2001 Annual Meeting2001 年度股东大会

2001 meeting

Morning session

1. Formal business meeting

(Video recording begins with meeting already in progress)

WARREN BUFFETT: And — (laughter) — Andy [Heyward], if you’re here, you could stand up, I think the crowd would like to say thanks. (Applause)

We have one other guest, too. After doing an incredible job for all Berkshire shareholders and particularly for Charlie and me, Ralph Schey retired this year. But Ralph and Luci, I believe, are here. And [if] Ralph and Luci would stand up, the shareholders and I would like to say thanks. (Applause)

Scott Fetzer was one of the best acquisitions we ever made, but the reason it was among the very best was Ralph. And a great many of the other companies that we own now, our ownership was made possible because of the profit that Ralph delivered over the years. So, thanks very much, Ralph.

Now we will come to order. I will go through this fast. I’m Warren Buffett, chairman of the board of directors of the company, and I welcome you to this 2001 annual meeting of shareholders.

I will first introduce the Berkshire Hathaway directors that are present in addition to myself.

First of all, of course, is Charlie, on my left. And if you’ll — the directors will stand when I give your name.

Howard Buffett, Susan Buffett — she was the voice on the songs, the ones that were sang — sung well — Malcolm G. Chace, Ronald L. Olson, and Walter Scott Jr.

Also with us today are partners in the firm of Deloitte and Touche, our auditors. They are available to respond to appropriate questions you might have concerning their firm’s audit of the accounts of Berkshire.

Mr. Forrest Krutter is secretary of Berkshire, and he will make a written record of the proceedings. Miss Becki Amick has been appointed inspector of elections at this meeting. She will certify to the count of votes cast in the election for directors.

The named proxy holders for this meeting are Walter Scott Jr. and Marc D. Hamburg. We will conduct the business of the meeting, and then adjourn the formal meeting. After that, we will entertain questions that you might have.

Does the secretary have a report of the number of Berkshire shares outstanding, entitled to vote, and represented at the meeting?

FORREST KRUTTER: Yes, I do. As indicated in the proxy statement that accompanied the notice of this meeting, that was sent by First-Class Mail to all shareholders of record, on March 2, 2001, being the record date for this meeting, there were 1,343,041 shares of Class A Berkshire Hathaway common stock outstanding, with each share entitled to one vote on motions considered at the meeting and 5,505,791 shares of Class B Berkshire Hathaway common stock outstanding, with each share entitled to 1/200th of one vote on motions considered at the meeting.

Of that number, 1,116,384 Class A shares, and 4,507,896 Class B shares are represented at this meeting by proxies returned through Thursday evening, April 26.

WARREN BUFFETT: Thank you. That number represents a quorum, and we will therefore directly proceed with the meeting.

First of order of business will be a reading of the minutes of the last meeting of shareholders. I recognize Mr. Walter Scott Jr. who will place a motion before the meeting.

WALTER SCOTT JR.: I move that the reading of the minutes of the last meeting of the shareholders be dispensed with.

WARREN BUFFETT: Do I hear a second?

VOICES: Aye.

WARREN BUFFETT: The motion has been moved and seconded. Are there any comments or questions? We will vote on this motion by voice vote. All those in favor, say, “Aye.”

VOICES: Aye.

WARREN BUFFETT: Opposed, say, “Bye, I’m leaving.” (Laughter)

The motion is carried. The first item of business of this meeting is to elect directors. If a shareholder is present who wishes to withdraw a proxy previously sent in and vote in person on the election of directors, he or she may do so.

Also, if any shareholder that is present has not turned in a proxy, and desires a ballot in order to vote in person, you may do so. If you wish to do this, please identify yourself to meeting officials in the aisles, who will furnish a ballot to you. Would those persons desiring ballots please identify themselves, so that we may distribute them?

I now recognize Mr. Walter Scott Jr. to place a motion before the meeting with respect to election of directors.

WALTER SCOTT JR.: I move that Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Jr. be elected as directors.

VOICE: I second the motion.

WARREN BUFFETT: It has been moved and seconded that Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Jr. be elected as directors. Are there any other nominations? Is there any discussion?

The nominations are ready to be acted upon. If there are any shareholders voting in person, they should now mark their ballots on the election of directors and allow the ballots to be delivered to the inspector of election.

Would the proxy holders please also submit to the inspector of elections a ballot on the election of directors, voting the proxies in accordance with the instructions they have received?

Miss Amick, when you are ready, you may give your report.

BECKI AMICK: My report is ready. The ballot of the proxy holders, in response to the proxies that were received through last Thursday evening, cast not less 1,126,480 votes for each nominee.

That number far exceeds a majority of the number of the total votes related to all Class A and Class B shares outstanding.

The certification required by Delaware law of the precise count of the votes, including the additional votes to be cast by the proxy holders, in response to proxies delivered at this meeting, as well as those cast in person at this meeting, if any, will be given to the secretary to be placed with the minutes of this meeting.

WARREN BUFFETT: Thank you, Miss Amick.

Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Jr. have been elected as directors.

The next item of business was scheduled to be a proposal put forth by Berkshire shareholder Bartlett Naylor. On April 20th, 2001, Mr. Naylor advised us he was withdrawing his proposal. Accordingly, we will not have the proposal presented at this meeting.

At the adjournment of the business meeting, I will respond to questions you may have that relate to the business of Berkshire, but do not call for any action at this meeting.

Does anyone have any further business to come before this meeting, before we adjourn? If not, I recognize Mr. Walter Scott Jr. to place a motion for the meeting.

WALTER SCOTT JR.: I move this meeting be adjourned.

WARREN BUFFETT: Motion to adjourn has made and seconded. We will vote by voice. Is there any discussion? If not, all in favor say, “Aye.”

VOICES: Aye.

WARREN BUFFETT: Opposed say, “No.” Meeting’s adjourned. (Applause)

I ask you, am I getting slower in my old age? No, I’m — (Laughter)

Now, the first — we’re going to go —

We have eight microphones strategically placed. We have the first two on my right. Far back, three and four, and over to this back area, over here, and then up front for the seven and eight.

And if you have a question, just go to the microphone, and queue up at the microphone, and we’ll keep rotating, like I say, until noon. Then we’ll have a break, and then we’ll start again around 12:30, or thereabouts, and go until 3:30.

2. Four-year-old and Buffett look ahead to Berkshire’s future

WARREN BUFFETT: Now, first question in area 1, we have a special guest.

I received a letter from Mark Perkins on April 5th, telling me about his daughter, who has been a shareholder since she was six months old.

And she’s going to be four in November, and she would like — Marietta would like to ask the first question.

And frankly, I take all the questions from four-year-olds, and Charlie handles them from anybody — (laughter) — that’s been around a little longer.

So Marietta, if you’ve got the microphone there, would you ask your question, please?

VOICE: Ask him. (Inaudible)

MARIETTA: (Inaudible)

VOICE: I’m Marietta.

MARIETTA: Marietta.

VOICE: I’m three. Speak up.

MARIETTA: I’m three.

VOICE: Berkshire Hathaway fistful of dollars.

MARIETTA: (Inaudible) dollars. (Laughter)

VOICE: Her — actually, her question was, she said she was three, and she says, “Berkshire Hathaway fistful of dollars,” and she says, “What should we invest in now” so that she’ll be ready when she goes to college?

WARREN BUFFETT: What should she invest in, or what should Berkshire invest in?

VOICE: What should Berkshire invest in?

WARREN BUFFETT: Well, Berkshire would like very much to buy businesses of the same quality, and with managements of the same quality, and at prices consistent with the eight businesses that we’ve bought over the last 16 or 18 months.

Our first preference is, and has been for many decades — although I would say most observers didn’t seem to realize it — but our first preference has always to been — to be buying outstanding operating businesses. And we’ve had a little more luck in that respect lately.

We also own lots of marketable securities. We’ve bought many of those, for example, in the mid-’70s, that did very well for us. But the climate has not been as friendly toward making money out of marketable securities.

And we, frankly, prefer — we prefer the activities associated with owning and operating businesses over time.

So what we hope to do, Marietta, is by the time you’re ready to go to college, I would hope that

well, first of all, I’d hope I’m still around. (Laughter)

But beyond that, I would hope that we would have — you’ll be ready in about 14 years or so. I would hope that we would have another, maybe, 40 businesses or so that would be added. And I would hope that we would have every business that we have now.

And I would hope we would not have more shares outstanding, or any — at least any appreciable number of more shares outstanding.

If we can get all that done, I think you’ll probably be able to afford college.

Charlie, do you have anything to add?

CHARLIE MUNGER: No. (Laughter)

WARREN BUFFETT: And there’s some things in life, Marietta, you can really count on. (Laughter)

3. Tech sector not comparable to pharmaceuticals

WARREN BUFFETT: OK, let’s go to microphone number 2.

AUDIENCE MEMBER: Good morning, Mr. Buffett, Mr. Munger.

VOICE: (Inaudible)

AUDIENCE MEMBER: Oh, sorry. OK.

If you want to trade a share of Berkshire A for 30 shares of Berkshire B, as you had mentioned before, a personal stock split, or vice versa, is this considered a wash sale for tax purposes?

Also, I’d like to ask you a question which you’ve heard before, but in a slightly different context. A few years ago, you said you had made a mistake by not buying shares of the major pharmaceutical companies around 1993.

You cited their value to society, as well as their terrific growth, high profit margins, and great potential. You said that while you didn’t know which companies would do the best, you could’ve made some kind of sector play, because the entire sector had been decimated.

These exact same words, including those about not knowing which businesses will dominate over time, can also be used to describe another industry, which has recently been decimated.

This is industry is, of course, technology. How do you see these two investment ideas, pharmaceuticals in ’93 and technology now, and what difference in the two situations makes the first a good opportunity for Berkshire, and the second not one?

WARREN BUFFETT: Well, Charlie answers all the questions about mistakes, so I will turn the second question over to him. (Laughter)

CHARLIE MUNGER: Personally, I think that the future of the pharmaceutical industry was easier to predict than the future of the high-technology sector.

In the pharmaceutical sector, almost everybody did well, and some companies did extremely well. In the other sector, why, there are many permanent casualties in the high-tech sector.

WARREN BUFFETT: Yeah, I would say that there’s certainly nothing obvious to us about the fact that the tech sector — as a group — viewed in aggregate — would be a good buy or be undervalued.

Whereas we should have had enough sense to recognize that the pharmaceutical industry, as a group, was undervalued.

But the pharmaceutical industry has a far, far better record of returns on large amounts of equity over time, and with a high percentage of the participants having those returns, than the tech industry. I wouldn’t regard those two as comparable at all.

4. Tax implications for exchanging Berkshire share classes

WARREN BUFFETT: Your first question about exchanging and whether you have a wash sale, and I think you indicated exchanging from B into A.

If you actually, physically, have a share of A, and turn it in for 30 shares of B, that is not a taxable transaction, so there is no sale under such a circumstance. If you —

There would be no reason, unless the B was at a significant discount, to actually sell the A and buy the B, but I — and I’m not giving tax advice on this — but I would think that they — I think the tax code refers to “substantially identical” securities when they talk about wash sales.

And I would think that you — that the IRS would be entitled to, at least, raise the question if you had an A share you were selling at a loss, and replacing it with 30 shares of B.

You’d have a better argument than if you bought a share of A back the next day, if you were establishing a loss. If you were establishing a gain, you’d have no reason — you know, they’re not worried about wash sales in that respect.

You can’t go from B to A by exchange, but you could go by selling 30 shares of B in the market, and buying a share of A.

Again, if that were being done at a loss, I think the IRS could well argue that they were substantially identical, but you could argue otherwise.

Charlie?

CHARLIE MUNGER: No, no, I think the IRS would win.

WARREN BUFFETT: Yeah. (Laughter)

Charlie might even go state’s evidence, you know, if there was a fee to testify.

5. Berkshire isn’t hindered by state insurance regulators

WARREN BUFFETT: OK, let’s go to zone 3.

AUDIENCE MEMBER: I’m Dan Blum (PH) from Seattle, Washington.

As an insurance holding company, Berkshire Hathaway is subject to regulation by insurance departments in every state in which GEICO or your other insurance subsidiaries do business.

Has that handicapped or affected your operations in any way? And do you have any trenchant or wise observations to make about governmental regulation in that context?

WARREN BUFFETT: Yeah, we’ve really not been impeded in any way by the fact that — Berkshire Hathaway itself is not an insurance company, but it owns various insurance companies. Of course, it owns a lot of other companies, too.

But being the holding company of insurance companies, which indeed are regulated by the states in which they’re admitted, it really has not slowed down any acquisition.

They are not — whereas with the Public Utility Holding Company Act, under that statute, the authorities are directed to be concerned with the activities of the holding company. And in the banking business, to some extent, they are.

In the insurance business, there’s relatively little in the way of regulation or oversight that extends up to the holding company. So, it has not slowed us down in that business, but it’s been reported recently in the electric utility business.

There’s a statute from 1935, the Public Utility Holding Company Act, the acronym is that euphonious term, PUHCA. (Laughter)

The Public Utility Holding Company Act has a lot of rules about what the parent company could do. And that act was put on the books because the holding companies of the ’20s, most particularly ones held by — formed by — Sam Insull, but there were others.

There were many abuses, and a good many of those abuses involved what took place at the holding company. So it was quite understandable that that act was passed in the ’30s. And it achieved a pro-social purpose at the time.

I don’t think there’s anything, frankly, pro-social about limiting Berkshire’s ability to buy into other utilities. We can buy up to five percent of the stock. But we might well, in the last year or two, have bought an entire utility business if it were not — if that statute weren’t present.

So we’re handicapped by the utility holding company statute, we are not handicapped, in my view, by any state insurance statutes.

Charlie?

CHARLIE MUNGER: Nothing to add. (Laughter)

6. “Pain today, gain tomorrow” insurance transactions

WARREN BUFFETT: Zone 4?

AUDIENCE MEMBER: Good morning.

WARREN BUFFETT: Good morning.

AUDIENCE MEMBER: Steve Bloomberg, from Chicago. I have two questions regarding the insurance operations.

With regard to the reinsurance contracts, which were written at what some consider and call “good losses,” you’ve discussed those insurance contracts in your report, indicating that it’s generated 482 million of losses in the year 2000.

Do we need an annual schedule disclosing the aggregate amortized charges of all current and past such deals, to make our adjustments, to reflect economic reality?

WARREN BUFFETT: Well, there are two unusual-type deals, and you referred to one type, what I call the “pain today, gain tomorrow,” or good losses-type deals.

And under the deals you’re describing, we record a usually quite significant loss in the current year, and then we have the use of float for many years to come, and there are no subsequent charges against that.

So in respect to those contracts, the important thing is that we tell you — and we should tell you — really, every quarter if they’re significant, and certainly yearly, any significant items that fall in that category.

And as you mentioned, you know, we had over 400 million last year. We had a significant amount the year before.

We have not had a significant amount this year. I think, in the first quarter, there may have been a 12 million charge for one of those.

If they’re significant, we’re going to tell you about them.

It’s a one-time adjustment in your mind that, in effect, should — you should regard as different than any other type of underwriting loss that we experience, because we willingly enter into these.

We take the hit the first year, and accounting calls for that. And over the life of the contract, we expect to make money. And our experience would be that we do make money.

But we’ll tell you about any significant item of that sort, so that you will be able to make an adjusted cost to float. I reported our cost to float last year at 6 percent, which is high. It’s not unbearable, but it’s high, very high.

And included in that 6 percent cost was — about a quarter of it came from these transactions that distorted the current year figure. And therefore, our cost of float, if we hadn’t willingly engaged in those transactions, would’ve been about 4 1/2 percent.

I should mention to you that I expect that our cost of float — I said in the annual report — that absent a mega-catastrophe — and I might define a mega-catastrophe as insured losses, we’ll say, of 20 billion or more, or something on that order — absent a mega-catastrophe, we expected our cost of float to come down this year, and I said perhaps substantially.

In the first quarter, our cost of float will probably run just a touch under 3 percent, and — on an annualized basis.

And I think that — I think the trend is in that direction, absent a mega-catastrophe. I would expect the cost of float, actually, to come down substantially this year.

But if we were to take on some of these “pain today, gain tomorrow” transactions — and we don’t have any in the works at the moment — but if we were to take those on, then it would be reflected in our cost of float, and we would lay out the impact of that sort of transaction.

Charlie?

CHARLIE MUNGER: Yeah, I think almost all good businesses have occasions where they’re making today look a little worse than today would otherwise be, to help tomorrow. So I regard these transactions as very much the friends of the shareholders.

WARREN BUFFETT: We have a second type of transaction, just to complete, which we also described in the report, which also creates a large amount of float, but where accounting rules spread the cost of that transaction over the life of the float.

And those do not distort the current-year figures, but they do create an annual charge that exists throughout the life of float. And that charge with us is running something over $300 million a year.

But there again, it’s a transaction that we willingly and enthusiastically engaged in. And that has this annual cost attached to it.

So when you see our cost to float at 3 percent, annualized, in the first quarter, it includes, probably, a $80 million charge or so, relative to those retroactive insurance contracts, which were the second kind described in the report.

I recognize this accounting is, you know — and even the transactions — are somewhat Greek to some of you. But they are important, in respect to Berkshire, so we do want to lay them out in the annual report for those who want to do their own calculations of intrinsic value.

7. “What really costs … are the blown opportunities”

WARREN BUFFETT: Zone 5?

AUDIENCE MEMBER: Good morning, gentlemen, my name is Jay Parker. I’m from Washington State. And this question regards mistakes. So that being the case, it should probably be directed to Mr. Munger.

Mr. Munger, I know you’re fond of evoking humility to promote rational thought. So my question is, what’s the most recent business mistake that you’ve made, Mr. Munger, and why did it occur? (Laughter)

WARREN BUFFETT: I’m going to take notes on this one. (Laughter)

CHARLIE MUNGER: The mistakes that have been most extreme in Berkshire’s history are mistakes of omission. They don’t show up in our figures. They show up in opportunity costs.

In other words, we have opportunities, we almost do it. In retrospect, we can tell that we were very much mistaken not to do it.

In terms of the shareholders, those are the ones in our history that it really cost the most. And very few managements do much thinking or talking about opportunity costs. But Warren, we have blown —

WARREN BUFFETT: Billions and billions and billions. I might as well say it. (Laughter)

CHARLIE MUNGER: Right, right. And we keep doing it. (Laughter)

WARREN BUFFETT: Some might say we’re getting better at it. (Laughter)

CHARLIE MUNGER: I don’t like mentioning the specific companies, because the — you know, we may, in due course, want to buy them again and have an opportunity to do so at our price.

But practically everywhere in life, and in corporate life, too, what really costs, in comparison with what easily might have been, are the blown opportunities. I mean, it just — it’s an awesome amount of money.

When I was somewhat younger, I was offered 300 shares of Belridge Oil. Any idiot could’ve told there was no possibility of losing money, and a large possibility of making money. I bought it.

The guy called me back three days later, and offered me 1,500 more shares. But this time, I had to sell something to buy the damn Belridge Oil. That mistake, if you traced it through, has cost me $200 million.

And I — it was all because I had to go to a slight inconvenience and sell something. Berkshire does that kind of thing, too. We never get over it. (Laughter)

WARREN BUFFETT: Yeah. I might add that when we speak of errors of omission, of which we’ve had plenty, and some very big ones, we don’t mean not buying some stock where we — a friend runs it, or we know the name and it went from one to 100. That doesn’t mean anything. It’s only —

We only regard errors as being things that are within our circle of competence. So if somebody knows how to make money in cocoa beans, or they know how to make money in a software company or anything, and we miss that, that is not an error, as far as we’re concerned.

What’s an error is when it’s something we understand, and we stand there and stare at it, and we don’t do anything. Or worse yet, what really gets me is when we do something very small with it. We do an eyedropper’s worth of it, when we could do it very big.

Charlie refers to that elegantly when I do that sort of thing as when I’m sucking my thumb. (Laughter)

And there really — I mean, we have been thumbsuckers at times with businesses that we understood well. And it may have been because we started buying, and the price moved up a little, and we waited around hoping we would get more at the price we originally started — there could be a lot of things.

But those are huge mistakes. Conventional accounting, of course, does not pick those up at all. But they’re in our scorebook.

8. Not worried “at all” about product liability involving sugar

WARREN BUFFETT: Zone 6, please.

AUDIENCE MEMBER: My name is Joseph Lapray (PH). I’m from Minneapolis, Minnesota.

In recent years, tobacco companies have been compelled to pay large damages for marketing their unhealthy, but discretionary, products. My question has two parts.

First, does the potential for similar damage liabilities reduce the intrinsic value of Coca-Cola, See’s Candies, Dairy Queen, or any other business, which sells discretionary products of questionable healthfulness? Not that I don’t like these products.

And second, are either of you concerned that a possible erosion in the principle of caveat emptor is undermining the legal basis of contracts, in general? Thank you for taking my question.

WARREN BUFFETT: Well, the products you described, I’ve been living on for 70 years, so — (laughter) — they’ll probably haul me in as a witness if I — that they don’t do much damage.

No, I think, if — you know, if you’re opposed to sugar and the — I think the average human being eats something like 550 pounds dry weight of food a year. And I think 125 pounds, or thereabouts — I’d have to look at it — it consists of sugar in one form or another.

I mean, it’s in practically every product that you have, and happens to be in Coca-Cola, it happens to be in See’s Candy, but it’s in practically everything you’re — I mean, it’s over 20 percent of what Americans are consuming, one way or another.

And, you know, the average lifespan of Americans keeps going up. So, I would not be worried at all about product liability in connection with those companies.

But product liability, generally, is an area that is a fertile field for the plaintiff’s bar. And it’s — we are conscious in buying into businesses, and we have passed up some businesses, because we were worried about the product liability potential.

Unless there is some legislative solution, I think you will see more and more of the GDP going into liability awards. And whether there will be any change by legislation, I don’t know. But, you know, it’s a big field.

And the lottery ticket aspect of it is so attractive. Because if an attorney can gamble a modest amount of time, or even a reasonable amount of time, and have a potential payoff of 10, or 20, or maybe, in some cases, hundreds of millions of dollars, you know, that’s a decent lottery ticket. Who knows what 12 people, you know, are going to be on the jury?

As one of my friends who’s a lawyer said, you know, he said, “Lincoln said, ‘You can fool all of the people some of the time, and all of the — some of the people all of the time, and all of the people some of the time, but not all of them all the time.’” He says, “I’m just looking for 12 that you can fool all of the time.” You know, and — (Laughter)

You know, and all you have to do is get an award. And the odds are fairly favorable in a nation where lots of zeros have sort of lost meaning to people. So it’s a very real concern in any business we get into, in terms of trying to evaluate product liability.

Charlie?

CHARLIE MUNGER: What’s particularly pernicious is the increasing political power of the plaintiff’s contingency, the bar.

If you’re on a state Supreme Court, for — in most places, you’re on for life. If you — at least, you’re on for life if you want to stay for life.

And the one thing that could get you off the court would be to really irritate some important group. And I think that greatly helps a lot of abusive conduct in the courts.

I think the judges of the country haven’t been nearly as tough as they should be on junk science, junk economic testimony, trashy lawyers. And I don’t see — (applause) — and I don’t see many signs that it’s getting better.

In Texas, they actually improved the Supreme Court of Texas, which really needed it. So, there are occasional glimmers of life.

WARREN BUFFETT: We make our decisions in insurance and in buying businesses with a very pessimistic attitude toward the chances of that particular ill that Charlie described being even moderated.

I mean, we think if — we would project out that the trend would accelerate, but that’s just our natural way of building in a margin of safety in decisions.

Don’t worry about eating the See’s candy, or the Dairy Queen, or the Coke.

You know, if you read the papers long — I use a lot of salt, and, you know, I was always being warned about that. And then, you know, few years ago they started saying, “You know, you can’t get enough salt” and all that. I don’t know what the answer is, but I feel terrific. (Laughter)

9. We don’t “have cash around just to have cash”

WARREN BUFFETT: Zone 7. (Applause)

AUDIENCE MEMBER: Good morning. I’m Murray Cass from Markham, Ontario.

The financial community relies heavily on the P/E ratio when evaluating prospective investments.

When you buy a company, you must certainly consider not just the future stream of earnings but also the company’s financial condition, among other things. By financial condition, I’m speaking mainly of cash and debt.

But the P/E doesn’t take into consideration either cash or debt. Occasionally, you see a company with consistently positive free cash flow trading just over cash value, effectively giving away the future earnings. In cases like this, the P/E looks terribly overstated unless adjusted for cash and debt.

I’ve always preferred companies with oodles of cash to those burdened with lots of debt. And then I read Phil Fisher’s book, “Conservative Investors Sleep Well.”

Well, I haven’t slept well since. He really confused me when he commented that “hoarding cash was evil.” He wrote that instead, “Companies should either put the cash to good use or distribute it to shareholders.” Can I get your thoughts on this?

WARREN BUFFETT: Well, there are times when we’re awash in cash. And there have been plenty of times when we didn’t have enough cash.

Charlie and I, I remember in the late ’60s, we were — when bank credit was very difficult — we were looking for money over in the Middle East. You remember that, Charlie?

CHARLIE MUNGER: Yes, I do.

WARREN BUFFETT: Yeah, and —

CHARLIE MUNGER: They wanted us to repay it in dinars.

WARREN BUFFETT: Yes, and the guy that wanted us to repaint it — repay him — in dinars — or “deeners,” or whatever the hell they call them — (laughter) — was also the guy that determined the value of those things.

So, we — (laughter) — were not terribly excited about meeting up with him on payday and having him decide the exchange rate on that date. (Laughter)

But we, obviously, are looking every day for ways to deploy cash.

And we would never have cash around just to have cash. I mean, we would never think that we should have a cash position of X percent. And I — frankly, I think these asset allocation things that tacticians in Wall Street put out, you know, about 60 percent stocks and 30 — we think that’s total nonsense.

So, we want to have all our money — (applause) — working in decent businesses. But sometimes we can’t find them, or sometimes cash comes in (un)expectedly, or sometimes we sell something, and we have more cash around than we would like.

And more cash around than we would like means that we have 10 or 15 cents around. Because we want money employed, but we’ll never employ it just to employ it. And in recent years, we’ve tended to be cash heavy, but not because we wanted cash per se.

