Berkshire Hathaway Part II

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

Ben: Welcome to season 8 episode 6 of Acquired, the podcast about great technology companies, and the stories and playbooks behind them. I'm Ben Gilbert and I am the co-founder and Managing Director of Seattle-based Pioneer Square Labs and our venture fund, PSL Ventures.

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

Ben: We are your hosts. In our last episode, we told the story of Warren Buffett in the years of running his own partnerships. Those 12 years leading up through 1969, when he shut it down after his best year ever and returned all the money to his investors. Today, we will pick up right where we left off, telling the story of the declining suit liner manufacturer that he bought, Berkshire Hathaway.

Today's story is one of an investment style in transition from a focus on cigar butts to focus on wonderful businesses, much of which was inspired by the man we've only briefly mentioned so far, Charlie Munger.

Now, you may be thinking to yourself, boy, it'll be really great to get the other half of the Berkshire story. To understand where they are today. Unfortunately, you should know David and I better than that. We were foolish to think that we could tell the whole Berkshire story in a mere two episodes. This episode is our Empire Strikes Back. It will serve as a bridge between the early forces that made Warren and the mature Berkshire that we have today.

What made Buffett start investing again after dissolving his partnership? And why on earth did he decide to do that inside of the shell of the declining Berkshire instead of just starting a new fund? Even so, how did he end up briefly as the Chairman of a Wall Street bank with a culture that he had criticized for his whole investing career? Here we are, part two of our Berkshire Hathaway trilogy.

David: It really is The Empire Strikes Back. It's going to get dark at the end.

Ben: Truly.

David: Be prepared.

Ben: There's a little bit of an apt analogy there, it's true. Folks, are you an Acquired Slack member yet? If not, what on earth have you been waiting for? It is a wonderful community. Discussing, of course, all things Acquired in recent episodes, but more importantly, it is a smart group of people having thoughtful, nuanced, and respectful discussions about tech, investing. You can join at acquired.fm/slack.

Now, on to our presenting sponsor for all of season eight, Tiny. In our last episode, we told you that if you were a proper Berkshire-nerd, you should check out Tiny storefront at berkshirenerds.store, to get your own Warren and Charlie Bronze busts.

Today, we will continue our exclusive miniseries with Jeremy at Tiny on building wonderful internet businesses. All right, Jeremy, longtime listeners of the show will know that David and I are fascinated by the idea of compounding returns showing up in the later years of companies, and how counterintuitive that notion is. Do you have an example of a Tiny company that you can share where you observe this power of compounding firsthand?

Jeremy: I think the best example of that is probably Tiny itself. For a long time, we would buy companies that were doing $1 million or $2 million in revenue and we don't make a lot of acquisitions. It's quite hard, at first, to build something big that way. But Tiny now has 30 operating businesses doing over $100 million in revenue with double-digit profit margins and 600+ employees across North America and Western Europe.

I think what we've seen is that each one of those companies are really high-quality businesses, are able to grow quite effectively, and just compound away when left alone. That sort of thing gets very substantial and you end up where we are. Which is through these small companies that are high quality, have strong pricing power, great operating leverage. It almost becomes a bit of an inevitability, as long as you don't actively step in and screw it up as Charlie Munger says.

Ben: That's great, thanks. Thank you to Tiny. If you are contemplating a sale or even wonder what that might look like for you in the future and your wonderful internet business, you should reach out and tell them that Ben and David from Acquired sent you. You can learn more at tinycapital.com or by clicking the link in the show notes.

Now, lastly, if you aren't an LP, you should become one. Aside from all the things that we tell you, every time we have a brand new LP event coming up that we are super excited about it. Our next book club will be with Brad Stone who famously wrote The Everything Store, The Upstarts. Now, David, what is his new book?

David: Amazon Unbound.

Ben: Part 2 of the Amazon Story.

David: Just like this is part 2 of the Berkshire story.

Ben: Our new format for the book club will be that David and I are going to interview Brad. If you're an LP, then you get to join on the Zoom as well, and we'll have time for Q&A. Everybody will, hopefully, have read the book before we do the interview. You can join at acquired.fm/lp and learn more about that program.

All right, David, before you take us in and listeners as always, this show is not investment advice. David and I may, I think we've already told you that we do have investments in the companies that are discussed on this episode. This show is for educational and entertainment purposes only.

David: All right, let's get to it. We have a lot to get through here. Last we left our friend, Warren Skywalker, Warren Buffett. He was wandering in the woods of Omaha after having closed down the partnership as you alluded to, Ben. Trying to figure out what to do with his life in his retirement. Before we pick back up with that story though, I think we have some unfinished business and a character that we need to introduce here.

Ben: This is like so, David. Even in an episode where we've already told you a multi-decade history, and we're in part 2, somehow you're finding a way to wind the clock back.

David: Indeed. We go all the way back to New Year's Day in 1924 in Omaha, Nebraska. The very same woods that Warren is wandering in.

Ben: That sounds like six years before Warren was born.

David: Yes, 6 ½ years before Warren was born. Where in Omaha? Al and Florence Munger, Florence gives birth to a baby boy whom they named Charles Thomas Munger, after his grandfather who is a widely respected federal judge in the Nebraska US District Court appointed by Teddy Roosevelt himself, Thomas Charles Munger. So Charles Thomas Munger, name of his grandfather, Thomas Charles Munger. He takes after his grandfather in many ways, his grandfather makes a big impression on him. Thomas's mantra in life was, concentrate on the task immediately in front of you and control your spending. It sounds similar to Ernest Buffett, similar ideals.

This instills this idea of gaining wealth through controlling your spending and focusing on doing a great job at the task in front of you in young Charlie. Charlie, much like Warren, decides that he wants to become wealthy so that he can not have lots of fancy toys to play with, but so that he can be independent. He has a quote, he says, "I wanted to get rich so I could be independent like Lord John Maynard Keynes." Of course, elementary school-aged Charlie Munger is aspiring to be like John Maynard Keynes.

This is where he's a little different than Warren. They really have the same aims and goals in life, but their styles around it are very different. Warren is just like, I don't want anybody telling me what to do. Charlie’s like, I want to be like Lord Keynes.

As we chronicled in part one, Charlie actually goes to work for Ernest Buffett at the grocery store as a kid. Unbelievable for Warren's grandfather. Just like Warren learns, he hates manual labor and being paid a pittance of a salary, and he thinks there's got to be a better way. He can use his mind to make money rather than manual labor.

Speaking of his mind, he loves to read. His parents give him and his sisters lots of books, he tears through them. Very early in life, he stumbles across Ben Franklin. Ben Franklin would become his hero in life, and that's where he develops this idea. I don't know if he stole it from Franklin or if he came up with it himself of making friends of the eminent dead. He decides he enjoys more the company of dead people—learning from them through their books—than people who are actually alive.

Ben: Kind of a one-way conversation, but there's probably a lot of wisdom there. Not to mention, revisionist history, survivorship bias, yada, yada, yada.

David: I think a lot of conversations with Charlie are one-way conversations, as we shall see. Also like Warren, he's kind of a wiseass as a kid and has a very high opinion of himself. His neighbor one, Ed Davis, who we discussed in part one, the doctor, is his father Al's best friend.

Ben: Just as a refresher, the Davis's would become one of the first families to invest in Buffett’s first partnership, right?

David: Yeah. If I remember right, the family in Omaha that gave him the most money of the initial group. I think they gave him $100,000 because Warren reminded them of Charlie. He ends up going to Michigan for undergrad. Sorry, Ben.

Ben: It's all right, these days I'm not sure there's much of a rivalry anyway.

David: Oh, burn, burn. Of course, Ben went to Ohio State. At Michigan, he majors in math and gets turned on to physics where he becomes really interested in physics. Then while he's still in Michigan, Pearl Harbor happens and the US enters World War II. Charlie joins the Air Force and is part of the intake process. They measure his IQ, and he's literally like one of the top IQ scores that the military that any branch has ever tested.

Ben: No major surprise there.

David: Yes, no major surprise there.

Ben: He's probably that top wiseass docile as well.

David: That is definitely true. They sent him first to the University of New Mexico to study engineering there. He then goes on to Caltech in Pasadena in Los Angeles and continues his engineering studies there. If I’m remembering this right, I don't have it in my notes, I think he ends up getting stationed in Alaska as a meteorologist during the war.

Ben: I remember him being in Alaska too as part of his duty.

David: Yeah. Anyway, after the war, he decided that he really enjoyed learning about engineering, physics, math, and all that. But for a career, he more wants to follow in the family footsteps of his beloved grandfather and his father and go into the law. Charlie being Charlie applies to Harvard Law despite the fact that he doesn't have an undergraduate degree.

Ben: Why should that stop him?

David: Yes, he didn't actually graduate from any of these institutions. He gets in and he goes to Harvard Law. He does very well there, graduating Phi Beta Kappa. He's thinking about going back to Omaha, but he decides, well, (1) Pasadena is really nice when I was there at Caltech. The weather in LA is hard to be, but also in typical Charlie fashion, he sort of asked himself a rhetorical question.

He's like, where can I be somebody? Omaha's obviously a rising town, a great city, but it's not Los Angeles. He says, what city is growing and full of opportunities so that I could make a lot of money, but not so big and well developed that it would be hard to rise into the ranks of the city's most prominent men? Which, of course, Charlie wants to be among those ranks.

Ben: You're already seeing a massive departure in the psychological makeup of Warren and Charlie here where that was never a thing Warren cared about. It was like, how much money will I have on the scoreboard when I die, and I'm sure no matter where I live, that'll get compared to everyone else. For Charlie it was, where can I be a man about town? That town should be big enough to be worth being a man about town. It's also funny to me that at this point, LA for him is something that he views as, oh, it's not too big yet.

David: I mean, right after World War II, obviously it was a big town and Hollywood had always been there. I think California, particularly Southern California, experienced a huge population boom after World War II, which Charlie was a part of.

Very tragically, after moving to LA, he had gotten married—I think right after the war when he started at Harvard. Tragically both his marriage is falling apart when he gets to LA, and much more tragically, his son Teddy is diagnosed with leukemia. In those days, there was no effective treatment for leukemia.

Ben: Yeah, just tragic.

David: It was totally tragic. Teddy would end up passing away in 1955 at age 9, which is unimaginable to lose a child at all, let alone in that way and at that age. Charlie's reaction to this, I think is very characteristic, very telling of who he is.

He's obviously absolutely devastated, but he decides that the thing to do is he needs to set new goals for himself and move forward versus being consumed by grief. After reflecting on this time, he says, one of his Charlie-isms, you should never—when facing some unbelievable tragedy—let one tragedy increase into two or three through your failure of will. Which is probably some advice, not I can imagine going through that.

Ben: That's also some incredible compartmentalization. Imagine going and speaking to a person who's grieving right now and telling them, hey, don't let this turn into two or three cascading failures or catastrophes. It's all only something you can decide and tell yourself. I think only if you are a person like Charlie.

David: Like Charlie. He sets two very specific goals for himself. (1) to find a new spouse, and (2) to diversify his business activities outside of law. I thought this was so funny. He's really worried, he's now a divorced man in his 30s. In California, he doesn't know that many people out there. He goes through all the math of, how many women are there in California? How many would be of marriageable age? How many are smart enough for me but not too smart? Of course, this is Charlie.

He happens on a foolproof strategy. He decides that he's going to do the most rational thing possible. He's going to start every day, scanning the divorce and obituary notices in the paper, looking for widows and recent divorces.

Ben: Oh my God.

David: I guess they weren't dating websites back in those days. That’s what he had to do. His friends are kind of alarmed by this. One of his law partners introduces him to a woman named Nancy Borthwick who fits all of his criteria, except maybe not being too smart. She’s quite smart, she was recently divorced, she was Phi Beta Kappa from Stanford, undergrad in economics. She actually had an undergrad degree, unlike Charlie. Most importantly, she took nobody's crap, including Charlie's.

Each of the two of them has two children, two surviving children from their previous marriages. They get married. They go on to have four more children together for an entire Munger clan of 10 people, 8 children, and 2 parents.

Ben: It's a lot of Mungers.

David: That is a lot of Mungers. If you see photos of them, of the Munger Clan to this day, especially with all the grandchildren, it is impressive. It's like a small city.

Ben: Do you know the thing that smacks you in the face? The thing she had in common with his first wife.

David: Yes. Her name.

Ben: Yes, they're both named Nancy. In some ways you're like, come on, that's pretty lazy. Like, you can't go marry someone again with the same name. Someone wants me to remark that Charlie was so sort of absent-minded and forgetful of names that, thank God his second wife was also named Nancy or he would have forgotten her name too.

David: Yeah, very Charlie. He is unique. On goal number two, he's doing very well as a lawyer in LA. As you can imagine, Charlie is an excellent attorney, but he decides that, even though he's having all this success, really the people who seem like they have a good life and who are really the sort of men—they're all men at this point—about town are the clients. In particular, one of his clients is the mining magnate Harvey Mudd who helped build Caltech into what it became and then helped build and found all of the Claremont colleges including the one that bears his name, Harvey Mudd. He was one of Charlie's clients.

What does Charlie do? He starts buying some stocks himself, but he also starts taking some of his fees from his clients in equity in addition to cash. He's like the early Silicon Valley, entrepreneurial startup lawyer type that takes some equity in addition to cash for doing the deals.

He also ends up getting into real estate. Which real estate in Southern California in the post-war era, was a great way to make a lot of money. He got his net worth up to about $1.5 million by the early ‘60s. Which if you remember from part one, he's right neck and neck with Warren at this point in time.

Ben: That's what like, $10, $15 million today?

David: Yeah, certainly more than anybody would need to be living the good life of a man about town at this point.

Ben: Right. You can imagine like someone in their mid-30s, you could kind of just live off that interest forever if you wanted to put it into fixed income and kind of call it.

David: Totally, which, unlike Warren, Charlie's not necessarily against something like that. He's definitely enjoying himself in LA. But along the way, as we alluded to in part one, the famous summer night in 1959 in Omaha, Charlie is back in town briefly to settle his father’s estate. His father, Al had passed away. The Davis’s say, we’re investors with this local guy Warren, we've told him about you.

Ben: Three years ago we met him, he seemed like you.

David: Let’s set up a dinner. We’ll introduce you, you guys can meet. Both Warren and Charlie are skeptical going into this dinner. But the legend goes that they'll sit down to dinner and it's electric. Warren and Charlie hit it off right away, which I think is true. Then the legend goes that, at this dinner, Charlie starts laughing at one of his own jokes so hard that he actually rolls out of his chair under the floor and starts rolling around on the floor. Now, that is not true, but it did happen later that week because Warren and Charlie got dinner together every night that week after that that they were there.

Ben: Oh, wow.

David: Yes. Apparently, Charlie did actually start rolling on the floor of a restaurant at one of his own jokes.

Ben: Which is the first of many pretty funny quips about Charlie at dinner parties and his eating habits and his mildly self-absorbedness when it comes to these things. There's another good one, where he's been known to, as he's telling a story or opining on something, sometimes, of course, he'll need to drink water. As he takes his glass and puts it up to his mouth, he puts his hand out to stop anybody else from talking, holds his hands up until he's done taking a sip, and then moves his hand out so he can finish telling the story. This is a man that loves to talk. It doesn't come out as much in Berkshire meetings until you get him going. But yes, in social situations, he is the center.

David: It's so funny because if you just watched the annual meetings, you would think that Charlie is the silent partner. Nothing could be farther from the truth. During this dinner, Warren and Charlie are enraptured with each other. As they go along, Charlie's getting more and more puzzled because all Warren is talking about is his businesses, companies, and investing. Charlie loves this. He thinks this is great, but it won't even cross any normal person’s mind that this could be your job at this point in time.

