Specific Businesses具体公司

Well in 1962 I learned from Ben Graham how to assess businesses. He also had the cigar butt analogy for buying businesses...you can usually get one good puff out of it and it’s free. Berkshire made a lot of money after WWII (more than Pfizer and Merck) and then it steadily went downhill. Between 1955 and 1965 Berkshire went from 12 mills to 2 mills and they bought their own stock as mills closed. We bought 100,000 shares out of 1 million in 1962 at $7 3/8 and the company had $10-11/share in working capital...I knew I wouldn’t lose money because of the working capital. It was losing money but it was also liquefying assets by closing mills. Seabury Stanton was running Berkshire at the time and I went to go visit him. We had an agreement that Berkshire would tender $11-1/2 for my shares of the company. At this point, I could not buy any stock as I had inside information. A few weeks later I received a letter from Old Colony Trust containing a tender offer of $11-3/8. Early the following week, Seabury tendered the stock at 11 3/8. As result, I began buying more Berkshire. Other family members of Seabury Stanton sold their shares to me and I gained controlling interest in the company. The family members weren’t very happy with Seabury either really. We ran the mills until 1985.

See’s Candy is an example of low rate of return on capital expenditures individually yet the company as a whole makes loads of money because of the great brand of See’s. We bought See’s in 1972 and every year since then we have raised the prices the day after Christmas and it never hurt the business. When we invest we ask one question, how long do you have to wait to raise the prices? If you are an airline today and you try to raise your prices, an hour later, you will be lowering them because of competition. Not the case with a good brand like See’s. If I were to give you a $100 million, I’m not going to, but if I did, you could not damage the See’s brand in the minds of 30 or so million Californians. Only See’s can do that. Their brand is their promise to provide the quality and service that people have grown to expect.

Well, basically I love it, but because the market for Coca-Cola products will grow far faster over the next twenty years internationally than it will in the United States. It will grow in the U.S. on a per capita basis. The fact that it will be a tough period for who knows—three months or three years—but it won’t be tough for twenty years. People will still be going to be working productively around the world and they are going to find this is a bargain product in terms of a portion of their working day that they have to give up in order to have one of these, better yet, five of them a day like I do.

This is a product that in 1936 when I first bought 6 of those for a quarter and sold them for a nickel each. It was in a 6.5 oz bottle and you paid a two cents deposit on the bottle. That was a 6.5 oz. bottle for a nickel at that time; it is now a 12 oz. can which if you buy it on Weekends or if you buy it in bigger quantities, so much money doesn’t go to packaging—you essentially can buy the 12 ozs. for not much more than 20 cents. So you are paying not much more than twice the per oz. price of 1936. This is a product that has gotten cheaper and cheaper relative to people’s earning power over the years. And which people love. And in 200 countries, you have the per capita consumption use going up every year for a product that is over 100 years old that dominates the market. That is unbelievable.

One thing that people don’t understand is one thing that makes this product worth 10s and 10s of billions of dollars is one simple fact about really all colas, but we will call it Coca-Cola for the moment. It happens to be a name that I like. Cola has no taste memory. You can drink one of these at 9 O’clock, 10 O’clock, 1 O’clock and 5 O’clock. The one at 5 o’clock will taste as good to you as the one you drank early in the morning, you can’t do that with Cream Soda, Root Beer, Orange, Grape. All of those things accumulate on you. Most foods and beverages accumulate; you get sick of them after a while. And if you eat See’s Candy—we get these people who go to work for us at See’s Candy and the first day they go crazy, but after a week they are eating the same amount as if they were buying it, because chocolate accumulates on you. There is no taste memory to Cola and that means you get people around the world who will be heavy users—who will drink five a day, or for Diet Coke, 7 or even 8 a day. They will never do that with other products. So you get this incredible per capita consumption. The average person in this part of the world or maybe a little north of here drinks 64 ozs. of liquid a day. You can have 64 ozs. of that be Coke and you will not get fed up with Coke if you like it to start with in the least. But if you do that with anything else; if you eat just one product all day, you will get a little sick of it after a while.

It is a huge factor. So today over 1 billion of Coca-Cola product servings will be sold in the world and that will grow year by year. It will grow in every country virtually, and it will grow on a per capita basis. And twenty years from now it will grow a lot faster internationally than in the U.S., so I really like that market better, because there is more growth there over time. But it will hurt them in the short term right now, but that doesn’t mean anything. Coca-Cola went public in 1919; the stock sold for $40 per share. The Chandler family bought the whole business for $2,000 back in the late 1880s. So now he goes public in 1919, $40 per share. One year later it is selling for $19 per share. It has gone down 50% in one year. You might think it is some kind of disaster and you might think sugar prices increased and the bottlers were rebellious. And a whole bunch of things. You can always find reasons that weren't the ideal moment to buy it. Years later you would have seen the Great Depression, WW II and sugar rationing and thermonuclear weapons and the whole thing—there is always a reason.

But in the end if you had bought one share at $40 per share and reinvested the dividends, it would be worth $5 million now ($40 compounding at 14.63% for 86 years!). That factor so overrides anything else. If you are right about the business you will make a lot of money. The timing part of it is very tricky thing so I don’t worry about any given event if I got a wonderful business what it does next year or something of the sort. Price controls have been in this country at various times and that has fouled up even the best of businesses. I wouldn’t be able to raise prices Dec31st on See’s Candy.But that doesn’t make it a lousy business if that happens to happen, because you are not going to have price controls forever. We had price controls in the early 70s.

The wonderful business—you can figure what will happen, you can’t figure out when it will happen. You don’t want to focus too much on when but you want to focus on what. If you are right about what, you don’t have to worry about when very much.

Coca-Cola is a fabulous company. It will sell over 21 billion cases [of all of its products] around the world and that goes up every year. It’s a really wonderful business that sold at a silly price a few years ago. The stock sold at $80 [in the late 1990s] when earnings were $1.50. Earnings are higher quality today [at $2.18 per share in 2005, while the stock trades around $43]. Every year, Coke accounts for a little greater percentage of the liquids consumed in the world.

It has $5-6 billion of tangible assets and makes a similar amount of pre-tax earnings. There are not a lot of big businesses that earn 100% returns on tangible assets.

The stock was ridiculously overvalued, but you can’t blame [CEO Neville] Isdell today for that. You can fault me for not selling at 50x earnings.

I expect we’ll own it 10 years from now.

I’ve been drinking five cokes a day for years and I feel terrific.

We passed one time on the chance to buy a terrific business, [even] after we [spent the time and] met management. They were fine people, but we didn’t want to be in the business. But we’d buy stock in the business.

[I initially thought Buffett might be referring to UST, but a friend emailed me the following: “The company was Conwood in the late 1980s. Conwood was shopping itself to avoid a raider that it didn't want to get involved with. It eventually went private with the Pritzker family of Chicago. Buffett discussed this at a meeting some years back. I think he said he passed on owning the whole thing because of the even slight risk that he'd have to spend any of his time with lawyers suing the company.” Another friend added, “Interestingly, Conwood has been gaining market share at UST’s expense ever since then, and also collected a huge antitrust judgment against UST a year or two ago. So as usual, WEB and CM were right when they identified it as a terrific business many years ago. But I have no regrets that they passed on the deal. Apart from the moral grounds, we don't need the legal risk.”]

I don’t have any problem with buying stock or bonds of companies that engage in activities that I wouldn’t endorse myself, but I’d have a problem with owning outright and directing the activities myself.

Every retailer sells cigarettes, but it doesn’t bother me to own the retailer.

[CM: But you wouldn’t own the company that made the tobacco or the advertisements.

Yes. I can’t tell you why I draw the line there, but I do. One time, I owned the bonds of RJR, and I’d still do it, but I would not buy the company. We walked [away from] one [situation like this] – we were thinking about it…

[CM: We didn’t think very long. We don’t claim to have perfect morals, but at least we have a huge area of things that, while legal, are beneath us. We won’t do them. Currently, there’s a culture in America that says that anything that won’t send you to prison is OK.

Eating hamburgers or drinking Coke – that’s a choice. If one lives to 75 eating what they want or 85 eating carrots and broccoli – who’s lived a better life? I know where I come out on that. [Laughter.]

I’ve never been near a Whole Foods Market.

[CM: My idea of a good place to shop is Costco – it has these heavily marbled fillet steaks. The idea of eating some wheat thing and washing it down with carrot juice has never appealed to me.]

Charlie and I never disagree on where to eat.[Laughter.]

Well, P&G is a very, very good business with strong distribution capability and lots of brand names, but if you ask me and I am going to go away for twenty years and put all my family’s net worth into one business, would I rather have P&G or Coke? Actually P&G is more diversified among product line, but I would feel more sure of Coke than P&G. I wouldn’t be unhappy if someone told me I had to own P&G during the twenty-year period. I mean that would be in my top 5 percent. Because they are not going to get killed, but I would feel better about the unit growth and pricing power of a Coke over twenty or thirty years.

Right now the pricing power might be tough, but you think a billion servings a day for a penny each or $10 million per day. We own 8% of that, so that is $800,000 per day for Berkshire Hathaway. You could get another penny out of the stuff. It doesn’t seem impossible. I think it is worth a penny more. Right now it would be a mistake to try and get it in most markets. But over time, Coke will make more per serving than it does now. Twenty years from now I guarantee they will make more per serving, and they will be selling a whole lot more servings. I don't know how many or how much more, but I know that.

P&G's main products--I don't think they have the kind of dominance, and they don't have the kind of unit growth, but they are good businesses. I would not be unhappy if you told me that I had to put my family's net worth into P&G and that was the only stock I would own. I might prefer some other name, but there are not 100 other names I would prefer.

Coke's market share is about 50% of the worldwide soft drink business, and Gillette has about 71% by revenues of the worldwide razor blade business -- both are higher than they were when I called their businesses 'inevitables' five years ago.

With the world's population growing 2% annually, it is crazy to think they can grow profits at 15-18% per year, or even 10%, when unit grow is sure to be slower. But people got carried away, due to Wall Street and to some extent, company pronouncements.

When I talked about Coca Cola being an "inevitable," I talked about the probabilities that Coke will dominate the global market for soft drinks. I don't think anything will change that. It has a huge distribution system and position in people's minds worldwide. They'll make a little more profit per drink sold over time as well. I don't know how anyone could dethrone them.

We don’t want to dart in and out of businesses we love. It’s too hard to get the timing right, and then there’s the problem of taxes.

Coke and Gillette have both had their disappointments. It happens. It’s not in the nature of everything to go right all the time in a straight line. The same thing goes for Disney.

I see nothing to upset the trendline of the blade and razor business or the Coke business.

[A shareholder asked what Buffett thought of the Calpers/ISS proposal that he should not be on Coke’s audit committee. (From a Forbes article: “The California Public Employees Retirement System, or Calpers, and investor advisory group Institutional Shareholder Services argued that votes for Buffett for the Coke board should be withheld because Berkshire subsidiaries, such as ice cream chain Dairy Queen and food distributor McLane Co., do business with the world's largest soft drink maker… In defending the decision last month, an ISS spokesman said the group didn't want Buffett off the board entirely, just off of the audit committee, which should operate with zero tolerance for any conflicts. The spokesman said they don't make exceptions for anyone, even Buffett.”) Buffett replied:]

I would say that whoever suggested that should do 500 sit-ups [this was a reference to a skit in the movie shown before the meeting, in which Arnold Schwarzenegger punishes Buffett for talking about raising taxes in California by making him to do 500 sit-ups].

Actually, Charlie and I have encouraged the idea that shareholders should behave like owners, not sheep – where, in too many cases, they’ve been shorn. Big institutional shareholders have too long sat on the sidelines when they should have been active. [Now that they’re finally waking up,] the question is: Can they behave like intelligent owners? In last year or two, as they’ve woken up, they’ve searched for checklists, but frankly, a checklist is no substitute for thinking. Bertrand Russell once said: “Most men would rather die than think. Many do.”

