Monday, March 07, 2005

Mono-linked chains

Warren Buffett just released his annual letter to shareholders, which explained the results of Berkshire Hathaway in 2004. He commented on a $579 million loss in a zinc mining loss:

Our failure here illustrates the importance of a guideline — ­ stay with simple propositions —­ that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for —­ if you'll excuse an oxymoron —­ mono-linked chains.

This is such a good analogy. I also think it reflects an investment philosophy I didn't know I held until now. My first (and one of my favorite) investments was Oracle. Over the years, it has taken some huge, bet-the-company risks. But in every case (at least from what I remember reading Softwar) the risks have involved one, key variable. For instance, each of the complete software rewrites (which are very risky) pivoted on having a better product at the end of the processes and little else. Time and again Larry Ellison bet Oracle the company on Oracle the database. Buying PeopleSoft, in fact, will have been a successful risk if Oracle manages to move a wide variety of applications onto a single database schema.

Select Comfort is also a one-link chain: the adjustable airbed. Like Oracle, the company has focused on one, big idea — the hedgehog approach. Since Sleep Number beds can fold into a handful of boxes, they are shipped directly to the customer. Since most people aren't familiar with the idea, Select Comfort stores, commercials, QVC shows, and the website are geared toward showing how the beds improve a person's quality of life. Since the beds are made to order, customers have a range of choices about which controls, mattress covers, air pumps, pillow tops, sizes (including the Grand King (80" x 98") designed for 6'11" Kevin Garnett), and foundations. There are any number of things that can go wrong, but as long as it's possible to sell high-quality air mattresses, Select Comfort is probably going to do alright.

Raytheon is moving in the direction of being a single link. It used to sell everything from microwave ovens to Patriot missiles. At some point, this made sense — microwaves used to be high-technology. Lately, Raytheon has been selling off or ending businesses that don't fit into the government contracts umbrella. Increased dependence on one customer might seem foolish except that the customer is schizophrenic. It still has too many links, but at least management has learned its lesson from the diversification adventure.

I have a harder time justifying Canon on the "one-link" criteria. I'm tempted to say optics excellence, but one of Canon's biggest revenue streams is printer ink. Fujio Mitarai, Canon's CEO, says, " Canon was built on the foundation of original innovative technology." But I think Canon's success is due to a uniquely Japanese ability to mold thousands of employees to a single philosophy. Many of Canon's investor relations documents describe the idea of "kyosei", which is translated "living and working together for the common good". If so, the risk is that this bubbly optimism might fail to produce new and better products at a reasonable expense.

Maybe it's naive to think that Canon has really implanted kyosei into its culture. But look at this quote in a press release of the death of Sony's founder:

"Mr. Ibuka has been at the heart of Sony's philosophy. He has sowed the seeds of deep conviction that our products must bring joy and fun to users. Mr. Ibuka always asked himself what was at the core of 'making things,' and thought in broad terms of how these products could enhance people's lives and cultures.
Or this quote from the Toyota Forklift division:
At Toyota facilities around the globe, "kaizen" is a word mentioned frequently. The word means "continuous improvement" and is a key factor in Toyota quality. Kaizen has been incorporated into the Toyota Production System driving our engineering and manufacturing teams to constantly improve our lift trucks. It also drives our service personnel.

Coming full circle, Berkshire Hathaway is a horrendously complicated company rivaled only by GE. Any attempt to evaluate the company would require intimate and detailed knowledge of a company that sells everything from candy to catastrophic re-insurance. Ultimately, Berkshire investors are risking their investment on the philosophy described in the Berkshire "Owner's Manual".

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