The Value of Quality Management

Warret Buffett is recognized being one of the worlds most successful investor. What are the key issues when deciding to invest? Some of the most relevant factors are written here. If you want the source himself, please go to Warren Buffett here.

Managing the Buffett way
By Stuart Crainer

The naive figure who utters profound truths holds a perennial and universal appeal. The naïf who succeeds and mysteriously makes sense of an alien environment is the subject of movie after movie – from Peter Sellers’ Being There to Tom Hanks’ Big.

Something of the same phenomenon can be seen in the business world. Ben and Jerry fascinate because they appear so blithely straightforward and enthusiastic. Sir Richard Branson remains immune to criticism despite Virgin’s occasional misadventures. He is an engaging innocent, an enthusiast in a woolly jumper. There is a sense that these people are from a different time, an era of decency and simple pleasures. They are idiosyncratic throwbacks to bygone ways of doing business, cavaliers in an age of roundheads.

The investor Warren Buffett is part of this phenomenon. He successfully ignored the new economy bubble and emerged to tell a tale of even greater riches. The Sage of Omaha has been enormously successful in a field where competition is ruthless. As you’d expect, Buffett’s achievement has been examined from every angle. Yet, if emulation is a measure of understanding, it appears little understood.

Buffett, a man of resolutely simple tastes, someone who oozes old-fashioned decency from every pore, stands above the maelstrom of analysts, commentators, and private investors. As he has become more famous and his investment company Berkshire Hathaway ever more successful, Buffett’s public utterances and writings have become more playful.

As happens in Wall Street all too often, what the wise do in the beginning, fools do in the end,” he wrote in 1989. This was followed in 1990 by: “Lethargy bordering on sloth remains the cornerstone of our investment style”. Of all the markets he has conquered, the one in homespun wisdom may be his surprising legacy.

Investors buy books on the great man in their millions (there is a book called Buffettology though the most useful is The Essays of Warren Buffett) and pore through them in search of a formulaic approach to investing. They will, of course, be disappointed. It is not that Buffett does not have a formula. He does.

Buffett advocates “focused investing”. When gauging the wisdom of an investment, investors should look at five features:

  1. The certainty with which the long-term economic characteristics of the business can be evaluated.
  2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
  3. The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself.
  4. The purchase price of the business.
  5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

Buffett admits that many will find such criteria “unbearably fuzzy”. This is only partly the case. Analysis can lead to conclusions about the long-term economic prospects of a business. Analysis can also establish what is a reasonable purchase price and help predict future macroeconomic conditions likely to impact on the investment. Where analysis falls down and things do begin to become fuzzy is in assessing the incumbent management.

Time and time again in his wry annual letters to shareholders, Buffett returns to the issue of sound management. Given the right conditions, good managers produce good companies. Never invest in badly managed companies.

The trouble, it seems, is that there are a great many poor managers. “The supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate,” lamented Buffet in 1988, going on to criticize the comfortable conspiracies of too many boardrooms. “At board meetings, criticism of the CEO’s performance is often viewed as the social equivalent of belching.”

Buffett believes that executives should think and behave as owners of their businesses. He is critical, therefore, of the “indiscriminate use” of stock options for senior executives. “Managers actually apply a double standard to options,” Buffet writes. “Nowhere in the business world are 10-year, fixed-price options on all or a portion of a business granted to outsiders. Ten months, in fact, would be regarded as extreme.”

Such long-term options, argues Buffet, “ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital”.

Buffett is a slow-moving minimalist in an age of hyperactive behemoths. In the Berkshire Hathaway boardroom, belches are welcomed.

Copyright © 2000 FT Knowledge Limited

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S@R develops models for support of decision making under uncertainty. Taking advantage of recognized financial and economic theory, we customize simulation models to fit specific industries, situations and needs.

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