We talked about in part one, maybe a couple of people in New York, maybe Ben Graham could do this. The idea that somebody in Omaha, even somebody in LA could do this as their full-time job, only Warren was thinking this way at the time. Eventually, Charlie asked Warren, well, what do you do exactly for a living? Buffett’s like, well, I have these various vehicles, these various partnership vehicles. Because at this point, he hasn't consolidated them all yet. He has seven or eight different partnerships that he invests from.

Ben: Mind you, the setup is there are no fees. He's not drawing a salary from any of these.

David: Yeah. He's just working out of his spare bedroom at the house in Omaha, living off of his (what was it) $175,000 that he had when he left Graham Newman. Charlie strikes him as brilliant. He looks at Warren dead serious for once and he says, do you think I could do something like that out in California? Supposedly, Warren, as chronicled, sits there, he thinks for a minute. Because Warren he's very polite, but he's also—especially with people he respects—very honest and direct. He doesn't think many people can do this. But he thinks and he says, you know, yeah. I'm quite sure you could do this.

It changes his life, this dinner. He goes back to LA, he keeps practicing law. He's not ready to go all-in yet on investing, but he raises some money. He starts a partnership and he starts emulating Warren, investing on his own out in Los Angeles. Susie Buffett who is at the dinner, although a silent participant says in a quote in The Snowball says, I think Warren felt that Charlie was the smartest person he'd ever met, and Charlie felt that Warren was the smartest person that he’d ever met. For the two of them that was quite the high compliment.

Munger goes back to LA, he starts investing. He also leaves the law firm that he was at and starts a new law partnership, which was originally called Munger, Tolles & Hills, later becomes Munger, Tolles & Olson. Which to this very day does all of Berkshire's legal work and will become very instrumental in the story at the end as we shall see here. He doesn't stay there long. He only stays at this new firm that he started for three years.

Then in 1965, he's doing so well investing that with Warren's encouragement, he actually left MTO and just like Warren, became full-time running his partnerships, investing.

Ben: MTO, despite the fact that Charlie was only there three years, is still MTO today, right?

David: Still MTO today, yup.

Ben: Amazing. Imagine starting a firm, naming it after yourself, then leaving, and then all of your partners and everyone else who works there asking you, hey, can we still keep it with your name on it?

David: And your name first?

Ben: Right, it's wild.

David: Totally wild. Charlie starts out in his investing style doing the cigar butts and the like. He's talking to Buffett all the time. They're always on the phone. He's absorbing all the Ben Graham philosophy. But it quickly becomes clear that he's wired a different way. He starts saying to Warren and some of their other friends this line that is sort of puzzling to them. Charlie says, I just like great businesses. That's like not computing with Warren and the rest of the crew.

Ben: Warren’s like, you mean mispriced assets? Because that's what we're doing here. We're buying mispriced assets. When you say great businesses, what do you mean by that?

David: Right. I mean, as we talked about last time, Warren, when he gets a great business like a GEICO or an AmEx, he still only thinks about them in terms of the value that he can arbitrage out relative to their hard asset, net worth, or their cash on the balance sheet.

Charlie though, the story goes that what really gets him down this line of thinking is at one point, he invests in a Caterpillar tractor dealership in Southern California, and this becomes a total albatross because the problem was as the dealership you got to buy the tractors from Caterpillar upfront, which cost a lot of money. Then they don’t turn over that fast. They're just sitting on the lot. And then every time one goes out the door, you have to put more capital up to buy a new one. It's incredibly capital intensive, it's always tying up capital. If you want to grow, you want to add new stores. You got to invest in all the inventory upfront.

Charlie, ever the rationalist, realizes that, hey, wait a minute, the goal of owning a business should actually be (1) that the business spits out more cash than it consumes, and ideally (2) that it consumes as little cash as possible.

Ben: Right, then when it spits off cash, that you actually can do something with that cash, not have to go buy more Caterpillar pieces of machinery.

David: He's like, I want to give you cash once and very little of it, and then I want you to give me a lot more cash over time with me never giving you any more.

Ben: This is best paraphrased in the line from Poor Charlie's Almanack, which was an awesome source, which is a better business, and that postulates, "There are two kinds of businesses: The first earns 12% and you can take the prophets out at the end of the year. The second earns 12% but all the excess cash must get reinvested—there's never any cash. It reminds me of the guy who sells construction equipment. He looks at his used machines, takes it in as customers buy the new ones and says, 'There's all my profit, rusting in my yard.' We hate that kind of business."

David: Totally. All right, Charlie is starting to think about this and he starts really going down the rabbit hole sleep. He’s like, what? How can you achieve such a state in business? That leads him to think about this idea of competitive advantage. This is all probably seeming duh, normal stuff to everyone now, but nobody is thinking this way at the time.

What is competitive advantage? It's almost like a moat. It's like, if your business is a castle, you have a moat around your castle so that nobody can attack it. It's a reason why competitors can't come and arbitrage your differential profit. It sounds like Hamilton Helmer in Powers, right?

Warren and Charlie are spending a lot of time together. Famously, Warren and Susie start vacationing in Southern California just so that Warren and Charlie can talk for hours. When they come out, Warren's already a millionaire at this point. The family stays in a motel on Santa Monica Boulevard, and then commutes or drives over Pasadena.

Ben: Of course.

David: Of course. (1) they're hanging out because they respect each other's intelligence, but (2) Alice points out in The Snowball, there's actually a second reason why Warren likes Charlie so much. And that’s as Warren starts to get more and more known in Omaha and on the national scene for his investing track record, nobody's willing to tell him he's wrong anymore, everybody's super differential to him. As Alice puts it, "Charlie's deference to Warren was limited by his high opinion of himself."

Ben: That's awesome. That is something that we start to see play out here in the late ‘60s where Buffett was famously very shy about ever sharing investment ideas. I think like, occasionally, at that annual group that he would convene of all the Ben Graham disciples, his fellow classmates, which he then started bringing Charlie into, they would occasionally sort of alluding to some investing ideas they were thinking about. Maybe this business is interesting, but they would kind of talk around it.

Warren really found in Charlie someone that he could literally present, here's the name that I'm thinking about, and start talking through the business and look for holes in his thinking in a way that he never opened up to anyone else to ever say the name of a company he was thinking about buying.

David: Yup, totally. At the same time, Charlie is starting to go down this different path in philosophy. Munger starts saying and he says to Buffett, he’s like, hey, you're obsessed with this Graham guy. I'll give it to you that that's a great strategy, it works. Graham at several points, this time Graham also lives in Southern California by now. He's like, hey, he's not God. There's a flaw in cigar butt thinking, which is that it was driven by the environment that Graham came of age in and the depression. The quote from Charlie is that the flaw is that Graham believes that the future is more fraught with hazard than ripe with opportunity.

Here in the post-war era in the U.S. especially in California, it's super hard to look at the future and not see opportunity. Charlie starts ringing Warren about this. Here's a great quote, "Because Warren is so good at explaining Ben Graham, he's behaving like the old Civil War veteran. Who after a few minutes of ordinary conversation, always interjects, 'That reminds me of the Battle of Gettysburg.'" In other words, Warren is falling victim to one of the oldest human misjudgment tendencies in the book, the man with a hammer syndrome.

Ben: What's that like, when you have a hammer, everything looks like a nail?

David: Exactly. Eventually, Charlie does start breaking through to Warren, right around this time as Warren shutting down the partnership. He's so depressed, he's worried about the market, he doesn't see opportunity ahead, he only sees hazard. But at heart though, Warren is an optimist.

Ben: Yeah, it's interesting. When you're 95% aligned with your teacher, it's easy to just try and do things exclusively their way, and it's only when you start really feeling yourself and feeling your legs under you a little bit can you start saying, wait a minute, I am a little bit different. And I can act as completely my own agent rather than following their playbook.

David: All right, this leads us to the first big thing that Warren and Charlie do together, which is Blue Chip Stamps. I remember when I used to hear Warren and Charlie talk about the Blue Chip Stamps company, I thought this was a quaint stamp collecting store franchise.

Ben: I assume that too. Yeah.

David: Exactly, like a baseball card shop or something. No, this is totally not what this was. This is some wild Americana history.

Ben: When we say the first thing they do together, we should be crystal clear here. They are not Warren and Charlie on a stage the way that you see them today. There is Charlie who is doing Charlie's partnerships, and Warren who's doing Warren's partnerships.

David: Yup. What is Blue Chip Stamps? Around the turn of the 20th century, department stores used to hand out—this is crazy—stamps as a bonus incentive for customers to pay cash for goods instead of buying on credit. The idea was if you bought something with cash, the store then handed you a certain number of stamps, which you could paste into a booklet. When you filled up the booklet, you could exchange it for prizes. Redeem it for furniture, jewelry, a bike for the kids, or something like that.

Ben: They did want to incentivize paying with cash because of cash flow.

David: Exactly. This was a way to incentivize paying with cash. Somebody had a brilliant idea that it would be better if you actually operated the stamp service as a separate business from anyone’s store so that customers can get stamps from lots of stores and then aggregate them. Get lots of stamps and then redeem them for more prizes.

Ben: It sounds so convoluted when you explain it this way.

David: Totally. But this business turned out to have two extremely attractive qualities. (1) It had float. The stamp companies that were running the stamp operation, the businesses, the stores bought stamps in advance from the stamp company. You’re a department store. You’re like, I’m going to buy $500,000 worth of stamps that I'm then going to give out to my customers over time to incentivize them, and they buy it at a discount.

Ben: Wow, you better keep those in a safe because those are like cash.

David: Yeah, exactly. They would give money, give US dollars to the stamp company in exchange for the stamps. Then the customers of the store would get the stamps, and then they would redeem them, there’d be breakage. It could be years from the time the stamp company sold the roll of stamps to the store.

Ben: Sounds like an insurance company.

David: Exactly, exactly, so there's float. (2) Even better, there's network effects in this business, two-sided network effect. The more stores that use a given stamp system versus another one, the more consumers are going to be incentivized to buy at those stores because they want those stamps that they can redeem for big prizes.

Ben: Right. Consumers want more stores to support it, stores want more consumers to use it. Yeah, it makes total sense.

David: By the middle of the century, there was one dominant national player in the stamp business, the S&H Green Stamps, except in California where a bunch of stores had banded together, shut-out S&H, and launched their own stamps, the Blue Chip Stamp Company.

Ben: Amazing.

David: Unbelievable. I had no idea about any of this. In 1963, S&H and the Department of Justice both sued Blue Chip for monopolistic practices. S&H is trying to get into California and recruits the DOJ. Why the DOJ wasn't like, hey, S&H, you’re a monopoly too, but anyway. Regulatory capture, I guess.

The stock gets pummeled when these lawsuits happen, but Mungers heard about this in LA, and he tells Buffett and also their friend Rick Guerin, who’s part of the Graham Group which becomes the Buffett Group. Remember, Munger’s like a highly, highly experienced, top-notch corporate lawyer. He says, what's going to happen here is Blue Chip itself is going to be fine. But the government, what the DOJ will do, they're going to force all of the California store chains that collectively own Blue Chip to divest in. Who better buy it than us. Indeed, that is what happens.

In 1968, Blue Chip agreed to a consent decree with the DOJ where the stores had to sell off 45% of the company, and boom, a combination of Munger, Guerin, and Buffett all snapped up 45-ish% in Blue Chip.

Ben: This sounds complicated to me because each of them represents a different shareholder base, their sort of talking to each other. It feels like something could be fishy there.

David: It could be, it could be. As the line that we shall see in a minute is, there's got to be an indictment in there somewhere. Okay. Now we're in 1970, Warren has just unwound his partnership and distributed out shares of Berkshire, Diversified Retailing, which was a JV essentially that he had with Munger’s partnership to invest in department stores, ill-fated idea, and then Blue Chip. Remember, Warren told his partners in the letter where he said he announced that he was winding down the partnership that he intended to buy more of all of these companies. He does.

Ben: Just to be super crisp here, Warren owns some Berkshire, but Charlie doesn't own any Berkshire at this point, this is 1970.

David: I think none at this point.

Ben:m They've created the JV of diversified, they're definitely in that together, and they both sort of share this idea about Blue Chip so they both are big holders of Blue Chip as well?

David: Yup. After Warren winds down the partnership, he buys so much stock in these three companies from his former partners that his ownership of Berkshire doubles from 18% to 36%. His ownership of Diversified doubles from 20% to 39%, and he buys so much Blue Chip that he goes from 2% to 13% ownership in Blue Chip, just personally. Susie’s like, oh no, the second retirement is going to look exactly like the first retirement here.

Ben: This really was the case, right? He was like, I'm winding down my partnerships, I'm done. What was the line? Something about his style and sensibility is no longer being suited to the current environment, and yet here he is heavying up on these three stocks.

David: Yeah. Warren isn't the only one buying these stocks. Berkshire itself starts buying Blue Chip. Pretty soon, Warren's own 13% of Blue Chip, Berkshire holds 17% of Blue Chip. Diversified owns 16% of Blue Chip, and Munger’s partnership on his own, owns 8%, and Guerin owns 5%. So 60% of Blue Chip is owned by these six different entities, all of which also owned stock in each other.

Ben: Listeners, if you're feeling like this is convoluted and a little bit messy, maybe even they might be hiding something with the lack of simplicity here, so does the SEC.

David: Which we will get to you in one sec. Ironically, while they're doing all of this buying, they're just so thrilled at the prospects of what they're doing. The actual business of Blue Chip enters a major secular decline. During the decade of the 1970s, Blue Chip’s core business—even though they settled the DOJ suit—declined 90% over the decade because consumers are just not that interested in stamps anymore. Credit cards are becoming a thing, it seems like an outdated kind of thing so the business is declining.

Ben: Then why were they so excited about buying the stock, just because it was at historical lows and they felt like it was a low multiple of the profits it was generating?

David: I think the other part of it is the float. Just like Berkshire, Blue Chip is declining in its core business, but it's still got this super attractive float dynamic.

Ben: If they don't own it outright, why is that attractive? Because they can't use that. They can't take the cash out from the float to use it for something else, right?

David: Right. They can't take the cash out of Blue Chip, but they can redeploy it within Blue Chip. They say, hey, let's run the Berkshire playbook that Warren just did with Berkshire. Let's start looking for other operating businesses to go by with our float here at Blue Chip.

They tell Blue Chip’s president, a guy named Bill Ramsey to start looking for companies to acquire. One day in 1971, he called Warren and Charlie and he's like, hey, I've got it. I've got a pretty interesting acquisition target here. It's a small little family company here in LA called See's Candy. Warren and Charlie come in, they start looking at the company, and it's actually pretty interesting.

People love it. It becomes wildly popular across California, starts expanding, they develop a slogan that they want to be known for See’s quality, which is supposed to be even better than top-quality. You've got high quality, top quality, and then See’s quality. It's so ubiquitous in California that, you know the famous I love Lucy episode?

Ben: Already no.

David: You definitely know this. It's like one of the most famous moments in television, in the ‘50s where Lucy and Ethel are working in the chocolate factory and they’re on the production line. They’re supposed to wrap the chocolates as they go by, the chocolate starts going so fast that they can't keep up, and they're stuffing the chocolate all in their clothes.

Ben: Oh, I do know what you're talking about. Yeah.

David: Yeah, it's amazing. It was modeled after a See’s Candy Factory. The problem with See’s though, from Warren and Charlie's perspective, is it is decidedly not a cigar butt. The factory, the stores, and the hard assets on the books are valued at $5 million but See's already has an offer on the table for $30 million. This fails every Ben Graham test in the book.

