Case Study CG16-PDF-ENG Berkshire Hathaway Havard Business School PDF

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ROCK CENTER FOR CORPORATE GOVERNANCE CASE: CG-16 DATE: 01/01/09

THE MANAGEMENT OF BERKSHIRE HATHAWAY The highest form of human governance is not a lot of procedure-driven decision making. The right culture, the highest and best culture , is a seamless web of deserved trust.1 —Charles T. Munger, Vice Chairman, Berkshire Hathaway The important thing that we do is find managers that are .400 hitters and then don‟t tell them how to swing…. The second thing we do is allocate capital. Aside from that, we play bridge. That’s Berkshi re.2 —Warren E. Buffett, Chairman and CEO, Berkshire Hathaway

INTRODUCTION To some extent, this reputation is well founded, given the investment success that the company has enjoyed under his leadership. By comparison, during this period, the Standard & Poor‟s 500 Index delivered total annual returns of 3 A significant amount of this result was driven by concentrated investments in publicly traded companies, such as The Washington Post Co., GEICO, Capital Cities/ABC, The CocaCola Co., Gillette, Wells Fargo, and American Express.4

1

Keynote speech by Charles T. Munger, Stanford University Director‟s College, held at Stanford Law School, June 26, 2006. Edited for clarity. 2 Berkshire Hathaway, 1994 Annual Meeting, cited in: Outstanding Investor Digest, Vol. IX, Nos. 3 & 4, June 23, 1994. Edited for clarity. 3 Berkshire Hathaway, 2007 Annual Report, http://www.berkshirehathaway.com/reports.html. 4 In 2008, GEICO was a wholly-owned subsidiary of Berkshire Hathaway; Capital Cities/ABC was owned by The Walt Disney Co.; Gillette was owned by Procter & Gamble. Professor David F. Larcker and Brian Tayan prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The authors would like to thank Warren Buffett and Charlie Munger for reviewing the case. The Rock Center for Corporate Governance is a joint initiative between the Stanford Graduate School of Business and the Stanford Law School. Copyright © 2009 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: [email protected] or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate School of Business.

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Less attention, however, has been paid to the management success of Berkshire Hathaway. that returns earned from marketable securities drove the company‟s investment . For example, in the 14 years ending 2007, the company‟s per-share investment in marketable securities increased 14.3 percent annually. By comparison, during this period, per share operating earnings grew at a 23.5 percent annual rate (see Exhibit 1).5 Importantly, Buffett indicated that the contribution of earnings from whollyowned companies would continue to rise as Berkshire Hathaway placed more emphasis on buying companies outright. It included

(GEICO, General Re, Berkshire Hathaway), (McLane),

(Clayton Homes), (MidAmerican), and many (see Exhibit 2). Even more unique was the operating structure that the company employed to manage these operations. It was While many public corporations implemented strict controls and oversight mechanisms to ensure management performance and regulatory compliance, Berkshire Hathaway moved in the opposite direction. The company had only two main requirements for operating managers: submit financial statement information on a monthly basis and send free cash flow generated by operations to headquarters. Management was not required to meet with executives from corporate headquarters or participate in investor relations meetings; nor was it required to develop strategic plans, long-term operating targets, or financial projections. Vice Chairman Charles T. Munger described the Berkshire Hathaway system as tion just short of abdication.”6 Many of these operating principles, however, were in stark contrast to those generally employed by most public corporations. Indeed, Berkshire Hathaway‟s fundamental practices were based on policies decried by many governance experts as detrimental to shareholders because of the risk that they might allow management to engage in self-serving behavior. Nevertheless, these principles had been effective as practiced at Berkshire Hathaway.

HISTORY The that were founded in the late nineteenth century and subsequently merged in 1955. 5

Ibid., loc. cit. Period 1993-2007, includes earnings from non-insurance subsidiaries only. The figures cited are before taxes. 6 The DuBridge Distinguished Lecture Series, “A Conversation with Charlie Munger,” California Institute of Technology, March 11, 2008. 7 Note: This case reviews only the operating principles that govern Berkshire Hathaway. The company‟s investment principles are not discussed, other than the extent to which they are based on a common philosophical approach.

