Category Archives: Invest in Companies with Great Management

Buffett Taps Combs – Confirms Principles

Warren Buffett surprised the financial world this week when he announced that Todd Combs would take over the management of Berkshire Hathaway’s investment portfolio when Buffett steps aside or dies.

If Buffett is anything, he is consistent, and the selection of Combs only further shows Buffett’s adherence to his core principles.

Trust your own judgment

Many times over his career, Buffett has referred to Benjamin Graham’s maxim that, “You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.”

Most of us would reflexively pay lip service to this maxim, but in reality we tend to seek at least some level of comfort from the warmth of the herd. We may dress up our conclusions with the garb of facts, when indeed we are actually only justifying a position we came to as a result of being influenced by the opinions of others.

Buffett made up his own mind about Combs based on his own judgment and reasoning. He is perfectly comfortable in doing so because he has been operating this way his entire adult life. He is not looking for approval, and it means little to him how it was received by others.

For the record, Buffett has a pretty good track record picking talent. After Buffett interviewed Lou Simpson for the GEICO CIO job, he called then GEICO chairman Jack Byrne and said, “Stop the search. That’s the guy.” Simpson’s performance at GEICO has been outstanding.

When Buffett wound up his investment partnership, he referred limited partners to Bill Ruane, who started the Sequoia Fund to manage funds for former Buffett limited partners. Ruane went on to build a superlative long-term track record.

Process over outcome

Investors should focus on process instead of outcome in selecting both investments and investment managers, knowing that if you get the process right, the outcome will take care of itself. If you focus solely on the outcome you may be disappointed down the road to learn that is was achieved by chance or in conjunction with a dangerous level of risk.

Buffett obviously saw in Comb’s work an investment process that would serve Berkshire shareholders well over the long term – one that per Jason Zweig’s article yesterday in the Wall Street Journal, focuses, first and foremost, on the downside, that is grounded in deep fundamental research and staying within Comb’s circle of competence, that is long-term oriented, and that tends away from closet indexing towards concentration.

Temperament is key

Buffett has said that genius is wasted on investing and, given a certain level of intelligence (which Buffett pegs as an IQ of 130); the important thing is to have the right temperament. That temperament includes a great respect for risk, the ability to wait (and wait) for the right opportunity to come along, the ability to be fearful when others are greedy and greedy when others are fearful, the ability to think for yourself (see first point), and a high level of passion for what you’re doing.

I believe Buffett saw the right temperament in Todd Combs. Here’s Buffett, “He is a 100% fit for our culture. I can define the culture while I am here, but we want a culture that is so embedded that it doesn’t get tested when the founder of it isn’t around. Todd is perfect in that respect.”

Once again, Buffett has surprised us by doing the unanticipated. In reality, he was following a set of well-tested principles that date back to his mentor and friend Ben Graham. Time will tell, but I would be surprised if Combs does not work out well.

Berkshire’s Scott Fetzer: A Lesson in Durable Competitive Advantages

Followers of Warren Buffett spend a lot of time writing and thinking about durable competitive advantages – what Buffett calls a moat. Buffett likes to buy companies with a strong moat and asks Berkshire’s managers to focus on making the moats of their respective businesses deeper and wider, with alligators added, if possible.

Buffett has argued that one of the best tests of whether a business has a moat is its ability to raise prices. Buffett writes about how it was near impossible for Berkshire Hathaway to raise prices on its textiles, such as suit linings, while See’s was able to take price increases on its candy virtually every year.

Academicians and analysts have attempted to categorize the source of durable competitive advantages and construct a framework for understanding them. Michael Porter of Harvard is famous for his five forces. Bruce Greenwald of Columbia teaches that high returns on invested capital and stable market share provide quantitative evidence that a business has a moat. Greenwald’s basic argument is that these high returns could not persist without a durable competitive advantage because, absent a moat, new entrants would come into the market and compete away any excess returns. Greenwald indentifies four areas of advantage.

