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Note:
This is not a transcript. No recording devices were allowed at the
meeting, so this is based on many hours of rapid typing, combined
with my memory (egads!). I have reorganized the content of the
meeting by subject area. All quotes are Buffett's unless otherwise
noted. Words in [brackets] are my comments or edits.
For
more on this meeting, see my 5/5/03 column, Report from Berkshire's Meeting. For my columns and
notes on previous Berkshire and Wesco meetings, click here.
To read
the transcript formatted in MS Word, click here.
To download a Word version, RIGHT-click here and select
"Save Target As."
COMMENTS ON BERKSHIRE HATHAWAY
Q1
Results
The
economy has been quite sluggish -- it has been for a very long time.
Right after 9/11, I posted a letter that said we had been in a
recession [even prior to 9/11]. Since 2000, housing and autos have
done very well, but everything else has been quite sluggish.
Interest rates are down to 1.5%, but business continues to be
sluggish.
So, our
non-insurance businesses didn't do so great in the first quarter.
But insurance businesses did great. The first quarter will show $290
million of pre-tax income, after $140 million in charges for
retroactive insurance contracts. And, our float grew $1.3 billion to
$42.5 billion in float. (Float is what people pay us to use the
money.) I don't see our float growing much from this point, but
Charlie said that at last year's annual meeting [and it's grown 8.8%
from Q1 02 to Q1 03].
I think
our insurance businesses are in exceptionally good shape. We have
some terrific businesses. Geico's premium volume was up 16% in Q1,
with a 6% underwriting profit. Gen Re, thanks to Joe and Tad, has
turned the corner in a big way. And Ajit Jain [of National
Indemnity] made so much money in the first quarter that I don't even
want to tell you about it. [Audience and Munger applauded.] When you
see Charlie clap, you know he's made us a lot of money.
You
never know what's going to happen in insurance -- there could be a
big earthquake tomorrow or huge hurricanes -- but I can't imagine
having a better group of companies and people. For a while Gen Re
was a drag, but that's not true right now. We have a very good
chance of having low or no cost float for as far as the eye can see.
Having $42.5 billion for free is a good thing.
Q1 was
a very good quarter. Pre-tax operating earnings were around $1.7
billion (not including securities gains). [Buffett later clarified
that after-tax earnings, including securities gains, were also about
$1.7 billion.]
Munger:
I hate to be an optimist, but we have really added a lot of
wonderful businesses to Berkshire over the past few
years.
Berkshire's Float
I wish
our float would keep growing at 10%/year as long as it's profitable.
But with $42.5 billion of float and a US P&C [property and
casualty insurance] market of $500 billion, we are 8-9% of the
market so it's going to be much harder to grow at significant rates
in the future. What we really want is low-cost float. That's what I
tell my managers.
Every
once in a while, we get off track. I don't think most companies in
the P&C business will generate float at an attractive cost. You
have to be exceptional, and we have some exceptional businesses. If
GEICO grows 16%, it adds $1 billion of float. GEICO will grow -- I'd
bet my life on that.
Munger:
With interest rates where they are right now, the float we've built
up isn't worth so much to us right now. We have $16B of cash earning
very low rates. But eventually we'll get more than 2%.
Buffett: We're getting a lot more than 2% [I think he was
referring to the total return from Berkshire's float]. We have
roughly $16 billion in cash, excluding the finance operation, and
we're getting about 0.75% on it [1.25% pre-tax], which does not make
us salivate. But we'd rather avoid salivation than have problems.
We
earned $1.7 billion in Q1, pretty much all cash, plus $1.3 billion
of float, so there's a lot of money coming in. We're getting chances
to deploy it. If we get it at low cost, then it's pretty close to
equity.
COMMENTS ON BERKSHIRE HATHAWAY HOLDINGS
McLane
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. [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
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 (we owned Oakwood's junk
bonds), 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.
NetJets
We took
a loss in the first quarter and will have a loss for the year. It's
our only business that's losing money.
The
used aircraft market has excess capacity, which is pushing down
prices. We bought back some planes from our owners, which we've
always done and will continue to do. [Because NetJets owns both new
and used aircraft -- before selling them to fractional owners -- I
believe it had to take a non-cash charge in Q1 for the decline in
this asset's value.]
We're
slightly profitable in the US and losing money in Europe. 1/2 of all
[business jet] miles flown in Europe are by Americans, and this will
rise. We've made a huge investment Europe and there will be no
competitors behind us.
There
are three major competitors. We have always been the biggest and our
market share is rising. At 75% recently. I believe all of our
competitors are losing money on an operating basis -- not even
including asset write-downs. I think some of them will exit the
industry -- look at Raytheon's recent prospectus. There will be a
shake out, and we will not be one of the ones shook.
This
will eventually be a huge business for us -- 10 times what it is
currently.
MidAmerican Energy Holdings and Investment Opportunities
in the Energy Sector
MidAmerican is already a big part of Berkshire. It could be
much bigger if PUHCA [Public Utility Holding Company Act] were
repealed. It was enacted in 1935 in response to abuses -- it was
needed then, but it's now outdated. A couple of companies could be
in bankruptcy if we hadn't stepped in [to buy some of their assets
last year].
I think
there's a reasonable chance of repeal [of PUHCA, and if so]
MidAmerican could be quite a bit bigger and could be a whole lot
bigger. We might acquire a natural gas pipeline or a utility. We'll
look at what comes along and we're always ready to act. We'll look
at some big deals this year -- whether we'll get one done is another
matter. The good thing about this sector is that you're always
talking about big deals.
There's
fabulous management at MidAmerican. Dave Sokol and Greg Abel have
done things that have made Berkshire money that hasn't benefited
MidAmerican -- they didn't get paid a dime. They are terrific
assets, and we love the idea of pouring money behind them.
Munger:
The interesting thing is the field is so big -- it's enormous. One
thing a modern civilization needs is energy.
Value Capital
Value
Capital is run by Mark Byrne. We've made a lot of money with the
Byrne family. [Jack Byrne turned around GEICO in the 1970s, making
Berkshire a ton of money, and has recently been doing the same with
White Mountains Insurance, in which Berkshire also has an
investment.] Mark is a very bright guy and runs a hedge fund
specializing in fixed income securities around the world. The Byrnes
have put in money, but we own 95% of the capital -- though we are
exposed to no further risk. Value Capital uses some leverage, but
not as much as similar funds. We're comfortable with it, as long as
Mark has upside and downside, which he does. We disclose the
numbers. Value Capital has $600 million or so, including $200
million of retained earnings. We do not regard it as a business part
of Berkshire. We are a limited partner (even if accounting rules say
we have to consolidate it). There are no guarantees, but we're very
happy with it. I've looked at Mark's portfolio and I like the
positions.
Gen
Re and Goodwill
If you
buy a business over tangible assets [e.g., you pay more than the
value of the company's tangible assets], you set up a goodwill
account [for the difference] and if it becomes impaired, you run a
charge through the income statement. We took on a lot of goodwill
when we bought Gen Re. If you looked at the last few years, you'd
say Gen Re was impaired and we would have agreed, but I think Gen Re
is now worth more today than when we bought it. It's generating
substantial float and it's low cost.
Circle of Competence, Telecom, Level 3 and Junk Bonds
I don't
have the faintest idea how to evaluate what telecom companies will
look like down the road. I only understand a little of what they do.
