By Maurie Cashman
Berkshire Hathaway is a wonderful example of the age-old axiom: grow or die, as true today as it has ever been. Last week we talked about the formula O+P=R. The best example of this I can think of is an analysis of Warren Buffettâ€™s Berkshire Hathaway performance.
Iâ€™ve drawn in a few trend lines to help show the relative performance of Berkshire Hathaway vs. the S&P annual growth rate. Note that the S&P rate is pre-tax, which would improve its performance in down years and decrease it in up year on an after-tax basis, making Berkshires outperformance even more astounding. This graph compares growth in Book Value. Its growth in market value, while more volatile, is even more impressive.
While Berkshire Hathaway performed well during its early years, it was on a fairly small base. These were undoubtedly years in which Buffett, and later Charlie Munger, were laying down foundational ideas for how they would grow the value of Berkshire Hathaway in the way in which they have, employing what I believe is a philosophy similar to O+P=R.
If you look at the following chart you can see the massive growth rate that they achieved over time relative to the S&P and how they have now reverted more closely to the mean. However, small increases in growth rates now mean huge returns due to the massive base that Berkshire Hathaway now operates from.
How has Berkshire Hathaway Achieved This?
1. Berkshire Hathaway Looks at â€œNormalized Earningsâ€.
The chart above is a comparison of five year rolling averages of earnings. Buffett and Munger expect power to increase every year. They do not get too wound up if a business has an off-year. To be sure, they expect to understand the factors that contributed to that underperformance. But they learn what they can and continue to move the business forward, measuring its performance over longer periods to keep it on a positive trend. This allows them to build the earnings power of this business so that they can reap massive returns when the underlying factors (the economy, one-time events, etc.) are removed or improve.
2. Infrastructure Investment in Good Times and Bad
One of the keys cited by Buffett and Munger for their success in the railroad business was the fact that they invested massively in infrastructure in a down period. This allowed them to be positioned to capture huge market share gains when volume came back online. In so doing they became a strong number one among the seven large American railroads (two of which are Canadian-based), carrying 45% more ton-miles of freight than their closest competitor.
Berkshire was able to do this due to the strong cash-flow from their other diversified businesses but also because of their strategic planning for the long-term performance of the railroad business. While other rail lines were cutting capital spending to preserve cash, Berkshire was investing cash to position themselves to take market share from their competitors by differentiating themselves through massive infrastructure improvements.
3. Berkshire Picks the Right People
â€œIf you want to guarantee yourself a lifetime of misery, be sure to marry someone with the intent of changing their behavior.â€ -Charlie Munger
Berkshire Hathaway has a philosophy of not buying companies or hiring people with the intent that they are going to change them. They do not follow many of their contemporaries who buy down-trodden companies with the intent to fire all of the employees and slash operating costs.
Berkshireâ€™s philosophy is to find good companies at fair prices and hire strong management teams. They want to expose those companies and managers to the others in their portfolio so that they learn from one another. In this way, Berkshire companies and managers are constantly exposed to strong operating strategies, and the rising tide raises all boats.
4. Berkshire Lets Managers Operate
Once it has the right companies and people on board, Buffett and Munger let them operate their businesses. They operate with extreme decentralization. They believe in their ability to pick companies with superior market positions and management. That is what they do best. They also recognize what they do not do best â€“ or are at least less passionate about, and that is actively managing companies. They set forth a clear set of expectations, incent their managers to meet those expectations, and then get out of the way.
5. Berkshire is Realistic About the Future
Letâ€™s be frank (or Charlie if you prefer). It is very difficult to be very optimistic about the future of the United States, or the world for that matter, if you listen to the incredibly pessimistic and irresponsible discourse of this cycleâ€™s crop of presidential candidates. It is disheartening and disappointing to see the coarseness that we have descended to.
However, we can easily be misled into thinking that the world is coming to an end. We remain the most powerful nation on earth, with a military that is stronger than the next nine nations combined. The worldâ€™s reserve currency has always belonged to the state with the strongest navy and ours is unchallenged. It is unthinkable that the United States will not succeed in spite of itself. While it is true that other nation states have disintegrated, it has been over a very long time period that they have fallen. The world needs the United States to be successful. In spite of our elected â€œrepresentatives,â€ I agree with the optimism exhibited by Buffett and Munger.
Buffett tempers his optimism with a heavy dose of reality, however. He points to the stagnant recovery as an indication of some tough times ahead and particularly to the need to increase productivity if we are to maintain our standard of living.
When you look at your business, how do you react to these core principals? How can you adapt your style and find opportunities to grow the value of your company? Your ownership transition options may depend on it.
Â© 2016 Aspen Grove Investments, Inc.