The Remarkable Iscar Story

“Follow your heart and invest your time and resources in a product that you love.  If you are excited about what you are making, it will hold your interest and you will be well equipped to interest your customers in it.”  — Stef Wertheimer

Contemporary business success stories often focus on entrepreneurs who come up with an idea, obtain funding, and score quickly by selling the business at an attractive valuation either via acquisition or through an offering of stock to the public.  There can be no doubt that a sub-set of these entrepreneurs have made real and lasting contributions to society in astonishingly short periods of time, but often we are left scratching our heads wondering about the valuations obtained by companies with no compelling business model or pathway to profitability.  In contrast, individuals who spend a lifetime building up a business do not typically receive the same attention.  Perhaps this is because the value of their creation is not recognized dramatically in a few years but snowballs over many decades.  However, if one seeks insight into how real and lasting value is created, reading the biographies and memoirs of entrepreneurs who have spent decades perfecting their craft is usually worthwhile.

The Habit of Labor:  Lessons from a Life of Struggle and Success

Habit of LaborStef Wertheimer’s formative years were spent in his native village of Kippenheim, Germany during the turbulent years leading up to the second world war.  Mr. Wertheimer’s prosperous family was deeply impacted by the Nazi persecution of Jews during the early-mid 1930s and the family decided to emigrate to British-controlled Palestine in 1937.  At the age of ten, Mr. Wertheimer found himself in an unfamiliar culture and had to grow up quickly as his family’s economic security deteriorated after his father’s business began to fail.  An early entrepreneurial aptitude coupled with a rebellious streak led Mr. Wertheimer to make important contributions to Israel’s early industrialization.  Iscar was founded in 1952 in a shack next to Mr. Wertheimer’s home.  It was valued at $5 billion 54 years later when Berkshire Hathaway acquired a majority interest.  The story of this extraordinary up-from-the-bootstraps business success is the main subject of Mr. Wertheimer’s book, The Habit of Labor:  Lessons from a Life of Struggle and Success.

Mr. Wertheimer did not complete his formal education and learned various crafts through experimentation, independent study, and apprenticeships as a young adult.  His subsequent experiences in the Palmach in the mid-late 1940s, particularly working in urgent situations requiring quick development of military supplies, clearly contributed to his leadership skills and aptitude for innovation under extreme pressure.  Nevertheless, in post-independence Israel, Iscar did not immediately prosper and the company faced five lean years with little monetary reserves.  Government policy did not recognize the importance of industrialization, offered little support, and there was very limited credit available for expansion.

Through the course of the narrative, Mr. Wertheimer provides many details regarding the rise of Iscar from these modest beginnings to the export powerhouse it became prior to Berkshire’s acquisition in 2006.  Additionally, readers who are interested in the economic development of Israel will find many aspects of the book interesting, particularly those related to Mr. Wertheimer’s lifelong focus on industrialization and the impediments that he faced.  There is much to learn regarding the benefits of vocational training coupled with attractive industrial parks focused on integrating education, manufacturing, arts, culture, and a high quality of life in communities that were previously agrarian, isolated, and undeveloped.

Berkshire’s Acquisition of Iscar

In late 2005, Eitan Wertheimer, who had taken over management of Iscar from his father, sent a brief letter to Warren Buffett describing Iscar and concluding that Berkshire Hathaway would be an ideal home for the company.  At the time, Mr. Buffett had never heard of Iscar and had never purchased a subsidiary outside the United States.  However, Mr. Buffett found Iscar’s primary business of developing consumable cutting tools attractive and was impressed with management, as he wrote in Berkshire’s 2006 annual letter to shareholders (pdf):

ISCAR’s products are small, consumable cutting tools that are used in conjunction with large and expensive machine tools. It’s a business without magic except for that imparted by the people who run it. But Eitan, Jacob and their associates are true managerial magicians who constantly develop tools that make their customers’ machines more productive. The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.

Stef Wertheimer provides an account of the deal in his book and states that the $4 billion price tag was not the primary factor that led his family to pursue the deal with Berkshire.  Mr. Wertheimer was primarily concerned with “the continued Israeli production, in the Galilee, by Israeli hands and with an Israeli brain, within an advanced and competitive world.” Obviously the Wertheimer family wanted a fair deal for the product of sixty years of effort but non-economic factors clearly played an enormous role.  We are reminded of the factors that led Bill Child to sell R.C. Willey to Berkshire Hathaway a decade earlier.  History doesn’t always repeat but it often rhymes.

