Monday, July 12, 2010

A Short History of the Sequoia Fund

Sticking to What Works

Reopened after a 26-year closure, Sequoia hews to a time-tested approach

This month Sequoia Fund marks its 40th anniversary. It's a milestone rarely achieved in an industry where three years is considered long term.

Even more remarkable is that Sequoia is being run pretty much the same as it was when Warren Buffett's friend and stockbroker, the late Bill Ruane, launched the fund in 1970. It's still a concentrated portfolio with two or three dozen stocks, all heavily researched and bought with the idea that the market is valuing them at less than their true worth. Co-managing the fund is Robert Goldfarb, whose tenure at the New York firm dates back to 1971.

In 2008 the fund re-opened its doors to new investors for the first time since 1982. Some wondered whether the reopening of this exclusive club somehow indicated that it was past its glory days. But its managers at Ruane, Cunniff & Goldfarb Inc. don't seem to be resting on the fund's reputation.

Sequoia's returns have bested the Standard & Poor's 500-stock index over the past three, five and 10 years. In 2008, amid the financial crisis, Sequoia held up better than 97% of the competition in Morningstar Inc.'s large-blend category. As stocks snapped back from the bear market, Sequoia initially lagged, but as of June 30, the fund was three percentage points ahead of the S&P over the prior 12 months with a 17.5% gain, beating 90% of its peers.

Still, Sequoia had its worst year in 2008—a 27% decline. In the wake of those losses, the fund's managers made a concession to recent market developments: While continuing to focus on the prognosis for individual stocks, they decided to pay more attention to "macro" market and economic forces than they have in the past.

Time Warp

But when Sequoia held its annual shareholder meeting in mid-May at the posh St. Regis Hotel in midtown Manhattan, the event was like a trip back in time. On the dais, seven men in dark suits answered questions from well-dressed investors in a room where chandeliers hung from the ceiling and sconces adorned mirrored walls.

Each annual meeting for Sequoia is an unscripted event that would give marketing officials at most fund companies fits. No opening statement, no PowerPoint presentation—just questions and opinions from Sequoia investors who are well versed in the fund's portfolio and investing philosophy.

The managers spoke bluntly, not just about the fund's performance, but about the management of companies in which they invest. And this, too, was a rarity, as many fund managers are loath to criticize corporate executives for fear of having access cut off.

David Poppe, Sequoia's co-manager, said that an investment in Porsche Automobil Holding SE "has been a disaster" thanks to a decision to merge with Volkswagen AG that he also called a "disaster" created by Porsche's management. And in response to a question about why Sequoia owned shares of two competing auto-parts chains but not Autozone Inc., Mr. Goldfarb noted that the fund had owned Autozone but "made the mistake of selling it."

No Pushing

In words and deeds, Sequoia's managers go their own way. Despite re-opening the fund, there's been no marketing push to attract investors. In fact, despite its performance, the $3 billion fund has taken in only a net $144 million since allowing in new shareholders. Mr. Goldfarb, meanwhile, though he agreed to be interviewed for this article, declined to be photographed.

In a conversation several weeks after the annual meeting, seated in a conference room at the firm's offices sporting a spectacular view north over Central Park, Mr. Goldfarb says that "to understand our culture you need to understand Bill Ruane."

Mr. Ruane, who died in 2005, "loved the craft of investing," Mr. Goldfarb says. As the long closure of Sequoia indicates, he wasn't interested in raking in profits by continuously bringing in money from new investors. And it was crucial to Mr. Ruane that the firm be independent and not part of a big mutual-fund company.

Mr. Ruane founded the firm with Richard Cunniff, 87, who is no longer involved with the firm on a daily basis but is still vice chairman of Sequoia Fund.

Mr. Goldfarb, 65, recalls how he came to join Ruane, Cunniff in 1971. His father, who was in retail, met Mr. Buffett and mentioned that his son, Bob, was looking for a job on Wall Street. Mr. Buffett suggested getting in touch with Mr. Ruane. But he cautioned that given Mr. Ruane's attitude toward maximizing profits, "I'm not sure Bob is going to make serious money."

But the firm, of course, has prospered. It manages $13 billion, including $3 billion in Sequoia. The firm also manages private accounts for institutions and affluent investors and has been in the hedge-fund business since 1996, branded with the name Acacia. Like Sequoia, the hedge funds are value-oriented offerings. But they include short positions to bet that certain stocks will fall, and they are more internationally focused.

For years Sequoia has been associated with Mr. Buffett, not just because he referred clients to Sequoia when he closed his partnership in 1969, but also because the fund, since first buying Berkshire Hathaway stock about 20 years ago, has made it a major holding. At one point it was nearly 30% of the portfolio.

Normally Sequoia won't hold more than 15% of its assets in a single stock. But an exception was made for Berkshire because it's a widely diversified company and Sequoia managers long believed it was trading well below its intrinsic value.

But in the first quarter, Sequoia made a significant reduction in its Berkshire position, cutting it to about 15% of assets from 20%. Mr. Goldfarb said the managers were heeding Mr. Buffett's prediction that future growth in Berkshire's book value—essentially its assets minus liabilities—would slow. In addition, with a surge in Berkshire's stock price accompanying its entry into the S&P 500 earlier this year, Sequoia's managers believe the stock isn't as inexpensive as it used to be.