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For decades, the New England textile industry had been . Despite deep layoffs and investments in plant modernization, s. In , Warren Buffett purchased a controlling interest in the company through an investment partnership that he managed out of Omaha, Nebraska. Buffett believed that, despite the company‟s precarious financial and competitive situation, an investment offered compelling value in comparison to the purchase price, grounded mostly in the opportunity to reduce large amounts of working capital and free up cash. He also believed that operations might be improved with a change in management. After years of effort, the company‟s 8

In

, Buffett announced to his partners that he was

given a sustained run-up in equity prices. Rather than change his investment style to suit the times, Buffett decided it was better to return capital to investors. He gave investors the option of receiving in interest either a cash distribution or shares in Berkshire Hathaway. Buffett indicated that he would retain his personal ownership of Berkshire stock, including any Berkshire stock he received because other investors chose cash. of $105,000 in 1956, had grown to $104 mill

Still operating in Omaha, Buffett He took what cash could be extracted from the company‟s operations and used it to purchase large interests in . Eventually, all of these companies were combined into Berkshire Hathaway, and Warren Buffett‟s friend Charlie Munger, who had separately owned stakes in Blue Chip Stamps and Diversified Retailing, became vice chairman. In contrast to Berkshire Hathaway‟s textile operations which required significant investments in working capital and plant and equipment, t company‟s Buffett and Munger used this money to purchase more companies that were characterized by high cash flow, such as See‟s Candies and the Buffalo News.10 Berkshire also expanded in the insurance industry, after its acquisition of National Indemnity.

. These became part of what later was known as Berkshire‟s “permanent 8

In 1985, the company closed the last of its textile operations. About.com, “Warren Buffett Timeline, A Chronological History of the Oracle of Omaha,” http://beginnersinvest.about.com/cs/warrenbuffett/a/aawarrentimeln_2.htm (November 15, 2008). 10 The Buffalo News became highly profitable a few years after purchase, when its competition closed publication. 9

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holdings.” The Washington Post investment grew from $11 million in 1974 to $1.4 billion in 2007.11 Berkshire made an investment of $45.7 million in GEICO stock between 1976 and 1980 for what eventually became a 50 percent interest in the company; in 1995, it purchased the remaining 50 percent of GEICO that it did not own for $2.3 billion, and GEICO became a wholly-owned subsidiary of Berkshire Hathaway.12 In the Berkshire Hathaway continued to make significant, concentrated equity purchases. The most prominent of these were During these years, Berkshire also . For example, it purchased the (the largest retail furniture store in the U.S., based in Omaha), Borsh (the second-largest jewelry store by volume in the U.S.—after Tiffany‟s Manhattan store—and also based in Omaha), and (diversified company selling World Book encyclopedias, Kirby vacuum cleaners, air compressors, burners and water pumps). In the , Berkshire The company also (the third largest reinsurance company in the world), (operator of flight simulators used in aviation training), (the largest provider of fractional ownership in private jet aircraft), several additional furniture retailers, and other companies. The General Re acquisition was the largest in Berkshire‟s history, valued at $23.5 billion.13 By the 2000s, Buffett indicated that, because of Berkshire Hathaway‟s large asset base, it would be less likely to make sizable investments in publicly traded securities. Instead, the company would further shift its focus toward acquiring companies outright. Berkshire Hathaway continued its buying spree, purchasing (the largest carpet manufacturer in the U.S.), (gas and electric utilities in the U.S. and U.K.), (provider of manufactured housing and related financing), (high-precision replacement parts for carbide metal-working tools, based in Israel), and (diversified businesses previously owned by the Pritzker family of Chicago). By 2007, Berkshire Hathaway‟s insurance and non-insurance subsidiaries generated (before minority interest). 14 Munger commented on the company‟s success: We have about $120 billion in cash and marketable securities, all these wonderful businesses, and all [of this grew] from a place that was worth about $10 million when Warren took over. And we had about the same number of shares outstanding then as now. It‟s a very extreme result…. In the social sciences,

