Remember the saying “from poverty to poverty in three generations”? With a few minor amendments we can apply it to the future course of corporations.
The meaning of the saying: a new fortune is created by the founder, who usually starts out with nothing. His children maintain and even expand that wealth. The grandchildren (or sometimes the children) squander it.
But let’s consider why there is truth in this saying.
As we’ve seen with Howard Schultz, John Mackey, Sam Walton, and Ray Kroc, the founder is a person with a unique vision, mission, and combination of talents including superb, inspirational management.
People with this unique combination of traits are few and far between.
The founder’s children grow up surrounded, so to speak, by the unique culture their (usually) father created. They absorb that culture. So when the founder dies or retires, the children take over and perpetuate that culture to some greater or lesser degree.
Not always. Ray Kroc’s successor was Fred Turner, who joined McDonald’s as a kid and rose through the ranks. He and many of his various associates absorbed the company culture that Kroc had created.
Turner was a worthy successor, expanding McDonald’s beyond even Kroc’s expectations.
So a corporation has two sources of continuity: the founder’s children, and the company’s managers and employees who were heavily influenced by the founder.
But there’s a problem. Collectively the children and/or successor managers may have all the talents and abilities of the founder. Individually, none of them does.
We can state this categorically for one obvious reason: not one of them has started anything from nothing. Even a son or a daughter who has gone off to start his or her own business doesn’t count as an exception—if Daddy gave them a helping hand.
A crucial moment in the life of every new corporation comes—
When the Founder Dies
Even when, like Ray Kroc and Sam Walton in their later years, the founder has stepped back from being the hands-on, day-to-day source of leadership and inspiration, he remains a source of wisdom, advice—and guidance.
What’s more, despite his best intentions, he can’t usually completely divorce himself from the business. Both Kroc and Walton were still focused on their “babies” long after they’d supposedly delegated everything to others.
As News Corporation CEO Rupert Murdoch said when asked what he’d do if he retired: “Die pretty quickly.”
When the founder dies, what’s left is his memory. For example, my mother died twelve years ago—yet I still carry on conversations with her in my head. Indeed, with my father, too, even though he is still alive.
In the same way, the founders’ successors retain a similar mental replica, its strength depending on how fully they absorbed the founder’s mentality.*
However, this mental replica is not identical to the original: it’s a subconsciously created “mental construct,” filtered through and colored by each person’s own experiences, memories, and mental processes. The closer a person was to the founder, the more “real” the replica will be—but it’s never exactly the same. Nevertheless, it still serves as a guide.
But when the third generation have direct experience of the founder, it’s as young grandchildren or lowly beginning employees. So to the extent they imbibe the founder’s culture, it’s mostly second- or thirdhand.
Our focus here is on first-generation companies—while the founder is still in the saddle. Clearly Walmart and McDonald’s are now into their third, fourth, or fifth generation of management. It’s clear, especially with McDonald’s, that some of the founding culture has gone.
By comparison, Walmart continues to follow Sam Walton’s vision relentlessly, mainly because succeeding managements have kept Walton’s focus and Walmart’s USP (Unique Selling Proposition) of the lowest possible prices every day. A focus that relative to others such as Ray Kroc’s QSCV (Quality, Service, Cleanliness, and Value) is exceptionally simple. That Ray Kroc, when visiting a McDonald’s store, often cleaned the parking lot before going inside indicates that the C of QSCV didn’t get all the way down.
A Company’s Culture: Conscious or Unconscious?
Just as understanding a company’s culture—that is, the combination of mission, vision, and operational methodology—is the key to identifying the next Starbucks, so determining how deeply the founding culture is embedded in a company is the key to forecasting its future after the founder departs.
The two simplest measures for an outsider to observe are:
1. Whether the culture’s rationale has been fully outlined.
2. How effectively that culture is transmitted at the customer interface.
A third factor may be difficult for the outsider to establish:
3. Whether the company has a succession plan.
1. Is the Company’s Culture Clearly Defined?
When you can easily understand a company’s underlying values and processes, the culture has been made conscious.
