Stig Brodersen  08:38

Yeah. So if you read the annual letters from Warren Buffett, he’ll be talking about that. He actually looks at Berkshire Hathaway as having four different companies or four different segments. And you know, I think that’s probably a very good way of looking at Berkshire Hathaway because Berkshire Hathaway owns so many businesses. I think that they’re probably own around 80 or something like fully owned, and then they own like part so they own shares in, you know, multiple other companies.

So now really to get an overview of how a Berkshire Hathaway looks today, I think the best way is to look at us as four different businesses within Berkshire Hathaway. And the first business I like to talk about is insurance. So insurance was actually a way that Warren Buffett really early get capital to invest in other businesses and we will actually return at a later segment to talk about specifically how this business model works.

09:38

The second one is a regulated capital intensive business. So that would be, for instance, something like Berkshire Hathaway Energy. It used to be called MidAmerican. But it’s that type of business. So in the energy for instance…

Preston Pysh  09:54

And Buffett owns, isn’t it like 80% of all the energy in the state of Nevada? Like his business owns all the power that’s basically being provided in Nevada. Is that right?

Stig Brodersen  10:05

Yeah, he has close to a monopoly in that huge region. Yeah, I think it’s true. And another thing, there is also the railway. So you will probably know this as BNSF.

So these are somewhat new purchases from Warren Buffett. I mean, this is not how he started, because these businesses are very capital intensive. So this is something worth mentioning that if you hear about Warren Buffett talking about it’s really important not to buy into businesses that acquire a lot of capital. And then you’re thinking he’s in energy and he’s in railways. You know, what’s happening here? This is basically Warren Buffett’s, let’s call the new approach of how to apply capital. He’s been saying it himself that it is not the most optimal way, but he actually is sitting on so much cash right now that this is still the best way for him to buy into good businesses.

Preston Pysh  10:59

When Stig says that he’s sitting on a lot of cash, what’s he sitting on right now? 60 billion?

Stig Brodersen  11:05

Yeah, I think. That’s a lot of cash.

Preston Pysh  11:08

Just a little bit. He’s just sitting on a little bit of cash.

Stig Brodersen  11:12

Yeah. So actually, I think it is relevant to speak about because the second one there was a regulated capital intensive business. And the third one is manufacturing service and retailing operations. And so this was actually some of Warren Buffett’s first buy so that would be some, you know, everything from lollipops to Cee’s candy, for instance, to NetJets. But a lot of these companies, especially in the beginning, you know, they were really, really good returns on net tangible assets. And those are really like the core of understanding how Warren Buffett invests. You know, these are really good business because they don’t take that much capital to make a decent profit.

And again, you might be thinking, so why doesn’t he do that? Why don’t you buy you know, new See’s Candy? Well, there’s just not enough See’s Candy out there for Buffett to invest in.

Preston Pysh  12:06

Well, I think you got to look at it this way too, is for him to invest in a company like See’s Candy. Let’s say that the company might have a market cap of 50 million. That’s not even going to make a dent in his overall portfolio because it is so big, it’d be kind of like, let’s say you have a million dollars, your net worth is a million dollars and somebody comes along when they want you to invest in a company that has a market cap of $3,000. That’s not even going to move your needle at all. So why would I spend my time, which is his most valuable asset? Why would I spend my time researching and digging into this making sure that it’s a good buy when it’s not even going to make a dent in my portfolio movement? So he’s really looking for those big hits like you saw him invest in Heinz in the past couple years, things like that, that are really going to move his needle. That’s the things that he’s really trying to pay close attention to.

Stig Brodersen  12:56

Then the fourth business segment that is finance and financial products. So just to give you a brand that might be something like Clayton Homes, for instance. So there will be like rental, trailers furniture, and this sort of business. And it is actually the smallest one of the four. So I mean, they are quite independent. They’re quiet, you know, for itself. But, you know, these are like the four business segments of Berkshire Hathaway.

So now you might be sitting out there thinking about investments. Like, we know that he’s a great stock picker but where are all the investments and that is actually… I’ll put that as a part of the insurance in general, I’ll put that as a part of the insurance business. But we definitely return to that.

Preston Pysh  13:41

I think the key takeaway here and this is the thing that people really got to understand if you’re really trying to be a business leader, is where in that list that Stig just named, the composition of this company, where did he mentioned textile business? And he didn’t, it’s not there. Okay, so he bought a company back in 1965. That was a textile company. And now you go 50 years into the future where we’re at right now. And the company has had a total transformation. And that’s the key here is change.