As we noted recently, Berkshire was a very large company in 2006 but still relatively small compared to what it has become today.  With shareholders’ equity of $91 billion at the end of 2005, Berkshire’s purchase of 80 percent of Iscar for $4 billion represented a significant allocation of capital.  It is interesting to note that approximately half of the purchase transaction was accounted for by goodwill, representing the consideration paid in excess of identifiable assets:

Iscar

The Wertheimer family retained a 20 percent interest in the business until 2013 when they exercised a put option to sell their remaining interest (pdf) to Berkshire for $2.05 billion.  Based on this purchase, the implied value of Iscar was $10.25 billion in mid 2013, up from $5 billion seven years earlier, as Mr. Buffett noted at the time:

“Since the time IMC entered our lives, my partner, Charlie Munger, and I have enjoyed Berkshire’s association with the company, the Wertheimer family, and the company’s management team,” said Warren Buffett, Berkshire Hathaway Chairman and Chief Executive Officer. “As you can surmise from the price we’re paying for the remaining interest, IMC has enjoyed very significant growth over the last seven years, and we are delighted to acquire the portion of the company that was retained by the Wertheimer family when IMC first became a member of the Berkshire group of companies. We look forward to continuing our stewardship of this unique company founded by the Wertheimer family in Israel 60 years ago and nurtured into a truly global enterprise.”

Berkshire provides limited disclosure on Iscar in its annual reports so we do not have the information required to independently analyze Iscar’s value.  However, the valuation arrived at in 2013 was clearly set in 2006 at the time of the original acquisition.  The Wertheimer family negotiated a put option with Berkshire that specified the value of their remaining stake based on some kind of formula that clearly took into account the economic value of the company.  The model of acquiring a large majority stake from a family owned business and having the family retain significant ownership has been used before (Nebraska Furniture Mart is an example that comes to mind) and can align the interests of the family with Berkshire in the years immediately following an acquisition.  Ultimately, however, Mr. Buffett is relying on the management of these formerly family owned businesses to continue coming to work far past the point where there is any economic need to work.

After the 2013 transaction, Mr. Buffett noted that arcane accounting rules required Berkshire to substantially write down the value of the initial 80 percent ownership of Iscar due to the fact that the company acquired the remaining 20 percent.  This mystifying accounting rule also caused Berkshire to write down the value of Marmon when a similar series of transactions eventually resulted in full ownership.

Berkshire has paid a total of approximately $6 billion in aggregate for full ownership of Iscar which had a valuation in excess of $10 billion in mid 2013, and part of the $6 billion (the amount was not specifically enumerated) has been written down due to accounting requirements.  We do not know whether Iscar has remitted any cash to Berkshire over the years, or the precise amount if it has.  However, based on the information we do have, it is quite clear that Berkshire’s acquisition of Iscar worked out very well.  The Wertheimer family no longer has an ownership interest in Iscar but Eitan Wertheimer continues to be involved in the business along with the management team that he assembled over the past three decades.

Given Berkshire’s current shareholders’ equity, it would take a deal almost three times the size of the initial Iscar acquisition in 2006 to have a similar impact today.  The number of family owned businesses like Iscar of a size required to “move the needle” at Berkshire is smaller today than it was in 2006.  Nevertheless, this acquisition model can still be useful for Berkshire as well as for aspiring “mini Berkshires”.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

How to Become a Better Reader

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero. You’d be amazed at how much Warren reads–and at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”  — Charlie Munger

It is almost certain that the typical reader of this article has come across Charlie Munger’s famous quote on reading countless times.  The need to read extensively, not only when it comes to investment topics but much more broadly, is almost an article of faith for anyone who has spent considerable time studying the habits of highly successful investors.  Investing is a discipline in which one benefits from the cumulative effect of knowledge compounded over a lifetime.  In conjunction with life experience, pursuing a habit of regular reading can accelerate the wisdom required to identify opportunities with confidence.

Anyone who recognizes the truth in Charlie Munger’s statement is already well ahead of the vast majority of investors and has most likely already made efforts to emulate his approach.  For many people, doing so amounts to a completely different lifestyle in which diversions such as television are reduced or even eliminated in favor of several hours of reading per day.  However, those who are most interested in investing often make three choices that are likely to result in a sub-optimal return on the time invested.  First, most investors focus mainly on current events and therefore spend a great deal of time with newspapers and business periodicals.  Second, most investors will gravitate toward books on business or investing topics rather than adopt a more multi-disciplinary approach.  Finally, the scorecard investors use to measure their reading is often related to the sheer volume of material that has been read which puts an emphasis on speed and quantity rather than quality.

