Last Updated on November 21, 2020 by Oddmund Groette
Introduction and summary:
Most investors know very well the story of Berkshire Hathaway and Warren Buffett. However, the many advantages of the Berkshire business model have some very interesting features that we believe are less understood and very underrated, and the aim of the article is to look more into these features and why they matter.
In short, by investing in investment companies like Berkshire Hathaway you invest in a group of managers that are better investors than you, they charge you a low “management fee” for their services, they are investment agnostics, have a long-term mindset and culture, do rational capital allocations, management has skin in the game and they attract the “correct” shareholders. Last, but not least, they offer you the chance to “sit on your ass and do nothing”, as Charlie Munger says. Or, as Terry Smith in Fundsmith says: Buy good companies, don’t overpay, then do nothing.
Every listed company is unique in itself. There will never be another Berkshire Hathaway, and hopefully, the reader understands that. Nevertheless, some similarities do exist and the aim of the article is to highlight those similarities. But all companies mentioned in this article are run and managed differently. Tom Gayner in Markel might admire Warren Buffett, but he invests based on his own opinions and checklists. None are mimicking Berkshire, which will ultimately fail.
If you read this article you might be interested in our portfolios. It’s a work in project and many more portfolios will be added in the coming months.
What is a “clone/mini/baby” Berkshire?
What might not be known for many investors except for the hardcore Berkshire Hathaway owners, is the existence of quite a few other public companies that can be labeled as “clone/mini/baby” Berkshires. They are not many, but they exist. The expression simply refers to public stocks that somehow resemble the business model of Berkshire Hathaway. This term is of course pretty inaccurate for many companies, but no matter what they still offer some of the same investment features that are covered in this article.
Some of the best known “clone/mini/baby” Berkshires are these:
- Markel (USA)
- Alleghany (USA)
- White Mountains Insurance (USA)
- Fairfax Financial (Canadian)
- Investor AB (Swedish)
- Brookfield Asset Management (Canadian)
There are of course many others and smaller, something we will cover later as we aim to cover many similar companies in all corners of the world in the coming years. Please check out our other articles on investment companies.
Berkshire’s business model is very intriguing but difficult to execute successfully. But if executed successfully, we are more than happy to own a small part of the business for a long time, for the reasons outlined below:
The moat is the culture
First and foremost the model is built around developing a superb investment culture. Berkshire started as a partnership but evolved into an insurance giant when Buffett saw the potential in the float. Secondly, it’s all about human resources. Buffett most likely is exceptionally good at judging people, and he has placed very resourceful people around him. We see the same pattern in the other Berkshires.
A strong corporate culture is the best moat there is. Moats from brands, goodwill, barriers of entry are less robust than culture. We would go as far as to say there are no moats at all except those built by corporate culture. Of course, corporate culture can also vanish, but it’s much more difficult to copy and is “sticky” as long as nourished. Culture can only be impaired from within, not externally.
Skin in the game – owner-operators/managers – aligned interests
Any investment in a public company is an investment in people and management. You are trusting people to make good decisions on your behalf, and it makes sense to align the interests of the management with yours. If they make a poor investment, they should feel the pain as all others outside shareholders. Skin in the game is an important factor when evaluating any investment company.
The average tenure of a CEO of an American public company is five years. What drives their thinking? Are they stewards of shareholder capital, making decisions to benefit their companies for the coming decades? Or do they lay awake at night, counting their compensation? Unfortunately, we believe the truth is, in too many cases, the latter. To avoid this, make sure your investment company has substantial skin in the game.
Management thinks like investors
There is a big difference between being a manager/operator and an investor. In the Mini-Berkshires the CEOs are more investors than operators (see more below). They are capital allocators. We can say they somehow resemble an actively managed mutual fund. The subsidiaries pay dividends upstream to HQ, which HQ allocates where they see the best future returns. This means management can focus 100% on capital allocations, while the operators in the subsidiaries can solely focus on what they do best: running their company. Most managements are either good operators or allocators, but rarely both. The business model makes both parties, the HQ and the subsidiaries, rely on division of labor and complementary abilities: each focus on what they do best.
