I recently published two SA articles focusing on strengths of Berkshire Hathaway (BRK.B). The first sprang from a Buffett comment about owning stocks you would be happy to own if the market were closed for a significant period and asked which of the five largest U.S. companies by market cap you would be reasonably confident owning if the market were closed for twenty years. I explained why my first choice would be Berkshire and my second would be Exxon (XOM) - the companies with the greatest capital discipline and strongest reinvestment opportunities.
In the second piece I questioned the methodology of an assertion by the recent "Buffett's Alpha" paper that Berkshire's public portfolio had outperformed its private holdings. Not only have the private holdings probably outperformed (although exact measurement is difficult), but I argued that recent major acquisitions have begun a transformation into a New Berkshire Hathaway, which is less an investment company and more an operating company. I saw this transformation as a positive ongoing development which held the promise of renewed and sustained growth.
I have very strong conviction on both of these points, but it would be wrong not to test this positive view against what I see as the two major threats to Berkshire's future. One of these risks, by the way, was articulated very well by archae86 in a comment to the second piece cited above. In this article I will look at what Berkshire has been historically and is currently becoming and also at Buffett, not just as an asset allocator but as the crafter of an institution. I will then examine the two major threats which might diminish a Berkshire without Buffett in command, as well as the means by which they are likely to be addressed.
Buffett and the Berkshire Edge
Warren Buffett (may he live 200 years!) is a cultural icon. As investors, capitalists, and citizens of the land of opportunity Buffett is our anchor. His creation, Berkshire Hathaway, is the shining standard for our liberal capitalist way of looking at the world. But the next decade and decades to follow will test Buffett's legacy. We will find out whether a corporate standard combining integrity and profitability can be more than the product of a single human being.
A Berkshire Hathaway without Buffett is an inevitability. We all know this, and so does Buffett. He has a team in place that is incomparable in quality and which will function very well after he is available only in the realm of seances. (Buffett has an admirable sense of humor about this sort of thing.) The specific functions of executive leadership will continue to be performed with excellence on a day to day basis. The many businesses will continue to deliver regular and growing cash flow. The investment decisions of his two new managers will be excellent. Even the deals will continue to come, although perhaps not quite so easily. I expect, though, that Ajit Jain, Ted Weschsler, Greg Abel and others will find a way to put their heads together and offer Berkshire as Buffett has done - as the buyer of first resort for those who wish to resolve the transition problems of a family business or wish simply to link on as part of a great enterprise.
None of this will be diminished - for the first few years. There are two areas, however, which may be harder to sustain without the presence of Buffett himself.
(1) Human excellence. This is the real Berkshire edge. Will it be maintained?
(2) A unique model of decentralized management but centralized capital allocation. This is made possible in part by the excellence of the managers of the various parts and in part by the authority of Buffett himself, who has allocated capital both internally and externally with no formal help beyond the suggestions and inputs of Charlie Munger and a few of his lieutenants. Is this model sustainable without Buffett?
Let's consider these two questions.
Why Do Such Good People Work at Berkshire Hathaway?
Why? That's easy. They want to live in Omaha. Just kidding of course, but maybe not as entirely as you may at first think. Buffett himself made the decision to live in Omaha after giving the East Coast a try. He has occasionally said that Omaha is just the right distance from New York to think clearly about the markets. I think that's the reductive version of a more complex reason. Omaha is two things. The first is a small city on the edge of the abyss where ships fall off, surrounded by corn fields with giant mechanical irrigators, more than halfway to Japan on the famous New Yorker cover. It is also a mythic realm of the spirit where core American values continue to exist in their pristine form. People, and values, are still simple there. That's the myth, anyway. It's in this dual world - Omaha the hick town and Omaha the repository of American ideals and nostalgia - that Buffett bought the famously modest ($31,500 but paid for) house where he continues to live today.
The amazing thing is that so many extremely capable managers are eager to work for a company with Omaha at its spiritual epicenter. I first thought about this when Todd Combs and Ted Weschsler went to work for Berkshire. Of course they can do their work from wherever they choose, but why, in a world where money is the measure of all things, would they work for less than they could get somewhere else? What was wrong with them? Nothing that I could see. So maybe the question was, what was right with them and wrong with everybody else?
Human beings of great ability generally tend to cluster around the bright lights, but there is something different about the people who work at Berkshire. For one thing its important figures generally seem unassuming and down-to-earth. For another, while they are very well compensated for what they do, most of them would be paid a good bit more if they chose to join another organization and alter their ways of doing things just a little.
