Could There Be More Berkshire Hathaways?
Berkshire Hathaway is a hybrid between an investment firm and an operating company, akin to a publicly traded partnership that actively owns operating companies. Berkshire’s management, guided by Warren Buffett and Charlie Munger, chooses a diverse portfolio of firms to invest in, then monitors those firms as an active, attentive owner would. Berkshire shareholders are treated as co-owners of the firm and managers of subsidiaries are expected to act as though they were the sole owners of their divisions. Everyone is expected to have a long-term time horizon. Everyone is expected to pay attention.
Despite being operated very differently from most modern, publicly traded corporations, Berkshire Hathaway is remarkably successful. Some might attribute the firm’s great success to the particular business acumen of Buffett and Munger. Others might attribute it to the fact that the firm is run by its controlling shareholders. In letters to shareholders, edited by Larry Cunningham into essays in The Essays of Warren Buffett: Lessons for Corporate America, Buffett himself attributes the firm’s success to a number of his business philosophies that define every part of Berkshire’s operations from executive compensation to corporate charitable giving to bookkeeping and communication with shareholders.
In light of the tremendous success of Berkshire Hathaway as a whole, and its various subsidiaries individually, I have often wondered why there are not more firms like it. Of course, there is only one Warren Buffett, a point Berkshire shareholders apparently make every year at the annual meeting. But why are more firms not adopting Buffett’s business philosophies and strategies? Berkshire might provide a model for investment firms trying to build a diverse portfolio of firms to offer their investors. It may also teach institutional shareholders how to monitor the managers of the firms in which they have invested. Officers and directors could learn how they should operate a firm for long-term success and how managers should be compensated to encourage optimum performance without giving them perverse incentives.
Still, almost no firms follow this “publicly traded partnership” model. Because Berkshire Hathaway is a holding company, it can seem a bit more like an investment firm than an operating company. Berkshire is an active, attentive owner of its subsidiaries and both defers to the managers of subsidiary firms and monitors them closely. It prides itself on choosing a diverse set of companies to invest in and in finding good managers to run the operating firms. Buffett compares Berkshire’s returns to those of an S&P 500 index fund and noted that investors would not “need” Berkshire if it did not generally out-perform the S&P. (Buffett Essays, p. 36.) In part because Buffett has the vast majority of his wealth tied up in Berkshire, the firm is organized such that an investor could be sufficiently well-diversified even if she only invested in Berkshire stock.
But Berkshire Hathaway is not only an investment vehicle, not merely an over-sized mutual fund. The “co-owners” mentality borrowed from the partnership form pervades the operation of the firm from the ground up. Managers are supposed to think of themselves as sole proprietors who can never sell their businesses. Shareholders are to think of themselves as co-owners and take solace in the fact that the managing partners have significant personal wealth tied up in the firm. This long-term, sink-or-swim together mentality sets Berkshire apart from other public corporations where anonymous shareholders trade stock frequently over anonymous exchanges and almost never meet. Berkshire Hathaway’s shareholders actually show up to the annual meeting and participate in the proceedings. This culture and philosophy sets Berkshire apart from both public operating corporations and investment firms.
The “ownership” mindset takes apathy out of the publicly-traded corporation equation at Berkshire. Most shareholders of public corporations are rationally apathetic about the business and management of those firms because the cost of paying attention far outweighs the benefits any individual shareholder could realize. But Berkshire is run by shareholders who have most of their personal wealth invested in the firm. They are most certainly not apathetic and very motivated to pay attention. Because Buffett and Munger are only diversified to the extent Berkshire is, they cannot abide by the Wall Street Rule if they are unhappy with how a subsidiary is performing. Indeed, they have a firm policy against unloading underperforming divisions of the firm. Significant exercise of voice, not exit, is the only permissible option.
Buffett takes care to note that Berkshire managers are not compensated with fixed options, but rather, receive bonuses that reward them for their own particular achievements. (Buffett Essays, pp. 67-77.) Managers are welcome to use their cash bonuses to purchase Berkshire stock, but Buffett firmly believes that managers must be vulnerable to the downside they can impose on shareholders, not just the upside options would give them. Again, managers must be owners to experience the full upside potential of the equity position. Managers of Berkshire divisions must be willing to invest heavily in the business. Not only is their livelihood tied to their performance, but the performance of a great deal of their personal investment may be as well. This incentive structure might lead managers to be very risk averse, an outcome most firms try to avoid by using option compensation. Such risk aversion fits perfectly with the Berkshire philosophy, however. Buffett wants each manager to act as though she is managing a sole proprietorship she cannot sell. He wants his managers to shoulder heaps of firm-specific risk because he thinks that leads to the best, most reliable long-term business outcomes.