Intellectually understandable principles help transmit the culture from one generation to another by making it clear why the company does what it does. The absence of the specific rationale behind a company’s culture is an inevitable source of problems when the founder departs the scene.
Consider the family of a self-made man. Normally, the father is so busy building his business that he has little time to spend with his children. The result: the extent to which his children inherit their father’s outlook on life is a result of unconscious copying.
If the father has explained how and why he does what he does, his children will have the intellectual understanding in addition to the unconscious copying. Thus, it is far more likely that this second set of children will perpetuate their father’s heritage than the first set.
So it is in a company.
Consider the difference between Walmart and McDonald’s. Walmart’s simple USP made it easy for successive generations to follow it faithfully. Ray Kroc, acting primarily from gut feel, did not consciously institutionalize the culture he created.
To appreciate how fragile a company’s culture can be, consider what happened to Starbucks when Howard Schultz stepped back in 2000 (see here).
2. At the Customer Interface
Second, we can easily estimate whether a company’s culture is embedded all the way down by analyzing our experience with it as a customer.
Does that experience communicate to us what the company says it stands for?
Answering that question is far easier when the principles behind the company’s culture have been made fully conscious.
3. Is There a Succession Plan?
A third consideration is the nuts and bolts.
If the company’s CEO is run over by a bus, are there designated candidates for succession trained and ready to step into his shoes?
“It’s My Baby”
The relationship between a company’s founder and his company can be, emotionally, as close as that between a mother and her favorite child.
James McLamore—cofounder (in 1954) and first CEO of Burger King—unwittingly demonstrates the truth of this proposition as he tells his and the company’s story in his book The Burger King.
In 1967, Burger King merged with Pillsbury. McLamore remained CEO of Burger King until resigning in May 1972.
He also joined the Pillsbury board as a director, an indirect link with Burger King that ended in January 1989, when Pillsbury was taken over by Grand Metropolitan.
Nevertheless, as he tells Burger King’s story from 1972 to 1998, when the book was completed, he always uses the word we, as if he were still part of the Burger King team.
What’s more, especially after Grand Metropolitan took control, he was invited to become actively involved as a source of advice and inspiration to get Burger King back on track. A role he eagerly accepted—with no financial compensation.
His only motivation—and only reward—was to see his baby thrive.
While our focus has been the period when the founder remains in the saddle, it’s important to understand generational transitions, especially the first one. As an example, let’s apply this analysis to Warren Buffett’s Berkshire Hathaway to determine the gold standard of succession planning.
Tap-Dancing to Work
Now in his eighties, Buffett remains firmly in the saddle of his creation: Berkshire Hathaway.
After he assumed control of Berkshire in 1965, the company became a vehicle for his investments. Both in the stock market and, with the purchase of National Indemnity in 1967, into insurance and later into buying whole companies.
Whether purchasing a portion of a company on the stock market or 80 percent to 100 percent of one, both are, from Buffett’s perspective, investments. Requiring an answer to the question “Do I want to buy this company with the existing management in place?”
In most takeovers, the purchasing managers are sure they can do better than the incumbents, so more often than not the target’s management is gutted.
Buffett’s approach is the opposite. He’ll only buy a company when the existing managers commit to stay on and continue to run the company after they’ve sold out.
The result: a conglomeration of businesses that have nothing to do with one another. No synergies are imposed by the head office—even when, as with Berkshire Hathaway subsidiaries Borsheims Fine Jewelry and Helzberg Diamonds, or Nebraska Furniture Mart, Jordan’s Furniture, RC Willey Home Furnishings, and Star Furniture, they’re all in the same business space.
And Buffett has often paid a lower price for many of these businesses than the sellers could have achieved elsewhere. Why? Because he guarantees that the seller’s baby will continue to exist as is, forever: he promises to never sell it, a major attraction to businesses’ creators who wish to see their legacy survive intact, long after they themselves have passed away.
The result is a unique company. A conglomerate of different businesses that actually works. Very different from ITT, LTV, Gulf+Western, and the other conglomerate “darlings of the market” in Wall Street’s go-go years (here).
A major reason it works is that Berkshire is more than a conglomerate of companies. It’s also a conglomerate of cultures.
