Episode Description
[00:00:00] So without further ado, you talk about initially what you call permanent capital. That can mean different things to different people. What did you mean by that? Sure. So let's define capital that's not permanent. Blackstone's capital is not permanent because they've got to return capital to investors through the life of their fund, eight to 10 years.
A hedge fund's capital is not permanent because if they get redemptions on a monthly or quarterly basis, which generally is pro cyclical, they're getting redeemed on at the best possible times to invest, that's not permanent capital. What is permanent capital? It's capital that cannot be called. That allows you to take advantage of opportunities when the tide goes out and when asset prices are cheap, which is also usually when people have the most fear in the market.
That's one of the reasons why Berkshire Hathaway has an edge over all of private equity. In the 2008 crisis, in October, that crisis unfolded [00:01:00] so quickly, private equity did not get a chance to go raise, A bank bailout fund. The Oracle of Omaha already had the capital lined up and the planes flew to Omaha and he got sweetheart deals off market deals because he was ready to provide liquidity and inject capital into those kinds of opportunities.
So that's what permanent capital helps you do. I think that's huge. And you just really mentioned arguably the number one benefit That you as a family office have, even if a modest size one, like me, investing in car washes and rolling up and things like that, you do have the opportunity of permanent capital.
We have time on our side. Private equity firms need to deploy capital. They need to have an exit. They often quote unquote overpay. They also are subject to regulatory issues that family offices may have usually more freedom on. Now, I'm not going to make this a discussion about the Corporate Transparency Act and beneficial owners.[00:02:00]
My concern is that could segue into the government looking to do more and more disclosures for single family offices, which would take away from the freedoms and liberties and shine. There is no question, family offices have a massive advantage there. Number two, you talk about tax efficient. What did you mean by that?
Sure. Buffett has three drivers of tax efficiency. One is. He does borrow and has an interest tax shield from his borrowing. Now his borrow cost is very low because he's a triple A rated player, but he takes advantage of what's called an interest rate tax shield. Borrows are a hundred billion dollars, by the way.
Okay. So that's one. Second, he's got depreciation on the assets that he acquires. That creates another kind of tax shield. To insulate from the income generated by his businesses that are cash flowing. So the third is when he acquires a business, he likes businesses that have brands. And when you acquire a [00:03:00] business that has a brand, generally you see that reflected in the goodwill of a company, right?
So the goodwill is defined as your acquisition price less than marketable value of the securities. The assets, and that difference is goodwill. It's the price of these intangibles. There's some value that the acquirer signed here and that goodwill can be depreciated as well. So there's a reason why Buffett likes brands and brands have multiple benefits and advantages, whether it's Wrigley's or Coca Cola or Dairy Queen or NetJets.
But one of the other advantages is that you can depreciate the. Acquisition costs of the brand, even though it's actually helping your business. So tax is a big part of this. One other part I w I want to call out though is back to private equity and like difference between Buffett and private equity is private equity firms have to sell their best [00:04:00] assets.
Ultimately, Warren Buffett doesn't have to do that. He can hold on to his finest prized crown jewels forever and let them internally compound. Private equity has a clock to them and private equities built some incredible businesses. The Invitation Homes was created by Blockstone. They were birthed in the wake of the 2008 crisis.
And they created the asset class of single family residential homes and now there's a big capital market around it. There's asset backed securities financing this asset class. It was a great business. I wouldn't buy it today, but all to say is Blackstone is forced to sell that. Now we have a housing shortage.
Those are assets I think they probably would have wanted kept and actually Buffett at the time, when Invitations Homes was being built, he said, there's one asset I'd want to buy in the aftermath of the 2008 crisis, [00:05:00] the single family home. So that's another advantage that Buffett has over private equity.
or a complex so you could break it down and that would be you write. Non callable carry trade. What did you mean? Yeah, this is a really interesting technical point, but it's, it is a crucial one. Okay. So some investors identify securities that they expect will appreciate in price based on a high sales or earnings growth.
Those are often like tech stocks, for example, right? Buffett is doing something else and maybe what I can do is share my screen here. To make this more visually clear, and those of you that are finance junkies and know the tangency portfolio will understand the point that I'm about to make, but I'm gonna try to explain it as simply as I can.
What Buffett is doing is he's not looking to maximize the total return. from any [00:06:00] given investment. He's looking to maximize the risk adjusted return. Exactly. So he's looking for assets that throw off cash flow and those assets have a spread over the funding costs that, that Buffett has, like the metric you might use here is called like return on invested capital.
Okay, so he's looking to compound assets and capture that spread between the return on the asset, less the funding cost of that asset. And then with that cash flow, plow back into the business and internally compound. But let's break this down a bit more because I know that's You know, a lot of that is, like finance jargon.
