To find new directors, we will look through our shareholders’ list for people who directly, or in their family, have had large Berkshire holdings… Individuals making that cut should automatically meet two of our tests, namely that they are interested in Berkshire and shareholder-oriented. In our third test, we will look for business savvy, a competence that is far from commonplace. Finally, we will continue to have members of the Buffett family on the board. They are not there to run the business after I die, nor will they then receive compensation of any kind. Their purpose is to ensure, for both our shareholders and our managers, that Berkshire’s special culture will be nurtured when I’m succeeded by other CEOs.
Warren Buffett1
If principles are dated, they’re not principles.
Warren Buffett2
Normal business was resumed for Berkshire Hathaway in 2002. In what Buffett described as a “banner year,”3 the book value of the company rose by 10 percent (trouncing the performance of the S&P 500 by over 32 percent), the insurance group increased its float by 16 percent to $41.2 billion, a number approximating 8 percent of the industry’s total, and the cost of float fell to 1 percent. At Berkshire’s annual meeting Buffett was in his usual form. He lambasted stock options as a “royalty on the passage of time,” compared the quick accounting fixes that present corporate earnings in a better light with heroin addiction (“difficult to get off”), advised shareholders not to listen to the projections of management but to look at business economics, and admitted that he had lost the company approximately $8 billion by walking away from the purchase of Wal-Mart shares when the price ran away from him. Most encouragingly, Buffett was able to confirm that General Re had “turned the corner in a big way.” Naturally, Berkshire’s shareholders were reassured by what they heard. The unanswered question was what the future might hold for them as Buffett advances into his seventies.
Buffett’s skill as chairman and chief executive of Berkshire Hathaway lies in combining the twin roles of leadership and capital management with the integrity to act like an owner. This should be the embodiment of any CEO. Current wisdom has it that this embodiment will disappear when Buffett departs the scene. It is commonly believed, for instance, that Lou Simpson, GEICO’s chief investment officer, who has overseen that company’s equity portfolio since 1979 and whom Buffett says uses the “same conservative, concentrated approach to investments that we do at Berkshire,” will take over the capital management role in Buffett’s absence. This would leave A.N. Other to become chief executive.
This arrangement looks suspect. Buffett has confirmed Simpson as one of Berkshire’s “Hall-of-Famers,” and attests that “his presence on the scene assures us that Berkshire would have an extraordinary professional immediately available to handle its investments if something were to happen to Charlie and me.”4 And that’s where it stops.
It is not immediately apparent from this inference that Lou Simpson will also be responsible for the capital allocation function, as opposed to the investment function. As CEO, Buffett chooses between an array of capital opportunities available to him, only one of which is to take fractional ownership of other companies via the stock market. Buffett makes no distinction between this exercise and that of buying companies outright, reinvesting in existing subsidiaries, or returning capital to shareholders. The best use of cash gets the cash. It seems imperative, therefore, that whether Simpson manages Berkshire’s equity investments or not, one man needs to be in place who can integrate a view on the valuation of equities into a decision incorporating their relative merit against all other possible uses. Current favorites for that post are Rich Santulli of Executive Jet and Ajit Jain.
Beyond this, and in deference to the model presented in this book, I am going to confine my thoughts about Berkshire Hathaway’s future to what I consider to be the knowable. In doing so, I will assert that Warren Buffett will stay inside his Circle of Competence and then address the two elements of the question suggested above, which indeed are suggested by the title of this book: the leadership challenge and the capital management challenge, a subset of which will include some thoughts about the market inefficiencies on which Buffett has relied in the past.
Charlie and I not only don’t know today what our businesses will earn next year—we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future.
Warren Buffett5
Numerous Buffett watchers have designated 2003 as the year that he left the confines of his Circle of Competence, deserting capital allocation for politics and taking up a new career forecasting the unforecastable. They are mistaken on both counts.
On August 13th the world did indeed wake up to find that Buffett had been named as financial and economic adviser to Arnold Schwarzenegger in the movie star’s quest to be elected Governor of California. But this new role should be seen as the latest iteration of a career-long involvement in politics, which Buffett has combined with his role as chairman and chief executive of Berkshire Hathaway. Look no further than previous public statements on taxation, the war in Bosnia, and the Buffett Foundation’s contributions to abortion and population control measures to see that this is so, or to his letters to shareholders in which he regularly holds forth on topics of a political (although admittedly self-interested) nature.
