One of the great ironies of the late-1990’s stock-market bubble is that more Americans followed the advice of Wall Street scam artists than that of Omaha billionaire Warren E. Buffett, the best money manager in the second half of the 20th century.
The “New Paradigm” fooled much of America; Buffett and his partner, Charlie Munger, however, shunned technology and internet stocks. “Only in the sales presentations of investment banks,” Buffett, the CEO of Berkshire-Hathaway, Inc., wrote to shareholders in March 2000, “do earnings move forever upward.” His remarks were prescient. The tech-heavy NASDAQ peaked the same month before losing 75 percent of its value, the Dow Jones Industrial Average fell three consecutive years (2000-02) for the first time in the postwar era, and Washington has struggled to restore public confidence in U.S. capital markets. Surveying this carnage, more Americans may wish they had listened not only to Buffett but to the best money manager of the first half of the 20th century—Julius Pierpont Morgan—who famously said, “I’m not interested in return on capital. I’m interested in return of capital.”
In some respects, Buffett, the second-richest man in America behind Microsoft’s Bill Gates, was the public face of the market in the 1990’s. The financial press extolled the man who compounded money at a 22.6-percent average annual rate after buying Berkshire in 1964. A $10,000 investment is worth more than $40 million today. By contrast, a similar investment in the S&P 500, which represents a broad cross section of corporate America, is worth only $144,000. Berkshire’s class-A shares, the world’s most expensive, have traded as high as $84,000 on the New York Stock Exchange. Buffett terms the firm’s annual meeting, held in Omaha in early May, “the Capitalist Woodstock.” It attracts upward of 15,000 pilgrims, including finance professors confused by Buffett’s ability to beat the market consistently, an event the Efficient Markets Theory (EMT), taught in business schools, suggests should not occur. “To invest successfully,” Buffett said,
you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools.
In other respects, Buffett’s critique of management practices is radical for a CEO. These include the expensing of stock options; the use of special charges for restructuring and mergers; and the ubiquitous Earnings Before Interest, Taxes, Depreciation, and Amortization (EBIDTA). “References to EBIDTA make us shudder,” Buffett noted; “[D]oes management think the tooth fairy pays for capital expenditures?” In 1998, he warned that “a significant and growing number of otherwise high-grade managers have come to the view that it’s okay to manipulate earnings to satisfy what they believe are Wall Street’s desires”—this at a time when much of the investor class wanted only to be reminded how rich the market was making them, a task the financial press was all too eager to perform.
James O’Loughlin does not dwell on these warnings. Instead, he examines Buffett’s and Munger’s management style, which he considers unique in corporate America. The duo, he argues, pursues a “hands off” management style based on “minimum rules of behavior, which tap into a form of motivation that comes from within.” According to this approach, no amount of “management of the individual will engender the desired behavior.” The dominant management style, he contends, is based on retired General Electric CEO Jack Welch’s “command-and-control style” of “alternately hugging and kicking, setting stretch goals, and relentlessly following up on people to make sure things get done.” A key conclusion is that Buffett relies on managers who act like owners. He holds more than 99 percent of his own personal net worth in Berkshire-Hathaway stock.
Mr. O’Loughlin describes how Berkshire has overcome the “institutional imperative.” “In business school I was given no hint of the imperative’s existence, and I did not intuitively understand it when I entered the business world,” Buffett said. In his own words, the imperative may be summed up as follows:
[(1) A]s if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill the available time, corporate projects or acquisitions will materialize to soak up additional funds; (3) Any business craving of the leader, however foolish, will be quietly supported by detailed rate of return and strategic studies prepared by his troops; (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
Buffett and Munger work to cripple the institutional imperative. “After 25 years of buying and supervising a great variety of businesses,” Buffett said, “Charlie and I have not learned how to solve difficult business problems. What we have learned is how to avoid them.” To those who adhere to strategic plans for the reassurance they provide, this mindset is deeply disturbing. There is no dynamic: Buffett has no strategic plan, because it would interfere with his ability to allocate capital, which he does exceptionally well, while Munger has developed a series of intellectual filters designed to prevent the duo from making investing mistakes.
We can see the influence of Howard Buffett (1903-64) operating on his only son, although Loughlin does not discuss it. Howard was a stockbroker, frugal in his habits, who aspired in college to a career in journalism. He was also a four-term Nebraska congressman, a prophetic figure of the Old Right (according to Murray N. Rothbard), and the Midwest campaign manager for Sen. Robert Taft’s doomed 1952 bid for the Republican nomination. (Warren, who began his career as a stockbroker, still lives in the same modest Omaha house and owns newspapers through Berkshire; his politics, however, are Democratic.) Howard, who encouraged independent thought as a habit, adopted from Emerson a favorite maxim: “The great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude.”
On January 18, 1965, shortly after his father’s death, Warren wrote shareholders of the Buffett Partnership, Ltd., “We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t.” The eagerness of managers to follow the institutional imperative, and of investors to follow the madding crowd, it seems, have replaced the critical thinking practiced by father and son.
[The Real Warren Buffett: Managing Capital, Leading People, by James O’Loughlin (London: Nicholas Brealey Publishing) 260 pp., $27.50]