Berkshire’s Two-Way Culture Flow
Each Berkshire subsidiary, when acquired, came with its own culture—a combination of mission, vision, and operational methodology. That culture—when embedded all the way down—was perpetuated, regardless of Warren Buffett’s or other Berkshire subsidiaries’ preferred practices.
The result is a two-way culture flow. From bottom up, and from top down.
However, Buffett required new subsidiaries to make two major exceptions, two changes:
1. Capital allocation was reserved for the head office. Thus, each subsidiary acquired, on top of its original culture, Buffett’s top-down capital discipline. Projects requiring capital injections had to meet Buffett’s standards to go ahead. This restriction—not a real restriction if you’re a rational manager—was quickly embedded into the subsidiaries’ cultures.
2. Succession: a subsidiary’s CEO had to nominate his successor. Which implies that one (or more) of his managers is trained to be ready to step into his shoes.
So the post-Buffett question now becomes, which part(s) of which culture(s) are likely to be disrupted by his passing on?
Buffett’s Roles
Before addressing that question, we need to consider Buffett’s roles as Berkshire’s CEO.
He has reserved two functions for himself (everything else being delegated):
1. Capital allocation: investing Berkshire’s continually growing pile of cash.
This consists of two parts:
1a. Purchasing whole businesses as investments with management in place.
1b. Purchasing portions of businesses via the stock market and related investment activities.
2. Inspiring entrepreneurs who’ve just received a large check or oodles of Berkshire stock to show up for work every day as if nothing had changed.
These roles are, naturally enough, directly related to Berkshire primary sources of income:
1. Earnings from the company’s diverse range of subsidiaries.
2. Insurance, which generates float that can be used for investment.
3. Profits and dividends from Berkshire’s investment portfolio.
Buffett’s involvement ranges from minimal (#1) to medium (#2) and intense (#3).
So let’s consider them in order in relation to Buffett’s roles.
Earnings: Going Concerns That Keep on Going
As noted, Buffett’s acquisition criteria (“with management in place—we can’t supply it”) ensure that postacquisition, there is no disruption of the new subsidiaries’ operations.
While Warren Buffett will be sorely missed, as these subsidiaries are effectively separate operations from the head office, his absence should have little immediate impact on their sales, profitability, or operations.
If Warren asked me to do anything, I would do it.
—Richard Santulli, former CEO, Executive Jet Inc.
After all, the CEOs of those businesses are still there because they love what they do (see “It’s My Baby”). Buffett’s passing won’t change that. And while they’ll no longer be able to call Buffett for advice (which most of them don’t), when in doubt they’ll be able to answer the question “What would Warren do or say?” themselves with reasonable accuracy from their mental replica.
So we can also be reasonably certain that Berkshire’s existing businesses will continue to operate in the same way. Not just in the short term but for as long as each subsidiary’s culture continues to be passed on from one management generation to the next.
The current performance of Berkshire’s earlier acquisitions—See’s Candies, Nebraska Furniture Mart, Borsheims, and GEICO, to name just a few—suggests that forever is an achievable time perspective for their continued successful operations.
Buffett’s respectful treatment of his managers has instilled in them an ambition to “make Warren proud,” as one puts it.
—Businessweek
The major effect in the medium term may be in the acquisition of new businesses.
Warren Buffett is a superb judge of character. As Buffett’s friend and fellow Benjamin Graham “alumnus” Walter Schloss put it:
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 really didn’t 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. [Emphasis added.]1
This is arguably the Buffett talent that will be hardest to replace.
Should Berkshire’s post-Buffett management be more in the Walter Schloss mold, the success rate of post-Buffett acquisitions may inevitably decline.
Overall, given the enormous cash-generating power of Berkshire’s existing subsidiaries, it will be many years (if not longer) before any such effects will have a significant impact on the company’s bottom line.
That said, Berkshire HQ is not the only source of acquisitions. Many of the company’s subsidiaries are, in a sense, “mini-Berkshires,” making what Buffett calls “bolt-on” acquisitions. Acquiring companies that fit or extend their business model, that are too small to be on Buffett’s radar. Collectively, they continually have a significantly positive impact on Berkshire’s total earnings.
