Warren Buffett’s annual letter to shareholders came out a few days ago, and it’s a delight to read. A lot of people have been picking out their favorite bits–see, for example, FT Alphaville on the value of gold vs. productive assets, Felix Salmon on Buffet’s acquisitions, Calculated Risk on Buffet’s view on housing, and Kid Dynamite on a whole bunch of topics. The whole letter’s worth a read, but one passage in particular stood out to me (emphasis added):
A few [of Berkshire’s companies], however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. These errors came about because I misjudged either the competitive strength of the business being purchased or the future economics of the industry in which it operated. I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor. Charlie’s has been better; he voted no more than “present” on several of my errant purchases.
Berkshire’s newer shareholders may be puzzled over our decision to hold on to my mistakes. After all, their earnings can never be consequential to Berkshire’s valuation, and problem companies require more managerial time than winners. Any management consultant or Wall Street advisor would look at our laggards and say “dump them.”
That won’t happen. For 29 years, we have regularly laid out Berkshire’s economic principles in these reports (pages 93-98) and Number 11 describes our general reluctance to sell poor performers (which, in most cases, lag because of industry factors rather than managerial shortcomings). Our approach is far from Darwinian, and many of you may disapprove of it. I can understand your position. However, we have made – and continue to make – a commitment to the sellers of businesses we buy that we will retain those businesses through thick and thin. So far, the dollar cost of that commitment has not been substantial and may well be offset by the goodwill it builds among prospective sellers looking for the right permanent home for their treasured business and loyal associates. These owners know that what they get with us can’t be delivered by others and that our commitments will be good for many decades to come.
Please understand, however, that Charlie and I are neither masochists nor Pollyannas. If either of the failings we set forth in Rule 11 is present – if the business will likely be a cash drain over the longer term, or if labor strife is endemic – we will take prompt and decisive action. Such a situation has happened only a couple of times in our 47-year history, and none of the businesses we now own is in straits requiring us to consider disposing of it.
Buffett is admitting here that his decisions are motivated by more than his desire to make money for Berkshire Hathaway. In this case, the commitments that Buffett has made to the sellers of businesses that he’s purchased takes precedence over his duty to maximize value for shareholders. You could argue that the signaling value of this commitment to prospective sellers of businesses outweighs the lost profits of this strategy. What’s interesting, though, is that although Buffett acknowledges this possibility, it’s clear that the financial gains are a second-order effect for him and that simply upholding of commitments, whether he’s legally bound to or not, is what matters.
Of course, there are limits to the extent to which Buffett will hold onto a lagging business. The commitments that he makes to business are contingent on them not losing money in the long-term. Moreover, as Buffett explains in Berkshire’s “Owner’s Manuel,” he’s not going to pour money into unprofitable businesses in the hopes of reversing their fortunes:
[W]e react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.)
Buffet’s stance is in stark contrast to the model of private equity proposed by Andrei Shleifer and Larry Summers in their 1988 paper entitled “Breach of Trust in Hostile Takeovers.” Shleifer and Summers make the argument that for the most part the profits made in hostile takeovers are due not to increased efficiency but to the breach of implicit contracts made between a target company’s shareholders and stakeholders which help “promote relationship specific capital investment by the stakeholders.”
For example, a company might underpay employees while they’re younger employees as they’re learning skills specific to their job. In return, the employees expect secure employment when they’re older as well as wages greater than their marginal product. This might be an efficient arrangement benefiting both the employees and the company, but a private equity firm can still profit by taking over the firm and firing the older employees. The end result is that the PE firm profits at the expense of stakeholders and destroys the increased efficiency that results from the firm’s ability to enter into implicit contracts with stakeholders.
Buffett operates in the exact opposite way. As his effusive praise for the managers of Berkshire’s subsidiaries throughout his letter makes clear, Buffett believes that value is created by upholding rather than destroying these implicit contracts, including those that he makes when he acquires a company. Morality aside, this actually fits with Shleifer and Summer’s hypothesis. The difference (one among many) between Buffett and private equity firms engaged in leveraged buyouts is that Buffett takes a long-term view of value creation while private equity firms often take a short-term view. Breaching these implicit contracts might be a good strategy for enriching shareholders in the short-term, but by eliminating the possibility of implicit contracts, this strategy can damage the long-term value of a company and therefore doesn’t make sense for a long-term shareholder like Buffett.