1. “There are two main reasons Berkshire has succeeded. One is its decentralization. Decentralization almost to the point of abdication. There are only 28 people at headquarters in Omaha. The other reason is our extreme centralization of capital deployment. Our centralization is just as extreme as our decentralization.” Systems are important in Charlie Munger’s world. I have already written a blog post in this series about one system called “the value investing system.” This post is about another system known as “the Berkshire System.” These two systems are related, but distinct. A system can be defined as a set of processes and methods that produce a desired result that is more than the sum of the parts. Charlie Munger is an example of a “systems level thinker.” Munger thinks deeply about things like understanding that local optimizations that actually decrease performance of the overall system. Munger also talks a lot about lollapaloozas and the impact of 2nd and 3rd order effects. Howard Marks is doing this too with his second level thinking idea. Nassim Taleb thinks in the same way, including the nonlinear impact of systems level interactions. The best investors and business people think hard and a lot about systems.
The Berkshire system is not the only system for operating a business but it is a very good one. Attempts have been made to replicate the Berkshire system but they are unlikely to be successful without adopting all of the elements that will be described below. In other words, half of the Berkshire system will not be much of an effective system. For example, delegating control without trustworthy people throughout the organization will fail. Decentralization of everything including capital allocation will fall prey to what Buffett calls “the Institutional Imperative: “rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated…Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.” Professor Lawrence Cunningham, who has written an excellent book on Berkshire writes: “The only qualifications on managerial autonomy at Berkshire appear in a short letter Buffett sends its unit chiefs every two years. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations.”
People sometimes are get confused about what Warren Buffett does at Berkshire. Munger puts it simply: “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.” It is worth noting that it is Buffett and not Munger who ultimately who makes the capital allocation decisions. Buffett seeks Munger’s guidance and thoughts but Buffett pulls the capital allocation trigger. I have another blog post in the works on the capital allocation process at Berkshire, which will take the total number of planned posts on Munger up to a Spinal Tap-style #11. Buffett has said on the capital allocation system: “Berkshire wants the capital in the most logical place. Berkshire is a tax efficient way to move money from business to business, and we can redeploy capital in places that need them. Most of the managers of companies we own are already independently rich. They want to work, but don’t have to. They don’t horde capital they don’t need.” The management at a subsidiary like See’s Candies is given a capital allocation by Buffett, not the reverse. Superior capital allocation skill is one of Warren Buffett’s unique gifts. Some people can do things like skateboard very well and some people can allocate capital very well. Buffett has pointed out: “If all of us were stranded on a desert island somewhere and we were never going to get off of it, the most valuable person there would be the one who could raise the most rice over time. I can say, “I can allocate capital!” You wouldn’t be very excited about that. So I have been born in the right place.”
2. “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.” These three sentences capture the essence of what drives the success of the Berkshire System and the necessary preconditions for that system to work effectively. Firms exist to reduce the cost of coordinating economic activity versus the alternative approach. The Berkshire System implemented in a firm will not generate the desired efficiency and results unless the organization has trust in trustworthy people. That efficiency makes the businesses, managers and employees in the Berkshire system better able to adapt to changes in the environment. Professor Lawrence Cunningham relays this interesting snippet from a private conversation: “Munger told me: take Coase seriously/avoid middlemen.” People talk about capitalism being the most efficient way to allocate resources, but it is capitalism’s ability to drive innovation via discovering new innovation that makes is the best possible economics system. A person saying that socialism is more efficient than capitalism since it is more efficient to have only a few types of phones is an absurdity. Innovation and progress requires failure. Lots of failure. Munger has said, after giving the hat tip to Allen Metzger for the phrasing: “I regard it as very unfair, but capitalism without failure is like religion without hell.” If course, markets sometimes fail too, which is why programs and policies like a social safety net are needed. Munger described this in his typical blunt fashion: “Greenspan was a smart man but he overdosed on Ayn Rand at a young age.” Munger also said once at one of his most famous speeches given at USC: “Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind. … When you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out, what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind.”