A board’s real job is to find the right CEO and prevent him or her from overreaching. Not much else matters.

I think it’s absolutely silly, if Berkshire Hathaway owns 200 million shares of Coke worth $10 billion, to think that because Berkshire Hathaway sells a few hours of flight training to Coke, that I’m conflicted. It's almost absurd that people don't understand proportionality at all.

I receive $100,000 per year [to sit on Coke’s board]. This is obviously a tiny amount of money to me. If we picked someone from the welfare line and gave them the same money, this would represent all of their income, yet they’d be considered independent, but they wouldn’t really be. This thinking is kind of silly.

I encourage institutions and large owners to behave like owners and think carefully about what causes to take on.

[CM: The cause of reform is hurt not helped when an activist makes an idiotic suggestion like saying that having Warren on the board of Coke is contrary to the interests of Coke. Nutty behavior undermines their cause.

It’s like having a slicing machine in an apple orchard. The machine picks up things like rocks, so you program it to slice only red round things, but when red balloons come down the conveyor belt, the machine doesn’t know what to make of it.

Institutions are coming around to new ways of thinking. Hopefully, with evolution, they’ll think about what’s actually good for the shareholders of the company.

In the annual report we talked about Coca-Cola and Gillette in terms of their base business as being what I call the Inevitables, and that related to obviously the soft-drink business in the case of Coca-Cola and razors in the case of Gillette. It doesn't necessarily extend to everything they do, but fortunately in both those companies those are very important products. I would say that in the food business, you would never get the total certainty of dominance that you would get in products like Coca-Cola and Gillette. People move around in the food business from where they eat. They may favor McDonald's, but they will go to different places at different times. If someone starts shaving with a Gillette Sensor Plus, they won't go elsewhere in my view. You'd never get in the food business in my judgment quite the inevitability you would get in the soft-drink business with a Coca-Cola. You'll never get it again in the soft-drink business. I mean, it took 111 years to get to the point where they are. The infrastructure is just incredible. So I wouldn't put McDonald's in the same class in terms of inevitability. That doesn't mean it couldn't be an even better stock investment, depending on the price. But you're not going to get the price from me and knowing Charlie I doubt that you'll get the price from him but I'll give him a chance. (Munger remains silent; Buffett holds a hand-held mirror up to Munger's face and announces "He's breathing, folks, he's breathing." Crowd laughter.)

McDonald’s has a lot of things going for it, particularly abroad again. Thee position abroad in many countries is stronger than it is here. It is a tougher business over time. People don't want to be eating--exception to the kids when they are giving away beanie babies or something--at McDonald’s every day. If people drink five Cokes a day, they probably will drink five of them tomorrow. The fast food business is tougher than that but if you had to pick one hand to have in the fast food business, which is going to be a huge business worldwide, you would pick McDonald’s. I mean it has the strongest position.

It doesn't win taste test with adults. It does very well with children and it does fine with adults, but it is not like it is a clear winner. And it is gotten into the game in recent years of being more price promotional--you remember the experiment a year ago or so. It has gotten more dependent on that rather than selling the product by itself. I like the product by itself. I feel better about Gillette if people buy the Mach 3 because they like the Mach 3 than if they get a Beanie Baby with it. So I think fundamentally it is a stronger product if that is the case. And that is probably the case.

We own a lot of Gillette and you can sleep pretty well at night if you think of a couple billion men with their hair growing on their faces. It is growing all night while you sleep. Women have two legs, it is even better. So it beats counting sheep. And those are the kinds of business...(you look for). But what type of promotion am I going to put out there against Burger King next month or what if they sign up Disney and I don't get Disney? I like the products that stand alone absent price promotion or appeals although you can build a very good business based on that. And McDonald’s is a terrific business. It is not as good a business as Coke. There really hardly are any. It is a very good business and if you bet on one company in that field bet on (garbled) McDonald’s. We bought Dairy Queen a while back that is why I am plugging it shamelessly here.

You won't get the Inevitable in food that you will get in a single consumer product, such as blades. If I'm using a Gillette blade today, chances are I'll buy the next generation that comes out. A very high percentage of people who shave (including women) are happy with the product--it's not expensive--and if you're getting a great result, you're not going to fool around. Whereas, a great many decisions on fast food are based on which one you see. Convenience is a huge factor. So if you are going by a McDonald's or a Burger King or a Wendy's, and you happen to be hungry, you may very well stop at the one you see. So there's a loyalty factor, but it's just not going to be the same in food. People want to vary where they eat. Well, I don't, I'm happy to eat [at McDonald's] every day. They don't really have the same desire to vary their soft drink. So no knock on McDonald's; it's just the nature of the kind of industry they're in. Charlie?

[CM: I can't think of anyone before McDonald's that did what they did, create a chain of restaurants on such a scale that worked. A lot of failures ... It's a much tougher business that McDonald's is in.]

It's price sensitive, too.

[CM: Part of that's comparative. You can spend a lot more money on hamburgers in the course of a year than razor blades. You can't save that much by changing razor blades.]

Yeah, the average person in the United States buys 27 Sensor Excels in a year, one roughly every 13 days. I don't know what the retail price is, because they give them free to us as directors (laughter), but if they're a dollar that makes it 27 bucks. Around the world, people are using cheap double edged blades, and they'll keep moving up the comfort scale ladder and Gillette is a direct beneficiary. The difference between having great shaves and so-so shaves and pocks and nicks and scratches is 10 or 12 bucks a year. That is not the type of cost that'll make people change their habits.

It’s clear that it’s a consumer powerhouse of sorts and Gillette, in its field, has about as strong a consumer franchise as you’ll ever see (the blades and razors part of it).

Retailers are becoming more concentrated and brands of their own, so the struggle between manufacturers and retailers will continue. If I were on either side, I’d want to strengthen my hand by getting bigger. I think P&G and Gillette will be stronger as a combined enterprise, given the strength of the Wal-Marts and Costcos of the world.

I don’t know a thing about P&G’s pharmaceutical business. [A shareholder specifically asked about this.]

[CM: That makes two of us.]

PetroChina is not opaque. It’s very similar to big oil companies elsewhere in the world. It’s the 4th most profitable oil company in the world – it produces as much crude as Exxon. It’s not complicated – it’s a big integrated oil company, so it’s fairly easy to get your mind around the economics of the business.

The annual report will tell you more about the business than [the annual reports of] other oil giants. They tell you they’ll pay out 45% of their earnings, barring the unexpected. I like knowing that that cash will come to Berkshire.

It was bought because it was very, very cheap by any metric – far cheaper than Exxon, BP, Shell... You could say it should be cheaper, given that it’s 90% owned by the government of China, which is a factor, yes, but not so big for me. If you read the annual report of PetroChina, you’ll have as good an understanding of the company as reading the annual report any other oil company. Then, you can think about risks such as a disruption of US-China relations.

[CM: I think if it’s cheap enough, you can afford more country risk or regulatory risk. It’s not complicated.]

There’s Yukos, the big oil company in Russia. In evaluating country risk, you can reach your own judgments. In our view, PetroChina had less risk.

[Later in the meeting, Buffett and Munger returned to the discussion of this company:]

You don’t need any blinding insights to invest in PetroChina. They’re producing 2.5% of the world’s oil, it’s priced in US dollars, they control a significant part of the refining in China, and they pay out 45% of their earnings in dividends. If you’re buying something like that at 1/3 the valuation of comparable companies, it’s not hard. You just have to do the work.

[CM: But when you were buying, no-one else was. It required uncommon sense.]

We bought it a few years ago, investing $400 million. It was my first investment in a Chinese stock.

I read the annual report. They produce 3% of the world’s oil, about 80% as much as Exxon Mobil. Last year, it earned $12 billion in profit – only maybe five US companies earned as much last year.

The total market value when I bought it was around $35 billion, so I paid only three times last year’s earnings. The company does not have unusually large amounts of leverage and – this is unusual – has a stated policy of paying out 45% of its earnings in cash, so that’s a 15% cash yield [based on last year’s earnings, since Berkshire bought it at 3x those earnings].

The Chinese government owns 90% and we own 1.3%, so if we vote with them, together we control the business. (Laughter)

Unfortunately, we don’t own the same shares [as the Chinese government]. [We own another class of shares such that] we had to report our interest [in the company] at 1.3%. We would have liked to buy more, but the price jumped up [after our ownership stake was disclosed].

[CM: It would be nice if this [finding really cheap stocks] happened all the time. Unfortunately, it doesn’t.]

I simply read the annual report. I had no contact with management nor did I attend any management presentations. I just sat in my office and invested $400 million, which is worth $1.2 billion today.

I also looked at Yukos, the big Russian oil company [at the time I bought PetroChina] and compared the two at the time. PetroChina was far cheaper and I thought the economic climate was likely to be better in China. Yes, there was risk of tax laws or ownership rights changing, but the price was ridiculous.

[Q - In 2002, you invested in PetroChina and all you did was read the annual report. Most professional investors have more resources at hand. Wouldn’t you want to do more research? What do you look for in an annual like that? How could you make the investment only on a report?]

WB: I read it in the spring of 2002, and I never asked anyone else their opinion. I thought it was worth $100 billion after reading the report. I then checked the price, and it was selling for $35 billion. What is the sense of talking to management? It doesn’t make any difference. If the market value was $40 billion, you would need to refine the analysis. We don’t like things you have to carry out to 3 decimal places. If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision — I would know they were fat. If you can’t make a decision on PetroChina off the figures, you go on to the next one. You weren’t going to learn more if you thought their big [oil] field was going to decline out slightly faster, etc.

CM: We have lower due diligence expenses than anyone in America. I know of a place that pays over $200 million to its accountants every year, and I know we are safer because we think like engineers — we want margins of reliability. It is a very dicey process.

WB: If you think the auditors know more about an acquisition, then they should run the business and you should take up auditing. When we got the call on Mars-Wrigley I wasn’t going to look at labor costs or leases. The value of Wrigley does not depend on the value of the lease or an environmental problem. There is a whole lot of trivia that doesn’t mean anything. I never made an investment that would have been avoided due to conventional due diligence. We would have lost deals. On big deals, people rely more and more on process. When people want a deal, they will come to us. Mars only wanted to deal with Berkshire — there were no lawyers involved and no Directors involved. I got a call, it made sense, and I said yes. There was no material adverse change clause. Our $6.5 billion will be available regardless, even if Ben Bernanke runs off to South America with Paris Hilton. [eruption of laughter] That assurance is worth something. If you say, ‘I’ll do it, but I need X, Y, Z, etc.’— that is costly.

[Q - I’m here with a group of Chinese executives. We came here to see how companies should be run. You did a quick trade on PetroChina. What comes to your mind when selling? Any suggestions for these Chinese executives?]

WB: I met Dr. Gao recently from the China Investment Corp. for lunch. I was very impressed with him. We had lunch in Omaha. PetroChina was a $35 billion company when we bought [and I thought it was worth $100 billion]. When oil was at $70-75 per barrel, the analysis was the same but I then thought it was worth about $275-300 billion. That is about where it was then trading, so we sold. It went up significantly after- wards because of the A-share listing, and at one point, it became the most valuable company in the world by market cap. They’ve done a terrific job. If it went to a significant discount, we would buy again. I’m not so sure we don’t have a lot to learn from China vs. what we have to teach. China has a remarkable society. I traveled 45 minutes outside of Dalian, and saw hundreds of plants that were developed in recent years. The Chinese are starting to realize their potential. There is lots of ability, but the system did not realize its potential. I think it will continue to get better. I would look for the best practices and I would discard the rest. If you look at effective individuals—why do people want to be around them? You should copy those qualities. I would look for what I admire and emulate it, and try not to let distasteful things be copied.

