Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results. In later life, I have been surprised to find that this statement holds true in business management as well.
Warren Buffett1
Intelligent control appears as uncontrol or freedom. And for that reason it is genuinely intelligent control. Unintelligent control appears as external domination. And for that reason it is really unintelligent control.
Lao Tzu2
The most profound statement that Warren Buffett has made with regard to the edge that Berkshire Hathaway has over other companies does not pertain to how he values stocks. Nor is it contained within a piece of advice about investing.
It is this: “We do have a few advantages, perhaps the greatest being that we don’t have a strategic plan.”3
Buffett says that the numbers posted by Berkshire Hathaway
have not come from some master plan we concocted in 1965. In a general way, we knew then what we hoped to accomplish but had no idea what specific opportunities might make it possible. Today we remain similarly unstructured: Over time, we expect to improve [our figures]… but have no road map to tell us how that will come about.4
Stephen Schneider of CPS, a company that specializes in this area, points out that strategic plans and leadership are inextricably linked. He defines a strategy as a “process of positioning an organization for future advantage,” which requires a deep understanding of the internal and external factors that influence a company. “Leadership,” he continues, “is the weapon that provides strategic impact,” demanding “the articulation of an argument so compelling that other people see its merits and are prepared to act on it.”5
Professing not to have a strategic plan is therefore an extraordinary statement for the chairman of any public company to make. According to Schneider’s definition of the term, it amounts to an abdication of leadership. The chairman who has no plan has no basis on which to lead.
Equally, he has no road map of the future—and this is sufficient to strike fear into the heart of anyone whose task is to navigate an uncertain terrain and get others to follow him.
All humans, not merely managers and their employees, crave the visibility that strategic plans deliver. Conversely, they loathe uncertainty and will strive to eradicate it. That is why, when human culture advanced to the colonization of new habitats other than the savannah plains where our wiring evolved, instinct told us to map out these areas, find the lay of the land, and familiarize ourselves with the surroundings in order to “remove the terror of a landscape lacking a frame of reference,” as Stephen Pinker puts it.6
By planting guideposts in an uncertain future, strategic plans fulfill this role for the managements of corporations and their employees. They set the direction for the company. Internally, they inform people of their roles, let them know where they are going and how they will get there. Externally, they seek to influence proceedings, shaping the marketplaces in which companies operate, molding them to management’s desires by prescient manipulation of supply and demand.
Schneider is right therefore: Strategic plans are indeed the instruments of leadership. They are a mechanism for subjugating the fear contained in uncertainty that we have been wired to abhor. And they do this by asserting control over it. By proclamation, however, Warren Buffett has no such instrument. In the face of uncertainty, he does not seek control—either internally or externally.
He does, of course, have a very clear goal, which is to grow the value of Berkshire Hathaway at a rate of 15% per annum over the long term. But he has no preconceived notion of how he is going to achieve this, and provides no specific route for his employees to follow:
At Berkshire, we have no view of the future that dictates what business or industries we will enter… We prefer instead to focus on the economic characteristics of businesses that we wish to own and the personal characteristics of managers with whom we wish to associate—and then hope we get lucky in finding the two in combination.7
To Buffett’s mind, the way in which we strive to assert control over the corporate environment, planning, budgeting, forecasting, managing—processes, people, and results, by decree—simply replaces the fear of uncertainty with other fears. Contained in one place, this emotion squeezes out elsewhere, and finds itself expressed in the fear of not complying with ancient rules of behavior that are the accidental impedimenta of every strategy.
For Warren Buffett, strategic plans are the genesis of the institutional imperative, whereby managers are deprived of and/or lose their perspective as allocators of capital.
Therefore, in order for him to retain his perspective, Buffett has excised the strategic plan from his organization. By so doing, he has been able to restrain its dynamics before they get a chance to break into their stride, thereby allowing him to maintain his focus on his vision to act like an owner.
Thus, in respect to both managing the company and managing the managers within it, Buffett lets go of the controls to which most people in his position cling. Strategically, Berkshire Hathaway is effectively inert and in the management of its subsidiaries Buffett does nothing—it seems. But the logic of this approach is that neither he, nor the managers who work for him, ever lose sight of the fact that their job is to act like owners.
After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is how to avoid them.
Warren Buffett8
I kind of made up my management approach as I went along… but I learned more from Warren, and from his example, than from anyone else.
Chuck Huggins, See’s Candies9
So in order to minimize the influence of the institutional imperative within Berkshire Hathaway, Buffett hobbles its dynamics. As we have seen, the principal mechanism by which he does this is to remove the strategic plan from his organization. He says:
To earn 15% annually… will require a few big ideas—small ones just won’t do. Charlie Munger, my partner in general management, and I do not have any such ideas at present, but our experience has been that they pop up occasionally. (How’s that for a strategic plan?)10
To those who cling to strategic plans for the reassurance they provide, and to those whose behavior strategic plans orient, this mindset is deeply disturbing. Buffett relinquishes control in the face of uncertainty. He is spectacularly nonspecific in his management of Berkshire. In effect, he favors torpor over activity. He does not clearly articulate to people what they should do. He does not tell them how to get to their goal. He is reactive to the environment, rather than proactive. He does not appear to manage anything.
