[00:02:45] Jacob McDonough: Yeah, that’s always an interesting place to start. It’s definitely an interesting story and very unique, but basically, Warren Buffett himself had a history of purchasing cheap stocks, so the main answer there, Berkshire was a cheap stock, it had a low valuation.

[00:02:59] Jacob McDonough: I. When Buffett was pretty young, that’s how he got his career off the ground, how he started making money. Early on, he was looking at cheap stocks, those that maybe had a lot of assets. You could liquidate the company for a profit based on like what the valuation was. More so hypothetically. I mean, I, I don’t think too many actually liquidated, but it, he was more of a balance sheet investor.

[00:03:20] Jacob McDonough: And looking at stocks that maybe were selling below liquidation value, or at least had very reasonable expectations of the future or pretty low expectations of the future for that business. And so Berkshire was one of those cheap stocks. He managed a fund at the time, he called it Investment Partnership Buffett, Partnership Limited BPL.

[00:03:38] Jacob McDonough: And so he actually started buying Berkshire just as a, a stock for his fund. And so I don’t think he had any expectations. He’d take it over. And managed the company for so many decades. I don’t think that was quite part of the plan. So I think it was one of the same story he’d been following for many years, buying a cheap stock.

[00:03:55] Jacob McDonough: And hopefully something happens where eventually you can sell for a little more and you know, keep running that playbook. And so maybe what might help is a little background on Berkshire, why it was so cheap or, or unloved. So Berkshire had a long history before Buffet got involved. It was a textile manufacturer, like you mentioned, and one of the products they did, they worked on was they made the inside lining of suit coats.

[00:04:18] Jacob McDonough: So they didn’t make the whole suit coat, but just when you open up like the, the jacket, the inside lining there was one of the things they made. And so at one time, I know they made half of all suit coat linings in the US at least for men’s suit coats. And they were supplier of the year, one time at least for Sears Roebuck.

[00:04:36] Jacob McDonough: And so, They had good service apparently, at least in one point in time. But even with that being said, Sears was not gonna pay them a premium. If Berkshire charged too much, Sears would go find another supplier. There was nothing special that Berkshire did that some other textile manufacturers couldn’t do.

[00:04:52] Jacob McDonough: And there was no real brand to Berkshire because like I said, they didn’t make the whole suit coat. So there was no Berkshire brand on the, the suit coat. Really, it was just the inside lining. And not many people really open up that jacket and didn’t really care about what’s on the. The inside there, and then it sold through places like Sears.

[00:05:08] Jacob McDonough: Berkshire didn’t really have their own distribution and there was no Berkshire type store, so the end consumer wouldn’t really be aware of Berkshire too much, and so there’s no brand, not too many competitive advantages, so it was a pretty much a commodity business. In a commodity business, the low cost producer usually wins.

[00:05:24] Jacob McDonough: Berkshire and their annual reports, even back in this time period would mention that they were not the low cost producer in Japan. There were some Japanese competitors that had much lower operating costs, wages, labor was much cheaper In Japan back in the fifties, I believe the minimum wage in Japan might’ve been 15 cents an hour versus I believe a dollar an hour in the US at the time.

[00:05:42] Jacob McDonough: So it was a tough, tough business, but the market knew that. So it was a pretty cheap. Low valuation which attracted Buffett in the first place. 

[00:05:51] Clay Finck: Yeah. How about we tap into the valuation there? ’cause, you know, the business was not a high quality business. It’s a very commoditized product. They, you know, probably had much higher cost relative to many of the other textile makers, so obviously is the valuation that Buffett was attracted to.

[00:06:06] Clay Finck: So paint some color around that. 

[00:06:09] Jacob McDonough: Yeah, so in terms of valuation, it was selling when Buffett first bought the stock, it was selling for a third of book value about that and below net current assets. So I could define both of those and maybe it helped to give a little more info on, on how the balance sheet looked for Berkshire, since that was a big reason why Buffett wanted to invest in the first place.

[00:06:27] Jacob McDonough: But book value is the shareholder’s equity, the equity capital in the business. So it was selling for about a third of that. And net current assets would just be just the current assets, minus all liabilities. And so, yeah, to explain further, the balance sheet for Berkshire looked like it was pretty heavy in inventory.

[00:06:45] Jacob McDonough: Inventory needs. They owned real estate, they had manufacturing facilities, and so they had a lot of PP and E as well, property, plant and equipment to operate those plants. They had a decent amount of receivables as well, but there was not very much in terms of liabilities to offset these assets. So what this means is equity capital basically funded most of the business, and that means it’s a pretty capital intensive business.

[00:07:08] Jacob McDonough: Some companies might have some funding from suppliers in terms of accounts payable or funding from customers in terms of like deferred revenue. But Berkshire didn’t really have too much of that and didn’t have too much debt either. And so there wasn’t too much leverage. It was mostly funded with equity capital, like I said, and so it took a lot of assets to run the business and it was pretty capital intensive.

[00:07:28] Jacob McDonough: And so back to some of those, the metrics I mentioned, net current assets, so that’s basically receivables and inventory. Berkshire had even minus all the liabilities. The valuation was below that. So theoretically you could think you could liquidate the inventory and collect your receivables and maybe, you know, the valuation would still be below that, assuming the accounting value.

[00:07:48] Jacob McDonough: Was accurate for the inventory and that none of it was obsolete or anything like that. But that’s without counting the long-term assets like the, the real estate and the, the plants and equipment. So when you factor that in, that’s how you get to the, the book value. And once you add in the, the real estate and stuff that’s when the valuation was a third of, of book value.

[00:08:06] Jacob McDonough: So it was. It was pretty cheap in terms of assets and yeah, that’s, that’s really how Buffett got attracted to it in the first place. 

[00:08:14] Clay Finck: Yeah, so Buffett, you know, as many in the audience know, he followed really Benjamin Graham’s approach to investing in many ways. You know, he’s looking for something that’s really cheap, oftentimes trading below book value, and then anticipating that eventually the price and the value are gonna converge over time.

[00:08:30] Clay Finck: So Buffett, I’m sure is looking at. You know what the business is actually doing. Some of the metrics for Berkshire, they were, you know, abysmal. The return on equity was very, very low relative to many other industries. So I’m curious what your take is on what Berkshire was doing, like with their business, with their profits up to the time where he eventually took ownership of the business.

[00:08:54] Jacob McDonough: Yeah, it was very unique what Berkshire was doing during this time period. They were buying back a decent amount of stock. Which today plenty of companies buy back stock, but back in the, in the fifties it was more rare and especially, it was rare for a company like Berkshire to be doing that. So number one, they had some excess capital, but number two, they had some unprofitable plants.

[00:09:12] Jacob McDonough: That management, before Buffett was involved, management decided to close some of those plants, gather up that capital and buy back stock. Like I said, that was unique for that time period, and management wrote about their plans to do that in some of the annual reports back in that time period. So that’s clearly something Buffett could see they were doing.

[00:09:30] Jacob McDonough: And he might’ve liked that capital allocation strategy. At least it still didn’t make it a, you know, it wasn’t gonna be a high growth stocker. It wasn’t gonna get the market too excited, but still it was, even though it was a bad business, they were doing some interesting things or unique things from a capital allocation standpoint that might’ve attracted Buffett.

[00:09:48] Jacob McDonough: And it was a relatively small company, at least in terms of valuation. And so you knew management talked about they’re gonna buy back stock. So you, in one sense, you knew there was a large buyer of stock. I would wanna, you know, continue purchasing stock. So as Buffett accumulated a, a stake in the company, he’s talked about, he might’ve thought that management will come and, and wanna buy back some of his stock.

[00:10:09] Jacob McDonough: Given he’d be a major shareholder there, he would be someone they could buy from. And so that might’ve been his plan from the beginning. It didn’t really work out that way for him, but it was very unique in that time period, what Berkshire was doing. 

[00:10:20] Clay Finck: And then it was in 1965 where Buffett ended up taking full control of the company.

[00:10:26] Clay Finck: I’m curious if you could tell a bit of the backstory of, you know, 1962, he is just purchasing it because it’s a cheap stock, make a return for his partners and himself through his partnership. So what was the story of why he ended up taking full control of the company in 65? 

[00:10:42] Jacob McDonough: Yeah, so I know in some of the biographies they do a good job of explaining how he met with the, the previous management team or the, the previous c e o of Berkshire and they agreed on a price.

[00:10:52] Jacob McDonough: Berkshire was gonna buy back Buffett steak or BPL stake his fund. The, the stake is fund owned at a certain price and back then, Stocks were quoted in eighths, like one eighths of a dollar or a point, is how they were quoted back then. And so whatever price they agreed upon, the actual offer that came back was like an eight of a dollar below what they agreed upon.

[00:11:11] Jacob McDonough: So apparently Buffett has said he, he felt a little cheated. And so that’s kind of when his decisions changed on what to do there, whether he was gonna take the lower price that. It was below what they agreed upon or if he was gonna continue buying even more of the stock, which is the route he ended up going.