CM: I hope you will go back to China and tell them that you found one individual that really approves of Confucius’ respect for elderly males.

We are very big in insurance and having the wrong incentives in place could be very harmful.

[Buffett had prepared slides and had them put up on the screens in the convention center. Slide 1 showed Berkshire Hathaway’s balance sheet shortly before it bought National Indemnity.]

For 15 minutes each year, Jack Greenwald [the owner of National Indemnity] would get frustrated with something and want to sell his company. I told Charlie that the next time he was in heat, bring him to me. So, we bought it in ’67 for $7 million.

[Slide 2 showed premium volume for National Indemnity from 1980 through 2003. It was $80 million in 1980, rose to $366 million in 1986, then declined nearly every year down to $54 million in 1999, and then spiked up to $595 million in 2003. Buffett highlighted the decline from 1986 to 1999 and asked:]

How many public companies in America would see premiums go down every year for such an extended period?

[Slide 3 showed the number of employees at National Indemnity from 1980-2003. The number rose from 1980-86 and then declined from 1986-99, but much more slowly than premiums declined. Buffett noted:]

We never fired anyone – the decline in headcount was solely due to retirements. The key is you can’t fire people if they don’t write business, or they’ll write business. You must be able to tell them that if they write no business, their job is not in jeopardy.

[Slide 4 showed National Indemnity’s expense ratio from 1980-2003, which was as low as 25.9% in a peak year, and as high as 41% in the worst year, 1999. Buffett noted that:]

Some companies would feel that this is unacceptable. [We don’t.] We can take an expense ratio that’s out of line, but can’t take writing bad business.

[Slide 5 showed the combined ratio at National Indemnity from 1980-2003. The combined ratio exceed 100 during a few bad years for the industry in the early 1980s, which is what led to the hard market that peaked in 1986, but National Indemnity’s combined ratio has been below 100 – e.g., the business has been profitable – in every year for the past 20. Buffett pointed out:]

In 1986, our combined ratio was only 69.3 because we did the most volume ever that year, up to that point [the company has done more volume in the past few years]. We coined money when we wrote a lot of business, and made a little when we didn’t. We’re the only company like this. We’ll have a high expense ratio when business is slow.

National Indemnity was a no-name company when we bought it, and has no copyrights, patents, etc. to distinguish it, but they have a record like no-one else because they had discipline.

You can’t run an auto or steel company this way, but it’s the best way to run an insurance company.

[CM: Nobody else does it, but to me it’s obviously the only way to go. A lot about Berkshire is like this. Being controlling owners is key – it would be hard for a committee to make these kinds of decisions.]

HomeServices will grow. It owns 15-16 local real estate firms, which retain all of their local identities – akin to the whole Berkshire model. Managers operate them as if they owned them themselves. We have no national identity, unlike Cendant, which operates under a few big names.

There’s no question that we’ll buy a few – or a lot – of [real estate brokerage] companies over the next 10 years. It’s a great company with great management. Last year, we participated in $50 billion of transactions – but this was only a small percentage of the national total. We’re big in California, Minnesota and Nebraska.

It’s a good business, but very cyclical. It’s very good now. We’ll go through a bad period, but we’ll keep buying. I don’t know how big it will become, but it’s conceivable that as we grow, we’ll add things like buying furniture. When people buy a new house, they need a lot of things.

[In response to another question about whether the internet will threaten the commission structure of real estate brokers like HomeServices, Buffett replied:]

I think commissions in HomeServices are sustainable. Barry Diller is interested in the space via Lending Tree, and the internet is a threat to any business, including real estate brokerage. But when I think about the process of owning a home, the for-sale-by-owner (FSBO) was with us 50 years ago and it is now [but it hasn’t affected commissions]. My guess is that 30 years from now, a very significant percentage of home sales will be done through the brokerage system like today’s, though there are people trying to change it.

[CM: [speaking to Buffett]: You tried to change it dramatically in Omaha, and you fell on your ass. [Chuckling.] You tried to take home listing business from the Omaha World Herald with your little paper and failed.]

We don’t think the way homes are bought and sold will change very much. Some will disagree, but we don’t think the internet will change this. [Buying and selling a home] is the biggest financial decision most people will make] and people will continue to want to have a 1-on-1 relationship with a real estate broker. [It also will be] a local business, so we’ve retained the local identities.

It’s almost certain that we’ll be a lot bigger [in this business] in 5-10 years. It depends on how many acquisitions we make, but we’re a good buyer and owner.

[CM: As to whether we’d prefer to buy brokerages or real estate, obviously we like brokerages better.]

The idea of direct marketing in auto insurance at GEICO came from Leo Goodwin and his wife. They came from USAA, which was established because US military personnel moved around a lot and had trouble getting insurance. Leo took this idea and broadened it beyond military officers. It’s a better system.

Going back 100 years, auto insurance was sold by casualty companies via a system of agents that charged large commissions. It was a cartel. State Farm was formed in the 1920s and had the idea of a captive agency force, which brought down costs. It became the largest auto insurer, and Allstate because #2 following the same model. This was a better system.

Leo bypassed the agents and brought down costs even further.

Every American family has to buy auto insurance. It’s not a luxury item, so cost is key and the low cost is going to win. The direct sellers, GEICO and Progressive, will slug it out and will win. GEICO has a tough competitor in Progressive – they’ve seen how we’ve done it [the direct model] and are moving to it.

Dell is very efficient. I’d hate to compete with them. If they turn out a decent competitive product at a good price, that system will win.

Charlie is on the board of Costco. Costco and Wal-Mart have figured out how to do this [be ultra-low-cost] and they’re winning.

It’s always a good idea to go with the low-cost producer over time. Being the low-cost producer of something that people need is a good business.

Right after yearend, we completed the purchase of 100% of GEICO, the seventh largest auto insurer in the United States, with about 3.7 million cars insured. I’ve had a 45-year association with GEICO, and though the story has been told before, it’s worth a short recap here.

I attended Columbia University’s business school in 1950-51, not because I cared about the degree it offered, but because I wanted to study under Ben Graham, then teaching there. The time I spent in Ben’s classes was a personal high, and quickly induced me to learn all I could about my hero. I turned first to Who’s Who in America, finding there, among other things, that Ben was Chairman of Government Employees Insurance Company, to me an unknown company in an unfamiliar industry.

A librarian next referred me to Best’s Fire and Casualty insurance manual, where I learned that GEICO was based in Washington, DC. So on a Saturday in January, 1951, I took the train to Washington and headed for GEICO’s downtown headquarters. To my dismay, the building was closed, but I pounded on the door until a custodian appeared. I asked this puzzled fellow if there was anyone in the office I could talk to, and he said he’d seen one man working on the sixth floor.

And thus I met Lorimer Davidson, Assistant to the President, who was later to become CEO. Though my only credentials were that I was a student of Graham’s, “Davy” graciously spent four hours or so showering me with both kindness and instruction. No one has ever received a better half-day course in how the insurance industry functions nor in the factors that enable one company to excel over others. As Davy made clear, GEICO’s method of selling – direct marketing – gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up. After my session with Davy, I was more excited about GEICO than I have ever been about a stock.

When I finished at Columbia some months later and returned to Omaha to sell securities, I naturally focused almost exclusively on GEICO. My first sales call – on my Aunt Alice, who always supported me 100% – was successful. But I was then a skinny, unpolished 20-year-old who looked about 17, and my pitch usually failed. Undaunted, I wrote a short report late in 1951 about GEICO for “The Security I Like Best” column in The Commercial and Financial Chronicle, a leading financial publication of the time. More important, I bought stock for my own account.

You may think this odd, but I have kept copies of every tax return I filed, starting with the return for 1944. Checking back, I find that I purchased GEICO shares on four occasions during 1951, the last purchase being made on September 26. This pattern of persistence suggests to me that my tendency toward self-intoxication was developed early. I probably came back on that September day from unsuccessfully trying to sell some prospect and decided – despite my already having more than 50% of my net worth in GEICO – to load up further. In any event, I accumulated 350 shares of GEICO during the year, at a cost of $10,282. At yearend, this holding was worth $13,125, more than 65% of my net worth.

You can see why GEICO was my first business love. Furthermore, just to complete this stroll down memory lane, I should add that I earned most of the funds I used to buy GEICO shares by delivering The Washington Post, the chief product of a company that much later made it possible for Berkshire to turn $10 million into $500 million.

Alas, I sold my entire GEICO position in 1952 for $15,259, primarily to switch into Western Insurance Securities. This act of infidelity can partially be excused by the fact that Western was selling for slightly more than one times its current earnings, a p/e ratio that for some reason caught my eye. But in the next 20 years, the GEICO stock I sold grew in value to about $1.3 million, which taught me a lesson about the inadvisability of selling a stake in an identifiably-wonderful company.

In the early 1970’s, after Davy retired, the executives running GEICO made some serious errors in estimating their claims costs, a mistake that led the company to underprice its policies – and that almost caused it to go bankrupt. The company was saved only because Jack Byrne came in as CEO in 1976 and took drastic remedial measures.

Because I believed both in Jack and in GEICO’s fundamental competitive strength, Berkshire purchased a large interest in the company during the second half of 1976, and also made smaller purchases later. By yearend 1980, we had put $45.7 million into GEICO and owned 33.3% of its shares. During the next 15 years, we did not make further purchases. Our interest in the company, nonetheless, grew to about 50% because it was a big repurchaser of its own shares.

Then, in 1995, we agreed to pay $2.3 billion for the half of the company we didn’t own. That is a steep price. But it gives us full ownership of a growing enterprise whose business remains exceptional for precisely the same reasons that prevailed in 1951. In addition, GEICO has two extraordinary managers: Tony Nicely, who runs the insurance side of the operation, and Lou Simpson, who runs investments.

Tony, 52, has been with GEICO for 34 years. There’s no one I would rather have managing GEICO’s insurance operation. He has brains, energy, integrity and focus. If we’re lucky, he’ll stay another 34 years.

Lou runs investments just as ably. Between 1980 and 1995, the equities under Lou’s management returned an average of 22.8% annually vs. 15.7% for the S&P. Lou takes the same conservative, concentrated approach to investments that we do at Berkshire, and it is an enormous plus for us to have him on board. One point that goes beyond Lou’s GEICO work: His presence on the scene assures us that Berkshire would have an extraordinary professional immediately available to handle its investments if something were to happen to Charlie and me.

GEICO, of course, must continue both to attract good policyholders and keep them happy. It must also reserve and price properly. But the ultimate key to the company’s success is its rock-bottom operating costs, which virtually no competitor can match. In 1995, moreover, Tony and his management team pushed underwriting and loss adjustment expenses down further to 23.6% of premiums, nearly one percentage point below 1994’s ratio. In business, I look for economic castles protected by unbreachable “moats.” Thanks to Tony and his management team, GEICO’s moat widened in 1995.

Finally, let me bring you up to date on Davy. He’s now 93 and remains my friend and teacher. He continues to pay close attention to GEICO and has always been there when the company’s CEOs – Jack Byrne, Bill Snyder and Tony – have needed him. Our acquisition of 100% of GEICO caused Davy to incur a large tax. Characteristically, he still warmly supported the transaction.

Davy has been one of my heroes for the 45 years I’ve known him, and he’s never let me down. You should understand that Berkshire would not be where it is today if Davy had not been so generous with his time on a cold Saturday in 1951. I’ve often thanked him privately, but it is fitting that I use this report to thank him on behalf of Berkshire’s shareholders.

