This is a continuation of my previous blog on Warren and Charlie’s top ten insights. See the first part here.
6. To be a winner, work with winners
In the 2002 Annual letter to Shareholders, Warren in his usual anecdotal way, narrated the story of Eddie Lampert, a bat boy. Eddie first lifted bats for Chicago White Sox and the White Sox went to the world series that year. Later he switched to another team, which too won the title. And so on- wherever Eddie went, lady luck followed. While fame and fortune followed Eddie, Eddie himself didn’t believe in his own special powers. Instead, as per Warren (with my emphasis):
Eddie understood that how he lugged bats was unimportant; what counted instead was hooking up with the cream of those on the playing field. I’ve learned from Eddie. At Berkshire, I regularly hand bats to many of the heaviest hitters in American business.
If I had started listing Warren and Charlie’s investment decisions that turned out to be their best, I would have missed a deep meaning lesson here- to be a winner, work with winners. One of Berkshire’s biggest strengths is the group of managers running their companies and hitting home runs (sales and growth of profits with high rates of return). So many names come to mind: Ajit Jain, Mrs Blumkin, Bill Child, Tad Montross, Tony Nicely, Dave Sokol, Ralph Schey, Chuck Huggins, Harry Bottle and so on. Warren and Charlie’s brilliance was having managers of such high caliber and integrity run their own businesses and to not get in their way. None of these star managers has ever quit Berkshire to work for someone else.
Readers of the Annual letter would recall one of Warren’s favorite- Mrs. Rose Blumkin. See this short video, where Warren pays one of the best tributes to her.
And this what Warren had to say about Mrs B (before she passed)
Aspiring business managers should look hard at the plain, but rare, attributes that produced Mrs. B’s incredible success. Students from 40 universities visit me every year, and I have them start the day with a visit to NFM. If they absorb Mrs. B’s lessons, they need none from me.
Last year I had written a blog on this subject too. In that I had argued that its better to be an average guy in a star team than a star in an average team; the former is bound to be better for you in the long term; the latter just an ego trip.
Charlie and I know that the right players will make almost any team manager look good. We subscribe to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy: “If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.
For most part of my life, better people made me uncomfortable. And so I would seek out mediocre people that made me feel like I fit in. This was clearly a wrong strategy. Its better to be with better thinkers and be uncomfortable rather than feel better with mediocre circle. You are, after all the average of the five people you associate with the most.
7. Being risk averse and not loss averse
We (Charlie and Warren) are willing look foolish as long as we don’t feel we have acted foolishly.
Losses and mistakes are a part of every endeavor of life. I dont know about you, but this didn’t hit me until recently. What matters is not a success here or a failure there. But its the collection of activities or a portfolio of stocks that determine the final score. I wrote about my late realization in my blog on Samuelson’s problem.
Think of Berkshire’s big mistakes- Dexter Shoes, investments in the textile business, in the 2nd rate retail, not investing in Walmart and Costco and many more. There were both- mistakes of commission and omission. But none of these mistakes have bankrupted Berkshire- because on the whole Berkshire is very very resilient. Refer to Prof. Bakshi’s blog on staying power. I will try to rate Berkshire using that template:
- Business Model of Berkshire
- Diffused conglomerate
- Ownership of companies and investments in marketable securities
- Low customer concentration risk
- Low supplier concentration risk
- Moat is not derived from political clout
- Solid entry barriers
- Low cost businesses such as GEICO, NFM
- Strong Brands such as Duracell, See’s Candies
- Willingness to do business when otehr competitors aren’t – reinsurance business
- Corporate culture (See # 10 below) of Berkshire
- Willingness to cede market share rather than cut prices – NICO was losing volumes for 14 consecutive years as BH was unwilling to write policies without underwriting profit
- Refusal to invest in businesses destined to die – Textiles and Dexter shoes
- Unwillingness to bet the bank on any one idea (insurance, reinsurance, capital intensive businesses, retail, investments)
- Willingness to make multiple small bets (each of the above is a small proportion of the overall Berkshire)
- Ownership structure of Berkshire
- Warren holds 30-40% of Berkshire and has never sold a single share. And Berkshire accounts for 99% of his wealth.