More Attention to Macro

Another recent change: a decision to pay closer attention to the possible effects of macro forces on the fund's investments.

"We're really one-balance-sheet-at-a time, one-company-at-a-time kind of investors," Mr. Poppe said in May 2008 at the shareholder meeting. "We don't spend a lot of time on macro."

Months later, the financial crisis hit, and economic forces swamped stock-picking skills.

Sequoia wasn't hurt as badly as some funds were, because it wasn't heavily invested in financials. But the fund suffered losses on companies heavily dependent on economic growth, such as flooring manufacturer Mohawk Industries Inc.

Today, the focus is still on balance sheets, but the Sequoia managers try to minimize the impact of economic ups and downs on the portfolio. "There's a heavier burden on a cyclical company" to find its way into the portfolio, says Mr. Goldfarb.

For Mr. Goldfarb, however, one-stock-a-time investing is what the firm is really about. "I wish we could go back to the old days," he says.

Saturday, June 12, 2010

Mr. Buffett's "Lat Pack"

COVER STORY February 25, 2010, 5:00PM EST

When CEOs Have Warren Buffett in Their Boardroom

What's it like to have America's greatest investor as your shareholder? Buffett's biographer talks to CEOs who know

By Alice Schroeder

Who wouldn't love to pick up the phone and ask Warren Buffett for advice? People have spent more than $1 million just to have lunch with the man. He was voted the most admired corporate director in America by Directorship magazine in 2008. Chief executives of companies he has a stake in laud his patience, foresight, and ability to capture the essence of a complex financial situation in just a few words. They also like the fact that he usually leaves them alone as long as they're getting the job done.

Sometimes Buffett emerges from behind his desk and shows a side of himself that's far less familiar. When he sees something he doesn't like in a company whose shares he owns, the famously passive investor can swing into action to protect his investment—jawboning behind the scenes, scolding, cutting opportunistic deals, even hiring and firing CEOs. For some of those on the receiving end of his activism, it can feel a bit like being attacked by Santa Claus.

Buffett's virtues and philosophy are well known, and at 79, his ability to spread them throughout the business world has never been greater. In mid-February, his holding company, Berkshire Hathaway, (BRK.A) was listed for the first time on the Standard & Poor's 500-stock index, and the stock price and volume jumped as investors rushed in. His annual letter to shareholders, to be released on Feb. 27, is always one of the most parsed memos of the year. Berkshire's purchase of Burlington Northern (BNI) in November 2009—a self-described all-in bet on America—and its $5 billion stake in Goldman Sachs (GS) make Buffett a major stakeholder in the global economic recovery, with tentacles that span from coal to collateralized debt obligations. And his now infamous dressing down of Kraft (KFT) CEO Irene Rosenfeld over Kraft's purchase of Cadbury (CBY) proved that behind that Cherry Coke smile, there's still plenty of bite.

In speaking with CEOS for this story, and in writing the 2008 biography The Snowball with Buffett's cooperation, I learned a great deal about the way he manages the people he counts on to make money for him and his shareholders. He is, in many cases, just as genial and supportive as his persona would lead you to believe. "First my mother and then I have been able to call and ask his advice on matters affecting the company, large and small," says Donald E. Graham, CEO of Washington Post Co (WPO). "His advice has been worth billions to our not-so-large company."

During the credit crunch of March 2008, American Express (AXP) CEO Kenneth I. Chenault had to ask for help from Buffett at a moment when Berkshire's stake in American Express had lost $8 billion because of credit losses and concerns the company could not borrow to fund its operations. One might think Chenault had reason to fear the call. Instead, he knew Buffett, whose company owns 13% of American Express, would be his "confidence booster." Even in the highly charged atmosphere of a financial meltdown, his style is unwavering—"objective, direct, and he knows what he believes," Chenault says. The CEO felt fortunate that Buffett was indifferent to the market pressure on American Express.

At the time, Chenault faced intense pressure to cut the company's payout to investors, as his peers had done. Buffett "understood the reputational reasons why American Express should not cut the dividend," he says, and backed the decision to maintain it. Since the crisis, Berkshire's investment has recovered $4 billion of its value.

When other CEO friends got into trouble during the downturn, Buffett offered them more than advice. William C. Foote, head of wallboard and gypsum product maker USG (USG), first met the investor before Berkshire backstopped a USG stock offering in 2006, buying a 17% stake in the company. Foote tried to impress his new shareholder by reciting housing statistics from the 1960s to the 1980s—and was shocked when Buffett immediately responded with data from the 1940s and 1950s.

Although USG was struggling through bankruptcy, Buffett treated Foote with the benevolent neglect he generally displays toward managers whose companies are cruising. Foote would call occasionally and traveled to Omaha two or three times a year, spending a couple of hours chatting in Buffett's office before eating a steak at one of his favorite restaurants. He "doesn't offer suggestions as much as answer questions and provide perspective," Foote said.

