CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than solve it.
Warren Buffett1
At Berkshire, our carefully-crafted acquisition strategy is simply to wait for the phone to ring.
Warren Buffett2
Ultimately, Warren Buffett does one of two things with the excess cash that his managers send him. He invests it in the stock market or, preferably, he uses it to buy other companies outright, which is no easy task. As he says:
Many managements were apparently overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain that their managerial kiss will do wonders for the profitability of Company T(arget)… We’ve observed many kisses but very few miracles.3
The fact is, Buffett is right: The miracle-to-kiss ratio is low—far lower than those who pucker up might imagine.
Most studies put the percentage of mergers and acquisitions that fail to create shareholder value at over 60%. So whenever two companies come together in an embrace, the chances are high that the initiator of this act will destroy value in the capital with which it cements the relationship. Moreover, even if return on capital is not uppermost in the minds of management, it remains the case that the majority of acquisitions still fail to live up to their expectations, whether these be measured in cost savings, revenue enhancement, or profitability. Indeed, often-times they will seriously impair their entire business in the process.
In deploying the savings of his shareholders in this field, therefore, the odds are against Warren Buffett. Nevertheless, he is unabashed.
“What really makes us dance is the purchase of 100% of good businesses at reasonable prices,” he says, and he has premised the growth in Berkshire Hathaway’s economic value largely on the back of acquiring other companies.4 This means finding the right businesses, buying them at the right price, and thereafter ensuring that they continue to perform in the fashion that he found attractive in the first place—the latter representing the rock on which so many acquisitions fail. So Buffett had better be sure of his case.
He is. When Warren Buffett commits to an acquisition, he chooses the businesses and managements with whom he wants to associate very carefully, sets out his stall to get these to come to him, stacks the odds in favor of consummating the marriage at a fair price, and thereafter elicits massive loyalty and complicity with his objectives.
Whether he is making acquisitions of controlling interests in other companies or investing in them, the same requirement is made of Warren Buffett: He has to make a judgment as to the appropriate valuation of the company in question. Nevertheless, it is with respect to his ventures into the stock market that his approach to this task has attracted most attention, and he is famous for at least three characteristics that he brings to bear in this arena. These are:
1 His ability to strip emotion from his analysis. “Success in investing,” he says, “doesn’t correlate with IQ once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing.”
2 His discipline with respect to price. “Rule No.1,” he says, is “Never lose money.” And “Rule No. 2: Never forget rule No.1.”5
3 His preference for investing only in business franchises. “Look for the durability of the franchise,” maintains Buffett when assessing an economic model. “The most important thing for me is figuring how big a moat there is around a business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”6
Yet, as recognizable as this identikit of Warren Buffett the investor remains when describing Warren Buffett the acquirer of entire corporations, it fails to capture the full likeness of a man who engages in an exercise in which the odds of failure are even higher than those of picking individual stocks that will outperform an index.
It cannot. The art of making successful acquisitions is more complex than investing in the stock market. It requires additional skills and it calls for a modification of those enumerated characteristics for which Buffett is most famous. This is “an extraordinarily difficult job,” he confirms, “far more difficult than the purchase at attractive prices at fractional interest.”7
Asked what he looks for when he acquires a controlling interest in another company, Buffett replied:
I would think very hard about getting into a business with fundamentally good economics. I would think of buying from people I can trust. And I’d think about the price I’d pay.8
This chapter will take each of these in order and delineate where the challenges exist in effecting successful corporate acquisitions, how Warren Buffett overcomes these, and where the modification of his best-known traits lies.
Economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to high business returns.
Warren Buffett9
Widen the moat: build enduring competitive advantage, delight your customers, and relentlessly fight costs.
Warren Buffett10
Having learnt his lesson the hard way in Berkshire Hathaway’s textiles operations, the economics of the businesses that Buffett acquires are now of paramount importance to him.
Buffett was under no illusion as to the deficiencies of the textiles industry when he bought into it. He knew he would be selling a product that could not be differentiated from the offerings of his competitors, that those competitors were numerous, and that barriers to entry existed only to those without capital. He knew, therefore, that at best the returns on capital employed in this business would be low. Attempts to stay ahead of the curve, say by investing in state-of-the-art plant and machinery, would grant temporary reprieve but, in the long term, the benefits of these kinds of expenditures would fail to stick to Berkshire’s ribs. Instead, because of competitive pressures, they would be passed on to consumers in the form of lower prices and higher quality.
The law of the economic jungle is that high returns on capital revert to the mean. Unless a business is characterized by sustainable competitive advantage, observes Buffett, it “earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight.”11 Recurrent capital expenditures in Berkshire’s textiles business therefore would not become instruments of competitive advantage, but would be the price of staying in the game.
However, Buffett did believe that prescient management could stem the tide of these poor fundamentals and make a difference at the margin.