Buffett has delivered Jeremiads from time to time on the ridiculous level of executive pay, with special reference to stock options. His message is clear: people should not need special incentives for doing their jobs. Every informed investor understands that he is right about executive pay. It is one of the major ongoing scandals of corporate America. Buffett makes a nominal statement of his own by working for $100,000 a year himself - easy for Buffett, you no doubt think, but also scrupulously consistent with his corporate philosophy and view of effort and reward. He got his billions by being an owner and taking the risks.
What is astonishing is that so many exceptionally capable people not only buy into Buffett's argument about compensation but are willing to work for a company where actual compensation is based on it. Another reader of my previous article cited the case of See's Candies in which the owner sold to Buffett and continued to work for a percentage of the annual cash returned to Berkshire headquarters. Business schools should look at this as a model of the way management should be compensated in the capitalist system. It is a core precept at Berkshire.
In fairness, some of it may have to do with the industries which are Berkshire's largest pieces. Railroads and insurance companies are companies which are usually managed by individuals of high competence who are well paid for that competence but who are not high-fliers like partners at Goldman Sachs. You can't leverage a couple of hundred freight cars fifty to one and "earn" a billion dollars by next Wednesday. So people like Ajit Jain, Tony Nicely, Greg Abel, Tad Montross, and Matt Rose, to name a few, come from the right corporate cultures. So do the many entrepreurs who brought their life's work to Berkshire and stayed on as managers. Still, we Berkshire holders are so familiar with the excellence of this lineup that we may fail to see it as the exception that it is.
We probably grasp the quality of Berkshire people most clearly when the occasional bad apple is exposed. Buffett has fired people from time to time, always like a small town grocery store owner who hates to have caught a kid with his fingers in the till. A firing at Berkshire seldom makes it into the business news until long after the fact. The great exception was the case of David Sokol, who in retrospect never quite seemed to fit at Berkshire (at least to me). He was great at fixing broken areas of the firm, but the way he went about it often seemed to lie somewhere between the darker side of Jack Welch and the unabashed brutality of Al Dunlap. When Sokol was exposed for front-running the Lubrizol deal, Buffett's hesitant response was that of a man stunned by a betrayal he could hardly comprehend. To do such a thing, to betray something so important, for mere... money?
For Buffett, it was never just about the money. Money is just one of the measures, and a bad one - at least not the most important one. There's that moment in the movie Lawrence of Arabia when the makeup of Lawrence's army is changing, and his Bedouin friend warns Lawrence that the newcomers are cutthroats. They come for money. Lawrence may still win the battles, but something important has been lost. The good ones came for something more important than money. They came for Lawrence himself. They came for a great idea.
At Berkshire the good ones came for Buffett. There is really just one question: Will the good ones continue to come to Berkshire (Buffett's great idea) for something more important than mere money?
What Is Berkshire Hathaway anyway?
Berkshire Hathaway is a wonderfully profitable company which has grown from almost nothing in 1965 to the fifth largest American corporation by market cap. But Berkshire is a lot more than that. Berkshire is a validation of principles going back to Adam Smith. It's how the capitalist world should be. Here from Buffett himself are two of the most important principles - in my opinion the most important:
Principle Number One: "Decide early in life to make your money selling things that you really believe are good for your customers."
Principle Number Two: "Lose money and I will forgive you, but lose even a shred of reputation and I will be ruthless."
This is a model of business as a high calling. To understand how rare such principles are, try to think of another figure in finance and business who stands for the same things. The only one who pops immediately to mind is John Bogle, who invented the model of reasonable low-cost investing for amateurs (and many pros, for that matter) and didn't even bother to make himself a billionaire in the process. Both the Berkshire crowd and the Bogleheads are communities interested in making money but not in making money to the exclusion of all other values.
Buffett has gathered into his circle the kind of people who work for the love of doing the work and for the sense that what they do is a high calling. Will this extraordinary culture survive in the long term after Buffett's departure? The appointment of his son Howard as non-executive chairman and custodian of corporate values shows that Buffett himself has some anxiety about this question.
In the absence of Buffett the next tier of executives would certainly close ranks in the effort to keep Berkshire what it has been. Vultures will nevertheless certainly descend upon Berkshire and seek to benefit from spin-offs or financial reengineering. The Berkshire culture will resist. Will the center hold?