The USG chief found the advice valuable and enjoyed the feeling that Buffett had enough confidence in him not to meddle. Then the housing market imploded and demand for wallboard collapsed. Buffett leaped into the fray in a way that benefited both Berkshire and USG. Berkshire took $300 million of a $400 million issuance of 10% notes convertible until 2018 at Berkshire's discretion into stock at $11.40 per share. (USG was trading at around $5.66 before the deal and is now at about $13.40, meaning the conversion feature is in the money). The equity sweetener effectively raised the cost of the notes, while limiting the impact on USG's income statement to its $30 million annual cash interest tithe to Berkshire, helpful at a time when USG is losing hundreds of millions of dollars a year.

When Buffett is unhappy with a CEO, you can tell mostly from what he doesn't say. "He criticizes by omission and faint praise," says former Wells Fargo (WFC) Chairman Richard M. "Dick" Kovacevich, a longtime friend and world-class manager whom Buffett has compared to Wal-Mart (WMT) founder Sam Walton. "If you are a close observer of him, it's not hard to figure out."

To be publicly criticized by Buffett, even subtly, might send a shiver through any executive who does business with him. It happened to Irene Rosenfeld on Jan. 21, after Kraft agreed to buy the iconic British candy company Cadbury for $13.17 a share. Berkshire is Kraft's biggest shareholder, with a 9.4% stake. Buffett had opposed an earlier version of the deal but said if Kraft put up more cash in a revised deal that didn't "destroy value," he would approve.

Kraft's share price rose because the remarks seemed to indicate that a modestly higher bid could meet his terms as long as it contained less stock. When Rosenfeld carried out a version of the plan, agreeing to pay $7.74 in cash and offer 0.1874 new Kraft shares for each share of Cadbury, investors assumed the two had worked out a deal. On the day it was announced, William Ackman of hedge fund Pershing Square Capital Management appeared on CNBC and predicted the investor would support it.

Instead, minutes later, Buffett turned up on CNBC and called Rosenfeld's agreement with Cadbury a "bad deal" for Kraft shareholders and a "big mistake." His televised griping stunned observers because it was so uncharacteristic. "You would think he would have been happy—she did what he wanted," says a major shareholder who asked not to be named because he values his relationship with both CEOs. "He reversed himself."

Buffett made it clear he thought the revised bid "destroys value." He seemed especially irate that Kraft had sold its profitable frozen pizza business to Nestlé (NSRGY) to raise cash for the Cadbury acquisition (and take its rival out of the bidding for the confectioner). He described the sale price of the pizza business as a cheap nine times earnings (a good deal for a unit that reported significant margin and sales growth during the recession). To avoid a $1 billion tax bill, he argued that Rosenfeld should have spun the unit off tax-free instead. Buffett also seemed to covet the business himself, saying, "I wish I would have bought the pizza business at nine times pretax earnings."

Kraft Senior Vice-President Perry Yeatman says the company respects Buffett and expects him to see the wisdom of the deal someday. Other defenders of Rosenfeld say Buffett's TV appearance was mainly to distance himself from the deal because he didn't get his way. Asked twice by CNBC whether he would sell his Kraft stock, he ducked the question.

Buffett, who did not respond to questions for this article, denied there is a personal rift between him and Rosenfeld; he told CNBC that he likes Rosenfeld, considers her straightforward, and would even have her as a trustee of his will. James M. Kilts, who ran Kraft when it was part of Philip Morris and was CEO of Nabisco before serving as chief of Gillette from 2001 to 2005, is a longtime friend of both. Kilts had no comment on the supposed rift but noted that with Buffett, "It's always business. It's never personal." Buffett's own summation, too, was financial, and he expressed his disappointment in the simplest terms. "I feel poorer," he said.

A FRIEND IN NEED

Buffett's vocal treatment of Kraft is poles apart from his handling of most companies in which Berkshire invests. Usually he is warm, helpful, and waits to be asked for his opinion. Despite receiving $600 million from the Troubled Asset Relief Program, M&T Bank (MTB), another Berkshire investment, remained relatively stable during the credit crisis. Instead of leaning heavily on Buffett, CEO Robert G. Wilmers spent much of his time the past two years sitting in Buffalo and scooping up other distressed banks. Buffett has always had kind things to say about M&T, partly because Wilmers makes sound acquisitions. He mostly talks with Buffett on the phone. "Eighty or 90% of the time it's on my nickel," he says. He thinks of the investor as a "priceless" sounding board who gives superb advice. In one memorable instance, Wilmers turned to him while being pressured by regulators and investment bankers to participate in the first Chrysler bailout in 1979. Buffett's pithy advice: "Those who won't fill your pocket will fill your ears."

This is how Buffett has typically viewed investment bankers: as useless, self-serving windbags, which is why he doesn't waste time befriending them. His one early effort to profit from investing in Wall Street came to tears when he put $700 million of Berkshire's money into Salomon Brothers in 1987. Buffett was a passive board member until he had to personally rescue Salomon after one of its traders defrauded the government in treasury bond auctions and the firm nearly failed. Then he waged a bitter fight over severance with ousted Salomon boss John Gutfreund. Managing an investment bank that was teetering on the brink of bankruptcy for nine months was a miserable experience. Buffett later said an important lesson from Salomon was that he had mistakenly trusted the bank's management.