Reflecting on Buffett’s prognostication in October 2003 on the likely course of the US dollar, some would say he has departed his Circle of Competence in a more serious fashion. “Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency,” proclaimed Buffett. “Since then Berkshire has made significant investments in—and today holds—several currencies… [and] to hold other currencies is to believe that the dollar will decline.”6 So saying, it looked like Buffett had become what he distrusts: A CEO who claims that he does know the future. Casual observation tells us that currency forecasting resides firmly in the quadrant of the important but unknowable and, as such, cannot be deemed to be within Buffett’s Circle of Competence. Casual observation is mistaken. Buffett is fond of quoting Herb Stein on the subject of forecasting: “If something cannot go on forever, it will stop.”7 In the same way that Buffett is happy to warn his shareholders that Berkshire cannot possibly grow at 23 percent and more ad infinitum, this is the extent of Buffett’s forecast of the dollar. It is based on a mathematical and economic truth that sits inside his Circle of Competence: “We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits.”8
The catalyst that has transformed a forecast into action is the pace at which the US trade deficit has worsened, “to the point,” says Buffett, “that our country’s ‘net worth,’ so to speak, is now being transferred abroad at an alarming rate… A perpetuation of this transfer will lead to major trouble… We have entered the world of negative compounding.”9 However, Buffett also has his eye on Berkshire’s economics. The purchase of General Re means that Berkshire has considerable foreign currency liabilities. A weak dollar would magnify the cost of a major disaster outside the US and this is a risk that Buffett wants to hedge. “Charlie and I believe Berkshire should be a fortress of financial strength—for the sake of our owners, creditors, policyholders and employees,” says Buffett.10
Note that timing is not a feature of this forecast. Timing never has been for Buffett. “The course of the stock market,” he told his partners in 1966, “will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.”11 Over 35 years later, Warren Buffett remains true to those words. He continues to operate inside his Circle of Competence and he will stay there for the remainder of his career.
What happens to this place if you get hit by a truck?
Anonymous and ubiquitous, reported by Warren Buffett10
Ten years back, the question that was most often asked about the future of Berkshire Hathaway centered around the possibility of Buffett’s accidental death. As Buffett creeps up the mortality tables, that question has morphed into one of a more delicate, more pressing nature and, as far as I know, remains unspoken: “What will happen when you die/lose your mental faculties?”
From a personal perspective, no one is more sensitive to these issues than Buffett himself. From a managerial perspective, therefore, the planning is well in hand. “All in all, we’re prepared for ‘the truck.’” says Buffett, contemplating the perhaps more polite version of the issue.12
Buffett is aware that, when there is separation of ownership from control in an enterprise, it is vital that the board of directors, who represent the interests of its owners, think like owners. Berkshire Hathaway’s board, post Buffett, most assuredly will think like owners. These people are intimately familiar with and share Buffett’s philosophy on this subject. And they will oversee a chief executive who is no less familiar with the principles involved.
Berkshire Hathaway is in safe hands from a corporate governance perspective. Buffett has already identified those who will succeed him in the managerial role. Their names are sealed in an envelope, to be opened at the appropriate time, with a letter that begins: “Yesterday I died. That is unquestionably bad news for me but it is not bad news for our business.”13 (He also jokes that the first thing it says is “Check my pulse again.”14) When the names in the envelope are read out, nothing at Berkshire Hathaway will change. Warren Buffett has championed a corporate culture second to none. It will survive him. Managers who acted like owners in the past will continue to act like owners in the future. That is in the nature of The Committed.
Important challenges will lie ahead, however. Perhaps the biggest weakness in Buffett’s succession plans lies in the secrecy, for want of a better word, surrounding them. The core of Buffett’s status as a CEO lies in his personality as a leader: in his high-profile beliefs, integrity, standards, and impeccable honesty. Since Buffett is choosing his own successor, that person will possess similar qualities. While his identity remains a secret, he cannot have the same profile.
The conduct of Jack Welch’s succession at General Electric was a public affair, featuring a runoff between three managers, measured over several years. This gave time for GE’s shareholders and employees to identify with the next in line. Jeff Immelt was a known quantity when he replaced Jack Welch. Interested parties had already assimilated what he stood for.
At Berkshire Hathaway, Rich Santulli and Ajit Jain, if it is to be one of these two, both have outstanding reputations. Either one of them will benefit enormously from Warren Buffett’s endorsement. However, how many of Berkshire Hathaway’s shareholders or employees really know these men in the same way that they know Warren Buffett? Some of Berkshire’s managers have never even met each other. They certainly have not communicated with its shareholders.
A large element of the commitment Buffett has elicited from his shareholders and employees is personal. It is to Warren Buffett. It is him whom Berkshire shareholders trust. It is Buffett whom Berkshire’s managers are eager to please. No one can replace this in an instant. The patina has to be built up over years, of example and of conditioning.
The immediate risk to Berkshire is that this reduces its capacity to attract the right people to the organization. Buffett’s acquisition strategy is premised on providing the ideal home to managers who already act like owners or have what it takes to do so. If the allure of Berkshire Hathaway as such dies with Buffett, then so will one of its competitive advantages. A minimum prerequisite of Berkshire’s next CEO is that he too is able to take his hands off the reins and give managers their freedom.
