Buffett FAQ

A compendium of Q&A sessions with Warren Buffett.

Please note that Warren Buffett and CNBC have now launched a very thorough and fantastic resource of Berkshire meeting videos and transcripts at http://buffett.cnbc.com.

Sections

Investing Approach

  1. Have you ever bought a company where the numbers told you not to? How much is quantitative and how much is qualitative?
  2. What is it that really piques your interest in a stock? What tells you that it could be interesting?
  3. What is your investment process?
  4. What's your acquisition criteria? What has made you successful in this area where most others have failed?
  5. Do you have any investing tips?
  6. Advice for getting into investing?
  7. How to approach index funds?
  8. If you were today 20-something years old would you primarily be searching for: a) Situations reminiscent of 1957 – akin to Daehan Flour Mills, or b) Situations reminiscent of 1987 – akin to Moody’s Corporation?
  9. First, would you say 'I could make you 50% a year on $1 million' again today? Second, what else would you do differently?
  10. Do you believe that we'll have significant mispricings again? And if you were 26 today how would you generate the 50% returns that you said you might do with smaller amounts of capital?
  11. Could you describe the capital allocation process you follow? How do you determine the charges for capital to your different managers?
  12. How would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?
  13. What impacts have Graham/Dodd and Phil Fisher had on your investment philosophy? What percentage of your investment philosophy would you attribute to each of them?
  14. Since Ben Graham isn't around anymore, what money managers do you respect today? Is there a Ben Graham today?
  15. If you were to teach an investment course, besides works by Ben Graham and Phil Fisher and your book on the instalment basis, what would be on the syllabus
  16. Who do you think will be one of the next greatest investors and are you partial to favoring someone with a similar investment style as yours?
  17. Why do you think that despite making your methods publicly available, that relatively few people have been able to emulate your success?
  18. How much and how does risk factor into your investment decisions? Would you invest in emerging markets?
  19. You have espoused a constant ROE on the stock market of about 13%, over time. Do you think that such an expectation is reasonable if you factor into equity and ROE the effect of stock options granted to managements? When option programs are present in a company, what do you think is a realistic way of valuing them on a cash basis?
  20. Investors eventually repeat their mistakes. How can you prevent this--through fast growth or safety?
  21. From the partnership letters in 1964, you had a strategy called ‘generals relatively undervalued.’ We have recently begun to implement a technique where we buy something at 12x, when comps sell at 20x. Comps go to 10x. Is this pair trading?
  22. There is always mention that some of your success could be attributed to not buying in to the Wall Street mania b/c you are in Omaha—what importance do you give to balance as it pertains to work and life and what do you do to maintain your appropriate balance?
  23. There are a record number of ‘value’ investors here this year. Are there fewer $100 bills? Should I go to run a business instead of being a value fund manager?
  24. Have there been instances in your career where you have been tempted to deviate from your strategy and if so, how did you handle that?
  25. Don't you have a lot of competition to buy great businesses? For example, from private equity funds?
  26. We know that you are a big bridge player. Do you think that bridge correlates to investing? Are there any traits or characteristics that might carry over from one to the other?

Valuation

  1. How do you think about value?
  2. What do you believe to be the most important tools in determining intrinsic value? What rules or standards do you apply when using these tools?
  3. Could you comment on the matter of intrinsic value as it applies to some of the Inevitables?
  4. When you estimate intrinsic value in capital intensive companies like McDonald's and Walgreens where a very healthy and growing operating cash flow is largely offset by expenditures for new stores, restaurants, etc how do you estimate future free cash flow? And at what rate do you discount those cash flows?
  5. If you can’t talk with management, and can’t read the annual report, and didn’t know the price, but could only look at the financial statements, what metric would you look at?

How to Think About Businesses

  1. What's your philosophy in buying businesses?
  2. What is the ideal business?
  3. What makes a great business?
  4. Would you comment on the quality of earnings in capital-intensive businesses, like utilities?
  5. Please talk about the shift to investing in capital intensive businesses and the ultimate impact on intrinsic value. Help us understand the time value of the necessary capital expenditures.
  6. How do you place a value on intangible assets? What are the signs of great “moats” around a business and great managements? Do you place a dollar value on this? What discount rates do you use?
  7. Not too long ago, a reasonable person might have concluded that Kellogg and Campbell Soup had big moats around their businesses, but that has proven not to be the case and their stocks have languished. What might we learn from this?
  8. Could you explain a little more about the mind of the consumer and the nature of the product? And explain how you actually apply these concepts to find the companies with the best potential?

Alternatives to Common Stock

  1. Your opinion on derivatives? (2003)
  2. Muni bond defaults you described in 2008 -- they haven’t materialized. Should investors worry about getting higher returns?
  3. Investing in ethanol?
  4. Any comments on commodities?
  5. Do you hedge and what are your thoughts on the U.S. dollar?
  6. Early on in you career you bought some land and then rented this out to some local farmers? Why didn’t you pursue this type of investment in real estate?

Accounting, Corporate Finance, & Investing

  1. What can be done to improve the accuracy of financial statements of financial institutions? What can be done to improve the integrity of financial statements?
  2. Would you comment on companies you say use questionable accounting practices to make their operations look good?
  3. How do you know when you are going to lose money and when you aren't? Since the stock market changes every minute.
  4. Can you forecast the continuing debate between Efficient Market Theory (EMT) proponents and value investors? Are your designated successors “outliers” as well?
  5. What is your unified principle?
  6. Does protection of the banking system warrant the lack of public disclosure in Bank of America’s purchase of Merrill Lynch?
  7. Insurance pricing and risk?
  8. Opinion on the likely housing bubble? (2005)
  9. Can you comment on the subprime market?

Foreign Investments

  1. What are your requirements for investments outside the U.S.?
  2. When looking at other countries Mr. Buffett, do you look at the country’s overall financial status or do you look at the financials of that specific company in a foreign country? You mentioned investing in Korean companies – do you ever look at the state of the country you are investing in?
  3. How large is the universe of companies whose intrinsic value you know? Why invest in South Korea or China?
  4. Investing in Brazil?
  5. Investing in Russia?
  6. Investing in Africa?
  7. Are you concerned with the effects of foreign economies and their weak currencies? These have played a role in Coca-Cola’s profitability recently - and Coke is trading at P/E multiple of 75. (1999)
  8. Please talk about Greece, the future of the Euro and fiscal discipline in the world. Greece and other countries are clearly in trouble and BRK has investments in Europe. How is BRK positioned for currency failures? What is your advice to investors regarding the future of the Euro?
  9. How will Buffett invest in China in the future? What will happen to the purchasing power of China’s large holdings in U.S. Treasuries?
  10. Why is car insurance business not expanding globally? Why not China?

The Investment Industry

  1. Is the individual investor even capable of assessing the riskiness of securities given the large number of institutions/hedge funds in the market?
  2. What do you think about all the money flowing into private equity and hedge funds? And do you see the future of buying businesses changing based on the considerable increase in private equity activity?
  3. What effect does large institutional ownership have on stock price volatility?