I suppose if you gave me some information, I could regurgitate it
back to you but in terms of understanding their economic
characteristics down the road, I don't know. Charlie, what do you
know about the telecom business?
Munger:
Less than you do.
Buffett: Then you're in trouble. I know people will be
drinking Coke, using Gillette blades and eating Snickers bars in
10-20 years and have rough idea of how much profit they'll be
making. But I don't know anything about telecom.
It
doesn't bother me. Somebody will make money on cocoa beans, but not
me. I don't worry about what I don't know -- I worry about being
sure about what I do know.
Munger:
Berkshire in its history has made money betting on sure things.
Buffett: We might buy some junk bonds in that business
[telecom], and we have, but we expect losses in junk bonds -- though
we expect a decent result -- because we're dealing with institutions
that have demonstrated problems. In some cases -- not at all with
Level 3 -- there are management issues. We expect to have
significant losses, and we haven't seen our biggest loss yet,
believe me.
It's
like being an insurer of substandard risks -- you'll have more
accidents, but can charge a premium.
We
don't buy businesses in which 15 will be train wrecks and 85 will
work out OK.
There
are all kinds of businesses where you can't predict what they're
going to earn, so we try to favor a few where we can.
At
Level 3, they are fine people and they acknowledge that they
borrowed too much money. I have yet to see an electron and have no
working relationship with them at all. I don't know anything about
the technology at all, but I understand the people involved. It's of
a different sort [of investment] than we usually do, but we're happy
we did it.
Acquiring More of Cologne Re
What
really happened was Gen Re acquired a significant position in
Cologne Re with a put and call arrangement for the remainder. It was
a two-step purchase. So all along, we have accounted for it as if we
would acquire it. We will have about 89% when the options exercise.
There's nothing new about this arrangement and we made no new
judgment or decision. Cologne is an integral part of Gen Re. We knew
all along that we would own 89% of it.
PetroChina and Foreign Investments
We have
five equity investments in foreign companies. We don't list all of
our investments -- only those larger than $500 million -- and none
of our foreign investments have hit our reporting threshold since
Guinness. In the case of PetroChina, the government owns 95% of it,
but Hong Kong stock exchange rules require disclosure if an investor
owns more than 5% of a stock, and we own 13% of H shares. It's a
fluke of reporting that we have to report it. We don't make any
great judgment about China -- we simply look at investments around
the world and buy things that make the most sense [offer the most
value]. We prefer slightly things in the US and avoid some countries
altogether.
Coca
Cola's Inevitability
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.
BERKSHIRE'S ACQUISITION PROCESS
Deal
Flow
We
don't like the term "deal flow" because we don't view them
[businesses we might buy] as deals. We look at deals a few times a
year. In the US, we get a pretty reasonable percentage of the calls
we should get. We didn't get those calls 20-40 years ago because we
weren't as well known.
It
feeds on itself. If we acquire companies and people say good things,
we'll hear from more. We acquired one furniture company, which led
to four more.
It's
like a snowball. By being around 38 years, it's been a high mountain
[and Berkshire is now a] big snowball and attracts a lot of snow.
Outside
the US, we don't see many deals because we're not as well known.
I don't
hear about one [deal] a week or even a month. But most we want to
hear about, we get a good percentage of the calls. It would be a
plus [if we were to see more deals] outside this country.
Munger:
The general assumption is that it must be easy to sit behind a desk
and people will bring in one good opportunity after another -- this
was the attitude in venture capital until a few years ago. This was
not the case at all for us -- we scrounged around for companies to
buy. For 20 years, we didn't buy more than one or two per year.
Buffett: We didn't have the money to do many deals. When we
bought National Indemnity, it was a big deal for us. We hope there's
a lot of mountain left and a lot of wet snow.
Munger:
It's fair to say that we were rooting around. There were no
commissioned salesmen. Anytime you sit there waiting for a deal to
come by, you're in a very dangerous seat.
The
Story of Buffett Buying National Indemnity
Jack
Greenwald would want to sell National Indemnity for 15 minutes per
year -- a claim would come in that upset him or something like that.
I discussed the phenomenon of Jack being "in heat" 15 minutes per
year. One day, Charlie called and said Jack's ready and he came over
and we made deal in 15 minutes.
Having
made the deal, Jack really didn't want to do it. He tried to get out
of it by saying, "I suppose you want audited financial statements."
I said "No." If I'd said yes, he would have called off the deal. He
said, "I suppose you want to buy the agencies." I said, "I wouldn't
buy them under any circumstances." Again, if I'd said "Yes," he
would have backed out. Finally, he gave up and I bought the
business. He was an honorable guy. After we closed the deal, Jack
was 10 minutes late to pick up the $7 million check because he was
looking for parking meter with a few minutes left on it -- that's
when I knew he was my kind of guy.
Bidding for Bankrupt Companies; Burlington Industries
We
submitted a bid of more than $500 million for Burlington, which
included $14 million in breakup fees. When we submitted the bid, it
has to remain outstanding for many months. This has option value [to
the company and its creditors]. For $14 million, we told creditors
that they could sell business for that amount, or very close to it.
That's a very low price for a put, but it's customary. A court said
that's too much to charge, so they set up a new procedure that will
end up having Burlington sold to someone else under the new
procedure.
We'd
never agree to anything like this except in the case of bankruptcy.
Look at how stocks move 50-100% per year. We will not participate in
a procedure in which we bid hundred of millions of dollars and then
if there's a World Trade Center disaster or earthquake, our bid sits
out there and we only get paid $5 million [to assume this risk].
It's
tough to buy things out of bankruptcy, though we've done it twice
successfully. We tried with Burlington and we spent a lot of time
and money and it was not accepted.It's a lot
easier to make a deal with Wal-Mart [e.g., McLane] where we sit for
an hour and have a deal. But it's probably a necessary part of the
procedure. You gotta follow the bankruptcy laws. If we have to bid
where we have our bid sit out there, and get paid [only a] 1%
[breakup fee], we won't make many bids.
Munger:
We don't think a modest 2% fee was too much, but the court
disagreed.
OTHER BERKSHIRE HATHAWAY COMMENTS
Information on Berkshire
We want
you to understand Berkshire. I hope you see that. We want to you
have the information we'd want if our positions were reversed. You
need some basic information. We give information that Charlie and I
would need to come up with our rough estimates of Berkshire's
intrinsic value. You don't need to focus on all of the details, like
whether we lease a particular building, but you can judge roughly in
aggregate.
Munger:
I think our reporting, considering the complexity of the enterprise,
is better than that of any enterprise I know at giving shareholders
the information they need. We do it conscientiously and I don't
think it will get better.
Approach to Risk
We have
some structured contracts with paraplegics who are depending on a
piece of paper with our name on it that says we're going to pay them
for the rest of their lives. So people who care about this should
come to us.
What
To Do With Berkshire's Cash
We have
$16 billion in cash not because of any predictions [about a market
decline], but because we can't find anything that makes us want to
part with that cash. We're not positioning ourselves. We just try to
do smart things every day, and if there's nothing smart, then we sit
on cash.
Investment Hurdle Rates
10% is
the figure we quit on -- we don't want to buy equities when the real
return we expect is less than 10%, whether interest rates are 6% or
1%. It's arbitrary. 10% is not that great after tax.