There are a few indications to watch for. Are key personnel staying in place and grooming successors? Or is there evidence of in-fighting, jockeying for position, and internal dissent? Do the major new figures continue to leap out as exceptions to the dismaying mediocrity and greed of the American executive class?
A seemingly peripheral but very important signal may be come from the "Woodstock" indicator. The unique qualities of Berkshire are celebrated one weekend a year at the annual meeting, quite properly dubbed the "Woodstock of capitalism." There the principles underlying Berkshire are put on public display. There is Buffett drinking Cherry Coke (which obviously doesn't kill you before the age of 83) and there is Helzberg's Diamonds where you can buy jewelry for your wife where Buffett took his buddy Bill Gates to buy his future wife's engagement ring ("if you don't know jewelry, know your jeweler"). There the chieftains and various categories of footsoldiers and supporters commingle in honest celebration of their shared enterprise - an enterprise where executives, employees, shareholders, and customers form a sort of capitalist commune in the broad tradition of the great American social experiment - a Brook Farm of capitalism.
Will the princes of Berkshire still walk around and commingle with ordinary shareholders? Will the top leaders still sit on a stage and give frank and honest answers to all questions including those of their critics? Do all the public interactions between Berkshire and its various communities continue to have a feeling of authenticity? The signs will be subtle but decisive.
Will the Unique Model of Capital Allocation Be Sustained?
At corporate headquarters in Omaha there are only 24 employees. Berkshire as a whole employs 288,500 people. That is a description of the purest form of operational decentralization. Buffett is not a micro-manager. Berkshire's more than fifty different businesses - the number depends on what you count as a separate entity - manage themselves without day-to-day intervention from headquarters. In fact, there is no intervention from headquarters at all unless something is going seriously wrong - a relatively uncommon event. With a headquarters staff of 24, Buffett clearly does not have the means to engage in detailed operational control. It's a unique frugality among large corporations, but it is also a way in which Buffett has put himself on a power diet. He couldn't intervene if he wanted to. He allows the subsidiaries to run themselves. A major increase in headquarters staff would be a very bad sign.
So what does Buffett do? Surprisingly, the selection of publicly-traded investments is the least of it. The most surprising fact about the publicly held portfolio is it has never involved a research staff. Buffett has always made stock investments the same way you and I do - studied up on a company, thought about it, summoned his reservoir of knowledge and experience, and then decided to buy or not (He rarely decides to sell.) Consider how different this is from the way decisions are made at mutual funds, hedge funds, or Goldman Sachs. At Berkshire Buffett has been helped by Charlie Munger and in the past laid off part of the job to the very capable Lou Simpson. Remarkably, that task is still performed by just three individuals, Buffett, Combs, and Wechsler. Buffett has been continuously increasing the share of the task performed by the other two and that is a good thing. So far it seems likely that the baton will be passed gradually and gracefully to the new managers.
Where Buffett has been uniquely effective is in the larger task of deploying capital within the broader range of options - internally and externally, public holdings and large acquisitions, buyback policy, and cash required for emergencies. When asked exactly where his gifts lie Buffett often uses the term "asset allocator." This puts him in the center of what capitalism is supposed to do - not so much buy shares of stock in an aftermarket as distribute capital to ventures where it produces a return by generating and selling useful products. This is real world capital allocation, and Buffett has become the master of it. When capitalism does this it justifies its existence and primacy among all systems for organizing economic life.
Having started as a Ben Graham "cigar butt" investor Buffett has evolved to being a growth-and-value investor and finally to being the master of a corporate empire which generates enormous amounts of cash flow (more than $2 billion every month). Sums of this magnitude could not be invested to produce above-market returns in the public markets. These surplus cash flows return to headquarters where Buffett allocates them to whatever internal or external, public or private investment offers the best return. Increasingly these investments have been either in special deals involving such things as partnering (the Heinz buyout) or in direct acquisition of whole businesses. When Buffett criticizes himself for having a bad year, it is not for poor returns on his stock portfolio but for failure to make a large acquisition.
It all started with Burlington: I suspected that this is what analysts will say in a decade or two when describing the most recent stage of Buffett's (Berkshire's) evolution. An acquisition like General Re was meaningful in its day: an ingenious way Buffett found in an overpriced market to dilute the percentage of equities in his portfolio without selling by buying a bond-heavy insurance company). But a company like General Re was virtually a bolt-on to Berkshire's ongoing definition as an insurance company (although its legacy derivatives positions gave Buffett fits).
