Friday, November 18, 2011

Buffett on the "Institutional Imperative": Berkshire Shareholder Letter Highlights

Some of my previous posts have made reference to what Warren Buffett has called for years the "institutional imperative". In a nutshell, it's the tendency for organizations, led by the CEO and others in the executive ranks, to mindlessly imitate the behavior of peers no matter how foolish it may be to do so.

You won't always see the impact of this behavioral tendency in the short run numbers but, over the long haul, it matters a lot when it comes to the creation intrinsic value for owners.

The excerpt below, from the Mistakes of the First Twenty-five Years section of the 1989 Berkshire Hathaway (BRKashareholder letter, provides a more complete explanation of what Buffett means by "institutional imperative":

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative." In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. 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.

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.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.

It's a big factor in many large (and sometimes not so large) organizations. The problem is it's not always visible to an investor. Yet, carefully watch a CEO's and other senior executive behavior and decision-making over time and, on occasion, it will reveal more than you'd expect.

Independent minded, creative CEO's who build organizations that are less susceptible to the "imperative" are out there. Even if hard to gauge from the outside it's worth attempting to figure out who gets it.

Owning shares of the businesses they run certainly doesn't hurt returns.

Adam

Long position in BRKb

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