Finally, given the institutionalization of Buffett’s capital-allocation role, we can confidently assume that all subsidiaries’ surplus cash will continue to be forwarded to the head office for investment purposes.
4. Insurance: Positive Float
Similarly, all Berkshire’s insurance subsidiaries have absorbed the Buffett culture of walking away from any insurance deal that is not favorably priced.
“Favorably priced” means a manageable risk of loss combined with a price that will generate an underwriting profit. As Buffett puts it:
The nature of our insurance contracts is such that we can never be subject to immediate demands for sums that are large compared to our cash resources. This strength is a key pillar in Berkshire’s economic fortress.
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money—and, better yet, get paid for holding it.2
From Buffett’s point of view, the beauty of insurance (provided it is correctly priced) is that premiums are received up front while claims are paid later—often, many years later.
The result is “float”: premiums received that can be invested until claims must be paid. Here, from Buffett’s 2014 “Letter to Shareholders,” is the growth of Berkshire’s float for the previous forty-four years:
Year |
|
Float3 ($ millions) |
1970 |
|
$39 |
1980 |
|
$237 |
1990 |
|
$1,632 |
2000 |
|
$27,871 |
2010 |
|
$65,832 |
2014 |
|
$83,921 |
As with Berkshire’s other subsidiaries, there is every reason to assume that the ingrained culture of underwriting discipline will continue to generate increasing float for the foreseeable future. Subject to payouts of long-standing claims (such as asbestos) that will soon come due.
5. Investments
Buffett’s investment ability has been the driving force for Berkshire’s success since he assumed control in 1965.
Aside from Lou Simpson, who managed GEICO’s investment portfolio until he retired in 2010, all investment decisions were made by Warren Buffett.
Until recently.
Most people (including me) have assumed that Warren Buffett’s talents in this field were irreplaceable.
But as Buffett himself implies in his essay “The Superinvestors of Graham-and-Doddsville,”4 this is far from the case.
His essay profiles eight investors who were all influenced by Benjamin Graham’s investment methods. All outperformed the S&P 500 over different time periods.
Buffett tapped Todd Combs (who joined Berkshire in 2010) and Ted Weschler (2011) as investment managers. They have since proved their worth—as Buffett reported in his 2013 “Letter to Shareholders”:5
In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They’ve earned it.
I must again confess that their investments outperformed mine. (Charlie says I should add “by a lot.”)6
Intriguingly, when the value of Berkshire’s fifteen largest stock holdings is subtracted from its total stock investments (of $117.47 billion), the balance (listed as “Others”) is $15.7 billion. Which suggests Combs and Weschler may be managing close to all of Berkshire’s “other” stock holdings.
Either way, Buffett clearly hired these two because they were already “graduates of Graham-and-Doddsville,” with records as hedge fund managers to prove it.
So in the investment field, as with Berkshire’s subsidiaries and its insurance operations, we can assume with reasonable safety that post-Buffett, Berkshire’s investment returns will continue to exceed those of the S&P 500 for many years to come.
Indeed, having spent four years (so far) working under the Master, it is highly probable that both Todd Combs and Ted Weschler will have a highly accurate mental replica of Buffett’s investment approach.
Structure
Perhaps more than any other CEO in the history of business, Warren Buffett has established various controls to ensure, as best as anyone can, that not only management operations but Berkshire’s unique culture will continue after his departure.
Via his “Letters to Shareholders” he has assured his coinvestors that he and the board have developed a detailed succession plan, though he has not revealed all the details:
Essentially my job will be split into two parts. One executive will become CEO and responsible for operations. The responsibility for investments will be given to one or more executives. If the acquisition of new businesses is in prospect, these executives will cooperate in making the decisions needed, subject, of course, to board approval. We will continue to have an extraordinarily shareholder-minded board, one whose interests are solidly aligned with yours.