What he found was that these unattractive business economics are not susceptible to a cure by even the most skilled of managers. He says:
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row.12
We could all go count restaurants for the next three miles and in five years, many of them will not be there with the same names. There are no prizes if you don’t run them right. That’s why I buy good businesses to begin with.13
Henceforth, therefore, Buffett would look to acquire businesses with economic characteristics that were the obverse of the textiles industry: in particular businesses possessed of sustainable competitive advantage, where the price of staying in the game, as measured by the level of capital expenditure required merely to maintain competitive position, is low.
Sustainable competitive positions produce the economic returns that Buffett is seeking. High levels of profitability on a low capital base, combined with low maintenance costs, produce the excess capital that can be recycled into growth opportunities within the industry (or elsewhere).
Given that he is renowned on the topic, however, it is commonly believed that ever since the Damascene revelation imparted by Charlie Munger, Warren Buffett has sought out durable competitive advantage in companies that occupy competitive positions of a certain type. Buffett’s definition of the term “franchise” describes a company that offers a product or service that: “(1) is needed or desired; (2) is thought by its customers to have no close substitute; and (3) is not subject to price regulation.”14
Since they are “virtually certain to possess enormous competitive strength ten or twenty years from now,”15 companies that occupy such franchises are generally thought to be the ones that Buffett looks to own and invest in. And they possess the quality of last resort to which Buffett is attracted. “Franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”16
However, while Buffett’s definition of a franchise might easily fit the more famous of the companies in which he has fractional stakes—such as Coca-Cola, Gillette, and American Express—it does not appear to cut the mustard with that long list of companies that Buffett owns outright.
Buffalo Evening News, Executive Jet, FlightSafety, and See’s Candies all fit the bill. Each has an inimitable position in its industry. But where exactly are the castellations of H.H. Brown Shoe Co., Nebraska Furniture Mart, and Fechheimer Bros. Co.? How exactly do R.C. Willey Home Furnishings, GEICO, International Dairy Queen, and Borsheim’s pull up the drawbridge against the competition?
This is an unlikely (and incomplete) list of companies for those seeking to identify businesses that possess strong franchises in the sense that most people would understand the phrase, and certainly not as it has come to be associated with Warren Buffett. As Buffett himself said in his year 2000 letter to the company’s shareholders: “We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement.”17
Nevertheless, all of these companies do occupy franchises of a sort.
Products and services “that have no close substitute” are not the sole preserve of companies that sell unique-tasting colas, state-of-the-art shaving systems, or fractional ownership of airplanes. Warren Buffett has found that sustainable competitive advantage can also be found in the combination of two factors: permanently low-cost offerings and managerial excellence that is baked into a corporate service culture.
GEICO’s sustainable cost advantage is what attracted me to the company way back in 1951, when the entire business was valued at $7 million. It is also why I felt Berkshire should pay $2.3 billion last year [1996] for the 49% of the company that we didn’t then own.
Warren Buffett18
Since GEICO is the Berkshire subsidiary that sells perhaps its most commodity-like product and therefore the company that we should least expect to occupy a franchise, it serves as a useful example of Buffett’s seemingly contradictory logic. It is distinguishable from other purveyors of auto policies purely by the fact that it is the low-cost operator in the industry.
This does not mean that the company is immune to the vagaries of that industry or, indeed, to mistakes of its own commission. In the 1970s, it ran into extremely severe operating difficulties. “They made all kinds of mistakes,” says Buffett, they “didn’t know their costs… and they got captivated by growth.”19
However, the company was able to tolerate mismanagement. In Buffett’s words, although “they did all kinds of things wrong… they still had the franchise. They still were a low cost operator.”20 This is what sustained them. And this is what will continue to sustain them. Buffett said in 1986, for instance:
The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise.21
In a difficult industry, characterized by intense competition, low barriers, or mixed results, because GEICO’s cost structure relative to that of its competition can be forecast with near certainty, Buffett can assure himself that the advantage accruing from this is sustainable. GEICO will out-earn the industry.
So it is with Buffett’s other subsidiary companies. He comments:
We don’t care whether we’re buying into a people-intensive business, a raw-material intensive business or a rent-intensive business. We want to understand the cost structure.22
Nebraska Furniture Mart et al. share the same characteristic. They are low on the overhead, incidental, and running costs that other companies seem to accumulate by degree. Knowledge of this fact does not allow for its replication by a competitor. A company might be able to attain similar business economics at a given point in time. However, the ability to sustain and improve these economics comes from a managerial mindset that few possess. This advantage is passed on to the consumer in price and selection, setting up a virtuous circle whereby Buffett’s companies tend to dominate the markets in which they operate. Thus, they garner economies of scale that, in reality, cannot be matched by the competition, and these are also passed on in price.
I don’t worry about the dumbest competitor in a business that’s service-oriented.
Warren Buffett23
As well as being low cost, most of Berkshire’s subsidiary companies are also essentially service providers, and quality of service at the point of execution is an essential element of the franchise in which Buffett is interested. Buffett is attracted to some industries in which players only have to be smart once. The Buffalo Evening News dominates its market, for instance. In order to emerge as number one, it had to do something clever in some point in its history. But thereafter, as the community bulletin board, it would have to do something dumb to lose its position. By comparison, retailers and their like have to be smart every day, and a major part of being smart is the provision of a customer experience that gets people to come back.
