Jacob McDonough, how is Warren Buffett’s capital allocation?

Jacob McDonough (his Twitter) has written a very interesting book: Capital Allocation: The Financials of a New England Textile Mill. During the RV Capital Meeting 2023, we could chat about this book and learn more about Jacob’s partnership.

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We have discussed the following topics:

Introduction

[00:00:00] Rob Vinall: It was great that you reached out to me. If you hadn’t reached out, we wouldn’t be sitting here today and it occurred to me when I was thinking of putting together the agenda for today or the weekend’s meetings that– We’ve had a few authors here in the past actually. We had Wil Thorndike here a few years ago who wrote a very influential book for many of us, The Outsiders, and in hindsight, I’m like why on Earth didn’t I get him up on stage to speak with him? Thankfully I didn’t make the same mistake this time. So you wrote a wonderful book which I read earlier this year called Capital Allocation. This is the book and there are plenty of copies here, so Jacob’s going to do a signing in the break afterwards. But before we get to the book, I’m sure many of the audience here don’t know you, Jacob, so why don’t you introduce yourself?

Meet Jacob McDonough

[00:00:52] Jacob McDonough: Yeah. I’m Jacob McDonough and going to Omaha for the Berkshire events, a lot of fun, you see a lot of celebrities and Rob is one of them. So I got to see him and bumped shoulders with him there, so that’s good. But I’m from Grand Rapids, Michigan in the US. A year and a half ago I went off on my own to manage capital for outside clients in a separately managed account structure to keep overhead low and get myself as long a runaway as possible but eventually would love to go to the fund structure when the time is right.

Jacob’s book Capital Allocation

In May 2020, I published a book that we’re going to talk about, Capital Allocation. I took the point of view of a practitioner, someone who would love to create a company like Berkshire, and I think there’s a lot of opportunity to do that still today, especially in areas like Japan. So I wrote the book, as I said, from a practitioner. In 1965, what could have been analysts seen in the financial statements in the annual reports of Berkshire, the companies they acquired, and the companies they invested in. I read as many books as I could on Berkshire and Warren Buffett, and I was disappointed there wasn’t as much financial data as I wanted, so I had to hunt down the annual reports, and financial statements and that took a lot of time and energy in libraries and some other investigation and I figure some readers would want to see that data and might not have the time or energy to hunt that down. So I figured it might be a good project to turn into a book.

Jacob’s background

[00:02:21] Rob Vinall: We’re already getting towards the book but yourself. What were you doing before you started your partnership?

[00:02:27] Jacob McDonough: Yeah, so I went to Michigan State University, studied finance and moved to Nashville, TN and worked for a great investment research firm down there at new constructs. We didn’t manage money ourselves, but we built models for 2000 companies. My job was to dig through 10Ks and 10Qs, and try to find interesting things in the footnotes, not recurring charges and make sure try to see where reported accounting net income maybe didn’t match the economic reality of the business, so that’s where I got my experience.

[00:02:58] Rob Vinall: It sounds a little bit like The Karate Kid where you have to polish the car hundred times to the left, a hundred times… a lot of grunt work, but then maybe at the end of the process you’re a pretty good investor.

[00:03:09] Jacob McDonough: Yeah, so I enjoy now investing, studying, deeper diving on a smaller number of companies instead of trying to manage 2000 or so.

Aha moment

[00:03:18] Rob Vinall: And the question I’d love to ask is most people come to value investing more through a kind of like a very suddenly as opposed to it being something that sort of gradually creeps up to them. We talk about that aha moment, was there an aha moment for you with investing?

[00:03:34] Jacob McDonough: Yeah, I’d say. When I was young, just learning about compound interest, kind of got me excited knowing that it wasn’t just about a salary as long as you save money started early and owned equity, a salary didn’t matter so much. So when I was sitting in school that was kind of nice to know. From there, eventually, just a love of studying business that drove me towards this line of work.

[00:04:04] Rob Vinall: Did you come across the Buffett letters at some point in the?

[00:04:08] Jacob McDonough: Yeah, exactly in college. Yeah, Buffet’s letters and reading all the books that could be on there was a big head start.

Good Investing Plus – A warm invite to apply

Hey, Tilman here. It’s great that you have made it that far into the video. It shows a particular passion for investing you’re having.

If you want to dive deeper and go further down the rabbit hole, you are kindly invited to apply to my community Good Investing Plus. It’s a place that’s very helpful to people who are ambitious about investing and is helpful to investment talent and experienced fund managers. So if you’re interested, please click on the link below.