Industries

  1. In the domestic soft drink model, is it winner take all, or is there room for three competitors?
  2. You’ve recently invested in Goldman Sachs and GE. Is the financial sector a good buy right now?
  3. Berkshire has invested in several insurance companies, would you go into the health insurance business?
  4. Have you ever considered concrete as an understandable business for investment purposes?
  5. When do you expect to see a return on investment in wind farms and other alternative energy sources?
  6. What industry will be the next growth driver in the 21st century and what do you see that supports that?

Specific Businesses

  1. How do you distinguish the Cokes of the world from the Proctor & Gambles of this world?
  2. Coke and Gillette are off something like 30% from their highs. Do you still consider them exciting businesses?
  3. What did you think of the Calpers/ISS proposal that you should not be on Coke’s audit committee?
  4. Could you comment on more on McDonald's.....how does it stack up on the inevitables?
  5. Opinion of Procter & Gamble?
  6. Could you talk us through your thinking of the acquisition of Larson-Juhl?
  7. BYD [Buffett’s recent Chinese investment] seems like a speculative or venture capital investment, instead of a “value” investment. Could Buffett explain?
  8. Opinion on Fannie Mae, Freddie Mac and Other Highly Leveraged Financial Institutions? (2003)
  9. You were rumored to be one of the rescue buyers of Long Term Capital, what was the play there, what did you see?
  10. I cannot buy See’s Candies in Bonn Germany. See’s Candies vs. Lindt. Sees’ has a 20% profit margin; their growth is okay. Lindt does 14%, but is now global. Which is better, high profits with low growth, or high growth with lower profits?
  11. Could you give a post-mortem on the Gen Re acquisition?
  12. General Electric and Goldman Sachs: GE has a history of trying to manage earnings. Do you regard GE and Goldman as attractive businesses or attractive securities?
  13. Swiss Re - I'd like to know about its float and risks. How can you be comfortable with the situation?
  14. Goldman Sachs - Every year you use clip from Solomon Crisis where you warned Solomon’s employees that you will be ruthless if reputation if the firm stained. Clearly GS has lost reputation. What is your reaction to the lawsuit, its affect on your GS investment, and what advice you have now for GS based on your experience at Solomon?
  15. On Goldman, if Lloyd Blankfein had to leave, who would you like to see run GS, were you made aware of the Wells notice, was it material, and would you have disclosed it? Have you been contacted regarding Galleon investigation?
  16. BNSF deal. You have discussed the certainty of allowable returns in the industry. How are these calculated?
  17. Moody’s had potential conflicts of interest. Why do you retain Moody’s in Berkshire’s portfolio? Why didn’t you use your influence to address Moody’s perceived problems?
  18. The tobacco industry has been under fire recently for its unhealthy products. Does this potential exist for Berkshire Hathaway holdings of Coca Cola, Dairy Queen and See's Candies? Is there a potential risk of loss of intrinsic value of these companies due to the current health concerns?
  19. Wells Fargo was a good deal at $9 per share, but AIG, the Irish banks, Fannie Mae, and Washington Mutual got there, and weren’t. How do you know the difference?
  20. Wells Fargo reportedly wanted to decline TARP funds, and its Chairman, Dick Kovacevich, referred to the TARP as an “asinine” government program. Do you agree with the Wells’ chairman, Charlie? And Warren, do you agree with Charlie?
  21. Could you give some specific numbers that relate to Coca Cola, Executive Jet, and some of the other acquisitions?
  22. To what extent should preferred shareholders and debt holders of GM and Chrysler should be exposed to losses in the restructurings of those companies?
  23. What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lambert do at bringing Kmart and Sears together?

Berkshire

  1. What explains the extraordinary success of Berkshire Hathaway?
  2. Over the years, what has Berkshire Hathaway come to mean to you?
  3. What is the intrinsic value of Berkshire? Can you use book value as a guide to company valuations?
  4. You've targeted Berkshire Hathaway's book-value growth at 15%. You have come through at about 24%. That is a big gap of 9% between your modesty and the outcome. Why is there such a big gap?
  5. Why don't more people copy Berkshire as an investment vehicle--a corporation that pays no dividend?
  6. In the Annual Reports, look-through earnings, and unaudited financials, are no longer included. Why has it changed?
  7. There are a lot of questions you do not get asked. So, what questions would you ask yourselves regarding BRK’s financials?
  8. What’s the cheapest form of financing for Berkshire Hathaway? Would it make sense to issue bonds right now?
  9. Do you have an opinion on whether BRK should or shouldn't be included in the S&500? (1999)
  10. Can you tell us what are your goals and expectations for the value of Berkshire Hathaway’s float?
  11. Why has Berkshire Hathaway avoided the life insurance business? And also, can you explain why there are discounts on A or B shares from time to time?
  12. How did you select the four investment professionals who could succeed you in the CIO [Chief Investment Officer] position?
  13. How did the four investment managers waiting “in the wings” to eventually replace you perform in 2008? How would you rate these managers? Are all four still on the list?
  14. Why are you reluctant to bring in your [CEO] successor now? Why not train him now?
  15. Does Berkshire have a succession plan for Ajit Jain (the head of Berkshire’s insurance operations)?
  16. Given you [Buffett and Munger] are Berkshire’s sustainable competitive advantage, would you invest in Berkshire now?
  17. What is the impact of Berkshire losing its AAA rating? What will it take to restore it?
  18. Do you have a target rate of growth for Berkshire, given its size? Greater than 20% seems unlikely.
  19. What is the worst-case scenario for Berkshire's insurance business?
  20. You are giving a lot of BRK stock to the Gates Foundation each year and they are selling. Won’t the foundation selling create downward pressure on the stock?
  21. Managers are allowed to operate without interference with Omaha. What would happen if BRK found illegal activity? Would they intervene?
  22. How is BRK ok with models used by its insurance companies after the widespread failure of models during the financial crisis? Are they different and/or safer than the ones that failed Wall Street?
  23. Please discuss some of the synergies among BRK companies and whether or not you encourage companies to do business with one another. e.g. At my local Dairy Queen, they don’ t accept Amex, and they still sell Pepsi.
  24. If one day I apply as manager to Berkshire company, what should I work on now, and what should I do to become your successor?
  25. You stated your policy about retaining earnings in the 1984 annual letter. Would a distribution be warranted based on 2005-2009 stock performance?
  26. Berkshire has bought a lot of shares in the last twelve months of listed companies (2008). Do you expect returns to be between 7-10% over many years? Well below your achievements in the past.
  27. How do U.S. government guarantees hurt Berkshire competitively?
  28. What do you see as the net effect of government interventions on Berkshire’s business? Will there be new rules of the game?
  29. What is your level of involvement when the company has an ethical dilemma? For example, Fruit of the Loom’s competitors have sweatshops.
  30. Can you comment on the protests by Salmon Fisherman of PacifiCorp’s Dams on the Klamath River?

