Lessons from Buffett: Running a Business

Buffett, the well-written biography of Warren Buffett by Roger Lowenstein, offers an interesting biographical sketch with several insights into principled business and investing.  In this first reflection I am going to compare Warren Buffett’s management philosophy with that of Charles Koch’s.

While their businesses face a host of different incentives — Berkshire Hathaway a publicly owned company and Koch Industries privately held — their principled approach to business echoes many similarities.

Value Creation

Both Buffett and Koch approach business with an openness to change and with a focus on creating value, wherever they can find it.

“Buffett did not think of Berkshire necessarily as a textile company, but as a corporation whose capital ought to be deployed in the greenest possible pastures.”  As Berkshire’s textile business struggled, Buffett began directing it’s profits into new sectors and opportunities.

Similarly, Koch, initially in the oil refining business, diversified his re-investments in the company into other more value-rich propositions — from commodities trading to fiber.  Koch Industries’ vision does not focus on a particular industry, but on value creation:

“Apply Market-Based Management to identify and capture those opportunities for which our capabilities will create the greatest value and develop and implement strategies that will maximize this value long-term.”

Measure Meaningful Things

To reach these lofty goals both Koch and Buffett rigorously look to align the incentives of their companies and employees with creating value for shareholders and society.

“I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.”  Buffett’s basic theory of return on investment is to focus on “the return on equity capital — that is, the percentage profit on each dollar invested.”  He strongly emphasized not wasting time on quarterly projections and other time-wasters.

Koch also frowns on needless paperwork and aims to measure profitability whenever it is practical, placing emphasis on value created by the economics means rather than by the political means.

Compliance

After a series of government investigations and media attacks in the 1980s 1990s, Koch restructured his company and added an entire division to focus on the public sector and compliance. This fueled a new stage of growth.

Buffett also sees the value in operating within the legal environment.  While he does his best to invest in companies with high standards and good management, from time to time he finds himself holding a bad apple. When unordinary situations have arisen, such as they did with the fraud at Salomon Brothers, Buffett felt it his duty as a long-term investor to help restore the company’s long-term position as a financial leader.

As Lowenstein frames it: by the end of the ordeal, Buffett had been so compliant that if the regulators had punished him too severely, they would be encouraging less cooperation in the future from other corporations under similar investigations.

Focus on Good People and Long-term Relationships

Though perhaps the value that trumps all else is one of character. ”[M]ost people, regardless of what they say, are looking for appreciation as much as they are for money,” writes Lowenstein.

Buffett and Koch both seem to understand this and act accordingly as they search for new investment opportunities and new personnel.  Their investment decisions focus on long-term value.

Koch avoids operating as a public company as he believes their quarterly requirements to be adverse short-term incentives. Buffett refuses to offer dividends or divide his stock in order to attract long-term investors.  Koch upholds a rigorous hiring process and would place a higher value on someone with good character and adequate skills over someone with adequate character and high skills.  Buffett chooses to invest in companies whose management he trusts and believes will be running their company for a long time.

Book Review: Why Wages Rise

At a talk this Fall, Charles Koch mentioned that the book Why Wages Rise by F.A. Harper was an influential book in his career.  Curious of the subject and the inspirations of such a successful man, I decided I best read it myself.

It was fascinating to see that the book did not begin with much framing and jumped right into the discussion with a focus on labor unions and the misperception that their demands lead to a rise in wages.  This says a lot about who Harper was trying to communicate these ideas to and places the stage of development of the US economy at the time the book was written, in 1957.

Harper draws a nice analogy to explain why it can be harmful to simply raise workers wages without a commensurate increase in productivity:

During 1955, the average pay of an employee of GM was $5,011.  Yet GM’s profits for the year were $1,189,477,082 (or $3,751,477,082 before any ascertainable taxes) on a total business of $12,433,277,420.  It can be seen at a glance that doubling the pay of this employee would be no more noticeable in the whole enterprise than would be the adding of another automobile to those owned in the State of Michigan.

Doubling the pay of all GM employees, however, would be quite a different story.  It would eat up in one year more than the total value of the firm’s real estate, plants, and equipment.

He continues to explain how productivity is the true source of real wage increases and how inflation can harm wages.  He emphasizes the role a sound currency play when considering wages:

When you accept money in trade, you are proceeding on faith in it as a sort of implied contract.  The implied contract is this:  When you trade something for money as an intermediate step to getting what you eventually want in exchange, you are operating on the assumption that the money will serve your intent rather than thwart it.

Harper’s broad approach to understanding the forces which influence wages is commendable.  I truly enjoyed Harper’s use of images throughout the book to complement his main points.  Here are a few of my favorites:

The Business Cycle

The eloquence of this graph captures the fluctuation of the economy as a force that is always present rather than a cycle that fluctuates around some sort of equilibrium, as the business cycle is often depicted.

Buying Power

What I particularly like about this graph is how it labels the section in between the citizens buying power before taxes, and the citizens buying power after taxes. The section is labeled: The Cost of Being Governed.  I find the language eye opening in a small way.  Most of the costs that we have in our life we try to find a way to reduce.  Increased productivity involves identifying better ways to do things and then changing our ways accordingly, freeing up more time to invest in other ways or for leisure in the process.  By framing the data in such a way, it suggests that governance has a specific role in the economy and leaves the hope that: if we can improve the ways in which we currently govern our society, we can reduce our necessity of this governance, freeing up more time to invest in other ways or for leisure across the society.  A very nice way to put it.

Networks and the Semantics of War

Thomas Friedman says that supply chain relationships will prevent wars.  Anyone know how many jobs the US has outsourced to the Middle East recently?  It seems Russia is discussing outsourcing uranium enrichment with Iran.

Rock stars are also using social relationships to find prosperity.  (For some more contemplation of networks, Grant McCracken tells a story about how two Russian mathematicians got involved with digital images of unicorn tapestry.  If Part I peaks your interest, there are 5 more parts to follow)

John Mackey also speaks up on collective relationships involving the freedom to choose.  Check out his new business paradigm.  He talks down on profit maximization assumptions of free-market economists.  I see it more as a semantic debate over agreed upon relationships, though the environment may be right for a euphemistic shift.

It seems not all business have been taking this into consideration while outsourcing.  Some countries don’t even take it into consideration when creating an institutional structure.