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the long view

If you’re looking at investing in Berkshire, take heed of Warren Buffett’s outlookJIM YOUNG/Reuters

History's most successful investor is now wrestling with what he calls the ABCs of business decay – arrogance, bureaucracy and complacency.

Warren Buffett believes his flagship, Berkshire Hathaway Inc., can still triumph against the forces of darkness. But if you've been pondering an investment in the firm, you may want to think through some of the issues that emerged in his annual letter to shareholders this month.

Forty years ago, perhaps even 10 years ago, Mr. Buffett could still be viewed as a scrappy entrepreneur with an ingenious strategy. He used the "float" provided by his insurance operations – essentially a low-interest-rate loan – to buy the shares of cheap, safe companies with strong brand names. Over time the difference between the cash generated by those investments and the trifling cost of the float turned into an enormous, never-ending gusher of money.

But recent years brought new tensions. As Berkshire grew too big to find opportunities of sufficient size in public markets, it had to focus on buying entire companies. As it sprawled in size and scope, and moved further away from public markets, it developed capital allocation issues akin to those of a national economy.

And why not? Berkshire is closing in on $200-billion (U.S.) in annual revenues, similar to the GDP of New Zealand or Kuwait. Even if we include only its profit – nearly $20-billion – Berkshire outranks Jamaica or Iceland.

Like those other economies, Berkshire has to decide how to parcel out its investments. In a free-enterprise systems, those decisions are typically made in a decentralized fashion, by people who are managing factories and stores on a day-to-day basis.

In a socialist system, the capital allocation decisions are the domain of remote central planners, far removed from operations. This arrangement may achieve social justice. However, it is not noted for rapid growth, perhaps because the planners are no longer close enough to the action to seize opportunities.

So here's a seeming paradox: The handful of arch-capitalists, including Mr. Buffett, who constitute the core control group at Berkshire, function very much like the central planners in a socialist economy.

This small team allocates capital across their vast empire, deciding which operations are most attractive and which aren't. In Mr. Buffett's words, "we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise."

To be sure, other giant companies do the same thing, but they nearly all focus on a single industry, where they have special expertise. Berkshire, in contrast, is a sprawling conglomerate that operates in a slew of unconnected industries, from insurance to railroads to energy generation to candy manufacturing. It's not clear what its particular expertise can be.

For it to prosper, the market has to be dim enough that a handful of people in Omaha can reliably spot opportunities for capital allocation that rival companies, closer to the action, are missing. So that's another apparent paradox: This monument to capitalism can keep on winning only if other capitalists are a pretty unimpressive lot.

Here's yet another seeming paradox: Mr. Buffett embraces Berkshire's status as a conglomerate while acknowledging that earlier conglomerates, like ITT, Litton Industries and Gulf & Western, all fell short. "Conglomerates … have a terrible reputation with investors," he wrote in his recent annual report. "And they richly deserve it."

The billionaire's argument is that Berkshire can escape the dreaded ABCs of business decay by giving its operating managers an unusual degree of control, while leaving the big capital allocation decisions to the people at the centre who have no vested interest in maintaining the status quo.

But that seems rather hopeful. If conglomerates were so superior by nature, they would be the predominant form of business organization. For that matter, if central planning were the best way to allocate capital, the former Soviet bloc would have been a haven of affluence.

Maybe, just maybe, Mr. Buffett's faith in Berkshire's sprawling structure is misplaced. Perhaps it will keep outperforming as long as he's around. When the 84 year old dies, however, his successor – whoever that is – will be left at the helm of an unwieldy corporate jumble.

Mr. Buffett, to his credit, acknowledges the problem. "The bad news is that Berkshire's long-term gains [in future decades] … will not come close to those achieved in the past 50 years," he writes. "The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won't be great." Those are words potential Berkshire investors should keep in mind.