Lawrence Cunningham (00:03:21):

He can tell in a minute whether this CEO will be a faithful steward of Berkshire capital, he can tell pretty easily whether this family will be a reliable partner in a long term business, whether this CEO of this publicly traded company is worthy. How can he do that, or what can we get out of that? I’d say the skill is uncanny, it’s hard to teach. But here’s the tip I have, and the lesson I’ve taken from it. It’s another thing he does, at the slightest whiff of lack of trustworthiness, he goes away.

Lawrence Cunningham (00:03:51):

So he’s ultimately a very skeptical person of human nature of the incentives that drive us to be selfish or to be emotional, irrational. It’s a high hurdle to gain Warren’s trust. He runs a trust based organization, he delegates his managers enormous lee way as we’ll get into, but he does all that only with a handful of people. And that I think, helps him with this sort of ability to discern trustworthiness, his hurdle is very high. He has the neat tests may be used for ordinary people thinking about how to do this themselves. He calls it the son in law test or the daughter in law test. He only wants to go into business with people he’d be happy to have his child marry or the other version of the test is the executive test, that people he’d be happy to have administer his will, carry out his wishes after he’s not around.

Lawrence Cunningham (00:04:40):

Those are pretty high hurdles that a lot of people go into business with people they wouldn’t want to watch a football game with over trust with their estate. But he’s been pretty rigid about that. And so when you look around at his inner circle, let’s say the CEOs of the companies, members of his board, top shareholders of the company, the CEOs, and investors are all very high grade people. They’re very not just professionally competent, but ethical. And so there have been a couple of mistakes, everyone makes mistakes, including Warren. But so I think you’re right, it’s hard to replicate the skill set, I think any of us would be happy to have one or two of those four virtues or skills, combined with them. But I think we can all learn something from each of those.

Trey Lockerbie (00:05:23):

That’s really interesting. I’ve never actually thought about it that way. After meeting Buffett and hearing him speak even for a short while, you see the high intelligence level, the high IQ, and he’s rattling off numbers from memory from dating back decades. He’s always citing dates with events, he just really has a mind for numbers, and it’s very apparent, he has a very high IQ. But what you brought up now almost as a superpower, is that he actually has a… sounds like a high emotional intelligence or EQ. And you don’t often find both. I’ve never actually really considered that with Buffett having both in that department. But that sounds a little bit like how you’re describing him.

Lawrence Cunningham (00:06:00):

I think you’re absolutely right. I should concur particularly with the high IQ and his mastery of data and history, facts and numbers. I just add a point where the IQ and the EQ go together in a business setting. I get this question from young CEOs a lot about well, how much diving into the details do I do versus how much delegation? And what’s Buffett’s approach? And my impression from Warren is, he dives into the details, he knows exactly how many candy bars See’s is selling, what the skill content of Precision Castparts assembly is, he knows all that stuff. He enjoys and remembers it.

Lawrence Cunningham (00:06:37):

But he doesn’t second guess people on it. He doesn’t say I think you ought to make more candy bars or reduce the steel, raise insurance rates. So he stays out of direction, but he knows what’s going on. And so it’s kind of a nose in body out kind of idea. And why is that useful? It’s useful precisely if your plan is to trust people a lot. And you won’t know whether they’re vindicating that trust unless you know the facts. So you know the facts, and then leave them alone. And then you’ll know, when the occasional miscreant appears. And they don’t tell… The things they tell you, aren’t the things you know, be true. And you’ll be able to weed out the mistakes. So that combination of IQ and EQ, I think you’re exactly right, Trey, it’s rare. It’s extremely valuable. And I think being aware of it can help us ordinary people do better in settings where the combinations are really useful.

Stig Brodersen (00:07:28):

I’m glad you touched on that, because I don’t think Buffett gets enough credit for being an operator to wipe out the things of Buffett as a stock picker, and he’s surely doing a great job of that. But what he really excels in is running a conglomerate with wholly owned subsidiaries, and what you just touched upon, I think that’s really the holy grail of running your business, right? Figuring out how to set up a decentralized system where you don’t have to be included in every single decision. Otherwise, you just can’t scale. But also knowing what’s going on in the business so you can incentivize and motivate everyone the right way. And you know, like you said that Lawrence Buffett does that better than anyone.

Lawrence Cunningham (00:08:05):

You’re absolutely right. And I think his investment successes in the long run and well known, again 60 years ago, it was really spectacular for the first 20 of those, and then excellent for the next 20. It’s been a little more ordinary in the last 10 or 15, mainly because of the massive size of the organization. But also during that recent period diversified into ownership of businesses and the balance sheet is what described, but he’s been a steward in the ability to manage or oversee such a large, diverse group of businesses.

Lawrence Cunningham (00:08:36):

And I think that his ability to do that is now worth studying. What did he do? How did he do it? How does he continue to do it? Because I think it’s useful for other managers. I think people are increasingly studying Berkshire, and it’s decentralized, autonomous acquisitive, trust based culture. And we’ll come to rank it as important in management as value investing has been in securities analysis and investment. And in this sense, everybody listening probably has heard of Ben Graham, Warren made famous as a theorist or philosopher of valuation, value analysis, security analysis, stock picking and so on.

Lawrence Cunningham (00:09:16):

As they study Warren’s approach to management and organizational structure, though the famous person who will emerge there is Tom Murphy. And Tom is as many people may know, he’s on the board of directors of Berkshire now, and has been for about 20 years. Warren’s been a close friend to his 50. Tom built up the Capital Cities Communications company. That’s a relatively small radio and television broadcasting company in the north, that Tom built and grew through organic growth and acquisitive growth over a long period of time, eventually acquiring it or merging with ABC and then eventually selling that whole thing to Disney.

Lawrence Cunningham (00:09:52):

And along the way, tutoring Bob Iger who has been a great running CEO of Disney was Tom Murphy protégé. But Tom did all that using the principles that Warren has adopted: very acquisitive, trust based, approval, focused on high quality businesses and high wattage managers, and then left them alone. Even an autonomous structure gave managers an enormous way to run their businesses in a very highly decentralized way. And so a couple years ago, I published a book about Berkshires culture. And I asked Warren, who should write the preface? He said, “Tom Murphy.” He said, “Because Tom Murphy taught me everything that you say I do in this book.” And so I think as we study Berkshire Hathaway, and it’s the recent phase of the past 20 years of becoming 80% owner of subsidiary own companies, we’ll learn more and more about Tom Murphy, and his approach to business management.

Trey Lockerbie (00:10:45):

So in 1972, Buffett in large part, Charlie Munger’s influence started to pivot away from buying what he calls fair companies at a wonderful price to buying wonderful companies at a fair price, mostly exemplified by his purchase of See’s candy. And this brings up the topic of quality investments, which you also wrote the book on. And I find quality to be an elusive muse, right? I’m reminded of one of my favorite books, Zen and the Art of Motorcycle Maintenance, in which the protagonist goes on a motorcycle journey across America solely as a means of discovering the definition of quality.

Trey Lockerbie (00:11:19):

And just a side note, I just cracked open your book this week. And I saw this exact analogy on the first page, I just thought it was so funny that we were just really quickly aligned on that. And so through this book, you’ve achieved a definition of your own, when it comes to what makes a quality investment. So can you describe to our audience how you define quality, and how much it factors into your own investment philosophy?

Lawrence Cunningham (00:11:42):

Thanks, Trey. I think what quality investing is, is wonderful companies at a slightly high price, at a fair plus. It’s okay to pay up for quality, if you’re going to buy a significant position in a high grade company that you expect to be around for a long time, you expect to hold for a long time, and has quality attributes that I can get into, paying a little extra for that is reasonable. If you’re right, and your analysis backs a conclusion that this company will generate high returns on invested capital for the foreseeable future of 369 plus years, if it’s trading at a little bit of a premium, don’t worry about that.

Lawrence Cunningham (00:12:22):

And so, it’s the opposite of deep value, the opposite of what Ben Graham did. And it may be a little more generous than what Charlie recommended more than be willing to do it, in the See’s Candy pivot. And so by quality, look, that’s a realistic appraisal of the current environment, there’s just… And I don’t mean just sitting here now in December of 2020. But for the last 10 years or 20, it’s extremely hard to find those Ben Graham’s value opportunities, or even the Warren Buffett value opportunities just in the public capital markets.

Lawrence Cunningham (00:12:54):

But if you sit down, and what we did in that book is describe an approach to identifying what we call quality companies and making quality investments. And then we start with micro economic analytical analysis about industry structure and barriers to entry, economies of scale, rationality among competitors, and then looking at particular companies to discern their most… Their competitive advantages, what structural protections they have at guest invasive rivals and technological disruption.

