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Warren Buffett – Managerial Economics

Business managers through out the world have to make decisions in all aspects of their respective businesses, but these managers have to make ethical and sound decisions that will bring success to the organization. Managerial economics is the application of economic theory and methodology to business decision-making (Hirschey, p 3). One of the world’s greatest business manager and leader, investor, and businessman is Warren Buffett the famed billionaire and entrepreneur. This paper will address Warren Buffett’s strategies and philosophies involving investing and business decisions as it pertains to managerial economics.

Introduction : This paper aims to study and discuss the appliction of managerial economic theories by the legendary investor and the world’s richest person as of 2008, Warren Buffet in making his business decisions. This paper attempts to understand the investment strategies and philosophies of the man using which he has been able to amass great wealth. To effectively analyze the application of managerial economics by Buffet, this paper takes a few important decisions Buffet had to take in his role as the chairman of Berkshire Hathaway as examples.

Managerial Economics- Background: Managerial economics, also known as business economics is the study of application of microeconomic theories and analysis as an important part of making business decisions. Managerial economics bridges the gap between theoretical economics and practical economics. By practicing managerial economics, managers formulate business strategies based on various micro and sometimes macro economic theories with a view to accelerate growth objectives and increase revenue.

Implementation of such strategies is done by allocating the right amount of resources and establishing an organizational structure for the flow of command and monitoring. Decisions on diversification issues and marketing plans are also a part of business that requires the application of managerial economics. Economic theories and analysis are required as and when the circumstances of businesses change with the times altering various factors like the availability of resources, introduction of competition, manpower and macro economic changes.

Managerial economics plays a key role also in the matters of integration of a company’s different divisions and also the merger and takeover activity between two companies. ( Economy watch, 2008) Warren Buffett- background : Warren Buffett is considered to be the greatest investor of all time with his net worth estimated at $62 billion, making him the richest man in the world, as of 2008. He is the chairman of Berkshire Hathaway, a holding company for most of his investments. (Investopedia, 2008). Born on August 30, 1930 Warren Buffett had an unusual childhood.

He was not interested in playing games like other kids his age. He would rather make money by selling bottles of Coke and delivering newspaper in the neighborhood. He discovered the virtues of saving money by avoiding luxuries, at a very early age and started investing in shares when he was just 11. (Kennon, 2001). It was while doing graduate studies at Columbia, that Warren was initiated into the depths of stock market analysis by none other than Ben Graham, the author of legendary books on stock trading such as Security Analysis, The Intelligent Investor and Mr.

Market. (Kennon, 2001). But instead of adopting his mentor Ben Graham’s idea of studying the balance sheets and income statements to understand the prospects of a company, Warren developed his own methods of analyzing the financials of companies, by going a step further to apply the managerial economic theories to analyze the companies prospects and study leadership strengths of the top management in order to determine the intrinsic value of a company’s stocks.

His way of investing was, to find companies that were trading below their intrinsic value as perceived by him and to buy the stock below this value and then hold the stock for very long periods. (Little, 2004). He had strong conviction in his ways of valuing a company and never wavered from them. Warren Buffett and Managerial Economics : Warren Buffett is a prime example of a managerial economist and in his work as the Chairman of Berkshire Hathaway one can see the perfect application of managerial economic theories in action.

The fact that Buffet used managerial economic theories can be understood by the following words of the economist Sahu. “Examples of questions that managerial economics attempts to answer are: What determines whether an aspiring business firm should enter a particular industry or simply start producing a new product or service? Should a firm continue to be in business in an industry in which it is currently engaged or cut its losses and exit the industry? Why do some professions pay handsome salaries, whereas some others pay barely enough to survive? How can the business best motivate the employees of a firm?

” (Sahu, 2008) These are exactly the kind of questions that Warren Buffett keeps asking about the companies he is considering investing or has already invested. Frequently Warren is required to analyze the performance of companies that Hathaway owns or have a considerable stake in or is considering taking over or buying a major bulk of the shares. Based on his research he decides on whether Berkshire should invest in this company as a stockholder or whether they can offer to buy the company or whether the company is in too bad a shape to consider any actions on it.

He makes these decisions based on the analysis of several factors regarding the company in question. Such as, what type of products or service does the company deal in? Do they manufacture it or outsource it?. If they manufacture it, how effective is their supply chain management? How is the availability of their raw material? Can the company market their products worldwide? Are there any governmental regulations or trade sanctions regarding their products existing with any country?

How much of the market have they covered? What is the growth potential ? How much of capital would the company need to expand in order to meet the increasing demands? What type of technology is used by the company? Does it require any major changes in the short run? What type of market does the company operate in? Is it a monopoly, oligopoly or perfect competition? What kind of competition exists? What are the entry barriers for new companies into the market? What are the long term prospects for the company?

Apart from the analyses of various economic factors like these, the other considerations that he gives a lot of importance while finalizing his decision on a company are, how good the current management is and how effective the existing leadership is in taking the company forward into the future. These are the kind of questions that Warren Buffett have, to consider before passing his judgment on investing or taking over or leaving alone a particular company. And this is what he does on a continuous basis regarding the companies that he already owns through Berkshire Hathaway.

