TIP697: The Secret to Buffett’s Business Success w/ Lawrence Cunningham
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On today's episode, I'm joined by Lawrence Cunningham to discuss the value of trust-based cultures and organizations and the value Warren Buffett has created by implementing such a culture at Berkshire Hathaway. Cunningham is the director of the University of Delaware's John Weinberg Center for Corporate Governance. He's also the sitting director on three public company boards, Constellation Software, Markel Group, and Kelly Partners Group, and a bestselling author of a number of books, including the essays of Warren Buffett, Quality Investing, and Quality Shareholders.

During this episode, we discussed the primary role of the board of directors for a public company, the key attributes and the value of trust-based cultures and organizations, how Warren Buffett identifies trustworthy people, the story of David Sokol breaking Warren Buffett's trust, Lawrence's thoughts on Berkshire's $300 billion cash position, how Lawrence navigates investing in a world where a premium is placed on high-quality businesses, and so much more. With that, I really hope you enjoyed today's discussion with Lawrence Cunningham.

Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Fink. Welcome to the Investors Podcast. I'm your host, Clay Fink. And today I'm happy to welcome back Lawrence Cunningham. Lawrence, it's so great to have you back on the show. Great to be here.

In 2017, you joined the board of Constellation Software. And just to provide full disclosure at the top, I do own shares of this company. And since you joined the board of Constellation, you've also joined the board of Markel Group and Kelly Partners Group. And upon the joining Constellation's board, you reached out to Warren Buffett for advice on how to best serve a company on their board and add value. What did Buffett advise you on this matter? Warren Buffett

He said, you have two jobs. One is to hire an outstanding CEO and two, to stay out of the CEO's way. And so we could have left it at that. But he emphasized that if you do get number one right, you don't really have any problems. If you don't get number one right, you got all kinds of problems.

Another comment you've mentioned to me is Buffett's practical bottom line test for finding the right CEO is looking at somebody and finding somebody you can trust and ask yourself if you would be happy with that person marrying your son or daughter.

It resonates. It may be hard to articulate all of the skills and behaviors and attributes and pluses and minuses that you're willing to live with and stuff for any given role in life, including a CEO. But probably the most intuitive and compelling is that one, the son-in-law or daughter-in-law test.

And so it's really useful to people because we could make the list and you still might want to make the list if you're trying to focus on rational capital allocation or stewardship or industry knowledge. So there may be some things to prioritize and you can put them on a list. But ultimately, it's that sense of inhuman appeal. Other than picking the right CEO and just letting him or her run the show, what are some other ways that you or other board members add value in serving on a board of directors?

Being a sounding board, a confidant, being a CEO can be a lonely job. You're there facing every challenge that the company has and most of the hardest challenges have come up all through the ranks and you're the last one and the only one remaining to weigh in or to decide.

You have a little bit of a team around you, but ultimately, you're going to make the call and that could be a lonely place to be if you have good directors who are available and then will listen and reflect a little and, you know, ask some discerning questions, provide a little sound, I like to call it a sounding board. And it's not directional in that sense of being a director, but being thoughtful and helpful, constructive people.

So I think that's the most valuable thing. And that's obviously a 24-7 possibility. And then in terms of the periodic engagements where we have a quarterly evaluation, we have a deck of information and financial reports and trying to navigate the challenges and seize the opportunities, being thoughtful about that process, appreciating the line between the director role and the managerial role and

avoiding breaching that, stepping over, trying to tell the CEO how to do his or her job. And I guess finally, Clay is being that shareholder steward that reminding anyone who needs reminding that we're in this for the owners, for the shareholders, and that we've got to make that our North Star. And the CEOs I've worked with have not needed that coaching, but sometimes that's an important job the director can play.

Robert Leonard : Yeah. And it can hold everyone accountable having the right people in that ecosystem. And during today's discussion, I wanted to talk a lot about trust and culture is a topic you've thought quite a lot about, and I thought there'd be no better person to discuss those topics. So in your book, Margin of Trust, you outline the value of key managers that shareholders can trust. It reminded me of a book I recently just covered on the show. It was called The Power Law. And

the book outlined the best investors in the world of venture capital. And what I found so interesting about that book was that the best investments in the world of venture capital were with founders who would have been extremely difficult to trust. So you think of these unpredictable entrepreneurial misfits that are looking to change the world, take an unconventional path. And these types of CEOs can be quite volatile, which goes quite to the

to the contrary of the managers that someone like Buffett would be looking for. So Bruce Whitman, who was the CEO of Flight Safety, which is a Berkshire subsidiary, he stated, Buffett trusts me so much with Berkshire's money that I am even more careful in handling Berkshire's capital than I am in handling my own capital. And then you can contrast that with someone like Mark Zuckerberg, who in the early days of Facebook, he showed up to a

Sequoia Capital meeting in his pajamas and would give a presentation to them. Why is it that a culture based on trust can be so valuable to an organization?

Well, those are interesting observations. And I think there's a range of characters out there, personalities, and they maybe run from the very trustworthy and reliable to the wildly unpredictable and volatile. And investors will have different appetites to run with different individuals. And so this is not a prescription that says, you know, run away from the unpredictable, volatile, pajama-clad entrepreneurs.