Lawrence Cunningham (00:13:26):

And so we give example, the obvious examples are things like brand strength, and network effects. And we gave some other more subtle examples such as having a friendly middleman. That is you’re selling eyeglasses, let’s say, through optometrists to patients. And if you are able to enlist a loyal cadre of optometrists who recommend your lenses, your products, that gives you a significant mode of competitive advantage. This can happen across a lot of those sorts of industries with middle width, plumbing, housing fixtures and so on.

Lawrence Cunningham (00:14:01):

But we go through and identify through micro economic analysis and then pick at a company analysis, the kinds of competitive advantages that people listening will recognize and then we demonstrate through… Either we do 25 different case studies in that book of mostly European based international, global all stars, people will recognize [Biagio 00:14:23] or Hermes and many others. And so the conclusion, the idea, and finally to your question about quality investing is that it’s not highly likely that you’ll be able to get Hermes on sale, or L’Oreal take another one, Biagio.

Lawrence Cunningham (00:14:38):

But if you’ve done the homework and identified a company highly likely through competitive advantages to be able to maintain high returns on invested capital over the foreseeable future and beyond, you don’t need to get it on sale. And massively overpaid for a market but a slightly elevated price shouldn’t be a target. That’s the main thesis of that book.

Trey Lockerbie (00:15:00):

And I want to stick on this for a minute because you talk a lot about quality, quality investments, quality shareholders, it’s a pretty important word, I think, in your research and literature. And it’s just interesting how hard it can be to define. So going back to zen, that book, which is the top philosophy book, a top selling philosophy book, it really showcases how elusive it can be as a word. And Phaedrus, the protagonist, as you mentioned, in your quality book, you quote him saying, “it’s hard to define but you know what it is when you see it.” My take away from that book was sort of like quality is getting at least what you put into something out of it, and then some, right?

Trey Lockerbie (00:15:38):

As he’s tinkering with his motorcycle, he’s getting more out of that machine. I’m just curious, is that beyond predictable cash, beyond high returns on capital, and attractive growth companies, which is how you define it, in a bullet point fashion in the book. Is there anything philosophically important or something that’s, I guess, even beyond that for you when it comes to the term quality itself?

Lawrence Cunningham (00:16:01):

You’re right about those points in the list of best and so on. But I think I’d say the key and unifying feature of that notion that you do know when you see, that it’s almost never accidental. And certainly if we’re talking about the quality of things that human beings create, diamonds, high quality, and humans didn’t have any accident in geology and so on. But if you are talking about a company, or a firm of investors to achieve that kind of stats to be recognized and worthy of calling high quality is the result of conscious effort and deliberate concentration and cultivation.

Lawrence Cunningham (00:16:36):

And so why is there a Maze high quality company? It’s because for years, they have devoted themselves to delivering an extremely appealing product with excellent materials, the finest craftsmanship with deliberate efforts to restrict supply and to cultivate a clientele, pay up for what they’re selling. And so this is a process in which they deliver high quality products, and they deliver it with very high margins as a result. So if luxury shoppers are willing to pay up their products, and that’s a quality business, quality business model.

Lawrence Cunningham (00:17:11):

And it’s the result of deliberate conscious effort, usually over a long period of time. And so the same would be true for those other companies that we’re describing in the book. And so we can talk soon about the other side of… this is about a quality business, the other side’s about a quality shareholder, what makes a high quality shareholder? It’s also going to be a product of a deliberate and conscious and very reflective mental engagement. And so that’s maybe the philosophical version of my use of the term in both of those settings.

Stig Brodersen (00:17:43):

I love that. So Lawrence, another pivot that Buffett has performed in the last couple of decades is flipping Berkshire from being primarily a holder of public entities to prominently holding private companies. And one might think that this is so that Buffett would have more control over the management of these companies. But the opposite seems to be the case. He has expertly distributed and delegated oversight in a decentralized fashion. And as an operator of my own business, I know how counterintuitive it can feel, to trust your team to guard themselves effectively.

Stig Brodersen (00:18:15):

And even more counter intuitively, perhaps, is how much the autonomy can generate accountability. For example, in your book, Margin of trust, which you wrote with your wife, Stephanie Cuba, you quote Jim Weber, the CEO of Brooks Running shoes, because he said, “I never felt so much autonomy in my career. I never felt so accountable.” So I absolutely love that quote. And you highlight that Buffett’s investing principles have been well documented for over 60 years. But the organizational structure could be a new lesson to learn. In fact, you highlight how giant tech companies like Alphabet had taken interest in developing a similar approach. Could you please outline the pillars of this approach for our listeners?

Lawrence Cunningham (00:18:54):

You’re right, Warren has developed and perfected it within Berkshire in the past 20 years. His motivation is what Jim Weber testified to. That, surprisingly perhaps, or counterintuitively perhaps, people who are trusted are actually more likely to do well for you. Trust is often vindicated. There are studies of workplace productivity that show a culture where people are authorized to exercise judgment and discretion, when developing a product or selling it or administering the operation. They’re much more productive. They’re much more successful, they get better outcomes, than one where people have very few degrees of freedom, and they’re simply directed to follow, here is the production manual. Here’s the Salesforce playbook. And you must just do these sets.

Lawrence Cunningham (00:19:40):

And Warren has known that, he learned a lot of this from Tom Murphy, who developed his company using this model. And so most large companies, especially in corporate America, have a bureaucratic hierarchical command and control based culture where reporting structures are clearly delineated, approvals are required for a designated set of things through a given channel. And there are constraints on employee discretion. The effect of that is to limit creativity, limit willingness to reach in very many cases.

Lawrence Cunningham (00:20:15):

And so the Berkshire and most of its subsidiaries, including Jim Weber’s Running shoe company, the idea is to dismantle or just not even have those reporting structures, those approval requirements and those manuals and regulations. But instead, I have broad goals, like, “I want you to sell this many running shoes this year,” or “I like our running shoe to be ranked.” I like to have at least three running shoes, three models of our shoes that are worn by the top 50 people in the Boston Marathon. You give them broad general targets, goals, and then so, how do you do that stuff? I don’t know how to make shoes, I know how to sell,” Warren would say. And so Jim, that’s up to you. But this is what I’d like to see.

Lawrence Cunningham (00:20:57):

And then you can also set incentive compensation around goals like that. And so the reason for this trust based culture is to realize human potential. People will do better for you when they’re given some leeway, when they have autonomy. And so that’s an exceptional cultural feature of Berkshire. Berkshire is not unique. It’s not alone. You mentioned Google, or Alphabet has consciously tried to replicate that approach as they… when they changed their name from Google to Alphabet, they identified 26 different… I think there will be 26 different business units that are meant to operate in an autonomous manner, giving the leader leeway, whether it’s the search for autonomous vehicles to make upon or the Venture Capital Group.

Lawrence Cunningham (00:21:39):

But the leaders of those businesses have carte blanche, it’s their P&L. It’s their leadership, they get to stake their claim. And we will do better as a company by allowing all of these different groups to march to their own drums. And in the book, Margin of Trust, we give examples of a dozen other companies who do this. A lot of them happen to be in the insurance business. But there are also a lot of other industrial companies that do it too. Danaher comes to mind, Post is a good example, Constellation Software where I happen to be on board is an example.

Lawrence Cunningham (00:22:14):

The insurance industry is an interesting specimen because there’s so many. Markel, Fairfax, Berkeley, obviously, Berkshire itself has a huge insurance business. And I draw from that a couple of points of, what does it take to organize and one to lead a trust based culture, as opposed to this command and control culture? One thing is, you have to have a long term view, you have to trust people and give them the leeway and the latitude to build up their businesses over long periods of time. And insurance business is innately long term. And so I think that helps explain it.

Lawrence Cunningham (00:22:47):

But perhaps the biggest reason is, what they sell is trust. The product of the insurance company is a promise to pay money in the future. That’s all it is. And so customers, policyholders will only pay for that if they trust you to pay back, to honor the commitment. So there’s a sort of trust in the air in the insurance industry. But absurd sort of reason is that the people who lead those companies tend to be value minded or value investor minded, they focus on capital allocation, they are in the business, in effect, they’re receiving premiums and then investing those funds in order to have a capital to pay claims.

Lawrence Cunningham (00:23:22):

And so they’re long term. They’re trust focused, and they have to invest in a prudent way for the long term. So I think those ingredients help to explain why trust does seem to percolate in an insurance business, maybe more than industrial companies, but the examples of Danaher, Post and Constellation and others, I think, also is a testament to the value of autonomy in corporate America. It’s something that I would not personally like to see more of, but you see it too.

Lawrence Cunningham (00:23:49):

I’ll give you another example that’s in the news, not just on this day, we’re doing this but this quarter is Pfizer. Pfizer is a trust based culture that is autonomous, it’s decentralized. Scientists who are experimenting in laboratories with all sorts of drugs and treatments have enormous leeway, and they need teams and they need a long time, in most cases to do the research and testing to deliver useful pharmaceuticals. And they’ve just done it. We’re in the middle of doing it, what appears to be a highly successful capability in addressing the coronavirus pandemic, with a vaccine.