Given that history, investors were shocked when Buffett poured $5 billion of Berkshire's money into Goldman during the depths of the financial crisis. Goldman is the one firm that Buffett has traded with throughout his career, ever since Goldman banker Byron Trott, who has since left the firm, won his trust around 2002 by finding companies for Berkshire to buy.

As a 10-year-old in 1940, Buffett once told me, he met Goldman senior partner Sidney J. Weinberg during a tour of the New York Stock Exchange (NYX). ("What stock do you like, Warren?" Weinberg asked him.) Until the financial crisis, though, Buffett had never shaken hands with Goldman CEO Lloyd C. Blankfein. Days after the collapse of Lehman Brothers, when it appeared that all major U.S. banks could fail, it was Trott who approached the investor on Goldman's behalf with a deal richer than that offered by any other company. Berkshire paid $5 billion for 10% perpetual preferred shares of Goldman with attached warrants at $115 at a time when the stock was trading at $125 per share, meaning the warrants were already "in the money." If Berkshire had exercised them immediately, it would have netted $10 per share. Buffett's reputation helped Goldman raise another $5 billion of capital, twice as much as it originally sought.

A few days after, Buffett and Blankfein met for the first time and shared a jovial moment at a conference. Buffett later took steps to protect his investment, first by using his personal capital as America's most trusted investor to publicly defend the federal bailout of Wall Street, then—after Goldman fueled public anger by setting aside billions for employee bonuses—by teaming with its management to put up $500 million to assist small businesses.

Buffett, an outspoken critic of CEO greed, pays himself $100,000 a year. He has nearly all the managers of Berkshire's wholly owned businesses set their own pay, and in light of his tiny compensation, they usually err on the low side, too. When it comes to the companies in which Berkshire invests, though, he takes a broader view. Wells Fargo's Kovacevich reaped tens of million from stock options but opposed reporting them as company expenses. Buffett was a vocal advocate of expensing them, but that didn't hurt their relationship in the least.

On the same day that Buffett pummeled Rosenfeld on CNBC, he praised Blankfein to Bloomberg News. "I don't think anybody could have done a better job at Goldman Sachs than Lloyd Blankfein," he said. "I give him enormous credit for how he's run Goldman. You've got to expect vilification of banks." Rosenfeld made Buffett feel poorer. Blankfein is making him noticeably richer.

THE ULTIMATE COMPLIMENT

Buffett is fascinated with executives who display unusual mastery at operating a profitable business. He appreciates the nuances of the craft the way an art patron enjoys watching a sculptor at work. Wells Fargo's Kovacevich is one of his favorite CEO artisans, yet Kovacevich calls Buffett "more hands-off than any investor." He says the two have had, at most, 20 conversations in 10 years, even though the bank is one of Berkshire's most important investments. Kovacevich was CEO of Norwest bank when it acquired Wells Fargo in 1998, and at the time Buffett insisted that Kovacevich not tell him anything that would make him an insider, because that would preclude Berkshire from buying or selling the stock.

When Buffett met Jim Kilts in 2001, he told Fortune that Kilts—who had turned around Nabisco—"made as much sense in terms of talking about business in general as anybody I've ever talked to." Kilts came out of retirement that year to rescue Gillette, doing so partly because he wanted to work with Buffett, since Berkshire owned 9% of the company. The Omaha investor's fondness for him grew rapidly as Gillette's performance rebounded.

At the time, Gillette was suffering from the multibillion-dollar blunder of overpaying for battery maker Duracell. It had also promised investors unrealistic 15% to 20% annual earnings growth, and was channel-stuffing product to its distributors to meet projections. To Buffett's applause, Kilts dropped the practice of issuing earnings guidance entirely. He cut thousands of jobs, closed plants, paid off debt, and shifted resources into new products and advertising.

Even so, Kilts says he tried not to bother Buffett. "It would be so easy to misuse the fact that he was available," Kilts says, "because he would be obligated to talk to me if I picked up the phone." Buffett, he says, was a quiescent board member, but when he did speak "he had such power and weight and clarity that it was memorable." At one board meeting, Kilts proposed increasing directors' pay. Two other directors spoke passionately against the move. Buffett quickly shut down the discussion while saving face for the dissenters by saying, "Well, I'll just take your increase, then."

After the Gillette turnaround, Buffett paid what Kilts considered the ultimate compliment by withdrawing entirely; he resigned from the board. "If you've got the right person running the business," he said at the time, "you don't need me."

WHEN WARREN STANDS BACK

Few companies need Buffett more than Moody's (MCO), the troubled credit-rating agency. Moody's and its peers have been blamed as enablers of the financial crisis because they inflated the credit ratings of dubious mortgage-backed securities. In March 2009, Berkshire owned more than 20% of Moody's. Why, several former ratings analysts ask, didn't the investor light a fire under the board to tighten the company's standards, or speak out? Surely he was as obliged to denounce flawed ratings that endangered the global financial system as he was to offer an opinion of how much Kraft paid for Cadbury.

A former Moody's employee with intimate knowledge of the executive suite there describes Buffett as "not a very engaged investor." (Like most Moody's sources, he asked not to be identified in light of ongoing investigations into the company.) Another insider confirms that senior management of Moody's, including CEO Raymond W. McDaniel Jr., "doesn't have regular conversations with" Buffett nor does it "seek advice from him on corporate governance or business strategy." Moody's declined to comment.

