to tell you that the in 1996 the 2.3 billion that was used to purchase the second half of Geico you might be saying to yourself Why did it take so long if you really like this business forever? Well Berkshire had a lot of cash tied up another stuff for a while and a thing that happened pretty much immediately before this 2.3 billion dollar transaction for half of Geico was that Warren Had a big investment in capital cities and Disney came in and bought ABC capital cities Which then of course in that outright sale All the proceeds went to good old Berkshire and that was a little bit More capital than 2.3 billion but about the same amount that suddenly they had to play with to go put to work somewhere else and Geico was where they decided to go put it to work what better Jewel to Put that capital into think Geico amazing. So you know, it's funny. We said on or I said on the first episode Something that I was totally convinced was right at the time and now maybe not where I said that Got a if Warren had just held on to Geico and not sold Imagine what his returns could have been You know who knows what would have happened otherwise, but You know Geico almost died rightly if he had held on what he've had this ride anyway and ended up here He got to buy back in it two bucks a share Totally Yeah, that's a good point. He did get it at an extremely low-basis even though he skipped a few decades of compounding and growing in there It is also worth pointing out that despite the fact that it is above at mantra to hold businesses forever hold great businesses that you believe in forever He can dump a stock just as fast as the next guy I mean the way that he dumped all the airline stocks at probably the low point of the covid stock crash It was really interesting hearing him on stage last week where he's he was totally unapologetic for that Thought it was totally the right move and you could imagine that He easily could have been convinced that that was the right thing to do in the Geico situation too totally and all that matters is The long run So as a Charlie monger would say who is it? I think it's Charlie quoting John Maynard Keynes that in the long run we're all dead so But in the long run Geico becomes you know one of the major jewels if if not the the most important piece of Berkshire Especially given all the float that they Generally I guess that is that is the big thing that Berkshire and Warren miss over That 20 year period where he's not invested in Geico is using the float Yep, there is a playbook theme. I want to pull forward here Which is and it's actually two themes and it's important to know how they're different The first one is identifying things that have far less risk than the market perceives them to have And that's things like American Express that's things like He's realizing that brands are more powerful than value investors Give them credit for or the magical thing of a monopoly franchise newspaper But then there's the second category of identifying things that should you act Will have far less risk than the market perceives them to have and even more importantly If you uniquely have the capability to act Then you actually can be value creative like the thing that he did with Geico in making sure that that financing got done There's not a lot of people out there whose name can be traded on to get an offering done like that And buff its willingness to both strategize and then put his name on the line And of course this name wasn't really on the line because otherwise he just would have gotten this scream and deal But did it thing that he was uniquely suited to do and able to do It meant that in a self-fulfilling prophecy way the investment was way less risky merely because he was involved Yep. Oh boy. Is that ever Is that ever the case and does Warren ever know it David? I figured I'd set you for that next story We got good. Well, you really are you toss that ball in the air and I just I cannot wait slam it But before we get to Warren getting punch drunk on his own reputation and ability to To save businesses So all the Geico situation wraps up got around 1980 and you know, it's off to the races The rest of the beginning of the 80s is just more goodness for Warren and Charlie and Berkshire So Finally when Paul Volcker becomes chairman of the Fed first at the end of the Carter administration and then under the Reagan administration He Enacts the you know correct fiscal and monetary policy to reverse the terrible inflation that had been happening and the 80s just become you know We're both children of the 80s like an immense period of prosperity the 80s and 90s for America So the 80s in the go-go years, you know, this is Wall Street movie this is Access this is everything and it's a good time for Berkshire in Omaha too So we won't go into all the details but they buy the Nebraska furniture mark from Mrs. B Incredible story she Think it's upset with the way her children who are like in their 80s at this point or nine 70s are running the business She leaves starts a competitor across the street at age 95 Wood Berkshire has to buy it back for five million bucks and sign a non-compete with her at age 95 amazing There's the Buffalo evening news in here sort of the early 80s, which is when Buffett really is at the early 80s Yep early 80s. Yeah, he gets it into a good old-fashioned newspaper war He's trying to be the franchise newspaper in the city ends up sinking tons of capital in gets into a Oh, not a fight, but a few disagreements and has some words with with Charlie about the right things to do But you know buffets a committed guy There's a bunch of stuff that happens in here that we could do 10 episodes and wouldn't have time for it all Totally he he goes to war with the efficient market hypothesis theorist, which is amazing It's just like at Columbia's 50th anniversary event of the security publishing of security analysis He gives this talk where he just like calls it the super investors of Graham and Doddville. It gives this long talk Viscerating the efficient market hypothesis Folks economists which basically their hypothesis is that all markets are efficient and that changes in price are simply volatility and Around the efficient price and that volatility equals risk and so that is Market beta and that's all there is like when if you're investing there is no such thing as investing acumen You're just taking volatility risk in the market Charlie has a one word Retort to that which is bullshit Warren goes through and eloquently explains why that's wrong Well, and and they just have a lifetime of investment results to prove it like they actually can generate alpha How well like otherwise you have to believe that Buffett has Has flipped a coin and it's come up heads, you know 100,000 times in a row like you're into these crazy probabilistic scenarios where you know at some point It's too many standard deviations away from the mean for you to believe that it's possible Yep, and the reason this is important for what's about to come is So like all this is theory right this is like economic theory But it has a very very important real world consequence in the 80s which is that People who you know use to their advantage the Academic thinking behind the efficient market hypothesis that risk equals volatility They realize that well wait if risk equals volatility and you can't get alpha the way you can get more returns if you Take something that has a certain degree of volatility And then you lever the crap out of it with debt you magnify that volatility And then you can magnify your returns if you arbitrage that and so this is when you know The 80s are the debt fueled decade, you know mortgage-backed securities get introduced all the junk bonds and Michael Milken and DLJ and corporate Raiders and corporate takeovers are all happening all massive leverage buyouts You get barbarians at the gate. Yep, Ardaren Abisco everything Yeah, and Buffett and Charlie are sitting and looking at this and they're like volatility being risk is nonsensical risk is risk that you go out of business and introducing debt into the equation Far from not changing your risk it massively increases your risk because what causes