But it is, to Bruce Whitman's point, an observation or inquiry into how a person who's trustworthy or an institution that attracts that kind of person and builds on trust can gain competitive advantages against a different kind of culture, volatile one or however you want to describe it. The idea of trust and why it might be appealing, why it might work for people, why it worked for Bruce.

in working for Warren and why it might work for Bruce's people down below him is that research indicates that people who are trusted tend to want to vindicate that trust. They tend to perform better. They aspire to validate the person's confidence in them. So when people are given autonomy, they have responsibility or they accept responsibility. Not everyone, there are miscreants, but broadly, people who are asked to

To be honorable? Well, tend to be honorable. The evidence also shows that companies with a culture that attracts and retains that kind of person tend to be able to attract customers more effectively and to retain the loyalty of customers. They tend to have better relationships with important resources like their suppliers. They tend to have... There's evidence that shows that trust-based corporations

corporations can obtain lower costs of funds, lower interest rates.

looser covenants on their promises, that the people actually take seriously the intangible cultural commitment, delivering products, paying bills, paying loans back. And when you take it all together, such a collection of benefits can be a competitive advantage, can be a moat, as Buffett likes to call it, that a company that has a reputation as trust-based

can win compared to rivals in a variety of markets. So, it's not inexorable, but there is pretty, you know, there's good academic research and some intuition that says that that kind of behavior is valued by people and a company constituted that way can capture that value.

Abraham Lincoln, he has this quote, the people when rightly and fully trusted will return the trust, which ties into a point you just made. And based on my experience, I've worked a few jobs in my career so far, and I just totally agree with you. I mean, if you're working with someone who's untrustworthy, you're almost waiting for them to do something in their best interest against your best interest. Whereas if you're working with someone trustworthy, it's almost like you're both looking to lift each other up and

and provide value to the other person. Nick Sleep has this wonderful saying where, I don't know if it was him or Kay Zachariah, essentially one of them handed over a loaded revolver and said, feel free to shoot if you want to. And it's like just full trust between that sort of partnership.

I appreciate that Lincoln quote in your own experience. And you can experiment with this and possibly in some of your own leadership roles or lateral roles. But if you take a staffer and have the supervisor be a micromanager who second guesses everything and has a bunch of rules that need to be followed, and you switch that supervisor out for someone who says, please exercise your judgment within these parameters and then let me know how it turns out.

I think you're going to see that worker be less productive in the rules-oriented supervision and more productive in the trust-oriented one. I've seen it myself where people simply feel shackled in the first place and they're not going to be creative, they're not going to be innovative, they're not going to try to solve problems.

or reach out to customers or suppliers or other constituents, but the person who's given some leeway there will, at least to that person's capability, live up to it and help solve problems, help lead solutions. So I think we don't overgeneralize or overstate the case, but certainly a strict rule-bound environment versus a sensible trust-based environment will likely produce different behaviors and different outcomes among the staff.

Yeah, I actually had a question on this exact topic. So if we think about two ways that an organization can broadly operate, we can think about the first way you mentioned where it's almost rules-oriented, where there's policies and guardrails in place to ensure people are behaving in a way that the company wishes them to. It's almost that bureaucracy that inevitably creeps in as organizations get bigger and bigger. And then the second approach, we can just simply call it a trust-based approach, which has fewer guardrails and it really

encourages people to just achieve a stated objective in the best way that they see fit. And I feel that each approach is going to work based on just the organization and the people that are in it. As I mentioned, I've worked a few jobs since college, and I can certainly say that I prefer the second one. But I can clearly see that many people just like to have the rules laid out for them, what they can and can't do, what's expected of them. And I'm not saying one way is necessarily better than the other.

Since we're all wired differently, I was curious if you could maybe dive in more on the pros and cons of each approach and how they might apply to different organizations. Yeah, absolutely right. And there are certainly pros and cons to each philosophy. And as a practical matter, a culture or a staff situation is going to be on some continuum. I doubt that there are any organizations where no one has any degree of freedom at all.

So there's no strictly rules-bound world. Some new situations will come up and someone will have to wing it or make an audible call. And likewise, on the other hand, I doubt there's any organization that has no rules or no frames or no oversight mechanisms at all. And even Berkshire Hathaway has some rules and parameters. So there's a continuum between the rules-based and the trust-based.

And what I'm trying to explain in the book is that there's a habit in our civilization to lean organizations towards the rule end of the spectrum and away from the trust end. And I'm trying to illuminate how there's a lot of value to moving over to that trust end. So on the pros and cons, you know, of a rule-based civilization.

system, a pro is we have some pretty bright line set of expectations and boundaries. People have a sense of security, of knowledge of this is what I can and cannot do. And so if the transaction is above $2,000, I need to get approval. Or at the end of the day, I need to get someone else to sign off on this. And so it's very clear. And that's very helpful in certain settings.

Bank tellers, for example, maybe want a very strict system of counting the money and double-checking it and then adding it and locating it. And so, you know where you're staying. I mean, the downside of a strict rules-based organization is it's very difficult to anticipate every situation. It's very hard to anticipate shocks, surprises, changes where a person will really need to make judgments.

