ONLY GOOD INVESTORS CAN BE GOOD MANAGERS

ONLY GOOD INVESTORS CAN BE GOOD MANAGERS

’Charlie and I see CEOs all the time who, in a sense, don’t know how to think about the value of the business they’re acquiring. Therefore, they go out and hire investment bankers... If you learn to think intelligently about how to invest successfully in businesses, you’ll become a much better business manager than you will if you aren’t good at understanding what’s required for successful investment.’

What is the essence of a good investor? For Warren Buffett, it means becoming proficient at determining the value of a business. Determination of the intrinsic value of a business is not easy, and it is much more difficult for some businesses than others. Even Buffett admits that the intrinsic value calculation is of necessity an estimate. This estimation process accounts for may variables, and prjects them into the future. The greater the variables, the greater the chance of wide errors in the calculation. This variability is not the problem; it is simply a reflection of reality. The problems start when we deny this reality.

Buffett’s conclusion is that if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. Naturally, to do this the business manager needs to think like an investor--not a speculator, but an investor like Warren Buffett. One of the most glaring indications of business managers failing to think like fundamental investors is their emphasis on growth. Instead of focusing on growth, Buffett argues, they should be thinking about how capital can be best deployed.

When Buffett hears management say we must grow, his response is, Who is the ’we’? For present shareholders, the reality is that all existing businesses shrink when shares are issued. Were Berkshire to issue shares tomorrow for an acquisition, Berkshire would own everything that it owns now plus the new business, but existing shareholders’ interests in such hard-to-match businesses as See’s Candy Shops, National Indemnity, etc. would be automatically reduced.

The only thing that grows with most acquisitions is managerial domain. In order to emulate Warren Buffett, therefore, the first thing a CEO must do is adopt the right mindset. They may have come up through the ranks as an operational manager, but if their predisposition as a chief executive is to manage, the institutional imperative wil color any ’rational’ debate about the conduct of the firm.

For example, one aspect of institutional imperative is the common finding in studies of group decision making that--’as if governed by Newton’s First Law of Motion,’ Buffett reminds us--the process of deliberation serves only to polarize the opinions of the group further in the direction of their pre-deliberation bias. Accordingly, all CEOs need to establish where the rhetorical advantage lies within the companies that they manage. All too often, it lies in clinging doggedly to a growth strategy that, in many cases, eventually will bring the company to its knees.

Management frequently has trouble putting themselves in the shoes of their shareholder-owners, observes Buffett. It is clear at Berkshire Hathaway that Buffett’s predisposition is not to pursue a pre-ordained strategy, but to allocate capital. In order to act like an owner, first you must think like an owner. And Buffett explicitly embeds this rhetorical advantage into the deliberation process that precedes his capital management. The intellectual framework to which he adheres in this respect considers the following points in turn:

1. Does it make more sense to pay (the capital) out to the shareholders than to keep it within the company?
2. If we pay it our, is it better off to do it via repurchases or dividend?
3. If you have the capital and you think that you can create more than a dollar, how do you create value with the least risk?
4. The cost of every deal that we do is measured by the second best deal that’s around at a given time--including doing more of some of the things we’re already doing.

Buffett’s task in corporate governance is to calculate the current intrinsic value of the enterprise, which naturally includes the intrinsic value of current investable opportunities and an option value on opportunities not yet in view. The results of this calculation, which he compares to the value at which Berkshire trades in the marketplace, informs Buffett of the relative merit of capital retention versus payout.

Once a business manager begins to think in terms of capital allocation instead of growth-- thinking like the owner of a business-- the next step toward Buffett-like success if the design of proper remuneration programs that encourage and reward the proper behavior, but that is an entirely new subject to save for another day.

Sage@wallstraits.com

Credits: Much of the information used to create this article was extracted from a new book by James O’Loughlin, The Real Warren Buffett.