If you’re a leader, you have to adapt to change, or change will make you change. And that’s more of a Jack Welch kind of quote, but it’s so vitally important for people out there. To stay competitive, you have to be adaptable, you have to move with the punches, you have to see what’s common, and you have to be able to really adapt to that quickly. You got to be the first person, you got to be that person, but not assume a lot of risk at the same time. And that’s hard to do. You’ve got to be a balanced person in order to conduct that change and that changing environment.

14:52

So as we go through this, think about that and think about what Buffett has really done as a business leader, co-chairman of the board. He led this organization and I think that that’s one of the key things that a lot of people don’t look at, they only look at a stock-picking ability, when in all actuality this guy is a business magnate and tycoon that has led an organization to be, you know, market cap over $300 billion.

Stig Brodersen  15:18

Yeah. I really would like to talk about Warren Buffett’s leadership skills because that was something I really found profound when I was reading the letters. He’s so good at delegating and good at motivating people. And so let me just give you two short notes on that. The first one that I found really interesting is that he keep kept mentioning people by name whenever he’s writing these letters. So he’ll easily name like 20 or 30 different people and saying, “Well, we should really be thankful to this manager because he has done an amazing job.”

So you actually have a lot of people you know, this is not like, I don’t think he’s manipulating or anything but it’s really like a human thing that we all like praises. And Warren Buffett is really, really good at praising people if they’re doing a good job. I mean, that’s something he always mentioned.

Preston Pysh  16:11

I think you can see when you’re talking about his leadership ability, which you really are, what you’re seeing is how patient he is. Whenever he’s dealing with his subordinate leaders within his company, which he’s got tons, I mean, just the operational subsidiaries. I’m not even talking like the non-operational ones like Bank of New York and Wells Fargo and all those. When you’re talking about the ones that he owns 100% of, he has like 60 different managers and business leaders beneath him. He is insanely patient, like to the point that most people would not be able to do that if somebody comes in and they have a bad year.

My impression is that there’s often very little said because people know what that expectation is. And so when do you see leaders that if somebody does something wrong, he doesn’t really necessarily say anything, they just know that they’ve done wrong. And they know they better improve, because if they don’t, then maybe they’ll do something about it later. But he’s giving them that opportunity to fail. He’s charging them with enormous responsibility. And when he does that, and he kind of stays out of it. It’s amazing that he’s actually getting better results in that leader that’s really trying to oversee and micromanage things. And it’s just an amazing approach. And he’s been so successful at it. You set that precedence of how you should operate, and you watch and you monitor, and if people abuse it, well, then you do something about it. But if they have one bad downturn, maybe it wasn’t their fault. Maybe it’s something that… they had a rough patch, and they’re going to get back on their game. So, go ahead, Stig.

Stig Brodersen  17:46

Yeah, and I think that the best way to think about this is to think about how many people know Warren Buffett having his headquarters. Like he actually likes to joke about… I just can’t remember the exact figure or something like 30 people or something like that. I mean, how can you like to have the… I think by market cap? Or is it by revenue is like the fourth biggest company in the listed company in the US? You know, I think that if you compare them to the other companies around that, you know, they will have hundreds, if not thousands of people in headquarters and he has like 30 people.

Preston Pysh  18:17

Well, what he does at the end of each shareholder letter is he has a picture of his headquarters. And just to kind of give you an idea of the size, it’s a single photograph, and you can make out every single person’s face in the photograph very easily, then there are only three rows of people. So they’re probably they’re like 10 wide. So it’s like this tiny little photo, you think it was like a little family reunion kind of thing. And that’s his whole headquarters for his $300 billion company.

Stig Brodersen  18:45

So for the next segment, I would like to talk about Berkshire Hathaway’s special conglomerate structure. And I think you know, whenever we talk about conglomerates, you always have very different opinions on whether or not that’s a good idea because can you like… One of the most told arguments is that can you keep focused when you have so many different things to keep track of? And, you know, in my opinion, I think that a conglomerate, for a company like Berkshire Hathaway, that’s really the main secret to their success. I mean, yes, of course, it’s fantastic that Warren Buffett is good at picking stocks. I mean, no argument there. But I think that the structure where they can actually invest where the money makes more sense when you are as good as capital allocation as Warren Buffett, that’s really the secret to his success.