Munger:
We're guessing at our future opportunity cost. Warren is guessing
that he'll have the opportunity to put capital out at high rates of
return, so he's not willing to put it out at less than 10% now. But
if we knew interest rates would stay at 1%, we'd change. Our hurdles
reflect our estimate of future opportunity costs.
Buffett: We could take the $16 billion we have in cash
earning 1.5% and invest it in 20-year bonds earning 5% and increase
our current earnings a lot, but we're betting that we can find a
good place to invest this cash and don't want to take the risk of
principal loss of long-term bonds [if interest rates rise, the value
of 20-year bonds will decline].
Smooth vs. Lumpy Earnings
We have
a preference for a lot of money coming in all of the time. But we
write huge insurance policies where money could come or go in big
chunks. All other things being equal, we like smoothness, but we
often get offered a spread to take on lumpiness.
Pepsi
is running a contest in which one person will have a 1-in-1,000
chance of winning $1 billion -- a present value of $250 million
[since the billion is paid out over time]. [If the person wins,] we
will pay it. We are willing to assume that for a payment, and very
few people would be. We would be willing to assume a $2.5 billion
payout (but not $25 billion) if we got paid more than proportionally
more.
Munger:
If you're risking a $250 million payout and you have $60 billion of
capital, it's not crazy. But I think it's crazy to do it based on
someone else's circumstances or abilities.
Investment Mistakes
If we
start buying a stock, we want to go in heavy. I can't think of a
stock where we wanted to quit.
We've
made some big mistakes starting to buy something that was cheap and
within our circle of competence, but trickled off because price went
up a bit. Good ideas are too scarce to be parsimonious with.
Munger:
After nearly making a terrible mistake not buying See's, we've made
this mistake many times. We are apparently slow learners. These
opportunity costs don't show up on financial statements, but have
cost us many billions.
What
Do You Look for in a Manager?
We look
for managers that have a passion for their business. We've had
terrific luck with entrepreneurs who love their businesses like I
love Berkshire. They'll tell me to butt out if I'm going to screw it
up. They are part of Berkshire, but guard their businesses jealousy.
We got
a book from an investment bank from someone who bought a business a
few years ago [and now wanted to sell it]. The business was a piece
of meat to them. What are the odds that they didn't doctor the
books?
[I look
for people who] have a lot of love for their business. There can't
be a company in the country, if you could measure passion for the
business, no-one would come close [to Berkshire].
Munger:
What matters most: passion or competence that was born in? Berkshire
is full of people who have a peculiar passion for their own
business. I would argue passion is more important than brain power.
Buffett: By the time they get to us, if they didn't have
brainpower, they wouldn't have gotten to us. We're not going to see
an incompetent but passionate manager -- those got weeded out a long
time ago. But I do have to weed out a manager who just wants to cash
out.
We see
lots of businesses that play games with their accounting and just
want to cash out.
Berkshire's Compensation Systems
When a
business requires no capital, we reward the manager on earnings. If
it does [require capital], then we add a charge for the cost of
capital. We don't have one compensation system.
We've
never had problems with compensation. If capital is an important
part of business, we include a charge for it. If not, if we don't.
Our
compenastion systems are simple. This is not rocket science [though
Corporate America seems to make it so]. Read proxy statements --
it's mind-boggling the complexity. Compensation consultants have to
earn their fee [by coming up with a complex plan that they can]
tweak each year. It's becomes an industry and it won't break itself
up. True of any bureaucracy.
We
could spend $1 million per year on something we could figure out in
five minutes. Can you imagine a consultant giving you a one-page
compensation agreement? They couldn't charge you a lot of money for
that.
The
main reason we get good results from our managers is that they like
batting .400. Yes they like the pay, but it's incidental. It has to
be fair, but that is not a complicated procedure. It's tailored to
things under their control.
Some of
our businesses are easy, so they much achieve high performance
before [the CEO's] bonus kicks in. In tough businesses, lower
performance requires as much hard work, so the hurdle is lower.
Morale
is pretty good in Berkshire subsidiaries. Berkshires managers hardly
ever leave. In 38 years, we've never had a CEO leave to work for a
competitor. We face one management succession problem roughly every
18 months.
Do
Berkshire's Manager's Enjoy Coming to the Annual Meeting?
We have
many managers here. We don't require them to come. Some have rarely
come. If they enjoy it, they come. We have a sensational group of
managers. We don't get in their way and don't demand anything except
that they work for the owners. I hope you thank them when they see
them.
Munger:
I don't think our managers who come to this meeting are picking up
new tricks -- they know all the tricks related to their business --
but this is an interesting place and it gets more interesting every
year and they like being part of it.
Buffett: In some cases, our managers will check with each
other to see what they're paying for things, combine purchasing
power, etc. Sometimes they save real money, but this is not
organized by Omaha and nobody has to play.
Berkshire's Intrinsic Value
I think
(and Charlie does too) that Berkshire's value has grown
significantly over past few years.
Intrinsic value is the stream of cash from now until judgment
day, discounted based on consideration of other uses. You have to
understand what kinds of businesses you can make a reasonable
assessment of. At Berkshire, you have two questions: 1) what its
businesses are worth now, and 2) what we do with the capital. 35
years ago, people underestimated what we would do with the capital.
But we're now in a whole different game, with lots more capital.
Stock Prices and Share Buybacks
In 1999
[the 1999 annual letter, published in early 2000, in which he offered
to buy back shares at $45,000 or less], I thought Berkshire was more
attractive than the general market.
We
addressed share buybacks in the annual report released on the exact
day that the Nasdaq hit its high and Berkshire hit its low [March
10, 2000]. Our preference is to buy business of a quality and
managers of a quality comparable to those we already own. We would
only buy back stock if we thought Berkshire was significantly
undervalued and didn't think we could put money to work elsewhere.
Intrinsic value is a range. We'd leave a significant margin
of safety. It's not our #1 preference -- we love adding good
businesses to Berkshire. We'd have to give all shareholders relevant
info. I think it's unlikely that that happens. It could happen
though -- it almost happened in March 2000 and then things turned
around very abruptly.
I have
not thought stocks were cheap at all for quite some time. I've never
wanted to encourage anyone to hold Berkshire. I've never sold a
share. I think we had a great bubble.
We
don't comment on specific stocks, including our own, and only
occasionally comment on the market in general.
Currency and Inflation Risks
Berkshire has a couple of billion dollars of liabilities
denominated in other currencies, but also has roughly the same
amount of assets in other currencies -- we don't spend much time
worrying about precisely balancing this. We have little exposure to
currency risk.
Corporate Governance
We'll have new independent directors by next meeting. They
will be experienced and have interests aligned with shareholders;
they will own a lot of stock. Shareholder Resolution [A shareholder
presented a resolution whereby anyone who owned 7 Berkshire B shares
or more could participate in Berkshire's shareholder charity
program. Under this proposal, each B share would be entitled to 60
cents/share.]
When we
offered the B shares, we laid out certain rights and we're not going
to give B shareholders any additional rights, but they can also be
assured that we're not going to give A shareholders any additional
rights either. A deal's a deal.
Munger:
There are also significant administrative costs that would make the
proposal impractical.
[Buffett then asked if someone wanted to second the motion.