In 1996, for example, Buffett observed:
See’s is different in many ways from what it was in 1972 when we bought it: It offers a different assortment of candy, employs different machinery and sells through different distribution channels. But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business. Moreover, these motivations are not likely to change over the next 20 years, or even 50.24
Buffett’s managers understand the service business. They know how to drive their passion for the business down to the point of execution, to people whom they may not be able to see but whom they know will share their ethos. It’s a reflection of the same leadership skills that Buffett possesses and it all starts with the men and women who run the companies.
The Blumkins, the Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan Lipsey, Ralph Schey and Frank Rooney… are all masters of their operations and need no help from me. My job is merely to treat them right.
Warren Buffett25
I could no longer have fingertip control of all the details. That made my obsession with people even more intense.
Jack Welch26
In 1987 Buffett coined the collective term The Sainted Seven to describe Berkshire’s subsidiary companies: Buffalo Evening News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s, and World Book. By implication, he also applied the term to the managements of these companies. As his acquisition activity has continued apace, events have overtaken his prose and this epithet no longer quite captures its original meaning. Nevertheless, in respect of the kinds of people with whom he looks to associate, the phrase says it all.
Of the personnel in Berkshire Hathaway’s insurance operations, for instance, Buffett tells his shareholders: “We have an advantage in attitude.”27 It doesn’t stop there.
Buffett’s managers are doppelgängers of himself and Munger. Those with whom he chooses to associate “work because they love what they do.”28 In short, like Buffett and Munger, they are intrinsically motivated. And this shines through in the economics of their businesses. Says Buffett:
We like to do business with someone who loves his business… When this emotional attachment exists, it signals that important qualities will likely be found within the business: honest accounting, pride of product, respect for customers, and a loyal group of associates having a strong sense of direction.29
This is why The Sainted Seven run low-cost operations and enjoy economies of scale in their local markets that cannot be matched. The businesses are based on execution, attention to detail, and reputation. For example, Buffett says of See’s:
Cheerful, helpful personnel are as much a trademark of See’s as is the logo on the box. That’s no small achievement in a business that requires us to hire about 2000 seasonal workers. We know of no comparably-sized organization that betters the quality of customer service delivered by Chuck Huggins and his associates.30
Managements such as Chuck Huggins’ at See’s form an essential element of the franchise that Buffett buys. They “unfailingly think like owners (the highest compliment we can pay a manager),”31 says Buffett and, as such, they bring with them the business economics that he is looking for.
They are the business. They are the value. And for a man whose capital allocation skills are too valuable to allow him to sweat the details, they are the franchise.
Perhaps not surprisingly, Buffett has found that most managers who fit the requirement of acting like owners are resident in enterprises that are managed by their proprietors. This does not guarantee that an individual will act like an owner in the management of a firm, however. The institutional imperative is not choosy about whom it leads away from the straight and narrow.
Therefore, in addition to running a check over the return and capital intensity economics of every company he buys, Buffett runs a concomitant check over managements’ capital allocation policy—looking for those who have “unfailingly” husbanded it wisely, rather than become entrapped in dynamics from which they cannot escape, drawn to ventures long on psychic benefits but short on economic profitability.
To that end, Buffett will routinely retrieve a company’s 20-year history, often going back as far as records will allow, and will always examine the realized capital allocation record of target companies over the period during which incumbent management has been in place. “We never look at projections, but we care very much about, and look very deeply at, track records,” he says.32
Like a geologist analyzing a deep core sample of the earth’s crust, from the fragmentary and layered information that this process makes available a vivid picture emerges to Buffett—of the inherent economics of a business model, including the amount of free cash flow that it generates, the element most easily usurped by the institutional imperative. Where managers have shown themselves immune to the imperative and skilled in their allocation of cash, checking these results against those attained by their direct competitors and the industry in general to gauge to what extent they have established a franchise, then Warren Buffett becomes interested. But only interested: There are other checks to be run.
Giving a lie to the economists’ version of human nature, experimental work has shown what Warren Buffett has known all along—the rock on which he has built his leadership—that human beings care deeply about fairness and will reward it when present and punish it when absent.33 Nevertheless, although Warren Buffett’s managerial style may rely on the reciprocation of trust and fairness with effort, he is not so naïve as to believe that every competent manager uncovered by his research will possess the kinds of personal qualities that reflect this.
In those same experiments revealing that most people care about fairness, a significant minority—more than any manager would care to contemplate within his or her workforce—is also found to be selfish.34 These are the natural-born cheats and free riders inside every organization, those who would bring down Buffett’s hands-off approach to management if they stalked the corridors of Berkshire Hathaway.