[00:11:26] Jacob McDonough: And so interesting to think what could have been. But I’m sure glad he went down this path ’cause it’s been a lot of fun to study over the years as he took over this company. I. 

[00:11:35] Clay Finck: And then once he did take full control of it, you know, this is when Berkshire, it really just went through a transformation period where a whole new mindset entered the management team with Buffett now running the company, what were some of the key decisions he made early on once he did take full control in 65 that, you know, just really teach us a lot about capital allocation here.

[00:11:56] Clay Finck: What were some of the things he did? 

[00:11:58] Jacob McDonough: Well, what was varied key was right away he was able to generate some cash profits, which we could talk about later, how he’s actually able to do that. But he was able to generate some cash profits right away, and most people would take that cash and put it back into the business.

[00:12:13] Jacob McDonough: They’re, they’re used to what they’re currently in, but instead, Took that cash and temporarily put it into his stock portfolio of stocks. That portfolio did really well, more than doubled in a couple years, and I assume he was just looking for an acquisition to make. In the meantime, he bought a couple businesses after that, so he bought National Indemnity and Insurance Company and he bought Illinois National Bank, a bank that was located in Rockford, Illinois.

[00:12:34] Jacob McDonough: Those two businesses ended up being very good, produced plenty of cash flow and stuff, and so those were some of the early decisions that really kicked off Berkshire on its journey from being this. Bad business that was, you know, doomed to, to go extinct eventually and kinda helped generate some cash to move, move in the right direction because before Buffett took over, like I said, they were buying back stocks.

[00:12:52] Jacob McDonough: So they were really shrinking the business. They were purposely closing down some of the plants, buying back stocks of the capital and the business was going down. They’re shrinking, getting lower and lower sales as some plants closed. Obviously Berkshire’s crossed a trillion dollars in assets this last quarter actually.

[00:13:06] Jacob McDonough: So they’ve the opposite from a shrinking dying business into what it is today is just incredible. 

[00:13:12] Clay Finck: And one of the key things that sort of stuck out to me in what Buffett was doing at this time is he was drastically trying to cut costs because the profit margins in this business were just. Razor thin.

[00:13:24] Clay Finck: And you know, it just makes me really think about, one of the key takeaways I think from Buffett in this example of at least, is how mindful he is of costs. I remember reading Alice Schroeder’s book to snowball and just thinking, nobody is as cheap as this guy. You know? He is always looking for ways in his personal life to increase his income, decreases expenses, and I think it, the takeaway here is that, You know, when you’re looking at a management team or a C E O and you see that they’re very mindful of their expenses, and that’s just a very admirable quality.

[00:13:54] Clay Finck: You know, it’s so easy for management teams and CEOs to just expense these extravagant business trips and put it on the company, go fly first class, et cetera. I think Buffett cutting costs was a really critical decision in this case, you know, because of the razor thin margins, and then that allowed him to go out and make those acquisitions that you mentioned.

[00:14:14] Jacob McDonough: Yeah, that’s very true. There’s some CEOs that likeBuffett treat shareholders money in a very conservative way and they don’t act like it’s their own personal bank account to dip into. It helped that Buffett owned a lot of stock himself, so it was, he was one of the shareholders that helps align incentives, but he definitely didn’t waste any, any of the shareholders’ monies by any means.

[00:14:32] Jacob McDonough: And so, yeah, one thing he was able to do right away, like you said, cut costs. I didn’t really realize this until I was studying this time period for my book, but when he took over Berkshire, cost of goods sold, dropped by 10%, which might not sound too crazy, but like you said, the margins were very low. So any little bit of cost savings you can get, achieve would be meaningful.

[00:14:51] Jacob McDonough: And in his first year, that cost savings, 10% of cost of goods sold, ended up being about $5 million of cost savings. And so it really flipped from being negative profits to maybe break even. And then him having that cost savings flipped to them having some solid profits. The first couple years he was in charge.

[00:15:07] Jacob McDonough: His first year, they had $4 million of profits and $5 million a second year. And so in 1962 when he first invested, it had a $12 million valuation Berkshire did. And so he got about $9 million of profits his first two years in charge, so he got most of his money back right away. They also had some tax credits, tax lost carry forwards built up from years of losses before he took over, which again was in the annual reports leading up to to this time period.

[00:15:31] Jacob McDonough: So the profits he made. We’re tax free. And so this was really $9 million of cash flow in his first two years after tax cash flow he could actually take out of the business and reinvest. Like I said, he didn’t put it back into the textile mill. He didn’t throw good money after bad. He put the money into stocks first.

[00:15:49] Jacob McDonough: Which one interesting thing is some of the stock portfolio was some quality companies. They owned American Express, Disney and Wrigley at the time. Those were just three of the, the companies and 55 years later, those are still quality businesses. Very durable and even close to the time period he bought ’em, American Express and Disney.

[00:16:06] Jacob McDonough: Some people considered part of the Nifty 50, so these were quality names. He wasn’t just only investing in the Berkshire Net current asset, cheap stocks. He also had some quality names, even in his younger days that, you know, I feel like I personally didn’t know about before researching for my book. So he did have some quality in the portfolio, which is interesting.

[00:16:25] Jacob McDonough: The other thing I wanna mention too, though, with that time period is. He did have some really nice profits those first two years. There might be a little luck involved, or at least a little cyclicality involved there, because in future years, even when Buffett was in charge and, and running Berkshire, there’s plenty of years of losses or poor returns on capital for the textile mill, it was a cyclical business, so maybe Buffett knew someday soon they would have some profits in the site when the cycle turned good.

[00:16:50] Jacob McDonough: But I don’t think just ’cause his first two years that he took over, they, they had some solid profits. It didn’t mean that he turned around the business for good. I mean, I. With him in charge and him cutting the cost. They definitely were much more profitable than they would’ve been with the previous management team.

[00:17:03] Jacob McDonough: But it still, by any means, wasn’t a great business. It was just one way he was able to generate capital and the previous manager, some books write that he had a penthouse office and his secretary had a secretary. So that might be the type of c e O where Buffet, if he got to know him or, or see anything as an investor before he took over the company.

[00:17:22] Jacob McDonough: Maybe he could have spied some ways, he could have reduced costs a little bit. And they, in your report they mentioned that overhead was reduced and so there’s not too much more information besides that. But clearly he was able to run a much more lean operation once he was in charge. 

[00:17:37] Clay Finck: And then one of the key highlights, it was in 1967 where, you know it was sort of a pivotal moment in Buffett’s investment career.

[00:17:45] Clay Finck: In 1967, Buffett for the first time allocated capital outside of the textile industry for Berkshire, and that was with the purchase of National Indemnity out of Omaha, which you mentioned earlier. It was March, 1967, Berkshire paid $8.6 million for 99% of shares in National Indemnity, and then a hundred percent of shares in National Fire and Marine Insurance Company.

[00:18:06] Clay Finck: So I’d love for you to just walk us through how fundamentally National Indemnity was just a much better business than the textile business that Buffett originally got into in 62. 

[00:18:17] Jacob McDonough: Yeah, the insurance business was a better business, and part of the reason is how much capital needed to be invested in the business and how you could invest that capital.

[00:18:26] Jacob McDonough: How you could use the assets. So an insurance company doesn’t technically require any capital to operate. There’s no real inventory needs, and you don’t really need much equipment or plants or anything like that. Not much real estate, but what you do need is some capital to fall back on in case there’s losses, in case there’s tough times, and you owe a lot of money on the policies you’ve.

[00:18:45] Jacob McDonough: Promise to policy holders. And so since you need capital to, to kind of cushion yourself, it can be in cash. The capital can be invested in cash bonds or stocks or other types of investments. And so it made it for a perfect situation for someone like Buffett who was gonna have stocks anyway, it didn’t quite matter if the stocks were in his personal account or in, in an insurance company.

[00:19:06] Jacob McDonough: Someone like that could put the capital work in a much better way. I could talk about Float in a minute here too, which is a big part of the story. And it definitely changed over the years how we could use float. But an insurance company, again, you have your equity capital, your book value, that’s your shareholders’ funds, and then you have your liabilities, which mostly were policy holders funds kind of known as float what you owe policy holders in the future.

[00:19:30] Jacob McDonough: So unlike Berkshire, it had a lot of liabilities that leveraged the business. A lot of liabilities that finance those assets at Berkshire of national indemnity, excuse me, the, the insurance company. And it made for a very different business than than Berkshire. In a way though, there is a few similarities.

[00:19:45] Jacob McDonough: Insurance can be pretty cyclical. It’s not many barriers to entry and insurance. So when times are good, more and more firms kind of rush in or maybe. Lower prices and then when times are bad, some firms exit and prices can go up. So it is a little cyclical, kinda like the, the textile mill too. So it’s not a perfect business by any means.

[00:20:03] Jacob McDonough: But it was much better than the textile mill. 

