[00:03:18] Kyle Grieve: So I think Buffett probably already had the makeup of patience at this time, but he hadn’t had the opportunity to express it in the stock market as this was his first experience. So I’m interested in knowing a little bit more about if you think Warren has learned his most valuable lessons from his own mistakes, or if he’s learned them from learning from others.

[00:03:36] Robert Hagstrom: I think it’s a combination of both, Kyle. I think, some of the, you learn from your mistakes, but hopefully you’re learning how to be successful from others. I mean, his dad was a stockbroker, and we can fast forward, 10 years and Ben Graham will do that. I’m sure later in the show, but clearly I think the lesson that he learned at city services preferred was the mistake that he was forced to make because he had pulled his money with his sisters, Doris and Bernie.

[00:04:02] Robert Hagstrom: Yeah. And to buy some city services preferred, I think you bought 3 shares, the stock was 100, 111 bucks or something like that. And it subsequently started to go down in price and his sisters were just losing their mind just, Warren, this is terrible. I can’t believe you lost all our money and they’re.

[00:04:20] Robert Hagstrom: like today’s equivalent of how the clients treat their financial advisors from time to time have just totally lost their mind. Now, nevermind that we’re in the middle of World War Two. And, as Warren said, the front page of the newspapers never had good news and the market was dealing with, the outcome of the war and stuff like that.

[00:04:37] Robert Hagstrom: But he said he finally just basically had to buy, had to sell the stock because he couldn’t take the harassment anymore from his sisters. And he made just a little money, not a lot, but had he held on it to it for, I think, another year or two years, he probably would have tripled his money. And I finally just said to him, I can’t live like this.

[00:04:55] Robert Hagstrom: I can’t people either yelling at me and screaming me about it, or, he said, I was a capitalist at a young age, his dad being a libertarian, a congressman, a big believer in the United States of America that did a dope bet against America in the long run, it’s going to work out. I think that was deeply grained into his psyche, even at that young age.

[00:05:14] Robert Hagstrom: And so I think, patience was something that he learned early in life, even though he didn’t have the methods from Graham yet, he did learn that, just hang in there and eventually everything will be okay. that was kind of the first lesson. 

[00:05:30] Kyle Grieve: One of Warren’s biggest mistakes other than buying the original Berkshire Hathaway textile mill was Dexter Shoes, a business that he bought in 1993.

[00:05:38] Kyle Grieve: So when I first researched some of Buffett’s mistakes, this one really stood out to me just because not only was it not necessarily a good investment, but he also used Berkshire stock to purchase it. My most significant insight from this one, this mistake was that whenever you buy a company, you should be trying to ensure that the business can’t be decimated by low cost competition.

[00:05:58] Kyle Grieve: But there was an excerpt from your book discussing the Berkshire textile mill in the 1980s. And it also talked about how the Berkshire textile mill was actually getting a little bit worse. And that was also due to foreign low cost competition. So in some ways, Warren kind of made the same mistake twice with the Dexter shoe acquisition.

[00:06:15] Kyle Grieve: So I’m just interested in knowing a little bit more about how you think he’s fared since then, in terms of, not repeating similar mistakes. 

[00:06:23] Robert Hagstrom: I’ll let you ask Warren that question. I don’t want to bring it up, but you’re right. I mean, the way that, which you phrased the question, having that painful lesson of Berkshire buying the textile mill, and it was very painful for him to, finally shut it down, he said, as long as they can at least earn a modest amount of profit.

[00:06:43] Robert Hagstrom: I won’t shut it down, but neither will I fund it from the profits of other businesses at Berkshire to keep them alive and eventually just got to be to the point that it was just a money losing operation. So yes, he would say the first mistake was buying Berkshire itself. That was a bad business as Charlie Munger pointed out it.

[00:07:01] Robert Hagstrom: Warmly wrote about Charlie in this year’s annual report and the tribute to Charlie as the architect, like now that you bought Berkshire Hathaway, never buy a company like this ever again. But you’re right. I mean, very good observation. You think about Dexter shoe and the double pain of the double. Slash on the back was not only did he buy a bad business, but he used Berkshire stock and that is a double painful whammy.

[00:07:24] Robert Hagstrom: I don’t know, Kyle, you’ve asked a very good question. I don’t know. Obviously he must’ve had pressure from the owners of Dexter shoes that they didn’t want a capital gains transaction. So we’ll take the stock in kind, which worked out swimmingly well for them. I mean, they became very rich, helped Berkshire stock, even though Dexter shoe went to a zero.

[00:07:43] Robert Hagstrom: But you’re right. Good point. I mean, foreign competition for the manufacturing of shoes versus, making shoes here in the US. You would have thought he would have seen that one. I don’t have a good answer, but you have a very good observation. And it’s even more when I think back to Berkshire and Warren’s talk about this before he said, instead of rolling the 25 million into Berkshire Hathaway.

[00:08:03] Robert Hagstrom: That then subsequently bought national indemnity of which, I owned less than 40 percent of the business. Just think if I would have rolled the 25 million into national indemnity and never owned Berkshire, and I would have had a hundred percent of national indemnity, what kind of world that would have turned into so very good observations.

[00:08:20] Robert Hagstrom: I wish I had a good answer for your audience, but I don’t know. You might just say, he missed on that one. 

[00:08:26] Kyle Grieve: One question I’ve had for you, seeing as you obviously studied Berkshire in a lot of detail is on the insurance float area of things and using insurance companies as kind of an investment vehicle is just because, that float in the right hands, like with Warren Buffett, it’s just like magic, right?

[00:08:44] Kyle Grieve: But a question I’ve had is why don’t more insurance companies take advantage of hiring like a really, good investor to manage their They’re float because it just seems like such a home run, but you know, it kind of seems like a lot of them are just investing in, bonds or other assets that are barely beating inflation.

[00:09:02] Kyle Grieve: So I’m just interested in knowing, getting your insights on that. 

[00:09:06] Robert Hagstrom: Yeah, and you think about Lou Simpson at GEICO doing the same thing. my first answer when I thought about the question was, the mismatch between when you have to get a premium and when you have to pay a claim, sometimes you can’t.

[00:09:18] Robert Hagstrom: The time horizon is not such that, you can put money to work in the market for a year or two if you’re already paying out claims. And so you’ve got to keep it liquid. But I think maybe the better answer of how Lou Simpson did that at GEICO and how Warren has done this is that, the cap, the capital ratios at Berkshire were just so phenomenal that the insurance regulators didn’t require them to keep.

[00:09:39] Robert Hagstrom: 90 percent plus and liquid overnight paper to play claims. The other thing too, and Berkshire being different than GEICO, particularly national indemnity in a sheet is the long tail super cap policies that don’t have to be paid out for three, four, five, six, seven years. So in that situation, obviously a premium income that doesn’t have to be paid out for at least five years or more.

[00:10:01] Robert Hagstrom: That would be ideal for the stock market. So then the question then becomes those that are in that business, if their capital ratios are strong enough to allow them to invest for five years, why aren’t there more, Warren Buffett type investors and insurance companies, and that goes to the Charlie Munger quote that.

[00:10:19] Robert Hagstrom: if we’re so right, why are so many intimate places so wrong? Why aren’t other people doing that? And that’s a phenomenally great question because it’s very clear. Not only the Berkshire approach, Warren’s approach, Charlie’s approach is now called high active share investing. We called it focus investing when we wrote the Warren Buffett portfolio in 98, but now the academicians got a hold of it in the early 2000.

[00:10:42] Robert Hagstrom: I think it was Martin Kramers and Pettigrew still at Yale University that quantified what focus investing was now called high active share. And high active share investing is a predictor of future performance and that you have to be different than the market to generate returns different from the market.

[00:10:58] Robert Hagstrom: Then they subsequently went on and discovered of the high active share portfolios. It was the low turnover portfolios that were this, the very best high active share. So you have the math, you have the architecture, if you will. High active share, low turnover portfolios have the highest probability of generating returns in excess of the market.