Says Buffett of this type of individual:
You learn a great deal about a person when you purchase a business from him and he stays on to run it as an employee rather than as an owner. Before the purchase the seller knows the business intimately, whereas you start from scratch. The seller has dozens of opportunities to mislead the buyer—through omissions, ambiguities, and misdirection. After the check has changed hands, subtle (and not so subtle) changes of attitude can occur and implicit understandings can evaporate. As in the courtship–marriage sequence, disappointments are not infrequent [emphasis added].35
This was another lesson that Buffett had learned the hard way, at Dempster Mills. He corrected it at Berkshire Hathaway with Ken Chace. And he’s been correcting it in every business association he has entered into since then. If he were to get the people side of the equation wrong, with his management style, acquisitions would fail in the integration process and the business economics he is attracted by would wilt on the vine.
Hence Buffett engages in the kind of “scuttlebutt” research that another of his heroes, Phil Fisher, recommended all investors to pursue. Buffett’s network of acquaintances is huge. (“He has more tentacles out than anyone,” says Welch.37) Largely these acquaintances exist inside the shareholder register of Berkshire Hathaway, and he sounds them out in order to establish the character of the management he is looking at. Do they have the integrity that he both requires and demands?
If they do, it will show up in their reputations. If not, it will very quickly be apparent. Of Jordan’s furniture stores, acquired in 1999, Buffett had this to say, for instance:
Jordan’s furniture is truly one of the most phenomenal and unique companies that I have ever seen. The reputation that Elliot and Barry [Tatelman] have earned from their employees, their customers, and the community is unparalleled. This company is a gem!38
Once he is happy that he can trust managers, Buffett does so. It’s as simple as that.
When he made the purchase of See’s Candy he says, “We shook hands with Chuck [Huggins] on the compensation arrangement—conceived in about five minutes and never reduced to a written contract—that remains unchanged to this day.”39 And with regard to Borsheim’s, as with Jordan’s, although the company had no audited financial statements when be bought it, Buffett says that “nevertheless, we didn’t take inventory, verify receivables or audit the operation in any way. Ike [Friedman] simply told us what was so—and on that basis we drew up a one-page contract and wrote a large check.”40
However, you can only place such trust in the people that you deal with if you have done your homework beforehand.
Having established what he’s looking for in the type of people with whom he wants to associate, and knowing how vital it is to the organization to get this right, Buffett is faced with a challenge, which makes finding these people and their businesses look easy by comparison. How does he get these paragons to sell their businesses to him—and at a fair price?
He cannot go out and buy them forcibly—hostile acquisitions would defeat the object of his hands-off managerial approach, which is to crowd in intrinsic motivation. The franchise, in other words, would be lost. Buffett is confronted with a very real dilemma, therefore. In the face of it, he has derived a cunning plan.
He does nothing; or close to it. He simply lets these people, rarities in the world of commerce and on whom Berkshire’s future is premised, find him!
How much better it is for the “painter” of a business Rembrandt to personally select its permanent home than to have a trust officer or uninterested heirs auction it off. Throughout the years we have had great experiences with those who recognize that truth and apply it to their business creations.
Warren Buffett41
When Buffett says that his acquisition strategy at Berkshire is to wait for the phone to ring, it does not do so by chance. The right type of managers, with the right type of businesses for sale, call Warren Buffett because, whether they know it or not, they have been infected by a virus that inclines them toward him at their point of sale.
As with their biological equivalent, successful viruses of the mind—such as the instrumental memes of Buffett’s leadership—spread throughout a human population because they are bred for fitness. The most popular viruses tend to be those that play on our primary motivations to avoid loss and to reproduce: the danger and sex contained in any good soap opera.42 But the microbe launched by the way in which Warren Buffett organizes and runs Berkshire Hathaway homes in on vendors where they are most susceptible—on the fears that they experience when they contemplate a transaction that will change their lives for ever.
Managements with businesses for sale approach Buffett, he says, “because a manager who sold to us earlier has recommended a friend that he think about following suit.”43 That’s the virus in action. It says, “Berkshire Hathaway provides shelter from all your fears.”
We don’t want managers… to ever lose any sleep wondering whether surprises might occur because of our… ownership.
Warren Buffett44
Buffett knows that the people with whom he wishes to associate feel the same way about the businesses they own and/or manage as he does about Berkshire Hathaway. Being careful not to squander their resources, they have crafted them over their lifetime (perhaps even generations); they love them and gaze on them as they would their children. They care deeply about what happens to them after they have been sold. Naturally, this makes them reluctant to let go, but let go they must, usually to diversify their wealth away from the single business they own. Nevertheless, this reluctance finds itself expressed in a desire to stay on as an interested manager—they want to monetize their interest (“sometimes for themselves,” says Buffett, “but often for their families or inactive shareholders”45), not discard it.
Equally, Buffett knows that because of this, they are also dogged by uncertainty. Few, if any, will have sold a business before. Most will never have worked for a company that they did not also own. And they know that most corporate acquirers would not treat their businesses with the loving care that they have for years, or, in fact, treat themselves as they would want to be treated as employees.