Someone who is accustomed solely to looking things up in a rule book and following a strict script is going to be less capable of adapting on the fly. And the other sort of con there is that, in a bigger sense, it tends to lead people to make decisions by reference to that rule book to decide, can I do this or can I not do this? Let me look in the rule book. And sometimes, often that'll work, but there's going to be some occasions where the

What's in the rule book doesn't really fit the situation and so you end up doing things that are lawful but maybe wrong. And flip it around on the trust-based side, pro is precisely that you promote people's discretion and responsibility and ability to adapt and respond and to grow and to improve their judgment and to develop a sense of what is right and what is wrong. What is within my scope of autonomy and what should I check with my supervisor

or some other party do. So, you develop that capacity. The downside is, of course, that some people put in that position will exploit it, will fiendishly use it for their own advantage. And that could be by taking higher commissions than they should or channeling opportunities to friends when that's not the right thing to do. But overall, in a trust-based culture, there will be some miscreants, but you've got to constantly try to reinforce

a set of norms and expectations that will weed those people out and develop an internal sense of what's right and wrong, a moral compass, a set of norms where people recognize that, "I don't think that it's right to give that opportunity to your sister. That's not how we do things here. That's putting your own interests above the firm's and that's not okay."

Those are sort of the broad trade-offs. And as I said, most organizations are going to have some continuum. And so, you know, some optimal might be that here are some basic principles, rules we live by, and then within that, please exercise your judgment and wisdom accordingly. That's really what Berkshire does, although they're more toward the trust end of the spectrum than most organizations. Most organizations, especially large corporations, have developed lots of rules

protocols, controls, systems that try to control behavior. Some of that might be good, again, and it might be right to say, for some organizations, that's the only way to go. Maybe banks, maybe nuclear power plants, but for others, most businesses probably, a little discretion will go a long way.

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All right, back to the show. When I think about the key themes of a trust-based organization, what's enabled some of the most successful companies in the world to continue to just do exceptionally well, I think about autonomy, decentralization, and entrepreneurial culture from top to bottom, and a lack of bureaucracy. And it's interesting how in my previous comment, I said, some companies are going to need more of a rules-based formula, and some are going to

follow this trust-based approach. And Mark Leonard and Buffett use these attributes that I mentioned where they want to minimize bureaucracy. Leonard's written about this in his letters where he wants to give each individual business unit full autonomy so they can make the best decisions for their organization. Yeah. I was curious maybe if you could speak to bureaucracy. And of course, we can understand why that continues to creep up as an organization grows, but maybe you can just speak more to a

It seems that it's obvious that it can hinder a company's ability to continue to perform well and do what we'd like it to do as quality shareholders, but it's just hard to do. It's hard to commit to.

Yeah, I think those are the key traits of a trust-based organization or especially a business corporation, autonomy, decentralization, entrepreneurship, and sort of anti-bureaucracy or anti-red tape. And I think you're right that with both Buffett and Leonard, their theory is to get the most out of the organization in terms of what products we're developing and selling, how we're selling them, how we're pricing them, how we're servicing them, how we're collecting the payments.

and then how we're allocating that. The best way to optimize that system is to have decisions made by the people who are closest to the relevant decision. And so that will generally mean pushing down decision-making power to the sales manager, to the product team, to the inventor, to the designer of the process, to the collector of receivables, to the accountant who tries to aggregate all the information, put the decision-making at those nodes

and you'll get the best results. You'll get the most efficient product, the swiftest recovery, and the most useful financial statements. And so that's autonomy. So let the marketing team, let the accounting team make calls in their areas. How do you do that? Well, you do that by pushing business units down or keeping them down so that people can develop the expert knowledge about a

a particular product, customer, supplier, and so on. And so both of those companies, the units are separate. They're decentralized from the senior management. So the calls are made, the decisions are made by the managers of that unit rather than the managers of the companies that own that unit. So it's

delegation, autonomy, decentralization. And you'll find, again, just to repeat on that trust-based point, people who receive that sort of autonomy, the managers of these business units and of those particular elements of it, step up. They appreciate the trust that's been reposed in them and they act more honorably as Bruce Whitman talked about. And concerning the operators of those businesses, the inventors, the creators, the innovators,

their entrepreneurial juices will flow more richly because they know that they've got the capacity, they've got the bandwidth, they can do this if they want to. They won't be second-guessed by headquarters, they won't be punished, they won't be ostracized. And so, at Berkshire and at Constellation Software, the idea is to have the business units call the shots. Constellation in particular, it has acquired more than 1,000 individual business units across the world in lots of different verticals, lots of different markets.

and it tends as much as possible to let those business units call the shots. And at Berkshire, it's famous for buying companies and trying not to tell them anything. You know, I think the guardrails at Constellation are worth noting though, it's not as if just going back to that sort of that spectrum of pure rules to pure trust, no one's at either extreme. At Constellation, it's an extraordinary degree of trust but there's a framework of expectations

And because all of these businesses are in the same industry, they're all software firms, they're in different verticals, but they tend to share and face similar economics. And so we can articulate a set of benchmarks or expectations, ratios that every one of these businesses ought to be able to meet.

And so, those who are out of line may get a phone call. They may get a little attention to say, "Well, maybe some of the independent judgment you're exercising is not appropriate. Can we help?" And you may soon get some of that at Berkshire as Warren leaves the scene and Greg Abel takes over. He's a little more willing to say, "Hey, your score is low." But you're absolutely right. And then that fourth point on bureaucracy and red tape is with the effect of this system of decentralization, autonomy, and entrepreneurship is to

Reduce red tape or maybe just not create it in the first place. And the opposite of that would be a board of directors in Omaha or Toronto articulating a bunch of rules about

what products you can pursue or when you can make new ones or how quickly the customers must pay or what trainings you have to give your workforce or what your workforce has to look like. You get a lot of rules coming down from the top, then they have to be enforced. So that means the people who are on the front lines have to follow these rules, fill out a form, send them back up, sometimes get approval, and that's red tape, right? That's bureaucracy. And

And it's a symptom and a feature of the rules-based organization. And so, on that spectrum, what Warren Buffett and Mark Leonard have appreciated is that you're going to have a much more effective team if those closest to the decision get to make them. That's the method. That's the philosophy. You know, avoided lots of red tape that entangles other firms.