[00:11:16] Robert Hagstrom: Then how come they’re not more? High active share, low turnover portfolio managers. And this is a big puzzle. we tried to answer it the best we could. There just weren’t that many that were raised under the principles. Of what Warren was doing when modern portfolio theory, which was invented in the 1950s with Markowitz and refined by Sharpe in the 60s, you can go to Eugene Fama in the 70s and 80s.

[00:11:43] Robert Hagstrom: Modern portfolio theory was really just academic type thinking until the 73, 74 bear market. And then. When everybody blew up the bear market value, investing actually wasn’t being taught then at Columbia, there was a void and people were really decimated. People who had retirement savings were wondering if they could retire market down 50 percent and people were looking at each other going.

[00:12:08] Robert Hagstrom: What do we do? What do we do? And. These academicians from the ivory towers raised their hand and said, Hey, I’ve got an idea. What about low price volatility? Lots of diversification. So if anything goes wrong, you don’t have all your eggs in one basket. And we’ll do quota reporting and that will show you exactly what your portfolio is worth, every three months.

[00:12:27] Robert Hagstrom: And that took over the money management business in the early 1980s at the beginning of the big bull market. And we created, the standard of investment management up principles of modern portfolio theory. And that became the edifice, the Leviathan, if you will. And from that, we just didn’t germinate.

[00:12:46] Robert Hagstrom: A lot of Worm Buffets. They’re just, we know a few of them, they’re, well recognized. We know their firms, but as a percent of the total money managed and money management and the total number of people, the percents are so small. It’s baffling. Why more have not reproduced and had a lot more?

[00:13:07] Robert Hagstrom: It’s a wonderful question. And even Charlie was mystified by it. But I think, it’s kind of quixotic to kind of fight the windmills of modern portfolio theory to say, you guys are crazy. This doesn’t work. And you guys are losing money. That’s why people are indexing and going to alternatives because you can’t beat the market.

[00:13:24] Robert Hagstrom: I think S& P just finally came out with the new data. 93 percent of all active managers can outperform over five years yet, but they still stay in business. I don’t know how that you don’t have performed for five years, but you still stay in business. And they should go away, right? They should shut their doors and go away, but they somehow or another find ways to stay in business.

[00:13:43] Robert Hagstrom: But the more perplexing part is why we haven’t replicated more Warren Buffett’s and Charlie Munger’s. Answer may be, Kyle, you and I have talked about that, is the temperament required. To run these high active share low turnover portfolio is a temperament requirement that is beyond the ability of most people to have patience to suffer through periods of underperformance.

[00:14:08] Robert Hagstrom: When we looked at the high active share managers in the Warren Buffett way. And this goes back to Sequoia fund and Lou Simpson and Charlie. you can go back to John Maynard Keynes who ran the chess fund. Phenomenal long term track records, but their batting average was about 50%. they outperformed month to month, quarter to quarter, year to year, only 50 percent of the time and the other 50 percent of the time they underperformed.

[00:14:32] Robert Hagstrom: And of course, when I say this, people say, how did you beat the market for five or 10 years if you underperformed half the time? And the answer is, that’s the difference between frequency and magnitude. It’s not how many times you beat the market. Less how many times you don’t beat the market. It’s how much, how much money you make when you beat the market, less how much money you give back.

[00:14:49] Robert Hagstrom: And so when you make money as a concentrated big bet portfolio, you make a lot of money. And if your valuations are good, when the market is against you, you’re just not giving it back wholesale. And so the net difference between those is your excess return. And that seems to be academically proven.

[00:15:08] Robert Hagstrom: And we know that, but then the psychology of being wrong half the time, On a month to month, quarter to quarter basis, as we know from, Danny Kahneman and Amos Tversky’s prospect theory that those that unit of not being the market for the quarter of the month is twice as painful. As the unit, the next month, a quarter when you do beat the market.

[00:15:29] Robert Hagstrom: And so you’re in a constant psychological impaired position, running high active share portfolios, the rational logical people understand it and move through it. Those that, that don’t really have the rationality to their back get whipsawed by it. So it’s a, combination of a lot of things, but the proof is in the pudding.

[00:15:51] Robert Hagstrom: It’s still stupefies me that they’re not a ton more. Warren Buffett like money managers out there. 

[00:15:58] Kyle Grieve: It’s funny too, that you mentioned, obviously those tremendous track records of people that I love following, especially John Maynard Keynes, who’s very underrated, but it’s funny also when you, also add the psychological impact of managing other people’s money to the fact that when you do have, a concentrated portfolio, your long term results are probably going to be really good, but you also have to deal with the personal aspect.

[00:16:20] Kyle Grieve: Of having people that you have to talk to being like, Hey, what happened this year? What happened this quarter? Yeah. And that, that alone is I’m sure very painful. 

[00:16:30] Robert Hagstrom: Yeah, I worked with Bill Miller for 14 years. when I, so if you kind of think about the writings of Warren Buffett, it’s kind of like I did my PhD dissertation, kind of went to grad school and wrote a PhD dissertation.

[00:16:42] Robert Hagstrom: The other half of my experience, so it was actually the practicalities, actually being in the hospital with Bill Miller, working on patients. And here’s a guy that had a phenomenal track record. And he was, when I joined him, I think he had beaten the market six years, seven years in a row.

[00:16:57] Robert Hagstrom: And as kind of a newcomer on the team, I acted as a portfolio specialist. So I was running a growth portfolio as a retail fund. Bill wouldn’t let me run it institutionally until I had a five year track record at Lake Mason. So most of the time I spent, I was managing the growth mutual fund. But at the same time I was out on the road.

[00:17:17] Robert Hagstrom: Helping bill with this institutional accounts and these, institutional consultants, very smart people go to grad school, stuff like that. And so you’ve got a guy that obviously knows what he’s doing. He’s brilliant, writes brilliantly, has performed brilliantly. And it seemed if he had a bad month, bad quarter, you’re sitting there trying to explain why is bill wrong?

[00:17:39] Robert Hagstrom: Bill’s not wrong. the market gravitates for a lot of different reasons, other than arbitraging price and value. There are a lot of reasons why stock prices move. But you’re right, even at the institutional level where you think they are above the individual irrationality level, they still had the same pressure points.

[00:17:56] Robert Hagstrom: We’re underperforming, we’re behind the benchmark. And I’m like, you guys are just, of course, I couldn’t say that, but you know, you just kind of look at them and go, you really are in charge of these multi billion dollar plans. And these are the decisions you’re making. You just kind of shake your head and go, God, no wonder this is a mess.

[00:18:13] Robert Hagstrom: It is a mess. 

[00:18:15] Kyle Grieve: I enjoyed how you mentioned more about the history of invest Buffett’s investing philosophy in this edition. So you wrote quote, all of these separate components, your view of the market, your methods and your temperament as an investor reflect the totality of your philosophy of investing unquote.

[00:18:29] Kyle Grieve: So we could easily probably spend an entire conversation discussing this one quote, but we won’t. However, I do want to dig into one point, which is your view of the market. Buffett learned a lot about this view of the market from Benjamin Graham in his book, The Intelligent Investor. This approach is obviously much different with that is taught in higher education, which you kind of just pointed out, but I’m also interested in learning just a little bit more about what differentiates Warren Buffett versus the majority of people in finance.

[00:18:58] Robert Hagstrom: I think where I think Warren had the benefit that he was able to lever into this long term track record is that he did two things. One is that it resonated with him when Ben said, stocks are businesses and we’re trying to buy businesses at cheap prices. Ben didn’t say we’re trying to buy great businesses at cheap prices.

[00:19:20] Robert Hagstrom: We’re just, we’re trying to buy this business at a cheap price. And as Warren said, as soon as I figured out that what Ben was saying is we’re going to buy a dollar’s worth of value for 50 cents, I got it and I ran with it and so early on at 19 years old, he said, stocks are just businesses and I think it was Graham that said in the intelligent investor that the moment you buy a common stock, you have a choice.

[00:19:45] Robert Hagstrom: Instantaneous choice. You’re going to decide to be an owner of that company, which legally you are now an owner of that company, or you just hold a piece of paper that you can trade moment to moment, week to week, month to month. And you can decide which one you’re going to be. Warren chose the former, which is, I’m I own a business and I’m going to hang on to it for a while.