In the mid-’70s, you know, we were scraping around for every dime we could find to buy things. We don’t like lots of leverage, and we never will. We’ll never borrow lots of money at Berkshire. It’s just not our style.

But you will find us quite unhappy over time if cash just keeps building up. And I think, one way or another, we’ll find ways to use it.

Charlie?

CHARLIE MUNGER: I can’t add anything to that.

10. Costs vary by type of business

WARREN BUFFETT: Zone 8.

AUDIENCE MEMBER: Good morning. My name is Mark Dickson (PH) from Sarasota, Florida. And I’d like to thank you for providing this forum for all of us. It’s wonderful.

In past years, you’ve been very specific about some of the numbers related to Coca-Cola, Wells Fargo, Rockwood — specifically like with Coca-Cola — cost of aluminum, and sugar, and all that. It goes into the bottom line of Coca-Cola.

Can you provide some of the specific numbers that go into some of your more recent purchases over the last couple years?

WARREN BUFFETT: Well, they have such different characteristics. That’s very difficult. I mean, we have service businesses such as FlightSafety, and Executive Jet is a service business.

And, you know, in many of those companies, the big cost is personnel. I mean, we need people with — at a FlightSafety, we’ve got a lot of money invested in simulators. We’ll put over $200 million into simulators this year, just as we did last year.

So we have a big capital cost in that business, and then we have a big people cost because we are training pilots. And that’s very person-on-person intensive. NetJets, part of Executive Jet, very people-intensive. I mean, we are absolutely no better than the people that interact with our clientele.

You get into something like the carpet business, and maybe only 15 percent of your revenues will be accounted for by employment costs. And you’re a very heavy raw material buyer. I mean, you’re buying lots of fiber.

So it varies enormously by the kind of business you’re in.

I mean, when we’re in the insurance business, you know, we’re in the business of paying future claims. And that’s our big cost. And that’s — obviously, involves estimates because sometimes we’re going to pay the claim five, 10, or 20 years later. We’re not going to know about it sometimes till 20 years later.

So, it’s very hard to generalize among the businesses.

If you’re in the retail business, which we are in the furniture and jewelry in a significant way, purchased goods are very — obviously — very important. We don’t manufacture our own goods to any extent in those businesses.

And then, the second cost, of course, is labor in a business like that.

But we don’t have any notions as to what we want to buy based on how their costs are segmented. What we really are looking for is an enduring competitive advantage. I mean, that’s what’s going through our mind all the time.

And then we want, obviously, top-notch people running the place, because we’re not going to run them ourselves. So those are the two factors we look at.

We want to understand the cost structure, but Charlie and I can understand the cost structure of many companies — there’s many we can’t — but we can understand a good many companies.

And we don’t really care whether we’re buying into a people-intensive business, a raw material-intensive business, a rent-intensive business. We do want to understand it and understand why it’s got an edge against its competitors.

Charlie?

CHARLIE MUNGER: Yeah, basically, to some extent we’re like the hedgehog that knows one big thing. If you generate float at 3 percent per annum and buy businesses that earn 13 percent per annum with the proceeds of the float, we have actually figured out that that’s a pretty good position to be in. (Laughter)

WARREN BUFFETT: It took us a long time. (Laughter)

Incidentally, I would hope that we would — and actually expect that — absent a mega-catastrophe — that 3 percent figure will come down over the next, well, in the near future.

But a mega-catastrophe could change all of that. I mean, if you had a $50 billion insured catastrophe — Tokyo earthquake, California earthquake, Florida hurricane — I mean, those — we’re in the business of taking those risks.

We’re the largest insurer, as you may know, of the California Earthquake Authority. I have a sister here who is from Carmel, and she used to call me when the dogs and cats start running in circles. (Laughter)

So we’re exposed to some things that could change.

But absent a mega-catastrophe, experience is going in the right way at both — at really at all of our insurance companies. And I would expect that to continue for a while. And then at some point I’d expect it to reverse itself. Isn’t that helpful? (Laughter)

11. Airlines must keep costs in line with competitors

WARREN BUFFETT: Area 1, please.

AUDIENCE MEMBER: Good morning. I’m Martin Wiegand from Chevy Chase, Maryland.

WARREN BUFFETT: Good to have you here, Martin. (Laughs)

AUDIENCE MEMBER: Thank you. Thank you for the wonderful shareholder weekend, and thank you for the leadership and education you give your shareholders and the general public.

My question. Large airlines are in the news negotiating labor contracts. They claim they can’t pass along rising labor costs to their customers.

In the annual report, you say Executive Jet is growing fast and doing great. Executive Jet seems to be able to pass along its rising labor cost to its customers.

Is this because Executive Jet has a rational compensation plan that keeps employee salaries in line with billable services? If not, why does Executive Jet do well while the airlines experience troubles?

WARREN BUFFETT: Well, the big problem with the airlines is not so much what their aggregate payments will be. The real problem is when you’re in the airline business and your wage rates are out of line with your competitors.

When you get right down to it, the figure to look at with an airline — among a lot of other things — but you start with the cost per available seat mile. And then you work that through based on the capacity utilization to get to the revenue per — or the cost per — occupied seat mile.

And the — you could have labor costs or any other costs. You certainly have fuel costs up dramatically for the airlines from a couple of years ago.

As long as you’re more efficient than your competitor, and your costs are not higher than your competitor, people will continue to fly.

It’s when you get your costs out of line with your competitor, which was the situation that — where Charlie and I were directors of USAir a few years back — and our costs per seat mile were far higher than competitors.

And that was fine where we didn’t have competitors on some — many of the short routes in the East. But as the Southwest Airlines would move into our territory — and they had costs, we’ll say, of — and this is from memory — but they might have had costs below eight cents a seat mile. And our cost might have been 12 cents a seat mile.

You know, that is a — you’re going to get killed, eventually. They may not get to this route this year, but they’ll get there next year or the year after.

So if you’re running a big airline at Delta or United or whatever, if your costs are on parity or less — labor costs — than your other major competitors, that is much more important to you than the absolute level.

And the NetJets service is not really designed to be competitive with United Airlines or an American or something of that sort. It has a different group of competitors.

And I think we have a absolutely terrific pilot force there. And we want them to be happy. But there’s a lot of other ways. I mean, you want to pay them fairly. But with our pilots for example, it’s extremely important to them, in many cases, to be able to live where they want to and to work the kind of shifts that we can offer. So we attract them in many other ways than bidding against United Airlines or American Airlines.

Big thing in — you just can’t take labor costs that are materially higher than your competitor in a business that has commodity-like characteristics such as airline seats. You just can’t do it over time.

And you can get away with it for a while. But sooner or later, the nature of a capitalist society is that the guy with the lower cost comes in and kills you.

Charlie?

CHARLIE MUNGER: The airline unions are really tough. And it’s interesting to see a group of people that are paid as well as airline pilots with such a brutally tough union structure. That really makes it hard in a commodity-style business.

And no individual airline can take a long shutdown without having considerable effects on habit patterns and future prospects. It’s just a very tough business by its nature.

Passenger rail travel, even in a previous era, was a pretty tough way to make a buck. And nothing is all that different with the airline travel.

We hope that our services are preferred by customers more than one airline seat is preferred compared to another.

WARREN BUFFETT: Yes, fractional ownership is not a commodity business. I mean, the people care enormously about service and the assurance of safety. And I don’t think that, you know, I don’t think if you were buying a parachute you’d want to take the — necessarily take the low bid, and —

CHARLIE MUNGER: Yeah. (Laughter)

WARREN BUFFETT: Now with the big commercial airlines with millions and millions of passengers, people, I think probably correctly assume, that there’s quite a similarity in both service and safety.

But if you’re in a business that cannot take a long strike, you’re basically playing a game of chicken, you know, with your labor unions. Because they’re going to lose their jobs, too, if you close down. So you’re playing a game of chicken periodically.

And it has a lot — there’s a lot of game theory that gets involved.

To some extent, you know, the weaker you are, the better your bargaining position is. Because if you’re extremely weak, even a very short strike will put you out of business. And the people who are on the other side of the negotiating table understand that. Whereas, if you have a fair amount of strength, they can push you harder.

But it is of — it is no fun being in a business where you cannot take a strike. We faced that one time back in the early ’80s when there were — we were in kind of a death struggle in Buffalo with The Courier-Express.

And when I bought The Buffalo News — actually Charlie did. He was stranded there during a snowstorm, and he got bored. So, he called me and said, “What should I do?” I said, “Well, you might as well buy the paper.” (Laughter)

And so we were in this struggle. And — but when we bought the Buffalo News, we had two questions of the management, and one of them I can’t tell you.

But the second one was, we wanted to meet with the key union leaders, and we wanted to tell them, “Lookit, if you ever strike us for any length of — significant length of time — we’re out of business.

“You know, you can make our investment valueless. So we really want to look you in the eye and see what kind of people you are before we write this check.” And we felt quite good about the people, and they were good people.

And we had one situation in 1981, or thereabouts, where a very, very small union, I think, less than 2 percent of our employees, struck over an issue that the other 10 or 11 unions really didn’t agree with them that much on.

But they struck, and the other unions observed the picket line, which you would expect them to do in a strongly pro-union town, such as Buffalo.

And I think, as I remember, they struck on a Monday. And I remember leaders of some of the other unions actually with tears in their eyes over this, because they could see it was going to put us out of business.

And frankly, I just took the position then, I said, “Lookit, if you come back in a day, I know we’re competitive. If you come back in a year, I know we will not be competitive.

“And if you’re smart enough to figure out where exactly the point is that you can push us to and still come back and we have a business and you have jobs, I said, you’re smarter than I am. So, you know, go home and figure it out.”

And they came back in on Thursday, and we became very competitive again. But they could’ve — I mean, it was out of my hands. I couldn’t make them work, and if they decided they were going to stay out long enough, we were not going to have a newspaper.

And that’s the kind of situation, occasionally, you find yourself in. And I would say the airline industry is a good example of people — where people find themselves in that position periodically.

Charlie, anything you want —

CHARLIE MUNGER: Well. The shareholders may be interested to know, vis-à-vis competitive advantages in our NetJets program, that the day that other charter plane crashed in Aspen, NetJets refused to fly into Aspen at all. People remember that kind of thing.

WARREN BUFFETT: Yeah.

12. Berkshire’s advantages, and one big disadvantage

WARREN BUFFETT: Zone 2?

AUDIENCE MEMBER: Good morning, gentlemen. David Winters from Mountain Lakes, New Jersey. Thank you for hosting “Woodstock for Capitalists.” (Laughter)

Berkshire seems to have an enormous long-term advantage in spite of its large size and high equity prices.

The structure of the company’s activities, non-callable capital, substantial free cash flow, and improving insurance fundamentals, permit Berkshire to capitalize on potential asset price declines and dislocations in financial markets, while most investors would not either have the money or the cool minds to buy.

Am I on the right track here?

WARREN BUFFETT: Well I think, in certain ways, you are. But we do have disadvantages, too.

But we have some significant advantages in buying businesses over time. We would be the preferred purchaser, I think, for a reasonable number of private companies and public companies as well.

And we — our checks clear. So we — (laughter) — we will always have the money. People know that when we make a deal, it will get done, and it will get done as fast as anybody can do it. It won’t be subject to any kind of second thoughts or financing difficulties.

And we bought, as you know, we bought Johns Manville because the other group had financing difficulties.

People know they will get to run their businesses as they’ve run them before, if they care about that, and a lot of people do. Others don’t.

We have an ownership structure that is probably more stable than any company our size, or anywhere near our size, in the country. And that’s attractive to people, so —

And we are under no pressure to do anything dumb. You know, if we do things dumb, it’s because we do things dumb. And it’s not — but it’s not because anybody’s making us do it.

So those are significant advantages. And the disadvantage, the biggest disadvantage we have is size.

I mean, it is harder to double the market value of a hundred billion dollar company than a $1 billion company, using our — what we have in our arsenal.

And that isn’t — I hope it isn’t going to go away. I mean, I hope we don’t become a billion dollar company and enjoy all the benefits of those. (Laughter)

And I hope, in fact, we have the agony of becoming, you know, a much larger company.

So, you are on the right track. Whether we can deliver or not is another question. But we go into combat every day armed with those advantages.

Charlie?

CHARLIE MUNGER: Yeah. This is not a hog heaven period for Berkshire. The investment game is getting more and more competitive. And I see no sign that that is going to change.

WARREN BUFFETT: But people will do stupid things in the future. Even — there’s no question. I mean, I will guarantee you sometime in the next 20 years that people will do some exceptionally stupid things in equity markets.

And then the question is, you know, are we in a position to do something about that when that happens?

But we do — we continue to prefer to buy businesses, though. That’s what we really enjoy.

When Charlie mentioned hog heaven, I thought we ought to open the peanut brittle here, which I recommend heartily. (Laughter)

13. “There is no such thing as growth stocks or value stocks”

WARREN BUFFETT: Zone 3.

AUDIENCE MEMBER: Good morning. Mo Spence from Waterloo, Nebraska.

You’ve often stated that value and growth are opposite sides of the same coin.

Would you care to elaborate on that? And do you prefer a growth company that is selling cheap or a value company with moderate or better growth prospects?

WARREN BUFFETT: Well, actually I think you’re — you may be misquoting me. But I really said that growth and value, they’re indistinguishable. They’re part of the same equation. Or really, growth is part of the value equation.

So, our position is that there is no such thing as growth stocks or value stocks, the way Wall Street generally portrays them as being contrasting asset classes.

Growth, usually, is a chance to — growth, usually, is a positive for value, but only when it means that by adding capital now, you add more cash availability later on, at a rate that’s considerably higher than the current rate of interest.

So, there is no — we don’t — we calculate into any business we buy what we expect to have happen, in terms of the cash that’s going to come out of it, or the cash that’s going to go into it.

As I mentioned at FlightSafety, we’re going to buy $200 million worth of simulators this year. Our depreciation will probably be in the area of $70 million or thereabouts. So we’re putting $130 million above depreciation into that business.

Now that can be good or bad. I mean, it’s growth. There’s no question about it. We’ll have a lot more simulators at the end of the year. But whether that’s good or bad depends on what we earn on that incremental $130 million over time.

So if you tell me that you own a business that’s going to grow to the sky, and isn’t that wonderful, I don’t know whether it’s wonderful or not until I know what the economics are of that growth. How much you have to put in today, and how much you will reap from putting that in today, later on.

And the classic case, again, is the airline business. The airline business has been a growth business ever since, well, you know, Orville [Wright] took off. But the growth has been the worst thing that happened to it.

It’s been great for the American public. But growth has been a curse in the airline business because more and more capital has been put into the business at inadequate returns.

Now, growth is wonderful at See’s Candy, because it requires relatively little incremental investment to sell more pounds of candy.

So, its — growth, and I’ve discussed this in some of the annual reports — growth is part of the equation, but anybody that tells you, “You ought to have your money in growth stocks or value stocks,” really does not understand investing. Other than that, they’re terrific people. (Laughter)

Charlie?

CHARLIE MUNGER: Well, I think it’s fair to say that Berkshire, with a very limited headquarters staff — and that staff pretty old — (laughter) — we are especially partial to laying out large sums of money under circumstances where we won’t have to be smart again.

In other words, if we buy good businesses run by good people at reasonable prices, there’s a good chance that you people will prosper us for many decades without more intelligence at headquarters. And you can say, in a sense, that’s growth stock investing.

WARREN BUFFETT: Yeah, if you had asked Wall Street to classify Berkshire since 1965, year-by-year, is this a growth business or a value business — a growth stock or value stock — you know, who knows what they would have said.

But, you know, the real point is that we’re trying to put out capital now to get more capital — or money — we’re trying to put out cash now to get more cash back later on. And if you do that, the business grows, obviously. And you can call that value or you can call it growth. But they’re not two different categories.

And I just cringe when I hear people talk about, “Now it’s time to move from growth stocks to value stocks,” or something like that, because it just doesn’t make any sense.

14. Advice to young people: Invest in yourself

WARREN BUFFETT: Zone 4?

AUDIENCE MEMBER: Hi. My name is Steven Kampf (PH) from Irvine, California. I’m 10 years old and this is my fourth consecutive year here.

WARREN BUFFETT: Terrific.

AUDIENCE MEMBER: How I got —

WARREN BUFFETT: We’re glad to have you here.

AUDIENCE MEMBER: Thanks. This is my fourth consecutive year here, and how I got to owning stock is my dad taught me to start my own business. And I bought Berkshire Hathaway stock with my profits.

In school, they don’t teach you how to make and save money, not in high school or college. So my question is, how would you propose to educate kids in this area?

WARREN BUFFETT: Well, that’s a good question. Sounds to me like — (Applause)

Sounds to me like you could do a good job yourself, too. And, you know, at 10, you’re way ahead of me. Unfortunately, I didn’t buy my first stock until I was 11, so I got a very slow start. And — (Laughter)

It’s, you know, what it takes really is — and you find it in some classrooms and you don’t in others — but it takes teachers who can explain the subject. Charlie would say Ben Franklin was the best teacher of all in that respect.

But, you know, it looks like you either got it from your parents — an education on that — and parents can do more education, really, in that respect, even, than teachers.

But it’s, you know, I get a chance to talk to students from time to time. And, you know, one of the things I tell them is, you know, what a valuable asset they have themselves.

I mean, I would pay any bright student probably $50,000 for 10 percent of his future earnings the rest of his life. So he’s a $500,000 asset just standing there. And what you do with that $500,000 asset, in terms of developing your mind and your talents, is hugely important.

The best investment you can make, at an early age, is in yourself. And it sounds to me like you’re doing very well in that respect. I congratulate you on it.

I don’t have any great sweeping program for doing it throughout the schools though. We have — here in Nebraska — we have an annual get-together of students from all the high schools throughout the state. And it’s a day or two of economic education. I think it’s a very good program.

But I think if you just keep doing what you’re doing, you may be an example to other students.

Charlie?

CHARLIE MUNGER: Well, I’d like to interject a word of caution. You sound like somebody who’s likely to succeed at what you’re trying to do. And that’s not always a good idea.

If all you succeed in doing in your life is to get early rich from passive holding of little bits of paper, and you get better and better at only that for all your life, it’s a failed life.

Life is more — (applause) — than being shrewd at passive wealth accumulation. (Applause)

WARREN BUFFETT: I think he’s going to do well in both.

15. Internet “was a chance for people to monetize the hopes of others”

WARREN BUFFETT: Zone 5?

AUDIENCE MEMBER: Good morning. My name is Thomas Kamay (PH). I am 11 years old and from Kentfield, California. This is my fourth annual meeting.

Last year, I asked how the internet might affect some of your holdings. Since a lot of the internet companies have gone out of business, how are — has your view of internet changed?

WARREN BUFFETT: Well, that’s a good question. I think that the internet probably looks to most retailers like less of a competitive threat than it did a couple of years ago.

For example, if you look at the jewelers who have been on the internet and, in many cases — in several cases, at least, had very large valuations a couple of years ago, so the world was betting that they would be very effective competitors against brick and mortar jewelry retailers.

I think that that threat has diminished substantially. I think that’s been true in the furniture business. In both of those industries, very prominent dot-coms that had aggregate valuations in the hundreds of millions have vanished in short order.

So I would say that we think the internet is huge opportunity for certain of our businesses. I mean, GEICO continues to grow in a — at a significant rate in internet business.

See’s Candies’ internet business is up 40 percent this year. Last year it was up a much larger percent from the year before, and it grows and it will continue to grow.

So the internet’s an opportunity, but I think the idea that you could take almost any business idea and turn it into wealth on the internet — many were turned into wealth by promoting them to the public. But very few have been turned into wealth by actually producing cash results over time.

So I think there’s been a significant change in the degree to which I perceive the internet as a possible threat to our retail businesses. There’s been no change in the degree to which I regard it as an opportunity for other of our businesses.

Charlie?

CHARLIE MUNGER: Well, Warren, you and I were once engaged in the credit and delivery grocery business. And it was a terrible business. It barely supported one family for a hundred years with all of them working 90 hours a week.

And somebody actually got the idea that was the wave of the future and turned it into a great internet idea. That can only be described as mania. And it sucked in a lot of intelligent people.

WARREN BUFFETT: Yes, Charlie is talking about the infamous Buffett & Son Grocery Store, which did barely support the family for a hundred years. And, only then did we support the family by hiring guys like Charlie for slave wages. (Laughter)

But I used to go out on those delivery trucks, and it was pretty damned inefficient. You know, people would phone their orders in. And now it’s true we took them down with a pencil and an order pad instead of punching them into a computer.

But when we started driving around the trucks and hauling the stuff off and everything, you know, we ran into the same costs that Webvan is running into now.

What the internet offered was a chance for people to monetize the hopes of others, in effect. I mean, you are able to capture the greed and dreams of millions of people and turn that into instant cash, in effect, through venture capital and the markets.

And there was a lot of money transferred in the process, from the gullible to the promoters. But there’s been very little money created by pure internet businesses so far. It’s been a huge trap for the public.

Charlie?

CHARLIE MUNGER: Nothing more.

16. “We don’t have a master plan”

WARREN BUFFETT: Zone 6.

AUDIENCE MEMBER: Thank you for taking my question. My name is Frank Gurvich (PH). I’m from London, Ontario. It’s great to see all the young people asking questions. I even have my own 11-year-old here, Matthew, this year.

I first want to start by passing on a message from my wife to you, Mr. Buffett. And that is, “Thank you, Mr. Buffett for your autograph that Frank brought back last year. However, quite frankly, the ring in the Borsheims box you autographed was far more precious.”

WARREN BUFFETT: You can repeat that if you’d like. (Laughter)

AUDIENCE MEMBER: My question relates to the future of Berkshire. Back in 1994, there was a PBS video interview of you at the Flagler Business School. And I believe you said Berkshire was not an insurance company.

It appears that’s not quite the case as much anymore, and I suppose insurance acquisitions will provide the financial fuel and the stability the Johns Mansvilles and MidAmerica types of acquisitions will need for their future growth.

But I’m hoping that you and Charlie can describe for us an anticipated future look at, say, 20 years out, of how Berkshire might be different and — from how it is today — and perhaps a couple of the not so obvious problems that Berkshire will need to contend with.

And thank you for all the apparently wonderful acquisitions you’ve made on our behalf in the last year.

WARREN BUFFETT: Well, thank you. I think you ought to take your wife another ring, too. (Laughter) But thank you.

We actually, as long ago as — I don’t remember whether it was in the 1980 annual report, but at least 20 years ago, we did say that we thought insurance would be our most significant business over time.

We had no idea that it would get to be as significant as it is. But we’ve always felt that that was — we would be in many businesses — but that insurance was likely to be our largest business.

Right now, it’s not our largest business in terms of employment. It’s our largest business in terms of revenue. And we would hope it gets a lot bigger over time. We don’t have anything in the works that would make that happen, although we will have natural growth in what we already own.

But we will just keep acquiring things. And sometimes — some years we’ll, you know, we’ll make a big acquisition. Some years we’ll make a few small acquisitions.

We’ll do whatever comes down the pike. I mean, if there’s a phone call waiting when this meeting is over and it’s an interesting acquisition, it’ll get done.

We don’t have a master plan. We don’t — Charlie and I do not sit around and strategize or talk about the future of various industries or do anything of that sort. It just doesn’t happen. We don’t have any reports. We don’t have any staff. We don’t have any of that.

We try to look at what comes in — we try to survey the whole financial field. We try to look at what comes in and look for things we understand, where we think they have a durable, competitive advantage, where we like the management, and where the price is sensible.

And, you know, we had no idea two or three years ago, you know, that we would be the 87 percent owner of the largest carpet company — broadloom carpet company — in the world.

You know, we just don’t — we don’t plan these things. But I would tell you in a general way that 20 or so years from now, we will own a lot more businesses.

I would still think it likely — I mean, I think it’s certain that insurance will be a bigger business for us in 20 years than it is now. Probably much bigger. But I think it’s — and I think it’s also likely it will be our biggest business still. But that could change.

I mean, we could get a deal offered to us tomorrow that, you know, was a 15- or $20 billion deal, and then we’ve got a lot of money in that industry at that point.

So it’s — we have no more master plan now than we had back in 1965 when we bought the textile mill, really.

I mean, we had a lousy business. I didn’t realize it was as lousy as it was when I got into it. And we had to, you know, we just had to start trying to deploy capital in an intelligent way.

But we’ve been deploying capital, you know, since I was 11. And I mean, that’s our business and we enjoy it. And we get opportunities to do it. But the bigger you are, the fewer the opportunities you’re likely to get.

Charlie?

CHARLIE MUNGER: Well, I think it’s almost a sure thing that 20 years from now there’ll be way more strength and value behind each Berkshire share. I also think it is an absolutely sure thing that the annual percentage rate of progress will go way down from what it has been in the past.

WARREN BUFFETT: No question about it.

17. Buffett’s cholesterol level

WARREN BUFFETT: On that happy note, we move to zone 7. (Laughter)

AUDIENCE MEMBER: Good morning, Mr. Buffett, Mr. Munger. My name is Gary Radstrom (PH) from right here in River City [Omaha]. I’ve been a shareholder since ’93, and have loved every minute of it.

Recently, there’s been medication available to reduce cholesterol. My doctor even gave it to me since mine is kind of high.

Every time I hear what you like to eat, Warren, it makes me wonder what your cholesterol level is — (Laughter) — or if you even worry about it. I think everyone here wants you to be with us for a long time, so have you considered taking this new medication to reduce your cholesterol level? (Laughter)

WARREN BUFFETT: I do know the number, and I don’t remember it. My doctor tells me, “It’s a little high,” but if he says it’s a little high, it means it isn’t that high, or he would — because he always tries to push me into making a few changes in my life.

But he — I’ve got a wonderful doctor. And I was lucky last year, because I hadn’t been in to see him for about five years. And — (laughter) — due to — those guys cost a lot of money, I mean. (Laughter)

And due to purely an accident, a reaction to some other medicine I was given when I was out of the city, he got a hold of me, and then he shamed me into having a physical. And it was extremely lucky, because I had a polyp in the colon that would have probably caused trouble, you know, within a couple of years.

I would say that if you ask my doctor, he would want me to make a few changes, but he would also say that my life expectancy is probably a lot better than the average person of 70.