A less immediate risk is posed by another succession challenge, which presents itself whether Buffett is CEO or not. Many of Berkshire’s subsidiary companies are essentially second-generation family businesses. The risk of failure for such businesses rises with each generation’s handover. Certainly by the third generation, if family members of the requisite managerial skill are not available, the intrinsic motivation that drove generations one and two has normally departed.
Buffett has requested that his current managers think long and hard about this issue. He requires each of them periodically to inform him in writing of the names of those who will succeed them, their strengths and weaknesses, and alternative candidates. Buffett says, “I need to have your thoughts in writing rather than try to carry them around in my memory.”15 I doubt this is the reason.
Written commitments, backed up with reasoned argument, take much more deliberation than their mental equivalents.16 They have a finality about them, suggesting that they are difficult to alter. Knowing that they do not have the escape clause of easily changing their minds, Berkshire’s managers will be as diligent in their succession plans as Buffett is in his, and the generational risk attached to the enterprise will be meaningfully reduced.
We find doing nothing the most difficult task of all.
Warren Buffett17
If anything is knowable about Berkshire Hathaway’s future it is that there is a mathematical limit to the pace at which it can grow once it has reached a certain size. In Chapter 1 I remarked that if Berkshire Hathaway continues to grow at its historical rate, it will become so large that it will absorb the whole of the US economy. An impossibility. At some point between now and 2032, the company’s growth rate has got to revert to something more akin to that of the economy and the average of those companies comprising it.
This is an unavoidable fact. And it has to be discounted into any assessment of the company from a shareholder’s perspective.
Given Buffett’s capital management skills, Berkshire is likely to continue outgrowing the average longer than most mathematically challenged companies would find possible. Indeed, the mother of all mathematical impossibilities threatens to present itself because of Buffett’s managerial talent in this regard.
If Warren Buffett is still at the helm when this happens, no problem. He is the first to admit this reality:
Carl Sagan has entertainingly described this phenomenon, musing about the destiny of bacteria that reproduce by dividing into two every 15 minutes… That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain... in two days, more than the sun—and before very long, everything in the universe will be made of bacteria. Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth. The bugs run out of food, or they poison each other, or they are shy about reproducing in public.18
Buffett will not attempt to outgrow Berkshire’s potential if it has reached that potential; an attempt that would only destroy value. If he has done his succession planning properly, the next CEO of Berkshire Hathaway will accept reality in like manner. When the limit of Berkshire’s ability to reinvest its excess cash at rates that can sustain above-average returns in the long term is reached, stand back. The floodgates are going to open and the cash that normally finds its way to Omaha will be distributed in large amount to all points on the compass.
The challenge in the meantime for Buffett’s successor may be more difficult to overcome. The essence of Buffett’s Circle of Competence lies in the capacity to do nothing when there is nothing to be done. If anything sits at the heart of illusory competence it is our compulsion to take control, to do something.
In the modern era, mistakes that come from doing something are rarely fatal. In our Stone Age past, they may well have been. In “getting away with it,” many of us have lost the most basic survival instinct, intolerance of risk. Warren Buffett has never lost this element of human wiring. He will not risk Berkshire’s capital unless he is virtually certain of the outcome. He treats all unquantifiable risks as though they were potentially fatal. In order to emulate the quality of his capital management, Buffett’s successor will need to do the same.
I’d be a bum on the street with a tin cup if the market were efficient.
Warren Buffett19
Capitalism is a stripling. The intellectual means by which to tackle uncertainty for gain—capitalism’s essence—have only been available to humanity since the Renaissance. We have spent the last 450 years or so refining this ability, only the last 70 or so of which have incorporated understanding of the valuation of the companies that have become the expression of capitalism.20
What started as Warren Buffett’s playground has grown into a more difficult environment in which to ply his skills. With each successive intellectual advance, markets are becoming increasingly efficient. If I can make any claim for this book, when the Circle of Competence dispels the Circle of Illusory Competence and filtered rationality displaces bounded rationality, the mistakes of capital management will grow still more rare. The fat pitches will be fewer and further between, and the batters awaiting them more numerous. Just as Berkshire will run out of the mathematical opportunity to grow, it seems likely that, unless the human condition remains unchanged, it will also be deprived of the natural—and I use that word advisedly—opportunities on which it relies.
Observing that gambling pre-dated the understanding of probability by centuries, Ian Hacking, a scholar in this field, has conjectured that, traveling back in time several centuries, “someone with only the modest knowledge of probability mathematics could have won himself the whole of Gaul in a week.”21
A similar thing might be said of Warren Buffett. In that era of capitalism in which we had scaled the intellectual barriers to progress but not yet torn down the walls of psychology and emotion, Buffett will stand out as the man who did. He says:
I was born at the right time and place, where the ability to allocate capital really counts. I’m adapted to this society. I won the ovarian lottery. I got the ball that said, “capital allocator—United States.”22
We may never see the like of Warren E. Buffett again. Let’s learn from him now.