[00:20:03] Robert Hagstrom: And I think that was hugely important. Then let’s layer on top of that, the actual experience when he put Berkshire Hathaway together of both having privately owned businesses, go back to Berkshire Hathaway, you can then talk about the insurance companies and go to Nebraska Furniture Markets.

[00:20:22] Robert Hagstrom: He’s Candies and Buffalo Evening News and on. He owned these companies. They didn’t have common stock prices. He owned the businesses. And he intellectually thought about those businesses exactly the same way he thought about owning Washington Post, or Cap Cities, or GEICO, or, go on down the list, Coca-Cola.

[00:20:45] Robert Hagstrom: For him, the mindset, the telescope of how he thought about it was identical. So he didn’t say, I own these businesses over here, Nebraska Furniture Mart and See’s Candy, but I also own Coca-Cola, so I’m going to analyze Coca-Cola differently than I do Nebraska Furniture Mart and See’s Candies. So I think you there’s a quote that you and I’ve talked about before that Warren thinks that stocks are really an abstraction.

[00:21:08] Robert Hagstrom: Common stocks in and of themselves are really abstractions. he doesn’t think in terms of common stocks, sectors, correlations, diversification. He doesn’t think about stock market theories. He doesn’t think about macro economic concepts. He just thinks about the business. Now, compare and contrast that with, an institutional money manager.

[00:21:27] Robert Hagstrom: All they do is think about stocks, common stocks, and they think about the beta. The variability and the information ratio and all this nonsense. And they’re worried about what sectors they’re in, what they’re not in, the correlations, they’ve got all these theories about the stock market, which tells them what they should overweight and underweight and God, they’re all into macroeconomic concepts, predicting what the economy is going to do is going to tell you what the stock market is going to do, which tells you what sectors can be in, which one does 0 of that 0.

[00:21:56] Robert Hagstrom: And at the end of the day, I think his competitive advantage is that he does none of that. He has purposely divorced himself from everything else that consumes 99 percent of the people that invest in the market. It’s his purposeful detachment from the stock market that has allowed him to behave so rationally over these last 50, 60 years.

[00:22:19] Robert Hagstrom: And that behavior is the source of his excess returns. And when you think about it in those terms, Getting into that mindset early and then having it perpetuated by both owning private companies simultaneously with public companies and decided to treating them exactly the same. That’s the golden sauce.

[00:22:38] Robert Hagstrom: That’s the golden egg right there. 

[00:22:41] Kyle Grieve: Moving on to Warren’s father, obviously you mentioned him as being a pretty massive influence on him. One of his biggest lessons, sorry, that Warren learned from his father was that nothing can bring you peace, but the triumph of principles, which I think is a wonderful little quote there.

[00:22:56] Kyle Grieve: And as we look at Warren’s evolution as an investor, I would say this has definitely held true, but he has obviously had this significant evolution in his investing strategy from when he was younger and he was a grey amite moving from cigar butts to, moving more towards the quality end of the spectrum.

[00:23:13] Kyle Grieve: So I’m just interested in learning your opinions a little bit more about how he made this transition while also staying true to his over guiding principles. 

[00:23:22] Robert Hagstrom: Let’s start. There’s two pieces to that. If we unpack it, the first part is his dad, Howard Holman. But as I said, it was libertarian. He was both a teacher too.

[00:23:31] Robert Hagstrom: I mean, he taught in Sunday school. He volunteered for the school board. he was a teacher by being a congressman, but he was also deeply influenced by the philosophy of Ralph Waldo Emerson. He was an Emersonian. And if you think, if you go back and look at Emersonian philosophy, probably the most celebrated.

[00:23:48] Robert Hagstrom: Essay was self reliance. So in the book, we kind of walked through self reliance step by step. And when you do that, you actually see Warren Buffett every step of the way. Independent thinking, right? It’s not what the community thinks is what you think your principles, not with the, it’s what he was talking about the community warrants and at the stock market, right?

[00:24:06] Robert Hagstrom: It’s your principles, not the stock market’s principles. People are going to tell you what you think you should do. Don’t listen to them. Do what you think you should do. That was all powered by his dad, Howard Holman Buffett, and I owe a nod to Roger Lowenstein, who wrote a great book about the making of American Capitalists that came out in the spring after Warren Buffett Way came out in 94, and was also a New York Times bestseller.

[00:24:28] Robert Hagstrom: Great book. Roger’s a wonderful writer. And it was Roger that basically helped me make that connection because he talked about it was the sweet philosophy of Emerson that led to Warren’s principles of self reliance, if you will, which is the cornerstone of self confidence, which is what you need to have in the market to operate independent of what the market’s doing.

[00:24:51] Robert Hagstrom: So we spent a lot of time going through all of that. And you can see that had you been 10, years old and every night, remember in the 1940s. there are no video games, there’s no cable TV, there wasn’t even TV, it was radio, occasional Saturday movie if you got lucky, but the rest of the time you’re reading, and when you got to the table, you talked, and so here’s this dad, wonderful teacher, just pounding his son on Emersonian philosophy and libertarianism, and it’s the self, is what governs you, not the community.

[00:25:24] Robert Hagstrom: And so that was inbred in him really at a young age. And I think that was his backbone that allowed him to make these moves. And then, as you kind of go, the aggravation of owning Berkshire Hathaway and then Dempster Hill manufacturing and the department stores that were all bought under the principles of Ben Graham, low price, to book, low price to earnings were cheap businesses, but they were bad economic returning businesses.

[00:25:54] Robert Hagstrom: And it was Charlie, as Warren testified in the annual report this year, whose insistence that they buy See’s Candies, which violated every single principle that Ben Graham had ever said. By the Graham principles, Warren should have never bought See’s Candy, but you know, Charlie probably browbeat him down and he paid three times book value and it became, I argued in the book, probably became one of the most dollar for dollar, the most profitable investment that he’d ever made.

[00:26:20] Robert Hagstrom: The light bulb then goes on, right? It’s wait a minute, I bought something here that didn’t comport to my mentor’s process of methods of buying stocks. And this thing was a home run. And, he began to think about, as he looked at his companies, it’s the cash that comes out. And, what do you do with that cash?

[00:26:39] Robert Hagstrom: And the cash that was coming out of Berkshire Hathaway and Dempster Hill Manufacturing and the retail store, there was no cash coming out. They were broke every year. So there was no money to take out of those bad businesses to go buy other businesses where C’s was gushing cash. And with that money, you could go buy other businesses that were gushing cash that could allow him to go buy other businesses with gushing cash.

[00:26:59] Robert Hagstrom: So that tangible, real experience of owning a company that did that. Then he looked at Coke and he said, this thing is gushing cash. Roberto Gazieta had showed up, changed the economics of the business after Paul Austin almost drove it into the ground. And it was buying back stock and it was raising the dividend cash just kept flooding out.

[00:27:21] Robert Hagstrom: And it’s been argued and I think it’s true that the lessons he learned from sees candy got into Coca-Cola and American Express and. There’s some that argue that same cash gushing phenomena at Apple is what turned him on. Remember in the last 10 years, Apple’s bought back half of its stock.

[00:27:40] Robert Hagstrom: It’s reduced its share count by 50 percent on the way going from 600 billion to 3 trillion. And you bought back half your stock. That’s a lot of cash coming out of there. So that always, that goes in my mind all the way back to see his candies. 

[00:27:55] Kyle Grieve: So I want to turn to some of Buffett’s learnings on intrinsic value as he evolved.

[00:28:00] Kyle Grieve: So when he was a pure gray, I might, intrinsic value is essentially just a benchmark to reach that would trigger the sale of an asset. But as Buffett began scaling up capital, he realized that holding businesses where intrinsic value would continue growing were a better option for him than just, finding something that wouldn’t grow.

[00:28:18] Kyle Grieve: It’s funny because his success with the Graham approach kind of necessitated him moving on from it as it was just no longer an effective strategy as his capital grew as well. A lot of these opportunities he was looking at were small, right? And just it wouldn’t work with a lot of capital. So I’m just interested in knowing what were some of Buffett’s other well known aspects of Graham that maybe he had to ditch as he began scaling up his capital.