3. “The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.” The culture of a business is more than the sum of its parts. The totality of the vision, values, norms, systems, symbols, language, assumptions, beliefs, and habits of a business is what creates the culture of a business. Munger and Buffett are huge proponents of creating a strong organizational culture: “Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.…Cultures self-propagate.” Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior.”
4. “We want people where every aspect about their personality makes you want to be around them. Trust first, ability second.” The greater efficiency that Munger talks about flows from trust. When trust exists you can eliminate lots of inefficient procedures which must exist in a system that must deal with people who are not trustworthy. This means trust is an essential element in hiring people and that exhibiting a lack of trust is something that should result in a dismissal from the business. Buffett’s stated philosophy on this point is well known: “Lose money for the firm and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.” Are they perfect in implementing this philosophy? No. They admit mistakes for the reasons my previous blog posts have discussed. Mistakes are feedback and if you don’t try to learn from mistakes you are not only missing and opportunity, you are a fool.
5. “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.” “The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it.” The acquisition process Berkshire uses is very deliberate. Berkshire only buys businesses that meet certain criteria including having an existing moat and existing high quality management. They do not want to create moats or supply management. They greatly admire people who create moats but know that creating moats is not their best game in terms of circle of competence. Munger has said: “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.” The same principle applies to moats: spotting a business with an existing moat is vastly easier than trying to spot a new moat emerging from a complex adaptive system. Seeing something emerging from nothing is a really hard problem compared to seeing something that is already there. Munger does not like really hard problems. He likes easy problems that have very favorable odds of a big payoff if he is right.
6. “We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.” Munger is talking about the importance of creating and maintaining the Berkshire culture which enables and depends upon trust. It is tremendously cost efficient to have a culture that is based on trust, since you don’t have the cost or the inefficiency associated with layers of management and complex systems that try to act as a substitute. David Larcker and Brian Tayan in a paper cited in the notes below write:“A trust-based system [requires] the development and maintenance of a culture that encourages responsible behavior. As Munger says, “People are going to adopt to whatever the ethos is that suffuses the place.” Which means that this ethos is worth paying close attention to and developing well including being based on a high degree of trust.
7. “A lot of people think if you just had more process and more compliance — checks and double- checks and so forth — you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.” “I think your best compliance cultures are the ones which have this attitude of trust and some of the ones with the biggest compliance departments, like Wall Street, have the most scandals.” Buffett has said: “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.” Lawrence Cunningham writes in his book: “At most companies, CEOs might formulate a general acquisition program with little board involvement and then present specific proposals to the board, which discusses deal terms and approves funding. The board’s role in this setting is an example of its service as an intermediary. Berkshire does the opposite, enabling Buffett to seize opportunities that would be lost if prior board involvement occurred…. Berkshire’s success at such internal capital reallocation has vindicated its conglomerate business model that has otherwise been denigrated across corporate America. The strategy skillfully avoids intermediaries. Cash transferring subsidiaries distribute cash to Berkshire without triggering any income tax consequences. Cash-receiving subsidiaries obtain corporate funding without frictional costs of borrowing, such as bank interest rates, loan covenants, and other constraints. Some subsidiaries generate tax credits in their businesses that they cannot use but can be used by sister subsidiaries.”
8. “Everybody likes being appreciated and treated fairly, and dominant personalities who are capable of running a business like being trusted. A kid trusted with the key to the computer room said, ‘It’s wonderful to be trusted.’” “We promised our CEOs that they could spend 100% of their time on their business. We place no impediments on them running their businesses. Many have expressed to me how happy they are that they don’t have to spend 25% of time on activities they didn’t like.” People value working for a business that trusts them. In other words, working for a business that trusts you is a non-financial employee benefit. When this trust exists great people like to work for the business and that makes recruiting other people easier. This attracts other great people since this attribute and success feeds back on itself. One of the attractions of Berkshire as a buyer to a person selling a business is that Buffett and Munger will continue to let them run their business and won’t break it into pieces like an automobile chop shop like most private equity buyers. The managers of Berkshire subsidies love Buffett and Munger for giving them freedom to run their business.
