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Buffett and Munger: What's So Great About Berkshire Hathaway's Corporate Structure?

Previously, we looked at how Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) leaders Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) defined the ideal business. In a nutshell, the best business provides excellent returns on invested capital and has the ability to scale; that is, it can earn the same percentage returns on every additional (incremental) invested dollar. In practice, there are very few businesses like this. Most of the companies Berkshire has acquired over the years have good returns, but don't scale. Here is how the conglomerate's structure allows Buffett and Munger to efficiently reallocate capital to where it is most productive, a topic they expanded on at the 2003 Berkshire annual shareholder meeting.

Moving money to where it is most productive

Buffett explained the way Berkshire is set up allows him and Munger to take the cash generated by companies like See's and Coca-Cola (NYSE:KO) and invest it into more productive places, many of which may be in completely different industries.

"The one good thing about our structure at Berkshire is that we can take those businesses that earn good returns in their business but don't have the opportunity for returns of a similar magnitude on incremental money and we can move that money around to buy more businesses. Normally, if you're in the newspaper publishing business, you earned terrific returns on your own invested capital but if you went out to buy other newspapers you had to pay a very fancy price. And you didn't get great returns on incremental capital."

Buffett and Munger aren't limited to just the newspaper publishing and candy businesses. They can move it to wherever they want:

"We can take See's Candy, which has produced probably $1 billion pre-tax for us [since its acquisition in 1972]. If we tried to employ that in the candy business, we would have gotten terrible returns over time, we wouldn't have gotten anything to speak of. But because we moved it around, it enabled us to buy some other businesses over time and that's an advantage of our structure."

Two types of good business

This appetite for cash that can be transferred to other businesses means Berkshire primarily likes to buy companies that have great free cash flow. Munger explained why this is the case:

"If you take on a business that is a good business, but not a fabulous business, they tend to fall into two categories. One is the business where the whole reported profit just sits there in surplus cash at the end of the year, and you can take it out of the business and it will do just as well without it as it would if it stayed in the business. The second business is one that reports 12% on capital, but there's never any cash. It reminds me of the used construction equipment business of my old friend John Anderson, and he used to say: 'In my business, every year you make a profit, and there it is - sitting in the yard!' And there are an awful number of businesses like that where just to keep going, to stay in place, [costs money] and there's never any cash!"

Munger and Buffett then both went on to say that in their opinion, the overall track record of capital reallocation by American companies has been pretty poor, suggesting that executives are poorly-positioned to make such decisions. Nonetheless, that hasn't stopped the Berkshire due from being pretty successful at this particular game.

Disclosure: The author owns no stocks mentioned.

Read more here:

  • Warren Buffett and Charlie Munger: What Does the Ideal Business Look Like?
  • Warren Buffett and Charlie Munger: Become a Better Investor by Using Feedback Mechanisms
  • George Soros' Investment Philosophy, Part 3

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This article first appeared on GuruFocus.