There is no dynamic.
The dynamic of the institutional imperative requires a foundation from which it can proceed to extend its influence, tendril-like, throughout an organization. That foundation is the strategic plan.
The strategic plans of companies establish the commitments to which they feel they must remain consistent. This inclines them to polarize around these plans to the exclusion of other possible uses for their capital and usually, since this is where their self-interest is located, to lurch toward growth. That is why Warren Buffett refuses to make a commitment to any of the businesses in which he has chosen to engage.
Having been ensnared by the dictates of commitment before, he is determined not to let this happen again. Hence he makes this statement:
We’re not in the steel business, per se. We’re not in the shoe business, per se. We’re not in any business, per se. We’re big in insurance, but we’re not committed to it. We don’t have a mindset that says you have to go down this road. So we can take capital and move it into businesses that make sense.11
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.
Warren Buffett12
“Taking capital and moving it into businesses that make sense” is the essence of Buffett’s raison d’être.
His resolve not to commit to any particular functional manifestation of capital allocation guarantees that he never loses sight of the fact that the real business he is in, whether he is writing insurance policies, making candy, or training airline pilots, is the allocation of capital.
That explains why he and Charlie
feel no need to proceed in an ordained direction… but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us… Our practice of making this comparison… is a discipline that managers focused simply on expansion seldom use.13
And it explains why commitments at Berkshire Hathaway, such as they are, have no hold over the company: “We can expand the business into any areas that we like—our scope is not circumscribed by history, structure, or concept” [emphasis added].14
If a manager can adopt this perspective, and maintain it (perhaps the most difficult challenge given the way commitments operate), then the efficiency with which capital is allocated will be materially enhanced. Unfortunately, this is not a perspective that most (any?) other chief executives possess. Says Buffett:
After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.15
However, he continues:
The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in some area such as marketing, production, engineering, administration—or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They must now make capital allocation decisions, a critical job that they may never have tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve… [and] in the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)16
Allocating capital is not what these people do. Although capital necessarily forms the DNA of the people, products, marketing, research and development, and plant and machinery that they manage, it is essentially invisible to them. Things are what they touch—processes too. Their managerial function is defined with reference to this to the most important people who check for consistency of behavior with prior definitions of self—themselves.
Given that the salaries of managers (not to say their egos) are correlated with size, the risk of bankruptcy negatively so, and the probability of exercising their stock options, if they have them, considerably enhanced if they are able to stick around for long enough, the self-interest of these people finds itself expressed in a resolve to grow. Given their perspective of their role, it’s only human nature that this should be the case.
At the end of every year about 97% of Berkshire’s shares are held by the same investors who owned them at the start of the year. That makes them savers.
Warren Buffett17
Having graduated from investor to manager, Warren Buffett took a different route to the top. This meant that his insight into the management function was, and still is, entirely novel.
The task facing Buffett as an investor was to find value within the universe of opportunities available, and to buy the one that offers the highest return (risk-adjusted, technically):
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase—irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low price in relation to its current earnings and book value.18
As an investor, Buffett became accustomed to dealing with capital as an abstraction—as the discounted stream of cash produced by those assets in which it is embodied. This abstraction is also available to managers, and they are accustomed to evaluating projects on this basis. Buffett’s physical separation from operational management, however, granted him an intellectual perspective that does not come naturally to managers who have graduated the Jack Welch way. When Buffett exported this perspective to the same function as Welch et al., he became not a manager, steel executive, or insurance man, but an allocator of capital.
Buffett looks on himself as a fragment of a capital market, the job of which is to allocate resources where they can be most efficiently utilized within an economy. Indeed, in a fractal sense, he is a one-man capital market, allocating capital to its point of best use within his area of competence.
As such, Buffett recognizes two characteristics of the capital he manages:
1 It is fungible. It will assuredly become embodied in some form of activity, but Buffett sees the DNA of the form, not its flesh. His concern therefore is not for the form itself but for the replication of each unit of capital that comprises it—and this might be better achieved in some other body host.
2 To the extent that he manages this replication, he does so only on behalf of the company’s shareholders (among whom he is counted, of course). As such, his self-interest is not found in writing insurance policies, or in making widgets. Instead, it is in looking after other people’s savings—and in as much as they store their wealth with him, he husbands it for them in his allocation of capital at Berkshire.
By investing in Berkshire Hathaway for the long term, its shareholders “are automatically saving even if they spend every dime they personally earn,” says Buffett.
Berkshire “saves” for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners’ indirect savings program will be.19
This is what it is to act like an owner in the management of an enterprise.
Most managers have no sense of this perspective. If they have any relationship with the market as allocator of capital, it is one in which they feel they must manage, manipulate, and, in fact, use it to their own advantage. Most often, CEOs consider the market as a nuisance that only complicates their real job, which is to obey the imperative and grow the business. Sometimes they do not consider the capital allocation relationship at all.