No-one did so it died.]
Munger's Influence on Buffett
Munger:
I think there's some mythology in this idea that I've been this
great enlightener of Warren. He hasn't needed much enlightenment.
But we know more now than five years ago.
Relationship with Charlie Munger
Charlie
and I have been partners in some way since 1959. We worked together
in a grocery store and both came to the conclusion that we don't
like hard work.
We have
never had an argument. You just have to learn how to calibrate his
answers. If you ask Charlie something and he says "no," then we put
all of our money in it. If he says "that's the stupidest thing I've
ever heard," then we make a more moderate investment. If you
calibrate his answers and then you'll get a lot of wisdom.
RISKS IN THE FINANCIAL SYSTEM
Financial Guarantee Companies
In many
cases, people participating in this [the credit guarantee] business
don't know what they're doing. In the insurance business, people
hand you money to put something on a piece of paper. What you put on
that paper is very important, but the money can tempt you to do dumb
things.
At a
firm in Omaha a while back [he was referring to Mutual of Omaha], in
a short time someone wrote a very few contracts [about 10] that
wiped out half of the company's net worth.
If
you're willing to do dumb things, people will find you. Even if
you're in a rowboat in the ocean, the brokers will swim to you, with
their fins showing. It's brutal. You'll see a lot of cash, won't see
any losses for a little while, and then the roof will fall in.
I
mentioned in this year's annual report that GEICO took in $70,000 [in the
annual report, he said a net of $72,000; $3,051,000 in premiums for
commercial umbrella and product liability insurance, offset by
$2,979,000 in reinsurance purchased] for a few policies, and so far
we've lost $93 million [$94.1 million from the annual report: "Of
the total loss, uncollectable receivables from deadbeat reinsurers
account for no less than $90.3 million…So much for 'cheap'
reinsurance."]. We could only make 70,000. When you're playing in a
game like that, you can't afford to make a mistake. A few mistakes
can wipe out a lifetime of earnings. You make a few cents when
you're right and lose a fortune if you're wrong.
Financial guarantors use back-tested arrangements, but the
problem is correlation. When things go bad, all sorts of things
correlate that no-one ever dreamed was possible. Look at what
happened in the in energy sector. There's nothing more deadly than
unexpected correlations.
To get
a BBB credit enhanced to AAA, a guarantor might charge 15 basis
points, but the spread is 100 basis points. That's not very smart
[for the guarantor to charge such a low price].
They
[the financial guarantors] are rated AAA for claims paying, but not
generally AAA. Only one other insurance company, AIG, is rated AAA
[like Berkshire is].
I would
say you could get into a lot of trouble levered 140:1 issuing
[financial] guarantees.
Munger:
Accounting [for financial guarantees] is terrible, and is most
terrible in accounting for guarantees a long way out. People pay
attention to numbers without consideration for reality, which can
lead to bad decisions.
Buffett: I will guarantee you that for every single contract
written, there was recognized some sort of income entry and someone
got paid for it. You know it's going to be a terrible contract.
Nobody ever wrote a loss at the time, but if someone sold them to
me, I would sell them at a loss.
I find
it extraordinary that if Dealer A and Dealer B do a deal, both can
write a profit, especially on a 20-year contract.
Derivatives and the Story Behind Pre-Releasing Part of the
Annual Letter in Fortune
I was
interested in the section on derivatives -- I thought it had a
broader audience. It had no relation to Berkshire directly. The
primary reason is that I hoped for a wider audience.
Charlie
and I think that there is a low but not insignificant probability
that at some time -- I don't know when; it could be three years, it
could be 20 years -- derivatives could lead to a major problem. The
problem grows as derivatives get more complex. We hoped to give a
mild wakeup call to the financial world that there's a problem. In
the energy sector, derivatives destroyed or almost destroyed
institutions that shouldn't have been destroyed. [He mentioned
Enron.]
Charlie
and I would not know how to regulate it. We have some experience
seeing specific dangers in that field and some insight into systemic
problems that can arise. People don't want to think about it until
it happens, but it is best thought about before it happens.
It's a
low probability, but we think a lot about low probability events. We
have some experience with Salomon and Gen Re. Charlie saw some
things on Salomon's audit committee [that were very
risky/questionable].
Munger:
In engineering, people have a big margin of safety. But in the
financial world, people don't give a damn about safety. They let it
balloon and balloon and balloon. It's aided by false accounting. I'm
more pessimistic than Warren. I'll be amazed if we don't have some
kind of significant blowup in next 5-10 years.
Buffett: Derivatives are advertised as shedding risk for the
system, but they have long crossed the point of decreasing risk and
now increase risk. The truth is that Coca Cola could handle risk [I
think he was talking about currency exposure], but now with every
company transferring risk to very few players, they are all hugely
interdependent. Central banks are exposed to weaknesses. If Salomon
had failed, the problems for the rest of the system could have been
quite significant. When you start concentrating risk in institutions
that are highly leveraged, [watch out]. They have big trading
departments with people who make a lot of money.
It's
not a prediction, it's a warning.
Fannie Mae, Freddie Mac and Other Highly Leveraged
Financial Institutions
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.
Munger:
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.
Buffett: 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.
Other Insurance Companies
Munger:
I certainly hope that we're better underwriters than Munich Re.
Buffett: Let's not name names. Munich Re is a fine company.
Our policy is that we compliment by name and criticize anonymously.
They [Munich Re] lost their AAA because they were too exposed on the
asset side -- they would tell you this. They have an important
position and we do a lot of business with them.
Some
reinsurers we won't do business with. If there were a major
financial or natural catastrophe, there are a number of reinsurers
who wouldn't pay.
INVESTMENT ADVICE
The
Ideal Business
The
ideal business is one that generates very high returns on capital
and can invest that capital back into the business at equally high
rates. Imagine a $100 million business that earns 20% in one year,
reinvests the $20 million profit and in the next year earns 20% of
$120 million and so forth. But there are very very few businesses
like this. Coke has high returns on capital, but incremental capital
doesn't earn anything like its current returns. We love businesses
that can earn high rates on even more capital than it earns. Most of
our businesses generate lots of money, but can't generate high
returns on incremental capital -- for example, See's and Buffalo
News. We look for them [areas to wisely reinvest capital], but they
don't exist.
So,
what we do is take money and move it around into other businesses.
The newspaper business earned great returns but not on incremental
capital. But the people in the industry only knew how to reinvest it
[so they squandered a lot of capital]. But our structure allows us
to take excess capital and invest it elsewhere, wherever it makes
the most sense. It's an enormous advantage.
See's
has produced $1 billion pre-tax for us over time. If we'd deployed
that in the candy business, the returns would have been terrible,
but instead [we took the money out of the business and redeployed it
elsewhere. Look at the results!]
Munger:
There are two kinds of businesses: The first earns 12%, and you can
take it out at the end of the year. The second earns 12%, but all
the excess cash must be reinvested -- there's never any cash. It
reminds me of the guy who looks at all of his equipment and says,
"There's all of my profit." We hate that kind of business.
Buffett: We like to be able to move cash around and find it's
best use. We'd love to have our companies redeploy cash, but they
can't. Gillette has a great business, but can't sensibly reinvest
all of the profit.
We
don't think the batting average of American industry redeploying
capital has been very great. We knock other people doing what has
made us so successful.
