More Praise for The Warren Buffett Way, First Edition

particular, he respects managers who are able to communicate the per-
formance of their company without hiding behind Generally Accepted
Accounting Principles (GAAP).
Financial accounting standards only require disclosure of business
information classif ied by industry segment. Some managers exploit this
minimum requirement and lump together all the company’s businesses
into one industry segment, making it diff icult for owners to understand
the dynamics of their separate business interests.
“What needs to be reported,” Buffett insists, “is data—whether
GAAP, non-GAAP, or extra GAAP—that helps the f inancially literate
readers answer three key questions: (1) Approximately how much is
this company worth? (2) what is the likelihood that it can meet its fu-
ture obligations? and (3) how good a job are its managers doing, given
the hand they have been dealt?”
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Berkshire Hathaway’s own annual reports are a good example. They
meet GAAP obligations, but they go much further. Buffett includes the
separate earnings of each of Berkshire’s businesses and any other addi-
tional information that he feels owners would deem valuable when judg-
ing a company’s economic performance. Buffett admires CEOs who are
able to report to their shareholders in the same candid fashion.
He also admires those with the courage to discuss failure openly.
He believes that managers who confess mistakes publicly are more
likely to correct them. According to Buffett, most annual reports are a
sham. Over time, every company makes mistakes, both large and in-
consequential. Too many managers, he believes, report with excess op-
timism instead of honest explanation, serving perhaps their own
interests in the short term but no one’s interests in the long run.
Buffett credits Charlie Munger with helping him understand the
value of studying one’s mistakes instead of concentrating only on suc-
cess. In his annual reports to Berkshire Hathaway shareholders, Buffett
is open about Berkshire’s economic and management performance,
both good and bad. Through the years, he has admitted the diff iculties
that Berkshire encountered in both the textile and insurance businesses
and his own management failures with these businesses.
His self-criticism is blunt, and unstinting. The merger with General
Re reinsurance company in 1998 brought significant trouble, a good
deal of which remained undiagnosed for several years, and came to light
only in the wake of the World Trade Center bombing in 2001. At the
time of the merger, Buffett said later, he thought the reinsurance com-
pany operated with the same discipline he demanded of other Berkshire
insurance companies. “I was dead wrong,” he admitted in 2002. “There
was much to do at that company to get it up to snuff.”
12
The General Re problem was not limited to its insurance practices.
The company also had a division that dealt in trading and derivatives, a
business Buffett considered unattractive at the time of the merger (al-
though, as part of the package, unavoidable) and financially disastrous
several years later. In 2003, he wrote this straightforward apology to
shareholders: “I’m sure I could have saved you $100 million or so, if I had
acted more promptly to shut down Gen Re Securities. Charlie would
have moved swiftly to close [it] down—no question about that. I, how-
ever, dithered. As a consequence, our shareholders are paying a far higher
price than was necessary to exit this business.”
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T H E W A R R E N B U F F E T T W AY
Critics have argued that Buffett’s practice of publicly admitting his
mistakes is made easier because, since he owns such a large share of
Berkshire’s common stock, he never has to worry about being f ired.
This is true. But it does not diminish the fundamental value of Buffett’s
belief that candor benef its the manager at least as much as it benef its the
shareholder. “The CEO who misleads others in public,” he says, “may
eventually mislead himself in private.”
14
Coca-Cola
Roberto Goizueta’s strategy for strengthening Coca-Cola when he took
over as CEO pointedly included shareholders. “We shall, during the next
decade, remain totally committed to our shareholders and to the protec-
tion and enhancement of their investment,” he wrote. “In order to give
our shareholders an above-average total return on their investment, we
must choose businesses that generate returns in excess of inf lation.”
15
Goizueta not only had to grow the business, which required capital
investment, he was also obliged to increase shareholder value. By in-
creasing profit margins and return on equity, Coca-Cola was able to in-
crease dividends while simultaneously reducing the dividend payout
ratio. Dividends to shareholders, in the 1980s, were increasing 10 per-
cent per year while the payout ratio was declining from 65 percent to 40
percent. This enabled Coca-Cola to reinvest a greater percentage of the
company’s earnings to help sustain its growth rate without shortchang-
ing shareholders.
Coca-Cola is undeniably a superior company with an outstanding
historical economic performance record. In the most recent years, how-
ever, that level of growth has moderated. Where some shareholders
might have panicked, Buffett did not. He did not, in fact, do anything;
he didn’t sell even one share. It is a clear testament to his belief in the
company, and a clear illustration of staying true to his principles.
T H E I N S T I T U T I O N A L I M P E R AT I V E
If management stands to gain wisdom and credibility by facing mistakes,
why do so many annual reports trumpet only successes? If allocation of
capital is so simple and logical, why is capital so poorly allocated? The

