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The 'Berkshire System': Life Advice From a Shareholder Letter
"Berkshire had a big task ahead. It solved that problem by avoiding bureaucracy and relying on one thoughtful leader as he kept improving and brought in more people like himself."
Warren Buffett’s track record at Berkshire has been so remarkable that even Buffett himself, if he were young again, couldn’t repeat it. At least that’s what Charlie Munger believes.
Ordinarily, a casualty insurance business is a producer of mediocre results, even when very well managed. Berkshire’s better outcome was so astoundingly large that I believe that Buffett would now fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth.
Munger mused about this topic in 2014, when, in celebration of Buffett’s fiftieth anniversary at Berkshire, he and Buffett published a lengthy 42-page annual letter.
Fifty years ago, today’s management took charge at Berkshire. For this Golden Anniversary, Warren Buffett and Charlie Munger each wrote his views of what has happened at Berkshire during the past 50 years and what each expects during the next 50.
That year’s annual report contained some memorabilia in the appendix (like the 1964 annual report and the two-page purchase contract for National Indemnity). Most importantly though, both Buffett and Munger separately reflected on the factors behind Berkshire’s success. Munger’s analysis of what he calls the “Berkshire system” in particular is a must-read (and hey, it’s still shorter than the Snowball…).
After 50 years, Buffett’s track record at Berkshire was remarkable:
Per share book value compounded at 19.4% and per share earnings at 20.6%
Per share price compounded at 21.6% (for a nice cumulative 1,826,163% return)
Another remarkable statistic Buffett shared was the realized losses in Berkshire’s investment portfolio.
In the past 50 years, we have only once realized an investment loss that at the time of sale cost us 2% of our net worth. Twice, we experienced 1% losses. All three of these losses occurred in the 1974-1975 period, when we sold stocks that were very cheap in order to buy others we believed to be even cheaper.
(Presumably this excludes any wholly-owned assets such as Dexter Shoe and the original textile mills.)
Berkshire’s growing capital base required a constant evolution to sustain any chance of compounding at high rates. Munger divided the company’s history into two eras: at first, Berkshire was primarily a vehicle for Buffett the stock picker. Over time, it developed structural and cultural advantages that provided an edge at scale.
In the early decades of the Buffett era, common stocks within Berkshire’s insurance subsidiaries greatly outperformed the index. And, later, when both the large size of Berkshire’s stockholdings and income tax considerations caused the index-beating part of returns to fade to insignificance, other and better advantages came.
Ajit Jain created out of nothing an immense reinsurance business that produced both a huge “float” and a large underwriting gain. And all of GEICO came into Berkshire, followed by a quadrupling of GEICO’s market share. And the rest of Berkshire’s insurance operations hugely improved, largely by dint of reputational advantage, underwriting discipline, finding and staying within good niches, and recruiting and holding outstanding people.
Then, later, as Berkshire’s nearly unique and quite dependable corporate personality and large size became well known, its insurance subsidiaries got and seized many attractive opportunities, not available to others, to buy privately issued securities. Most of these securities had fixed maturities and produced outstanding results.
Let’s dig into Munger’s take on Berkshire.
Charlie Munger speaks.
Munger sets out to explain five things.
(1) Describe the management system and policies that caused a small and unfixably-doomed commodity textile business to morph into the mighty Berkshire that now exists,
(2) Explain how the management system and policies came into being,
(3) Explain, to some extent, why Berkshire did so well,
(4) Predict whether abnormally good results would continue if Buffett were soon to depart, and
(5) Consider whether Berkshire’s great results over the last 50 years have implications that may prove useful elsewhere.
Well, why did Berkshire do so well? Munger points out four factors:
(1) The constructive peculiarities of Buffett,
(2) The constructive peculiarities of the Berkshire system,
(3) Good luck, and
(4) The weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press.
I like that he admits the role of luck. But what does he mean by Buffett’s ‘constructive peculiarities’?
Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza.
Buffett was, in effect, using the winning method of the famous basketball coach, John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players. That way, opponents always faced his best players, instead of his second best. And, with the extra playing time, the best players improved more than was normal.
And Buffett much out-Woodened Wooden, because in his case the exercise of skill was concentrated in one person, not seven, and his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player does.
Shareholders benefited from Buffett’s singular focus and the fact that he never stopped learning and improving. His knowledge, skills, and relationships kept compounding. And unlike an athlete, Buffett’s body didn’t force him to exit the game. But even an exceptional athlete needs a system that maximizes their impact.
The “Berkshire System”
Munger notes that Buffett, because he controlled Berkshire and “was completely trusted by all the other big shareholders”, had the luxury and freedom to design his own management system for the company.
(1) Berkshire would be a diffuse conglomerate, averse only to activities about which it could not make useful predictions.
(2) Its top company would do almost all business through separately incorporated subsidiaries whose CEOs would operate with very extreme autonomy.
(3) There would be almost nothing at conglomerate headquarters …
(4) Berkshire subsidiaries would always prominently include casualty insurers. Those insurers as a group would be expected to produce, in due course, dependable underwriting gains while also producing substantial “float” (from unpaid insurance liabilities) for investment.
(5) There would be no significant system-wide personnel system, stock option system, other incentive system, retirement system, or the like, because the subsidiaries would have their own systems, often different.
(6) Berkshire’s Chairman would reserve only a few activities for himself.
(7) New subsidiaries would usually be bought with cash, not newly issued stock.