Munger:
I'm uncomfortable with that, which is why we say negative things [to
discourage others from trying to do what we do].
Types of Businesses To Look For
We want
a business that we think, if run well, is going to have a
competitive advantage. We don't buy hula hoop or pet rock companies,
or companies with explosions in demand but we don't know who the
winners will be.
The
Importance of Buying a Good Business
The way
to get a reputation for being a good businessman is to buy a good
business.
Cigar Butts vs. Quality Businesses; Learning from
Constructive Criticism
Munger:
If See's Candy had asked $100,000 more [in the purchase price;
Buffett chimed in, "$10,000 more"], Warren and I would have walked
-- that's how dumb we were.
Ira
Marshall said you guys are crazy -- there are some things you should
pay up for, like quality businesses and people. You are
underestimating quality. We listened to the criticism and changed
our mind. This is a good lesson for anyone: the ability to take
criticism constructively and learn from it. If you take the indirect
lessons we learned from See's, you could say Berkshire was built on
constructive criticism. Now we don't want any more today. [Laughter]
Buffett: The qualitative [evaluating management, competitive
advantage, etc.] is harder to teach and understand, so why not just
focus on the quantitative [e.g., cigar butt investing]? Charlie
emphasized quality [of a business] much more than I did initially.
He had a different background.
It
makes more sense to buy a wonderful business at a fair price. We've
changed over the years in this direction. It's not hard to watch
businesses over 50 years and learn where the big money can be made.
Even
when you get a new important idea, the old ideas are still there.
There wasn't a strong line of demarcation when we moved from cigar
butts to wonderful businesses. But over time, we moved.
Think Independently
When we
were viewed as out of step a few years ago, I didn't care as long as
I felt okay about how Berkshire was doing.
Calculating Intrinsic Value
Intrinsic value is terribly important but very fuzzy. We try
to work with businesses where we have fairly high probability of
knowing what the future will hold. If you own a gas pipeline, not
much is going to go wrong. Maybe a competitor enters forcing you to
cut prices, but intrinsic value hasn't gone down if you already
factored this in. We looked at a pipeline recently that we think
will come under pressure from other ways of delivering gas [to the
area the pipeline serves]. We look at this differently from another
pipeline that has the lowest costs [and does not face threats from
alternative pipelines]. If you calculate intrinsic value properly,
you factor in things like declining prices.
When we
buy business, we try to look out and estimate the cash it will
generate and compare it to the purchase price. We have to feel
pretty good about our projections and then have a purchase price
that makes sense. Over time, we've had more pleasant surprises than
we would have expected.
I've
never seen an investment banker's book in which future earnings are
projected to go down. But many businesses' earnings go down. We made
this mistake with Dexter shoes -- it was earning $40 million pretax
and I projected this would continue, and I couldn't have been more
wrong.
20% of
Fortune 500 companies will be earning significant less in five
years, but I don't know which 20%. If you can't come up with
reasonable estimates for that, then you move on.
Discount Rate Investors Should Use
We use
the same discount rate across all securities. We may be more
conservative in estimating cash in some situations.
Just
because interest rates are at 1.5% doesn't mean we like an
investment that yields 2-3%. We have minimum thresholds in our mind
that are a whole lot higher than government rates. When we're
looking at a business, we're looking at holding it forever, so we
don't assume rates will always be this low.
Losing and Regaining Competitive Advantage
There
aren't many examples of companies that lose and then regain
competitive advantage. I have a friend who likes taking over lousy
businesses and trying to turn them into great businesses [I wonder
whether he was referring to Jack Byrne of White Mountains
Insurance?]. I asked him for examples of this [bad businesses
turning into good businesses] over the past 100 years [and he
couldn't name very many].
Sometimes businesses have problems, but haven't lost their
competitive advantages. When GEICO had problems [in the mid-1970s],
the model wasn't broken.
One
example: Pepsi lost its edge post-WW II when costs went up, but they
successfully changed. To some extent Gillette lost its competitive
edge in the 1930s to penny blades, but then regained it.
But
generally speaking, when a company loses its edge, it's very
difficult to regain. Packard [cars] went downscale one year and
never regained its upscale image. Department stores have done this.
You can always juice sales by going down market, but it's hard to go
back up market.
Focus Investing
You
don't have to be right on everything or 20%, 10%, or 5% of
businesses. You only have to be right one or two times a year. I
used to handicap horses. You can come up with a very profitable
decision on a single company. If someone asked me to handicap the
500 companies in the S&P 500, I wouldn't do a very good job. You
only have to be right a few times in your lifetime, as long as you
don't make any big mistakes.
Munger:
What's funny is that most big investment organizations don't think
like this. They hire lots of people, evaluate Merck vs. Pfizer and
every stock in the S&P 500, and think they can beat the market.
You can't do it. Very few people have adopted our approach.
Buffett: Ted Williams, in his book The Science of Hitting, talked about how he carved
up the strike zone into different zones and only swung at pitches
that were in his sweet spot. Investing is the same way.
Temperament of Successful Investors
Munger:
I think there's something to be said for developing the disposition
to own stocks without fretting.
Buffett: I think it's almost impossible to do well investing
over time without this. If the market closed for years, we wouldn't
care. Would still keep making Sees candy, Dilly bars, etc.
If you
focus on the price, you're assuming that the market knows more than
you do. That may be the truth, but in that case you shouldn't own
it. The stock market is there to serve you, not to instruct you.
Focus
on price and value. If a stock gets cheaper and you have some cash,
buy more. We sometimes stop buying when prices goes up. This cost us
$8 billion a few years ago when we were buying Wal-Mart. When we're
buying something, we want the price to go down and down and down.
Investor Expectations
The
problem is the starting point in predicting modest returns for
equity investors. [Expectations were too high.] In 1999, a Gallup
poll showed people expected 15% [returns from stocks] in a low
inflation environment. In a low inflation environment, how much will
GDP grow? If there's 2% inflation and 3% [real] growth, that's 5%.
This will be the rate of corporate growth, so if you add dividends,
you get 6-7% [annualized returns] before frictional costs -- and
investors incur high frictional costs (they don't have to, but they
do) -- which adds up to 1.5%. [This 4.5-5.5% is] not bad.
Munger:
My attitude is slightly more negative than Warren's.
Buffett: It [6-7% growth] is not the end of the world. If we
get 5-6% of the pie -- those of us who put our capital out -- I
don't know if it's exactly what someone who designed the universe
would come up with, but I don't think that's crazy in either
direction. It provides a pretty decent real return in a period of
low inflation. If you get high inflation, you could get very low
real returns, even negative.
Munger:
I don't you'll get real help from me or from economists either. If
an economist saw a job going to China, he doesn't care -- it saves
costs. But if all the jobs go to China, what then? People actually
get paid to say things like this.
Buffett: Maybe we should export all economists to China.
Meeting with Managements
Almost
everything we learn is from public documents. I read Jim Clayton's
book, for example. There is adequate information out there to
evaluate businesses. We do not find it particularly helpful to talk
to managements. Often managements want to come to Omaha to talk, and
they come up with all sorts of reasons, but what they really hope is
that we become interested in their stock. That never works. The
numbers tell us a lot more than the managements. We don't give a
hoot about anyone's projections. We don't want even want to hear
about it.