1. Economies of scale (high fixed costs, network effects)

2. Customer captivity (habit, switching costs, search costs)

3. Cost advantages (proprietary technology, being ahead on the learning curve, access to resources)

4. Government protection (licenses, patents)

Greenwald does not view operational effectiveness as a competitive advantage, but rather the “first priority and the last” of businesses without a competitive advantage. Here’s Greenwald from the book Competition Demystified (pages 10-11):

“If the advantages dissipate, whether through poor strategy, bad execution, or simply because of the unavoidable grindings of a competitive economy, these firms will find themselves on a level economic playing field … – where life is all work and where profits, except for the exceptionally managed companies, are average at best.”

What about those exceptionally managed companies? Should investors be looking for those too, if they can deliver exceptional returns on invested capital, even if they don’t have a competitive advantage that fits the academic model?

At the beginning of 1986, Berkshire purchased Scott Fetzer for $315.2 million. This extraordinary business earned $40.3 million on $172.6 million of book value in 1986 for an ROE of 23.4%. ROE was understated because Scott Fetzer held excess cash; it paid Berkshire a dividend of $125 million in 1986.

By 1994, earnings had grown to $79.3 million on a beginning book value of $90.7 million for an ROE of 87.4%. According to Buffett, that meant Scott Fetzer ranked 4th among all Fortune 500 companies, and would have been first but for some accounting flukes in the ROE calculations of the higher ranked companies.

Here’s Buffett in Berkshire’s 1994 shareholder letter on Scott Fetzer’s stellar economic performance:

“You might expect that Scott Fetzer’s success could only be explained by a cyclical peak in earnings, a monopolistic position, or leverage.  But no such circumstances apply.  Rather, the company’s success comes from the managerial expertise of CEO Ralph Schey [emphasis added], of whom I’ll tell you more later.”

“The reasons for Ralph’s success are not complicated.  Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.  In later life, I have been surprised to find that this statement holds true in business management as well.  What a manager must do is handle the basics well and not get diverted.  That’s precisely Ralph’s formula.  He establishes the right goals and never forgets what he set out to do.”

So, Scott Fetzer was clearly one of those “exceptionally managed companies” that Greenwald mentions in passing. My take on this is that, in addition to searching for companies that possess the classic durable competitive advantages listed above, you should not overlook companies that, absent these advantages, possess exceptional management. These are the Michael Jordon’s of managements.

I’ll give one example. Prem Watsa of Fairfax Financial started with $30 million in assets and $7.6 million in equity in 1986. At the end of 2009, assets stood at $28 billion and equity at $7.4 billion. That’s almost a thousandfold increase in a business (insurance) that, according to Buffett, has no competitive advantages.

6 Ways to Evaluate Whether Management is Capable and Honest

Earlier this week, I mentioned in my article “Opportunity Cost: Buffett & Munger’s Powerful Investing Filter” that Buffett looks for companies with capable and honest management. In response, a reader at where the article was also published asked if I had, “Any additional insight into the exact qualifications and evaluation criteria that he may use to evaluate this.” This is a very important question so I am posting my answer on the blog.

1. Do they have a meaningful part of their net worth invested in the company?

2. Is their compensation reasonable?

3. Do they try to manage earnings (a negative) or do they manage the business for the long-term as evidenced by being honest about short-term volatility and challenges they are facing?

4. Is the discussion of the business in the annual report forthright and honest or it is promotional and filled with marketing speak? Does it appear to be written by the CEO or the head of investor relations?

5. What is their record on capital allocation? Go over their track record for the past ten years. Do they repurchase shares when the company is clearly undervalued? Have they made dumb acquisitions by overpaying for businesses with mediocre prospects or devoid of competitive advantages?

6. Have they stayed focused on what they set-out to accomplish? Is it impressive? Buffett has grown book value 434,000% over the past 45 years vs. 5,430% for the market (no typo). Prem Watsa has grown per share book value at a rate of 25.7% for 24 years. Sometimes it just jumps off the page. Look for the .400 hitters and hitch a ride.