Ben: It's so crazy to me, this notion of cigar butt that you're trying to pay less than, literally, just the property of plant and equipment effectively. We're not even talking about profit multiples here. We're literally just talking about, well, are they asking you to pay more than the liquid value of all their assets? And like, oh no, six times the property plant and equipment. Ahh, too far afield for me.

David: But this is where—remember, when we're talking about Charlie's starting to get this tingling about great businesses and he's influencing Warren. He's like, hey, Warren, let's actually look at the revenue and earning side of the equation here. This company is doing $4 million in annual pre-tax profit, and that's growing at 12% per year without putting any more capital into the business. It might actually be worth paying this price.

Ben: Then what? That's about 8X trailing 12 months profit multiple.

David: Totally. Imagine that.

Ben: That's the offer.

David: That's the offer on the table. Warren, of course, hems and haws about it. He's like, ugh, I can't do $30 million, but we could offer $25 million. The only reason he justifies it to himself at this point is he thinks, well, they probably have pricing power because people love the candy so much. If we raise the prices, maybe I can get comfortable.

Ben: This is sort of the brand notion that he's learned at this point of, hey, there actually is a thing that doesn't show up on the balance sheet that has value.

David: Yeah, he's starting to come around. They do get the deal done with the family. Blue Chip buys See’s for $25 million. Over the ensuing years, this little candy company delivers over $2 billion in free cash flow to first the Blue Chip, and then whenever it would get absorbed into Berkshire Hathaway for a purchase price of $25 million.

This is the first time that this concept of a wonderful business at a fair price versus a fair business at a wonderful price is executed by Warren with Charlie's influence. Warren, after a brief period of time of seeing the See’s operating results, becomes a total comfort. He would say later about this idea that it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. He says Charlie understood this early, I was a slow learner.

Ben: Love it.

David: Meanwhile, Charlie is also learning from Warren that managing other people's money maybe isn't so great. Charlie's partnership before 1971, 1972 had done, not quite Buffett levels of performance, but generated 28.3% IRRs for the first decade, which is still fabulous performance.

Ben: But not as steady as Warren, that's the thing you notice about Charlie. He did lose money some years.

David: He did. He had some real big years and some down years. Then in 1973 and 1974, Charlie's partnership fell 31.9% and then 31.5%. This is super scarring for Charlie. He feels like, if he can get almost like Warren, his sister, and the first stock he bought back in the day, he's like, if I can get the partnership level back to roughly what it was, I'm going to work like hell to do that but then I'm out.

He did that in 1975. He returned 73.2% on the partnership in 1975, and then he winds it down, he's out. He says you know what, Warren's having a good time with this Berkshire model, I'm going to do the same thing here with Blue Chip.

Ben: Yup. The difference being, Charlie was still running other people's money at that point. I think he was doing a more traditional model: management fees and effectively carried interest or some kind of promote that he was getting above some certain hurdle. In that business, when you're losing the money you feel it really hard because you're being judged on that performance.

Whereas with Warren, the only other stakeholders that he had to think about were the other shareholders in those businesses, but Warren had made no promise to them of, I'm going to be effective with your capital. The structure was look, I'm invested in this company, this C-corp, you're invested in this company, this C-corp. You can get out anytime, I'm not managing your money for you. He just has all the weight off his shoulders. He can only lose his own money, there's no one else to be mad at him. If he does well, it's just for himself, but he's got a lot of money. He has the firepower of a lot of capital without it being other people's capital.

David: Yup. If the stock goes down, great, he might just buy more of the stock. He doesn't need to feel terrible about it.

Ben: Right. He’s not going to put up a negative number at the end of the year for someone.

David: Right. He does want to make sure that Berkshire never goes out of business, that's incredibly important to him. Any given year's performance doesn't really matter, that's not how he looks at things anymore.

All right. In 1971, back when they were starting to look at See’s—Warren and Charlie for Blue Chip—Bill Ruane from the Sequoia Fund called up Warren and said, hey, next time you're in New York, I want to set you up with one of my classmates from HBS. This guy that I really think you'll enjoy meeting. Why don’t you get dinner with them? His name is Tom Murphy.

Ben: This is probably the fourth episode that Tom Murphy's come up on is Acquired.

David: Yes. We've talked a lot about Tom Murphy or Murph as he is known. He’s still alive. I think he's 95.

Ben: Awesome.

David: Yeah, amazing. His partner, Dan Burke who, of course, ran Cap Cities and we talked all about them on the ESPN episode and turned it into this incredible media empire that today is pretty much at least 50% of Disney, more?

Ben: Yeah, I think that's right.

David: ESPN, ABC, all the television stations, and they do it all with no further capital investment after that one TV station.

Ben: Unbelievable.

David: With one very large and notable exception that we're going to talk about in a few minutes here. They get together, and Warren is immediately impressed with Murph and with Capital Cities. He just loves everything about this business. Of course, he's already familiar with the media industry, intimately familiar with the newspaper industry. He knows a little bit about the—if not television, the sort of moving picture aspect of the media business because of maybe the second biggest investing mistake that he made after Intel, which we intentionally skipped over in part 1 to have the big reveal here.

Ben, what is the unbelievable company that in addition to GEICO, in addition to AmEx, Buffett had briefly owned 5% of during his partnership days?

Ben: Disney, the freaking guy owned Disney and he sold it, after what? Two years or something of owning it when it reached what he felt was a good price for him to get out.

David: Unbelievable. I think it was one year. In 1966, Disney has been trading at an $80 million market cap. The Walt Disney Company at an $80 million market cap. It's not like Disney was much smaller back then, it was still freaking Walt Disney. It had theme parks and everything. Mary Poppins had just come out and made $30 million at the box office, and the stock went down because Wall Street was like, well, movies, that's a hit-driven business. In the next couple of years, comps are going to be really tough after Mary Poppins.

Ben: Mary Poppins just made $30 million in revenue and the whole company is valued at a market cap of $80 million?

David: Yes.

Ben: Unbelievable.

David: Warren though, being smart, being Warren, he's like, wait a minute, it's Mary Poppins. They're going to be able to generate revenues for years after this. Kids aren't only going to want to see Mary Poppins once and in one year, every generation of kids is going to want to see this thing, take it out of the Disney Vault.

He values the company in his head just off Mary Poppins. It's like the theme parks, all the other movies, let's assume all that is zero, that's my margin of safety. He thinks that it's still worth more than $80 million just on Mary Poppins. He puts $4 million of partnership capital into Disney, buys 5% of the company, and then of course Warren being Warren at the time, within a year he's made $2 million on that, he's made a 50% return, and he sells the whole thing.

Ben: My God. What's the quote? "Better to be approximately right than precisely wrong." Sure, he was approximately right, but you have to stretch that approximately pretty far to be like it was the right decision for you to get out of that business. I mean, okay, so the principle of that quote is, look, there's no way that you're going to be able to exactly know the intrinsic value of the company. You will never know exactly what you should pay for it either on your entry price or your exit price.

It's the margin of safety idea that you should be approximately right, so if you can get a big margin of safety then you're sort of okay on the entrance price and you're okay on the exit price, even if they're not precisely correct.

Well, you were way, way off on what the intrinsic value of this enterprise could be. Sure, you made money, but this is the sin of, I suppose it's an omission that he didn't continue to make money. In a way, it's commission because he actually had to act to sell the stock. But how different his net worth would be and who knows about Berkshire's future if he had continued to hold 5% of Disney at that point.

David: Totally. I mean GEICO, Amex, Disney, we're not even talking about Intel. These are all companies that Buffett owned a meaningful percentage of in his very early days and he didn't hang on to them.

Ben: All right. He knows about the moving picture business from owning a little bit of Disney. He's sitting down.

David: He’s sitting down with Murph.

Ben: He and Murph are hashing it out and Murph says to him what?

David: After the dinner, Murph is so impressed with Warren's management, investing mind. These are two people cut from the same cloth. He decides that he wants Warren to join his board. He flies out to Omaha, he makes a pilgrimage to go see Warren, and he says, hey, I really want you to join the Capital Cities’s board.

Ben: He would have been really impressed with Warren’s head office.

David: Yeah, exactly.

Ben: If you think about how Capital Cities is incredibly lean, this is the only person who would walk into Warren Buffett's office, look around, and be like, awesome, love it.

David: I think there's some famous story. Tim is telling the ESPN episode about how they only painted the fronts of their buildings and not the sides and the back.

Ben: That sounds right though.

David: Amazing. Warren's like, look, Tom, I love you and Dan, but honestly, the only way that I can join your board is if I were to own a large chunk of your company. This is an impasse because just like Warren, Tom equally feels issuing stock is the ultimate sin and he refuses to do it. They agreed that they're just going to be friends, but they will turn to each other for advice on their various businesses for the time being, but there's not going to be any formal relationship.

It was also quite convenient for Warren to do this because he knew that the FCC rules were such that they would not let anybody be on the board of multiple different companies that owned television stations around the country. Warren's got his eye on another company that owns some television stations, The Washington Post company.

Ben: Ah, right. I forgot they had gotten into TV at this point already.

David: Yup. They had. His boyhood dream, his paper route. The reason he's got his eye on The Post is they've just done a public offering.

Ben: What year is this?

David: This is 1971.

Ben: 1971, okay. Still only a year or two after he winds down the partnership.

David: He’s still in retirement mode.

Ben: Here's a little early carve out too. For anyone who wants an unbelievably good sort of dramatic telling of that IPO and the events around it, go watch The Post with Meryl Streep.

David: The Post, oh, it’s so good. We definitely have to do a whole episode on the Washington Post company at some point. But suffice to say for now that the story is equally, if not more, amazing than the New York Times company. The short version of it is that heading into the IPO, The Post has been in the Meyer/Graham Family for 40 some odd years at this point. The CEO of The Post, but not the chairman is a woman named Katherine Graham. Her story is just—probably many folks have heard of her—is just amazing. Watch The Post and we will tell it someday.

She assumes the role of publisher and CEO at age 46 with four children, has never worked a job in her life, and goes on to become one of the greatest CEOs in American history. Sees the paper through the Pentagon papers, through the Watergate scandal, grows the value of the company enormously. She was one of the CEOs that Will Thorndike profiles in The Outsiders book. So great.

Warren sees all this from the outside. He's got the attachment to The Post. The IPO is happening and he says, this is going to be my opportunity to come back. He reaches out to her initially with an idea. He wants to tread carefully. He's very respectful of Kay, the Graham family, and what they've built. He also knows that it's a dual-class share structure. They have control. No matter how much stock he buys, all the decisions in the company are getting made by the Graham family just like at the New York Times. He reaches out with an idea and says, I've heard that the New Yorker, the magazine, is for sale. Would you be interested in maybe doing a 50–50 bid JV to buy it together?

Ben: She has no interest in that, right?

David: She’s like, I'm learning how to be a CEO here, we're taking the company public, The Pentagon papers are happening. No, it's very nice to meet you Mr. Buffett from Omaha, but thanks but no thanks. Warren’s like, it’s okay, I've gotten to know her, I've got my foot in the door.

Two years later, the person who was chairman of The Washington Post company, Fritz Beebe, who I believe was a longtime family lawyer of the Meyers and the Grahams. He dies and his estate is being liquidated of which there's a lot of Post stock in it. Warren arranges to buy a $50,000 share block from the estate.

Ben: Which has to feel underhanded, right? If you're the Graham Family, you're like, sorry. Wait, who's buying what?

David: Yeah. Who? This guy at Omaha? He'd also been buying on the open market too and he now owns 5% of the company. He's having dinner with Murph, he's already got his plans in motion here. He writes Kay a letter, remember, they've already met. He says, this purchase represents a sizable commitment to us (being Berkshire) and an explicitly quantified complement to The Post as a business enterprise, and to you as its Chief Executive. Writing a check separates conviction from the conversation. I recognize that The Post is Graham-controlled and Graham-managed and that suits me fine.

Ben: He already got this beginning of him wanting to be an owner of wonderful businesses without controlling them and leaving family owners in control.

David: Exactly. He wants to be a partner to great managers and stewards of generational businesses. Kay, nevertheless, probably is a little spooked.

Ben: I bet. You get an activist investor who suddenly sends you a letter and says, by the way, I own 5% of your company.

David: Yup. You're just so great, it suits me fine that you control it.

Ben: It probably also is known at this point the way that he sort of raided the textile mill company of Berkshire Hathaway.

David: If you go digging on Warren, you can find some skeletons in the closet.

Ben: Yup.

David: She agrees to meet with him briefly when she's out in Los Angeles and Warren’s thrilled. She shows up at the meeting famously looking like Kay, she's Kay Graham, she's become the most prominent.

Ben: Stately.

David: Stately, one of the most prominent people in the Washington social scene. She's probably the most powerful woman in America at this point in time.

Ben: Hanging out with presidents, yeah.

David: First-name basis with everybody in Washington. Warren shows up looking like the bedraggled, wrong-size suit guy from Omaha, from the Hills. She thinks this is just hilarious. They hit it off right away in this second meeting. She says you know what, maybe this Warren guy isn't so bad. Why don't you come back out and meet with me again in Washington?

He comes back out to Washington, shows up right in the middle of the Watergate proceedings where Kay and her publisher, Ben Bradlee, pulled an all-nighter the night before making decisions about what to publish about Watergate. She still makes time for him. They go out to lunch, and then afterward, Buffett presents her with a contract that he's had drawn up that legally binds him and Berkshire that they will never buy another share of the post without the Graham family's permission. By the way, by that time, Warren already owns 12% of the company because he's kept buying.

Ben: In exchange for what? Why would he say, we voluntarily…

David: Not an exchange for anything. He just really wants to be on Kay’s good side and he really, really wants to be on the Washington Post board. He's kind of presenting. I think he uses the term, he invokes Little Red Riding Hood and the wolf. I may look like the big bad wolf, but we're going to take the fangs right out of the wolf. I’m never going to buy another share without your agreement. I've had this contract drawn up.

It's kind of funny, but Kay loves it and they seal the deal. She says well, okay then. I'll start calling you for advice. What Warren really wanted her to say was, why don't you join the board then as a 12% owner of the company but she doesn't. Warren desperately wants to get on the board.

Ben: Why does he want to get on the board? Is it an emotional thing? We haven't talked about why Warren views a paper like this as such an incredible business. Is it worth taking a moment on that?

David: I think the board thing specifically is probably an emotional thing. But the paper, yeah, at this point it's not only the dominant paper in Washington, but it's one of the foremost publications in the country if not the World after the Pentagon Papers and the Watergate scandal.

Ben: It both has that franchise effect in Washington? I mean, it is the paper for that city, which I think comes from a little bit of a different story with the Buffalo Evening News, which I don't think we'll get to today. But Buffett famously referred to being the only paper in town or the biggest paper in town as an unregulated tollbooth that you have. Where you basically have pricing power and everybody's going to subscribe to the newspaper, so it's a license to print money.

There's definitely his notion of a franchise town newspaper is awesome. This is one of the ones in the most important town in America, and now it has this national/international reach. Not to mention, all of these great characteristics of a media business where you create the content once and then it's infinitely replicable, and of course, there are delivery costs, but it’s a freaking good business. It's wonderfully defensible.

David: I think specifically on that defensibility of the newspaper part of the business at the time and the winner-take-all network effect in any given geography, is that if you're able to amass enough readers—it's just like the stamps business—then the advertisers want to be where the majority of the readers are. And once you get the ad dollars flowing in from the advertisers, then you can offer deals.