you to Get game over. It's when you go bankrupt and you can't pay off your debt Yeah, so while they're out there espousing this philosophy in the meantime Well, they do do the capital cities deal finally with Tom and Dan so Buffett stepped off the board of the post to be able to do the Cap cities investors deal so we invest 517 million in cap cities to help them by ABC 517 million like I mean that's a big chunk of money, but he can do this at Berkshire now like they're enormous They're a multi-billion dollar company. He's a billionaire himself already at this point And so if these guys are anti leverage and they're trying not to you know Do the LBO thing where you lever up and then buy something and then have to make debt payments forever Out of the profits of the thing that you just bought How does the Cap cities transaction work then where cap cities is able to be the minnow that swallows the whale Well a big part of it is That 517 million in equity from Berkshire coming in to the deal. I see so they basically Have a very large post money valuation effectively because they're issuing a whole bunch of new primary shares out of Cap cities to be able to have enough money on the balance sheet to buy ABC. So I don't know I don't have notes on exactly what the structure the deal was I believe it was some cap city stock Plus the 500 million in equity from I think it was convertible equity from Berkshire and then they probably did add on some debt as part of it But you know like got like a reasonable amount of debt like right especially with a predictable cash flow business You know that that's reasonable Where Warren and Charlie get themselves into Not just like Trouble on the order of the trouble with the feds earlier in the episodes or actually the multiple troubles with the feds earlier at the episodes But real honest to god like Frankly the worst moments of their lives Trouble is when they think That their reputation and their ability to save companies and their ability to Be this capital partner to companies is so great That they can come in and save Wall Street itself or Wall Street from itself or Wall Street from itself With Solomon brothers Oh boy Here we go So remember we told you to remember John good friend and Solomon brothers Who had helped Geico Do the convert deal that Warren backstopped You know Warren Thanks good friend walks on water at this point The only bank that was willing to do this Warren famously and Charlie they famously hate Wall Street they hate banks but like You know, okay, you did be a solid And we know these guys so we feel for them a little bit they don't we trust seem like the enemy. They're kind of our you know We know them. Yep so We're now in the late eighties Good friend has become the CEO of Solomon brothers They've gone through a series of mergers and acquisitions The firm is much bigger than it was before it's now publicly traded And Solomon already was the debt king But in this environment of the debt fueled everything we were just saying about the eighties Solomon is like the king they sold the first mortgage back security And in glorious honor if there ever was one They go deep into junk bonds derivatives all kinds of hairy stuff It gets so extreme at Solomon that in I think it was 86 a young Princeton graduate shows and aspiring a writer shows up at the firm as a new hire Michael Lewis on the Bond sales and trading desk and ends up writing a book about his experiences intended to be as a cautionary tale of the wretched excesses of Wall Street has the exact opposite effect called liar's poker It's inspirational beacon for a generation of of Wall Streeters to come Look, I remember reading the book when I was graduating from Princeton and about to go work on Wall Street myself And it's just it's like the social network 20 years later. It's like you know, this was meant to be at Most at best a you know Show all sides of a complicated situation and it worst a cautionary tale And instead like a whole generation of young people just look at it and they say like I want me some of that Sounds fun you get rich great I'll just read one quote from the book where Lewis writes about the famous 41st floor home of the bond traders at Solomon He says because the 41st floor was the chosen home of the firm's most ambitious people And because there were no rules governing the pursuit of profit and glory The men who worked there including the more bloodthirsty had a hunted look about them The place was governed by the simple understanding that the unbridled pursuit of perceived self-interest was healthy Eat or be eaten The men of 41 worked with one eye cast over their shoulders to see whether someone was trying to do them in For there was no telling what manner of man had leveled himself to the rung below you and was now hungry for your job The limit of acceptable contact within Solomon brothers was wide indeed Here was capitalism at its most raw and its most self-destructive. I love Michael Lewis I could make every single one of his books a carve out at some point so great so Despite this immense success in the bond market Solomon and good friend have gotten themselves in kind of a pickle here Because it's working too well all these traders all these wolves of Wall Street They are generating so much money But they're demanding that they're going to get paid all the money So there's all of it gets paid out in bonuses to all the traders who are constantly demanding more and threatening to leave for other firms that The corporation itself the you know recently public now public company Solomon brothers The profits are actually declining. I was seeing some stat that even in a year I think it was in a year where they underperformed the S&P 500 There were still over a hundred people at the firm that were paid out over a million dollars in their bonus Oh totally. Yeah one year where that happened famously one guy just individual trader made a 23 million dollar bonus in one year in like 1987 or something right which is I don't know to two x two and a half x By inflation today whatever it is. That's a damn lot of money for rent seeker You know like where's the value creation there? Oh, there is only value destruction happening here There is nothing being created for certainly value capture. Oh absolutely So because Solomon itself is Suffering they start attracting the attention of corporate raiders and in particular Ron Perlman Revlon right yeah Revlon. Yeah, he buys out Solomon's existing largest shareholder And he starts agitating like he's gonna he's gonna take over Solomon brothers Which good friend of nobody at the firm because they just want to keep paying themselves the bonuses They of course don't want this so you've got basically The 100% most anti Buffett and munger at least what they say Situation possible here a bunch of people at the firm management Quote and quote there's no management going on but like employees to simply enriching themselves at the cost of shareholders while ratcheting up risk in the economy and Creating no value What could be better good friend calls Buffett he's worried about he doesn't want to get thrown out by Perlman And he says he needs to cash in the favor from the Geico deal and Warren, you know a Berkshire has such a reputation of being the white knight and saving companies at this point that and being management friendly I'm being management friendly exactly. It's all gonna come back to bite him that good friends is like Hey, if I can get Warren to join the board. I'm gonna get Pearlman off off my rear end. So Warren and Charlie agreed to do it and And they both take board seats, right they get two seats to both take board seats So here's how it goes down. It's Russia Shauna weekend in September 1987 and Perlman is like a orthodox Jew So he's he's out of commission. You know, he's not he's not doing anything over the weekend and of course good friend knows this and so he Times everything so he gets the deal done in secret with Buffett and Berkshire over that weekend Berkshire buys seven hundred million dollars of convertible preferred stock in Solomon So more than the money than they put into cap cities With a 15 15% interest rate coupon on attached