And now, without further ado, enjoy the conversation.

How did the book come about?

[00:04:15] Rob Vinall: Awesome, so let’s turn to the book. So how did the book come about? Where did the idea come from?

[00:04:22] Jacob McDonough: Yeah, so I tracked down the inner reports as I said. I was going to do that anyway and it took a lot of time to find them, especially in the 1950s, 1960s and a lot of the companies they acquired See’s Candies, National Indemnity, the Illinois National Bank of Rockford. I thought they were private companies. I’ve never seen any data on them before the acquisitions in any of the other books but hunting through libraries through Moody’s manuals. There were decades of financial data on those companies even before he acquired them, so it was great just to see the lead-up. Buffett always talks about flipping through modes manual. So, uh sitting in the library, you kind of can picture him flipping through the Moody’s manuals just like you and imagining maybe what he was looking at the time.

[00:05:06] Rob Vinall: Mathias might be getting excited that it sounds like there’s a business in reselling some of those old manuals for Moody’s. In very broad strokes, obviously, I’m guessing a lot of the audience won’t have read the book. For those of the audience whom I assume everyone knows Bookshare Hathaway, but just broadly in very broad strokes. What is the book about?

[00:05:28] Jacob McDonough: Yeah, so the book starts 10 years before Buffett took over Berkshire. So those ten years I focused on what Berkshire was before he got involved. And then the next one–

[00:05:37] Rob Vinall: So just for context, he was managing a fund at this time and he bought Berkshire Hathaway as an investment in his fund.

[00:05:45] Jacob McDonough: Yeah, he was an emerging manager. Like a lot of people in this room ran a fund for about 12 years. Before fees, I believe he compounded at a rate of 31% per year with no down years. So pretty successful. He closed the fun in 1969, but through the fun in 1962 he started buying Berkshire stock and continued buying it. In ’62, Berkshire had a valuation of 12 million. I think the valuation got up to 16 million by the time he finished accumulating shares in 1965, and by then I think its fund owns 65% of Berkshire and he became chairman in ‘65.

Berkshire Hathaway

[00:06:24] Rob Vinall: And the book describes, obviously, the initial investment in Berkshire Hathaway and various investments he made subsequent to that.

[00:06:32] Jacob McDonough: Yeah, that’s right. Yeah, Berkshire was a very bad business, even worse than I would have thought beforehand. It’s a commodity business with no brand or differentiating aspect to it. Some commodity businesses can be good if they’re the low-cost operator, but even in the annual reports prior to buffet taking over, management was very clear that they were not the low-cost operator, their Japanese competitors had much lower cost structures. The workers in Japan were paid $0.15 per hour back then and it was a dollar per hour minimum wage in the US at the time the cost structure just didn’t work in the US anymore compared to the competition overseas.

[00:07:10] Rob Vinall: So it was a terrible investment. So there’s hope for all of us.

[00:07:13] Jacob McDonough: That’s right, yeah, it lost money a lot of years every once a while though they’d have a few profits through the cycle, but yeah, a cycle of losing money in a couple of years of it looking okay.

Warren Buffet’s capital allocation

[00:07:27] Rob Vinall: So he took the money out of Berkshire, a failing business and allocated it into a much better business. What were some of those businesses?

[00:07:33] Jacob McDonough: Yeah, So what I was most interested in is seeing, how do you do that? How do you take capital out of a textile manufacturer and how do you move that into new businesses? So in 1965 and ‘66, his first two years he took over. They had some profits, which a small part of that might have been just the timing of the cycle, they had some profits, but he cut costs in a major way. In 1965, the cost of goods sold declined by 10%, which 10% might not sound too crazy. But in terms of overall dollars, it was major, so it was a very low-margin business. So that means revenue compared to profits is very high. Revenue compared to their valuation is very high, so any little piece of any sale that you can keep to the bottom line, in addition, is very meaningful.

So the 10% cost of a reduction in the cost of goods sold was huge, so they profited like 4.5 million of net income, of pre-tax income in ‘65. Five million of pre-tax income in ‘66 so that 9.5 million of pre-tax income was a major portion of the 12 million valuations that it had in ‘62 and that the 16 million I think was valuation in ‘65.

Tax Credit

[00:08:50] Jacob McDonough: He had tax credits as well. They had losses in the years leading up to it. The tax credits were going to expire in the next five years, but luckily he had profits those two years. So it was tax-free, so that was 9.5 million of free cash flow in his first two years was a major portion of the purchase price he got out of textiles and any other textile manager would have put that right back into the same old business. But what he did was how he got capital out was when they had profits, he avoided reinvesting and he got that elsewhere. First, he invested. He had a stock portfolio for a few years. I think three years. He doubled his money there, which is nice. And then he moved that money into National Indemnity and the Illinois National Bank of Rockford first two being acquisitions.