It's like the group buying clones in China. You can offer subscription deals to enough subscribers to grow your subscriber base, that you can crowd out all the competition, and the market just naturally tips to a single player. That's happening in Washington, a large city, a fantastic newspaper franchise.

Ben: All right. He's built himself a 12% position. He really likes the company. He wants to get on the board, but he's not on the board.

David: He's not on the board. What happens next is like a middle school dance. It's hilarious. He doesn't have the courage to say to Kay in the meeting, hey, I’d really like to join the board and I presented you with this contract. Instead, he calls up Murph and he says, gosh, Murph, I really want to join the board of the Washington Post, but Kay doesn't seem to be getting the message. Do you think you could go see her and tell her how great a guy I am, that I'm really not so bad, and I really do want to join the board if she would just ask me.

Ben: Wow.

David: Tom goes to see Kay and tells her, and she's like, oh my, well, yeah, I guess it would be nice to have them on the board. I really respect him. Well, but I can't really just send him a letter and ask him. He should really ask me. Warren is like, I'm going to invite Kay out to—by this point in time, he and Susie have a house in Emerald Bay in Laguna Beach in Orange County in California. I'm going to invite Kay out for a weekend at the family house in California, and it's going to be perfect. I'm going to host Kay, this socialite, to make it perfect for her. At the end of the weekend, I'm going to ask to join the fort. He's really putting on a show for Kay.

She comes out, she's a little puzzled. The whole weekend goes by. He doesn't ask, he doesn't ask. Then on Sunday morning, Kay finally turned to Warren and said, I hear you want to join the board, but I'm waiting for the right time to bring it to my other board members. Supposedly, Warren looks at her with longing eyes and says, Kay, when is the right time then? They fall into each other's arms and she says, oh, join my board.

This is the beginning of an immense friendship between them. They become incredibly close for the rest of Kay’s life. They go to events together. They spend weeks at a time together in each other's houses, in each other's apartments in various cities. It's never been written whether this relationship was purely platonic or also romantic, unsure, but it certainly becomes an amazing relationship. Warren would stay on the board of The Post for most of the next 37 years.

Ben: I didn't realize it was that long.

David: Yup. The 12% stake that Buffett bought for Berkshire cost $10 million. In 2014, to put a bow on The Post investment, Berkshire sold its stake in what is then Graham Holdings, all the rest of the Washington Post businesses after Bezos bought The Post itself. Berkshire sells its stake for $1.1 billion, which is only a 12% IRR from the initial $10 million investment. However, the post has also been paying dividends all throughout those 40, 50 years. I don't have the data on how much Berkshire received in cash flow in dividends from The Post. Suffice to say, it was an excellent investment on Warren’s part.

Ben: Ten million for $1.2 billion?

David: One point one.

Ben: One point one. Wow, by that point, it’s funny, it's actually not a big holding for Berkshire, relative to everything else they owned by the time Bezos buys The Post.

David: Yeah. Bezos ends up buying The Post, I think, for $250 million.

Ben: Something like that.

David: When that happens in 2013, 2014. Certainly, the value of the post during the heyday of the newspapers of the ‘90s and 2000s was much, much, much higher than that, and the cash flows that it was spinning off and sending back to Berkshire and other shareholders were significant.

Ben: Did you hear, by the way, a little Easter egg that in the annual meeting, one of the questions that Becky Quick from CNBC was written by Don Graham?

David: No, I didn't see that. Amazing. Don, of course, being Kay’s son who took over. I think he became CEO before her death, and then after her death became Chairman and CEO.

Ben: All right. That's the Post. Let's reset a little bit on the time frame in Warren's evolution here. Everything's not yet consolidated under Berkshire, right? Who was accumulating the shares of The Post?

David: That was Berkshire.

Ben: Okay, but he's got this whole Blue Chip stamp thing going on?

David: Yup, and Diversified. We've been alluding to the hot water that they get into with the Feds. Right as Charlie's closing down his partnership.

Ben: This is like 1975-ish?

David: Yeah, in 19775. He and Warren got a call from one of Charlie's former partners at MTO, Chuck Rickershauser, who had done the See’s deal for them. Chuck says, hey guys, I just got off the phone with the SEC and they're considering pressing charges against you for securities violations for this Russian doll version of corporate structure that you've got going on here.

Chuck would spend weeks putting together a corporate flow chart of all these different entities and who owns what. We'll try to link an image of it in the show notes, it's amazing. There are so many different subsidiaries and subentities, and he looks at it and he says, there's got to be an indictment in here somewhere, guys. I don't know what you've been doing.

Ben: I remember reading this when I was doing the research. The Buffett image that you know of today—the sort of folksy, near benevolent, multi-billionaire or multi-deca-billionaire (I don't even know the right phrase for it, would be a hundred billionaires if he wasn't donating so much to the Bill and Melinda Gates Foundation. That he was in hot water with the SEC. It's just the last thing that I would have expected as sort of the Buffett novice before I started doing the research.

David: When I was reading about this, I was picturing Warren and Charlie like Tupac in Picture Me Rollin’, the Federales want to see him dead.

Ben: Now, David Rosenthal, that is an image I can never unsee.

David: You can never unsee that, but it's so apt. Literally, the Feds are like, I don't know what's going on here, but I don't like it.

Ben: Clue me in. It was something to do with the fact that they ended up paying more for something when they could have actually paid less.

David: My understanding is I think the Feds had sort of been on the tail because Warren, especially, now becoming so known. He's high-profile, right? He's on the board of The Washington Post. How much more high-profile with agencies in Washington can you get? The investigation comes to center of a company called Wesco Financial that Blue Chip had bought. After See’s, they kept looking for other great businesses, and that they’d bought a stake in Wesco.

Ben: Is this some kind of bank? Like a financial services business at this point?

David: Yeah, it was a financial services business in Southern California. What happened was there was another company, Financial Corp Santa Barbara, that had a buyout offer for Wesco. Warren and Charlie thought it was undervalued, stepped in and scuttled the merger, and ended up investing through Blue Chip in Wesco instead. There's still a stub, kind of public.

Ben: They basically backstop the price because they’re like, we hold a bunch of this already. We're not going to let you buy it for this really cheap-per-share price, so we're going to come in. We're going to lead another investment round effectively in it or buy some more of it at a higher price to make it so that you're not going to get away with this steal that you're conning in.

David: The way it goes down is, through their work in commencing the board and the family that owned most of Wesco, they convinced them to drop the merger. When the merger dropped, the Wesco stock fell, of course. That's when Warren and Charlie invest, but they feel bad about tanking the stock price.

They worked out a deal with the company with the family that they'll buy shares and invest. I can't remember if it was at the merger price or maybe even slightly above. The Feds are like, wait a minute, there's got to be some shady going on here because (a) you scuttled the merger, (b) you then could’ve just bought the stock for lower but you paid this artificially high price. What's going on?

Ben: Every other time we're investigating someone, what they ended up doing was buying the stock as cheap as possible after they precipitated an event that made the stock price fall.

David: They're very confused. Warren ends up getting subpoenaed and testifies that they paid the price they did because, "It was important how Wesco management feels about it." Now you can say, 'Well, we own the controlling interest so it doesn't make any difference.' But Louis Vincente, who is the president of Wesco, doesn't really need to work for us. If he felt that we were slobs or something, it just wouldn't work."

Munger, when he's testifying, of course, invokes, who else but Ben Franklin in his testimony. He says, "We didn't feel our obligation to the shareholders was inconsistent with leaning over backward to be fair. We have that Ben Franklin idea that the honest policy is the best policy. It had sort of a shoddy mental image to us to try to reduce the price."

Ben: It's almost like the notion of the VC founder-friendly thing where we're saying, hey look like, let's take a super long lens here and say that the way that we're going to maximize value for everyone—including ourselves way down the line—is by making sure that management likes us as shareholders, feels that were deferential to them, and not capturing every little bit of value we possibly can out of their company at their expense.

David: He's totally right. This is something I've always wondered from afar looking at Berkshire. They buy these companies that are, if not wholly family-owned businesses, many of them are public companies but have a large family controlling ownership like Wesco, like The Post. They buy these companies and then the family or the current management often stays on and keeps working there. I'm like, why would they do that?

This is the key because they're playing the long game. What they really want is great managers who built great companies to stay running them. The way to do that isn't to negotiate every last dollar out of them.

Ben: Or even if it is, I think we're conflating two things here a little bit. I think Berkshire does make sure they get a great deal when they buy a family-owned business outright. They’re going to buy low. But they either just believe that the business has so much future upside in it that they're willing to meet in the middle on price, or they are very good at identifying managers who have a splinter in their mind to continue to do the work.

They're very good at this shrewdly evaluating, even if this person no longer holds a single share of their company, they’re going to show up for work every day because this is their life's mission and purpose. I don't think that's what was going on in the Wesco Financial situation. But I think when they buy these family-owned businesses, there's a lot of that in the evaluation of the business.

David: They definitely compensate those managers well for their continued performance. I think that was part of it here too because it's almost like this is part of the upfront compensation is the price that they're going to pay for the company.

Ben: This whole thing sucks though. This is like a multi-year drawn out thing with the SEC. It's hard for them to get on with their business and every other facet because they have this thing going on.

David: Not to mention, it's not great for their reputation when they're going out trying to talk to the Kay Grahams of the world and saying, hey, no fangs here when the SEC is investigating them. They end up sort of coming to this gentleman's agreement with the Feds where Blue Chip, which had been the primary player in the Wesco saga. Although I think Berkshire and maybe Diversified we're also buying shares too.

Ben: Of course.

David: They’re just part of the problem. Promises not to do it again, something like this.

Ben: It’s like no admission of guilt, but we also won't do it again.

David: We won’t admit that we did it, but if we did do it, we won't do it again. Most importantly, Warren and Charlie agree to start taking steps to "simplify" this complicated rat's nest structure of companies that they have.

Right off the bat, they finally merged Diversified into Berkshire, which they had wanted too anyway. By this point, Diversified owns a large chunk of Berkshire shares. Charlie gets installed as the Chairman of Wesco to be more arm's length than Warren. They make it a gold and merge Blue Chip into Berkshire as soon as all of the remaining legal suits wind up and settle here. That actually takes a while, but it finally does happen in 1983.

Ben: Wow. That really took a while then.

David: It really does take a while. I'm not sure exactly why, especially since the SEC wants them to merge it all into one company. Warren and Charlie want to as well. For whatever reason, it takes until 1983.

Ben: All right. They're making an effort to clean things up. They've got this SEC thing behind them. It's the late ‘70s. There's another chapter on the horizon for Berkshire.

David: Oh yes. Is there ever. And indeed is a chapter involving an old flame, the original crush of Warren's. I think this is the thing about Warren. I don't know about his romantic life and situation. It's certainly also complicated. There's a lot about that in The Snowball and elsewhere, not the scope of our show to get into. But he certainly has a serial love affair with companies.

Ben: Somehow, there are all these businesses that he has like a romantic flame for from his childhood and from various parts of his life that just so happened to be these unbelievable businesses. Where it's a Furniture Mart, it's the soda he drank growing up, or it's the newspaper he delivered. Investing in each and every one of those proves to be like a once-in-a-generation unbelievable business.

It's almost like a Big Fish in a way. This man's life is just surrounded by these six sigma events or Forrest Gump. What are the odds that the smartest guy that the army ever surveyed or the Air Force ever surveyed in that generation, IQ-wise, happens to also be born in Omaha and then get introduced to him.

David: Work at the grocery store.

Ben: It's just crazy. Worked for his grandpa.

David: It's also funny that Warren and Charlie, more Warren here than I think Charlie. He's so smart and so analytical. Charlie Munger thinks Warren is the smartest person he's ever met. That's saying something. At the same time, Warren is also so emotional and nostalgic, and has this—I think you said it in the last episode—sense of what he looks for in companies and what he absolutely wants to be himself is viewed as an artist painting a painting. Of course, we're talking here about GEICO.

Ben: If we're going to go back into insurance here, David, I can imagine no better time than to thank our friends at Vouch. You think I should do it?

David: I think we should do it.

Ben: All right. Well, just as last episode insurance is my cue. This time it is not national identity but GEICO that has brought upon us an opportunity to thank an unbelievably awesome modern insurance company for startups, Vouch.

Vouch provides business insurance for top startups. You all know the story. I have reached out to one of the cofounders of Vouch for coverage for Acquired as a business since the founder’s a listener and member of our community. The experience was awesome versus every other experience I had in the past getting business insurance for startups. They were the fastest experience in the industry. They have next-day coverage. Their digital app takes 10 minutes to get coverage.

They have proprietary coverages that are engineered specifically for startups. They're backed by Munich Re so you get the benefit of a great user experience in the product, the stability, and the backing of a large and well-known insurance company. Their service is great. You can get expert guidance via Zoom, chat, call, or email to work with a licensed insurance advisor. They are backed by incredible investors like Ribbit, YC, SVB, and Index.

If this sounds interesting to you, you're a company founder, you may be founding a company in the future, you might be taking investment for the first time and having something specified in your investment documents that say, you really should have business insurance and hey, you don't, so go figure that out. You can get an extra 5% off of coverage by clicking the link in the show notes or going to vouch.us/acquired to learn more.

David: I think the only thing that would make Vouch more attractive would be if they had some sort of small, cute, reptilian mascot.

Ben: We know people there. We know some of their top folks. We will channel that David.

David: We’ll put the request in. Great.

Ben: Yeah, see what we can do.

David: Back to GEICO. At this point, it was 20 years or so, two decades since Buffett had tragically sold his GEICO stake. The company grew immensely. It made the Acquired-like growth in its target market when we went from just acquisitions to telling the story of all the great companies.

Ben: It’s like, where are you going there?

David: Beyond just targeting government employees to opening up to anybody. Non-government employees can also get their auto insurance through GEICO. This is huge. The problem though was that in chasing this growth in this new market, the tight underwriting and pricing of risk of all of these new customers didn't quite keep pace.

If you remember, one of the reasons why GEICO was such a great business was through the customers that they were targeting. Government employees, for whatever reason or another, happened to be much safer drivers than the average population.

Ben: It's a known data set, it's a pre-homogeneous group, and it's a lower risk homogeneous group.

David: Totally. They didn't really update their pricing enough as they broadened out to the rest of the population. As we talked about last time in insurance, there is never any such thing as a bad risk, but there is such a thing as a bad price.

The doubly compounding problem for an insurance company when you've been mispricing your risk over many years is that just like you get the amazing benefits of the float business model where you get the money upfront, you get to use the money before you need to pay out claims. When you misprice your risk, that ripsaws on you. Once you realize that you're going to be on the hook for a lot more dollars than you have capital available, you're in for a long period of pain because the premiums that you got are already in the bank. You can't go get more money from these customers.

Ben: That’s brutal.

David: But you know that you're now facing years of streams in the future of more money that you're going to have to pay out than you have.

Ben: It's like you just let someone walk into your casino without testing the game, and it turns out, the game actually pays out the people who are playing at the casino more than it does to the house.

David: Totally. You're not able to change your odds or the structure of your game for a very long time. You can only change it for new customers who come in.

Ben: The analogy breaks down somewhere in here.

David: It's bad, suffice to say. It's bad and it’s not getting better any time soon. In 1976, the company announced a $190 million underwriting loss, the largest in its history. Maybe even the largest in auto insurance history at that point in time. They eliminate the dividend for the company because they need to conserve all the cash that they can to deal with this.

Wall Street figures out they don't have enough capital to cover future losses. This is like a crisis situation. Insurance regulators descend on the company. The stock drops from $61 a share to $2 a share. Can you imagine that? What's that like? 90% value destruction?