to that Wow convertible preferred stock So it's like the companies in dire straits and the CEO really doesn't want or really does want to incentivize these particular shareholders to become shareholders Well, that's what's so disgusting about this situation is like The revenue line essentially of the firm has never been better like these traders You can see what you will about what they're doing, but they are raking in money For the top line But then they're paying it all off to themselves in bonuses. So the firm is suffering Can't put those coming in they do this Really tough terms deal simply to save You know again quote-unquote management's own skin It's it's really something that goes on here. I know I mean It's crazy that Warren and Charlie and Berkshire do this Even you know loyalty is super important to them and good friend and Solomon having saved Gecko Anyway, they do it both of them join the board and there's this famous scene Where they fly to New York the two of them over this weekend Maybe this must be like on the Friday and they uh They go to the Solomon building to sign the papers and good friend takes them on a tour They go to the balcony overlooking floor 41. It's like a call back to child Warren overlooking the balcony of the stock exchange and being like Well, there's so much money here. I want me some of that and they're looking down on what's essentially like a Seathing gladiator pit below and Charlie looks at Warren and he says So you really want to invest in this huh And Warren supposedly just kind of like silent for a minute you can just see him feel like What am I getting myself into and he finally says Mm-hmm In like a slow and then he goes and signs the papers and you know credit to Charlie for asking the question But Charlie falls him into the pit too and oh 100% and joins the board as well totally and Probably regretted it every day after so they do the deal. This is September of 1987 October 19th of 1987 is black Monday when the Dow falls 22.6% oh my god essentially a flash crash I had this confused in my mind. I thought Black Monday and 87 was the long-term capital management thing. No, that happened much later This was actually a flash crash so like nobody really knows why this happened Of course the market was overheated. Of course there was way too much leverage in the system But things recover pretty quickly. That's not what triggers a meltdown So Solomon of course gets crushed like the rest of Wall Street. They lose $75 million in trading losses On that day the stock gets crushed But they're not in any better or worse shape than any other investment bank But the stock is way down So buffeted munkers show up to their first board meeting after this happens Which is like the next month maybe in November and good friend and management puts a deal on the table to reprice all employees stock options because the stock is down and Buffeted munger flip they're like wait a minute you guys lost a ton of money for the firm Like we as you know as shareholders in the firm like Our stock that we just invested our 700 million is now worthless And you guys are saying you want to take advantage of this lower stock phrase to repress all of your options That you're then just going to trade out of immediately as soon as they vest and liquidate cash Right, it's like you know no one here wants to become bigger owners of this thing You all just want to a quick arbitrage opportunity exactly exactly But they acquiesce you know they don't really want to fight with management And they also know that if they get into kind of a public fight with if this becomes public that they're fighting with good friend And then the board stock price drops you and price is going to drop you in further They got 700 million dollars at stake here And so they don't really want to do that So I mean we're already pretty far down the slip race slope here This is when the real slide starts so not only do the options get repraced But then in secret behind the board's back Good friend reaches a deal with the head of the best performing Trading desk on the floor the so-called magical arb desk the bond arbitrage desk Run by John Maryweather who runs the domestic fixed income arbitrage group To directly pay them 15% of all the trading profit they make as bonuses So like no longer even just to like hey Management will decide your bonus at the end of the year It'll be based on the performance of the firm It's now like Your prop shop like 15% of all of your Profits you're gonna take home with none of your own capital at risk and on the hook for none of the downside when you have losses Wow I don't I don't understand if I some bad behavior Yeah, so things limp along for the next couple years Warren and Charlie aren't Thrilled about everything that's going on but so then the shoe drops In August of 1991 buff. It is on vacation in Reno, Nevada And he gets a call from not from good friend From Solomon's president Tom Strauss and its general counsel Don Ferrstein who Behind the scenes at Solomon Don is referred to as quote the Prince of darkness For all of the dirty work That's I never want to be called yeah, then he all of the sticky situations that he gets Solomon out of and all the dirty work He does this is amazing you can't make this stuff up so Warren's on vacation he gets a call. This is not a call you want to get and So Warren suspicious then they get on the phone and they're like well Our firms outside counsel Solomon's outside counsel has figured out that the head of our government bond trading desk Paul Moser who reports to Maryweather He's apparently been violating some of the treasury department's rules when bidding on government bond auctions The way the Fed controls the money supply the way that interest rates are set they bid out bonds government debt And then all the big investment banks get to place bids in terms of industry and then the government selects Which banks by the debt and there's only a few what is it 40 banks or something that are even allowed to be involved in these options That are allowed to have the privilege of buying debt from the US government. Yeah, this is the way The money supply gets into the economy to be one of these banks means that you are controlling You have a direct relationship with the federal government and the treasury controlling the economy so Moser's been violating the rules They don't say exactly how or why and that they've suspended him and Solomon is gonna, you know, notify their regulators about this And more and it's like oh the Prince of Darkness is calling me for this like That doesn't seem that bad like you violated some rules. Okay, but like While this is really important and prestigious. This is like kind of a sleepy part of the firm You wouldn't think that the government bond desk is something that could like blow up the firm You know, you'd be more worried about the arb desk per se So he's like all right. Well, you know, culturally he's the lawyer between us. You know, he'll know what to do Just some rules like how bad could it really be I'm sure it's just some regulatory tastes some regulatory stuff So they're like oh, yes, we've already talked to Charlie He's totally cool with it like No worries. So we're like okay great. I'm gonna go back to vacation Well turns out Charlie wasn't totally cool with it and turns out that maybe Moser did a little bit more than just Violet the treasury's bidding rules What he actually did was he submitted fake bids on behalf of clients for the treasury auctions both fake bids for real clients and fake bids for fake clients. So on behalf of people who weren't even Customers of Solomon Brothers and his goal in doing this Was to essentially corner the market in this auction when all of the auction for These treasury bonds and put the squeeze on all the other participants who needed the bonds to sell to their reselled of their clients so that he could then Sell it a massive profit in the market which he did and of course Well, it's illegal to bid on behalf of your clients who are not placing orders and then it's even more illegal to bid on behalf of imaginary clients It's also illegal to try and quarter the market on a given auction