[00:28:41] Robert Hagstrom: Graham, he gave him a temperamental foundation, which we could talk about, but also a methodological foundation, which was absent, Buffett actually was a chartist. He was doing technicals and stuff like that until he read the intelligent investor and finally that was the epiphany and he applied it to the Berkshire, I mean, to the, Buffett partnership from 56 to 69 with great success.

[00:29:02] Robert Hagstrom: Which, gave him financial independence, financial security for his family, and then obviously gave him the resources that he eventually was able to take control of Berkshire Hathaway. So to say that Graham wasn’t a big, huge part of his success, it played a very big role for a period of time.

[00:29:20] Robert Hagstrom: You rightly point out, Kyle, that as the asset base got higher and bigger, moving money around a lot, because in the Graham approach, once you got to fair value, you had to sell and move on fair value being you were trading at book value, or you were trading near the market multiple and having bought it at a discount to the market multiple or a discount book value.

[00:29:42] Robert Hagstrom: You are of that until it got to Graham’s definition of fair value, and then you had to move on, you had to sell it and buy something else. as you’re working with bigger and bigger sums of money. This kind of high, this high, not high trading, but often need to buy and sell things was impractical for him at Berkshire Hathaway.

[00:30:04] Robert Hagstrom: And, he finally learned that buying and holding a mediocre company over time gives you mediocre returns. And so if I can’t buy and sell them, as I did in my partnership years, and I got to buy and hold, sees candy taught him buy and hold good stuff. And of course, national indemnity was teaching that at the same time.

[00:30:23] Robert Hagstrom: The water was dripping down on him, buy and hold good things that generate a lot of cash. And you’ll be in pretty good shape. So then he was definitely moved on from Buffett’s methods of picking stocks. But the two parts that are still today, ever present chapters, eight chapters, 20, and the intelligent investor, one is the margin of safety by something for less than it’s worth calculated.

[00:30:46] Robert Hagstrom: It’s intrinsic value by it at a discount. He goes today, those are the, still the right three words, margin of safety. And then in chapter 20, it was, the temperament of the market. distancing yourself, a purposeful detachment from the market. The market is not your boss. It is there to serve you, not guide you.

[00:31:07] Robert Hagstrom: And those two parts are still the cornerstone of its philosophy. And those are Graham, principles. So you could say Graham still carries a very big arc of influence on Warren, but it’s now been reduced to buy value at a discount margin of safety, which was there in 1934. And how to think about the stock market from a temperamental standpoint, which was there in 1949, and the intelligent investor, so it carries a lot of weight.

[00:31:35] Robert Hagstrom: Then the question then becomes what happened after that? You and I have talked about the influence of Phil Fisher. Fisher was not methodologically about the quant side as Ben Graham was. He was looking for great companies run by great managers, so he was more on the fundamental side, things that were not easily quantifiable, but if you bought a great company run by a great manager and held on to it for a long period of time, usually something good happened to you.

[00:32:02] Robert Hagstrom: The compounding and holding of great businesses was Phil Fisher’s reward. And, so Warren slowly was merging these things together. The quote that I think is misunderstood is in the 1960s, he said, I’m 85% gram and 15% Fisher. And that’s a quote that has been used often by times, but you gotta put it in context.

[00:32:24] Robert Hagstrom: That was before he bought Sees Candy. if you would’ve said, what’s that quote? After he bought Seas Candy, it might’ve been 50 50. Today it might be 50 50, which is business and management matter a lot. The kind of business that you’re in, future prospects of the business that you’re in. Is it favorable?

[00:32:42] Robert Hagstrom: Do they earn above the cost of capital? Do they increase shareholder value? Those aspects of business that Graham never talked about are important, just as it’s important that management rationally allocate the resources of the company back to the company itself, as opposed to themselves making stupid acquisitions for the sake of enlarging the company.

[00:33:02] Robert Hagstrom: The corporate edifice, some management and the type of business started to write very high and the compounding of as well. I would argue today, if you would said, I think it’s more 50 gram Fisher, but even that, where do you put Charlie and I’d probably put Charlie in the Phil Fisher camp who was the actual.

[00:33:23] Robert Hagstrom: Proponent, the actual practicality of the Phil Fisher philosophy. Charlie was probably more akin to Phil Fisher and the types of stocks that he bought were more like Phil Fisher stocks. Charlie didn’t have a lot of Ben Graham stocks, didn’t have bad businesses that were cheap. He had pretty decent companies and, those that he held, compounded at a high rate.

[00:33:44] Robert Hagstrom: So you got to put Charlie in that Phil Fisher bucket and then it tips maybe more than 50 50 by Charlie and Phil Fisher together, but that’s a pretty big bucket. It’s a big pocket. 

[00:33:55] Kyle Grieve: So you wrote a fascinating point that you kind of actually touched on a little bit earlier about how Buffett looks as stocks is an abstraction, but I just want to say this quote.

[00:34:02] Kyle Grieve: So quote for Buffett stocks are an abstraction. He doesn’t think in terms of market theories, macroeconomic concepts or sector trends. He makes investment decisions based only on how a business operates. So you kind of did a really good job of talking about that abstraction and why he thinks of it, but I want to actually just invert the question and ask you if you think there’s any potential downsides to looking at a stock the way he does as an abstraction.

[00:34:27] Kyle Grieve: I’m just interested in knowing your opinion on that. 

[00:34:30] Robert Hagstrom: Only in the short term. Because there’s still enough people that are still looking at stocks as these abstractions of beta information ratio correlations and stuff like that. If the game is short term and there are people that play the short term game, it’s embedded in modern portfolio theory.

[00:34:45] Robert Hagstrom: It’s practice largely in the standard approach to investment management that people want smooth returns, non correlative returns, conservative returns, but they want consistent returns. All those things are important, and you would say, market theories and macroeconomic concepts, it stupefies me that people still feel the need to embrace or at least are attracted to these concepts, where we already know, scientifically proven, that there is no model, no individual, no model that can predict complex adaptive systems.

[00:35:21] Robert Hagstrom: Go to the Santa Fe Institute. Bill Miller introduced me to that in the 1990s. The Nobel Prize winners out there, they will tell you there is no science on this planet Earth that can predict the behavior of a complex adaptive system three months out, six months out, nine months out, twelve months out. Much less, you might argue overnight, still people are obsessed with talking about it, thinking about it, believing in it.

[00:35:47] Robert Hagstrom: and I, once again, these are one of the things like, why is that psychological need? I think the idea that you are willing to say, I don’t know what’s going to happen tomorrow, but it’s not important to my investment process because I have a good business, right? I don’t know if the economy is going to grow fast or slow.

[00:36:03] Robert Hagstrom: I don’t know if the stock market is going to go up or down. I don’t know what the geopolitical outcome is in the Middle East or Ukraine. Nobody knows. We don’t know. And absent that you go, what are you going to do in the stock market? But I can say, whatever happens, I want a good business. So if the economy is accelerating, what do you want?

[00:36:21] Robert Hagstrom: I want a good business. Now, if the economy is going into recession, what do you want? I want a good business. If inflation is going up, what do you want? I want a good bit. I don’t want a bad business. I’m like good business. if we get into a geopolitical war, what do you want? I want a good business almost in every outcome that you come up with.

[00:36:37] Robert Hagstrom: That can be bad. What is the best solution? Own a good business. That’s very The only time someone says, I really want to own a bad business, is that if you can think you can sell it real quick. I buy it now and I sell it pretty quick. But this, psychological need that I can’t operate without having some grasp, even though it’s, obviously bleeding.

[00:37:00] Robert Hagstrom: That what’s going to happen tomorrow, next week, next month, if we just people spend 80%, 90 percent of their time on these things, they can’t predict and on things that have nothing to do with business value. Warren Buffett spend 95, 99 percent of his time on nothing but business. Just think about that nothing, he does nothing but think about businesses and hardly ever about the stock market only glancing at it every once in a while to see if it’s done something foolish that allows him to take advantage of a misprice in the market.