Lawrence Cunningham (00:24:23):

It’s doing quite well in the trials. And I think it’s corporate culture has a lot to do with that, you see it from the CEO, that’s something that the culture believes in. Scientists in particular, thrive more when they’ve got degrees of freedom to run experiments to learn from prior results without necessarily having to report up the chain of command and get new authorizations and so on. So I think there’s a big lesson in there for corporate America.

Trey Lockerbie (00:24:52):

So for the retail investor, this obviously sounds like a metric to identify quality management, but how does a retail investor you just mentioned Pfizer and how you see this trust factor from the CEO? Where are you seeing that? Are you seeing it in the shareholder letters and interviews? How do you identify that?

Lawrence Cunningham (00:25:09):

You see it in the shareholder letters and interviews. Another book that I’ve come out with that I know you want to talk about soon, is called Quality Shareholders. It focuses on what the most focused and patient shareholders look for in their investments, and how management can offer that menu. It’s a iterative relation that end up talking to each other, having the minds meet at a large number of companies and the way the two come together or first a management team that believes in a certain set of values, long term, higher returns on invested capital, stewardship as their primary duty, stewardship of shareholder capital.

Lawrence Cunningham (00:25:50):

And then internally, they create structures that achieve results like that long term, high returns on invested capital from shareholders over many periods. And so attentive shareholders, ordinary shareholders, as well as professional fund managers who are trying to select outstanding securities for their funds, and their clients can discern signals and cues from the source you just mentioned, a shareholder letter, or annual meeting restraint in around quarterly calls. You could have quarterly calls, they’re not in themselves problematic.

Lawrence Cunningham (00:26:23):

But when managers overemphasize quarterly results, and typically using quarterly guidance, that creates perverse incentives for the troops to meet short term goal posts. That would be particularly bad in a case like a pharmaceutical company where products take years to develop or a computer software company where products typically take a long time and years to develop. So worrying about the quarter, fixating on a quarter is usually a bad setup for a long term focused shareholder, and articulation about the thinking around capital allocation.

Lawrence Cunningham (00:26:57):

Capital allocation is in some ways the fundamental idea and certainly is in the value investing world, the quality shareholder world where we wonder how each dollar of corporate wealth is used. And there’s every single dollar and it can be used in a variety of ways concurrently, but you should go down a list and think about while reinvesting in the current business to deliver increased profit margins or… And that’s useful to do if you can make that dollar work. 

Acquisitions is an appealing use of dollars, so long as the investment thesis is sound and the internal rate of returns satisfied, discipline, hurdle rates, those acquisitions can either be add ons or bolt ons to the existing operation or tuck ins or you could even go beyond the current business. But in each case, you’re thinking analytically about the internal rate of return in your hurdle.

Lawrence Cunningham (00:27:52):

If organic growth and acquisition growths are available, or you sort of exhausted your current capability to exploit those, then you think about reinvesting in your own shares. Buying back stock if the price value relationship is attractive, your stock is trading at low compared to intrinsic value. There’s a good use of corporate cash. It also has an incidental benefit of paying cash to people who want to exit and receive a tax event while not inflicting a tax event on others that dividend.

Lawrence Cunningham (00:28:21):

And that’s the last typical uses. If organic growth, acquisitive growth and buybacks, you still have extra cash flow, distribution to the holders. I’ve just gone through a simplistic statement of capital allocation, quality shareholders look for managers who understand what I’m talking about, who think in those terms, and they’re rare, or at least not every CEO thinks that way. Not every member of every board of directors think that way. Why? Well they have risen through the business ranks in other departments, in merchandising or production, sales, administration, what have you, and not been exposed to this particular highly disciplined, investment oriented way of thinking about management.

Lawrence Cunningham (00:29:04):

But savvy investors, certainly the value crowd quality shareholders are attracted to managers who think that way. And managers display that thought in the forums you mentioned. Shareholder letter, the annual meeting, reticence around quarterly results. And so there are other ways that managers, CEOs and boards can signal to ordinary investors or again, fund managers who care about this.

Stig Brodersen (00:29:29):

Another thing that drives total myopia is compensation because a lot of CEOs are incentivized by short term metrics. How are you identifying the alignment between the CEO and the shareholders?

Lawrence Cunningham (00:29:41):

I’m sure you know the funny quote or quote, I guess that is attributed. Charlie Munger said, “Show me how someone’s compensated and I’ll show you what they’re likely to do.” Incentive compensation is the term and boards, intelligent boards set CEO compensation, knowing that it will lead to behaviors and consequences. You know, moments ago, I said, what Warren tries to do with his CEOs is identify the targets, the broad big targets. How many shoes are we going to sell, or how many shoes are going to be ranked high in the Boston Marathon? What’s the premium volume or underwriting profit, let’s say at Geico?

Lawrence Cunningham (00:30:18):

And then tie the leader’s compensation to that outcome. And in cash, not stock options, not prescribing how they go about it, but having broad big targets and big payoffs. And that compensation system will produce certain results. These have a tendency to do that. Not every board is able to think that way or to negotiate successfully with their CEO to achieve that result. And so you do have, compensation consultants may not always find that. The most lucrative advice is very simple, it doesn’t require lots of consultation.

Lawrence Cunningham (00:30:52):

And so you get a proliferation of forms of compensation, many of which do induce shorter term thinking. Stock options may be the best example or it’s certainly a good one. Their goal is to meet this quarter and get stock price up, and they expire and they’re accounted for. I think the accounting for stock options continues to be a serious problem, the real cost of options is not recorded on even gapless financial statements.

Lawrence Cunningham (00:31:18):

And so another point to make this is very important for investors. Not every CEO cares about the long term. Not every CEO is interested in the longevity of his or her company, the durability of the brand. Plenty of CEOs are just interested in making a lot of money as soon as they possibly can, running a wonderful environment doing something else or being prepared to leave without much concern. The average CEO tenure in America is quite short, I forget the most recent but it’s not longer than seven years for a lot of people and shorter.

Lawrence Cunningham (00:31:46):

So I think savvy investors should focus on compensation backtest, what the likely effects are, and what the likely incentives are. And we see in very many cases, the alignment is more towards short term. And I think being careful about that is important. One interesting thing we try to look at, is the CEO’s who have eliminated their compensation, CEOs who just take $1. It’s a funny thing. It’s a small group, they’re only about 50. We thought when we did it, what we’d see is that these all tended to be longer term thinkers, they tended to focus on capital allocation, they tended to attract high quality shareholders.

Lawrence Cunningham (00:32:22):

It turns out, it’s not a simple story, a lot of them have taken the dollar, because the company has actually gone bankrupt, lost a lot of money, but it’s a useful place to zero in because within that group, it’s a small group. And if you just do data quickly, yeah, S&P will float that, find your data set, just isolate the CEOs who have been paid $1 a year from sale. Some CEOs just do it for one year, and they’re back on the $16 billion treadmill. But a lot of CEOs have taken just a dollar for five or seven or nine years.

Lawrence Cunningham (00:32:51):

And that will start to, I think, be an appealing place to probe further for integrity, for quality, for high returns on capital allocation. And I do think it’s probably the pocket of governance that is least amenable to fix it. Well and cure for just about everything else, the liability of financial statements, compliance, disclosure around diversity or climate change. They’re just enormous mechanisms that seem to be available to channel governance in almost every way compensation, executive compensation has [inaudible 00:33:24] any meaningful constraints.

Lawrence Cunningham (00:33:27):

We had tax laws that would only permit deductions for incentive based compensation and that actually promoted the use of stock options. It has disclosure rules that require CEOs committees to list the peer compensation. So our CEO has earned this and here the compensation of the peer CEOs. The thought was that this would embarrass people who were overpaid, and tamp down on levels. The opposite happened. The theory was jealousy, the lower paid on those scraps, complained to their board that they’re worth at least as much as this fell off. So there was actually an increase.

Lawrence Cunningham (00:34:05):

The latest is the idea, let’s require disclosure of the ratio between the highest paid at the company and the median paid. And what you see is extremely high ratio in a lot of companies. Average is more than 200, I think much higher than that. A lot of places, it has not had the desired effect yet reducing that ratio, but certainly not on average, maybe it has particular places, but I’m not aware of it. I think as likely, that approach is likely to just create more criticism and anxiety heat than good results. But I don’t have a quick fix. But I do think it’s one of the biggest problems.

Lawrence Cunningham (00:34:40):

And I would say just pushing a little harder, one of the most important things I like to look at, is the source and level of director ownership in companies. And the reason I think back to… I mean, instructors can exert significant influence on a company if they’re properly motivated to do so. There are others who are incapable of negotiating in a hard headed way, a compensation package that assures alignment. And these may be wonderful people and even good directors in lots of other ways, but directors I most trust, look to, are those with significant portions of their own personal net worth in the companies where they’re serving. Ideally, that they purchased with cash, and that they held for a long time and plan to hold for a long time.