Moody's and Buffett had reason to keep their distance; it's a conflict of interest for the agency to rate a major investor such as Berkshire. Analysts who review a company are supposed to be free of thoughts of what a downgrade might mean to their personal net worth. Moody's discloses the Berkshire conflict in a Securities & Exchange Commission filing.

Even so, one former Moody's analyst describes e-mailing Buffett in 2007 to warn that rating securitized products was a ticking time bomb, and to ask whether he wanted more information. His e-mailed response, says this analyst, said he was a passive investor with a hands-off approach to Moody's. Buffett didn't respond to requests for comment about the e-mail.

It is impossible to quantify the cost of Buffett's disengagement from the rating agency under these unusual circumstances. Moody's stock has since declined more than 50% and investors in asset-backed securities have lost billions. The agency downgraded Berkshire's top AAA rating by one notch in April 2009; Buffett began to sell in July 2009 and has since disposed of about one-third of Berkshire's holdings.

FORCING AN OUSTER

If Moody's is an illustration of what it means to have Buffett's money but not his engagement, Coca-Cola (KO) is a portrait of the investor exploring virtually every kind of relationship with management. For years, Buffett admired Coca-Cola's revered CEO, Roberto Goizueta, and never meddled; Goizueta did not want advice. When the beverage giant began to falter after Goizueta's unexpected death from cancer in 1997, Buffett helped force the early departure in 1998 of Goizueta's successor, M. Douglas Ivester. That year, Coca-Cola stock was at a peak and Berkshire's stake was worth $17 billion. For the next few years, the company meandered further off course, and as it did, Buffett became increasingly involved in trying to set things right. In 2000, Ivester's successor, Douglas N. Daft, proposed buying Quaker Oats for its Gatorade brand. Buffett quashed the idea at a special board meeting, using a trademark one-liner: "We would have given up 2 billion cases a year of Coca-Cola to get something like 400 million cases a year of Gatorade." PepsiCo (PEP) subsequently bought Quaker Oats in a deal that is widely regarded as successful, and the wisdom of Coca-Cola in passing up the opportunity has been debated far and wide. What is not debated is Buffett's influence.

Buffett became deeply disturbed by Coca-Cola's chaotic culture and poor earnings, but few people knew how upset he was because he said little in public. Daft retired in February 2003, citing health reasons. Buffett became directly involved in the CEO search. He tried to charm Kilts into taking the job. When Kilts said no, he tried to recruit former General Electric (GE) CEO Jack Welch. Eventually, Buffett signed off on bringing former Coca-Cola executive E. Neville Isdell out of retirement to stabilize the company. When Isdell retired, he was succeeded by Muhtar Kent, who has offset declines in domestic sales with growth in emerging markets. As Coke's fortunes improved, Buffett's relationship with its CEOs grew more cordial. He withdrew from his activist role, resigning from the board in 2006. Berkshire still owns 200 million shares and 8.6% of Coca-Cola, a stake now worth $11 billion.

BETTING ON A "CHOO-CHOO"

In April 2008, Buffett took a hamburger- and jellybean-fueled trip on a vintage railcar from Kansas City, Mo., to Chicago with Matthew K. Rose, CEO of Burlington Northern Santa Fe (BNI). They used the 430-mile journey to talk over Rose's plans to move the railroad's recent turnaround into high gear. Rose showed his guest Burlington's Chicago intermodal freight yard, which handles containers that move among ships, trains, and trucks without being unloaded. Buffett eventually increased Berkshire's ownership of Burlington to 22%.

In 2009, Rose agreed to sell the rest of the railroad to Berkshire for $26 billion, giving Buffett what he calls his "choo-choo." Buffett described this as an "all-in wager on the economic future of the U.S." He's betting that rail traffic will grow, and imports from Asia will continue to dominate as the economy mends. Burlington is the nation's biggest coal hauler—coal transport represents more than a fifth of its revenues—so he's assuming the world will keep using coal even if the U.S. switches to cleaner energy sources. Lastly, Burlington could be a big winner if railroad rights-of-way become power corridors to conduct energy from wind farms.

Buffett always likes a sweetener, and Burlington gives him one in the form of information. He learns about wallboard demand from USG and consumer-credit trends from American Express, but Rose has called the railroad a kaleidoscope of the economy. Rail traffic patterns are a window on commodity, wholesale, consumer, and international trade flows. Buffett is adding this kaleidoscope to what his other CEOs tell him about the "reset of the consumer" to a lower level of spending. They feed him data from Berkshire's portfolio of companies—sales of building materials, jewelry, furniture, real estate, credit, fractional jets, vacuum cleaners, fabricated steel, newspaper ad lineage, and other products and services. He may now command as much information about the state of the U.S. economy as anyone, including the Federal Reserve—and probably gets his faster.

This should go a long way toward maintaining Rose's relationship with his new boss. What else can he expect now that he works for Buffett? He can call whenever he wants and get the best advice in corporate America, and Buffett will put on events to boost his employees' morale. In return, Rose, who declined comment, needs to make money for Buffett. If he does, he will be celebrated at Berkshire's annual meeting in Omaha—where Buffett sells all of his products to the 35,000 investors who come for the show—and cheered in Berkshire's shareholder letter, Buffett's annual report card on his managers, in which he praises loudly or faintly, or punishes with silence.

