(The following is an excerpt from Chapter 8, Autonomy, from Lawrence Cunningham’s upcoming book, Berkshire Beyond Buffett: The Enduring Value of Values; the full text of the chapter, which considers the case for Berkshire’s distinctive trust-based model of corporate governance, can be downloaded free here.)
. . . Berkshire corporate policy strikes a balance between autonomy and authority. Buffett issues written instructions every two years that reflect the balance. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations. Otherwise, Berkshire stresses that managers were chosen because of their excellence and are urged to act on that excellence.
Berkshire defers as much as possible to subsidiary chief executives on operational matters with scarcely any central supervision. All quotidian decisions would qualify: GEICO’s advertising budget and underwriting standards; loan terms at Clayton Homes and environmental quality of Benjamin Moore paints; the product mix and pricing at Johns Manville, the furniture stores and jewelry shops. The same applies to decisions about hiring, merchandising, inventory, and receivables management, whether Acme Brick, Garan, or The Pampered Chef. Berkshire’s deference extends to subsidiary decisions on succession to senior positions, including chief executive officer, as seen in such cases as Dairy Queen and Justin Brands.
Munger has said Berkshire’s oversight is just short of abdication. In a wild example, Lou Vincenti, the chief executive at Berkshire’s Wesco Financial subsidiary since its acquisition in 1973, ran the company for several years while suffering from Alzheimer’s disease—without Buffett or Munger aware of the condition. “We loved him so much,” Munger said, “that even after we found out, we kept him in his job until the week that he went off to the Alzheimer’s home. He liked coming in, and he wasn’t doing us any harm.” The two lightened a grim situation, quipping that they wished to have more subsidiaries so earnest and reputable that they could be managed by people with such debilitating medical conditions.
There are obvious exceptions to Berkshire’s tenet of autonomy. Large capital expenditures—or the chance of that—lead reinsurance executives to run outsize policies and risks by headquarters. Berkshire intervenes in extraordinary circumstances, for example, the costly deterioration in underwriting standards at Gen Re and threatened repudiation of a Berkshire commitment to distributors at Benjamin Moore. Mandatory or not, Berkshire was involved in R. C. Willey’s expansion outside of Utah and rightly asserts itself in costly capital allocation decisions like those concerning purchasing aviation simulators at FlightSafety or increasing the size of the core fleet at NetJets.
Ironically, gains from Berkshire’s hands-off management are highlighted by an occasion when Buffett made an exception. Buffett persuaded GEICO managers to launch a credit card business for its policyholders. Buffett hatched the idea after puzzling for years to imagine an additional product to offer its millions of loyal car insurance customers. GEICO’s management warned Buffett against the move, expressing concern that the likely result would be to get a high volume of business from its least creditworthy customers and little from its most reliable ones. By 2009, GEICO had lost more than $6 million in the credit card business and took another $44 million hit when it sold the portfolio of receivables at a discount to face value. The costly venture would not have been pursued had Berkshire stuck to its autonomy principle.
The more important—and more difficult—question is the price of autonomy. Buffett has explained Berkshire’s preference for autonomy and assessment of the related costs:
We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that [disagreeable] operating and capital decisions are occasionally made. . . . Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly—or not at all—because of a stifling bureaucracy.
Berkshire’s approach is so unusual that the occasional crises that result provoke public debate about which is better in corporate culture: Berkshire’s model of autonomy-and-trust or the more common approach of command-and-control. Few episodes have been more wrenching and instructive for Berkshire culture than when David L. Sokol, an esteemed senior executive with his hand in many Berkshire subsidiaries, was suspected of insider trading in an acquisition candidate’s stock. . . .
[To read the full chapter, which can be downloaded for free, click here and hit download]
The following company is featured as the best monthly investment idea in the current issue of The Moat Report Asia, authored by Singapore-based value investment analyst Koon Boon Kee. Guess the name of the company and receive the full research report absolutely free! Submit your entry below. (One guess per person. The first five people to guess the idea correctly receive the full report.)