The Market

  1. Opinion of forecasts?
  2. Mr. Market is valuing Dow Jones at about 7000, and the S&P at about than 800. What is a fair valuation? (1997)
  3. The S&P 500 has a return on equity of 22%, compared with a 12-13% average for corporate America over the past decade. How did we get to this point of extraordinary profitability? (1997)
  4. Back in the Sixties, you disbanded the Buffett Partnership when you perceived the market to be overvalued. If you had only 100 partners in Berkshire Hathaway, would you disband it? (1999)

Management

  1. What do you look for when you hire someone? What specific qualities do you seek?
  2. Machiavelli said that a man could be feared and loved. But one might want to be more feared than loved. Do you agree with this? Has there ever been a situation where you had to be more feared than loved?
  3. It has been well documented that you don’t manage your managers. Do you possess a strong intuition about people or do you have a process when you evaluate the management of companies that you are looking to purchase?
  4. If two people had the same knowledge base but one had two-years experience and one had ten-years experience, which one would do a better job?
  5. What qualities in managers set them apart as great leaders, in essence, where do you find the right balance between "hard" and "soft" skills?
  6. Your thoughts on management compensation? Management compensation in a cyclical industry?
  7. You take great pride in keeping your schedule wide open. Do you believe that corporate America is overscheduled and overstretched?
  8. Has the financial and economic crisis changed the integrity of management?

Technology

  1. I have worked in various technologies businesses, but I understand that you do not typically invest in the technology sector. Why is that? How do you view technology as an individual and as an investor?
  2. Because of the Internet, certain stocks will show great revenue and income growth like AT&T and Nokia. Would you consider investing in the telecommunications industry this way? (1999)
  3. Won’t Microsoft be doing software development ten years from now, just like Coke will be selling soda? Doesn’t that make it a candidate for investment?

Education

  1. What is your opinion of the importance of technology in business education today?
  2. Could you comment on the state of financial literacy? Is there anything that could be added to educational curricula to improve it? What should future generations know?
  3. What can be done to educate children of financial management, and prevent future financial mayhem?
  4. You began you university education at another institution, what are you thoughts on the education you received at the University of Nebraska?
  5. What's the one thing that your MBA didn't prepare you for when you got out into the real world?

Personal

  1. How would you define your character? And what portion of your character do you believe contributed the most to your success?
  2. After all your accomplishments, what legacy do you want to leave behind?
  3. Are you a goal oriented person? When you were in college did you set goals for yourself?
  4. Who are your heroes?
  5. What goals do you set for yourself today; do you have goals you still want to accomplish?
  6. If you could have lunch with one person you have never met, who would it be and why?
  7. How do you stay so down to earth and humble? Are there specific people or lessons you have learned throughout your life that enable you to maintain this outlook?
  8. How do you think differently today than you did twenty years ago? Where do you expect to see the greatest differences in 2030?
  9. What do you think were the major qualities that you have that distinguish you from the majority?
  10. What was your reasoning behind your huge contribution to the Bill and Melinda Gates foundation?
  11. If you could come back again, would you want to be Warren Buffett?
  12. Why don't you charge a percentage management fee to Berkshire, given that you earned 25% of the profits above 6% each year when he ran the Buffett Partnership. Is it because you believes, as you've said before, that "it's better to give them to receive"?
  13. What's the motivation behind giving your fortune away? your philanthropy?
  14. Has there been any question that you haven’t been able to get a comfortable answer to that also can’t go in the “too difficult” pile?
  15. Your comments on Phil Fisher?
  16. I know you like baseball. My favorite team is the Chicago Cubs. Would you like to buy the Chicago Cubs from Sam Zell? Is it a good investment?
  17. You have said that your assistant pays a higher tax rate than you does and that to be equitable the tax rate should be higher on you than on others. In reality, the bulk of estate will not be taxed due to your charitable donations. How do you change the system so people like you pay more tax?

Advice

  1. I worked in the paper and packaging business this past summer and really enjoyed my experience. None of my classmates are interested in the paper business and the company I worked for has not had MBA interns in years. Clearly the paper business has its challenges, but do you see this as an opportunity or a roadblock?
  2. At the Wesco annual meeting last year, Charlie said, "The best way to get success is to deserve success". Do you recall anything from your experience which best demonstrates how you were able to position yourself to deserve success, and do you have any advice for students on how they can position themselves to deserve success as well?
  3. What advice would you give the average person in the U.S.?
  4. What graduate school would you recommend and whom would you recommend to study with in the area of investments?
  5. Importance of maths? Why does math reflect reality?
  6. Are there any up-and-coming role models we should study?
  7. Can you comment on the student visits to Berkshire? and more widely on investment education?
  8. What advice would you give to the quieter, introverted population, in order to raise their visibility and gain the recognition they deserve?
  9. I’m 12 years old. There are a lot of things they don’t teach you in school. What things should I be looking into?
  10. I have four children. Can you give them advice about keeping up with the Joneses?
  11. What exactly does it mean to be financially successful? How can one properly prepare themselves for the economic future?
  12. I started babysitting and I am really happy to get the money and put it in my saving's account but I want a raise. How should I ask?
  13. My mom says I should save my money, but I want to buy a video game. What do you think?
  14. I teach at a community college in Florida, teaching students to invest in themselves. Financial independence and freedom. Slow and steady wins the race. Law of reciprocity. Etc, etc, etc. What else should I be doing?
  15. What advice do you give to young entrepreneurs? I am starting a business, and I want it to be successful. Aristotle, when asked definition of wealth, said it is he who spends less than he earns.
  16. What's a good thing to buy and than sell for a profit? For example candy or something in that nature?
  17. I want to start my own business, what should I do? A car wash?
  18. Partly because of marrying well, I am able to manage the money of my husband and myself full time. I wanted to ask a diversification question. Each of us has a traditional and a Roth IRA. Should the assets in those accounts be separated, or managed as a single entity?
  19. Imagine you are investing with small sums of money at 30 years old, with your first $1 million. Your savings can cover expenses for 18 months. You are not a full-time investor. What advice do you have, please be as specific as possible. What asset classes and what percents?