[00:37:28] Robert Hagstrom: And we, the majority of we, spend 90 some of our percent, what are we doing, pontificating about the market, pontificating about the economy, pontificating about geopolitics, the presidential politics, who’s going to win, who cares, I don’t care, does it matter, whatever the outcome, what do I want a good business, that simplifies your role pretty quick, but as you well know, in this business.

[00:37:52] Robert Hagstrom: Out of 10 phone calls you get, nine of them are going to ask you those questions. So you’re not going to have a long career if you don’t at least contribute something to it, even though I say to them, I have no idea, but you might think about it this way or that way. what are you doing? I’m going to go, I’m buying good businesses.

[00:38:08] Robert Hagstrom: That’s all I’m trying to do. Just buy good businesses. It’s pretty simple to me. 

[00:38:13] Kyle Grieve: So before we go to the next question, you’ve actually mentioned something, the information ratio twice. So just for listeners who might not know what that is, do you mind just quickly explaining what it is? 

[00:38:22] Robert Hagstrom: It’s just, yeah, it’s a stupid term that came out of my portfolio theory that basically looks at the volatility, the return of the stock to the actual return of the stock.

[00:38:31] Robert Hagstrom: And if the actual return of the stock is higher than the volatility, then you have an excess return that shows up in the information ratio, the higher the information ratio. That you have, it is perceived that you’ve made a, a smart calculation that rewarded you beyond the volatility, efficient market hypothesis would say that, and, there’s still people that believe in that nonsense, but basically say, if you bought a high beta stock.

[00:38:57] Robert Hagstrom: And you had a high return. It was only because you bought a high beta stock. But, information ratio says you bought a high beta stock, but you actually got a return that was even higher than what the volatility would imply that you got from the return. There are people that actually pay a lot of attention to that.

[00:39:11] Robert Hagstrom: Warren doesn’t. I don’t even know. I don’t even think Warren knows how to define it. Yeah. 

[00:39:17] Kyle Grieve: And we’ll actually be covering that, question on that in a little bit. but yeah, let’s get back to it. So You made a really good point about Buffett and his, evolution towards Philip Fisher. So obviously, you’ve already talked about how a lot of moving on to Philip Fisher was kind of moving on to the qualitative end of, investing and, relying less so on the quantitative ends.

[00:39:38] Kyle Grieve: But, if you had to really distill Warren’s biggest takeaway from, Philip Fisher, what do you think that one thing would have been? 

[00:39:47] Robert Hagstrom: Actually, the famous term, circular competence actually originated from Phil Fisher. and that was in his 16 points. He has 16. If you go to the book, common stocks and uncommon profits, he has lifts or points.

[00:39:59] Robert Hagstrom: That’s his checklist. And one of them is just stick in your circle of competence and know what you know and know what you don’t know and stick with what you know, if you don’t know something, you’re not going to do a good job analyzing it. And when the price deviates, because you don’t know a lot about it, you’ll never know if you’re right or wrong.

[00:40:14] Robert Hagstrom: And then the game’s up, gigs up. If if you’ve lost the self confidence, am I right? Am I wrong? Gigs up. What was the famous quote from Warren Buffett? If you’re a poker game for 20 minutes and you don’t know who the Patsy is, you’re the Patsy, right? the market’s the and Warren’s like the market’s the Patsy.

[00:40:30] Robert Hagstrom: I know who the Patsy is. Patsy is the market. It’s going to make some dumb bets, right? It’s a sucker on the other side of the poker table, right? I’m just waiting for them to make a wrong bet with the cards that they have in their hand. And I’ve got a pretty good idea what the cards are and they’re going to make a stupid bet.

[00:40:47] Robert Hagstrom: And then I’m going to bet. Contrary to that. So I think, circular competence is real good. He did talk about management and channeling the rewards of management back to the company. Phil Fisher was big about compounding. He didn’t need the dividends. They’ll put it back in the company, that’s one don’t pay it out on the dividend.

[00:41:06] Robert Hagstrom: If I’m earning above the cost of capital, just say your opportunity cost of capital is 10%, which is what Charlie believed the cost of capital was not the capital asset pricing model definition, but just your opportunity cost of capital. If you’re lending money to the stock market, it’s perceived that you should generate at least a 10 percent rate of return historically speaking.

[00:41:24] Robert Hagstrom: So if I’m lending money at 10%, I should expect back at least 10 percent if not more. If I’m not getting back 10 percent or more, then what’s the purpose of doing this? If your cost of capital is 10, your company earns 15 or 20, or Apple earns 100, what do you want them to do? Keep the money, just keep it all, don’t pay a dividend.

[00:41:48] Robert Hagstrom: And that’s the Amazon story, I don’t know, we’re on the day here that Andy Jassy wrote the, And a report on Amazon, it’s just wonderful and work. But if you look at the operating cash flow of Amazon before it takes it to the bottom line to pay corporate taxes or give out a dividend, they put it back into the company.

[00:42:08] Robert Hagstrom: But that operating cash flow before they reinvested about it in the company is probably a 3 or 4 percent cash flow yield. That’s pretty good, but then they’d say, why don’t I want to pay tax on that when we’re growing double digits, earning above the cost of capital, put it back in AWS, put it back in retailing, put it back in advertising, put it back in Amazon Prime.

[00:42:28] Robert Hagstrom: So Amazon has been a high PE stock since 1999. And it’s, a 2 trillion business. So much for high PE, low PE investing has nothing to do with the growth in intrinsic value. It has every bit to do. Did you earn above the cost of capital? So I deviated a little bit from your original question, but Once again, what are we talking about?

[00:42:47] Robert Hagstrom: Businesses. Talking about the economic returns of businesses, what are we not talking about? PEs, we’re not talking about sectors, we’re not talking about, is the economy going up or down? what’s going on with interest rates? Oh, it’s inflation’s up, the Fed’s not going to cut interest rates.

[00:43:03] Robert Hagstrom: Who cares? Just buy a good business, that’s all we have to do. 

[00:43:07] Kyle Grieve: So we’ve obviously spent a lot of time thrashing portfolio management theory and efficient market hypothesis, but you know what, we’re going to keep going with that on that theme. you pointed out in your book that Harry Markowitz developed this theory at the very young age of only 25, and he assumed that the unpleasantness of price volatility was the risk that investors should avoid, which is an interesting conclusion.

[00:43:29] Kyle Grieve: But I’m just interesting. I know that you spoke a little bit about how. security analysis was already out at this time. And he clearly just, obviously he ignored it or I don’t know, but I’m just trying to figure out why he completely missed the point about the underlying value of a business.

[00:43:46] Kyle Grieve: And I’m just kind of interested in knowing your, thoughts on why it came to the conclusion. 

[00:43:50] Robert Hagstrom: I’m so glad that you brought this up. So when Charlie said, we’re so right, why are so many eminent places not copying us? It goes back to why is modern portfolio theory the dominant standard management practice.

[00:44:02] Robert Hagstrom: And so we went back to, you go to first movers, right? So how did this whole thing started? So here you have this little kid, 22, 23 years old, right? mannered boy, play the violin, great grades. David Hume, the Scottish philosopher, was his, his favorite philosopher. Goes to University of Chicago, decides he wants to stick around, spent some time at the Coles Commission, which had done, that came over from Yale, had done a lot of work on.

[00:44:27] Robert Hagstrom: Forecasting markets got intrigued about the stock market decides he wants to get his PhD in economics and decides one day that he’s going to write his PhD on the stock market and kind of gets because, it’s more of an economic thing. It’s into risk and return. So I went back to the original paper.

[00:44:45] Robert Hagstrom: It’s a very unimpressive paper. I mean, for a PhD dissertation, I think it’s 14 pages. Most of it’s graphs and tables. There was only three citations. One of them, which was John Burr Williams, which we’ll talk about in a second, but he writes in there. And so he kind of says, this is the right thing. The person is, we consider the rule that the investor does or should consider expected return is a desirable thing, right?

