What We Can Learn from Berkshire's Conviction

This year I took Hundun Academy’s “The One” thinking course, studying the essential logic of things, the point of breakthrough, and iterative feedback. For my capstone defense case in March, I chose Berkshire Hathaway.

For what Hundun Academy’s “The One” thinking course is, please look it up on the “Hundun Academy” official account, or click “Innovative Thinking Now Has an ‘Operating System.’”

Who Is Berkshire Hathaway?

This question may seem to distrust most people’s basic knowledge, but there may still be some who are not too familiar with the name. One thing is certain: this company is neither an oil company nor a food company.

Let us first look at a brief profile of this U.S.-listed company:

On March 18, 2022, its share price was USD 512,991—the highest-priced stock in history—with a total market capitalization of USD 755.7 billion. It ranked 11th on the 2022 Fortune Global 500.

It manages total assets of about USD 1 trillion, of which USD 150 billion is liquid assets such as cash or bonds, USD 350 billion is stock holdings, and USD 500 billion is equity investments. It controls key American infrastructure in transport, energy, and communications, and also owns many traditional enterprises with abundant cash flow.

Guess how many people work at the headquarters that manages all these assets?

Twenty-five!

Consider Berkshire’s stock performance: if in 1965 you had invested USD 10,000 in Berkshire (BRK) stock, by 2021 you would own USD 364 million.

From 1965 to 2021, over those 56 years, that is an annualized compound return of 20.1%, far surpassing the S&P 500’s 10.5%.

And the boss of Berkshire Hathaway is none other than the famous Warren Buffett.

The old man—a Virgo born on August 30, 1930—made his first stock investment at eleven, studied under the value-investing master Benjamin Graham at nineteen, and at twenty-seven founded his own limited investment partnership.

In 2022, at ninety-two, according to the Forbes list his personal wealth stood at USD 99.6 billion, sixth in the world, and he had already given nearly 90% of his wealth back to society.

What Is Berkshire Hathaway’s “One”?

The question: What exactly is Berkshire’s “One,” and how does this value proposition differ from that of other investment companies? Why, among investment masters such as Peter Lynch, Soros, Fisher, and Dalio, does the public dote on the old man alone, honoring him as the “God of Stocks”?

Buffett Dissolves His Investment Partnership

After returning to Omaha from Graham’s firm, Buffett opened his own investment firm in 1957, starting with assets under management of USD 105,000. Buffett told his partners that he hoped to beat the Dow Jones index by 10 percentage points each year.

The result: from 1957 to 1961, the Dow rose 75% while the partnership rose 251%; over the ten years to 1966, the Dow rose 123% while the partnership rose 1,156%. Buffett greatly exceeded his target, with an actual annualized return of 35%.

And yet, in 1969, Buffett dissolved the investment partnership.

Tell me why. With such fine performance, he should have been raising capital aggressively—so why dissolve the partnership?

Buffett said: “Here is a market with only tens of thousands of dollars’ worth of opportunity, and yet I can’t find a way to intelligently invest 105 million dollars. I know that in an environment where I don’t think I can do well, or where I’d be forced to do well, I don’t want to be managing other people’s money.”

1969 was indeed a crazy market, and Buffett was unwilling to change the investment rules within his own heart.

After dissolving the partnership, he devoted all his energy to the seemingly “failed” investment—the textile firm Berkshire Hathaway.

How Does Berkshire Differ from an Ordinary Fund Company?

Berkshire is in essence a capital holding company, managing its own money, whereas an ordinary fund company manages, for the most part, investors’ money.

This gives Berkshire a fundamentally different view of money from an ordinary fund company—Berkshire regards its own money as capital.

According to Foundations of Western Economics: “Capital is a part of the means of production; it is the source of the assets an enterprise acquires in order to carry out its production and business activities. It is the investors’ investment in the enterprise, appearing on the right side of the balance sheet. The essence of capital is to obtain profit.”