Preston Pysh  19:35

So what he does, it’s different than any other company whenever they buy a subordinate business, is when you typically see that happen, the parent organization will come down and say these are the new rules the way that you’re going to operate. All your letterhead is now going to have our business’s name on it. And they basically take control of that business and they bring them into their architecture and into their standard operating procedures.

Buffett has the exact opposite approach. He will buy a business. And he’ll look at the manager and he’ll say, “You know what, you guys obviously know what you’re doing a lot better than I know what to do. So just keep doing exactly what it is that you’re doing. That’s the reason I bought you. And you just report your numbers, show me your accounting at the end of the year. You keep your brand name, you keep everything the way it is. And I’m just going to be standing over here. And in fact, if you make profits, you keep those profits down at your level because you’ll know how to employ those a lot better than I would know how to employ them.”

And I think that that’s just an amazing approach that just no one does that. And you find that these businesses that do start trying to take control of these smaller businesses, they come in and they just mess it all up. I mean, it’s not always the case, but it’s usually the case. I know whenever there’s a business that is getting ready to buy a subordinate business, I always get a very good concern with that… I get concerned that they’re going to overextend themselves, they’re going to take on too much debt. They don’t understand even that line of business. And so by getting their hands in there, they basically throw all this drag into the equation. And it creates, you know, a bad situation. Berkshire Hathaway takes the exact opposite approach.

Stig Brodersen  21:17

Yeah, I think that the best way to really understand the true benefit of Berkshire Hathaway is to compare it to let’s call it a normal operating business. So for instance, let’s take a company like Exxon Mobil. I mean, it could also be Apple or any other business. But if you look at a company like Exxon Mobil, whenever they make a profit, they have three different options of how that will benefit the shareholders and the first one that will be the dividend. So they would pay out some of that profit to the shareholders.

Now, as a shareholder, this is not a very efficient way of getting that because you have to pay taxes and you might just want to reinvest in that business. But basically, that’s one way to do it. Berkshire Hathaway doesn’t do that because they’re saying that instead of paying $1 out in dividends, they can create more than $1 in value.

22:05

Now, the second thing that a company like Exxon Mobil can do is that they can invest in the existing business. But the problem is for a lot of listed companies that they’re are so big. So they cannot keep investing in really profitable projects. I mean, they would be first taking all the 20% per year projects and then they would invest in all the 15% of your projects and 10%, and so on.

So a lot of the projects that they can invest in, you know, they will not be good businesses. Berkshire Hathaway would take that money that they may have profit and buy new businesses, or they might be, you know, widen the mode of some of the existing businesses. Now for a lot of the really big companies that are listed, they also repurchase the shares.

Now, Warren Buffett, he’s really, really good at this because he’s very, very adamant about buying shares in his own company at a really good price. But a lot of these big companies they have this year were repurchased programs where we will just keep repurchasing shares, you know, every day, every quarter every year. And I guess, you know, to some extent, that’s okay. At least it’s tax-efficient, but they are not buying the shares back at really good prices. And Warren Buffett is very, very clear on that.

Preston Pysh  23:18

So I used to wonder years ago when I look at Berkshire Hathaway, I would get frustrated when he wouldn’t be buying back shares at certain points in time. But the more that I’ve learned, and the more that I’ve studied him, I think Buffett has enormous respect for the power of liquidity. And I think that’s one of the main reasons why he does not do share buybacks like you see a lot of companies like IBM, for example. Just going bananas on their share repurchasing.

But I think Buffett has such a respect for the power that liquidity demands during stressful times and the deals that he can get that he actually values that more than maybe buying back his own equity whenever he could. Maybe Berkshire Hathaway is slightly undervalued compared to the rest of the market.

Something else that I want to highlight real quickly back to the previous conversation that we’re having about him buying up all these different businesses and basically leaving them in place and not doing anything. The only way you can really do that successfully is if you’re finding managers that are absolutely incredible. And that’s one of his four tenets, one of his four rules that we’ve talked about, and what was it our second or third podcasts that we did?

