Berkshire’s Enigmatic Secret Sauce
A former student of mine is working on a project that seeks to identify the factors that lead to sustained superior business performance. Her task brings to mind Warren Buffett, both for his philosophy and his experiences.
Berkshire Hathaway is surely the dominant example of a company that has delivered consistent superior returns throughout its history. Buffett states, in his letters compiled into The Essays of Warren Buffett, that his returns, first at Buffett Partnership and then Berkshire Hathaway, have averaged 20% per year, as compared to the 10% return delivered by the general market. Buffett himself notes that this differential is likely to be considered “statistically significant.”
Understanding how to think about Buffett’s remarkable success is challenging, however. Buffett offers a broad-based set of investment principles that are easily embraced by the average investor – do not try to time the market, invest for the long term, minimize your transaction costs, and invest in businesses that you can understand. Over time, empirical studies confirm that these strategies are likely to generate better returns than alternatives.
Yet, they fail to explain Buffett’s remarkable investment success. Buffett himself explains that investors cannot expect to generate, on the average, a better return that the market, and that his strategy is more suited to avoiding egregious mistakes than identifying big winners. Buffett’s track record belies this conservatism, and his letters suggest that it is possible to outperform the market over time, by identifying outstanding businesses and investing for the long term.
Buffett’s investment performance is difficult to explain, in part, because Berkshire Hathaway defies easy categorization. The company is a curious hybrid between an investment fund and an operating company. Berkshire Hathaway owns a substantial number of minority positions in publicly-traded companies, positions that have a current market value of around $90 billion. These positions include large pieces of companies such as Coca-Cola, Wells Fargo and American Express.
Although some commentators argue that Buffett overstates the success of these investments, they nonetheless reflect consistently stronger “stock-picking” skills than those of the most successful mutual fund managers. Of course mutual fund managers do not invest large chunks of patient capital, the way Berkshire Hathaway does. And mutual fund managers, as Buffett acknowledges, are limited by market forces in their ability to deviate substantially from the investment strategies of their peers.
At the same time, unlike a true investment fund, Berkshire Hathaway also owns substantially all the stock of many core businesses. Perhaps these investments are the equivalent of private equity investments. Yet the nature of private equity funding requires true private equity funds to turn over their positions, either by selling to other private equity firms or taking their businesses public. In contrast, as Buffett explains, his contemplated holding period is forever. A critical component of this difference is Buffett’s ability to use individual companies to generate capital for the entire enterprise rather than managing each business to maximize its attractiveness to a subsequent buyer.
Ultimately, Buffett’s success is due in large part to the manner in which he, at the top of Berkshire Hathaway, allocates the firm’s capital to new investments. Because of the firm’s structure, Buffett has an unlimited choice of investment options — including public and private companies as well as a limited number of financial instruments – options that most other investors cannot access. Although Buffett highlights several of his highly successful investments in public companies, it is far more challenging for the average retail investor to apply Buffett’s principles successfully by investing only in publicly traded companies.
Second, as Buffett himself observes, timing is critical. Some of Buffett’s investments, Coca Cola, for example, were fantastically successful for a period of time, but have since lagged the overall market.* Others, such as US Air and Salomon, appeared to be disasters yet, through circumstances that Buffett apparently did not anticipate, experienced “miraculous” resuscitations. Given Buffett’s acknowledged mistakes in evaluating these companies, the obvious takeaway for retail investors hoping to learn from Buffett’s experience is that it is often smarter to be lucky than it’s lucky to be smart.**
More generally, after reading The Essays of Warren Buffett, one is left with the question, how much of Berkshire Hathaway is unique to Warren Buffett? And more importantly, what challenges does this raise with respect to succession? After all Warren Buffett is 82 and even if he is in “excellent health,” he will not be around forever.
Given the importance of the succession question, it is one to which Buffett devotes surprisingly little attention in his letters. We all remember the abrupt departure of David Sokel, who was widely believed to have been heir apparent to the Buffett throne. Since then, Buffett has firmly stated that a succession plan is in place and indicated that his position will likely be shared among two or more candidates, but has not named names.
To succeed Buffett’s successors must bring to the table, individually or collectively, two critical skills – the ability to kick the tires and identify quality companies and the discipline to resist trends, fads and market impulses, in overseeing the allocation of capital mandated by the Berkshire Hathaway business model. Whether one or more successors have the fortitude to adhere to these principles in the absence of Warren Buffett’s oversight remains to be seen.
* See, e.g., Adam Levine-Weinberg, Coke Stock: One of Warren Buffett’s Biggest Investments Might Be His Worst, The Motley Fool, Apr. 13, 2013 (available here).
** The line is a lyric from Steven Schwartz’s Pippin, which has recently been revived on Broadway.
Jill E. Fisch is the Perry Golkin Professor of Law at U. Penn Law School, where her work focuses on the intersection of business and law, including the role of regulation and litigation in addressing limitations in the disciplinary power of the capital markets. She is a member of the American Law Institute and a former chair of the Committee on Corporation Law of the Association of the Bar of the City of New York. A more complete bio appears here; her scholarship is available on SSRN here.