Delegate, but not Everything
With only a little over 20 people working at Berkshire, Buffett and Munger must leave it to the managers to run the businesses in the portfolio since they don’t have the staff to do otherwise. This is, of course, by choice since what the two men love most is investing. Munger has said:
“We have extreme centralization at headquarters where a single person makes all the capital allocation decisions, and we have decentralization among our operations without a big bureaucracy. That’s the Berkshire Hathaway model.” http://mungerisms.blogspot.com/2010/05/charlie-munger-on-how-hed-make-volckler.html
An investor like Munger finds his “comparative advantage” in investing rather than “making sure the trains run on time” like Matt Rose of Burlington Northern. Of course, what Matt Rose does as a “trains run on time” manager is not only invaluable, but essential. Munger says this about See’s candy and delegation:
“There are a lot of people who would have bought it and would have screwed it up. They would have thought that headquarters knows best.” http://bit.ly/Ug9yV9
When Munger and Buffett do engage in company management, they focus on two tasks:
1. Capital Allocation
Management of the businesses within Berkshire is extremely decentralized, but the management of cash is extremely centralized. The primary management activity at Berkshire is capital allocation. Charlie writes:
“Proper allocation of capital is an investor’s number one job” Poor Charlie’s Almanack (p. 63)
Buffett’s view is no different:
“Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.” http://www.economist.com/node/12677005
Munger has pointed out that capital allocation should not be combined or confused with what is essentially what he calls “gambling at a casino” as is the case with many large investment banks. Charlie has said publicly that he “makes Paul Volcker look like a sissy” when it comes to investment banking reform:
“I would separate derivatives from the basic bridges of civilization. We don’t want civilization contaminated by extreme speculation. I’d ban all the derivatives trading except for metals and commodities. The new stuff is a marvelous gambling game. It swamps any commercial transactions that are needed. Gambling does not become wonderful just because it pertains to commerce. It’s a casino.” http://theinvestmentsblog.blogspot.com/2010/05/if-i-were-lee-kwan-yew.html
2. Compensation Systems
This task is not as simple as it might seem since the Berkshire managers in many cases are rich and have little financial need to work. For this reason, Munger and Buffett select managers who love what they do enough that financial motivation is only part of the reason they love the work they do. The best place to see this philosophy set out s in the Berkshire “Owner’s Manual” at: http://www.berkshirehathaway.com/owners.html
Munger believes compensation systems are important- too important to delegate:
“It isn’t enough to buy the right business. You’ve also have to have compensation system that’s satisfactory to the people running them. At Berkshire Hathaway, we have no [single] system; we have different systems. They’re very simple and we don’t tend to revisit them very often. It’s amazing how well it’s worked. We wrote a one-page deal with Chuck Huggins when we bought See’s and it’s never been touched. We have never hired a compensation consultant.” http://www.tilsonfunds.com/wscmtg05notes.pdf
“A man does not deserve huge amounts of pay for creating tiny spreads on huge amounts of money. Any idiot can do it. And, as a matter of fact, many idiots do do it.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“I’d rather throw a viper down my shirt front than hire a compensation consultant.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
As an example, a manager like Mark Hurd might do very well with Larry Ellison keeping watch, but manage the company to maximize his compensation to the detriment of the company if supervised by a weak board of directors.
Micro-managing what their CEOs do is not in the Berkshire playbook:
“In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s big and whether it’s material. You can do a lot to mitigate bad behavior, but you simply can’t prevent it altogether.” http://gongol.com/research/berkshire/2012/
Of course, fear of micromanagement is not a reason to abdicate responsibility as Scott McNealy did with Jonathan Schwartz at Sun. A board of directors letting a parade of managers run down a business is not justified by a fear of micromanagement either. Should Leo Apotheker have been given the freedom to buy Autonomy? No. Buffett writes: “A managerial “wish list” will not be filled at shareholder expense” at Berkshire. http://www.berkshirehathaway.com/owners.html This raises the Institutional imperative problem that will be discussed later in this series. As Buffett has written:
“[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.” http://emlab.berkeley.edu/~ulrike/Papers/OCmergers_Final_JFEformat_20feb2008.pdf
“the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. …CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it. In the end, plenty of unintelligent capital allocation takes
place in corporate America. (That’s why you hear so much about ‘restructuring.’)” http://www.berkshirehathaway.com/letters/1987.html
Delegation to the extent practiced by Munger and Buffett only works if you follow this rule says Munger:
“Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. But if you’re going to provide minimal oversight, you have to buy carefully. It’s a different model from GE’s. GE’s works – it’s just very different from ours.” http://www.tilsonfunds.com/wscmtg05notes.pdf
Buying a “turn-around” business like Sears is not an example of a Berkshire approach despite what was claimed by investor Eddie Lampert. The idea that Lampert would be “the next Warren Buffett” was and is baffling given their different styles as investors.
