In reading David Merkel’s third posting on Warren Buffett’s latest shareholder letter, I came across the following:
it should be no surprise that as BRK grew, given Buffett’s desire for owning as much of great businesses as he could, that BRK became a conglomerate, albeit one dominated by its leading insurance businesses.
David’s making a particular point using the language of “conglomerate” in a specific way– the idea of a company operating in multiple industries, none of which are necessarily related or complimentary to the other businesses in the portfolio. He’s observing Buffett’s behavior from the standpoint of acquisitions and trying to arrive at a meaningful interpretation of why and how Buffett has acquired as he has, resulting in his business representing a conglomerate.
It’s a worthwhile consideration but I want to try standing Merkel’s perspective on its proverbial head with the help of my friend Murray Rothbard, and see if some new insights aren’t arrived at. This is from chapter ten of his opus, Man, Economy and State, discussing “Cartels, Mergers and Corporations“:
What happens when a partnership or corporation is formed? Individuals agree to pool their assets into a central management, this central direction to set the policies for the owners and to allocate the monetary gains among them. In both cases, the pooling, lines of authority, and allocation of monetary gain take place according to rules agreed upon by all from the beginning. There is therefore no essential difference between a cartel and an ordinary corporation or partnership.
Before you start getting upset (you who are having your worldview challenged here), read on:
Yet clearly the only difference between a merger and the original forming of a single corporation is that the merger pools existing capital goods assets, while the original birth of a corporation pools money assets. It is clear that, economically, there is little difference between the two. A merger is the action of individuals with a certain quantity of already produced capital goods, adjusting themselves to their present and expected future conditions by cooperative pooling of assets.
I think this can be taken a step further, even, by saying that mergers don’t actually exist, there are only acquisitions. The reason I say this is because after every merger, “of equals” or otherwise, someone is left with de facto, if not technical or legal, control over the combined entity.
When two public corporations “merge”, the minority capital owners can de-merge (or escape acquisition) by liquidating their shares in the market. Their financial capital is freed to be placed elsewhere but their physical assets (the property of the merged corporation) remain. In this sense, clearly what has occurred is an acquisition of real capital goods, not a “merger”.
Does this logic apply to liquid investment partnerships, such as hedge funds, as well? By my definition, a hedge fund is not a “merger” (temporary, at that) because mergers don’t exist… it’s an acquisition by the portfolio manager. But there is no physical capital involved at this level, it is all liquid financial assets which represent claims to real, physical capital. And if the “merged” partner decides to de-merge, the portfolio manager has to sell a corresponding number of securities and financial assets to liquidate him, the control of which he does not hold onto going forward, unlike the corporation in which investors are made liquid not by the corporation but by outside investors.
I’ll have to think about that one a bit more. In the meantime, I’ve got another Rothbard quote on the subject, from the same chapter:
a merger and the original formation of a corporation do not, as we have seen, essentially differ. The former is an adaptation of the size and number of firms in an industry to new conditions or is the correction of a previous error in forecasting. The latter is a de novo attempt to adapt to present and future market conditions.
Why mention this? What does any of this have to do with David Merkel’s article, Buffett and corporate conglomeration?
Merkel notes that Buffett has talked a lot about acquisitions over the years for a good reason: all investors are acquirers. Great investors are great acquirers (and tend to be extremely acquisitive, as well as extremely conscious of their status as acquirers). Buffett, as arguably the greatest investor of all time, is also one of the greatest acquirers of all time.
Many people talk about the investment process as one of efficiently and profitably allocating capital, and they talk of Buffett as an especially talented capital allocator. Few of these people realize how close they are to the profound, in this sense. Acquisitions and mergers are part of the capital allocation process. Acquisitions decide who will make future capital allocations with regards to a current pool of capital as well as its anticipated future capital yield.
Before Buffett was the head of a big time corporate conglomerate, he was a small investor. But even then, he was still an acquirer and involved in constant corporate acquisition, just like you, me and anyone else who makes small investments periodically. Every time we purchase a security, even if it is a fractional interest in an enterprise, we are acquiring that real capital and adding it to our own enterprise, corporate or otherwise. We are expanding our own personal domain as it pertains to the total pool of capital in the economy (local, national, global) and simultaneously someone else is either transferring their domain or relinquishing it in favor of consumption.
The corporate conglomeration is the natural, logical outcome of a track record of successful, long-term serial acquisitiveness, aka “investing”. In fact, it would be extremely odd to find a successful investor who hadn’t assembled a conglomerate. No, it would be impossible!
“What about a Buffett-contemporary like Walter Schloss?” you might be asking. He didn’t assemble a corporate conglomerate.
True, Schloss did not possess the precise econo-legal structure of the corporate holding company that Buffett did. But he was still a conglomerator– he acquired small pieces of many different businesses and essentially pooled their assets under his control.