The $26 billion acquisition of Burlington, and a cluster of smaller acquisitions just before and after, were different. Their effect was to set in motion a metamorphosis of Berkshire toward being an operating company. Many of these acquisitions (Marmon, Iscar, MidAmerican Energy, Lubrizol among them) were capital hungry businesses which were able, however, to get a high level of assured return from CAPEX. This provided an ideal symmetry with the insurance side of Berkshire, which generates enormous and regular cash. In my earlier article I referred to Berkshire as the New Berkshire Hathaway, recognizing this elegant and synergistic architecture which pulls in and employs cash in the piston-like fashion of a smoothly operating machine.
The problem with this strategy is that it requires finding good uses of capital for a big chunk of the $25 billion or so of new cash every year. Because of this it is heavily dependent on the attraction of Berkshire's unique culture and on Buffett himself. Entrepreneurs and family business owners have been willing to turn over their life's work to Berkshire at a good price because it is a quality organization with good values and a good place to continue doing what they love without the stresses and succession issues of a stand-alone business. This was also true of publicly traded companies like Burlington and Lubrizol. For a reasonable markup the owners and top executives were willing to merge their assets and their working lives into Berkshire because it does things honestly and correctly and has good future prospects. And also, of course, for Buffett.
Will this institutional structure still work when Buffett no longer runs it? The historical record is mixed. Great organizations do have a way of finding people who can step up when the time comes. Rome kept finding great soldiers, and Britain kept finding great sailors. Roman legions prevailed over the Epirotes, the Carthaginians, and for centuries the barbarian hordes to the north and west. The British Navy prevailed for centuries over the Spanish, the French, the combined Spanish and French, and the German navies. They lost battles but won wars. They lost leaders but new leaders somehow stepped up from the ranks. The secret in both cases was a strong and enduring organizational culture.
It's not impossible, but it's not easy. The Standard Oil Company (now Exxon Mobil, Chevron (CVX), and others) was built well enough to withstand various historical storms and be called one of history's great empires, but most businesses were not. The founding fathers of the U.S. built supremely well, a political system which in ordinary times could be run by a "ham sandwich" and often has been, but which has a way of finding a great leader when one is truly needed. The essence of organizations that do well is that they inspire a community of purpose and conviction. I do believe that Berkshire Hathaway has a good measure of this element.
Can anyone else step up from obscurity and do what Buffett does? The good news is that the next leader of Berkshire probably won't have to. We still probably have plenty of time for Berkshire's future to unfold while potential successors are vetted. There is a pretty good chance that Buffett will carry the transformation of Berkshire quite a bit further on his own watch. I agree with Whitney Tilson that Buffett looks pretty hale and healthy and should be able to continue guiding the fortunes of Berkshire for another five to ten years. Happy and loved human beings who are engaged in the world tend to beat the actuarial tables.
Buffett's life has had such persistent growth in scope and the range of his business skills that it seems unlikely that he would not, at this stage, have given a lot of thought to these questions. One of the marks of great institutional leadership is the ability to relinquish control to subordinates in order to test their ability to rise to future leadership. Ironically, despite the unfortunate frontrunning episode, the Lubrizol deal shows that Buffett has been able to bring his top lieutenants into the deal-making forefront.
Greg Abel at MidAmerican recently took the lead in the NV Energy takeover. Buffett has ceded increasing amounts of investment responsibility to both Ted Weschler and Todd Combs. Weschler, for one, would move immediately to the forefront among possible Buffett successors as deal-maker-in-chief if he stood at Buffett's side for a takeover of DaVita (DVA) or DirecTV (DTV), or another of the major positions which differ somewhat from the profile of Buffett's past. Another candidate for this kind of growth is Matt Rose, who has the strongest operational experience outside of Berkshire's insurance side and was Buffett's partner for Berkshire's BNSF acquisition, which was essentially a handshake deal.
Abel, Weschler, and Rose are about the same age, all about thirty years younger than Buffett, but one should not rule out Ajit Jain, about twenty years Buffett's junior, whose command of the core Berkshire philosophy is unsurpassed. None of Buffett's lieutenants comes in for higher praise or is given freer reign with larger deployments of capital. The fact is that all of these individuals are excellent at their tasks, all have embraced the Berkshire philosophy, and all have shown themselves capable of growth. A simple calling of the roll of these lieutenants suggests that Berkshire should be able to maintain its current level of performance well into the future.