Showing posts with label berkshire hathaway. Show all posts
Showing posts with label berkshire hathaway. Show all posts

Sunday, April 20, 2014

In Defense of Shareholders

. . . our whole attitude in [Berkshire Hathaway] and what we like to see with the businesses we own stock in is we want to run them for the people who are going to stay in rather than the people who are going to get out. “ Warren Buffett
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Whenever a lean blog publishes a post on the subject of shareholders, it’s usually focused on the negative effects that they can have on a company’s long-term performance.  This one is going to be different.  Reading Warren Buffet’s 2014 letter to Berkshire-Hathaway shareholders reminded me of the important role shareholders play in a company’s success and wonder what business would be like if all investors approached business the way he does.

Investing 101

Investors are a critical part of the operation and growth of a company.  Financing all investment opportunities with debt would be cost prohibitive, and result in stunting growth or sinking the company altogether if interest payments became due before revenue streams from the investments began to occur.  Since interest payments provide the bank’s revenue stream that supports its operation, it needs to be as predictable as sales of products are to a manufacturing or distribution company – which is why shareholders came into the picture.  In the most basic sense, banks finance an organization’s short-term needs while investors finance long-term growth.    Investors who have a “day job” generally rely on salary or wages to finance their day-to-day lives (i.e., their operation) and use investments to finance long-term needs.  Investors without a regular job usually buy stocks that provide little growth but stable income in the form of dividends.  [Note to Finance Professionals . . . this is very basic, so please just go with it]

A combination of the immense growth in stock prices over the years and the instant gratification society in which we live has led many shareholders to begin to act like banks and demand short-term returns for their long-term investments.  As a result, the balance between short-term and long-term performance has been upset.  In an effort to keep up with the demands of shareholders (and continue to efficiently finance growth), decisions are sometimes made that can actually damage the company’s long-term success (e.g., mass layoffs or curtailing needed investment).  Focus and energy are steered toward satisfying the needs of shareholders rather than customers and the death spiral begins (although the effects may not become evident for many years).  In an effort to assure that the value of a company remains high boards started basing executive bonuses on share price.  As a result, some executives ended up losing sight of the true target condition – lower the overall cost to finance long-term growth – and focused only on the share price by taking action that increases the short-term stock value while actually hurting the long-term.  Imagine how different things would be today if, decades ago, companies like IBM, Exxon, or Boeing focused more on short-term performance than long-term development and growth.

To survive and grow, companies must continually build new factories and develop new products, processes, or services.  And, although the leadtime for new developments has dropped, it still takes time to do it successfully.  Developing a new car model or explore and develop a deepwater oil field can take years and cost billions of dollars and, even though the payback may not be seen for many years, it is a necessary investment to assure an ongoing revenue stream.

Are We Are Part of the Problem?

Not surprisingly, I’ve met many people over the years who complained about decisions and actions taken by their employers because they appeared to focus more on the short-term share price than the long-term growth and overall health.  It is surprising, though, that many of these same people check the share prices of the stocks they own several times a day, and buy and sell stocks throughout the year in response to rising and falling prices.  It is easy to get disappointed when the value of a stock we own drops, just as it is to get excited when it rises.  As an example, after making resounding returns on Google stock, many people sold their shares in July of 2011 when the price dropped 20% within one month.  I wonder how many of these same people realize that, had they held on to their shares and thought more about the ongoing earnings and long-term growth potential of the company than the short-term share price, their investment would have increased more than 120% since that time.

We would all like the share prices of the stocks we own to increase every day, indefinitely.  This is not possible, though, so we have to invest in companies that have a high likelihood of increasing over the long-term – i.e., have a clear vision, high quality leaders, a believable estimate of future earnings, and demonstration of the ability to continually improve.  Once these things become evident and we make the investment, we need to get out of the way and let the company operate.  Over the last several years, following this type of philosophy would have led to the decision to invest in companies like Google, Amazon, Tesla . . . oh, and Berkshire-Hathaway.

The Shareholder Activist

In recent years, the activist investors have taken a much more prominent role in the business world.  In some instances where activists successfully shook up the company, the result has been positive while in others it has been disastrous.  I believe it comes down to a question of motives.  Those who have already invested in the company and, in an effort to protect their investment by stopping an ineffective management team from damaging the company often result in positive change and long-term growth.  On the other hand, those who are short-term investors or are on an ego trip can cause considerable destruction to its employees and its longer-term shareholders.  In either case, though, the battle between the activist and company leaders creates an ugly and stressful situation for everyone involved.