- Long term oriented
- Balance sheet of Berkshire
- No debt
- Excess cash
- Liquid balance sheet (Remember Warren has a $20 B liquidity fund that hardly earns anything but allows them to sleep peacefully at night)
- P&L of Berkshire
- Diverse earnings streams (70 odd businesses)
- Some businesses like See’s enjoy pricing power.
- Some businesses enjoy low cost advantages like BNSF, BHE, Geico, NFM and so on.
- No debt
- No economic depreciation in some businesses like See’s and insurance subsidiaries; medium to high in Capital intensive businesses like BNSF, BHE, Mormon etc. (But these assets are long-lived and regulated according to Warren)
- Significant discretionary spending (like advertising in Geico, h=growth capex in BNSF and BHE)
- Cash Flow of Berkshire
- No interest repayments
- Maintenance capex and Working capital needs
- High maintenance capex in Capital intensive businesses; others like See’s, NFM should be very low
- Negative working capital in Geico, NFM, See’s etc
- Ability to handle volatility through financial strength
- Long term view about investing
- GEICO took nearly 20 years to go from 2.5% to 12% market share;
- Through repeated investments in capex over 5 years, BNSF is increasing market share
- Ability to fund growth and maintenance with internal accruals
In other words, most of what can bankrupt other organizations is almost unlikely to harm Berkshire (think Inversion).
8. From Investments to Owning Companies to Owning regulated capital-intensive businesses
In the 2017 letter, Warren said:
I earlier described our gradual shift from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses. Launching that transition, we took baby steps — making small acquisitions whose impact on Berkshire’s profits was dwarfed by our gains from marketable securities.
Up until the 90s, Berkshire was open to both forms of investing: public investments in high grade companies run by intelligent and ethical managers as well as outright purchase of businesses. Having a liking for both was akin to being bi-sexual which would double your chances of a date on a Saturday night.
Then in the 1990s, Warren and Charlie had a preference for complete purchase of private businesses (like Scott Fetzer, Geico, NFM, R C Wiley, Net Jets, FlightSafety and so on). Warren said it was due to the nature of taxation. A $1 Million dividend paid by Coca Cola to Berkshire would get taxed at 35%, whereas a $1 Million dividend paid by NFM wouldn’t, because of the ownership structure.
But there’s also a powerful financial reason behind the preference, and that has to do with taxes. The tax code makes Berkshire’s owning 80% or more of a business far more profitable for us, proportionately, than our owning a smaller share. When a company we own all of earns $1 million after tax, the entire amount inures to our benefit. If the $1 million is upstreamed to Berkshire, we owe no tax on the dividend.
Contrast that situation to what happens when we own an investment in a marketable security. There, if we own a 10% stake in a business earning $10 million after tax, our $1 million share of the earnings is subject to additional state and federal taxes of (1) about $140,000 if it is distributed to us (our tax rate on most dividends is 14%); or (2) no less than $350,000 if the $1 million is retained and subsequently captured by us in the form of a capital gain (on which our tax rate is usually about 35%, though it sometimes approaches 40%). We may defer paying the $350,000 by not immediately realizing our gain, but eventually we must pay the tax. In effect, the government is our “partner” twice when we own part of a business through a stock investment, but only once when we own at least 80%.
Then in the 2000s, Warren and Charlie again switched gears to make large purchases of regulated, capital-intensive businesses like BNSF (railroad) and BHE (power utility). Why? From what I understand:
- Transportation and Service are always going to be needed by society.
Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investments in both transportation and energy.
- Berkshire can deploy large sums at attractive rates to expand the operations of BNSF and BHE
A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire.
After a poor performance in 2014, our BNSF railroad dramatically improved its service to customers last year. To attain that result, we invested about $5.8 billion during the year in capital expenditures, a sum far and away the record for any American railroad and nearly three times our annual depreciation charge. It was money well spent. BNSF moves about 17% of America’s intercity freight (measured by revenue ton-miles), whether transported by rail, truck, air, water or pipeline. In that respect, we are a strong number one among the seven large American railroads (two of which are Canadian-based), carrying 45% more ton-miles of freight than our closest competitor.
When BHE completes certain renewables projects that are underway, the company’s renewables portfolio will have cost $15 billion.
- BNSF and BHE provide services that are good for the society and good for the planet. Customers love them and regulators welcome them.