There is a simple formula, if we set aside the cost of capital: Long-term capital value = capital invested × (1 + rate of return on capital) ^ time.

In managing its own capital, Berkshire—compared with other asset-management companies—bears no redemption risk and can operate in perpetuity; what the company earns is the value of capital compounding through its own cycle.

An asset-management company’s funds, by contrast, may—because of market volatility, investor redemptions, or a fund’s maturity—prove impossible to manage over the long term.

The capital markets assign different valuations to the two models. BlackRock manages nearly USD 10 trillion in assets with a market cap of USD 112.3 billion; Berkshire manages USD 1 trillion in assets with a market cap of USD 755.7 billion.

To answer the question “How does Berkshire differ from an ordinary fund company”: a fund company is an asset-management company, whose core is short-term investment value; Berkshire is a capital holding company, pursuing long-term capital value.

Buffett, as the major shareholder, should rather be called a capitalist than merely an investment expert.

What Did Berkshire Hathaway Break Through?

The question: What did Berkshire break through in the field of capital management that lets it be so different?

Since this is capital management, let us return to Marx’s Das Kapital and ask what the essence of capital is.

According to Marx’s Das Kapital: “One of the essential features of capital is its motion. The reason capital can increase in value, can bring surplus value, is that it is in ceaseless motion, continually passing from the sphere of circulation into the sphere of production, and from production back into circulation. This uninterrupted motion of capital is the necessary premise and condition for capital to achieve its increase in value; once motion stops, capital cannot increase in value.”

The most important thing for increasing capital’s value is to raise the efficiency of its motion; the higher that efficiency, the faster capital grows.

Marx also noted: “The transformation of surplus value into profit presupposes the transformation of the rate of surplus value into the rate of profit; that is, by means of the rate of profit, the surplus value that has been transformed into an excess over the cost price is further transformed into the excess, over a certain turnover period, of the total capital advanced above its own value. In short, surplus value is the inner essence or substance, while profit is the outward appearance or form.”

So, according to Marx’s theory, is a company with a high net profit margin necessarily a good company?

Buffett once said: “There are three most important things in investing: first, preserve your principal; second, preserve your principal; third, always remember the first two.”

And let us hear what Buffett’s first teacher, Benjamin Graham, said: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations that do not meet these requirements are speculative.”

And he raised that important term, “margin of safety”: “People are willing to pay any price for a stock, with no thought of quantitative analysis at all; whatever price an optimistic market marks seems worth it. At this peak of madness, the line between investment and speculation blurs. One must select stocks by the method of the margin of safety.”

And by a simple mathematical equation— margin of safety = enterprise value − enterprise price —since the enterprise price can be found in the market, how to assess enterprise value correctly becomes the most important thing of all.

Here we arrive at a term very familiar to us—value investing—which is the effective assessment of an enterprise’s true value.

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Buffett has 12 tenets for valuing and investing in a company.

The core of the three business tenets is to make judging a company’s value simple—don’t invest in what you don’t understand. He said: “I won’t attempt high-difficulty maneuvers. It’s like the hurdles at a track meet: if there’s a one-foot bar, I will never choose the seven-foot one.”

The core of the three management tenets is that Buffett hopes to find managers like himself, who can allocate the company’s capital effectively and be truly answerable to shareholders’ interests.

The core of the four financial tenets is how to find the metrics and sets of metrics that correctly reflect a company’s operating capability, to calculate the true “owner earnings,” and to find companies with high profit margins.

The core of the two market tenets is to determine a company’s market value by discounting future cash flows, and then, according to the margin of safety, to judge whether it can be bought at a discount to that value.

I looked up several companies Buffett has held for years—The Washington Post, Coca-Cola, GEICO, Capital Cities, and others—and even if not all 12 tenets applied, most of them did.

So, for the second question, “What did Berkshire break through,” the answer is: enterprise value with a margin of safety.