Therefore, as much as the letters that Buffett takes care to draft in every annual report are put there for the benefit of his shareholders, they are also designed to reach a much larger audience, including potential vendors (or their acquaintances). Primarily this is where Buffett embeds his virus—a virus more potent since it can now be caught from reading the annual reports on the internet.
Revisiting a theme in his letter to the shareholders in 2000 that he has woven into his prose over many years, Buffett said:
When a business masterpiece has been created by a lifetime—or several lifetimes—of unstinting care and exceptional talent, it should be important to the owner what corporation is entrusted to carry on its history. Charlie and I believe Berkshire provides an almost unique home. We take our obligations to the people who created a business very seriously, and Berkshire’s ownership structure ensures that we can fulfill our promises. When we tell John Justin that his business will remain headquartered in Fort Worth, or assure the Bridge family that its operation will not be merged with another jeweler, these sellers can take those promises to the bank.46
Buffett is careful to ensure that individuals with businesses for sale are aware that Berkshire Hathaway presents them with a rare and unusual opportunity. He offers them the prospect of replacing uncertainty, fear, and suspicion with a known proposition. This is the DNA of Buffett’s virus. People who care about their businesses and fret about their futures know exactly what to expect when they sell to Warren Buffett and stay on as managers.
Buffett’s letters to his shareholders have established him as a leader among men, chairing a company with a clear and credible mission. A man of massive integrity, who upholds the highest standards of corporate governance, who will treat managers fairly, reward them appropriately, and grant them autonomy, trusting in their judgment as they fulfill this role. A man who will change nothing in the way the enterprise is run, except, perhaps, the compensation system, but only in a way that makes eminent sense: “We buy to keep, but we don’t have, and don’t expect to have, operating people in our parent organization.”47 And a man who presents sellers with a cast-iron guarantee that “this operational framework will endure for decades to come.48
The contrast with other buyers could not be more extreme—and Buffett is not loath to remind vendors of this fact. He told one prospective seller that practically all buyers except Berkshire Hathaway fall into one of two categories, each of which has “serious flaws” for the seller of a business that “represents the creative work of a lifetime and forms an integral part of their personality and sense of being.”49 These buyers will either be
a company located elsewhere but operating in your business or a business somewhat akin to yours. Such a buyer—no matter what promises are made—will usually have managers who feel they know how to run your business operations and, sooner or later, will want to apply some hands-on “help.” If the acquiring company is much larger, it will often have squads of managers, recruited over the years in part by promises that they will get to run future acquisitions. They will have their own way of doing things and… human nature will at some point cause them to believe that their methods of operating are superior.50
Or they will be “a financial maneuverer, invariably operating with large amounts of borrowed money, who plans to resell either to the public or to another corporation as soon as the time is favorable.”51
In addition, Buffett laces his annual reports with other fragments of the virus addressing vendors’ desire to diversify and preserve their wealth. Held out as an example, for instance, is Barnett Helzberg, Jr., the chairman of Helzberg’s Diamond Shops, who, in Buffett’s words, “owned a valuable asset that was subject to the vagaries of a single, very competitive industry, and he thought it prudent to diversify his family’s holdings.”52
As payment for assets Buffett offers sellers
a stock backed by an extraordinary collection of outstanding businesses. An individual or a family wishing to dispose of a single fine business, but also wishing to defer personal taxes indefinitely, is apt to find Berkshire stock a particularly comfortable holding.53
To ensure that only those vendors with the right kind of business approach him, however, Buffett places an ad in his annual reports so that people can check to see if their businesses fit his acquisition criteria. This first appeared in 1982 and he has repeated the exercise ever since, varying the prose only to alter the size requirements.
The original went as follows:
This annual report is read by a varied audience, and it is possible that some members of that audience may be helpful to us in our acquisition program. We prefer:
1 Large purchases (at least $5 million of after-tax earnings).
2 Demonstrated consistent earnings power (future projections are of little interest to us, nor are “turn-around” situations).
3 Businesses earning good returns on equity while employing little or no debt.
4 Management in place (we can’t supply it).
5 Simple businesses (if there’s lots of technology, we won’t understand it).54
And Buffett urges potential vendors: “If you are running a large, profitable business that will thrive in… [the Berkshire] environment, check our acquisition criteria… and give me a call.”55
Once the virus has gotten their attention, he knows that he will have elicited a psychological commitment at least to entertain the idea of selling their business to him. Indeed, as much as commitment that, to borrow a phrase from Cialdini, “grows its own legs” is something that Buffett avowedly avoids in his capital management, this is exactly the kind of process he is looking for as a leader in his prospective associations. “If you aren’t interested now, file our proposition in the back of your mind,” Buffett tells this constituency.56
Their immune systems are low. They are prone to infection.
Now, having committed to the idea that they will at least bear Buffett in mind when the moment comes to sell, each time a potential vendor subsequently reads one of Buffett’s letters, it will feed the tendency within them to seek out support in favor of their prior conclusions. The virus will start to multiply, the legs of commitment to grow.
