Why Smart Managers Make Dumb Decisions
- The Institutional Imperative: An invisible force that makes good managers act irrationally
- It explains why companies resist change, waste money, and follow competitors blindly
- Buffett calls it “my most surprising discovery” about business
- Good management means resisting these pressures — bad management gives in
Buffett’s Most Surprising Discovery
In 1989, Buffett shared something unexpected:
“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’ In business school, I was given no hint of the imperative’s existence… I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so.”
This is remarkable. He’s not criticizing bad managers. He’s saying good managers — smart, experienced, well-meaning people — still make irrational decisions because of institutional pressures.
Four Ways It Shows Up
Buffett identified four symptoms:
1. Resistance to Change
Organizations develop momentum. Strategies harden. Cultures calcify. Even when the world changes, the institution keeps doing what it’s always done.
Example: Kodak Kodak invented the digital camera in 1975. Their managers saw the threat. But switching to digital would destroy their profitable film business. So they kept making film — until bankruptcy in 2012.
The managers weren’t stupid. They were trapped.
2. Available Money Gets Spent
A company earns $1 billion in profit. Does it: - Return the money to shareholders, or - Find something — anything — to spend it on?
Usually the second option.
Example: Oil Companies (2005-2008) High oil prices created huge cash flows. Rather than returning the cash, companies made expensive acquisitions at peak prices. When oil crashed, they wrote off billions.
The money was there. It demanded to be spent.
3. Employees Justify the Boss’s Wishes
The CEO wants to buy a competitor. Suddenly, every analysis confirms it’s a brilliant idea.
This isn’t conspiracy. It’s human nature. People want to please the boss. Analysts who raise objections don’t get promoted.
Example: Almost every acquisition Most big acquisitions come with “strategic rationale” presentations showing great returns. Most big acquisitions destroy value. The presentations were written to justify decisions already made.
4. Following the Herd
“Everyone else is doing it” becomes sufficient justification.
Competitors are acquiring? We should too. Competitors are entering China? We can’t be left out. Competitors pay executives $20 million? We need to match.
Example: The Dot-Com Bubble By 1999, every traditional company was launching an internet strategy. Most had no idea why. “Our competitors are doing it” was enough.
The institutional imperative isn’t about individual failure. It’s about structural pressure.
Managers who resist it face real consequences: - “You’re not ambitious enough” - “You’re letting competitors get ahead” - “The market expects growth”
Being rational often requires being willing to look foolish. Most won’t take that risk.
How to Spot Bad Management
When evaluating a company, look for warning signs:
🚩 Empire building Acquisitions that grow revenue but not profits. “We’re now a $10 billion company!” means nothing if returns didn’t improve.
🚩 Following competitors Major strategy changes that mirror what rivals just announced. Original thinking is rare.
🚩 Excessive executive pay If the justification is “competitive pay,” that’s the institutional imperative talking.
🚩 Spending all the cash Companies that never return money to shareholders despite having no good investment opportunities.
How to Spot Good Management
Look for the opposite:
✓ Returning excess cash Dividends and buybacks show discipline. “We couldn’t find anything good to buy, so here’s your money back.”
✓ Saying no to deals “We passed on that acquisition because it didn’t make economic sense.” Rare and valuable.
✓ Going against the crowd Buying when others are scared. Selling when others are greedy. Acting independently.
✓ Owner mentality Managers who own significant stock behave differently. Their interests align with yours.
Buffett’s Test for Management
From his 1983 letter:
“We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.”
Simple rule: If management keeps $1, it should create at least $1 of value.
Many companies fail this test. They keep the money, waste it on bad acquisitions or pet projects, and destroy value.
Good management either invests wisely or returns the cash. Bad management hoards and squanders.
Why This Matters for Valuation
You might calculate that a business is worth $100 per share based on its profits.
But if management: - Wastes cash on bad acquisitions - Pursues growth for its own sake - Copies competitor mistakes - Pays themselves excessively
Those profits never reach you. The intrinsic value calculation assumed rational capital allocation. The institutional imperative ensures many managers aren’t rational.
A wonderful business with bad management is not a wonderful investment.
The Institutional Imperative is an invisible force that makes good managers act irrationally — resisting change, spending available cash, justifying the boss’s wishes, and following competitors blindly.
When evaluating management, look for discipline: returning excess cash, saying no to deals, and acting independently of the herd.
A business’s value depends not just on its profits, but on whether management will actually deliver those profits to shareholders.
Next up: Part 7 — The Yardstick Rate. How does Buffett compare different investments? It’s simpler than you’d think.
References
Buffett, W. (1989). Berkshire Hathaway Shareholder Letter. Berkshire Hathaway Inc.
Buffett, W. (1983). Berkshire Hathaway Owner’s Manual. Berkshire Hathaway Inc.