Lawrence Cunningham (00:35:27):

The other fashion in corporate governance in the last three or five years is to encourage these additional investors and proxy advisors, encouraging boards to adopt policies that require their directors to own a certain number, or level of shares. And it’s typically set at a multiple of their annual retainer, three times or five times. I say too cheers for that. I think the motivation is right, to focus on the importance and value of having directors with skin in the game.

Lawrence Cunningham (00:35:58):

But I look for the director who does it on her own and does it with a lot of money. I’m not that impressed by a board decision. Let’s all make sure we do it, so we’ll have to, and then have it three times our little retainer, that’s a small amount, even for directors of modest net worth. So I applaud it. But it’s just too, I’m not that impressed by a board that says, “Well, we all have $600,000 worth of our net worth in our stock because we passed a resolution saying we must. I looked for the [inaudible 00:36:26] with 10s of millions.”

Lawrence Cunningham (00:36:27):

And you can get that data right off of the proxy statements, it indicates how many shares everybody owns. And again, I also like that the director bought that share with her own money, not by grants that companies give, that’s pretty easy. But if you believe in the company, your coaching or advising, overseeing, I think you ought to buy stock meaningful amounts.

Stig Brodersen (00:36:51):

And Buffett certainly does that. He has 99% of his net worth in Berkshire Hathaway. And I would love to jump back to Buffett and talk more about how he makes acquisitions because of a competitive advantage that sometimes might be overlooked, it’s just that. Could you please walk us through how Buffett approaches acquisition versus other companies, or even private equity? And how this could be considered to be a part of a Berkshire’s moat.

Lawrence Cunningham (00:37:16):

You’re absolutely right, that Berkshires approach to acquisitions is part of its most underappreciated part. And so it’s distinctive in just about every respect. And so I’ll try to run through it more or less in chronological order. And the first is sourcing, most companies have an acquisition department, big companies have an acquisition department, or an acquisition team and they’re out and about searching for opportunities. And then reeling them in. Some of those firms even use brokers to con.

Lawrence Cunningham (00:37:42):

Berkshire didn’t do any of that. He famously has said, “I wait for the phone to ring.” He didn’t take an ad out in the Wall Street Journal once about 30 years ago, that said, “Here’s what we’re looking for. If you’ve got a company like this ready for sale, call.” Minimum earnings, management in place, easy to understand, you see the criteria in his letters, and in the essays, but beyond that initial vocal pitch that he now repeats in every letter, they wait for the phone to ring.

Lawrence Cunningham (00:38:07):

And so there’s no internal pressure to make an acquisition. It’s nice, it means most companies have an acquisition department. It can add value. It can be useful, but it requires enormous discipline. Because if you’re not making acquisitions, you may feel like you’re not doing your job. But if that’s how you feel, then you might start to overpay. So you’ve got to have other constraints on that hurdle rates would help supervise people making investment memo that has to be approved by the board or something like that. But it does differently. So I’m not going to go out trying to find acquisitions. I want them to come to me.

Lawrence Cunningham (00:38:39):

And the second step in that is, I mentioned that many companies have brokers out there taking treats, those people are paid a fee. Therefore, their incentive is to sell the deal even if it’s a little overpriced, or it’s not what you’re really looking for, but the management, it’s price is terrible. Warren doesn’t do that. They’ve almost never hired a broker to make an acquisition. Instead they rely upon a network of business connections And friends, which is a very large network at this stage, but have relied on that since 1968.

Lawrence Cunningham (00:39:05):

He bought National Furniture Market from a local family friend, he bought National Indemnity, largest reinsurance company in the world from a friend. And that just discontinued. Now the friend circle is millions of people. And then the third thing is, there’s another… the standard way of making acquisition is to conduct extensive due diligence, financial statements, contracts, operations, personnel, site, plant visits, it’s all very important and useful. And Berkshire does a little bit of that, they don’t emphasize it so much. They go a little bit of that.

Lawrence Cunningham (00:39:34):

But the main thing that Warren does, he reads the publicly available information, public companies and private financial statements for others, and has a good sense in his mind about the business based on those things that all of us could gather. And then he sits down and talks to the people, he’s got a very high threshold for deciding I’d like to buy your company, he’s got to understand the financials, like there is a moat in a sustainable business that he can understand. He’s really got to trust that manager. That’s I think the most important part of Berkshire due diligence.

Lawrence Cunningham (00:40:06):

The fourth thing is that what promises Berkshire makes, and this is where the competitive edge really starts to seep in and distinguish itself from most other companies. That when Berkshire buys a company, he makes two commitments, permanent ownership and manager autonomy. We will never sell you, come hell or high water, thick or thin, and so on. Our plan is to hold this business forever. There are two exceptions for labor unrest or just hemorrhaging cash, if we’re doing okay, we’re not going to sell.

Lawrence Cunningham (00:40:33):

And sellers who value that commitment are willing to monetize, they take a discount on a purchase price, when on the strength of that commitment, that’s a huge competitive advantage. The related promise is autonomy. In his pitches, we don’t have management to put in. So any business we buy has to have management in place, and he makes a promise that will keep you in place, you’ll continue to run the business the way you’ve done, and as you see fit with no intervention from me.

Lawrence Cunningham (00:41:00):

And again, sellers who want to continue to do that, entrepreneurs, family businesses who have a vision, they just need more capital, or better home, value the promise of autonomy as well. So that commitment is an intangible part of the purchase price and rivals can’t match. So there’s a great example when Berkshire bought the furniture store in Utah, it was bidding against Goldman Sachs. And Goldman Sachs bid was 12 and a half percent higher than Berkshire’s. And both were cash, all identical, except for that big difference in price.

Lawrence Cunningham (00:41:33):

The selling family accepted the Berkshire bid. And they explained to me they value the commitment to permanence and the commitment to autonomy. As a third generation family business of Mormons with a certain way of doing things and certain outlook, and Goldman was not likely towards that. They had to intervene and tell them they had to open on Sunday and other things. Warren said, “I’ll let you guys keep doing this for as long as you want.” They valued that to the 12 and a half percent.

Lawrence Cunningham (00:41:59):

That’s a huge competitive advantage that Berkshire has, and he’s done that in scores of acquisitions. And now that it’s taken years to achieve, obviously, because he’s able to… That promise of permanence, if you look at the record, they’ve only ever sold two or three subsidiaries. And they were odd, strange, weird circumstances. They sold a small insurance company because it was archrival to another subsidiary. They were cannibalizing each other. They sold in the newspaper subsidiary, because sorry for all the journals out there, but the local newspaper business is gone.

Lawrence Cunningham (00:42:29):

So the businesses that have struggled, Benjamin Moore, Paint, NetJets, Pampered Chef, they hold them without hemorrhaging cash. And the point of autonomy is vindicated with practice too, if you talk to any. The seller or business can talk to any CEO of Berkshire company and get the same report that, “No, I never talked to Warren unless I call him.” And someone say, “I haven’t talked to Warren in years.” Others say, “I talk to him all the time, because I can, I really enjoy doing it.”

Lawrence Cunningham (00:42:54):

So now rivals have a hard time monetizing a commitment. It’s all tough. I’ve seen that out of the marketplace, most sellers don’t care. Most sellers want the highest cash price, the highest economic price. For them the promise of permanence or autonomy doesn’t doesn’t mean much. But that’s fine for Berkshire, because they don’t want those businesses. They don’t want people who have the mindset of the highest media cash price, because that’s not the kind of business they want to acquire. They want to acquire a business that’s been run by a guy that really wants something more than immediate cash maximization.

Lawrence Cunningham (00:43:26):

So it’s worked for Berkshire, it’s hard to copy. People can do it to a degree. And I’ve seen other companies do it a little bit here and there. But it is a little bit harder to do. But I’d say when you join the family of Berkshire, that burnished such a wonderful image that it’s the all star arena, it’s major leaks. You’re a manager of a certain temperament or a family becoming part of the Berkshire enterprises is a special thing. But to get in, it’s hard. I mean, they didn’t make a major energy acquisition this year, but the acquisition basis is quite slow right now.

Lawrence Cunningham (00:44:00):

And I think with private equity, it’s very different in a lot of these ways, they tend to be interventionists, they tend to have an idea that they really ideally like to sell as soon as they possibly can. And they use a lot more leverage than Berkshire does. And they’re able to pay more. And there’s a lot of private equity capital available, buying businesses just active in the acquisition market. So premiums are above Berkshire’s toleration. And also the amount of gain you get from permanence or autonomy is maybe just not enough. 12 a half percent is good data but that may not be enough right now. Markets change, environments change, I think the Berkshire model remains worthy of certainly use at Berkshire and emulation if you can do it.