Flow

[00:09:41] Rob Vinall: So the first two big acquisitions were an insurance company and a bank?

[00:09:46] Jacob McDonough: Yeah, that’s right and the interesting acquisitions to study because I was confused about flow before writing the book. Honestly, just how aggressive could you be with the flow? That capital seems like it could be redeemed if you have some major losses on policies in certain years. So I was curious they seem very conservative and I was just wondering from my point of view, how could you sleep well at night? How aggressive could you get? And so what I learned is they talk all the time about how they can use float to buy stocks and private businesses. But that wasn’t till much later in the ‘90s and early 2000s through today, they definitely can, but that’s just because of their size.

They’re so diverse, so big that they have earning streams coming in outside of insurance that now they can do whatever they want with the float. The railroad was purchased through an insurance company Burlington Northern, and that’s unheard of in the insurance industry. I don’t think anyone else does that, not too many other players.

[00:10:46] Rob Vinall: But just so everyone understands the float is the premiums that people pay for insurance, and it’s the money they have at their disposal to do whatever they want with.

[00:10:55] Jacob McDonough: That’s right.

Rockford Bank

[00:10:57] Rob Vinall: Describe one or two of the acquisitions which you thought were the most interesting. Maybe bearing in mind that the audience that everyone here is going to be an investment professional, so just at a high level, some of the acquisitions and what made them, what you learned from them. What did you find exciting about it?

[00:11:13] Jacob McDonough: Yeah, I like the Rockford Bank that he bought so it was very unique that in Illinois at the time there was a state law where a banking business could only own one branch location and so there’s not much growth opportunity for the Rockford Bank. They only have one location, but it makes a good situation for Berkshire where they could take their profits. Just send them to Omaha and Buffett could reinvest it, reinvest it there. But it’s very interesting because they had huge economies of scale you wouldn’t think of one branch I think would have economies of scale, but what I learned is economies of scale kicking at different levels for different businesses or industries it’s not the overall largest dollar amount of revenue that gets the economies of scale, it doesn’t work that way in banking.

The Rockford Bank with one branch. They had about $100 million of deposits in the ‘70s at one branch location adjusted for inflation today that blows anyone out of the water today of any bank. And today you have Internet banking and mobile banking. You’d think there’s less need for branch locations. But yeah, the Rockford Bank blew them out of the water. And if you think about it, if you jump from 50 million in deposits to 100 million deposits and you’re not adding any locations, your costs are not doubling, you shouldn’t have to double your staff or your equipment, so non-interest income as a per cent of income kept getting lower and lower through the years and so profit margins kept going up and up at the Rockford Bank which is fascinating. And there are some small banks today that you can see parallels to that. So economies of scale at a bank are at the branch level and then also it’s how much work you can do per employee, how efficient you are, how much leverage you can work, you can leverage per employee, their economies of scale come in. It was interesting to learn about that acquisition.

Finding Cash

[00:13:01] Rob Vinall: Yeah, that was one of the most important lessons I took away from your book was how laser-focused Buffett was on finding cash. He didn’t care if the business could reinvest that cash, that didn’t bother him. If there were no additional branches, Rockford Bank had open because he could take the cash and invest it himself. What were some other examples of that?

[00:13:24] Jacob McDonough: Yeah, there were so many. I was a little surprised at the valuations because when he talks about his young days, it’s a lot of obscure names with incredibly cheap valuations. I saw a lot less of that in this period, but a lot more examples of companies that they had were great businesses, consistent businesses, but they had way too much cash on hand because they had nowhere to put it. So See’s Candy had maybe half their assets were cash.

[00:13:50] Rob Vinall: See’s Candy, the West Coast confectioner.

[00:13:52] Jacob McDonough: Yeah, that’s right. He tried to acquire Detroit International Bridge Company, a toll bridge, which to me was fun to look at because it’s he always talks about a toll bridge as an ideal business and he almost bought one, but someone outbid him there. That one was another one where they weren’t going to build another bridge, so they had nowhere to reinvest their cash. And half their assets again, where maybe cash and there were a lot of examples of overcapitalized businesses where that’s why I think Berkshire has a structure underrated because it’s very tough to find companies that can compound consist only for 70 years, a hundred years. But if you had a Berkshire structure where it doesn’t, you can have a business that can’t keep compounding, can’t keep reinvesting, but if you’re able to move that capital and compound it somewhere else without having to pay dividends and get tax on dividends or realised gains by selling in stock to buy another one, the structure itself, I think is a little underrated.