The Big Picture

  1. How should we take care of those who are harmed by the system, like your former textile mill workers?
  2. With the recent changes in the global political economy and surges in terrorist activity, some would argue that uncertainty is increasing for all types of global markets. Where do you think things are heading and how should we deal with this heightened uncertainty?
  3. What kind of impact will the demographic shift (i.e. baby boomers) have on the United States?
  4. Do you believe that the Federal Reserve is fostering moral hazard thereby leading to the misallocation of capital and subsequent asset bubbles? If so, what are the long term risks?
  5. Could you comment on the current rise of sovereign wealth funds from theMiddle East and Asia and how they are playing an increasing role in how corporations raise capital. Is competition from these sources for the cash flows of corporations affecting your investment strategies or opportunities?
  6. It seems that the worldwide trend is towards lower corporate tax rates. Do you think that the US risks becoming less competitive if it maintains its current corporate tax rate?
  7. What do you think about the U.S. trade deficit?
  8. What level of taxation on capital gains is most conducive to the long-term economic health of this society, and is that also the fair and just rate?
  9. What's your opinion on global warming? climate change?
  10. What's your opinion on politics, elections, and the political system?
  11. Maybe there should be a Buffett/Munger Presidential ticket. Please name three difficult policy decisions and three perfect solutions to better the country.
  12. Can volunteering help the economy? If so, then why aren't people doing it? I stick to my motto if you see something that needs doing, do it.
  13. Should the U.S., and U.S. companies such as Coca-Cola, withdraw sponsorship of the Beijing Olympics because of humanitarian values?
  14. Is there a chance the CDS [Credit Default Swap] market may eclipse subprime?
  15. How do you envision a nationalized healthcare system, and how it would affect Berkshire’s portfolio?
  16. Would the government’s stimulus spending be better spent acquiring national infrastructure, as during the Great Depression, in order to put people to work?
  17. Will retail, manufacturing and service businesses still be below their 2007 levels three years from now, given how they have been affected by the recession?
  18. Financial reform, what are the good ideas, and what are the bad ideas?
  19. The leading cause of death among young people is car crashes. BRK insures many of these crashes. New technology is helping give people feedback on their driving. How are GEICO and the Gates Foundation positioned to help save lives and improve this technology?
  20. What is biggest challenge facing the US economy – what are implications of that for investing globally over next decade?
  21. Given that we are not out of the woods yet in terms of the economy and the financial system, how would you assess the current buying opportunity for stocks?

Investing Approach

Have you ever bought a company where the numbers told you not to? How much is quantitative and how much is qualitative?

The best buys have been when the numbers almost tell you not to. Because then you feel so strongly about the product. And not just the fact you are getting a used cigar butt cheap. Then it is compelling. I owned a windmill company at one time. Windmills are cigar butts, believe me. I bought it very cheap, I bought it at a third of working capital. And we made money out of it, but there is no repetitive money to be made on it. There is a one-time profit in something like that. And it is just not the thing to be doing. I went through that phase. I bought streetcar companies and all kinds of things. In terms of the qualitative, I probably understand the qualitative the moment I get the phone call. Almost every business we have bought has taken five or ten minutes in terms of analysis. We bought two businesses this year.

General Re is a $18 billion deal. I have never been to their home office. I hope it is there. (Laughter) “There could be a few guys there saying what numbers should we send Buffett this month?” I could see them going once a month and saying we have $20 billion in the bank instead of $18 billion. I have never been there.

Before I bought Executive Jet, which is fractional ownership of jets, before I bought it, I had never been there. I bought my family a quarter interest in the program three years earlier. And I have seen the service and it seems to develop well. And I got the numbers. But if you don’t know enough to know about the business instantly, you won’t know enough in a month or in two months. You have to have sort of the background of understanding and knowing what you do or don’t understand. That is the key. It is defining your circle of competence.

Everybody has got a different circle of competence. The important thing is not how big the circle is, the important thing is the size of the circle; the important thing is staying inside the circle. And if that circle only has 30 companies in it out of 1000s on the big board, as long as you know which 30 they are, you will be OK. And you should know those businesses well enough so you don’t need to read lots of work. Now I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the “Scuttlebutt Approach.” I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Everytime I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, “If you could only buy stock in one coal company that was not your own, which one would it be and why? You piece those things together, you learn about the business after awhile.

Funny, you get very similar answers as long as you ask about competitors. If you had a silver bullet and you could put it through the head of one competitor, which competitor and why? You will find who the best guy is in the industry. So there are a lot of things you can learn about a business. I have done that in the past on the business I felt I could understand so I don’t have to do that anymore. The nice thing about investing is that you don’t have to learn anything new. You can do it if you want to, but if you learn Wrigley’s chewing gum forty years ago, you still understand Wrigley’s chewing gum. There are not a lot of great insights to get of the sort as you go along. So you do get a database in your head.

I had a guy, Frank Rooney, who ran Melville for many years; his father-in-law died and had owned H.H. Brown, a shoe company. And he put it up with Goldman Sachs. But he was playing golf with a friend of mine here in Florida and he mentioned it to this friend, so my friend said “Why don’t you call Warren?” He called me after the match and in five minutes I basically had a deal.

But I knew Frank, and I knew the business. I sort of knew the basic economics of the shoe business, so I could buy it. Quantitatively, I have to decide what the price is. But, you know, that is either yes or no. I don’t fool a lot around with negotiations. If they name a price that makes sense to me, I buy it. If they don’t, I was happy the day before, so I will be happy the day after without owning it.

  • Source: Lecture at the University of Florida Business School
  • URL:

What is it that really piques your interest in a stock? What tells you that it could be interesting?

We're so limited now because we can only go into very big companies. Charlie and I are probably familiar with every company in the United States--in a general way--that we can have the kind of position we would need to have [to make a difference in Berkshire Hathaway's performance]. We look for the ones where we think we know what they're going to look like in 10 years. If the price gets attractive and we know a little about the management, and we're quite sure--within a range--what they're going to look like in 10 years, we're in our area. We buy them when the prices are right, like Coca-Cola was some years back.

What is your investment process?

  • In the past some things were cheap enough WB could decide in a day (this was somewhat a function of a time period where companies would sell at 2-3x earnings)
  • Decisions should be obvious to onlookers. You should be able to explain why you bought something in a paragraph.
  • “I don’t do DCF” (WB says he does a rough approximation in his mind)
  • Finding ideas is a function of cumulative knowledge over time. Something just comes along - usually an event takes place, like a good management team screwing up that creates the opportunity (WB seems to imply here that his reading isn’t specifically targeted at finding ideas, but rather that ideas jump out at him as a natural consequence of vociferous reading)
  • You must be patient...good ideas tend to be clustered together, and may not come at even time intervals...when you don’t find anything for a while it can be irritating
  • WB isn’t bothered by missing something outside his circle of competence - Missing things inside the circle is nerve racking...examples include WMT, FNM

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[When asked about the relative attractiveness of bonds, arbitrage, etc., Buffett replied:]

Charlie and I are competent to make judgments on certain things, and not other things. We try to focus on what we can understand, which is a reasonable amount.

In the summer to mid-fall of 2002, when junk bonds became very attractive, we bought a lot. But we did not make a big decision to buy junk bonds – it’s just that a lot of them got really cheap.

We have an open mind – whatever we see on a given day that overcomes our resistance to take risk, we’ll do. Charlie and I do not have a checklist to prioritize categories. I hope he gets a good idea, he hopes I have one and if we find one, then we move, hopefully in a big way. It has to be big.

We’re recently made big investments in currencies and viatical settlements. We don’t do arbitrage any more because we’re too big.

[CM: We have a lot of cash because we don’t like any of those fields at the moment. Trying to prioritize among things we’re unlikely to do is pretty fruitless.

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[Q - How do you get better at valuing companies?]

WB: Very very good question. I started out not knowing anything about valuing companies. Ben Graham taught me a way to value certain type of business, but the selection of available companies dried up. Charlie taught me about durable competitive advantage. Not how big circle of competence is, but knowing where the edges are is most important. Think about businesses in your own home town. Ask questions about the businesses. Which do you want to buy into, which are hard to compete with, talk about businesses with people. What is working, what is not? You have to ask. You would be surprised at how many companies I know nothing about. The goal is to find companies that will be around for 20 years and offer a margin of safety. You have to recognize your limitations to be successful in this business. 6-7yrs ago I looked at Korean stocks, and I could see a number of businesses that met margin of safety. I bought 20 and diversified.

