A post in a Facebook group called Charlie Munger Fan Club prompted me to write this note on that group. I thought of reproducing it here (with minor changes).
“You should invest in a business that even a fool can run, because someday a fool will.” Warren Buffett’s famous quote, is often misunderstood. When he spoke those words, I don’t think he meant them strictly. Some investors I know, however, disagree with me. They cite other quotes which reinforces the viewpoint.
Here is the first one, from his 2007 letter:
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low- cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”
Here is the second one from his 1991 letter:
“An economic franchise arises from a product or service that:(1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”
And here is the third one from his 1980 letter:
“We have written in past reports about the disappointmentsthat usually result from purchase and operation of “turnaround” businesses. Literally hundreds of turnaround possibilities indozens of industries have been described to us over the yearsand, either as participants or as observers, we have trackedperformance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
All of the above thoughts expressed by Mr. Buffett make many of his followers believe that superior management is irrelevant for investment evaluation purposes. And it’s easy to come to that conclusion if you go by what Mr. Buffett has said in the above quotes.
But if you go deeper, you find something else. I did, and here’s what I found.
In his 1990 letter, Mr. Buffett articulated his rationale for investing in Wells Fargo. He wrote:
“The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussingthe “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.”
His words “leverage magnifies the effects of managerial strengths and weaknesses” imply that whenever leverage is high, management factor is important.
Take HDFC Bank. Would you like to remain invested in HDFC Bank if it was run by a fool who doesn’t know anything about risk management and would love to learn on the job?
Which other highly leveraged industry has attracted Mr. Buffett’s interest? Well, the answer of course is the insurance industry.
Insurance uses float (other peoples’ money) which is another form of leverage. The role of management becomes terribly important in this business. That’s because its easy for a fool to under-price insurance contracts, the consequences of which will not show up in the P&L for many years.
This even more true in the Super Cat insurance business. That’s because there is little baseline information to be relied on to adequately price insurance contracts.
The same logic applies to derivatives, where leverage magnifies the effects of smart, as well as, dumb behaviour.
Imagine if one day someone like Kenneth Lay replaced Ajit jain to run Berkshire Hathaway’s Reinsurance business and its derivatives book!
Which other business models require you to focus a lot on managerial skills? Well, one that comes to mind would be a good business which operates on wafer-thin margins but still delivers an acceptable return on equity because of high capital turns and/or presence of float.
Take, for example, the case of Mclane, a Berkshire Hathaway subsidiary which is a distributor of groceries, confections and non-food items to thousands of retail outlets, the largest of them being Wal-Mart.
In his 2003 letter, Mr. Buffett wrote: “McLane has sales of about $23 billion, but operates on paper-thin margins — about 1% pre-tax.” In 2014, McLane earned $435 million on revenues of $47 billion.
In his 2009 letter Mr. Buffett acknowledged the importance of the management factor in Mclane. He wrote:
“Grady Rosier led McLane to record pre-tax earnings of $344 million, which even so amounted to only slightly more than one cent per dollar on its huge sales of $31.2 billion. McLane employs a vast array of physical assets – practically all of which it owns – including 3,242 trailers, 2,309 tractors and 55 distribution centers with 15.2 million square feet of space. McLane’s prime asset, however, is Grady.“
Running a business like McLane profitably is not easy. The wafer thin margin of just about 1% means that a small slippage in costs can quickly turn the business from being profitable to become a loss making one. And when you combine very high capital turns with operating losses, you sprint towards bankruptcy. So you have to be very very efficient to run a business like McLane. A fool cannot run a business like that successfully.
Based on what I wrote above and other stuff I have read on this subject, I do not think Mr. Buffett meant it literally when he said “You should invest in a business that even a fool can run, because someday a fool will.”
If you read between the lines you find that there have been several occasions — and I just cited three)— where without a highly competent manager in place, Mr. Buffett would never have invested in the business.
We should look at the whole picture and carefully observe what Mr. Buffett does, not just what he says. And, to my mind, he has never invested in a business where he felt the incumbent management was foolish. Nor, in my view, would he like any of his businesses to be eventually run by a fool.
While reading through Buffett letters and other material on Charlie Munger, I came across some important passages which deal with the management factor. Indeed, they reinforce what I wrote above. I am reproducing them here.
Source: Warren Buffett’s Letter to BRK Shareholders in 1990 Annual Report
Take another look at the figures on page 51, which aggregate the earnings and balance sheets of our non-insurance operations. After-tax earnings on average equity in 1990 were 51%, a result that would have placed the group about 20th on the 1989 Fortune 500.
Two factors make this return even more remarkable. First, leverage did not produce it: Almost all our major facilities are owned, not leased, and such small debt as these operations have is basically offset by cash they hold. In fact, if the measurement was return on assets – a calculation that eliminates the effect of debt upon returns – our group would rank in Fortune’s top ten.
Equally important, our return was not earned from industries, such as cigarettes or network television stations, possessing spectacular economics for all participating in them. Instead it came from a group of businesses operating in such prosaic fields as furniture retailing, candy, vacuum cleaners, and even steel warehousing. The explanation is clear: Our extraordinary returns flow from outstanding operating managers, not fortuitous industry economics.
Source: Warren Buffett’s Letter to BRK Shareholders in 1988 Annual Report
At Fechheimer, the Heldmans – Bob, George, Gary, Roger and Fred – are the Cincinnati counterparts of the Blumkins. Neither furniture retailing nor uniform manufacturing has inherently attractive economics. In these businesses, only exceptional managements can deliver high returns on invested capital. And that’s exactly what the five Heldmans do.
Source: Charlie Munger on Elementary Worldly Wisdom talk given at The University of Southern California in April 1994.
I do not think it takes a genius to understand that Jack Welch was a more insightful person and a better manager than his peers in other companies. Nor do I think it took tremendous genius to understand that Disney had basic momentums in place that are very powerful and that Eisner and Wells were very unusual managers.
So you do get an occasional opportunity to get into a wonderful business that’s being run by a wonderful manager. And, of course, hat’s hog heaven day. If you don’t load up when you get those opportunities, it’s a big mistake.
Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks – who was second generation in Marks & Spencer of England – was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man.
These people do come along – and, in many cases, they’re not all that hard to identify. If they’ve got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party – then management can matter much.
However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager.
But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.