Focus on small companies

[00:14:49] Rob Vinall: And another feature that jumped off the page to me when reading your book was it’s not just about finding companies with the cash, it’s having the possibility to get your hands on the cash.

[00:15:01] Jacob McDonough: Yeah, that’s right, and maybe that’s why in his early days he focused on small companies because then maybe if he could acquire the stock, then he had the potential to take over the business. If he was buying the stock of the largest companies back in the day, he might not ever have had a chance to acquire the company. So in your letter like you said, if the stock goes up, you could sell it. If it didn’t, he could take over the company and I think that’s why he focused on smaller companies back then, but you did have a question yesterday, someone in the audience had a question, can you have an edge on small companies versus large companies?

And it’s interesting to see in his early days, he did look at a lot of small companies, a lot of obscure companies, but even when he moved capital out of textiles in the ‘60s, he had a portfolio there for three years. Disney was in there and American Express and Wrigley, chewing gum. They’re a lot smaller than they are today, but I mean, back then Walt Disney was a celebrity Disneyland, was open in California and I believe Mary Poppins had just come out. That was a kind of worldwide sensation. So it was a big name. It was not very obscure at all, so he was very opportunistic. He was willing to– I feel like he didn’t follow any rules, it didn’t have to be below book value even back in the ‘60s and ‘50s.

Warren Buffett’s rough patches

[00:16:19] Rob Vinall: Yeah, it’s a wonderful thought and another thing is when we talk about it, it sounds like everything was perfect, but he also had his rough patches.

[00:16:27] Jacob McDonough: Yeah. He definitely did. That’s why I love studying history because it helps put the context of what we’re going through today. That brings me comfort. But in 1971, Blue Chip Stamps had a stock price of I think $19.75.

[00:16:45] Rob Vinall: Nineteen or ninety?

[00:16:45] Jacob McDonough: Nineteen.

[00:16:46] Rob Vinall: Nineteen. OK.

[00:16:47] Jacob McDonough: Yeah, but three years later.

[00:16:48] Rob Vinall: I love the way you know the sense as well.

[00:16:51] Jacob McDonough: That’s right, and three years later though, the stock price was 77% lower, so they went through a very tough time.

[00:17:01] Rob Vinall: Seventy-seven?

[00:17:02] Jacob McDonough: Seventy-seven per cent and 73, they’re down like 53%, the next year down 28%. So back-to-back it was very tough for the client and Charlie Munger was the chairman of Blue Chip back then. The business Blue Chip and Berkshire were, they were intertwined but they really, that’s kind of why they had to merge later into one company, but at this time in the ‘70s, they were separate public companies but very intertwined. Buffet and Munger definitely worked together, but I’m sure Warren Buffett wasn’t yelling at Charlie Munger. He didn’t fire Charlie Munger with a 77% decline in that time period, but it’s interesting to think how much they’ve accomplished since then. You know, getting past that rough patch, but most importantly, I love looking at the valuation at the time in ‘74, and that’s where it was an extreme bargain.

Whether you want to look at earnings or assets the year before, well, the valuation of Blue Chip was $23 million back in 1974, so much smaller than what we’re talking about today with Berkshire. But the year before they earned $8 million. So at the time, they’re selling less than three times their earnings. It was understated net income as well because 2/3 of their assets were in stocks, which they are long-term holders of stock. So on the income statement, you don’t get the benefit from those assets every year unless you realise the gain so 8 million in net income was mostly through See’s Candy, the candy company they owned and so cheap on earnings. But then on the asset side, 2/3 of your assets were a stock portfolio managed by Warren Buffett and Charlie Munger, legends, who already had a great track record and yet, I believe the price to book value they’re trading below 40% of book value, so a discount discounted assets when the assets are managed by some legends. It was just an insane valuation back then, so it’s always nice to know markets can do crazy things. It’s guaranteed that they’ll do crazy things from time to time, and it’s guaranteed that stock prices. Go down not just up all the time.

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Staying flexible and opportunistic

[00:19:02] Rob Vinall: So having looked at all of these investments, what was the most important lesson you took away?

