This approach led to lumpy, but highly profitable, underwriting results. As an example, in 1984, Berkshire’s largest property and casualty (P&C) insurer, National Indemnity, wrote $62.2 million in premiums. Two years later, premium volumes grew an extraordinary sixfold to $366.2 million. By 1989, they had fallen back 73 percent to $98.4 million and did not return to the $100 million level for twelve years. Three years later, in 2004, the company wrote over $600 million in premiums. Over this period, National Indemnity averaged an annual underwriting profit of 6.5 percent as a percentage of premiums. In contrast, over the same period, the typical property and casualty insurer averaged a loss of 7 percent.
Buffett’s approach to capital allocation was unique: he never paid a dividend or repurchased significant amounts of stock. Instead, with Berkshire’s companies typically requiring little capital investment, he focused on investing in publicly traded stocks and acquiring private companies, options not available to most CEOs who lacked his extensive investment experience. Before we look at these two areas, however, let’s first examine a critical early decision.
After a brief flirtation with the textile business, Buffett chose early on to make no further investments in Berkshire’s low-return legacy suit-linings business and to harvest all excess capital and deploy it elsewhere. In contrast, Burlington Industries, the largest company in the textile business then and now, chose a different path, deploying all available capital into its existing business between 1965 and 1985. Over that twenty-year period, Burlington’s stock appreciated at a paltry annual rate of 0.6 percent; Berkshire’s compound return was a remarkable 27 percent.
These differing results tell an important capital allocation parable: the value of being in businesses with attractive returns on capital, and the related importance of getting out of low-return businesses.
This was a key decision for Berkshire and makes a more general point. A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns. The outsider CEOs were generally ruthless in closing or selling businesses with poor future prospects and concentrating their capital on business units whose returns met their internal targets. As Buffett said when he finally closed Berkshire’s textile business in 1985, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
Buffett’s pattern of investment at Berkshire has been similar to the pattern of underwriting at his insurance subsidiaries, with long periods of inactivity interspersed with occasional large investments. The top five positions in Berkshire’s portfolio have typically accounted for a remarkable 60–80 percent of total value. This compares with 10–20 percent for the typical mutual fund portfolio. On at least four occasions, Buffett invested over 15 percent of Berkshire’s book value in a single stock, and he once had 40 percent of the Buffett Partnership invested in American Express.
The other distinguishing characteristic of Buffett’s approach to portfolio management is extraordinarily long holding periods. He has held his current top five stock positions (with the exception of IBM, which was purchased in 2011) for over twenty years on average. This compares with an average holding period of less than one year for the typical mutual fund. This translates into an exceptionally low level of investment activity, characterized by Buffett as “inactivity bordering on sloth.”
American oil - bought during Salad Oil scandal
WP - bought during broadcast license change
GEICO - during potential insolvency
Wellfargo - SC recession and real estate crisis
Fmac - Recession
GD - defense industry slump
Buffett never participates in auctions. As David Sokol, the (now former) CEO of MidAmerican Energy and NetJets, told me, “We simply don’t get swept away by the excitement of bidding.”9 Instead, remarkably, Buffett has created a system in which the owners of leading private companies call him. He avoids negotiating valuation, asking interested sellers to contact him and name their price. He promises to give an answer “usually in five minutes or less.”10 This requirement forces potential sellers to move quickly to their lowest acceptable price and ensures that his time is used efficiently.
Buffett does not spend significant time on traditional due diligence and arrives at deals with extraordinary speed, often within a few days of first contact. He never visits operating facilities and rarely meets with management before deciding on an acquisition.
Pre-Paid Legal Services was until recently a publicly traded company that sold legal plans to individuals and businesses. These plans are effectively insurance products—in return for an annual premium, customers are covered for expenses that might arise from a wide range of potential legal activities, including litigation, real estate, trusts, and wills. These plans were invented in the 1970s, and Pre-Paid Legal grew rapidly throughout the 1980s and 1990s. What’s interesting about the company is that after this strong initial growth, its revenues have been virtually flat over the last ten years.