Every day, our two subsidiaries power the American economy in major ways: BNSF carries about 15% (measured by ton-miles) of all inter-city freight, whether it is transported by truck, rail, water, air, or pipeline. Indeed, we move more ton-miles of goods than anyone else, a fact establishing BNSF as the most important artery in our economy’s circulatory system. BNSF, like all railroads, also moves its cargo in an extraordinarily fuel-efficient and environmentally friendly way, carrying a ton of freight about 500 miles on a single gallon of diesel fuel. Trucks taking on the same job guzzle about four times as much fuel. BHE’s utilities serve regulated retail customers in eleven states. No utility company stretches further. In addition, we are a leader in renewables: From a standing start ten years ago, BHE now accounts for 6% of the country’s wind generation capacity and 7% of its solar generation capacity.
9. The Berkshire Culture
Culture is a difficult thing to describe, so I will just list some of the key tenets of the unique Berkshire culture:
- Putting the power of incentives to work (or avoiding it)
- Managers’ incentives linked to performance of businesses. Incentives are not tied to Berkshire’s performance or that of other subsidiaries.
- Incentives are aligned with owners: earnings with minimal use of additional capital.
- Lack of a team for Acquisitions. Such a team would have incentives to suggest dumb acquisitions; good for itself but bad for the owners. This is what Charlie had to say in Vice Chairman’s thoughts on Past and Future
Well, Berkshire, by design, had methodological advantages to supplement its better opportunities. It never had the equivalent of a “department of acquisitions” under pressure to buy. And it never relied on advice from “helpers” sure to be prejudiced in favor of transactions.
- Warren and Charlie have maintained their reputation, never going back on their words, seldom changing managers and even more infrequently shutting unprofitable businesses. They want to be the choice for good well run businesses in the future as well and one way to do it to make sure their reputation precedes them.
- Complete autonomy over the operations of the business with oversight from Warren only where needed
- Long term thinking or Pain-today-Bigger gain-tomorrow
- Being ethical and fair in all dealings with customers, shareholders, suppliers and the government. This led to what Charlie calls -“operating in a seamless web of deserved trust” that eliminates frictional costs in all their dealings.
10. Becoming the forever home for great businesses and its CEOs
Please watch Warren’s answer at the 2017 AGM (at the 2hr 19 min mark):
And this is what Charlie had to say in the 50th year letter:
Then, as the Berkshire system bestowed much-desired autonomy on many subsidiaries and their CEOs, and Berkshire became successful and well known, these outcomes attracted both more and better subsidiaries into Berkshire, and better CEOs as well. And the better subsidiaries and CEOs then required less attention from headquarters, creating what is often called a “virtuous circle.”
So you see by operating in an honest and fair manner, Berkshire created a reputation for itself. For Businesses that wanted the best price, they could sell to a private equity player who would either add more debt or break it into parts and resell it; the associates working there would mostly be fired. Whereas a business owner that cares about his business and his associates is going to call Warren about a deal; he may get a lower price but his business will continue to run by him exactly the way he has been doing so with minimal inputs from Warren. For a lot of Business Owners who are independently wealthy, this sort of an arrangement works well, simply because the other options (LBO, Private Equity) are simply terrible.
That’s all folks!
As I mentioned in the first part of the Blog, I just finished my second reading of all the Buffett letters and I thought it would be a worthwhile challenge to list Berkshire’s ten best insights while it was still fresh in my memory. Looking for notes, quotes and videos to substantiate, has been challenging and fun. I’ve probably put in 12-15 hours over weeks writing these 2 blogs and in the process have become somewhat of a buffet-o-phile.
A disclaimer: I don’t know for sure if these are the 10 best insights. Secondly, you would notice an overlap of insights; my personal view, there should be an overlap of insights, only then would there a lollapalooza effect (Remember Charlie’s talk on Worldly Wisdom). I also kind of know that these insights can be repackaged into something better. But this has been my best attempt given my limited resources.
I hope to evolve as an investor and thinker and writing is one of the catalysts. When I look at my old notes, I am usually embarrassed by it. But it is also because while the written word is etched forever, I have continued to evolve. I hope to look back at these blogs and feel embarrassed!
If you have made it this far, you have my thanks and appreciation.