Trey Lockerbie (00:44:45):

Well, that kind of begs the question of what happens to Berkshire beyond Buffett, which I’m actually surprised that this is actually seems to be a topic of discussion for almost over 25 years now, people have been talking about what’s going to happen to Berkshire Beyond Buffett. And here we are. And you’ve written extensively about how it might look once Buffett passes on. And I’m just curious how you address the concerns of shareholders who are weighing up the risk of holding Berkshire beyond Buffett.

Lawrence Cunningham (00:45:12):

I’ll tell you a quick joke. First, speaking of 25 years, when I had that conference that produced the essays, one of the questions during one of the segments from the audience was, what will happen to the stock price if Warren gets hit by a truck? I don’t think they put it in that jacket away. I think if he dies tonight, we debated for a couple minutes and Munger made him quit. And so, some of us don’t like talking about this subject.

Lawrence Cunningham (00:45:33):

Warren said, “Hey, it’s okay, Charlie, but my opinion for what it’s worth is that it won’t be as bad for the stockholders as it will be for me.” He had been thinking about it for 25 years. And that’s what five years ago, I published Berkshire Beyond Buffett to address that question, to ask what will happen? And I did it to address shareholder anxiety. I go to the meeting every year, as you do, we usually go in 2020 and not in 2021. But that’s a high most popular topic of conversation around the informal gatherings at Berkshire meetings, what happens? So I wrote the book to address that.

Lawrence Cunningham (00:46:07):

And my thesis is that the company he’s built is larger than the man who built it. He has infused Berkshire with a set of cultural attributes that give it the very best chance of surviving and prospering long after he is gone and includes these points about permanent ownership, about autonomy, about trust, about having a very high her for investments, and for people. And others at Berkshire get that, everybody, not all 400,000 people, but all the leadership, all the management, and all the subsidiaries understand these principles of permanence, autonomy and trust, and they repeatedly vindicate them and instantiate them every day.

Lawrence Cunningham (00:46:51):

And that’s especially true of the 18 or 20 people with the highest influence. All the members of the Board of Directors, the people who help with investments, and run the internal audit, they all get this. And in particular, the two fellows who were years ago, put onto the board and named vice chairman Ajit Jain, who’s been at Berkshire for 25 years now runs all the insurance operations. And Greg Abel, who has been at Berkshire for 23 years and runs all the energy businesses. Favorite Buffett quote, these guys have Berkshire blood in their veins, they may know more and embrace these values, even more deeply than Warren.

Lawrence Cunningham (00:47:29):

That’s absolutely true for the board of directors. That board of directors, they’ve got Berkshire blood in their veins. And I can tell you a story if you want to, why I believe that they may even get these values more than Warren does. So these will be the stewards of the legacy. They have every conviction to sustain it, and the fortitude and the ownership, or significant portions or net worth in Berkshire, all the heads or the CEOs have this view. It’s a culture of self replication, self selection, people don’t fit in, they leave voluntarily or involuntary. That 20 or so CEOs over the last 20 years in that category.

Lawrence Cunningham (00:48:06):

And there may be one or two of them left who don’t belong, but there’ll be a natural selection, they will pose any [inaudible 00:48:12] from problems. So I think the culture will help sustain. Moreover, I think they have designed the best possible succession plan, Warren’s job is going to be divided into multiple separate functions. As chairman of the board, the plan is to have the board appoint Howard Buffett, Warren’s son who’s been on the board for 20 or 30 years and has the Buffett legacy. He wants the company to succeed and to prosper, and I think he’ll succeed in that job. Notably, this is a job that Warren’s never had to do.

Lawrence Cunningham (00:48:42):

And so any idea that well, Howard’s not Warren doesn’t matter. Warren had to build a place and develop all these cultural motifs. Howard simply has to enforce them. So it’s a very different job. I think Howard is well suited to do it. As CEO, the likely candidate is Greg Abel. It hasn’t been announced, but he is… Not to make a pun, but able. He is allocating capital very successfully for a long time at Berkshire energy and has proven chops. And I think he will be a very capable capital allocator.

Lawrence Cunningham (00:49:12):

And Ajit, Jane will be there to help with, play a bit of a Charlie Munger role, a bit of a, “No, I don’t think so,” when that’s necessary. As investment officers, they’ve got two there now, Ted Weschler and Todd Combs who’ve been there now for almost 15 years. And each of them manages 10, or 15, or something billion of the portfolio. They had proven records before they joined first year in the philosophy that your audience well knows, very skillful investors, disciplined, focused, long term, patient, outstanding people, high octane, very ethical.

Lawrence Cunningham (00:49:49):

And Warren jobs split those three or four different ways, and the fifth function, obviously, Warren has always played is as controlling shareholder. He’s been producing his ownership stake gradually over the past 12 years through gifts, mostly to Gates Foundation, and to his kids. And then 12 years after, I think he is going to gradually sell off a little more of the stock all the way through that tail. And so it will remain controlling shareholder for a while, and his estate will vote his shares and exert some influence from the grave, as he once put it. But he will gradually call from a company to a controlling shareholder to what it is.

Lawrence Cunningham (00:50:23):

And so during that period, that’s when the role of the shareholders is going to be vital. And I think they’re going to play a positive role. Berkshire has attracted among the greatest densities of long term focused shareholders in corporate America. They are loyal, faithful, and most of them will stick around and give that team a chance, give Greg, Ajit, Howard, Todd, Ted and the board a room. For what? Not forever, they’re not fools. They’re not [inaudible 00:50:53], they’re not in love. This is not romance, they want sustained return. I don’t know what… People have different thresholds for that.

Lawrence Cunningham (00:50:59):

But give him a chance and demonstrate that this model isn’t unique anymore. Warren is right, this culture is self propagating. And that they will be able to make investments and make acquisitions and run the overall successfully. And if we’re able to do that, Berkshire will survive and thrive and will be operated according to the principles that Warren developed over all these years. If they’re not able to do that, the shareholder base will leave, they’ll start selling and deciding, it was a special thing. It was a special company. It was a personal company, your business and it’s not the same, and they’ll gradually sell off. And I can tell you what I predict, what happened after that. My money is all great, and the model. I think the model works. And I think Greg knows how to work.

Stig Brodersen (00:51:43):

So to comment about CEOs coming and going voluntarily or involuntarily. We have to mention the David Sokol scandal back from 2011. And David Sokol was seen by many as one of the candidates to become the next CEO of Berkshire. In short, he bought stocks in Lubrizol and later presented the idea to Buffett about Berkshire acquiring the company, clearly an illegal move. As an expert in corporate governance, what is your take on this? And how does this tie into this discussion about the succession of Buffett?

Lawrence Cunningham (00:52:11):

When David told Warren, “Oh, I bought some stock in this company.” And he’d also said, “Oh, I used a broker.” That’s how it came up. A broker called Warren to congratulate him and say, “I’m glad we were involved,” which surprised Warren, because we don’t use brokers. So he called David to say, “Did you use a broker?” He said, “Oh, yeah. Did I not tell you that?” “No, you didn’t. Is there anything else, you didn’t tell me?” “Oh, yeah. I bought $3 million worth of stock. I think it’s our policy. I think I know how to do that.”

Lawrence Cunningham (00:52:35):

I think they decided David had to resign. And Warren wrote his own press release saying, “David did this, and he’s resigning,” and then extolling all of the wonderful achievements that David contributed to Berkshire over 20 years, including turning around net jets, dealing with Johns Manville, and running the energy business and growing it, and the shareholders went nuts. And the press been worse because Warren had for years been pressing ethics and the center of the playing field, not hurting a shred of the reputation of the company. They all said that’s a shred or worse.

Lawrence Cunningham (00:53:05):

So this slight slap on the wrist didn’t seem right, didn’t seem Berkshire, and this came out 10 days before the annual meeting. So there was a lot of spotlights on this. The board took control of the map. Ron Olson is the chair of the audit committee, along with Susan Decker and Sandy Gottesman did an internal, you put this in the frame of corporate governance, they executed a perfect corporate governance measure. They investigated what had happened. They interviewed David, they interviewed the folks at the company at Lubrizol, they documented conversations with Warren, the times of his trades and so on, and concluded that he had violated Berkshire policy and that under the terms of his clinic contract, he was terminated for a cause. Which meant that he was stripped of all sorts of benefits, mostly economic benefits.

Lawrence Cunningham (00:53:48):

And worst of all, this was throwing him under the bus. You know, his reputation is in tatters. The private… sort of little resignation, he had been immediately rehired and none other great things in the public limelight. With this repudiation, this review, he couldn’t do that. So it was a stinging renunciation of David. The board also reported the matter to the federal securities authorities at the Securities Exchange Commission, because it probably there was a case to be made buying the stock before encouraging its acquisition violating federal securities law, so they referred it to the SEC.

