Successful Business Leadership

Warren Buffett is known as the “Oracle of Omaha” because he has invested in businesses and stocks since his childhood and amassed a net worth in excess of $50 billion, becoming the second wealthiest person in the world. This article is not about investment advice from Buffett, but instead summarizes his ideas and words from the infamous Letters to Berkshire Hathaway shareholders regarding the characteristics of successful businesses. Use his insights into what a successful investor believes are the characteristics of a business worthy of investment, to then learn how to lead and run a business yourself. I’ve underlined what I see as critical points.

Buffett focuses on high-quality businesses with enduring competitive advantages. He describes a competitive advantage as a “moat” that keeps rivals at a distance (versus businesses that provide undifferentiated products and face stiff direct competition). His classic example of a moat business is Coca-Cola, because consumers are willing to pay more for a Coke than for other beverages with a similar taste.

• “Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now.” 2005 Letter.

• “When short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.” 2005 Letter.

• “Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.” 2004 Letter.

When Berkshire Hathaway acquires a business, he indicates that he will not interfere with how the company is run. In other words he empowers the management team with clear objectives and incentives. His approach enables leaders to act as owners and decision makers for the business. In other words, the people in the business have a strong motive to succeed.

Buffett is skilled in managing the balance sheet as much if not more than the income statement. He weighs every decision for its impact on the balance sheet. Why? To target an effective use of assets by earning a return on investment greater than the cost of capital.

In Mary Buffett’s book, Buffettology, she identified the following fundamental questions used to evaluate a business and its leadership (perhaps this could be your research of a business you are evaluating):

• Is the business in an industry with good economics (not an industry competing on price)?

• Does the business have a brand name that commands loyalty? Can a competitor with increased resources compete successfully against the business?

• Are earnings increasing with healthy, consistent margins?

• Is the debt-to-equity ratio low or is the earnings-to-debt ratio high? Can the business repay debt if earnings decrease below average?

• Does the business have a high and consistent Return on Capital?

• Does the business retain its earnings for investment in good opportunities? Does management have a positive track record of profiting from investments?

• Does the business have high maintenance cost of operations? High capital expenditure? (Not the same as expanding capacity)

• Is the company adjusting prices for inflation?

Here is what Buffett says about the type of people needed in business and how to lead:

“Picking the right person…(is) not an easy task. It’s not hard, of course, to find smart people, among them individuals who have impressive…records. But there is far more to successful long term investing than brains and performance… We need someone genetically programmed to recognize and avoid serious risks, including those never before encountered…Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior are vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.” 2006 Letter.

“Berkshire employs many different incentive arrangements, with terms depending on such elements as the economic potential or capital intensity of a business. Whatever the compensation arrangement, though, I try to keep it both simple and fair. When we use incentives they are always tied to the operating results for which a given CEO has authority. We issue no lottery tickets that carry payoffs unrelated to business performance.” 2006 Letter.

“We have jobs that we love and are helped every day in a myriad of ways by talented and cheerful associates.” Give credit where credit is due. 2004 Letter.

“The other group to which I owe enormous thanks is the home-office staff. After the eight acquisitions more than doubled our worldwide workforce to about 112,000, Charlie and I went soft last year and added one more person at headquarters. (Charlie, bless him, never lets me forget Ben Franklin’s advice: “A small leak can sink a great ship.”) Now we have 13.8 people. This tiny band works miracles. In 2000 it handled all of the details connected with our eight acquisitions, processed extensive regulatory and tax filings (our tax return covers 4,896 pages), smoothly produced an annual meeting to which 25,000 tickets were issued, and accurately dispensed checks to 3,660 charities designated by our shareholders. In addition, the group dealt with all the routine tasks served up by a company with a revenue run rate of $40 billion and more than 300,000 owners. And, to add to all of this, the other 12.8 are a delight to be around.” Notice his humility and appreciation for people in the 2001 Letter.

“The critical variables, therefore, are managerial brains, discipline and integrity.” 2003 Letter.

“We find it meaningful when an owner cares about whom he sells to. We like to do business with someone who loves his company. When this emotional attachment exists, it signals that important qualities will likely be found within the business: honest accounting, pride of product, respect for customers, and a loyal group of associates having a strong sense of direction. The reverse is apt to be true, also. If owners behave with little regard for their business and its people, their conduct will often contaminate attitudes and practices throughout the company.” 2001 Letter.

He demonstrates the meaning of accountability in leadership:

“If we fail, we will have no excuses…To begin with, we are supported by an incredible group of men and women who run our operating units…Any shortfall in Berkshire’s results will not be caused by our managers…At Berkshire, neither history nor the demands of owners impede intelligent decision-making. When Charlie and I make mistakes, they are – in tennis parlance – unforced errors.” 2003 Letter.

“At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed. What Charlie and I would want under that circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business. We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented. We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. We expect a company’s CEO to explain in his or her own words what’s happening.” 2001 Letter.

“Though our corporate performance last year was satisfactory, my performance was anything but. I manage most of Berkshires equity portfolio, and my results were poor, just as they have been for several years.” Notice his humility and accountability in the 2001 Letter.

“The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more heroic. These can turn fudging into fraud.” 2001 Letter.