9. “When you get a seamless web of deserved trust, you get enormous efficiencies. … Every once in a while, it doesn’t work, not because someone’s evil but because somebody drifts to inappropriate behavior and then rationalizes it.” “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.” “By the standards of the rest of the world, we over-trust. So far it has worked very well for us. Some would see it as weakness.” There will be instances where someone is not as trustworthy as anticipated. This is a necessary price to pay to harvest the operational efficiencies when trust is deserved. Mistakes will happen and must be corrected. For example, CNBC noted: “Buffett did admit that he “obviously made a big mistake by not saying ‘Well, when did you buy it?’ when Sokol first told him he owned Lubrizol stock in January. Buffett also apologized for not including more ‘outrage’ in his March 30 letter announcing Sokol’s ‘resignation.” Munger added, ‘I think we can concede that that press release was not the cleverest press release in the history of the world.’” Everyone makes mistakes and will keep making mistakes. Don’t let one or even a few lousy outcomes throw you off the right path. If you have a sound process you will make less mistakes overall and come out ahead.
10. “There’s money in being trusted. It’s such a simple idea, and yet everybody rushes into every scummy activity that seems to work.” Munger is saying that not only is being trustworthy the right thing to do morally, ethically and in terms of being happy in life, but it is the most profitable way to live your life. In short, being trustworthy is more profitable than being untrustworthy. “A trust-based system can be more efficient than a compliance-based system, but only if self-interested behavior among employees and managers is low” write Larcker and Tayan in the previously cited paper.
11. “We want very good leaders who have a lot of power, and we want to delegate a lot of power to those leaders. It’s crazy not to distribute power to people with the most capacity and diligence. Every time I see an opportunity to choose somebody, the second best guy is just awful compared to the guy we hire. Usually the decision is a no-brainer. We have to give power to the people who can wield it efficiently in serious game of survival.” “A lot of corporations are run stupidly from headquarters, driving divisions to increase earnings every quarter. We don’t do that. The stupidity of management practices in the rest of the corporate world will last long enough to give us an advantage well into the future.” Tom Murphy once described the best approach to decentralization of operating decisions this way: “don’t hire a dog and try to do the barking.” Managers who are on the line in a business actually interacting with customers and systems are in the best position to make the necessary decisions if they are the right people. So work really hard to get the right people with the right skills and let them do their job. By accepting that sometimes businesses have lumpy earnings and letting talented managers run their business without interference Berkshire earns a superior long term return. The idea that this advantage is not possible or sustainable because markets are perfectly efficient is rubbish to anyone actually running a business.
12. “One of the greatest ways to avoid trouble is to keep it simple.” “When you make it vastly complicated—and only a few high priests in each department can pretend to understand it—what you’re going to find all too often is that those high priests don’t really understand it at all…. The system often goes out of control.” “We operate Berkshire [via] a seamless web of deserved trust. We get rid of the craziness, of people checking to make sure it’s done right.” “Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional — it isn’t the way things are normally done. We have low overhead, don’t have quarterly goals and budgets or a standard personnel system, and our investing is much more concentrated than average. It’s simple and common sense.” A simpler system results in fewer mistakes and makes life much more pleasant. What could be more simple?
Notes:
Lawrence Cunningham: Berkshire Beyond Buffett: The Enduring Value of Values http://www.amazon.com/Berkshire-Beyond-Buffett-Enduring-Values/dp/0231170041 and Berkshire’s Disintermediation: Buffett’s New Managerial Model http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2602825
Corporate Governance According to Charles T. Munger https://www.gsb.stanford.edu/sites/default/files/38_Munger_0.pdf
- A Dozen Things I’ve Learned from Charlie Munger about Mistakes
- A Dozen Things I’ve Learned from Charlie Munger about Capital Allocation
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