In your book, you also highlighted Berkshire's acquisition of National Indemnity and Nebraska Furniture Mart, which we can really refer to as handshake deals where each party just fully trusted each other. No lawyers had to be hired. No audits were performed to get the deal done. And these two acquisitions were hugely successful. However, not all of us are blessed with the level of intelligence that Buffett has in identifying trustworthy people and potentially catching any

red flags that could have been seen. And it can be a little bit dangerous almost to trust someone and come to find out that they weren't who we thought they were. So to what extent do you feel that we mortals can fall back on fully trusting people that we deem to be trustworthy? Yeah, it's an excellent concern. And one point I'd stress about Warren, he

is I would say it's not so much that his superpower is discerning the trustworthy from the selfish person, although I think he is probably better than average and certainly skilled at that. But I think what makes him different, I think we're in a small class of people, is his willingness or his very high bar to win his trust. So, he is skeptical of human nature by birth, by constitution,

He thinks most people earn it for themselves and most people can't be trusted. That's his sort of starting point. So when he meets someone, in a way, he'll assume you can't be trusted. And then he'll talk to them and so on. And if there's any doubt...

He will almost always just say, "Pleasure to meet you. Good luck," and not go into business with him. So I think that's his greatest ability that distinguishes him from most of the rest of us is just absolutely being willing to say no and walk away unless that person absolutely passes that son-in-law test. And I think a lot of us are much more willing to say, "Well, the economics of the deal are so good," or, "The business that this fellow represents is so attractive,"

Or I think I'm going to be good enough at monitoring this person so that I'll go along with even though I'm not so sure that he's reliable in that way. Warren just won't do that. Go back to your example in the beginning of that volatile entrepreneur who's totally unpredictable and all that. A lot of people...

I'd say, well, he is a little crazy or a little unreliable, untrustworthy, but nevertheless, he does seem like a genius and he's got a track record. So I'm going to take a shot on him. That's something Warren just wouldn't do. I mean, he may agree with you exactly on the economics, the track record, even the prediction.

but say, "I can't sign that. I can't shake that hand." I think that's his greatest skill. So, in terms of what we mortals can do would be, I think, enhance our own skepticism and say, "Well, the bar is high. Would I let you marry my daughter?" And then the second thing I'd say is that there are other techniques. Warren is famous for sizing people up in a meeting in an office.

And I guess he is good at that. And if some of us are not good at that, you can take other more elaborate techniques to probe for trustworthiness. And a good example is Danaher Corporation, industrial conglomerate, now heavy in life sciences.

founded by the Rails Brothers 50 or so years ago. And it has a version of this that it's acquisitive and that it tries to hold businesses as separate units and delegate responsibility to leaders of those businesses. But it's got this thing called the Danaher system that, like Constellation, provides some expectations and best practices across the units,

But on this topic, it also has a screening process where before hiring a manager, the person has to go through a battery of tests and simulations. The tests are tests of industrial psychologists, right, who test your ability or your propensity towards certain behaviors in the workplace. And so, they conduct a formal evaluation that proves for a number of factors, but including trust. Does this person, can we trust this guy? So,

So, Warren's looking in the guy's eye, Danaher's putting them through a test. I think those people also have to kind of work in the company for some period of time as a kind of probational matter. I forget the details, but it's a more rigorous assessment. So, that's one approach. Warren's approach is, you know, just sitting there having a hamburger. The rails were, you know, much more scientific, if you like, and rigorous. And probably most companies will find, or most of us, most people hiring someone will find some position along that continuum.

But I'll just repeat Warren's point. It's just

I'm bragging that Warren is able to say no and saying, "Well, if you got to pass the Sunderland Law test or I won't go into business with you." And the rest of us might say, "Yeah, but Warren gets thousands of opportunities a year. Everyone's calling them up. We don't get that many." So he can afford to just pick one or only pick that spotless trustworthy person. The rest of us may have to accept or tolerate some doubt around that. And it's a fair point, but at least you should be aware of what you're doing.

I wanted to jump back to trust-based organizations by reading an excerpt you shared from Mark Leonard's 2011 letter that I thought was just wonderful. So I'll read the direct quote here and give you a chance to comment if you like. And it's a bit long, so it should give you plenty to work with here. So a long-term orientation requires...

a high degree of mutual trust between the company and all its constituents. We trust our managers and employees and hence try to encumber them with as little bureaucracy as possible. We encourage our managers to launch initiatives which in our industry often require five to 10 years to generate payback. We nearly always promote from within because mutual trust and loyalty takes years to build.

And conversely, newly hired smart and or manipulative mercenaries can take years to identify and root out. We incent managers and employees with shares escrowed for three to five years so that they are economically aligned with shareholders. And in return, we need and want loyal employees. If they aren't planning to be around for five years, then they aren't going to care much about the outcome of multi-year initiatives. And they certainly aren't going to forego short-term bonuses for long-term profits.

Yeah, excellent quote. And I think it underscores some of the points we've been discussing about autonomy and entrepreneurship and anti-red tape. And I think it beautifully illustrates all those themes in that it adds an important dimension to about time horizon. He's reflecting another advantage, another pro of the trust-based culture is that it tends to facilitate longer-term thinking.

