Tuesday, 8th December 2009

Warren Buffett Investment Lessons, part 7

Written by George Traganidas Topics: Stock Investing

How he runs Berkshire Hathaway

In 1992, Warren Buffett say that Berkshire’s after-tax overhead costs are under of 1% of reported operating earnings and less than 1/2 of 1% of look-through earnings. In 1996, the after-tax headquarters expense amounts to less than two basis points (1/50th of 1%) measured against net worth.

Warren Buffett does not believe in flexible operating budgets, as in “Non-direct expenses can be X if revenues are Y, but must be reduced if revenues are Y – 5%”. In addition, it makes no sense to add unneeded people or activities because profits are booming, or cutting essential people or activities because profitability is shrinking.

His managers will look for ways to deploy their earnings advantageously in their business. What’s left they will send to Charlie and Warren and then they will try to use these funds in ways that build per-share intrinsic value.

In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls. When capital invested in an operation is significant, we also both charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release.

The product of this money’s-not-free approach is definitely visible at Scott Fetzer. If Ralph can employ incremental funds at good returns, it pays him to do so: His bonus increases when earnings on additional capital exceed a meaningful hurdle charge. But our bonus calculation is symmetrical: If incremental investment yields sub-standard returns, the shortfall is costly to Ralph as well as to Berkshire. The consequence of this two-way arrangement is that it pays Ralph – and pays him well – to send to Omaha any cash he can’t advantageously use in his business.

Berkshire’s compensation principles are based on goals that are:

  • Tailored to the economics of the specific operating business
  • Simple in character so that the degree to which they are being realized can be easily measured
  • Directly related to the daily activities of plan participants


We eliminate all of the ritualistic and nonproductive activities that normally go with the job of CEO. Our managers are totally in charge of their personal schedules. Second, we give each a simple mission: Just run your business as if:
1) You own 100% of it
2) It is the only asset in the world that you and your family have or will ever have
3) You can’t sell or merge it for at least a century
As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations. We want our managers to think about what counts, not how it will be counted.

Warren Buffet and Charlie Munger have two simple goals in reporting:

  • Give investors the information that they would wish to give them if their positions were reversed
  • Make Berkshire’s information available to all of the investors simultaneously


At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance. Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don’t provide them with officers’ and directors’ liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years). Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family’s net worth, not by their compensation. That’s the equation for Charlie and me as managers, and we think it’s the right one for Berkshire directors as well.

To find new directors, we will look through our shareholders list for people who directly, or in their family, have had large Berkshire holdings – in the millions of dollars – for a long time. Individuals making that cut should automatically meet two of our tests, namely that they be interested in Berkshire and shareholder-oriented. In our third test, we will look for business savvy, a competence that is far from commonplace.

Two post-bubble governance reforms have been particularly useful at Berkshire, and I fault myself for not putting them in place many years ago. The first involves regular meetings of directors without the CEO present. I’ve sat on 19 boards, and on many occasions this process would have led to dubious plans being examined more thoroughly. In a few cases, CEO changes that were needed would also have been made more promptly. There is no downside to this process, and there are many possible benefits.

The second reform concerns the “whistleblower line,” an arrangement through which employees can send information to me and the board’s audit committee without fear of reprisal. Berkshire’s extreme decentralization makes this system particularly valuable both to me and the committee. (In a sprawling “city” of 180,000 – Berkshire’s current employee count – not every sparrow that falls will be noticed at headquarters.) Most of the complaints we have received are of “the guy next to me has bad breath” variety, but on occasion I have learned of important problems at our subsidiaries that I otherwise would have missed. The issues raised are usually not of a type discoverable by audit, but relate instead to personnel and business practices. Berkshire would be more valuable today if I had put in a whistleblower line decades ago.

Warren Buffett and Charlie Munger are not big fans or resumes. Instead, they focus on brains, passion and integrity.

In good years and bad, Charlie and I simply focus on four goals:

  • maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash;
  • widening the “moats” around our operating businesses that give them durable competitive advantages;
  • acquiring and developing new and varied streams of earnings;
  • expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.


Berkshire Hathaway wants to be the buyer of choice for businesses. The way to achieve this goal is to deserve it. That means they must keep their promises; avoid leveraging up acquired businesses; grant unusual autonomy to their managers; and hold the purchased companies through thick and thin.

Follow the practical way,
George

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