Author Background:
Lawrence Cunningham is a leading authority on corporate governance culture and on Berkshire Hathaway and Warren Buffett. He has written several books on value investing and is the authorized editor of The Essays of Warren Buffett: Lessons for Corporate America. A popular professor of business law at George Washington University, his latest book is Berkshire Beyond Buffett: The Enduring Value of Values, in which executives from dozens of Berkshire’s subsidiaries cooperated.
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Transcript:
Jake: Welcome to Five Good Questions. I’m your host, Jake Taylor. Our guest today is Lawrence Cunningham.
Larry is a leading authority on Corporate Governance and Culture as well as on Berkshire Hathaway and Warren Buffett. He’s written several books on value investing and is the authorized auditor of the Essays of Warren Buffett Lessons for Corporate America. In my opinion, it’s one of the best books of business out there.
A professor of Business Law at George Washington University. His latest book is Berkshire Beyond Buffett The Enduring Value of Values. Larry worked with dozens of executives from Berkshire’s subsidiaries to put this book together. Let’s ask him five good questions.
Welcome everybody. My guest today is Lawrence Cunningham. He’s the author of Berkshire Beyond Buffett. Larry, thanks for coming on the show today.
Larry: Pleasure to be here.
Jake: I have to admit that I’m actually I consider myself a bit of a Buffett aficionado and a Buffett geek. But I feel like you put me to shame. And I mean that completely as a compliment.
Larry: Well, thanks. Everyone keeps calling this a deep dive. And really I didn’t thought of it that way. But I really like that idea that it’s down 2 or 300 feet whatever a good deep dive is. So it’s more than people typically go.
Jake: Yeah, I feel like that what Alice Shroeder did for Buffett the man in The Snowball; you’ve done for Berkshire, the company, in the same way of cataloguing the evolution of it. It’s really great.
Larry: Well thanks very much, Jake. I appreciate that.
Jake: So Larry, are you ready for five good questions?
Larry: I am. I love the concept.
Jake: Alright. Question #1. First off, what’s your definition of a moat?
Larry: Oh well, I guess I follow the canonical definition that it is a durable competitive advantage that protects a business’s profitability in long term prospects. And so they come in a variety of forms. And people have catalogued the classifications in a lot of different ways. I like what Bruce Greenwald did. He really tried to boil it down to relatively finite set and simple steps of a few things. But they can still have a variety of merchandising capability, product branding, cost of entry and so on.
And Berkshire obviously has companies that have a wide variety of moats. And right so the question, I don’t know if we’re moving on with it.
Jake: Yeah.
Larry: We have a question I ask in the book. In a way is, gee, if Berkshire subsidiary companies all need to have a moat and tend to have moat. Does Berkshire need a moat? Does it have one?
Jake: Yeah. And what would you say that the parent overarching companies, their overarching moat would be?
Larry: Well, this is what I come out with in the book. And I start first with possibilities that I didn’t rule out. One possibility would be Warren, Warren Buffett. The iconoclastic founder and leader and builder of that company and is sort of the face of the company. And certainly has a set of skills that are very difficult to compete with or difficult to match.
But the reason I wouldn’t leave it there is because one element with the definition of moat is that it’s going to be durable. And so a person, well, contributing enormously to a competitive position, competitive advantage wouldn’t be a moat within that definition.
And well, the second thing is the capital resources and especially through the insurance companies. And again while I think those are formidable, a very strong competitive advantage, very difficult for anybody to match the capital strength, the balance sheet size and so on. There are potential rivals.
And the market that I’m really talking about when I talk about Berkshire having a competitive advantage and needing one is the rivals in the acquisitions market. So private equity firms, LBO operators, other conglomerates and even insurance companies or strategic buyers or some of the particular businesses. So capital strength is important. It’s a part of Berkshire’s brains. But it more contributes to the moat rather than defines it.
So what I finally figured out is that there’s a core set of common values that animate all of Berkshire’s operating subsidiaries. And it’s those core values that define Berkshire’s identity, give it a corporate culture, give it a path, a special place that is very difficult to replicate. That can and I think properly managed and that will endure. And so that combination to me adds up to a moat of the Berkshire Hathaway. So long as everyone protects it. All moats need to be protected and widened. And so long as the people within the company get that this culture, these special features of the business or part of its moat, I think it will be sustainable and durable within my definition.
