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 calls "the institutional imperative". In a nutshell, it's the tendency for organizations to:

- resist changes in direction;
- make less than optimal use of corporate funds;
- support even very foolish initiatives;
- imitate, at times rather unwisely, the actions of peer companies.

As Buffett explains below, the "troops" will all too often just fall in line with the folly.

In fact, he explains that they will even provide the supporting justification for ill-advised initiatives simply because it has become the focus of their business leader.

An investor won't necessarily see the impact of this behavior in the short run numbers but, over the long haul, it matters a lot when it comes to the creation per share intrinsic value for owners.

Tough to quantify; very real.

The excerpt below, from the Mistakes of the First Twenty-five Years section of the 1989 Berkshire Hathaway (BRKa) shareholder letter, provides a more complete explanation of what Buffett means by "the 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 the investor.

Yet it's still worth watching for clues.

Occasionally, the actions of senior management will reveal a whole lot over time.

Independent minded business leaders who build organizations that are less susceptible to the "imperative" are out there. Even if hard to gauge from the outside, it's still worth attempting to figure out who "gets it" and are willing to take appropriate action; it's worth figuring out who understands the damage it does and how to create an environment that mitigates the tendency.

Some certainly do.

Capable leaders of good businesses can end up producing lots of additional wealth for owners by creating the right kind of corporate culture.

Adam

Long position in BRKb

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