Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is one of the best-performing stocks of all time, powered by Warren Buffett's incredible record as an investor and capital allocator. But there's more to Berkshire than the fact that it has a legendary investor calling the shots.
I'd argue that Berkshire Hathaway's success is driven by three very simple things the company does better than just about anyone.
1. Paying employees the right way
When it comes to compensating employees, Berkshire Hathaway simply does it right. It's simple, but it works: Berkshire pays its people in cash based on factors they can actually control. That's hardly revolutionary, but it's a critical component of what makes Berkshire one of the greatest companies of all time.
At the 2003 annual shareholders meeting, Buffett had a lot to say about how companies were doing the wrong thing by paying managers in stock options rather than cash, a hot-button issue at the time.
Options are a royalty on the passage of time. They put management's interests contrary to the interests of shareholders. We believe in tying incentives to things under management's control. To give a lottery ticket to someone who runs 1% of Berkshire is really crazy.
There are two messages here. First, stock options effectively punish or reward people based on the performance of their average colleague. Think about this in context of Berkshire Hathaway as we know it today. Berkshire's real estate company, HomeServices, is an absolutely trivial component of the overall company. It could go to zero tomorrow or grow five times over and no one would be able to tell the difference in Berkshire's earnings reports.
So imagine if you were a real estate executive who, despite doing well in your little corner of Berkshire Hathaway, ended up missing out on a big bonus because the utility executives or railroad crew goofed up that year. If your compensation is entirely disconnected from your personal performance, why bother showing up?
Image source: The Motley Fool.
Secondly, Buffett realizes that stock options create lottery-ticket-like outcomes. If you give a manager stock options at $60 per share, they earn the same amount from those options (nothing!) if the stock closes at $59 or $0.59. It incentivizes dangerous behavior since it's a "heads I win, tails I lose nothing" reward.
Publicly traded companies pay their employees in stock for a number of reasons, but in many cases, it's because stock-based compensation allows for more accounting gimmickry. Paying employees in stock rather than cash has the effect of boosting metrics like free cash flow, and many companies highlight "adjusted" figures that subtract stock-based compensation as if it isn't a real expense. Buffett has said a lot about why ignoring stock-based compensation makes no sense.
The very name says it all: compensation. If compensation isn't an expense, what is it? And, if real and recurring expenses don't belong in the calculation of earnings, where in the world do they belong?
In some industries, if a company issued a lot of stock, it would earn tarnishing labels like "serial issuer" and people might even say it was "capital markets dependent" -- meaning that it relied on the health of its stock price to survive. Yet when technology companies -- some of the most prolific payers of stock-based compensation -- dole out stock in lieu of cash compensation, people talk about their "robust free cash flow" or "impressive adjusted EBITDA margins."
Perception really is everything, and some companies know how to game it well.
2. Communication with shareholders
If every company spent the time writing a detailed annual letter to shareholders, as Buffett does, I suspect investors would be much better off. A Standard & Poor's study once bore this out, albeit indirectly, suggesting that "the amount of information companies provide in their annual reports is correlated to market risk and valuations." In other words, companies with detailed disclosures had less volatile stock prices and traded for higher multiples than companies that did not.
Many companies and their executives write letters worth reading, even if you don't invest in the stock. Markel, W.R. Berkley, and JPMorgan, just to name a few, have fantastic annual letters everyone should read. But these are the rare, actually informative letters. Most read as if the CEO is just regurgitating numbers from the income statement and balance sheet with little additional context.
Though I haven't read every annual report ever published by every public company, I've read enough to say that Berkshire Hathaway has to be among the top 5% for consistency in disclosure. Try reading its 1999 annual report side by side with its 2017 annual report. You'll find its layout, tables, metrics, etc. have changed very little, despite the fact that Berkshire is several times larger today than it was then.
3. A willingness to take short-term pain for long-term gain
Fund manager Tom Russo often talks about how the best-performing companies often have one trait in common, which he calls the "capacity to suffer" -- meaning the ability to take a short-term hit for a long-term benefit. Many of Berkshire's greatest business decisions, Russo has argued, came from its capacity to suffer.
Take GEICO, for instance, a company Berkshire acquired in 1994. Rather than immediately raid GEICO for its earnings power, Berkshire plowed more of its profits into advertising, making it the largest TV-advertising buyer in the United States. Not many companies can credibly make a billion-dollar acquisition and then manage it in such a way that would reduce short-term earnings. But that's what Berkshire did, and it was the smart thing to do because it earned astronomical returns on advertising, even if it wasn't immediately apparent in the income statement.
Sometimes, the link between Berkshire's capacity to suffer and its profits is even more obvious. In the 2000s, the company effectively insured some investors against stock market losses over a period spanning 15 to 20 years. These bets produced wild, billion-dollar swings in Berkshire's net income, but Buffett felt the end result would be almost-certain profits. In effect, Berkshire agreed to run someone else's earnings volatility through its own profit and loss, charging more than $4 billion upfront for the service.
Behavior that destroys long-term shareholder value for short-term benefit is widespread. One study polled more than 400 senior financial executives, finding that only 59% of respondents would take on a project that creates long-term wealth for its shareholders if it means missing quarterly earnings expectations by an amount less than 6%!
Look, Berkshire isn't perfect. No company is. But I'd argue that these three things are at the core of why Berkshire has compounded its investors' wealth at a rate twice that of the large-cap average for more than 50 years running. Sometimes, it's the little things that make a big difference.