We acquired a large, extremely well managed company called Iscar. Last October, I’d never heard of this company, but then I got a 1 1⁄2 page letter from Eitan [pronounced “Ay-tohn”] Wertheimer. Sometimes I get a letter and a person’s character and intellect jump off the page at me. So I met Eitan and his top managers in Omaha. They subsequently met Charlie. This all came to fruition yesterday when we signed the deal. [Click here to read the press release.]

As hard as this is to believe, Charlie is as enthusiastic about this as I am.

[CM: This company rose from very modest beginnings to be the best company in its field in the world. It’s not the largest, but that leaves them something to do. [Laughter] The quality of the people in this company is off the chart – and they’re young. This is a real quality enterprise and we can learn a lot from them. [According to a friend, at another venue Charlie said that a person like Eitan Wertheimer comes along “every 200-300 million people.”]]

I’d like Eitan and his two managers to stand up. Jacob Harpaz is President and CEO. Danny Goldman is CFO. Take a good look at these people – they’re going to do very, very well for you.

Eitan Wertheimer: It’s a beautiful day in Omaha. We bring our family to a new home. I bring more than 5,000 people here, and their families. For years, we weren’t sure what to do [in terms of monetizing our ownership of Iscar]. Then someone came to me and said, “Have you heard of Berkshire?” We found that Berkshire, like us, is a family company with a strong culture. And Berkshire is run by young people who we’d like to work with for 20-25 years. [Laughter] We had a very interesting lesson from Warren and then Charlie – and we survived! [More laughter]

I represent a big family. We make cutting tools and molds for cars, washing machines, the mold for Coke bottles, etc. I want to thank our customers, not only for buying from us but for trying new things. We try to stay competitive...

This is Jacob. In reality, my job is not to disturb him. Jacob gently fired me many years ago.

The company is 34 years old. We’re in 61 countries around the world. We have to fulfill a lot of expectations and work very hard to make sure everyone in this room is glad that we joined the family. Let’s be successful and look to the future. Every year, I look forward to coming to Omaha when the fields are green and the days get longer.

[At this point, on the main screen, there was a 10-15 minute movie about Iscar and its many worldwide subsidiaries, products and markets. The company makes all kinds of highly specialized cutting tools that are used in a wide range of industries, including automobiles and aerospace. The movie also touched on the history of the company, which was founded in the mid-1950s by Stef Wertheimer, Eitan’s father, who is currently honorary Chairman.]

This is an important acquisition. We paid $4 billion for 80% of the company. It’s the first business we’ve purchased that is based outside the U.S., though many we’ve purchased have major operations outside the U.S.

I think you’ll look back at this in 5 to 10 years as a very significant event in Berkshire’s history.

[This was, in effect, a very public wedding: both sides making vows of lifelong love, loyalty and commitment, in front of a vast number of friends, family and witnesses. In addition, the press in Israel has been remarkable. Here’s an excerpt from one article:

Prime Minister Ehud Olmert called Eitan Wertheimer last night to congratulate him on the sale. “It’s terrific tidings and a great gift to the State of Israel,” Olmert said. “We tip our hat to you, personally and in the name of the whole country.”

Eitan Wertheimer said selling the company for him is “lighting an economic torch,” just as his father Stef lit a torch on Independence Day. According to him, Buffett’s expression of faith is an important declaration for the country, “and just as they talked about the Balfour Declaration – now they’ll talk about the Buffett Declaration.” Olmert will speak with Buffett today. A government source said Olmert was indirectly involved in the deal.

A friend observed this and (correctly) commented:

The huge edge Buffett has built is represented in the phenomenal global celebration of the Iscar acquisition.

Eitan Wertheimer is now a hero and favored son of the state of Israel and, in selling his company to Buffett, he has achieved a phenomenal stature relative to his peers. Selling to Bain Capital would have not gotten anywhere this level of press, nor generated a call from the Prime Minister.

Is this level of instant global recognition worth offering Mr. Buffett a price he can’t refuse? You betcha! Watch the global competition to be the next ‘Omaha Idol’ heat right up!! What an edge!]

[Buffett talked about the trip he and Munger made to Israel to visit Iscar and they showed some photos of their visit to Iscar’s major plant, which is located only 10 miles or so from the Lebanese border. They were incredibly impressed. Munger commented: “It was a great experience. I have never seen anything as automated as that Iscar operation. I think they view it as a disgrace if any human hand has to do anything.”]

[Q - Chinese tungsten prices are going up — will this have an impact on Iscar’s machine tool production?]

WB: The reason the Iscar plant was built in China was to serve China. It’s growing. It’s nice to be near a raw material, but the geographic plant decision has nothing to do with changes in the price of the product. If you are creating a higher value-added product like Iscar, there may be a three-to-six-month adjustment to raw material prices, but there won’t be substitutes for tungsten as a raw material for cutting tools in the near term. Raw materials do get passed through. In the carpet business, oil-based raw materials are having more trouble passing costs. Over time it will pass through. But we’d be having trouble in that anyway. This candy will reflect sugar and cocoa over time. You can have squeezes here and there, but it’s not a big deal. When I visited the facility in Dalian, I had very high expectations for Iscar and they’ve been exceeded in every way; both financial and human expectations.

CM: I would say that the short answer is that while we don’t like inflation because it is bad for our country and civilization, we will probably make more money over time because there is inflation.

NetJets has grown rapidly and so far our expenses have grown faster. We have top service, the only worldwide service and the only service with larger planes. I thought we’d have economies of scale, but if anything we’ve had diseconomies of scale. I could give you reasons, but Rich Santulli knows the business and is addressing it. He works 16 hours a day. There is no one I have greater confidence in to fix this business. High fuel costs are a pass-through but affect the business. I think it’ll be profitable before long, but I’ve been wrong so far.

We have a good business. Nearly everyone who wants a large plane comes to us. We are able to get full price, but expenses got out of control last year. You can hold me accountable for paying a lot of money for the business a number of years ago and we haven’t made any money yet.

I looked at Raytheon’s annual report and they lost a lot of money in this area, but they’re selling their own planes so maybe they don’t care.

[CM: The product integrity is so extreme between NetJets [and its competition]. For example, NetJets’ pilots are subjected to real oxygen withdrawal so they’ll recognize the symptoms. Not everybody does that because it’s expensive. They’re obsessive about product integrity. My guess is that this will be rewarded eventually.

[Q - What errors were committed? What was learned and how do you prevent it from happening again?]

Buffett: I probably won't. Mistakes will be made over time. Sometimes situations are extraordinary. We were buying at fictitious plane prices that were based on how much people thought they could be sold for vs. what we would later sell them for. In the end they were not prepared for what was obviously happening and we had to write down a lot of the planes. They also let operating costs get out of line with revenues. Remember that I stayed in the textiles business for 20 years before I finally woke up. Charlie was telling me it was lousy in year one. It was a big mistake. NetJets last year posted a $711m loss. It is now operating with a decent pretax profit, with well over $50m pretax profit in Q1 and not with any boom in plane sales. They have a new business plan that has no diminution of service or safety but is now more in line with revenues. David Sokol turned the place around like no one could have.

Munger: Yes, but I believe the episode should be reviewed in context. If we buy 30 businesses and let the managers run them without interference, where 95% of the time it works well, then it is not a bad failure record. So, they will not change the management approach at all. They will continue to trust people to manage their own companies. This is how it has worked for years.

Buffett: This doesn't change our management strategy. We let managers do their stuff. And we will keep doing it.

Yesterday we announced a deal to buy McLane from Wal-Mart. Wal-Mart announced that the price for the two deals it did -- one was a small trucking company -- was $1.5 billion. [It's been reported that the purchase price McLane was $1.45 billion.] McLane is a wholesaler to convenience stores, quick-serve restaurants, Wal-Mart, movie theaters and so forth. It will have about $22 billion in revenues this year. Wal-Mart had owned it since 1990 and it grew substantially while they owned it. It is run by a terrific manager, Grady Rosier, and under his leadership, it grew from $3 billion to $22 billion.

Wal-Mart, for very good reasons, wants to specialize on what they do extremely well. We were approached by Goldman Sachs to buy the business a week ago. It makes sense for both sides. It was a sideline business for Wal-Mart. Their ownership of McLane resulted in certain people who would be logical customers not to do business with McLane because they didn't want to do business with a competitor. We'll be seeing them soon to explain that they can sleep well at night buying from us.

A representative of Wal-Mart, the CFO, came up to Omaha last Thursday. In one hour, we had a deal and shook hands, and when you shake hands with Wal-Mart, the deal is done. There needs to be regulatory review, but we fully expect that in just a few weeks, McLane will become part of Berkshire.

It serves presently 36,000 of the 125,000 convenience stores in the United States, and has 58% share among the largest chains. To each store, it sells about $300,000 of products/year. McLane also serves 18,000 quick-serve restaurants, mainly those operated by YUM Brands (Taco Bell, Pizza Hut and KFC).

It's a tough business. You have Hershey and Mars on one side and 7-11 Eleven on the other side, so you have to work hard to earn 1% pretax. [Tilson - If McLane earns 1% pre-tax on $22 billion in sales, that's $220 million, so Buffett may have bought this business for 6.6x pre-tax earnings. I think this is a good price, especially if the business can grow substantially under Berkshire, but not a steal -- the guys at Wal-Mart aren't fools. But I think they let it go for a below-market price to Buffett because their biggest concern is that the business continue to be a reliable supplier to their stores. Such a low-margin business has little room for error, and it could get into trouble (as other similar companies have) under the ownership of a financial buyer that used too much leverage or tried to tinker with its operations.]

Clayton Homes is the class of the manufactured home industry. The deal came about in an unusual way. Every year, a class (about 40 students) from the University of Tennessee comes to Omaha. They visit some sights and then we a have classroom session for a couple of hours. Afterward, they typically give me a football or basketball. Last year, Bill Gates happened to be in town. This year, we had a good session and when they got through, they gave me a book, the autobiography of Jim Clayton, the founder of Clayton Homes. He'd written a nice inscription. I said to the students that I was an admirer of Jim's. I read the book and called Kevin Clayton, Jim's son, and said how much I'd enjoyed his dad's book. I said if they ever decided to do anything [regarding selling the company], we'd be interested and I told him what price I'd be willing to pay. A few phone calls later, we had a deal. That's the way things tend to happen at Berkshire.

The manufactured home industry got in a lot of trouble. They'd gone crazy with credit and when you go crazy with credit, you get into a lot of trouble. Look at Conseco and Oakwood, which went into bankruptcy. The industry lost the ability to securitize receivables and was in the tank. There were 160,000 new manufactured homes this year, but there were 90,000 repossessions, so this hurts demand. For the strong, like Clayton, especially with a backer like Berkshire, it should be a good time in the industry. And it's a big industry -- about 20% of new homes are manufactured. We can put you in one for $30/square foot. Compare the prices -- that's a deal.

Competitors admit that Clayton is the class of the field, but even for Clayton, financing was hard. The lenders had gotten burned. Clayton did a securitization earlier this year, but [to get the deal done, they] had to keep more of the risk on their books

[Later in the meeting, in response to a question, Buffett commented further on Clayton Homes:] In the manufactured housing industry, everyone is losing money, but Clayton is making money. Most of Clayton's houses are sold through 297 outlets that they own. Managers are in a 50/50 profit split with Clayton. This is unlike what was going on in the industry a few years ago, whereby dealers would have a floor plan and the [manufactured housing] company would finance 130% of the purchase price, so the dealer would bring in any warm body. The system was designed for disaster. At Clayton, if a dealer takes in an inadequate down payments, it's his problem and he has to take care of repossessing it. This creates the right incentives.

If you read Jim Clayton's book [First A Dream], he tells about the first home he sold [when working for someone else] and all of the funny business and gaming of the financing. These activities are coming home to roost in a huge way among the manufacturers and those who financed them. There's such a stain that Clayton is only one that can securitize, and without us, not to the extent they wanted. They are a class player and have the right systems in place with the right incentives. We will not securitize -- we will keep it for the portfolio.