[00:20:06] Clay Finck: Yes. And it’s national indemnity. It’s not a cigar but type business. So could you walk us through maybe a bit of a valuation comparison of how national Indemnity looked when he purchased it, versus Berkshire Hathaway, which was definitely more of a cigar butt type play.

[00:20:21] Jacob McDonough: I mentioned Berkshire was selling for a third of book value when he first invested in that company and national indemnity, he actually had some goodwill in the purchase, which means he paid above book value for that company. And so what’s really interesting is that he talked about his purchase price in later years that he paid for National indemnity.

[00:20:39] Jacob McDonough: And one thing that was interesting was he knew that the. The book value, the equity capital of national indemnity could be invested in stocks. So just using round numbers. If he made a $10 million acquisition for paying book value for an insurance company, it didn’t really matter if he had $10 million of stocks in his personal account or $10 million in insurance company, that was kind of a wash.

[00:21:00] Jacob McDonough: So if he paid book value, He didn’t really consider much of a purchase price because like I said, he, he was gonna have that $10 million invested in stocks either way. But what it could do, it would leverage his stock portfolio into additional income streams, which means he’d have the potential with an insurance company, one, to earn a return on stocks just like he would in his personal account.

[00:21:20] Jacob McDonough: But then he’d have the opportunity to potentially have underwriting income. You’re also taking risk on, in terms of maybe having underwriting losses as well, and then you’d have potential to earn interest income on bonds. A fixed income portfolio, if you invest your, your float, your policy holders liabilities into into bonds, and so the additional income streams will be underwriting profits and interest income on a fixed income portfolio.

[00:21:42] Jacob McDonough: Would be two ways. He was able to leverage his stock portfolio into additional income streams. So that’s pretty interesting. So National Indemnity, though, he paid above book value and some people might wonder why he did that because some insurance companies, I think plenty of insurance companies would sell below book value back then.

[00:21:58] Jacob McDonough: And even today. I mean, valuations change. Constantly. Like I said, it’s a cyclical business, but even in modern times there’s plenty of insurance companies that will dip below book value from time to time, and really what it comes down to is Buffett was laser focused on finding a high quality insurance underwriter.

[00:22:14] Jacob McDonough: Like I said, I. He was leveraging additional income streams, but he was taking on risk from potential underwriting losses, so he was willing to pay some goodwill, willing to pay above book value for a insurance underwriter that he could trust that would be a profitable underwriter. Over time, national Indemnity proved to be high quality in that regard, and so he paid a little bit above book value, but.

[00:22:34] Jacob McDonough: Still, the goodwill was pretty low, so even under modest assumptions with interest income on bonds, it was still gonna be attractive, an investment as long as underwriting could remain, break even, or profitable, even if it was just slightly negative underwriting, it’s still, the math would work out to be a pretty attractive purchase price.

[00:22:52] Clay Finck: And you know, a key part of him purchasing national indemnity. I’m sure this really, really attracted him to that business. It’s the float. So policy holders, they purchase an insurance policy with national indemnity. They get to hold the money until they have to pay out claims later. So they have some leeway with some of the things they can do with that float.

[00:23:11] Clay Finck: And Buffett, of course is thinking, I’m gonna go out and purchase. Bargains out on the market and use that capital and you know, grow the company even more through that. So talk about how Buffett used this flow, how much leeway he was given, and maybe touch on some of the regulatory pieces that work around this.

[00:23:27] Clay Finck: ’cause insurance is definitely a pretty regulated business. 

[00:23:31] Jacob McDonough: Yeah, that’s right. Insurance is regulated heavily and it’s state by state, so they’re state regulators that, that you have to deal with. And regulators look at a few different things, but mainly how it affects insurance companies, at least from an investor standpoint, is how aggressive a company can be in terms of its revenue and also how aggressive it can be with the assets that it has.

[00:23:50] Jacob McDonough: And so Berkshire today looks very different than it, than it did when he first bought National Indemnity Berkshire’s Insurance companies. Today, Berkshire’s size is so massive. It has very few limits on what it can do. There’s no one who matches Berkshire’s size in the insurance industry and very few companies that match its size in terms of, maybe not sales exactly, but equity capital and its balance sheet and stuff.

[00:24:11] Jacob McDonough: There’s very few companies that have retained as much earnings over the years and just compounded over such a long time. Berkshire’s in the league of its own. So due to its size mainly, but also ’cause of some of its diverse earning streams outside of insurance, it has very few if no limits on what it can do.

[00:24:28] Jacob McDonough: Even in, in the two thousands, it bought Burlington Northern B N Ss F through the insurance company, through National Indemnity. They acquired a railroad, a private business, which. Really, no one else could really do that. And I think it might’ve been the nineties really when this started to change, where they got big enough to really maybe not have quite so much limits on what it could do.

[00:24:47] Jacob McDonough: And again, that was just due to its size. In the early days though, when Berkshire first bought National Indemnity, it looked much more like a normal insurance company. And if I tried to acquire an insurance company today, I would’ve to operate much like National Indemnity did in the very early days. And in that case, in the first few decades, Berkshire.

[00:25:03] Jacob McDonough: Was heavily invested in stocks, but just related to its equity capital. And then the, the float was more so invested in bonds, but it was still very attractive for a person, like, like Buffett based on the, the purchase price he paid. And I mentioned regulators, what they look for. One thing in terms of revenue, you could call it.

[00:25:21] Jacob McDonough: Underwriting leverage. A way to explain it is each, when an insurance company makes a sale, they’re taking on risk because it’s an insurance policy that they might have to pay out claims on later. And so each sale you’re taking on more and more risk. And so what a regulator usually looks for is how much revenue or premiums written you have.

[00:25:40] Jacob McDonough: Compared to your capital, statutory surplus or, or your equity capital because your capital’s your cushion, you can fall back on in in tough times. So you would be considered pretty leveraged if you had a high amount of revenue compared to that. That capital and regulators will limit how high certain companies can go with that.

[00:25:58] Jacob McDonough: A high quality. Underwriter that maybe is pretty safe on the balance sheet side of things could maybe, in extreme case, write four or five times as much revenue, as much premiums as like the capital it has on hand. Geico actually was one who did that before Buffett got involved, but a lot of companies just have one or two times as amount.

[00:26:16] Jacob McDonough: Amount of revenue as their capital and Berkshire was actually pretty safe over its history. There’s plenty of times where they had far less revenue than capital. Their capital might have been even maybe 10 times as much as their revenue in some years of their insurance company. So they were much more safe in terms of like leverage my underwriting aspect.

[00:26:33] Jacob McDonough: But that’s one thing I didn’t realize in the sixties when they first acquired National Indemnity Buffett was much more limited on what he could do with the float. And today they’re just so unique in terms of their size that there’s much more, much more things they can do with it in that aspect. 

[00:26:46] Clay Finck: I’m also curious if you could talk to some of the advantages that Berkshire has being in the insurance industry.

[00:26:54] Clay Finck: You mentioned insurance, you know, being cyclical where companies get, get excited, they jump into the insurance market and then they jump out when things aren’t going as well. So Berkshire’s unique in that, you know, it has this insurance operation, but it’s a conglomerate, so it’s investing in other things.

[00:27:08] Clay Finck: You mentioned the B N S F that purchased that they made in the two thousands. So talk to the advantages that Berkshire has. Being in the insurance industry, purchasing national IND indemnity, and then turning into a conglomerate that you know has a bit more flexibility in some of the things they can do and the advantages they have there.

[00:27:26] Jacob McDonough: I. Yeah, so I’m a big fan of the Berkshire structure itself. I think the media and investors watch Warren Buffett plenty and the stocks he invested in which is deserved. He does a great job. But I think Berkshire as a company and Berkshire as a structure sometimes gets overlooked or maybe overshadowed from, I.

[00:27:42] Jacob McDonough: Warren Buffett the person, ’cause he’s such a genius. But the Berkshire structure has a lot of advantages and the national indemnity is a great example of, of some of those advantages. Number one, Berkshire really retained all their earnings since Buffett got involved. They really haven’t paid any dividends.

[00:27:56] Jacob McDonough: They’ve repurchased some shares in recent years and and stuff like that. But for the most part, for many, many decades, they retained all their earnings. Their capital grows and grows. So in a way, having more capital, you become a, a safer corporation versus a company that’s always paying out all their dividends.

[00:28:11] Jacob McDonough: If you kind of run into a, a tough time or a hiccup, you might wish you had some of that capital back that you paid out as a dividend. So that’s number one. Number two, they had a diverse earning streams from many different industries, and that’s really helped too in tough times. Insurance is cyclical and if there’s ever a a difficult period in one industry, they have some profits coming in from some others.

[00:28:31] Jacob McDonough: So those are two main ones, but I think the most important to me is how aggressive subsidiaries could be within Berkshire versus as a standalone company. Maybe one example would be See’s Candy. If it was a standalone company, it might keep a lot more cash on hand. Then when it’s within Berkshire and, you know, when Covid hit and, and a company like CS had to close down for a while, it would really want some, some cash if it was a standalone company.