Even a person who has concentrated their investing into ONE firm over their entire career is essentially an acquirer and a conglomerater, assuming this firm grows profitably. Through profitable growth, the firm generates retained earnings which are essentially internal corporate savings that the firm can use to ACQUIRE new capital goods and assets. Cornelius Vanderbilt, the steamboat and railroad magnate of the 1800s, is a good example of this. Even though he did not acquire a number of other firms, he acquired additional assets such as steamships, railroad cars, raillines, etc., from suppliers and thereby put these capital goods under his direct control. John D. Rockefeller is an extreme example of the acquisitional behavior of an investor-entrepreneur– he acquired into his oil empire not only oil equipment and oil reserves but entire capital good suppliers related to his business, such as railroads, warehouses and service stations.
Returning to Buffett, as Merkel says:
Once BRK got big, that meant becoming a conglomerate, albeit a special one, was the logical outcome. And I could be wrong, but that is the final corporate form for BRK. There may come a day in a post-Buffett era when it may do many things, such as spin off companies, or centralize functions.
I don’t think conglomeration had anything to do with hitting a size threshold. I think it is related to Buffett’s long-term success as a capital allocator, which is dependent upon his ability to acquire the right assets over time. I think Merkel is correct that this will be the final corporate form of BRK.
And, I think Merkel is onto something when he says there could come a day when BRK spins off companies or otherwise transforms itself, particularly in the post-Buffett era. As we learned in our reading of Value: The Four Cornerstones of Corporate Finance, a particular asset will have numerous “best owners” over its entire lifetime. Looking at a collection of assets in the form of a contiguous business, this business will have numerous “best owners” over time, as well. From start-up, to growth, to maturity and eventually decline, ownership of the business will naturally transfer to those who are best positioned to maximize value (that is, future cash flows) from the business in its present form and at that particular stage of its lifecycle. The general trend is increasing acquisition of assets until the terminal point is reached at which point assets are divested and spun-off as the business declines and ultimately fails or disappears via merger/acquisition into the total control of another enterprise.
Merkel makes an important observation about the above-average ownership period of the average Buffett investment:
BRK is the acquirer of choice for those that want to cash out, but don’t want the unique character of their organizations to change, which Buffett points at in the present Shareholders’ Letter as a unique competitive advantage.
Buffett finds himself to be the “best owner” of various assets he has acquired for periods that seem much longer than most others because he has determined that committing himself to this role gives him a competitive advantage in convincing the previous owners to allow him to acquire the assets in the first place. Although Buffett as a capital allocator (acquirer) may have no particular advantage in managing businesses and assets involved in any particular late-phase lifecycle such as maturity and decline, by creating a credible belief that Buffett will preserve a business he aims to acquire, he is granted opportunities to acquire that might not exist for anybody else due to non-financial (such as emotional or prestige) reasons.
So far, this strategy has proven to be a good one, and a unique one for the most part. But it remains to be seen how this strategy will hold up when Buffett himself is no longer around, and many more of his businesses have entered the maturity/decline phases. After all, Buffett eventually sold off his textile mills, albeit for pennies on the dollar, though, it could be argued, not before extracting from them substantial free cash flows he was able to allocate into better businesses.
As investors, we’re all in the acquisition game. Like Buffett, whether we’re buying public or private companies, whole businesses or tiny slivers, we’re constantly acquiring (and sometimes divesting) pools of real capital.
How does acknowledging this fact change your perspective, and your behavior?
There is nothing inherently efficient about the corporate conglomeration as an entrepreneurial structure. In fact, the conglomerate form (in the more traditional sense in which Merkel uses it) is generally found to be less efficient because it causes management to make decisions about business activities it may have substantially less expertise in, while simultaneously dividing total management attention and thereby causing distractions.
Frankly, there is no reason why a company like BRK, which owns candy confectioners, insurance companies and railroads, should necessarily have any special ability to compound wealth merely because of the corporate combination of these assets and businesses. If it were true that the corporate conglomeration was inherently more efficient and profitable, this business form would be vastly more prevalent than it currently is, if not entirely dominant.
The reality, however, is that most conglomerates are not specially profitable. They are not specially efficient. They suffer from bureaucratic operation, distracted management and huge internal calculational problems as they grow in size.
In that sense, Buffett (and Munger, to some extent) is the unique competitive advantage that BRK as a corporate conglomerate is blessed with. And it is for this reason that I believe the death of Buffett will be devastating to BRK’s market value and will most likely result in massive divestitures and the eventual break-up of the entity.
One final note, which I couldn’t help but to mention: the totalitarian state is the penultimate corporate conglomeration. And it suffers mightily as an economic entity, as a result.