Why Warren Buffett is worth $72 billion and you're not
By Neil Irwin
Consider these two truthful sentences:
Academics who study corporate finance overwhelmingly believe that conglomerates - giant companies that operate in a wide range of industries, often built through acquisitions - are an awfully inefficient way to organize businesses.
And one of the most successful US companies of the past 50 years is a conglomerate called Berkshire Hathaway, run by the renowned investor Warren Buffett, which is the fourth-most valuable firm in the United States, behind only Apple, Google and Exxon Mobil. It employs 340,000 people, roughly the population of Honolulu.
Buffett gave his best go at explaining this seeming contradiction in his latest letter to shareholders released this past weekend, in effect a guide to why he has been able to build such a vast corporate empire and a $72 billion personal net worth. It lays out two theories of why Berkshire has been so successful. But those two theories have radically different implications for how the company will fare after the 84-year-old chairman's retirement or death.
It helps to understand why finance economists don't much like the idea of conglomerates in the first place. Back in the 1960s, a popular strategy was to buy up random industrial companies and use accounting tricks to create the illusion of growth even when the underlying performance of the acquired companies was no better, and often worse, than it had been when they were run separately.
It's easy to look at Berkshire Hathaway over the past couple of generations and see a version of the same thing. Buffett has bought enough seemingly random companies over the years that the combined entity defies any simple description (In short: A giant insurance company plus a giant railroad plus a giant electric utility plus a giant stock portfolio along with various and sundry investments, including in private jet travel, mobile homes, men's and women's underwear, and dairy-based desserts. Oh, and half of Heinz ketchup).
Finance theory would say that there is no real reason for all those unrelated businesses to be underneath the same corporate umbrella. The company is an extreme example of decentralization, with Berkshire Hathaway's corporate headquarters in Omaha, Nebraska, employing only 25 people to oversee this vast empire. All meaningful operational responsibility remains with executives who run all those portfolio companies.
Why shouldn't they each exist on their own, or as part of a larger company with a narrower focus? Here's Buffett's explanation:
"One of the heralded virtues of capitalism is that it efficiently allocates funds," he writes. "Nevertheless, there are often obstacles to the rational movement of capital," for example the reluctance of a CEO in a declining business to shut down factories and return capital to shareholders to be reinvested elsewhere, or the tax and transaction costs for investors who wish to shift money from one sector to another.
"At Berkshire, we can - without incurring taxes or much in the way of other costs - move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That's important: If horses had controlled investment decisions, there would have been no auto industry."
In effect, Buffett is arguing that he and the vice chairman, Charlie Munger, and their 25-person team in Omaha are better at deciding the appropriate allocation of capital among different potential investments than the entire infrastructure of the modern financial system - banks, stock and bond markets, buyout funds and so on - that are supposed to do just that.
The key advantages that Berkshire may have, in other words, are that the company decides how to allocate capital with neither the self-interested decision-making of many operating executives (most people don't want to dismantle the company they lead, after all, even if its business prospects have collapsed), nor the high fees and short-term perspective of private equity and other buyout artists.
If you believe Buffett, Berkshire is able to achieve the analytical rigor of the latter mixed with the long-term perspective of the former.
But there's a bit more to his success than just being really good at capital allocation. There are surely thousands of people who can match Buffett's talent for evaluating the prospects of a business and deciding which should get more investment and which less. But most of them won't end up with a $72 billion net worth and 340,000 employees.
Buffett acknowledges a second reason for his company's success: "We are now the home of choice for the owners and managers of many outstanding businesses." In other words, if you are a family looking to cash out of a business but want to leave the company intact and keep longtime employees in place to run it, selling to Berkshire Hathaway looks mighty attractive. But there's a good chance you're going to have to accept less money than a private equity firm or a strategic acquirer would offer.
The unique art of Buffett and Berkshire, as Matt Levine writes at Bloomberg View, is in the ability to "be rigorous while seeming sentimental, to drive a hard bargain by looking like a teddy bear." In effect, he is able to get favorable deals on his acquisition because of a reputation built over a lifetime for buying good companies and more or less leaving them alone.
That's the giant question for the future of this enormous company. To the degree that this new-style conglomerate has succeeded because it has found a better way to allocate capital than the one the rest of the world uses, it should have a long and bright future under its next chief executive, thought to be either Ajit Jain or Greg Abel.
However, if you want to chalk up Berkshire's success to its ability to persuade sellers of businesses to accept less than a market value for some of the Buffett Mystique, the new leadership, whenever it takes charge, will face a steep challenge in building the same sort of reputation.That's the giant question for the future of this enormous company. To the degree that this new-style conglomerate has succeeded because it has found a better way to allocate capital than the one the rest of the world uses, it should have a long and bright future under its next chief executive, thought to be either Ajit Jain or Greg Abel.
However, if you want to chalk up Berkshire's success to its ability to persuade sellers of businesses to accept less than a market value for some of the Buffett Mystique, the new leadership, whenever it takes charge, will face a steep challenge in building the same sort of reputation.
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