Like their mentor Benjamin Graham, Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) firmly believe that buying shares of a company is buying a proportional share of an underlying business. A share is not a piece of paper; it is an investment in a living and breathing business operation.
In chapter seven of “Charlie Munger: The Complete Investor,” author Tren Griffin reported that a critically important part of ownership is knowing if managers have the right stuff. Griffin provided a list of five management skills and traits that can be applied to management at any company:
First, capital allocation skills: This refers to the ability to take a company’s cash and deploy it internally or externally in a way that optimizes its return. It is considered critical; Buffett said, “Charles T. Munger, vice-chairman, and I really have only two jobs. … One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.”
In the minds of Munger and Buffett, too many managers failed learn this skill before they became CEOs and don’t know how to make important decisions in this area. The gurus also worry about what they call the “institutional imperative,” which is a set of behaviors triggered by managerial hubris. Pet projects, for example, may materialize and use up all available capital, rather than being deployed in true growth projects.
Buffett said, “Many managerial [princes] remain serenely confident about the future potency of their kisses—even after their corporate backyards are knee-deep in unresponsive toads.”
Second, aligning compensation systems with shareholder goals. As noted, this is second of two elements of management that Munger and Buffett take on themselves. Griffin added that the compensation issue at Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) has an additional wrinkle: Most of the managers are already rich and not particularly affected by compensation levels. However, they love what they do and love working for the gurus.
They also try to avoid being micromanagers, but at the same time do not abdicate their responsibilities. As Griffin put it, “A board of directors letting a parade of managers run down a business is not justified by a fear of micromanagement.”
Third, moat-widening skills: So having a moat isn’t, by itself, enough for the gurus. Munger has said:
“The only duty of a corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it’s too tough. But duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you.”
Since most companies are run by a succession of professional managers, all but the first inherit a competitive advantage. They should avoid complacency and grow their moats just as they’re expected to grow their fundamentals.
Fourth, integrity: There are many reasons to seek out managers with integrity. They can be counted on, for example, and they increase efficiency because fewer resources are needed to ensure their honesty and compliance. Munger has no tolerance for any lack of integrity, just as he has no time for a “mostly honest” character.
From another perspective, the gurus do not invest in “turnarounds” (often companies that got into trouble because their leaders lacked integrity) because that seldom happens. And they want moats that are strong enough to survive bad management. Munger added, “Network TV [in its heyday,] anyone could run and do well. If Tom Murphy is running it, you’d do very well, but even your idiot nephew could do well.”
Integrity also refers to an ownership mentality. Within this context, the gurus want managers to have “skin in the game,” an ownership stake in the companies they manage. They should share the pains and gains with shareholders. Put another way, there should be a symmetry between risk and benefits. For Buffett, this means having “a major portion of their net worth invested in the company. We eat our own cooking.”
Fifth, superbly talented managers: On rare occasions, Munger and Buffett have come across managers with such an abundance of talent that they may not need a moat. As examples, Munger cites Simon Marks, the second generation in Britain’s Marks & Spencer (MKS, Financial), as well as John Patterson of National Cash Register (NCR, Financial) and Sam Walton of Walmart (WMT, Financial).
But even superior talent may not be enough; Munger wrote, “averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.”
Buffett saw superb talent in Ajit Jain, the vice chairman of insurance operations at Berkshire Hathaway, saying he “has created tens of billions of dollars in value for this company out of nothing but brain and hard work.”
The right stuff for managers, then, is made up many components, including talent, skills and the right traits. When those components come together, the companies these managers run should be good investment choices.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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