Jack Welch’s description of what it is to be a CEO, for instance, may be more colorful than Buffett’s but lacks his clarity, focus, and sense of wider purpose:
Being a CEO is nuts! A whole jumble of thoughts come to mind: Over the top. Wild. Fun. Outrageous. Crazy. Passion. Perpetual motion. The give-and-take. Meetings into the night. Incredible friendships. Fine wine. Celebrations. Great golf courses. Big decisions in the real game. Crises and pressure. Lots of swings. A few home runs. The thrill of winning. The pain of losing.20
The allocation of capital is in here somewhere—in a way. The CEO as corporate saver is most definitely not.
Indeed, comparing Buffett’s perception of his role with Welch’s is rather like the apocryphal story of the article run by a leading national newspaper when the Cold War was at its height. A journalist asked the president of the US and the leader of the Soviet Union, individually, what they would like for Christmas. Next day, it ran with the front-page headline:
Brezhnev Calls for World Peace this Christmas: Carter Asks for Basket of Glazed Fruit
It’s a vision thing. A perspective thing. It’s about putting yourself in context.
This is exactly why Warren Buffett has no strategic plan. In pursuing one, he too would risk losing his perspective in the allocation of capital. The seductive nature of commitments would ensure that were so. Says Buffett, “We think it’s usually poison for a corporate giant’s shareholders if it embarks upon new ventures pursuant to some grand vision.”21 Thus, at every point in the capital allocation process Buffett now stops and measures his use of capital in that venture against all other possible uses:
Prior commitments to particular ventures are no longer subject to the risk of entrapment.
First conclusions are no longer buttressed by the search for reasons in their support, but rather constantly challenged as to whether they stand on their own and relative merits.
Walking away from these invokes no discord within him, because they are superseded by a prior commitment of a greater calling, which is to allocate capital.
He has a way of motivating you. He trusts you so much that you just want to perform.
Bill Child, R.C. Willey Home Furnishings22
Note Buffett’s statement that he and Charlie Munger perform just two tasks at Berkshire Hathaway:
First, it’s our job to keep able people who are already rich motivated to keep working at things they… don’t need to do for financial reasons… Secondly, we have to allocate capital.23
Notice how he puts the motivation of his managers first in order of priority. That’s because, in pursuing his objective of acting like an owner, the strategic impact of Warren Buffett as a leader is to elicit compliance with this objective: to motivate everybody who counts in his organization to think and act in the same way as he does in the allocation of capital.
Buffett’s perspective of the proper function of a manager would count for naught if he could not get the managers of Berkshire Hathaway subsidiaries to tilt their efforts as diligently as he does in the direction of the owners of the firm.
In striving to do this, Buffett has rejected the strategic plan as an instrument of leadership. But that is not to say that he does not have any instrument at all. He does: the vision contained in his ambition to bridge the gap between the management of the firm and its shareholders.
The articulation of the vision: The Owner’s Manual as meme
I want employees to ask themselves whether they are willing to have any contemplated act appear on the front page of their local paper the next day, to be read by their spouses, children and friends.
Warren Buffett24
The philosophy underpinning this ideal is pervasive in Buffett’s behavior at Berkshire Hathaway and in his communication with his shareholders. “Act like an owner” is the meme—the directive from on high—that Warren Buffett spreads throughout his organization. It is in what he says, in what he does, and, as we shall see later, enshrined in the rules of conduct (such as they are) that he prescribes for his managers to follow.
If he specifically distills this meme anywhere in concentrated form, he does so in what he calls the company’s Owner’s Manual. This document—which, interestingly given his entrapment in the textiles industry, did not appear in his annual reports until 1983—has been reprinted in every annual report since then. In it, Buffett articulates the principles that guide his stewardship of other people’s money.
Its main principles are the following:
1 “Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and as ourselves as managing partners… We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.”
2 “We do not measure the economic significance of Berkshire by its size; we measure by per-share progress… The size of our paychecks or our offices will never be related to the size of Berkshire’s balance sheet.”
3 “A managerial ‘wish list’ will not be filled at shareholder expense… We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying through direct purchases in the stock market.
4 “We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.”
5 “We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less.”
Aimed at explaining Berkshire’s “broad principles of operation” to the shareholders of the company, Buffett’s Owner’s Manual furnishes by example the principles to which he expects the managers of his subsidiary companies to adhere.
If we were not paid at all, Charlie and I would be delighted with the cushy jobs we hold.
Warren Buffett25
The greatest strength he has—giving you a lot of freedom to run the business the way you want. And that way, you can’t pass the responsibility back to him.
Ralph Schey26
The Owner’s Manual is no public relations bullshit mission statement, ghostwritten ideals of the marketing department to which the chief executive “aspires” but against which more often fails. This is the substance of the way Buffett behaves, the way he has striven to behave in the past, and the way he most assuredly will behave in the future.
In managerial terms, it occupies the unassailable high ground of corporate governance, to which other public companies do not even come close. And it establishes Warren Buffett’s integrity as corporate saver.