Ben: You want to get to the exits before anybody else does if you're a shareholder.

David: Totally. Warren, fortunately, hasn't had all of the cigar butts. Ironically, Ben Graham with GEICO philosophy was beaten out of him. This piques his interest again in GEICO. He thinks he's found another Amex-type of situation.

Ben: Where is Buffett to say that they're going to recover from this. That he’s not going to catch the knife on the way down.

David: Right. He wants to find out, can this actually be turned around? Unlike the salad oil thing where it was pretty easy to figure out like—this is going to be good—that's not going to be the case here. There is no way to avoid years of pain ahead that GEICO is going to go through. But there is something that Warren sees happening that the rest of the market doesn't quite understand yet. Which is that GEICO did a good move, fires all of its management team, and brings in a new CEO. Literally grizzled veteran of the insurance industry who Warren had heard about named Jack Byrne. This guy is a legend.

Ben: Does Warren have anything to do with installing him?

David: No. This is Warren just watching from afar. He's waiting to see if there's something that a glimmer of hope that maybe GEICO could make it out of this because the stock is super attractive at $2 a share.

Ben: This is their current board figuring out what to do here.

David: Yup. Partially at the, shall we say, request of the regulators. You guys are really getting yourself up a creek here. Jack had been one of the top execs at Travelers Insurance before he resigned in a huff when he was passed over for CEO.

Ben: Wow, that's going to come full circle.

David: Totally. It’s absolutely going to come full circle.

Ben: Listeners, remember Travelers Insurance just so David and I aren’t making inside jokes here as we get to the end of the episode.

David: Jack is the man for the job. He comes in and he engineers a plan to go out to all the other auto insurers in the industry. Basically argued to them, hey, if GEICO goes under, yeah, you'll lose a competitor but it's actually going to be terrible for you because if we go bankrupt, all of these underwater policies, the regulators are going to make you guys absorb them. You don't want that.

Ben: Oh man, was that true? Is that what would happen?

David: I mean, you can't operate a motor vehicle in America without car insurance. If your insurer goes under, you need insurance and especially if you got claims underway, what's going to happen to those if the insurance company behind those claims goes away?

Ben: Interesting.

David: This is the argument that Byrne makes to the industry and it mostly works. The deal that he proposes is to get all these other auto insurers, not to buy GEICO, but to reinsure GEICO for some of these future losses off of their own balance sheets.

Ben: Remind us what reinsurance is?

David: Reinsurance is anytime an insurer is selling off some of their risk in their portfolio to another insurance organization. There are large reinsures like Kettle that we've talked about on the show. One of my angel investments. All they do is they buy risk off of other primary insurers’ books, but primary insurers can also buy risk off of each other's books.

Ben: This is just to keep bringing it back to Vegas for fun, if a sportsbook messes up and sets the line in the wrong place and then they up 70/30 on whether the Patriots are going to win or the Buccaneers are going to win. I can’t remember if they were playing the Super Bowl but just throw names out. They will go to another casino and bet the other side to basically make it so that they're sure they're not going to make as much money on an expected value basis. But now, at least they're not overexposed on one side versus the other.

David: Exactly. In your example, I mean, Tom Brady's going to win either way. That's the bet to make.

Ben: Whichever team currently has Tom Brady is the answer to that game.

David: There's probably a way to make that bet somewhere. I love it. We digress though, we digress. Buffet is like, that's a good plan. That's a creative plan. That could work. He gets Kay. Remember GEICO's in Washington and Kay knows everybody in Washington. Buffett doesn't actually know Jack. He gets Kay to broker an introduction for them. They meet at Kay’s house in Washington. Buffett grills Byrne for hours and he's like, oh yeah, this guy's going to do it.

Just like the first time that Buffett met GEICO, when he goes, takes the train down, he meets Lorimer Davidson, and the very next day he liquidates 75% of his portfolio to load up on GEICO.

Ben: Ben Graham.

David: The next day after the dinner with Byrne at Kay's house, he buys $4 million of GEICO stock at $2 a share. He loads up, he's all in.

Ben: How much of the company is that?

David: I didn't actually disentangle that versus what he would buy in what's going to happen next. It's some meaningful percentage, but after what happens next, Buffet is going to end up with a third of the company.

Ben: This is a high single-digit, low double-digit that he just bought at the company.

David: Yeah, probably in the double digits. Now, GEICO is backed by Buffett. Byrne is the man for the job, things are looking up, but they still need capital to operate. They're out of money. They're going to sell off some of the risks, but they've got claims that are happening now that they need to pay off. They need to go raise money.

Buffett tells Byrne to go up to New York and do the rounds with the investment banks and line somebody up to do secondary equity offerings out there. None of the big established banks wanted this situation except for one. There's one bank that is willing to take on enough risk and enough risk to their reputation of what could end up being a broken offering here. Which all the white shoe banks are like, we don't do broken offerings here.

Ben: I don't actually remember who this was. I'm going to guess by the relationship that gets forged for future events that it's Salomon Brothers.

David: It is Salomon Brothers, indeed. The old bank of Liar's Poker, Michael Lewis fame, which we will definitely come back to in a sec. They're the only bank that is willing to underwrite what ultimately ends up being a $76 million convertible debt deal, convertible into equity, that they underwrite. And it’s not just Salomon Brothers, it's one specific person at Salomon Brothers. A guy named John Gutfreund is a rising star there. Remember that name folks.

Gutfreund and Salomon underwrite the $76 million deal. Buffett flies up to New York to sit down with Gutfreund and tell him, hey look, I know this is going to be a tough deal to get through. Even Salomon Brothers famous sales distribution channels, even your famous [...] that's out there if things go sideways, Berkshire were willing to underrate the deal and do all of it. But we're going to do it at a much lower price than what you go out with if the deal is broken.

All right, great. I'll go to trade on your name then at least and say tell all my clients, hey, Warren Buffett already owns a large percentage of this company and he's willing to...

Ben: Okay, what do you mean trade on his name? What do you mean Buffett will do it all but at a lower price. He would buy the whole offering? If they're trying to sell a whole swath of stock at a certain price, is this the convertible preferred that they're selling?

David: Yeah. I think it's convertible debt, not convertible preferred.

Ben: Okay.

David: Essentially what Buffett says is he's like, look, I'm good for the $76 million, but I want you to go out there and try and get this deal done at less dilution, essentially a higher price on that convert.

Ben: It's like when an insider in a venture round tells the company, hey, I'm good for my pro-rata. In whatever round you raise, go raise the round, go get a price. If you were to lead an inside round, I’d lead it if you wanted to do an inside round. But it won't be at the price where you could go raise your external round.

David: That's exactly what's going on here. Gutfreund’s like, all right, I can work with that. They go out, Salomon Brothers sales and trading famous, aggressive sales and trading desks. They get the deal done, it ends up being oversubscribed. Buffett does end up, even though it's oversubscribed and goes out at the price that they wanted, Warren’s like, all right, I think this company is going to make it. He ends up buying 25% of the deal even at full price for Berkshire.

Even though they just issued new convertibles into equity securities, the stock jumps to $8 a share because people realize, hey, this is good news.

Ben: This thing could make it out alive, and if it does, damn good business.

David: Yeah, exactly. GEICO has now got two of the three problems solved. It's capitalized, it’s got enough money to make it through, it’s laid off a lot of the tail of risk in their current book over the coming years with the reinsurance deals that they do. But it's still not pricing right. The thing about auto insurance and most consumer insurance is you need licenses to operate in any state. And part of the licensing process is you have a license to sell insurance at a certain price. You can't just arbitrarily change your price on your customers. The regulators don't allow that. It's a super weird market. It's not like we can change the price of the LP Show tomorrow if we want.

Ben: We’re only allowed to make a certain amount of profit too. There is a cap on the profitability of insurance businesses.

David: Exactly. This is Byrnes’s time to shine. This is amazing. This is my favorite moment I think of this whole second episode. He goes out to all the states individually and he explains the situation. He’ll be like, hey, we were mispricing. We got to raise prices on consumers, and some of the states are okay with it. Apparently, New York right off the bat is like, yeah, we get it. Okay, fine. But some of the states are playing hardball and in particular, New Jersey is playing hardball.

Ben: It’s the Florida of the north.

David: Yeah, Byrne himself is from New Jersey. He's like, all right, you want to do some mafia tactics here, I’ll do some mafia tactics. I'm just going to read what happens next from The Snowball because I can't do this any better than Alice did here. "Byrne marched into the New Jersey Commissioner's Office with a copy of the company's license to operate in the state in his pocket and told Sheeran (the commissioner) that GEICO must have a rate increase." This is now a quote from Byrne. "He had a sour-ass, little wizened actuary at his side who had been fired by some insurance company and had a bone to pick."

"Sheeran said my numbers didn't justify a rate increase. 'I did all the arm-waving and stuff that I could, and Mr. Sheeran was intractable.' Byrne pulled the license out of his pocket and threw it on Sheeran's desk, saying, 'I have no choice but to turn in the license,' or something to that effect with more four-letter words. He then drove off to the office with his tires screeching, sent out telegrams to 30,000 policyholders in New Jersey canceling their insurance that day, and fired 2000 New Jersey employees in a single afternoon, before Sheeran could go to court and get an injunction to stop him."

Byrne says, "'It showed everybody, all audiences, I was serious about this. And that I was going to fight for the life of this company no matter what, including walking out of a state, which wasn't done back then.' Byrne’s impalement of New Jersey had exactly that effect. Everybody knew he was serious."

Ben: So do they end up actually just vacating New Jersey and just didn't serve policies there?

David: Yeah. They literally vacate New Jersey, they vacate a bunch of other states. By then he was like, look, this is war. We got to reprice, so either we're going to burn the house down and vacate these states, or we're going to be allowed to reprice. GEICO by the end of this has shrunken down to only seven states.

Ben: It’s like the original Travis Kalanick.

David: I know. It's amazing. Has shrunken down to only seven states. Byrne has completely swapped out everybody in the company. Famously, a lot of the middle and lower management in the company was from the old days, undisciplined days. Apparently, at one point, the then-existing HR Director is giving a speech in front of the company and Byrne gets so upset that he storms on stage and fires him on the spot. Literally gives them the hook, takes him onstage, points to somebody in the audience, and says you're the new HR Director. Breaks them up on stage. Amazing.

Ben: Is Lorimer still there at this point in history?

David: Lorimer is long retired at this point in time, but he's cheering on from the sidelines, and he's advising Byrne and Buffett behind the scenes.

Ben: Wow.

David: Amazing. They shrink GEICO down to only the seven states and DC that let them change the rates, and they write the ship. They priced the policies appropriately. The company gets profitable. It stops losing money. It starts growing again and then would go on to become—what did Warren say in the annual meeting this weekend? I think that they have what?

Ben: Second largest insurance company.

David: Yeah, Progressive is slightly larger, but I think they each have about 25% of the US market, something like that. Incredible.

Ben: He spent $47 million from 1976 to 1980 to buy, is it about half the company?

David: Yes, by the time the debt offering closes and then when the share price jumps, I assume the debt converts at that point. Berkshire owns 33% of GEICO, but because he's Warren and because this is now one of his jewels, he runs the playbook that he's also helping Kay Graham run at The Post—GEICO starts buying back its own stock. By the mid-90s, we'll get to this later in the next episode. By the mid-90s, Berkshire had 50% of the company without putting in another dollar.

And then in 1995, Berkshire bought the rest of GEICO that it doesn't own for $2.3 billion. Half the company for 47 million and half the company for 2.3 billion. Either way, they get a hell of a deal because estimates are that GEICO's worth probably about $50 billion today, maybe more. That's $25 billion of value, assuming that's 50 on $45 million and $25 billion in value on $2.3 billion.

Ben: Either way pretty good.

David: Either way pretty good. Warren's like, look at me now Feds.

Ben: Listeners, even though this is going to be in the final part of the trilogy, we do have to tell you that in 1996, the $2.3 billion that was used to purchase the second half of GEICO, you might be saying to yourself, why did it take so long if he really likes this business forever?

Berkshire had a lot of cash tied up in other stuff for a while, and the thing that happened pretty much immediately before this $2.3 billion transaction for half of GEICO was that Warren had a big investment in Capital Cities and Disney came in and bought ABC Capital Cities. Which then, of course, in that outright sale all the proceeds went to good old Berkshire. That was a little bit more capital than $2.3 billion, but about the same amount that suddenly, they had to play with to go put to work somewhere else and GEICO was where they decided to go put it to work.

David: What better jewel to put that capital into than GEICO. Amazing. It’s funny, I said in the first episode something that I was totally convinced was right at the time, but now maybe not. Where I said that God, if Warren had just held on to GEICO and not sold, imagine what his returns could have been. Who knows what would have happened otherwise. But GEICO almost died. If he had held on, would he have had this ride anyway and ended up here? He got to buy back in at $2 a share.

Ben: Totally. Yeah. That’s a good point. He did get it on an extremely low basis even though he skipped a few decades of compounding and growing there. It is also worth pointing out that despite the fact that it is a Buffett mantra to hold great businesses that you believe in forever, he can dump a stock just as fast as the next guy. The way that he dumped all the airline stocks at probably the low point of the COVID stock crash. It was really interesting hearing you on stage last where he was totally unapologetic for that. He thought it was totally the right move.

You could imagine that he easily could have been convinced that that was the right thing to do in the GEICO situation too.

David: Totally. All that matters is the long run, Charlie Munger would say. I think it’s Charlie quoting John Maynard Keynes that in the long run, we’re all dead. But in the long run, GEICO becomes one of the major jewels, if not the most important piece of Berkshire. Especially given all the float that they generated. I guess that is the big thing that Berkshire and Warren miss over that 20-year period where he’s not invested in GEICO is using the float.

Ben: Yup. There is a Playbook theme I want to pull forward here, and it’s actually two themes and it’s important to know how they’re different. The first one is identifying things that have far less risk than the market perceives them to have. That’s things like American Express, that’s things like him realizing that brands are more powerful than value investors give them credit for, or the magical thing of a monopoly franchise newspaper.

But then there’s this second category of identifying things that should you act, will have far less risk than the market perceives them to have. Even more importantly, if you uniquely have the capability to act, then you actually can be value-creative. The thing that he did with GEICO in making sure that that financing got done, there’s not a lot of people out there whose name can be traded on to get an offering done like that.

Buffett’s willingness to both strategize and then put his name on the line. Of course, his name wasn’t really in the line because otherwise he just would have gotten this [...] deal. But doing the thing that he was uniquely suited to do and able to do meant that in a self-fulfilling prophecy way, the investment was way less risky merely because he was involved.

David: Yup. Oh boy is that ever the case, and does Warren ever know it.

Ben: David, I figured I’d set you up for that next story we got coming.

David: You tossed that ball in the air and I cannot wait to slam it. But before we get to Warren getting punch drunk on his own reputation and ability to save businesses. The GEICO situation wrapped up around 1980 and off to the races. The rest of the beginning of the ‘80s is just more goodness for Warren, Charlie, and Berkshire.

Finally, when Paul Volcker becomes the true Chairman of the Fed, first at the end of the Carter Administration and then under the Reagan Administration, he enacts the correct fiscal and monetary policy to reverse the terrible inflation that has been happening. The ‘80s just became—we’re both children of the ‘80s—an immense period of prosperity, the ‘80s and ‘90s, for America.

The ‘80s in the go-go years, this is Wall Street movie, this is excess, this is everything. It’s a good time for Berkshire in Omaha too. We won’t go into all the details, but they buy the Nebraska Furniture Mart from Mrs. B. Incredible story. She then gets upset with the way her children, who are in their 80s at this point or 70s are running the business. She leaves, starts a competitor across the street at the age of 95. Berkshire has to buy it back for $5 million and sign a non-compete with her at age 95. Amazing.