Lawrence Cunningham (00:54:22):

Now it turns out the SEC conducted its own investigation and decided not to enforce. It didn’t mean he was exonerated, or vindicated, or anything like that. There are many reasons why the SEC might not bring a case. But what it certainly meant was, they didn’t think it was so obvious that they should do it. So the read I get from that is that the board took the ethics and the play in the center of the field and not a shorter reputation much more seriously and warranted, they got that set of values and ethics fully and firmly. I mean, Warren’s famous phrase that the first 100 in congressional testimony when he took over the scandal with Salomon Brothers bank was lose money for the firm, and all the understanding, lose reputation for the firm, even a shred of reputation, that’ll be ruthless.

Lawrence Cunningham (00:55:04):

But what happened in this case was that he personally was not willing to be ruthless. David did lose a shred of reputation, and Warren was not ruthless. The board was. And so I take that it means that that board… and they’ll be re… If something happens to Warren, Ron, Susan, the chain is getting a little older, but the Audit Committee believes in these ideas. They acted decisively. So to me, what it says is, it’s a data point in my argument that the company’s bigger than the man. He incubated it, and put all sorts of values and culture in there. And it’s part of the institution now, and the institution acted, they acted in a much more effective way than Warren did.

Trey Lockerbie (00:55:43):

Yeah, I think that’s an important point, right? It definitely showcases how the company can operate or is operating even beyond Buffett already. And it’s almost like David was a sacrificial lamb of sorts to solidify that company culture and to prove it out. It’s really quite fascinating. So I want to just touch on a question that I’m curious about. And it surrounds this idea of conglomerates that have fallen out of fashion, right? But Berkshire is a massive, massive conglomerate, maybe obviously one of the biggest in the world, if not the biggest.

Trey Lockerbie (00:56:12):

So Berkshire itself is this massive conglomerate. And back in the 80s and 90s, conglomerates were falling out of fashion, they were getting taken over by corporate raiders like Carl Icahn or buyout firms that would break them up and sell them off. But Berkshire avoided all of that. And I actually have this impression. I don’t know if you agree, but Berkshire almost has this halo effect of being somewhat of like a benevolent conglomerate, if you could use that word, right? Whereas Amazon, for example, has a totally different distinction, our perspective on it and Amazon, my take on it is the sum of Amazon’s parts make up a monopoly, whereas Berkshire that’s not quite the case. There are subsidiaries across multiple industries that don’t quite create a synergy for each other.

Lawrence Cunningham (00:56:56):

It’s a profoundly deep insight and avenue for investigations. It’s an excellent thesis. I think that sort of Halo, the halo effect, the benevolent conglomerate, I think those are descriptions for Berkshire and a big part of that is how Warren positioned himself in the company. And as a member of the sensible center, he’s a capitalist with heart, it’s a money making machine, but they care about their customers and their employees. Even in the scrapes that some of the subsidiaries have gotten into, and they’ve gotten into them, they’ve managed to work through them. But the energy company, sometimes accused of not handling customers well.

Lawrence Cunningham (00:57:33):

The Clayton Home building company was attacked for predatory lending and manipulating relatively poor people into buying things and taking loans that they really couldn’t afford. The insurance companies, some of them being slow pay and not acting in good faith. They said they had pockets [inaudible 00:57:51], but they survived those and I think for good reasons. I think most of the arguments I’ve written about this were not correct or credible, but Berkshire itself has managed to be like Halo benevolence, and also a little bit of a Teflon, they get hit.

Lawrence Cunningham (00:58:05):

You know, that so called episode is a good example in the papers and big deal, but so everyone sold it off. It’s managed to do that. And your thesis might be right, that it’s not a juggernaut like Amazon. Amazon is a very different animal, as you say. It’s in your face for one thing that the whole operation is very consumer facing, boxes, all in uniform. But a lot of employees are below on the employment totem pole. And when they have grievances, they get aired and magnified in ways that Berkshire is much more diffuse and operating through all these different units.

Lawrence Cunningham (00:58:42):

So it is completely different. I think you’re absolutely right about that. The other thing I’d say just about the house, why does Berkshire get to be a conglomerate, so many others have been attacked. But one obvious thing is that Warren has basically the golden chair, if Carl Icahn wanted to attack, wanted to take a shot at Berkshire, he’d almost certainly lose immediately, partly because Warren’s got the block. And equally because he’s got seven… The other shareholders would absolutely agree with him. It’s not a crowd that’s likable, except Carl’s argument over Warren’s.

Lawrence Cunningham (00:59:12):

Maybe another thing, and maybe it’s a part of that. I think those activists assaults on the conglomerates that began in the ’80s and ’90s including [inaudible 00:59:20] Carl, Nelson Peltz and others. And they continue today, modern technologies, DuPont. Part of the argument is about how it’s invisible, it’s hard to identify the separate units and to appraise the value of the units and some of them and that you need to break these up so that we have visibility, so that we can see exactly what this one is worth, and exactly what this one is worth. And then the added argument is that when you do it that way, you will unlock value, people will be able to see, you’re actually worth six instead of five. So let’s unlock the value.

Lawrence Cunningham (00:59:52):

These conceptions are not at home with Berkshire absolutely. There’s no thought that we need to unlock value, or that you need to have a valuation on these units. Those ideas are very much, what’s the market price? And how high can you make it today? This [inaudible 01:00:07] Berkshire Hathaway, it’s not about getting a market valuation on these units. That’s not important at all. It’s not even important to have a market valuation for Berkshire as a whole. And it’s certainly not interesting to find out what it is today, compared to what it is tomorrow.

Lawrence Cunningham (01:00:20):

This crews looking out forever, in a practical way, at least three, six or nine years. And Warren uses 10 or 20. So the philosophical attack, you’re trying to break up DuPont, and Nelson tells you, you’ve got to separate paints in the pharma and bio, life sciences so we could see what each one’s worth. That attack, we’ve only barely succeeded. Voters actually voted the other way, but there was so much momentum behind it. So that’s how it just wouldn’t work philosophically at Berkshire.

Lawrence Cunningham (01:00:48):

I’ll just say one final thing is that there are other conglomerates. I agree with you that most have disappeared, but there are quite a few and they survive, thrive. And I’m thinking about Danaher, and ITW, that’s Illinois Tool Works, even [inaudible 01:01:04] Technology. So all three of those have been targeted by activists campaigning for spin offs, investors, breakups, deep [inaudible 01:01:14] Asia. And all three of them did a little bit, but all three of them maintain significant parts of their culture and their philosophy.

Lawrence Cunningham (01:01:23):

Danaher in particular it’s done, I think two major spin offs so that it’s shrunk, creating greater visibility and added value market capitalization. So we’re doing that, but it remains Danaher itself. Acquisitive, decentralized, autonomous, trust base, it’s going to build and build and build and it’s still conglomerate. Illinois Tool Works, similar story. 100 year old Chicago based manufacturer of industrial parts and products, and at one point, I think it had 800 different business units, 800 different separate P&Ls, the results of acquisitions that were managed by independent managers who ran their own businesses.

Lawrence Cunningham (01:02:01):

Now they did [inaudible 01:02:01]with the ITWA which is sort of entrepreneurial, innovative customer facing there’s sort of a ethos around the company that you treat customers first. But it was a huge diverse, enormously deep, though vastly decentralized and I think it was relational, [inaudible 01:02:18]. And but Scott Santi CEO, they did some trimming. They went through a divestiture process, they sold a bunch of things, they combined some things, they listened to what the shareholder activists thought was ideal, but they didn’t destroy the cup. They didn’t just break it all up, sell it off. 800 little different companies.

Lawrence Cunningham (01:02:36):

Ideally it’s still acquisitive, decentralized, autonomous, living by values that is published for 100 years. And so even in this world, this anti conglomerate world, and this agitation by activists who oppose conglomerates, are important parts of the model that remain value and remain durable. And so darn right. It’s still possible.

Stig Brodersen (01:03:00):

Well put. So Lawrence, I would like to talk about the concept of quality shareholders. Because you said the one of the biggest concerns in today’s market is the rise of investors just owning an index, and how that indirectly contributes to the deterioration of quality shareholders. So, perhaps first, if you can define what makes up a high quality shareholder, and then why an investor should pay close attention to the risk of so called low quality shareholders.

Lawrence Cunningham (01:03:26):

Yes, thanks. I took this term quality shareholder from Warren in his 1978 letter. And then again, we’re fully in his 1983 letters. So that’s early days for Berkshire. He explained that he wanted to attract to Berkshire a certain kind of shareholder. And that kind of shareholder was the long term focused shareholder. And he called them a high quality Cheryl. And he made a joke about how hard it is to turn a corporation into a club like that. He made a joke about lady Astor being able to choose which 400 people she’d have in her home or in the social register.