Advice from the Oracle

It continually amazes me how so many tend to ignore the advice of Warren Buffett who is arguably the best investor of our time, and instead follow the high-profile activist investors.  While we all respect Buffett and can’t wait to learn about his next investment, though, we continue to look at share prices daily and sell shares when prices fall over a given period of time.  His comment in the letter about his farm sums up the fallacy of this approach:

. . . if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his -- and those prices varied widely over short periods of time depending on his mental state -- how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

We don’t expect the companies to act this way with markets and offerings, so why do we think it’s okay to do it with our investments?  The people who sold Google stock in 2011 reacted to the neighbor yelling a lower and lower price every day, even though the company had a strong revenue stream and many new products in the pipeline that would allow that revenue to continue to grow.  Many of the people who sold their shares did so because they did not understand this and feared that the stock was overvalued.

Where We Are

It would be great for companies – particularly well-managed ones – if all investors followed Buffett’s investment strategy.  Effective leaders could focus on what’s best for the long-term and build strong, healthy companies without worry of distractions from shareholders focusing on quick gains.  Since this is not – and likely never will be – the case, we’ve got to learn to live with the demands of investors.  They are, after all, important stakeholders in the business and their needs cannot be ignored. 

Taking care of shareholders, though, does not mean focusing on short-term actions that do nothing but increase share price.  It means focusing on the customer, developing new products and services that continually take care of customer needs, and doing it safely, quickly, and efficiently.  We need to partner with shareholders in a way that everyone wins.  Warren Buffett has done this by being very open about his focus and making it clear that Berkshire Hathaway is not a company for the short-term investor.  To be successful with this approach, however, requires effective leadership, clarity and constancy of purpose, and the ability to deliver as promised.  And even though adjustments will be required during downturns or when things do not go as planned, leaders must never make decisions or take actions that stray from the purpose.  They must keep investors updated on the outlook and planned adjustments (including the reasons for the adjustments), and respect the fact that they are partners in the business and have a stake in its success.

Interesting that it still comes down to effective leadership . . . something that companies like Amazon, Toyota, Google, and Berkshire Hathaway remind us every day.

Monday, March 8, 2010

Berkshire's Future Management Tool?

Projected Successor to Buffet Uses Termination List to Motivate

Every year, speculation increases as to who will one day succeed Warren Buffet as CEO of Berkshire Hathaway.  According to an article in the February 27th issue of the Wall Street Journal, the most likely heir apparent at present is David Sokol, chairman of MidAmerican Energy Holdings Company and chairman/CEO of NetJets, Inc. (both are units of Berkshire Hathaway).

Mr. Sokol's record at MidAmerican has been impressive.  He took over the company in 1993 and, since Berkshire Hathaway began investing in the company in 2000, earnings have increased from roughly $109 million to $1.7 billion.  Results like this, along with Sokol's reputation as a deal-maker, and his close relationship with Buffet have increased the speculation that he will be the next Berkshire Hathaway CEO.

Many people wonder how the company will change when someone other than Buffet is in charge.  The fact that he ahs been running Berkshire Hathaway since the mid-1960s and has built it from a small, unknown textile manufacturer to the 18th largest company in the world with 250,000+ employees makes discussion and debate about its future very interesting.

Leading Via a Termination List

With Sokol, we do get a glimpse into his leadership style through the book, Pleased But Not Satisfied, that he authored in 2007.  The book presents his philosophy on a variety of business issues, including leadership.  On the topic of managing people, he wrote that he maintains a notebook of the successes and failures of each person on his team.  He uses the information to evaluate and rank each person in terms of whom he would terminate at any given time.

Although I've seen a number of different approaches to leadership over the years, I've never seen one that makes use of a termination list.  In previous blog posts, I've written about the importance of being people-oriented when leading a company.  I believe that an often forgotten responsibility of a CEO is to continually motivate, develop, and focus the efforts of people.  If the leader is not fundamentally people-oriented, attempts to create the type of culture that motivates and unleashes the potential of team members will be a constant struggle.

Keeping a list of successes and failures for coaching purposes is potentially an effective way to develop people.  Ranking people, based on the list, in order of expendability turns the list from a development tool into management by fear.

I'm sure that Mr. Sokol has some very talented people on his team.  I can't help but think, though, that the fear created by the termination list results in burying some of the talent and motivation, discourages people from taking chances or setting aggressive goals for fear of failure, and has resulted in the loss of some potentially excellent workers.

In some way, the results Sokol has achieved at MidAmerican makes it difficult to argue with his approach.  I believe a more open, servant leadership style, however, would lead to even greater results because when people are relaxed and secure in their positions, they are more innovative, less competitive with each other, and willing to strive for the impossible.

The Draw of Berkshire

It is Warren Buffet's reputation as a leader that gives Berkshire Hathaway first shot at many acquisitions - sometimes before anyone else even knows a company is for sale.  Many companies actually approach Buffet when they are ready to sell because they feel comfortable with the way Berkshire treats companies (and the people working in them) after the acquisition.  This gives Berkshire Hathaway the ability to target strong, well-run companies, while avoiding desperate and troubled organizations.

I'm not sure a CEO with a termination list will give an acquisition by Berkshire the same level of desirability.