Were we to need the management structure I have just described on an immediate basis, our directors know my recommendations for both posts. All candidates currently work for or are available to Berkshire and are people in whom I have total confidence. Our managerial roster has never been stronger.7
Possible candidates include Ajit Jain (BH Reinsurance CEO) and Greg Abel (MidAmerican), who are, says Berkshire vice chairman Charlie Munger, “proven performers who would probably be under-described as ‘world-class.’ ‘World-leading’ would be the description I would choose. In some important ways, each is a better business executive than Buffett.”8
Buffett also suggests that his successor as chairman will be his son Howard Buffett:
My only reason for this wish is to make change easier if the wrong CEO should ever be employed and there occurs a need for the Chairman to move forcefully.… In my service on the boards of nineteen public companies, however, I’ve seen how hard it is to replace a mediocre CEO if that person is also Chairman. (The deed usually gets done, but almost always very late.)9
This division of chairman from CEO is a safeguard that is rarely found in listed companies anywhere in the world.
On the Downside
Another unique feature of Berkshire Hathaway is that it’s the only listed stock in the world that has a guaranteed downside.
Buffett has indicated that Berkshire will repurchase shares if the price ever falls to 120 percent of book value.
There is every reason to assume that in at least the medium term, the post-Buffett management will follow that rule.
A “Buffett Premium”?
In the days following Warren Buffett’s departure, absolutely nothing in terms of operations, profits, or earnings at Berkshire Hathaway will change.
What may change is the market’s perception of Berkshire Hathaway’s future.
If, as seems highly likely, Berkshire’s stock price has a “Buffett premium” that disappears on his departure, given our analysis, it should be an excellent time to load up on Berkshire Hathaway stock.
In the longer term, Berkshire will face the same problem it faces now, except on a larger scale.
Long gone are the days when a See’s Candy (purchase price, $25 million) or Nebraska Furniture Mart (purchase price, $55 million) can impact Berkshire’s bottom line.
Today, Buffett repeatedly points out that only “elephants,” such as Burlington Northern or MidAmerican, will suffice.
Should Berkshire’s cash pile continue to grow, even elephants will not be enough. The post-Buffett management may have to find mammoths or mastodons instead.
In sum, with minor exceptions, most of Berkshire’s sales, revenues, and profits for this year are the result of processes initiated and decisions made and executed in the preceding several years, if not decades.
The main short-term difference might be that Berkshire would miss out on a few “elephant” opportunities that Buffett would have purchased had he been on the spot. But as the results of a new purchase don’t have a material effect on Berkshire’s bottom line immediately, there would be little change in Berkshire’s profits for that year.
To put it another way, Berkshire is a cash-generating machine that will certainly go on generating cash for many years after Buffett departs.
Inevitably, there will come a time, due to its size, when Berkshire can no longer outperform the market by any significant amount. Or certain crucial aspects of its culture may fade away.
That’s a long-term rather than medium-term possibility. In the meantime, we can confidently conclude that Berkshire Hathaway, post-Buffett, will continue to follow its current growth path.
Berkshire’s Corporate Gold Standard
Berkshire’s succession plans provide another corporate gold standard we can use to evaluate the likely course of other companies when their founder departs.
Here are a few questions to determine whether a company has a clear succession plan.
IS there a succession plan?
If not, and if no one has been groomed to fill the founder’s shoes, the company may go through several CEOs before finding its feet again.
An easy way to find out? Go to an annual meeting and ask the CEO, “If you were to walk out the door at the end of this meeting and be run over by a bus, what would happen to the company?”
If the CEO stutters, you know there’s no succession plan in place.
Is someone groomed to step into the CEO’s shoes?
If so, the chances of a smooth transition are higher than if the new CEO comes from outside the company.
Is the company’s mission and vision really clear, and simple to understand?
The simpler the company’s USP, the easier it is for everyone to follow.
For example, Walmart’s “lowest everyday prices” makes it clear to everyone, from the CEO to the greeter at the store entrance, what the company aims to achieve.
To put it another way, the simpler the vision, the harder it is for anyone, including an incompetent CEO, to screw it up.
How deeply is the company’s culture embedded?
If not deeply embedded, the company may go through several CEOs before finding its feet again.
Similarly, if the company’s culture has been made conscious, it is more likely to endure after the founder departs.