[00:19:09] Jacob McDonough: For me, staying flexible, and staying opportunistic because there’s plenty of times where, you know, I mean textiles is a good example. He pulled money out of textiles. Not many people would do that back in that time period. But there were other examples too. They got into Westco Financial, a savings and loan business, and within a few years, they pivoted that business into many other things, so they were very quick to see if they had a mistake within a few years. They weren’t afraid to admit that and change their ways, and Westco was another one where they kind of got out of that business. That’s not one where I think they were planning on it right away, but they stayed flexible and opportunistic and I think weren’t very rigid on rules or following the original plan they had they were willing to change.

For me, staying flexible, and staying opportunistic because there’s plenty of times where, you know, I mean textiles is a good example. He pulled money out of textiles. Not many people would do that back in that time period. But there were other examples too. They got into Westco Financial, a savings and loan business, and within a few years, they pivoted that business into many other things, so they were very quick to see if they had a mistake within a few years. They weren’t afraid to admit that and change their ways, and Westco was another one where they kind of got out of that business. That’s not one where I think they were planning on it right away, but they stayed flexible and opportunistic and I think weren’t very rigid on rules or following the original plan they had they were willing to change.

How he sold his book to Warren Buffett

[00:19:58] Rob Vinall: Yeah. Flexibility is definitely key. Lots of books get written about Warren Buffett, about Bookshare Hathaway. Very few of them get sold at the Berkshire Hathaway shareholder meeting. It’s an enormous compliment to you and to the book. How did that come about though?

[00:20:18] Jacob McDonough: Yeah, so that came about because right before I published it, I sent a message to Warren Buffett’s secretary just because I have quotes from Buffett in the book and quotes from annual reports. So I want to make sure it’s okay. Within one business day, they responded. I’m a random person. They’re busy with hundreds of thousands of employees, and one business day they got back to me and asked me to send him the exact quotes, one business day later they approved it and then I asked if I could mail a couple of books to their office. Three months later, I got a nice little note from Mr Buffett inviting me to sell it at a meeting in a few nice words. So it’s incredible that he took the time to do that and that they were quick to respond to me. I don’t think many companies would do that.

Yeah, so that came about because right before I published it, I sent a message to Warren Buffett’s secretary just because I have quotes from Buffett in the book and quotes from annual reports. So I want to make sure it’s okay. Within one business day, they responded. I’m a random person. They’re busy with hundreds of thousands of employees, and one business day they got back to me and asked me to send him the exact quotes, one business day later they approved it and then I asked if I could mail a couple of books to their office. Three months later, I got a nice little note from Mr Buffett inviting me to sell it at a meeting in a few nice words. So it’s incredible that he took the time to do that and that they were quick to respond to me. I don’t think many companies would do that.

What good things have come of the book

[00:21:06] Rob Vinall: What a wonderful story and a wonderful guy. So what good things have come of the book?

[00:21:18] Jacob McDonough: Well, this is definitely one. This is a surprise but yeah, I got to meet a lot of nice people. A lot of fun putting the book together, it’s tough to start when you’re staring at a blank page, but the ball kind of slowly gets rolling. The more you write and then by the end, I didn’t want it to be over, so I thought I’d write another book, but I’m all out of ideas right now, so I don’t know if that’s going to happen.

[00:21:41] Rob Vinall: Fantastic, so we’ve got about 10 minutes of time for questions from the audience. If I, my microphone assistants are here. Who’d like to ask? There’s one at the front there.

Did Buffett have to buy National Indemnity

[00:22:01] Speaker 5: Hi thanks a lot for the book. I’m just wondering did Buffett have to buy National Indemnity and all those companies that he bought earlier in the years through Berkshire? Or does he have a lot of cash on the side that he could buy out of his personal accounts like, why was it structured in a particular way?

[00:22:20] Jacob McDonough: That’s a great question and in the book, that’s the main reason why I wrote that I thought buying Berkshire was a mistake. Buffett said it was a mistake. Now I’m second guessing that I think it’s a lot more nuanced than that, but to your point, one reason why I thought it was a mistake is that he was running his fun BPL and they bought 65% of Berkshire. So if they didn’t do that, BPL could have bought 100% of National Indemnity. National indemnity is very valuable today, so he and all his partners could have owned basically everything you see today instead of just 65%. So Buffett could have been could have made something of himself and could have been a lot richer if he didn’t do that mistake.

[00:23:08] Rob Vinall: Thank you. Who else has a question, Kevin? Try. At the back. Yeah.