[00:28:54] Jacob McDonough: For situations like that, that might be rare, but. It really doesn’t need any cash or very little if it’s within Berkshire, because Berkshire, the parent company, has plenty of cash and the ability to borrow since it’s so large as well, that it could help See’s candy out when it’s within the parent company there.

[00:29:10] Jacob McDonough: National indemnity, I talked about underwriting leverage before, I think as a standalone entity, they may be, they didn’t have too aggressive of leverage, but maybe a little more leverage than someone like Warren Buffett would have if he, if that was the only business he was ever gonna own. But once they joined Berkshire National Indemnity could keep being as aggressive as they wanted with their capital as a subsidiary.

[00:29:33] Jacob McDonough: And maybe it looked slightly aggressive if you only looked at that one subsidiary level. But if you zoom out to all of Berkshire, how much more capital Berkshire had. It was very, very safe, very conservative from a leverage standpoint. And so each subsidiary maybe could keep less cash on hand, could be more aggressive with their underwriting leverage or, or their leverage within the Berkshire system than without it.

[00:29:56] Jacob McDonough: And maybe last but not least, the during the period my book covers, there’s tons of examples of overcapitalized firms that have a ton of cash on the balance sheet. They just have nowhere to put it. They might be great businesses in a niche or in one geography, but they just ran outta room to grow, ran outta room to reinvest, and so that’s okay.

[00:30:15] Jacob McDonough: Within the Berkshire system, they can get rid of that cash, send it to Omaha, Buffett can reinvest it elsewhere, and it, it’s a perfect home for a Berkshire type company. Yeah, those 

[00:30:25] Clay Finck: are all fantastic points and I’m reminded of when I read The Outsiders, they have a chapter there that, you know, covers Warren Buffett and the Outsiders that really talks about all these CEOs and the unconventional things they’re doing, and I’m reminded that with the insurance business, with it being so cyclical, I.

[00:30:41] Clay Finck: Buffett, you know, he wants to be really conservative with the insurance operations, but due to that cyclicality, he’ll like really take advantage of those periods where he’s able to get really attractive risk reward opportunities within the insurance industry. And then when you know, people get too excited, they jump in and you know, rates start going down relative to the amount of risk taken, then Buffet’s willing to pull back.

[00:31:02] Clay Finck: And I think another point that ties into that. Is investors can get upset at him because you know, the operating results can be a bit choppy, but Buffett is all about creating that shareholder value, and he is not really worried about what the accounting numbers are gonna look like from year to year.

[00:31:17] Clay Finck: He’s just really, you know, focused on long-term shareholder value and isn’t falling prey to what Wall Street wants and what shareholders want. 

[00:31:26] Jacob McDonough: They proved time and time again that over the decades there was plenty of periods where insurance revenue in particular dropped by a very large amount, and a standalone insurance company, especially one that had to answer to Wall Street and large shareholders.

[00:31:39] Jacob McDonough: If that was a standalone company, they might take some heat, especially if they didn’t have a large shareholder like Buffett kind of in charge and. In running the show. So they had the culture in place to allow revenue to, to decline when it made sense. Because in insurance you have to say no to bad sales, which sounds easy, but it’s tough when you need, you have a quota you have to hit for the month or a sales goal, and you just talk yourself into maybe lowering your price just a little bit.

[00:32:03] Jacob McDonough: The next time, you’ll lower it a little more and you can really fall prey to that. And in insurance, you get cash right away and you deal with problems later in terms of claims being paid out later. So it, it is tempting for some people to kind of make some excuses or talk yourself into lowering your prices to have cash come in the door right away.

[00:32:20] Jacob McDonough: Berkshire proved it had the culture. To say no to it. B, never put pressure on that for companies, for sales goals or growth and insurance all the time. But the Berkshire structure was a big reason why the culture was in place, but the structure really made it make sense where they could go through long periods of big decreases in sales, and it still was okay.

[00:32:37] Jacob McDonough: From a corporation standpoint, 

[00:32:39] Clay Finck: since we talk about flow and national indemnity, I’m reminded of. Blue chip stamps and you know, I remember reading this Schroeder book on the snowball and they keep mentioning this company, blue Chip Stamps. I’m like, what in the world is this business? So what did you find about blue chip stamps and the, the way Buffett got into this one, and maybe how float sort of relates into this business too?

[00:33:02] Jacob McDonough: Blue Chip’s a really interesting business. So Buffett and Munger both bought stock of Blue Chip stamps a publicly traded company back when they were running their fund operations, BPL and, and Munger ran Wheeler, Munger, I believe it was called. He had his own partnership or fund set up. So they each kind of separately were buying stock.

[00:33:20] Jacob McDonough: Although you could say they’re collaborating on that position, but basically what Bluechip was was a rewards program. A loyalty program for retailers. So say grocery stores or something like that would, you know, hand out some trading stamps to customers and they could collect them over time and eventually if they got enough stamps, they could redeem ’em for merchandise.

[00:33:38] Jacob McDonough: And so Bluechip kind of like insurance float. They’d get paid right away by sending the stamps out, and then once merchandise was redeemed, then Bluechip would have some of their costs come in so much like insurance float, get cash first and pay some claims or expenses later. It was a form of deferred revenue or flow for Bluechip.

[00:33:55] Jacob McDonough: It happened to be unregulated because there was no, unlike insurance, the trading stamp industry was not really regulated too much. There was a few antitrust issues with some of the big companies, but it was a pretty interesting business. And so what they’re able to do with that, really from day one, there was some.

[00:34:11] Jacob McDonough: Many years, in the early days, even once Buffett and Munger took over where stocks, they were able to use the float to buy stocks right away. They didn’t have to wait till they got a massive scale in size. There were plenty years in the early days where you could see the equity securities. The investments on the balance sheet far exceeded the book value of the company, the equity, which means that liabilities must have been funding some of those assets, some of those stocks.

[00:34:33] Jacob McDonough: In this case it was float and so it blue chip. Actually, pretty quickly the the original trading stamp business declined. And in the period my book covers, my book goes from 1955 to 85, 10 years before Buffett took over Berkshire all the way until 85. When the textile mill closed down in that same timeframe, blue chip basically went extinct.

[00:34:52] Jacob McDonough: The original trading stamp business by 1982, I believe revenue was down 93%. Almost zero by that point, but it was still a very successful investment in company. Blue chip. That was because they actually bought See’s candy through a blue chip, and they bought Buffalo Evening News through Blue Chip and some of their stock investments did really well.

[00:35:10] Jacob McDonough: And eventually Berkshire owned Bluechip stock and then Bluechip merged into Berkshire later on. And so even though this business declined, it ended up being really well just because of what they did with the float. 

[00:35:21] Clay Finck: Another question that comes to mind here. Speaking of a dying business, I think about the textile business again, Buffett took over this business in 65, and it wasn’t until the 1980s where he decided to fully liquidate the textile business, but it was very clear to him that this was not a good place to allocate capital.

[00:35:40] Clay Finck: And you know, he is compounding all this capital in these other areas. Insurance and then purchasing securities. So Buffett being the. Kinda the master capital allocator that he is. I’m curious what your thoughts are on why he didn’t just, you know, by the late, say the late 1960s, why he didn’t just liquidate the textile business and start, you know, plowing it into other businesses.

[00:36:02] Jacob McDonough: Yeah, that’s definitely an interesting question and I think, and mostly I assume, has to come down to the personal side. It’s difficult to not only fire employees, but completely shut down a business. And maybe my speculation on the very early days before he took it over, or maybe the first two years he took over Berkshire, maybe he thought he could turn it around slightly.

[00:36:21] Jacob McDonough: I don’t think he ever thought it’d be a a great business by any means, but maybe especially after the first couple years, it was pretty profitable. I just wonder if he thought maybe I could turn this around to make it achieve. Okay. Returns on capital or decent returns on capital, acceptable levels where they wouldn’t have to shut it down.

[00:36:39] Jacob McDonough: Potentially. Over time, more and more it became clear that that was not gonna be the case and, and it was not gonna earn acceptable returns on capital. But the other thing too is over time it became more and more irrelevant in terms of the size of the operation. Berkshire was growing, growing, and growing, but that original textile mill was kind of shrinking and not, definitely not growing.

[00:36:57] Jacob McDonough: So over time it became less and less meaningful as a percentage of earnings or. Capital invested even. So it was pretty irrelevant. So on one sense, for a while, maybe you were thinking, well, it, it’s not dragging us down too much of overtime, like once the years went on. So maybe you could kind of just let it continue on for the, the sake of some of those employees there.

[00:37:17] Jacob McDonough: Where it finally became, where they had to shut it down was Berkshire. Allowed it to continue operating, but they did not invest heavy in capital expenditures. They didn’t throw more good money at this textile mill. Good money after bad. And by 1985, I believe it would’ve required some major capital investment to keep it going.

