Warren Buffett’s ‘Secret Sauce’
by JC Spender

Posted on Posted in 8th Global Peter Drucker Forum

There is a small industry of commentators who decode the Berkshire Hathaway (BHI) Annual Letter to Shareholders – which includes Bill Gates.  Their findings vary but the letter released this February was especially interesting (in Gates Notes – “the best ever”).  Most focused on BHI’s financials, only to be expected.  But the letter included wide-ranging remarks by the ‘Sage of Omaha’ on the economy, the history of US productivity, and today’s social inequality.  Few remarked his stating that an economy driven by rising productivity leads to job losses for people whose skills get outmoded or when production moves elsewhere.  Or that ‘safety nets’ are needed, fabricated in Congress’s ‘contentious clashes’.  His analysis was ultimately sunny as he argued US productivity would continue upwards, the US’s ‘secret sauce’.  Few disputed this, given we are only beginning to digest the contrary view provided in Robert Gordon’s monumental The Rise and Fall of American Growth (Princeton University Press 2016) – a few pages longer than Thomas Piketty’s equally monumental Capital in the 21st Century (Belknap 2014) (also applauded in Gates Notes).  If economy-wide productivity increases no longer pay for the safety nets Congress finally fashions, Buffett’s sun sets.  Perhaps the 99%’s and Reich’s ‘anxious class’ sense a different future.


Of course Buffett is a practicing manager and less interested in academic talk and macro-generalities than in the specifics of the firms in which BHI invested – whose managers were surely measured on how they pushed their firm’s productivity ahead.  His letter was a superb lesson on ‘business models’, the topic of much sloppy academic talk.  But Daniel Gross, executive editor at strategy+business, seemed alone in noting the letter’s display of Buffett’s deeper grasp, his own ‘secret sauce’.  Buffett’s tale of what happened to BHI’s Dexter shoe-making operation differed from the usual story of overseas competition’s impact.  It suggested a more fundamental business model or ‘theory of the firm’ – that firms can sometimes evolve faster than the people they employ.


How can this happen?  As shareholder value overtook firm growth as the goal, Wall Street innovated with maneuvers that included liquidating the firm, laying off its people, and directing the funds released into different lines of business.  So long as relevant markets existed, tangible (tradable) assets can be reallocated almost instantly.  People, less tradable, get left behind.  Buffett was not sympathetic, writing “When Wall Street gets innovative, watch out!” and that BHI “only goes where it is welcome”, recognizing every firm is more than its tradable assets and has been created by a workforce and community whose future cannot be airbrushed out with simplistic finance talk.  Entrepreneurial managers have a double responsibility; to make the firm’s future, but also to deal with its past.


There has been plenty of discussion about the ‘structural unemployment’ resulting from investor-oriented strategizing.  There is also a huge literature on ‘change management’ – but little attention to firms changing faster than the people who bring them to life.  Firms are actually puzzles we do not understand well – as Nobel-winner Ronald Coase pointed out in 1937 when he asked why firms exist and are as they are.  The most familiar metaphors for firms are: (a) carefully designed and operated machines, (b) communities of motivated people, or (c) as Citizen’s United vs FEC suggested, economic actors or ‘persons’ themselves.  None tell us much about firms and people evolving at different rates.  What was Buffett thinking?  Gross explained people face barriers to change that firms do not and so have fewer options and ‘levers to pull’.  True, but there seems to be more to it and maybe Buffett intuited something about the nature of firms, to use Coase’s term, that is unlike the nature of either people or machines.  Perhaps, being so thoughtful about the nature and social place of private sector firms, as well as successful, he knows something about (c) that informs BHI’s investing.


