The Value of N+1 and Integrity
The Value of N+1 and Integrity
Quality of management drives robust opportunity
But first, some pontification…
The idea of redundancy in physical, biological and process systems is not a overly complex idea. The human body that has evolved to feature a design that encompasses redundant components and features where it has contributed to the specie’s survival and no redundancy where extra would promote the opposite risks due to vulnerabilities, excessive energy requirements, etc.
Economics is viewed as a discipline that is mainly concerned with ‘simplistic’ theorizing, centered upon constrained optimization. As such, it is ahistorical and outcome focused, ie, it does not deal with economic processes. It is argued that all parts of the economy are inhabited by complex adaptive systems operating in complicated historical contexts and that this should be acknowledged at the core of economic analysis. It is explained how economics changes in fundamental ways when such a perspective is adopted, even if the presumption that people will try to optimize subject to constraints is retained. This is illustrated through discussion of how the production function construct has been used to provide an abstract representation of the network structures that exist in complex adaptive systems such as firms. It is argued that this has led to a serious understatement of the importance of rule systems that govern the connections in productive networks.
John Foster, Why is Economics not a Complex Systems Science?, 2004
In systems that people make, if it involves safety of the user or the public, there is often strict regulations and oversight of design concepts to incorporate redundancy to promote some minimum level of risk that is deemed acceptable. For many businesses that operate, this concept is either non-existent or underutilized. For some industries that are heavily regulated such as banks, insurance, utilities, these concepts are integrated into the requirements for operation but as is evident in the recent Silicon Valley Bank failure, there are no guarantees of their success.
The problem of course, is misaligned incentives. In a physical system, like a suspension bridge, there are ways to model the risks somewhat accurately and control many of the parameters that would be difficult to misrepresent or hollow out. Risk management in a bridge design, although highly technically demanding to understand, is more well defined such that the uncertainties can be addressed with acceptable levels of margin in the design. When considering the capitalization requirements of a bank, it would seem that there are always ways to shift risk in the system instead of address it head on and simply add margin to address uncertainty. It is a complex adaptive system that will move its characteristics depending on what constraints are placed upon it.
A complex adaptive system is a system that is complex in that it is a dynamic network of interactions, but the behavior of the ensemble may not be predictable according to the behavior of the components. It is adaptive in that the individual and collective behavior mutate and self-organize corresponding to the change-initiating micro-event or collection of events.
And now, to get to the point…
That’s all well and good but what is the point? The idea of having some useful redundancy in a business that otherwise will have agents that are not incentivized to consider this resilience (as it has a cost contrary to what they are trying to optimize - short term profit). The idea of having N+1 (or redundancy) can also apply to how the business plans and prepares for the next opportunity or downturn in its core business. If you use a conglomerate as an example, there are some that take on debt and have very little cash on hand to pursue a future acquisition when they go on sale. Berkshire Hathaway has often been ridiculed for hoarding cash when stocks go on long bull market runs such as the late 1990’s and 2010’s. At the time, it would appear that Buffett is missing the opportunities as valuations increase and markets rally for years. In reality, this behavior, which is impregnated in the organization’s culture, is exactly why it has trounced the performance of basically every business in the modern world over decades.
As for the future, Berkshire will always hold a boatload of cash and U.S. Treasury bills along with a wide array of businesses. We will also avoid behavior that could result in any uncomfortable cash needs at inconvenient times, including financial panics and unprecedented insurance losses. Our CEO will always be the Chief Risk Officer – a task it is irresponsible to delegate. Additionally, our future CEOs will have a significant part of their net worth in Berkshire shares, bought with their own money. And yes, our shareholders will continue to save and prosper by retaining earnings. At Berkshire, there will be no finish line.
- Warren Buffett, 2022 Berkshire Hathaway Shareholder Letter
The Takeaway
The real takeaway here is that there are intangible qualities such as the incentives, motivation, reputation and integrity of management that will be crucial in determining how the business will deal with bumps in the road. When there is no finish line, the objectives that are optimized will not be short term in nature and not be about winning when times are good, but rather surviving and thriving over the long term.
Now why did I ever sell Berkshire? Darn.
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Excellent article Simon.