This is important because, as Donald Langevoort notes, “the widespread belief among employees that their firms’ integrity policies are insincere is consistent with a view that the belief is manufactured out of convenience.”27 When this is the case, leaders do not get buy-in. If their employees fall into line with the philosophy espoused, they do so because of the presence of control mechanisms encouraging the desired kind of behavior rather than because they believe in what they are doing. However, says Robert Cialdini:
One problem with controls… is that when people perceive of themselves performing the desirable monitored behavior, they tend to attribute the behavior not to their own natural preference for it but to the coercive presence of the controls. As a consequence, they come to view themselves as less interested in the desirable conduct for its own sake… and they are more likely to engage in the undesirable action whenever controls cannot detect the conduct.28
When intrinsic motivation—behaving in a particular fashion because you believe it is right—is lost, effort falls and compliance is low. Buffett is looking for the inverse of this system among his managers. He wants them to take inner responsibility for their actions.
Rather than telling them how to behave, he would prefer them to pay deference to the authority contained in that still small voice that comes from within. The voice planted there by Buffett whispers the logic of acting like an owner.
Cialdini reports on the effectiveness of this form of motivation.29 Jonathan Freedman conducted an experiment in which he first instructed a group of boys (individually), on pain of punishment, not to play with a toy robot out of a selection of toys made available for them. Consequently, while he was present, they did not. Six weeks later, however, back in the same room but this time with Freedman absent, most of the boys did play with the robot. Externally imposed rules did not work.
Next, Freedman gathered another group who were also warned against playing with the robot. Only this time Freedman added a reason: “It is wrong to play with the robot.” Again, most obeyed the rule. But with this group, six weeks later most were still obeying the rule.
The difference was, of course, that the rule now came from the inside—the boys had decided that they would not play with the robot because they did not want to. They had taken inner responsibility for their actions and it was not necessary for Freedman or anyone else to be present to police their behavior with outside pressures. They could trust them because they had explained why they did not want the boys to play with the robot. Munger confirms a similar view:
Just as you think better if you array knowledge on a bunch of models that are basically answers to the question why, why, why, if you always tell people why, they’ll understand it better, they’ll consider it more important and they’ll be more likely to comply.30
Serendipitously, getting his managers to take inner responsibility for their behavior means that in order to police it, Buffett does not have to be present in the managerial sense of the term; they police their own conduct. He then sets up a virtuous circle in which his managers’ intrinsic motivation is fostered by the very freedom from control that his managerial style requires.
Our contribution to See’s Candies has been limited to leaving it alone. When we bought it, it already had a wonderful culture, a wonderful trademark and a wonderful reputation. Our contribution was not screwing it up. There are a lot of people who would have bought it and would have screwed it up. They would have thought that headquarters knows best.
Charlie Munger31
In managing Berkshire Hathaway’s subsidiary companies toward an objective of growing the intrinsic value of the whole at a rate of 15% per annum, Warren Buffett does not intervene in the conduct of his managers. There is no formal, tangible mechanism of control at Berkshire Hathaway. Instead, Buffett takes his hands off the reins.
He is there as a sounding board whenever required and supplies advice when requested. Says Chuck Huggins:
He’s always available, and that’s really remarkable. He looks at the successes and the mistakes of all these companies that he deals with directly, as well as those where his contact is not direct, and he’s always willing to share whatever lessons there are to be learned.32
Buffett is supportive at all times: “We avoid the attitude of the alumnus whose message to the football coach is I’m 100% with you—win or tie,” he says.33 But he never prescribes behavior. In keeping with his philosophy, if a manager comes to him for counsel, Buffett gives his spin on the situation and then leaves that person to decide what action to take.
He requests only that they “run their companies as if these are the sole asset of their families and will remain so for the next century.”34 As they go about doing this, he assures them that there will be no “show-and-tell presentations in Omaha, no budgets to be approved by headquarters, no dictums issued about capital expenditures.”35 Indeed, there is no centralized budgeting process to which they are either expected to adhere or to contribute. “In most cases,” says Buffett, “the managers of important businesses we have owned for many years have not been to Omaha or even met each other.”
“The only item about which you need to check with me,” he tells his managers, “are any changes in post-retirement benefits and any unusually large capital expenditures.”36 (Projects of sufficient size to have a meaningful impact on Berkshire’s fortunes are those in which Buffett wants to bring his capital allocation skills to bear.)
The principles contained in Buffett’s Owner’s Manual are sufficient to orient his key employees in the right direction—and no more. Thereafter, in putting these into effect, he eschews the role of grand designer. He does not specify how these high ideals should be met at the operating level. Instead, he supplies the barest of rules required to do this. He sets some loosely defined boundaries for the firm to meet its target, creating enabling conditions only for this to be met, and then lets Berkshire Hathaway find its own form. Crucially, this feeds back into allowing his managers to find their own way of complying with Berkshire’s overall objective.
The managers of his subsidiary companies, Buffett says, “are truly in charge.”37
We are surrounded by evidence of the antithesis of Buffett’s managerial model—command and control—and hence of his apparent recklessness in not adhering to it. As Mitch Resnick points out:
When we see neat rows of corn in a field, we assume correctly that the corn was planted by the farmer. When we watch a ballet, we assume correctly that the movements of the dancers were planned by a choreographer. When we participate in social systems, such as families and school classrooms, we often find that power and authority are centralized, often excessively so.38
For instance, when we consider the behavior of a colony of ants, or a flock of birds, we tend also to believe that this complex pattern of behavior is the product of centralized control—an ant general or a lead bird. In fact, this behavior is determined by the interaction between the agents, each of which behaves according to a simple set of rules.