[00:45:07] Robert Hagstrom: Your return is desirable. I get that. And then he writes and the variance of the return as an undesirable thing. Okay, so he’s saying variance, price volatility is undesirable. I let him slide on that. Since they both have sound points, blah, blah, blah. But then he says the term yield and risk frequently appear in financial writings, but are not always used in precision.

[00:45:29] Robert Hagstrom: Even Graham said, sometimes investing is not precisely defined. But then he says this is where the slope gets slippery. He says if the term yield, which is expected return, was replaced with expected return, And risk, now he’s defining risk right here, by the variance of returns, little change in the apparent meaning would result.

[00:45:52] Robert Hagstrom: Okay, so right there, there’s this 25 year old boy who’s never invested in the stock market, never owned a company, never been in business, anything. And he’s all of a sudden going to define risk as variance, volatility. Okay. If I’m writing a PhD dissertation, and I have a dissertation committee, much less a dissertation thesis advisor, and I make a statement like that, it has to be defended.

[00:46:17] Robert Hagstrom: Better yet, you have to look at the counterfactual. What do other people say about risk? Is there somebody else that has a different definition about risk? And so to your point, this was 1952 that the paper was published. So go back. in 1934, security analysis published. And right there, margin of safety is defined as risk.

[00:46:39] Robert Hagstrom: If you’re operating with a margin of safety, that’s low risk. If you’re operating above intrinsic value, that’s bad. Then go to 1938. Theory of investment value is published. He cites the book in defense of his thesis. If you go to John Pearl Williams, he says this, investment value defined as the present value of future dividends and future coupons in principle.

[00:46:59] Robert Hagstrom: It’s a practical importance to every investor because it is the critical value above which he cannot go in buying and holding without added risk. John for William saying is if you buy something above its intrinsic value, that is risk. Okay. There’s a different opinion about risk. And then 1940, security analysis, second edition, 1949, the intelligent investor, Benjamin Graham, writes it all down.

[00:47:24] Robert Hagstrom: Difference between short term quotation loss, permanent capital loss, margin of safety. Then 1951, the year before his thesis is published, the third edition of security analysis. Columbia University in security analysis owned the finance Academia. Here he is at University of Chicago, Marshall Ketchum, who was the dean of the economics department and his PhD advisor and on his PhD dissertation, had a brand new academic journal that had just been launched called the Journal of Finance.

[00:47:57] Robert Hagstrom: It’s only just a couple of years old. Kind of fledging, didn’t know what to do with it. Markiewicz’s paper ends up in the Journal of Finance. And no one on the dissertation committee ever said, there’s some other people that have a different definition of risk. Never mentioned. So nothing happens.

[00:48:13] Robert Hagstrom: He goes off and works for the Rand Corporation in the 1950s, and then Bill Sharp shows up, and he’s looking for a thesis of his people. He was at UCLA, and they said, oh, track down Markiewicz. He goes to see Markiewicz. Instead of doing all the non colleges, strategies or doing the tabulations of non correlations, he says, why don’t we just do a, find 1 thing to measure everything against what has the most influence on the market is beta.

[00:48:37] Robert Hagstrom: I mean, is the market price itself and gave it a name called beta. If your price bounced higher than the market, you had a beta greater than 1. 0. If it bounced less than the market. So any portfolio, the weighted average of its betas in the portfolio, if it was above 1. 0, you were riskier than the market.

[00:48:55] Robert Hagstrom: And if it was less than 1. 0, you were less risky in the market. Okay. That’s 1963. Nobody gave a damn. Nobody on wall street paid attention to it. Nobody care. It was never mentioned much of anything ever again until the 73, 74 bear market. And as we talked about early, you wiped out half of people’s money because people were into the nifty fifty stocks, the go stocks.

[00:49:17] Robert Hagstrom: They weren’t doing valuation work. It was all momentum trades. It was Jerry’s eye at the Manhattan fund. it was the go years. Great book by John Brooks, one of Warren’s favorite books talks about it. The important part was that value investing had gone away at Columbia university. So Graham retires 1956.

[00:49:35] Robert Hagstrom: There was a guy named Roger Murray that took over his spring seminar class. David Dodd retired in 61, 62. Roger Murray then taught the fall investment management class that David Dodd taught and then the spring class. And he was the guy, he was the guy from the 1950s and he retired in 1977. And the attendance of the value investing classes continued to go down through the late sixties into the early seventies because everybody was in the nifty fifty.

[00:50:04] Robert Hagstrom: Those weren’t low PE, low price to book a stock. So there wasn’t a lot of people attending value investing classes. In 1977, Roger Murray retired. That was the end of the security analysis course. There was no security in that there was no value investing being taught at Columbia university. The ashes of the 73, 74 bear market, where their portfolios are in rubble, everything is down.

[00:50:30] Robert Hagstrom: But as what typically happens, time passes and people begin to return to the stock market and they were returning. And as we got to the early 80s, interest rates were being cut. That was the beginning of the big bull market and firms were being organized again. People were starting investment management firms and they kept saying, what are we going to do?

[00:50:49] Robert Hagstrom: How should we do this? And a couple of these guys that were disciples of Markowitz and Sharp, and they were still in the business. Teaching and stuff like that said, Hey, that’s 73, 74. Yeah. What if we did non correlation and wide diversification and stay away from high beta stocks? And we do conservative returns and we think price volatility is the evil that must be slain.

[00:51:11] Robert Hagstrom: What do you think about that as a money management practice? And they went, yeah, this’ll sell. This is what we got to do. We’ve got something for you. That’s going to prevent what happened in 73 and 74. And so it took off. Now, Buffett shows up back at Columbia in 1984 for the 50th anniversary of security analysis and the very famous speech that he gave the super investor of Graham and Doddsville kind of lit a spark back into Columbia, David Dodds family endowed.

[00:51:44] Robert Hagstrom: Professorship got named Robert Helbram got involved and they started to resuscitate value investing, but it wasn’t until 1991 that yeah, it was Bruce Greenwald, 1991 that became a professor and he himself then was probably the most responsible for rejuvenating security analysis course came back. Value investing became a harbinger of Columbia, but it was too late by then.

[00:52:10] Robert Hagstrom: You were 10 years into the bull market and money. Modern portfolio theory was ubiquitous everywhere. And so I think that period between 77 and 82, 83, almost seven years where the value investors were absent and weren’t there who, to offer a counter, a counter argument. Allowed modern portfolio theory to get a lead it took off and, create a little biothon that is still the dominant theory today.

[00:52:42] Robert Hagstrom: And that’s kind of how we think about it. So then the question is, if, in fact, the Berkshire Hathaway is the rational way in which to do it, and all this other stuff doesn’t meet markets over the time, why don’t we change? And then you go to Thomas Kuhn’s theories of scientific revolutions and talk about paradigm shifts.

[00:52:58] Robert Hagstrom: Go ahead and tell a couple of professors that had their PhD in modern portfolio theory. Probably a theory. It’s a bunch of bunk and see if they agree with you. They’re out of a job. They don’t have a class to teach. Go tell guys that have billions of dollars. In modern portfolio theory. Oh, you know what?

[00:53:13] Robert Hagstrom: That, that money management practice is making you millions of dollars a year. That gets you all the luxuries and everything that you want. Oh, you need to shut that down. It doesn’t make any sense anymore. no, they’re not going to do that. They’re going to defend that till hell freezes over. So we’re now, we have these two paradigms, right?

[00:53:31] Robert Hagstrom: And, that’s kind of where we are now. And so one of Charlie’s favorite quotes, I think was Max Planck, the German physicist said, science advances one funeral at a time. You just have to wait for these guys to die off and hopefully going to be repopulated with, the Berkshirist. They’re going to rise up.

[00:53:50] Robert Hagstrom: I don’t think we have to wait that long. And I have some ideas, maybe how we can try to light a light, a spark under it. But it gave me. A great deal of satisfaction, personal satisfaction to understand how to answer Charlie’s question, which is what we do makes a lot of sense makes a lot of money. How come it’s not taught?

[00:54:09] Robert Hagstrom: I think I got to the bottom of why that happened. 

