Although he didn’t mention it in this letter, Warren Buffett has repeatedly mentioned that he likes to keep a minimum of $20 billion in cash on hand to be placed in Berkshire’s coffers. The reason why he does this is because he wants Berkshire to be protected in the event of an extraordinarily rare catastrophe loss. Berkshire is susceptible to deep earthquakes in California, hurricanes in the southeast, and those extremely rare earthquakes in the Midwest. For instance, Berkshire provides much insurance coverage along the New Madrid Fault, which last went off in February 1812 and destroyed St. Louis in under thirty seconds. It was so deep that the writings of the time suggested that the Mississippi River flowed backwards.
Well, there are three theories regarding the New Madrid Fault: one is that it is now dormant and won’t erupt again. Another is that it only ought to erupt in five-hundred year intervals so that you won’t have to worry about the threat until the 2300s. And the third is that the New Madrid fault could blow at any time, in which case you’ll have to say your Hail Mary quickly. This will always be an unknown until the moment of eruption, and Berkshire Hathaway insures some property against this risk.
How is it that Buffett is able to maintain so much capital on hand in case of an emergency, while other insurance companies typically keep capital as low as is regulatorily possible so that the maximum amount of funds can be invested to fuel growth? One of the reasons is the amount of control that Buffett has always retained at Berkshire. By the time Buffett took control of Berkshire by gobbling up 300,000 shares of the stock and firing Seabury Stanton, he controlled 61% of the company either directly or indirectly. About half of that 61% ownership was money in his name and his wife Susan’s name, and with the rest being people that entrusted their life savings to the twenty-something and then thirty-something Buffett. When he took over Berkshire, the ownership was filled with Buffett people.
This is a noted part of Buffett’s success, but it is rarely dwelt upon. Incentives matter, especially when they affect power. It’s a common theme discussed here. There are many men out there who are brilliant but don’t have the basic infrastructure to execute their long-term plans. Even Bruce Berkowitz of the Fairholme Fund is not immune from these pressures. He was buying bank stocks and insurance stocks in the immediate aftermath of the financial crisis when many value investors were sure they were cheap. The problem? There is no rule that cheap stocks can’t get even cheaper, and there is a substantial portion of mutual fund investors that see something fall 20%, 30%, 40%, and then sell the mutual fund. This means that Berkowitz—who was buying banking stocks precisely when he knew they were cheap—had to sell them because his investors grew skittish. He had no choice but to sell something cheap. Buffett has been able to build what he has because he removes the impediments to realizing his vision—the interference of other people that can’t stand volatility or conservative practices of keeping much cash available.
In his letter that came out today, Buffett mentioned that Berkshire Hathaway has fallen 50% three times since he took over (on previous occasions, Munger has said it happened four times, but you get the point). If he didn’t have such large ownership control or a long-term record that preceded it, he could have been booted out of the CEO and Chairmanship position and been nothing more than a footnote to history because his subsequent efforts would have likely been through private investment efforts (in which case he’d have the public profile of someone like Seth Klarman). A lot of people could achieve more satisfying results if they asked themselves the question: what do I seek to achieve, what obstacles emerge at the low point of trying to realize that objective, and how can I sidestep that to get what I want, anyway.
If I were Bruce Berkowitz, I would have arranged my investors with others through a closed-end fund arrangement so that skittish investors wouldn’t actually affect your ability to buy bank stocks when you desire. The downside of this approach is that don’t get as easy of a cash infusion during good times to invest. I would consider this tradeoff worth it.
When Munger mentioned in his letter that Buffett has the right incentives at Berkshire, he said that Buffett regularly gets sent the extra cash on hand at the operating companies. He did not elaborate on how Buffett is able to do so readily get his managers to do this. Perhaps a story from Munger’s biography (written by Janet Lowe), Damn Right, would illustrate this point well. After Buffett and Munger bought See’s Candies for $25 million, they made a deal with Chuck Huggins—the CEO that they had installed. The arrangement called for an enhancement of See’s competitive position based on certain market share qualifiers, and he got bonus money based on how much money he shipped to Omaha. The bonus grew quite substantial if the cash increase was 12% above the previous year.
Buffett reportedly remarked to Huggins, “I hope to write you bigger and bigger checks for the rest of your life.” This is truly remarkable thinking. Most executives would eventually grow angry once the bonus money consumed a certain amount of capital, and would look for ways to get out of the arrangement. That is not how Buffett’s management incentives work—they more cash you send him, the more you get paid. The ending result of this arrangement gives you absurd figures like this: Since acquiring See’s Candies in 1972, Berkshire Headquarters got sent $1.9 billion while See’s only needed to keep $40 million of profits to reinvest into the company.
That’s $40 million with an “m” and $1.9 billion with a “b”. Other than the insurance float, See’s Candies is one of the reasons why Berkshire has become Berkshire. That little San Francisco candy company has given Warren Buffett almost $2 billion to invest into new stocks since then. I don’t for a moment think that Buffett would have had that much money wrung out of the company if Buffett merely said to Huggins, “Send me what you can” and left it at that.
Buffett is one of the few people that has successfully demonstrated what can be accomplished when you get financial executives right (interestingly, Anheuser Busch’s Belgian management team has also gotten this right, rewarding site managers and regional executives based on productivity gains related to low capital deployment. It explains why profits have grown 95% while the amount of beer being sold over the past five years has only increased by 33%).
The other things that Buffett practices, mentioned by Munger in his letter, involve his interactions with people. He does not tell them to retire because they are old. He does not hassle them for updates. His only request is that bad news be promptly reported (bad news doesn’t get you into trouble with Buffett, burying personal troubles like Bob Merritt did at Benjamin Moore paints is what led to his ouster). It’s possible to attract top talent—even when you are dealing with people not accustomed to working for others—if you let them initiate contact with you, create a hassle-free environment, give them significant financial incentives, and even give them an allowance for personal mistakes as long as it is promptly reported. Buffett has never said this directly, but the reason he has such great managers is because he simulates the experience of being an owner for those whom he makes a subsidiary employee. It’s a wise lesson to keep in mind if you ever find yourself needing to keep a truly indispensable employee.
My favorite part about Buffett’s management style mentioned by Munger? That Buffett has adopted Munger’s practice of setting aside time each morning for personal learning and self-improvement. It was something that Munger did in his early days while he was a lawyer charging $15 per hour (the equivalent of $110 today) before migrating over to business full time. He would think about where he wanted to go, and then break down the necessary steps to accomplish it. It prevented him from aimlessly meandering his way through life. As Munger found business success, he continued the process because he believed it led to his success. Regular contemplation provided him with the necessary insights to make money, and then once he did that, to reflect upon why it was personally important for him to have it in the first place.