Jake: Yeah. That’s a great segue for Question #2 and it has to do with Berkshire’s reputation. You know Buffett has a famous quote about it takes 20 years to build reputation and five minutes to lose it and that you should act accordingly. Is there a way to measure how that reputation manifest itself into economic gains so whether it’s a specific example like a discount that Berkshire receives when they buy a company that the seller is willing to take less money because they’re selling to Berkshire?
Larry: I think that’s a great example. And reputation is it one of the 9 values that I identify in the book as part of Berkshire’s moat part of what make Berkshire itself distinctive. And that distinctiveness is also a feature of virtually all of the subsidiaries. Virtually all of the subsidiaries also enjoy strong reputations in their worlds. And the leaders and managers of those companies invest considerably in reputation. They share Warren’s quip about 20 years to build a reputation, you can lose it in a minute.
And you are right that at the Berkshire level, reputation translates into economic gain because sellers of businesses will very often be happy to sell to Berkshire at a lower price than they could get elsewhere where they would be fair in a market valuation. Because Berkshire offers a reputation for a variety of things, integrity in of itself, but also a reputation through allowing its managers to run their own shows. And so many people, especially entrepreneurs, try to find a home for their businesses or particularly happy with Berkshire because they know they will be able to call their own shots and not be micromanaged. And so that’s one reason that an entrepreneur might sell to Berkshire at a price less than a rival bid or less than fair market value.
And similarly, Berkshire has a reputation for permanently owning the subsidiaries that it has acquired. It hasn’t sold the subsidiary in 40 years. And its test for selling a subsidiary is very generous.
Jake: Yeah.
Larry: That the company has to be doomed to failure…
Jake: Yeah.
Larry: …for Berkshire to sell it. So a company that struggles. And we’ve got several right now that are struggling whether NetJet, See’s Candy, Pampered Chef and even Johns Manville. There’s no consideration that, well, “Gee, we may sell this one. Maybe it’s too much of a (Inaudible 07:55) and we want to get rid of it.” There’s no thought of that. The idea is let us maintain it at a minimum and as long as it doesn’t absorb a lot of capital we’ll continue to nurture it.
And so people value that sense of permanence, that sense of autonomy especially family businesses but others. And they were likewise sell to Berkshire the price below rival bids and market values because they assign some value, some economic price, to that promise that reputation for permanence and autonomy.
And this question of how reputation translates into economic gain at the subsidiaries is best illustrated by an example I include in the book about Clayton Homes. That’s the Tennessee based manufacturer of trailer homes. And also a leading lender to people who tend to buy those trailers, who tend to be lower income people or fixed income people.
Well, Jim Clayton, the man who founded that company who I’ve gotten to know, had a very unusual approach to building and lending. He’d sit down with his customers and figure out what their income was and what their assets were and then work backwards to build homes and make loans that fit their budget. And that was extraordinary as we saw in the 2008 financial crisis; a lot of rivals didn’t do that.
Jake: Right.
Larry: They did instead simply try to build the biggest tunnel and make the biggest loan for people who really couldn’t afford it. So that when the crisis hit, those people couldn’t pay, their homes are foreclosed. And many of those lenders went out of business. Well, the effect of that was that Jim Clayton’s company went from being a strong number 4 in the industry to number 1.
So as an example, you know, I sat down with Jim and he’s like the most solid, earnest, salt of the earth kind of a guy. And he just thought, you know, that’s the way to do business. I mean, he cares a lot about what his reputation, or what I call reputation, and he just thought of it in terms of how to be with your customers. Like that’s the right way to be.
Why? Well because you don’t want to chisel cheat your scheme. You want to be direct and forthright and good. And then the off shot of that as I tell you in the book is that doing right by people in that way is actually not only they’re ethical or moral or correct human thing to do, it’s also the proper thing to do. So and again and again at the Berkshire companies we see how that interest in reputation invariably turns into an economic gain.
And so I agree with you entirely, Jake, reputation’s a big part of Berkshire. And it starts with Warren and his joke about 20 years, 1 year…
Jake: Yeah.
