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:
"...capital 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
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).
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