There are rules in place that say things like you can't Try and bid for more than 35% of any given auction because we need it to be able to be spread around because we don't want this big second market for people You know paying a big premium because someone managed to go get 90% of the allocation Totally and the reason they don't want this to happen is what actually happens as a result of Moser's actions Like three or four small financial firms that couldn't absorb this price volatility go bankrupt So this is like this is real what the dude did and I think He did this like four or five times and the net of all of it was Solomon made an incremental four million dollars in profit All this for four million dollars So it turns out he did it multiple times It turns out that Maryweather who was his boss and the chain of command and good friend knew about this four months ago And they knew about it because the SEC started investigating and gotten touched with them and when that happened The general counsel the Prince of Darkness told good friend that what was happening here was criminal But that technically they didn't have any technical obligation to report it to anyone The CEO is sending letters to the general counsel without Notifying the board like hey, I got this letter from the SEC they're investigating us But just our GC needs to know about it. Yep. Not notifying the board not notifying the shareholders of the public And equally if not worse Not Notifying the other regulators that this is going on So the SEC is investigating but they haven't found any they just found some irregularities Internally Solomon found oh no, this is criminal like what's going on here? So they don't tell anybody and not only that They don't fire Moser They leave him in place running the government bond desk And There's no audits or controls on what he's doing so basically they're like Don't do that again wink wink wink wow and then they turn around and look the other way So at this point in time the SEC has like figured out like yeah, these are just irregularities They figured out what's going on where it starts to get out on Monday after this August 12th the Wall Street Journal runs a big piece about how bad this could be and how little is known Solomon's counter parties their lenders and their trading partners Start like getting cold feet about dealing with Solomon and all the markets that they operate in and Solomon it turns out they're the second biggest bank on Wall Street at this point in time They have a hundred and fifty one five zero billion of capital Like in the markets wow But they only have four billion dollars of equity all the rest of it is like Short-term paper and debt and leverage and like everything that has been building up in the 80s So they're like what's that? 60 times levered on their Oh my god And all of a sudden their counter parties start getting cold feet about trading their paper and 50 billion five zero billion of the 150 billion rolls over every single day That's really short-term paper So if there's a problem It's going to be instantaneous and the firm is dead so Also on that same day on that Monday This is probably the worst thing that happens So the Federal Reserve sends a letter to good friend and Solomon saying I think only good friend and the general counsel see this Saying that it is quote deeply troubled by both the firms actions and lack of actions And it is questioning whether it can continue to have a business relationship with Solomon brothers This is the Federal Reserve Unless the firm responds to this letter and significantly changes its business practices within the next 10 days Now if the Fed ends its business relationship with Solomon Game over like it's dead all the counter parties are going to stop trading with Solomon Wow, like it's literally game over instantaneously Good friend and then G.C. just sit on the letter they don't tell the board they don't tell anyone else They don't tell the share Nobody knows about the letter except the two of them The feds assume that the board knows about the letter that's like Solomon is doing something But good friend and the G.C. covered up But Buffett by this point in time he gets in touch with Charlie and Charlie's like Yeah, you should be concerned about this So the board convenes they issue a press release Saying that you know they're looking into this and Figuring out what happened the firm stock drops 30% that day The Fed meanwhile is like you guys aren't responding to our letter like Oh, they're just getting angry or an angry or every day that goes by on Friday of that week the New York Times runs a headline while street sees a serious threat to Solomon brothers and The Fed finally's had enough the lead investigator running the case at the federal reserve calls good friend and says You need to resign like today and you knew installed new management or else You know as a huh When good friend gets that call he calls Buffett who's still in Omaha And he essentially just tosses him the keys to the firm and he's like I'm gonna resign somebody has to step in and Run the place and deal with this And it's probably gotta be you so good luck with that wow not quite in that language But that's essentially how it goes down Pretty intense stuff Warren and Charlie are Legitimately frightened at this point and the argument there is like hey, I have to be out Uh, we don't have any ideas for who's next yep. There's no plan. There's no man Whoever steps in has to have the reputation to be able to save this firm and like Nobody wants their investment to go to zero So I pick you as the person who seems like you might be able to save this thing Well at this point the fiduciary responsible people are the board And who are the most prominent people on the board? Warren and Charlie and Warren specifically So like You know, my good friends already out as he go so there's nobody left except Warren to come in wild Deal with this so Warren it immediately gets on plane to New York And he goes and meets with the federal reserve And tries to like understand and sweet talk them This is amazing to me the fed I think assumes that Warren knows about their letter But he doesn't and that wires still get crossed in this meeting So Warren doesn't understand what the worst case scenario really is And cryptically at the end of the meeting buffets trying to you know sweet talk them and by more time The fed tells Warren that to quote prepare for all eventualities IE that they're gonna yank the right to you know participate in the treasury auctions and Solomon's gonna go down the tubes So now it's Friday night into Saturday morning and Warren has to make a choice He can Walk away From Solomon say I'm resigning and 700 million dollars goes up in flames, but he can walk away Or the other option is he can take the reins of the company and try and steer this thing through As he's thinking about it and talking about Charlie He realized he actually doesn't have a choice Because if he walks away his reputation is toast If he walks away 100% his reputation is toast and like he leaves it 700 million like that'll be fine But like what company is gonna do a deal with Brooks or Hathaway ever again after this right and if he stays You know Probably there's a good chance. He's not gonna be able to navigate through this in which case his reputation is also toast Which this brings up that George Bernard Shaw quote that I think it's Charlie who likes to quote it Never wrestle with a pig you just get dirty, but the pig enjoys it And like you can imagine that moment where they're standing out looking over the trading floor Knowing that they're about to wrestle with a pig and then this is the eventuality of what happened with that Yep, and this is where as he's realizing this so Alice rates and the snowball Quote at some point during that long horrible Friday He recognized with a sickening jolt that investing in Solomon a business with problems over which he had essentially no control Had put it all at risk and by all she means everything not just the 700 million in Solomon like Everything that were and at Charlie together have built you know, they're both on the board So he decides he has