Part I of this series introduced the concept of positioning, as practiced by Warren Buffett (Trades, Portfolio) and Charlie Munger to produce Berkshire Hathaway's (BRK.B, Financial) results over a 50-year period. Because the casual observer may overlook important attributes, we took out X-rays to spot deeper pockets of information and characteristics. Similar to a radiologist, we searched these X-rays for answers to questions like "What else do we see, apart from The Washington Post, Coca-Cola (KO, Financial) and Geico?" Our actions were driven by the insight that our growth as investors requires comprehensive studying of current and former great investors.
"Structure determines behavior." Charlie Munger (Trades, Portfolio).
The X-rays revealed the careful positioning that spanned both business and personal lives of Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio). This careful positioning was a major factor contributing to their success, possibly even the most important. Part I of this article series described how both men are low-cost operators, shun hubris, have a clear sense of purpose, attract quality people and build compounding machines.
Let´s revisit the low-cost aspect, the general attitude to never overspend. Its weight and value can be clarified with a comparison to our personal lives. Basic human nature calls for increased personal spending when household income increases. More money means more stuff, right? Correspondingly, with an increased salary comes more outdoor dining, more expensive holidays, a bigger car or more expensive suits.
But how does that affect our overall economic position? What are the effects of spending more, just because we have more? First, we become more dependent on our monthly salary. Although that does not have to be a bad thing, in the context of this article it may not be optimal. Second, we squander the means to build a war chest for future use. Similar to investors, individuals never really know when the next negative surprise or beneficial opportunity may come along. Third, we may experience increased anxiety later in life when promotions dry up and competition from younger co-workers increases.
Hence, the simple decision to be a low-cost operator can severely influence the trajectory of our personal lives. Looking back later on, we may realize that the wise route was to continually improve ourselves, lower personal costs while increasing savings and investments. This is no different in business. Similar to people, companies need to be low-cost operators. They too, continually need to improve, prepare for surprise opportunities and for a tougher future with increased competition. As Buffett learned in his early years, current company size or competitive advantage may only bring temporary relief. For his own survival, he was forced to transform Berkshire Hathaway into a compounding machine, even though it was already a big, low-cost textile producer.
For increased clarity, let's look at compounding and include the consequences of not being a low cost operator – $10,000, invested in a 2% savings account doubles after 35 years, at 7% it doubles after 10 years and at 25% after 3 years. Compounding therefore has the initial amount and growth rate as interlocking parameters. Unfortunately, if we have built our 25% compounding machine and then discover there is nothing to compound, much goes to waste. Let's say our initial $10,000 has been diminished by frivolous spending or wasteful projects. Consider the two figures below.
Figure 1. The compounding machine.
Suppose that our compounding machine needs a "period" to double its input. In period A our initial unit doubles. In period B, both units double again. After period C, we have eight units, and 16 total units after period D. If our machine's doubling period is three years and we start with $ 10,000, then after 12 years our result is $ 160,000. Now suppose we waste 50% of our initial unit on frivolous spending or a bad project. The figure below shows the difference.
Figure 2. The compounding machine, if it starts with only half a unit.
Starting with half a unit, the result after 12 years is a dramatic loss of eight total units compared to a scenario that starts with a full unit. From this example we can conclude, like Buffett did many years ago, that it's no use building a compounding machine without a low-cost attitude. That requirement holds in every sense of life, personal and business. A company that pays out hefty salaries, grants stock options or starts so-so business projects neutralizes any effort by the investor at effective compounding. In our example, such a company may chip off units provided to it, destroying value the investor built up in earlier phases. It's wise to take this into consideration when analyzing companies.
From this increased insight of the relationship between a low-cost attitude and a compounding machine, we now understand why Buffett and Munger don't award employee stock options – because they are not essential. If the compounding machine design and overall positioning are good, it makes as much sense to hire highly paid employees as it is to lease more expensive office space. On the contrary, we could argue that the presence of stock options is a bad sign that promotes a "take the money and run" habit among employees. Although high pay can and does attract talent, we can ask if it's really the best model. Berkshire seems to answer that question for us. At Berkshire, employees must first save – thus are encouraged to adopt a low-cost life style and way of thinking – then buy Berkshire stock to join the ownership rank and hence enjoy the benefits of the compounding machine they are part of. From a perspective of long-term investors, this model is the intuitive winner over the highly paid hired-gun mercenary version.
Next to the low-cost attitude, avoiding value-destroying business projects is the second vital part of any compounding system. This shows us the next important position Buffett and Munger take with Berkshire. It builds on a subtle but important distinction between wise investing and entrepreneurship. Talk to any newbie entrepreneur and you discover their energetic world changing intentions, aspiring to be the next Microsoft (MSFT, Financial), Google (GOOG, Financial) (GOOGL, Financial) or Apple (AAPL, Financial). Unfortunately, their statistical models miss the hundreds of thousands of failures that don't get similar press as Google and Microsoft. Insert any such entrepreneur into the compounding machine above and notice how the risk profile changes. This is the reason why Buffett is not a world changer and accepts the world as it is. He positions himself with current human behavior versus perceived or expected future behavior, a costly mistake that many entrepreneurs make depending on their experience. Because we all buy insurance, drink beverages and need bulk goods transported, that's where Berkshire is.
There is, however, one exception to this rule of never starting new businesses. That Berkshire should provide this exception shows the intellectual depth at the helm. Human beings have a natural tendency for consistency thinking and following and applying the rules – especially if these rules are there to avoid disaster. In investing, however, precision thinking can be your enemy. Buffett and Munger recognized this when they started Berkshire Hathaway Reinsurance group (BHR), run by Ajit Jain.
Looking back at our compounding machine in figure 1, we could say that BHR was formed during period D in Berkshire's life under Buffett and Munger. With Berkshire having accumulated enough assets, Buffett started BHR to occupy a unique position in major catastrophe reinsurance. Supported by Berkshire's diverse assets and revenue streams, BHR could write larger insurance policies than any other re-insurer was willing or able to take. The formation of BHR fortified and enhanced the compounding machine while it was simultaneously being supported by it.
"If we believe the price to be right, we are willing to write a net line larger than that of any but the largest insurers." Buffett, 1995 letter to shareholders.
Returning back to earth to the average Gurufocus reader: while the talent, hard work and personal sacrifice required to mimic Buffett and Munger may seem overwhelming, we can start with insights from the compounding machine. What are the attributes of the next company you consider buying? What return do you expect over which period? What is your "doubling period" considering your experience?
In concluding this series, the next and hopefully final article will discuss Buffett's X-ray of soft skills, how he relates to others on a personal level and why he seems unable to dislike. Contrary to Buffett, Charlie Munger (Trades, Portfolio) has no need for friends and will list your shortcomings in a heartbeat. This good cop bad cop positioning works well for Berkshire.