You know, I have no stress whatsoever. Zero. You know, I mean, I get to do what I love to do every day. You know, and I’m surrounded by people that are terrific. So that problem in life just doesn’t exist for me. You know, and I don’t smoke or drink or, well, we’ll end it right there. (Laughter)

And so, you know, if you were an underwriter for a life company, you would rate me considerably better than the average. You’d rate Charlie better than average, too.

And I’m sure that, you know, I could change it slightly, perhaps, on the probabilities, you know, if I change my diet dramatically or something. But it’s very unlikely to happen.

Actually, when my mother got to be 80 — you know, the most important thing in life, in terms of how long you live, is how long your parents live. So I got her an exercise bike when she got to be 80. (Laughter)

She put 40,000 miles on it. And I told her to watch her diet and do all these things. And I mean, she lived to be 92, so you know, she did her share, and I helped her do it by giving her the exercise bicycle. So, I think that improved my odds at that point.

Charlie?

CHARLIE MUNGER: Yeah. I have a book recommendation which will be very helpful to all shareholders that worry about Warren’s health and longevity.

And that’s this book called “Genome” by Matt Ridley, who was, for years, the science editor of The Economist magazine. And if Ridley is right, Warren has a very long life expectancy.

There are very interesting correlations between people who cause stress to others instead of suffering it themselves. (Laughter and applause)

And Warren has been in that position ever since I’ve known him. (Laughter)

And the figures that Ridley quotes are awesomely interesting. It is a fabulous book.

Of course, I’m recommending a bestseller, but they’re selling it in the airport. It’s called “Genome,” and you’ll feel very good about Warren’s future if you agree with the science of the book.

18. Unrealistic investment expectations for pension funds

WARREN BUFFETT: Zone 8.

AUDIENCE MEMBER: My name is Charlie Sink (PH). I’m from North Carolina.

Mr. Buffett, your article last year in Fortune Magazine was excellent.

I’m thinking — well, I’m wondering what your thoughts are on American business profit margins and return on equity in the future. I also would like your thoughts about the — some businesses today with their huge inventory write-offs, what your thoughts about those are.

WARREN BUFFETT: Yeah, well, in that article I talked about the unlikelihood of corporate profits in the United States getting much larger than 6 percent of GDP. And historically, the band has been between 4 and 6 percent. And we’ve been up at 6 percent recently.

So, unless you think that profits, as a part of the whole country’s economic output, are going to become a bigger slice of the pie — and bear in mind, they can only become a bigger slice of the pie if other slices get diminished to some extent, and you’re talking about personal income and items like that.

So, I think it’s perfectly rational and reasonable that in a capitalistic society the corporate profits are something like 6 percent of GDP.

That does not strike me as outlandish in either direction. It attracts massive amounts of capital, because returns on equity will be very good if you earn that sort of money.

And on the other hand, I think it would be very difficult in the society to get where they’d be 10 percent or 12 percent, or something of the sort because it just — it would look like an unfair division of the pie to the populace.

So, I don’t see any reason for corporate profits — they’re going to be down in the near future as a percentage of GDP from recently, but then they’ll go back up at some point. So I think 10 years from now, you’ll be looking at a very similar picture.

Now, if that’s your assumption and you’re already capitalizing those profits at a pretty good multiple, then you have to say that you have to come to the conclusion that the value of American business will grow at a relationship that’s not much greater than the growth in GDP.

And most of you would estimate that probably to be, you know, maybe 5 percent a year, if you expect a couple percent a year of inflation.

So, I wouldn’t change my thoughts about the profitability of American business over time. And I wouldn’t change my thoughts much about the relationship of stock prices over time to those profits. So, I — you know, I would come down very similarly.

Now, interestingly enough, some of those same relationships prevailed decades ago, but you were buying stocks that were yielding you perhaps 5 percent or something like that, so that you were getting 5 percent in your pocket, plus that growth as you went along.

And of course, now if you buy stocks you get 1 1/2 percent, if you’re the American public, before the frictional cost. So that the same rate of growth produces a way smaller aggregate return. And some —

You know, I think stocks are a perfectly decent way to make 6 or 7 percent a year over the next 15 or 20 years. But I think anybody that expects to make 15 percent per year, or expects their broker or investment advisor to make that kind of money, is living in a dream world.

And it’s particularly interesting to me that back when the prospects for stocks were far better — I even wrote something about this in the late ’70s — pension funds were using investment rate assumptions that were often in the 6 percent or thereabout range.

And now when the prospects are way poorer, most pension funds are using — building into their calculations — returns of 9 percent or better on investments. I don’t know how they’re going to get 9 percent or better on investments.

But I also know that they change the investment assumption down, it will change the charge to earnings substantially. And they don’t want to do that.

So, they continue to use investment assumptions which I think are quite unrealistic. And with companies with a big pension component in their financial situation, and therefore in their income statement, that can be quite significant.

It will be interesting to me to see whether in the next couple years where pension funds are experiencing significant shortfalls from their assumptions, how quickly they change the assumptions.

And the consulting firms are not pushing them to do that at all. It’s very interesting. The consulting firms are telling them what they want to hear, which is hardly news to any of us. But it’s what’s taking place.

The second question about inventory write-offs. You know, that gets into the category entirely of big-bath charges, which are the tendencies of management, when some bad news is coming along, to try and put all the bad news that’s happened into a single quarter or a single year —and even to put the bad news that they are worried about happening in the future into that year.

And it’s — it leads to real deception in accounting. The SEC has tried to get quite tough on that, but my experience has been that managements that want to do it usually can find some ways to do it.

And managements, frequently, are more conscious of what numbers they want to report than they are of what has actually transpired in a given quarter or a given year.

Charlie?

CHARLIE MUNGER: Yeah, pension fund accounting is drifting into scandal by making these unreasonable investment assumptions. It’s — evidently, it’s part of the human condition that people extrapolate the recent past.

And so, since returns from common stocks have been high for quite a long period, they extrapolate that they will continue to be very high into the future. And that creates a lot of reported earnings, in terms of pension benefits, that aren’t available in cash and are likely not to be available at all.

And this is not a good idea, and it’s interesting how few corporate managements have just responded like Sam Goldwyn: “Include me out.”

You’d think more people would just say, “This is a scummy way to keep the books, and I will not participate.” Instead, everybody just drifts along with the tide, assisted by all these wonderful consultants.

WARREN BUFFETT: Yeah, I don’t think — I don’t know of any case in the United States right now, and I’m sure there are some, but except for the pension funds that we take over, I don’t know of any case where people are reducing their assumed investment return.

Now you’d think if interest rates drifted down several percentage points that that might affect what you would think would be earned with money. It certainly is to bond holders or to us with float or something of the sort.

But most major corporations, I believe, are using an investment return assumption of 9 percent or higher. And that’s with long-term governments below 6 percent, you know, and maybe high-grade corporates at 7.

They don’t know how to get it in the bond market. They don’t know how to get it in the mortgage market. I don’t think they know how to get it in the stock market. But it would cause their earnings to go down if they change their investment assumption.

And, like I say, I don’t know of a major company that’s thinking about it. And I don’t know of a major actuarial consultant that’s suggesting it to the managements. It just — they’d rather not think about it.

CHARLIE MUNGER: The way they’re doing things would be like living right on an earthquake fault that was building up stress every year and projecting that the longer it’s been without an earthquake the less likely an earthquake is to occur.

That is a dumb way to write earthquake insurance. (Laughter)

And the current practice is a dumb way to do pension fund planning and accounting.

WARREN BUFFETT: If you talk —

CHARLIE MUNGER: Dumb and improper.

WARREN BUFFETT: If you talk to a management or board of directors about that, you get absolutely no place.

CHARLIE MUNGER: No, they — their eyes would glaze over before the hostility came. (Laughter)

19. Executive Jet won’t be a “mature” business “for decades”

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: Good morning, gentlemen. Marc Rabinov from Melbourne, Australia. I had a question on two of our key operating businesses.

Firstly, Executive Jet. Once this becomes a mature business, would it be fair to say that its net margin should be about 5 percent?

And secondly, would it be fair to say that our current insurance businesses are likely to grow aggregate float at about 10 percent over time?

WARREN BUFFETT: Well, it’s really anybody’s guess. I mean, I don’t expect Executive Jet to become a mature business for decades. I mean, it — there’s a whole world out there on that one.

And we have something over 2,000 customers in the United States at the current time. We have a little over a hundred, but in Europe.

But there are tens and tens and tens of thousands, and perhaps hundreds of thousands, of people or businesses where it does make sense over time. So it’s going to be long time.

I mean, there are only 700, roughly, jets a year being produced. And of course, up until a few years ago that was limited to people who wanted to buy single planes.

But you won’t change that output much in the next five years. But — so, you couldn’t really take on —

We can take on about 600 customers a year, just in terms of the delivery schedule that we have built into our business. And we couldn’t change that — we couldn’t double that — because the planes simply aren’t available in the next year or two, although we have orders further out.

But I would say it will be a long time until Executive Jet is a mature business, and I would say that — a long, long time.

I mean, we’re going to, when we get Europe — as we make progress in Europe, we’ll move to Asia. We’ll move to Latin America over time. And so we’re going to be, I think, growing that business significantly for a very long time.

When it becomes mature, or close to it, you know, if you’re talking 5 percent after-tax margins, I’d say that that’s probably a reasonable figure. But we’re so far away from even thinking about that, that, you know, it’s pure speculation.

20. “There’s an unlimited market for dumb insurance policies”

WARREN BUFFETT: In our insurance business, we’ve grown our float and then we’ve purchased businesses to add to the float.

This year, I would certainly expect, unless one — a big transaction would fall through or something — I would certainly expect our float to grow at least 2 1/2 billion. And that is close to 10 percent of the beginning of the year float.

That’s a rational expectation. But whether it can grow 10 percent a year, you know, how far you can do that — I would say the total float of the property-casualty industry in the United States is — I’m pulling this out from making some other calculations in my head as I talk — but it wouldn’t be much more than 300 billion.

So, we are close to 10 percent of the entire U.S. float now, and I don’t think the U.S. float — the aggregate float — you know, is going to grow at a 10 percent rate.

So when you’re as big a part of the pie as we are, it may be difficult to sustain a 10 percent rate. But we’re doing everything possible that makes sense to grow float. I mean, that is a major, major objective. But the even bigger objective is to keep it low-cost.

I don’t think you can see — unless the world changes in some way — I don’t think you can see 10 percent growth over 25 years. But we’ll do our darnedest to get it, you know, at the rate you suggest for at least the near future.

Charlie?

CHARLIE MUNGER: Well, I certainly agree that long term, it’s not going to happen. Good, but not that good. (Buffett laughs)

WARREN BUFFETT: But we’ve been surprised at what’s happened. I mean, there’s no — I mean, when we bought Jack Ringwalt’s company in 1967, you know, my memory is Jack had a float of, you know, less than 15 million.

And would we have ever guessed that we might hit something close to 30 billion this year? We never dreamt of it. But we just kept doing things, and we’ll keep doing things.

But it can’t be at huge rates for a long period of time, because we’re too big a part of the pie now. We were nothing initially, and we kept grabbing a little more of the pie as we’ve gone along. And we like that, but it can’t go on forever.

CHARLIE MUNGER: Yeah. That’s what I call really low-cost float. If it ever should be advantageous for us to go into what I would call higher-cost float, that might change the figures upward, in terms of growth of float.

WARREN BUFFETT: Yeah. Although, that won’t be — I mean, it could happen that we could take on incrementally some higher-cost float under very special circumstances if we saw unusually good ways to use it, but that — we don’t even like to think about that.

We certainly don’t want the people running our businesses to think about that. Because keeping it low- cost, you know, that is the big end of the game.

Anybody can generate float. I mean, if we gave our managers a goal of generating 5 billion of float next year, they could do it in a minute, you know, and we would be paying the price for decades to come.

You can write dumb insurance policies, you know. There’s an unlimited market for dumb insurance policies. And they’re very pleasant, because the first day the premium comes in and that’s the last time you see any new money. From then on, it’s all going out. And that’s not our aim in life.

21. GEICO focusing on U.S. instead of global expansion

WARREN BUFFETT: Zone 2?

AUDIENCE MEMBER: My name is Kjell Hagan (PH). I’m a Norwegian working in Tokyo in Japan.

I’m very satisfied to have more than 95 percent of our family’s savings in Berkshire. I have two questions.

In my work, I’ve seen a lot of insurance companies in Europe and Japan. And I think that GEICO’s business model is quite superior to most primary insurance companies in Europe and Japan.

And I think that GEICO would be very successful in Europe and Asia. So I’d like to hear what are the views and plans for GEICO doing business in Europe and Asia.

Second, regarding Coca-Cola — living in Japan, I notice that Coke has a relatively low presence in advertising, although they are the largest player with 30 percent market share versus 15 for the number two. I think Coke is being too cheap on advertising, thus hurting the long-term position.

I wonder if advertising strategy internationally is a high enough priority of Coke’s management, and if aggressiveness is sufficient. I’d like to hear if you have any comments on this.

Also I’d just like to thank you very much for this experience and for the wonderful company you have created.

WARREN BUFFETT: Well, thank you very much.

Clearly when you’ve got a business model that works as well as GEICO has in this country and it continues to work well, and has that fundamental advantage of being a low-cost operator, we think about every possible way that we can take that idea and extend it.

It’s been remarkably hard to do it. I mean, the management has tried various things, ever since Leo Goodwin started the company in 1936, to take it into other areas, and those efforts have been modestly successful at certain things like life insurance, but then they got out of it, and various other things.

But it’s an idea still. We have — you know, we have 4 percent or so of the market in the United States. This market is so huge. And as we look at the drain on human resources involved in extending it into other countries, and we’ve looked at it a lot, and it may be something we’ll do at some time.

But we’ve never felt that the possible gain, considering the rigidities of these other — both in Europe and in Asia — of breaking in — it’s not easy to get into those markets. And the cost, the time, we just felt that it would be better to concentrate those same resources in this country.

It’s not a question of capital at all. I mean, we’d put the money in in a second. And we’re doing it in something like NetJets in Europe. I mean, we — there’s a human cost to it, there’s a financial cost to it.

Financial cost bothers us not at all. Human cost is a real question, because it gets back to Charlie’s opportunity cost.

We have talented managers, but we have a finite number of them. And I would rather have Tony Nicely and Bill Roberts and their crew focusing on how to gain additional market share in this country at the right rates than I would starting in a project in Europe or Asia now.

But that’s — it’s a very good question. It’s something I can guarantee you we think about all the time and will continue to think about.

We’ve tried to extend geography. Coke has been the most successful company in the world in extending geography.

We’ve tried to do it with See’s Candy, and it’s had limited — very limited — success. I mean, we’ve tried 50 different ways, because the trials are relatively cheap to do.

And we think it should work, we just haven’t been able to make it work. But that — it’s a very good question.

22. Coca-Cola advertising in Japan

WARREN BUFFETT: The question about Coke’s advertising in Japan. As you know, Coke has a terrific presence in Japan.

Japan’s an interesting market, because the percentage of soft drinks sold through vending machines is just far, far higher than any place in the world. And the United States is a very distant second. And then, the rest of the world, there’s very little done in the way of vending machines.

I don’t know the specifics of the advertising in Japan, but of course, Doug Daft who now is the CEO of Coke, comes with a huge background in Asia. I mean, that was his territory for much of his career.

And Doug — we have a new major — very major — advertising campaign coming up. And you probably read that Coke is going to spend 300 million-plus additional on marketing beyond the normal spend, which is huge.

And I can’t tell you the specific markets in which that will be, but I would be surprised if Japan isn’t a big part of it, because Japan is an enormous market for Coca-Cola.

Charlie?

CHARLIE MUNGER: I have nothing to add.

23. Berkshire’s asbestos exposure

WARREN BUFFETT: Zone 3, please.

AUDIENCE MEMBER: Hi. My name is Steve Rosenberg (PH). I’m from Ann Arbor, Michigan.

First, I just want to thank both of you for being two phenomenal role models. I’ve really looked up to you both for a long time.

My first question is about reinsurance. I believe that you’re willing to write larger policies in reinsurance than anyone else, but that you still insist on the amount of your liability being capped.

I’m wondering, with your investments in companies with — that have exposure to asbestos, have you somehow capped that? Or is that unlimited, especially given joint and several liability?

My second question involves auto insurance. And I was wondering, does State Farm’s structure as a mutual insurance company compensate it — or help it compensate — for having a higher cost structure because, over the long term, it need only remain solvent and not provide an adequate return on capital to its investors?

WARREN BUFFETT: The first question, on asbestos. We have not put any significant money, to our knowledge, in any company that has any asbestos exposure now.

You know, we have a small amount of money in USG, where the subsidiary, United States Gypsum, has a major asbestos exposure. But that’s a very, very minor investment. The — and that would be the only one that I can think of.

We’ve walked away from several deals that were quite attractive in every respect except asbestos. But that’s like saying to a 120-year-old, you know, “You’re in good health except for the fact that you’re dead.” (Laughter)

So we don’t go near asbestos.

Now, in terms of our retroactive insurance policies, we are taking over the liabilities of companies that have lots of asbestos exposure. And in that case, we assume that those exposure — that those contracts — will be paid in full.

I mean, we make no assumption of any reduction in asbestos costs, but we do cap them.

There’s a couple things you can’t cap in insurance. You can’t cap workers’ compensation losses. I mean, they —you can as a reinsurer, but I mean, the primary insurer can’t do that.

I believe in auto, for example, in the U.K., that it’s uncapped. And I think that nobody thought that was very serious until they had a recent accident that caused — I think it involved a car doing something that — an auto doing something to a train that was unbelievable.

So they — there are a few areas where insurance is written on an uncapped basis. And in our case, we write some auto insurance in the U.K. and we write some workers’ compensation, primarily in California.

But generally, in the reinsurance business, you are capping the liabilities you take on.

I mean, obviously, when we bought General Re, they had asbestos liabilities from reinsurance contracts they had written. But the reinsurance companies are pretty careful about writing unlimited policies.

We write huge limits. We’re the biggest — you know, if somebody wants to write a huge limit, or an unusual limit, they should call us. Because there’s no one else in the world that will act as big or as promptly as we will. But we don’t write things that are unlimited.

Now, the interesting thing is that the biggest exposures, in our view, are the people that write a lot of primary business and don’t have the catastrophe cover they need.

I mean, if you write 10 percent of all the business in homeowners on — or 15 percent — on Long Island or in Florida, I mean, you are writing a catastrophe cover that would blow your mind.

If you’re Freddie Mac or Fannie Mae and you’re guaranteeing mortgages, you know, for millions of people in areas like that, and they don’t have insurance — earthquake in California or property insurance in Florida — they’d be less likely to have earthquakes someplace — you are taking on enormous risks.

I mean, huge risks, far beyond what we would ever take on. They just — but you don’t get paid for them, unfortunately.

I mean, just take the New Madrid section of Missouri, down in the corner. That was the area of three of the greatest quakes, that are sort of related in time, in the — certainly in the recorded history, they were the three greatest quakes in the United States.

You know, how much homeowners’ business, how much commercial property business, does somebody have in that huge territory, which you know, supposedly caused church bells to ring in Boston when it happened back in whenever it was — 1807, or ’9, or something like that?

So, there are all kinds of risks that can aggregate in huge ways that companies are not thinking about at all.

I mean, I don’t know whether Freddie Mac or Fannie Mae, for example, is demanding that all of the homes they insure in the, you know, 300-miles radius of New Madrid, have earthquake insurance.

But, you know, it — that sort of thing never comes to mind until the unthinkable happens. But in insurance, the unthinkable always happens.

24. Praise for State Farm

WARREN BUFFETT: State Farm, as a competitor, is a mutual company, and it has a huge amount of net worth.

You referred to them as a higher-cost — a high-cost operator or higher cost — but they’re really a relatively low-cost operator. But they’re not anywhere near as low-cost as GEICO. But they’re a low-cost operator compared to many people in the insurance business.

And it’s certainly true that they do not have the demands for profitability, partly because they’ve done such a great job in the past and built up so much surplus.

I have nothing but basically good things to say about what State Farm has done over the years.

They do not need — they can subsidize, to some extent, current auto policy holders with the profits that were derived from auto policy holders of the past. But that’s always true when a stock company competes with a mutual company. And, you know, we know that when we go in the business.

And that’s true of — there are a lot of other mutual companies out there that operate without the demands of earning a high return on capital. But if I were State Farm, I’d, you know, I’d probably be doing what they’re doing. I don’t criticize them at all.

Charlie?

CHARLIE MUNGER: Well, I don’t criticize State Farm, either. State Farm is one of the most interesting business stories in the United States.

The idea that it could get as big as it is and has as good a distribution system as it does, it’s a thoroughly admirable company. In fact, Berkshire has bought insurance from State Farm. Not auto insurance. (Laughter)

WARREN BUFFETT: GEICO still has a lower cost structure. I mean, it is a great business operation. And we have invested significantly to build that, because it is so attractive.

And, as I pointed out in the annual report, the incremental investment we made last year did not produce the same results as incremental investments in previous years.

So we are finding it hard to grow the business under current circumstances on a basis that we would like to.

But it’s a wonderful business, and it has, you know, it has a business model that I wouldn’t, you know, I wouldn’t trade for anything.

25. “Nobody’s going to catch” NetJets

WARREN BUFFETT: Zone 4?

AUDIENCE MEMBER: Hi, Mr. Buffett, Mr. Munger. My name’s Dan Sheehan from Oakville, Canada.

Following up on your discussion about GEICO, you’ve often talked about their advantages as a direct seller and investor of float.

My question is, how do you control claim costs versus your competitors, other than through good underwriting?

Some may have advantages in terms of economies of scale or cutting corners you won’t do. And this might allow them to eliminate some of the advantages you’ve gained on the other side of the combined ratio.

And my second question is, you’ve said, “It’s hard to be smarter than your dumbest competitor.” And along that line, what are your thoughts about a recent Wall Street Journal article about a major airline getting into the fractional jet business? Thank you.

WARREN BUFFETT: I don’t worry about the dumbest competitor in a business that’s service. The customer will figure that out over time.

And we have a huge advantage in the fractional ownership business. I mean, we have 265 planes flying around now, and you can get one on four hours’ notice at any one of 5,500 airports. We have planes in Europe for our American customers. We have planes here for our European customers. And nobody’s going to catch us, in my view, in fractional ownership.

And we’ve had some dumb competitors in the past in that business. And, you know, they bleed. And to the extent, you know, we’ve got more blood than they have.

26. Buffett on the “trick” of good underwriting

WARREN BUFFETT: In the question of GEICO and underwriting, you know, that — it’s a fascinating business because there are — in this audience — there are people with hugely different propensities to have an accident. And of course, most people figure they’re better than average.

Now, part of the propensity to have an accident will depend on how many miles you drive. Obviously, somebody who never takes the car out of the garage is — no matter what their driving skills might be — is not going to have an accident.

They drive 10 miles a year, you know, you’re pretty safe with almost anybody. But — so there’s a relationship to miles driven. But there’s a relationship to all kinds of other things.

And the trick, in insurance, is being able to figure out the variables and not have them too many, because you still have to get people to fill out a form, and you don’t want something that has practically no significance.

But the trick is to find out what questions you need to ask to determine in which category to place people as to their propensity to have an accident.

Now, in the life insurance business, you know, even Charlie and I figured out that the older you get, the more likely you are to die in a given year.

Now that’s not the only factor, but everybody understands that. That the older you are, the mortality risks go up. And they’ve learned a few other things. They’ve learned that females live longer than males.

Now that doesn’t get into a judgment as to why or anything else. You just know it. So, you build that in if you’re pricing the product. And then you know a whole bunch of other things.

You may even know that cholesterol’s bad — you know, that makes a difference in terms of predicting mortality.

But in the auto insurance business, there are lots of variables that correlate with the frequency with which a person will have an accident per mile driven.

And the more experience you have with a large body of people whom you’ve asked a lot of questions about and can draw conclusions there from, the better off you are.

State Farm has got a wonderful body of information. I mean, their actuarial judgments should be better than anybody else’s, because they’ve got more experience with more cars and drivers.

But our experience with close to five million policy holders enables us, I think, to underwrite quite intelligently. But every day, you know, we’re looking for some variable that will tell us more.

People with a good credit history are better drivers by a significant margin than people with a lousy credit history.

Why? We don’t care too much why, because it wouldn’t help. What we really need to know is that the two factors correlate. And we’re looking for correlations all the time, and we’re trying to avoid spurious correlations, which you can have.

And it’s, you know, it’s a moving target. You keep working on it all the time. But we’re better at it than we were five years ago and we’ll be better at it five years from now than we are now.

When we go into a new state, we will have a very small body of policy holders. And some of the factors, obviously, prevail over all states, but there’s certain things that you learn, actually, only if you’re in a given state for a while.

You know, you’re more likely to have an accident if you’re a — everything else being equal — if you’re an urban driver — city driver in a big city — than if you’re driving in an area that’s very rural where the density of other cars is very low.

If you’re the only guy in the county with a car, you know, you’re not going to have a lot of two-car accidents.

So, the underwriting question is all important. And fast, fair settlement of claims is very important, because people who really weren’t injured start feeling worse and worse as they talk to more and more lawyers.

So, you know, the claims delivery is a vital part of running a good property-casualty operation. And all I can tell you is, at GEICO, that we think very hard about those things, but we’ll be thinking about them tomorrow as well as today.

Charlie?

27. Challenges for United’s fractional jet venture

CHARLIE MUNGER: Well, vis-à-vis the fractional jet ownership program, which has been announced for United Airlines, I find that very interesting.

A senior United Airlines pilot now makes about $300,000 a year plus fancy fringes, including pension. And what he does is work a very limited hour — number of hours a month. And about half of that he spends sleeping in a comfortable bunk on long ocean flights.

That is not a culture that will work well in fractional jet ownership. Maybe they think they’ll get some advantage in recruiting new pilots or something. I don’t know why they’re doing it. I would not have done it.

WARREN BUFFETT: Well, they haven’t done it yet, either, but the — many of the airlines have organized second companies to take care of commuter flights and all of that.

And, you know, that does produce problems when the pilots of the subsidiaries start comparing their benefits to the pilots, you know, of the parent, and all that. I mean, they try to get lower cost structures by doing that.

But I would guess that if you were wanting to set up a fractional ownership company, that — and you were — you would probably not think about trying to align yourself with somebody that has extremely high costs in other areas.