What Is Berkshire Hathaway’s Iterative Feedback?

As a diversified holding enterprise, Berkshire manages nearly a trillion dollars in assets. Of the non-listed portion, the great majority is wholly owned or can be consolidated; and in the listed portion, its stakes are mostly those of a relatively large shareholder, or come with a board seat.

Berkshire’s various subsidiaries generate large cash flows that they hand up to the Omaha headquarters. This cash comes from the float of its enormous insurance business and from the operating profits of its wholly owned non-financial subsidiaries.

Berkshire reinvests this cash as a factor of capital, in opportunities that can generate still more cash.

Each subsidiary has a talented management team handling the day-to-day work, so that Buffett can concentrate 100% of his energy on the efficient allocation of capital.

How does Buffett do this work of efficient capital allocation so well?

We come to John Whitmore’s performance formula: p = P − i, where the first p is performance, the second P is Potential, and i is interference.

Most people’s potential is much the same, but their interference values differ greatly. Our performance is low not because our potential is low, but because the interference is too great.

So, how does Buffett reduce interference?

The Minimalist Life in Omaha

First, Buffett lives neither in New York in the east nor Los Angeles in the west, but in Omaha, Nebraska, in the middle of the country. His office is in a building he has used for 60 years, renting only half a floor; the house he lives in he bought 60 years ago for USD 50,000. Quietly reading annual reports and making phone calls in the office each day has become the habit of a lifetime.

A Counter-Consensus Understanding of Risk

On the basis of Markowitz’s Modern Portfolio Theory, Eugene Fama’s Efficient Market Hypothesis, and Sharpe’s Capital Asset Pricing Model, most asset managers regard volatility as the greatest risk in the capital markets, and so diversification and non-correlation are their most important approach to controlling it. To give an analogy: it is like digging a pool with an opening one kilometer wide and one meter deep.

Buffett, by contrast, holds that the greatest risk is the loss of an enterprise’s intrinsic value: if the value is gone, the margin of safety is gone, and the stock should be sold. In choosing excellent value enterprises, the number one can analyze thoroughly is certainly small. So Buffett digs his pool with an opening one meter wide and one kilometer deep.

So, between concentration and diversification, Buffett chose an almost unbelievable concentration of holdings—reducing the number of decisions in order to reduce the number of mistakes. Buffett’s trading is for the sake of not trading: finding good companies and holding them for good. This is a Zuo Hui–style “hard but right thing.”

Mathematical Probability as a Foundation

On decision-making, Buffett said: “All we have to do is multiply the probability of gain by the amount of possible gain, and subtract the probability of loss multiplied by the amount of possible loss.

In 1654, an exchange of letters between Blaise Pascal and Pierre de Fermat laid the foundations of probability theory—Fermat using algebraic methods, Pascal geometric ones. The work of Pascal and Fermat marks the beginning of decision theory, which is the process of deciding what to do when you are uncertain what will happen.

Bayesian analysis provides a mathematical procedure for adjusting our prior expectations in light of newly obtained information, so as to alter the corresponding probabilities. Universities use Bayesian analysis to help students learn decision-making; in the classroom it is called decision-tree theory. Munger said: “Everything you learn in the first year at Harvard Business School, taken together, is really decision-tree theory.”

On the basis of Shannon’s information theory, the mathematician Kelly built an optimization formula. In his 1948 paper “A Mathematical Theory of Communication,” Shannon addressed the optimal amount of information that could be transmitted over a copper wire—regarded as a mathematical formula for the optimal probability of success.

In 1956, Kelly wrote “A New Interpretation of Information Rate,” proposing an optimal growth strategy: if you know your probability of success, you know what proportion to allocate. The formula is 2p − 1 = X. If the probability of winning is 55%, then 2 × 55% − 1 = 10%, so you should allocate 10%; if the probability of winning is 75%, then 2 × 75% − 1 = 50%, so you should allocate 50%.

