2006
Click here to read the letter.🧠 Key Takeaways
The giants of one era often end up getting passed by because they become too slow and too stuck in their ways. Ironically, the same thing that once made them powerful eventually becomes the thing that causes their decline.
When a business is directly helping its customers make more money, it becomes much harder to replace, which naturally creates higher switching costs. And when your success is tied to your customer’s success like that, it creates good incentives and can become a very durable competitive advantage.
Since a CEO’s compensation is typically public information, they naturally compare their pay to that of their peers. And no CEO wants to be the lowest-paid among that group.
✍️ Memorable Quotes
“Charlie Munger - my partner and Berkshire’s vice chairman - and I run what has turned out to be a big business, one with 217,000 employees and annual revenues approaching $100 billion. We certainly didn’t plan it that way. Charlie began as a lawyer, and I thought of myself as a security analyst. Sitting in those seats, we both grew skeptical about the ability of big entities of any type to function well. Size seems to make many organizations slow-thinking, resistant to change and smug. In Churchill’s words: “We shape our buildings, and afterwards our buildings shape us.” Here’s a telling fact: Of the ten non-oil companies having the largest market capitalization in 1965 - titans such as General Motors, Sears, DuPont and Eastman Kodak - only one made the 2006 list.”
I think it’s a bit ironic what Warren is saying here.
In some capacity, expanding your organization is necessary if you want to scale it. More growth requires more people, more structure, and more coordination.
But Warren is pointing out that there’s a tradeoff. At a certain point, size and scale can actually become detrimental to an organization’s ability to grow.
As a company adds more employees, more departments, and more layers of management, the organization naturally becomes more hierarchical. Decisions aren’t made as quickly anymore because everything has to move through the chain of command.
Over time, that process causes the organization to become slower and less nimble. And perhaps more importantly, it becomes more resistant to change.
After all, if the current way of doing things got the company to where it is today, then it must be working…right?
That’s what makes Buffett’s point so ironic. The same thing that helps a business grow can eventually become the thing that slows it down.
Over time, the focus slowly shifts away from innovation and improvement and toward maintaining the system that already exists. It becomes about checking boxes, appeasing your boss, and following the status quo.
That’s when a company starts to become overly corporate and robotic, and history shows us how dangerous that can be.
The giants of one era, like the ones mentioned in Buffett’s quote, often end up getting passed by because they become too slow and too stuck in their ways.
In other words, the same thing that once made them powerful eventually becomes the thing that causes their decline.
“ISCAR’s products are small, consumable cutting tools that are used in conjunction with large and expensive machine tools. It’s a business without magic except for that imparted by the people who run it. But Eitan, Jacob and their associates are true managerial magicians who constantly develop tools that make their customers’ machines more productive. The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.”
I really like the idea of this “money maker” moat that Buffett is describing here.
You see something similar with Watsco (WSO) and their OnCallAir platform, which is an app that helps their customers (contractors) drive more sales and make more money.
The reason I like this type of moat is because it creates a win-win, non-zero-sum situation between all parties involved.
In Watsco’s case, they benefit through the sale of HVAC products. Their customers benefit from an easy-to-use sales platform that helps them close more sales and increase revenue.
And even the end customer benefits because the entire process of working with a contractor becomes more streamlined and efficient. Overall, everyone is better off.
When a business is directly helping its customers make more money, it becomes much harder to replace, which naturally creates higher switching costs.
And when your success is tied to your customer’s success like that, it creates good incentives and can become a very durable competitive advantage.
“CEO perks at one company are quickly copied elsewhere. “All the other kids have one” may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees. Irrational and excessive comp practices will not be materially changed by disclosure or by “independent” comp committee members. Indeed, I think it’s likely that the reason I was rejected for service on so many comp committees was that I was regarded as too independent. Compensation reform will only occur if the largest institutional shareholders - it would only take a few - demand a fresh look at the whole system. The consultants’ present drill of deftly selecting “peer” companies to compare with their clients will only perpetuate present excesses.”
As time goes on, the spread between a CEO’s pay and the average employee’s pay continues to grow wider and wider — almost exponentially.
At least part of the reason for that is because the goalposts keep moving.
Since a CEO’s compensation is typically public information, they naturally compare their pay to that of their peers. And no CEO wants to be the lowest-paid among that group.
Adding to that, the compensation committees responsible for deciding CEO pay are rarely as independent as they appear.
These are well-paid positions that are relatively low-effort, so there’s an incentive to stay in those roles. And part of staying in those roles often means staying in the good graces of the CEO.
It creates a sort of “if you scratch my back, I’ll scratch yours” dynamic. And because compensation is always being compared to peers, the cycle pushes the goalposts further and further over time.
Warren’s point in the quote is that this cycle is unlikely to change on its own. Disclosure doesn’t fix it, and merely labeling committees as “independent” doesn’t really mean anything.
The system keeps perpetuating itself, and real change would likely only come if the largest institutional shareholders stepped in and decided things had gone too far.
But in reality, those same institutions are often part of the ecosystem, so the chances of that actually happening are probably pretty slim.
Memorable quotes and key takeaways from the 2006 Berkshire Hathaway shareholder letter.