8 4
that his company would quadruple its $214
million in sales in
ten years; he did it in eight years.
Clearly, Bob Shaw managed his company well, and in a
way that f its neatly with Buffett’s approach. “You have to
grow from earnings,” Shaw said. “If you use that as your phi-
losophy—that you grow out of earnings rather than by borrow-
ing—and you manage your balance sheet, then you never get
into serious trouble.”
4
This type of thinking is right up Buffett Alley. He believes
that management’s most important act
is the allocation of capi-
tal and that this allocation, over time, will determine share-
holder value. In Buffett’s mind, the issue is simple: If extra cash
can be reinvested internally and produce a return higher than
the cost of capital, then the company should retain its earnings
and reinvest them, which is exactly what Shaw did.
It was not just that Bob Shaw made good f inancial deci-
sions, he also made strong product and business decisions by
adapting to changing market conditions. For example, Shaw
retrof itted all of its machines in 1986
when DuPont came out
with new stain-resistant f ibers. “Selling is just meeting people,
f iguring out what they need, and supplying their needs,” Shaw
said. “But those needs are ever changing. So if you’re doing
business the same way you did it f ive years ago, or even two
years ago—you’re doing it wrong.”
5
Shaw’s strong management is ref lected in the company’s
consistent operating history. It has grown to the number one
carpet seller in the world, overcoming changing marketplace
conditions, changes in technology,
and even the loss of major
outlets. In 2002, Sears, one of Shaw’s largest vendors at the time,
closed its carpet business. But the management appeared to see
those difficulties more as challenges to overcome rather than
barriers to success.
In 2002, Berkshire bought the remaining portion of Shaw
that it did not already own. By 2003, Shaw was bringing in
$4.6 billion in sales. Except for the insurance segment, it is
Berkshire’s largest company.
I n v e s t i n g G u i d e l i n e s : M a n a g e m e n t Te n e t s
8 5
capital,
over time, determines shareholder value. Deciding what to do
with the company’s earnings—reinvest in the business, or return money
to shareholders—is, in Buffett’s mind, an exercise in logic and rational-
ity. “Rationality is the quality that Buffett thinks distinguishes his style
with which he runs Berkshire—and the quality he often finds lacking in
other corporations,”
writes Carol Loomis of
Fortune.
6
The issue usually becomes important when a company reaches a cer-
tain level of maturity, where its growth rate slows and it begins to gen-
erate more cash than it needs for development and operating costs. At
that point, the question arises: How should those earnings be allocated?
If the extra cash, reinvested internally, can produce an above-average
return on equity—a return that is higher than the cost of capital—then
the company should retain all its earnings and reinvest them. That is the
only logical course. Retaining earnings to
reinvest in the company at
less
than the average cost of capital is completely irrational. It is also
quite common.
A company that provides average or below-average investment re-
turns but generates cash in excess of its needs has three options: (1) It
can ignore the problem and continue to reinvest at below-average rates,
(2) it can buy growth, or (3) it can return the money to shareholders. It
is at this crossroad that Buffett keenly focuses on management. It is here
that managers will behave rationally or irrationally.
Generally, managers who continue to reinvest despite below-
average returns do so in the belief that the situation is temporary. They
are convinced that,
with managerial prowess, they can improve their
company’s prof itability. Shareholders become mesmerized with man-
agement’s forecast of improvements.
If a company continually ignores this problem, cash will become an
increasingly idle resource and the stock price will decline. A company
with poor economic returns, a lot of cash, and a low stock price will at-
tract
corporate raiders, which often is the beginning of the end of cur-
rent management tenure. To protect themselves, executives frequently
choose the second option instead: purchasing growth by acquiring an-
other company.
Announcing acquisition plans excites shareholders and dissuades cor-
porate raiders. However, Buffett is skeptical of companies that need to
buy growth. For one thing, it often comes at an overvalued price. For
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