The science behind this principle traces its roots back to a computer simulation developed in 1987 by Craig Reynolds.39 The simulation consists of a collection of autonomous agents—the boids—in an environment with obstacles. In addition to the basic laws of physics, each boid follows three simple rules:
1 Try to maintain a minimum distance from all other boids and objects.
2 Try to match speed with neighboring boids.
3 Try to move forward to the center of the mass of boids in your neighborhood.
Remarkably, when the simulation is run, the boids exhibit the very lifelike behavior of flying in flocks. Their behavior emerges from their interaction. They self-organize. They do not require the existence of a grand plan or a central manager to function efficiently. They produce a symphony without a conductor. They flock even though there is no rule explicitly telling them to do so.
This is Warren Buffett’s model of management.
It was pointed out by a colonel that GE had plenty of intelligent leaders who would always be clever enough to define their markets so narrowly that they could safely remain No. 1 or No. 2…. for nearly 15 years, I had been hammering away on the need to be No. 1 or No. 2 in every market. Now this class was telling me that one of my most fundamental ideas was holding us back.
Jack Welch40
Craig Reynolds showed with his boids that complex behavior can be ordained by simple rules, minimum specifications (min specs) of conduct for each agent. In the same way that Reynolds designed three simple rules governing the behavior of the boids, in imposing external rules of behavior for his managers Buffett designs his in minimum form.
The principles contained in the Owner’s Manual are a recipe for eliciting behavior that is the inverse of the institutional imperative: They set objectives in light of the knowledge that the shareholders of Berkshire Hathaway have alternative uses for their money. The allocation of capital within Berkshire therefore has to meet their return requirements. Nevertheless, with the right rules of behavior in place, Buffett can have complete confidence in setting his managers free to attend to this.
To that end, rather than fall into the same trap as Jack Welch, Buffett has been careful to design rules ensuring that the behavior of his managers self-organizes around the interests of Berkshire Hathaway’s owners. Thus, the rules require the following:
1 Remuneration packages are compatible with the principle of taking inner responsibility for behavior.
2 Self-interest is oriented toward return on capital and not growth.
3 The optimum amount of capital is retained within the enterprise, with the excess sent to Buffett.
4 If Berkshire’s managers find themselves struggling, they do not throw capital at the problem.
However, in designing these rules, Buffett has gone one better than Reynolds. He has turned to nature and borrowed from the codes it conceived for governing behavior—the wiring inside all our brains. Rather than telling people how to behave, Buffett influences the way in which they behave by allowing their wiring to do his management for him. Now his rules are truly min specs.
In Warren Buffett’s fly-by-wiring model, the specifications for managers do not appear as such. The managers’ complicity with his objectives is not forced. Their behavior is completely “natural.” And it taps into the most powerful motivational force that any human knows—one that comes not from complying with rules imposed by some external body, but from within: the intrinsic motivation that Warren Buffett is looking to nurture inside Berkshire Hathaway.
To the casual observer, it may look as though Buffett interferes very little in the day-to-day management of his subsidiary companies, but in reality he is in constant (ethereal) attendance. The trick is to mediate in the interaction between the agents and their environment, rather than to control it.
Buffett is very careful about his incentive schemes, and usually they are the only things he changes in a company when he acquires it. “At Berkshire,” he comments, “we try to be as logical about compensation as about capital allocation.”41
That’s how important this subject is.
First and foremost, therefore, if Buffett is to rely on the intrinsic motivation of his managers to comply with the Owner’s Manual, he has to establish this as correct behavior and answer the natural human question: “What’s in it for me?” He does this with a compensation scheme that rewards “correct” behavior appropriately (and potentially very handsomely). Nevertheless, in accordance with the principle of getting people to take inner responsibility for their actions, the primary driver in his compensation packages is that people should own their efforts. That is why they only get paid in relation to the performance of the part of the organization that they can influence. Says Buffett:
Arrangements that pay off in capricious ways, unrelated to a manager’s personal accomplishments, may well be welcomed by certain managers… But such arrangements are wasteful to the company and cause the manager to lose focus.42
The origin of that loss of focus can be found when a manager becomes distracted by behavior that is in his best interest. Leaving his colleagues to attend to the greater good, he knows that they will deliver the bonus that is tied to overall corporate performance. In this kind of free-rider problem, the catch is, of course, that a manager rarely operates under this illusion alone.
To obviate this tendency, Buffett employs an
incentive compensation system that rewards key managers for meeting targets in their own bailiwicks. If See’s does well, that does not produce incentive compensation at the News—nor vice versa… In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls… We believe, further, that such factors as seniority and age should not affect incentive compensation… a 20-year-old who can hit .300 is as valuable to us as 40-year-old performing as well.43
At Berkshire Hathaway, you reap what you sow.