11

Berkshire Hathaway, 2007 Annual Report, loc. cit. Berkshire Hathaway‟s initial investment amounted to an ownership position of 33.3 percent. Because of GEICO‟s share repurchase activity, Berkshire‟s ownership position grew to 50 percent by the time it acquired GEICO in 1995. Berkshire Hathaway, 1995 Annual Report, http://www.berkshirehathaway.com/reports.html. 13 “Business and Finance,” The Wall Street Journal, June 22, 1998. 14 Financial Times, Global 500, based on market capitalization as of March 31, 2008. 12

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really extreme results almost always come from a confluence of 15

BUSINESS MODEL

The corporate office, which Buffett referred to as “world headquarters,” was maintained on very low overhead. As of 2008, only 19 people were employed at headquarters, despite the fact that Berkshire‟s total employment base had over 230,000 individuals working in more than 70 business units. Munger estimated that Berkshire had the lowest ratio of corporate overhead to investor capital of any insurance operation (and likely any major corporation) in the world.

This work was entirely handled by Buffett as chief executive officer and—to the extent that he wanted a sounding board for his ideas—Munger. There was responsible for generating investment ideas or performing macroeconomic or industry analysis. There was also responsible for reviewing and approving potential investments in marketable securities or the outright acquisition of businesses. Instead, the responsibility to source, price, and execute deals lay entirely with the chief executive officer. accessing capital markets when necessary, preparing financial and tax filings, and complying with other administrative and regulatory obligations as required. The company did not employ centralized staff in the areas of human resources, purchasing, marketing, legal, or investor relations. When the media sought public comment from the company, they contacted Buffett directly or, in his absence, spoke with his administrative assistant. When in the office, Buffett was known to answer his own telephone calls. One was the that came from a reduction in rent, salaries, and benefits. Another was the that could arise from having a large staff. For each additional staff member that was hired, work had to be created to keep that individual occupied, and this incremental work could be wasteful or unnecessary. Third, . A large corporate office naturally organized itself to adopt elaborate procedures as more staff members wanted to weigh in on decisions. Berkshire sought to avoid these formalities and increase the pace which with work was accomplished. Most importantly, a small corporate office allowed Buffett to dedicate the majority of his time to his two primary responsibilities: reviewing investment opportunities and discussing business issues with managers. Although Buffett was responsible for allocating capital at the corporate

15

Wesco Financial, 2007 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 1 & 2, February 29, 2008.

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The Management of Berkshire Hathaway CG-16

level, managers had complete discretion about how to allocate capital within their own businesses. Buffett explained: [Charlie and I] tell [our managers] to mail all the money to Omaha. Then when it gets there, we put our arms around it, and we allocate all of it ourselves. That‟s our job. We take responsibility for all capital decisions other than sort of routine expenditures at the operating businesses. And we don‟t get into those at all. For example, if one of our managers is spending $3 million or $4 million on plant and equipment, we have no review process…. We don‟t waste the time to do that. We think those people know how to allocate the money that relates to the actual operations of their businesses. [Charlie and I] think in terms of the capital generated above that.16

Management, in turn, appreciated the autonomy afforded them. According to Munger: The people in the subsidiaries have a feeling that the subsidiaries are more important [than headquarters]. After all, they don‟t much need headquarters. And if you run an imperial headquarters, which exacts a big overhead charge on the provinces, the provinces resent it. The Berkshire system has avoided that.17

. ATTRIBUTES OF THE BUSINESSES Although highly decentralized, the business model of Berkshire Hathaway was not built on a blind delegation of authority to business managers.