[00:37:35] Jacob McDonough: A lot more equipment and maybe new factories and stuff like that. Eventually, it was gonna need more money plowed into it to keep it going, and at that point it finally was, they weren’t gonna put any more capital in. So that’s when it finally closed down. 

[00:37:49] Clay Finck: Before we transition to talk about the 1970s, what you called, you called the expansion period for Berkshire.

[00:37:55] Clay Finck: Let’s talk about how Berkshire’s shares performed, because Buffett’s kind of known for just compounding at crazy rates in his early days. So how did Berkshire’s stock do throughout the 1960s and what were some of the key drivers you found in, you know, the performance of the stock? 

[00:38:11] Jacob McDonough: Yeah, it did pretty well in the sixties.

[00:38:13] Jacob McDonough: The seventies were a little more, there were some tougher times, a little more interesting to talk about, which we could talk about in a minute here. But in the sixties it did pretty well, and so it had an evaluation around $12 million when he first invested by the end of 1969, by the end of that period, it was over $40 million, so 12 million to over 40 million in valuation.

[00:38:34] Jacob McDonough: The stock did a little better though because. There was some shares being repurchased in the early days before Buffett took over those first couple years, and maybe even a little bit of shares repurchase once. He did take over the company there too. And so I believe maybe 27, 20 8% compound return from 62 when he first invested all the way until the till 1969.

[00:38:53] Jacob McDonough: So very good returns. And the business also was growing at a nice rate, like book value was compounding at a nice rate and. Was in roughly the same ballpark as how the stock performed, but the company’s invested in much better businesses in terms of much better return on capital and much better growth prospects by 1969 and more diverse, definitely than the early period too.

[00:39:15] Jacob McDonough: So it was growing. It was getting better and better over that time period as well, and the stock did pretty well through 1969, 

[00:39:23] Clay Finck: turning to the early 1970s Berkshire, they continued their expansion in the insurance industry. They opened up shop in the reinsurance space and home state insurance segments as well, and then they acquired.

[00:39:35] Clay Finck: An urban auto business too. So one of the interesting pieces that stood out to me in reading this part of your book and studying the sixties and the seventies is looking at Berkshire’s unconventional use of debt. I talked about how Buffett was pretty unconventional and being kind of counter-cyclical with the insurance segment, and then he kind of applied this unconventional approach to using debt as well.

[00:39:57] Clay Finck: So talk to us about how Buffett utilized debt in expanding the conglomerate Berkshire. 

[00:40:04] Jacob McDonough: Yeah. One thing I noticed, it was pretty clear that Puff and Munger really valued liquidity and flexibility over maybe being debt free. They felt much more comfortable having a little debt with plenty of liquidity versus maybe drying up some liquidity, but being debt free.

[00:40:20] Jacob McDonough: And so they did have more debt than, I would’ve assumed they had more debt than, than just, I would’ve assumed from listening to the more recent annual meetings or reading some of the more recent letters, but it was never too crazy. Of debt and compared to maybe average corporations or some conglomerates out there that maybe get more aggressive with leverage or private equity or leverage buyout firms, they were never quite, you know, they were still pretty conservative overall in terms of their debt, but they just had a little more than I would’ve assumed just from listening to the more recent, more recent times.

[00:40:51] Jacob McDonough: But they always structured the debt to be very long term. So usually the debt wasn’t due until 10 to 20 years out. So that gave them some flexibility from that, that aspect. It was very long-term debt. And then also, like I said, they had plenty of liquidity. So maybe like a blue chip stamps, when they made an acquisition of Buffalo Evening News, they had enough stocks on hand.

[00:41:11] Jacob McDonough: Stocks and cash to make the acquisition, but they didn’t sell those stocks. They didn’t, maybe they would’ve had to pay some taxes on the stocks that went up in value and then they would’ve had less liquidity. They didn’t sell their stocks. They didn’t get rid of their cash to make the acquisition.

[00:41:23] Jacob McDonough: They’d take out some debt and either over time they could feel confident, either from cash flow from the businesses, the diverse group of businesses could pay off that debt, or they could sell some stocks over time if they needed to. They had some flexibility. But they valued the liquidity, they valued, they didn’t wanna get rid of the stocks they had that were businesses that they, they liked.

[00:41:42] Jacob McDonough: So they were willing to take on a little debt in those early days, especially. 

[00:41:46] Clay Finck: So as I mentioned, you referred to the 1970s as the expansion phase for Berkshire. We could probably make this podcast hours long if we talk about all the businesses that Buffett got involved with. But what were some of the high points for the 1970s in their expansion phase?

[00:42:02] Jacob McDonough: Yeah, I’d say the biggest driver of expansion in the seventies was See’s candy. See’s candy itself kept growing, but it also didn’t really need any capital even when it was growing. All that, not only was it growing, but the cash it was producing was able to be sent elsewhere to to be invested elsewhere. So See’s Candy was definitely a very stable, important part of the growth story, especially in the seventies.

[00:42:23] Jacob McDonough: Besides that, they made some really great stock investments. Some of their legendary investments in equity securities happened in the seventies because there was a tough bear market that we could talk about too. But two of that came up, were Washington Post. During that time period and Geico, both during that time period.

[00:42:38] Jacob McDonough: And so those definitely were, were major growth drivers. I think they put less than 10 million in cost into Washington Post. By the end of the period my book covers that was over 200 million worth, over 200 million. They eventually put in 45 million into Geico, and that was worth almost 600 million by the end of the period.

[00:42:54] Jacob McDonough: So, I mean, considering Berkshire started with a $12 million valuation, when you start approaching a billion dollars in just a couple stocks, it’s just incredible growth to see. And I could talk about Geico, the Geico point there too. I actually did a, a podcast on my own on recently on Geico in the seventies.

[00:43:09] Jacob McDonough: And that went over an hour and a half just on that topic of Geico in the seventies. So I’ll try to make my points a little quicker here, but it, it’s definitely an interesting time period. And Geico was very close to bankruptcy in the seventies. They had decades of growth, nonstop growth. Decades of profitability.

[00:43:25] Jacob McDonough: They were an excellent company, but insurance is a tough industry and you have to always execute. And Geico faced some struggles and management did not execute at the time. If you’re in a great business, in a great industry, maybe you can, it’s okay to fall asleep at the wheel a little bit there and maybe not always be executing and you can survive and maintain your place in in the insurance industry if you.

[00:43:48] Jacob McDonough: Don’t execute. You could risk bankruptcy or at least lose your place in a big way. And so inflation was a major problem in the seventies. There was a couple years where there was double digit inflation, double digit percentage inflation for a couple years straight. While Geico didn’t really in increase their prices, they were charging customers.

[00:44:05] Jacob McDonough: And so insurance is a very low margin business and just a, with a low margin business, if inflation raises your cost by 10% or more for a couple years straight and you don’t raise your prices that you’re charging customers. You’re gonna be in in some big trouble. Another issue with insurance businesses, it’s delayed when you recognize some issues.

[00:44:24] Jacob McDonough: You might have an insurance policy that you don’t owe on for a couple years, so, In the meantime, you’re kind of estimating your costs, but it might not become apparent those exact costs until years later. And so Geico was definitely slow in recognizing they had an issue and it, it almost got them into bankruptcy.

[00:44:40] Jacob McDonough: And another issue with Geico is they were very leveraged in terms of underwriting leverage that I was talking about earlier. Their revenue was four to five times higher than their capital. And so that means they had very little room for error. That’s about as high as regulators will allow you to go in their annual reports.

[00:44:56] Jacob McDonough: At the time they mentioned regulators were okay with the high leverage management mentions. It is very high leverage, and they said regulators were okay with it because Geico had a history of underwriting profitability. And then at the time Geico was. Pretty conservative with their balance sheet in terms of how they invested a lot of safe bonds and some cash and stuff like that before Buffett got involved.

[00:45:15] Jacob McDonough: And so they had very little room for error in a couple years of poor execution. You know, they, they had some major, major losses that put ’em on the brink of bankruptcy. Jack Byrne entered the scene and, and helped right the ship and he really turned things around. And Buffett was patient investing. I know I was reading the annual reports and they had decades straight of growth and profits and they looked great.

[00:45:36] Jacob McDonough: They had one bad year of one negative year of underwriting profits and the stock took a major hit. And I’m looking at this and I’m thinking, you know, one bad year out of 20 or 30, you know, maybe that would’ve been the time to buy, but Buffett waited a couple more years. He was smart enough to realize that the company.

[00:45:51] Jacob McDonough: Was under reserving on some of their cost reserves. Their pricing was, was off. He was an expert in the insurance industry and he was patient. Waited a couple more years and, and really didn’t invest until Jack Byrne was involved in the great c e o. Was there to orchestrate the turnaround. 