You can form a longer-term horizon when you're given some autonomy about the horizon. Let me take this project forward and I will deliver the results.

And so, you don't have to deliver in three months or six months or nine months according to some schedule, some set of rules in effect. In a rules-based system, you don't have to worry as much about time horizon. You can just make short-term judgments, short-term objectives because it doesn't really help one way or the other on the time horizon. With a trust-based culture, it really facilitates long-term

long-term thinking, long-term planning, long-term strategy. And to flip that around, there is this great quip that Warren has that emphasizes that some CEOs will repeatedly tell people that the performance is temporary and that in the long run, it'll get better. But if he keeps saying that quarter after quarter and year after year, there's problems. The short-term sometimes

comes today. And I think what Mark is talking about there is that if you give people the latitude and the runway, they will tend to want to be loyal, to work on that, to stick around, to deliver over that period of time. So I think that's what that passage, in addition to the other points, I think that reflects that trust-based cultures may enable longer-term thinking in a way that rules-bound cultures simply do not direct.

Robert Leonard Yeah, that totally makes sense. And the time horizon piece certainly can't be overlooked. You recently joined our mastermind community for a Q&A, and one of our members, who is a former portfolio CEO at Constellation, he brought up a really interesting point that during his time at Constellation, nobody ever talked about culture, but there was still such a clear and definitive culture. There's a core set of values that people...

there have. And to the best of my knowledge, it's not something that's posted on the wall or something that each employee is reciting every morning. Is culture a self-reinforcing cycle that sort of starts with the founder and the key managers, then they just attract these certain types of people and it's just a self-reinforcing in that way? Or how do you think a culture like that permeates throughout the organization?

Yeah, I think you're right. And it reminds me that observation. I enjoyed meeting with your group. And I remember that observation making me think about the fish never talks about water. And the human, we don't really talk about oxygen. It's here. It's essential. And when we don't have it, it's going to be a problem. And in a culture, you may not talk about it, think about it.

You just breathe it, you live it, and then until one day you get some rupture in it, some miscreant misbehaves, and then it's strikingly obvious. But to your question, yes, I think that organizational culture tends to be produced from the top. It starts with the tone at the top, the leader, the founder, and her or his own personality starts to fill in the office, the research lab, the facility.

And that person will attract people who share that sensibility, thrifty or for spendthrift, conservative or aggressive capital allocator versus short-term profits. So that leader will start to signal what we value here and other people who join and stay will tend to appreciate those expectations, those values and norms will form around that.

And as you grow and grow, more and more people who fill in will follow that. And so, it does become self-propagating, self-replicating. In a place like Constellation, Mark Leonard certainly put his personality or his stamp or fingerprints on the firm from the beginning.

He attracted a group of first three and then six or 10 people who are still at the company, still leading the company, who had overlapping sensibilities on core topics. They're very different in lots of ways, politics, religion, philosophy, maybe even some strategic decisions, but they share a sense of autonomy, rationality, delegation, capital allocation, stewardship, measurement, data-driven decision-making, a bunch of things that permeated that culture and

And so your colleague wouldn't have been able to say, hey, it's written down that we got to be rational, we got to delegate, we believe in autonomy, we believe in decentralization, we believe in capital allocation and stewardship. It's not written down, but it's quite clear that those are the norms, those are the expectations. And if a person enters this business who clearly lacks that, well, they'll either decide this place isn't for me.

I want short-term and I want rules-based and I want to make all the decisions for all my groups. Well, that person can probably leave on their own or just get nudged out. And so you're right about that. You're right that in general at Constellation, the managers have not written down a set of credo or a set of commandments or expectations. But even on that topic, leaders are free to. And so you actually, if you go around those thousands of business units at Constellation, you'll see that in some of the shops,

the leader has said, here are the 10 things we believe in, or here are the 10 rules you have to follow. And they'll be very precise about, and it might be some of these exact themes, autonomy, delegation, entrepreneurship, no red tape. But they thought, in the exercise of their autonomy, it's valuable to spell out what our cultural credo is. And I know one of the managers at one of the operating groups has done that as well. So it's neat at a place like that, that you're right, that the culture is

formed to a large degree spontaneously through leadership actions and personalities. But sometimes a person will think or a leader will think, I think writing these down will be useful for our organization. So, I think that's an example of the autonomy at Constellation where there are leaders who might choose to interpret or articulate culture in different ways and that's allowed, that's part of the culture.

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All right, back to the show. You can almost put yourself in the mind of an entrepreneur and it's like, as they're growing their business, they start hiring people. Of course, they're going to be worried about, if this person leaves, then we'll be in all this mess. So they put these systems in place and like, here's what this person does. You put all these rules in place. So it's kind of easy to see why you would want all these rules and these systems. Of course, you need some rules and systems, but if you do it too much, then it can just...

push out the type of people that you would want to attract in the first place.

That's a great point about sort of titles and roles that an organization with an organizational chart that has specific job functions and descriptions of them and if a person leaves, they need to fill that role. It may be possible to go out and get an individual who exactly fits that. It's as likely that the best person you can find has a skill set that is larger than that box or smaller. The best thing for the company is actually to call it something else and let her have a different role or bandwidth.

And rules-based cultures have a hard time doing that. So, she'll know this is the C-32-6 rule. So, she can't come. She doesn't have a master's degree.