His brilliance in spotting undervalued companies is well documented in the example of his relationship with Washington Post Company in 1973. Washington Post’s stock was trading with a market capitalization of $100 million at the time, but Warren had been analyzing the company for a long time by then and knew better. His own estimates put the intrinsic value of Washington Post to be between $400 and $500 million (Nofie Iman, 2005). So Warren started buying the stock and by the year end Berkshire Hathaway held over 10% shares which increased over the years after he became one of the directors of the company.

By 2004 the value of Warren’s holdings of Washington Post has multiplied fifty fold (Hagstrom, Miller & Fisher, p. 57). And till today Warren has not sold a single share of WP even though there were many ups and downs along the way. Warren’s decision to invest in Washington Post can be attributed to his application of managerial economics on the company’s future. He was convinced with WP’s strong brand value in the local market, the profitability of its subsidiary, NewsWeek and the robust prospects of its five TV/radio stations. (Olson, 2006).

Likewise, there were several instances in his experience when he decided to sell or close operations of the companies that he owned after he judged that the company is not going to be significantly profitable. His interest in the Textile Industry is an example of his detached and rational decision making. Textile was one of the core focus industry of Hathaway investments in the 1970s. But soon Warren could see that it would be difficult to compete with the imports coming in cheaper with lower labor costs of the developing countries.

Warren had two choices, either he could infuse huge amounts of fresh capital to upgrade the technology in order to lower manufacturing costs so that they could compete with the world market prices or he could close down. This decision could be seen as one of the typical predicament of managerial economics. He had to decide if the capital required to succeed would outweigh the proceeds of the exercise. He spent a lot of time making the decision to sell the textile business. However, the revenues generated from the textiles business until then were utilized funding his investments in the Insurance sector.

(Hagstrom, Miller & Fisher, p. 29-31) Warren Buffett’s Investment Philosophies, as he laid out in 1977, are that Berkshire Hathway would select equities of businesses that 1) ….. they can easily understand – This explains why Warren has avoided the entire high technology and software sectors in his portfolio. He has adhered to this principle by sticking to companies like Coca Cola, Gillette, Washington Post and businesses like Insurance, Banking and consumer goods. 2) ……offer good prospects in the long term – Warren always advocated choosing the stocks very carefully and holding them for very long periods.

3) ….. are operated by honest and competent people – Warren Buffett had a knack of understanding people and their motives. He did not believe in taking over companies and then trying to run it better than the previous management. In all his acquisition he let the old team of management continue the day-to-day operations of the company. 4) ….. are available at very attractive prices – This is where is managerial economic skills came to the forefront in analyzing the intrinsic value of a company and comparing it with its market value.

If there were enough “margin of safety” between the two he would jump in and invest in the company. (Miles, 2004) Even in his philanthropic ways one can see his brilliance in managerial economics. In 2006 he pledged to donate $37 billion of his fortune to the Gates Foundation managed by Bill Gates of Microsoft and his wife Melinda. Here also he has used the same strategies that has behind his decisions for investing, all his life. “Backing good organizations with good management” (Ivan Png, 2007,p. 219)

Conclusion : This paper sets out to discuss Warren Buffett’s strategies and philosphies managerial economics for investing and making business decisions. It is established that Warren Buffett is the most effective investor the world has ever seen considering that the bulk of his wealth comes from stock appreciation. He believed in spending enormous amounts of time doing careful analysis of companies in the market looking for what he called “gems” that are trading considerably below their intrinsic value. His brilliance was in calculating this intrinsic value as precisely as possible.

And once he found the “gems” he invested and stayed invested for as long as he could. And he applied the best of managerial economic theories to find out what the future holds for a company. When he found companies with unique products that had a world market waiting to be tapped but did not have the resources to go the distance he took them over without changing the management team. It can be concluded that Warren Buffett was a profound applicator of managerial economics in all its senses.

References

Robert G. Hagstrom, Bill Miller, Kenneth L.Fisher, 2004, The Warren Buffett Way, John Wiley and Sons Ivan Png, 2007,Managerial Economics, Dale Lehman, Blackwell Publishing, p. 219 Robert P. Miles, 2004, Warren Buffett Wealth, John Wiley and Sons Joshua Kennon, 2006, The Story of Berkshire Hathaway’s Billionaire Chairman, Warren Buffett Biography, About. com Retrieved November 5, 2008 http://beginnersinvest. about. com/cs/warrenBuffett/a/aawarrenbio. htm Nofie Iman, November 6th, 2005, Wisdom of Warren Buffett, Retrieved November 5, 2008 http://nofieiman. com/2005/11/wisdom-of-warren-Buffett/Mark Olson, 2006, Warren Buffett and the Washington Post, Retrieved November 5, 2008, http://www. gannononinvesting. com/newsletter/2006/12/warren_Buffett_and_the_washing_1. html Economy Watch, 2008, Managerial Economics and Business Strategy Retrieved November 5, 2008, http://www. economywatch. com/business/managerial-economics-and-business-strategy. html Investopedia, 2008, Warren Buffett Retrieved November 5, 2008, http://www. investopedia. com/terms/w/warrenBuffett. asp Anandi P Sahu, 2008, Managerial Economics, Retrieved November 5, 2008 http://www. enotes. com/biz-encyclopedia/managerial-economics

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