This process will be nurtured by each and every horror story of a business combination that foundered on a clash of cultures. It will luxuriate in tales of incumbent management ousted by new owners, of assets stripped, autonomy lost, companies broken up, and legacies destroyed:
You and your family have friends who have sold their businesses to larger companies, and I suspect that their experiences will confirm the tendency to take over the running of their subsidiaries, particularly when the parent knows the industry, or thinks it does.57
And it will be fed annually by stories lifted straight out of Warren Buffett’s letters to his shareholders.
Here potential vendors will find repeated testimony bearing witness to the fact that selling their companies need not feel like selling their children. He says:
You know some of our past purchases. I’m enclosing a list of everyone from whom we have ever bought a business, and I invite you to check with them as to our performance versus our promises.58
Testimony of how folks, just like them, facing the same uncertainty, found everlasting contentment by selling their businesses to Berkshire Hathaway.
The social proof that Buffett puts on display and encourages them to check out works best in influencing other people’s decision making when they are keying their behavior off relevant (similar) others, but even more so in the presence of uncertainty.59 Past vendors to Berkshire Hathaway are similar to prospective vendors (Buffett has delineated their personal characteristics at length in his letters). And prospective vendors exist in a condition of uncertainty.
The virus overtakes their immune systems and they decide to sell to Buffett.
Warren is an unusual guy because he’s not only a good analyst, he’s a good salesman, and he’s a very good judge of people. That’s an unusual combination. If I were to [acquire] somebody with a business, I’m sure he would quit the very next day. I would misjudge his character or something—or I wouldn’t understand that he didn’t really like the business and really wanted to sell it and get out. Warren’s people knock themselves out after he buys the business, so that’s an unusual trait.
Walter Schloss60
Here comes the twist. Now that these people are well and truly on the psychological hook—barbwired, so to speak—Buffett subjects them to a trial, an examination that they must pass if they are to enjoy the sanctuary that is on offer inside Berkshire Hathaway.
The trial is contained in this statement: “After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.”61
The purchase contract that Buffett draws up, such as it is, is one that every vendor knows is based purely on trust and the knowledge that Buffett only associates himself with managers whom he “would love to have as a sibling, in-law, or trustee of my will.”62
Cialdini says that one way in which commitments influence our behavior is that people like and believe in what they have to struggle to get. Thus trials of initiation, common throughout human culture, help to ensure the lasting loyalty and dedication of those who make it through them. The more onerous the trial, the greater this effect.63
Move now to Berkshire Hathaway, the most exclusive of clubs. To get inside, vendors have to look deep within themselves. They have to reaffirm their intrinsic motivation to act like owners. They have to affirm their willingness to do so within another organization. They have to confirm their similarity with those on whom Buffett has already conveyed a blessing. To pass the test, they have to be made of the right stuff—and they know that Warren Buffett also knows, or will assuredly find out, whether they are or not. Says Buffett:
We do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We’ve never succeeded in making a good deal with a bad person.64
Hence if he does decide to go with a manager, those characteristics for which he selects become massively reaffirmed by what amounts to a personal benediction from a demigod of finance.
“I have friends who wish that Warren Buffett would come talk with them, who wish that they were running their businesses so well that he would be interested in their companies,” says Randy Watson of Justin Brands.65
“I love the association with him,” says Bill Child of R.C. Willey. “Working for him is like getting a hole-in-one, or having a dream come true. It’s a kind of climax to a wonderful business career. Warren is a great hero of mine.”66
“I would like to recognize all those individuals who have helped to build our company over the past 61 years,” wrote Seymour Lichtenstein, CEO of Garan, in the wake of its acquisition by Buffett in 2002. “It is indeed a credit to their efforts that Warren Buffett and Berkshire Hathaway have chosen to make this investment.”67
Managers like these would not express such sentiments were Buffett the emotionless stock picker he is sometimes portrayed as. Only Buffett the warm, loyal, and fair-minded leader would attract them to his company. When they get there, managers such as these can no longer be called The Sainted Seven. They desperately want to sell their businesses to Warren Buffett. They are intensely keen to stay on as managers, reporting to him. They have been subject to a trial of personality. From then on, these people should be known as The Committed.
Chuck gets better every year. When he took charge of See’s at age 46, the company’s pre-tax profit, expressed in millions, was about 10% of his age. Today he’s 74, and the ratio has increased to 100%. Having discovered this mathematical relationship—let’s call it Huggins’ Law—Charlie and I now become giddy at the mere thought of Chuck’s birthday.
Warren Buffett68
Buffett’s management task is made all the easier for their rites of passage.
The bounty of Buffett’s selection process is that the excellence he identified within the managers he wants on board is both durable after he has acquired them and increasing. If their commitment was to act like owners prior to their blessing, they now act even more like owners. Thereafter, the definition of their personal and managerial qualities that granted them entry to Berkshire Hathaway (normally) as owners is the one to which they strive above all else to remain consistent when they get inside, as managers.
