On Buffett and the Virtue of Smallness

13 Feb 2023

a few scattered thoughts on Warren Buffett and some non-obvious implications of his investment philosophy…

Lately, I’ve been reading some of the literature on Warren Buffett: I’m about halfway through the Berkshire Hathaway letters, I just finished “The Deals of Warren Buffett, the First $100m”, and I’m working my way through “The Snowball”.

In reading these things, I am trying to accomplish two things. First, I want to get a better sense of the beginning of Buffett’s career, because I find that many of the biographies of extremely successful businessmen tend to be heavily whitewashed. (You know what they say about history being written by the victors, and powerful men and their sycophants). And, after all, it is quite easy to make money once you have it, but comparatively difficult when you don’t, so it is more valuable to understand what Buffett did when he didn’t have any money. Secondly, I find that most of the commentary on Buffett’s investing philosophy is rather basic. I think this is for two reasons: (a) Buffett deliberately puts on a (somewhat disingenuous) folksy grandpa facade that obscures the heavy-hitting implications of his investment praxis and (b) public commentators are inherently mediocre, and therefore inevitably fail to do justice in their articulations of subtle ideas.

Peeling back the onion of Buffett’s thought has yielded some interesting insights in relation to intelligent investing, sound capital allocation, and the capital allocation today.

Conceptually, CEOs have eight actions they can take. There are three sources of capital with which they can finance a company (equity, debt, and cash flow), and five ways to deploy that capital (invest in operations, buy other companies, repay debt, repurchase equity, and pay dividends to shareholders). Theoretically, a CEO should raise capital as cheaply as possible and invest it to maximize shareholder return, or the net present value of future cash flows.

As stated, these directives seem tautologically true, but in reality they are rarely practiced. Among many reasons, this is because of principal-agent problems which sometimes emerge between the CEO (the agent) and his/her shareholders (the principals). Buffett describes the ego of the CEO driving him/her to expand a business empire beyond its scope of competence—e.g., cavalierly acquiring businesses, or otherwise investing in frivolous operations to cultivate a sense of importance and control, rather than the potential for return.¹

Instead, Buffett famously focused on “return on equity” and “return on invested capital” ratios over the more commonly used “price-to-earnings” and “price-to-book” ratios. The importance of this distinction is subtle, and its counterintuitive merit is illustrated by Buffett’s decisions to turn business away and shrink the (absolute) size of his insurance businesses.² (What CEO or manager today wouldn’t instinctively flinch at the idea of reducing the size and scope of their company?) The core idea is that it is quite easy to grow earnings if you simply raise more equity or debt capital to throw at the problem. But higher profits don’t necessarily mean better business. What the intelligent investor ought to care about instead is the efficiency with which capital is deployed. A classic value investing puzzle goes something like: there are two companies which make the same revenue and profits, but one has a much larger asset base (aka, invested capital) than the other. Buffett would argue that you ought to prefer the one with fewer assets, because it produces disproportionally more profit.

This seems intuitive in theory, but is not, in practice. Most CEOs deploy their efforts toward growing absolute profits, and this leads to a sort of metastatic growth in assets relative to earnings. Contrast this with Buffett’s strict guidelines for financial discipline, and his practice of taking excess cash flow from cash-generating companies and deploying it elsewhere.

When a company generates excess cash flow, as many tech companies have in the last decade, it is somewhat constrained to invest each marginal dollar made back into its operations or into acquisitions (since it is not in the “DNA” of many companies, particularly in tech, to utilize debt, repurchase shares, or pay dividends). But not every project or acquisition requiring capital outlays is a great return on investment—profit-generating, perhaps, but not necessarily great ROI. At some point in a company’s lifetime, it picks all of the “low hanging fruit”, and each additional dollar invested no longer yields the same return as previous investments. Instead, by buying companies outright, Buffett is able to redirect the earnings of subsidiary companies to the opportunities where they will earn the highest marginal return, rather than being arbitrarily forced to double down into lower and lower quality projects. In this way, Buffett sweeps the efficient frontier and finds the highest return for every dollar.

There is an interesting upshot here which I think most CEOs fail to or don’t want to realize: there is a natural limit to and an optimal size for every company, past which every dollar spent produces a lower marginal return. I’d venture a guess that this point occurs much sooner than most CEOs would like to admit. Exceedingly few companies have been able to successfully expand into adjacent markets or create products fundamentally different than their core or initial product: Google and Facebook are still fundamentally ads businesses; most fintechs will not become the one-stop shops or superapps they aspire to become; etc. To this end, many of Buffett’s best investments never grew past very small teams, and his obsessive focus on cost-cutting kept organizational and managerial bloat in check. This is in stark contrast to practices in Silicon Valley, for which a “growth-at-all-costs” mindset is the precondition of every enterprise. Such an attitude towards capitalism produces a number of deleterious side effects, such as the proliferation of vacuous middle managers³ and the accompanying sociopathic hierarchy which measures an employee’s standing in an organization by the number of “reports” they have, not to mention the vast destruction of economic value⁴ which the last decade of zero rates has enabled. Perhaps soon we can return to a more sensible paradigm of capital allocation.

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