CM: Obviously if you want to get good at something which is competitive, you have to think about it and practice a lot. You have to keep learning because world keeps changing and competitors keep learning. You have to go to bed wiser than you got up. As you try to master what you are trying to do – people who do that almost never fail utterly. Very few have ever failed with that approach. You may rise slowly, but you are sure to rise.

WB: When did you start valuing businesses?

CM: I never took a business class, except accounting. When I was a boy, there was a man who came to the club every day at 10:30am. I asked my dad about him – he had such a good life! My Dad said, “He gathers up and renders dead horses.” I learned from that. Many businesses are sold under distress. Life is hard to get near top, and hard to hold position once attained. I think you could predict that Kiewits would win, they cared more. I would not have bet on anyone else. Half Dutch half German – and that is coming from me, I’m named Munger. I was automatically doing it – what was working and what wasn’t. If you have that temperament, you will gradually learn. If you don’t have that temperament, I can’t help you.

WB: Avoiding the dumb things is the most important. Learn more, know limitations, avoid the dumb things. Charlie often thought about his client’s business. He was incapable of thinking about a business without noticing the fundamental economics.

CM: I had a client who sold a Caterpillar dealership business for a crazy price to an oil business. The oil business had consultants and a concept and a strategy!

What's your acquisition criteria? What has made you successful in this area where most others have failed?

We look for people who have a passion for their business. We frequently buy businesses the owners still manage, where they are monetizing a lifetime of work. They often don’t want to sell but need to for estate planning or other reasons.

They need to have a passion because we don’t have any employment contracts – because we don’t think they work – we don’t stand over them with whips, and they’re already rich. We just try not to kill or dampen their love for their business.

We also look for three things: intelligence, energy and integrity. If you don’t have the latter, then you should hope they don’t have the first two either. If someone doesn’t have integrity, then you want them to be dumb and lazy. (Laughter)

We look them in the eyes and ask, “Do they love the business or the money?” If someone wants to cash out, then we have a problem because we only have 16 people at Berkshire’s headquarters and can’t run it ourselves.

Munger: The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it. (Laughter)

We criticize it [acquisitions], but then we do it. But we have different motivations.

We’ve been reasonably successful in having people run their businesses with the same passion as before we bought them.

Gillette, the oil companies, etc. all went out and bought a lot of businesses and tried to run them themselves. We’re under no illusions that we can do that. We think that having lots of Executive Vice Presidents, directives from headquarters, centralized Human Resources etc. can destroy the incentives of the people who’ve already gotten rich, and we’re counting on them making us rich.

The successor to me will come from Berkshire, knows our system, has seen that it works, and will be surrounded by people who believe in it. So it’s not going to be so hard to keep this train going down the tracks at 90 miles per hour.

[CM: Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. (Laughter)

But if you’re going to provide minimal oversight, you have to buy carefully. It’s a different model from GE’s. GE’s works – it’s just very different from ours.]

We are a conglomerate – and we hope to become more of a conglomerate.

We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.

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[BRK2006 - Update on acquistions]

Russell is in process – it’ll probably be a couple of months before completion. I described the Business Wire acquisition in the annual report. I got a letter from Cathy [Baron Tamraz, CEO of Business Wire]. [Regarding the purchase of GE’s Medical Protective Corporation,] I knew [GE CEO Jeff] Immelt wanted to shed some insurance assets and I suggested we’d be interested in that part of it, so we talked and made a deal.

One thing we haven’t done is participate in auctions. I get books occasionally and the projections are just plain silly. Maybe that’s why they don’t sign them. I’d love to make a bet with the investment bankers about whether the companies achieve the earnings in the pitch books.

The calls we want to get are from people who care about their business, who for tax or family-ownership reasons want to sell to us. They’re looking to change the ownership structure, not the operating personality and culture of the company they care deeply about.

The owners of Iscar are keeping 19% [I think he meant 20%]. They think [Berkshire] is the best place for their business and their people, and where they’ll have the most opportunity to grow. I don’t know how many stories you read about a $4 billion deal that doesn’t say anything about an investment banker on either side.

[CM: The interesting thing about it to me is the mindset. With all these “helpers” running around, they talk about doing deals. We talk about welcoming partners. The guy doing deals, he wants to do a deal and then unwind it in the near future. It’s totally opposite for us. We like to build lasting relationships. I think our system will work better in the long term than flipping deals.

I think there are so many of them [helpers] that they’ll get in each other’s way. I don’t think they’ll make enough money to meet their expectations, by flipping, flipping, flipping.]

By charging fees, fees, fees. [Laughter]

[CM: Warren talked to guy at an investment bank and asked how they made their money. He said, “Off the top, off the bottom, off both sides and in the middle.” [Laughter]]

[A shareholder asked if he’d be interested in buying Oriental Trading Company, a direct marketer of novelties and gift items, which is based in Omaha.] I looked at Oriental Trading a few years ago. I didn’t know it was for sale again. I don’t know, but I suspect some private group bought it and is now selling it. We see that all the time. They invariably try to sell it quickly to a strategic buyer, which is another way of saying someone who pays too much. Anytime someone calls me and says we’d be a logical strategic buyer, I hang up the phone faster than Charlie would.

The idea that we’re going to find a business to buy from a guy who’s been thinking from the moment he bought only about how he’s going to spruce it up and get out, is very low. It’s Fund A selling to Fund B to Fund C. The irony is that the same pension fund may be invested in all three funds, so they’re just paying all of the money managers to flip it to one another.

[CM: In the 1930s, there was a stretch where you could borrow more against the real estate than you could sell it for. I think that’s what’s going on in today’s private- equity world.]

What's your acquisition strategy? How do you get deals?

We'd like to keep buying businesses like the eight we bought last year. Our first preference has always been to buy outstanding operating businesses outright. We've made money in stocks, especially in the 1970s, but the climate is not so favorable now.

There are enough businesses that meet our criteria to do two acquisitions per year on average. What we'd really like to do is a $10-15 billion acquisition, but it's hard to find one that's not being auctioned, which we don't do.

We haven't had much luck buying businesses overseas, but that's because our phone hasn't rung. We're not on the radar screen, but we're hoping this will change.

Our best source of deals is word of mouth, generally in industries we're invested in. Sort of like NetJets, where 70% of our new customers are referred by current customers.

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It’s important to note that in this world where many businesses get dressed up and auctioned off, we occasionally hear from people who consider their business too important to auction off. We don’t participate in auctions. I can’t recall buying a business at auction, can you Charlie?

[CM: I can’t remember one.]

People who won’t put their business up for auction like a piece of meat and care about the home in which their business resides are the type of people we want to be partners with. It says something very important about how much they care about their business, their customers and their employees. We’ve acquired a number of businesses like this in the past couple of years and the crowning one is Iscar. I’m going to Israel in September to see if there are any more girls like Iscar there.