“The manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are continually below those of his competitors,” says Buffett, identifying the way personal commitments grow the legs for which he is looking.69 His managers, already committed to running tight ships, continually cast around for reasons in support of their philosophy, constantly finding new ones, ignoring the temptations to add the costs that aggregate around others who do not share this mindset. This leaves Buffett’s companies as the low-cost providers in their markets.
Similarly, referring to the institutional imperative, Buffett says, “Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.”70 Knowing this, Buffett can count on his managers’ commitment to act like owners being sustained and bolstered.
One remarkable example of this will suffice. It summarizes the kinds of people with whom Buffett associates. At R.C. Willey, one of Berkshire’s furniture store operators, CEO Bill Childs pursued a policy of closing his stores on Sundays for religious reasons and he wanted to continue this policy in a region in which the company had not previously operated. Buffett was skeptical that a new store could work against entrenched rivals that did open on Sundays, yet, as befits the freedom he gives his managers, he told Childs to follow his own judgment.
“Bill then insisted on a truly extraordinary proposition,” says Buffett. He would buy the land himself and build the store (at a cost of around $9 million), sell it to Berkshire at cost if it proved to be successful, but exit the business, at his expense, if it was not.71
The store opened, was a huge success, and Berkshire wrote him a check for the cost. Adds Buffett:
And get this. Bill refused to take a dime of interest on the capital he had tied up over the two years… If a manager has behaved similarly at some other public corporation, I haven’t heard about it.72
A by-product of the careful front-end-loaded selection process that brings people like Bill Childs on board “is the ability it gives us to easily expand Berkshire’s activities,” says Buffett:
We’ve read management treatises that specify exactly how many people should report to any one executive, but they make little sense to us. When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap. Conversely, if you have one person reporting to you who is deceitful, inept or uninterested, you will find yourself with more than you can handle. Charlie and I could work with double the number of managers we now have, so long as they had the rare qualities of the present ones.73
We do have filters… we really can say no in 10 seconds or so to 90%+ of all these things that come along simply because we have all these filters.
Warren Buffett74
There is still some unfinished business to attend to before these psychic benefits start to accrue to Berkshire, and that’s the price at which the deal is finally struck. Buffett comments:
The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives.75
This is the case because the institutional imperative, which informs managements that they must grow, can mean that they need to undertake acquisitions. This inclines them to overpay: It is a seller’s market and the price they receive is, in effect, an unfair one.
To serve the interests of Berkshire’s shareholders, Buffett cannot let this happen in his acquisitions. Therefore he restores the balance so that the price paid is fair to both parties. Consequently, he extracts the institutional dynamic from his side of the process, leaving the only dynamic in play on the vendor’s side.
Earlier, I omitted two points that Buffett includes in his ad in the annual reports. These are that he prefers to see “an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown),” and that he promises “a very fast answer to possible interest—customarily within five minutes.”76
It is these two additions that restore the balance.
When Buffett does make a commitment to a transaction he ensures that it is rationally based. The specification in the ad that he wants to see an offering price immediately curtails any further dynamic to a commitment that might form in that instant. When that phone rings, he usually knows the economics of the business (he has already analyzed every company that fits his acquisition criteria). He knows that it is being run by people who act like owners (he’s checked out their capital allocation record and their reputations). He knows that they have contracted the virus, that they are The Committed and will bring on board all that phrase implies. And he does not want to get involved in any “due diligence” other than that he has already performed.
Once a commitment is made, further due diligence invites the egregious imbalance that manifests itself in most acquisitions. Says Buffett:
The idea of due diligence at most companies is to send lawyers out, have a bunch of investment bankers come in and make presentations and things like that. And I regard that as terribly diversionary—because the board sits there entranced by all of that, by everybody reporting how wonderful this thing is and how they’ve checked out all the patents.77
He continues:
If, however, the thirst for size and action is strong enough, the acquirer’s manager will fill ample rationalizations for… a value-destroying issuance of stock.78
The first-conclusion-stands, onward-ever-onward nature of this dynamic has been nicely illustrated by Stuart Oskamp, who carried out an experiment on a group of clinical psychologists using data from a real-life case. Historical background on the patient was summarized and organized into chronological sets of information that were presented to the judges in four successive stages. After stage one the judges made their initial clinical judgment. They were given the opportunity to review their diagnosis after each successive stage of due diligence. Oskamp discovered, however, that as more information was presented, the number of changed answers decreased markedly and significantly.
“This finding,” he says, “suggests that judges may frequently have formed stereotype conclusions rather firmly from the first fragmentary information and then been reluctant to change their conclusions as they received new information.”79
At the same time, Oskamp measured the confidence that each psychologist had in his judgment at each stage of the process. He found that as each new layer of information on the patient was revealed, these professionals became convinced of their own increasing understanding of the case. In fact, their confidence rose to such a degree that it dwarfed the increase in accuracy of their diagnoses: “The final stage of information seems to have served mainly to confirm the judges’ previous impressions rather than causing them to revamp their whole personality picture [of the patient].”