24:29

One of his rules is that he only invests in companies that have superior management. And so by doing that, by ensuring that he has somebody with a track record and years of experience that he trusts, that he knows is going to get results and that is always going to tell him the truth, he’s putting him in a situation where he can actually employ those techniques. If you’re buying a business and you don’t really and you’re looking at the management like they’re like okay, that’s probably not somebody you want to entrust with just total control. And I think that that’s a key point that we got to highlight if we’re bringing that up. So back over to Stig as he kind of runs the discussion here.

Stig Brodersen  25:09

So the third segment I’d like to talk about is how float works. And if you don’t know exactly what float is, let me just give you an introduction here. So, Berkshire Hathaway, they are an insurance company, or at least they have a very huge insurance division. And whenever they’re writing premiums for say something like $100, you know, the premiums that they’re writing, you know, that is money that they are getting. I mean, that is liquidity. And of course, they have to repay a lot of that, you know, in claims and expenses and so on. But that how that actually works… If you just think about this in terms of, like $100, Berkshire Hathaway because they’re so good at writing insurance, they would keep some like $2 to $3 on average, of that hundred dollars. So this has two huge benefits. The first one is that whenever they are, you know, having revenue of hundred dollars, they will have $2 to $3 in profit. That’s one thing, but the most important thing is actually in the meantime, they can actually hold on to that money and invest that in, you know, businesses, stocks and bonds, and they will give 100% of the proceeds from that.

Preston Pysh  26:22

So this one’s huge. I mean, really, this is the bread and butter of Berkshire Hathaway. And this is the reason Buffett has been able to compound at such a high rate is that he’s sitting on this enormous amount of money. And Geico is the engine here, okay? He even says that in the shareholder letters, “Geico is the engine of my vehicle.” And the reason why is because it’s got all this float, he can reinvest that at you know. As the market changes, he’s adjusting the assets that are sitting on that float that are most optimal, that are giving him the highest return. And then if there’s an event that occurs that requires a large amount of capital outlay, based on the facts that some type of unprofitable event happens, he’s got the money sitting there He can transfer that to the people that would have claims. So that’s big. And I don’t think people really realize how robust his insurance business is. When you think Berkshire Hathaway, you should really be thinking insurance company because that’s really the engine of the whole thing.

Stig Brodersen  27:21

Yeah. I know that we’re just throwing a lot of numbers on you. And it might be hard to hard to get a grasp on. But he has $84 billion right now, as afloat as he can invest in. And just in comparison, he has $117 billion in different stock investments. So I mean, this is really, really something that’s important for Berkshire Hathaway

Now, where they really distinguish themselves from other insurance companies, because you know, this is the business model for insurance companies in general, is simply that Warren Buffett has been really, really good as finding great investments, and he has been really good at allocating that capital.

Preston Pysh  28:00

So something I want to throw out there because we talked about Mohnish Pabrai a lot. So Mohnish Pabrai i is getting ready to start his own holding company. We’ve heard that that’s going to happen this year, that his company is going to be formed this year. And what’s his engine? He’s using an insurance company, he’s taking the exact same model that Buffett did. So he can invest that float and he can have larger returns. So it’s going to be very interesting and really fun to track Mohnish Pabrai’s progress as he stands up his new company.

Stig Brodersen  28:32

Yeah. I think that will be really, really interesting. And just to also give people a peace of mind if the thing about insurance companies, it’s not like insurance companies can just take that float and then invest 100% of that inequities. So I mean, obviously I just want to make that clear. It’s actually kind of more like banks and they had like tier one and tier two capital, and a lot of that should be fixed and fixed maturity asset, so on. I just wanted to throw that out before we actually go into the fourth segment.

So, Preston, I don’t know what you thought when you read through all these letters, and there was a long time ago for you, but when you realize that he was actually Warren Buffett and Berkshire Hathaway, they’re using derivatives. I was actually quite surprised when I read that in the beginning.

Preston Pysh  29:20

So I think people will hear the word derivative, and they immediately think that’s a bad thing. But they don’t understand maybe the context and the way and how it was being used. So let’s talk about futures and let’s talk about derivatives for people to maybe understand the advantages and disadvantages.

So if I’m a farmer, okay, and I have a plot of land, and say I’m a wheat farmer, and I can’t be susceptible to major price swings in my crop whenever I sell it. For me, a futures market adds a whole lot of comfort and a lot of value because I can sell the week that I’m going to manufacture at a price that I know I’m going to get if I entertain this idea of a futures market and selling things based off of a price that I know that I’m going to be able to get.

