2016: How can investors tell when cost cuts have gone too far?

CAROL LOOMIS: Questions continuing to come in about the financing and working relationship that Berkshire formed with 3G a couple of years ago, and this is one of those questions:

“While 3G has been very successful in cutting costs and increasing margins at Kraft Heinz, the company has seen volumes and revenues decline.

As a long-term investor, how do you judge when a management is cutting muscle as well as fat? Can a business increase revenues while cutting costs?”

And I forgot to say, this came from Rick Smith at New York City.

WARREN BUFFETT: Well, the answer is, yes, that sometimes you can cut costs that are a mistake to cut, and you can — and sometimes you can keep costs that are a mistake to keep.

Tom Murphy had the best approach. I mean, he never hired a person that he didn’t need, and therefore, they never had layoffs.

And you might say that at headquarters at Berkshire, we follow a similar approach. You would never — we just don’t — we don’t take on anybody.

Now, I think it is totally crazy when companies are in — now, if you’re in a cyclical business, you may have to cut a workforce because there aren’t as many carloads of freight moving, or something like that, so you cut back on crane crews and all that — but the idea that you give up your staff, whatever it may be, economists or something like that, because business has slowed down — if you didn’t need them — if you don’t need them now, you didn’t need them in the first place, you know.

I mean, the people that are there just because somebody started a department, and they hired more people, and so on, I would argue that — since we’ve forgotten to insult this group so far — I would suggest that happens in investor relations departments, perhaps, or something of the sort.

You know, you get people — you get a department going and they’re always going to want to expand.

The ideal method is not to do it in the first place. But there are all kinds of American companies that are loaded with people that aren’t really doing anything or are doing the wrong thing. And if you cut that out, it should not really have any significant effect on volume.

On the other hand, if you cut out the wrong things, you could have a big effect. I mean, it can be done in a dumb way or a smart way.

My impression, with everything I’ve seen, and I’ve seen a fair amount so far, is that 3G, in terms of the cost cuts that they have made, have been extremely intelligent about it, and have not done things that will cut volume.

It is true that in the packaged goods industry, volume trends for everybody — whether they’re fat or lean in their operation — volume trends are not good. And the test will be over time — you know, three, five years — are the operations which have had their costs cut, do they do poor, in terms of volume, than the ones, that in my judgment, look very fat? So far I see no evidence of that whatsoever.

I do think at Kraft Heinz, for example, we’ve got certain lines that will decline in volume. I think we’ve got certain lines that will increase. But I think overall, the packaged goods industry is not going to go anyplace in terms of physical volume, and it may decline just a bit.

I can’t — I’ve never — I’ve never seen anybody run anything more sensibly than 3G has, in terms of taking over operations where costs were unnecessarily high, and getting those costs under control in a hurry.

And the volume question, we’ll look at as we go along. But believe me, I look at those figures every month, and I look at everybody else’s figures every month, and I try to — I’m always looking for any signs of underperformance because of any decisions made, and I’ve seen none. Charlie?

CHARLIE MUNGER: Yeah. And sometimes when you reduce volume, it’s very intelligent, because you’re losing money on the volume you’re discarding.

It’s quite common for a business, not only to have more employees than it needs, but sometimes it has two or three customers that it would be better off without. And so it’s hard to judge from outside whether things are good or bad just because volume is going up or down a little.

Generally speaking, I think the leanly-staffed companies do better at everything than the ones that are overstaffed. I think overstaffing is like getting to weigh 400 pounds when you’re a normal person. It’s not a plus.

WARREN BUFFETT: Yeah. Sloppy thinking in one area probably indicates there may well be sloppy thinking elsewhere.

And I have been a director of 19 public corporations, and I’ve seen some very sloppy operations, and I’ve seen a few really outstanding business operators. And there’s a huge, huge difference.

If you have a wonderful business, you can get away with being sloppy. We could be wasting a billion dollars a year at Berkshire, you know, 650 million after tax, that’d be 4 percent of earnings, and maybe you wouldn’t notice it. But —

CHARLIE MUNGER: I would.

WARREN BUFFETT: — it grows. (Laughter)

Charlie would notice it, so I —

But it’s the really prosperous companies that — you know, some — well, the classic case I think were the tobacco companies many years ago. I mean, they, you know, they went off into this thing and that thing and — and it was practically play money because it was so easy to make, and it didn’t require, you know — it didn’t require good management, and they took advantage of that fact. You can read about some of that in “Barbarians at the Gate.”