The less risk you take the more rewarded

[00:23:15] Speaker 6: Hi, thank you very much. Nice speech and I wanted to know about the teachings of Buffett. Something that shocked me was when I was learning the way he was thinking about investments. Through practice and his own words, he sometimes mentioned that the less risk you take, the more rewarded you are, right? So maybe that is similar to the opportunistic thing you have mentioned also. But have you noticed this practice of being less and less risky rewards you more and more?

[00:23:59] Jacob McDonough: Yeah, I think that’s a great question too, because I’m sceptical that risk and reward are maybe as tight as some people teach, but they were very, very conservative. If you compare it to General Electric or a lot of other conglomerates or insurance companies back in the day, they were very conservative, if you look at leverage. I mean they did take out some debt, but it was always very modest and especially in the insurance business you can get into a lot of trouble. More from operating leverage. If you have too many premiums written compared to the capital you have on hand and Berkshire, they were always very conservative on that basis before they bought GEICO or before Berkshire acquired stock in GEICO, that was one example where they wrote very extreme when they almost got went into bankruptcy and that was because they wrote an extreme amount of premiums compared to the capital they had on hand. They’re very over-leveraged and GEICO had 28 straight years of generating profits. One kind of bad year in year 29. And then you’re 30. They’re just about bankrupt, so if you take on too much risk, even the best of businesses, just with one hiccup, can get into trouble. So he was very conservative, and yet I’d say his returns were still excellent.

[00:25:26] Kevin: Yes, how did writing the book change your approach to investing?

[00:25:33] Jacob McDonough: I’d say I enjoyed the process of hunting down the annual reports and I enjoyed flipping through Moody’s manuals, and since I had fun doing that, I try to keep that in my research approach for finding companies I don’t like using screeners. I like flipping like A to Z on a set group of companies, I enjoy Japan, so there’s a Japanese company handbook and you get to flip through that book. It feels kind of fun. It feels like you’re flipping through a Moody’s manual, so I feel like maybe it changed me in terms of the research process and then also just learning a lot about the businesses helped as well.

I’d say I enjoyed the process of hunting down the annual reports and I enjoyed flipping through Moody’s manuals, and since I had fun doing that, I try to keep that in my research approach for finding companies I don’t like using screeners. I like flipping like A to Z on a set group of companies, I enjoy Japan, so there’s a Japanese company handbook and you get to flip through that book. It feels kind of fun. It feels like you’re flipping through a Moody’s manual, so I feel like maybe it changed me in terms of the research process and then also just learning a lot about the businesses helped as well.

Warren Buffett’s Tough Times

[00:26:15] Rob Vinall: On the back there, Alex?

[00:26:21] Speaker 7: Yeah, thank you for your book. I’m looking forward to reading it. I wasn’t aware of it, so this is an A+ for this meeting. Thank you. I did something similar to you. I read in parallel many books on the ‘70s period of Warren Buffett, and when you petition value investing, the first time you get this article on Forbes that he says he feels like an oversexed guy in a whore house and you have the feeling that this was the best time of his life, you know. But when you start reading the books in parallel, you discover that Munger is heavily down on his investments.

Some friends of his have to liquidate his fund because they overleveraged Rick Guerin was overleveraged so Buffett took over shares from Rick Guerin in Berkshire. He had an SEC investigation into Blue Chip Stamps that did consume a lot of time. There was the Omni affair in National Indemnity, where there was a risk that he had to put a lot of capital into National Indemnity and he was probably the only guy who could do that at the time. Then later on Washington Post, where there was a strike and burned down the newspaper facilities. So in hindsight, you read about that and it was the greatest time that he had. But at that moment it was pretty stressful. So I thought it would be a good thing to write a book about Buffett’s toughest moments because everybody writes about his track record and says he’s the best in the world, but I think he had a lot of stress during his career and maybe this could help. Also people like us who from time to time run into stress.

[00:28:02] Jacob McDonough: Yeah, that’s a good idea and I think his excitement in that period was when I described the Blue Chip valuation, how low it got when he would think about that. I think that got him fired up. That was the exciting part, but you’re right, there was a lot of stress outside of the financial statements outside of the valuations at the time, so the valuations got them excited but yeah, they’re definitely tough times, but I think how he got through that he set up his life that worked for his personality in terms of his day-to-day his office. So because the important part of compounding is if you have a very long runway. I mean they’re Mungers 99, so if you can manage your stress to have a very long runway then it helps.