This pattern of rapid growth followed by a sudden and extended flattening in results has historically been a recipe for horrific stock market returns. Over that same period of time, however, Pre-Paid’s stock appreciated fourfold, dramatically outperforming both the market and its industry peers. How did the company achieve these results? Starting in late 1999, its CEO, Harland Stonecipher, realized that his market was maturing and that additional investments in growth were unlikely to have attractive returns. At the urging of his board (which, unusually for a public company, included several large investors), he began a systematic and aggressive program of optimizing free cash flow and systematically returning capital to shareholders through an aggressive stock repurchase program. Over the next twelve years, Stonecipher bought in over 50 percent of shares outstanding, to the sustained applause of his shareholders and the stock market, and in June 2011, agreed to sell his company to a private equity firm for a significant premium.
Probable reasons why WB purchased Exxon?
Since Pre-Paid Legal is a smaller, closely held company, it’s important to look for another example among larger firms. A big one—a really big one—is ExxonMobil, the world’s largest company by market capitalization. Since 1977, Exxon (and later ExxonMobil) has generated a phenomenal 15 percent compound return for its investors, dwarfing both the market and its peers, a truly remarkable record given its size. When we look at how its managers achieved these results, the similarities with the outsider CEOs are striking. A handful of lessons stand out.
Under the leadership of CEO Rex Tillerson and his curmudgeonly predecessor, Lee Raymond, ExxonMobil has exhibited similar discipline, requiring a minimum 20 percent return on all capital projects. During the recent financial crisis, as energy prices fell, Tillerson and his team were criticized by Wall Street analysts for lowering production levels. They simply refused, however, to pump additional oil from projects with insufficient returns, even if it meant lower near-term profits.
In widely varying industries and market conditions, this group independently coalesced around a remarkably similar set of core principles. Fundamentally, Stonecipher, Tillerson, and their fellow outsider CEOs achieved extraordinary relative results by consistently zigging while their peers zagged; and as table 9-1 shows, in their zigging, they followed a virtually identical blueprint: they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.
1. The allocation process should be CEO led, not delegated to finance or business development personnel.2. Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes).Comment: Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the midteens or higher).3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions.Comment: Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic—it is often corporate code for low returns. 4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark.Comment: While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices.5. Focus on after-tax returns, and run all transactions by tax counsel.6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees—how does this compare to your peer group?)8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns.
Buffett’s approach to capital allocation was unique: he never paid a dividend or repurchased significant amounts of stock. Instead, with Berkshire’s companies typically requiring little capital investment, he focused on investing in publicly traded stocks and acquiring private companies, options not available to most CEOs who lacked his extensive investment experience. Before we look at these two areas, however, let’s first examine a critical early decision.
After a brief flirtation with the textile business, Buffett chose early on to make no further investments in Berkshire’s low-return legacy suit-linings business and to harvest all excess capital and deploy it elsewhere. In contrast, Burlington Industries, the largest company in the textile business then and now, chose a different path, deploying all available capital into its existing business between 1965 and 1985. Over that twenty-year period, Burlington’s stock appreciated at a paltry annual rate of 0.6 percent; Berkshire’s compound return was a remarkable 27 percent.
These differing results tell an important capital allocation parable: the value of being in businesses with attractive returns on capital, and the related importance of getting out of low-return businesses.
This was a key decision for Berkshire and makes a more general point. A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns. The outsider CEOs were generally ruthless in closing or selling businesses with poor future prospects and concentrating their capital on business units whose returns met their internal targets. As Buffett said when he finally closed Berkshire’s textile business in 1985, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
Buffett’s pattern of investment at Berkshire has been similar to the pattern of underwriting at his insurance subsidiaries, with long periods of inactivity interspersed with occasional large investments. The top five positions in Berkshire’s portfolio have typically accounted for a remarkable 60–80 percent of total value. This compares with 10–20 percent for the typical mutual fund portfolio. On at least four occasions, Buffett invested over 15 percent of Berkshire’s book value in a single stock, and he once had 40 percent of the Buffett Partnership invested in American Express.