And the advertising campaign will be kind of interesting, too. You know, “Give up first class travel. Start traveling right,” you know, or something. It’ll be interesting.

But I would tell you that we have competitors in the fractional ownership business, the two largest being companies that are part of plane manufacturers. And you can understand why they went into it, but it is not an easy business. And we’ve got the best hand, frankly.

28. Calling it a “hedge fund” doesn’t make you any smarter

WARREN BUFFETT: Zone 5?

AUDIENCE MEMBER: Michael Wong (PH), San Diego, California. First of all, I would like to thank both of you.

My question is, when you started your business, why you started an investment partnership instead of a mutual fund?

And also, can you recommend a good book, or books, regarding how to start an investment partnership fund and how to service clients, et cetera?

WARREN BUFFETT: Yeah, I don’t know of any books on starting partnerships or hedge funds. Do you know, Charlie?

CHARLIE MUNGER: No, but people seem to manage to create them without the books. (Laughter)

The incentives are awesome.

WARREN BUFFETT: Yes. And the one thing, I mean, it’s always interesting to both of us how you get certain things that are fashionable. And people think that by naming something a given name, that somehow that makes everybody smarter or able to make money in it.

I mean, there is no magic to private equity funds, international investing, hedge funds — all of the baloney that gets promoted in Wall Street.

What happens is that certain things become very promotable, usually because there’s been recent successes by other people, and that the new entrants extrapolate the successes of a few people in the past to promote new money from people currently.

So, they adopt titles that, you know, that they think will attract money and they — but it doesn’t make anybody any smarter if they hang out a shingle in front of their house that says, “hedge fund” or they have a shingle that says “asset allocation firm” or something of the sort. The form doesn’t create talent.

I backed into the business. I mean, I’d worked for a mutual fund — closed-end investment company. In fact, there’s a fellow here today who’s a friend of mine that — the two of us worked there, and we were 40 percent of the whole company because there were three other people, all of whom outranked us considerably. And that firm was Graham-Newman Corp, from 1954 to 1956.

And it was a regulated investment company. It was about $6 million in assets, which seemed like a big deal at the time. And Ben Graham was one of the best known investors in the world, and he had $6 million in his fund.

There was a sister partnership called Newman and Graham, which operated in what would, today, be called “hedge fund style,” as far as a partnership split of the profits and so on.

And when I left there in ’56 and I came back here, we had seven people, a couple of whom are here in the room, who said, “Do you want to manage money?” And I said, “Well, here’s what I learned at Graham-Newman,” that Newman and Graham is a better way to do it than Graham-Newman.

So I formed a little partnership, and then I met Charlie a few years later. And he figured, if I was making money doing it, he’d make a lot more. So — (laughter) — he formed one. And that was the carefully calculated strategy of how we both became involved in the partnership business.

Charlie? (Laughs)

CHARLIE MUNGER: Yeah, it is amazing how big the hedge fund industry has become. They have conventions on the subject now. And in the late ’20s, you could take a course on how to run a crooked security pool.

And these things come in great waves. I’m not suggesting the hedge funds are crooked, but I am suggesting that you get these waves of fashion that go to great extremes. The amount of money, what is it now, Warren, in hedge funds?

WARREN BUFFETT: It’s very big, although it’s a little less in a few quarters than it used to be. (Laughs)

But I would be willing to put a lot of money up that if you take the aggregate experience of all the hedge funds — as starting right today and going for the next 15 years — I would bet a lot of money it will not hit 10 percent, in terms of return to partners. And I would, if you push me, I would bet at a lower figure than that.

CHARLIE MUNGER: Then you have Bernie Cornfeld’s idea, the Fund of Funds. There are people who want to get paid for selecting hedge funds for other people. And that didn’t work very well for Bernie Cornfeld.

WARREN BUFFETT: Well, it worked pretty well for Bernie for a while, but it didn’t work so well for his investors, actually. (Laughter)

Yeah. That result was probably something Bernie had in mind at the start maybe.

29. Investing small amounts allows bigger opportunities

WARREN BUFFETT: Zone 6.

AUDIENCE MEMBER: I’m Michael Zenga from Danvers, Massachusetts. That’s a town whose band Mr. Buffett so generously sent to the Rose Bowl parade last year, so you’re a very popular guy in my town.

Good morning, Mr. Buffett and Mr. Munger.

Mr. Buffett, I wanted to ask you this question last week when I ran into you after Gillette’s annual meeting, but I choked. So now that there’s no pressure, here goes. (Laughter)

In the years from — from my reading — in the years from 1956 through ’69, you achieved the best results of your career quantitatively. Twenty-nine percent annually against only 7 percent for the Dow.

Your approach then was different than now. You looked for lots of undervalued stocks with less attention to competitive advantage or favorable economics and sold them rather quickly.

As your capital base grew, you switched your approach to buying undervalued excellent companies with favorable long-term economics.

My question is, if you were investing a small sum today, which approach would you use?

WARREN BUFFETT: Well, I would use the approach that I think I’m using now of trying to search out businesses that — where I think they’re selling at the lowest price relative to the discounted cash they would produce in the future.

But if I were working with a small amount of money, the universe would be huge compared to the universe of possible ideas I work with now.

You mentioned that ’56 to ’69 was the best period. Actually, my best period was before that. It was from right after I met Ben Graham in 19 — early 1951 — but from the end of 1950 through the next 10 years, actually, returns averaged about 50 percent a year. And I think they were 37 points better than the Dow per year, something like that. But that — I was working with a tiny, tiny, tiny amount of money.

And so, I would pour through volumes of businesses and I would find one or two that I could put $10,000 into or $15,000 into that just were — they were ridiculously cheap. And obviously, as the money increased, the universe of possible ideas started shrinking dramatically.

The times were also better for doing it in that time.

But I think that, if you’re working with a small amount of money, with exactly the same background that Charlie and I have, and same ideas, same whatever ability we have — you know, I think you can make very significant sums.

But you — but as soon as you start getting the money up into the millions — many millions — the curve on expectable results falls off just dramatically. But that’s the nature of it.

You’ve got to — you know, when you get up to things you could put millions of dollars into, you’ve got a lot of competition looking at that. And they’re not looking as I did when I started. When I started, I went through the pages of the manuals page by page.

I mean, I probably went through 20,000 pages in the Moody’s industrial, transportation, banks and finance manuals. And I did it twice. And I actually, you know, looked at every business. I didn’t look very hard at some.

Well, that’s not a practical way to invest tens or hundreds of millions of dollars. So I would say, if you’re working with a small sum of money and you’re really interested in the business and willing to do the work, you can — you will find something.

There’s no question about it in my mind. You will find some things that promise very large returns compared to what we will be able to deliver with large sums of money.

Charlie?

CHARLIE MUNGER: Well, yeah, I think that’s right. A brilliant man who can’t get any money from other people, and is working with a very small sum, probably should work in very obscure stocks searching out unusual mispriced opportunities.

But, you know, you could — it’s such a small world. It may be a way for one person to come up, but it’s a long slog.

30. Promotion, not performance, is Wall Street’s biggest money maker

WARREN BUFFETT: Yeah, most smart people, unfortunately, in Wall Street figure that they can make a lot more money a lot easier just by, one way or another, you know, getting an override on other people’s money or delivering services in some way that people —

And the monetization of hope and greed, you know, is a way to make a huge amount of money. And right now, it’s very — just take hedge funds.

I mean, it’s — I’ve had calls from a couple of friends in the last month that don’t know anything about investing money. They’ve been unsuccessful and everything else. And, you know, one of them called me the other day and said, “Well, I’m forming a small hedge fund.” A hundred and twenty-five million he was talking about.

Like, the thought that since it was only 125 million, maybe we ought to put in 10 million or something of the sort.

I mean, if you looked at this fellow’s Schedule D on his 1040 for the last 20 years, you know, you’d think he ought to be mowing lawns. (Laughter)

But he may get his 125 million. I mean, you know, it’s just astounding to me how willing people are, during a bull market, just to toss money around, because, you know, they think it’s easy.

And of course, that’s what they felt about internet stocks a few years ago. They’ll think it about something else next year, too.

But the biggest money made, you know, in Wall Street in recent years, has not been made by great performance, but it’s been made by great promotion, basically.

Charlie, do you have anything?

CHARLIE MUNGER: Well, I would state it even more strongly. I think the current scene is obscene. I think there’s too much mania. There’s too much chasing after easy money. There’s too much misleading sales material about investments. There’s too much on the television emphasizing speculation in stocks.

31. Powerful forces don’t want to expense stock options

WARREN BUFFETT: Zone 7.

AUDIENCE MEMBER: Robert Piton (PH) from Chicago. The Honorable Warren Buffett and the Honorable Charlie Munger, I felt it would be appropriate to address you both in a manner that reflects the tremendous amount of value that the two of you have been instrumental in unleashing for your shareholders, your employees, and the good of society. (Applause)

The area that I’d like to inquire about is stock options. As you are aware and have written about in the past reports, companies have been taking advantage of, and contributing to, FASB’s inadequate rules regarding stock options.

In particular, the lack of having to expense them on the income statement and the lack of having to report them as a liability on the balance sheet.

My question is, are either one of you doing anything to help FASB’s current stance on the issue?

If not, have either one of you ever considered establishing a, quote, “real,” end quote, independent body of accountants that would actually try to make companies produce accounting statements that reflect economic reality?

WARREN BUFFETT: Charlie, I’ll let you. You have the history on it.

CHARLIE MUNGER: Well, we don’t like the accounting, which we’ve called “corrupt,” or at least I have. And I don’t think that’s too strong a word. I think it’s corrupt to have false accounting because you like a certain outcome better than another.

All that said, I don’t think either of us spends a lot of time fighting with FASB or trying to create a better one.

It’s like splitting your lance against stone or something. You can get a lot of back pressure from the butt of the lance. And we can’t be expected to cure all the ills of the world.

WARREN BUFFETT: We’ve written about it and talked about it. Obviously, you’ve picked up on it. And when it was an active issue whenever it was, about, I don’t know, four years ago or so, Senator [Carl] Levin of Michigan was one of those who felt as we did. And, of course, FASB felt as we did.

But the pressure was incredible that American business brought on, on Congress. They weren’t getting — they tried to put pressure on FASB and they weren’t getting a result, so they just said, “Well, we’re not going to let FASB set the accounting rules, we’ll have Congress set the accounting rules.”

And I thought that was a bad idea, per se, but I thought in this — and, but they got plenty of supporters. Got a huge number of supporters. I mean, they —

And at the time, I compared it, I think — there was a bill introduced in the Indiana legislature in the 1890s, I believe. And the bill was to change the value of the mathematical term “pi” to three even, instead of 3.1415... (Laughter)

And the legislator who introduced it said that it was too difficult for the school children of Indiana to work with this terribly long, unending term. And it would be so much easier if pi was just three. And he thought they ought to enact that.

Well, I thought that was quite rational compared to, you know, what the Congress of the United States was going to do in telling people that, since it — one of the arguments was that, “It makes it very tough for startup companies if they have to expense this.”

Well, it makes tough if they have to pay their electricity bill, too. But, I mean, but those were the kind of arguments you got.

And my memory is, Charlie is better on this than I am probably, but I think the accounting firms 40 years ago or 50 years ago were in accord with our position.

But every client would put pressure on, you know, and they don’t want to report expenses. They particularly don’t want to report expenses that are paid to them, and that could be huge, and that might prove obnoxious if recorded by conventional accounting. But if it’s sort of lost in a table in the proxy statement, people don’t pay much attention.

So, the only way it will get changed — we wrote about it and I even talked to a few senators at the time — the only way it will get changed is — and this is the only way corporate governance problems generally will get changed — if 15 or 20 large institutional investors would band together in some way on this.

But some of them have the same problem because they’re getting paid extraordinary sums for doing something that, you know, is really not adding that much value.

So, they’re not really inclined to call attention, in many cases, to what Charlie would refer to as “obscenities” in other people’s compensation.

So, I think it’s going to go on. I mean, it’s a fascinating subject. But the institutional investors seem to focus very much on matters of form and not substance.

I mean, you get a lot of — they, you know, they cluck a lot about little things that don’t have anything to do with their economic return over time, whereas on stock options they’re something that’s terribly important. They’re the ones that are paying the costs, and the costs are there whether they get recorded or not.

But American management will not change its position on that voluntarily. Consultants will never change their position. They’re getting paid to encourage people to look at other companies, and it just keeps ratcheting up. So, I don’t think you’re going to see change unless institutional investors do it.

As I say, I get these questionnaires, you know, about the composition of the board or a nominating committee. None of that makes any difference in terms of how a business performs.

I got one form that said they wanted a list of directors broken down by sex. And I said, “None that I know of.” (Laughter)

But it just is not germane.

Charlie?

CHARLIE MUNGER: Well, I can’t top that one. (Laughter)

32. No company should predict 15 percent annual growth

WARREN BUFFETT: Zone 8, please.

AUDIENCE MEMBER: Steve Casbell (PH) from Atlanta.

My question concerns Gillette. Do you think their goal of trying to grow earnings at 15-plus percent kind of got them into their current inventory problems at the trade?

And as well, the Duracell acquisition. I know at the time, neither one of you were the biggest fans of the deal. I just want to know how you feel about it now.

WARREN BUFFETT: Well, I would say it’s a mistake. And I’ve said it. I think it’s a mistake for any company to predict 15 percent a year growth. But plenty of them do.

For one thing, you know, unless the U.S. economy grows at 15 percent a year, eventually any 15 percent number catches up with you. It just, it doesn’t make sense.

Very, very few large companies can compound their earnings at 15 percent. It isn’t going to happen.

You can look at the Fortune 500, and if you want to pick 10 names on there that will compound their growth from — other than some extraordinarily depressed year, I mean, if they had a year where they just broke even so the number’s practically zero.

But if you pick any company on there that currently has record earnings, and you want to pick out 10 of them that over the next 20 years will average 15 percent or greater, I will, you know, I will bet you that more than half of your list will not make it.

So, I think it’s a mistake, and as I’ve said in the annual report, I think it leads people to stretch on accounting. I think it tends to make them change trade practices.

And you know, I’m not singling out Gillette in the least, but I can tell you that if you look at the companies that have done it, you will find plenty of examples of people who have made those sort of mistakes.

And I think that, in connection with Duracell — I mean, obviously, Duracell has not turned out the way that the management of Gillette, at the time, hoped that it was going to do. And the investment bankers who came in and made the presentations, those presentations would look pretty silly now.

Charlie?

CHARLIE MUNGER: I think that kind of stuff happens all the time. It will continue to happen. It’s just built into the system.

I see more predictions of future earnings growth at a high rate, not less. I mean, a few people have sort of taken an abstinence pledge, but it’s very few. It’s what the analysts want to hear.

WARREN BUFFETT: It’s what the investor relations departments want the managements to say. It makes their life easier, you know. But they don’t have to be there five years from now or 10 years from now doing the same thing. It’s —

If we predicted 15 percent from Berkshire, you know, 15 percent means that — assuming the same multiples — I mean, that means in five years, 200 billion. In 10 years, 400 billion. You know, 15 years, 800 billion. A trillion-six in 20 years. And the values get to be crazy.

And you know, if you have a business with a market value of 4- or 500 billion — and you had a few of those not so long ago — just think of what it takes to deliver, in the way of future cash, at a 15 percent discount rate to justify that.

If you’ve got a business that’s delivering you no cash today and it’s selling for $500 billion, you know, to give you 15 percent on your money, it would have to be giving you 75 billion this year.

But if it doesn’t give you 75 billion this year, you know, it has to be giving you 86 and a quarter billion next year. And if it doesn’t do it next year, it has to be giving you almost a hundred billion in the third year.

It just — those numbers are staggering. I mean, the implications involved in certain market valuations really, you know, belong in “Gulliver’s Travels” or something. But people take them very seriously.

I mean, people were valuing businesses at $500 billion a year, a year-and-a-half ago, and there’s just no mathematical — almost no mathematical calculation you could make that would — if you demanded something like 15 percent on your money — there’s almost no mathematical calculation you could make that would — could possibly lead you to justify those valuations.

Charlie, have any more?

CHARLIE MUNGER: You know, I said on another occasion that, to some extent, stocks sell like Rembrandts. They don’t sell based on the value that people are going to get from looking at the picture.

They sell based on the fact that Rembrandts have gone up in value in the past. And when you get that kind of valuation in the stocks, some crazy things can happen.

Bonds are way more rational, because nobody can believe that a bond paying a fixed rate of modest interest can go to the sky, but with stocks they behave partly like Rembrandts.

And I said, suppose you filled every pension fund in America with nothing but Rembrandts? Of course, Rembrandts would keep going up and up as people bought more and more Rembrandts, or pieces of Rembrandts, at higher and higher prices.

I said, “Wouldn’t that create a hell of a mess after 20 years of buying Rembrandts?” And to the extent that stock prices generally become sort of irrational, isn’t it sort of like filling half the pension funds with Rembrandts? I think those are good questions.

WARREN BUFFETT: Once it gets going, though, people have an enormous interest in pushing Rembrandts. I mean, it creates its own constituency.

33. “It’s stupid the way people are extrapolating the past”

WARREN BUFFETT: Zone 1?

AUDIENCE MEMBER: Mr. Buffett, Mr. Munger, my name is Joe Schulman (PH). I’m a shareholder from Oxford, Maryland. Thank you for a wonderful meeting.

In order for Berkshire to have an opportunity to hopefully grow its earnings by about 15 percent per year, if we can do that, at least for the next few years, it’s obvious that because of the redeployment of earnings and float, the existing businesses do not need to grow at 15 percent.

At what rate would you expect the existing businesses to grow to achieve an aggregate rate close to what I’m describing? And what do you think the probability is of achieving that?

WARREN BUFFETT: Yes. Well, I think the probability of us achieving 15 percent growth in earnings over an extended period of years is so close to zero, it’s not worth calculating.

I mean, we’ll do our best, and we have a lot of fun doing it. So it is not something where we have to come down and do things that are boring to us or anything of the sort.

I mean, our inclination is to — very much — to do everything we can, legitimately, to add to Berkshire’s earnings in things we can understand. But it can’t happen, over time. You know, we will have years when we do it, but —

And you’re quite correct in pointing out we don’t need to do it from the present businesses — we will add things all the time — any more than we needed to do it from the current business back in 1965 with the textile business.

I mean, we have to improvise as we go along. And we will. And the businesses we have are good businesses, in aggregate. They will do well.

They won’t do anything like 15 percent growth per annum, but we will take a good rate of progress from those businesses, and we will superimpose upon that acquisitions which will add to that.

But we can’t do 15 over a period of time, and — nor, incidentally, do we think any large company in the United States is likely to do.

There will be a couple that do it for a long period of time, but to predict which of the Fortune 500 will end up being the one or two or three, would be very hard to do.

And it won’t be more than a couple out of 500, if you take large companies not working from a deflated base year.

I think our method is a pretty good one. I mean, I think the idea of having a group of good businesses to throw off cash in aggregate, in a big way, that themselves grow, that are run by terrific people, and then adding onto those, sometimes at a slow rate, but every now and then at a good clip, more businesses of the same kind, and not increasing the outstanding shares, I think that’s about as good a business model as you can have for a company our size. But what it produces, we’ll have to see.

Charlie?

CHARLIE MUNGER: I certainly agree that the chances of this 15 percent per annum progress extrapolated way forward is virtually impossible. I think, generally, the shareholding class in America should reduce its expectations a lot.

WARREN BUFFETT: Including the pension funds.

CHARLIE MUNGER: Yeah, including the pension funds, you bet.

It’s stupid the way people are extrapolating the past. Not slightly stupid, massively stupid. (Laughter)

WARREN BUFFETT: And this is a message, incidentally, if you think about it. I mean, nobody has any interest in saying this — a financial interest in saying it — whereas people have all kinds of financial interest in saying just the opposite.

I mean, so you do not get an information flow — if you listen to the financial world or read the financial press — you do not get an information flow that is balanced in any way, in terms of looking at the problem, because the money is in believing something different.

And money is what, you know, it’s what causes people to become prominent, or it flows from becoming prominent in the investment world in terms of whether you go on television shows, or whether you manage money, or are trying to attract it through funds, or whatever it may be.

I don’t think if you were an actuarial consultant and you insisted that the companies that you gave your actuarial report to use a 6 percent investment rate, I don’t think you’d have a client.

So, it’s almost impossible for the advisors, in effect, in my view, to be intellectually honest on it. Don’t you think so, Charlie?

CHARLIE MUNGER: Yeah. There was a very smart — there is a very smart investment advisor in my town, and he said that, “Years ago, some risk arbitrage firm would tell his clients, ‘We know how to make 15 percent per annum year in and year out.’”

And he said, “Years ago, everybody said, ‘That’s impossible.’” He says, “Now in this climate, they say, ‘So what?’” You know, who’s interested in a lousy 15 percent?

WARREN BUFFETT: And it was easier in the earlier climate, obviously, because the money hadn’t been attracted into it.

CHARLIE MUNGER: Generally speaking, there’s more felicity to be gained by — from reducing expectations than in any other way. It is simply crazy for this group to have very high expectations. Moderate expectations will do fine for all of us.

34. No comment on USG investment

WARREN BUFFETT: OK. We’ll take one more before we go — we break for lunch. We’ll go to number 2.

AUDIENCE MEMBER: Good morning. My name is Ken Goldberg from Sharon, Massachusetts.

A few questions ago, you mentioned the company’s investment in USG. I was wondering how the company — how you got comfortable with that as an investment, in light of the asbestos exposure?

Do you view the company — the stock — as cheap enough and the asbestos exposure as manageable enough over time, so that the investment is justified?

Or do you view it as, in a worst-case scenario, if the subsidiary with asbestos exposure blows up, the rest of the solid businesses are insulated from that and are alone worth the price of the investment?

CHARLIE MUNGER: Let me answer that. I don’t think we want to comment. (Buffett laughs)

WARREN BUFFETT: Yeah. It’s one-tenth of one percent of Berkshire, roughly. I mean, but as Charlie says, that gets too close to giving stock advice.

But I will tell you their asbestos problems are serious, and they would be the first to tell you that.

Afternoon session

1. “Insurance float has been a huge asset to Berkshire”

WARREN BUFFETT: OK.

I hope you’ve all had a cholesterol free lunch. And — (laughter) — we will move on. And when we stopped, we were about to go to zone 3.

AUDIENCE MEMBER: Hi, my name is Jason Tank from Traverse City, Michigan.

I’ve got one kind of quick question that I’m sure you can answer relatively quickly, if you’re not interested.

I know that Walter Scott’s on the board of directors and he’s also on the board of directors of a company called Level 3 Communications that is in an industry that’s — well, there’s been a lot of change happening and stock prices have been plummeting. I wonder if you’ve ever —

You’ve probably spoken to him at great length about the economics of that business. And have you ever expressed any interest that business, especially at the prices today?

That’s the first question. The second question is — if you look at Berkshire Hathaway as a portfolio, you’ve got wholly owned subsidiaries as operating businesses, marketable securities, common stocks and bonds. If you strip out — and if my premise is wrong, just please tell me.

If you strip out the leverage effect of the cost of the float being, you know, nearly zero or negative throughout the years — if you look at the portfolio minus that leverage piece, how fast do you think your book value would’ve grown over the last 30-plus years? Are we talking about 5 percent or 6 percent due to just the leverage piece on the insurance float?

WARREN BUFFETT: I don’t think it would run as much as 5 or 6 percentage points, but the float has been very useful to us. And actually, I’ve never made the calculation.

So you could well be correct that if it was 5 or 6 points, that would be a quarter of our book value gain over the years being attributable to insurance float.

And I think that’s probably maybe on the high side but — and you can’t make it —

We don’t look at insurance float 100 percent the same as we would look at equity, but we’ve looked at it a good bit, you know. It’s largely tantamount to equity because we’ve had so much equity, we could afford to do it that way. So I — you’ll have to make that calculation yourself.

We think insurance float has been a huge asset to Berkshire. We think it’ll continue to be a huge asset. And we look for every way possible to increase the amount of low-cost float.

On a small scale, we added US Liability last year, an excess surplus lines carrier based in Philadelphia. And so far, that’s working out extremely well. Got a terrific guy running it. And, you know, in a small way, we add float there. I just looked at the first quarter on it, and we had a significant underwriting profit and we had float added. And, you know, that’s the best of all worlds.

So we’ll keep working on it, and it will add — it’s a big asset that Berkshire has that a great many companies — I mean, virtually no other company has it to the degree that we have that also invests in other businesses and uses it as a source of money to invest in other businesses.

The question about Level 3, I obviously can’t answer. I just — I can tell you that you have two enormously smart and high-grade guys in Walter Scott and Jim Crowe in that business. But it’s not a business I know a lot about. And if I did, I wouldn’t talk about it.

Charlie?

CHARLIE MUNGER: I cannot talk just as well as you can. (Laughter)

WARREN BUFFETT: Not always. (Laughter)

2. Accounting “shenanigans” and “gamesmanship”

WARREN BUFFETT: OK. Section 4.

AUDIENCE MEMBER: John Golob from Kansas City.

I have a follow-up question to your comments about how financial statements can be distorted by making over-optimistic assumptions about returns for the pension portfolio.

If you believe accounting statements, as published in annual reports, returns on equity for U.S. businesses are amazingly high — higher than in Europe, higher than they’ve been historically, higher than Japan.

Are these highs, do you think, completely attributable to accounting shenanigans? Or are there any fundamental reasons in addition that might make returns in the U.S. higher than in Europe or higher than they’ve been historically?

WARREN BUFFETT: Well, I would say that they certainly — to the extent that American returns have been higher than those around the world, at least in developed countries, I would say that they are not solely due at all to accounting shenanigans.

I think that the absence of honest accounting for option costs and — has been a factor. But American business has done very well, excluding — very well — excluding any accounting activities that Charlie and I might differ with.

You know, I’m no expert on exactly what returns have been around the world in developed countries, but my impression definitely is that American business is well above averaged — average — for the developed world, in terms of profitability.

And, you know, I don’t have the answers as to why that’s occurred. I think that American business, and I think the whole American system, has reflected more of a meritocracy than exists in many countries.