[00:28:48] Rob Vinall: I love the idea of a book about Buffett’s tougher moments. It’s also a reminder, I think when people look at the past, that some of the crazy share prices and the opportunities and it kind of in hindsight, it looks very easy, but as we all know, when those crazy share prices happen, it’s normally because there’s some kind of stress externally or at the companies and so. it’s never as easy as it looks in hindsight, yeah. I think we’ve got time. Oh, we’ve got a few more minutes, yeah, are there any other questions? Right at the back there.

What we can learn from Buffett

[00:29:27] Speaker 8: Thanks for the talk. I like your command of the numbers. We’re all trying to learn from the best investor probably of all time, what would you think or say, are the things that we probably can’t replicate from his success? Because there are probably things we can learn, but what would you say we probably can’t copy?

[00:29:44] Jacob McDonough: Yeah, that’s great because earlier in my talk I said I would love to replicate the Berkshire model and the important thing to distinguish is not the returns. The stock price that Berkshire had over this period was 26% compounded over the 20-year period. And I don’t think it’s very smart to start with like a goal trying to achieve because he is a genius. So I think lower lowering your expectations is huge, but the structure of the company itself, if you lower your expectations much further, still has a lot of benefits towards like lengthening the runway that you can compound out of business, even if you’re just talking 10%, 12%, or 15% instead of the 26 and 30% of that Buffett did. That would be the main thing that I think only Buffett did, and then the other thing we’re lucky with is that only Buffett could have been maybe the first person to do this, but now that he’s kind of paved the way for other people, that also helps for people who might be a little more mortal.

[00:30:52] Rob Vinall: Who else has a question? Well, you’re thinking maybe I’ll ask another question then. Especially for the emerging managers here, a lot of them will be looking to enter the industry through some kind of fund structure. That’s also how Buffett started, but he ended up investing effectively through a company. Now obviously there are lots of regulatory and tax considerations around that, depending on where your base is, but just let’s leave those aside, but just at a high level, which is for you the optimal way to go?

[00:31:26] Jacob McDonough: In terms of structure? So yeah he did do a fund and I think from the very early days and he started with very very low AUM so I don’t think maybe that’s a good lesson not to get down if it’s if you’re starting with low AUM, that’s exactly what he did too. But I think you do have to structure a little differently in the early days. If you do have low AUM, I want this separately manage account structure because there are fewer in the US, at least, there are fewer costs involved and a little less regulation so just maybe go with that structure first to keep costs low. You know, I think in Buffetts day costs already were low and regulations were less so he had less to worry about and could do more of a fund structure from day one. But I think that might be the main point to take there.

[00:32:11] Rob Vinall: There’s a question from Chandan here at the front.

Why stop in 1985

[00:32:18] Chandan: Thanks for coming. It was great to hear you. Why stop in 1985?

[00:32:23] Jacob McDonough: Good question. Nineteen eighty-five is when the textile mill closed down and so I thought it would be fitting to show the change from 10 years before you took over all the way until the original business was dead and the three I said it started with three failed businesses. Blue Chip Stamps was a rewards programme for retailers. Hochschild Kohn was a Baltimore Department store that was bought through an entity called Diversified Retailing and by 1985 all three of those businesses were extinct basically.

Blue Chip Stamps was still hanging by a thread. Their revenue dropped over 90%, so it was basically done with but the textile mill was completely shut down. Hochschild Kohn was out of business completely and so trying to see the change over those two decades by the time the original businesses were dead and then just trying to figure out how do you get to a $700 billion market cap today with those struggles is important to look at and if you look today, I think Berkshires is number six, in terms of market value worldwide. Only one company ahead of them was in existence in 1965. Saudi Aramco apparently was founded in the 1930s. The Saudi Arabian oil company, but every other company ahead of them are tech companies that were invented and created after Buffett took over, so he blew past any other company that was around in the whole world based through starting with three failed businesses, which to me is the most incredible part of the story.

Opportunities today

[00:33:54] Rob Vinall: It’s incredible. Maybe another question from me. The type of investments Buffett was making or the type of opportunities he had in the sort of ‘60s and ‘70s. Do you see that type of opportunity anywhere else today?

[00:34:15] Jacob McDonough: Yeah, I do and I think anywhere around the world you do run into companies that are great, consistent and run out of opportunities to reinvest. So there are overcapitalised businesses anywhere where you get into trouble as you might not be able to do anything with that because it might be founder lead, or there might be reasons they need to be overcapitalised, but I do like the valuations in Japan, a lot of companies seem overcapitalise there and the valuations seem lower and just when I flip through the Japan Company Handbook, it just reminds me of the research I did in my book. It seems like a lot of parallels there.