Self-Discipline When Investing
I'd
feel more qualified to talk about self-discipline if I weighed about
20 pounds less. [Laughter.]
Critique of How Most Money Is Managed
Munger:
We have this investment discipline of waiting for a fat pitch. If I
was offered the chance to go into business where people would
measure me against benchmarks, force me to be fully invested, crawl
around looking over my shoulder, etc., I would hate it. I would
regard it as putting me into shackles.
Buffett: I would hate it. In 1956 [when I started the Buffett
Partnership], I passed out the ground rules, which said "here's what
I can do and can't do." The idea of setting out to do what you know
you can't do [is terrible].
Munger:
The general systems of money management [today] require people to
pretend to do something they can't do and like something they don't.
It's a terrible way to spend your life, but it's very well paid.
Stock Market Predictions
Munger:
I don't know if we'll ever see stocks in general at mouthwatering
levels that we saw in 1973-4 or 1982 even. I think there's a very
excellent chance that neither Warren or I will see those
opportunities again, but that's not all bad. We'll just keep
plugging away.
Buffett: It's not out of [the realm of] possibility though.
You can never predict what markets will do. In Japan, a 10 year bond
is yielding 5/8 of 1%. [Who could have ever imagined that?]
Munger:
If that could happen in Japan, something much less bad could happen
in the US. We could be in for a period in which the average fancy
paid investment advisor just won't do very well.
Buffett: Chaotic markets might not be good for society, but
create opportunities for us.
There
were some great opportunities in junk bonds last year and we
invested in a few. But money is pouring into junk bonds right now,
$1 billion per week. The world hasn't changed that much.
Cost
of Capital
Charlie
and I don't know our cost of capital. It's taught a business
schools, but we're skeptical. We just look to do the most
intelligent thing we can with the capital that we have. We measure
everything against our alternatives. I've never seen a cost of
capital calculation that made sense to me. Have you Charlie?
Munger:
Never. If you take the best text in economics by Mankiw, he says
intelligent people make decisions based on opportunity costs -- in
other words, it's your alternatives that matter. That's how we make
all of our decisions. The rest of the world has gone off on some
kick -- there's even a cost of equity capital. A perfectly amazing
mental malfunction.
Building Investment Knowledge
We read
a lot: daily publications, annual reports, 10Ks, 10Qs, business
magazines, etc.
Fortunately, the investment business is one where knowledge
accumulates and builds into a knowledge base that's useful. There's
a lot to absorb over time. 40-50 years ago, I visited a lot of
companies, but haven't done this in a long, long time.
Munger:
The more basic knowledge you have, the less new knowledge you have
to get. The guy who plays chess blindfolded [a chess master comes to
Omaha during Berkshire's annual meeting weekend and, in an
exhibition, plays multiple players blindfolded] -- he has a
knowledge of the board, which allows him to do this.
I'd
hate to give up The Wall Street Journal.
Buffett: You'd also hate to give up the Buffalo News [which
Berkshire owns]. [Laughter.] You want to read a lot of financial
publications. The New York Times has a much better business
section than it had 25 years ago. Read Fortune.
I don't
read any analyst reports. If I read one, it's because the funny
pages weren't available. I don't know why anyone does it.
Favorite Book on Accounting
I
haven't read an accounting book years. I think I read Finney[?] in
college. I'd suggest reading Berkshire reports and things like
magazine articles about accounting scandals. You need to know how
figures are put together, but also have to bring something else.
Read a lot of business articles and annual reports. If I don't
understand it [an annual report], it's probably because the
management doesn't want me to understand it. And if that's the case,
usually there's something wrong.
Munger:
Asking Warren what good books he knows about accounting is like
asking him what good books he has on breathing. You start with basic
rules of bookkeeping, and then you have to spend a lot of time [to
really become knowledgeable].
ACCOUNTING SHENANIGANS
Gen Re
was discounting Workman's Comp reserves at 4.5% -- figures we
inherited. These were not conservative, so we're now using 1% in
2003 and going forward. Thus, our figures [reported profits in Q1]
would be even better if we hadn't made this change.
Munger:
This accounting change is typical of Berkshire. We're so horrified
by aggressive accounting [that is rampant in Corporate America] that
we reach for ways to be conservative. It helps our business
decisions and protects Berkshire. How did we get in situation where
we're all so close to the line?
Buffett: I felt much more comfort working with financial
statements in the 1960s than today. There was more information then,
even through there was less disclosure.
In the
case of Gen Re, [having overly aggressive] Workman's Comp reserves
was a quick fix, but it's like heroin. Like trade loading, people
seek a quick fix. People are encouraged by their CFO or auditors to
play with their numbers. It never works, though I guess if you're 64
and a half [years old and about to cash in your stock and retire],
maybe it does. It's so much better to address problems.
[In a
news conference on Sunday, Buffett was quoted as saying: "You would
be amazed how compliant auditors have been in the past decade, not
only co-operating but suggesting techniques for making numbers less
useful -- less truthful -- to investors."]
The
real problem is [accounting for] pension and healthcare liabilities.
I've looked at companies recording pension income of hundreds of
millions [of dollars] when their pension plan is underfunded by
billions [of dollars]. It's the same mentality as stock options.
[I have
written many columns about accounting shenanigans in: Corporations Favor Fudge, Where Has Corporate Integrity Gone?, More Earnings Shenanigans, IBM's Accounting Tricks, Lessons from the Enron Debacle, Lessons from Lucent's Cash Flow, Stocks to Avoid, More Stocks to Avoid, Another Financial Scandal? and Accounting for Non-Paying Customers.]
Adjustments to Reported Earnings; Depreciation and EBITDA
[When
goodwill was required to be amortized,] we ignored amortization of
goodwill and told our owners to ignore it, even though it was in
GAAP [Generally Accepted Accounting Principles]. We felt that it was
arbitrary.
We
thought crazy pension assumptions caused people to record phantom
earnings. So, we're willing to tell you when we think there's data
that is more useful than GAAP earnings.
Not
thinking of depreciation as an expense is crazy. I can think of a
few businesses where one could ignore depreciation charges, but not
many. Even with our gas pipelines, depreciation is real -- you have
to maintain them and eventually they become worthless (though this
may be 100 years).
It
[depreciation] is reverse float -- you lay out money before you get
cash. Any management that doesn't regards depreciation as an expense
is living in a dream world, but they're encouraged to do so by
bankers. Many times, this comes close to a flim flam game.
People
want to send me books with EBITDA and I say fine, as long as you pay
cap ex. There are very few businesses that can spend a lot less than
depreciation and maintain the health of the business.
This is
nonsense. It couldn't be worse. But a whole generation of investors
have been taught this. It's not a non-cash expense -- it's a cash
expense but you spend it first. It's a delayed recording of a cash
expense.
We at
Berkshire are going to spend more this year on cap ex than we
depreciate.
Munger:
I think that, every time you saw the word EBITDA [earnings], you
should substitute the word "bullshit" earnings.
STOCK OPTIONS AND COMPENSATION SYSTEMS
Value of Stock Options
Charlie
and I have thought about options all of our life. My guess is that
Charlie was thinking about this in grade school. You don't have to
understand Black-Scholes at all, but you have to understand the
utility and value of options, and cost of issuing them -- a very
unpopular topic in some quarters.