And the trust base, they say, "But wait a second, you really think she's the best one and that she could tap dance a little in this area and really deliver in this one? Well, then we should probably roll with that." So that's a good example in that organizational chart. And Ben Berkshire famously doesn't have one. In the book, I made one up. If they had one, here's what it would look like. It's a very highly decentralized structure.

At Constellation, we don't have an organizational chart either. It wouldn't make any sense. They may have one, again, at business units. So you're operating a 40-person vertical market software business for the automotive industry in Brazil. You might have a chart that says, I'm the business unit manager, and you're the assistant manager, and you're the controller, and you're the product specialist, and you're the customer service person. So they may well have that, and that's fine. No one in Toronto is going to second-guess that. They can do that. If that leadership decides that is the most effective

method of organizing that unit, that's fine. And to your point very early on, different organizations will have different optimals. And it's better to let those unit managers decide where on that spectrum of rules to trust you want to operate rather than have Toronto telling them.

So of course, there's still some drawbacks with a trust-based culture, one of which is that senior managers can abuse the trust they've been given. And at this point, I'd like to talk about David Sokol and his role at Berkshire. I was curious if you could just share a background on who David Sokol is and what led to his departure from Berkshire Hathaway. David Sokol

Yeah, sure. It goes back in time a little to about 2011 when David Sokol was widely recognized as Warren Buffett's number two and likely successor. David had a spectacular career building up an energy business that was called Cal Energy and then MidAmerican Energy, really successful entrepreneur with dazzling skills and

in capital allocation and operations. And Berkshire acquired that company. David came along with it and was very impressive to Warren and they got along great. And so David assumed more and more significant roles.

not only within the energy business at Berkshire, but troubleshooting for some of the sister subsidiaries and had just done such a great job. It looked like if anything happened to Warren, Dave would be the perfect person to take his place. You know, and at some point around 2010, Warren asked David to scout for acquisitions in a certain sector, I think it was the industrial lubricant sector, and see if he could deploy a large amount of capital, like 10 billion or something like that for Berkshire. It was partly, I guess,

a bit of a leadership test, a capital allocation test. Let's prove David is really good at this important part of the job. And so David went out, next thing you know, he comes back with an opportunity for Berkshire to acquire Lubrizol, which is a leading industrial lubricants manufacturer up in Ohio.

and explained the company to Warren, who understood it, and asked some business questions and gave David the green light, thought this does look like a good investment. So David went and closed the transaction and brought it home. It was publicly disclosed. And that morning when it was publicly disclosed, Warren received a call from

from an old friend, John Freund, who is a banker at Citi, calling Warren to congratulate Berkshire on the Liberzal acquisition and to say how delighted John was to have had an opportunity to help Berkshire.

And Warren was puzzled by that comment because he didn't know anything about any bank helping Berkshire. It's Berkshire policy in this sort of sense of trusting ourselves and not trusting others. It's Berkshire policy is not to hire bankers or brokers to find acquisitions. He had told David to go out and find it. So Warren thanked John with his

eyebrows crooked and had a colleague call David to say, "Did Citi help?" And David said, "Oh, yeah. Did I mention that to you?" "Yeah, I had Citi help." And Warren was puzzled. He said, "Well, what else didn't you tell me?" And David scratched his head for a minute and said, "Did I tell you I bought stock in Lubrizol before I pitched the acquisition to you?" That really took Warren by surprise because Lubrizol is a publicly traded company and Berkshire has a policy against its people buying stock in a company they might acquire.

There are also federal securities laws that limit insider's rights to do that under a nickname called front-running. And so Warren said, "Look, these are very significant non-disclosures you made to me." And I had a confidential conversation with David that said, you know, David had wanted to leave Berkshire a couple of times.

I guess it was taking too long for Warren to leave the scene. But Warren always kept them in, kept them there. But in light of this, Warren was really leaning to let them go. And so they agreed that that's what should happen. And so Warren wrote a press release saying that David will be leaving and that he's made these wonderful contributions to Berkshire Hathaway. And there was this recent transaction where he bought stock in a company we then announced to acquire and that wasn't right. And the public went berserk.

There was instant and intense criticism of Warren's handling of David's infraction. Warren has always emphasized the value of this trust-based culture, that he has a famous statement that he made years earlier when he was rescuing a bank that had some corrupt people inside of it. He made a speech to that bank that said, "Look, people,

I have the direct quote here. You want to read it? Sure. Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless.

There you go. And he had repeated this over and over and again for 15 or more years. So the press and shareholders said, "Warren, I think David just lost a shred of reputation for the firm by front-running," or at least allegedly, "and you were not ruthless." It's just patting him on the back and parting ways. I mean, they'd pushed really hard. And this was just a few weeks before the annual meeting. So the spotlight was intense, the pressure was intense.