There is only one way for a company that's wholly owned by Berkshire to make money for Buffett—by earning it. Berkshire can't offer high-priced deals like USG's and Goldman's to its own businesses when something goes wrong because the proceeds would come straight out of its vault. So Rose's No. 1 job is to keep Burlington out of trouble.

Buffett is betting that Rose can do it. He bought Burlington partly out of confidence in the executive. If all goes right, their dealings will be long, friendly, and mutually profitable. As former Gillette CEO Kilts says, "We had a warm, close, personal relationship, but at the end of the day, I knew it was business."

For more about the unique way Warren Buffett interacts with CEOs of companies he invests in, check out our Behind The Cover Story podcast with Buffett biographer Alice Schroeder athttp://www.businessweek.com/go/10/buffett

Saturday, January 16, 2010

Excerpt from "Checklist Manifesto"

‘Airline pilot’ protocols in finance

By Atul Gawande

Published: January 16 2010 00:04 | Last updated: January 16 2010 00:04

In the late 1990s, the early go-go years of the internet, a psychologist at Claremont Graduate University, east of Los Angeles, began a study of 51 venture capitalists. Geoff Smart wanted to know how they decided whether to give entrepreneurs money or not. The venture capitalists must yea or nay high-risk, multi-million-dollar investments in unproven start-up companies. The ideas might be little more than scribbles on a sheet of paper or clunky prototypes that barely work – but then again, that’s how Google and Apple started out. You would think venture capitalists’ decisions would centre on whether an entrepreneur’s idea was a good one. But finding a good idea is apparently not all that hard, Smart learnt. Finding an entrepreneur who can execute a good idea is a different matter entirely. You need a person who can take the idea from proposal to reality, work the long hours, build a team, handle the pressures and setbacks, manage technical and people problems alike, and stick with the effort for years on end without getting distracted or going insane.

Such people are rare – and extremely hard to spot. Smart identified half-a-dozen different ways the venture capitalists he studied decided whether they’d found such a person. These were styles of thinking, really. He called one type of investor the “art critic”. He or she assessed entrepreneurs almost at a glance, the way a critic can assess the quality of a painting – intuitively and based on experience. “Sponges” took more time gathering information about their targets, soaking up whatever they could from interviews, on-site visits, references and the like. Then they followed their gut.

The “prosecutors” aggressively interrogated entrepreneurs; “suitors” focused more on wooing people than on evaluating them; “terminators” saw the whole effort as doomed to failure and skipped the evaluation part. They simply bought what they thought were the best ideas, fired entrepreneurs they found to be incompetent and hired replacements. And then there were the “airline captains”. Studying past mistakes and lessons from others in the field, they built formal checks into their process. They forced themselves to be disciplined and not to skip steps, even when they found an entrepreneur they “knew” intuitively was a real prospect.

Why were these last, methodical types labelled “airline captains”? Four generations after the first aviation checklists went into use – lists deemed necessary to get giant, complicated aircraft off the ground and over oceans and continents with minimum risk to passengers – people are starting to apply that methodology to a range of fields. In three years of research, I found that checklists were being used to improve patient outcomes after surgery, keep buildings from collapsing and ensure consistently excellent food at popular and high-quality restaurants. I also found that checklists seem able to protect their users against failure where they might have made mistakes – even the experts.

Sure enough, when Smart tracked the venture capitalists’ success over time, it became clear that the airline captains had by far the most effective style. Those investors taking the checklist-driven approach had a 10 per cent likelihood of later having to fire senior management for incompetence or concluding that their original evaluation was inaccurate. The others had at least a 50 per cent likelihood. The results showed up in their bottom lines, too. The airline captains had a median 80 per cent return on the investments studied, the others 35 per cent or less.

Those with other styles were not failures by any stretch – experience does count for something. But those who added checklists to experience proved substantially more successful.

Smart’s most interesting discovery was not the relative success of the airline captains, in fact. Rather, it was that most of his subjects were either art critics or sponges – intuitive decision-makers instead of systematic analysts. Only one in eight took the airline captain approach. Now, maybe the others didn’t know about the airline captain approach. But even knowing seems to make little difference. Smart published his findings more than a decade ago. He has since gone on to explain them in a best-selling business book on hiring called Who. But when I asked him, now that the knowledge is out, whether the proportion of major investors taking the more orderly, checklist-driven approach has increased substantially, he could only report, “No. It’s the same.”

We don’t like checklists. They can be painstaking. They’re not much fun. But I don’t think the issue here is mere laziness. There’s something deeper, more visceral going on when people walk away not only from saving lives but from making money. It somehow feels beneath us, an embarrassment, to use a checklist. It runs counter to deeply held beliefs about how the truly great – those we aspire to be – handle situations of high stakes and complexity. The truly great are daring. They improvise. They do not have protocols and checklists. Maybe our idea of heroism needs updating.

. . .

Smart certainly isn’t the only one noticing society’s – and industry’s – resistance to change. Recently I’ve met three investors who have taken a page from aviation to incorporate formal checklists into their work. Mohnish Pabrai is managing partner in Pabrai Investment Funds in Irvine, California, and runs a $500m portfolio; Guy Spier is head of Aquamarine Capital Management in Zurich, a $70m fund; the third did not want to be identified or to reveal the size of the fund where he is a director. But it is one of the biggest funds in the world and worth billions.