I'm going to share my screen here. Let's see, share screen. I just looked up, kind of Efficient Frontier. Can nerd out here a bit. I'm going to add it to the stage ROM. So give me a second. I think we're there right now. There you go. Got it. So what this [00:07:00] shows on the Y axis is the return of an asset on the right hand side shows the risk or the volatility of an asset.
So what, most investors are doing is those that seek to maximize total return, they're finding an asset that has high return, but also has high risk. So it's somewhere on the,
And, give me a moment here, tangency portfolio, let me look this up here. Oh, there we go. It's much better chart. Okay. So if you look here, what Buffett is, investor A is trying to find this asset. That, that dot on the efficient frontier, volatility. Okay. Maybe that's like Snowflake, which is down 40 percent down a lot.
And it's, these are risky businesses, right? Cause higher earnings growth, high sales growth attracts competition. And those names are often glamor stocks. They get bid up a lot. They get expensive. And they have risk of disappointment. Look at cybersecurity stocks, for example, okay, [00:08:00] where the forward PEs are very, expensive.
Now here's what Buffett is doing. Buffett's saying, I want high return, but I don't want that risk. So he's finding this portfolio, this little dot in red, it has lower volatility. These are cash cows, and he's borrowing with debt to extend the return from this asset on this line here, this diagonal line that we draw from the risk free rate, which he borrows pretty close to the risk free rate as a AAA borrower.
And obviously the insurance float helps as a source of financing. And he is accessing a set of opportunities that dominate the opportunities others have to access in the public markets, right? If you buy an asset, you're not financing that with AAA debt. You might finance it with margin debt, which you shouldn't do, but that's callable debt.
So in addition, what Buffett is doing is he's financing with non [00:09:00] callable debt. That means he cannot get a margin call. So he has permanent capital and permanent financing. He's linking the duration of the asset, which he wants to hold forever with the duration of his financing. Okay. So very difficult for investors to do this.
You can do it in public markets. You can't do it in public markets. You can do it in private markets, if you approach your financing carefully.
Excellent. And yes, I know that was a little bit of a.
But number four is high return on equity, ROE. What did you specifically mean to that, by that, and why is that important? So let's go back to the establishment of Berkshire Hathaway. So Berkshire Hathaway was a textile mill that was in decline and Buffett acquired this business And it was a cash cow and that cash cow was used to finance the acquisition of other businesses and the Berkshire Hathaway [00:10:00] name stuck.
They just took the name of the textile and put it on the flag, the masthead and the rest is history. So the key is, you want assets that throw off cash flow so that. When Mr. Market, either public or private, has a dislocation, you have a move to make. You have liquidity. You have liquidity through the cash generating power of your assets.
So one of the metrics that Buffett likes is return on equity. His return on equity is the net income generated by an asset divided by the equity cost of the asset. He likes 20%. If you look at the free cash flow generation of Berkshire Hathaway. In a given quarter, even it is substantial. He's generating so much cashflow every quarter.
When there's a market dislocation, again, he's got the liquidity to make a move. And by the way, his [00:11:00] cashflow generation is even higher for wholly owned businesses. So Buffett owns, Berkshire owns 80 plus businesses. And so the free cashflow that's generated by those firms, he can access and tap as opposed to having to rely on a dividend yield in public markets.
And that's a big difference. Okay. Let me illustrate with a simple example, JP Morgan has a return on equity of 15 percent plus, which is extraordinary for the United States is the largest bank in the land. Okay. 15 percent return. I'm talking about scalable compounding. However, the dividend JP Morgan pays is relatively paltry.
It's a couple of points, dividend yield. Okay. If you're Berkshire Hathaway and you own that asset outright. The cash flow stream you access to is the full 15%. You can do a lot with that. You can do a lot with that. So those are, the reasons why See's Candy, for [00:12:00] example, he bought decades ago has returned over 80 times its initial capital.
The, the idea that you can, harvest the cash flows and then internally compound, internally compounds like a word. That investors have forgotten in the go 2010s, which are tech oriented. Everything went up into the right, things went up into the right because of earnings growth and because of, multiple expansion.
But that idea of internal compound, it's like, Hey, how do I take cashflow and plow it back into my business? And grow that business, right? So if I have a return on invested capital, that's positive, let's call it 20%. And I have incremental projects that will generate that return of 20%. I've got cashflow and I can invest in my own business and grow.
That's a wonderful thing. That's what JP Morgan has done, by the way, of course. So that's the opportunity that a family office has. In the private markets, because if you're buying JP Morgan [00:13:00] today, you're buying that asset at a price to tangible book value. That is expensive. It's a great business, right?
Whereas if you access opportunities in the private markets that are less covered, you're, Less picked over, for example, low, lower middle market firms where private equity doesn't play or those firms cannot access financing. The multiples are cheaper. Where there's an opportunity to consolidate.
Perhaps there are different ways to approach it. Then you can build a machine that also internally compounds with the cashflow generation of the business. Maybe one comment I'll make building upon that and what we're leading.