[00:34:53] Rob Vinall: Yeah, a lot of people, probably in this room as well have spent a lot of time looking at Japan, given how low the valuations are, a lot of companies with more cash on the balance sheet than the theoretical market cap. But especially after reading your book, it struck me that if you don’t have a method or a path to get to that cash then it’s just theoretical. That situation could persist forever.

[00:35:17] Jacob McDonough: Yeah, that’s right, yeah, so it’s a big red flag if the company has very high insider ownership and cash has sat in the balance sheet for decades. There’s very little chance there’s anything you can do with it, and the cash might stay there for many years. So with a lot smaller AUM, if I do look at a place like Japan, I know I’m not going to take over any time suits, so it’s definitely looking for companies where you’re happy with what management’s doing. You agree with what they’re doing and you’re in a lot better shape then.

[00:35:49] Rob Vinall: I think we have a question from the Internet, what was the most difficult part about writing the book?

[00:35:57] Jacob McDonough: Most difficult part, besides hunting down the annual reports and financial statements, was questioning if there needed to be another Buffett book. There are so many books already written about Warren Buffett, written about Berkshire Hathaway. You know, I didn’t want to step on any toes of what’s already been written and covered really well. So over time, I was questioning if there was a need for an additional book, but I’m happy I went through the process.

Most difficult part, besides hunting down the annual reports and financial statements, was questioning if there needed to be another Buffett book. There are so many books already written about Warren Buffett, written about Berkshire Hathaway. You know, I didn’t want to step on any toes of what’s already been written and covered really well. So over time, I was questioning if there was a need for an additional book, but I’m happy I went through the process.

How to approach companies

[00:36:23] Speaker 10: Regarding Japan, do you have any recommendations on how to approach those companies? For example, I invested in a company called Chinookan Group. It was basically a compounder perfect stock to just fire and forget. Of course, net cash and stuff like that. They did buy back so the management showed some shareholder alliance. And then the company was taken private. And it seems like a paradise, but hell in the same way. So I’m just curious how do you approach or what do you look for in management stuff in Japan?

[00:37:09] Jacob McDonough: Yeah, I had a similar experience too. There was a company I enjoyed as well that one to hold for a long time and it did get taken private. And so on one hand, when it’s taken private, maybe that’s validation that there was some value there, and that obviously someone wanted to buy it. But I do know when I speak to people that invest heavily in Japan they do preach patience and so it might not work out in every case. But it’s definitely at least a pond worth fishing in.

Some successful companies

[00:37:47] Speaker 11: I would like to ask about Berkshire’s successful history. There are a few companies in the world that try to replicate what Berkshire does. Do you think that there are some successful companies that can make it? Thank you.

[00:38:07] Jacob McDonough: Yeah, so there have been companies that have tried and there are a few that have some success. Markell is one that would come to my mind but I believe were in existence long before Berkshire itself. So part of the way they might other companies I’m sure was their own decision, but I’m sure they are influenced by Berkshire over the years as well. So Markell has been successful and there have been a few other companies that have tried and maybe not found so much success but I do think, I’m just surprised, not many people have tried, but I’m struggling to think of too many besides Markell that have had success.

[00:38:50] Rob Vinall: OK, one last question.

Evaluation of Japanese companies

[00:38:57] Speaker 12: I assume, maybe wrongly, that you do not speak Japanese. How do you evaluate the management of Japanese companies?

[00:39:04] Jacob McDonough: Yeah, that’s a good question. I only know English and I feel guilty about it as I travel through different countries here, but no, a lot of people stay away from Japan because like you said, the language barriers and that’s definitely it’s something I’m personally comfortable with just because if it was apples and apples, I would love to just own a company that’s right next door to where I live and I could meet management and all that. But it’s not exactly apples to apples in terms of valuations and the opportunity set, so that’s kind of what leads me to investigate there.

And the only way I deal with it is by trying to use multiple sources for multiple data sources. So if I’m using one trying to find multiple other translations, maybe that to compare to. You’re not just relying on Google Translate, but I have found a lot of companies report their Investor Relations website and English and Japanese and have found plenty of websites that have decades of financial data that they translate into English and technology is improving in terms of translation technology. And who knows, maybe ChatGPT, whatever might be able to help me someday as well. So I try to use more and more sources to make up for instead of just relying on one translation I guess.

[00:40:24] Rob Vinall: I enjoyed it, Jacob. It was a wonderful talk.

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Tilman is a very enthusiastic, long-term investor. Over the last years he has taught himself important investing concepts autodidactically. He tries to combine a positive climate and environmental impact with his investments.
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