Better to Have a Great Moat than a Great Manager (But Get Both When You Can)
Munger would rather have a great moat than great managers, but would love to have both so he as a greater margin of safety. “Good jockeys will do well on good horses, but not on broken down nags” quips Buffett. For example, both the New England textile business and the department stores that Berkshire owned had very competent managers, but the underlying businesses the managers had to run were lodged in quicksand. Ron Johnson who formerly was in charge of Apple’s retail operations may be a great manager of a retail business, but JC Penny’s reputation as a lousy business seems likely to make the critical difference in terms of a financial result. Lots of really great managers will do poorly running startup because the distribution of financial returns in venture capital is a power law distribution.
Munger admits there are rare exceptions to the moat rule:
“So you do get an occasional opportunity to get into a wonderful business that’s being run by a wonderful manager. And, of course, that’s hog heaven day. If you don’t load up when you get those opportunities, it’s a big mistake. … Averaged out, betting on the quality of business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.” http://ycombinator.com/munger.html
The Only Duty of Management is to “Widen” the Moat:
In typical fashion Charlie gets right to the point here:
“The only duty of corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it is too tough. But duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on ball of widening the moat, to be a steward of the competitive advantage that came to you. A General in England said, ‘Get you the sons your fathers got, and God will save the Queen.’ At Hewlett Packard, your responsibility is to train and deliver a subordinate who can succeed you. It is not all that complicated – all that mumbo jumbo. We make bricks in Texas which use the same process as in Mesopotamia.” http://mungerisms.blogspot.com/2009/08/2008-annual-meeting-notes.html
Munger wants managers of the business who have “an ownership mentality” toward the business, not just the attitude of manager.
“Carnegie was always proud that he took very little salary. Rockefeller, Vanderbilt were the same. It was a common culture in a different era. All of these people thought of themselves as the founder. I was delighted to get rid of the pressure of getting fees based on performance. If you are highly conscientious and you hate to disappoint, you will feel the pressure to live up to your incentive fee. There was an enormous advantage [to switching away from taking a percentage of the profits to managing Berkshire, in which their interests as shareholders are exactly aligned with other shareholders].” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3
Munger and Buffet want managers with what Nassim Taleb calls “skin in the game.” They hate situations in which the result is: “heads managers win and tails managers do not lose.” They want risk and benefits to be symmetrical. For Munger the presence of the right incentives for manager is critical. Buffett adds that he wants to see managers have: “a major portion of their net worth invested in the company. We eat our own cooking.”