Let's
say you sold a house and you asked for an option on the future
appreciation of the house. Wouldn't you say that this option had
value?
Any
option has value, and that's why some people who are kind of slick
in business matters get options for nothing or little -- far less
than market value. The Black-Scholes model is an attempt to measure
market value of options. It cranks in various variables, mainly past
volatility of the asset involved, which are not the best judge of
value. [For example,] Berkshire had a very low beta -- experts like
to give complex Greek names to simple things -- but that doesn't
mean the option value to anyone who understood it was lower than
another stock with higher volatility.
As
Charlie said, Black-Scholes can give silly results over longer term.
Last year, we made one large commitment in which somebody on the
other side was using Black-Scholes and we made $120 million. We love
the idea of someone else using mechanistic formulas. They may be
right 99% of the time, but we can pass 99 times and only invest the
one time they're wrong.
Munger:
Black-Scholes is a know-nothing system. If you know nothing about
value -- only price -- then Black-Scholes is a pretty good guess at
what a 90-day option might be worth. But the minute you get into
longer periods of time, it's crazy to get into Black-Scholes. For
example, at Costco we issued stock options with strike prices of $30
and $60, and Black-Scholes valued the $60 ones higher. This is
insane.
Buffett: We like this kind of insanity. We will pay you real
money if you deliver someone to our office who is willing to offer
us three-year options that we can pick and choose from.
Options
have value. We issued them last year when we sold $400M of bonds
[the SQUARZ deal -- see my column, Berkshire's Unusual Security]. We knew what we were
giving up -- it had a negative coupon, but options have value.
Accounting for Stock Options
They
[other companies] pay people with options, [whereas] we pay with
cash bonuses. We'd love to not record this expense. Why the
opposition? Some people [CEOs] care a lot. They argue that the cost
of options is included in the footnotes [of the 10-K], [to which I
say] why not pull all expenses in footnotes? Then you could just
have two lines on the income statement: sales and the same amount on
the next line, profits.
It's
amazing what people with high IQs will do [for money]. Charlie has a
theory [that it's more than money -- that it's driven by pride.]
Munger:
I'm so tired of this subject. I've been on this topic for so long.
It's such a rotten way to run a civilization to make the accounting
wrong. It's like getting the engineering wrong when making a bridge.
When perfectly reputable people say options shouldn't be expensed,
it's outrageous.
Buffett: The auditors swing back and forth. Now four firms
[the Big Four accounting firms] that lobbied against options as an
expense in 1993 are on the other side. I don't know how this could
be [options were not an expense then, but are now, but I'm happy to
see it].
[For
more on stock options, I wrote a three-part series on the topic: The Stock Option Travesty, Stock Options' Perverse Incentives, and Rebutting Stock Option Defenders.]
Compensation Systems
Munger:
As the shareholders know, our system is different from most big
corporations. We think it's less capricious. The stock option system
may give extraordinary rewards to some people who did nothing, and
give nothing to those who deserve a lot. Except where we inherit it
[a stock option program], we don't use it.
Buffett: We inherited stock options, primarily with Gen Re.
Those options turned out to be quite valuable. Would not have been
if Gen Re had been a stand-alone. Not to criticize anyone, but some
people made a lot of money who contributed nothing. Options are a
royalty on the passage of time. They put management's interests
contrary to the interests of shareholders.
We
believe in tying incentives to things under management's control. To
give a lottery ticket to someone who runs 1% of Berkshire is really
crazy. We saw more crazy stuff in the 1990s than in the previous 100
years. There was wealth transfer that has never been experienced
before. I'll accept lottery tickets, but they would have no impact
on my decisions or behavior.
A
properly designed option system, tied to performance, can be
sensible. But to just pass them out, give a 10-year ride and grant
more if the stock goes down, doesn't make sense.
Munger:
If we're right, then it has considerable implications. [It would
mean that] more than 99% of corporate compensation systems are more
than a little crazy. We're not against vast rewards for people who
deserve them, but [most stock options programs don't achieve this.]
Buffett: We love to see people at Berkshire making money, but
only if they're making money for you. Compensation is an interesting
subject and I'm going to write about it next year.
It's
not a market system. Compensation people say it's like baseball
negotiation [between a team owner and a star player], but it's not.
The player is negotiating with someone who's paying the money. But
at large corporations, on one side is guy who really cares and on
the other side is the compensation committee -- generally people who
are not picked for their strong spines -- to them, it's play money.
It's almost meaningless to the guy on one side if the CEO gets
100,000 shares of restricted stock or one million, but the guy on
the other side cares a lot. You get parity in negotiations with
unions -- that's real negotiation.
I've
never seen a compensation consultant say that the Board should
reduce the CEO's salary or get rid of this bozo. They'd never get
hired again. It's a bad system and needs improvement. There have
been some improvements. It [improvement in this area] is the acid
test of corporate reform.
Over
time, a vast disparity in pay has arisen, and there's a disconnect
between performance and pay. So arise, shareholders!
Buffett's Salary and CEO Compensation
[The
questioner asked why Buffett doesn't charge a percentage management
fee to Berkshire, given that he earned 25% of the profits above 6%
each year when he ran the Buffett Partnership. Is it because he
believes, as he's said before, that "it's better to give them to
receive"?" Buffett replied, to great laughter, "Try again."]
I would
pay a lot of money for the job I have. If I can work with people I
like, why do I need to make a further override when I already have a
lot of money? I was changing my life at the time [when I ran the
Buffett Partnership] and I needed money then. I got no management
fee at all.
Berkshire was originally owned by the [Buffett] partnership
and I would be double dipping [to also take a fee from Berkshire].
By that time I had all of the money I needed. It [taking a
percentage of Berkshire's profits] would make a difference in the
size of my foundation, but I like the way that I live.
Munger:
Carnegie was always proud that he took very little salary.
Rockefeller, Vanderbilt were the same. It was a common culture in a
different era. All of these people thought of themselves as the
founder. I was delighted to get rid of the pressure of getting fees
based on performance. If you are highly conscientious and you hate
to disappoint, you will feel the pressure to live up to your
incentive fee. There was an enormous advantage [to switching away
from taking a percentage of the profits to managing Berkshire, in
which their interests as shareholders are exactly aligned with other
shareholders].
Buffett: Bill Gates takes a small salary -- the only reason
he takes a salary at all is so that he can reduce it if they have a
bad year. He wants to be able to take a 90% cut. He's also never
taken a stock option. I think this is true of Steve Ballmer as well.
They got rich with their shareholders, not off of
their shareholders.
EVA
Compensation Systems
We
would not dream of using EVA [Economic Value Added], though some of
our subsidiaries do. They set pay [scales] below the CEO level.
Munger:
On EVA, there are implicit ideas that we use, such as hurdle rates,
but the system has a lot of baggage.
COMMENTS ON OTHER ECONOMIC MATTERS
The
Banking Industry
Banking, if you can just stay away from following the fads
and making bad loans, has been a remarkably good business. Since WW
II, ROE for banks that have stayed out of trouble has been good.
Some large well-run banks earn 20% ROE. I've been surprised that
margins in banking haven't been competed away.
Munger:
What you're saying is that we screwed up, because banking has turned
out to be better than we thought. We made a few billion [dollars]
from Amex while we misappraised it. My only prediction is that we
will continue to make mistakes like that.