[Tilson Notes - I think the Iscar acquisition is fantastic news for three reasons:

  • 1. It’s big – at $4 billion, it’s the 3rd-largest deal Buffett has ever done);
  • 2. It appears to be an awesome business. According to an article in an Israeli newspaper, Iscar was valued at $800 million in 1997, so it’s increased in value by more than 6x in nine years (that’s 22.6% compounded annually); and
  • 3. It’s the first business Buffett’s ever bought that is headquartered overseas. This is a huge step forward in expanding his hunting ground to the entire world for the “elephants” he’s seeking. Having lived and traveled all over the world, I know that there are many fabulous, privately held businesses like Iscar, and Berkshire is the perfect buyer for many of them.]

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.

[CM: 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.]

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.

[CM: 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.] back to the questions.

What sources of investment ideas are available today?

First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don't understand and can't reasonably predict. An example is chewing gum versus software. You also have to recognize what you can and cannot know. Put everything you can't understand or that is difficult to predict in one pile. That is the too-hard pile. Once you know the other pile, then it's important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don't want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis. We're getting ready to make a $5 billion investment and this was the process I used.

Do you have any investing tips?

  • B: Start with the A's and examine all of them
  • CM: Dancing in and out of your favorite companies is not a good idea.
  • B: Have to make two decisions right, when to buy and when to sell. Also have to pay taxes along the way.
  • B: Investing is about valuing businesses. Encourage us to look at inefficiently priced businesses.
  • B: Built snowball on top of a very long hill, start very young and live a long time. Keep expenses low.
  • B: Find out what you know and don't know. Think for yourself
  • CM: First struggle is to get to $100,000. Underspend income grossly to get there quicker.
  • B: Valuation is an art
  • B: Get a strong enough moat so management less of a factor
  • B: Standard Deviation doesn't tell you anything
  • B: Better investor if look back at decisions you make and determine if you make the right decision
  • B: Pick out five to ten companies in which you understand their products, get annual reports, get every news piece on it. Ask what do I not know that I need to know. Talk to competitors and employees. Essentially be a reporter, ask questions like: If you had a silver bullet and could put it into a competitor who would it be and why. In the end you want to write the story, XYZ is worth this much because…
  • Cm: The question why is the most important of all.

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[Munger: "To some extent, stocks are like Rembrandts. They sell based on what they've sold in the past. Bonds are much more rational. No-one thinks a bond's value will soar to the moon."

"Imagine if every pension fund in America bought Rembrandts. Their value would go up and they would create their own constituency."]

How do you build your 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.

[CM: 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.]

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.

Is there an organizational model that allows you to deal with all the information?

The beauty of valuing large companies is that it is cumulative. If you started doing it 40 or so years ago, you've really got a working knowledge of an awful lot of businesses. There aren't that many, to start with. What are there, 75 or so important industries? You get to understand how they all operate, and you don't have to start over again every day, and you don't have to consult a computer or anything like that. So, it has the advantage of the accumulation of useful information over time. Why did we decide to buy Coca-Cola in 1988? Well, it may have been because of a couple of small, incremental bits of information, but that came into a mass that had been accumulated over decades. That's why we like businesses that don't change very much.

Do you have advice for the individual investor to help them narrow the stock universe?

They ought to think about what he or she understands. Let's just say they were going to put their whole family's net worth in a single business. Would that be a business they would consider? Or would they say, "Gee, I don't know enough about that business to go into it?" If so, they should go on to something else. It's buying a piece of a business. If they were going to buy into a local service station or convenience store, what would they think about? They would think about the competition, the competitive position both of the industry and the specific location, the person they have running it and all that. There are all kinds of businesses that Charlie and I don't understand, but that doesn't cause us to stay up at night. It just means we go on to the next one, and that's what the individual investor should do.

So if they're walking through the mall and they see a store they like, or if they happen to like Nike shoes for example, these would be great places to start? Instead of doing a computer screen and narrowing it down?

A computer screen doesn't tell you anything. It might tell you about P/Es or something like that, but in the end you have to understand the business. If there are certain businesses in that mall they think they understand and they're public companies, and they can learn more and more about them.... We used to talk to competitors. To understand Coca-Cola, I have to understand Pepsi, RC, Dr. Pepper.

[CM: And Cott. Cott is the one you have to understand more than anything else. [Note: Cott is a Canadian company specializing on low-priced, private-label soft drinks.]]

What advice would you give to new investors?

I think you should read everything you can. In my case, by the age of 10, I’d read every book in the Omaha public library about investing, some twice. You need to fill your mind with various competing thoughts and decide which make sense. Then you have to jump in the water – take a small amount of money and do it yourself. Investing on paper is like reading a romance novel vs. doing something else. [Laughter] You’ll soon find out whether you like it. The earlier you start, the better.

At age 19, I read a book [The Intelligent Investor] and what I’m doing today, at age 76, is running things through the same thought process I learned from the book I read at 19.

I remain big on reading everything in sight. And when you get the opportunity to meet someone like Lorimer Davidson, as I did, jump at it. I probably learned more in that four hours than in almost any course in college or business school.

Munger: Sandy Gottesman, a Berkshire director, runs a large, successful investment firm. Notice his employment practices. When he interviews someone, he asks: “What do you own and why do you own it?” If you’re not interested enough to own something, then he’d tell you to find something else to do.

Buffett: Charlie and I have made money in a lot of different ways, some of which we didn’t anticipate 30-40 years ago. You can’t have a defined roadmap, but you can have a reservoir of thinking, looking at markets in different places, different securities, etc. The key is that we knew what we didn’t know. We just kept looking. We knew during the Long Term Capital Management crisis that there would be a lot of opportunities, so we just had to read and think eight to ten hours a day. We needed a reservoir of experience. We won’t spot every one, though – we’ve missed all kinds of things.

But you need something in the way you’re programmed so you don’t lose a lot of money. Our best ideas haven’t done better than others’ best ideas, but we’ve lost less. We’ve never gone two steps forward and then one step back – maybe just a fraction of a step back.

Munger: And of course the place to look when you’re young is the inefficient markets. You shouldn’t be trying to guess if one drug company is going to have a better pipeline than another.

Buffett: You should do well in games with few other players. The RTC [Resolution Trust Corporation] was a great example of a chance to make a lot of money. Here was a seller [government bureaucrats] with hundreds of billions of dollars of real estate and no money in the game, who wanted to wrap up quickly, while many buyers had no money and had been burned.

There won’t be any scarcity of opportunity in your life, although there will be times when you feel that way.

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  • Don’t worry too much about your mistakes
  • Don’t learn too much from your mistakes:
    • Don’t become Mark Twain’s cat that never sat again on a stove after being burned
    • BUT...never be willing to play a “fatal” game
  • Don’t confuse social progress with the chance to make money – look at airlines and autos for examples
  • Law degree is not essential, but good if you think it will help in your specific career
  • Learning to think like a lawyer is a valuable trait
  • Allocate even more of your day to reading than he does
  • Read lots of K’s and Q’s – there are no good substitutes for these - Read every page
  • Ask business managers the following question: “If you could buy the stock of one of your competitors, which one would you buy? If you could short, which one would you short?”
  • Always read source (primary) data rather than secondary data
  • If you are interested in one company, get reports for competitors. “You must act like you are actually going into that business, and if you were, you’d want to know what your competitors were doing.”