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answer, Buffett has learned, is an unseen force he calls “the institutional
imperative”—the lemminglike tendency of corporate management to
imitate the behavior of other managers, no matter how silly or irrational
that behavior may be.
He says it was the most surprising discovery of his business career.
At school, he was taught that experienced managers were honest, intel-
ligent, and automatically made rational business decisions. Once out in
the business world, he learned instead that “rationality frequently wilts
when the institutional imperative comes into play.”
16
Buffett believes that the institutional imperative is responsible for
several serious, but distressingly common, conditions: “(1) [The organi-
zation] resists any change in its current direction; (2) just as work ex-
pands to f ill available time, corporate projects or acquisitions will
materialize to soak up available funds; (3) any business craving of the
leader, however foolish, will quickly be supported by detailed rate-of-
return and strategic studies prepared by his troops; and (4) the behavior
of peer companies, whether they are expanding, acquiring, setting ex-
ecutive compensation or whatever, will be mindlessly imitated.”
17
Buffett learned this lesson early. Jack Ringwalt, head of National
Indemnity, which Berkshire acquired in 1967, helped Buffett discover
the destructive power of the imperative. While the majority of insur-
ance companies were writing insurance policies on terms guaranteed to
produce inadequate returns or worse, a loss, Ringwalt stepped away
from the market and refused to write new policies. ( For the full story,
refer to Chapter 3.) Buffett recognized the wisdom of Ringwalt’s deci-
sions and followed suit. Today, Berkshire’s insurance companies still
operate on this principle.
What is behind the institutional imperative that drives so many
businesses? Human nature. Most managers are unwilling to look fool-
ish and expose their company to an embarrassing quarterly loss when
other “lemming” companies are still able to produce quarterly gains,
even though they assuredly are heading into the sea. Shifting direction
is never easy. It is often easier to follow other companies down the same
path toward failure than to alter the direction of the company.
Admittedly, Buffett and Munger enjoy the same protected position
here as in their freedom to be candid about bad news: They don’t have to
worry about getting fired, and this frees them to make unconventional
decisions. Still, a manager with strong communication skills should be

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able to convince owners to accept a short-term loss in earnings and a
change in the direction of their company if it means superior results over
time. Inability to resist the institutional imperative, Buffett has learned,
often has less to do with the owners of the company than the willingness
of its managers to accept fundamental change.
Even when managers accept the notion that their company must
radically change or face the possibility of shutting down, carrying out
this plan is too diff icult for most managers. Many succumb to the
temptation to buy a new company instead of facing the f inancial facts of
the current problem.
Why would they do this? Buffett isolates three factors he feels most
inf luence management’s behavior. First, most managers cannot control
their lust for activity. Such hyperactivity often f inds its outlet in busi-
ness takeovers. Second, most managers are constantly comparing the
sales, earnings, and executive compensation of their business with other
companies in and beyond their industry. These comparisons invariably
invite corporate hyperactivity. Lastly, Buffett believes that most man-
agers have an exaggerated sense of their own management capabilities.
Another common problem is poor allocation skills. As Buffett points
out, CEOs often rise to their position by excelling in other areas of
the company, including administration, engineering, marketing, or pro-
duction. Because they have little experience in allocating capital, most
CEOs instead turn to their staff members, consultants, or investment
bankers. Here the institutional imperative begins to enter the decision-
making process. Buffett points out that if the CEO craves a potential ac-
quisition requiring a 15 percent return on investment to justify the
purchase, it is amazing how smoothly his troops report back to him that
the business can actually achieve 15.1 percent.
The f inal justif ication for the institutional imperative is mindless
imitation. If companies A, B, and C are all doing the same thing, well
then, reasons the CEO of company D, it must be all right for our com-
pany to behave the same way.
It is not venality or stupidity, Buffett believes, that positions these
companies to fail. Rather, it is the institutional dynamics of the impera-
tive that make it difficult to resist doomed behavior. Speaking before a
group of Notre Dame students, Buffett displayed a list of thirty-seven
failed investment banking firms. All of them, he explained, failed even
though the volume of the New York Stock Exchange had multiplied