Over the long-term, the result of your investment is dependent on your marginal rate of return on retained earnings, not your initial capital. Thus, how management invests or redeploys earnings is paramount, and thus a good manager should have a good sense of where to invest.
The Berkshire managers are pretty good at judging when they get more than a dollar back for a dollar spent. Furthermore, they have research, connections, and access to information that most investors don’t have. And they know when to say no or yes to an investment. They fully understand opportunity costs.
They are better investors than you
Ample evidence points toward a huge underperformance among private investors. The tendency to prefer “lottery stocks” and concentrate on just a few holdings are very detrimental in the long run. Highly likely the management in an investment company can do substantially better than you. Even better, they don’t charge much for this:
Low “management fee”
Warren Buffett has 100 000 USD in annual salary for working 60 hours a week (!). The costs of running a public investment company are in many cases much cheaper than the management fee offered by active mutual funds. For example, the famous investment company Investor AB, controlled by the Wallenberg family, has an overhead of only 0.11% of the market cap, even cheaper than the majority of passive mutual funds. For this low fee, you own a slice of a company that has outperformed the Swedish stock market for over 100 years! The fee is in the ballpark of both Berkshire and Markel.
Think about it: Most hedge funds charge 1-2% in annual management fee and additionally charge a 10-20% success fee on the returns! Compared to this, the Berkshires are a “steal”.
- Investor AB: The Swedish industrial mini/baby-Berkshire
- Why invest in Scandinavia/The Nordic region? Better performer than the US
Decentralized – antifragile
Because management operates more like capital allocators than operators, they run a “hands-off” management style. Each manager of the subsidiaries is free to run their operations as they please, obviously as long as they perform satisfactorily.
Autonomy and responsibility attract and motivate the best managers and employees. It takes an unusually trusting culture and a long investment horizon to support a multitude of small and big businesses and their entrepreneurial managers.
Additionally, such a decentralized structure makes them much more antifragile, to borrow a phrase from Nassim Nicholas Taleb.
Sit on your ass and do nothing
Charlie Munger is famous for his “sit on your ass” analogy. The best investments are the ones where you can keep your hands off and “sit on your ass”. The Mini-Berkshires are perfect examples of that. There are none or little dividends to reinvest (makes you not sit on your ass anymore) and very little to follow-up.
Evidence suggests women are better investors than men. Why is that? One of the mains reasons is that they buy and hold and are less likely to fiddle with the portfolio, and thus less liable to behavioral mistakes. By investing in an investment company you are probably more likely to manage such a buy and hold strategy.
The Berkshires or any investment company own a lot of assets or businesses. Thus, you are indirectly diversified, even though if you for example own just 3-4 of these stocks.
Internal compounding – no inefficient distributions
The Berkshire model has an agnostic view on capital allocations: they invest where it makes sense, given an appropriate risk and reward, and distributes only when they see no other options to use the capital internally. This makes a lot of sense, please read this:
If return on capital employed is high or at least acceptable, why on earth would you want a dividend? If you need capital you simply sell shares when you need that capital. The link above explains in simple math why it makes sense to allow the capital to stay in the company, of course given an acceptable return. Instead of transferring the reinvestment burden back to you as an investor, the investment companies do it for you. And they are much likely better investors than you are and they have better options on where to invest.
Long-term mindset – delayed gratification
Delayed gratification is a great asset for a long-term mindset, and the managers in the Berkshires easily pass the marshmallow test: Do they want one marshmallow today or two in the future? Of course, they choose the latter. The management has one long-term goal: to create value for all stakeholders. They understand the stakeholders are not necessarily only the shareholders and the employees, but also society and customers.
A long-term mindset from the management requires a long-term commitment from the shareholders as well:
The Berkshires attract the “correct” shareholders
A respected investor told me, “You end up with the shareholders you deserve”. I’m hoping that’s true.