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[Re: Ongoing Learning]

I haven’t been continually learning the basic principles [of sound investing], which are still Ben Graham’s. They were affected in a significant way by Charlie and Phil Fisher in terms of looking at better businesses. And I’ve learned more about how businesses operate over time.

You need an intellectual framework, which you can get mostly from The Intelligent Investor. Then, think about businesses you can get your mind around if you really work at it. Then, you will do well if you have the right temperament.

[CM: I’ve watched Warren for decades. Warren has learned a lot. He can pooh pooh investing in PetroChina, but he’s learned, which has allowed him to [expand his circle of competence so he could invest in something like PetroChina.

If you don’t keep learning, other people will pass you by.

Temperament alone won’t do it – you need a lot of curiosity for a long, long time.]

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It’s hard for individual investors to successfully pick stocks or time the market. The best investment you can make is in your own abilities. Anything you can do to develop your own abilities or business is likely to be more productive than investing in foreign currencies.

If you own your own business in America [and you run it well, you’ll do OK].

When I was seven years old, I first took an interest in stocks. My dad was in the business, so I’d go with him to the office and I saw interesting things. [When I was a little older,] I went to the library and read every book on markets and investing.

When I was 11, I bought my first stock – three shares. I was following charts. When I was 19, I read The Intelligent Investor and it changed my whole framework.

My advice is to read a lot. There are no secrets in the business that only the priesthood knows. It’s all right there.

It requires qualities of temperament way more than qualities of intellect.

Once you have a 125 IQ, much more doesn’t matter. Look for opportunities that fit your framework. Try to learn every day, but you can’t act every day. It’s important to enjoy the game, just as it is to enjoy bridge or baseball [if you’re going to play those games seriously].

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Ben Graham said you’re neither right nor wrong if you’re investing with the crowd – you’re right if your facts and reasoning are right. Once you have the facts, you have to think about what they mean. You don’t take a survey.

You should focus on what’s important and knowable. There are many things that are important but now knowable, like [whether there will be] a nuclear attack tomorrow. You can’t focus on those.

As Ben Graham said in chapter 8 of The Intelligent Investor: The market is there to serve you, not instruct you. If it does something silly, it gives you a chance to do something. It just sets prices. If it doesn’t give you an opportunity, go play bridge and come back the next day. And the nice thing is that the prices will be different.

During the Long-Term Capital Management crisis, we were getting calls on Sunday from people. By the way, you can make a lot of money on calls on Sunday – that means things are really screwed up. Just make sure you’re the callee and not the caller.

At that time, there was [an unprecedented] 30 basis point spread between on- versus off-the-run 30-year Treasuries. All you have to do [in such situations] is make sure you can play out your hand under all circumstances. If you can and you have the right facts – and you let the market serve rather than instruct you – you can’t miss.

Munger: I’d say some of you probably can miss. [Laughter]

Advice for getting into investing?

I love the treasure hunt. Learn as much as you can. Just jump right into the pool.

Where is a good place for new investors to invest right now?

That’s very difficult - we don’t have one-line advice on that. Maybe for a small investor, continuous investment in index funds might work - but not for us. I like the businesses we’re in, so I wouldn’t be giving up any of my businesses.

Investors have to remember: corporate profits are going up, but stocks are going up faster. How can that continue indefinitely? Investors can only earn what companies themselves can earn; the government or the markets themselves don’t kick anything in. How can you get anything more out of a farm than what it grows?

There’s nothing magical added by the stock market to corporate returns. It just doesn’t create more earnings to pay out to investors. If you trace out the mathematics of the market’s logic, you begin to see the limits to the logic.

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We think we’re in a pretty good group of businesses for the world we face. We don’t know which will be super-winners, but we think a significant number will do okay. We don’t buy businesses with much thought of world trends, but we do think about businesses subject to foreign competition, with high labor content and a product that can be shipped in.

I bought into an airline [US Air] with high seat-mile costs of 12 cents. It was protected, but that was before Southwest showed up with 8-cent costs.

The variables you name don’t bother us. We have good businesses, deal from strength, always have a loaded gun and have the right managers and people and an owner-oriented culture.

Munger: We learned about foreign labor competition in our shoe business. It reminds me of Will Rogers, who said he didn’t think man should have to learn easy lessons in such a hard fashion. You should be able to learn not to pee on an electrified fence without actually trying it. [Laughter]

What advice would you give to non-professional investors?

  • If you like spending 6-8 hours per week working on investments, do it
  • If you don’t, then dollar cost average into index funds. This accomplishes diversification across assets and time, two very important things.
  • “There is nothing wrong with a ‘know nothing’ investor who realizes it. The problem is when you are a ‘know nothing’ investor but you think you know something.” [NOTE: this is analogous to the concept of ‘metaknowledge’ that Mauboussin talked about...there’s also a Confucius quote on this]

Are investors more or less knowledgeable today compared to ten years ago?

There is no doubt that there are far more “investment professionals” and way more IQ in the field, as it didn't use to look that promising. Investment data are available more conveniently and faster today. But the behavior of investors will not be more intelligent than in the past, despite all this. How people react will not change – their psychological makeup stays constant. You need to divorce your mind from the crowd. The herd mentality causes all these IQ's to become paralyzed. I don't think investors are now acting more intelligently, despite the intelligence. Smart doesn't always equal rational. To be a successful investor you must divorce yourself from the fears and greed of the people around you, although it is almost impossible.

Do you think Ponzi was crazy? The tech and telecom madness that existed just 6 years ago is right up there with the craziest mania's that have ever happened. Huge training in capital management didn't help.

Take Long Term Capital Management. They had 100's of millions of their own money, and had all of that experience. The list included Nobel Prize winners. They probably had the highest IQ of any 100 people working together in the country, yet the place still blew up. It went to zero in a matter of days. How can people who are rich and no longer need more money do such foolish things?

Your thoughts on index funds?

Just pick a broad index like the S&P 500. Don't put your money in all at once; do it over a period of time. I recommend John Bogle's books -- any investor in funds should read them. They have all you need to know."

[CM: One could imagine a period like Japan 13 years ago, however, in which indexing over time wouldn't work.]

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[When asked whether one should buy Berkshire, invest in an index fund, or hire a broker, Buffett replied:]

We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund – where you don’t put the money in at one time, but average in over 10 years –you’ll do better than 90% of people who start investing at the same time.

[CM: It’s hard to sit here at this annual meeting, surrounded by smart, honorable stock brokers who do well for their clients, and criticize them. But stock brokers, in toto, will do so poorly that the index fund will do better.]

If you were today 20-something years old would you primarily be searching for: a) Situations reminiscent of 1957 – akin to Daehan Flour Mills, or b) Situations reminiscent of 1987 – akin to Moody’s Corporation?