[00:46:05] Clay Finck: Yeah. I think most people are pretty familiar that Geico, you know, is one of the big winners for Berkshire over the years and.

[00:46:12] Clay Finck: Geico was also one of Benjamin Graham’s really big winners too. He is the cigar bud investor, but one of his, you know, he made a lot of his money just buying and holding Geico for so many decades, and it’s amazing just like how much struggle that business went through throughout the seventies to paint some color on how dire the situation was for them.

[00:46:30] Clay Finck: Geico shares. In, I think it was 19 73, 74, that time period, the shares declined by 96%, and I, I read in 1976, Berkshire owned 15% of Geico, and then by the end of 1980, they owned 35% of Geico. I’m almost curious if you know Berkshire being this conglomerate and they’re so well capitalized. Do you think that, you know, being in the situation they were, they were sort of able to hedge a lot of the bankruptcy risks with Geico, where if Geico needed the capital Berkshire kinda step in and provide that back stuff for them.

[00:47:05] Clay Finck: So do you think Buffett, you know, was kind of thinking about this too when he was purchasing a big stake in them? I. 

[00:47:11] Jacob McDonough: Yeah, you’re right. It was a tough period and two of Buffet’s heroes had a major stake in Geico. Ben Graham made a fortune on the stock, and Lauer Davidson, someone who he met with and taught Lauer Davidson, taught Buffett a lot about an insurance.

[00:47:23] Jacob McDonough: In one fateful meeting, they had a major portion of their net worth in the business, and a declined of 96% after making a fortune in it. It’s tough to swallow. I mean, it was hanging by a thread and almost went into bankruptcy, so it was a tough period. So, but you’re right. There was. In terms of hedging, it is pretty interesting in some ways.

[00:47:40] Jacob McDonough: I would say yes, it, he definitely had some sort of hedge there and, but maybe not fully, because I think Geico had a public offering. They raised capital, and Berkshire did participate in that. They bought some of their stake through the offering of a convertible preferred stock, and Buffet wanted to buy more.

[00:47:56] Jacob McDonough: He wanted to, he was willing to purchase the whole offering, I believe. But other investors wanted it too, so he wasn’t able to get as much as he wanted in that offering. So in a sense, He had more capital he wanted to put into Geico. So yes, that does. I mean, if the company needed more, more capital, Berkshire Buffett wanted to do that.

[00:48:13] Jacob McDonough: He also, Berkshire also took some of the reinsurance that Geico needed. So reinsurance is when a, a separate insurance company takes on some of the insurance policies of another insurance company. Basically one insurer is taking out a policy from another insurance company. It’s a way that Geico, when they’re in trouble and don’t have enough capital, they can get rid of some of their risk, give it to other firms who have plenty of capital that wanna take on some of that risk.

[00:48:38] Jacob McDonough: So Berkshire was one of the many. There’s many, many firms I. That did some of the reinsurance deal with Geico at that time, and Berkshire was willing to do some of that as well. So those are two ways where they were willing to help Geico put some capital into Geico, at least help reduce risks. But when I take a look, I don’t think Berkshire had enough capital to fully acquire Geico in this time period.

[00:48:56] Jacob McDonough: Not quite enough capital to take on all the liabilities, just because one due to size, but two due to. Berkshire’s insurance companies were going through a difficult period as well. The whole insurance industry was going through some struggles then. And so you never know how long that kind of tough period’s gonna last as well.

[00:49:13] Jacob McDonough: And maybe if it’s gonna get worse from there too. Maybe like the Great Depression lasted 10 years and I think that’s why it sticks in people’s minds so much compared to maybe there was some tougher periods that people forget about that were just quicker and, you know, we, people bounce back a little quicker so it gets forgotten about in history a little bit there and, and when you’re living through it, you don’t really know if it’s gonna be.

[00:49:32] Jacob McDonough: Something that maybe could bounce back quicker. It’s gonna be a 10 year tough period where you going to really buckle in. But with that being said, maybe Buffett’s a, a creative smart guy. Maybe he could have figured out a way to acquire Geico in terms of maybe he could have raised capital. He never really wanted to dilute his stake in Berkshire and raise capital, but maybe he could have done that for a Geico.

[00:49:51] Jacob McDonough: Maybe he could have found some creative financing or a partner to. To partner with him to buy it. Or maybe he could have taken on some reinsurance himself too, so maybe there would be a way, but he definitely had some ways to kind of hedge it in, at least in terms he wanted to put more capital in. But I’m, I’m not sure if at that point in time, if they’re big enough to acquire Geico quite yet.

[00:50:11] Clay Finck: And as you mentioned, the seventies were just a brutal period for businesses in general, you know, yet high inflation. Stock market was going through a really tough period at that time. His valuations really got compressed, which of is of course great for Buffett if he’s wanting to be a buyer of stocks.

[00:50:26] Clay Finck: Can you speak to the impact that high inflation had on insurance given it played such a critical role in Berkshire’s conglomerate? And, you know, I think about kind of the, the regulators too. You know, if there’s higher inflation, Regulators might be a little bit hesitant to let insurers just jack up their rates.

[00:50:43] Clay Finck: You know, insurers, they have to run a lot of these things by regulators. So talk to the impact that high inflation had on the insurance business. 

[00:50:52] Jacob McDonough: Yeah, you’re exactly right. Seventies were a tough period. Inflation was a big reason. There are some tricky ways that relates to the regulatory issues, and so in one sense, well, I don’t think I’ve talked about this yet.

[00:51:04] Jacob McDonough: Car insurance in particular has a few different types of policies they would take on. So voluntary insurance business is your standard type of business. It’s like customers you choose to take on. That’s pretty normal in business, but car insurance also had. Involuntary policies or assigned risk. And that meant regulators would assign policies to your company and it was based, it was spread out to all companies based on how much revenue you had, how much size your company was, is is kind of how those would get spread out to you.

[00:51:31] Jacob McDonough: And basically that meant that bad drivers, I. Drivers where insurance companies would think they’re too risky to insure, or at least too risky, where they would have to charge very, very high rates, too high of rates to those kind of drivers. The, the government or regulators would help out those drivers obtain insurance by kind of forcing insurance companies to take that on through assigned risk or.

[00:51:56] Jacob McDonough: So for Geico during this period, I wanna say maybe five or 6% of their premiums, their revenue was from this assigned risk, this involuntary portion that regulators just sent to them on a state by state basis. Even though it was small, I. The five or 6% Geico had was a major portion of their losses during this time period as well.

[00:52:15] Jacob McDonough: And so one state in particular in New Jersey was pretty strict and pretty tough on the fact raising rates and how much assigned risk they spread out. And so one of the first things Jack Burn did actually, when he took over Geico, he exited the state of New Jersey. They completely left New Jersey and that got rid of a major portion of their assigned risk.

[00:52:35] Jacob McDonough: Policies. It was a tough decision ’cause they spent decades trying to build up that business. They spent a lot on advertising and investments in the state and just to leave it completely was a tough pill to swallow. But it really helped them get back to profitability. And it just kinda shows you how much leeway different states had and.

[00:52:51] Jacob McDonough: In terms of regulator decisions, but I can see it being difficult from a regulator standpoint of maybe they got surprised or caught flatfooted from inflation. When you’re living through it, it’s tough to tell if it’s like a temporary phenomenon or if inflation’s gonna keep running rampant for a few more years.

[00:53:08] Jacob McDonough: It’s, it can be tough to forecast that, I guess. And so I can see why maybe regulators would be a little slow sometimes to react to, to high inflation in terms of the assigned risk. ’cause you’re dealing with drivers who have. No other options really. Some states like New Jersey, were slow to approve price increases, even for voluntary normal drivers, which was rare because usually in regulators, I think we’re pretty quick to approve those price increases because those kind of drivers could just leave.

[00:53:36] Jacob McDonough: If the prices are too high, they could just leave and go to another insurance company, and if companies are price gouging, I mean, that’s just an opportunity for a new company to kind of rise up and charge a more fair price. But even, I think New Jersey was a little slow to grant price increases even on.

[00:53:49] Jacob McDonough: The normal voluntary policies. And so some of the annual reports of Geico even mentioned regulators were thinking costs would go down some years because of changes in, say, I think they mentioned the 55 mile an hour speed limit, rural changes in some states and gas shortages during this time period was a major difficult piece of the, that economic scene.

[00:54:09] Jacob McDonough: They thought maybe that’d leave to less driving and therefore less accidents and maybe people would carpool more so. Some people were predicting maybe like cost dropping lower in insurance, and that was not. Case that’s, that didn’t end up happening, but kind of highlights how underwriting is a, can be a pretty tricky business.

[00:54:27] Jacob McDonough: I’m guessing how costs would change over time. 

[00:54:30] Clay Finck: I think it’s impossible to talk about the beginning of Berkshire Hathaway without talking about Charlie Munger. He oftentimes gets credit for kind of pushing Buffett more on the quality side of. Looking for higher quality businesses. So tell the story of, you know, Charlie Munger, how him and Buffett sort of interacted, and then Munger eventually joining Berkshire Hathaway.

