Adam Mead’s book “The Complete Financial History of Berkshire Hathaway: A Chronological Analysis of Warren Buffett and Charlie Munger’s Conglomerate Masterpiece” offers a fascinating view into the capital allocation decisions made through its history. He writes: “Berkshire Hathaway [is] among the greatest of human achievements. Berkshire’s financial outcomes were a result of business mastery, the perfection of a system that cultivated human potential. The capitalist system put in place by America’s Founding Fathers and the incredible tailwinds of the mid-twentieth century provided the rich soil to allow the genius of Warren Buffett and Charlie Munger to flourish. The full story of Berkshire Hathaway is worth understanding for what it can teach us about continuing timeless methods of excellence in business and in life.”
In a section on capital allocation, Mead writes:
Berkshire’s philosophy: Treat subsidiaries as investments, providing for operational independence. Use the cash flow from them, along with capital gains from investments, for organic expansion.
Early conglomerates: Acquire diverse businesses to achieve synergies or take a hands-on approach to managing them post-acquisition.
A successful business of any kind is the result of rational capital allocation over time. Berkshire Hathaway grew out of the philosophy Warren Buffett internalized from Benjamin Graham early in his career. A bedrock principle was that stocks represented ownership in a business. This framework gave Buffett an important vantage point to survey the economic landscape. No business or industry would be out of reach if Buffett could understand the business and its economics. Berkshire could allocate capital to wholly-owned businesses or buy pieces of businesses in the stock market, depending on which was more attractive at the time.
Crucially, the ownership philosophy set the stage for decentralization. Buffett and Munger’s early years were spent buying stocks as part of a portfolio. Berkshire was constructed using what might be termed a portfolio approach. It became a collection of businesses and not one large business with operational oversight of multiple business activities. This is an important distinction. Berkshire’s capital allocators were accustomed to acting as owners, not managers. If a hands-off approach worked for passive investments in stocks, why should the approach change much upon gaining control? Berkshire could view ownership of a subsidiary as equivalent to a stock in a portfolio and let it operate independently. The only difference between the two approaches was that Berkshire had a much higher threshold for divesting an operating subsidiary.
… The conglomerate structure also provided an important relief valve to subsidiaries. Berkshire’s subsidiaries could grow to their optimal size and send surplus cash flow to headquarters. Buffett and Munger were in the best position to allocate capital to the highest use once it could not be used for expansion at the subsidiary level. This afforded Berkshire the opportunity to buy businesses with strong competitive positions but little growth potential.
Since 1965, Berkshire Hathaway has provided over 20% average returns since its inception, almost double the 10% of the S&P 500.