In applying the Kelly formula, however, Buffett is often very cautious: when the result is a 20% allocation, he manually adjusts it downward, usually to one-half or one-third of the original figure.

So, viewed through the lens of probability theory, Buffett’s investment decision process is as shown below:

Rationally facing the mischievous “Mr. Market,” who keeps running up to give you a quote

Look at a stock like this, and you might feel its volatility is too great

But look at this stock, and you’ll feel the earlier you get on board the better.

Yet these two are the same stock—the famous Apple—only observed at different time frequencies.

Buffett said: “Investing is like baseball: to score, everyone must keep their attention on the field, not fixed on the scoreboard.”

When market prices swing up and down, the composure Buffett shows is only natural—his inner standard for risk control is that the enterprise’s intrinsic value is not lost, not the share price.

Buffett has an over-quoted maxim: “Be greedy when others are fearful, and fearful when others are greedy.”

What Buffett is certain of is value, while what others fear and covet is the share price. A falling market is, on the contrary, the greatest buying opportunity, because the margin of safety is larger.

The Conclusions of Behavioral Finance

In 2011, Nobel laureate Daniel Kahneman’s Thinking, Fast and Slow divided the cognitive process into two modes of thought—intuition and reason, that is, System 1 and System 2. System 1’s decisions are mostly mechanical, fast, and made without deep deliberation; System 2’s decisions are carefully thought through, deliberated, and demand focus.

Of himself and of the management of the companies he invests in, what Buffett demands most strictly is rationality—especially the rationality embodied in the efficient allocation of capital.

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Buffett said: “Our job is to select those excellent companies in which every dollar retained will ultimately create more than a dollar of capital value.”

When invested capital moves again and again, bringing capital value, this simple and magical formula is fulfilled: Long-term capital value = capital invested × (1 + rate of return on capital) ^ time.

A simple thing, because few variables affect its outcome, is often the least risky thing, and the most enduring.

Looking at Berkshire’s “The One” framework diagram as a whole, the breakthrough point—investing in enterprises on the basis of value—is strongly isomorphic with the Berkshire that Buffett himself manages. Buffett screens the companies he invests in after his own image.

In this way, multiple Berkshire fractals are produced, continually resonating at the same frequency, raising Berkshire’s overall capital value.

But facing this simple and magical formula—Long-term capital value = capital invested × (1 + rate of return on capital) ^ time—one must always ask oneself:

Is it true?

Is it always true?

Are there exceptions?

In 1776, Adam Smith gave an exquisite description in The Wealth of Nations: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. Every individual who employs capital and labor intends neither to promote the public interest, nor knows how much he is promoting it. He is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest, he frequently promotes that of society.”

So, in a market with little regulation—one that relies more on the price mechanism, that invisible hand of the market—limited resources come to be allocated rationally. The magnificent development of the American market economy and capital markets over sixty years created the larger environment for Buffett’s wealth.

So how does Buffett, possessing such enormous wealth, face it?

Buffett said:

“Whenever I told Susan we would be rich, she never showed much excitement—either she paid no mind, or she didn’t believe it. When we truly amassed a great fortune, we were quite of one mind about how to dispose of it: to give it back to society.”

“Susan and I never felt we should leave so much money to our children—our children are all outstanding. But one thing I must state plainly: in their upbringing and in the educational opportunities they received, they already enjoyed every advantage; so to bestow untold money on them besides would be neither right nor sensible.”

“In fact, in a society that prizes merit, they already hold an overwhelming head start. Enormous wealth handed down through the generations would further worsen the social fairness we ought to be striving to uphold.”

The Snowball, by Alice Schroeder

At the New York Public Library on June 26, 2006, Buffett took out five envelopes, each containing an arrangement for distributing his wealth, needing only his signature to take effect. The first three were simple: he signed them “Dad” and gave them to his three children—his daughter Susie, his elder son Howard, and his younger son Peter. The fourth he handed to a representative of the charitable foundation to which his late wife had donated. These four envelopes came to a total of USD 6 billion.