Similarly, peeling back the onion on an acquisition target often serves only to reinforce a commitment already made. So much for the idea of due diligence at most companies. Frequently, as Buffett observes, people “go into it for their protection. Too often, they do it as a crutch—just to go through with a deal that they want to go through with anyway.”80
And of course, as the supporting cast members in this dynamic catch a glimpse of the storyline, they edit their script accordingly and the entire troop polarizes further in the direction of executing the plot. Observes Buffett: “If the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.”81 That is, “both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told they are naked.”82 Thus it is that “while deals often fail in practice,” according to Buffett “they never fail in projections.”83
In contrast, when an acquisition opportunity presents itself to Buffett, he is not in the habit of seeking outside counsel on the wisdom of effecting acquisitions. “Don’t ask the barber whether you need a haircut,” he says.84
Thus Buffett is not exposed to any dynamic in the acquisition process. As the buyer he has no plan, but the vendors do. He has made no commitment; they have. The only institutional dynamics in play are on the other side of the fence. The balance is therefore on its way to being restored.
Now for one last push from the virus. Buffett’s promise of normally a five-minute response to an offer is his version of “offer must end.” It invokes the notion of scarcity, and our wiring has evolved to tell us that something that is difficult to possess is generally better than something that is easy to possess. Therefore we have a heuristic that allows us to judge an item’s quality very quickly by its availability.85
If Buffett and Munger do not like the price, no matter how “attractive” the business, they will decline the deal. Door closed. The offer will not be entertained again. As Barnett Helzberg of the eponymous diamond store chain that Berkshire now owns says: “Basically the way to negotiate with Warren Buffett—you don’t negotiate. He tells you the deal and that’s the deal.”86 As the seller, therefore, you either pitch your business at the right price, or you can forget about selling to Berkshire Hathaway.
Now the price is approaching a fair one. Nevertheless, a delicate balance holds at this point—because the price has to be fair to both parties. Operating from a position of strength (because he has made it so), Buffett cannot afford to gouge on the price. He has designed his acquisition process to overcome the greatest downfall of most takeovers: the failure to elicit the complicity and loyalty of the human assets in the transaction. By redressing the second greatest failing of corporate acquisitions, the price paid, he does not want to ruin his good work by alienating the very people who are an integral part of the franchise he is buying. It just would not work that way. The people who join Berkshire Hathaway have to feel good about the whole process. Therefore, he relaxes the strict discipline with respect to price for which he is renowned in his dealings in the stock market. “I used to be too price-conscious,” says Buffett. “We used to have prayer meetings before we’d raise the bid an eighth and that was a mistake.”87
He is helped in this departure by the advantage the tax code conveys on outright, versus fractional, ownership. He observes:
When a company we own all of earns $1 million after tax, the entire amount inures to our benefit. If the $1 million is upstreamed to Berkshire, we owe no tax on the dividend. And, if the earnings are retained and we were to sell the subsidiary—not likely at Berkshire!—for $1 million more than we paid for it, we would owe no capital gains tax. That’s because our “tax-cost” upon sale would include both what we paid for the business and all earnings subsequently retained.88
In contrast, if Berkshire were to own the same $1 million of earnings through an investment in a marketable security, on its distribution it would be subject to state and federal taxes of about $140,000.89 Alternatively, if these earnings were retained by the investee company and subsequently captured by Berkshire as a capital gain, they would then be subject to “no less than $350,000” in tax, depending on Berkshire’s capital gains tax rate (which varies between 35% and 40%).90
Thus, on an after-tax basis, identical cash flows are substantially more valuable to Berkshire if it owns the company (more than 80% of it, technically) than if it invests in its stock. This helps when deciding whether to quibble over an eighth.
Nevertheless, when Buffett listed those three qualities that he looks for in an acquisition—“getting into a business with fundamentally good economics… buying from people I can trust. And… the price I’d pay”—he added, “I wouldn’t think about the price to the exclusion of the first two.”91 To attract the right people to Berkshire Hathaway, with the right businesses, he cannot afford to.
Thus the perfect acquisition candidate is allowed to move forward and assume his position in a perfect home.
The odds that the acquisition will continue to perform in the same fashion that first attracted Buffett are considerably raised. In the short term, he has removed the nagging uncertainty that wrecks most integration efforts. Where this is not addressed it saps motivation and the new entrant to the organization wilts under its weight.92 In the long term, Buffett has elicited buy-in to his concept of acting like an owner from people who generally acted in this fashion before, but who will definitely act in this fashion going forward in order to remain loyal to the personal commitment they have made to do so.
To see this buy-in in action, let’s move on to the conduct of Buffett’s insurance operations. These will illustrate how he puts the managerial principles to which he aspires into practice and serve, by example, to show how Buffett influences the behavior of those whose activities he does not oversee on a day-to-day basis.