Munger also fears bureaucracy and Berkshire works hard to prevent it from lowering returns. Munger:
“For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. But, of course, it isn’t. It’s not done until AT&T delivers what it’s supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies…. The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments—because we do. But it’s a terrible problem to get big bureaucracies to behave.” http://ycombinator.com/munger.html
Management Already In Place with Integrity
Munger has made it clear that integrity is just as significant an investment filter as talent. When Munger buys a company or makes an investment he wants both:
“We would vastly prefer a management in place with a lot of integrity and talent.” http://www.youtube.com/watch?v=3XlBrohrIUc
“Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“I think track records are very important. If you start early trying to have a perfect one in some simple thing like honesty, you’re well on your way to success in this world.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“When you mix raisins with turds, they are still turds.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“All investment evaluations should start by measuring risk, especially reputational.” Poor Charlie’s Almanack (p. 61)
“Avoid dealing with people of questionable character.” Poor Charlie’s Almanack (p. 61)
As was noted in the earlier post on mistakes, no one is perfect, including Charlie says Charlie:
“[I know] of a company with a great culture and a great business and he and Warren admire the guy who runs the company. But, the man just made an awful acquisition. … you have to be willing to be disappointed by managers. All managers are going to drift. If [we] could be so wrong as to buy Dexter Shoes then we should not be surprised that others make acquisition mistakes. If you are not frustrated by what you see, you don’t understand it.” http://www.watheeqa.com/App_Themes/watheeqa/pdf/Conversation%20with%20Charlie%20Munger.pdf
It is harder to spot a lack of integrity than many people imagine. Munger:
“Bernie Ebbers and Ken Lay were caricatures – they were easy to spot. They were almost psychopaths. But it’s much harder to spot problems at companies like Royal Dutch [Shell].” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
The David Sokol case involving Berkshire is interesting to think about. http://www.berkshirehathaway.com/news/MAR3011.pdf Why would someone so rich like Sokol take an action that involved relatively little money as potential gain? That very rich people fall from grace in a huge way over small amounts of money defies easy explanation. Why take a risk that has small upside and massive downside like DennisKozlowski the former head of Tyco did in trying to avoid sales taxes on some art? As an analogy: Why cheat on a spouse with prostitutes when you are in a position of power like Eliot Spitzer? The answer, of course, is that humans are often emotional rather than logical and understand statistics in a dysfunctional way. Munger has said that if you think this sort of thing is easily explainable, you do not understand the problem. Complexity, risk, uncertainty and ignorance are impossible to avoid.
At a small scale reading how to respond when a lack of integrity is uncovered, Munger has said:
“Well in the history of the See’s Candy Company they always say, “I never did it before, and I’m never going to do it again.” And we cashier them. It would be evil not to, because terrible behavior spreads.” http://22.214.171.124/search?q=cache:3sSZnXLbvQEJ:www.loschmanagement.com/Berkshire%2520Hathaway/Charlie%2520munger/The%2520Psychology%2520of%2520Human%2520Misjudgement.htm+%22charlie+Munger%22+%22the+way+Zeckhauser+plays+bridge%22&hl=en&gl=us&ct=clnk&cd=1
Regarding where to draw the line, Munger points out
“We think there should be a huge area between what you’re willing to do and what you can do without significant risk of criminal penalty or causing losses. We believe you shouldn’t go anywhere near that line. You ought to have an internal compass. So there should be all kinds of things you won’t do even though they are perfectly legal. That’s the way we try to operate.” http://www.fusioninvesting.com/2011/04/david-sokols-honesty-is-the-question/
Munger makes it clear that he has no desire to buy an otherwise “good” business and they try to find someone to run it:
“We don’t train executives, we find them. If a mountain stands up like Everest, you don’t have to be a genius to figure out that it’s a high mountain.” http://www.designs.valueinvestorinsight.com/bonus/bonuscontent/docs/Tilson_2006_BRK_Meeting_Notes.pdf#search=%22Charlie%20munger%20and%20foundation%20and%20croupier%22
The two investors are not interested in investing in a company “turnaround,” since they “seldom actually do. Charlie hopes that the moat of the company he is investing in is strong enough to survive bad management. As was discussed in a previous post in this series, Charlie would prefer to have a moat that is so strong that it could survive if the company was run by “an idiot nephew.” Neither Buffett nor Munger is going to buy a business and “let” some friend or relative “run it.” But if they hypothetically did, they would hope that it would still perform adequately as a business due to the moat.
The Rare Exceptions to the Moat Rule
Occasionally Munger and Buffett find a person who they can bet on who has such superior talent that they really don’t need much of a moat (regarding moats see my previous post). This situation is rare, but it does happen.
“Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks – who was second generation in Marks & Spencer of England – was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man. These people do come along – and in many cases, they’re not all that hard to identity. If they’ve got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party – then management can matter much. However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Sometimes, as is the case with Berkshire itself, it is worthwhile to bet on a superior manager. Charlie has said:
“There are people- very few- worth paying up to get in with for a long term advantage’. http://bitly.com/RzDIys
Buffett has pointed out that the talents of Ajit Jain in the reinsurance business are just such a case. Buffett said at the most recent Berkshire meeting: “Ajit Jain has created tens of billions of dollars in value for this company out of nothing but brain and hard work. “ That is high praise indeed since there is no mention of any moat in that business. Wells Fargo as has previously been mentioned is also described by Munger and Buffett as a company that relies mostly on management instead of a moat. I would disagree since I think being “too big to fail” like Wells Fargo is a form of moat since it gives them an artificially low cost of capital. The CEO of Wells thinks his business is all about execution:
“We always say we could leave our strategic plan on an airplane, somebody could pick it up, and it wouldn’t matter. It’s all about execution.” http://management.fortune.cnn.com/2012/11/26/wells-fargo-stumpf/
Certainly the way Wells Fargo “cross-sells” to existing customers in order to lower the cost to acquire new business is about great execution, but the bank in my view starts from a base of “too big to fail” which is a moat.
Charlie feels that the management of a company like Costco is a case in which management adds to the company moat. Charlie is a huge fan of Costco’s James Sinegal for example. But Munger clearly feels that companies which have managers like Costco are not easy to find.
“I think it’s dangerous to rely on special talents — it’s better to own lots of monopolistic businesses with unregulated prices. But that’s not the world today. We have made money exercising our talents and will continue to do so. I’m glad we have insurance, though it’s not a no-brainer, I’m warning you. We have to be smart to make this work.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Munger also believes that a skilled manager can sometimes find a relatively safe market niche in some cases:
“I find it quite useful to think of a free-market economy – or partly free market economy – as sort of the equivalent of an ecosystem. Just as animals flourish in niches, people who specialize in some narrow niche can do very well.” http://www.thepracticalway.com/2010/12/20/quotes-charlie-munger/
This strategy is similar to what Professor Michael Porter calls “differentiation.” It can be workable, but is inherently riskier to find a haven from competition in a niche than to have a moat (it is better to have both). An example of a niche market where Munger and Buffett find a gem of a management team is Iscar:
“Judging the management at a company like Iscar is easy—those people are enormously talented and wonderful. But, there aren’t many managements like that and few people with the incentive of such intensity.” http://www.watheeqa.com/App_Themes/watheeqa/pdf/Conversation%20with%20Charlie%20Munger.pdf
“The reason I got so high on it so fast was that the people are so outstandingly talented. The idea of being in business with them just struck me worth straining for. We didn’t know when we were young which things to stretch for, but by the time we reached Iscar, which we never would have bought when we were young, we knew to stretch for the right people. It’s a hell of a business. Everything is right there. Isn’t it good that we keep learning? Better late than never.” http://www.tilsonfunds.com/Whitney%20Tilson’s%20notes%20from%20the%202007%20Wesco%20annual%20meeting-5-9-07.pdf
This post is getting beyond my self-imposed limit so I will let Bill Gates summarize the Munger/Buffett management philosophy:
“[Warren’s] penchant for long-term investments is reflected in another aphorism: “You should invest in a business that even a fool can run, because someday a fool will.” He doesn’t believe in businesses that rely for their success on every employee being excellent. Nor does he believe that great people help all that much when the fundamentals of a business are bad. He says that when good management is brought into a fundamentally bad business, it’s the reputation of the business that remains intact. Warren installs strong managers in the companies Berkshire owns, and tends to leave them pretty much alone. His basic proposition to managers is that to the degree that a company spins off cash, which good businesses do, the managers can trust Warren to invest it wisely. He doesn’t encourage managers to diversify. Managers are expected to concentrate on the businesses they know well so that Warren is free to concentrate on what he does well: invest.” http://money.cnn.com/magazines/fortune/fortune_archive/1996/02/05/207334/index.htm
The next post in this series on 25IQ is about Munger’s Methods: Charlie Munger on Margin of Safety (The Fouth Essential filter).