Wednesday, January 27, 2016

Berkshire's Structure: Why It Works

Conglomerates, according to Warren Buffett, "have a terrible reputation with investors" that they "richly deserve".

I covered this, at least to an extent, in a post late last year.

So, if that's the case, why does the conglomerate structure work -- when it comes to maximizing the growth of capital over the long haul -- for Berkshire Hathaway (BRKa) but not some other companies?

It comes down to, at least in part, whether investors can generally count on the wise allocation of capital on a consistent basis (and, ideally, with many decades in mind).

Unfortunately, intelligent capital allocation in the real world is far from a given. Warren Buffett, in his 2014 Berkshire special letter*, uses the textile industry as one example:

" withdrawals within the textile industry that should have been obvious were delayed for decades because of the vain hopes and self-interest of managements. Indeed, I myself delayed abandoning our obsolete textile mills for far too long."

He also points out that taxes and frictional costs are a big factor because "mouths with expensive tastes...clamor to be fed – among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don't come cheap."

Now here's how Buffett goes on to explain Berkshire's advantages:

"...a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Of course, form itself is no guarantee of success: We have made plenty of mistakes, and we will make more. Our structural advantages, however, are formidable.

At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That's important: If horses had controlled investment decisions, there would have been no auto industry.

Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a. common stocks. That's not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety. Additionally, the gains we've realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.

In effect, the world is Berkshire's oyster – a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that's a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry. On top of that, we can profitably scale to a far larger size than the many businesses that are constrained by the limited potential of the single industry in which they operate."

One of Berkshire's businesses, See's Candy, produces lots of earning power yet requires a rather small amount of capital. Unfortunately, it doesn't internally have many good uses for all the excess cash it produces. Buffett, using See's as an example of how excess capital can be moved from where it can't be put to good use to where it can be, explains it this way:

"We would have loved, of course, to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See's to help purchase other businesses. If See's had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs."

It seems like a structure like Berkshire should be more common but, well, it's just not. Another advantage Buffett covers is that Berkshire has become the "home of choice" for some great businesses. Berkshire is unique in that it offers a place where a "company's people and culture" has the best chance to remain in tact even if, inevitably, personnel changes will occur.

The compounded effect of wise capital allocation and low frictional costs is not small even if, due to its sheer size, Berkshire can longer compound at anywhere near as high a rate as it has in the past.


Long position in BRKb established at much lower than recent market prices

Related posts:
Corporate Hocus-Pocus
Charlie Munger: Focus Investing and Fuzzy Concepts
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting

* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Charlie Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, January 4, 2016

Quotes of 2015

Here's a collection of quotes said or written at some point during 2015.

John Bogle on Investor Returns
"Advisers or whoever saying you should get out of healthcare and into technology or into financials. That's a way to manage money that doesn't work. Who knows what will do best? I don't even know anybody who knows anybody who does." - John Bogle

Stocks and Risk
"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray." - Warren Buffett

Investment Sins
"Investors, of course, canby their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy." - Warren Buffett

Berkshire's Architect

"What most of you do not know about Charlie [Munger] is that architecture is among his passions. Though he began his career as a practicing lawyer...he designed the house that he lives in today – some 55 years later. (Like me, Charlie can't be budged if he is happy in his surroundings.) In recent years, Charlie has designed large dorm complexes at Stanford and the University of Michigan and today, at age 91, is working on another major project.

From my perspective, though, Charlie's most important architectural feat was the design of today's Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices." - Warren Buffett

What's Gold Intrinsically Worth? 
"You don't want to be one of these people, spending years telling reality that it is wrong." - Jason Zweig

Buffett on Value vs Growth 
"I always say if you aren't investing for value, what are you investing for? And the idea that value and growth are two different things makes no sense. I mean, growth is part of the value equation and a company that grows and uses little capital in doing obviously worth more money than one that doesn't grow. That doesn't make the one that doesn't grow valueless though." - Warren Buffett

Bogle on Speculation 
"It's just speculators not speculating on what they think is going to happen but what they think other speculators think is going to happen..." - John Bogle

"This speculative binge that we're seeing here … has nothing to do with the fundamentals behind the long-term value of equities in particular, which are created by the values of corporations, earnings and dividends, and reinvestment in the business." - John Bogle

Activists & the AmEx Buyback, Part II 
"People assume when we buy some stock we want it to go up. We don't want it to go up. Maybe, obviously, eventually... five or ten years from now [we'd like it]." - Warren Buffett

Corporate Hocus-Pocus 
"Berkshire is now a sprawling conglomerate, constantly trying to sprawl further.

Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it." - Warren Buffett

"Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s. The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate's stock to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied 'pooling' accounting to the acquisition, which – with not a dime's worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. - Warren Buffett

Munger on Efficient Markets, Indexing, & Stock Pickers 
"They were teaching my colleagues that the stock market was so efficient that nobody could beat it....I knew it was bull. When I was young I never went near a business school so I didn't get polluted by the craziness.


I never believed it. I never believed there was a talking snake in the Garden of Eden. I had a gift for recognizing twaddle, and there's nothing remarkable about it. I don't have any wonderful insights that other people don't have. I just avoided idiocy slightly more consistently than others." - Charlie Munger

Happy New Year,


Quotes of 2014 Part I & II 

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.