You're right [he was speaking to the questioner] that if you see companies with lots of gains on sales, be suspicious.

[The manufactured-home industry has] an interesting history. There have been years in which manufactured housing accounted for 20% of the new housing stock built in this country, but it’s now at the lowest level it’s been in 40 years. It’s fallen to 6-7% of new housing starts in the past few years, despite considerably better quality – you can look at the two [Clayton Homes] houses on the exhibition floor [of the Qwest Center]. They cost only $45 per square foot. That’s good value.

There’s been resistance by local builders to manufactured housing, but we’ve made progress. They’re now building subdivisions [for manufactured housing].

[For quite some time until the crash in this industry a few years ago,] the houses were mis-sold. The retailers were selling the houses to people who shouldn’t have been buying them, getting the down payment, and then taking the loans and selling them to some insurance company who lost a lot of money. [The subsequent crash] created a hangover that’s still being worked through.

[Mortgages on manufactured homes] should be financed on shorter terms. Terms of 30 years are a mistake. The terms got very lax and we’re bearing the consequences.

Somewhere down the road there will be 200,000 units [of manufactured housing sold], but not in the next year or two.

The number of competitors is down. Clayton’s record is so much better than anyone else’s that you have to look hard for the #2 player. Clayton may become biggest homebuilder in the U.S.

[CM: I think [the quality of] manufactured housing will continue to get a lot better and these types of homes will take more of the market. It’s so logical that I think it will happen.]

Most of the time, our actual decision [to buy] takes about two seconds. In the case of Anheuser- Busch, I bought 100 shares 25 years ago so that I would get the annual reports (you get the annual reports a little quicker if you own the stock in your own name). So, I’ve been reading the company’s annual reports for 25 years. Recently, beer sales have been flat. Wine and spirits are growing, at the expense of beer, and Miller has been rejuvenated to some degree. So, Anheuser-Busch has been experiencing very flat earnings; they’ve had to spend more to maintain share and even do a bit of promotional pricing. They are going through a period that is certainly less fun for them than was the case a few years ago.

It’s been a fascinating industry over the past 50 years. Omaha used to be a brewing town and Storz beer had 50% of the local market, but then the national brands took over.

Anheuser-Busch will have a strong position for a long time. The beer business is not going to grow significantly in the U.S., but worldwide beer is popular in a great many places, and Anheuser-Busch has a very strong position. I would not expect the earnings to do much for some time, but that’s fine with us.

[CM: In our situation, it’s rare that we can buy into a good company – we almost need a little unpleasantness.]

That’s true for Berkshire too.

In beer, you don’t see the rise of generic brands, as we’ve seen in so many other categories. But beer consumption per capita is going nowhere.

Americans drink about 64 ounces of liquid per day. 27% of that is soda (11 ounces are Coke products), beer is about 10% and, despite the rise of Starbucks, a fine company, coffee has gone down and down over time.

[CM: There used to be hundreds of brewers. I think the trend toward giant companies [dominating the beer industry] is permanent.]

Schlitz used to be the #1 brand of beer.

There’s a great book on the history of the beer industry [he didn’t give the title, though mentioned it was written by a Wall Street Journal reporter. Most likely it is Travels with Barley: A Journey Through Beer Culture in America, by Ken Wells.]

[On December 17, 2001, Berkshire Hathaway announced that it was acquiring Albecca (known as Larson-Juhl), the nation's leading provider of custom picture frames. Buffett was asked to talk about this business (these comments are from the annual meeting, plus those made at another presentation):]

Craig Ponzio, the owner of Larson-Juhl called me, told me about his business, its sustainable competitive advantages, its financial characteristics, and the price he wanted. Shortly thereafter, he came to visit me at 9am and by 10:30 we had a deal. I haven't seen him since.

The company has $300 million in revenues, earns $50 million in pre-tax profits, ties up no capital, is growing slowly, and distributes every dime of profit.

There are about 18,000 picture framing shops in the United States, mostly very small businesses with a few hundred thousand dollars per year in sales. They can't afford to have much inventory, so they show a catalogue to a customer who chooses the frame. Then, if they call Larson-Juhl before 3pm, 85% of the time the frame will be there the next day. Larson-Juhl and its customers are focused on service, not price.

Larson-Juhl calls on its 18,000 customers an average of five times/year. It has an incredible distribution system. Tell me how you'd attack that business? You wouldn't want to anyway, as the market's not big enough. Larson-Juhl has a HUGE moat. I always ask myself how much it would cost to compete effectively with a business. With businesses like these, nothing's going to go wrong. If you bought 20 of them, 19 of them would work out well.

Craig wanted to sell to me because he didn't want to waste a year doing a deal that might fall through at the end. With us, it's 100% certain that the deal gets done, and he can enjoy life.

The only thing that's unfortunate is that it's a small business.

Buffett: All investments are “value” investments. What other kind can there be? You always expect to get more in the future [for what you’re investing today].

Munger: BYD is not some early-stage venture capital company. The founder is around 43 years old. They’re a main manufacturer of rechargeable lithium batteries, from a standing start. Then they became big in cell phone components, with a huge position. They recently entered the auto industry, and from zero, rapidly made the best-selling [Chinese-manufactured] car model in China, against Chinese joint ventures with leading manufacturers. This is not unproven. It’s not speculative. It’s a damn miracle. They hired 17,000 engineering graduates at the top of their classes. It’s a remarkable aggregation of talent. Chinese people succeed mightily. Batteries are totally needed in the future of the world. I don’t think Warren and I have gone crazy. They make every part in the car, except [possibly] the windshield and the tires. I regard it as a privilege for Berkshire to be associated with BYD. I will be amazed if great things don’t happen. I wouldn’t bet against 17,000 Chinese engineers led by Wang Chuan-Fu. BYD is a $4 billion company—a small company, but their ambition is large.

Buffett: BYD was Charlie’s [idea], the Irish banks were mine.

[Q - BYD. How do you analyze a technology company like this when for so many years you shied away from investing in tech companies?]

Buffett: Deferred to Charlie

Munger: BYD is an interesting example because 5-10 yrs earlier BRK would not have made the investment. The old men are continuing to learn. Berkshire would have lower potential if we had stayed the way we were. I wasn’t sure I could get Warren to do this. Dave Sokol was inveigled to go to China and the both of us helped the Chairman with the ‘learning’ process.

I like the 15%. I measured that 15% against other credits and it looked attractive on both a relative basis and an absolute basis. Also, we have to have a certain amount of the portfolio go to debt. Lately, the government has become the guarantor for some companies but not for others and the “haves” and “have-nots” determined by certainty of government assistance rather than the credit quality. These finance companies have a problem getting funded, not with their customers. Any company where you can get your customers to tattoo your name on their body has quite a strong brand. For this investment I had to think what is the probability that they will not pay me back and would I want to own the company if they did not, basically that the equity isn’t worth zero. Risk premiums in the corporate bond market went from real low to real high. Right now, they’re out of whack. The flip side is that governments are overpriced. We have a bubble in governments. T-bills actually had a negative interest rate. I never thought I’d see that. A mattress is a better investment than the US 10 Year. Buying corporates and shorting the 10-year is a great idea and smart guys went broke doing it because even if you’re right, you need to be able to play out your hand. I always think about what I would do if a nuclear bomb went off or if Bernanke ran off with Paris Hilton to South America.

[In 2000, Berkshire Hathaway sold its large, long-term holding in Freddie Mac.] "We felt uncomfortable with certain aspects of the business as they developed, though they may not hurt the company. We did not sell because we were worried about more governmental regulation -- the opposite if anything. We felt the risk profile had changed."

Munger added, "Maybe it's unique to us, but we're quite sensitive to financial risks."

Buffett continued, "There are many things you don't know by looking at a financial company's financial statements. We've seen enough to be wary. We can't be 100% sure that we like what's going on. With some types of companies, you can spot problems early, but you spot troubles in financial institutions late."

Munger: "Financial institutions make us nervous when they're trying to do well." [Think about that one for a while.]

At another point in the meeting, after a question about the underwriting risks in Berkshire Hathaway's portfolio, Buffett said, "the biggest risks are [assumed by] those who write lots of homeowner's policies. If you're Freddie Mac or Fannie Mae, guaranteeing mortgages for millions of people, what happens if an earthquake hits California? They're taking on enormous risk. I don't know if Freddie Mac and Fannie Mae are demanding that all homes with mortgages they guarantee have earthquake insurance." [That's Buffett's polite way of saying they don't.]

I have a lot of respect for Frank Raines [the CEO of Fannie Mae]. I think he's done a good job at Fannie Mae. The problem with Fannie Mae, Freddie Mac and the S&Ls in the past -- they have a terrible problem of matching assets and liabilities. The problem is the optionality of mortgage interest. You have a 30-year instrument [e.g., a fixed-rate home mortgage] if you [the homeowner] have a good deal and a 30-minute deal if it's a bad one [e.g., interest rates fall further]. The public has been educated and will refinance. It's a big problem when you are operating on borrowed money in a very big way. If you run an institution that is highly leveraged, you'll look for one way or another to try to match liabilities as close as you can with the duration of assets. And you try to deal with the optionality of your counterparty. It's not easy to do. Fannie and Freddie try to mitigate this risk through various ways, and do a good job -- probably better than we could. But it's not perfect. I'd try to reduce this optionality and would be careful of counterparty risk.

The things that really destroy people are 5- or 6-sigma events -- things that really aren't supposed to happen. Financial markets don't do every well at modeling this. It works until it doesn't. There are more theoretical 6-sigma events than any theory of probabilities will come up with. When you have gaps, markets close, etc., this is what causes companies to go out of business. Derivatives increase the chance of this happening and magnify the damage if it does.

If anyone uses precise figures in finance, be careful.

When Long-Term Capital Management had trouble with one type of asset, they had troubles with other types of assets -- and everyone else did too. The Fed stepped in -- something they never dreamed they would have to do -- because it threatened stability of the US financial system.

[CM: I agree with [Warren's points about] counterparty risk. I think Fannie and Freddie have been thinking about a lot of scenarios where they'll be okay if the counterparties pay. But I'll bet they weigh the risk of counterparties not paying a lot lower than I would.]

I'll bet Fannie and Freddie are handling this better than their counterparties, such as the financial guarantors.

The best thing you can do is count on your own resources. That's what we do at Berkshire. Charlie and I are rich enough that we don't need to stay up at night.

The GSEs were a very logical development. For a fee, which used to average 25 basis points, they would allow someone 3,000 miles away to buy a mortgage [or portfolio of mortgages] and not worry. The GSEs were looked at as government guaranteed, so investors didn’t worry.

They became all about leverage – they could access capital at a low rate and built a huge carry trade [borrow at low short-term rates and lend at higher long-term rates]. Then they got carried away when they promised high rates of steady growth. It was madness – you can’t do that. If you lend for 30 years to someone who can repay in 30 seconds, as a practical matter you can’t perfectly handle that risk. So, they first enlarged their portfolios and then engaged in financial shenanigans.

It boggles the mind how, with good auditors and board members, they misrepresented billions of dollars. They now have $1.5 trillion of mortgages and the Federal government is on the hook – markets believe it and it is – because two companies wanted earnings per share to go up. They acted like the two largest hedge funds in history.

People are now seeing the consequences of the government issuing a guarantee. Congress should be paying a lot of attention to this. You can’t shut them down, but you can increase capital requirements and capital ratios. You could put them into run-off mode. There are plenty of other mortgage guarantee providers. It would not be the end of the world at all if the GSEs were put into run-off mode.