So that adds a lot of value to certain markets. So when you think about the airline industry, they’re heavily reliant on oil prices. If oil prices are all over the place, and they want to have some type of stability and be risk-averse to that fluctuation, they can buy their fuel on these futures markets in order to mitigate those risks.

So for some people, it’s a total risk mitigation strategy because they know what kind of price they’re going to be dealing with and they know what prices they can offer their customers in advance because they’ve paid for that in advance.

30:43

Where it gets really risky and where it gets the bad name is traders who are just basically manipulating the market and have no interest in a product or a service that they’re actually providing to customers, and that they’re just basically manipulating the system. Because they’re taking a wild risk by taking on leverage and investing and things that they’re just basically making bets. That’s where it gets bad.

So whenever I look at Warren Buffett, and he owns Coca Cola, he owns a large portion of Coca Cola, I think, what 15% or something like that. So when you look at Coca Cola, he’s heavily reliant on sugar prices, just as one example of one ingredient. There are many other things that like BNSF. He owns 100% of BNSF. I mean, that’s a railroad company, heavily reliant on fuel prices. That stuff is very important. So for me, that makes total sense. But I think for somebody that would be, you know, you know, his quote, where he talks about how derivatives are weapons of mass destruction, financial weapons of mass destruction. He has that quote, and I think so people would see they’d start reading shareholder letters and they see that he’s involved in this stuff, but in a way, he kind of has to be just because of the inherent nature of his business.

Stig Brodersen  31:55

Yeah, and let’s just take an example like if you weren’t a stock investor, how that would work, actually doing business with Warren Buffett and Berkshire Hathaway. So I might be managing a mutual fund. And I would really not like the monitor drop. So what I would do is I would buy a production. So as a put option, I would benefit from a drop in the market. And that might seem a bit contradictory, but this is kind of insurance for me because as a mutual fund I make money when the market goes up. So one way to secure that I have a stable profit would be for me to buy a put option.

So where could I do that? Well, I could do that using Berkshire Hathaway as my counterparty. So Warren Buffett would be selling put options. So basically, what that means is that if the market drops, then he would lose no money, at least theory. Now the specifically puts that here and been selling you know, they’re really nicely structured because first of all, people would pay him money upfront, again. So it’s actually kind of insurance float, you can invest that money. And it’s only if the market drops over, you know, 10 to 20 years that you have to pay some of that money back. And so he actually makes a few calculations of this and you know, the market really, really has to drop for him to lose money. And then he’s saying, even if he does that, he probably has a better return holding onto the premiums, to begin with anyway.

And the really important thing here is that Berkshire Hathaway has no counterparty risk that. Usually, at least for some of those derivatives, you know, if the counterparty went broke, you know, you’re sitting on the risk yourself, and there were some of the problems that happened in the crash 2008. But since it is Berkshire Hathaway’s, that is the ensure they don’t have any counterparty risk. So that’s just something I found really interesting that he’s always protecting his downside, even though its derivatives.

Preston Pysh  33:53

Okay, so the next category that we have listed here is how do you value Berkshire Hathaway? I think this is probably one of the most fun exercises that you can have, because this is such a unique company, and has so many different variables. And I think it has a few hidden variables, which I’d also like to discuss. So how would you do this?

For Stig and I, we think that the best approach is a discount cash flow model. We look at how stable has the company been for Berkshire Hathaway. It’s been extremely stable, very predictable in the movement that it’s had. That doesn’t necessarily mean that that’s how it’s going to perform in the future. But I think that we have a higher probability and expectation that it will perform that way into the future just because of its past record and past performance. But it definitely does not guarantee it. And I think that’s really important, whether you’re investing in Berkshire Hathaway or any other company, that the future is unknown, and you don’t know what kind of events are going to occur and you’re always assuming risk at an individual level when you invest in an individual stock picks. So I want that to be very clear.

But for me, whenever I would be valuing Berkshire Hathaway, I would look at his past performance, how fast is he growing that cash flow? And if it’s somewhat predictable, then I would make some assessments as to what I think would do into the future. Then I would discount that back at an appropriate discount rate. So whenever we look at and so that’s the big question that a lot of people have when you’re conducting the intrinsic value of a company, what discount rate do I use? And it’s really up to the individual, like how much risk are you willing to assume? So whenever I look at the current market here in June of 2015, when I look at the S&P 500, based on how it’s currently priced, I would estimate that the S&P 500 is going to give me about a 4% return.  Whenever I look at fixed-income bonds, like a 10-year bond, they’re at about what two and a half percent in the United States? So those are some pretty low returns 4%, two and a half percent.