-Mark Leonard, Constellation Software.
The Berkshires are fully aware they need to attract the “correct” shareholders to make them carry out long-term value creation. Management doesn’t operate in a vacuum and needs to answer to both society, shareholders, customers, board, regulators, and employees.
Competent ownership doesn’t come out of thin air. Mark Leonard in Constellation Software says in his shareholder letter that “you end up with the shareholders you deserve”. Attracting the “correct” shareholders is a very underappreciated aspect of creating shareholder value. How can management think long-term if the shareholders are mainly so-called activists?
A common denominator among all Mini-Berkshires is their shareholder letters which are in a league of their own. There are very detailed and seek to educate the shareholders and what to expect. I believe it’s safe to say the shareholders in these companies are much more knowledgeable and long-term than in other companies.
They focus on profitability, not growth and empire-building
It is human nature to build empires, and it takes great discipline to say no to a business proposition if it doesn’t pass the hurdle rate. You will never see Mini-Berkshires write “We are #1 in this large and growing market”.
They don’t outsource their thinking
Managers are usually recruited internally or joined via an acquisition. The CEOs are the responsible risk manager and they never use consultants or outsiders to do their thinking. Furthermore, they are all independent thinkers, which is extremely rare. They are not afraid to differ from “peers” and risk looking stupid, as perhaps many think about Buffett right now (June 2020, Berkshire has still lots of cash while markets are at all-time highs). Buffett was a laughing stock in 1999 when he underperformed as he refused to invest in dotcom stocks (which he didn’t understand), but in the end, he was proven right.
They are investment agnostics
Management doesn’t walk into the office in the morning with a clear-cut plan. They are investment agnostics and not bound by any “strategy”. They are simply focused on creating values, wherever they see opportunities. White Mountains Insurance, for example, has transformed itself over the last decade from an insurer to an “insurer” with almost no insurance liabilities. Likewise, Alleghany sold off most of its assets in the late 90s and early 2000 and reinvested into insurance.
They don’t have any “vision”. Long-term predictions have a poor track record. Remember the works of Philip Tetlock.
Circle of competence
Most investors have no deep knowledge of the companies they invest in, neither are they aware of their limited knowledge. On the other hand, the managers of the Mini-Berkshires are perfectly aware of both their knowledge and their limitations. They stick to their circle of competence.
You are most likely to pick the wrong stocks:
Choosing the right stock for investment is extremely difficult because statistics show that most stocks perform very poorly. According to the famous study by Hendrik Bessembinder the median stock “survives” only seven years, and only 27.6% of the listed stocks manage to beat treasury bills. Thus, the median stocks have returned less than treasury bills even though the averages have performed so well (read here for an explanation of averages and median).
How are you going to pick those few good stocks? It’s extremely unlikely. Research shows small retail investors underperform both the market and mutual funds. By investing directly in the stock market you highly likely fail and end up trailing the market averages. It’s the few outliers that have driven the superior performance for stocks compared to the other asset classes.
They love what they do – not for the money
Berkshire managers love what they do. We believe this is a very underappreciated variable for success. They are not in it for the money.
Finally, investors should attempt to find companies that are capable of compounding employed capital at satisfactory rates for long periods of time without paying taxable distributions to shareholders. Taxes are a huge headwind in the long-term:
It’s of course difficult to find such companies that can reinvest earnings for many years to come. Because of this, these companies also tend to have high valuations. However, many of the Berkshires trade at low multiples. Berkshire Hathaway does, most likely because of negative sentiment or a discount for being a “conglomerate”. That is good. As a long-term shareholder and future net buyer you don’t want your holdings to trade at high multiples:
At the end of the day, we believe the best investment advice is to invest alongside a team that has a proven record in what they are doing, carry the same risk as outside investors and charge a low “management fee”. This is exactly what you get by investing in the Berkshires.
You can spend your time on other things, probably more profitably, and let more able people manage your money.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.