In contrast, at GE Jack Welch took the opposite tack. He scrapped a system similar to Buffett’s stating that “if you did well—even if the overall company did poorly—you got yours.”44 His reasoning was sound. A compensation system like Buffett’s did not support the behavior he required. “If we wanted every business to be a lab for ideas, we needed to pay people in a way that would reinforce the concept,”45 he said, and a company-wide bonus scheme “reinforced the idea of sharing among the top 500 people.”46
However, this was all about managing change, shape shifting the whole company in response to new threats and opportunities. That is why Welch also changed his compensation systems. He said:
Static measurements get stale. Market conditions change, new businesses develop, new competitors show up. I always pounded home the question “Are we measuring and rewarding the behavior we want?”47
Buffett has no such worries. If he had to change his compensation system at every turn, then he’d be using the wrong one. A company like Berkshire, which earns over 20% on its equity and reinvests the lot, has the potential to renew itself every four to five years and there’s only one type of behavior that needs to be measured and rewarded when this is the case: that those responsible for reinvestment act like owners.
Having assured his managers that they will receive reward in proportion to their own efforts, Buffett lets them know how he measures that. It is not measured in the growth of their managerial domain, it is by the return on the capital that they tie up in the business.
Buffett will not tell his managers what constitutes the right amount of capital to retain in a business, however. That would be imposition of an external control. Instead, he lets them decide what this is. But, says Buffett:
When capital invested in an operation is significant we… charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release.48
Buffett is happy to fund businesses that have the opportunity to grow profitably. “Guess what you get to do today?” he tells new managers. “Start breaking all your banking relationships, because from now on I’m your bank.”49 But he also wants to ensure that if they do need recourse to external financing, it comes from Berkshire and not some other intermediary. Buffett wants to be able to charge them for the true cost of employing that capital, which is the opportunity cost of what it would earn if he deployed it elsewhere. “Easy access to funding,” he says, “tends to cause undisciplined decisions.”50
Thus, a manager’s results are only credited in relation to the amount of capital employed to produce them, and a manager’s self-interest becomes defined in relation to this metric. It is vital that this is so, because the predictable sustainability of the profitability of Berkshire’s noninsurance operations provides a significant competitive advantage to its insurance businesses. Buffett observes:
In managing insurance investments, it is a distinct advantage to know that large amounts of taxable income will consistently recur. Most insurance companies are unable to assume consistent recurrence of significant taxable income. Berkshire insurance companies can make this assumption confidently, due to the large and diverse streams of taxable income flowing from Berkshire’s numerous non-insurance subsidiaries.51
As a rule, insurance companies have to invest most of the capital supporting their operations in high-grade fixed-income instruments.52 Warren Buffett can hunt for bigger game and therefore out-earn the industry.
However, as much as rewards for posting high-return-on-capital results are on offer to the managers of Berkshire’s subsidiaries, Buffett also puts them at risk. He says:
If Ralph [Schey, for example] can employ incremental funds at good returns, it pays him to do so. His bonus increases when earnings on additional capital exceed a meaningful hurdle charge. But our bonus calculation is symmetrical: If incremental investment yields substandard returns, the shortfall is costly to Ralph as well as Berkshire. The consequence of this two-way arrangement is that it pays Ralph—and pays him well—to send to Omaha any cash he can’t advantageously use in his business.53
He continues:
It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside. Many “alignment” plans flunk this basic test, being artful forms of “heads I win, tails you lose” [emphasis added].54
At Berkshire, however, managers “truly stand in the shoes of owners.”55
Putting rewards at risk is an important concept. Once again, it does not seek to impose a rule that defines how much capital to employ, but it does tap into an internal rule of behavior that Buffett can rely on to do his management for him, in this case loss aversion, which is that integral part of human wiring anchoring most contestants on the television show Who Wants to Be a Millionaire? to the questions they know they can get right.
In accordance with the principle that managers will receive compensation for performance within their own remit, Buffett also ensures that “performance” is defined appropriately—in this instance by reference to the business cards they have been dealt.
Warren Buffett is not biased in his attribution of talent. When he looks at managerial performance he does not blindly ascribe it to the personal qualities of his managers, rather than the quality of the businesses they happen to be running. Therefore, he does not make the mistake—as the majority do—of rewarding managers in businesses in which excellent results accrue by dint of the fundamentals of the business more highly than those equally skillful managers toiling to eke excellent results out of less attractive businesses. For the latter, who—like the majority—ascribe their performance more to the situation they find themselves in, rather than to their own particular talent, this would appear grossly unfair, and the danger is they would start to work in their own interests, rather than for Berkshire Hathaway.
To counteract this, Buffett defines performance
in different ways depending on the underlying economics of the business: in some our managers enjoy tailwinds not of their own making, in others they fight unavoidable headwinds.56
Therefore, he tailors each package to fit the degree of difficulty of the enterprise being managed: “the terms of each agreement vary to fit the economic characteristics of the business at issue.”57 This grants him the perspective to be able to recognize and reward, and therefore incentivize, those “excellent managers”58 who nevertheless “struggle” in difficult environments. Thus at Berkshire managers get paid according to ability, and in the past Buffett has found managers of his less than stellar businesses to be “every bit the equal of managers at our more profitable businesses.”59 Buffett’s capacity to distinguish between the individual and the environment means that he does not alienate his managers.
Basing his compensation packages on return on capital and putting bonuses at risk naturally remove a bias to growth from Buffett’s managers. Growth is not ruled out (you might be able to raise returns by getting larger), but it is not generally a profitable strategy to pursue, and may well prove costly to both Berkshire and the manager.