Larry: And it just, yeah. And it percolates straight across the subsidiaries. All the men and women who led these companies tend to embrace that idea.
Jake: Yeah, that’s great. And I think it’s almost refreshing that kind of old fashioned approach to business these days. So we’ve gotten so used to expecting someone to try and take every last penny off the table. That when they don’t, all of a sudden you’re feeling you want to reciprocate back to them.
Larry: I think that’s so true, Jake. I mean, I’ll tell you. You know, you asked before we begin the formal interview about the book tour. So I’m out at different cities around the country talking about the book to a wide range of audiences. And one of the subgroups within the audiences has been this group of people who in some way or another are skeptical of corporations in general. That corporations as a group got a bad reputation in America.
And one of the delightful things that I’ve heard so often from this subgroup is, what you just said, that it’s refreshing to hear that there are corporations who believed in the basic principles of The Golden Rule. The things we’re all taught in third grade in elementary school. That there are companies out there that still behave that way. And as long as if they’re being altruistic or abandoning the duty they owe to their owners to generate big returns on capital. But that they see that it’s perfectly possible to be good and profitable at the same time.
So that’s one of the neatest things that I’ve found so far with the book and on the tours. There are some group of Americans who think, “You know what, I have a new view or a new hope in Corporate America.”
Jake: Yeah. I think it probably comes from a little bit longer term approach. Like are you optimizing for the short term or for the long term? So if it’s short term then you’re probably going to be more transactional based versus the relationship of the long term.
Larry: Excellent point and Clayton Homes is a good example of that. That from 2000 to 2008, they were #4 in their industry. They were not gaining and winning. It looked like Fleetwood or Champion, I forget who their rivals, who went bust but it looked like they were winning. They were making more in the short term.
But then as you said, that sort of focus can really skew your sense of what is right and what worked not just tomorrow but 10 years, 15 and 20. And that’s how Jim Clayton has always operated Clayton Homes.
And you’re entirely right that a long time rising is a staple quality of all the virtual subsidiary. That starts at the top too. As you know, I quote in the book that Warren sends a directive to his CEOs every two years. And it’s an astonishingly modest directive. There are only six things on it. And it fit on half a page, really. And one of them is to protect the company’s reputation. That’s just a statement.
And the other is to think about your business on a 50 year time horizon. Just think about your business and assume that it’s the only asset that your family owns and that you can’t sell it, pledge it, hypothecate or do whatever for 50 years. I mean in Corporate America, there is a tendency I think for people to think of long term as 5 years or 7.
Jake: Yeah.
Larry: Or even less, right? So yeah, Berkshire is very unusual. And you’re entirely right that I think… And it’s not easy and I don’t mean to criticize people. It’s very easy to think only about tomorrow or only about next year. Or even for private equity firms to think, “Gee, I know exactly what’s wrong with this company. I can fix it in two or three years. There’s probably a place for that in the economy but that’s, of course, not what this book is about.
Jake: Sure.
Larry: What I’m really saying in this one is there’s really valuable place for the company that can look out 50 years and end up, you know, a big authority. Even in my book is I hope that we will continue to have an environment where that kind of company is possible.
Jake: Yeah. So let’s move on to question #3. And this one has to do with, this actually kind of personal question that I have. That something I haven’t been able to square with my understanding of Mr. Buffett. And it goes down to; I know that he has a compulsion for just very extreme capital allocation. Like making sure that each dollar goes to the most profitable place.
And as an example of that It’s kind of I’ve never seen it written anywhere. But, you know, going to the Berkshire meetings every year, he had this bet with a fund of funds like a hedge fund. And it was a zero coupon bond that they had purchased that would be maturing and it was going to a charity whoever won this bet. And it had to do with whether the S&P 500 would do better than a fund of funds.
So it turns out that Buffett, you know, he actually got out of that bet by pledging his personal like amount of money so that he could buy Berkshire stock with it instead of the zero coupon bond. So like every dollar for him has to be put in the right spot.
Larry: Right.
Jake: Okay. So then that’s one part of it. And then the other part that I have a hard time squaring is that this trust to the point of abdication that they practice at Berkshire where they basically let the subsidiaries really operate on their own. And really just say, “Hey, mail in cheques”, you know, if there’s extra money laying around back to Omaha. I have a really hard time putting those two things together that he could just let capital kind of flow out there nebulously and not really knowing exactly what’s going on versus having every penny allocated in the best possible way. What are your thoughts on that?
