Other People's Money
The flip side of the problems created by cheap money is the benefit that comes from tight money. It teaches respect for capital. The managers of Berkshire's various wholly-owned businesses can get all the money that they want, but they have to pay. On the other hand if the CEO returns money from earnings to the parent, Berkshire pays them a nice return (2% to 3% below the respective interest charged).
At the 1995 Berkshire Hathaway annual meeting, a shareholder asked Buffett to describe the capital allocation process that he and Munger use. Buffett replied that there is "no better way to make managers understand how valuable capital is than to charge them for it." The rates varied from company to company depending upon the industry, company history, and typical capital requirements for its sector. The amount charged to the individual manager, "varied from 14 to 20 percent at times." The important thing Buffett emphasized it that, "we don't want managers to think of other people's money as 'free' money."
There is no free money at Berkshire, no IPO's, no secondary offerings. In this system, even internally generated cash from operational cash flow has a cost (the return that Buffett will pay if the cash flow is sent to Omaha). This establishes a discipline that helps the business managers avoid silly capital expenditures.
So, Berkshire managers can have all the money they want, but in most cases they are going be to better off giving the money to Warren to manage. The real cost of money within the Berkshire system is not the interest rate (the amount that they paid Berkshire to use the money), but rather the opportunity cost (the profit they lose by not turning the money over to Warren). This makes money at Berkshire very expensive all of the time.It is my opinion that this capital allocation policy is one of the essential elements of Buffett's genius, and is a product of his ability to see things very differently from most people. The idea that expensive capital could be his vehicle to build a giant conglomerate flies in the face of common sense.
Screams erupted in December when the Fed left interest rates unchanged. Larry Kudlow accused the Fed of attempting to destroy American prosperity. They are denying the flow of capital necessary to fuel the tech revolution. On the surface this argument seems to make sense. Business needs capital to expand and popular wisdom says, the easier that capital is to get, the faster the economy will grow. But the history of the last two years surely destroys this theory. Never have so many CEOs pissed away so much money so fast with so little benefit to anyone.
At the same time we have the example of the Nebraska Furniture Mart and Borshiem's—two retail operations that have lived with Warrens tight money for quite a few years. When you walk in to either of these stores there is no sense of capital deprivation—just the opposite. The stores are modern and beautiful, merchandising is top of the line, and the depth of inventories is awesome. Respect for capital has not restricted growth, but persevered and enhanced it. The 450,000 Square Foot Furniture Store
When Berkshire purchased NFM in 1983, the company's annual sales were $88 million. 16 years later, in 2000, total sales were $365 million. The company's sales have increased every year, but the rate of growth at 7.5% per year has not been spectacular, but the result has been absolutely spectacular. At $350 million in sales from a single location, it is not only the largest volume store in the United States, but it dwarfs the sales of the second largest operation which is in Houston Texas (about $100 million a year in sales). No rational person would pick Omaha, Nebraska as the site for a furniture store which the owner intended to build into the largest in the world. But there it sits on 72nd Street, between Dodge and Pacific—a tribute to its founder, and now its parent company.
Logical Paradox
This is a logical paradox. Easy money should produce growth, but if it gets too easy what it produces is waste. Expensive capital should produce stagnation, but at Berkshire it teaches respect for other people's money, effective capital allocation, and promotes the growth of earnings. Common sense tells us that tight money is bad for profits. The cost of money is an expense, and it limits the amount of capital available for expansion. Yet NFM and Borshiem's have operated in a system that, arguably, has the highest cost of capital anywhere, since their acquisition by Berkshire. Now they are two of the most impressive retail operations I have ever seen.
If you want further evidence of beneficial long-term effect of tight money, look at history. Many causes have been proposed for our 18-year bull market that began in 1982, and the economic boom that inspired it. The stage for this expansion was set many years ago by the rigid monetary discipline in the late 1970s and early 1980s.
The cost of money has an important role through its influence on the behavior of corporations. When interest rates are high, as they were during the above period, businesses are forced to find the most productive use for their money. If money is cheap, capital gets pissed away. The long period of tight money caused a massive change in the behavior of American business, and the effect was profound precisely because rates were so high.
The problem is in the limits of human intelligence, and our failure to recognize those limits. Predicting the future is difficult to impossible, yet it is always easy to find managers who are sure they know how to spend their shareholders' money. Capital allocation is essentially an exercise in crystal ball gazing. Inevitably it degenerates into an exercise in the endless extrapolation of past trends into the future. This process works the best in boring businesses and long economic cycles. It works very poorly in high tech businesses were rapid change makes the past a very poor guide to anything. The point is to invest in those areas where capital allocation is easy and avoid those where it is difficult.
2000 Results
As you can see from your statements, December was a good month. This helped to make 2000 good year. Any year that you out perform the averages is a good year. But the best of all possible worlds is to be up when the market is going down. Our accounts managed to beat the S&P by anywhere 7% to 38% for the year 2000. For the conservative investor, 2000 was a very easy year to beat the averages. Whereas in 1999 it was impossible.
By the end of the year 2000 all of our managed accounts have beaten the S&P since their inception. The account that has been managed for the longest period is up 1258.57% over thirteen years, versus 434.35% for the S&P during that period. The accounts that have been managed for shorter periods are not yet showing this kind of gain, but the worst five-year account has an annual appreciation of 122% versus 101% for the Wilshire 5000 index.
More important is the fact that there are many good companies available at prices that are more attractive now than they have been since the early 1990s. This in turn is allowing us to take positions that are setting the stage for good performance over the next ten years.