[00:54:12] Kyle Grieve: Yes, I agree. And thank you for that excellent historical breakdown. So I want to discuss now Buffett’s points on risk and how it obviously differs a lot from the portfolio management theory. So Warren’s view on risk is the possibility of injury or harm to the intrinsic value of the business.

[00:54:28] Kyle Grieve: It has nothing to do with the fluctuations in stock prices that are taught in a portfolio theory. You wrote, quote, In Buffett’s view, harm or injury comes from misjudging the primary factors that determine the future profits of your business. One, the certainty with which the long term economic characteristics of the business can be evaluated.

[00:54:46] Kyle Grieve: Two, the certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows. Three, the certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself.

[00:55:02] Kyle Grieve: And for the purchase price of the business unquote. So what really stood out to me on this incredible list is the word certainty, obviously it’s mentioned in three out of four of the points. So I’m interested in knowing just kind of more, this is more of a question to you than what Buffett would say, but you can obviously inject anything that you think Buffett would say, but.

[00:55:19] Kyle Grieve: Obviously the market loves certainty, but the problem with certainty is you pay for it. So I’m kind of interested in knowing, how can investors best balance being certain about investment and coming up with a purchase price. That makes sense. 

[00:55:33] Robert Hagstrom: I mean, it’s long been said that Warren’s investment approach is to buy certainties at a discount.

[00:55:38] Robert Hagstrom: Your point, or at least your observation would be, oftentimes, certainties are priced at a premium. And that’s probably true, but not always true. As Warren says, the market is frequently efficient, not always efficient. And there are times when the market’s got it wrong. go back to Coca-Cola. Coca-Cola was trading at a high, its price earnings multiple was above the market.

[00:55:57] Robert Hagstrom: High price to book value, low average dividend yield by every metric you can think about in 1988. Got it. Call it was no screaming bargain whatsoever. Warren invested 1 billion, a third of his portfolio, and what he believed was a certainty of all those things that you just said. Good business, good long term outlook, good management, going to allocate the capital rationally, and I got it at a good price.

[00:56:21] Robert Hagstrom: In 10 years, that billion went to 10 billion. A billion in the S& P went to 3 billion. Did he buy a certainty at a discount? Yes. Was it perceived to be above its intrinsic value? Yes. But, the way in which you think about value sometimes is different than how the market thinks about value. and we go back to the dividend discount model.

[00:56:40] Robert Hagstrom: It’s a different way to think about value than price earns ratios. Warren kind of continued to elaborate on this, so if we kind of think about three certainties that we’re trying to get right, which is what are the economics of the business and the persistence of the company to continue to generate attractive economic returns, that’s one certainty bucket I’m trying to figure out.

[00:56:59] Robert Hagstrom: The second certainty is who are the people running the company? Are they going to rationally allocate the capital and in doing so, will they do it to enrich shareholders themselves? And third is purchase price. He goes on all those three things. I rarely have gotten the purchase price wrong and I’ve really gotten management.

[00:57:18] Robert Hagstrom: The mistakes I’ve made is miscalculating the persistence of the company to generate high returns of capital over time, that which was generating attractive returns, just didn’t do it for as long as possible. And so that’s why he spends so much time on moats. Moats are the ability that, if a company has a big moat, Which is nothing more than it has the ability, a competitive advantage period that’s going to last for a long period of time.

[00:57:46] Robert Hagstrom: People that have competitive advantage period that last a long time and Warren’s metaphor have big moats that people can’t attack the castle and take their business away. So the mistakes that he has made, the biggest mistakes that he has made is that a company that he thought had a moat and a long competitive advantage period did not.

[00:58:05] Robert Hagstrom: Now, you could argue that was probably that you didn’t buy something as cheap as you thought it was. It wasn’t as worth as much as you thought it was. And there’s some, rationale to that. But really, it gets down to when you’re a long term investor and you’re compounding something. You own something that generates good returns on capital that can be reinvested back in the company to compound, It’s your thinking on who are the competitors, how quickly are they coming over the moat, how quickly are they going to take your business away, or how quickly do your customers decide they want something else. That, that, that’s the problem. And so much of the thinking today for, I think, value investors that are compounding money.

[00:58:52] Robert Hagstrom: It’s basically trying to answer that question, whether it’s MasterCard, Visa, or credit card processors, or, and in my case, we own a lot of technology. So it’s how long does Amazon keep doing this or Google the cloud service providers? how long can they keep doing this? When is somebody going to come over the wall, attack the castle and do what they do cheaper and better?

[00:59:15] Robert Hagstrom: And what they’re doing. So we spent a lot of time thinking about that competitive threat because that’s the one certainty that Warren has gotten wrong, which is, could be then argued that’s been the biggest risk in his portfolio is misjudging the certainty of a company to do that for a long period of time.

[00:59:34] Robert Hagstrom: Does that make sense? 

[00:59:36] Kyle Grieve: Yes, that makes perfect sense. And that actually leads kind of really well into the next question I had, kind of about Buffett’s franchise definition. a big takeaway I had from your book on the GEICO and Coca-Cola case studies was, his variant perception of these robust franchise characteristics.

[00:59:54] Kyle Grieve: Just for people not familiar with those characteristics, basically, it’s an economic franchise arises from a product or service that is one needed or desired to thought by customers to have no close substitutes and three is not subject to price regulations. I just want to learn a little bit more about how Buffett success is kind of interplayed with these franchise characteristics in terms of, do you think his biggest wins have come from franchise type businesses or do you think he’s been able to find success in other areas as well?

[01:00:24] Robert Hagstrom: Yeah, I think the franchises are a huge part. let’s just think about Coca-Cola. Warren said, and this is 20 years ago, he goes, they said something, I gave you 10 billion right now, you couldn’t unseat Coca-Cola, it’s the number one manufacturer of concentrate syrup that combines with carbonation, makes soda pop, you couldn’t do it.

[01:00:42] Robert Hagstrom: There’s no chance. Okay. That’s pretty interesting to think about, right? And then think about GEICO, who’s going to take their business away for a long time, being an agentless direct provider of insurance products. Was taking market share from Allstate and Prudential and on down a lot until Progressive and Progressive came in and done a phenomenal job and now GEICO and Progressive are going at it pretty hard.

[01:01:06] Robert Hagstrom: So you kind of look at who are you going to, who’s going to come take your business away or who could potentially come take your business away? So then this looked as, Warren doesn’t own cloud, but I think cloud is pretty interesting. These hyperscalers, right? You think about these huge data centers, AWS.

[01:01:23] Robert Hagstrom: Azure at Microsoft or Google. And you say to me, okay, who’s going to take this business away? If I gave you 10 billion, 20 billion, 30 billion, could you go take out AWS? No, you’re not enough money for you to go ahead. Now, will there be more oracles coming into the game? IBM’s coming into the game, but if you look at how the market shares are changing, a little market share is changing and adjusting a little bit, but they’re not going to go away.

[01:01:51] Robert Hagstrom: I mean, they are. is anybody going to disrupt app? Amazon is the world’s leading online retailer. Can anybody do it cheaper and better? How much money do I have to give you to become the world’s best at this? Yeah, that’s really, Google search with all the angst about Google search and everything that’s going on.

[01:02:12] Robert Hagstrom: And we have, being at Microsoft and we have Yahoo and we have DuckDuck and all that. Google is still 93 percent market share. It’s okay, who else are you going to throw at me? So you kind of begin to think about who can take my business away. And I would have to say, Kyle, I probably spend more than half of my time reading and thinking about that.

[01:02:34] Robert Hagstrom: I mean, I read the balance sheets, I read the income statements, I read the quarterlies, I listen to the management, just to make sure that they’re doing what I think they should be doing or what they said they would be doing. You can understand balance sheets and income statements relatively quickly and easily to see, where the levers are moving left or right, but I spend more time thinking about competitive threat.

[01:02:53] Robert Hagstrom: And, who can take me out and, for a compounder, which owns a business that earns above the cost of capital that is thought to be able to do that for a long period of time. That’s what I spend most of my time thinking about. 

[01:03:08] Kyle Grieve: I discovered the rule of one from reading the third edition of your book a couple of years ago, and I’ve really enjoyed using it, but I have had quite a bit of pushback on it that I’d love to get your opinion on.