However, Buffett reinforces this notion with two other characteristics of his incentive schemes. First, given the role that options play in the growth dynamic (people get paid for sticking around and the best way of doing this is by growing), Warren Buffett does not use options—full stop. At Berkshire Hathaway, nobody is incentivized to grow for the sake of raising the odds that, one day, they may strike it lucky merely by being there.
Secondly, Buffett says, “We never greet good work by raising the bar.”60 In other words, if you are doing a good job with the cards dealt to you in your particular industry, and thereby earn a bonus, next year Buffett will not make it harder for you. Buffett’s managers have everything to gain by moving forward at top speed, but nothing to lose by standing still (if standing still is already excellent). The CEO who resets hurdle rates when they are exceeded runs the risk of encouraging managers who have this year’s bonus “in the bag” to hold some back for next year, and those who do not to destroy results this year so that a bonus may be earned next, when year-on-year results are measured.
Once he has established in your mind what excess capital is—it’s that which is left over after you have exhausted the possibility of garnering reward from your own efforts and you’re afraid it will cause you losses if you hang on to it—Buffett requires that it be forwarded to him.
This is a very simple rule. It is also very powerful.
It is in the deployment of excess capital that Buffett finds most managerial shortcomings. Generally this is because managers define themselves as managers rather than as allocators of capital, and this lays down an open invitation to the institutional imperative. Buffett observes:
By sending it to us, [managers] don’t get diverted by the various enticements that would come their way were they responsible for deploying the cash their businesses throw off.61
In other words, by taking control of the allocation of all of Berkshire’s excess capital, Buffett ensures that it is taken from those whose wiring may be prone to the intrusion of the imperative and given to one whose wiring—by adaptation—is not.
Nevertheless, what happens to those managers who truly are struggling? Those who are slipping behind even in tasks already recognized as difficult?
Buffett simply reassures these people of their position within Berkshire Hathaway. He is immensely loyal. As we shall see in the next chapter, he has gone to great lengths to get these people on board, and part of the package he offers them is that he is not in the habit of discarding poor-performing businesses so that he can pick up good ones. “Gin rummy managerial behavior (discard your least promising business at each turn) is not our style,” he says.62 Equally, he tells his managers: “I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return.”63 And, again as we shall see later, he does not judge performance on a short-term basis, already having factored into the purchase price of the businesses he acquires (which supply their own managers) the chance, nay the expectation, that success will not be an ever-present constant.
Thus reassured, struggling managers at Berkshire Hathaway who contemplate losses, either materially in their own incentive programs or relatively against prior reference points of performance, are not inclined, as most are when in a hole, to up the ante in order to get back to break even. By eradicating this “get-evenitis,” as Hersh Shefrin calls it,64 Buffett ensures that his managers do not succumb to the natural human response when threatened, which is to scramble madly in order to avoid the consequences—in this case by throwing capital at the problem—because, ultimately, in terms of their personal survival, there are none.65
Buffett’s retort to those in trouble? “You don’t have to make it back the way that you lost it.”66
Contracts cannot guarantee your continued interest; we… simply rely on your word.
Warren Buffett67
Having opened up the void between himself as owner and his managers, economists would recommend to Buffett that he elicit their compliance with his objective that they should act like owners too, by appealing to their selfish nature that would otherwise result in them pursuing their own interests.
Buffett knows that when his managers go to work in the morning, they do so as volunteers, able to determine within the guidelines set for them exactly how much of themselves they are willing to invest in the task at hand.68
Rather than appealing to their selfishness, Buffett prefers to appeal to their basic instinct to reciprocate his trust and the fairness with which he treats them (contained primarily in his min specs, which are designed above all else to be fair and to be perceived as fair) with diligence, honesty, and effort. In this way he can tap into the willing volunteer that exists in all of them.
Therefore contracts of employment, the device normally used to establish and enforce relationships within most workplaces, do not exist at Berkshire Hathaway. Warren Buffett does not believe in them—largely because he perceives them as a poor, second-best alternative for controlling managers.
By dint of the leeway that managers are given within Berkshire Hathaway, however, legal contracts are replaced with the same social contract that Buffett has engineered between himself and his shareholders (specified in the Owner’s Manual), which is premised not on Berkshire’s shareholders having recourse to the armory of enforcement sanctions available to them as owners of the firm, but on trusting him to do their bidding because he is intrinsically motivated to do so.
The same motivational mechanism that works for Buffett works for those over whom he presides: “Our basic goal as an owner,” he says, “is to behave with our managers as we like our owners to behave with us.”69 Therefore, in the same way that he is granted his freedom by his shareholders, he sets his managers free—pursuing a decentralized style of leadership that actively encourages the very separation of control from ownership that is so troubling to many.
Doing this fosters managers’ self-esteem, and with freedom to manage their self-determination is enlarged. This gives them a chance to show that they are doing the job because they love to, because they believe in the correctness of acting like owners, and not because Buffett is looking over their shoulders. And this is the mechanism by which intrinsic motivation is crowded in: Buffett can rely on their word.70
In contrast, command systems that crowd out intrinsic motivation set up a vicious circle in which control mechanisms escalate even as compliance falls. Sometimes these can be made to work. At GE, for instance, managers who do not acquiesce are sacked and, over time, the company has self-selected those personality types that thrive in a high-pressure, controlled environment. But systems like this require huge policing efforts on the part of senior management.
