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: Fooled by Randomness

“Reality is far more vicious than Russian roulette.  First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six.  After a few dozen tries, one forgets about the existence of a bullet, under numbing false sense of security,” says Nassim Nicholas Taleb.  He refers to this as the black swan problem.

Mistaking Luck For Skill

Fooled by Randomness is a book about mistaking luck for skill, a mistake Taleb sees most prevalent in journalism and the world of markets.  At the root, “risk detection and risk-avoidance are not mediated in the ‘thinking’ part of the brain but largely in the emotional one.”  “The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance.  Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.”

Yet, ”[p]eople fail to learn that their emotional reactions to past experiences (positive or negative) were short-lived.”  ”[T]hey continuously retain the bias of thinking that the purchase of an object will bring long-lasting, possibly permanent, happiness or that a setback will cause severe and prolonged distress (when in the past similar setbacks did not affect them for very long and the joy of the purchase was short-lived).”

He paraphrases a remark by Einstein: ”[C]ommon sense is nothing but a collection of misperceptions acquired by the age eighteen.”

Other Common Misperceptions

Taleb also redefines a common misperception of the word ‘mistake’:  “A mistake is not something to be determined after the fact, but in the light of the information until that point.”

This point ties succinctly with the concept of creative destruction which embraces the role of failure in development.  Mistakes need not be avoided, but learned from.  But, many environments are not conducive to such a framework.  Many of these frameworks have been engrained in society and social relationships for years.  Taleb explores why “bad traders have a short- and medium-term survival advantage over good traders,”  by tying the world of markets to naive evolutionary theories.

”[M]any amateurs believe that plants and animals reproduce on a one-way route toward perfection. Translating the idea to social terms, they believe that companies and organizations are, thanks to competition… irreversibly heading toward betterment.”  This is simply not true.

Taleb offers multiple reasons.  I will follow each with a few of my own thoughts.

1) Organizations do not reproduce like living members of nature.  Competition is never between buyers and sellers.  It is always between buyers and buyers or sellers and sellers.  While finding the perfect mate could fall in the same category as competition between businesses, reproduction is different in many ways.  Perhaps a more valid metric to compare the social environment of organizations to reproduction would be one of accessibility.  That is, to what level do companies, or mates, have the opportunity to enter or exit the marketplace?

2) Randomeness.  Some mutations are for the better, others for the worse.  “Negative mutations (Gould) are traits that survive in spite of being worse, from the reproductive fitness standpoint, than the ones they replaced.”  Again, this acquires a level of complexity when translated into social terms.  While market trends may be surprising on their own, subsidies, labor protection laws, and a variety of other market distorting policies add another level of randomness to the mix, often allowing unprofitable enterprises (negative mutations) to survive.

In Taleb’s mathematical verse: “Just as an animal could have survived because its sample path was lucky, the “best” operators in a given business can come from a subset of operators who survived because of over-fitness to a sample path—a sample path that was free of the evolutionary rare event.” ”[E]volution means fitness to one and only one time series, not the average of all possible environments.”

The Dive Bar that is Journalism

Distinguishing between signal and noise is widespread, though, journalism receives the largest swath of Taleb’s relentless skepticism: ”[J]ournalism may be the greatest plague we face today—as the world becomes more and more complicated and our minds are trained for more and more simplification.”

This effect of this large-scale compression—going from the particular to the general—“is the reduction in the degree of detected randomness.”  Journalism, through induction, favors the palatable over the counter-intuitive.  In sum: ”[M]ost poetic sounding adages are plain wrong.”

From journalism to winning streaks, “if someone performed better than the crowd in the past, there is a presumption of his ability to do better in the future.”  But this is a weak presumption.  It depends on two factors: “The randomness content of his profession and the number of monkeys in operation.”

While Taleb doesn’t offer any advice on which particular profession to choose, he does offer a suggestion.  Don’t shoot for a profession where you only like the way people live at the top. Consider the lifestyle of the average person, there are many more of them.

Escaping Randomness (Kind of)

The idea of alternative histories across several disciplines all seem to converge on the same concept of risk and uncertainty: “certainty is something that is likely to take place across the highest number of different alternative histories;  uncertainty concerns events that should take place in the lowest number of them.”  Taleb mentions examples in philosophy, physics and economics.

However certain this convergence may appear, one still has to stay alert.  Profits and losses are never guaranteed.  “The frequency or probability of [a] loss, in and by itself, is totally irrelevant; it needs to be judged in connection with the magnitude of the outcome.”

Productivity replaces No-productivity

The Power of Productivity, an excellent book by William W. Lewis of the McKinsey Global Institute has recently served as a marvelous lead for contemplation while on the bus here in Ecuador.  The bus, similar in shape and function to any bus you may now have as an image in your head, was driven by a man and his two sons while three other people collected money, arranged luggage and ran through the streets looking for riders.  It doesn’t always require six people to operate a small bus down here, but it is often more than I am used to and this example serves to draw out the productivity juxtaposition here.

It would be fine if you want to compare this experience to a bus experience in a higher-income country such as in Europe or the US, though I am going to continue with a more precarious contrast.  Google recently released the beta version of a program that guesses what web pages you are going to visit (from your past habits), preloads them (while you are using the web for other things), and then records how much time it saved you by having the pages preloaded. 

Lewis writes about a 12-year microeconomic study of several countries that he carried out that does an exceptional job at explaining how activities of higher productivity replace activities of lower productivity, and also exposits how excessive regulation and big government lead to lower levels of productivity.  Lewis beleives one major ideological differences between countries which reflect these atributes is the respect of consumer preferences over other special interests.  (Here is a related post on blogs and consumer power.)  I will be posting more ideas on these topics soon.