Investing in a firm like Berkshire isn’t for everyone. Buffett hopes to attract a certain kind of shareholder and to be unattractive to arbitrageurs and day traders. He does not want shareholders who live by the Wall Street Rule. He wants shareholders who plan to hold their Berkshire stock for decades. For a long time, Berkshire achieved this goal by resisting stock splits so that its shares remained unusually expensive and so relatively illiquid. Berkshire now allows shareholders to trade in its Class B stock, which is priced more modestly and is easier to fit into a well-diversified portfolio. Class B stock has only a small fraction of the voting power of Class A stock, however, and the offering of Class B stock was structured to prevent frequent trading. (Buffett Essays, pp. 192-196.) Buffett still hopes to create a culture of deep commitment to the enterprise among a group of long-term shareholders. He notes, “What we wish for are shareholders of any size who are knowledgeable about our operations, share our objectives, and long-term perspective, and are aware of our limitations….” (Buffett Essays, pp. 193-194.) That is extremely unusual in today’s public securities markets.
There are aspects of the Berkshire model that would be difficult for other firms to duplicate. Two in particular stand out: Warren Buffett and his long history of success. A very gifted controlling shareholder primarily manages Berkshire. There is no real separation of ownership from control. In that way, Berkshire is vastly different from most public corporations. Berkshire was extremely successful before it was offered to the public. There was a wealth of evidence that the managers of the firm knew how to make it extremely profitable. It would be difficult to recruit shareholders to invest in a firm with such a long-term focus without the long history of success Buffett has at the helm of Berkshire. Even the risk averse can settle into an equity stake in Berkshire with some confidence that they are making a safe investment that will literally reap dividends over the years.
When mercenary managers are hired to run a corporation for less than ten years on average, they cannot establish the same loyalty to one firm and long-term record that will convince shareholders that their judgment is worth the risk of undiversified investment. That is particularly true when those managers are judged by whether they have reached quarterly earnings estimates and by the daily stock price. Of course, corporate managers can and do begin projects that will serve the firm in the long term, but it is more difficult for mercenary managers to say, “Wait this out five/ten years, I think it’s going to be OK,” as Buffett can and has. A manager who is not also a significant owner works at someone else’s whim and simply cannot set the terms of the business as completely as Buffett can. The market will not allow it. Board of directors notwithstanding, Buffett has always been his own boss. He invites his co-owners to join him, not the other way around.
Even if most firms cannot completely replicate the Berkshire model, there are lessons all firms can take from Buffett’s letters. His explanation of executive compensation, for example, is a very convincing argument against the fixed options that dominate executive compensation now. (Buffett Essays, pp. 67-77.) Buffet encourages firms to reward managers on metrics other than stock price and earnings growth and explains why. If firms could measure executive performance by using a broad range of information, they may find a way to allow managers to develop a longer relationship with the firm and create more stability in the firm’s management.
Perhaps the most significant lesson corporate managers could learn from Buffett’s example is his communication with shareholders as owners, in plain English, about the fundamentals of the firm’ s business. Once a year, Buffett tells his shareholders how it’s going, in the terms he would want for himself, so they can make individual judgments about what their investment is worth and whether they should maintain their position in Berkshire. This voluntary disclosure is more meaningful to shareholders and the market than the mandatory disclosures most firms issue and may not be more expensive to produce. While most public shareholders are rationally apathetic, someone, somewhere should be paying attention to corporate disclosures and Buffett sets a wonderful example of the kinds of disclosures those paying attention would find useful and informative.
Kelli Alces is the Loula Fuller and Dan Myers Professor of Law at Florida State University where she specializes in corporate law. Kelli has been a visiting professor at George Mason University, University of Iowa and the University of Richmond. She practiced law at Gardner, Carton & Douglas in Chicago. Most of her scholarship can be found on SSRN here.