Lawrence Cunningham (01:04:03):

The Berkshire is a publicly traded company, anybody can buy a share. So he can’t simply admit you and not admit you. He said, there’s a certain kind of person I want, is the long term, I need people who are patient, I don’t want a lot of day trading. And I want them focused, I want them to put significant portions of net worth at Berkshire, I want them to pay attention. I want to be able to talk to them, teach them and I want them to understand it, stick around, come to my meeting. Let’s read my letter. So he said that early on.

Lawrence Cunningham (01:04:30):

And he said, and how am I going to do that? Well, I’m going to have a set of policies and practices that cater to that crowd, and only that crowd. And so those policies are stressing the long term, are stressing capital allocation, are stressing trust, autonomy, decentralization, the playbook. And so he consciously called [inaudible 01:04:49] into that group. And what I’ve come to realize over the past five years, studying Berkshire this whole time, looking at all the reasons for his success, we started this conversation identifying the personal characteristics of Warren that have contributed to this.

Lawrence Cunningham (01:05:04):

Well, there are many factors that contributed to Berkshire success. Warren personally, Charlie Monger’s role as number two, trust based culture, the commitment to permanence, autonomy, rationality and so on, the network and all of that. I came to eventually realize that all that’s important, the crucial side, he couldn’t have done any of that without the shareholder. Warren was right. He needed to have what he called high quality shareholders. He defined them long term and focused, because they helped him. They gave him a runway, they stuck with him through the thin. And there were a bunch of thins, there’s been the tough periods, they stuck with him. They gave him the strength, the fortitude to prevail, to be a CEO, he couldn’t have done all that.

Lawrence Cunningham (01:05:50):

Whatever his brain, his EQ, whose IQ, his brains, his brain trust and all that, wouldn’t have been able to achieve what he achieved without those long term patient holders. And so that’s what I came to realize, so five, four years ago, I started focusing on them, on books about their role in Berkshire. And then I realized that’s probably true in a lot of other companies too. So I broke down the prevailing shareholder demographic into four quadrants based on time horizon, and concentration.

Lawrence Cunningham (01:06:19):

And you’ve got basically four quadrants, you’ve got the indexers who are long term, they basically hold forever unless stock gets out of index, but never concentrate, they own small bits of every company, and so they can’t be focused. I mean, the staffs of big indexers are minuscule compared to the investees. BlackRock just increased its staff, the stewardship staff, as they called it to about 48 or 45 people, which doubled, that’s a lot more people. But they’re invested in 4000 US equities and 12,000 all over the world. They simply can’t consider, they can’t know.

Lawrence Cunningham (01:06:52):

And the business model isn’t to know, they just buy everything, every single stock, that’s the business model, and they don’t need to pay attention and they shouldn’t really be expected to pay attention. Their business model is just by the market. So that’s one caught, the indexers, they’re long term, but they’re not focused, they can’t be. And the next quadrant is sort of the opposite of that. The traders, the transits, the arbitrage shores, the robotics, the artificial intelligence, just the happy day traders, are just a lot of funds that are active and that move a lot and do a lot of buying and selling.

Lawrence Cunningham (01:07:22):

So the average holding periods are a year, maybe two and so they’re short term, and they might have high levels of ownership at certain times and they might concentrate but never hold for long. It’s those two quadrants that make the best majority of ownership of public equity today. The indexing segment is at least 30%. And then if you look at the publicly stated indexers, BlackRock, Vanguard, [inaudible 01:07:49], Northern Trust, that’s 20% right there. And then the smaller quadrant, Next is another five or eight or 10%. And then they’re just a lot of investors, institutions who are constant indexers.

Lawrence Cunningham (01:08:00):

Well we know they’d amortize themselves as picking stocks, but they really own 200 basically the index, more than 200. So, at least a third of the public equity is owned by indexers. And then another third is owned by transients, the average holding periods of a third of the equity is less than two years. Those are enormous. You’ll notice the powerful influences in public equity today. And they’re both useful in different ways. Indexers deliver, they market return for millions of ordinary people at virtually no… at very low cost and just the market risk. It’s a wonderful thing.

Lawrence Cunningham (01:08:36):

And so they add enormous value to society. And traders add value too. They do price discovery, they provide deep liquid markets, when people do have to sell, the long term people have to sell for bequests, or debts they provide the deep liquid capital markets in the United States as long been famous for. So this is not a condemnation of these cores, but they play those roles, they do not play the role of a focused long term shareholder, understands the business, gives managers the benefit of the doubt and a little leeway and is willing to engage constructively with managers.

Lawrence Cunningham (01:09:12):

And that’s the quality cohort, that’s the kind of holder Warren long ago said he wanted to have. The quality group is in some ways, the group…. these all three and the others do very important things. But the important thing that the quality group adds is an informed, incentivized focus that very often help management certainly elongate the time horizon, and so on. But they’re not fools. They’re not sycophants or cheerleaders, they’re in it for turns as well. And so managers are failing, they’ll sell, they’ll leave, join back in this campaign for that matter.

Lawrence Cunningham (01:09:47):

It’s sort of interesting when Warren wrote those letters 1970, 1983, indexing was in its infancy. I think he was mostly concerned about day traders and activism had a different texture. It was more rival companies doing hostile tender offers or occasional activists, but the real era had begun. So his statement was addressing a slightly different demographic. But what’s happened is, you get way more of the two things that he said he wasn’t really interested to track way more.

Lawrence Cunningham (01:10:16):

And the pressures on investors to index or to trade rapidly are huge. You know, indexers it’s safe, you just deliver the market return. Well, at least you didn’t lag, getting upset why you get a lot of closet indexers. And if you’re really angry, you’re really eager or your clients are urging, it’s tempting to design trading strategies that end up looking like you’re [inaudible 01:10:42], just doing a lot of shorter term trading. So the pressure is on the quality shareholder to join the others.

Lawrence Cunningham (01:10:50):

Nevertheless, I also think that the quality cohort knows that they are not only playing a valuable role, but through doing it can outperform the market, and certainly the day traders. And incidentally, the evidence, there was a huge debate, as you know about value versus index, or stock backing versus the index, significant studies that have often shown that there’s no systemic strategy that will be a passive index. Warren even did a famous bet with Ted Seides over the past decade, where Warren bought the S&P and Ted was able to assemble any group of hedge funds he wanted, stock pickers and see who would win.

Lawrence Cunningham (01:11:30):

And now it was a funny bet, it was over a 10 year period, the stock pickers actually won in a couple of years, but the index one overall after fees, peace and distress. The reason Warren made that bet and highlighted so much was to emphasize that the funds extract enormous fees from the client so that they may have outperformed, stock picking may actually be possible. Individuals may be able to discern quality, you get returns, but if you have to pay for it, managers pay high fees, that was his real critique.

Lawrence Cunningham (01:11:59):

But nevertheless it shined a spotlight on how difficult it is to pick stocks that outperform the average. And so it is and so that said, an important strand of that empirical research led by the Dean of the University of Notre Dame Business School, Martijn Cremers and others, an important strand has demonstrated that this strategy I’m talking about, the quality shareholder strategy, being patient and focused has a tendency to outperform, you’ve got to do other things. You’ve got that magic, you just don’t pick 30 stocks and hold them for five years. You’ve got to conduct the kind of homework and analysis that Warren’s famous for, that value investors do, what quality shareholder does.

Lawrence Cunningham (01:12:42):

But the research indicates that long holding periods of concentration going together contributes to the possibility of systemic outperformance. That’s a very important strand of research. Now it too is controversial. I’m sure your listeners know as well as I do that, some of the quant firms attack the research and there’s a great debate about it. But there’s no question that it is a genuine reliable contribution to the literature so that any idea that well you cannot outperform, value is dead or quality shareholding is wrong, and it is just wrong.

Lawrence Cunningham (01:13:17):

And so I think the quality cohort know that they add a lot. And they gain a lot from being who they are. And there’s a philosophy here too, and even a personality, different individual human beings and fund managers will have a greater or lesser affinity for merely indexing or being a day trader, or sticking with quality, or being an activist. It really depends on your appetite, or your willingness to do work, your toleration for risk, the level of willingness to be an agitator versus being a more of a diplomat. And so people self select into these styles and strategies ways that suit themselves. So I think it is, it’s harder to be a quality shareholder.

Trey Lockerbie (01:14:00):

So anyone who’s familiar with Berkshire probably is aware that they have a prominent insurance business unit, and that they use the float to allocate and grow other business units within the company. It’s part of the fuel that’s been driving the growth of Berkshire overall for many years. I’m just curious, because we’re in such an interesting economic environment where interest rates are lower than ever, and there’s no real sign of them being able to increase anytime soon, there’s even pressure to potentially go negative as they’ve done.