Warren decided, all right, I will step out of this. I'll turn this matter over to the board of directors of Berkshire and to its audit committee, which then took the file, took the matter, and conducted what the audit committee should do. It conducted an investigation, interrogating David about what happened and the timing, talking to John Freund, talking to the broker, finding out what happened. And they wrote a report about it and found and concluded that this activity, whatever it was,

the buying of the stock ahead of the reporting it, at least violated Berkshire Hathaway's policy. And under that policy, David should be terminated for cause, which under his employment contract meant that he forfeited any benefits at all, salary, severance, retirement, and anything else. And more to the point, the committee basically ruined or severely tarnished David's reputation. They threw him under the bus. And so,

The annual meeting came and the first 10 minutes or more Warren spent reflecting on this. And to this day, I think he's confounded because David at the time was making $25 million a year, had hundreds of million dollars net worth. And the gain on this little transaction was just fractions of that. So Warren

Just couldn't fathom it, couldn't explain it, couldn't understand it. But the takeaway to me, Clay, in terms of the book, The Margin of Trust, and I described this story in the last chapter of the book. There are a couple of things about it. One is that in a trust-based culture, you

you run the risk of someone disappointing that trust, sometimes in a dramatic way, as happened here. And the second important part of a trust-based culture, which we haven't touched on, is enforcement. When a miscreant appears, when someone disappoints that trust, it's important to let them know and let the teams know. And if it's a dramatic

breach like this one arguably was, that penalty, that enforcement has to be public, swift, and dramatic. It was odd that Warren was simply going to slap David on the wrist with a kind press release because it's certainly not consistent with what he said. You just quote it. That wasn't ruthlessness. So that was odd, but he trusted David, he loved David, so it's very disappointing for him.

But what I like about what happened is that the audit committee, the board of directors took charge of this. That speaks to how Berkshire's trust-based culture is really not about one person, it's the firm, it's the organization. And so even while Warren couldn't be ruthless, the board was. And they throw him under the bus and as I suggested, there was a possibility that

that David's action, it certainly violated Berkshire policy. There was a possibility it violated federal law, but the authorities, once they looked into the matter, the people at the Securities and Exchange Commission and the Justice Department, I think was involved, they looked into the matter and they decided not to proceed with the case. Doesn't mean he didn't violate it, but certainly they decided not to pursue it.

So, I thought that's a real tribute, I guess, to the board of directors, to the audit committee or a testimony to the sense that the trust at Berkshire really is institutional, it's corporate. It's not may have come down from Buffett, but it really pervades the governance, the infrastructure. So, that story has lots of lessons in it, but that's why I wrap up the book with that story.

So it was Salomon Brothers that Warren Buffett, he testified in court on behalf of Salomon Brothers back in 1991. And there's a two and a half minute clip on YouTube that I'll be sure to get linked in the show notes. I'd encourage the listeners to go and tune into. And Buffett played that clip at the annual meeting and went on to denounce Sokol's conduct as inexcusable and inexplicable. It's so tough because in any organization,

there's the opportunity for the individual to take advantage of the other person or take advantage of the organization. Well, in Sokol's case, of course, you're just going to get caught when you're purchasing $10 million worth of stock right before an acquisition goes through. That's something you can't just push under the rug, but there's so much more, just like these little things that people could do. So it's so important to be able to work with trustworthy people. Robert Leonard

Yeah, absolutely. And it's funny too because I also discussed another thing. I talk in the book about David's employment contract and I compare it with some others at Berkshire Hathaway. The others, for example, with the CEO of Scott Fetzer, one of his first acquisitions. It's a very simple agreement. It talks a lot about best efforts and good faith and it's a long-term agreement. So the CEO is supposed to just go out and use good faith and best efforts. David's

that came with him when Berkshire bought his energy company. He had already had this contract. It was a much more dense, technical, legal contract, more than 10 pages long with very extensive definitions, including a definition for cause. That's the word the board used to say he doesn't get any benefits. The definition of cause was 400 words long and had a bunch of caveats on it and requirements that the company notify him and he get a chance to remedy and all this stuff.

And so, he had a case and his lawyer even argued that, hey, David was allowed to do this under his employment contract or that somehow he had notified someone even if it wasn't Warren. And so, they made an argument that they had not disappointed anybody's trust. I think David actually believes that and even to this day. And so, he thinks he really did get thrown under the bus and I don't have a view on that. But in a trust-based culture,

Warren said about in that clip where he's talking to Solomon team and he's testifying, what he's saying is a shred of reputation. So not technical, legally for cause or technically legal violation, but a reputational thing that hurts the firm.

I wanted to talk a little bit about quality investing here to round out the show. You wrote a book titled Quality Investing. It's one of my favorite books. So my first question here is, as of late, Berkshire Hathaway has been raising a substantial amount of cash by selling down stakes in Apple and Bank of America. I'm curious to get your thoughts on this $300 plus billion cash position and how quality shareholders might view their stake in the company

do you think they're going to be able to put this level of cash to work? Are they simply going to do buybacks and dividends? And does that change how quality shareholders are viewing a company like Berkshire Hathaway?

Yeah, it's a great question. Everyone's asking that question and people may have different views. My own view is that, sure, the buybacks may be a way to deploy that capital. And they've been doing some buybacks over the past five or seven years when the price is attractive. I'm not going to use all that that way, but that would be a possibility. Dividends are a possibility, although Berkshire for 50 plus years hasn't declared one.

but it has a rule on that that says, or principle, I guess, that we will retain every dollar so long as we can deploy it to increase the market value of the stock by a dollar. And so far, they've been able to do that. If they find they're unable to do that, they will make a dividend. That's Berkshire's longstanding policy. So that is a possibility. They don't like to do that because most Berkshire shareholders are taxable and the receipt of those dividends would be taxable to them. Even if they didn't want it with a buyback,

people can decide they don't want to take it, they don't have any tax consequence, so the company can deploy the capital without hurting its shareholders. So, dividends and buybacks. Look, the other thing that Berkshire is famous for is seizing opportunities when markets are in turmoil and where there's capital problems in the system. And who knows what will happen tomorrow or next week or next year in the insurance industry? I don't know. No one knows. But

