Buffett has often said, “When a good manager and a bad business meet, the reputation of the bad business remains, but the reputation of the good manager goes.” Finding a sustainable competitive advantage for the business is always more important to Buffett than that of good managers. The latter come in handy for him. The most important individual in a company is the CEO. He must always prioritize the interests of the company. His ego must not demand much higher rewards even when his earnings are sufficient. The CEO must constantly fight against arrogance, bureaucracy and complacency, because they are the worst enemies of business.
A good manager has three special characteristics:
1. Reasonableness
2. Owner-friendliness
3. The ability to resist conformity, i.e. following others
The most important task of a manager is to allocate capital. Many CEOs fail Buffett in this task because they do not have enough experience in it before being elected as CEOs. This lack makes many fail even when the quality of the business is high. Capital allocation can be done in the following ways:
1. Investing in current operations
2. Repurchasing own shares
3. Paying dividends
4. Acquisitions
5. Paying off debts
The above allocation methods are not mutually exclusive. Many companies allocate their capital in all ways. The differences in their emphasis depend partly on where in the company's life cycle they are. In the development phase, the company loses money, so all the money goes to improving current operations. The company will probably also need to borrow money. In the rapid growth phase, most or all of the money goes to growth, i.e., current operations. A company that has reached the mature phase generates positive cash flow, which can also be used for alternatives other than investing in current operations. In the final, fourth phase, the company's turnover and profit begin to decrease as the company increases its capital, until the capital also starts to be lost and the company has to cease operations. In the last two phases, capital allocation has many options.
Berkshire invests mainly in companies at a mature stage. Let's start with investing in current operations. According to Buffett, a company should allocate its capital primarily to its current operations, i.e., efficiency, expansion of its scope of operations, expansion or improvement of current operations, and other measures aimed at increasing the moat. In reality, the situation is rarely such that a company should allocate all of its distributable assets to its own business. Investing in current operations only makes sense when the cost of capital acquisition is lower than the returns.
Buffett is considered to favor the purchase of its own shares as the best way for companies to distribute their excess capital to their owners. The most important criterion for Buffett is price. An owner or investor should favor this allocation method only if the company's shares are highly likely to be undervalued. Another reason for management to buy its own shares is that it signals that it has the best interests of its owners in mind. Buffett has two reasons for the wisdom of buying its own shares below their true value alternative. The first is when investments in the company's own business make more sense and debt growth does not make sense. The second, but less common, option is when the acquisition offers clearly more value to the owner than buying undervalued own shares.
The most important aspect of dividend distribution from Berkshire's perspective is whether the management of the acquired company can make more money for Berkshire by investing in its own business than Berkshire's ability to reinvest the same money elsewhere after taxes. There is no clear answer to this question, because company management has different abilities to allocate capital. In addition, the level of taxation affects the interest rate. Buffett favors buying sufficiently large shares of companies, because Berkshire's taxes are then lower. In that case, reinvesting the profits is more profitable from a tax perspective.
Buffett is skeptical about buying growth through takeovers or mergers. In his opinion, these take place on average at the expense of the current owners. The seller knows the value of his business better than the buyer on average. Sometimes, the seller may be in such a difficult situation that that the acquisition makes sense. For a company, managing a new business and merging it with its own business increases the likelihood of mistakes by management. It is better for it to distribute profits to owners, either as dividends or by buying back its own shares. The most important question a CEO can ask is “will the acquisition or merger make our current owners wealthier on a per-share basis than before?”
Berkshire focuses on investing mainly in companies with no net debt, so paying down debt as an alternative to allocating capital is rare for it. Paying down debt can be worthwhile when investing the company's capital cannot generate returns that are greater than the interest paid on the debt. In theory, the opportunity costs of paying down debt can be determined, but in reality they are difficult to calculate, at least if you believe Charlie Munger, who has said that no one at Berkshire knows how to calculate them.
Owner-friendliness is an important characteristic for managers. Corporate management is most likely to be owner-friendly when it has a large portion of its assets tied up in the company's shares. An even better situation is when management has purchased the shares with its own money and has not acquired them at the expense of other owners, such as through stock options. Corporate management must be absolutely honest and always tell the owners the truth. This also applies to its own mistakes. The most important things to tell financially literate owners help answer three questions:
1. What is the value of the company's business?
2. What is the probability that it will meet its future commitments?
3. How well has the management done compared to the opportunities given to it.
Business leaders must have the courage to openly talk about their mistakes, because they will make them sooner or later. Overly optimistic managers pursue their interests in the short term, but everyone suffers from exaggeration in the long term. An investor can examine the admission of mistakes and the extent of optimism by looking at what management has said about the future prospects in its previous reporting. The words can then be compared to the company's success after the reporting.
Capital allocation should be logical and simple. Why do so many business leaders still fail? According to Buffett, the main reason is the tendency of business leaders to conform, i.e. to follow and repeat what others do. For some reason, management rationality disappears as soon as herd mentality strikes. This has several consequences. The first consequence is the company's resistance to change. The second is the waste of funds generated by the company's projects or takeovers. The third is the need of the company's manager for acquisitions. He is supported by producing useless and detailed reports that confirm the damage caused by his stupidity. The fourth consequence is following other companies in the industry by expanding the business unnecessarily, by having similar option programs or by any other stupidity that has been imitated by others.
Unfortunately, few business managers dare to look stupid at a time when other companies are jumping off a cliff to their deaths. Changing direction or making decisions that seem different is not easy. It is easier for business owners to accept the inevitable short-term losses than to make the necessary changes in the management of the company. Instead of making changes, many managers do stupid things, believing that acquisitions will help them achieve better results. Three factors best explain Buffett's follies: First, most CEOs can't control their urges to do something that leads to acquisitions. Second, most CEOs compare their companies to others, whether they're in the same industry or something else. Third, most CEOs have too much confidence in their own abilities.
This is all a result of following other CEOs unreasonably. Part of the reason may also be the operating environment, where CEOs have to be able to justify their compensation while owners pursue short-term interests. Berkshire's unique corporate culture does not encourage this kind of behavior, so it has helped the company succeed. Buffett has never had to fear being fired, so he has been able to facilitate similar activities.
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