And I think that a meritocracy works best. I think — and I think that mobility between classes, which is the flip side of a meritocracy, you know, does tend to get the Jack Welches into positions of — whether they run a General Electric or an Andy Grove or an Intel or, you know, go with Sam Walton at Walmart.

I think if you’d taken those same individuals and dropped them down in most countries, they would’ve done very well. But I don’t think they would’ve done quite as well as here. And I think that what they have done well has spilled over, in a big way, to benefit the American economy.

So I would not lay it all on the accounting shenanigans.

And the pension funds accounting, that applies very heavily at some companies. And, of course, most newer companies don’t have pensions.

Companies that have started in the last 20 or 30 years are much more inclined to have various kinds of profit sharing or 401(k)s.

The older industries that took on pensions spurred, to a great degree, I think, by World War II, when you got excess profits taxes that ran to 90 percent. And there was a huge incentive to start pension plans and fund them heavily because the government, in effect, was funding 90 percent of your pension obligation.

So there was a great boon — boom period in the inauguration of pension funds. And, of course, that meant steel and auto and all of those big industries of that time.

Charlie?

CHARLIE MUNGER: Yeah. It isn’t so much accounting shenanigans as it is deliberate financial practice. Take General Electric.

There’s been a deliberate increase in financial leverage, which was made possible by the wonderful and deserved reputation. There’s been a deliberate increase in repurchase of stock, which General Electric has done even when they’re paying huge multiples of book value.

That sort of thing does wonders for returns on equity as reported, as does the process of writing off everything in sight and various extraordinary charges, removing the burden of past costs from future earnings.

You put all those things together, and American returns on equity are higher partly because the management has deliberately set out to paint the company as unusually efficient in its use of capital, meaning that it earns a high return on shareholders’ equity.

Think of how high we could drive our return on equity at Berkshire. I mean, we could make it almost any number you want if we just used enough leverage.

WARREN BUFFETT: Yeah, we could run it with no (inaudible).

CHARLIE MUNGER: We could run Berkshire with no equity. And then people could say, “Gosh, these guys have finally learned how to manage the damn thing.” (Laughter)

It’s not been an objective around here to reduce the equity to zero. But at other places, in order to make the reported return on equity good, they deliberately pound on the net worth as much as they can.

WARREN BUFFETT: Yeah. The questioner may have seen — if you look at the S&P figures of the last 15 years, they report them both before special charges and after special charges. And there’s been a very significant difference between those two figures.

American business likes to frequently write off things and say that doesn’t count. And, of course, that takes the equity down. And it actually frequently benefits future earnings because you remove costs that would otherwise hit the income statement in future years.

CHARLIE MUNGER: The truth of the matter is you have — part of this is shrewd and correct management of the companies’ financial structure and operations. And part of it can drift into gamesmanship.

3. Save money in your teen years and be very curious

WARREN BUFFETT: Region 5.

AUDIENCE MEMBER: Hi, Mr. Buffett. My name is Mallory Marshall (PH). I am 11 years old and I am from Kearney, Nebraska. I have 2 questions.

First, my dad would like to know if you have any grandsons my age. (Laughter)

WARREN BUFFETT: Any what her age?

CHARLIE MUNGER: She wants to know if you have any grandsons her age.

WARREN BUFFETT: How many shares of stock do you have? And I’ll tell you. (Laughter)

AUDIENCE MEMBER: Also, what investment advice do you have for young people of my generation?

WARREN BUFFETT: Yeah. Well, I’ve got a grandson fairly close to your age and he probably would go for a younger woman anyway, so — (laughter) — I will mention him to you. Mention you to him.

The — well, if you’re interested in financial matters, A, you’ve got to have something to work with. I mean, I was fortunate in that respect because my dad paid for my education. If he hadn’t, I probably wouldn’t have become educated if I had to pay for it myself, but —

So I was able to save $10,000 by the time I was 21. And, you know, that was a huge, huge head start. If I hadn’t have been able to do that and, you know, my first child came along when I was 22.

So it’s much easier to save in those teenage years if you’re lucky enough to be in a family where you don’t have — where your parents are taking care of your financial obligations. Every dollar then is, you know, worth making $10 or $20 later on.

And, so if you are interested in financial matters, getting a stake early is very useful, and getting knowledge early is very useful.

So, you know, I would say you’re well on the way if, at 11, you’re even interested in coming to a meeting like this.

And I would — if that interest is maintained, you know, I would read financial publications. I would read whatever was of interest to me. I’d be curious about how the businesses around the town of Kearney operated.

I would — to the extent that you can get people to talk to you — and people usually like to talk, you know — learn about who’s got good businesses in Kearney and why they’re good businesses. And learn about the businesses that went out of business and why they went out of business.

And just keep accumulating knowledge. That’s one of the beauties of the business that Charlie and I are in, is that everything is cumulative. The stuff I learned when I was 20 is useful today. Not in necessarily the same way and not necessarily every day. But it’s useful.

So you’re building a database in your mind that is going to pay off over time. But you have to have a little money to work with. So there’s nothing like getting a few dollars ahead. Stay away from credit cards. And you can have a lot of fun, if your mind goes along that track as you get older.

Charlie?

CHARLIE MUNGER: Well, I’m glad to see somebody that has, so early, shown an interest in getting ahead. There’s nothing wrong with getting ahead. (Laughter)

WARREN BUFFETT: And actually, she may have the best idea about getting ahead by learning the name of my grandson, too. (Laughter)

CHARLIE MUNGER: Well, there, I can give the young lady some advice. Before your feelings totally take over, you should look carefully at both parents and all four grandparents. (Laughter)

WARREN BUFFETT: Write Charlie and let us know how it works out. (Laughter)

4. GEICO policy retention rates

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: I’m Jack Hurst (PH), Philadelphia, Pennsylvania. Three notes of thanks. First, for American Express for the terrific job they’ve done the last three times in scheduling reservations for me.

The second is thanks for the care you take with your annual report. There is nothing more accessible than the statistics in that report, and the text is just absolutely marvelous.

The third one is the care and feeding you give to troubled businesses like World Book, which I’m glad has survived, and Dexter Shoes.

They’re closing the plant in Milo, Maine, which is advantageous for the shareholders. But they gave the people enough time that, because of the additional — Jackson Labs expanded, they’re hiring, and Fidelity brought 6,000 jobs into the area. So those people will have better chance for jobs than they had to — if they were kicked out right away.

The second point is a question about GEICO. You have a wonderful table in your annual report showing the number of policies issued and the policies in force at the end of each year, for the last seven or eight years.

In general, at the end of one year, the policies in force are equal to 95 percent of the policies in force at the beginning of the year, plus 60 percent of those that have been issued in the year.

And that’s been constant, up until this last year, when the amount in force at the end of 2000 is 24 percent of the policies issued in 2000 and 95 percent of those that were in force at the end of 1999.

I’m curious if Mr. Nicely has asked, first, “Why is there such a large difference in lapse between the first year policies and the renewal policies?” and, “Why is there such a discontinuity in the year 2000?”

WARREN BUFFETT: The — I’ll answer the last one first, about GEICO. The retention rate is affected overwhelmingly by two factors.

One is the mix between the below-standard business, the standard business, and the better business, in terms of risk. In other words, we have — just making a calculation here — we have 75 percent or so of our business, plus, in the preferred category.

But we have grown faster up till the last year or so — in the last three or four years before that — up till the last year in the standard and the non-standard business. Those latter two categories have far greater lapse — or non-retention ratios — or lapse ratios — than the preferred business.

They’re two different businesses almost. So any change in the mix between preferred and the other two categories will change the aggregate retention ratio very substantially.

The second thing is that the first year has a much higher retention — lapse ratio — than the second year of a policy. And, in turn, than the third, and so on.

In other words, if you get to preferred business that’s been with you five or more years, you have a very, very high retention ratio.

In the last few years, we’ve added more new business than we were adding in the years before that. So we have had a higher percentage of new business and we’ve had a higher percentage of non-preferred business, both of which would make the aggregate lapse ratio look higher, even though the lapse ratio, when categorized by class of business and age of business, really hadn’t changed very much.

Now, it’s true, however, our retention ratio in the preferred business has fallen by a point or so.

But that’s the big difference. And now, unfortunately, you know, our new business is not as strong. So you’ll actually see, and — but, our preferred business is running stronger than our standard and non-standard.

So you are seeing the mix go back in the other direction, right now. I mean, currently, that’s going on.

Through right to date this year, our preferred business is up in aggregate policy holders. And our standard and non-standard is down.

So what you’ve deduced from those figures reflects changes in mix and age of business far more than it does retention ratio, although there was a minor change in the retention ratio. And that will be true. And maybe I should explain that better in the annual reports in the future.

I touched on it once a year ago, but we can make that clearer in future reports.

What you said about the American Express people, I echo. I mean, they have just done a fabulous job with people.

We sort of turned the problem over to them of how people get here and where they stay and all of that. And we’ve had wonderful help from the local American Express office.

And frankly, they’ve been so good, we don’t even think about it. We just refer people on to American Express. And I congratulate them for the job they’ve done. Thank you. (Applause)

5. “True synergy” between General Re and Berkshire’s reinsurance operations

WARREN BUFFETT: Area 7, please.

AUDIENCE MEMBER: I’m Chip Mann (PH) from Minneapolis, Minnesota. Thanks again for this open format and your direct answers to our questions.

You’ve talked a bit about the super-cat class level of risk that you write. Could you share your thoughts about expanding the competitive advantage and the scale advantages at General Re, referring more to their traditional or historical franchise and the type of contracts they would write?

WARREN BUFFETT: Yeah. General Re was a — is a — and General Re and Cologne are a very different operation than the historical reinsurance business of National Indemnity.

National Indemnity had nothing like their distribution system. And they have a — and a knowledge base for a whole different form of reinsurance than we could ever accumulate at National Indemnity.

General Re did not — nor Cologne — did not take —retain — as much risk as we’re quite willing to retain because their financial profile was different before they joined Berkshire.

So it’s an opportunity for us, for two reasons, to make more money in that respect than General Re might’ve made on its own.

One is we can retain much bigger portions of what they would write in the first place, and which they’ve been writing over the years, but which they’ve laid off with other companies in what has the fancy name of retrocessionals.

And a second point is that they have a distribution capacity that may well have the ability to deliver to us a lot of big risks that we might not otherwise see. And that, in the past, they might not otherwise have had a good outlet for.

So there is — there’s really true — I hate the word — but there’s really true synergy in General Re Cologne being married to Berkshire Hathaway. And you’ve put your finger on, really, one point that has two aspects to it.

And we haven’t fully exploited that. We probably won’t fully exploit it, you know, 10 years from now.

But it’s very much in my mind and the minds of the managers at General Re and Cologne that we have expanded opportunities, simply because Berkshire is willing to take on more risk than just about anybody in the world knowingly takes on.

Although we think some other people take on a lot more risk, unknowingly.

But in terms of writing a specific contract, we are both bigger and faster, I think, than anybody in the world. In effect, we have some of the abilities that used to be associated with going to a Lloyd’s of London.

I mean we can — now, I don’t know how true all that was over the years, because I wasn’t around there then. But we really can give an answer on something in an hour that other companies wouldn’t know what to do with in a month. And that should be a plus for us in the world.

Charlie?

CHARLIE MUNGER: Nothing to add.

6. Why Buffett doesn’t like to buy a new car

WARREN BUFFETT: OK. Zone 8.

AUDIENCE MEMBER: My name is Ethan Berg. I’m from Cambridge, Massachusetts and I’d like to thank you for the education you’ve provided, particularly with the annual reports. I’ve got three brief questions.

Years ago, you wrote to your friend Jerry Orans that you were applying to Columbia’s Business School because they had a pretty good finance department and a couple of hot shots in Graham and Dodd.

If you were considering graduate or business school today, with which individuals or professors would you want to study?

The second question is, a friend who wants to know your thoughts on the concrete, cement and aggregates business.

And the third question is from my wife. You mentioned earlier if someone were buying a parachute, they wouldn’t buy based on lowest bid. We saw you tooling around in a car this week that, were it to be bought today, could probably be bought at a relatively low bid.

As someone interested in your health, she’s wondering whether you’ve considered a newer automobile, possibly one with lots of airbags. (Laughter)

WARREN BUFFETT: Actually, I picked out the car I have based on the fact that it had airbags on both sides. So that was a factor. It may be the first car of its type ever made with airbags.

But I think my car actually — it’s both heavy and has airbags, and those are two primary factors in safety. I don’t think any — I don’t think a safer car is necessarily being made. It might be safer to drive around in a big, heavy duty truck or something but I’m not ready for that.

Incidentally, on a car, I look at that like anything else. It would take me, probably, a half a day to go through, you know, the exercise of buying a car and reading the owner’s manual and all that. And that’s just a half a day I don’t want to give up in my life for no benefit.

You know, if I could write a check in 30 seconds and be in the same position I’m in now with a newer car, I’d be glad to do it this afternoon. But I don’t like to trade away when there’s really no benefit to me at all. I’m totally happy with the car.

I just don’t want to trade away the amount of time I’d have to spend fooling around to get familiar with and get title to and do all the rest of the things, pick one out, so a new car. But if there’s a safer car made, you know, I’ll be driving in it.

7. Concrete, cement, and aggregates are understandable

WARREN BUFFETT: The aggregates business, concrete, all of that, those are businesses that — and Charlie probably knows more about them than I do. We’ve looked at businesses like that.

In fact, we’ve even owned a few shares at one time or another, because it’s an understandable business. And it’s a business that — particularly if you get into concrete, cement, I mean, you know, there have been periods of substantial overcapacity, particularly on a regional basis.

But those are fundamental businesses. And at a price, you know, for low-cost capacity and advantageously located raw materials and so on, you know, we would do it. In fact, Charlie and I talked about one probably 10 or 15 years ago —

CHARLIE MUNGER: Yes.

WARREN BUFFETT: — quite a bit. And he’s had a fair amount of familiarity with it. And what was the other one? I jotted it down here. Let’s see.

8. Business schools are “pathetic” at teaching how to invest

CHARLIE MUNGER: He wanted to know what business school a young man should —

WARREN BUFFETT: Oh, business schools.

CHARLIE MUNGER: — go to.

WARREN BUFFETT: Yeah. Well, I would say this, that I think Bruce Greenwald’s class at Columbia is very good. He gets in a lot of people that are practitioners. So there’s a lot of practicality to the course.

And I think Bruce is good. He’s got a new book coming out probably within the next six months or so that will deal with that.

And then there also has been endowed, at the University of Florida, certain courses relating to value investing. And I think there’s been one at the University of Missouri.

So I would suggest you at least check out the curriculum at the University of Missouri and Columbia and Florida. And do a little comparison and maybe check with a few graduates — recent graduates — as to what kind of experience they had.

If you can find them, I think that’s the best system for evaluating a place. But those three, at least, have courses that, based on the catalogue, sound like they might be of interest to you.

Charlie?

CHARLIE MUNGER: Yeah. A huge majority of the business school teaching on the field of investment of (inaudible) portfolios of securities is not what we believe and not what Warren was taught years ago by Ben Graham. There’re just little pockets of our attitude left. There’s one at Stanford. Jack McDonald?

WARREN BUFFETT: Yeah, sure. Yeah, that’s graduate school. But yeah.

CHARLIE MUNGER: It’s graduate school. And what’s interesting about that is I think it’s the most popular course in the whole Stanford Business School. They’ve got some kind of a bidding system. And yet, I asked Jack how he felt and he said he felt lonely.

He’s got the most popular course, but in the whole professoriate, dealing with investment matters, the Jack McDonalds are a little clan of their own in a side pocket, so to speak.

Now, they’re right. And they can take whatever consolation they get from that. But mostly, if you go to business school you will learn a lot of things we don’t believe. (Laughter)

WARREN BUFFETT: Jack — Bob Kirby comes in and works with Jack sometimes, too. And Bob has got a terrific mind, in terms of investment. I mean, there’s no question about that.

You know, it’s not the easiest school in the world to get into and it is at the graduate level. But there are these occasional little anomalies, as they would say, in the teaching world.

I mean, what you really want a course on investing to be is how to value a business. That’s what the game is about. I mean, if you don’t know how to value a business, you don’t know how to value a stock.

And if you look at what is being taught, I think you’ll see very little of how to value a business.

And the rest of it is playing around, maybe, with numbers or, you know, Greek symbols or something of the sort. But it doesn’t do you any good. I mean, in the end, you have to decide, you know, whether you’re going to value a business at $400 million or $600 million or $800 million.

And then you compare that with the price. And that’s what investing is. And I don’t know any other kind of investing, you know, basically to do.

And there — that just isn’t taught. And the reason it isn’t taught is because there aren’t teachers around, you know, who know how to teach it.

I mean, they don’t know themselves. And since they don’t know themselves, they teach something that says, “Nobody knows anything,” which is the efficiency market theory. (Laughter)

And if I didn’t know how to do it — and if I ever teach physics, I’m going to come up with a theory that nobody knows anything, because it’s the only way I can get through the day, you know? But — (Laughter)

It’s fascinating to me how, you know, the really great universities operate in this respect.

If you get a sacred writ, I mean, you get in the finance department because you sign on, you know, to whatever the present group thinks. And if they think the world is flat, you’d better think the world is flat too, you know? And your students better answer that the world’s flat when they get it on exams.

I would say investment — finance — teaching in this country, in general, is kind of pathetic.

CHARLIE MUNGER: Well, I think the business schools do a pretty good job when it comes to accounting —

WARREN BUFFETT: Oh, accounting, sure, sure.

CHARLIE MUNGER: — or personnel management, or — there’re a whole lot of subjects I think they do quite well with. But they miss one enormous opportunity.

If you learn to think intelligently about how to invest successfully in businesses, you’ll become a much better business manager than you will if you aren’t good at understanding what’s required for successful investment.

So they’re missing a huge opportunity to improve the management profession by doing such a lousy job in teaching investment.

WARREN BUFFETT: Yeah, see, Charlie and I see CEOs all the time who, in a sense, don’t know how to think about the value of businesses they’re acquiring. And then, you know, so they go out and hire investment bankers.

And guess what? The investment banker tells them what to do, tells them to do it because they get 20X if they do it and X if they don’t do it. And guess how the advice comes out.

So it’s a — when a manager of a business feels helpless, which he won’t say out loud, but inwardly feels helpless in the question of asset allocation, you know, you’ve got a real problem.

And there aren’t — they have not gone to business schools that have given them any real help, I think, in terms of learning how to think about valuation in businesses. And, you know, that’s one of the reasons that we write and talk about it some, because there’s a gap there.

9. Credit card advice: “It’s crazy to get in debt

WARREN BUFFETT: OK. Number 1.

AUDIENCE MEMBER: My name is Martin Mitchell (PH). I’m from Bakersfield, California.

My question, a two-part question, is concerning debt. We know that individual debt can be devastating.

Do you — are you concerned that the American consumer is so far in debt, as a whole, as to be a problem?

And part two is, do you feel that our trade deficit with other countries is of concern to you?

WARREN BUFFETT: Well, the first question about debt, I think it’s very hard to answer about the consumer as a whole. I get letters every day from people who have problems in life. And they revolve — I mean, they’re either health or debt. And usually — frequently — the debt is connected with health, you know?

But they — it’s been very easy for them to borrow money, and they’re in over their heads, and it’s all over then.

And there’s no question that the American consumer is somewhat more indebted, in aggregate.

But it’s a very hard thing, I think, to come into conclusions about whether it poses a serious problem. You know, most people have had assets, directly or indirectly, that have gained in value enormously, particularly in real estate and some in securities.

So there’s a greater capacity to carry debt as earning power increases and assets held increases. I don’t — I can’t give you a useful answer, in terms of the world as a whole.

But I constantly give advice to young people, and those are the only people I talk to, aside from our shareholder group: just don’t start out behind the eight ball.

I mean, it’s crazy to get in debt because it’s so hard to get out of debt. And, I mean, the idea of having credit card debt — and we issue credit cards in all our businesses and, you know, so does every other retailer.

But the idea of trying to borrow money at 18 percent, you know, and thinking you’re going to get ahead in life, it isn’t going to work.

And I urge people — they can use their credit card, but I urge them to pay it off before it starts revolving because it’s just — it’s too expensive.

Charlie and I can’t make money with 18 percent money. I mean, we’re looking around for float because we don’t want to pay 5 percent for money.

And, so I’m very sympathetic to people get in debt. But once you get in it, it is hell to get out.

I mean, Charlie will have a few Ben Franklinisms to quote on that subject.

In fact, you want to give a few from Ben now? (Laughter)

CHARLIE MUNGER: Oh, no.

WARREN BUFFETT: He’d love to, but I led him into it the wrong way.

10. Long-term trade deficit is “a significant minus for the country”

WARREN BUFFETT: And the second question about the trade deficit, that’s a very interesting thing. Because when you run a trade deficit, what you’re doing is you’re trading assets of one sort or another for goods, beyond what you’re sending abroad.

So in effect, you are selling off a tiny bit of the farm so that the country can consume more than it’s producing. If you run a net trade deficit, the country, in aggregate, is consuming less than — or consuming more — than it’s producing.

And if you’re a very rich country, you can’t even see it because if you run a trade deficit of a few hundred billion dollars, you know, compared to an economy that’s maybe worth, what, 40 trillion or something like that, you don’t see it.

But you’re trading off a tiny bit of the farm every year to live a little bit better than if you just lived off the produce of the farm that year.

And you can do it with IOUs if you’ve got a good record. You can’t do it with IOUs if you’re a country that’s got a terrible record.

So they have to denominate their debt in dollars. And, of course, they don’t have the ability to denominate a lot of dollars, and people don’t want to accept a weak currency. So a weak country can’t get away with doing that, unless it’s getting special-type loans from agencies set up to do that.

We can do almost anything we want in this country, because we don’t confiscate property and we don’t — we haven’t destroyed a currency that the people have accepted, in terms of payment for their goods, over the years.

But I basically think a significant trade deficit over a long enough time is a significant minus for the country. You won’t see it though, day-by-day, or week-by-week, or month-by-month.

But eventually, if you trade for trinkets or whatever you’re getting beyond what you’re sending, and you trade away your assets —

Fortunately, some of the assets we traded not that many years ago, like movie studios and some of those things, the other people got the short end of the bargain on.

But by and large, it’s not a good policy for the country to run large trade deficits year after year.

Charlie?

CHARLIE MUNGER: Well, it’s — that’s certainly true if what you’re trading for is trinkets, or consumer goods, or something. But, of course, a developing country that ran a trade deficit to put in power plants and what have, that might be a very smart thing to do. In fact, the United States once did that.

WARREN BUFFETT: Yeah, we did it with railroads in a huge way, you know, and —

CHARLIE MUNGER: But under modern conditions, do we look like a twosome that would love a big trade deficit? (Laughter)

WARREN BUFFETT: No. It’s one thing to build railroads with the process, but it’s another thing, you know, to buy radios and television sets. I mean, it depends what you’re getting.

But by and large, we run a trade deficit on consumption goods. And that’s not a big plus over time.

11. Satisfied sellers are a “recruiting force”

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: Good afternoon. I’m Jim Hays (PH) from Alexandria, Virginia. I’d like to thank you and Mr. Justin for bringing his masterpiece into the Berkshire family.

But the question arises, will you soon run out of privately-held firms that meet the criteria for acquisitions of sufficient size to continue the returns to Berkshire?

WARREN BUFFETT: Well, that’s a good question because people who sell to us have the option of —private business — selling elsewhere or going public.

There seem to be enough people that have built businesses lovingly over 50 or 100 years, and their parents before them and grandparents, that really do care about the eventual disposition of them in some way beyond getting the last dollar that day, that we have a supply from time to time of those businesses. And I think we’ll continue to see them.

You do raise an interesting question. How many businesses like that are worth, you know, a billion dollars or more in the whole economy? There seem to be — you know, I wish there were more, but there are enough. So I think we will probably buy, on average, maybe two a year, something of that sort.

The really big ones — I mean, what we’d love to make is a 10- or $15 billion acquisition. And there would be very few private companies that would be in that category.

And then, from the ones that are in that category, you have to find somebody that is not going to conduct an auction.

We don’t — we just are not interested in auctions. If somebody wants to auction their business, we’re not that excited about getting in with them because we need people to run it after we buy it.

And, if that’s the way they look at their business, we may get more unpleasant surprises than we’ve tended to get in the past with the kind of criteria we’ve used.

Charlie?

CHARLIE MUNGER: Yeah. There’re two aspects of that situation. One is, are there going to be enough businesses? And two, how much competition are we going to get from other buyers?

One thing we do have going for us is that if you are the kind of a business owner that likes the culture that’s in this room today, there isn’t anybody else like us. Everybody else is off on a different path with a different culture. (Applause)

So — and look at all you. I mean, this culture is popular, at least with a certain group. And surely, there’ll be other people who like this culture in the future, as in the past, and will feel right about joining it with their companies.

WARREN BUFFETT: We haven’t had any luck internationally so far, but we would hope that that could change.

I was over in Europe about a month ago and I got asked the question a lot of times about whether we would be a prospect for businesses in Europe, for example.

The answer is yes. And then they say, “Well, you know, why haven’t you bought anything?” And I said, “The phone’s never rung.” I don’t know whether they thought that was a brilliant answer or not, but they — (Laughter)

But I left my phone number a lot of places, you know? Every time I got a chance, I gave that answer. And maybe the phone will ring.

I’ve got to believe that, if we were on the radar screen the same way in Europe over the last five years that we have been in the United States, we would’ve bought a couple of companies.

It’s just, they don’t think of us. And a lot of people don’t think of us in the United States, either, but more do now than did five or 10 years ago.

And we have, actually — a reasonable percentage of our acquisitions come, directly or indirectly, because we’ve made another acquisition in the past where the seller was happy. It’s very hard to find anybody that’s been unhappy dealing with us.

And they’re friends with other people in their industry, or whatever it may be. So, we hear about things now more often, because we actually have what you might call a recruiting force out there of people that have already done business.

It’s very much like NetJets that way. I mean, we spend a lot of money advertising at Executive Jet, the NetJet service. But still, 70 percent or so of our business comes from owners who are with us. They’re, by far, the best salespeople we have.

