How Berkshire Hathaway Got Bigger by Getting Better (Part One)

By Matthew DiLallo - July 3, 2012 | Tickers: AXP, BRK-B, CHK, KO, GMCR | 0 Comments

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I’m continuing a theme I picked up on from a story about Chick-fil-A founder Truett Cathy.  Back in the 1980s when Boston Chicken (now known as Boston Market) was growing rapidly after raising capital, the Chick-fil-A team spent a long time discussing how they too could get bigger in order to fend off this threat. After hearing all he could take on the topic, Cathy pounded the table and said, “I am sick and tired of listening to you talk about how we can get bigger. If we get better, our customers will demand we get bigger.” Too many companies are caught up in simply getting bigger, but those that strive to get better first tend to ultimately get bigger as a result.

Few companies touch the lives of everyday Americans like Berkshire Hathaway (NYSE: BRK-B) does, whether it’s GEICO insuring your car, a kitchen filled with Pampered Chef products or Benjamin Moore paint on your walls.  Over the decades founder Warren Buffett has grown the business from a failing textile company to a $200+ billion enterprise.  How did Warren and company do it?

It all starts at the top and the principles set out by management.  In 1996, Buffett issued a booklet titled “An Owner’s Manual” and in it he listed 13 owner-related business principles to help shareholders understand his managerial approach.  I want to look at the first two principles in more detail to demonstrate how their focus on getting better led to the company growing bigger. 

Principle #1: 

“Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.”

Unfortunately, today many so called investors are really traders or renters of companies.  We buy with the hopes of a quick gain and sell when we’ve either gotten that gain or if it has taken too long and something else catches our eye.  Not so with Berkshire -- they invest for the long haul and expect their shareholders to do the same.  Two examples he gives in detailing this approach to principle #1 are Coca-Cola (NYSE: KO) and American Express (NYSE: AXP), which were shareholdings back then and continue to be held today.  He calls them both extraordinary businesses, in which success is measured by long-term progress of the companies rather than the month-by-month movements of the stocks.

For Buffett you become a better investor when you take a long-term approach to the company you are investing in.  For him it is decades if not indefinite.  If we as investors are not taking the same long-term view (three to five years at a minimum) then we are doing our financial wellbeing a disservice.  If we want our portfolios to become bigger, we need to become better investors.  A key to that is to invest in better managers, which goes along well with his second principle.

Principle #2:

“In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.”

All too often publicly traded companies will be managed by those who do not have a lot at stake.  If they are paid via stock options they’ll quickly sell them to “diversify” their personal holdings.  Not so with Warren as 98% of his personal wealth was tied up in Berkshire stock when he wrote this principle.  Over the past few years we’ve seen management teams take the thought of eating their own cooking too far, causing themselves to choke after stuffing themselves using margin. 

Take the case of former Green Mountain Coffee Roasters (NASDAQ: GMCR) Chairman Robert Shiller who recently had to sell 5 million shares worth around $125 million to pay off loans he had taken out against his stock holdings.  While he certainly was drinking his own brew, he was on a bit of a caffeine-induced spending spree after pledging $619 million worth of shares as collateral against loans.  Among his purchases, New England Patriots’ Quarterback Tom Brady’s former $17.5 million Upper West Side apartment and over $50 million worth of Krispy Kreme Doughnuts stock.  As part of the margin call he was forced to liquidate his entire 12% stake in Krispy Kreme to go with the Green Mountain shares he was forced to sell.

In another egregious example of a manager biting off more than he could chew, Chesapeake Energy (NYSE: CHK) CEO Aubrey McClendon had been levering up to buy his own company’s shares on margin.  As the financial crisis rolled in he was forced to sell nearly his entire 5.8% stake in the company.  Not only was McClendon burying himself personally under a mound of debt but the company with a current market cap of $12.3 billion is being weighed down by $13 billion of debt its last quarterly report.  While McClendon’s land grab and eventual production could prove lucrative to shareholders, if another recession or credit crisis takes oil and gas prices down further the company could end up being crushed by the debt burden.

In the case of both of these founders their eyes were bigger than the market’s stomach churning volatility could handle.  Because you never know when the next crisis will hit it is wise to watch your leverage.  While I do feel that prudent leverage is a requirement in some businesses when it comes to their cost of capital, it should be part of a long-term strategy, not in order to get bigger faster. 

In both cases these executives tried to make their companies or their own wallets bigger but if they simply followed the examples of Warren Buffett they’d have strived to get better first.  They would have thought as long-term owners in the great businesses they were developing.  Instead they were short-sighted and focused on short-term results and the consequences were disastrous both for themselves and their shareholders. 

Stay tuned for Part II where we look at how Berkshire’s capital allocation decisions helped make the company better and from there the company grew bigger.   

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