Larry: Yeah, I mean the first example is more personal one. So I think he attaches strings to himself, right. That he looks in after every dollar, all hundred pennies of it. Whereas in the organizational model of letting the subsidiary managers lead and makes decisions, he is willing to be off by a few more pennies. It’s not a 100%. He gives them latitude because probably over the longer term, those guys will be better with allocating capital in their units than he would be.
With that said, the managers do have to generate the returns on capital over periods of years. So if a company is simply unable to demonstrate and really do that, their capital allocations from Berkshire will go down maybe to zero. And good examples of those kinds of companies or they could be otherwise wonderful companies who are just not growing and they’re not able to generate high returns on excess capital. Good examples of that are See’s Candy and Scott Fetzer. They have not proven that they are able to generate high returns on capital in the way that the others are. So they’re very profitable. I mean See’s Candies generate 80 or so million in profits a year. But it doesn’t have opportunities to reinvest those funds at the same level as the BNSF Railway or Berkshire Hathaway Energy. So Brad Kinsler at See’s will be sending them a big cheque up to Omaha. And the same is true of Scott Fetzer.
But I think with all of these fellows that the trust based model of delegation that Warren tells the CEOs, you know, just do these 6 things. There’s fellows that turn around and report periodically. There are no rules about how to do it. And each fellow really does it their own way. Some of them can call in and do that often. Some of them rather do monthly report. Some of them check in once a year. There’s sort of different levels of that.
So it’s a really loose way but the eye is on. And what you see is a pretty effective capital allocation mechanism. So if James Hambrick at Lubrizol, for instance, has a strong sense that he could use 1 billion that he probably generates or 2 or 3 that he need an infusion; he keeps Buffet enough up to date so when an opportunity like that arises, he is able to say, “Look here’s an opportunity.” And it might be like that pipeline lubricants business of Phillips 66 that they acquire at the end of 2013. You know, James’ like “Jay, here’s a $1.4 billion opportunity and maybe I’ve got close to that or maybe not.” Give Warren a call and the deal was done.
And so with Greg Abel at Berkshire Hathaway Energy where he is making very large investments in the acquisitions some 5 billion or 7 billion and some similar loans to 500 million or 800 million in renewable energies like wind and solar and stuff like that. Greg’s doing a lot of that on his own. But he’s checking in fairly very regularly, sometimes weekly.
So it is a very informal model and there’s definitely a huge amount of trust in it. But I wouldn’t say. So I think Warren definitely gives his lieutenants, his managers, a little more attitude than he gives his own pocket book, his own checkbook. I think he thinks that over periods of time that that model is more valuable. It’s more likely to produce superior economic returns on capital than one where he insisted on a bookkeeping record in a specific kind of report from each of these fellows.
Jake: Yeah. And I think he’s also pretty conflict adverse. So you know, just going with the flow seems to have worked pretty well for him.
Larry: I’ve noticed that too. It’s interesting that you noticed that. It’s hard to document but that’s an inference I make too. I mean one bit of evidence, and maybe you have some additional evidence, is when a CEO disappoints in some way or another. And I’ve given the book maybe 6 or 8 examples of CEO disappointing in one way or the other. He is not fired. He’s not embarrassed. I mean, it’s a very subtle almost counseling out “Gee, I don’t think this is a fit.” And I don’t even have a script. I don’t know what the phone call is like. But it’s not broadcasted, it’s not advertised. So I infer that, yeah, he doesn’t like the big conflict.
And actually I kind of like that. Personally, I like that too. I tell my students, you know, and I teach in the law school. And you know, half of lawyers are in the court fighting all the time and they enjoy the conflicts. And the other half of us are in board rooms and deal room trying to negotiate friendly solutions.
Jake: To stay out of the court room?
Larry: To stay, yeah, exactly. So I’m pretty much sympathetic to that conflict aversion thing. And yeah and I think that, you know, that’s probably one of the ingredients that makes managers respond. They appreciate the trust. They appreciate that they are probably not that keen on conflict either. So it’s a nice culture. And I’m pretty sure at Berkshire it starts at the top. But the neat thing is that these subsidiaries all tend to have brought that kind of culture with them too. So it’s a nice…
Jake: Yeah.