And incidentally, that’s the way I was introduced to the business. Frank Rooney, who’s in this room today, told me about his good experience with NetJets back in January or so of 1995. And that’s when I joined in. And if Frank hadn’t told me, I might — six years later, I might not have ever looked into it. I mean, you know, I might’ve just turned the pages past the ads and —

But when Frank said, “You ought to look into this,” I did. Well, that’s what we hope we have going for us on the acquisition front. And I think we do, to some degree. But we’d like it to be greater, and we would like it to be more widespread, geographically, than it is.

CHARLIE MUNGER: When I was a lawyer, I used to say, “The best business getter any lawyer has is the work that’s already on his desk.”

And similarly, probably the best business getter that Berkshire Hathaway has is the business practice that’s already on our desk. That’s what’s driving the new businesses in, right, Warren?

WARREN BUFFETT: Sure. Sure.

CHARLIE MUNGER: So it’s a very old-fashioned idea. You just do well with what you already have and more of the same comes in.

12. Why Berkshire sold its Freddie Mac and Fannie Mae stakes

WARREN BUFFETT: Zone 3, please.

AUDIENCE MEMBER: My name is Steve Sondheimer. I live in Chicago and I’m 14 years old. I’m a third generation shareholder and my question is, I noticed that you sold our position in Freddie Mac. What risks do you see in that industry?

WARREN BUFFETT: Are you Joe’s granddaughter?

AUDIENCE MEMBER: Yeah.

WARREN BUFFETT: Oh, good. We have an amazing number of second and third and even fourth generation shareholders, which I’m delighted with. I mean, I don’t think lots of companies — big companies on the stock exchange — are in that position.

It is true, we sold the Freddie Mac stock last year. And there were certain aspects of the business that we felt less comfortable with as they unfolded — and Fannie Mae, too.

And the consequences of what we saw may not hurt the companies, I mean, at all. But they made us less comfortable than we were earlier, when, actually, those practices or activities didn’t exist.

We did not — I would stress — we did not sell because we were worried about more government regulation of Freddie and Fannie. If anything, just the opposite, so —

It was not — it was not — Wall Street occasionally will react negatively to the prospect of more government regulation and the stocks will react sometimes short-term for that reason. But that was not our reason. We were — we felt the risk profile had changed somewhat.

Charlie?

CHARLIE MUNGER: Yeah, but that may be a peculiarity of ours. We are especially prone to get uncomfortable around financial institutions.

WARREN BUFFETT: We’re quite sensitive to —

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: — risk in — whether it’s in banks, insurance companies or in what they call GSEs here, in the case of Freddie and Fannie.

We feel there’s so much about a financial institution that you don’t know by looking at just figures, that if anything bothers us a little bit, we’re never sure whether it’s an iceberg situation or not.

And that doesn’t mean it is an iceberg situation, in the least, at banks or insurance companies that we pass.

But we have seen enough of what happens with financial institutions that push one way or another, that if we get some feeling that that’s going on, we just figure we’ll never see it until it’s too late anyway.

So we bid adieu without — and wish them the best — without any implication that they’re doing anything wrong. It’s just that we can’t be 100 percent sure of the fact they’re doing things that we like.

And when we get to that situation, it’s different than buying into a company with a product or something, or a retail operation. You could spot troubles usually fairly early in those businesses. You spot troubles in financial institutions late. It’s just the nature of the beast.

Charlie?

CHARLIE MUNGER: Yeah. Financial institutions tend to make us nervous when they’re trying to do well. (Laughter)

That sounds paradoxical, but that’s the way it is.

WARREN BUFFETT: Financial institutions don’t get in trouble by running out of cash in most cases. Other businesses, you can spot that way.

But a financial institution can go beyond the point — and we had banks 10 years ago that did that, en masse — but they can go beyond the point of solvency even while they still have plenty of money around.

13. Debating whether it’s good moats are harder to find

WARREN BUFFETT: Area 4, please.

AUDIENCE MEMBER: Good afternoon, Mr. Buffett, Mr. Munger. My name is George Brumley from Durham, North Carolina.

We often consider evaluating companies in the context of Michael Porter’s model of position relative to competitors, customers, suppliers, substitute products. You state that much more simply when you say you seek for companies with the protection of wide and deep moats.

To complete the valuation of a company, we all seek to choose the appropriate future cash flow coupons. A qualitative assessment of the protected competitive position is required to precisely forecast those future coupons.

In your opinion, are the dynamic changes in the nature of competition, distribution systems, technology, and even changes in customers, making it more difficult to accurately forecast those future cash flow coupons?

Are good, protected businesses going to be more rare going forward in — than they have been in the past? And if so, does that make the few that do exist more valuable?

WARREN BUFFETT: Well, you’ve really described the investment process well. I can’t see from here, but which George are you? Are you the — are you Fred’s brother-in-law or are you one generation down?

AUDIENCE MEMBER: George III. My father is here as well.

WARREN BUFFETT: OK, good. The questions you ask are right on the mark. And we do think, to the extent I understand what — or have read what Porter has written, we think alike, basically, in terms of businesses.

And we do call it a moat. And he makes it all into a book, but that’s the difference between the businesses we’re in. (Laughter)

I — and Charlie may have a different view on this. I don’t think that the quantity or sustainability of moats in American business has changed that dramatically in 30 or 40 years.

Now, you can say that Sears and General Motors and people like that thought there were some very wide moats around their businesses, and it turned out otherwise when, in the case of Sears, Walmart, for example, came along.

But, I think — the businesses we think about, I think the moats that I see now seem as sustainable to me as the moats that I saw 30 years ago.

But I think there are many businesses — industries where it’s very hard to evaluate moats. There — those are the businesses of rapid change.

And are there fewer businesses around where change is going to be relatively slow than previously? I don’t think so, but maybe Charlie does.

Charlie?

CHARLIE MUNGER: No, I would argue that the old moats, some of them are getting filled in. And the new moats are harder to predict than some of the old moats. No, I would say it’s getting harder.

WARREN BUFFETT: Well, there you have it. (Laughter)

Unanimity at Berkshire. OK.

I think it’s a very good question. And I really don’t — you know, Charlie may be right, I may be right. I think it’s a very tough one to figure.

But regardless of whether there are fewer or that — harder to find, that’s still what we’re trying to do at Berkshire. I mean, that is what it’s all about.

Our instructions to our managers — we don’t have budgets and we don’t have all kinds of reporting systems or anything else. But we do tell them to try and not only protect, but enlarge, the moat. And if you enlarge the moat, everything else follows.

14. How derivatives become “potential dynamite”

WARREN BUFFETT: Area 5?

AUDIENCE MEMBER: Bill Graham (PH) from Los Angeles.

Warren, you’ve made it possible for outside shareholders to understand Berkshire’s financial businesses.

But there is one that seems, to me, anyway, hard to understand, which is the financial products business, which I guess, involves trading of derivatives.

And for the same — given the same kind of concerns that you and Charlie voiced in relation to financial businesses, can you help us out on that and why you’re comfortable with it?

WARREN BUFFETT: Well, I think you put your finger on it, Bill.

It is a hard business to understand. And it’s a hard business to understand if you own it, let alone read about it in somebody else’s annual report.

And I would guess that most people who own complicated or extensive derivatives businesses, I would say that most of the CEOs probably don’t understand it. And how many of them stay awake at nights over that, I don’t know.

Actually, in financial products, what you see on that one line of income on that, and also what you see in the balance sheet items, is a combination of several things. It’s General Re Securities, which used to be GRFP, General Re Financial Products. It’s — and it’s a couple of other operations.

It actually had our — it has our — structured settlement business in it, which is quite predictable and a very easy business to understand.

And it actually has some trading business that I do that falls in there. It’s not our normal investment business, but it may involve, what I think are — it tends to be fixed-income related.

It might involve arbitrage or semi-arbitrage of various types of fixed-income securities. It wouldn’t involve any equity arbitrage. That would not be in there.

But I would say that it would be a fair criticism to say that neither Charlie nor I know fully, or even in large part, what goes on in the derivatives business.

Now, we have a fellow who is both smart and trustworthy running that in Mark Byrne. So we feel very good about the individual.

We do not feel the instinctive understanding of everything that’s going on that we do, probably, in most of the businesses that we’re in. I think we’ve probably got 17,000 outstanding tickets at General Re Securities. And those interplay in all kinds of ways.

And I don’t think that Charlie or I have my mind — our minds — around that book of products. That means we want to be very comfortable with the fellow whose job it is to have his mind around those products. And I will tell you that, you know, there’s nobody that I’d feel more comfortable with than Mark Byrne.

But it is — it’s not a natural-type business for us.

The other things in that area, and we made a fair amount of money in some things that aren’t related to the derivative business last year. And those are under my direct control. So I feel OK about that.

The structured settlement business is a minor profit area. But it’s made us some money. And right now, it’s not attractive. But it could be again in the future.

And there could be other financial-type things we would stick in there. But if we stuck in anything, it would be something that I would be running.

Charlie?

CHARLIE MUNGER: Yeah, that mix includes what I would call oddball pastimes of Warren Buffett — (laughter) — outside —

WARREN BUFFETT: The ones that are publishable. (Laughter)

CHARLIE MUNGER: — outside the common stock field. That I’m quite comfortable with, although I’m sure the results will be irregular.

The rest of it — and I think we also have what might be called oddball personal ideas of Mark Byrne, and I’m quite comfortable with those.

As you get away from that, into what might be called more standardized derivative trading businesses, I think it’s fair to say I like them less than most of the people do who are in them.

WARREN BUFFETT: Quite a bit less. (Laughter)

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: Yeah, we regard that area as potentially being dynamite because if you get a group — a large group — of people that, in many cases in that business — although we’ve tried to go away from it ourselves — but in many cases in that business are getting paid based on front-ending potential profits, you can get — I mean, that’s a dangerous situation to place a hundred people in. You’re going to find people who will crack under that, in terms of what they will do.

You know, they had — we had a case of it, actually, in the electric utility industry a year or two ago, when Edison in California, through a subsidiary, compensated people based on projecting the profitability of the business they were putting on the books that day.

That’s Wall Street practice and it was brought to the utility industry. And it produced I’d say predictable results.

So it’s dangerous to pay people to make deals where you won’t know the outcome for 15 or 20 years and give them a lot of money upfront for doing it.

And that’s fairly standard practice in the business. I mean, it was standard practice at Salomon when I was there. And as I say, people occasionally crack under that.

It isn’t exactly analogous, but it’s worth reading Roger Lowenstein’s book entitled “When Genius Failed,” because it touches on some of the problems we’ve described that Charlie and I are apprehensive about.

CHARLIE MUNGER: Yeah, the derivatives business has the very significant problem that the accounting profession sold out. The accounting is improper. It front-ends way too much income.

It’s irrationally optimistic because that’s the way the denizens of the field want it because it creates bigger compensation. This is intrinsically an irresponsible system. And it’s another case where the accounting profession has failed the wider civilization.

WARREN BUFFETT: We found — Charlie was on the audit committee at Salomon — and we found positons — single positions — mismarked by close to $20 million, for example, didn’t we, Charlie?

CHARLIE MUNGER: Oh, yeah. But deliberate mismarkings was not the main problem. The main problem is the whole system of accounting is wrong. The whole system of accounting is too optimistic. It would be like going into the taxi cab business with a 30-year depreciation rate.

WARREN BUFFETT: Yeah. Or it’d be like writing long, very long-tail insurance, and paying a big commission upfront based on the expected profit of that insurance over a 10-year period or something, with that prepared by the guy who wrote the policy.

There are certain activities that are really just dangerous in the financial world. And when you get close to that kind of situation, you just have to be very careful.

Now you — actually, Mark has been implementing a system that compensates — that accounts for this — significantly differently than occurs at many institutions. So, you know, you can try to attack it. But it’s also hard to get too far away from industry norms and still do business. I mean —

CHARLIE MUNGER: Yeah. Our accounting is way more conservative than the standard derivative accounting of the country, thank God.

15. GEICO’s Lou Simpson manages “autonomously”

WARREN BUFFETT: OK. Area 6.

AUDIENCE MEMBER: My name is Scott Tilson (PH). I’m from Owings Mills, Maryland.

Gentlemen, you have stated many times that Lou Simpson manages the GEICO investment portfolio on an independent and autonomous basis.

What unique or superior qualities does Mr. Simpson possess as an investor that has earned him this tremendous vote of confidence?

Secondly, Berkshire invests in privately-held businesses as well as publicly-traded securities. While the skillset required to value public and private businesses may be the same, does Mr. Simpson also have the additional experience and skills necessary to negotiate a private transaction, if called upon to do so?

WARREN BUFFETT: Yeah, I think he could. But I hope he doesn’t get called on to very soon. (Laughter)

Lou is smart, and careful, and high-grade, and experienced.

So he does manage a couple billion dollars autonomously. He will buy things. I won’t know about them until I either look at a monthly sheet or sometimes read it in the paper. And that’s fine, you know? He doesn’t know what I’m doing. I don’t know what he’s doing.

Every now and then, we’re in the same security, so we try and coordinate if we’re buying or selling under those circumstances.

And incidentally, you will occasionally read a headline, not a very big headline, but in the financial press that says, “Buffett buying X, Y, Z.” Well, sometimes it should say, “Simpson buying X, Y, Z.”

They — the reports we file would not necessarily tell the reader which one of us made the decision, because even if the reports show that something was bought in GEICO, that could be bought in — by me and placed in GEICO for various reasons.

Or conceivably, Lou can buy something and place it in National Indemnity or some other Berkshire company also for perfectly good reasons. But some of what gets reported as done by Berkshire is done by Lou entirely independent of me.

And most of it, in terms of dollars, is done by me. But Lou’s record is just as good as mine, so.

And Lou would know how to evaluate businesses, whether private negotiations or public securities, and — but I’m in no hurry to turn it over. (Laughs)

16. Berkshire’s investment in Finova

WARREN BUFFETT: Seven.

AUDIENCE MEMBER: Good afternoon. My name is Scott Croy (PH). I’m from Chicago, Illinois.

Mr. Buffett, could you please describe the situation — the extent, if any, of Berkshire Hathaway’s investment in Finova Group earlier this year? Finova’s back appears to be against the wall.

WARREN BUFFETT: Yeah. It’s worse than against the wall. They’re in Chapter 11. (Laughter)

But that was all contemplated, obviously.

Finova is the old Greyhound leasing company, and grew to about 13 or $14 billion in assets. And then just about a year ago, now, ran into funding difficulties.

And when you run a highly leveraged finance business and you run into funding difficulties, they compound on you very quickly.

You know, confidence is a real coward. I mean, it runs when it sees trouble.

And in a finance business, you’re constantly faced with refinancing old obligations, and you have commercial paper out and all of that. So there’s no honeymoon period when you get in trouble in the finance business.

And we’ve even seen big ones in the past, like Chrysler Financial and all of that. I mean, it can strike anywhere when confidence disappears.

And so that hit Finova about a year ago. And it became clear not that many months later that Finova would have to either be sold or reorganized.

And I think there were attempts made to sell the company to other finance companies, and even a couple of little portions of the portfolio were sold. But they didn’t make a sale.

And when the bonds started selling down to prices that I thought were very attractive, in the fall or whenever it was of last year — and by attractive, I mean, I thought that if they went into bankruptcy that the assets were considerably greater in relationship to the liabilities than indicated by the market — we started buying bonds.

And we bought — we publicly announced it. We bought $1,428,000,000 face amount of bonds or bank debt. So we, out of 11 billion of aggregate debt at Finova, we own $1,428,000,000 face value. And we bought those at prices that looked attractive then and look attractive now.

And it became clear — it was somewhat — it was clear all along that they were either going to sell or go into bankruptcy. And it became clearer that they weren’t finding a buyer as time went by. And so it became very likely that they would declare bankruptcy sometime earlier this year.

One of the reasons being is they didn’t want to use the available cash to pay out the creditors whose money was coming due tomorrow, and thereby shortchange creditors whose claims were due at later dates.

We thought, perhaps, somebody would come in with a plan of reorganization. And it got very close to where they —in our view — they were going to default. And so we jointly, with Leucadia, in a joint venture called Berkadia, put forth our own plan and made a — and arranged a transaction.

But they are now in Chapter 11, and there will be plans presented to the — a plan or plans — presented to the court in short order. And then the court will determine —

I’m not — Charlie may know more about exactly how bankruptcy works than I do, although I don’t think he’s had any personal experience — that a plan gets submitted to creditors for approval.

And we will have a plan, which will be — which has been outlined in the press, and will be submitted to the court, almost certainly within a week, and when you can read about it at that time.

And then we will see whether anything else happens. I mean, it may be that somebody else comes in with a plan. It may be that our plan is approved.

And if our plan is approved, it involves a significant additional investment so that an initial payment can be made to the present debt holders. And then we’ll see what happens.

We feel very good about Berkadia. I — we think Berkadia — well, we think the Leucadia part of Berkadia brings a lot to the party, in terms of efficiently managing the assets that are there. It makes it — when an entity gets in bankruptcy, it makes a lot of difference how it’s handled.

I mean it, you can — there can be a lot of wastage of assets in bankruptcy. Or there could be a reasonably efficient way of handling it.

We think that the Berkadia arrangement will maximize the value of the assets. And we think that’s important. But we’ll see what happens. I think our position is going to work out fine.

Charlie?

CHARLIE MUNGER: Yeah. I think it’s —

WARREN BUFFETT: Microphone.

CHARLIE MUNGER: — a very interesting transaction. And you would hope there would be more of it.

WARREN BUFFETT: There will be. (Laughter)

CHARLIE MUNGER: No, I mean, not more bankruptcy, but more cures of bankruptcy following this model. I think it’s a very intelligent model and a very clean, simple, prompt way of cleaning up a corporate mess.

And I hope the rest of the world feels about it the way I do, and that the judge and other people concerned will say, “Thank God,” and we want this one to go through and we want more like it to happen.

WARREN BUFFETT: That’s what we tried to do in Salomon, incidentally. I mean, we tried to behave in a somewhat different way, in terms of a corporate crisis, than typical.

And we hoped that if that got a good result, that that might become a model that people might gravitate toward in future problems, because there will be future problems.

We are the largest creditor of Finova now. So we have more money on the line than anybody else, and we don’t have an interest —

You know, our interest is not primarily in getting fees or extending the bankruptcy or, you know, any of that sort of thing. We want to get the greatest realization of assets as possible. And the swing in that between doing it right and doing it wrong, you know, could be measured in the billions.

17. GEICO’s Lou Simpson bought Berkshire’s Gap shares

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: Good afternoon. I’m Claudia Fenner (PH) from Long Island, New York and I have two questions.

The first is, as a big fan of the Gap, I’d like to know why at this time you feel that the Gap is undervalued.

And the second question, if you could direct your answer to my husband, as a shareholder, would you agree that buying a large present at Borsheims this afternoon is like taking money out of one pocket and putting it back in another? (Laughter and applause)

WARREN BUFFETT: I’ll let Charlie handle the second one. (Laughter)

He’s our expert on consumption at Berkshire.

The Gap is a good illustration of what I talked about earlier, because I think the world assumes that I made a decision to buy Gap at Berkshire. And actually, that’s totally, 100 percent a Lou Simpson portfolio investment.

I don’t think I’ve read the annual report of the — I know — I haven’t read the annual report of the Gap ever. And I don’t know anything about it. I mean, you probably know a lot more about it than I do, and I hope Lou knows a lot more about it than I do. (Laughter)

It’s not a company I’ve ever looked at.

And Lou operates — and he has people that help him — Lou operates in somewhat — he can look at smaller securities, in terms of aggregate market caps, than I can, because I’m investing $2 billion. He can work with $200 million positions or even $100 million positions sometimes.

And I will do that occasionally, just because I happen to bump into them, in effect. But I’m really looking for things that we can put a billion or 2 billion or more in. And Lou’s universe of possible candidates for purchase is a bigger universe than mine.

And that may be a good thing, I mean, having two of us in there. Because he just is going to see things that I’m not going to see. So you’ll have to ask Lou about the Gap.

18. Buffett’s never regretted buying jewelry

WARREN BUFFETT: But, well, Charlie, give her a little advice on Borsheim’s. (Laughter)

CHARLIE MUNGER: Well, I think when you’re buying jewelry for the lady you love, it probably shouldn’t get too much financial calculation into it. (Laughter and applause)

WARREN BUFFETT: I will say this. And this is true. And you’re talking to a guy who does not normally go down this path, but I would say this:

I’ve never bought a piece of jewelry that I’ve regretted, in terms of what has happened subsequently, so it — (Laughter)

Well, if that isn’t a sales pitch, I don’t know what is. (Laughter)

19. Why GEICO can’t give everyone a better deal

WARREN BUFFETT: Zone 1.

AUDIENCE MEMBER: You’re a tough act to follow.

I’m Matt Richards. I’m from Parkton, Maryland.

Last year at this meeting, a gentleman stood up and implored you, Mr. Buffett, to invest in some technology stocks to juice our returns. I would like to this year thank you for having not done that. (Applause)

My question is regarding GEICO. I’ve been a USAA preferred risk customer for something like 15 years now.

WARREN BUFFETT: Yeah. You’ll do very well with USAA. They’re a perfect —

AUDIENCE MEMBER: Yes, well —

WARREN BUFFETT: — company.

AUDIENCE MEMBER: — I’d prefer to be a customer of the company that I own part of. Unfortunately, due to an accident and two speeding tickets in the last five years, they will not accept me as a preferred risk.

And I wonder if this isn’t an untapped group of people who are preferred risks with their own company.

Couldn’t GEICO possibly take their current preferred risk status into account when determining whether to accept them as a customer?

WARREN BUFFETT: Yeah, I would — USAA, incidentally, is a terrific company.

And Leo Goodwin, who started GEICO, which was then called Government Employees Insurance Company in 1936 — Leo actually was a key employee of USAA, as was his wife, Lillian. They both came from USAA.

And, they felt that — I mean, USAA as you know, limits its clientele — at that time, they limited their clientele to the officers in the armed services. And Leo wanted to extend — and that was a preferred class, and history has shown it to be a preferred class.

Leo wanted to extend that to other classes that he felt also had similar characteristics that USAA was not interested in. And that’s the reason he formed Government Employees Insurance.

He felt that the preferred characteristic that could be determined by employment in that area as to their propensity for accidents would extend beyond the officer ranks of the armed services. And he was right. It’s a fascinating story.

And there’s a good book about USAA that came out about two or three years ago, tells the whole story.

It’s hard for us to take away the preferred customers of USAA. It’s hard for them to take away our preferred customers, too.

But USAA has some of the same qualities that we have talked about in terms of State Farm. It has, as I remember, maybe a $6 billion, maybe larger now, surplus.

It’s slightly different than State Farm. It’s not a true mutual. It’s a reciprocal, as I remember. But, it’s tantamount to a mutual.

So the 6 billion that has been accumulated over the years is working for present policy holders, which is a terrific asset for them.

And the fact that they keep you as a preferred risk probably means you are a preferred risk. I mean, their underwriting judgment is very good.

You know, we have various categories that relate to speeding tickets or accidents and all of that sort of thing. And in aggregate, they are a good predictor of future accident potential. But it’s only in aggregate.

I mean, it’s like saying, you know, “Because I’m 70, that I have X percent chance of dying,” but it doesn’t say what’s going to happen to me specifically. But it does mean if you’re insuring 100,000 70-year-olds, you’d better get this sort of price.

We have these predictors, too. And past driving history is an important predictor. But you’ve got this long history with USAA. And they, probably for very good reason on that total history, keep you in the preferred class.

And we, based on criteria that are developed from looking at 5 million policy holders, we can’t make the determination — we can’t come out and actually observe you driving, or anything of the sort.

We have to look at the information that comes to us, which if it says speeding tickets or accident, it does result in various scores being applied. So I really can’t offer you a better deal. I’d like to. I have a feeling you’d be a good client. If USAA ever gets mad at you, come over and see us.

20. “We regard volatility as a measure of risk to be nuts”

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: I’m Bob Kline (PH) from Los Angeles.

Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results. And likewise, evaluates money managers by their volatility — measures their risk by volatility, I should say.

And I know you guys don’t agree with that approach. I wonder if you could give us some detail about how you come at the concept of risk, how you measure it, and just in general how you approach risk.

WARREN BUFFETT: Yeah, we regard volatility as a measure of risk to be nuts.

And the reason it’s used is because the people that are teaching want to talk about risk. And the truth is, they don’t know how to measure it in business.

I mean, that would be part of our course on how to value a business. It would also be, how risky is the business? And we think about that in terms of every business we buy. And risk with us relates to —

Well, it relates to several possibilities. One is the risk of permanent capital loss. And then the other risk is just an inadequate return on the kind of capital we put in. It does not relate to volatility at all.

Our See’s Candy business will lose money — and it depends on when Easter falls — but it’ll lose money in two quarters of the four quarters of the year. So it has a huge volatility of earnings within the year.

It’s one of the least risky businesses I know.

You can find all kinds of, you know, wonderful businesses that have great volatility and results. But it does not make them bad businesses. And you can find some very — you can find some terrible businesses that are very smooth.

I mean, you could have a business that did nothing, you know? And its results would not vary from quarter to quarter, right? So it just doesn’t make any sense to translate — (laughter) — volatility into risk.

And Charlie, you want to add anything on that?

CHARLIE MUNGER: Well, it raises an interesting question, which is how can a professoriate that is so smart come up with such silly ideas and spread them all over the country? (Laughter)

It is a — it’s a very interesting question. If all of us felt that — (Laughter)

WARREN BUFFETT: Charlie, your Dilly Bar’s arrived.

CHARLIE MUNGER: Oh, good.

WARREN BUFFETT: Yeah. You’ve heard of getting a second wind.

CHARLIE MUNGER: Oh, fine.

WARREN BUFFETT: Thank you. (Laughter and applause)

You tip him. (Laughter)

I didn’t think our cracks were that funny. (Laughter)

CHARLIE MUNGER: Right, right. But I’ve been waiting for this craziness to pass for several decades now. I do think it’s getting dented some. But it’s not passing.

WARREN BUFFETT: If somebody starts talking to you about beta, you know, zip up your pocketbook. (Laughter)

21. Zen Buddhism and the value of low expectations

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: Brian Zen (PH) from China.

As a Coke addict myself, I’m excited to report to you — (laughter) — our worldwide promoter-in-chief, that the Cokes in Beijing taste just as wonderful as in Omaha.