to take the job He decides he's gonna become interim chairman of the company And he installs the head of the investment banking division a guy named Derek Amon as the CEO That's just kind of like a I mean the investment bank just that was the one thing that Solomon was not good at was the investment banking advisor Good business So he gets installed simply because he's just far away from all the toxicity and Then on Sunday The board Warren and Charlie and the whole board is at the office in New York. They're trying to figure out what to do When a letter arrives from both the federal reserve and the Treasury Department They haven't heard any response to their deadline of things. We've got to happen And thus far nothing has been announced from Solomon So they say they've had enough. It's the end like no more negotiating They're pulling the plug that afternoon And by the time the market opens in Tokyo Which is like I think late afternoon New York time This is Sunday afternoon. It's a Monday morning Tokyo time It's gonna be announced that the Fed has revoked Solomon's licenses and it's over so Warren Directs the board and the lawyers to start preparing a bankruptcy filing And in the meantime He desperately starts trying to call anybody he knows in the government using all of his Washington connections So like try and stay the execution here and he finally reaches the Treasury Secretary Nick Brady Which is the Treasury and the Fed jointly made this decision and Warren Literally like breaks down on the phone crying and like begs him Says this is the most important day of my entire life begs him to Stay the execution and just give them like a little more time and figure things out And so Brady is like moved by this if I literally Warren Buffett You know if there's anybody in the world who could get the government to change its mind And he says like okay, let me go talk to let me go talk to Greenspan that the Fed and Figure out what we're gonna do So hours go by It's all in limbo And they're just sitting in in the Solomon office This And then a call comes in from the assistant treasury secretary Do you know who that was at the time Call comes in for Buffett No one Jerome Powell Oh my god Then assistant secretary of the treasury incredible And He says Look Well, like this is bad. We're not gonna allow Solomon to bid itself in treasury auctions anymore So we are gonna like we need our pound of flesh We will however because of you Warren because you're stepping in and you're committing to making changes We will allow Solomon to continue to place bids on behalf of its clients That he says will that work And Warren is like that'll do Whoa, yeah, so he literally Gets the government to reverse their decision Unbulliable that's insane. So now they have to deal with the aftermath also It's incredible that good friend never showed the letter because I assume he was a sureholder too And of course it's gonna come out that there was a letter sent at some point So it's not like he's saving himself any like legal liability by not disclosing it Well, I think what happened. I don't know how far in advance he had Gamed this help What ends up happening I'll tell the story in a minute of how this all wraps up But as this is going down like concurrently that weekend Good friend and his lawyer They know because Warren still he doesn't know the extent of good friends You know deception here and cover up and he doesn't know about the letter He doesn't find out about the letter until later and so they go out to dinner And good friend and his lawyer A personal lawyer trying to get Warren and Charlie to sign a severance package for him Leaving the company they want a $35 million payout Your reaction is priceless there That's wild isn't that wild so they're trying to get the money as always and Fortunately, you know, they're dealing with Charlie Munger here So Charlie basically stone walls them. Yeah, he was amazing I don't know if the quote written down here, but this would later get arbitrated And Charlie would testify in the arbitration Under oath that Charlie's natural way of you know being with other people is he turns his brain off when he's not interested in things And he wasn't interested in what they had to say and so he was just muttering and not saying anything it It's amazing Negotiation yeah the negotiation so they don't agree to anything they don't sign anything and And ends up after years of fighting this in arbitration get zero dollars as he should Anyway, so They get the save the stay of execution from the government and then they have to deal with the aftermath So Warren has no interest or ability in actually running day-to-day Solomon brothers But what he can do is he can deal with the government and the public so he instructs Mawn the new CEO to clean up the firm inside you handle everything inside the building at his instructions are Get it right get it fast get it out in terms of dealing with all the corruption in Solomon and Basically the first thing that happens that week is he gets the Warren gets summoned before Congress to go testify in front of Congress and And this is brilliant. So they bring in MTO bunker Tulson and Olsen of course to represent them and all this and Roy Olsen comes in and Roy suggests this brilliant step that goes a long way. I think towards saving Warren and Solomon He suggests that they proactively go to the government and say we will wave our attorney client privilege so Everything which is this is like extraordinary this never happens So they're going to the government and they're saying All of our communications and anything that MTO finds at Solomon we will share with you Wow And you make sense to do that because they're the new guard So it doesn't there's no way it can reflect poorly on Warren Charlie MTO It's only gonna be Negative for all the people that Warren wants to fire anyway exactly. So Alice writes in the snowball about how perfect this was The more evidence that MTO found on employees that were guilty the more proof it would show the government that Solomon was cooperating And that Buffett was cleaning everything up and the employees meanwhile Must cooperate or be fired since none of that anything that they would say would be protected by attorney client privilege with MTO So the employees options were get fired or answer MTO's questions and anything you say to MTO is going directly to the government Yeah, so Warren's not there to protect anyone. He's there to This is a win-win for exactly exactly. This says Charlie's finger prints all over it Ha so Warren goes in front of Congress probably one of the most famous statements that Buffett's ever made and You know certainly corporate history where he's being grilled by senators about what he's gonna do at Solomon And how he's gonna turn it around and he says The way that Solomon's gonna operate going forward is lose money for the firm and I will be understanding lose a shred of reputation for the firm and I will be ruthless Hmm Fascinating and he kind of puts on a show and he wows Congress And Solomon ends up getting out of this thing with they settle in the next few months with the government for a 190 million dollar fine Plus a 100 million dollar restitution fund which I assume is maybe to go to The other financial institutions that were hurt by the cornering of the market in the treasury auction restitution It's gotta be it. Yeah, certainly that's a lot of money, but like This is amazing. He pulls this out the firm wow survives And so obviously Solomon is you know damaged, but over the next few years They recover and they end up a few years later. What when does Warren once he able like actually step out a day to day as soon as possible Basically as soon as the settlement hits. He's like And I'm out as chairman. He stays on the board though. He keeps the investment in and but he's no longer day to day So this happens in 92 Six years later in 98 Solomon gets acquired by City group the former travelers insurance As incredible put a bid in for nine billion dollars Which means that Berkshire Gets a return of 1.7 billion dollars on their seven hundred million dollar investment plus the 15% coupon that they had been They've been