[CM: I think their problems are due in part to their large derivatives books, which were sold to them by silver-tongued salesman. As many of you know, I believe there’s much wrong with derivative accounting and don’t believe the full penalties have yet been paid.]

If you can have a $5 billion mismark in one direction and a $9 billion mismark in the other direction [as was the case with Freddie and Fannie, respectively], I would say we’ve come a long way from Jimmy Stewart in “It’s a Wonderful Life”.

Salomon like I said, I went into that because it was a 9% security in 1987 in September 1987 and the Dow was up 35% and we sold a lot of stuff. And I had a lot of money around and it looked to me like we would never get to do anything, so I took an attractive security form in a business I would never buy the common stock of. I went in because of that and I think generally it is a mistake. It worked out OK finally on that. But it is not what I should have been doing. I either should have waited in which case I could have bought more Coca-Cola a year later or thereabouts or I should have even bought Coke at the prices it was selling at even though it was selling at a pretty good price at the time. So that was a mistake.

On Long-Term Capital that is—we have owned other businesses associated with securities over the years-–One of them is arbitrage. I’ve done arbitrage for 45 years and Graham did it for 30 years before that. That is a business unfortunately I have to be near a phone for. I have to really run it (arbitrage operations) out of the office myself, because it requires being more market-attuned because I don’t want to do that anymore. So unless a really big arbitrage situation came along that I understood, I won’t be doing much of that. But I’ve probably participated in about 300 arbitrage situations at least in my life maybe more. It was a good business, a perfectly good business.

LTCM has a bunch of positions, they have tons of positions, but the top ten are probably 90% of the money that is at risk, and I know something about those ten positions. I don’t know everything about them by a long shot, but I know enough that I would feel OK at a big discount going in and we had the staying power to hold it out. We might lose money on something on that, but the odds are with us. That is a game that I understand. There are few other positions we have that are not that big because they can’t get that big. But they could involve yield curve relationships or on the run/off the run governments that are just things you learn over time being around securities markets. They are not the base of our business. Probably on average, they have accounted for 1⁄2 - 3⁄4 a percentage point of our return a year. They are little pluses you get for actually having been around a long time.

One of the first arbitrages I did involved a company that offered cocoa beans in exchange for their stock. That was in 1955. I bought the stock, turned in the stock, got warehouse certificates for cocoa beans and they happen to be a different type but there was a basis differential and I sold them. That was something I was around at the time, so I learned about it. There hasn’t been a cocoa deal since. 40 odd years, I have been waiting for a cocoa deal. I haven’t seen it. It is there in my memory if it ever comes along. LTCM is that on a big scale.

It’s hard to tell what will cause a crisis: who will yell fire, how many people will rush to the exits, etc.

Look at Long-Term Capital Management, or what happened to the junk-bond market in 2002. It almost closed. It was chaos.

In mid-August 1991, when we were at Salomon, on a Sunday we were within half an hour of seeking out a Federal judge and handing over the keys and filing for bankruptcy. The lawyers were drafting the bankruptcy documents. Fortunately, [the Treasury ruling that would have forced Salomon to seek bankruptcy protection] was reversed.

But what would have happened if we’d filed? Coincidentally, Gorbachev was spirited away the same day [Monday, August 19] and the Dow was down a few hundred points. What would have happened when the markets opened in Japan if Salomon Japan couldn’t deliver securities, etc.? Plus, Salomon had a $600-700 billion derivative book.

Munger: It could have been absolute chaos. There’s a very interesting story, with an interesting moral. Nick Brady was Treasury Secretary at the time. He was a Berkshire shareholder because of his long relationship with the Chaces.

[From Buffett’s 1991 annual letter: “Malcolm G. Chace, Jr., now 88, has decided not to stand for election as a director this year. But the association of the Chace family with Berkshire will not end: Malcolm III (Kim), Malcolm’s son, will be nominated to replace him. In 1931, Malcolm went to work for Berkshire Fine Spinning Associates, which merged with Hathaway Manufacturing Co. in 1955 to form our present company. Two years later, Malcolm became Berkshire Hathaway’s Chairman, a position he held as well in early 1965 when he made it possible for Buffett Partnership, Ltd. to buy a key block of Berkshire stock owned by some of his relatives. This purchase gave our partnership effective control of the company. Malcolm’s immediate family meanwhile kept its Berkshire stock and for the last 27 years has had the second- largest holding in the company, trailing only the Buffett family. Malcolm has been a joy to work with and we are delighted that the long-running relationship between the Chace family and Berkshire is continuing to a new generation.”]

Munger: He [Nicholas Brady] knew about us and was following the story. He trusted you, Warren, and I think that mattered.

It was terrifying what could have happened that day.

Buffett: Kim Chace, who I introduced you to earlier [at the beginning of the meeting, Buffett introduced all of Berkshire’s directors], his father introduced me to Nick Brady when I was in my 30s. [In 1991,] he was head of the Treasury and they had issued a death sentence to us [Salomon] that morning. Fortunately Nick reversed it. [Had he not, we would have filed for bankruptcy and] it would have been a case study for a daisy-chain type of panic.

That was nothing compared to what would happen now. It’s not an experiment that you would want to voluntarily conduct, let’s put it that way. [Nervous laughter]

The Fortune Magazine that has Rupert Murdoch on the cover. It tells the whole story of our involvement; it is kind of an interesting story. I got the really serious call about LTCM on a Friday afternoon that things were getting serious. I know those people most of them pretty well--most of them at Salomon when I was there. And the place was imploding and the FED was sending people up that weekend. Between that Friday and the following Wed. when the NY Fed, in effect, orchestrated a rescue effort but without any Federal money involved. I was quite active but I was having a terrible time reaching anybody.

We put in a bid on Wednesday morning. I talked to Bill McDonough at the NY Fed. We made a bid for 250 million for the net assets but we would have put in 3 and 3/4 billion on top of that. $3 billion from Berkshire, $700 mil. from AIG and $300 million. from Goldman Sachs. And we submitted that but we put a very short time limit on that because when you are bidding on 100 billion worth of securities that are moving around, you don't want to leave a fixed price bid out there for very long.

In the end the bankers made the deal, but it was an interesting period. The whole LTCM is really fascinating because if you take Larry Hillenbrand, Eric Rosenfeld, John Meriwether and the two Nobel prize winners. If you take the 16 of them, they have about as high an IQ as any 16 people working together in one business in the country, including Microsoft. An incredible amount of intellect in one room. Now you combine that with the fact that those people had extensive experience in the field they were operating in. These were not a bunch of guys who had made their money selling men’s clothing and all of a sudden went into the securities business. They had in aggregate, the 16, had 300 or 400 years of experience doing exactly what they were doing and then you throw in the third factor that most of them had most of their very substantial net worth’s in the businesses. Hundreds and hundreds of millions of their own money up (at risk), super high intellect and working in a field that they knew. Essentially they went broke. That to me is absolutely fascinating.

If I ever write a book it will be called, Why Smart People Do Dumb Things. My partner says it should be autobiographical. But this might be an interesting illustration. They are perfectly decent guys. I respect them and they helped me out when I had problems at Salomon. They are not bad people at all.

But to make money they didn’t have and didn’t need, they risked what they did have and what they did need. That is just plain foolish; it doesn’t matter what your IQ is. If you risk something that is important to you for something that is unimportant to you it just doesn’t make sense. I don’t care if the odds you succeed are 99 to 1 or 1000 to 1 that you succeed. If you hand me a gun with a million chambers with one bullet in a chamber and put it up to your temple and I am paid to pull the trigger, it doesn’t matter how much I would be paid. I would not pull the trigger. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. Yet people do it financially very much without thinking.

There was a lousy book with a great title written by Walter Gutman—You Only Have to Get Rich Once. Now that seems pretty fundamental. If you have $100 million at the beginning of the year and you will make 10% if you are unleveraged and 20% if you are leveraged 99 times out of a 100, what difference if at the end of the year, you have $110 million or $120 million? It makes no difference. If you die at the end of the year, the guy who makes up the story may make a typo, he may have said 110 even though you had a 120. You have gained nothing at all. It makes absolutely no difference. It makes nodifference to your family or anybody else.

The downside, especially if you are managing other people’s money, is not only losing all your money, but it is disgrace, humiliation and facing friends whose money you have lost. Yet 16 guys with very high IQs entered into that game. I think it is madness. It is produced by an over reliance to some extent on things. Those guys would tell me back at Salomon; a six Sigma event wouldn’t touch us. But they were wrong. History does not tell you of future things happening. They had a great reliance on mathematics. They thought that the Beta of the stock told you something about the risk of the stock. It doesn’t tell you a damn thing about the risk of the stock in my view.

Sigma’s do not tell you about the risk of going broke in my view and maybe now in their view too. But I don’t like to use them as an example. The same thing in a different way could happen to any of us, where we really have a blind spot about something that is crucial, because we know a whole lot of something else. It is like Henry Kauffman said, “The ones who are going broke in this situation are of two types, the ones who know nothing and the ones who know everything.” It is sad in a way.

I urge you. We basically never borrow money. I never borrowed money even when I had $10,000 basically, what difference did it make. I was having fun as I went along it didn’t matter whether I had $10,000 or $100,000 or $1,000,000 unless I had a medical emergency come along.

I was going to do the same things when I had a little bit of money as when I had a lot of money. If you think of the difference between me and you, we wear the same clothes basically (SunTrust gives me mine), we eat similar food—we all go to McDonald’s or better yet, Dairy Queen, and we live in a house that is warm in winter and cool in summer. We watch the Nebraska (football) game on big screen TV. You see it the same way I see it. We do everything the same—our lives are not that different. The only thing we do is we travel differently. What can I do that you can’t do?

I get to work in a job that I love, but I have always worked at a job that I loved. I loved it just as much when I thought it was a big deal to make $1,000. I urge you to work in jobs that you love. I think you are out of your mind if you keep taking jobs that you don’t like because you think it will look good on your resume. I was with a fellow at Harvard the other day who was taking me over to talk. He was 28 and he was telling me all that he had done in life, which was terrific. And then I said, “What will you do next?” “Well,” he said, “Maybe after I get my MBA I will go to work for a consulting firm because it will look good on my resume.” I said, “Look, you are 28 and you have been doing all these things, you have a resume 10 times than anybody I have ever seen. Isn’t that a little like saving up sex for your old age?

There comes a time when you ought to start doing what you want. Take a job that you love. You will jump out of bed in the morning. When I first got out of Columbia Business School, I wanted to go to work for Graham immediately for nothing. He thought I was over-priced. But I kept pestering him. I sold securities for three years and I kept writing him and finally I went to work for him for a couple of years. It was a great experience. But I always worked in a job that I loved doing. You really should take a job that if you were independently wealthy that would be the job you would take. You will learn something, you will be excited about, and you will jump out of bed. You can’t miss. You may try something else later on, but you will get way more out of it and I don’t care what the starting salary is.

When you get out of here take a job you love, not a job you think will look good on your resume. You ought to find something you like.

If you think you will be happier getting 2x instead of 1x, you are probably making a mistake. You will get in trouble if you think making 10x or 20x will make you happier because then you will borrow money when you shouldn’t or cut corners on things. It just doesn’t make sense and you won’t like it when you look back.

WB: It doesn’t make any difference. We want a company with a durable advantage, which we can understand, a management we can trust, at a good price. We’ve looked at every confectionary business. We can sometimes take action. If you have a good private business, the best thing to do is to keep it. No reason to sell it. If you don’t need the billion, then it’s just a farm. We never urge people to sell good businesses, but if they do need to sell, they can keep more of the attributes they love by selling to Berkshire. We are a larger buyer. Most people shouldn’t sell us their business, but we want them to think of us if they do decide to sell. We want to be on the radar screen. We are going to get more on the radar screen in Europe. There is a price at which we would buy stock in Lindt, but it is unlikely to sell there. Many CEOs want to sell to me, but there are thousands of businesses in the world. We should buy the most attractive amongst the ones we understand and like. Stocks give you bargains, but individual owners won’t. But we will do it at a fair price. We aren’t going to look for a given confectionary company.

