On Management: Unfashionable values

Warren Buffett has demonstrated that a business model can succeed by meeting the demands of all its stakeholders.

by Simon Caulkin, World Business
Last Updated: 23 Jul 2013

Warren Buffett, chairman and CEO of Berkshire Hathaway, is often called the world's canniest investor. It's certainly true that he and his partner, Charlie Munger, have done Berkshire investors proud. Anyone who shelled out $15 for a share in his vehicle, then a struggling textile manufacturer, in 1965 would now be sitting on a capital gain of around $99,985, or 666,666%. Since 1990, Berkshire has given shareholders an annual return of 18.8%, twice the S&P average: not bad for a company with a market capitalisation pushing $175 billion.

But while numerous books have been written on his prowess as a stock-picker, a more interesting view of Buffett is as one of the world's most astute managers. In an age when quick flips, short-term efficiencies and financial engineering are the rule, Buffett demonstrates with remarkable clarity that, in the right hands, there's nothing wrong with the public-company framework that honesty, concentration on business fundamentals and a long-term focus can't dissolve. In fact, as both a management and an investment strategy, honesty, concentration on business fundamentals and long-term focus knock the alternatives into a cocked hat.

Pace private equity, there is no inevitable agency problem of misalignment between managers' and shareholders' interests; no conflict between short and long term; and no need to resort to eye-watering leverage to gain financial 'efficiency' or instil operating disciplines.

Buffett starts from the elementary principle that, on aggregate, you can't take more out of a company than it creates in value. Of course, through clever (or lucky) timing, some investors can do better than others, but the buying and selling rearranges wealth rather than creates it, and, worse, commissions and fees are 'frictional' costs eating into investor returns.

Frictional costs charged by private equity, hedge funds, consultants and other intermediaries are now a burden of 20% of corporate income, he says. If Isaac Newton hadn't been traumatised by his losses in the South Sea Bubble, Buffett surmises, he might have discovered a Fourth Law of Motion: "For investors as a whole, returns decrease as motion increases."

This starting point has two consequences. First, somewhat startlingly, Berkshire Hathaway has no exit strategy. It has an entrance strategy, but, as Buffett once succinctly put it, "our preferred holding period is forever". Berkshire is reluctant to sell even underperforming businesses provided they generate a bit of cash and "we feel good about their managers and labour relations. Gin-rummy managerial behaviour (discard the least promising businesses at each turn) is not our style."

The second is that the only way the company has of generating superior returns is improving operations.

To this end, the subsidiary managers' job is to do that, period - leaving the centre to allocate capital. Berkshire has a headquarters staff of 19 - yes, 19 - and a head-office payroll of $3.5 million for group revenues of $98 billion. It couldn't interfere if it wanted to.

The centre's other function is the 'care and feeding' of operating managers, many of whom Berkshire has made quite wealthy. Not through exorbitant salaries - Berkshire pays fairly, but not excessively. Nevertheless, except to death or retirement, Berkshire almost never loses a subsidiary CEO, and indeed it has become the owner of choice for managers who care more about building businesses than flipping them.

Berkshire doesn't do debt, either for acquisition or operating purposes, or buy businesses it doesn't understand, which, as Buffett cheerfully concedes, rules out most hi-tech. It is deeply suspicious of derivatives, and Buffett dwells at length in his annual letters to shareholders (a management must-read) on the potentially disastrous consequences of an unravelling of these thin-air instruments.

Yet in its business, as the world's largest writer of catastrophe insurance, Berkshire is happy to accept the hugest risks, including that of one-offs such as Andrew and Katrina. Unlike other insurers, Berkshire has computed the consequences of a $100 billion disaster - and promises that whatever happens, it has "the net worth, the earnings streams and the liquidity to handle the problem with ease". Anything else is not an option, since Berkshire promises "total security" to constituencies.

As well its other contributions, in 2006 Berkshire handed over $4.4 billion in US federal income tax, enough to keep the entire federal apparatus, from education to Medicaid to defence, going for more than half a day. "Had there been only 600 taxpayers like Berkshire," notes Buffett, "no one else in America would have needed to pay any income or payroll tax."

A business model that succeeds by meeting the demands of all its stakeholders - it could give capitalism a good name. So what are we waiting for?

Simon Caulkin is a freelance business journalist

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