But insurance is all about having underwriting risks, receiving some funds in order to pay out when risks are realized. And plenty of insurance companies go bust by writing a book of policies without accumulating sufficient capital to pay losses when they're due. And when problems like that arise, those companies go out of business and companies like Berkshire can add to their business.

buy those distressed companies and enter those markets. And it's not just poor underwriting. Sometimes catastrophe strikes in scale and scope way beyond any predictive model. So you have wide-scale destruction from wildfires, earthquakes, floods, hurricanes, terrorism, or what have you. You might need a Fort Knox like Berkshire. There may be, I'm not predicting this, I certainly don't want it, but there may be opportunities to deploy 100 billion earths

$150 billion in a setting like that and Berkshire would be ready to do it. That's not why he's doing it. That's not the plan, right? They're simply looking at the set of opportunities and not finding anything. But if calamity strikes, Berkshire will seize on it. I mean, the other kind of calamity would just be a financial market out like we had in the real estate and financial crisis of 2008, 2009 where capital markets simply froze. No one could find a dollar. Berkshire had maybe $100 billion. It was tens and tens of billions where it

went around to buy and share big blocks at Goldman Sachs, Bank of America, Harley-Davidson, Tiffany. The company has always been opportunistic in that way, and they save for the rainy day. So I don't know how to think about $300 billion in a company that's now, you know, market cap closing in on a trillion. So it is a massive amount.

Yeah, the other thing to appreciate is that there will be a changing of the scene for changing the guard here in the next probably certainly within the decade. You know, Greg Abel is being groomed and trained and ready to take over the reins or I think taking a lot of the leadership roles certainly in overseeing the managers. He's worn his number two now and so undoubtedly he is scouring the world for opportunities to deploy that capital. So for

From my own view, other quality shareholders or quality investors may have a different view, but that fact hasn't changed my view of Berkshire. I should say I'm also a shareholder of Berkshire and have been for a long time.

I've talked about, I guess myself and some of the other hosts at TIP have talked a good amount about quality investing. And I've been a bit surprised by how deeply it's resonated with a lot of our listeners. But we live in a world where the market puts a sizable premium on quality. On the one hand, I think the market tends to undervalue the highest quality companies, but at some point it just gets taken too far. I'm curious just to get your thoughts on how...

individual investors can approach this dynamic where the Constellation softwares of the world just continue to get bid up because the market recognizes how good of a business they are, but also being prudent and adhering to the value investing principles laid out by Buffett and his crew.

I go back to all the stories that I heard from most of my life, starting when I was 20, about Berkshire, where in 1980, it was actually my professor, Elliot Weiss, who introduced me to Berkshire.

In 1980, he worked with Warren on an SEC plain English disclosure project. So he got to know him and he was very impressed. So he went and looked up into Berkshire Hathaway stock and said, "Oh my God, it's trading at $300 a share. I'm not going to buy that. That's way too expensive." A couple years later, it was trading at 1,000, 2,000. Now it's almost a million. Then Elliot's like, you know, he kicked himself. And people have done that at every ladder. At 2,000, oh, that's too expensive. At 180,000, that's too expensive.

$270,000, whatever it is, they always do that. And people regretting and kicking that they didn't buy it. I'll bet the same thing is true of Constellation. I have bought the shares of both companies' stock at times when, you know, on the same day, but within periods, months or so, where people were saying, boy, that seems highly priced, that seems overvalued. I didn't think so, and I bought it. And

I haven't regretted that. This is not investment advice, but I think paying up for quality is a real thing. And you may have to. These are very high quality companies and the premium may be very high. I mean, on Constellation, I mean, there is math that indicates that a portion of the stock price is impounding, expected continued sustained returns on deployed capital in perpetuity for a very long time, essentially through

the system that the company has developed of finding excellent software businesses or troubled businesses and then bringing them in and making them better and giving them this home. Again, I'm not sharing trade secrets or giving investment advice, but if you look at the world of vertical market software, Constellation owns 1200 companies. That sounds like a lot, but there are many more and more being created all the time. So yeah, it could end.

But the market certainly doesn't think it will. That's what it's saying. And with Berkshire, I guess it's a similar story. It's not as focused or as sustained, right? They haven't made a big acquisition in years. But there does seem to be an implicit premium in there for the culture, for the quality. And I'm not in a position today to make a decision, you know, would I buy those shares? But I certainly wouldn't roll it out. I'd have to have a harder look.

Yeah, I think that is one of the things that some people miss with Constellation is despite them getting bigger and bigger, their total addressable market is expanding quite fast and thousands of VMS businesses are being created each year. And inevitably, many of those are going to be sold. Really appreciate you joining me here today. Thoroughly enjoyed this chat and think the audience is going to enjoy it as well. So please give the audience a hand off to any resources or anything you'd like to share here to close it out.

Thanks very much, Clay. Thanks, everyone, for listening. I enjoyed being here. I hope this was useful for you. And please get in touch with me in two ways. One is on LinkedIn. Lawrence Cunningham, I think they've got a pretty good search. You type that in LinkedIn, you'll probably get my page there. I post there fairly regularly, and you can ping me if that's of interest. I'm at the University of Delaware Weinberg Center for Corporate Governance. And so we've got an active website with interesting things. So that's weinberg at udel.edu.

Wonderful. I'll have both of those linked in the show notes. Lawrence, thanks again. I hope we can do it again someday. Thank you so much, Clay. I appreciate it. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com.

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