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f ifteenfold. These f irms were headed by hard-working individuals with
very high IQs, all of whom had an intense desire to succeed. Buffett
paused; his eyes scanned the room. “You think about that,” he said
sternly. “How could they get a result like that? I’ll tell you how,” he
said, “mindless imitation of their peers.”
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Coca-Cola
When Goizueta took over Coca-Cola, one of his f irst moves was to
jettison the unrelated businesses that the previous CEO had developed
and return the company to its core business, selling syrup. It was a
clear demonstration of Coca-Cola’s ability to resist the institutional
imperative.
Reducing the company to a single-product business was undeniably a
bold move. What made Goizueta’s strategy even more remarkable was
his willingness to take this action at a time when others in the industry
were doing the exact opposite. Several leading beverage companies were
investing their profits in other unrelated businesses. Anheuser-Busch
used the profits from its beer business to invest in theme parks. Brown-
Forman, a producer and distributor of wine and spirits, invested its prof-
its in china, crystal, silver, and luggage businesses, all of them with much
lower returns. Seagram Company, Ltd., a global spirits and wine busi-
ness, bought Universal Studios. Pepsi, Coca-Cola’s chief beverage rival,
bought snack businesses (Frito-Lay) and restaurants including Taco Bell,
Kentucky Fried Chicken, and Pizza Hut.
Not only did Goizueta’s action focus the company’s attention on its
largest and most important product, but it worked to reallocate the
company’s resources into its most prof itable business. Since the eco-
nomic returns of selling syrup far outweighed the economic returns of
the other businesses, the company was now reinvesting its prof its in its
highest-returning business.
Clayton Homes
In an industry that is strangled by problems of its own making, Clayton
stands out for its strong management and smart business model.
Manufactured homes now constitute 15 percent of the total housing
units in the United States. In many respects, their historically negative

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image is disappearing. The homes are becoming more like site-built
homes in size and scope; construction quality has consistently improved;
they are competitive with rentals; they have tax advantages in that own-
ers do not have to own the underlying property; and mortgages are now
supported by other large mortgage companies and government agencies,
such as Fannie Mae.
Still, since they are considerably less expensive than site-built
homes (2002 average prices: $48,800 compared with $164,217), the
primary market remains consumers toward the lower end of the eco-
nomic range. In 2002, over 22 million Americans lived in manufac-
tured homes, with a median family income of $26,900.
19
Many manufacturers were caught in a self-inf licted double bind in
the 1990s, and many of them failed. One arm of this double bind was
the increasing acceptance and popularity of these homes, which rushed
many in the industry toward overexpansion. The other squeeze factor
was simple greed.
The homes are sold through retailers that are either independent
dealers representing several manufacturers or company-owned outlets.
Right there, on the same lot, shoppers usually f ind a f inancing opera-
tion, often a subsidiary of the manufacturer/retailer. In and of itself,
there is nothing wrong with this; it sounds like, and in fact operates
like, a car dealership. The problem is that it has become endemic in the
industry to push sales to anybody who can sign their name to a sales
agreement, regardless of credit history, based on loans that are destined
to default.
Selling scads of units creates immediate profits for the retailers and
huge commissions for the salespeople. It also creates enormous economic
problems longer range. It is an unfortunate reality that many homes are
sold to people with fragile economic circumstances, and repossession
rates are high, which reduces the demand for new homes. As unemploy-
ment rates rose in the past few years, so did loan delinquencies. Factor in
the oversupply of inventory from the 1990s, and the tight economic
times that diminished spending across the board, and it adds up to a
sorry state of affairs for the industry as a whole.
Much of the problem can be traced to the very weak loans that are
so common in the manufactured home business. Why do they all do it?
Because they all do it, and each company fears losing market share if it
does otherwise. That, in a nutshell, is the curse of the institutional

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imperative. Clayton has not been completely immune, but it has
avoided the most egregious faults.
Most importantly, Clayton compensates its salespeople in a different
way. The commissions of sellers and managers are based not only on the
number of homes sold but also on the quality and performance of the
loans made. Sales staff share the financial burden when loan payments are
missed, and share the revenue when the loan performs well. Take, for ex-
ample, a sales manager who handles the sale and financing of a $24,000
mobile home. If the customer cannot make the payments, Clayton would
typically lose $2,500, and the manager is responsible for up to half the
loss.
20
But if the loan performs, the manager shares up to half of that, too.
That puts the burden to avoid weak loans on the sales personnel.
The methodology paid off: In 2002, “only 2.3 percent of the home-
owners with a Clayton mortgage are 30 days delinquent.”
21
That is
roughly half the industry delinquency rate. In the late 1990s, when more
than 80 factories and 4,000 retailers went out of business, Clayton closed
only 31 retailers and did not shut any factories. By 2003, when Buffett
entered the picture, Clayton had emerged from the downturn in the
economy in general and the mobile home industry in particular stronger
and better positioned than any of its competitors.
Warren Buffett bought Clayton Homes because he saw in Jim
Clayton a hardworking self-starter with strong management skills and a
lot of smarts. Clayton showed not once but twice that he could weather
a downturn in the industry by structuring his business model in a way
that avoided an especially damaging institutional imperative.
The Washington Post Company
Buffett has told us that even third-rate newspapers can earn substantial
prof its. Since the market does not require high standards of a paper,
it is up to management to impose its own. And it is management’s high
standards and abilities that can differentiate the business’s returns
when compared with its peer group. In 1973, if Buffett had invested in
Gannett, Knight-Ridder, the