CM: We don’t do anything when the phrase ‘regardless of price’ enters the equation. I watched a man who sold a business to a known crook just for a higher price, but who you knew would ruin the business. It’s better to sell companies you created to someone who would be a good steward at a lower price.

Buffett: We believe in post mortems, but not in making them public. You won’t attract businesses if you do. Charlie is a fan of rubbing their noses in what they’ve done. I will comment on Gen Re though. Gen Re has worked out well after a terrible, terrible start thanks to the combined work of Tad [Montross] and Joe [Brandon] who took over in 2001. I was terribly wrong in thinking it was the Gen Re of 15 years earlier. Gen Re now is the company I thought it was in 1998 when I bought it. It wasn’t an easy job.

Munger: That’s right. It’s very important that you have the ability to turn lemons into lemonade. It wasn’t pleasant, and it wasn’t pretty. You had to be very tough minded to fix Gen Re. We were very lucky to have Tad and Joe.

Buffett: Post mortems are evaluating our handiwork. Acquisitions are our choices— not another department or a consultant. We made some really dumb decisions.

Munger: Joe’s the hero.

Buffett: A very substantial fraction of American businesses over the last 15 years have managed earnings. We felt good about the quality of the businesses and the quality of the managements, but it was primarily the terms of the GE and Goldman deals that made them attractive. There were no second sources to GE and Goldman. I know the GE and Goldman CEOs quite well and am very happy with the deals. We’ve done a lot of business with Goldman over the years.

Munger: There’s been a lot of criticism of investment banking, but Berkshire has gotten help [from] investment banks. We’re comfortable with these businesses.

Buffett: We’ve bought I don’t know how many wind turbines from GE.

Buffett: We have several arrangements with Swiss Re. We invested three billion Swiss francs [$2.6 billion] in Swiss Re, and it pays us 12%. [This is] not a junior security. Their problems are not due to their [insurance] underwriting. They develop a large amount of float relative to premiums. Swiss Re’s problems were a little akin to AIG’s.

Munger: If Swiss Re’s a problem, we should have more [like that].

[Comment: They say a stressful situation that doesn’t kill you, makes you stronger. Somewhat similarly, a company’s problems that prove not to be fatal can make its investment case stronger—at a sufficiently low price. Obviously, Buffett didn’t view Swiss Re’s problems as being a lot like AIG’s.]

WB: Abacus was made subject of SEC complaint (22pages) and I think there has been misreporting on the nature of the transaction. I would like to clarify this transaction, as it is important and frequently mischaracterized. In the Abacus transaction, there were four losers. GS didn’t intend to lose but did, they couldn’t sell their piece. The main loser was a very large bank in Europe named ABN Amro. Why did they lose money? They guaranteed the credit of another company ACA. ABN was in the business of judging credits, deciding credit. They fronted the transaction, guaranteed it. We do it frequently here at Berkshire. Many in business will take a policy if we guarantee the policy. We’ve made a lot of money doing this over the years. We lost a fair amount doing this with some dishonest people in early 1970s. They were syndicates at Lloyds. In Abacus, ABN guaranteed $900m and was paid 17bps of insurance. They got $1.6m for $900m of insurance coverage. The company went broke, so they had to pay the $900m. The bank made a dumb credit deal. It is hard for me to be sympathetic for a bank that made a bad credit trade. ACA, and you wouldn’t know this from the reporting, but they were a bond insurer. They started in municipal bonds, like AMBAC, FSA, etc. Many of those companies started insuring municipal bonds some 30 yrs ago, and it was a big business. But the profits were squeezed. They found new places to insure – and got into insuring structured credits. I described it a few years ago in the annual report like Mae West, “I was Snow White but I drifted”. Almost all of them did it – they didn’t understand it well, but made more money. Then they all got into trouble. Is there anything wrong with insuring structured credits? No, but you better know what you are doing. We went into municipal bond business when others got into trouble, we got paid more, and we stayed away from CDOs or RMBS. These deals were too hard.

WB: We did insure something. It will help you understand Abacus. This deal [slide up on screen of portfolio of US state bonds] we did insure. A large investment bank came to us. We insure a local power generation company, and the Nebraska Methodist hospital. We have $100m with the hospital. An investment bank came to us, with this list of names of states -- $1.1b for Florida, $200m for California. Will you insure the bonds of these States that they will pay for the next ten years. I looked at list, and we had to decide a) do we know enough and b) what premium to charge. We insured $160m for 10yrs. On other side, someone is insured that we will pay if they don’t pay. We didn’t come up with list. There are four reasons we were showed this trade. Lehman might own it and simply want insurance, Lehman might be negative on it – and this is a method to short, they might have a customer wanting protection, or they might have a customer negative on it wanting to short. We don’t care why they wanted the insurance, it was our job to insure the bonds. If they told me Ben Bernanke was on other side of trade, it wouldn’t matter. If it matters to me, I shouldn’t take it. We did with the bonds what ACA did. With list of 120, ACA only accepted 50, then negotiated for 30 more. In Abacus it was a mutual negotiation. Unfortunately, all the bonds went south very quickly – it wasn’t clear this would happen in early 2007. If you look at how the ABX was trading, it wasn’t obvious. Now there can be trouble in these States bonds we have insured. Maybe the guy on other side knows more than me. But I see nothing, I won’t complain if I lose money. I can’t claim other side had superior knowledge. Central part of the SEC argument is that Paulson knew more about the transaction. In retrospect, it was just a dumb insurance decision. Charlie?

CM: My attitude is simple. This was a 3:2 decision by SEC commissioners where they usually decide unanimously. I would have voted with the minority.

WB: ACA was a bond insurer, not an investor, pure and simple. Well... simple as it turns out. The press seems to be misrepresenting the situation by calling ACA a manager. ACA lost money because they were a bond insurer. Ironically, this whole situation has helped BRK’s investment in GS. BRK got $5B in preferred stock (that pays $500M per year) that GS has the right to call at 110% of par and get rid of the preferred that costs them so much each year. BRK would have to put that money in ST securities if they got it back and every day that GS does not call the stock is money in the bank for BRK. In fact, it amounts to $15 per second. Tick, tick, tick. Don’t want those ticks to go away. He likes that they go on at night when he sleeps. GS would love to get rid of the preferred. They only decided to do it because it was the height of the crisis. The Fed has likely been telling GS that they can’t call the preferred and that has helped BRK. Buffett was hoping that the Fed would be quite tough when it came to allowing the preferred to be repaid. In effect, the recent developments have delayed the calling of the preferred. Now BRK will get $500M a year rather than $20M a year they would get from ST Treasuries. So Buffett loves the investment in GS. There is no question that the allegation alone caused the company to lose some reputation and all the negative press has hurt the company and morale. But this is not remotely fatal or anything like that. GS had a situation with Penn Central 30 years ago and one with Ivan Boesky that hurt. But the allegation of something does not fall into the category of losing reputation. When a transgression is found out about or alleged (His motto in such situations is: get it right, get it out, get it fast, get it over) it can take a while to figure out what went wrong. He does not hold the allegation against GS. If it leads to something more serious then he will re-look at it. But, when he looks at Abacus he sees it as a legitimate transaction.

[Q - And the latter half of the question, regarding your investment in GS and your advice to management?]

WB: It has probably helped our investment. We have $5bn in preferred stock at 10% (that pays $500M per year). They can call them at 110% of par and get rid of the preferred that costs them so much each year. BRK would have to put that money in short term securities (which might make $20m versus the $500m per year we now own) if they got it back and every day that GS does not call the stock is money in the bank for BRK. Every day, we get paid $15 per second. I don’t want those ticks to go away. Tick tick tick. They go on at night, and on weekends. I love this, I get paid when I sleep. Tick tick tick. They only agreed to this at the height of crisis, and they want them to go away. The government has been telling companies what to do about dividends and preferred shares. Government telling them what to do, and it is good for our shareholders! I was sitting here hoping that the Fed would continue to be quite tough about our preferred. I think recent developments have delayed the calling of our preferred. So we’ll continue to get $500m per year instead of $20m.

We love the investment. I would expect – there is no question that the allegation alone causes the company to lose reputation and obviously the press has hurt the company, and morale. It isn’t mortal, but it hurts. GS had a situation with Penn Central railroad -- that hurt forty years ago. There was a Boesky connection – it was painful at the time. But an allegation of something doesn’t fall into my category of permanent damage.

My advice is that when some transgression is found or alleged -- Ron Olson was manager of team [at Solomon], “Get it right, Get it fast, Get it out, Get it Over”. It does take some delays at the time, you have to gather the information and make sure it is right. An allegation has been made. Perhaps it turns into something more serious. But I do not see anything in Abacus that looks any different than our list of municipals. The allegation does not meet my criteria of losing reputation.

CM: I agree with all of that. But every business ought to decline business that is otherwise acceptable or legal. Standards shouldn’t be what is legal, but it should be different. Every investment bank took skuzzy customers. There are too many skuzzy customers and too many skuzzy deals.

WB: Should we have done our deal?

CM: I think it was a closer case than you do.

WB: We insure about $140bn of muni bonds. We aren’t bigger because we think the premiums aren’t the right price. Some people when premiums are wrong get busier – do more. We don’t, we go golfing. We think much is wrong on Wall Street. But our experience with Goldman goes back 44 years. We’ve bought more businesses through them than anyone else. We trade with them as well. We don’t use them as investment advisors – we make our own decisions. When we trade, they could be selling or buying for their own account. They don’t owe us a rationale or reasoning, nor do we owe them. They are acting in a non-fiduciary capacity when they are trading with us. If working on a transaction or financing, that is different. We have had a lot of very satisfactory business with Goldman. The first bond issue we did was 1967, on slide 2, an offering of Diversified Retailing Corp, $5,500,000. We were imaginative calling it diversified even though we only owned one business. NY Securities and Nebraska Securities were the underwriters. Usually the lead underwriter was at the top. We were having trouble raising the $5.5m. I called Gus Levy and Al Gordon at Kidder Peabody. No one wanted to give us the money. Both Gus Levy and AL Gordon said we’ll take a big piece. GS and Kidder were next largest underwriters, they asked us to leave their names off the tombstone. But they did come through for us, under an assumed name. Al Gordon died last year at 107, worked until 104. Gus Levy was a remarkable man.

WB: We were not contacted by the SEC about Galleon. I read about it. No contact. I can’t pronounce name of the guy who runs Galleon. I’ve talked to lawyers about Wells Notices. When Gen Re got wells, we stuck that in 10Q or maybe an 8K I think. That was not us receiving it but certain executives receiving it from the SEC. I have been on board of at least of one well known company when they got a Wells Notice and they didn’t publicize it, and it was nothing. If you regard it as material, you report it. If I had received something about Abacus, it would have been immaterial.

CM: I wouldn’t have regarded the Wells Notice as material. Companies can’t report every little thing that happens or it would produce way too much confusing info. If every company reported everything of low probability, reports would run to hundreds of pages. You don’t want to give blackmail potential to people.

WB: I don’t know what percentage of Well Notices are material to companies. Who do I want running GS? If Lloyd had a twin brother, I’d go with him. I’ve never given it a thought on who else should run Goldman Sachs. There is no reason to think about that. There is not a reason to worry who besides Gus Levy should be running GS in 70s during Penn Central or Weinburg during Boesky. This does not reflect on Lloyd. There is plenty of stuff we don’t like on Wall Street, but it is not specific to GS.

