Warren Buffett Explains His Cozy Embrace
Here are two of my favorite paragraphs from Warren Buffett's Berkshire Hathaway Golden Jubilee Shareholder Letter:
At Berkshire, we can -- without incurring taxes or much in the way of other costs -- move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.
Berkshire offers a third choice to the business owner who wishes to sell: a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed). Beyond that, any business we acquire dramatically increases its financial strength and ability to grow. Its days of dealing with banks and Wall Street analysts are also forever ended.
Those two paragraphs, two pages apart, sort of say opposite things, don't they? The first says that Berkshire is a ruthless allocator of capital, unsentimentally seeking efficiency, moving money to its best use, and discarding businesses and people and horses who no longer serve its profit-maximizing purposes. The second says that Berkshire is a cozy forever home for businesses and people: Unlike selling to a competitor that will seek "synergies" through layoffs, or to a private equity firm that will leverage the business and treat it like "a piece of merchandise," selling to Berkshire gives a business owner the comforting sense that his business will be in the hands of someone as sentimental about it as he is.
Warren Buffett demands a theory. There's the well-known challenge he poses to the efficient markets hypothesis: In his 50 years running Berkshire, it says right on the front page of his letter, he's compounded its book value at 19.4 percent a year, and its market value at 21.6 percent, versus 9.9 percent for the S&P 500 index. And there's the question of how he works as a matter of corporate finance, of why what his vice chairman, Charlie Munger, calls the "constructive peculiarities" of Buffett work as a matter of capital allocation and corporate governance. Most managers manage; Buffett doesn't particularly. Most conglomerates are inefficient empires built to aggrandize their chief executive officers; Berkshire, for all that it has aggrandized Buffett, has also been consistently good at making money for its shareholders.
The simplest theory of Warren Buffett is that a lot of his value-add comes from his ability to write those two paragraphs I quoted. The trick is to be rigorous while seeming sentimental, to drive a hard bargain by looking like a teddy bear. Some of this is fake, just carefully engineered perception. In his section of the shareholder letter, Munger cites as reasons for Berkshire's success not just those "constructive peculiarities" and "good luck," but also "the weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press." The week leading up to the release of this letter has been filled with more of the bizarre cuddly hagiography that centers around reminding us that Buffett really likes drinking Coke and eating garbage:
I checked the actuarial tables, and the lowest death rate is among six-year-olds. So I decided to eat like a six-year-old.
And being a beloved octogenarian/toddler pays off: He has instant and total name recognition, and engenders fond feelings not only from potential sellers but also from regulators and the public. If you're a beloved icon of financial probity and all-American pluck, your halo is valuable to embattled banks, and you can sell it to them at a steep price. You can minimize taxes with frequent cash-rich split-offs, indulge in leverage and derivatives, and fund a famous American company's tax inversion into Canada, without raising too many eyebrows. It's Warren Buffett, come on, give him a break, he eats ice cream for breakfast.
But a lot of the rigor/sentiment balancing is real, too. Much of Buffett's success is due to being really good at one decision point -- entry/exit -- and focusing exclusively on that. He famously does not micromanage. He does not mess with his portfolio companies' executives or their compensation. We talked about this last year, when Buffett criticized Coca-Cola's executive compensation plan but refused to vote against it, and I said:
Buffett's schtick is a key part of this business model: He's set himself up not as a hard-charging manager who will meddle with the companies in which he invests, but as a source of abundant and unintrusive capital who will confer his folksy halo to all his portfolio companies. All he asks in return is extremely favorable economic terms.
That's a trade that many managers would be happy to take, especially managers who are trading external shareholders' economics for their own managerial freedom. But it's also a trade -- economics for freedom -- that works out for Berkshire. Most conglomerate-builders, and even many of the activist investment managers who cite Buffett as a role model, just want to manage. They want to meddle, to do stuff, to be in charge. If you can forgo those psychic benefits, you can be rewarded for it in money. Also you can do less work, which, I mean, sign me up.
That works if Buffett is rigorous about the decisions he does make, the buying and selling decisions. He offers companies a cozy permanent home, until he thinks they're no longer a good investment. And then, bang, they're horses in an automobile age. Buffett is exacting in discussing his own delays in making these decisions: He berated himself this year for his "thumb-sucking" in delaying his exit from Tesco, and the historical section of the letter -- pages 24-28 -- is a catalog of mistakes that he made in buying or selling companies. (Most notably, in building his insurance empire through Berkshire Hathaway.) And the letter looks ahead to a time when, "Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings," when the clear-eyed unsentimental capital-allocation decision will be to give money back to shareholders to allocate how they want. That's where his focus is -- getting in and getting out -- and as long as he's ruthless there, he can be as cuddly and sentimental as he wants everywhere else.
Buffett helpfully provides the total gains: 751,113 percent for Berkshire's book value, and 1,826,163 percent for its market value, versus a shabby 11,196 percent for the S&P 500. That is sort of a silly way to write a 50-year compound growth rate, but who am I to begrudge him his fun.
Here's a weird paragraph on capital allocation:
At the shareholder level, taxes and frictional costs weigh heavily on individual investors when they attempt to reallocate capital among businesses and industries. Even tax-free institutional investors face major costs as they move capital because they usually need intermediaries to do this job. A lot of mouths with expensive tastes then clamor to be fed -- among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don’t come cheap.
Does that make sense? There's a Coasean/Hayekian sense in which a market should just be better at making capital-allocation decisions than an old guy in Omaha is. And Buffett's objections -- that accountants exist? -- don't really seem responsive. Money-shuffling in public stock markets is actually very cheap.
Which my Bloomberg View colleague Justin Fox discusses here.
Incidentally, from this year's letter:
Some years ago, we became a party to certain derivative contracts that we believed were significantly mispriced and that had only minor collateral requirements. These have proved to be quite profitable. Recently, however, newly-written derivative contracts have required full collateralization. And that ended our interest in derivatives, regardless of what profit potential they might offer.
So that's financial regulation at work.
Imagine if the guy who backed Goldman Sachs and funded Burger King's tax inversion was also the guy who wrote things like:
Our War on Poverty was successful in 1965.
Specifically, we were $12,304,060 less poor at the end of the year.
I've said before that I appreciate that obliviously nasty Buffett, but the current Buffett is considerably more news media-friendly. If you can stand it, pages 19-22 of this year's letter focus on all the folksy nonsense that will occur at the annual meeting.
Note that Buffett's letter talks about "business owners" who want to sell to Berkshire, but describes acquisitions like Duracell (a brand bought out of a conglomerate) and Heinz (a widely held, professionally managed public company). The model is not just entrepreneur-owners partnering with Berkshire; it's also professional managers who prefer Buffett as an owner rather than public shareholders. Though his letter also mentions Van Tuyl Automotive, still run by its founder's son, which Berkshire agreed to buy in October.
I feel like the model for Buffett is probably less "lazy" and more "invests his time and energy elsewhere," but he'll certainly take any opportunity to call himself lazy.
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Matt Levine at firstname.lastname@example.org
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Zara Kessler at email@example.com