getting so unbelievably I mean it literally takes Warren and Berkshire to the brink But the sense of being a really good investment for them Wow it makes so much sense why he Buffett then had the the quote it takes 20 years to build a reputation and five minutes to ruin it If you think about that you'll do things differently I bet he sort of imagines looking out on the trading floor when reflecting on how he might do things differently Totally I do wonder if he looks back on this and things was it worth it for that investment return probably not 100% not Yeah, 100% not you know the irony is like yeah 100% not But this only kind of adds to the myth of Warren and Berkshire right now. He's the guy He can he can save even the cesspool of Solomon brothers, you know what can't he do what can't he do Uh, so this is where we're gonna leave part two But there's one kota before we do then you may know you probably know but listeners I will ask do you know What other organization after this whole debacle That John Maryweather the head of fixed income trading at Solomon brothers would go on to found Two years later in 1994 David is it Something that had a crisis where you mentioned it earlier in this episode Yes, it would be My god, this is just crazy is he Part of the group that was the former Solomon brothers people that went to do long-term capital management Not only was he part of that group he was the leader of that group literally John Maryweather Founder and CEO of long-term capital management Wow, and he was the guy between Good friend who was the CEO and the guy directly underneath him was the guy doing the auction violations. Wow Yep How crazy is that Did any of these guys ever go to jail? The only guy who went to jail was Paul Moser the guy who did the auction violations and he went to jail for four months Oh Isn't that unreal Wow like literally I mean the thing that we didn't talk about in this history, you know, certainly the government was Impolienced by Warren's reputation and his pleading But they were also scared too like nobody knew what would happen if you just Took the second largest investment bank in the world out back and shot it like it for sure would have Created a financial meltdown and then of course, you know 16 years later. We got to that was this was the dress rehearsal for what we got to see Actually happened in 2008 Wow, which of course Berkshire also was an active participant. Yeah mostly mostly in buying the dip Yeah But wow, we'll save that story It's funny. We've got for part three. We'll have the whole tech bubble. We'll have 2008 will have the tech bull run of the last however many years and kind of the future of where do we think Berkshire goes from here But this feels like a good place to leave this part Yeah, I mean we intended this to be one episode on Berkshire originally and uh It's like the the deeper we go into it As we were doing the research. I mean this this Solomon episode. I knew that this had happened I didn't know That this had happened. No, I mean the only thing that I really knew was that uh Warren Buffett was called on to act as the head of Solomon brothers when they were under duress and his reputation alone was what saved it But like that is really true like that alone. Yeah, it's not just like that he was Acting as the head of the bank in a riskless way like He risked the whole future of Berkshire to make this happen. Yeah Yeah, in fact when you think about the return turning 700 million into one point what or he made 1.7 billion over how many years was that like six or seven I think he made it it was a billion so I think it was 700 million and then 1.7 out But he got the coupon payments also so So it's maybe like a 200% return over Over six seven years so good, but not for this risk. Yeah, no definitely not for this risk wild Well, I think before we talk about power we should do a quick review of the businesses that they had owned outright during this part of their history Because I think people have a general sense of the stuff that they own now Both through the businesses that they own holy and through their ownership of big public companies like you know Craft Hines or of Coca-Cola But let's review the things they bought in the 70s and 80s and then owned outright Seas Candy, Westco Financial, the Buffalo News, Precision Steel Warehouse, Nebraska Furniture Mart, thanks for the speed Scott Fetzer, Fekheimer Brothers, Borsheim's Jewelry, HH Brown, Central States Indemnity And then in 95 the the finishing touch on on Geico they bought Helzburg Diamonds and RC Wiley home furnishings So there's like a lot of Berkshire that you think about today that they don't own yet Yep on the public equity side the main positions we talked about the post Capcities Solomon Brothers and one that we didn't talk about them. We'll talk about more next time in Coca-Cola I think those represented significant parts of the value But again as we've seen they're taking a hands-off approach here As we analyze the power we think about them as sort of two different business lines Because it does feel like at the the business activities day-to-day are very different between those two things Which actually you see reflected in the management structure of the business flashing all the way forward to 2020 You have Ted and Todd On the sort of investment management side buying publicly traded companies that are investing in publicly traded companies And you've got Greg and Ajit on the you know wholly owned subsidiary side The insurance and the Adjeet running the insurance businesses and Greg running all the non insurance businesses and Insurance which is funny because it's like so diverse that you don't have a way to label It's just insurance and non insurance. Yep. So okay. Let's talk first about the wholly owned businesses So the business activities there are prospecting you know identifying the whole landscape of businesses you could buy evaluating those businesses on their fundamentals You know making the decision to invest or not invest and then making sure that you Leave or install the correct management in place to you know make those businesses hum over a long period of time And then of course Capital allocation where you're you're making sure that you're deciding if that Business is one that you like consuming capital and you want to funnel more capital through that business So it can reinvest in in growth or if that's a capital producer and you maybe like Uh your your jacket linings business or your Your stamps business you don't want that business consuming anymore capital and that should just spit off capital They get sent to the head office for a reallocation So with that preamble those are sort of the business activities of the wholly owned subsidiary side of the business Yeah, now of the Hamilton Helmer powers Which you know basically enable you to in a long-term way get a durable sustainable differential profits above your nearest competitors So here I think we should think other conglomerates. We should think private equity firms definitely private equity firms Yeah, think about these companies going public spacks weren't really a thing yet So that wasn't an option on the table strategic acquirers I think we're though the question is which of the seven powers sort of applies to Berkshire Yeah, this is gonna be fun Because it's not network economies It's not our it's not our usual favorite. It is definitely not. I'll make a first run at it And say counter positioning and certainly counter positioning versus anybody that's running money Yep, and I think to more finely articulate that I opened this episode by talking about the fact that Warren chose a very unique structure in choosing not to have a fund or a partnership But instead to have this operating business Berkshire that he uses the capital from to invest off the balance sheet and It's very interesting when you have that structure and you're not generating fees and you're not thinking about raising another fund And you're not getting a carry or a promote you have just as much downside risk as upside benefit and so you're incentives are Pure in a way you only want to make financial decisions that you know Bilo sell