“With more than 300,000 Berkshire employees, Buffett can almost guarantee that someone is doing something wrong somewhere in our business.” Charles Munger. Vice Chairman. Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Berkshire Hathaway’s 50th Annual Meeting. May 2015.
Berkshire Hathaway’s culture encourages its employees to “do the right thing.” In a 1991 letter to employees of a business in which Berkshire was an investor, Buffett wrote, “Whenever an employee of our business is contemplating an act, that individual should ask himself whether he would be willing to see it described by an informed and critical reporter on the front page of a local newspaper that is read by his spouse, children, and friends.”
Efforts to deceive its regulators, customers or employees will not be tolerated by Berkshire and its two senior executives. This principle is ingrained in the firm’s culture. It is because those two individuals want to “do the right thing.” It is also because Buffett’s and Munger’s perspective developed over their lengthy careers has reinforced their belief that Berkshire’s reputation will make a greater contribution to its sustainable profitability than any attempt to improperly maximize its short-term profits. Munger has commented “that is why Berkshire has an 800-number for our people to contact us if they are worried something isn’t right.”
Volkswagen’s culture seems to be much different.
On September 23, 2015, following discussions that lasted months between U.S. regulators and Volkswagen (XTER:VOW, Financial) about the car company’s diesel emission test results, the automobile manufacturer recanted its assertion that it had done nothing wrong. Volkswagen then admitted it had purposely installed “emission test defeating” software in more than 11 million diesel powered cars it had manufactured and sold between 2009 and 2015. Without this software, nitrous oxide emissions by Volkswagen’s diesel powered automobiles would have tested 35-40 times higher than permitted by law! Nitrous oxide is a pollutant that poses significant health dangers. Probably dozens, perhaps hundreds, of Volkswagen’s engineers and executives developed and installed this software. Many more probably knew about it.
“Where were the whistleblowers?”
Volkswagen is the largest automobile manufacturer in Europe. It produces 10 million cars annually. The company employs more than 600,000 workers worldwide, more than 300,000 in Germany alone. Volkswagen is the largest employer in Germany and one of that nation’s most important businesses.
Volkswagen apparently was unable to simultaneously meet increasingly stringent auto emissions and greater fuel economy standards required by regulators without adding materially to the cost of its diesel cars and negatively impacting its performance. Volkswagen’s diesel engines achieved fuel economy, an important feature to consumers, only by cheating with “emissions test defeating” software. The emissions tests were administered by testing companies hired and paid by Volkswagen. The tests took place in laboratories, not on roads, and used different car models than were sold to the public!
The big question, in our minds, is that since many individuals may likely have known that Volkswagen’s software illegally permitted violation of emissions and fuel economy standards, why didn’t anyone say anything? Where were the whistleblowers? Did Volkswagen’s culture, like that of General Motors’ regarding its faulty ignition switches and Toyota’s regarding its faulty braking systems, condition them to obey authority despite understanding they were aiding and abetting business executives to intentionally violate the law?
“It comes from the top.” Steve Cutler. General Counsel. J.P. Morgan. Former Director of Enforcement. U.S. Securities and Exchange Commission. 1993.
In 1993, the former SEC’s Director of Enforcement tried to explain that the culture of a business is created by its senior executives. That is why those executives and their general counsels take such care to outline “roadmaps” for employees’ behavior rather than provide them with explicit “directions.” It is also the job of senior executives to hire individuals having good character. “Character is what you do when you think no one is watching,” according to Roy Furman, the Vice Chairman of Jefferies, the institutional investment banking firm. Roy has been my friend since I met him in 1969 when I applied for my first job as a Wall Street securities analyst…which I didn’t get at his firm. Anyway, every year Roy now welcomes Jefferies’ new employees with a brief talk. “Reputation is what you earn from everything you do,” he tells his recruits. “Most individuals feel their interview ends when they get a job. That is not true. Your interview continues throughout your career. Everyone is watching everything you do every single day. Those actions create your reputation. That is also an ‘interview.’ ” It is shocking to me that at large firms like Volkswagen, General Motors, Toyota, and many others…when many had to know their firm was doing something wrong, no one spoke up!
A friend of mine is a senior partner at one of New York’s top law firms. He recently visited me for lunch. He told me he had significant liquidity and wanted to consider investing some of it with us. As our lunch meeting was ending and he was preparing to leave, he told me that he invests based on his assessment of an individual’s character and a firm’s culture. I was proud when he told me he was going to invest with us. He chose to invest with us for the same reason we choose to invest in businesses…our assessment of executives’ characters and firms’ cultures. We believe this approach provides us with a competitive advantage over passive investors who do not do this.
“It’s all about investing in people.” Jay Pritzker. Founder. Hyatt Corporation. 1975.