Our latest monthly issue for the month of September investigates an Asian-listed company who is the #1 pharmaceutical wholesaler and also one of the largest private sector manufacturer of off-patent medicines in its domestic market. Its integrated business model from pharma manufacturing to wholesale, distribution and marketing has carved out top-selling own-branded products such as #1 in medicated powder, #1 cough mixture, #1 cough expectorant etc. With its network of warehouses strategically located throughout the country, the company is able to provide comprehensive coverage and rapid access to markets and customers, delivering the “Medicines on Call” value proposition to over 4,000 private-sector customers from private hospitals, pharmacies to supermarkets and also serves as the long-term channel partner to international brands such as GSK, J&J, 3M, Colgate Palmolive, Nestle for over 30 years etc.
From FY2014 onwards, the company has operationalized the business to contract manufacture orthopedic components for top MNCs with the full array of machining, casting, coating and forging capabilities. In an economy where fortunes are built from government concessions or licenses, the company has forged a different path by relying on its own capabilities to provide quality pharmaceutical products and healthcare services largely in the private sector. Dr K, the chairman and CEO, and his management team have exercised prudence and discipline in executing their operations and capex plans with a strong balance sheet fortified by net cash that’s around 10.5% of market value while deepening their core competencies in warehousing, logistics, sales and marketing to connect to the fragmented market of over 4,000 clients. For the business model of a pharmaceutical wholesaler-distributor, working capital management is critical.
In terms of inventory management efficiency, at the inventory turnover period of 42 days, the company is nearly twice as efficient as state-linked giants and is nearly on par with world leaders McKesson and AmerisourceBergen, an impressive feat given the logistics challenge in emerging markets. The company’s 9.6% ROA is nearly double that of state-linked leader. At EV/EBIT 10.1x, EV/EBBITDA 8.4x, PE14e 10.2x and P/Book 1.9x, the company is reasonably decent in valuations for its resilient earnings and cashflow growth. Giant drug dealers McKesson (MCK US, MV $44.4bn) and AmerisourceBergen (ABC, MV $17.4bn) are also on the global hunt for acquisition targets; McKesson has bought Germany’s Celesio, one of Europe’s largest drug distributors, for $5.4bn in 4Q13, to link up the supply chains of Europe and US; ABC has acquired a 19.9% stake in Brazilian drug wholesaler Profarma in March 2014 for $100m. More consolidation in the sector globally is likely and could be the catalyst to drive up the valuation of quality emerging market companies in the sector. Long-term downside protection in terminal value is provided by MNCs who will be interested to acquire or partner with the company to possess its valuable wide-moat advantage in its network of warehouses and wholesale-distribution know-how to reach the fragmented customers.
The company has achieved an impressively consistent and improving performance in difficult times and is well-positioned in the local pharmaceutical industry which is among the few industries quite unaffected by economic cycles as the demand for drugs will continue even in difficult times. Public healthcare services in Asia face the problem of social and financial sustainability and the overcrowded public hospitals and clinics have sparked growing demand for reasonably-priced and quality private healthcare services, generic drugs and consumer healthcare products of which the company is a key provider and beneficiary.
What’s your best guess? Let us know and win!
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California, along with many other parts of the country, is experiencing a severe drought. The state’s major reservoirs are at 60% of capacity. Agriculture, consumer of 80% of California water, is reeling. Celebrities like Conan O’Brien and Lady Gaga are doing public service announcements urging Californians to conserve water. Fun fact: California almond growers consume enough water each year to supply 75% of the water used by all California households. Scientists speculate that we could be in an epic 150-200 year drought cycle. If so, we might spend the rest of our lives praying for more rain.
Yes, there is an investment angle here. As I left the office last week and headed for the elevator, an alert popped up on my cellphone. It’s a stock market app that I use to keep track of prices while I’m mobile. The message was company X – can’t mention the name, as we might buy more – was going to report earnings tomorrow, blah, blah blah. We don’t pay a lot of attention to quarterly earnings, but I found myself saying “I hope company X reports lousy earnings so other investors will get impatient and dump the stock”.
Why? We had been buying the stock and didn’t get a full position before the price moved upward. And just like tomatoes, tires or Tommy Bahama shirts – still popular, right? – we prefer to pay less when making purchases. And since the stock market is efficient and sane most of the time, and only occasionally nuts, we usually get the best opportunities when investors go temporarily crazy because of short-term issues.