high or Bilo hold forever and There's no other way that you make money. Well, all your only focus is long-term value creation Because nothing that you're gonna do is it gonna increase your fees or increase your Value in any set, you know fund life period of time or anything like that Right, so that makes you counter position to private equity firms And so then the question becomes is that actually power in a positive way or is it somehow negative? Is it just a disadvantage or are they counter position to you because Let me put it this way because they can make a deal Deals that a PE firm would do that Warren wouldn't do because the price is too high But is the opposite true can Warren get deals done Because the PE firms have an opposite business model Well It's interesting right because this is so obviously not a tech company in so many ways and This market that Berkshire operates it and the market of acquiring and then investing in other companies Is not a winner take all market. So it's interesting is like to succeed they need a niche and They certainly carve out their niche exceedingly well with counter positioning versus other players the best you know We didn't talk about this on the episode I'm gonna say because we didn't have time but like well what is time on an acquired episode anymore But uh, this is how they win the the Mrs. B deal the furniture mark deal You know buffets sits down with Mrs. B and says to her because she has other offers to buy the furniture mark for more money and says You know you you can certainly take those offers and I'm not gonna pay What the private equity firms and others will pay But at the end of the day those firms are what's motivating them is Is selling your business for more money and they may say lots of things to you and be aligned and love you And want to keep you and your family in place running it But at the end of the day They're gonna do anything to maximize them selling the business for more money within a separate period of time so that they can make Their fees I'm not gonna do that. I'm genuinely gonna leave you and your family to run this Right, it's like having a longer lens is actually the counter positioning here. Yeah, and Simultaneously holding true the belief that we're holding it to be true They're keeping the family in place to manage it is the long-term value maximizing decision. Yeah both of which are true Both of which can be true depending on yeah, if you acquire the right business It gets back to the fight with the efficient market hypothesis theorists and the nature of debt Which all of the private equity firms are using to buy these companies to lure up the companies buy them If the goal is to have the companies operate sustainably the Longest and generate the most cash flow over truly the longest period of time You don't want to use debt because debt is going to increase the chance that the company is bankrupt And so if as a seller if you care about the legacy of the company either for You know whatever your family working in the business, you know then making money you retain a part of it or or just for the legacy of the business Your interests are aligned with Warren's then Because he wants the long cash flows over the longest period which means he's gonna avoid debt Such a good point Okay, so I agree counter positioning for sure Definitely branding definitely. I mean like that's probably actually the place where you start Like the Warren Buffett brand just enables you to do things that like Literally the Solomon thing like anyone else crying on the phone to the federal government probably wouldn't have impacted them But because it was Warren's brand crying on the phone Totally It's right, but I'm trying to use the the seven powers language here A hundred percent I think the seven powers actually apply a lot. Yeah counter positioning apply but yeah branding 100% Like Warren Buffett and Berkshire Hathaway's money Is worth more than the equal amount of money from somebody else? Yep, absolutely Okay, so I don't think there's Necessarily scale economies. I mean, maybe you could argue a little bit that like the scale of the insurance businesses and the float enables more investing Which enables more operating businesses which you know Maybe I think that's a little bit of a stretch During this phase so it's interesting today. I think they actually have Disconomies of scale because they just have too much capital that they need to put to work But we'll save that for the next episode. I do think This period was the one for the first time where they did realize some economies of scale where there is this like nice middle ground Where like if you're really small Then you can't invest enough money to have sharp elbows on a board But if you have too much money then all you can buy is apple and You know nothing else moves the needle for you enough But during this period in the 80s they had like the perfect amount of money where they could be activist investors On boards and throw their weight around and that would deliver enough return for them to be needle moving Yeah, yeah, actually that's a really good point. That's a good point. It's a power right now But it's not a like sustainable power Yeah, oh, that's interesting to think about Okay, I don't think they're switching costs No, and that's all I've got for this so far the question is which of those apply to the public investing side of the house Oh, well the one I was gonna talk about I always have such a hard time thinking about this power And as Hamilton says it is the trickiest of the seven powers But is there process power here at for sure? I mean, it's funny Like thinking about process power in a super small organization feels like a de facto no Because the the always uses the example the Toyota production system that like the system was so complex It couldn't be written down to be retought to someone else because it's held in so many heads and The decisions are all made by one person. So like is there process power in Warren's head Well, he calls Charlie, but Warren ultimately makes the decision I think there's a liberal interpretation of process here to make that the case It's funny because I was there for public market investing. I was thinking like you know that might be the only really Arduable one You freaking efficient market hypothesis to you Well, uh, I know I'm definitely not an efficient market hypothesis disciple But I do I think there are definitely market inefficiencies as this episode shows, but I don't know that Brick sure had any sort of unique Any defensible ability versus others to see and then act on them. They acted on the ones that they saw Other people could act on once that they see Right But getting back to that point that I made earlier around Identifying things in the market that Not only have less risk, but actually exclusively have less risk than the market perceives them to have when you act I think I was sort of foreshadowing power there where There are things where Berkshire uniquely could have acted And therefore save the company got in the deal that they did were able to join the board whatever the thing is And so I'm trying to figure out how to quantify that So Wapo Solomon brothers these were things that Buffett could uniquely do in an advantaged way versus the their competitors Yes, their competitors being all other capital and why well Wapo was kind of buffett had to fight his way in It was sort of like maybe that was like part of developing this power Because you know, K was sort of like scared of him at first And certainly reluctant and then buffett fights his way in I don't know that like that was a power but then once he was on the Washington Post board And like the mystique of Warren Buffett had started To grow Then I think maybe it becomes Something defensible yeah, it's a great point Well normally here I would move us onto playbook I literally think we had discussed every playbook theme during the narrative during history in facts That I possibly could have brought up here. So I have Nothing to add in the playbook section this episode. Yes As as Charlie would say no nothing to add value creation versus value capture Let's do it. So Buffett