These three people are value investors, buying shares in under-recognised, undervalued companies. They don’t time the market. They don’t buy according to a computer algorithm. They do intensive research, look for good deals, and invest for the long run. Over the past 15 years, Pabrai has made a new investment or two every quarter, and he’s found that each one requires in-depth investigation of 10 or more prospects. The ideas can bubble up from anywhere but most drop away after cursory examination. Every week or so, however, he spots one that starts his pulse racing. It seems surefire. He can’t believe no one else has caught on to it yet. It could make him tens of millions of dollars if he plays it right. “You go into greed mode,” he said. (Spier called it “cocaine brain”.) And that, Pabrai said, is when serious investors try to become systematic. They focus on dispassionate analysis, on avoiding both irrational exuberance and panic. They pore over the company’s financial reports, investigate its liabilities and risks, examine its management’s track record, weigh up its competitors, consider the future of the market it is in.

The patron saint of value investors, of course, is Warren Buffett. Pabrai has studied every deal Buffett and his company, Berkshire Hathaway, have made – good and bad – and read every book he could find about them. He even pledged $650,000 at a charity auction to have lunch with Buffett. “Warren,” Pabrai said – and after a $650,000 lunch, I guess first names are in order – “Warren uses a ‘mental checklist’ process” when looking at investments. So, that’s more or less what Pabrai did from his fund’s inception. And he did very well following this method – but not always. He also made mistakes, some disastrous.

These were not mistakes merely in the sense that he lost money on his bets or missed making money on investments he’d rejected. That’s bound to happen. These were instances where he had miscalculated the risks involved, made errors of analysis. For example, looking back, Pabrai noticed that he had repeatedly erred in determining how leveraged companies were. The information was available; he just hadn’t looked for it carefully enough. In large part, he believes, the mistakes happened because he wasn’t able to damp down the cocaine brain. No matter how objective he tried to be about a potentially exciting investment, he found his brain working against him, latching on to evidence that confirmed his initial hunch and dismissing the signs of a downside. “You get seduced,” he said. “You start cutting corners.” Or, in the midst of a bear market, the opposite happens. You go into “fear mode” and overestimate the dangers.

He also found he made mistakes in handling complexity. A good decision requires consideration of so many different aspects of a company in so many ways that, even without the cocaine brain, he was missing obvious patterns. His mental checklist wasn’t good enough. “I am not Warren,” he said. “I don’t have a 300 IQ.”

So he devised a written checklist.

. . .

Pabrai made a list of all the mistakes he’d spotted (even Buffet made them) as well as his own – about a dozen. Then, to help him guard against them, he devised a matching list of checks – about 70 in all. Similarly, the anonymous investor I spoke to – I’ll call him Cook – made a checklist. But he was even more methodical. He enumerated the errors known to occur at any point – during the research phase, during decision-making, during execution of the decision and even in the period after making an investment. He then designed detailed checklists to avoid the errors, complete with clearly identified pause points at which he and his team would stop and run through the items together. He has a Day Three Checklist, for example, by which time, the list says, the team should confirm that they have gone over the prospect’s key financial statements for the previous 10 years, including specifically checking for items in each statement and possible patterns across the statements. “It’s easy to hide in a statement. It’s hard to hide between statements,” Cook said.

One check requires the members of the team to verify that they’ve read the footnotes on the cashflow statements. Another has them confirm they’ve reviewed the statement of key management risks. A third asks them to make sure they’ve looked to see whether cashflow and costs match the reported revenue growth. “This is basic basic basic,” Cook said. “Just look! You’d be amazed by how often people don’t do it.”

The checklist doesn’t tell him what to do, he explained. It is not a formula. But it helps him be as smart as possible every step of the way, ensuring that he’s systematic about decision- making, that he’s talked to everyone he should. With a good checklist in hand, he was convinced he and his partners could make decisions as well as human beings are able. And as a result, he was also convinced they could reliably beat the market.

Cook would not discuss precise results – his fund does not disclose its earnings publicly – but he said he had already seen the checklist deliver better outcomes for him. He had put the checklist process in place at the start of 2008 and, at a minimum, it appeared that he had been able to ride out the subsequent economic collapse, avoiding disaster. Others say his fund has done far better than that, outperforming its peers.

After about a year working with a checklist, meanwhile, Pabrai’s fund was up more than 100 per cent. This could not possibly be attributed just to the checklist. With it in place, however, he observed that he could move through investment decisions far faster. As the markets plunged through late 2008 and stockholders dumped shares, there were numerous deals to be had. And in a single quarter he was able to investigate more than a hundred companies and add 10 to his funds’ portfolios. Without the checklist, Pabrai said, he couldn’t have completed a fraction of the analytical work or have had the confidence to rely on it. A year later, his investments were up more than 160 per cent on average. He’d made no mistakes at all.

. . .