Buffett has no such problems. At Berkshire Hathaway, the only control he has left when he abrogates the normal tools of management is one based on trust, fairness, and reciprocity. Paradoxically, this creates loyalty among his managers and obedience to his wishes manifesting themselves in an overwhelming eagerness to please, rather than (which an economist or like-minded corporate manager might expect) a sly keenness to cheat. This should not be surprising. Trust, fairness, and reciprocity form the basis of the same social glue that has carried successful human organizations all the way from the savannah plains of Africa, where it evolved as the first-best solution to cooperation, exchange, and progress.
I try to make every shareholder proud. I feel very obligated to try to do that. I don’t want to run a company that you read bad things about in the newspaper.
Al Ueltschi, FlightSafety International71
As the institutional imperative seeks out the path of least resistance within companies, normally finding this in a manager’s interest in growing the business, within Berkshire Hathaway it zeroes in on the loyalty that Buffett shows to those with whom he has entered into a commitment.
Buffett still makes the occasional mistake in this regard. In a letter to his shareholders on November 9, 2001, he had to explain why he had overstayed his welcome in his ill-advised Dexter Shoe acquisition. He informed them:
At Dexter, we have sadly and reluctantly ended shoe production in the U.S. and Puerto Rico. We had an outstanding labor force but the ten-for-one wage advantage enjoyed by competitors producing elsewhere in the world finally forced us to act—after our having delayed longer than was rational. I cost you considerable money by my unwillingness to face unpleasant facts when they first became obvious.72
Having corrected for this type of error after his initial foray into Berkshire textiles, Buffett has virtually eliminated the “loyalty problem.” By ensuring that he only enters into commitments with people who also manage businesses that can create value on a durable basis, or at worst are likely to earn a minimum rate of return, Buffett’s internal conflict, which pits him acting like an owner for his shareholders versus him acting like a compassionate owner for his managers, is noticeable by its rarity.
Nevertheless, in spite of his vow not to abandon businesses for the sake of a marginal contribution to performance, any subsidiary that no longer holds out the prospect of earning its required rate of return will be put on severe capital rations. Not directly by Buffett, however, but by its own managers, acting out of an instinct borne of adhering to Buffett’s min specs.
Overridingly at Berkshire Hathaway, good money is not thrown after bad. Managers’ compensation packages reflect economic reality and Buffett has designed his min specs to ensure that they can still do well, and feel they are doing well, by competently managing businesses that face headwinds. More importantly, they are also intrinsically motivated to act as the owners of Berkshire Hathaway would want them to, and this kind of motivation transcends material gain.
To show how far this goes, managers who have found in the past that they have run out of opportunities to deploy their capital at returns comparable to those available elsewhere have been content—contrary to normal managerial instinct—to see their domains get smaller and smaller. At Berkshire, size does not matter—to anybody. Thus, after several years of harvesting cash from the “cornerstone businesses” of Berkshire Hathaway that existed at its inception after he closed the Partnership, Warren Buffett was able to report that they had “(1) survived but earned almost nothing, (2) shriveled in size while incurring large losses, and (3) shrunk in sales volume to about 5% its size at the time of our entry.”73 And yet, in his letter to his shareholders in 2000, Buffett could boast that “in our last 36 years Berkshire has never had a manager of a significant subsidiary voluntarily leave to join another business.”74
That is compliance.
Deep inside Berkshire Hathaway, Buffett has created an environment in which his managers are content to act in the interests of the company’s shareholders, even if this means passing up the temptations of the institutional imperative—a rare alignment. Going forward, any capital that cannot be employed profitably within one of Berkshire’s subsidiaries over the long haul will not be consumed by a manager who acts in his own interests, but will surely find its way into the hands of someone who can put it to good use. For instance Ralph Schey, the CEO of one of Berkshire’s largest subsidiaries, Scott Fetzer, was able to distribute $1,030 million to Buffett compared with a net purchase price of $230 million, during the 15 years of his tenure.75 And Chuck Huggins at See’s Candies put up earnings of $857 million pre-tax by 1999, on a purchase price of $25 million in 1972, absorbing very little additional capital in the meantime.76
The reciprocal nature of the contract between Warren Buffett and his employees achieves results such as these. It allows him to set them free. The company then moves in a direction set by Buffett but guided by min specs. These are not so much external impositions on behavior as they are internal—driven intrinsically by their wiring, in harmony with that wiring, and perceived as fair (and they therefore should be reciprocated with effort). In turn, this means that he can set his employees free—and this fosters the very intrinsic motivation on which the notion of decentralized management depends. The result is that the employees of Berkshire Hathaway flock to Warren Buffett even though there is no rule explicitly telling them to do so.
This is the intelligent control of Lao Tzu. This is leadership.
In the next chapter we will find out how the acquisitions that Buffett makes are shaped in such a way as to dovetail seamlessly into this model of leadership, if anything enhancing its effectiveness rather than multiplying its problems as Berkshire Hathaway grows in size and complexity.