[01:03:19] Kyle Grieve: I just want to give some background on to what the rule of one is in case people don’t understand. So basically it’s the rule that for each dollar that a business retains, it should earn at least a dollar of market value. And this is Buffett’s rule. So just to give an example in the Warren Buffett way, you mentioned that Coca-Cola created about a dollar, 1.

[01:03:35] Kyle Grieve: 02 in market value per dollar retained between 1974 and 1980. But when Roberto Goyzeta took over, he elevated that to 4. 66 between 1980 and 1987, which is incredible. Just kind of getting back to the pushback, a lot of what I get is that the market obviously is kind of in charge of assigning prices to a business.

[01:03:55] Kyle Grieve: Let’s say that there is a business that is retaining a lot of earnings, but maybe it’s not growing the earnings at a super high rate. It can still technically pass a rule of one if let’s say the market’s really euphoric and they’re just driving up the price of that business. I just kind of would love to hear your opinion on the rule of one as a tool for investors.

[01:04:15] Kyle Grieve: And if you think it’s still valid and kind of how you would kind of hit back against that common complaint that I’ve got. 

[01:04:22] Robert Hagstrom: I’ve heard that criticism before, Colin. I think it’s legitimate criticism. I think what you have to do is to put it in the right context. It was not meant to say that a dollar today in 2 years or 3 years or 4 years is worth more than a dollar if you’re in the middle of a bull market.

[01:04:35] Robert Hagstrom: It was straight up. That’ll kind of skew the numbers, I think it was kind of meant over, a decade type longer where you’ve gotten the fluff out of the market and maybe even been in a bear market. People would say, if you go into a bear market, are you being unjustly punished because stock prices are down far worse than what the economic returns are.

[01:04:53] Robert Hagstrom: So let’s just go back to first principles. The idea is that if you earn above the cost of capital, you’re increasing intrinsic value. If you earn below the cost of capital, you’re destroying intrinsic value. If you do either one of those things over a multi year period of time, it should show up in the market value of the intrinsic value of the business.

[01:05:10] Robert Hagstrom: So if I’m consistently earning above the cost of capital by reinvesting above the cost of capital, every time I put a dollar in the business, it should earn me at least a dollar, if not more and vice versa. I think the criticism is let it play out over a lengthy period of time. What I would say is that it really shines a very, bright light.

[01:05:33] Robert Hagstrom: On bad businesses, if you’re a bad business, I reinvestment low margin, capital intensive business, and you’re struggling to earn returns on capital that are below the business or own cost of capital. You can add up all the money that they’ve spent over 10 years. And if it doesn’t show up in a market dollars worth of market value, there’s something really bad going on here.

[01:05:56] Robert Hagstrom: And I’ll give you a perfect example. I was with Tom Russo, great value investor, a great super investor, and we were, visiting Peter Khan at the Wall Street Journal in the mid 1990s. And we happened to be in his office in New York and. Peter had done a great job running the business, but the economic terms just weren’t that good.

[01:06:17] Robert Hagstrom: And he looked up in the end report and looked at the back and actually was a line that said capital investment for 10 years. And the Wall Street Journal was investing in a lot of crazy things. Internet was coming on and, just money was just flying out the door because newspapers generate a ton of cash.

[01:06:33] Robert Hagstrom: I mean, they’re not capital intensive, but he was finding a way to reinvest it in a lot of things. And Tom just very gently said, when I add up this line of capital investment that you’ve spent and I look for the return of that capital investment, I can’t find it in the price. And it was so illuminating.

[01:06:51] Robert Hagstrom: It was yeah, where did the money go? What was the return on that money? And it’s not in the price. There’s a problem here. I get the argument that when you’re in a roaring bull market, it might be a false positive, right? That you’re getting more for the bang of the buck because the market’s going up multiples, but more often than not, it’s a huge tell on a bad business.

[01:07:16] Robert Hagstrom: You just add up money of bad businesses. That either put it into existing operations or bought other things in hopes of getting something better. If that doesn’t show up in price, meaningfully over 10 years, then that should be alarm bell, stay away. So that’s kind of how an answer.

[01:07:37] Kyle Grieve: Final question. The, there was a great excerpt from your book and this is from Warren Buffett. Quote, so why do smart people do things that interfere with getting the output that they’re entitled to? It gets into habits and character and temperament and behaving in a rational manner, not getting in your own way.

[01:07:52] Kyle Grieve: As I have said, everybody here has the ability to absolutely do anything I do and much beyond. Some of you will, and some of you won’t. For those who won’t, it’ll be because you get in your own way, not because the world doesn’t allow you. I think Warren is a very humble guy. I think he’s a genius.

[01:08:09] Kyle Grieve: I’m sure you probably agree with me there. So even though many of his attributes I do think are replicable by other people, maybe some areas of his temperament are, some aren’t. But I kind of want to get your opinion on what do you think is the most critical attribute that Warren Buffett has that if taken away would have drastically changed his outcome.

[01:08:29] Robert Hagstrom: I like that way to finish up. I would say, Warren said, what I do is not beyond the confidence of other people to do the same thing. And that was really the objective writing the Warren Buffett way. Warren says, what I do is not beyond the confidence of other people to do it. And we laid out all the methods and said, look, if you follow these methods, generally something good is going to happen to you.

[01:08:48] Robert Hagstrom: Then years later, he said. Investing is easier than you think, harder than it looks. And I went, okay, there’s a puzzle, right? easier than you think was, and we talked about this earlier, you don’t have to spend all the time worrying about the stock market and forecasting the economy, which nobody in the last three years, nobody’s been able to forecast this economy at all.

[01:09:06] Robert Hagstrom: You don’t have to do that. You don’t have to worry about the stock market. You don’t have to worry about who’s going to be present. I’ll take that off. Take that off. You don’t have to do it. It’s so much easier. But the harder part than it looks is, You own something whose price doesn’t always walk lockstep in the stock market when it goes up, or sometimes it goes down in price.

[01:09:28] Robert Hagstrom: And there’s, a divide, right? That you get to the river and people go, I just can’t cross it. So when I wrote the Warren Buffett way, and we were managing money, I, I’ve said this many times, I have never met anybody that I sat down with and said, this is how we think about investing.

[01:09:43] Robert Hagstrom: This is how Warren Buffett thinks about investing stocks and businesses. This is what we’re going to do. Do you think this would work for you? Do you think this is something you would like to do? 90 percent of the people said, yeah, I’m in. In about three months, three quarters of those people have already lost their mind.

[01:09:59] Robert Hagstrom: Oil’s going up, Robert. How come we don’t own oil stocks? Oh my God. you need to sell this over here. It’s not doing it. it’s the cycle. The hard part is the temperament part, right? The harder part is the sound mindedness. The harder part is disassociating yourself from the stock market.

[01:10:15] Robert Hagstrom: If you said to me, what is the one single, one characteristic that has made Warren Buffett successful? It’s been his purposeful detachment from all things that are in stock. Just divorced himself emotionally, mentally, whatever the cap, it’s not there. It is, it might as well be up at Jupiter and Mars. It’s not there.

[01:10:37] Robert Hagstrom: He owns a business. And that’s all he thinks about the rest of us. That’s all we do is think about it. And we don’t think enough about the business that we own. And when you look at it in that glaring light, that’s probably the single biggest reason what Warren doesn’t think about. We’re all consumed with what he does think about businesses.

[01:10:59] Robert Hagstrom: We don’t spend enough time thinking, 

[01:11:01] Kyle Grieve: Robert, I just want to say thank you so much for coming back on the show. Had an amazing time as usual. Where can the audience learn more about you and your books? 

[01:11:09] Robert Hagstrom: The book is pre ordered on Amazon. I think pub date is April 23rd. You can pre order it now. It is, I think, it is a compendium of everything that I’ve written about Warren these last 30 years, studying him last 40 years.

[01:11:23] Robert Hagstrom: So Juan, thank you. It’s always for your, wonderful invitation and thank you for a great conversation. You do a great job prepping and your questions are always very thoughtful. So thank you. 

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