As a ex-Zen monk, today I feel like visiting the Buddha of the financial world. (Laughter)

We have an investment club, but with a name that ends in .com, believe it or not, which tells you that the frenzy — .com frenzy — even seduced Zen monks when we tried to follow you.

We find that Mrs. Susan Buffett used to send Zen Buddhism books to her sorority sisters. That’s probably why she always has a peaceful smile due to her low expectation of life which, according to Buddha, is full of sufferings.

But Mr. Munger would tell me that Susan’s smile is because you, as the husband, exceeded her low expectations.

CHARLIE MUNGER: That’s right. (Laughter)

WARREN BUFFETT: Yeah. And her father’s even lower expectations. (Laughter)

CHARLIE MUNGER: Right, right.

AUDIENCE MEMBER: Anyway, my question is, did Susan also send those Zen books to your office or your bedroom?

And if you have read those books, what are the key ideas that contributed to your investment tao, which even made sense to secluded, narrow-minded Zen monks like me? Thanks for the financial enlightenments you’ve given us today.

WARREN BUFFETT: Thank you. I sent those books on to Charlie so I’ll let him answer. (Applause)

CHARLIE MUNGER: Actually, I tend to be a follower of Confucius. (Laughter)

And I think this room is full of Confucian values, you know? If the first law of Confucianism is filial piety, particularly toward elderly males, you can see why I like that system. (Laughter)

22. Capital and opportunity costs

WARREN BUFFETT: Area 4. (Laughter)

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. My name is Kevin Truitt (PH) from Chicago. I have three questions for you.

Mr. Munger, at last year’s shareholder meeting, you stated that you didn’t feel that the concept of the cost of capital made true economic sense. Would you explain why you felt this way and what you would do to replace it with anything?

My second question is to Mr. Buffett. You’ve stated the importance of an occasional big idea. How were you able to, in fact, tell when you had a big idea?

And my third question, Mr. Buffett, you have talked about the importance of the franchise and sustainable competitive advantage.

Companies like Kellogg and Campbell’s Soup are companies that most people would have said had those qualities. However, over time, those qualities were lost as a result of a change in consumer taste.

What gives you confidence that the same things won’t happen to Coke or Gillette?

WARREN BUFFETT: Charlie?

CHARLIE MUNGER: Well —

WARREN BUFFETT: Cost of capital.

CHARLIE MUNGER: Cost of capital, first.

Obviously, considerations of cost are important in business. And obviously, opportunity costs, which is a doctrine of economics, really a doctrine of lifesmanship, are also very important. And we’ve always had that kind of basic thinking.

Of course, capital isn’t free. And, of course, you could figure cost of capital when you’re borrowing money. Or at least you can figure cost of loans. But the theorists had to develop some theory for what equity cost. And there, they just went bonkers.

They said if you earned a hundred percent on capital because you had some marvelous business, your cost of capital was a hundred percent. And therefore, you shouldn’t look at any opportunity that delivered a lousy 80 percent.

That is the kind of thinking, which came out of the capital assets pricing models and so forth, that I’ve always considered inanity.

What is Berkshire’s cost of capital? We have this damn capital. It just keeps multiplying and multiplying. What is its cost? You have perfectly good, old-fashioned doctrines like opportunity cost, you know?

At any given time when we consider an investment, we have to compare it to the best alternative investment we have at that time. We have perfectly good, old-fashioned ideas that are very basic to use, but they weren’t good enough for these modern theorists.

So they invented all this ridiculous mathematics, which concluded that the companies that made the most money had the highest costs of capital.

Well, all I can say is, it’s not for us.

Now, the other half of that question I leave for Mr. Buffett.

WARREN BUFFETT: Yeah, what you find, of course, is that the cost of capital is about a quarter percent below the return promised by any deal that the CEO wants to do. It’s — (laughter) — very simple.

You know, we have three questions on capital — with capital, throughout — leaving aside whether we want to borrow money, which we generally don’t want to do.

And one is, does it make more sense to pay it out to the shareholders than to keep it within the company? A sub-question on that is if we pay it out, is it better off to do it via repurchases or via dividend?

The test for whether we pay it out in dividends is, can we create more than a dollar of value within the company with that dollar than paying it out? And you never know the answer to that. But so far, the answer as judged by results is yes, we can.

And we think that prospectively, we can. But, that’s a — you know, that’s a hope on our part. And it’s justified to some extent by past history, but it’s not a certainty.

Once we’ve crossed that threshold, then do we repurchase stock? Well, obviously, if you can buy your stock at a significant discount from conservatively calculated intrinsic value, and you could buy it in reasonable quantity, that’s a use for capital.

Beyond that, then the question becomes, if you have the capital, you think you can create more than a dollar, how do you create the most with the least risk? And that gets to business risk. It doesn’t get to any calculation of the volatility.

I don’t know the risk in See’s Candy as measured by its stock volatility because the stock hasn’t been outstanding since 1972. Does that mean I can’t determine how risky a business See’s is, because we don’t have a daily quote on it?

No. I can determine it by looking at the business, and the competitive environment in which it operates, and so on.

So once we cross the threshold of deciding that we can deploy capital so as to create more than a dollar of present value for every dollar retained, then it’s just a question of doing the most intelligent thing that you can find. And, you know, that is —

The cost of every deal we do is measured by the second best deal that’s around at a given time, including more — doing more of some of the things we’re already in.

And I have listened to cost of capital discussions at all kinds of corporate board meetings and everything else. And, you know, I’ve never found anything that made very much sense in it except for the fact that it’s what they learned in business school and that’s what the consultants talked about.

And most of the board members would nod their head without knowing what the hell was going on. And that’s been my history with the cost of capital.

23. How Buffett knows when he’s had a “big idea”

WARREN BUFFETT: Now, moving onto the big ideas, you know when you’ve got a big idea. And I can’t tell you, you know, exactly what happens within your nervous system or brain at that time.

But we’ve had relatively few big ideas, good ideas, over the years. I don’t know how many you think we’ve had in aggregate, probably, career, maybe 25 each or something?

CHARLIE MUNGER: If you took the top 15 out of Berkshire Hathaway, most of you people wouldn’t be here. (Laughter)

So, roughly one every two years.

WARREN BUFFETT: Yeah, one every year or two. And sometimes there’ll be a bunch of them, like in 1973 and -4. But the problem is, for us is that big, now, really means big. I mean, it has to be billions of dollars to move the needle very much at Berkshire.

But I would say that when I would turn those pages, 50 years ago in the Moody’s Manuals, I would know when I hit a big idea. I’ve got half a dozen of them that I keep the Xeroxes from those reports around from 50 years ago just because it was so obvious that they just — they were incredible. And that happens every now and then.

When I met Lorimer Davidson, you know, in end of January, 1951, and he spent four hours or five hours with me explaining GEICO, I knew it was a big idea.

Eight months later, no, probably 10 months later, I wrote an article for The Commercial and Financial Chronicle on “The Security I Like Best.” It was a big idea.

When I found Western Insurance Securities, I knew it was a big idea.

I couldn’t put billion — millions — of dollars into it, but I didn’t have millions so it didn’t make any difference.

And I — we’ve seen things subsequently. And we’ll see, you know. If we have a normal lifespan, we’ll see a few more before we get done, but I can’t tell you that —exactly how —

I can’t tell you exactly what transpires in my mind that says, you know, flashes a neon sign up that says, “This is a big idea.”

What happens with you, Charlie?

(Laughter)

Actually, one of my — I’ve have a real system. (Laughter)

My idea of a truly big idea is, one I get it and I call Charlie and he only says no, rather than, “That’s the worst idea I’ve ever heard of.” But if he just says no, it’s a hell of an idea.

CHARLIE MUNGER: You know, the game in our kind of life is being able to recognize a good idea when you rarely get it, and — or when it rarely is presented to you. And I think that’s something you have to prepare for over a long period.

What is the old saying? That opportunity comes to the prepared mind? And I don’t think you can teach people in two minutes how to have a prepared mind. But that’s the game.

WARREN BUFFETT: Things we learned 40 years ago, though, will help and recognize the next big idea.

CHARLIE MUNGER: And on opportunity costs, going back to that, the current freshman economics text, which is sweeping the country, has right in practically the first page. And it says, “All intelligent people should think primarily in terms of opportunity cost.” And that’s obviously correct.

But it’s very hard to teach business based on opportunity cost. It’s much easier to teach the capital assets pricing model where you could just punch in numbers and out come numbers. And therefore, people teach what is easy to teach, instead of what is correct to teach.

It reminds me of Einstein’s famous saying. He says, “Everything should be made as simple as possible, but no more simple.”

WARREN BUFFETT: Write that down. (Laughter)

24. Big retailers are attacking big brand-name moats

You asked an interesting question about franchises, too, and mentioned Campbell’s Soup and Kellogg.

And, you know, I’m no expert on that but I would say that, just based on my general observation over the years, is that the problems there came from two different things.

I think that the problems with cereal — ready-to-eat cereal — were not so much changes in taste or consumption patterns. But I think they maybe just pushed their pricing too far to the point that they lost market share without getting — without having — the moat that they thought they had, as opposed to the General Mills cereals, and the General Food cereals, and all of that sort of thing.

I mean, if you’re pricing really gets out of whack and people regard Wheaties or Grape-Nuts in the same category as they regard Kellogg’s Corn Flakes, you know, you’re going to lose share. And once you start losing share, it’s hard to get back.

The problems with soup I think relate more to lifestyle. I think it’s become — it’s a little less — it fits in a little less well with current lifestyles, maybe, than 40 years ago.

Soft drinks, — the consumption of soft drinks — I don’t have the figures here, but I would wager that in 110 years, the per capita of soft drinks has gone up virtually every year throughout that history.

I mean, it’s now 30 — close to 30 percent — of U.S. consumption of liquids. So, if the average American has about 64 ounces of liquids a day, you’re talking about, say, 18 ounces of that being soft drinks and 43 percent of that 18, or almost 8 ounces a day, of being Coca-Cola products.

In other words, 1/8th of all the liquid man, woman and child in the United States take in comes from Coca-Cola products. But that has gone up, virtually — well, throughout the world it’s gone up on a per capita basis, you know, almost since soft drinks were discovered.

I would say that that trend is almost impossible to reverse on a worldwide basis. I mean, there’s so much potential in countries where per capita consumption is like — well, I think it’s, you know, maybe 8 per capita, which is — 8-ounce servings they talk in terms — 64 ounces a year.

So you have 1/50th of the consumption, per capita, on Coke products in many — in some important countries — that you have here. I don’t — I just don’t see it as being —

Now, you can push pricing too far. I mean, there comes a point — it depends on the country in which you’re doing it, but that depends even on areas within the country in which you do it.

But if you establish too wide a differential between Coke and a private label product, you will change consumption patterns somewhat. Not huge, but enough so that you don’t want to do it. But I don’t think you’ll see —

It’s interesting. Coffee’s gone down every year. People talk about Starbucks and all that, but if you look at coffee consumption in this country, if you look at milk consumption in this country, you know, per capita, it just goes down, down, down, down, year, after year, after year, after year.

And I think it’s pretty clear what people like to drink once they get used to it, and with the price right.

Interesting thing about Coca-Cola is, when I was born in 1930, a 6 1/2-ounce Coke cost a nickel and you put a two cent deposit on the bottle. But forget about that, just take the nickel.

Now you buy a 12-ounce can or a larger product, and you’re paying, if you buy it on the weekends in the supermarket special or something, you’re paying maybe a little more than twice per ounce what you were paying in 1930, 70 years ago.

And compare that to the price behavior of almost any product, you know, that you can find except raw commodities. But compare it to cars, housing, anything. And there’s been very, very little price inflation in it.

And I think that’s a contributor, of course, to the growth in per capitas over time.

Charlie, how about cereals and soup?

CHARLIE MUNGER: Well, I think those are examples where the moats got less hostile for the competitors.

Part of the trouble was the buying power got more concentrated and tougher.

I mean, the big grocery chains now have a lot of clout. And then you add the Walmarts and the Costcos and the Sam’s and the — it’s a different world faced by the Kelloggs than the one they had 30 or 40 years ago.

WARREN BUFFETT: Yeah, there will be a battle, always, between brands and retailers, because the retailer would like his name to be the brand.

And, to the extent that people trust Costco or Walmart more than they — or as much as — they trust the brand, then the value of having the brand moves over to the retailer from the product itself.

And that’s gone on for a long, long time. You know, the first — I would — cases I know about in any real quantity were back with A&P in the ’30s. And A&P, I believe, was the largest food retailer in this country. And they were also a big promoter of private labels. Ann Page I think was a big private label with them, for example.

And they felt they could convince the consumer in the ’30s that their brand meant more than having Del Monte on it or Campbell’s or whatever it might be in the different categories. And people thought they were going to win that war for a while.

And who knows? I mean, I don’t know all the variables that went into A&P’s decline, but it was dramatic. I mean, it was one of — it was a great American success story for a while, and then it was a great American failure.

Charlie, you —?

CHARLIE MUNGER: The muscle power of the Sam’s Clubs and the Costcos has gotten very extreme. A little earlier this morning, when I was autographing books, a very good looking woman came up to me and said she wanted to thank me.

And I said, “For what?” And she said, “You told me to buy this pantyhose I’m wearing from Costco.”

And I’d evidently made some previous comment about how amazing it was that Costco could get Hanes, of all people, to allow a co-branded pantyhose, Hanes-dash-Kirkland, in the Costco stores. That wouldn’t have happened 20 years ago.

WARREN BUFFETT: She must’ve been pretty desperate if she was consulting with you on where to buy pantyhose, Charlie. (Laughter)

25. Selling short is “tempting” but “very painful”

WARREN BUFFETT: OK, let’s move to area 5.

CHARLIE MUNGER: Yeah, right.

AUDIENCE MEMBER: Hi, I’m Dave Staples from Hanover, New Hampshire and I’ve got two questions for you.

First, I’d like to hear your thoughts on selling securities short and what your experience has been recently and over the course of your career.

The second question I’d like to ask is how you go about building a position in a security you’ve identified.

Using USG as a recent example, I believe you bought most of your shares at between 14 and $15 a share. But certainly, you must’ve thought it was a reasonable investment at 18 or 19.

Why was 14 and 15 the magic number? And now that it’s dropped to around 12, do you continue to build your position? How do you decide what your ultimate position is going to be?

WARREN BUFFETT: Well, we can’t talk about any specific security, so — our buying techniques depend very much on the kind of security we’re dealing in. Sometimes, it’s a security that might take many, many months to acquire. And other times, you can do it very quickly. And sometimes, it may pay to pay up. And other times, it doesn’t.

And the truth is, you never know exactly what the right technique is to use as you’re doing it, but you just use your best judgment based on past purchases. But we can’t discuss any specific one.

Short selling, it’s an interesting item to study because it’s, I mean, it’s ruined a lot of people. It is the sort of thing that you can go broke doing.

Bob Wilson, there’re famous stories about him and Resorts International. He didn’t go broke doing it. In fact, he’s done very well subsequently.

But being short something where your loss is unlimited is quite different than being long something that you’ve already paid for.

And it’s tempting. You see way more stocks that are dramatically overvalued in your career than you will see stocks that are dramatically undervalued.

I mean there — it’s the nature of securities markets to occasionally promote various things to the sky, so that securities will frequently sell for five or 10 times what they’re worth, and they will very, very seldom sell for 20 percent or 10 percent of what they’re worth.

So, therefore, you see these much greater discrepancies between price and value on the overvaluation side. So you might think it’s easier to make money on short selling. And all I can say is, it hasn’t been for me. I don’t think it’s been for Charlie.

It is a very, very tough business because of the fact that you face unlimited losses, and because of the fact that people that have overvalued stocks — very overvalued stocks — are frequently on some scale between promoter and crook. And that’s why they get there. And once there —

And they also know how to use that very valuation to bootstrap value into the business, because if you have a stock that’s selling at 100 that’s worth 10, obviously it’s to your interest to go out and issue a whole lot of shares. And if you do that, when you get all through, the value can be 50.

In fact, there’s a lot of chain letter-type stock promotions that are sort of based on the implicit assumption that the management will keep doing that.

And if they do it once and build it to 50 by issuing a lot of shares at 100 when it’s worth 10, now the value is 50 and people say, “Well, these guys are so good at that. Let’s pay 200 for it or 300,” and then they could do it again and so on.

It’s not usually that — quite that clear in their minds. But that’s the basic principle underlying a lot of stock promotions. And if you get caught up in one of those that is successful, you know, you can run out of money before the promoter runs out of ideas.

In the end, they almost always work. I mean, I would say that, of the things that we have felt like shorting over the years, the batting average is very high in terms of eventual — that they would work out very well eventually if you held them through.

But it is very painful and it’s — in my experience, it was a whole lot easier to make money on the long side.

I had one situation, actually, an arbitrage situation when I was in — well, it was when I moved to New York in 1954, so it would’ve been about June or July of 1954 — that involved a surefire-type transaction, an arbitrage transaction that had to work.

But there was a technical wrinkle in it and I was short something. And I felt like a — for a short period of time — I felt like Finova was feeling last fall. I mean, it was very unpleasant.

It — you can’t make — in my view, you can’t make really big money doing it because you can’t expose yourself to the loss that would be there if you did do it on a big scale.

And Charlie, how about you?

CHARLIE MUNGER: Well, Ben Franklin said, “If you want to be miserable, you know, during Easter or something like that,” he says, “borrow a lot of money to be repaid at Lent,” or something to that effect.

And similarly, being short something, which keeps going up because somebody is promoting it in a half-crooked way, and you keep losing, and they call on you for more margin — it just isn’t worth it to have that much irritation in your life.

It isn’t that hard to make money somewhere else with less irritation.

WARREN BUFFETT: It would never work on a Berkshire scale anyway. I mean, you could never do it for the kind of money that would be necessary to do it with in order to have a real effect on Berkshire’s overall value. So it’s not something we think about.

It’s interesting though. I mean, I’ve got a copy of The New York Times from the day of the Northern Pacific Corner. And that was a case where two opposing business titans each owned over 50 percent of the Northern Pacific Company —the Northern Pacific Railroad.

And when two people each own over 50 percent of something, you know, it’s going to be interesting. And — (laughter) — Northern Pacific, on that day, went from 170 to a thousand. And it was selling for cash, because you had to actually have the certificates that day, rather than the normal settlement date.

And on the front page of The New York Times — which, incidentally, sold for a penny in those days. It’s had a little more inflation than Coca-Cola — front page of The New York Times, right next to the story about it, it told about a brewer in Newark, New Jersey who had gotten a margin call that day because of this.

And he jumped into a vat of hot beer and died. And that’s really never appealed to me as, you know, the ending — (laughter) — of a financial career.

And who knows? You know, when they had a corner in Piggly Wiggly, they had a corner in Auburn Motors in the 1920s. I mean, there were corners. That was part of the game back when it was played in kind of a footloose manner. And it did not pay to be short.

Actually, during that period — you might find it interesting — in the current issue of The New Yorker, maybe one issue ago, the one that has the interesting story about Ted Turner, there’s also a story about Hetty Green.

And Hetty Green was one of the original incorporators of Hathaway Manufacturing, half of our Berkshire Hathaway operation, back in the 1880s. And Hetty Green was just piling up money. She was the richest woman in the — maybe in the world. Certainly in the United States. Maybe some queen was richer abroad.

But Hetty Green just made it by the slow, old-fashioned way. I doubt if Hetty was ever short anything.

So as a spiritual descendent of Hetty Green, we’re going to stay away from shorts at Berkshire.

OK, area 6.

Hetty, incidentally — this story, it’s a very interesting story. As I read the story, it’s almost conclusively clear to me that she forged a will to try and collect some significant money from, I believe, her aunt.

And it was a very, very famous trial back in whenever it was, 1860 or ’70. And they found against Hetty when it got all through, but she still managed to become the richest woman in the country.

26. The value of Berkshire’s “loyalty effect”

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: Yeah, hi. I’m James Halperin from Dallas, Texas. And I’ve been a shareholder since 1995. And I feel great about it, so thank you.

This question has to do with Berkshire’s so-called permanent holdings and whether, when making investment decisions, you somehow mathematically calculate a value to Berkshire’s reputation for loyalty to its public investees.

Let’s say you are confident enough that Pepsi or Procter and Gamble would grow cash flow faster than Coke or Gillette would. And that the replacement value of the stock was less expensive enough to more than make up for the taxes.

Would you then sell Coke, for example, to buy Pepsi? And if not, why not? And how do you value this reputation for loyalty aspect in those decisions?

WARREN BUFFETT: Well, I think that’s a very good question.

I don’t think we would ever — I think it’s very unlikely we would come to the conclusion that we were that certain that — you mentioned P&G and Pepsi versus the ones — but that some major consumer products company would do better than the ones we’re in.

We might very well decide that some other one is going to do quite well and buy that additionally.

As a practical matter, if I’m on the board of a company, or Charlie were to be, representing Berkshire, it’s very difficult — I would say it’s almost impossible for us to trade in their securities.

It just — it creates too many problems. People would think we knew something we didn’t. Or, you know, particularly if we were selling it, you know, we would have people questioning very much whether we had detected something within the company that was not available to the rest of the world.

So we really give up an enormous amount of investment mobility when we go on a board.

And so I don’t even think about doing what you’re suggesting, although I might very well if I were just a money manager running the business.

We certainly, and we’ve laid it out in the ground rules in the back of the — in our Owner’s Manual back in the annual report — we’ve certainly said, in terms of businesses we buy control of, that they just aren’t for sale. And a fancy price will not tempt us.

And that we lay out that exception relating to businesses where we think there’s a permanent loss of cash for as far as the eye can see, or businesses where we have labor troubles, which we — I described earlier in the day, we might’ve had at The Buffalo News at that one period.

But otherwise, simply because we can use the money better someplace else, we’re not interested in it.

You know, I can’t really dig into my psyche and tell you how much of that is because I think that will help us buy businesses in the future if we behave that way, or how much is just my natural inclination that when I make a deal with somebody and I’m happy with how they behave with me, that I want to stick with them. It’s probably both, you know?

And I wouldn’t want to try and weight the two. I’m happy, you know, with the results of the first and I’m happy with the way I feel, essentially, about the second.

I just think it’s crazy — I know if I owned all of Berkshire myself, I wouldn’t dream of trading around businesses with people that have trusted in me and that I like and have been more than fair with me.

I wouldn’t dream of trading around businesses so that my estate was 105 percent of some very large number instead of 100 percent of some large number. I just would regard that as a crazy way to live.

And I don’t want the fact I run a public company to cause me to behave in a way that I would be uncomfortable behaving if we were a private company.

But I also feel that you, as shareholders, are entitled to know that that’s an idiosyncrasy of mine. And therefore, I lay it out, and have laid it out for 20 years, as something that you should understand, as an investor or before you become an investor.

I’m sure it helps us in acquisitions over time. But whether that in any way compensations the opportunity costs that Charlie talks about of making an occasional advantageous disposal, I don’t know and it’s something I’ll never calculate.

Charlie?

CHARLIE MUNGER: Well, I do tend to calculate it, at least roughly. And so far, I think that the loyalty effect is a plus in our life.

WARREN BUFFETT: Would you regard that as true though in both public — I mean, both marketable securities and owned businesses?

CHARLIE MUNGER: Oh, no. I don’t think the loyalty effect in lots of public companies is nearly as important as it is with the private companies.

WARREN BUFFETT: You can say it’s a mistake for us to be directors of companies, because we give up huge amount of flexibility in investment because we are directors. I — and there’s no question that we do.

It’s — if you’re thinking solely of making money, you do not want to be a director of any company. So there’s just no question about that.

27. Confidence that Berkshire’s culture will endure

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: Tom Harrison (PH) from Claremore, Oklahoma. Good afternoon, gentlemen. And thanks for a wonderful weekend.

This question’s for Mr. Buffett. Being somewhat pessimistic by nature, I have a recurrent nightmare of a Wall Street Journal headline proclaiming, “Buffett kicks bucket.”

WARREN BUFFETT: They may phrase it a little more elegantly than that — (laughter) — but someday, the headline will be there. (Laughter)

AUDIENCE MEMBER: And, of course, Charlie’s no spring chicken either. (Laughter)

In light of these concerns, could you please go into a little more detail than that presented in your annual report regarding the succession issue? And my apologies for the morbid nature of the question.

WARREN BUFFETT: Oh, there’s no reason to apologize. I mean, it’s a question I ask our managers, incidentally, every couple of years.

I — about every two years, I send them a letter and I say, you know, “If you die tonight, what will you — what will I wish you had told me tomorrow morning?” You know, because I have to make that same decision and I’m not conversing with them every night.

So I want them to put in writing to me, once every couple of years, what they think about the subject, who they think should succeed them, or whether there are several candidates, or what the strengths and weaknesses are. And I have that information available.

And, you know, you’re entitled to the same sort of answer about succession. It’s a part of buying into this business.

And it — I can tell you that no one has more of an interest in it than I do. And Charlie has a similar interest, because, we have a very high percentage of our net worth in the business.

Plus, we’ve got a lifetime of effort in the business. And we want it to succeed for both, in our cases probably, at least my case, the ultimate reward, the foundation I have.

But also because we just want — we like what’s happened so far and we want to prove that it can — it’s not dependent upon a couple of guys like us, but that it can be institutionalized, in effect.

And we have, and Charlie and I, we know who will succeed me in what are likely to be two jobs, one marketable securities and one business operations.

We want to be very sure that the culture is maintained. And I think it’s so strong that I think it’d be very hard to change it.

But in addition, the stock ownership situation with me is such that it can — if there were any inclination to change it, it can be prevented from happening. I don’t think it would, anyway.

Now, in terms of who succeeds me, that depends when I die. I — and there’s no sense telling you who it would be today. There’d be no plus to that, and it might not be the same 20 years from now.

I mean, 20 years ago, it would’ve been Charlie, obviously. But it won’t be Charlie now because of his age. And it’ll be somebody else.

But 20 years from now or 15 years from now it might be some third party. But we’ve got —we feel very good about the succession situation.

We feel very good about the stability of the organization, in terms of the stock ownership situation, because that is insured for a very, very long time to come. We couldn’t feel better about the managers we have in place and the culture we have in place. And, you know, the individual will be named.

