Warren Buffett is CEO of Berkshire Hathaway and one of the most successful investors of our modern age. He practices what is called ‘value investing’ – using his expert accounting knowledge to value businesses by estimating future cash flows and investing where the market undervalues them. But what are his principles of business ownership, and what can we learn from them?
I recently examined Warren’s address to shareholders in Berkshire Hathaway’s 1995 annual report (note: Berkshire Hathaway is the holding company responsible for his market investments).
And I picked out the following business principles as highlights from page 2: Owner-Related Business Principles.
These principles shed light on how Warren views business investment. They help us understand his methods of successful business management.
[To be clear, the operations of Berkshire Hathaway generally fall into two categories: businesses that are entirely owned by Berkshire Hathaway and those in which it holds shares. This section of the 1995 annual report refers specifically to those businesses owned by Berkshire Hathaway.]
Quoted below are excerpts of the annual report followed by my analysis:
CEO’s personal responsibility to shareholder communication
“With so many new shareholders, it’s appropriate to summarize the major business principles we follow that pertain to the manager-owner relationship.”
As CEO of Berkshire Hathaway, Warren Buffett places great importance on summarizing the business principles and approach to managing their owned businesses.
He appreciates the responsibility and rights given to every shareholder. And wants, as best as possible, to keep them onside with the leadership team’s intentions.
He openly shows his rationale with decision-making and even revels in his appointment to teach his shareholders his methods with candid transparency.
A partnership attitude, with big business structuring
“Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we also, are, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but, instead, view the company as a conduit through which our shareholders own the assets…”
Warren’s leadership style as CEO of a large corporation is not as removed or distant as many. He strives to foster a partnership feel to the arrangement. Sharing personal insights, thoughts, and stories of failure and success so that shareholders feel a high degree of engagement and involvement in the process, much like partners would feel in a partnership structure.
In fact, Warren’s company started as an investment partnership. And his seed investors were members of his own family. So, in a way, this tradition continues – although he has extended the shareholder base to include members of the public, his manner of relating to shareholders still resembles his familiar beginnings as an investor.
There are so many benefits from this style of management. In particular, the network effect of referral. This natural ‘word of mouth’ results from the financial rewards and sense of ownership each shareholder enjoys. From this, they are more likely to share or recommend Berkshire Hathaway to personal and professional contacts.
“In line with this owner-orientation, our directors are major shareholders of Berkshire Hathaway. In the case of at least four, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking.”
Warren’s investment style is ‘skin in the game’. He and all the principal directors of Berkshire Hathaway are major shareholders in the business. In fact, many have the majority of their net worth held in Berkshire Hathaway shares.
A clear demonstration that their money is where their mouth is. And proof that they believe in their investment policies. A simple way to show shareholders that the treatment of their investment money is no different to how they invest their own.
Increase the net worth of every shareholder
“Our long-term economic goal (subject to some qualifications mentioned later) is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.”
Warren’s measure of success is not the overall size of business value. But value per share. In other words, he is concerned about shareholders’ net worth increasing incrementally as a result of Berkshire Hathaway’s investment projects.
He wants every dollar invested with the company to add a dollar plus an accrual to the personal net worth of every associated investor.
Plus, he wants this accrual to be better than would be gained by investing in the average large American corporation (thus, eliminating opportunity cost and making Berkshire Hathaway a ‘no-brainer’ investment).
Cash-generating businesses offering above-average rates of return
“Our preference would be to reach this goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.”
Warren’s principal investment technique is buying cash-flowing businesses that offer unusually high returns on capital invested.
In other words, he seeks to invest in businesses that offer greater returns than their peers.
But it’s a patient game. And one that rewards due diligence. Warren is famed for stating that there are some years in which he might not place a single investment, waiting for the single opportunity which “…simply screams at you, saying: Buy me!”
Again, his expert accounting knowledge is a sound technical foundation for building such investment operations.
Protecting the balance sheet (investor net worth) at all costs
“We rarely use much debt and, when we do, we attempt to structure it on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results, but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.” (As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”).
Warren understands that excessive debt is the enemy of net worth.
And as net worth is the aim of the game, he invests largely without leverage. This does have the drawback of missing out on deals which are out of his price range.
But it also means that he never gets wiped out, nor is his place at the deal table ever jeopardised by insolvency or bankruptcy, as so many investment institutions have over the ages.