Ben: There's the Buffalo Evening News in here, sort of at the early ‘80s, is that the early ‘80s?

David: Early ‘80s, yup.

Ben: He gets into a good old-fashioned newspaper war. He's trying to be the franchise newspaper in the city, ends up sinking tons of capital, and gets into not a fight but a few disagreements and has some words with Charlie about the right things to do. But Buffett’s a committed guy. There is a bunch of stuff that happens here that we could do 10 episodes and wouldn't have time for it all.

David: Totally. He goes to war with the efficient market hypothesis theorists, which is amazing. At Columbia's 50th Anniversary event of the publishing of security analysis, he gives this talk where he just calls it The Superinvestors of Graham-and-Doddsville that gives this long talk eviscerating the efficient market hypothesis folks economists. Basically their hypothesis is that all markets are efficient and that changes in price are simply volatility and around the efficient price. That volatility equals risk, and so that is market beta. That's all there is.

If you're investing, there is no such thing as investing acumen. You're just taking volatility risk in the market. Charlie has a one-word retort to that, which is bullshit. Warren goes through and eloquently explains why that's wrong.

Ben: They just have a lifetime of investment results to prove it. They actually can generate alpha. Otherwise, you have to believe that Buffett has flipped a coin and it's come up heads 100,000 times in a row. You're into these crazy probabilistic scenarios where at some point, it's too many standard deviations away from the mean for you to believe that it's possible.

David: Yup. The reason this is important for what's about to come in, all this is theory. This is like economic theory, but it has a very, very important real-world consequence in the ‘80s. Which is that people who use to their advantage the academic thinking behind the efficient market hypothesis that risk equals volatility, realized that if risk equals volatility and you can't get alpha, the way you can get more returns if you take something that has a certain degree of volatility and then you lever the crap out of it with debt, you magnify that volatility, and then you can magnify your returns if you arbitrage that.

This is when the ‘80s are the debt-fueled decade. Mortgage-backed securities get introduced. All the junk bonds, Michael Milken, DLJ, and corporate raiders, and corporate takeovers are all happening.

Ben: Massive leverage buyouts. You get barbarians at the gate.

David: Yup. RJR Nabisco, everything. Buffett and Charlie are sitting and looking at this and they're like, volatility being risk is nonsensical. Risk is risk that you go out of business, and introducing debt into the equation, far from not changing your risk. It massively increases your risk because what causes you to get game over? It's when you go bankrupt and you can't pay off your debt.

While they're out there espousing this philosophy, in the meantime, they did the capital cities deal finally with Tom and Dan.

Ben: Buffett stepped off the board of The Post to be able to do the Cap Cities Investments?

David: The Cap Cities deal. He invested $517 million in Cap Cities to help them buy ABC. $517 million that's a big chunk of money, but he can do this at Berkshire now. They’re enormous. They’re a multi-billion dollar company. He's a billionaire himself already at this point.

Ben: If these guys are anti-leverage and they're trying not to do the LBO thing where you lever up, then buy something, and then have to make debt payments forever out of the profits of the thing that you just bought. How does the Cap Cities transaction work then where Cap Cities is able to be the minnow that swallows the whale?

David: A big part of it is that $517 million in equity from Berkshire coming into the deal.

Ben: I see. They basically have a very large post money valuation effectively because they're issuing a whole bunch of new primary shares out of Cap Cities to be able to have enough money on the balance sheet to buy ABC.

David: I don't have notes on exactly what the structure of the deal was. I believe it was some Cap Cities stock, plus the $500 million convertible equity from Berkshire. And then they probably did add on some debt as part of it. But they got a reasonable amount of debt, especially with a predictable cash flow business, that's reasonable.

Warren and Charlie get themselves into, not just like trouble on the order of the trouble with the feds earlier in the episodes, or actually the multiple troubles with the Feds earlier in the episode, but real honest-to-God, frankly the worst moments of their lives trouble is when they think that their reputation, their ability to save companies, and their ability to be this capital partner to companies is so great that they can come in and save Wall Street itself.

Ben: Or Wall Street from itself.

David: Or Wall Street from itself with Salomon Brothers. Oh boy, here we go. Remember we told you to remember John Gutfreund and Salomon Brothers who had helped GEICO do the convert deal that Warren backstopped? Warren thinks Gutfreund walks on water at this point. They’re the only bank that was willing to do this. Warren and Charlie famously hate Wall Street, hate banks. But okay, you did me a solid.

Ben: We know these guys. We feel for them a little bit. They don't seem like the enemy. We know them.

David: Yup. We're now in the late ‘80s. Gutfreund has become the CEO of Salomon Brothers. They've gone through a series of mergers and acquisitions. The firm is much bigger than it was before. It's now publicly traded and Salomon already was the debt king. But in this debt-fueled environment, everything we were just saying about the ‘80s, Salomon is like the king.

They sold the first mortgage-backed security, a glorious honor, if there ever was one. They go deep into junk bonds, derivatives, all kinds of hairy stuff. It gets so extreme at Salomon that in 1986, a young Princeton graduate and aspiring writer shows up at the firm as a new hire.

Ben: Michael Lewis.

David: Michael Lewis, on the bond sales and trading desk and ends up writing a book about his experiences. Intended to be a cautionary tale of the wretched excesses of Wall Street, has the exact opposite effect called Liar’s Poker.

Ben: It's an inspirational beacon for a generation of Wall Streeters to come.

David: Look, I remember reading the book when I was graduating from Princeton and about to go work on Wall Street myself. It’s like the Social Network 20 years later. This was meant to be, at best, a show all sides of a complicated situation and, at worst a cautionary tale. And instead, a whole generation of young people just look at it and they say, I want me some of that.

Ben: Sounds fun. You get rich? Great.

David: I’ll just read one quote from the book where Lewis writes about the famous 41st floor home of the bond traders at Salomon. He says, "Because the forty-first floor was the chosen home of the firm's most ambitious people, and because there were no rules governing the pursuit of profit and glory, the men who worked there, including the more bloodthirsty, had a hunted look about them. The place was governed by the simple understanding that the unbridled pursuit of perceived self-interest was healthy. Eat or be eaten.

The men of 41 worked with one eye cast over their shoulders to see whether someone was trying to do them in, for there was no telling what manner of man had levered himself to the rung below you and was now hungry for your job. The limit of acceptable conduct within Salomon Brothers was wide indeed... Here it was capitalism at its most raw, and it was self-destructive…"

Ben: I love Michael Lewis. I can make every single one of his books a carve-out at some point.

David: So great. Despite this immense success in the bond market, Salomon and Gutfreund had gotten themselves in a pickle here. Because it's working too well, all these traders, all these wolves of Wall Street are generating so much money, but they're demanding that they're going to get paid all the money. All of it gets paid out in bonuses to all the traders who are constantly demanding more and threatening to leave for other firms that the corporation itself, the recently public company, Salomon Brothers, the profits are actually declining.

Ben: I was seeing some stat that it was a year where they underperformed the S&P 500, there were still over 100 people at the firm that were paid out over $1 million dollars in their bonus.

David: Oh, totally. Yeah. One year where that happened, famously one guy, just an individual trader, made a $23 million bonus in one year in 1987 or something.

Ben: Which is 2X, 2.5X by inflation today.

David: Whatever it is, that's a damn lot of money.

Ben: For rent-seekers, where's the value creation there?

David: Oh, there is only value destruction happening here. There is nothing being created.

Ben: Or certainly value capture.

David: Absolutely. Because Salomon itself is suffering, they start attracting the attention of corporate raiders and in particular Ron Perelman.

Ben: Revlon, right?

David: Yeah, Revlon. He buys out Salomon's existing largest shareholder and he starts agitating. He's going to take over Salomon Brothers and nobody at the firm because they just want to keep paying themselves the bonuses. They, of course, don't want this.

You've got basically the 100% most anti-Buffett and Munger—at least what they say—situation possible here. A bunch of people at the firm "management." There's no management going on, but employees are just simply enriching themselves at the cost of shareholders while ratcheting up risk in the economy and creating no value. Oh, what could be better? Gutfreund calls Buffett, he doesn't want to get thrown out by Perelman, and he says he needs to cash in the favor from the GEICO deal.

Warren and Berkshire have such a reputation of being the white knight and saving companies at this point that…

Ben: And being management friendly.

David: And being management friendly, exactly. It's all going to come back to bite them that Gutfreund says, hey, if I can get Warren to join the board, I'm going to get Perelman off my rear end. Warren and Charlie agreed to do it.

Ben: And they both take board seats, right? They get two seats.

David: They both take board seats. So here's how it goes down. It's Rosh Hashanah weekend in September 1987. Perelman is like an orthodox Jew. He's out of commission. He's not doing anything over the weekend and Gutfreund knows this. He times everything. He gets the deal done in secret with Buffett and Berkshire over that weekend. Berkshire buys $700 million of convertible preferred stock in Salomon. More than the money that they put into Cap Cities with a 15% interest rate coupon attached to that convertible preferred stock.

Ben: It's like the company is in dire straits and the CEO really does want to incentivize these particular shareholders to become shareholders.

David: That's what's so disgusting about this situation is the revenue line essentially of the firm has never been better. You can say what you will about what they're doing, but they are raking in money for the top line. But then they're paying it all off to themselves in bonuses. The firm is suffering. Capital is coming in, they do these really tough terms deal simply to save again "management's own skin." It's really something that goes on here.

It's crazy that Warren, Charlie, and Berkshire do this. Loyalty is super important to them and Gutfreund and Salomon have saved GEICO. Anyway. They do it. Both of them joined the board and there's this famous scene where they fly to New York, the two of them over this weekend—this must be on a Friday, they go to the Salomon building to sign the papers and Gutfreund takes them on a tour. They go to the balcony overlooking floor 41. It's like a callback to child Warren overlooking the balcony of the stock exchange and being like, wow, there's so much money here. I want me some of that.

They're looking down on what's essentially like a seething gladiator pit below. Charlie looks at Warren and he says, so you really want to invest in this, huh? Warren supposedly just kind of silent for a minute. You can just see him being like, what am I getting myself into? He finally says, mm-hm. And then he goes and signs the papers.

Ben: Credit to Charlie for asking the question, but Charlie follows him into the pit too and joins the port as well.

David: Totally, and probably regretted it every day after. They do the deal. This is September of 1987. October 19th of 1987 is Black Monday when the Dow 22.6% in essentially a flash crash. I had this confused in my mind. I thought Black Monday in ‘87 was the Long-Term Capital Management thing. No, that happened much later. This was actually a flash crash. Nobody really knows why this happened. Of course, the market was overheated, of course, there was way too much leverage in the system, but things recovered pretty quickly. That's not what triggers a meltdown.

Salomon, of course, gets crushed like the rest of Wall Street. They lose $75 million in trading losses on that day, the stock gets crushed, but they're not in any better or worse shape than any other investment bank. But the stock is way down. Buffett and Munger show up to their first board meeting after this happens, which is like the next month, maybe in November. Gutfreund and management put a deal on the table to reprice all employees’ stock options because the stock is down.

Buffett and Munger flipped. They're like wait a minute, you guys lost a ton of money for the firm. We as shareholders in the firm, just invested. Our $700 million is now worthless. And you guys are saying you want to take advantage of this lower stock phrase to re-praise all of your options that you're then just going to treat out of it immediately as soon as they vest and liquidate the cash.

Ben: No one here wants to become bigger owners of this thing. You all just want a quick arbitrage opportunity.

David: Exactly. But they acquiesced. They don't really want to fight with management. They also know that if this becomes public that they're fighting with Gutfreund and the board.

Ben: Stock price drops even further.

David: The stock price is going to drop even further. They got $700 million at stake here. They don't really want to do that. I’m already pretty far down the slippery slope here. This is when the real slide starts. Not only did the options get re-priced, but then in secret, behind the board's back, Gutfreund reaches a deal with the head of the best performing trading desk on the floor—the so-called magical arb desk, the bond arbitrage desk, run by John Merriweather, who runs the domestic fixed-income arbitrage group—to directly pay them 15% of all the trading profit they make as bonuses.

No longer even just to like, hey, management, will decide your bonus at the end of the year. It'll be based on the performance of the firm. It's now like your prop shop. 15% of all of your profits you're going to take home with none of your own capital at risk and on the hook for none of the downsides when you have losses.

Ben: Wow. That’ll incentivize some bad behavior.

David: Yeah. Things limped along for the next couple of years. Warren and Charlie aren't thrilled about everything that's going on. So then, the shoe drops. In August of 1991, Buffett is on vacation in Reno, Nevada and he gets a call not from Gutfreund, from Salomon's president, Tom Strauss and its general counsel Don Feuerstein, who behind the scenes at Salomon, Don is referred to as "The Prince of Darkness" for all the dirty work.

Ben: Things I never want to be called.

David: Yeah. All of the sticky situations that he gets Salomon out of and all the dirty work he does is amazing. You can't make this stuff up. Warren’s on vacation and he gets a call, this is not a call you want to get. Warren’s suspicious, he gets on the phone and they're like, well, Salomon's outside counsel has figured out that the head of our government bond trading desk, Paul Mozer who reports to Merriweather has apparently been violating some of the treasury department's rules when bidding on government bond auctions.

The way the Fed controls the money supply, the way that interest rates are set, they bid out bonds, government debt, and then all the big investment banks get to place bids in terms of interest rate, and then the government selects which banks buy the debt.

Ben: There's only a few, what is it, 40 banks or something that are even allowed to be involved in these auctions, that are allowed to have the privilege of buying debt from the US government.

David: Yup. This is the way the money supply gets into the economy. To be one of these banks means that you have a direct relationship with the Federal government and the Treasury controlling the economy. Mozer has been violating the rules. They don't say exactly how or why they've suspended him, and Salomon is going to notify their regulators about this.

Warren’s like, oh the Prince of Darkness is calling me for this? That doesn't seem that bad. He violates some rules, okay. While this is really important and prestigious, this is like a sleepy part of the firm. You wouldn't think that the government bond desk is something that could blow up the firm. You'd be more worried about the arb desk per se. He's like, all right, call Charlie. He's the lawyer between us. He'll know what to do.

Ben: Just some rules, how bad could it really be? I’m sure it's just some regulatory tape.

David: Some regulatory stuff. They're like, oh yes, we've already talked to Charlie. He's totally cool with it. No worries. Warren was like, okay great. I’m going to go back on vacation. Turns out Charlie wasn't totally cool with it and turns out that maybe Mozer did a little bit more than just violate the Treasury's bidding rules.

What he actually did was he submitted fake bids on behalf of clients for the Treasury auctions. Both fake bids for real clients and fake bids for fake clients. On behalf of people who work, even customers of Salomon Brothers, and his goal in doing this was to essentially corner the market in this auction, win all of the auctions for these treasury bonds, and put the squeeze on all the other participants who needed the bonds to resell to their clients. So that he could then sell it at a massive profit in the market, which he did.

Ben: Of course, while it's illegal to bid on behalf of your clients who are not placing orders and that it's even more illegal to bid on behalf of imaginary clients, it's also illegal to try and corner the market on a given auction. There are rules in place that say things like you can't try and bid for more than 35% of any given auction because we need it to be able to be spread around because we don't want this big second market for people paying a big premium because someone managed to go get 90% of the allocation.

David: Totally. The reason they don't want this to happen is what actually happens as a result of Mozer's actions. Three or four small financial firms that couldn't absorb this price volatility go bankrupt. This is real. What the deed did. I think he did this like four or five times and the net of all of it was Salomon made an incremental $4 million in profit. All this for $4 million.