One benefit of investing with Baron Funds is that before, during, and after we invest in businesses, we “Question Everything.” In fact, questioning everything is so integral to our investment process that we have made “Question Everything” the theme of our annual conference this year that will take place on November 6, 2015. Questioning everything is what gives us confidence to “invest in people,” another tenet of our investment process. For example, we have made a significant effort to understand Tesla (TSLA, Financial)’s culture by tirelessly questioning its executives. As a result, it is unimaginable to me that if a car part or an assembly process wasn’t exactly “right” and potentially compromised the safety of Tesla passengers, that Elon Musk would lie about it. This is regardless of whether it cost his business millions to correct a problem or he had to miss projected car deliveries in a quarter and Tesla’s stock price would be negatively impacted for a period. Under Armour (UA, Financial)’s Kevin Plank wants to make the best products to help athletes perform better. That’s what his brand stands for. He wants kids who wear his gear to feel like Superman. He believes that it is necessary to make the highest quality products to protect his brand. If he doesn’t get it right, he fixes it. Regardless of the cost. All that you need to do to come to that conclusion is talk to Kevin. Another 40 something year old entrepreneur who is building a business by “doing the right things” is Inovalon’s Dr. Keith Dunleavy. Keith provides unique health care data and analytics to insurers and health care providers. He spends significant amounts every year so that better and more effective care at lower cost can be provided to all of us. He tolerates no shortcuts. It would be unimaginable for Hyatt Chairman Tom Pritzker and his tireless 52 year old CEO Mark Hoplomazian to alter software to avoid paying room taxes or to do anything else improper. Further, Tom and Mark have empowered their employees to do whatever is necessary to “fulfill the needs and desires of their guests.” This is to enhance the value of the Hyatt Hotels’ brands. They give their employees “a roadmap, not directions how to get there.” I am certain knowing Tom and Mark for many years it would never cross their minds to do anything improper. By questioning everything we come to conclusions about with whom we should invest.
“When the map differs from the terrain, suggest you go with the terrain.” Admiral Eric T. Olson, U.S. Navy (Ret’d), Former Commander, U.S. Special Operations Command. Director. Under Armour. 2015.
Admiral Eric T. Olson is an Under Armour Board member. During a recent conversation between Kevin Plank, Under Armour’s CEO, Michael Baron and me, we asked Kevin how he makes difficult tactical decisions. He answered by relaying the above advice he had received from Admiral Olson which I thought was so interesting, I have since been looking for a place to write about it.
Former Secretary of State Hillary Clinton, the current frontrunner for the 2016 Democratic Presidential nomination, recently countered criticisms that she was “constantly changing positions to satisfy political needs rather than in response to her core beliefs.” You “cannot be impervious to evidence of changed circumstances” was how she put it. Sort of another way to make Admiral Olson’s point.
At the start of the 2016 election campaign for President, several Republican candidates proposed that Congress repeal Dodd-Frank. The Dodd-Frank Act is the financial reform legislation that became law in 2010. After watching a recent interview with former Federal Reserve Chairman Bernanke, I thought Admiral Olson’s advice and Secretary Clinton’s answer were appropriate retorts to suggestions that Dodd-Frank be repealed.
Among other things, Dodd-Frank increases regulation of the financial derivatives that played such an important role in bringing our nation’s banking system to its knees during the 2008-09 financial crisis. According to former Fed Chairman Bernanke, Dodd-Frank, coupled with more stringent bank capital requirements and rules designed to curb risk taking by banks, limited systemic risk during volatile markets this fall. Since America’s banks have been recapitalized with equity and their activities as principals have been significantly constrained, banks and our financial system were little impacted by recent volatile markets. The dramatic decline in the price of oil and other commodities in 2015 preceded the 200 basis point repricing of high yield debt markets last month. The financial distress of commodity trading firm Glencore (LSE:GLEN, Financial) and the “emission cheating” software scandal at Volkswagen would likely have wreaked havoc on the more leveraged banking system infused with counterparty risk as it was constituted in 2008.
It seems to us that the “Invisible Hand” theory introduced by Adam Smith in 1759 is not applicable in all circumstances in today’s highly complex financial system. Regardless, Republican Presidential candidates, in the midst of an election campaign, continue to propose to eliminate banking regulation implemented since The Great Recession of 2008-09. Their politicized proposals ignore the fact that the actions of the Fed during the credit crisis and the regulation that followed are precisely what saved and strengthened our economy. Increased regulation has also provided safeguards to withstand future shocks. Since being recapitalized, banks have virtually eliminated their risk businesses, and, in many ways, have become more like utilities.
We think the proposals of Presidential candidates to repeal Dodd-Frank are the result of their looking at another “map,” without realizing the “terrain” now differs from that map. We believe our economy at present is on more secure footing. At Baron, we go with the terrain.
Baron Investment Conference 2015. November 6, 2015. Metropolitan Opera House. New York City.
We hope you will be able to attend our 24th annual investment conference on November 6th. For those of you who can’t attend, you will be able to watch the live webcast on the Baron Funds website (except for entertainment, which we are contractually prevented from streaming).
You can get a sense of our meeting by watching CNBC’s Squawk Box that morning from 6 a.m. to 8:30 a.m. EST. CNBC’s Andrew Ross Sorkin and I will be interviewing several executives with whom Baron Funds has invested and with whom we expect to make a lot more money...although, we obviously can’t promise that. Andrew will also interview me on Squawk Box live from the conference that morning.
We like to say, “We invest in people.” We hope when you attend our annual conferences or watch us on CNBC or visit our website, you will gain a better understanding of the businesses in which we invest, and the character and talent of the executives who run them as well as the people who work at our Firm.
Thank you for joining us as fellow shareholders in Baron Funds. We will continue to work hard to justify your confidence in us. See you in November.
Respectfully,
Ronald Baron
CEO and Chief Investment Officer
October 23, 2015
Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectuses contain this and other information about the Funds. You may obtain them from the Funds’ distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.
At September 30, 2015, Baron Small Cap Fund, Baron Fifth Avenue Growth Fund, Baron International Growth Fund, Baron Emerging Markets Fund, Baron Energy and Resources Fund, Baron Global Advantage Fund and Baron Discovery Fund did not own any of the securities listed above.
Portfolio holdings may change over time.
The discussion of market trends and companies throughout this report are not intended as advice to any person regarding the advisability of investing in any particular security. Some of our comments are based on current management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views are a reflection of our best judgment at the time of the publication of this report and are subject to change any time based on market and other conditions, and we have no obligation to update them.