So we pray for rain, a special Wall Street variety that occasionally gets dumped on companies who dare to disappoint the denizens of lower Manhattan. And unlike fickle Mother Nature, Wall Street can be relied upon to provide periodic rain storms to companies that dare to disappoint. When rain hits a company we admire, we’ll be positioned with a large bucket to catch the downpour from nail-biting investors who aren’t mentally prepared for occasional storms-meaning a lack of patience to wait for the clouds to depart and sunshine to emerge.
Mentally, it can be tough to buy what others are selling. It requires enough knowledge to reject the “herd mentality” that can push share prices down and a cast iron stomach to ignore the flood of sell orders.
Buy low, sell high. Easy to say. Tougher to do. Especially when it’s raining on Wall Street. We’re currently experiencing a drought of buying opportunities in the markets, and like Californians everywhere, we are praying for investment rain.
The above commentary is taken from The Misbehaving Investor, provided by Triad Investment Management.
“All men’s miseries derive from not being able to sit in a quiet room alone.”
– Blaise Pascal
A recent study published by Timothy Wilson, a professor of psychology at the University of Virginia, found that entertaining yourself for a short period of time is not as simple as one would think. Participants in his study were asked to sit quietly in an empty room for 6-15 minutes with only their thoughts to engage them. Even though there was nothing competing for their attention, most participants found they had difficulty relaxing or keeping a coherent train of thought, calling the time “unpleasant.” A total of 11 different experiments were conducted. In additional tests, participants were asked to spend the same amount of time in isolation, but this time they were allowed to read or listen to music. These test subjects found their time “enjoyable.” This finding led the researches to consider whether participants would rather engage in an unpleasant activity over no activity. A new test group of 42 participants, 18 men and 24 women, were asked to sit quietly in a room for 6-15 minutes, but this time the subjects could administer a mild electric shock to themselves from a 9 volt battery. Each subject was able to experience the impact of the electric shock before the test began. Twelve of the 18 men and 6 of the 24 women elected to give themselves at least one shock during their “quiet” time. One test subject, whose data was removed from the study, gave himself 190 shocks, but most participants, on average, delivered 7 shocks during their time alone. From the results of this study, one could easily infer that modern technology has created a society so reliant on constant mental stimulation that even spending 6-15 minutes alone with one’s own thoughts has become a daunting task. I disagree. I believe that Wilson’s results reveal the fact that even though our brains have evolved over time, they still are “hard wired” to be actively engaged and ready to react to changes (danger) within our environment.
Unlike what is popularized in the financial media, investing is not about reacting to the minute by minute changes within the financial markets, looking for a swift return and then moving on to the next opportunity. Investing is thoughtful patience requiring the mental strength to resist the primordial urge to take action. Much of the energy surrounding investing is spent learning about companies and their respective industries. But this is just the starting point. The real heavy lifting comes from distilling down the hours of reading, research, and fundamental analysis into a coherent investing thesis that can be summed up in a simple paragraph. When it comes to evaluating the competitive edge, the scarce resource, or the future cash flows of a company, there is no app, computer program or algorithm that can replace deep thinking. The determination of whether to make an investment is only achieved after spending “quiet” time reflecting upon the company’s future intrinsic value.
Investing is not easy. It requires persistence, focus, discipline, patience and the courage to go against the prevailing market consensus. Successful investing requires one to learn how to harness one’s natural emotions of fear and greed, and not let emotions hijack the investing process. There are times when a self administered electric shock is preferable to reading through another annual report or listening to a conference call. But the benefits received from the time spent quietly contemplating a company’s future more than makes up for the discomfort. Shakespeare wrote that in war, “the better part of valour, is discretion.” It is believed that Shakespeare wrote most of his plays at a quiet country inn in Stratford, England, miles outside the city of London. Besides being a prolific and insightful playwright of the human condition, William Shakespeare was also a successful businessman. His sizeable real estate purchases in Stratford had meaningfully increased during his lifetime. If he were writing about his real estate investments, I think Shakespeare would observe that “the better part of valour, is thoughtful patience.”
This article has been excerpted from the Hazelton Capital Partners 2nd Quarter 2014 Letter to Investors.