It turns out he did it multiple times. It turns out that Merriweather, who was his boss in the chain of command, and Gutfreund knew about this four months ago. They knew about it because the SEC started investigating and got in touch with them. When that happened, the general counsel, the Prince of Darkness, told Gutfreund that what was happening here was criminal. But that, technically, they didn't have any technical obligation to report it to anyone.

Ben: The CEO is sending letters to the general counsel without notifying the board. Hey, I got this letter from the SEC. They're investigating us. But just the GC needs to know about it.

David: Yup. Not notifying the board, not notifying the shareholders or the public, and equally, if not worse, not notifying the other regulators that this is going on. The SEC is investigating but they haven't found any. They just found some irregularities. Internally Salomon found, oh no, this is criminal. What's going on here? They don't tell anybody. Not only that, they don't fire Mozer. They leave him in place running the government bond desk and there are no audits or controls on what he’s doing.

Basically, they're like, don't do that again, wink, wink, wink. And then they turn around and look the other way. At this point in time, the SEC has figured out, yeah, these aren't just irregularities. They figured out what's going on. Words start to get out. On Monday after this, August 12th, The Wall Street Journal runs a big piece about how bad this could be and how little is known. Salomon's counterparties, their lenders, and their trading partners start getting cold feet about dealing with Salomon and all the markets that they operate in.

Salomon, it turns out, they’re the second-biggest bank on Wall Street at this point in time. They have $150 billion of capital in the markets, but they only have $4 billion of equity. All the rest of it is like short-term paper, debt, leverage, and everything that has been building up in the 80s. They're 60 times levered on their capital. All of a sudden, their counterparties start getting cold feet about trading their paper. And $50 billion of the $150 billion rolls over every single day.

Ben: That's a really short-term paper.

David: If there's a problem, it's going to be instantaneous and the firm is dead. Also on that same day on that Monday, this is probably the worst thing that happens. The Federal Reserve sends a letter to Gutfreund and Salomon—I think only Gutfreund and the general counsel see this—saying that it is "deeply troubled by both the firm's actions and lack of actions." And it is questioning whether it can continue to have a business relationship with Salomon Brothers—this is the Federal Reserve—unless the firm responds to this letter and significantly changes its business practices within the next 10 days.

If the Fed ends its business relationship with Salomon, game over. It's dead. All the counterparties are going to stop trading with Salomon. It's literally game over instantaneously. Gutfreund and the GC just sit on the letter. They don't tell the board. They don't tell anyone else. Nobody knows about the letter except the two of them. The Feds assumed that the board knew about the letter, that Salomon is doing something, but Gutfreund and the GC covered it up.

Buffett, by this point in time, gets in touch with Charlie, and Charlie's like yeah, you should be concerned about this. The board convenes, they issue a press release saying that they're looking into this and figuring out what happened. The firm's stock dropped 30% that day. The Fed meanwhile is like you guys aren't responding to our letter. They're just getting angrier and angrier every day that goes by.

On Friday of that week, The New York Times ran a headline, Wall Street sees a serious threat to Salomon Brothers, and the Fed finally had enough. The lead investigator running the case at their Federal Reserve calls Gutfreund and says, you need to resign like today, and you need to install new management or else.

When Gutfreund gets that call, he calls Buffett who’s still in Omaha, and he essentially just tosses him the keys to the firm. He's like, I'm going to resign. Somebody has to step in and run the place and deal with this. It's probably going to be you. So good luck with that. Not quite in that language, but that's essentially how it goes down. Pretty intense stuff. Warren and Charlie are legitimately frightened at this point

Ben: The argument there is like, hey, I have to be out. We don't have any ideas for who's next.

David: There's no plan, there's no manager.

Ben: Whoever steps in has to have the reputation to be able to save this firm. Nobody wants their investment to go to zero, so I pick you as the person who seems like you might be able to save this thing.

David: At this point, the fiduciarily responsible people are the board, and who are the most prominent people on the board, Warren and Charlie. Warren specifically. Gutfreund is already out as CEO. So there's nobody left except Warren to come in and deal with this. Warren immediately gets on a plane to New York. He goes and meets with the Federal Reserve and tries to understand and sweet-talk them.

This is amazing to me. The Fed, I think, assumes that Warren knows about their letter, but he doesn't, and that wire is still getting crossed in this meeting. Warren doesn't understand what the worst-case scenario really is. Cryptically, at the end of the meeting, Buffett’s trying to sweet-talk time and buy more time. The Fed tells Warren to "prepare for all eventualities," i.e. that they're going to yank the right to participate in the treasury auctions and Salomon's going to go down the tubes.

Now it's Friday night into Saturday morning and Warren has to make a choice. He can walk away from Salomon, say I'm resigning.

Ben: And $700 million dollars goes up in flames.

David: But he can walk away, or the other option is he can take the reins of the company and try and steer this thing through. As he's thinking about and talking with Charlie, he realizes he actually doesn't have a choice because if he walks away, his reputation is toast. If he walks away, 100%, his reputation is toast. He loses $700 million, that'll be fine. But what company is going to do a deal with Berkshire Hathaway ever again after this? And if he stays, probably there's a good chance he's not going to be able to navigate through this. In which case his reputation is also toast.

Ben: This brings up that George Bernard Shaw quote that I think it's Charlie who likes to quote it, "Never wrestle with pigs. You just get dirty and the pig enjoys it." You can imagine that moment where they're standing out looking over the trading floor knowing that they're about to wrestle with a pig, and then this is the eventuality of what happened with that.

David: Yup. As he's realizing this, Alice writes in The Snowball, "At some point during that long, horrible Friday, he recognized with a sickening jolt that investing in Salomon, a business with problems over which he had essentially no control, had put it all at risk." And by all she means everything. Not just the $700 million in Salomon, everything that Warren and Charlie together have built. They’re both on the board.

He decides he has to take the job. He decides he's going to become Interim Chairman of the company. He installs the head of the investment banking division, a guy named Deryck Maughan as the CEO. That was the one thing that Salomon was not good at was the investment banking advisor business. He gets installed simply because he's just far away from all the toxicity

Then on Sunday, Warren, Charlie, and the whole board are at the office in New York. They’re trying to figure out what to do. When a letter arrives from both the Federal Reserve and the Treasury Department, they haven't heard any response to their deadline of things that have got to happen. Thus far, nothing has been announced from Salomon. They say they've had enough. It's the end, no more negotiating. They're pulling the plug that afternoon.

By the time the market opens in Tokyo, which is late afternoon New York time—this is Sunday afternoon, so Monday morning Tokyo time—it's going to be announced that the Fed has revoked Salomon's licenses and it's over. Warren directs the board and the lawyers to start preparing a bankruptcy filing. And in the meantime, he desperately starts trying to call anybody he knows in the government, using all of his Washington connections to try and stay the execution here.

He finally reaches the Treasury Secretary, Nick Brady, which the Treasury and the Fed jointly made this decision. Warren literally breaks down on the phone crying and begs him. Says this is the most important day of my entire life. Begs him to stay the execution and just give them a little more time and figure things out.

Brady is moved by this. Literally, Warren Buffett. If there's anybody in the world who could get the government to change its mind. And he says, okay let me go talk to Greenspan, the head of the Fed, and figure out what we're going to do. Hours go by, it's all in limbo, they're just sitting in the Salomon office drafting up a bankruptcy filing, and then a call comes in from the Assistant Treasury Secretary. Do you know who that was at the time? A call comes in for Buffett.

Ben: No.

David: One Jerome Powell.

Ben: Oh my God.

David: Then Assistant Secretary of the Treasury.

Ben: Incredible.

David: Incredible. And he says, look this is bad. We're not going to allow Salomon to bid itself in treasury auctions anymore. We need our pound of flesh. We will, however, because of you, Warren, because you're stepping in and you're committing to making changes. We will allow Salomon to continue to place bids on behalf of its clients. And he says, will that work? And Warren is like, that’ll do. He literally gets the government to reverse their decision. Unbelievable.

Ben: That's insane.

David: Now they have to deal with the aftermath.

Ben: Also, it's incredible that Gutfreund never showed the letter because I assumed he was a shareholder too. Of course, it's going to come out that there was a letter sent at some point. It's not like he's saving himself and a legal liability by not disclosing it.

David: I don't know how far in advance he had gamed this out. What ends up happening, I’ll tell the story in a minute of how this all wraps up. But as this is going down, concurrently that weekend, Gutfreund and his lawyer—Warren still doesn't know the extent of Gutfreund’s deception here and cover-up. He doesn't know about the letter. He doesn't find out about the letter until later. They go out to dinner and Gutfreund and his personal lawyer try to get Warren and Charlie to sign a severance package for him leaving the company. They want a $35 million payout. Your reaction is priceless there.

Ben: That's wild.

David: Isn't that wild? They're trying to get the money, as always. Fortunately, they're dealing with Charlie Munger here. Charlie basically stone walls them. This is amazing. I don't know the quote written down here, but this would later get arbitrated and Charlie would testify in the arbitration under oath that Charlie's natural way of either being with other people is he turns his brain off when he's not interested in things. He wasn't interested in what they had to say, and so he was just muttering and not saying anything. It’s amazing.

Ben: In the negotiation?

David: Yeah, the negotiation. They don't agree to anything, they don't sign anything, and ends up—after years of fighting this in arbitration—getting zero dollars, as he should. They get the save, the stay of execution from the government, and then they have to deal with the aftermath. Warren has no interest or ability in actually running day-to-day Salomon Brothers, but what he can do is he can deal with the government and the public. He instructs Mon, the new CEO, to clean up the firm inside. You handle everything inside the building.

His instructions are, get it right, get it fast, get it out, in terms of dealing with all the corruption in Salomon. Basically, the first thing that happens that week is Warren gets summoned before Congress to go testify in front of Congress. This is brilliant. They bring in MTO—Munger, Tulles, and Olson, of course, to represent them and all this, and Roy Olson comes in. Roy suggests this brilliant step that goes a long way towards saving Warren and Salomon. He suggests that they proactively go to the government and say we will waive our attorney-client privilege.

This is extraordinary, this never happens. They're going to the government and they're saying all of our communications and anything that MTO finds at Salomon, we will share with you.

Ben: Wow. It makes sense to do that because they're the new guard. There’s no way it can reflect poorly on Warren, Charlie, MTO. It's only going to be negative for all the people that Warren wants to fire anyway.

David: Exactly. Alice writes in The Snowball about how perfect this was. The more evidence that MTO found on employees that were guilty, the more proof it would show the government that Salomon was cooperating and that Buffett was clearing everything up. The employees, meanwhile, must cooperate or be fired since anything that they would say would be protected by attorney-client privilege with MTO. The employees’ options were to get fired or answer MTO’s questions, and anything you say to MTO is going directly to the government.

Ben: Warren's not there to protect anyone. This is a win-win.

David: Exactly. This has Charlie's fingerprints all over it. Warren goes in front of Congress. Probably one of the most famous statements that Buffet’s ever made in certainly corporate history where he's being grilled by senators about what he's going to do at Salomon and how he's going to turn it around. And he says the way the Salomons can operate going forward is, "Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless."

Ben: Fascinating.

David: He puts on a show and he wows Congress. Salomon ends up getting out of this thing. They settle in the next few months with the government for a $190 million fine plus a $100 million restitution fund, which I assume is maybe to go to the other financial institutions that were hurt by the cornering of the market in treasury auctions.

Ben: Restitutions, got to be it.

David: Certainly, that's a lot of money, but this is amazing. He pulls this out. The firm survives. Obviously, Salomon is damaged, but over the next few years, they recover.

Ben: When was Warren able to actually step out day-to-day?

David: As soon as possible. Basically, as soon as this element hits, he's like I'm out as chairman. He stays on the board though, he keeps the investment, but he's no longer day-to-day. This happened in ‘92. Six years later, in ‘98, Salomon was acquired by CitiGroup, the former Travelers Insurance, as you put a pin in for $9 billion. Which means that Berkshire gets a return of $1.7 billion on their $700 million investment plus the 15% cash coupon that they had been getting.

It literally takes Warren and Berkshire to the brink, but this ends up being a really good investment for them.

Ben: Wow. It makes so much sense why Buffett then had the quote, "It takes 20 years to build a reputation and five minutes to ruin it." If you think about that, you'll do things differently. I bet he imagines looking out on the trading floor when reflecting on how we might do things differently. I do wonder if he looks back on this and thinks, was it worth it for that investment return? Probably not.

David: 100% not. The irony is 100% not, but this only adds to the myth of Warren and Berkshire.

Ben: Right. He can save even the cesspool of Salomon Brothers. What can't he do?

David: What can't he do? This is where we're going to leave part two, but there's one coda before we do. You probably know, but listeners, I will ask, do you know what other organization after this whole debacle that John Merriweather—the head of fixed income trading at Salomon Brothers—would go on to found two years later in 1994?

Ben: David, is it something that had a crisis where you mentioned it earlier in this episode?

David: Yes, it would be. My God, this is just crazy.

Ben: Is he part of the group that was the former Salomon Brothers’ people that went to do Long-Term Capital Management?

David: Not only was he part of that group, he was the leader of that group. Literally, John Meriwether, founder and CEO of Long-Term Capital Management.

Ben: Wow. And he was the guy between Gutfreund who was the CEO, and the guy directly underneath him was the guy doing auction violations. Wow.

David: Yup. How crazy is that?

Ben: Did any of these guys ever go to jail?

David: The only guy who went to jail was Paul Mozer, the guy who did the auction violations, and he went to jail for four months. Isn't that unreal? The thing that we didn't talk about in this history, certainly the government was influenced by Warren's reputation and his pleading. But they were also scared too. Nobody knew what would happen if you just took the second largest investment bank in the world out back and shut it. It for sure would have created a financial meltdown, and then, of course, 16 years later, this was the dress rehearsal for what we got to see actually happen in 2008.

Ben: Wow, which of course, Berkshire also…

David: Was an active participant in.

Ben: Yeah. Mostly in buying the dip. We’ll save that story. It's funny, for part three, we'll have the whole tech bubble, we’ll have 2008, we’ll have the tech bull run of the last however many years, and the future of where do we think Berkshire goes from here. But this feels like a good place to leave this part.

David: Yeah. I mean, we intended this to be one episode on Berkshire originally. The deeper we got into it as we were doing the research—this Salomon episode, I knew that this had happened. I didn't know that this had happened.

Ben: No. I mean, the only thing that I really knew was that Warren Buffett was called on to act as the head of Salomon Brothers when they were under duress, and his reputation alone was what saved it. But that is really true. It's not just that he was acting as the head of the bank in a riskless way. He risked the whole future of Berkshire to make this happen. In fact when you think about the return turning $700 million, he made $1.7 billion over how many years was that like 6 or 7?

David: It was $1 billion. I think it was $700 million in and then $1.7 billion out. But he got the coupon payments also.

Ben: Maybe like a 200% return over six, seven years. Good, but not for this risk.

David: Yeah, definitely not for this risk.

Ben: Wild. There's going to be some fun analysis in here. I want to talk about power. But before we talk about categorizing Berkshire’s power during this period, we want to thank our next sponsor Capchase, the official sponsor of analysis and grading of season 8 of Acquired. Boy is there a never better set of episodes for a unique, novel, creative, clever, innovative financial instrument like Capchase than these Berkshire episodes.