The recent Citizen’s United vs FEC and McCutcheon vs FEC judgments have centuries of legal debate behind them showing corporate lawyers are far from agreed about what firms are – even if management academics have no such doubts.  On the one side are ‘corporate nominalists’ who see the firm as a bundle of contracts between individual shareholders governing their property and its application.  On the other, ‘corporate realists’ who see firms as distinct legal entities with a ‘personality’ and rights and duties in the socioeconomy.  The 1930s development of ‘managerialist’ ideas, recognizing how in large corporations managerial control overwhelmed the share-owners’ rights, led many to see victory for the ‘realists’.  In the 1970s the tide was reversed by neoliberal ‘agency theorists’, sometimes to the extent that, along with pillorying government, managers were characterized as ‘the problem’ for corporate governance rather than its solution.  Maximizing shareholder value (MSV) is nominalism’s battle-slogan, corporate social responsibility (CSR) is realism’s.  The call for ‘more ethical management’ is realism pushing back against nominalism’s recent dominance.  For the most part management academics pay no attention to corporate law debates, choosing whatever position best suits the theory they purvey – without bothering to justify their choice as lawyers must when arguing real cases.  In contrast, Buffett is a practicing manager, aware of the dichotomy and its implications.  But with what resolution?  What is his working ‘business model’?  His letter suggested a model that escapes both corporate lawyers and management academics.


The American educationalist and philosopher John Dewey added to the legal debate in a 1926 article, arguing that realists treating firms as ‘legal persons’ misunderstood the complexity of ‘personhood’ in a capitalist democracy.  The dichotomy should be dismissed as confusing, obscuring the nature of the firm and the roles of investor and manager alike.  But Dewey also noted the concept of the corporation, to use Drucker’s term, had a ‘chameleon-like’ ability to change with the times.  In a footnote he recalled the older view of the firm as a ‘legal fiction’ which, stripped of its legal baggage, presents the firm as an ‘idea’ – not captured by either nominalist or realist views – noting such ‘imaginary creatures’ are ‘notoriously nimble’.  Today most theorists are stuck on one or other horn of the dichotomy, from where firms seem inherently static and lifeless, given changing assets or people is a challenge.  Thus ‘entrepreneurship’ often gets confused with ‘change management’.


But some are not so stuck, and Buffett may be among them.  Katsuhito Iwai, probing the differences between American and Japanese firms, embraced the firm’s ‘dual nature’, both nominalist and realist.  Rather than being tied to or defined by its tangible assets or its people, each firm is the flexible imaginary creature Dewey sighted inhabiting the middle ground between nominalist and realist abstractions.  How can this be?


Intangible assets, such as ‘know how’, shed some light here.  Buffett’s letter included many comments on intangible assets, the huge part they play in BHI, and the difficulties they present accountants, managers, and investors.  Nominalist theorists presume the meaning of assets is self-evident and that the firm’s accounts show the tangible and real.  Against this Edith Penrose pointed out the ‘nominalist fallacy’, that in practice assets are only as valuable as management’s ideas about how they can be applied.  At the other horn, realists presume people calculate rationally and know their purposes and aims.  Dewey pointed to the ‘realist fallacy’ that people do not know their own minds fully, that their tacit understandings matter.  Imai argued, as most of us do, that tacit knowledge emerges in the middle ground as people with assets pursue a shared idea or purpose.  Crucially this imaginary substance is living but cannot survive the cessation of the firm’s practice, its liquidation.  So the shareholders cannot reallocate it.  A ‘going concern’ has imaginary content that cannot be sold, yet is fundamental to its ability to transform the imagining that holds the horns of the dichotomy together into economic value.


This is not news to experienced managers.  But it is not easy to operationalize or explain as part of a specific firm’s business model, as Buffett did in his 2016 letter.  His language was homespun rather than academic, thank goodness, but not lacking in precision or power.  He identified three notions of a firm – nominalist, realist, and imaginary – so as to explain managing their intersection.  With a real business to run his model did what those of economists or management academics failed to: help BHI’s managers (1) embrace their particular firm’s trinity, (2) synthesize it into value-creating practice, and (3) highlight the risks of dichotomies between their firm, its people, and its surroundings, risks that are the focus of business ethicists and principal-agent theorists.  Leveraging from the insight that the nominalist, realist, and imaginary can change at different rates, Buffett’s model outlined answers to Coase’s questions about the nature of the firm – practical answers that bring the BHI shareholders’ concerns about productivity, managerial ethics, and financial performance together.  A secret sauce indeed.


About the author:

JC Spender trained first as a nuclear engineer then in computing with IBM.  He moved into academe as a strategy theorist, opening up a subjectivist/creative approach that complements mainstream rational planning notions of strategizing.  This 40-year project was brought to completion in Business Strategy: Managing Uncertainty, Opportunity, and Enterprise (OUP 2014).

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