Besides the owner-orientation reflected in Buffett’s disclosure practice and the owner-related business principles summarized above, the next management lesson is to dispense with formulas of managerial structure. Contrary to textbook rules on organizational behavior, mapping an abstract chain of command on a particular business situation, according to Buffett, does little good. What matters is selecting people who are able, honest, and hard-working. Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times.
Special attention must be paid to selecting a CEO because of three major differences between CEOs and other employees. First, standards for measuring a CEO’s performance are inadequate or easy to manipulate, so a CEO’s performance is harder to measure than that of most workers. Second, no one is senior to the CEO, so no senior person’s performance can be measured either. Third, a board of directors cannot serve that senior role since relations between CEOs and boards are conventionally congenial.
“It is better to be approximately right than precisely wrong.” Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such “flitting from flower to flower” imposes huge transactional costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor “is like calling someone who repeatedly engages in one-night stands a romantic.”
It rejects a prevalent but mistaken mind-set that equates price with value. On the contrary, Graham held that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference.
The difference also shows that the term “value investing” is a redundancy. All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation — the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained.
Buffett notes Phil Fisher’s suggestion that a company is like a restaurant, offering a menu that attracts people with particular tastes.
Stock splits are another common action in corporate America that Buffett points out disserve owner interests. Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both those effects, they lead to prices that depart materially from intrinsic business value. With no offsetting benefits, splitting Berkshire’s stock would be foolish. Not only that, Buffett adds, it would threaten to reverse three decades of hard work that has attracted to Berkshire a shareholder group comprised of more focused and long-term investors than probably any other major public corporation.
The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a short at a few extra percentage points of return. I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.
Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to payout losses. Both of these funding sources have grown rapidly and now total about $12B.
Better yet, this funding to date has been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting — which we have done, on the average, during our 29 years in the business — the cost of the float developed from that operation is zero. Neither item, it should be understood, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt — an ability to have more assets working for us — but saddle us with none of its drawbacks.
Of course, there is no guarantee that we can obtain our float in the future at no cost. But we feel our chances of attaining that goal are as good as those of anyone in the insurance business.
This devastating outcome for the shareholders indicates what can happen when much brain power an energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse — not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company — but not a remarkable business.
“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
First, we participate in only a few, and usually very large, transactions each year. Most practitioners buy into a great many deals — perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie and I wish to spend our lives. (What’s the sense in getting rich just to stare at a ticker tape all day?)
In any sort of a contest — financial, mental, or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.
When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.
The worst of these is perhaps, “You can’t go broke taking a profit.” Can you imagine a CEO using this line to urge his board to sell a star subsidiary? In our view, what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if the owned all of that business.
I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven product? Our motto is: “If at first you do succeed, quit trying.”
As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.
A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired an ability to clear seven-footers.
I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.
- An institution will resist any change in its current direction
- Corporate projects or acquisitions will materialize to soak up available funds
- Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops
- The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
We do not wish to join with managers who lack admirable qualities, no matter who attractive the prospects of their business. We’ve never succeeded in making a good deal with a bad person.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual forces in the financial world: “Most men would rather die than think. Many do.”
I again failed in my attempt to snatch defeat from the jaws of victory.
In another context, a friend once asked me: “If you’re so rich, why aren’t you smart?”
We neglected the Noah principle: predicting rain doesn’t count, building arks does.