(8) Berkshire would not pay dividends so long as more than one dollar of market value for shareholders was being created by each dollar of retained earnings.
(9) In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the Chairman could pretty well understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters.
(10) In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness, skill, energy, and love for the business and circumstances the CEO was in.
(11) As an important matter of preferred conduct, Berkshire would almost never sell a subsidiary.
(12) Berkshire would almost never transfer a subsidiary’s CEO to another unrelated subsidiary.
(13) Berkshire would never force the CEO of a subsidiary to retire on account of mere age.
(14) Berkshire would have little debt outstanding as it tried to maintain (i) virtually perfect creditworthiness under all conditions and (ii) easy availability of cash and credit for deployment in times presenting unusual opportunities.
(15) Berkshire would always be user-friendly to a prospective seller of a large business.
It’s a blueprint to build something very specific: a decentralized and antifragile conglomerate with an insurance operation at its core to provide structurally attractive leverage (float). It’s also a collection of principles for capital allocation and shareholder friendliness.
Munger described Buffett’s role with great specificity:
(i) He would manage almost all security investments, with these normally residing in Berkshire’s casualty insurers.
(ii) He would choose all CEOs of important subsidiaries, and he would fix their compensation and obtain from each a private recommendation for a successor in case one was suddenly needed.
(iii) He would deploy most cash not needed in subsidiaries after they had increased their competitive advantage, with the ideal deployment being the use of that cash to acquire new subsidiaries.
(iv) He would make himself promptly available for almost any contact wanted by any subsidiary’s CEO, and he would require almost no additional contact.
(v) He would write a long, logical, and useful letter for inclusion in his annual report, designed as he would wish it to be if he were only a passive shareholder, and he would be available for hours of answering questions at annual shareholders’ meetings.
(vi) He would try to be an exemplar in a culture that would work well for customers, shareholders, and other incumbents for a long time.
(vii) His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning; and
(viii) He would also spend much time in enthusiastically admiring what others were accomplishing.
The entire system is designed around the intersection of Buffett’s strengths and the highest value leadership activities:
Attracting, retaining, and motivating Berkshire’s operators;
As well as communication and culture.
Some of the activities may seem a little cheesy. Admire what others accomplish? But consider the challenge of retaining great managers after they sell their business and no longer need to work.
“A majority of the managers that work at Berkshire are independently wealthy. Our job is to make sure that they have the same enthusiasm, excitement, passion, for their job after the stock certificate changes hands, that they had before.” 2008 Annual Meeting
What key motivators besides money and the challenge and love for running one’s business can you think of? How about not being caught up in bureaucracy, earnings calls, and pointless meetings with headquarters? Or how about regular praise from one of the country’s most respected businessmen?
I read that Picasso occasionally paid restaurant tabs with his signature or little doodles. When Buffett praises his managers in public, including at a shareholder meeting attended by tens of thousands, he knows that his words have tremendous value in terms of motivation and even compensation. It’s an intangible asset not found on Berkshire’s balance sheet.
This is related to the “weirdly intense, contagious devotion” of shareholders and admirers. Becoming an attractive home for high quality businesses became a cultural competitive advantage for Berkshire. Importantly, if it could attract and retain high quality managers, they would “require less attention from headquarters.” This was not a luxury but a necessity if Berkshire wanted to continue acquiring companies while maintaining a skeleton staff at headquarters.
Munger points out that the system is not a “one-type-fits-all” solution to emulate. True. It was designed specifically around Buffett’s strengths and to account for Berkshire’s growing capital base. And all of its components are integrated. Remove a few and the flywheel may start to wobble. Even so, it’s filled with timeless ideas.
Consider how Munger framed Buffett’s goals. Buffett…
(1) … particularly wanted continuous maximization of the rationality, skills, and devotion of the most important people in the system, starting with himself.
(2) He wanted win/win results everywhere--in gaining loyalty by giving it, for instance.
(3) He wanted decisions that maximized long-term results, seeking these from decision makers who usually stayed long enough in place to bear the consequences of decisions.
(4) He wanted to minimize the bad effects that would almost inevitably come from a large bureaucracy at headquarters.
(5) He wanted to personally contribute, like Professor Ben Graham, to the spread of wisdom attained.
To me, this reads like a how-to for designing one’s life:
Maximize your impact by developing your unique skills, acting rationally, and empowering others.
Seek win/win relationships and be a good partner.
Think and act long-term to compound positive effects. Carefully consider and align incentives.
Be wary of the inevitable complacency, corrosion, and corruption. Design your life to minimize these forces.
Enrich the world by sharing what you learn.
Similarly, what made Berkshire successful at scale is a blueprint for compounding in life.
Rationally allocate your capital: your money, time, attention, and energy.
Attract high quality partners by being one. Praise their work.
Conquer scale by mastering delegation and associating with people who you can trust and delegate to. When you find those rare people, create conditions that allow them to flourish (mainly by getting out of their way).
Value your reputation and equity highly.
Build your life to be antifragile. Use leverage carefully and structured in such a way that it can’t kill you (or don’t use it at all). Develop a diversified portfolio of income streams. Maintain the cash flow or dry powder to allow you to pounce on unique opportunities when they arise.
Learn how to be a clear and effective communicator.
Lead by example.
Buffett turned his company into a preferred home for businesses he wanted to invest in and leaders he enjoyed working with. He did this by becoming what he wanted to attract.
So don’t let Berkshire’s 372,000 employees fool you. The ideas that made it successful work just as well when applied to one person’s life.
Thank you for reading,