Trey Lockerbie (01:14:29):

So in other parts of the world, there’s on top of that, even devastation caused by this global pandemic that will have consequences for insurance companies, and generally speaking. And we saw that, in Berkshire’s insurance earnings, they decreased about 60% in the last quarter. And I’m just curious, given that insurance is greatly affected by these interest rates, and that insurance makes up 27% of Berkshire overall, not to mention, it produces the float used for capital allocation. In your opinion, is Berkshire at risk as we enter this new economic environment, and how do you see it affecting the insurance portion?

Lawrence Cunningham (01:15:03):

Great question, Trey, you’ve really outlined a set of challenges that the industry generally faces and Berkshire in particular, because of its heavy, I wouldn’t say concentration, but big, big portion of its operations and strategy. It’s hard to know. I don’t have anything to pinpoint in your articulation. But in added a dimension in thinking about Berkshire’s insurance position is less gloomy in some ways.

Lawrence Cunningham (01:15:30):

I think that what Warren worries about most is catastrophic risk, and the massive claims that his companies and many others will face, no one can predict what the Black Swan, or whatever you’d like to call it is. It could be cybersecurity, it could be different aspects of pandemic, business interruption, there’s a good bet that there’s going to be continued bad effects of climate change, hurricanes, floods, tornadoes, fires and whatnot. And so this set of risks may well have been magnifying, not likely to change direction.

Lawrence Cunningham (01:16:05):

And so I think he might be expecting, I think insurance pricing shows some of this huge claims in the near term, little dwarf Hurricane Andrew and 911, you know, hundreds and hundreds of billions, and it’ll wipe out a lot of them. Many insurance companies will become insolvent, state funds will have to take over and Berkshire will remain a fortress. And because it has the strongest claims capacity, it’s got enormous capital, gushers of cash flow.

Lawrence Cunningham (01:16:35):

I think when it comes to insurance, that’s the thing I worry about the most for the industry and for society. But it’s going to actually be extremely beneficial for Berkshire, because it will be able to pay all its claims, it’ll be able to take over portions of the market or industry and thrive as a result. It struck me at the annual meeting in May, Warren certainly looked very gloomy. And it may have just been for the pandemic and he sounded dour. I mean, it was the least, he’s usually happy and fun, optimistic, realistic, but generally seen, you know, discerning the positive trends.

Lawrence Cunningham (01:17:11):

And America has had all those essays about Americans tale [inaudible 01:17:14], he did not see any of that that day. And maybe it was the pandemic, Charlie’s not there on the stage with him. And no one is there. Your cousin may have been there, but not many other people. 100 people not 40,000. So there are all kinds of reasons for gloomy. I just have a strong sense that… And I think he had read this in the comments that there are seismic catastrophic risks, and that a lot of insurance companies will be wiped out. And Berkshire would have a, more amounts of money, but it will be able to. That’s what you read on the letters. One of the most important things in Berkshire is that claims can’t pass it. He calls it a fortress in Fort Knox. And that’s a good advertising slogan for a big, reinsurance commercial property casualty insurance to say, we’ll leader your policy, not only can you trust us, but we’ve got enormous, we’ve got so much capital, there’s nothing… no tsunami is gonna starve us.

Lawrence Cunningham (01:18:04):

And that made me think Berkshire has got this enormous cash balance and treasuries 130, 40, 50 billion, I can’t keep track, Warren’s got that old joke when he uses microphones. 1 billion, 2 billion, 3 billion. What are those cashes? 141, 142? Is that a lot of money? Everyone thinks it is. He’s always said, we’re always going to have at least 20 billion of cash. He said that… I forget the last time he said. He said it more than once it’s been a policy.

Lawrence Cunningham (01:18:30):

I just wonder if that’s way too low. He hasn’t updated. Maybe 75 is better. That would explain half of the cash. Why you just were not going to buy another Precision Castparts right now. So I think you’re right in your analytics around the data earnings through the income state… part of the insurance operation, and even the investment part. I think it’s a balance sheet that’s going to matter. And I think Berkshire is going to proven [inaudible 01:18:56] once again. Sadly, I shouldn’t be laughing. Because it would be awful if those things did happen, but some of the trends seem to point more in that direction that the lower risk one.

Trey Lockerbie (01:19:07):

I love, that’s a great point, that it’s going to come to the balance sheet, it’s a great way to say it. I know we shouldn’t really focus on the daily share price of Berkshire, but something I read in your book, I just can’t really help myself, but ask you this question. So you’ve mentioned that Buffett likes to see the stock trade around its intrinsic value. But we’ve seen recently this year, he’s been buying back some shares. And if we look at Berkshire, the way Buffett does, he breaks out the business units as what he calls into these groves, right, that are kind of harvesting their own cash flow.

Trey Lockerbie (01:19:37):

And so you did this breakdown, this very back of the envelope math. But you mentioned there’s 115 billion or so of float, which we don’t actually factor in because it’s paid out. But there’s beyond that the 300 billion of subsidiaries, 200 billion worth of stock holdings, about 15 billion between his partnerships with private equity groups, and then this 100 billion dollars or so of treasuries. And so if you add all that up, and you divide it by the shares outstanding, which is about 1.37 billion shares, and you come up with this value of around $400 of a share, given that the stock price right now is in the low 200s, I’m just curious, do you currently see Berkshire as undervalued in that way, and by that much?

Lawrence Cunningham (01:20:20):

You’re right that I laid it out kind of a high level way, but I think it is roughly right. And if it is, then it’s a little undervalued. And I guess two checks make me feel more confident that one is that Berkshire is buying its own stock in significant levels for Berkshire. And the other is, I just understand that enormous capital is flowed into the fangs and the unicorns and just in, there’s a significant elevation in the overall stock market.

Lawrence Cunningham (01:20:50):

If you see snowflake, which I think is one of Berkshire’s recent investments at [inaudible 01:20:55] is priced at 200 times revenue, some stratospheric figure. So there’s enormous fascination, glamor and excitement. Companies are going to change the world. And with Facebook and Apple and Netflix and Google Alphabet. And so, Berkshire looks very old and simple and tired. So it’s not the glamor stock.

Lawrence Cunningham (01:21:17):

In my view, that’s good for Berkshire. One advantage of Berkshire buying back its own stock right now is that those who are… most of the sellers are probably not going to be the quality shareholders that I’ve been bragging about. They’re going to be people who bought it on spec for the short term. A very famous one is is Bill Ackman. Apparently his firm Pershing acquired a substantial stake around the onset of the pandemic. And last month or so sold it. I think Bill went on television somewhere saying, how much he lost. A very large… you know, hundreds of billions or something, large amounts of money.

Lawrence Cunningham (01:21:52):

And Berkshire, the headlines also Bill Ackman is one of the rare people who lost a lot of money with [inaudible 01:21:57]. But Bill explained it, “I bought the stock,” Bill said, “Because I assumed that Warren would deploy enormous amounts of capital at the depths of the pandemic and exploit the opportunity inside up. He didn’t do all that. So I’m going to sell.” well, that’s not quality shareholder thinking. That’s day trading thinking. It’s arbitrage, it’s opportunism. Again, there’s nothing wrong with it good for bill. But I like though.

Lawrence Cunningham (01:22:18):

I think if that’s the kind of person that is selling while Berkshire’s buying back, that improves the average quality of the shareholding base measured in the terms that I’ve described. So I think that’s probably another advantage. A slight advantage that you’re going to say, while I’m retired or left tomorrow, those quality shares are going to be more important than ever.

Stig Brodersen (01:22:39):

Lawrence, this has been absolutely amazing, having a chance to speak with you. Trey and I couldn’t be more grateful for your time. I’m sure the audience feel the same way. We would like to give you have the opportunity to talk a bit more about your publications, your initiatives, could you please give a handoff to where the audience can learn more about you?

Lawrence Cunningham (01:22:55):

The best place to get my books is our old friend, the juggernaut amazon.com. Go to that site and type by name, you’ll get a list of 20 to 30 books. If you don’t like Amazon, you can go to my University’s website, my quality shareholders initiative website contains, I think interesting information about my latest book and latest research about this quadrant, the long term focus shareholder. So I think if you just do a Google search, quality shareholders initiative, it’ll come right up.

Trey Lockerbie (01:23:23):

And we’ll be sure to provide links in the show notes to all the books we mentioned during this discussion for our listeners to check out. So, Lawrence, I so greatly appreciate you coming onto the show. You and I could probably sit here and talk all day about Berkshire. I know that we could, I hope we can do it again sometime soon. I really enjoyed having you on the show. Thank you.

Lawrence Cunningham (01:23:43):

Oh, thank you very much. Likewise.

Stig Brodersen (01:23:45):

All right. That was all the train I have for you for this week’s episode of The Investor’s Podcast. We’ll be back next week as always, Preston and his Wednesday releases with Bitcoin and then with our regular episodes next weekend. Have a wonderful week ahead.

Outro (01:23:59):

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