Larry: …reinforcing.
Jake: Right. They didn’t buy anything that needed that kind of shaping.
Larry: Exactly, very good. Well put. That you’re right.
Jake: I think that’s a good segue to question #4 and this has to do with after Buffett is gone. He’s obviously so revered by all of his managers that everybody wants to produce well for him. Is there any concern for Berkshire that that same imperative won’t be there when it’s the new guy that it’s like, well, that’s not Warren I’m going to try to do well but I’m not going to kill myself like I would to really impress Warren?
Larry: Yeah and I’ve heard that concern stated by many, many people outside of the research for my book. The research for my book which included interviews with a lot of the CEOs of subsidiaries and asking that kind of question and probing for that kind of peculiar motivation. Is your motivation to excel and to be excellent is on the personal one because of Warren Buffett or is it personal because of something about you? Bruce Weber, Bruce Whitman, Tony Nicely. Is it because of Warren is at the top or because it’s something about you?
And you know, these people tend to be modest and they don’t say, “Well, it’s me. I’m a very motivated fellow.” But I do get the sense that, well, Warren is an important part of it. He’s a charismatic leader and people do things for him. I do think a big part of it is the character of these men and women who are at Berkshire and they’re not there accidentally. They’re there because they had the same kinds of values that Berkshire has and then it attracted them to Berkshire.
So yes, I think that there’s something to that. But it’s far from everything. Look, you could if the successor alienated people, if Warren’s successor were a jerk and, you know, really made you not want to come to work that really made you feel mediocre or something. I mean that would have a negative and opposite effect. I mean the leader of the company is obviously very important.
But for that part of my argument, in my belief, is that since Warren has told us that the successor will be chosen from among the ranks of the subsidiary CEOs and my assessment of those people is that they have these qualities. They understand the importance of trust, reputation, integrity, over the long term since they’ve been drinking the Berkshire culture. That, yeah, so I don’t want to overstate the argument that I make. I mean it’s sort of the institution has been structured for the greatest possible change of durability. But if you got the wrong person in there, you could ruin that. Or they made the wrong decisions, if they made decisions that undermines some of these values, you could ruin Berkshire.
Jake: Yeah.
Larry: I mean, It’s not and like any institution has their peculiarity. But the key thing that I’m taking away that I found in the research is that there’s a lot more strength and durability in there than many people have seen.
Jake: Yeah. That’s a good segue for question #5. Obviously, this isn’t the first time that there’s been a key man that at the helm of a big company. Is there anything that we can take from the Pritzker Marmon transition that you actually talk about in your book that might foreshadow what we might see at Berkshire when that terrible day eventually comes?
Larry: That’s a great one, Jacob. Thanks. Yeah, I do think the Marmon group is a good model for Berkshire and its future. The Marmon group was built by Jay and Bob Pritzker, famous Chicago businessmen who had a lot in common with Warren Buffett. In fact, Warren knew Jay as a younger man, Warren probably 20 years younger than Jay had been, and admired his business strategy. Jay and Bob did a similar kind of thing in building the Marmon Group. But what Warren has done in building Berkshire; they were opportunistic, acquisitive, believers in autonomies. So they bought companies, they tended the whole of them. Bob was an engineer, an industrial engineer, so he occasionally did some turnarounds and did some fixing. But nevertheless, revered autonomy and gave his managers as much as of it as you can possibly imagine.
So the company after being built in the 60s, 70s, and 80s was in a 100 different lines of business, a dozen different industries; the most diverse conglomerate that you can imagine. And Bob and Jay sitting at the top of it were very much delegators. So you have all these autonomous operators. And it is just like what we’ve been discussing. I mean these guys believe in reputation, they have long term time horizons. They did a lot of capital allocation on their own at the subsidiaries. The subsidiaries were active acquirers too. So it look very much like Berkshire Hathaway just a little smaller.