[00:54:53] Jacob McDonough: Yeah, so Buffett and Munger met a number of years before this, but they really started collaborating with blue chip stamps and diversified retailing. And so I should give a little more background on that and I’ll do that. But Munger didn’t really, I don’t believe, joined Berkshire officially until 1978. A number of years after Berkshire was already on its way.

[00:55:11] Jacob McDonough: He was, he became Vice President in 1978, and the reason was diversified retailing merged into Berkshire in 78 and blue Chip didn’t merge into Berkshire until 1983. So basically Munger owned some of diversified retailing along with Buffett. And Munger owned some blue chip with, along with Buffett. So his blue chip stock became Berkshire stock.

[00:55:31] Jacob McDonough: Same with Diversified. And so through those mergers, that’s how he obtained his holding and, and Berkshire. And that’s when once those merged together officially, that’s when he was officially like vice president or. You know, on the board of Berkshire, they were very intertwined for a number of years though, and, and that’s kinda why they had to merge eventually.

[00:55:49] Jacob McDonough: They were a little too intertwined and overlapping in terms of Berkshire owning blue chip stock and diversified owning Berkshire stock and all that kind of thing. But all this story started from three failed businesses, basically diversified retailing, blue chip stamps and, and Berkshire. And they all kind of failed in this time period.

[00:56:05] Jacob McDonough: My book covers, so I already mentioned blue chip trading stamps failed in this time period. The textile mill closed in 85. And then Diversified Retailing was actually a company that Munger. Buffet and a man named Sandy Gottesman formed a private business. They just formed those three and they bought Hot Child Cone, a Baltimore area department store, and that one actually went outta business in the eighties as well.

[00:56:26] Jacob McDonough: They actually realized it was a bad business and sold it a couple years later. Blue Chip and Berkshire, they never sold but hot child within diversified retailing. They did. They did sell and get outta there. So Buffet and Munger and Sandy Gossman formed Diversified retailing. Their plan was to acquire a bunch of retailers.

[00:56:41] Jacob McDonough: Eventually it got down to they only owned one retailer. Called associated cotton shops and then they owned a couple stocks, blue chip stamp stocks and, and Berkshire stock. So it wasn’t very diversified, it wasn’t very much in retailing. They kind of were flexible with their original plan and changed their mind once they realized they made a mistake.

[00:56:57] Jacob McDonough: But that’s how Munger got involved. He first, they met maybe when they were in their thirties or so, I Munger at least, was in his thirties. They became friends. They started collaborating on Blue Chip and Diversified, and then I. Eventually that all got merged into Berkshire. 

[00:57:11] Clay Finck: You mentioned that probably the biggest winner for Berkshire was purchasing See’s Candy, and I wanted to highlight some of what was going on in that.

[00:57:19] Clay Finck: That purchase was See’s. They acquired 99% of that company in 1973. Very stable business, consistent cash flows. They paid $35 million and they got 2.3 million. In net income, which was growing over time, they had 9.9 million in cash on the balance sheet, zero debt, and the return on equity in this business was over 35% After you take the cash out.

[00:57:43] Clay Finck: Of the balance sheet there. And I think this business, in my opinion, it it was priced as if it wasn’t gonna grow at all. The earnings yield you were getting was 9%. The 10-year treasury at the time was 6%, but See’s, Candy’s revenue over the decade that followed that purchase, their revenue grew by 15% and then their operating profits compounded at 19%.

[00:58:04] Clay Finck: So it just, Looks to me like they got the best of both worlds, where they got a wonderful company at a wonderful price, given that the PE on it was trading at around 11 when they purchased. So talk to us about how See’s Candy was such a success for them, how this business grew so much over time. You know, it’s just a candy company, so talk to us about this. 

[00:58:25] Jacob McDonough: Yeah, you’re right. To me, it doesn’t look like that high of a valuation. You know, like you said, 11 times earnings and it had a lot of cash and it was a very strong growing business. So I know Buffett said it, it taught him to pay up for quality, but at the same time, especially compared to some valuations today, it doesn’t seem like that lofty of a valuation.

[00:58:43] Jacob McDonough: You’re right, and what’s interesting is Cs. Struggled to grow. They were very, very strong on the west coast of the US, but they struggled to grow elsewhere. I don’t know exactly why, but candy and chocolate seems to be one that different brands dominate different geographies in different countries as opposed to maybe Coca-Cola or some other brands that Coca-Cola seems to do pretty well in a lot of different countries and geographies and all that.

[00:59:08] Jacob McDonough: So See’s was un unable to really grow locations geographically. But on the flip side, that meant that their West Coast position was pretty protected and pretty strong because if See’s can’t grow elsewhere, their competitors can’t really grow into the West Coast too. So had a very strong competitive advantage and a strong brand known for quality on the West coast.

[00:59:29] Jacob McDonough: And they didn’t take much capital to operate the business, and it had a ton of cash on the balance sheet. I think over half, I think half of their assets on the balance sheet were cash and they, each year they were just spinning out more and more cash. So it was a perfect situation for a Berkshire structure company where that cash could move to Omaha, Buffett could reinvested elsewhere, and they didn’t have to physically grow locations of candy stores to really grow.

[00:59:51] Jacob McDonough: And so I believe in the decade plus 10, 12 years, that followed the acquisition.

[00:59:59] Jacob McDonough: See’s grew the revenue by about 13% per year,  while their volume of candy sold only grew maybe 3%. And so that difference three versus 13,  the real difference there is price increases on the candy.  Buffett and Munger maybe thought there was untapped pricing power.  And when inflation hits,  they could kind of raise prices and pass along cost increases to customers as well.  And so a big reason they grew was through price increases.  And like I said,  that really powered their growth for Berkshire in the 70s, really gave them consistent cash flow to go along with some of their cyclical insurance kind of businesses.

And it was perfect for the Berkshire structure.  I think when we’re looking at a lot of these businesses that Berkshire purchased throughout the 60s and 70s, I think it’s easy to believe that Buffett, you know,  he only got into things he thought were obvious bargains.  But one purchase that somewhat took me by surprise was the purchase of Buffalo Evening News.  He paid thirty-five million dollars in 1977 for a business that was only earning eight hundred and sixty thousand.

[01:00:37]Clay Finck: So what do you think Buffett was seeing in this one that other people were missing?  

[01:01:07] Jacob McDonough:  You’re absolutely right that this was unique and outlier kind of valuation. And I think it’s a good lesson that you can pay high prices,  you can pay high valuations,  but you have to your confidence in the quality and durability of that business has to match that.  So the higher price you pay,  the more you better be sure that actually is a quality business and a durable business. There’s plenty of businesses that seem strong but die out pretty quick. or maybe you realize it really wasn’t quite as strong as you thought.  Or maybe some that you just kind of judge, judge wrong.  So the higher price you pay,  the less margin of safety you have of whether you get that right or wrong.  In this case,  Buffett was,  I think,  another expert in the newspaper business.  He’d owned newspaper stocks for a while,  but also Berkshire itself acquired a small newspaper in Omaha,  the Sun News,  Sun newspaper. It always was a pretty minor piece of Berkshire from a earning standpoint in a capital amount of capital.  It took up standpoint even in the very early days.

It was minor. And then as Berkshire grew,  the Sun newspaper didn’t grow.  So it very quickly was pretty irrelevant economically.  But I think it’s interesting that Buffett had experience as a business owner of a newspaper.  I’m sure that helps in your knowledge as an investor there.  So when Buffalo Evening News came along,  he was an expert in the newspaper business.  And a few things.  Number one,  Buffett,  being a business owner of newspapers and kind of being an expert,  he quickly realized that Buffalo Evening News was a private business for many,  many decades, family run business.  And he noticed they were paying too high a prices on newsprint,  a raw material.  Apparently, they were sourcing it from a ton of different suppliers to make sure they always had it on hand in case if supplier went down on a strike or something.  They wanted to make sure they’re always safe.  Buffett and Munger, I guess they didn’t,  weren’t worried about that. So they took all their newsprint from one supplier and got a big discount on that.  That was pretty standard how the business operated,  industry operated back then.  So they were able to save some money on that right away.  Still, that was,  it was still a high purchase price,  even factoring that cost savings in.

That was kind of minor.  It was still a high purchase price besides that.  But Buffalo Evening News was the leading newspaper in Buffalo at the time, but they did not have a Sunday paper.  And Sunday was the time most people read newspapers.  So it was a unique circumstance where just historically there was two newspapers in the town,  weekdays,  Buffalo Evening News dominated, and then on Sunday,  they didn’t have a paper.  So another paper kind of gained a large readership in on Sunday.  And so they the first thing they did, they launched a Sunday paper when they bought the newspaper.