CM: There are plenty of CEOs I’d like to see dismissed in the US. Lloyd Blankfein is not one of them.

WB: I was worried he might start naming names [laughter].

Buffett: The authorities (the Service Transportation Board) have adopted a 10.5% ROIC as the agreed upon amount. Of course this could be adjusted if there was a huge change in interest rates. Utilities often get 12% ROE. Railroads go to returns on invested capital. I don't think this is a crazy standard. Railroads, unlike the electric utilities where you are guaranteed a rate of return, are more volatile due to the risk of large economic contractions. If you behave yourself in electric utility, you will almost always make your returns. Railroads have more up and down, more downside. In general, you want railroads investing a lot more than depreciation to improve the transportation system. 10.5% is inducement enough. CThe country as a whole and the railroad systems have a common interest in not earning a huge profit but generating a fair return that allows for continued investment. If Service Transportation Board says 10.5%, that is not a crazy number.

Munger: Railroads have been regulated successfully. They have been totally rebuilt over the last 30-40 years through improved tracks, bridges - the average train is twice as long and twice as heavy. By and large a system of wise regulation and wise management allowed this. That was not always the case. The existing system has worked very well for all of us.

Buffett: I don’t think conflicts of interest were the biggest causes of the ratings agencies’ problems. Five years ago, virtually everyone thought home prices couldn’t go down. Home prices always go up [it was widely believed]. There was an almost total belief that house prices would rise. They [the ratings agencies, investors, etc.] just didn’t understand the various things that can happen in a bubble with $20 trillion in total assets. People leveraged up their biggest asset enormously. As it began to melt down, it became self-reinforcing. They [the ratings agencies] would have been criticized [if they’d bucked prevailing wisdom]. Taking a different view 4 – 5 years ago might have led to Congressional committees asking how they could be so un- American as to take such a dim view of American homeowners. Ratings agencies and the American people made terrible mistakes. So did Congress and regulators. I never made a call to Moody’s regarding their procedures. When we own stock, we don’t own them [companies] to change them. We’ve had very little luck when we’ve tried to change companies. Ratings agencies are still a good business. It’s a business with few people [companies] in it, it doesn’t require capital, and it has the fundamentals of a good business. They won’t be doing the [previous] volume in capital markets for awhile. Charlie and I pay no attention to ratings. We don’t outsource credit analysis.

Munger: Ratings agencies eagerly sought models that let them use higher math and make the decisions they wanted to make. To a man with a hammer, everything looks like a nail.

Buffett: The people who stirred up the Kool-Aid drank it. It was stupidity, and everyone else was doing it. I send out letters to managers every couple of years: If you’re doing [something] because everyone else is, that’s the wrong reason. That’s not an acceptable excuse at Berkshire. We couldn’t get Salomon to stop doing business with Mark Rich [who Buffett likened to Al Capone in the 1930’s]. It’s hard to get large organizations to not do what successful competitors are doing.

[Q - Ratings agencies. Moody’ s stake is being sold, has the investment case changed?]

WB: We won’t discuss what we will or won’t do with our securities. Agencies have a wonderful business. Good pricing power, no capital required. People will need ratings agencies. They succumbed to same mania that infected everyone – it is hard to think contrary to the crowd. They couldn’t see a world where residential housing countrywide could collapse. Incentive may have been bad, but also it is just difficult to think contrary to the crowd. If structure doesn’t change, it is a pretty darn good business. You can’t shop pricing. We however have never paid any attention to ratings. If we can’t do it ourselves, we don’t do it. If model doesn’t change, it’s a good business.

CM: Ratings agencies in present form and present incentives have been a wonderful influence for many decades. Cognition faltered, and drifted with stupidity of the times. Part of it was asininity of American business education, their over-belief in models. I haven’t heard a single apology for their huge contribution to our present difficulties.

I have been living on these products for 70 years. It depends on how you feel about sugar. 20% of Americans consume something with sugar in it every day. The life span of Americans has increased. There is no worry of product liability but this is always a fertile field for plaintiffs. Berkshire Hathaway has passed on some opportunities because of the concern of product liability.

[CM: Perniciousness is the power of the plaintiff contingency.]

Decisions are usually made with a pessimistic attitude and it is projected that the trend will continue to accelerate.

Buffett: I couldn’t have been more wrong about the Irish banks. The $9.00 price isn’t the issue, it’s the business model. Nobody lied to me. It was a terrible mistake by me. I just plain wasn’t paying attention and should have known about their land development loans. Wells Fargo, among the largest banks, has the best competitive position. Regarding WaMu [Washington Mutual], there were a lot of signs of possible trouble if the model of ever-rising housing prices was wrong. They were doing things they shouldn’t be doing with leverage. If you read the [SEC Form] 10-Ks and 10-Qs, you could spot the difference. There’s no comparison between Wells Fargo versus WaMu. Banking has real differences, but people don’t look at them carefully. Think of a copper producer with costs at $2.50/pound versus another with costs of $1.00/pound. One’s done [if prices drop to] $1.50/pound, and the other is fine. Wells’ $600 million amortization of acquired deposits is not a real cost—yet nobody notices. I think it was pretty clear regarding Freddie and Fannie. We got calls from investment bankers [looking for interest in them]. One look and we could see they were in big, big trouble. People who don’t spend a lot of time investing can’t differentiate financial institutions. It’s easier with Coke or a utility. You have to know something about banking.

Munger: Accounting practices should not be constructed to allow banks to get into trouble with loans. GAAP [generally accepted accounting principles] allows conservative banks to increase earnings if [they] change policies to [those of] poor ones.

Buffett: Gen Re’s [derivatives] division cost us $400+ million to get out of. [It was] a black box to produce all sorts of numbers. It’s hard for a passive investor to discern.

Munger: A lot of new regulation wouldn’t have been needed if accounting had done a better job. If accountants don’t have shame, they’re not thinking right.

Munger: Government is reacting to the biggest financial crisis in 70 years. It’s unreasonable to expect perfect agreement with all of one’s ideas. Of course there will be some ideas that are foolish, but government is entitled to be judged more leniently in times of such trouble. I think the idea that [a company’s] earnings go up when its credit declines [due to the lower market value of its debt] is insane accounting.

Buffett: Mid-September was as close to a total financial meltdown as there could be. There was a commercial paper freeze-up, and $100 billion was taken out of money market funds. It required prompt action. We were looking into the abyss. I commend the actions taken, especially since they [government officials] were working 20 hours a day. Merrill Lynch would have gone if Bank of America didn’t buy it. I sympathize with Dick Kovacevich’s “asinine” comment. He was called on a Sunday and told to be in Washington D.C. the next day, without knowing why. He was told they [Wells Fargo] would take it [TARP funds], and he had an hour to sign. That’s the nature of an emergency. By and large, the authorities did a good job. Among the large banks, Wells is a wonderful bank and has some advantages that other banks don’t. I recommend [JP Morgan CEO] Jamie Dimon’s shareholder letter; it’s on JP Morgan’s website. Jamie did a great job. It’s as good a shareholder letter as I’ve seen. It’s a long letter, but worth reading. He did a great job writing about the crisis.

WB: Most big food businesses are good businesses in that they earn good returns on tangible assets. If you own important branded assets in this country, and you have good assets, it is not easy to take on those products. Just imagine Coca-Cola. They sell 1.5 billion servings every day. It has been in everyone’s mind since 1886—associated with good value, happiness and refreshment. It is virtually impossible to take it on in a huge way. It may not be the same with Kraft. Kool-Aid, but I’m not sure I want to take on Kool-Aid. To implant RC Cola in people’s minds globally is very, very difficult. A brand is a promise. Coca-Cola delivers something to you. Virgin Cola — an unusual promise in a product—tried and couldn’t figure it out. Whatever it was, it didn’t work. Don Keough would know. Who would buy a can for two-cents-a-can less than Coca-Cola? We feel pretty good about branded products if they’re leaders in their field. There is nothing unusual about Kraft that’s different from Kellogg. Some good factors are price. If you don’t pay too much, you will do okay. But you won’t get superrich, as the attributes [of a strong brand] are well recognized.

WB: I didn’t like the Cadbury or pizza deals. We’ve made our share of dumb deals at Berkshire. But even though the odds are that is dumb -- doesn’t mean it will be dumb. We get mad when other people do dumb things with our money. Sold $3.7b pizza business, and the other guy paid that, but Kraft received $2.4b net of tax. Pizza was earning $280m pretax in prior year. In 2009 it earned $340m pretax for sales that were growing faster. They didn’t get a great price. Cadbury is growing slowly. Karft quoted last year’s earnings for pizza and next year’s earnings for Cadbury. Giving up $340m pretax with sales growing faster than Cadbury was particularly dumb when Kraft had already shown they understood how to do an efficient deal like Post Cereals. I don’t do that [speak up] too often, but we owned a lot of it. I wanted to stick with pizza and skip Cadbury. Present price for Kraft is still well below the price the constituent pieces like Koolaid, Jello, and Oscar Meyer brands would sell for independently, particularly if valued the way Kraft valued Cadbury. I didn’t like them paying so much to buy Cadbury. In terms of compensation, we have a system which is rational. Many companies have different compensation systems. [laughter]

CM: People at the top of a business, they think they are smarter about strategy. They often tire of the fierce competitors in the business they are in and dream of something else, where [competition is imagined to be less] – so they want to do a deal.

WB: And they will have lawyers, consultants, investment banks and others in who get paid for deals, telling them to do a deal.

CM: We have avoided a slight subset of stupidities, and they are important.

The businesses have different characteristics: Service businesses such as Executive Jet have costs that are human-resource and capital heavy. The carpet company has a large raw-material-buyer cost, and only 15% human-resource cost. The costs vary by business. The retail business costs include purchased goods and labor, and insurance has claims costs that can extend out over years. The important part of knowing the business is that we understand the cost structure and that the company has an enduring competitive advantage with top-notch management.

Buffett: I’m quoting someone [William Lever, founder of Lever Brothers]: “We waste half the money we spend on advertising—we just don’t know which half.” We spend $800 million on advertising [at GEICO], which is more than the number one and two [auto insurers], State Farm and Allstate. We will spend more and more. We want everyone in the U.S. to know we can save people money. We want to be on everyone’s mind. A brand is a promise. The value of GEICO goes up by far more than its earnings each year.

Munger: If we don’t need GEICO to advertise [as much], then it’s that much more profitable.

Buffett: We’re getting more than our money’s worth on advertising. I’d spend $2 billion if we got the same return. We’re the low-cost producer of something people have to buy.

[Comment - A brand is a promise, and a fulfilled promise will create substantial value.]

Buffett: It’s institution specific. There’s no reason for senior debt to give up anything, if there’s lots of equity and earnings power. Wells Fargo and US Bank are making lots of money, and earning power is intact. There’s lots of equity beneath the preferreds. It’s like a 70% LTV [loan-to-value] homeowner [shouldn’t necessarily] lose because a 95%+ LTV homeowner is [losing]. I would love to buy all of US Bank or Wells Fargo. We can’t, because it would make us a bank holding company. GM and Chrysler are very different. They’re losing money, and there’s no common equity. If equity is wiped out, then you have to decide who gets losses. Wells Fargo and US bank are very different.

Munger: I have nothing to add.

Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn't really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

Retailing is like shooting at a moving target. In the past, people didn't like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1996 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn't going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore. It isn't good enough that there were smart people running it.

It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears' management (500 people). They've captured some savings already.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn't make any money.

How many retailers have really sunk, and then come back? Not many. I can't think of any. Don't bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart's and Sams'. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won't pick up new ones. Wal-Mart is also a tough competitor because others can't compete at their margins. It's very efficient.

If Eddie sees it as impossible, he won't watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won't be able to compete against Costco's margins.