On January 15 last year, US Airways flight 1549 took off from La Guardia Airport in New York with 155 people on board. It then struck a flock of Canada geese over Manhattan, lost both engines and famously crash-landed in the icy Hudson River. Everyone survived, and Captain Chesley B. “Sully” Sullenberger III, a former air force pilot with 20,000 hours of flight experience, was hailed the world over.

But Sullenberger said from the first of his interviews that the outcome was the result of teamwork and following procedure as much as of any individual skill he may have had. Before the pilots – Sullenberger was joined by first officer Jeffrey Skiles, whom he’d not met before – started the aircraft’s engines at the gate, they ran through their checklists. They did a short briefing, discussing the flight plan, potential concerns and how they’d handle any problems. And by adhering to this discipline – the kind most other professions lack or avoid – they not only made sure the aircraft was fit to travel but also transformed themselves from individuals into a team, one systematically prepared to handle whatever came their way.

I don’t think we recognise how easy it would have been for Sullenberger and Skiles to have disregarded those preparations. People fear rigidity if they adhere to protocol. They imagine mindless automatons, heads down in a checklist, incapable of looking out of their windscreen and coping with the real world in front of them. But what you find, when a checklist is well made, is exactly the opposite. The checklist gets the dumb stuff out of the way.

About 90 seconds after takeoff, US Airways flight 1549 was climbing through 3,000ft when it crossed the path of the geese. The aircraft came upon the birds so suddenly Sullenberger’s immediate reaction was to duck. Jet engines are designed to be able to shut down after ingesting birds – which aircraft hit all the time – without exploding or sending metal shrapnel into the wings or the passengers on board, and that’s precisely what the A320’s engines did. They immediately lost all power.

Once that happened, Sullenberger made two key decisions: first to take over flying the aircraft from his co-pilot, Skiles, and second to land in the Hudson. Both men had decades of experience but Sullenberger had logged far more hours flying the A320. All the key landmarks to avoid hitting – Manhattan’s skyscrapers, the George Washington Bridge – were visible from his left-side window. And Skiles had just completed A320 emergency training and was more familiar with the checklists they would need.

“My aircraft,” Sullenberger said, using the standard language as he took the controls.

“Your aircraft,” Skiles replied.

There was no argument about what to do next, not even a discussion. And there was no need for one. The pilots’ preparations had made them a team. Sullenberger would look for the nearest, safest possible landing site. Skiles would go to the engine failure checklists and see if he could relight them. But for the computerised voice of the ground proximity warning system saying “Pull up … Pull up… Pull up… Pull up”, the cockpit was virtually silent as each pilot concentrated on his tasks and observed the other for cues that kept them co-ordinated.

The aircraft had only three and a half minutes of glide in it. In that time, Skiles needed to make sure he’d done everything possible to relight the engines while also preparing the aircraft for ditching if it wasn’t feasible. But the steps required just to restart one engine might typically take more time than that. He had some choices to make. Plunging out of the sky, he judged that their best chance of survival would come from getting an engine restarted. So he decided to focus almost entirely on the engine failure checklist and run through it as fast as he could. The extent of damage to the engines was unknown, but regaining even partial power would have been sufficient to get the aircraft to an airport.

In the end, Skiles managed to complete a restart attempt on both engines, something investigators later testified to be “very remarkable” in the time frame – and which they found difficult to replicate in simulation.

Yet he didn’t ignore the ditching procedure, either. He didn’t have time to do everything on the checklist but he sent the distress signals and he made sure the aircraft was configured for an emergency water landing.

“Flaps out?” asked Sullenberger.

“Got flaps out,” responded Skiles.

Meanwhile, the three flight attendants followed through on their protocols for such situations. They got the passengers to brace for impact. Upon landing, the flight attendants gave instructions to don life jackets. They made sure the doors were swiftly opened when the aircraft came to a halt, that passengers didn’t waste time grabbing for their belongings. One flight attendant, Doreen Welsh, stationed in the back, had to wade through ice cold, chest-high water leaking in through the torn fuselage to do her part. Just two of the four exits were safely accessible. Nonetheless, working together they got everyone out of a potentially sinking aircraft in just three minutes – exactly as designed.

The entire event had gone shockingly smoothly. After the aircraft landed, Sullenberger told the press, “First officer Jeff Skiles and I turned to each other and, almost in unison, at the same time, with the same words, said to each other, ‘Well, that wasn’t as bad as I thought.’”

. . .

In aviation, everyone wants to land safely. In the money business, everyone looks for an edge. If someone is doing well, people pounce like starved hyenas to find out how. Almost every idea for making even slightly more money – investing in internet companies, buying tranches of sliced-up mortgages – gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists.

I asked “Cook”, our anonymous investor in Switzerland, how much interest others have had in what he has been doing these past two years. Zero, he said – or actually, that’s not quite true. People have been intensely interested in what he’s been buying and how, but the minute the word “checklist” comes out of his mouth, they disappear.

Even in his own firm, he’s found it a hard sell. “I got pushback from everyone. It took my guys months to finally see the value,” he said. To this day, his partners still don’t all go along with his approach and don’t use the checklist in their decisions when he’s not involved. “I find it amazing other investors have not even bothered to try,” he said. “Some have asked. None have done it.”

This is an edited extract from Atul Gawande’s ‘The Checklist Manifesto: How to Get Things Right’, published January 28 by Profile Books.