So when we’re talking about a discount rate of how I’m figuring out the intrinsic value of Berkshire Hathaway, I would say, I think it’d be very good to first start off by comparing it to what the S&P 500 rate is. So if that rate is 4%, I think I’d probably start off with what will a 4% return give me on the intrinsic value of Berkshire Hathaway? Because that way, I’m comparing apples to apples. If the market is going to give me a 4% return, and then I figure out that Berkshire Hathaway is going to give me a 4% return at the current price, which we have calculators at buffettsbooks.com, that helps you figure this out. We have a video at buffettsbooks.com, that takes you step by step on how to use the calculator. All this is free. You don’t have to pay anything, just go to our website, buffetsbooks.com, you can use these calculators.

But if I’m getting that same return with the S&P 500 at 4%, and I’m getting the same return with Berkshire Hathaway at the current market price at 4%, which is not. Just so you guys know, I’m just using this as a comparison. If those two are given me the same number, what would I invest in? Would I invest in the S&P 500? Or would I invest in Berkshire Hathaway? For me, that’s an easy decision. I don’t have to think about that. I’m investing in the S&P 500. And the reason I’m investing in the S&P 500 is that my risk is distributed across 500 companies. Whereas with Berkshire Hathaway, it’s only with one company.

37:23

I think some people might be really surprised to hear that. But the reason I say that is because it’s based on the current price. If the price is the same as the S&P 500, I don’t care how good Warren Buffett is. That selection of buying Berkshire Hathaway at a very high price, that’s pricing it at a 4% annual return doesn’t make any sense to put risk into a company that an individual company that could fail. Now, I think if you do the actual intrinsic value on Berkshire Hathaway right now, you’d probably get a much better return than what the market is offering at 4%. So when that comes into play…

Let’s say that we did it for Berkshire Hathaway right now, and it was an 8% return, okay, which is probably more realistic as to where it’s at. So you’re getting double the return, but you’re investing in an individual company. So there’s more risk associated with that. That’s where it becomes difficult for the individual person to make that decision. Which one do I go with? Because one has a little bit more risk because you’re dealing with an individual pick.

So that’s kind of my thought process as I go through selecting and valuing businesses is you gotta, first of all, you gotta consider all the variables. And there are a ton of variables at play here. But I think that you always go back to that benchmark of what’s the S&P 500 going to give me? What’s the fixed income bond going to give me, which is impacted by inflation, I will add, okay, so you got to consider that variable. So those are just some of the thoughts and some of the things that I’m thinking about as I go through it. I want to hear what Stig has to say though.

Stig Brodersen  39:00

Yeah, I think it’s, it’s really profound what you’re saying, Preston, and how we are evaluating businesses, because basically, we are always discounting, like the money we expect to receive from that company. But I would like to talk about why you can probably not look at the income statement of Berkshire Hathaway and compare it to other companies because the structure is very, very different because it’s a holding company and they own a lot of different investments.

So, what most investors do is that they will look at the bottom line and they would say, like net income, 2 billion. So then you might have this multiple saying, okay, I want to purchase companies less than 15 times earnings, okay? So that company would be 50 times that will be 30 billion. Now, I definitely see why you would do that. And for a lot of companies, at least if you do it for like multiple years, it makes some kind of sense just to give you an idea of how profitable business is.

But for a company like Berkshire Hathaway, I think that you should probably look elsewhere. Warren Buffett, he talks a lot about look-through earnings. I mean that’s one thing. And look through earnings is actually a very simple, simple concept is really because that they would own shares and say Coca Cola. Now, because they don’t own like a big share of Coca Cola, they only in less than 20% of the company, what is happening is that they only record the dividend that they received from this company. So say that Coca Cola would be making I don’t know how much money but let’s say that Berkshire Hathaway is part of that earnings would be 1 billion, that they might only be recording 300 million because the rest is not a dividend.

Preston Pysh  40:48

So I really like this idea of look-through earnings. And I think that it’s a concept that very few people understand. And I think it’s a concept that very few people actually discuss when they talk about Berkshire Hathaway. Buffett and his shareholder letters really only talk about look-through earnings a few times throughout the document, but when he does, it’s very profound. And I think a lot of people could miss the boat on what he’s talking about.