And unfortunately, they had a couple of tough years of losses because there were legal troubles,  some lawsuits,  some antitrust things about them opening a Sunday paper.  And some people worried that they’re going to drive out the competition in town and maybe be a monopoly in town.  But basically all across America, that’s what was happening.  Every town,  most towns were going down to like one newspaper.  Some towns historically in the early days of the newspaper industry had two or multiple newspapers in a town.  But over time,  more and more,  it kept converging to a winner take all in each city, each small town,  at least.  And so it was their theory that there was going to be one winner in Buffalo. And they thought they picked the one that would would win and end up being the dominant paper.  For a couple of years. They almost gave up.  They almost said they didn’t want to deal with the legal issues and the losses.  And they thought they made a mistake.  Eventually,  they succeeded and became the dominant paper in Buffalo.  And it was an excellent, excellent business all the way until the Internet really hurt newspaper businesses.  When, yeah, when the Internet came around, it was no longer quite such a dominant business.  

[01:04:32]Clay Finck: As I was reading through your book,  it kind of occurred to me that different  return metrics are probably more applicable to certain types of businesses.  For example,  the return on equity seemed to be pretty important for insurance.  And then you have return on assets that was highlighted when talking about the purchase of seized candy.  Then we have other metrics such as return on invested capital I’m curious when you’re analyzing a business,  how do you think investors should think about these different return metrics and what sort of things should be considered when looking at these here?

[01:05:06] Jacob McDonough: The return on assets was a very unique situation for maybe three,  at least three of the businesses I studied.  See’s Candy,  Detroit International Bridge Company,  which was a toll bridge in Detroit, Michigan,  Detroit to Canada that they tried to acquire.  They bought the stock of it and they tried to fully own it,  which would have made for a great story in the Berkshire history.  But someone outbid them and did really well with that asset over time.

And then Pinkerton’s,  a detective agency that gained a lot of infamy throughout  the decades and going back even more than a century.  And there was a lot of fictional detective novels written about the Pinkerton detectives and security guards and stuff like that.  So those are three businesses I studied that just had really unique,  very high return on assets.  And that’s just pretty rare to see that.  So what that tells you is without any leverage,  without any debt,  without any benefits from accounts payable, again,  from suppliers or deferred revenue from

[01:05:54] Jacob McDonough: Without any of that leverage,  they still would earn really good returns on assets.  And these businesses had a lot of cash on hand because I already mentioned Seized,  but the bridge is another good example.  They weren’t able to go build another bridge.  They just had all this cash piling up,  nowhere to put it.  It would have made for a great situation to join the Berkshire family.  But still, even with all this cash piling up for all three of these businesses,  their capital light,  cash piling up and return on assets was still great.

So it just shows how good the economics were for these three businesses.  And it just shows you how unique they were.  Return on assets,  a lot of people talk about for banks,  but for a bank,  like one to two percent return on asset is pretty good because a bank has to rely on leverage through deposits and insurance company has to rely on leverage through float,  like policy,  older liabilities,  or else they wouldn’t be good businesses.  They’d probably be worse than the textile operation if they didn’t have leverage and liabilities.  I mentioned earlier,  the textile operation didn’t really have much liability.

So their return on assets was pretty close to their return on equity,  which is also kind of kind of rare.  And so it’s a business by business situation.  I don’t really go around too often, like really paying much attention to return on assets, but it just really caught my eye.  Like, wow,  double digit return on assets or some of these cases,  more than 20 percent return on assets for this company that’s got way too much cash on hand.  It was it was very impressive,  very unique. 

[01:07:26]Clay Finck: Now, it’s very clear you’ve studied all Berkshires and your reports, studied their history,  studied, you know,  the amazing capital allocation decisions that Warren Buffett has made over his investment career.  What are some of the biggest takeaways that you found in studying capital allocation and studying Warren Buffett’s life?  

[01:07:46] Jacob McDonough: Yeah, I really learned a lot.  I learned a lot about specific industries like insurance and banking,  just forcing yourself to write or talk about. It helps you learn a lot,  too.  Even if you don’t write a book,  just even note taking and forcing yourself to sit and think about what you’re reading.

I know me personally,  sometimes I get in a groove of more passively reading things and not note taking and then later realize you don’t retain quite as much.  So doing the book helped me become a lot more active with my reading and note taking and all that coming on here helps as well being active with information.  But the biggest thing I learned,  I already talked about a little bit, but I’m going to repeat it just because for me, it was a major change of perspective. It might sound kind of simple,  but the National Indemnity Purchase Price,  just how Buffett kind of ignored the book value in terms of his purchase price,  because again,  just using round numbers,  if he was going to have $10 million in a personal account of stocks or 10 million with an insurance company,  that was a wash.  It didn’t matter.  So that was basically like not really part of his purchase price,  just the goodwill,  even if it was maybe $100,000 of goodwill he paid,  that’s all he really considered as purchase price in the acquisition.  Just call it $100,000. It wasn’t exactly that, but close on that $100,000,  you just got to make sure you earn an attractive return on that $100,000 from either bonds or from underwriting profits.

[01:09:02] Jacob McDonough:And so that really changed my perspective on how to think as an investor.  You know, if you’re a minority investor,  a passive investor, you don’t have a chance to really grab those assets like Buffett did,  but you can see what management does with it.  And really,  it made me think more from a business owner perspective.  What are you actually buying?  What is the capital of this business?  How is it invested in?  What is management going to do with it?  Do they tell you what they’re going to do or you can see their track record of what they’ve done?  And it really changed my perspective.  And I think that’s what I learned the most about it.

[01:09:31] Jacob McDonough: Maybe one more thing is reading history,  studying history really hammers home how crazy things can happen in the market for sure.  I mentioned the stock did really well in the sixties. In the seventies,  a 73 and 74,  the stock market went down in a major way.  I think, I think like the Dow Jones was down 45%. It was a major hit and Berkshire stock and blue chip stock were no exceptions.  They, they went down quite a bit too.  So from 1969 to 1974,  five year period,  Berkshire stock went nowhere.

In the meantime,  it went up and then it crashed back down.  But when the dust settled in 1974,  it was at the same level as five years earlier.  And Buffett’s someone who’s used to compounding money at high rates. So, I mean,  five years of no stock price changes a long time.  And when you do read history,  you might gloss over five years,  but when you sit in every single day,  if you’re checking your stock prices every day, or maybe even minute by minute or something,  I mean,  five years is a long time,  especially if you have investors answer to the business of Berkshire itself did really well over the time period.

I mean,  some of their stocks went down a value in the portfolio, but the businesses were earning money and, and compounding and stuff.  Blue chip stamp itself though,  their stock price went down 77%, I believe more than 75% and it was a really tough period.  And the valuation of blue chips got close to a third of the book value and close to three times earnings,  which is incredible because blue chips book value is mostly made up of a stock portfolio controlled by Buffett and Munger in their prime.  And then their earnings came from cease candy,  which we talked about how great a business that is.

So if you were sitting in 1974,  and if you happened to have some excess cash on hand,  you could have bought blue chip stock. You could have gotten a discount on Buffett and Munger managing your portfolio for you without having to pay any management fees or performance fees.  Could have owned See’s candy at a reasonable valuation.  So you can pay high prices,  but you have to be, You have to know that sometimes even these excellent businesses that are going to have great results in the future temporarily could go down quite a bit.  So studying history kind of helps emotionally put that into perspective when it actually is happening to you.

[01:11:32]Clay Finck: Yeah,  I totally agree that studying history can be just so, so humbling.  You mentioned earlier that the first three businesses that Berkshire was in,  they ended up going bankrupt,  but you look at some of these other businesses and they just went up like crazy.  So you just never know what can happen with businesses.  Capitalism is brutal.  We need to learn from our mistakes and, you know,  like adopt what Buffett and Munger do where they’re just learning machines and they’re always learning new things and studying their businesses.  So Jacob,thank you so much for joining me. This was really fun.  Really glad you joined me to cover Berkshire’s beginnings.  This was a really fun chat for me and I hope the audience really enjoyed it as well. So as always, I want to give a handoff to you,  tell the audience where they can learn more about you and please feel free to share your book where the audience can learn more about that and any other resources you’d like to share.  

[01:12:24] Jacob McDonough: Yeah, thank you.  It’s been a lot of fun.  Thanks for having me on here. The easiest place people can find me is on Twitter at mcd underscore investments. I’m on Twitter there.  I recently started doing a podcast myself,  the 10k podcast,  where I try to cover some of the early annual reports of businesses.  So far I’ve done Geico,  some of the very early reports of General Motors and National Cash Register.  Next,  I’m going to try working on Teledyne.  I’m in the middle of putting together some stuff on their reports of them.  So that’s on most places you can find your podcasts,  Spotify and Apple,  but again,  this was a lot of fun.  It’s an honor to be on your guys’ podcast.  This is a legendary one in the value investing community.  

[01:13:05] Clay Finck: Awesome.  Thanks so much,  Jacob.  This was fun.  

[01:13:08] Outro: Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or re-broadcasting.