I think I’ve mentioned, though, that when they open that envelope — all of the contents of that envelope are already known to the key people — but when they open that envelope, the first instruction is, you know, take my pulse again. (Laughter)

But if I flunk that test, there will be somebody very good in place.

Charlie?

CHARLIE MUNGER: The main defense, of course, is to have assets that will do well, more or less, automatically. And we have a lot of those.

And to the extent you improve that further by having very good managers in place and very good individualized systems for bringing new managers into the places, there’s a lot of momentum here that would go on very nicely with the present management gone.

And now, I don’t think our successors are going to be as good as Warren at actually — (applause) — allocating the money. (Louder applause and laughter)

WARREN BUFFETT: No, we ran a little test case 10 years ago because for nine months and four days, I took another job at Salomon. And things went fine at Berkshire.

We’ve got — the managers don’t need me. We have to allocate capital. We have to make sure they’re treated fairly. And —

But we are not making decisions around the place, except in the allocation of capital. And that will be important. But some of that is semiautomatic. And others, you know, it does require, you know, some imagination sometime or something of the sort.

But for nine months and four days in 1991, you know, Salomon was primarily on my mind and Berkshire wasn’t. And everything went on just as before. And we are far, far, far stronger now than we were 10 years ago.

So I’m very comfortable with 99 percent of my estate being in Berkshire shares. And I think it’s an intelligent holding, eventually, for the foundation. And knowing that, you know, I won’t be around at some point before the foundation gets it.

28. “We don’t want to talk about silver”

WARREN BUFFETT: OK, area 8.

AUDIENCE MEMBER: Hello, Mr. Buffett, Mr. Munger. My name’s Matt Ahner (PH). I’m from Tucson, Arizona. It’s a tremendous pleasure to be here today.

This question probably falls into Charlie Munger’s realm of oddball investment activities.

But considering Berkshire’s previous experience in silver, what are your thoughts on the silver market today? How do you analyze this market? Have you determined an equilibrium price for silver? And if so, would you share that price, or explain to us how you determined it?

CHARLIE MUNGER: The short answer is we don’t want to talk about silver. (Laughter)

WARREN BUFFETT: Yeah. We’re not going to comment, you know, on oil or the prices of anything in terms of making any forecasts about it.

The equilibrium price though I can tell you is whatever it’s selling for today. But there will be a different equilibrium price a year from now or five years from now. But we can’t tell you what it’ll be.

29. Electricity deregulation led to damaging shortages

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: Hello, Mr. Buffett, Mr. Munger. My name’s Bob Odem (PH) from Seattle, Washington.

Considering the political climate, and what seems to be a more regulated environment than not in the electric utilities market, and politicians that seem to be pacifying their constituents rather than the common sense of price and quantity —

Is it not a risky venture to participate in these markets more than what has already been done with MidAmerican, considering that, even with a possible repeal of the PUHCA laws, that they may be reinstated some years later, with the addition or subtraction of any other legislation that a politician may dream up, and then put the investment at risk?

WARREN BUFFETT: Charlie, you’re a resident of California. (Laughs)

CHARLIE MUNGER: Well, the production of electricity, of course, is an enormous business. And it’s not going away.

And the thought that there might be something additional that we might do in that field is not at all inconceivable. It’s a very fundamental business.

Now, you’re certainly right in that we have an unholy mess, in California, in terms of electricity.

And again, it reflects, I would say, a fundamental flaw in the education system of the country, that is many smart people of all kinds, utility executives, governors, legislators, journalistic leaders, they have difficulty recognizing that the most important thing with a power system is to have a surplus of capacity.

Is that a very difficult concept? (Laughter)

You know, everybody understands that if you’re building a bridge, you don’t want a bridge that will handle exactly 20,000 pounds and no more.

You want a bridge that’ll handle a lot more than the maximum likely load. And that margin of safety is enormously important in bridge building.

Well, a power system is a similar thing. Now, why do all these intelligent people, you know, ignore the single most obvious and important factor and just screw it up to a fare-thee-well?

So I’m giving you a response which is, of course, another question. As the — my old professor used to say, “Let me know what your problem is and I’ll try and make it more difficult for you.” (Laughter)

WARREN BUFFETT: Well, to me, the interesting thing is that you had a system — I mean, Charlie’s obviously right in that you’ve got about three goals in terms of — from a societal standpoint — you’ve got perhaps three goals in what you would like your electric utility business to be.

One is you would like it to be reasonably efficiently operated.

Secondly, since it does tend to have, in many situations, monopoly characteristics, you would want something that produced a fair return, but not a great return for capital. But enough to attract capital.

And then third, you’d want this margin of safety, this ample supply.

Now, when you’ve got a long lead time to creation of supply, which is the nature of putting on generation capacity, you have to have a system that rewards people for fulfilling that obligation to have extra capacity around.

A regulated system does that. If you give people a return on the capital employed, if they keep a little too much capital employed so that they have this margin of safety on generation, and they get paid for it, they stay ahead of the curve. They always have 15 or 20 percent more generating capacity than needed.

And one of the disadvantages of that regulation and the monopoly nature is that it doesn’t have the spur to efficiency. They try to build it in various ways, but it’s difficult to have a spur to great efficiency if somebody can get a return on any capital they spend.

So utility regulators have always been worried about somebody just building any damn thing and getting whatever the state-allowed return is.

But I would say that the problems that would arise from, say, a little bit of sloppy management are nothing compared to the problems that arise from inadequate generation.

So here you have in California — my view as an outsider — you had a situation under regulation where the utilities had the incentive to have a little extra generating capacity because they got allowed to earn a decent return on it, a return that would attract capital.

Then you had, I think, the forced sell-off of half of their generating capacity or something like that. And they sold it at multiples of book value to a bunch of people who were now just generators who were deregulated.

They’ve got — they don’t have an interest in having too much supply. They’ve got an interest in having too little supply.

So you’ve totally changed the equation because the fellow that now has the deregulated asset, for which he paid three times book, now has to earn a return on a three times book what the fellow was formally earning under the regulated environment at one times book.

And so, he is not going to build extra generating capacity. That — all that does is it brings down the price of electricity. You know, he hopes things are tight.

So you’ve created, in my view, a situation where the interests of the companies in the business have diverged in a significant way from the interests of society. And I — it just doesn’t make any sense to me. And I really think that the old system made more societal sense.

Let people earn a good return, not a great return, but a return that attracts capital, on an investment that has built into it the incentives to keep ahead of the game on capacity because you can’t fine tune it that carefully. And you do have this long lead time, so.

Now, what you do with the scrambled eggs now, you know, is something. And with all the political forces back and forth, I think that you’d better have a system that encourages building extra capacity.

Because you don’t know how much rainfall there will be in the Pacific Northwest and, therefore, how much hydro will be available. And you don’t know what natural gas prices will do. And therefore, you know, whether it’s advantageous for a gas-fired turbine to be operating.

And it — the old system really strikes me as somewhat better than this semi-deregulated environment that we’ve more or less stumbled into.

But Charlie, what do you think on that?

CHARLIE MUNGER: Of course, even the old system got in some troubles in that since everybody had the NIMBY syndrome — “Not In My Back Yard” — everybody wanted any new power plant to be anyplace not near me.

And if everybody feels that way, and if the political system means that the obstructionists are always going to rule, which is true in some places in terms of zoning and other matters, you get in deep trouble.

If you let the unreasonable, self-centered people make all the decisions of that kind, you may well get so you just run out of power. That was a mistake.

And we may make that mistake with oil refineries. It is — you know, we haven’t had many new, big oil refineries in the last, well, period. So you may get to do this all over again.

WARREN BUFFETT: All of that being said, there will be need for more generation capacity. I mean, the electric utility industry will be — will grow. It will need lots of capital.

And there should be ways to participate in that where we get reasonable returns on capital. We would not expect to get great returns on capital. But we would, you know, we would be happy to do that. We generate a lot of capital and we would be comfortable in that business.

We would not feel the risks were undue, as long as we didn’t go around paying incredible prices for somebody else’s capacity and then have people get very upset at what that meant in terms of their electric rates. You can’t go out and —

If you’ve got a utility plant in this country that was put in place at X and then you go out and encourage entrepreneurs to buy in at 3X, you cannot expect utility prices — electricity prices — to fall. And that was, in my view, a very basic mistake. I may not understand it fully.

30. Can a good business make up for bad management?

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: Good afternoon. My name is Pavel Begun. I am from Minsk, Belarus. And I have two questions.

And before I’ll have questions for you, I’d like to say thank you for recommending to read “Intelligent Investor.” It’s a terrific book and it reshaped me tremendously, literally, overnight. So I’d like to thank you for that.

And now the question. Say I’m an owner of the business. And the business has a durable competitive advantage and superior business model and is run by able people.

And then, you know, I start noticing that, basically, management starts doing things which are far from intelligent.

So what should I do as an owner, as an investor? Should I try to tell them how they should run the business? Or should I just sit back and do nothing because superior business model should overcome poor management? That’s the first question.

And the second question is, how important is nominal experience in the business of investing? And by saying nominal, I mean the number of — the actual time you’ve been in the business, as opposed to real experience that also includes experience you acquire from, say, Ben Graham, or you, or Peter Lynch, when you read books? So those are the questions.

WARREN BUFFETT: On your first question, did you assume that you had control of the business, or you just owned a marketable security?

AUDIENCE MEMBER: Yes, if I own, say, 20 percent of marketable securities.

WARREN BUFFETT: All right. Well, the situation you described is not hypothetical, in the first case. (Laughter)

And I would say that the history that Charlie and I have had of persuading decent, intelligent people, who we thought were doing unintelligent things, to change their course of action has been poor.

Would you agree with that, Charlie, or no?

CHARLIE MUNGER: Worse than poor.

WARREN BUFFETT: Yeah. (Laughter)

So I would say that if you really think you’re in with people that have got a good business, but they’re going to keep doing dumb things with your money, you’ll probably do better to get out and get in with people who’ve got a good business and you think they’re going to do sensible things with it. I mean, you’ve got that option.

Now, you also have the option of trying to persuade them to change their mind. But it’s just very, very difficult. I mean it is, you know, that’s been something we’ve faced for 50 years.

And initially, we faced it from a position where nobody even knew who the hell we were, or anything of the sort.

So we’ve acquired a certain stature over time, perhaps in talking on the subject. And we’ve written on the subject. And we still don’t get very far. I mean, when people want to do something, they want to do something.

And they didn’t rise to become the CEO of a company to have some shareholder tell them that their most recent idea is dumb. I mean, that is just not the type that gets to the top.

So I would say that, as a matter of investment technique, and maybe as a matter of, you know, avoiding stress in your life and all of that sort of thing, that it’s — and dealing with smaller quantities of stock so it’s easier to sell and buy and all that sort of thing — I would say that it’s better to be in with a management you’re simpatico with, than simply to be in a great business with a management that’s bent on doing things that don’t make much sense to you.

Charlie?

CHARLIE MUNGER: Well, I certainly agree with that.

31. Having “your head screwed on right in the first place”

WARREN BUFFETT: Second question — (laughs) — I gather is, sort of, how much does our actual business experience versus book experience help us?

AUDIENCE MEMBER: Well, it’s, you know, if you look at a person who has just made two years of being in the business of investing, versus a person who has been for 10 years in the business of investing.

And say the person who has been for two years, you know, has read a lot about, you know, Ben Graham’s techniques, and your techniques, and, say, Peter Lynch’s techniques. So would you say that the person who has only two years of experience may do much better than the second person?

WARREN BUFFETT: Well, if everything else is equal, I mean, everything else is equal, except the amount of experience you have, I think the experience is probably useful. But it isn’t going to be equal. And I don’t think that — I don’t think that the —

I think it’s way more important what you’ve thought about for two years than what you’ve practiced for 10 years. If you’re — if the direction — if there’s a divergence in techniques applied, I would rather be with the one that I’m philosophically in sync with.

If I’m philosophically in sync with both and one’s had 10 years of experience, the chances are they will know a little bit more about more businesses if they’ve been around for 10 years, looking at them, than if they’ve been around for two years.

But the biggest thing is that, you know, basically they’ve got their head screwed on right in the first place, in terms of how they value businesses and how they look at stocks.

Whether they look at them as pieces of businesses or whether they look at them as little things that move around, and that you can tell a lot by looking at charts or listening to strategists on or something of the sort.

We have — Charlie and I have learned a lot about a lot of businesses over 40 or 50 years. But I would say that, in terms of the new things that would come to us, at the end of the second year, we were probably about as good judges of them as we would be today.

But I think there’s a little plus to having seen — more in terms of human behavior and that sort of thing — than knowing about the specifics of a given business model.

Charlie?

CHARLIE MUNGER: Yeah, I think that — I’ve watched Warren for a long time now, and I would say he’s actually getting better as he gets older. Not at golf or — (Buffett laughs) — many other activities, but —

WARREN BUFFETT: Stay with generalities.

CHARLIE MUNGER: — as an investor, he’s better — (laughter) — which I think’s remarkable. It shows that scale of experience matters.

WARREN BUFFETT: Yeah, it helps somewhat to have seen a lot of business situation — I mean, Charlie talks about models and you construct your models as you go along based on observation.

And your models will — if you’re paying attention, your models will be somewhat better the more years you’ve spent really observing and not just trying to make everything fit into what you saw the first few years.

32. Berkshire stock recommendations would be “big mistake”

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: Hi, my name is Richard Marvel (PH) from Washington, D.C. And my question has to do with the intrinsic value of Berkshire Hathaway.

You’ve stated several times that you would prefer the stock to be neither overvalued nor undervalued so that the time people spend owning the security represents a gain from what the security — the results during that period of time.

However, it’s a very difficult security to value because of the disparate pieces.

And, as we saw last year, when you provide a little bit of guidance — in last year’s annual report you said that when the stock price hit $45,000 a share, you considered buying, but thought it was unfair until the annual report came out so everyone had the same information.

And while I also realize that you don’t feel there is a particular quote-unquote “correct” number, would you ever consider giving any guidance in this direction?

WARREN BUFFETT: Yeah. The answer is we really wouldn’t. I mean, to the extent that we were going to repurchase shares, you could certainly interpret that as indicating that we thought it was attractive from the standpoint of remaining shareholders to do so.

And we certainly wouldn’t be paying over intrinsic value, at least in our judgment, and benefiting the exiting shareholders to the disadvantage of the continuing shareholders. So you might draw that conclusion at that point.

But other than that, we’ve — you know, we would prefer Berkshire’s shares to fluctuate far less than they do. Because we would like the — ideally — we would like the experience of every investor during the time they held the shares to be exactly proportionate to the progress, or lack thereof, of the business.

And I think we’ve come, over the years, reasonably close to that, compared to most companies. But the nature of markets is such that reasonably close is as, you know, probably as good as it’s going to get.

We don’t know the exact intrinsic value of Berkshire, obviously. And if you looked at the figures, we — if we had written down secret figures over the — ever since 1965 — they would — some of them would look silly now, in terms of what has actually transpired.

But we try to give you — I think Berkshire is easier to value than most businesses, actually, because we give you all the information that, at least, is important to us in valuing it.

And then the biggest judgment you have to make is how well capital will be deployed in the future.

Because it’s easy — it’s relatively easy — to figure out the present value of most of our businesses, but the question becomes, “What do we do with the money, as it comes in?”

And that will have a huge impact on the value 10 years from now. And that will depend a lot on the environment in which we operate over the next 10 years. There’ll be a lot of luck in it.

I think — you know, I think there’s a reasonable chance of good luck. But who knows?

It would be a mistake for us to do anything — I mean, a big mistake — to ever recommend buying or selling the stock. I mean, how would you tell everybody to do it at once? You know, you would negate your own advice.

You’re certainly not going to tell one person, you know, to the advantage or the disadvantage of somebody else.

So there’s really no way for us to ever talk about whether we think the stock — whether we think it’s a buy or a sale, except to the extent, like I say, on repurchases where there’s obviously an implicit judgment being given the shareholders.

Charlie?

CHARLIE MUNGER: Yeah. I rather like the way it’s worked out.

If you average out the period that we’ve been through, we’ve come within hailing distance of the objective of having our stock track its intrinsic value. It gets a little ahead sometimes and a little behind other times, but averaged out, it’s worked pretty well.

33. Would Benjamin Graham’s “cigar butt” strategy work now?

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Good afternoon. My name is Martin O’Leary (PH) and I’m from Houston, Texas. My question to you is this.

In your annual report this year, in the letter to the shareholders, you indicated that it was 50 years ago that you met Benjamin Graham, and that he had a major impact in your life, especially in your investment success.

Moreover, you’ve stated in the past that “The Intelligent Investor” is, by far, the greatest book ever written on investing.

One of the central tenants in the book was that if you bought a group of stocks, say, 10 or 20, that traded at two-thirds or less than net current assets, that you would be assured of a margin of safety, coupled with a satisfactory rate of return.

Today, if you were to find 10 or 20 stocks that trade at two-thirds of net current assets, would you be inclined to purchase those stocks for your own personal portfolio, not for Berkshire Hathaway?

And the second question, since I’ve mentioned the book, I was wondering which books that you and Mr. Munger have been reading lately and would recommend. Thank you.

WARREN BUFFETT: Yeah, in respect to your first question, you could probably — if you found a group like that — and you won’t, I don’t think — you’d probably do all right buying the group.

But not because the businesses themselves worked out that well over time, but because there would probably be a reasonable amount of corporate activity in a group like that, either in terms of the managements taking them private, or takeovers, or that sort of thing.

But those sub-working capital stocks are just almost impossible to find now. And if you got into a market where a lot of them existed, you’d probably find wonderful businesses selling a lot cheaper, too. And our inclination would be to go with a cheap, wonderful business.

I don’t think you’ll get — in a high market or something close to it — I don’t think you’ll get a lot of sub- working capital stocks anymore. There’s just too much money around to promote deals before they really get to that point.

But that was a technique. It was 50 years ago.

And is Walter Schloss here still? Walter, are you here? Stand up if you’re here.

I met Walter 50 years ago when I met Ben Graham. I know Walter’s — came out this year, but he already knows everything I’ve been talking about, so he may have left.

But Walter, actually, has practiced in securities, much closer to the original — he’s run a partnership now for 46 years, I guess it is. And he’s done it much more with the type of stocks that Ben was talking about in those days.

And he has a record that is absolutely sensational, that is far better than people who get promoted and go on television shows and do all of that sort of thing.

And he’s done it in, you know, what I tend to call cigar butt companies. You know, you get one free puff and that’s about it, but they don’t cost anything.

And that’s — that was the sub-working capital type situations. Walter’s had to extend that somewhat, but it’s been a great, great record over a considerable — I mean, 46 years — a very considerable period of time.

So I think, if you found that kind of a group and did it as a group operation, and Ben always emphasized a group operation because when you’re dealing with lousy companies but you expect a certain number to be taken over and all that, you’d better have a group of them.

Whereas if you deal with wonderful companies, you only need a couple. But I think, if you see that period again, we’ll be very active. But it won’t be in those kind of securities.

Charlie?

CHARLIE MUNGER: Yeah. And there’s another change. In the old days, if the business stopped working, you could take the working capital and stick it in the shareholders’ pockets.

And nowadays, as you can tell from all the restructuring charges, when things really go to hell in a bucket, somebody else owns a lot of the working capital. The whole culture has changed.

If you have a little business in France and you get tired of it, as Marks & Spencer has, the French say, “What the hell do you mean trying to take your capital back from France? There’re French workers in this business.”

And they don’t care. They don’t say, “It’s your working capital. Take it back,” when the business no longer works for you. They say, “It’s our working capital.” The whole culture has changed on that one.

Not completely, but a lot from Ben Graham’s day. There’re a lot of reasons why the investment idiosyncrasies of one era don’t translate that perfectly into another.

WARREN BUFFETT: That list that was published, I forget whether it was published in the 1951 edition of “Security Analysis” or the ’49 edition of “Intelligent Investor,” but there were a list of companies.

There was Saco-Lowell, there was Marshall-Wells, there was Cleveland Worsted Mills, there was Foster Wheeler, and all those companies were sub-working capital companies selling at three or four times earnings.

And there was a — if you bought a group of stocks like that, you were going to do well. But, you know, I — you certainly don’t see that in companies of any size today.

And I’ve seen a few lists of tech companies selling below cash. But they’re determined to use that cash. And it may not be there in a year or two.

It was a different breed of animal, to some extent, in Ben’s list at that time.

34. Book recommendations

WARREN BUFFETT: Did you ask a second question?

CHARLIE MUNGER: Books you’ve read.

WARREN BUFFETT: Oh, books I’ve read.

Well, tell him what books you’ve read, Charlie. (Laughter)

CHARLIE MUNGER: Well, I mentioned that one book “Genome.” I have a hell of a time putting the accent on the first syllable. But that is a marvelous book.

And some shareholder sent me a book that not many of you will like, by Herb Simon I think, “Models of My Life.” And it’s a very interesting book for a certain academic type.

But that “Genome,” you know, which is the history of a species in 23 chapters, and it’s a perfectly amazing book, and very interesting.

WARREN BUFFETT: I may have recommended it before, but if you haven’t read “Personal History” by Katharine Graham, I think you’d find that it’s a fascinating story. And more amazing yet, it’s an honest story.

You know, if I ever write my autobiography, I’m going to look like Arnold Schwarzenegger, but — (Laughter)

But she is compulsively honest about what’s happened. And it’s really quite a saga.

CHARLIE MUNGER: It is a good book.

That Janet Lowe book about me I find has had a very interesting sub-chapter, so to speak, in its distribution.

I notice a considerable number of people buying that book and sending one copy to each descendant.

They believe that if they just do that, the descendants will behave more like the parents. It’ll be interesting to see if that works. If it does, it’s going to outsell the Bible. (Laughter)

WARREN BUFFETT: Hold your breath — (Laughter)

35. Congress should loosen capital restrictions for utilities

WARREN BUFFETT: Area 5.

AUDIENCE MEMBER: Good afternoon. I’m Laura Rittenhouse (PH) from New York City. And I want to say it’s a great pleasure to be here. You talked earlier about companies that monetize greed. And it’s great to be with people and with leaders who monetize values.

You — a couple years ago, you spoke very passionately about campaign finance reform, and I wondered if you could comment on your views of this, given recent developments related to another question in Washington.

What’s your expectation for the passage of the repeal of PUHCA? I know there was some recent activity in a Senate sub-committee.

And lastly, a question for Charlie. How would you, or do you, apply the principles of intrinsic investing to real estate?

WARREN BUFFETT: OK. In respect to PUHCA, it’s hard for me to — you know, I have no great record of handicapping legislative action.

But I would say that the awareness of the public problems in the electric utility industry under current circumstances, you know, has mushroomed. I mean, it’s ballooned.

And so I think that — I think it’s likely that Congress is more receptive to the idea that they need to do something that ensures that the power supply is adequate.

And I think that there’s probably a number of them that would think that PUHCA is a barrier to capital entering the industry from a lot of sources where capital is available. And that it’s going to take capital to solve this problem.

Now, they don’t have to solve it by letting Berkshire do more things. But it’s not a crazy approach to say that if Berkshire has billions of dollars to invest, that it might be a net plus for the availability of electricity down the road.

So I think that certainly the chances of repeal or major change are far higher now than they were a couple of years ago. And, I mean, politicians do not like to face major brownouts.

I mean, they can try and blame it on someone else and they may well be accurate in blaming it on someone else.

But the public is going to at least partially blame political leaders if this country runs out of electricity, because it hasn’t run out of the ability to build generators.

You know, we could create all the generators we needed to have plenty of electricity. And we could create the transmission lines and all of that.

But you do need a flow of capital to the industry. And PUHCA restricts that flow to quite a degree, I would say.

36. More regulation needed for campaign contributions

WARREN BUFFETT: Campaign finance reform, you’ve read about it as much as I have. You know, I happen to admire enormously what McCain and Feingold have done.

I don’t think it’s a panacea. I mean, money is going to find its way into trying to buy political influence one way or another.

But the present situation, in my view, has gotten totally out of control and, incidentally, totally out of sync with what the American Congress, even, as well as the public, intended, because in 1907, Congress said, and it’s never been changed, that corporations shall not contribute money to federal elections.

And in 1947, they said the same thing about labor unions. And then they enacted campaign legislation in the early ’70s which, when later interpreted by the Federal Election Commission, enabled corporations and unions to do on an unlimited scale, what Congress had said they shouldn’t do at all.

And politicians did not really understand the potential in that, initially. I remember the first guy that called me, Senate candidate, called me for a soft money contribution probably in 1985, or so.

And he was kind of embarrassed about it and sort of danced around the subject about how this money was going to find its way into his campaign and everything. And he was asking me for an amount of money that was illegal under the law, except if I did it via soft money.

And that has developed to the point where I have literally had people, where I have firsthand knowledge, of requesting million dollar contributions or larger, which would never be reported. We’d never be required to report it. And I regard that as a perversion of the system.

But I think we’re going to get some significant improvement. I think it was only possible because of the credibility that McCain built up with the public and the fact that he just wouldn’t let go of this issue.

So I’m — but I’m not hopeful about it changing the whole course of American democracy or anything of the sort.

But I am hopeful that the system of government where access is sold to the highest bidder, and where the bidding starts at a higher level, by a material amount, in every election cycle, will at least be checked for a while.

Charlie, she had a question for you.

CHARLIE MUNGER: Well, my trouble with campaign finance reform is that I fear career politicians just staying on and on just about as much as I fear special interests protecting themselves with money. And I never know exactly how the reform is going to work.

When I came to California, we had sort of a semi-corrupt, part-time legislature dominated by race tracks and saloons and liquor distributors, and so on.

And people went up and entertained the legislators with prostitutes and what have you. And I really sort of prefer that government, in retrospect — (laughter) — to the full-time legislators I have now.

So I just am more skeptical about my ability to predict which reform I’m going to like the results of and which I would like to trade back in for my former evils.

37. Munger has moved on from real estate investing

WARREN BUFFETT: Laura, you had one more, did you on —? Was it for Charlie?

AUDIENCE MEMBER: It was a question about the principles of intrinsic value investing applied to real estate.

CHARLIE MUNGER: Oh, that period of my life involved the remote past. And I much prefer business investment to real estate investment.

38. Q&A concludes

WARREN BUFFETT: OK. It’s 3:30. We’re going to have a directors meeting here, we do that once a year, following this meeting. And so I’ll ask the directors to stick around.