Buffett: It's pretty extraordinary that institutions
competing against each other without real competitive advantages can
all make high returns. Part of it is higher loan to value ratios
than in past years. Some banks get into trouble making bad loans,
but you don't have to.
Tort
Reform
I'm
sympathetic to what you're saying [the questioner had suggested that
Buffett use his clout to advocate for tort reform], but our clout is
nothing compared to that of trial lawyers. It's appalling the
friction costs to our society of tort insurance. People pay off
rather than go through the nuisance of a suit. The people that
pursue that activity pursue it not because it's right, but
profitable.
But
when I look at what's happened in Corporate America, I don't think
they should get off scot-free. I just wish the people who engaged in
the wrong-doing would pay, not the D&O insurance.
Munger:
If you say the tort system includes Workman's Comp, which I would,
I'd agree [that the system has serious problems]. In California,
Costco has 1/3 of its employees but pays 2/3 of its total Workman's
Comp [bill]. It's institutionalized fraud -- chiropractors, etc. all
working together. It'll cost jobs. I had a friend who moved his
plant from Texas, where his Workman's Comp was 30% [of wages] to
Utah, where it was 2%. In California, it's gotten so bad that I
think there will be reform, even though the legislature is
controlled by Democrats.
Most of
the time they [the plaintiffs' lawyers] are suing someone who has
done something terrible. A lot of defendants who are screaming about
plaintiffs bar have done some terrible things. The present system is
crazy, but I don't know how to fix it.
Buffett: Would you make people who did wrong things pay a
portion themselves?
Munger:
I think it would be a great improvement if there were no D&O
insurance . The counter-argument is that no-one with any money would
serve on a board. But I think net net you'd be better off.
Healthcare Costs
We looked at healthcare costs, which were exploding a few
years ago. Workman's Comp costs have risen dramatically, and are
huge for us. $6,000-$7,000 per employee. That's in inflationary part
of the US economy and we and our employees can't control it.
Health
costs will keep growing and we don't have any answers. But Charlie
runs a hospital, so maybe he'll have some insights.
Munger:
The quality of the medical care delivered, including the
pharmaceutical industry, has improved a lot. I don't think it's
crazy for a rich country like the US to spend 15% of GDP on
healthcare, and if it rose to 16-17%, it's not a big worry.
Buffett: But if other countries spend 7-8% [of GDP on
healthcare] and have good systems, are we getting a good deal?
Munger:
We're not on a dollar for dollar basis. But I'm not [troubled by how
much we spend].
Impact of Inflation
There's
no question that a lack of inflation is a plus for owners. The real
return from owning American businesses will be better if there is
low inflation over a long period.
The
biggest danger [to investors] is high inflation. There's not a small
chance of this in the next 20-30 years.
Social Security
Social
Security is a good thing and it works well. Don't try to change it.
The money should not be invested in stocks.
ADVICE ON LIFE AND OTHER
Happiness and Success
I tell
college students, when you get to be my age you will be successful
if the people who you hope to have love you, do love you. Charlie
and I know people who have buildings named after them, receive great
honors, etc., and nobody loves them -- not even the people who give
them honors. Charlie and I talk about wouldn't it be great if we
could buy love for $1 million. But the only way to be loved is to be
lovable. You always get back more than you give away. If you don't
give any you won't get any. Everybody loves Don Keough [former
senior executive and Board member of Coca Cola]. There's nobody I
know who commands the love of others who doesn't feel like a
success. And I can't imagine people who aren't loved feel very
successful.
Munger:
You don't want to be like the motion picture exec who had so many
people at his funeral, but they were there just make sure he was
dead. Or how about the guy who, at his funeral, the priest said,
"Won't anyone stand up and say anything nice for the deceased?" and
finally someone said, "Well, his brother was worse."
Buffett: Most people in this room and most college students I
talk to will have plenty of money, but some will have few friends.
View
on Cutting Taxes on Dividends
Currently, I'm paying about the same percentage of my income
to the government as my secretary does. I pay a higher income tax
rate, but she pays higher Social Security taxes as a percentage of
her income because taxes aren't charged on income above $68,400. At
Berkshire, if we declared a $1 billion dividend and it were tax
free, I might be paying 1/10th of the rate of my income as she would
be.
Now, I
could make argument that different structures shouldn't have
different rates, but I can make no argument that will all the luck
I've had that I would send 1/10th the portion of my income to the
federal government that my secretary does. So I am not for the Bush
plan.
Munger:
I agree with you. Even if you assume that the whole economy would
work better had we never had double taxation, having the envy and
resentment of the richest paying low or no taxes screams of
injustice. You have to have a fair system.
Buffett: The big benefits of no taxes on dividends will go to
people like me and Charlie and that's not going to stimulate the
economy, it will stimulate us.
Income Inequality, GDP, Decline in Consumer Spending
The
American consumer overall is better off, but not dramatically better
than 10 years ago. You're right that there's been increasing
inequality. We don't make decisions on what business we buy based on
some sweeping projections about what American consumers will do.
We're very certain that Americans will do better over time. Average
income per capita rose 7x in the 20th century. A simple phone call
across the country used to cost a great deal relative to income.
People will be better off decade after decade. We're not big on
being futurologists.
Our
consumer businesses -- candy, furniture, etc. -- are very very soft.
They were down in Q1. I think we've been in a recession -- although
not huge or violent one -- for two years. When government talks
about GDP growing 2%, keep in mind that the population grows 1%.
It's GDP per capita that counts. And GDP counts people who make you
take off your shoes before you get on a plane. It counts good and
services that we wish we didn't want. When you get into a war, if
you drop planes into the ocean, it [building replacement planes] is
part of GDP. Desirable GDP, my guess, has gone no place in the past
three years. The quality of GDP isn't talked about very much.
Munger:
Figures you gave on inequality obscure an important fact: if the
same family were always on the bottom, then you'd have big
resentments. But if DuPonts go down and Pampered Chef up, [that's
good]. That much churn makes people think the system is fairer.
Buffett: We don't like churn now, but we liked it more 30-40 years
ago. [Laughter.]
Philanthropy
[A
shareholder asked Buffett to ask his cousin, Jimmy Buffett, to play
at a charitable event to help save Cypress Gardens.]
I don't
ask my friends to do such things because it puts them in an
uncomfortable position. If they did it, I'd never know if they did
so because I asked them or because they believed in it.
Munger:
Both of us feel that those of us who have been very fortunate have a
duty to give back. Whether one gives a lot as one goes along as I do
or a little and then a lot [when one dies] as Warren does is a
matter of personal preference. I would hate to have people ask me
for money all day long. Warren couldn't stand it.
Buffett: Let's assume that I was in the womb and there was an
identical twin next to me, and genie appeared and said "You're going
to be born in 24 hours and one of you will be born in Omaha and one
in Bangladesh. You two decide which is which. Let's start bidding
and whichever one of you bids a higher percentage of your estate to
society when you die gets to be born in Omaha. I think the bidding
would be 100%. Imagine me in Bangladesh walking down the street
saying "I can allocate capital." I wouldn't last very long.
When we
were born, odds were 50 to 1 against us being born in the US. So we
were lucky. My lump sum should go to society. There's no reason
little Buffetts should be running around in 100 years rich because
they were lucky. | 
