CASE EXAMPLE The Dynamic Capabilities of Warren Buffett

Warren Buffett is CEO and chairman of Berkshire Hathaway; a diversified conglomerate which he runs with his long-time associate and friend, Charley Munger. Munger serves as vice chairman, and is six years Buffetts senior. Berkshire, as the conglomerate is commonly called, is based in Omaha, Nebraska. There, the similarity with any other company ends.

In his office in Omaha, Buffett displays only one certificate of his education. Despite having a degree in economics from Columbia Business School it is a certificate for something more mundane, for completing the Dale Carnegie Course in Effective Speaking, Leadership Training, and the Art of Winning Friends and Influencing people. It is dated 23 January 1952.

More than fifty years ago, Warren Buffett began investing the money of residents in his home town of Omaha. Few could have imagined back in 1956 that this scruffy young man would make them fabulously wealthy. Over time, he would gradually shift from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses. One of these businesses was a worthless textile mill called Berkshire Hathaway, which was eventually closed. Nowadays, the companys annual meeting attracts around 40,000 shareholders. Buffett and Munger spend five hours answering questions from shareholders, journalists, and analysts.

In an age when diversified conglomerates are out of fashion, Berkshires gain in net worth during 2016 was a phenomenal $27.5 billion. Berkshire owns more than sixty companies, including GEICO insurance, BSNF, a rail group, and Mid-American Energy, a utility company. Berkshire acquired Kraft Heinz, which it co-owns with 3G, a buyout fund. Its portfolio of investments includes large shareholdings in mainly American companies such as Coca-Cola, Wells Fargo, IBM, American Express, and recently Apple. Buffett first bought Apple stock in early 2016. The purchase marked a shift in strategy for the investor, who has steered clear of technology stocks; he doesnt even own a smartphone.

His insurance businesses, with premiums paid up front and claims paid later, provide a float for which to fund his investments. Assuming the risks are priced correctly when an insurance policy is written, the revenue generated is free cash. Buffett is keen to perpetuate the culture and character Hathaway embodies. A fellow board member is Bill Gates. In 2006, Buffett donated Berkshire Hathaway shares worth over $30 billion to the Bill and Melinda Gates Foundation, the biggest single charitable donation in history. The charitable Foundation has only three trustees; Bill and Melinda Gates, and Warren Buffett.

After his death, he intends his vast wealth to be given away. That said, he purports to be in excellent health on his regular diet of Cherry Coke and hamburgers. He plays the ukulele and bridge. The one exception to his humble lifestyle is a corporate jet, which is second-hand and named The Indefensible. This brings up the often-avoided question of succession.

In 2017, Warren Buffett and Charlie Munger were aged eighty-six and ninety-three, respectively. The partnership between the two men is one of mutual respect and admiration. As Munger puts it, they dont agree totally on everything, and yet were quite respectful of one another. Buffett points out that whenever they do disagree, Charlie says, Well, youll end up agreeing with me because youre smart and Im right.

Buffetts role is to deliver significant growth to shareholders over time. He has only two jobs, to attract and keep outstanding managers to run our various operations. The other is capital allocation. Over the past fifty-two years Berkshires per-share book value has grown from $19 to $172,108, a rate of nineteen per cent compounded annually. In contrast to other companies, Berkshire directors retain all earnings, paying no dividends. This reflects the belief that they can earn a greater return on capital by investing shareholder funds.

The Sage of Omaha, as Buffett is commonly called, is renowned for taking the right financial decisions. In the late 1990s Buffett warned against the excesses of the dotcom boom. While financial analysts were busy talking of a new investment paradigm he quietly avoided all the new start-up companies he did not understand. From 1998 to 2000 Berkshire Hathaways share price fell by forty-four per cent; at the same time the stock market rose by thirty-two per cent. When these new economy companies went bankrupt after the bubble burst, sticking to his principles paid off.

Prior to the financial collapse of 200708, he described derivatives as financial weapons of mass destruction, the very derivatives on which Lehman Bros and investment banks depended to turbo-charge their profitability prior to their collapse. It was Warren Buffetts reputation which allowed him to take a shareholding in Goldman Sachs and GE on advantageous terms during the financial crisis, which proved hugely profitable. In 2017 Forbes estimated his net worth at $75.6 billion, making him the second richest man in the world after Bill Gates.

Berkshires portfolio of shares and bonds has continued to grow and to deliver substantive capital gains, interest, and dividends. If he can acquire a companys shares when they are cheap, as he did with Coca-Cola after the new Coke fiasco, he will. But as Buffett puts it, its far better to buy a wonderful company at a fair price than a fair company at a wonderful price. The portfolio earnings have provided major support in financing the purchase of businesses.

There has occurred a gradual shift from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses. By the early 1990s, the focus was changing from financial investments to the outright ownership of businesses.

Buffett believes his unconventional, two-pronged approach to capital allocation provides him with a real edge. By 2016, investment in shares comprised only one-fifth of Berkshires assets.

Berkshire Hathaway is a closed-end fund, where shares can be redeemed by selling to another investor, unlike the open-ended funds, favoured by the European Union, which tends to constrain long-term investments. Buffett avoids the financial engineering and creative accounting prevalent among other conglomerates whose professed strength is transferable management capabilities.

His successful formula is to buy quality companies he understands with good defences against competitors. He trusts managers to run them as before, and retains them for the long term. His continued success is contrary to the efficient market hypothesis. This states that, over the long term, the current market price always reflects all available and relevant information about a company. This implies that over the long term you cannot outperform the market, which Buffett consistently does. His choice of acquisitions includes companies with advantage over their competitors that are hard to replicate. This might be a popular brand or companies with some degree of monopoly power; often in mature industries. He admires companies with a strong ethical culture, with managers whose focus is performing a good job rather than making money.

As for Berkshire, a major problem it faces is that its prospective returns fall as its assets increase. That said, Berkshire Hathaway trades at around forty per cent over its book value, evidence that conglomerates can add rather than destroy the value of the companies they own. As Andrew Campbell, co-author of Strategy for the Corporate Level states, no other firm in the past 100 years has been able to do consistently what Berkshire Hathaway has done.

Questions

1. What are the dynamic capabilities which Warren Buffett possesses?

2. Why do you think no organization has copied Berkshire Hathaways relatively simple business model?

3. How will Berkshire Hathaway survive the loss of Warren Buffett and Charlie Munger?