After signing the fifth envelope, Buffett handed it to Melinda, then the wife of Bill Gates. In it, Buffett donated his Berkshire stock—wealth then totaling USD 30 billion—to the world’s largest charitable institution, the Bill & Melinda Gates Foundation.

Buffett said: “They can use the money more efficiently. To find the person who does things the way you would, and does them better, and to entrust the matter to them—isn’t that more logical?”

This is Buffett all over—always full of reason.

So, in The Protestant Ethic and the Spirit of Capitalism, Max Weber said:

“The so-called spirit of capitalism refers to the individual’s regarding the effort to increase his own capital, as an end in itself, as a duty faithfully discharged—treating the making of money itself as an end, a professional obligation, an expression of virtue and of ability.”

“This economic conduct of modern rational capitalism is entirely consistent with the orderly, systematically arranged, this-worldly asceticism of the Protestant way of life. The ethic of Protestant asceticism provided the capitalist entrepreneur with a psychological driving force and a moral energy.”

The Protestant Ethic and the Spirit of Capitalism, by Max Weber

The spirit of capitalism—that is, the Puritan spirit—regards the gaining of wealth as a path to glorifying God, and the sharing of wealth as work done on God’s behalf.

At this point, Berkshire’s “The One” framework diagram is complete.

Berkshire’s value proposition is that of a capital holding company pursuing long-term capital value. Its breakthrough point is value investing, raising the efficiency of capital’s motion. The iteration is capital allocating assets effectively; the feedback is assets bringing capital appreciation. This embodies the elegant simplicity of mathematics: Long-term capital value = capital invested × (1 + rate of return on capital) ^ time.

The axiomatic thinking that supports this “The One” model is the political economy founded on The Wealth of Nations, together with mathematics; and the Puritan spirit becomes the intellectual source of inner conviction in the possession of wealth.

Can Berkshire Hathaway Be Replicated?

So, can Berkshire and Buffett be replicated?

The answer is no.

America’s twentieth century, America’s corporate value of “serving shareholders’ interests,” abundant insurance float, a non-hedge-fund structure, resources for interacting with the Federal Reserve in moments of crisis—these are opportunities not possessed by the ordinary asset manager or capitalist.

Why Still Speak of Berkshire and Buffett?

George Johnson, in Fire in the Mind, said: “Between the real and the illusory, deep in every heart lies a wish to discover a pattern, to make whole a disordered world.”

Everyone is searching for a pattern in their own inner world, but too much informational interference and too much inner disorder keep many from finding the way home.

Buffett said: “Our attitude is to let our character be consistent with the way of life we wish to lead.” In breaking through to value investing, he was at the same time breaking through to his own way of living and managing—his very way of life.

What we should learn is precisely this spirit: to pursue business value and the making of money as a goal; to live thriftily and seek quality without waste; and in the end to give wealth back to society.

So it is with Buffett, so with Berkshire, and so too with every company they invest in.

So, in 2015, at Buffett’s shareholder meeting, through a lucky draw I had the chance to put a question to him: “After managing Berkshire for so many years, why are you still so passionate, so interested?”

He answered: “I have the life I want, and I love every day. I mean, I tap-dance to work every day, drink six cans of Coke a day, and work with the people I like. There is nothing in this world more fun than working at Berkshire, and I am very lucky to be here.”

In Closing

My favorite book, Decisive Moments in History, says: “The greatest fortune in a person’s life is nothing other than to discover, midway through it—in the prime of one’s strength—one’s mission in life.”

Perhaps Buffett discovered his life mission not in middle age but as a boy.

The greatness of the energy released when person and enterprise fuse to answer a calling, the strength of the happiness when person and work become one, this love—for people, for the work, for society—is what we should learn, and is the true conviction at the heart of Berkshire.