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Before we talk about power, we should do a quick review of the businesses that they had owned outright during this part of their history. Because I think people have a general sense of the stuff that they own now, both through the businesses that they owned wholly and through their ownership of big public companies like Kraft Heinz or of Coca-Cola. But let's review the things they bought in the ‘70s and ‘80s and owned outright.

See's Candy, Wesco Financial, the Buffalo News, Precision Steel Warehouse, Nebraska Furniture Mart—thanks Mrs. B, Scott Fetzer, Fechheimer Brothers, Borsheims Jewelry, H.H. Brown, Central States Indemnity. And then in ‘95, the finishing touch on GEICO, they bought Helzberg Diamonds and RC Willey Home Furnishings. There's a lot of Berkshire that you think about today that they don’t own yet.

David: On the public equity side, the main positions we talked about, The Post, Cap Cities, Salomon Brothers, and one that we didn't talk about that we’ll talk about more next time, Coca-Cola. I think those represented significant parts of the value, but again, as we've seen they're taking a hands-off approach here.

Ben: As we analyze the power, we think about them as two different business lines because it does feel like the business activities day-to-day are very different between those two things. Which actually you see reflected in the management structure of the business flashing all the way forward to 2020. You have Ted and Todd on the investment management side buying publicly traded companies. They’re investing in publicly traded companies and you've got Greg and Ajit on the wholly-owned subsidiary side.

David: Ajit running the insurance businesses and Greg running all the not insurance businesses.

Ben: Not insurance, which is funny because it's so diverse that you don't have a way to label. It's just insurance and non-insurance. Let's talk first about wholly-owned businesses. The business activities there are prospecting, identifying the whole landscapes of businesses you could buy, evaluating those businesses on their fundamentals, making the decision to invest or not invest, and then making sure that you leave or install the correct management in place to make those businesses hum over a long period of time.

And then, of course, capital allocation where you're making sure that you're deciding if that business is one that you like consuming capital and you want to funnel more capital to that business so it can reinvest in growth. Or if that's a capital producer and you maybe like your jacket linings business or your stamps business, you don't want that business consuming any more capital and that should just spit off capital that gets sent to the head office for a reallocation.

With that preamble, those are the business activities of the wholly-owned subsidiary side of the business. Now, of the Hamilton Helmer powers, which basically enable you to in a long-term way, get durable, sustainable, differential profits above your nearest competitors. So here, I think we should think of other conglomerates. We should think of private equity firms.

David: Definitely private equity firms.

Ben: Yeah, think about these companies going public. SPACs weren't really a thing yet so that wasn't an option on the table. Strategic acquirers, I think, were tough. The question is, which of the seven powers applies to Berkshire?

David: Yeah, this is going to be fun. It's not network economies. It's not our usual favorite.

Ben: It is definitely not. I'll make the first run at it and say counter positioning, and certainly counter positioning versus anybody that's running money. I think to more finely articulate that, I opened this episode by talking about the fact that Warren chose a very unique structure in choosing not to have a fund or a partnership. But instead to have his operating business Berkshire that he uses the capital to invest off the balance sheet.

It's very interesting when you have that structure and you're not generating fees, you're not thinking about raising another fund, and you're not getting a carry or a promote. You have just as much downside risk as an upside benefit. Your incentives are pure, in a way. You only want to make financial decisions that buy low, sell high; or buy low, hold forever. There's no other way that you make money.

David: Your only focus is long-term value creation because nothing that you're going to do is going to increase your fees or increase your value in any set fund life period of time or anything like that.

Ben: That makes you a counter position to private equity firms. Then the question becomes, is that power in a positive way, or is it somehow negative? Is it just a disadvantage? Are they counter position to you? Let me put it this way because there are certainly deals that a PE firm would do that Warren wouldn't do because the price is too high. But is the opposite true? Can Warren get deals done because the PE firms have an opposite business model?

David: It's interesting because this is so obvious, not a tech company in so many ways. This market that Berkshire operates in—the market of acquiring in and investing in other companies—is not a winner take all market. It's interesting, to succeed they need a niche and they certainly carve out their niche exceedingly well with counter positioning versus other players.

We didn't talk about this in the episode. I'm going to say because we didn’t have time. But what is time on an Acquired episode anymore? This is how they win the Mrs. B deal, the furniture mart deal. Buffett sits down with Mrs. B—because she has other offers to buy the furniture mart for more money—and says you could certainly take those offers and I'm not going to pay what the private equity firms and others will pay. But, at the end of the day, those firms, what's motivating them is selling your business for more money.

They may say lots of things to you, be aligned, love you, and want to keep you and your family in place running it, but at the end of the day, they're going to do anything to maximize them selling the business for more money within a set period of time so that they can make their fees. I'm not going to do that. I'm genuinely going to leave you and your family to run this.

Ben: It's like having a longer lens is actually the counter positioning here. And simultaneously holding it to be true that keeping the family in place to manage it is the long-term, value-maximizing decision.

David: Both of which are true.

Ben: Both of which can be true depending on if you acquire the right business.

David: It gets back to the fight with the efficient market hypothesis theorist and the nature of the debt, which all of the private equity firms are using to buy these companies to level up the companies that buy them. If the goal is to have the companies operate sustainably the longest and generate the most cash flow over truly the longest period of time, you don't want to use debt because debt is going to increase the chance that the company is bankrupt.

If as a seller you care about the legacy of the company, either for whatever your family is working in the business, that making money, retain a part of it, or just for the legacy of the business, your interests are aligned with Warren's then because he wants the cash flows over the longest period. Which means he's going to avoid debt.

Ben: Such a good point.

David: I agree, counter positioning for sure.

Ben: Definitely branding. That's probably actually the place where you start. The Warren Buffett brand just enables you to do things. Literally, the Salomon thing. Anyone else crying on the phone to the Federal government probably wouldn't have impacted them, but because it was Warren's brand crying on the phone... It is trite, but I'm trying to use the 7 Powers language here.

David: I think the 7 Powers actually apply a lot. Counter positioning applied. Branding, 100%. Warren Buffett and Berkshire Hathaway's money is worth more than the equal amount of money from somebody else.

Ben: Yup, absolutely.

David: Okay, I don't think there's necessarily scale economies. I mean, maybe you could argue a little bit that the scale of the insurance businesses and the float enables more investing, which enables more operating businesses. Maybe I think that's a little bit of a stretch.

Ben: It's interesting. Today, I think they actually have diseconomies of scale because they just have too much capital that they need to put to work, but we'll save that for the next episode. I do think this period was the one for the first time where they did realize some economies of scale. There is this nice middle ground where if you're really small, then you can't invest enough money to have sharp elbows on a board. But if you have too much money, then all you can buy is Apple. Nothing else moves the needle for you enough.

But during this period in the ‘80s, they had the perfect amount of money where they could be activist investors on boards and throw their weight around, and that would deliver enough return for them to be needle moving.

David: That's a really good point. That's a good point. It's a power right now, but it's not a sustainable power.

Ben: Yeah, that's interesting to think about.

David: I don't think they're switching costs.

Ben: No. That's all I've got for this so far. The question is, which of those apply to the public investing side of the house?

David: The one I was going to talk about, I always have such a hard time thinking about this power. As Hamilton says it is the trickiest of the 7 Powers, but is there process power here at Berkshire?

Ben: It's funny, it's like thinking about process power in a super small organization feels like a de facto no. Because they always use the example of the Toyota production system that the system was so complex it couldn't be written down to be retaught to someone else because it's held in so many heads. The decisions are all made by one person. Is there a process power in Warren’s head?

David: He calls Charlie, but Warren ultimately makes the decision.

Ben: I think there's a liberal interpretation of process here to make that case.

David: It's funny because for public market investing, I was thinking that might be the only really arguable one.

Ben: You freaking efficient market hypothesis you.

David: I'm definitely not an efficient market hypothesis disciple, but I think there are definitely market inefficiencies as this episode shows. But I don't know that Berkshire had any defensible ability versus others to see and then act on them. They acted on the ones that they saw, other people could act on the ones that they see.

Ben: Right. Getting back to that point that I made earlier around identifying things in the market that not only have less risk but actually exclusively have less risk than the market perceives them to have when you act. I think I was foreshadowing power there where there are things where Berkshire uniquely could have acted, and therefore save the company, gotten the deal that they did, were able to join the board, whatever the thing is. I'm trying to figure out how to quantify that.

So WaPo, Salomon Brothers, these were things that Buffett could uniquely do in an advantaged way versus their competitors. Their competitors being all other capital and why.

David: WaPo, Buffett had to fight his way in. Maybe that was part of developing this power. Kay was sort of scared of him at first and certainly reluctant, and then Buffett fought his way in. I don't know if that was a power, but then once he was on the Washington Post board and the mystique of Warren Buffett had started to grow, then I think maybe it became something defensible.

Ben: Yeah, it's a great point. Normally here I would move us on to playbook. I literally think we had discussed every playbook theme during the narrative, during history, and facts that I possibly could have brought up here. I have nothing to add in the playbook section of this episode.

David: Yes.

Ben: As Charlie would say, no.

David: Nothing to add. Value creation versus value capture?

Ben: Let's do it. Buffett definitely created more value in this chapter than in the previous one. The previous one you're buying and selling, you’re buying at low prices, you're selling at high prices. Here you're doing things like they legitimately created value for Salomon's shareholders, like a lot of it.

David: Yes, they created $9 billion worth of value.

Ben: And the question is what other situations in the ‘70s and ‘80s did they create value? Certainly for Berkshire shareholders, by marrying insurance businesses in the operating businesses, for Berkshire shareholders to be able to realize the incredible benefits of those two things operating in tandem.

David: I think they also created value for GEICO in saving GEICO. Jack Byrne did all the legwork himself, but no question having Warren. They're both with the regulators and the government of, hey Berkshire Hathaway is behind us now. We're going to be okay. But then also specifically with the financing, with Salomon Brothers, and with Wall Street back stopping the deal.

Ben: Yup. Is there value destruction for the American consumer by making it so all those people who had GEICO in the states that they decided to pull out of lost their car insurance?

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

Ben: I mean, how hard is it to go get different insurance?

David: Right. And if GEICO wasn't going to make it, if they didn't make those changes.

Ben: Right. It's not like they corporate [...] it, went in, and it was going to go perfectly fine, but then they destroyed it Toys-R-Us style.

David: Now, what was interesting in that story though was I think GEICO and Byrne were the first to actually pull out of states. Nobody has ever done that before. They did sort of cross a Rubicon. Yeah, I don't know, it's a good question. Certainly, Salomon Brothers, you could debate a lot of value destruction there in aggregate.

Ben: From the entire time they were shareholders, certainly.

David: Now, did Buffett and Berkshire…

Ben: Meaningfully contribute to that?

David: No, probably not. Other than they did prop up corrupt management.

Ben: Yeah. Value capture to, move on to that and hit it real quick, it's Berkshire, it's Buffett. They always do a damn good job of capturing the value they create. No qualms there.

David: Yeah. Interestingly, especially over this period in the life of the company—probably because of the long-term focus and not selling investments with regard to tax liabilities—Berkshire and its shareholders pay. Because if you don't sell you pay no tax.

Ben: Right. Massive tax deferrals.

David: Massive tax deferrals.

Ben: All right, grading. I want to grade this the same way that we graded the last one, which is we are going to look at their pure performance versus the S&P 500 during that same time frame. You may recall that in the Buffett Partnership years, the annualized return was 29.5% annual return over those 12 years. Historic, legendary.

I think what we determined was something like a 28X. That 12 years you could comp nicely against a venture fund and say, if anyone could 28X the money, then they'd be a top decile fund for sure. And the Buffett Partnership had the increased benefit of you could take all your money out or put all your money in at any given year. You didn't even have to lock it up for the entire life of the fund the way that a venture fund does. Slam dunk, I think we call that an A or an A+.

This set of years were going to look at 1970, so the year immediately following the liquidation of the partnership, to 1992. We're going to look at just Berkshire Hathaway over that stretch of time. Their rate of return, pretty similar, 27.4%. I don't know how you like the Buffett Partnership years and don't like these. These is the golden years of Berkshire Hathaway.

David: Totally, wow. I didn't realize that that's what the number was. It's just like Michael Jordan. He went out at the top of his game, he came back and he won three more championships, and then he went to play for the Washington Wizards.

Ben: And actually, maybe we will see that last part here by tech stocks in the next next chapter. There's this scary thing where you look at this and you're like, maybe Buffett does know how to time the market. No one can, and yet the guy liquidated his partnership in ‘69, bought back in big in ‘71, ‘72, had this run all the way through the early ‘90s, started piling up cash in the ‘90s—and as we'll talk about, wrote a very famous article in ‘99 the year before the dot-com bubble burs,t articulating exactly how overheated everything was as he was piling up his cash.

He is acting on his thoughts here. Maybe he can time the market.

David: Maybe. We’ll save this for part three, but I would say the track record on market timing has not been great of late.

Ben: No, but just to put some numbers around this 27.4% rate of return, if you had bought Berkshire in 1970, on January 1st, which is the day that Buffett distributed it out to everyone when we closed down the partnership, it was $45 a share. At the end of 1992—and of course, these are what we now call the A shares—that was $11,750 a share.

David: Wow. That's bonkers. Today it's over $400,000. Is that right?

Ben: Yeah, it is a record high as of last Thursday and maybe up again this week.

David: Wow, my hat is off. What more can you say? What more can you say except the comparison is Michael Jordan?

Ben: Yeah. Listeners, we will know more in part three. Thank you for listening to The Empire Strikes Back episode of The Berkshire Trilogy. David, you want to do quick carve-outs?

David: Yeah, let's do it. So my carve-out is a great podcast episode on the Armchair Expert podcast, which is so good. Dax of Monica does such a good job. So many good episodes recently. But Seattle love, the Macklemore episode was amazing. Have you listened to this?

Ben: No, I haven't.

David: You got to listen to it. It's so great. Lots of Seattle talk. Dax loves Seattle. He recently was in Seattle. They spent a lot of time talking about it, but Macklemore is so great. They just get into so much great stuff. Just go listen to the episode, it's fantastic.

Ben: All right. Just add it to my queue, literally pulled out my phone and add it to my Overcast queue. Mine has its roots in something that you said earlier this episode. You mentioned the mafia, you mentioned the state of New Jersey. I, for the first time, am watching The Sopranos and it is excellent. I totally see how it kicked off this modern golden era of TV that we have going on.

It was lost on me. I was 9 or 10 when it first came out, but it was lost on me all these years where I've loved shows like Mad Men, Billions, Succession, and going back and watching The Wire. The Sopranos really did sort of kick it all off, it's violent, and it's horrifying in many ways, but God is the writing great.

David: So great.

Ben: I can't recommend it enough. I am in season 6A, so I am nearing the finish line. Nobody spoil it for me.

David: Amazing. What year did The Soprano start?

Ben: I want to say it was like ‘97, ‘98. It was right around the time The Matrix came out.

David: Wow. Oh man, that's a throwback, The Matrix.

Ben: They share a couple of actors between The Matrix and that. It's old enough where you see people who you know from things later in their career, and you're like, oh my God, it's a young so and so. I'm feeling quickly like my parents. When I was a kid, I remember watching things with my parents and they would say, oh my gosh, this movie has young so-and-so in it. That's now me.

David: That’s amazing. We're hitting that time of life.

Ben: We are. Listeners, if you want to talk about all things Acquired, things we missed, things we caught, little notions that you have that we may not have seen in the research. This is a three-parter, so it is not too late to tell us and we can insert these great tidbits into the final part of the trilogy.

Join us in the slack acquired.fm/slack. You could talk to lots of other people. There are 7000 people plus David and I, and it's always a great time there so you should join us.

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David: We'll see you next time.

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