So at 2008, Jay Pritzker had passed away. Bob Pritzker stepped down and died a few years later. He turned the leadership of the Marmon Group over to the fellow named John Nichols, also a Chicago businessman who had been the CEO of the Illinois Tool Works which in itself is a huge conglomerate even more diverse than either Berkshire or Marmon Group, hundreds of different lines of businesses. But similar set of principles of autonomy, of a long term horizon, acquisitions and so on.
When Bob Pritzker asked John Nichols to enter Marmon Group, John said, “Well, this is a tall order.” You know, taking over from the iconic Pritzker brothers. And he said. look, I share Bob Pritzker’s management style, Warren Buffett’s management style too of the long term, autonomy and so on. But John thought Bob built this company bit by bit over 30 or 40 years just a Warren built Berkshire bit by bit over 30, 40 years. John said there’s no way that I could know as much as Bob did. Just as there’s no way any successor for Warren can know as much as Warren did even if the person had a higher IQ or whatever. Though John said that the only way I’m going to keep these management principles in place but I wanted to make it work. He created 10 divisions within Marmon. And each of them had a separate president who had autonomy and then report up to John.
So there’s a slight centralization, an incremental bureaucracy. But still with that number, it made manageable wealth. Those individuals could still mostly call all their own shots. And so that explanation for what John did. And Frank Ptak who has succeeded John Nichols set the Marmon Group has followed that same path and I think they’re now 13 instead of 10 division presidents. And it still is a sprawling conglomerate. And it would make total sense to me if Warren’s successor decided to do a similar kind of thing. And the model really worked at Marmon Group of simultaneously sustaining the grand and successful tradition while enabling someone who wasn’t there at every minute like Warren to manage it and keep it together.
And so there are many of that, I have a whole chapter in the book about the Marmon Group because I found it to be such a strong parallel to the Berkshire situation. It’s much smaller company. And the reason it had to essentially find a new home, find a new owner in Berkshire was primarily due to disagreements among a wide number of numbers of the Pritzker family, Jay and Bob’s children and their children. A sprawling family group who, you know, they’re all great and wonderful, very successful business people and they have a large number of people who had ownership of the company and had a lot different views about going forward. And that’s a big difference at Berkshire, there’s no such a family. Warren owns it, owns a big block and his will, you know, provides for that can be distributed to the market place essentially through foundations. So that part of the analogy is missing. We don’t need to worry about it. It’s not as if you need to who would buy Berkshire Hathaway. That’s not really the question.
Jake: Right.
Larry: And yeah, can successors have a management model that enables its continuity without disturbing with special amount of history.
Jake: Right. Great. Well, those are our five good questions. Our bonus sixth question that we always ask is a book recommendation. And we refer something that you’ve given away a lot or you think that’s kind of underrepresented out there that’s kind of a hidden gem. What do you have for us?
Larry: Well, you know, it’s the hardest question. The other ones were relatively easy in comparison because I have given a lot of different books away and I own and admire… I’m lover of books obviously. So it’s kind of hard to choose. I work on it though and I chose a book. That this is the book by David, I’ve got the cover here I don’t know if you can see this. This is by David Bornstein How To Change The World. David was the librarian of Congress for many years. He’s the author of many books. A really intellectual, a real observer of society. And what he does in this, this is a collection of essays about people who he calls Social Entrepreneurs, people who use their innovation, imagination, energy with the business dimension to deal with challenges like the poverty, childhood education, health crisis like from AIDS to other epidemics. And it’s a set of inspiring stories about leadership. It’s a 10 or so years old but it really speaks. I think it resonates today particularly with people involved in impact investing Bill Gates and so on. So I think it’s underappreciated and I just put in a plug for that one. Because I see you’re sitting in a room full of books, they are obviously the things to do is to read as much as you possibly can.
Jake: Sure. Well, we really appreciate that recommendation. Larry, it’s been great having you on and keep up the great work. I mean your first book, The Essays of Warren Buffett is like just an icon; it’s an MBA in a, you know, couple hundred pages. And your new book here, Berkshire Beyond Buffett, is also very good. And just keep up the good work for all of us Buffett followers.
Larry: Thanks so much. It’s been a pleasure to do both of those books. And the opportunity to meet with folks like you is really terrific. So thank you very much.
Jake: Great. Larry, have a great day.
Larry: Thanks, you too.
Jake: Alright.