How To Read a bookThere are certain books of great value that can suffer from an overly simplistic title.  How to Read a Book, by Mortimer J. Adler and Charles Van Doren seems to fit in this category since, at a surface level, most of us have been reading books since grade school.  At varying levels of seriousness, most of us had to read hundreds of books of all types in order to graduate from college and for the most part, our intuitive sense of how to go about the process must have led to at least some success.  However, the number of truly influential books – those that we go back to mentally again and again – is a much smaller number, and perhaps it need not be so.  Perhaps we have suffered from the manner in which we have gone about reading over the years and could have retained much more value over time.

Most readers never consciously think about the various levels of reading when tackling a new book.  For the most part, readers will look at the cover, superficially skim the table of contents, and then just dive into the book and go through it in a linear manner.  However, at best, this process only goes through the first two of the four levels of reading documented in How to Read a Book. 

The first level of reading is referred to as elementary reading and is something the vast majority of people learn in grade school.  We understand what the sentences and paragraphs say in a basic sense because we understand the language that we have chosen to read in and have a decent vocabulary built over the course of many years.  However, merely understanding the words and paragraphs is only the most basic form of reading and has little to do with comprehension and true understanding of what the author is attempting to convey.  Some enhanced level of understanding occurs when one proceeds to inspectional reading which is really the art of systematic skimming.  The authors provide useful steps that will increase the return on the time spent at this level of reading.  One of the common errors is that readers often achieve only superficial knowledge of a book because they simply read through it in a linear manner rather than inspect the book systematically first.  The techniques to do so are quite valuable and most likely steps that most readers have not made explicitly in the past.

The authors emphasize that a thorough inspectional reading of a book may be all that is warranted based on the nature of the book.  It is not always necessary to proceed to the third step:  analytical reading.  Reading at this level requires a reader to go through an organized process wherein several questions are asked regarding a book and answers are sought.  As the authors state, analytical reading is “chewing and digesting it”.  This level of reading is not typically warranted if the reader is seeking entertainment or merely seeking information.  Analytical reading requires a significant time investment and it may be enough to simply do an organized inspection of a book.  It is up to the reader to determine whether it makes sense to proceed to an analytical reading of a book once the inspectional phase is complete.

Syntopical Reading is the highest form of reading because it involves reading a number of books on the same topic analytically and then placing the books in context in relation to one another and the overall subject.  This level of reading has the potential to bring about insights that are not found in any one of the books when considered in isolation.

As an example relevant to investors, one might want to conduct an analytical reading of Benjamin Graham’s The Intelligent Investor and Philip Fisher’s Common Stocks and Uncommon Profits and then come to grips with the underlying themes expressed in both volumes while drawing conclusions on investing that might not appear in either book in isolation.  This approach can, of course, be applied to other forms of literature including biographies.  It is quite possible than a thorough analytical reading of Roger Lowenstein’s Buffett: The Making of an American Capitalist and Alice Schroeder’s The Snowball: Warren Buffett and the Business of Life could lead to insights about Warren Buffett that one could not achieve by reading one of these books in isolation.

It would be difficult to do justice to the techniques expressed in How to Read a Book in a brief review, and this article is not so much a book review as a strong recommendation to pick up a copy and give the ideas serious consideration.  The fifteen distinct steps associated with reading well should resonate with most serious readers and bring about a better sense of understanding and comprehension resulting in a greater payoff for the time invested.

Charlie Munger likes to use the phrase “You are like a one-legged man in an ass kicking contest” to refer to individuals who have attempted to engage in some activity without satisfying the basic prerequisites necessary to have a good chance of success.  How to Read a Book significantly reduces the probability of being that one-legged man when it comes to reading comprehension.  It probably should be required reading for all incoming college freshmen, but it is better late than never.

In the video below, William F. Buckley interviews Mortimer J. Adler on Firing Line in 1970.  How to Read a Book was first published in 1940 and extensively revised in 1972.  Mortimer Adler died in 2001.


Book Review: Berkshire Beyond Buffett

I love running Berkshire, and if enjoying life promotes longevity, Methuselah’s record is in jeopardy.

-Warren Buffett, Berkshire Hathaway Owner’s Manual

Berkshire Hathaway will soon reach an important milestone with the fiftieth anniversary of Warren Buffett’s control of the company.  Nearly forty percent of Mr. Buffett’s tenure at Berkshire has been accomplished as a senior citizen and he is clearly not ready to retire anytime soon.  However, Berkshire shareholders are faced with the fact that an 84 year old man has an life expectancy of approximately six years.  It is prudent to consider succession issues carefully.  Mr. Buffett has assured shareholders that the company is well prepared but how can shareholders be certain?