definitely created more value in this chapter than in the previous one Okay, the previous one you're buying in selling you're buying at low prices your selling at high prices Here you're doing things like they legitimately created value for Solomon shareholders You created nine billion dollars worth of value The question is what other situations in the 70s and 80s did they create value Certainly for Berkshire shareholders by marrying the insurance businesses and the operating businesses For Berkshire shareholders to be able to sort of realize the incredible Benefits of those two things operating in tandem. I think they also created value for Gecko in the Saving Gecko now, you know jack baron did all the legwork himself but no question having Warren You know there both with the regulators and the government of like Hey Berkshire Hathaway is behind us now. We're gonna be okay But then also specifically with the financing and with Solomon brothers and with Wall Street, you know backstopping the deal Yep, is there value destruction for the American consumer by making it so all those people who had Gecko in the states that they decided to pull out of Lost their car insurance. Hmm. That's a good question. I don't Think so I mean how hard is it to go get different insurance? right and If Gecko wasn't gonna make it if they didn't make those changes Right, it's not like they corporate raider didn't win in and it was gonna go perfectly fine But then they destroyed it because they're a style now what was interesting in that story though was You know, I think Gecko and Bernd were the first to actually pull out of states like nobody had ever done that before So they did sort of cross a Rubicon So yeah, I don't know that's a good question Now certainly Solomon brothers you could to be a lot of value destruction there in aggregate Oh from the entire time they were shareholders certainly yeah now did Buffett and Berkshire Meaningfully contribute to that No probably now other than they Did prop up corrupt management Yeah, like value capture to move on to that and hit it real quick. It's Berkshire. It's Buffett They always do a damn good job of capturing the value they create No qualms there. Yeah, interestingly especially Over this period and the life of the company probably because of the long term Focus and not selling investments with regard to tax liabilities You know Berkshire and its shareholders pay If you don't sell you pay no tax right massive tax deferrals massive tax deferrals yep All right grading I want to grade this the same way that we graded the last one which is we are going to look at their pure performance versus the S&P 500 During that same time frame and you you may recall that in the Buffett partnership years the annualized return was a 29.5 Percent annual return over those 12 years historic legendary And I think what would be determined that was something like a 28x and you actually that that 12 years you could comp nicely against a venture fund and say If anyone could 28x the money then they'd be a top-design fund for sure and the Buffett partnership had the increased benefit of you could take all your money out or put all your money in any given year You didn't even have to lock it out for the entire life of the fund the way that a venture fund does So you know slam dunk. I think we could call that an ARNA plus this set of years We're going to look at 1970 so the year immediately following the liquidation of the partnership to 1992 and we're going to look at just Berkshire Hathaway over that stretch of time their rate of return Pretty similar 27.4% Dang Like I don't know how you like the Buffett partnership years and don't like these I think this is like yeah This is the golden years of Berkshire Hathaway Totally wow. I didn't realize that that's What the number was. I mean it literally is it's just like Michael Jordan You know he went out at the top of his game he came back and he won three more championships And then he went to play for the Washington Wizards And actually maybe we will see that last part here and uh a little bit of course I text docs in the next next chapter. Yeah, but truly I think There's this scary thing where you sort of look at this and you're like Maybe Buffett does know how to time the market like no one can And yet the guy liquidated his partnership in 69 bought back in big in 7172 Had this run all the way through you know the early 90s Started piling up cash in the 90s and as we'll talk about wrote a very famous article in 99 You know the year before the the dot com bubble burst articulating exactly how overheated everything was as he was piling up his cash So he is acting on his thoughts here Maybe he can time the market Maybe Although Well, we'll save this for part three, but I would say track record on market timing has not been great of late No, but just to put some numbers around this 27.4% uh rate of return if you had bought Berkshire in 70 on January 1st Which is uh that day that Buffett distributed it out to everyone when he closed down the partnership It was 45 bucks a share and at the end of 1992 and and of course these are what we now call the A shares In 1992 that was 11,750 dollars a share well That's bonkers bonkers And today it's over 400,000 is that right Yeah, so does a record high as of last Thursday and maybe up again getting this week wow My hat is off All right, what work can you say all right what work can you say except like the comparison is Michael Jordan Yeah, well listeners we will know more in part three and thank you for listening to the Empire Strikes Back episode of the Berkshire trilogy David you want to do quick carve outs? Yeah, let's do it So my carve out is a great podcast episode on the armchair expert podcast which is so good so good Daxi Monica do such a good job so many good episodes recently, but Seattle love the Maclamore episode was amazing have you listened to this? No, I haven't oh you got to listen to it It's so great lots of Seattle talk Dax love Seattle. He recently was in Seattle's there It's been a lot of time talking about it, but Maclamore was so great. They just get into so much great stuff lots of discussion about That just that we're just gonna listen to the episode. It's fantastic All right, just added it to my queue literally pull out my phone and add it to my overcast queue Mine has its roots in Something that you said earlier this episode you mentioned the mafia you mentioned the state of New Jersey I for the first time and watching the sopranos and it is excellent and I Totally see how it kicked off this like modern Golden era of TV that we have going on and I think It was lost on me. I mean, I was what nine when it first came out or ten when it first came out But it was lost on me all these years where I've loved shows like madman and Billions and succession and Going back and watching the wire like the sopranos really did sort of kick it all off and it's violent It's horrifying in many ways, but God is the right and great So can't recommend it enough. I am in season six a so I am nearing the finish line So nobody spoil it for me amazing what year did the soprano start? I want to say it was like 97 98 It's like right around the time the matrix came out. Wow. Oh, man. That's a throwback Yeah Matrix wow And they share a couple of actors between the matrix and that which is it's it's old enough where You see people who you know from things later in their career and you're like oh my god It's a young so and so and I'm I'm feeling Quickly like my parents like when I was a kid. I remember watching things with my parents And they would say oh my gosh this movie has young so and so in it and that's now me That's amazing That's amazing. Well, we're hitting that time of life We are Well listeners If you want to talk about all things acquired this episode things we missed things we caught Little notions that you have that we may not have seen in the research This is a three-parter so it is not too late to tell us and we can insert these great tidbits into The final part of the trilogy join us in the slack acquire.fm slash slack You can talk to lots of other people. 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