The other distinguishing characteristic of Buffett’s approach to portfolio management is extraordinarily long holding periods. He has held his current top five stock positions (with the exception of IBM, which was purchased in 2011) for over twenty years on average. This compares with an average holding period of less than one year for the typical mutual fund. This translates into an exceptionally low level of investment activity, characterized by Buffett as “inactivity bordering on sloth.”
American oil - bought during Salad Oil scandal
WP - bought during broadcast license change
GEICO - during potential insolvency
Wellfargo - SC recession and real estate crisis
Fmac - Recession
GD - defense industry slump
Buffett never participates in auctions. As David Sokol, the (now former) CEO of MidAmerican Energy and NetJets, told me, “We simply don’t get swept away by the excitement of bidding.”9 Instead, remarkably, Buffett has created a system in which the owners of leading private companies call him. He avoids negotiating valuation, asking interested sellers to contact him and name their price. He promises to give an answer “usually in five minutes or less.”10 This requirement forces potential sellers to move quickly to their lowest acceptable price and ensures that his time is used efficiently.
Buffett does not spend significant time on traditional due diligence and arrives at deals with extraordinary speed, often within a few days of first contact. He never visits operating facilities and rarely meets with management before deciding on an acquisition.
Pre-Paid Legal Services was until recently a publicly traded company that sold legal plans to individuals and businesses. These plans are effectively insurance products—in return for an annual premium, customers are covered for expenses that might arise from a wide range of potential legal activities, including litigation, real estate, trusts, and wills. These plans were invented in the 1970s, and Pre-Paid Legal grew rapidly throughout the 1980s and 1990s. What’s interesting about the company is that after this strong initial growth, its revenues have been virtually flat over the last ten years.
This pattern of rapid growth followed by a sudden and extended flattening in results has historically been a recipe for horrific stock market returns. Over that same period of time, however, Pre-Paid’s stock appreciated fourfold, dramatically outperforming both the market and its industry peers. How did the company achieve these results? Starting in late 1999, its CEO, Harland Stonecipher, realized that his market was maturing and that additional investments in growth were unlikely to have attractive returns. At the urging of his board (which, unusually for a public company, included several large investors), he began a systematic and aggressive program of optimizing free cash flow and systematically returning capital to shareholders through an aggressive stock repurchase program. Over the next twelve years, Stonecipher bought in over 50 percent of shares outstanding, to the sustained applause of his shareholders and the stock market, and in June 2011, agreed to sell his company to a private equity firm for a significant premium.
Probable reasons why WB purchased Exxon?
Since Pre-Paid Legal is a smaller, closely held company, it’s important to look for another example among larger firms. A big one—a really big one—is ExxonMobil, the world’s largest company by market capitalization. Since 1977, Exxon (and later ExxonMobil) has generated a phenomenal 15 percent compound return for its investors, dwarfing both the market and its peers, a truly remarkable record given its size. When we look at how its managers achieved these results, the similarities with the outsider CEOs are striking. A handful of lessons stand out.
Under the leadership of CEO Rex Tillerson and his curmudgeonly predecessor, Lee Raymond, ExxonMobil has exhibited similar discipline, requiring a minimum 20 percent return on all capital projects. During the recent financial crisis, as energy prices fell, Tillerson and his team were criticized by Wall Street analysts for lowering production levels. They simply refused, however, to pump additional oil from projects with insufficient returns, even if it meant lower near-term profits.
In widely varying industries and market conditions, this group independently coalesced around a remarkably similar set of core principles. Fundamentally, Stonecipher, Tillerson, and their fellow outsider CEOs achieved extraordinary relative results by consistently zigging while their peers zagged; and as table 9-1 shows, in their zigging, they followed a virtually identical blueprint: they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.
1. The allocation process should be CEO led, not delegated to finance or business development personnel.2. Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes).Comment: Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the midteens or higher).3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions.Comment: Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic—it is often corporate code for low returns. 4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark.Comment: While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices.5. Focus on after-tax returns, and run all transactions by tax counsel.6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees—how does this compare to your peer group?)8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns.
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