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December 15, 2023 - February 10, 2024
His contrarian insight was that companies with low capital needs and the ability to raise prices were actually best positioned to resist inflation’s corrosive effects. This led him to invest in consumer brands and media properties—businesses with “franchises,” dominant market positions, or brand names. Along with this shift in investment criteria came an important shift to longer holding periods, which allowed for long-term pretax compounding of investment values.
Charlie Munger has said that the secret to Berkshire’s longterm success has been its ability to “generate funds at 3 percent and invest them at 13 percent,” and this consistent ability to create low-cost funds for investment has been an underappreciated contributor to the company’s financial success.1 Remarkably, Buffett has almost entirely eschewed debt and equity issuances—virtually all of Berkshire’s investment capital has been generated internally.
The company’s primary source of capital has been float from its insurance subsidiaries, although very significant cash has also been provided by wholly owned subsidiaries and by the occasional sale of investments. Buffett has in effect created a capital “flywheel” at Berkshire, with funds from these sources being used to acquire full or partial interests in other cash-generating businesses whose earnings in turn fund other investments, and so on.
When Buffett acquired National Indemnity in 1967, he was among the first to recognize the leverage inherent in insurance companies with the ability to generate low-cost float. The acquisition was, in his words, a “watershed” for Berkshire. As he explains, “Float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money.”
This sawtooth pattern of revenue (see figure 8-2) would be virtually impossible for an independent, publicly traded insurer to explain to Wall Street. Because, however, Berkshire’s insurance subsidiaries are part of a much larger diversified company, they are shielded from Wall Street scrutiny. This provides a major competitive advantage—allowing National Indemnity and Berkshire’s other insurance businesses to focus on profitability, not premium growth.
In both insurance and investing, Buffett believes the key to longterm success is “temperament,” a willingness to be “fearful when others are greedy and greedy when they are fearful.”
Whenever Buffett buys a company, he takes immediate control of the cash flow, insisting that excess cash be sent to Omaha for allocation. As Charlie Munger points out, “Unlike operations (which are very decentralized), capital allocation at Berkshire is highly centralized.”
the more investment options a CEO has, the more likely he or she is to make high-return decisions, and this broader palate has translated into a significant competitive advantage for Berkshire.
A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns. The outsider CEOs were generally ruthless in closing or selling businesses with poor future prospects and concentrating their capital on business units whose returns met their internal targets.
Buffett’s approach to managing Berkshire’s stock investments has been distinguished by two primary characteristics: a high degree of concentration and extremely long holding periods.
Buffett believes that exceptional returns come from concentrated portfolios, that excellent investment ideas are rare, and he has repeatedly told students that their investing results would improve if at the beginning of their careers, they were handed a twenty-hole punch card representing the total number of investments they could make in their investing lifetimes.
The top five positions in Berkshire’s portfolio have typically accounted for a remarkable 60–80 percent of total value. This compares with 10–20 percent for the typical mutual fund portfolio.
He has held his current top five stock positions (with the exception of IBM, which was purchased in 2011) for over twenty years on average. This compares with an average holding period of less than one year for the typical mutual fund.
Buffett has created an attractive, highly differentiated option for sellers of large private businesses, one that falls somewhere between an IPO and a private equity sale. A sale to Berkshire is unique in allowing an owner/operator to achieve liquidity while continuing to run the company without interference or Wall Street scrutiny. Buffett offers an environment that is completely free of corporate bureaucracy, with unlimited access to capital for worthwhile projects. This package is highly differentiated from the private equity alternative, which promises a high level of investor involvement
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As Charlie Munger has said about Berkshire’s approach to acquisitions, “We don’t try to do acquisitions, we wait for no-brainers.”
the touchstone of the Berkshire system is extreme decentralization.
The CEOs who run Berkshire’s subsidiary companies simply never hear from Buffett unless they call for advice or seek capital for their businesses. He summarizes this approach to management as “hire well, manage little” and believes this extreme form of decentralization increases the overall efficiency of the organization by reducing overhead and releasing entrepreneurial energy.
Buffett has developed a worldview that at its core emphasizes the development of long-term relationships with excellent people and businesses and the avoidance of unnecessary turnover, which can interrupt the powerful chain of economic compounding that is the essence of long-term value creation.
The outsider CEOs believed that the value of financial projections was determined by the quality of the assumptions, not by the number of pages in the presentation, and many developed succinct, single-page analytical templates that focused employees on key variables.
“Capital discipline is so ingrained in our managers that very few low-returning proposals are ever presented to us.”
their companies were “an odd blend of decentralized operations and
The outsider CEOs were also distinctly unpromotional and spent considerably less time on investor relations than their peers. They did not offer earnings guidance or participate in Wall Street conferences. As a group, they were not extroverted or overly charismatic.
These executives were capital surgeons, consistently directing available capital toward the most efficient, highest-returning projects. Over long periods of time, this discipline had an enormous impact on shareholder value through the steady accretion of value-enhancing decisions and (equally important) the avoidance of value-destroying ones. This unorthodox mind-set, in itself, proved to be a substantial and sustainable competitive advantage for their companies.
Today, the combination of record corporate cash levels and generally low interest rates and P/E ratios presents a historic opportunity for aggressive capital allocation. This
Fundamentally, Stonecipher, Tillerson, and their fellow outsider CEOs achieved extraordinary relative results by consistently zigging while their peers zagged; and as table 9-1 shows, in their zigging, they followed a virtually identical blueprint: they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.
The right capital allocation decision varies depending on the situation at any given point in time.
They had the perspective of the long-term investor or owner, not the high-paid employee—
The good news is that you don’t need to be a marketing or technical genius or a charismatic visionary to be a highly effective CEO. You do, however, need to understand capital allocation and to think carefully about how to best deploy your company’s resources to create value for shareholders. You have to be willing to always ask what the return is and to go forward only with projects that offer attractive returns using conservative assumptions. And you have to have the confidence to occasionally do things differently from your peers.