So let me just kind of describe this from my own experience, so Stig and I both own our own companies. So inside of our company, we have different assets that we’ve created. So for example, one of our books, the Warren Buffett Accounting Book, that’s one of our assets. So that brings in a certain amount of money every single month, but that is an asset that we have to report all of that income onto our income statement. So now is that one asset, let’s just say that book is producing a flow of revenue and a flow of earnings. Some of that is retained within each of our companies. So what do we do with that money that’s retained from that asset? Well, we invest in other assets. So we have the option to create let’s say we want to write another book. Okay, we could invest in that. Or we could invest in something that’s non-operational, meaning I could invest in a share of General Electric. Okay, so that’s an example. So if I invest in that share of General Electric, all inside of my company well, okay, that would be another asset that will be added to my balance sheet that one share of General Electric.

Now, what’s interesting is if I do that, General Electric, let’s say that that one share of General Electric produces $3 of earnings. So do I list $3 of earnings on my company’s income statement? No, I don’t do that. But if General Electric pays me a dividend, I will list that revenue stream on to my income statement.

Now, what people don’t realize is that that dividend is only a small portion, typically around I would guess 33% to 50% of what the company actually earned, that one share. Okay, so I’m only really reporting a portion of the earnings that that one share, that one asset actually made for the year. So what Buffett is saying in his shareholder’s letters, and this is really important, what he’s saying is that “Hey, I own 100 billion dollars worth of non-operational stock. Okay? The only thing that I’m reporting on my Berkshire Hathaway shareholder or my Berkshire income statement, is the dividends that I’m actually receiving from that hundred billion dollars worth of stock. There are more earnings that are being produced from owning those companies, but I don’t have to report that that’s being retained within those companies. But don’t forget, that is real value. That is real earnings, even though I’m not reporting it.”

And so whenever the stocks grow in value over time as he continues to hold them and continues to hold them. That’s actually materialized. into market value and increase market value over time. And that’s what he’s talking about whenever he says, “Look through earnings.” If you want to study something out of the shareholder letters, one thing, I would argue that that’s the one thing you need to study, because if you’re trying to value Berkshire Hathaway appropriately, I think you’ve got to include the value of look-through earnings into your calculation. And I think very few people actually do that. So this is probably in my opinion, the most important thing we’ve discussed in this entire podcast episode is this idea of look-through earnings.

Stig Brodersen  44:37

Yeah, I definitely agree with that, Preston. I also think that that’s one of the reasons why so many people will have trouble evaluating Berkshire Hathaway because either they’ll be looking at net income or they will be looking at the comprehensive income. But the problem with the comprehensive income is that includes all the unrealized gains that they have acquired through that year. So if stock market roars, you know, that would be reflected in the currents of income, or, you know, if the opposite happens, it’s really, really hard to evaluate a business that operates like that. And the key, that solution to do that is really to look beneath the earnings and say, “What is the underlying value of this stream? How much has the underlying value of all these businesses really increased during that year?” So I said that was the solution but it’s really, really hard because they own so many businesses.

Preston Pysh  45:29

Yeah. As a rule of thumb, my personal experiences, as I’ve done this calculation in the past, is that when you add in a new account for the look-through earnings, I think that you really do add about 20 to 30% more to the cash flow of the business. So if you’re saying the cash flow is 100, I would say that the cash flow is actually like 120 or 130. Just because of this look through earnings piece that people do not account for, and that’s obviously a rule of thumb. You’d want to actually do the calculation if you’re strongly considering putting in a large chunk of your portfolio in Berkshire.

So there’s a lot of other things that we want to talk about. We actually had a very long list of different items here. But we’re actually getting pretty long on the podcast here. And I’m sure all this accounting talk is probably boring. Some people, other people might be eating it up. But one of the things that I really wanted to talk about, but we don’t have time to talk about is this idea of intangible assets being protected from inflation. So if you have time to do a little research, look at that idea, maybe type in Warren Buffett and tangible assets, inflation-proof or something like that, and you can maybe read up some of that on your own.

Preston Pysh  46:43

But what we’re going to do is we’re going to transition and take a question from our audience. And this question comes from Dylan Richardson.

