Margin of Trust: The Berkshire Business Model by Lawrence Cunningham & Stephanie Cuba

Reason to Read:

This book reveals some of the driving principles that helped Warren Buffet build Berkshire Hathaway into the impressive conglomerate and long-term organization it is today. 

Summary & Key Insights:

Margin of Safety describes the investment principles of Warren Buffet in which there must always be a considerable safety margin between the actual value and the price.

Analogous to this investment theory of Warren Buffet is the Margin of Trust management theory, which highlights cooperation with those you deeply trust. 

The central management principles of Berkshire are autonomy and decentralization. 

All CEOs of Berkshire companies have complete autonomy and often freely delegate themselves further down into the product, marketing, etc. departments. The payoffs of this culture are more effective leadership, lower administrative costs, and better performance. 

Berkshire bought companies in diverse industries with diverse backgrounds, but all had one thing in common: shared common values.

The Berkshire Hathaway Values: Integrity, Autonomy, Patience

The Anti-PE Fund

Berkshire acted in the exact opposite way a private equity fund would: 

  • Retain workforce without cost-cutting
  • Do not relocate headquarters and management
  • Long-term focus with the plan “To Never Sell.”

That’s why Berkshire wins deals on more favorable terms. Also, Berkshire waits for deals rather than actively searching for them, but this needs an extensive referral network and a good reputation.

Berkshire Hathaway never had a department or a plan. It was much more of opportunism and chance. Instead of working with brokers, the holding company relies on an ever-growing network of partners, colleagues, friends, etc. 

Berkshire rarely triggers the process but waits for offers, and even then, large deals often take no more than a month because of mutual trust.

Circle of Competence & Circle of Trust:

When Warren Buffett lacks competence – whether in the business, about the business method or in judging the people involved – he passes.

Concerning trust, in particular, if Buffet has any doubt about the trustworthiness of a prospective business colleague – seller, manager, or otherwise – he politely declines interest. That is his Margin of Trust.

Internal Capital Allocation

Berkshire’s conglomerate structure enables internal cash reallocation to businesses generating the highest returns on incremental capital. Cash-transferring subsidiaries distribute cash to Berkshire without any tax consequences.

Cash-receiving subsidiaries obtain corporate funding without frictional borrowing costs, such as bank interest rates and other constraints.

Organizational Structure

Each Berkshire subsidiary has all the traditional operational functions from HR to marketing.

Also, each company has a board with typically five members, and the CEO always has one of the five board seats. Often the CEO of one subsidiary also has a board seat in another subsidiary. The rest come from Berkshire directly.

Reporting decentralization occurs by reducing the direct reports of senior managers without adding layers of bureaucracy, chiefly by collecting logical business units into group portfolios. 

All organizational structures have advantages and disadvantages. Often, the advantage of centralization is avoiding duplicate resources.

Berkshire seems to work the other way around: There may be 60 legal departments instead of just one, but the alternative would be one sizeable legal office which would probably require more employees than those working in the 60 individual ones.

“Efficiency follows because each manager has economic and cultural incentives to minimize the size of his staff. ” Also, each CEO can build their org chart to make the best possible sense for their particular business.

Picking the right Leader

The most important thing is to pick an excellent and trustworthy CEO and stay out of his or her way.

When Berkshire finds managers it trusts, it leaves them alone. The only qualification on managerial autonomy at Berkshire appears in a short letter Buffet sends unit chiefs every two years. The letter states the mandates Berkshire places on subsidiary CEOs:

  1. Guard Berkshire Reputation
  2. Report Bad News Early
  3. Adopt a 50-year time horizon
  4. Refer any opportunity for a Berkshire acquisition to Berkshire Headquarters 

“Buffet attributes Berkshire’s success to its managers. Buffet extols his subsidiary heads in his famous annual shareholder letters, aptly dubbing them the “All-Stars” of American business.”

Most executives started as youngsters and stayed permanently, becoming trusted, culture-fit CEOs. 

How to incentivize Leaders

The incentive structure of all CEOs and managers should be kept as simple as possible.

Buffet notes that you measure all CEOs by a set of performance standards.

A board’s external directors must draft these standards and regularly evaluate the CEO in light of them – in the CEO’s absence. If the executive’s performance consistently falls short of the standards set by external directors, then the board must replace them. The same goes for all senior managers they oversee, just as an intelligent owner would if present. 

At Berkshire, they tie many compensation arrangements to subsidiary profits. Warren Buffets’ model aspires to create a win-win situation. 

The cautionary note is that clear-sustained segmentation can be more effective than combination.

Our decentralized, entrepreneurial culture allows us to be fast, focused, and responsive. 

CEO pay is clearly tied to performance metrics under their control.

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