According to Buffett, Berkshire

“(1)…

usinesses.” These were generally characterized They also operated in fairly stable industries so that their cash flow generating abilities could be preserved over time. Buffett and Munger believed that investments in great businesses required fewer tough decisions about strategic direction and whether to invest incremental capital. Furthermore, the two men believed that opportunities to invest in these types of businesses did not come frequently, so that when one did become available, Berkshire Hathaway needed to be ready to act. (See Exhibit 3 for 16

Berkshire Hathaway, 1994 Annual Meeting, cited in: Outstanding Investor Digest, loc. cit. Wesco Financial, 2008 Annual Meeting, cited in: Outstanding Investor Digest, Vol. XXI, No. 4 & 5, August 31, 2008. 18 Source: Berkshire Hathaway, “Shareholder Letters,” 1977, http://www.berkshirehathaway.com/letters/letters.html. 17

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more information on the company‟s acquisition criteria. See Exhibit 4 for a more detailed discussion of “great businesses”). To that end, Buffett and Munger focused on developing what they referred to as a . After the circle was defined, all of their time was spent learning and preparing for potential opportunities that lay within it. Buffett explained: You have to stick within what I call your circle of competence. You have to know what you understand and what you don‟t understand. It‟s not terribly important how big the circle is. But it is terribly important that you know where the perimeter is.19 Munger explained that they used such a system to filter through investment opportunities and determine which to pursue. For example, they felt that it was outside their abilities to understand and value industries that were subject to significant change in terms of product, pricing, and competitive landscape (such as consumer electronics, pharmaceuticals, and computer and internet technologies). We‟re like the man who said that he had three baskets on his desk: in, out, and too tough. We have such baskets —mental baskets—in our offices. An awful lot of stuff goes into the „too tough‟ basket. And then we work with the rest. Now, we can‟t put a thing in the too tough basket if it‟s some subsidiary of our own. We‟ve got to deal with it. But if it‟s some security we don‟t own now and it looks too tough to decide whether or not to own it, we just put it in the „too tough‟ basket and think about something else.20 A company with an economic moat was one with a either in terms of low-cost production, economic franchise, consumer brand, trademark, or patent— . For example, among Berkshire subsidiaries, See‟s Candies had an economic franchise that allowed the company to raise the price of its product from less than $2 per pound in 1972 to $14 per pound in 2007, and at the same time increase annual sales volume from 16 million to 31 million pounds.21 Similarly, the direct sales model of GEICO auto insurance gave it a competitive advantage in terms of lowcost policies that allowed it to increase market share from 3 percent in 1997 to 7.2 percent in 2007.22 Finally, Business Wire (along with its main competitor PR Newswire) had a positional advantage in terms of distribution and reach so that companies wanting to disseminate corporate news were highly likely to use its services. 19

Berkshire Hathaway, 1993 Annual Meeting, cited in: Outstanding Investor Digest, Vol. VIII, No. 3 & 4, June 30, 1993. 20 Wesco Financial, 2008 Annual Meeting, cited in: Outstanding Investor Digest, loc. cit. 21 Berkshire Hathaway, 1984, 2007 Shareholder Letters, http://www.berkshirehathaway.com/letters/letters.html. 22 “State Farm Bites Back: Geico Says Not Afraid of Big Dog,” Dow Jones News Service, December 11, 1998; “Ad Wars,” Best’s Review, October 1, 2008.

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Berkshire incorporated The term margin of safety is an engineering concept based on the principle of conservativeness. In civil engineering, the margin of safety is the difference between the maximum weight-bearing capacity of a structure and the actual weight that the structure is expected to bear. Engineers build a margin of safety into their analyses to protect against failure. For example, after Berkshire Hathaway purchased General Re in 1998, Buffett discovered that the company‟s culture of underwriting was not as disciplined as he had anticipated, meaning the company had been writing policies that were inadequately priced. The strength of the company‟s industry position—in terms of reputation and distribution—was such that Berkshire could install a new chief executive officer (Joseph Brandon) to restore underwriting discipline without General Re suffering a permanent loss of market share. Berkshire also incorporated margins of safety when valuing a business. This term was first applied to investing by Columbia University Professor Benjamin Graham who prescribed that an investor factor in a margin of safety between the investor‟s estimation of the intrinsic value of a company and the price s/he would be willing to pay for it. This margin of safety helped to protect the buyer against moderate ...