Dylan  46:50

Hi, guys. My name is Dylan. And I’ve been listening to your show, and love what you guys are doing. Earlier this year, I bought Ben Graham’s Intelligent Investor book, the one with Jason Zweig commentary giving updates to some of his principles, and I’ve studied it as if it were a textbook. I’m in the process of rebalancing my stock portfolio in accordance with his defensive investor guidelines and have a question for you guys. I have most of my portfolio invested in individual stocks as well as an S&P 500 index fund. I’m reducing my individual stock concentration while trying to increase my exposure to international stocks. I’m looking at ETFs as the way to gain international exposure, specifically, some of Vanguards low-cost ETFs. My question to you is this. How would Ben Graham analyze an index fund or an ETF? He laid out very clear steps in chapter 14 of his book for analyzing individual companies, but nothing for analyzing larger groups of stocks such as index funds. How can a Ben Graham defensive investor analyze an index fund? Thank you for taking the time to listen and answer my question and keep up the great work.

Preston Pysh  48:10

Hey, Dylan, love this question. And it really pertains to the discussion we’re previously having in the episode where we were talking about the return that you got on the S&P 500. So I made the comment that I thought that the return would be 4%. So this is so simple, and it’s not anything that really takes a lot of effort. When I’m coming up with that figure, all I’m doing is I’m taking the overall PE ratio of the market. So for the S&P 500, you could take, you know, I like to use the Schiller PE. So right now, the Schiller PE is around like a 27. So all I’m doing is I’m taking one divided by 27, you’re always going to take one divided by whatever the PE number is. And by doing that, you’re basically flipping the PE ratio upside down and you’re inverting it. So it’s an EP ratio.

When you do that, what you’re doing is you’re actually taking the earnings, the profit of the overall SP  500. And you’re dividing it by the price that everyone’s willing to pay to own the S&P 500. When you do that, you come up with a percent. So one divided by 27, given you that rough number that I keep throwing around 4%.

49:17

So, Graham. I love the fact that you referenced chapter 14 in the Intelligent Investor because that’s exactly where Graham passively talks about this idea. Graham talks about that if you would take the earnings to price ratio, and he actually calls it that, which is the same thing that I just quoted to you taking one divided by the PE. He says that if you take the earnings to price ratio, you should be at least as high as the current high-grade bond rate. And that was the exact discussion we were having earlier in the show.

So Graham doesn’t come out and say, hey, this is how you value an index because the index is during his time really weren’t anything like what it is now. But this is how ahead of his time that he actually was working. He was already really talking about this concept, he was just kind of doing it passively. So that’s how he values an index, there’s really not too much more to it than that. Whenever you’re evaluating an individual company, you’ve got a lot more risk to be concerned with, because that risk isn’t distributed across 500 different companies. So whenever I’m valuing an index, it’s really just that simple. I’m just taking the PE ratio and inverting it. And that’s really the end of my analysis. I know that might sound really simple and simplistic, but that’s really all it is.

Stig Brodersen  50:28

Yeah, and just one thing really quickly to say about being Graham, is that I think that he would have a very quantitative approach. I know that we talked a lot about Warren Buffett, and we’re talking about how he evaluates companies, but his mentor and his old Professor Benjamin Graham, he was a lot more quantitative than Warren Buffett. So I actually think that, first of all, being Graham would really like ETFs and indexes. And I think that he would really emphasize that the cost was low and also that it has some very strict measures we’re looking at. So he wouldn’t like personal judgment in those funds. He would have like investing in companies that had the lowest book value or invest in the companies that had the lowest price to sales or such metrics. So if you find ETFs like that, I’m pretty sure that Benjamin Graham would like that.

Preston Pysh  51:23

All right, Dylan, so awesome to have you part of our community. We’re going to send you a free signed copy of our book, the Warren Buffett Accounting Book. And for anybody else out there, if you have a question like Dylan, and you want to try to get it played on the show, go ahead and go to ask theinvestors.com. You can record your question there. And if we really like it, and we think that it fits with the episode, we will definitely play that and try to give you a good response. So everybody out there, thank you so much for everything that you do. You’re helping us out tremendously by going to iTunes leaving reviews, sending us emails, and we just appreciate it so much. It’s just so much fun to interact with our audience. So we really appreciate that. We hope that you guys really got a lot of value out of this discussion of Berkshire Hathaway shareholder letters. And we’ll see you guys next week.

Outro  54:00

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit stage.theinvestorspodcast.com. Submit your questions or request a guest appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of The Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.