BerkshireBeyondBuffettWarren Buffett almost certainly has higher name recognition in the United States today than all but a small number of public figures.  Even individuals who have no background in business and investing recognize Mr. Buffett’s name but what is interesting is that he is almost always characterized as an investor rather than as a manager.  In Berkshire Beyond Buffett, George Washington University Professor Lawrence Cunningham paints a compelling portrait of Berkshire’s culture that demonstrates how Mr. Buffett’s skills as a manager have been key to the company’s growth over the past two decades.

Berkshire Hathaway’s portfolio of common stocks attracts a great deal of attention, but the bulk of the value of the company has resided in wholly owned subsidiaries for quite some time.  Mr. Buffett has assembled a diverse group of businesses over the years and has characterized his management approach as delegating “almost to the point of abdication”.  While Mr. Buffett has involved himself in operating decisions in rare cases, his primary role is to allocate free cash flow generated by the non-insurance subsidiaries as well as “float” obtained from the insurance businesses.  Berkshire’s subsidiary managers have generally proven to be very capable with many of the original family owners continuing to run businesses even with no financial need to do so.

The Economist published a skeptical article on Berkshire earlier this year questioning how Mr. Buffett will “play his last hand”.  This article is useful in that it outlines many of the concerns skeptics typically point to when it comes to succession planning.  Specifically, it is alleged that Berkshire’s business model is simply not scalable or sustainable in the absence of the man who built the company.  Would a break-up of Berkshire create more long term value for shareholders after Mr. Buffett leaves the scene?

Professor Cunningham’s book is perhaps the most comprehensive examination of this question that has been published up to this point.  The book examines the origins of today’s Berkshire Hathaway and attempts to paint a picture of how Mr. Buffett has gone about building the conglomerate seemingly “by accident”.  Whether by accident or by design, over the years, Berkshire Hathaway developed a culture that ties together seemingly unrelated business units in a manner that makes Mr. Buffett’s extreme decentralization work.  Charlie Munger likes to describe the culture very succinctly as a “seamless web of deserved trust”, and Professor Cunningham’s work provides insight into how this web has developed and can be sustained.

The core of the book investigates how Mr. Buffett has balanced autonomy and authority through the examination of several Berkshire subsidiaries.  Professor Cunningham conducted numerous interviews with subsidiary CEOs as well as shareholders so the book is based on primary research and unprecedented access.  While some of the businesses have been analyzed in depth elsewhere in the past, the book also covers smaller subsidiaries that have received less attention such as the Pampered Chef.

One of the most interesting chapters goes into detail regarding the evolution of the Marmon Group, one of Berkshire’s wholly owned subsidiaries.  Marmon is a diversified conglomerate that was built by brothers Jay and Robert Pritzker. The company was considered too unwieldy and diverse to be successfully managed after the Pritzkers left the scene, but it turns out that little changed in terms of the company’s decentralized management approach.  John D. Nichols was CEO from 2002 to 2006 and Frank Ptak has been CEO since that time.  Both CEOs spent most of their careers at ITW, a diversified conglomerate with a structure similar to Marmon.  Mr. Nichols did introduce ten division presidents to logically group together Marmon’s subsidiaries but otherwise left the units mostly unchanged.

When Mr. Buffett leaves the scene at Berkshire, it is likely that the next CEO will need to create divisions since it would be very difficult to handle over eighty direct reports.  The Marmon model might offer a potential roadmap for how this can be accomplished in a manner that does not erode the operational autonomy that Berkshire has granted to subsidiaries.

Professor Cunningham concludes his book by conceding that some “slippage” is inevitable at Berkshire:

At Berkshire after Buffett, expect slippage.  Deals may not come Berkshire’s way. Offers Berkshire makes may not be on terms as agreeable as they have been.  Negotiations may be less favorable.  Getting through the screen may be a few more subpar businesses or disappointing managers.  If the big deals do not come or the great managers do not follow, returns will be lower.  But absent some extraordinary disruption, returns will not be so disappointing as to warrant dismembering Berkshire or some other radical change.  Its design for sustainability is more powerful than that.

Indeed, Berkshire Hathaway will not be the same after Warren Buffett leaves the scene.  But that is not really the question that needs to be answered.  The question really boils down to whether Mr. Buffett’s creation is worth preserving over time.  The litmus test is not going to be evaluated based on Berkshire’s stock price in the short run but based on growth of intrinsic value over many years and decades.  Logically, intelligent capital allocation across subsidiaries can remain extremely powerful even if the capital allocator in question is not Mr. Buffett.  If subsidiaries can continue to operate well in the future without significant oversight and capital allocation between subsidiaries remains intelligent, there is no reason for the model to fail anytime soon.   Professor Cunningham’s book provides ample evidence to believe that Berkshire’s business model should outlast Warren Buffett.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.