Either is fine. a) is better for small sums. b) is better for large sums

[Mr. Buffett, on June 23, 1999 you shared with Business Week:

If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.] [At a talk to Columbia students in 1993 you shared: When I got out of Columbia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody's industrial manual, banks and finance manual and public utilities manual. I went through all those page by page. I found a little company called Genesee Valley Gas near Rochester . It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share. I found Western Insurance in Fort Scott, Kansas. The price range in Moody's financial manual...was $12-$20. Earnings were $16 a share. I ran an ad in the Fort Scott paper to buy that stock. I found the Union Street Railway, in New Bedford, a bus company. At that time it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.] [Along similar lines, in late 2005 I understand you explained to a group of Harvard students the following: Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified. Korea rebuilt itself in a big way post 1998. Companies overbuilt their balance sheets – including Daehan Flour Mill with 15,000 won/year earning power and selling at “2 and change” times earnings. The strategy was to buy the securities of twenty companies thereby spreading the risk that some of the companies will be run by crooks. $100 million was quickly put to work.] [The “1987” Fisher Approach -The following excerpts from an article written by Carol Loomis published on April 11, 1988 in Fortune provide interesting clarity on the modus-operandi of Berkshire circa 1987: Unusual Profitability (High ROE with Low Debt; i.e. high ROIC) - …But in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned, after taxes, $100 million. That's a return on equity of 57%, and it is exceptional. As Buffett says, ''You'll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.'' Unusual Growth (Opportunities for Reinvestment of Retained Earnings) - …Some folks of the right sort, by the name of Heldman, read that ad and brought him their uniform business, Fechheimer, in 1986. The business had only about $6 million in profits, which is an operation smaller than Buffett thinks ideal. …A few hundred miles away at Fechheimer ( …1987 sales: $75 million) Paying for Quality - …By 1972, Blue Chip Stamps, a Berkshire affiliate that has since been merged into the parent, was paying three times book value to buy See's Candies, and the good-business era was launched. ''I have been shaped tremendously by Charlie,'' says Buffett. ''Boy, if I had listened only to Ben, would I ever be a lot poorer.]

What's your opinion of cigar butts vs quality businesses?

[CM: 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]]

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.

If you were starting out today, what would you do the same or differently?

We started out this snowball at the top of a very long hill. My advice is either start very early or live very long. I guess I’d do it the same way: maybe I’d start with small companies and buy good businesses. Or little pieces of ‘em called stocks.

[CM: The first $100,000 is probably the hardest part. Staying rational and significantly underspending your income helps, too.]

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If we were to do it over again, we’d do it pretty much the same way. The world hasn’t changed that much. We’d read everything in sight about businesses and industries we think we’d understand. And, working with far less capital, our investment universe would be far broader than it is currently.

There’s nothing different, in my view, about analyzing securities today vs. 50 years ago.

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We formed our first partnership 50 years and two days ago, on May 4, 1956, with $105,000. If we were starting again, Charlie would say we shouldn’t be doing this, but if we were, we’d be investing in securities around the world. Charlie would say we couldn’t find 20, but we don’t need 20 – we only need a few that can pay off very big. We’d also be buying [stocks in] smaller companies.

If we were planning to buy [entire] businesses, we’d have a tough time. We’d have no reputation and only $1 million.

Charlie started out in real-estate development because with only a little capital, brain power and energy, you could magnify the returns in real estate unlike in other sectors.

I’d just do it one foot in front of the other over time. But the basic principles wouldn’t be different. If I’d been running a little partnership three years ago, I’d have started out 100% in Korea.

Munger: You should find something to invest in and then compare everything else against that. That’s your opportunity cost. That’s what you learn in freshman economics, even if it hasn’t made it into modern portfolio theory. That’s why modern portfolio theory is so asinine.

Buffett: It really is.

Munger: When Warren said he’d put 100% of his fund in Korea, maybe he wouldn’t quite do that, but pretty much. Most people won’t find a lot of great things [to invest in]. Instead, you’ll want to find a few things that are much better than anything else. Act on these.

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[RE: How Buffett Would Invest with a Small Amount of Money]

If I were working with a very small sum – you all should hope this doesn’t happen – I’d be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you’re investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can’t do it, but if you know what you’re doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $5 billion in a stock. It won’t work – it’s not even close.

If Charlie and I had $500,000 or $2 million to invest, we’d find little things we could do, not all of it in stocks.

Munger: But there’s no point in our thinking about that now.

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You have to find your passion in life. I would choose the same job. I enjoy it. It is a terrible mistake to sleepwalk through your life. Unless Shirley MacLaine is right, you won’t have another one. My dad had a business with [investment] books on his shelves, and they turned me on. This was before Playboy. If he was a minister, I’m not sure I would have been as enthused. If you have obligations, you have to deal with realities. I tell students to go work for an organization you admire or an individual you admire, which usually means that most MBAs I meet become self-employed. [laughter] I went to work for Ben Graham. I never asked my salary. Get the right spouse. Charlie talks about the man who spent twenty years looking for the perfect woman and found her. Unfortunately, she was looking for the perfect man. If you are lucky, you will be happy and as a result, you will behave better. It makes it easier.

CM: You’ll do better if you have passion for something in which you have aptitude. If Warren had gone into ballet, no one would have heard of him.

WB: Or would have heard of me very differently. [laughter]

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[Q - With small sums of money, what strategies would you pursue?]

WB: If I were working with small sums of money, it would open up thousands of possibilities. We have found very mispriced bonds. We found them in Korea a few years ago. You could make big returns but had to be of small size. I wouldn’t be in currencies with a small amount of money. I had a friend who used to buy tax liens. I’d look in small stocks or specialized bonds. Wouldn’t you say that, Charlie?

CM: Sure.

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[Q - If you were starting a $26 million fund, what would you do differently with a smaller asset base? How many positions would you hold, and what kind of turnover would you have? What would you do if some investments lost 50% and some gained?]

Buffett: We would hold the half-dozen stocks we liked best. We would do the same thing if they lost 50%. Cost has nothing to do with it. We look at price and think about what something is worth. Keep it in the few you know.

Munger: He [Buffett] has tactfully suggested you adopt a different way of thinking. [laughter]

[Comment: As Buffett stated, cost basis has nothing to do with investment judgment (apart from tax considerations). Nevertheless, many investors (like the questioner) pay way too much attention to what they’ve paid, rather than its value.]

According to a business week report published in 1999, you were quoted as saying “it's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn't have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50's. Money gets to be an anchor on performance. At Berkshire's size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

Do you believe that we'll have significant mispricings again? And if you were 26 today how would you generate the 50% returns that you said you might do with smaller amounts of capital?

Attractive opportunities come from observing human behavior. In 1998, people behaved like frightened cavemen (referring to the Long Term Capital Management meltdown). People make their own opportunities. They will be frozen by fear, excited by greed and it doesn’t matter what their IQ, degrees etc is. Growth of 50% per year is with small capitalization, not large cap. The point is I got rich looking for stock with strong earnings.

The last 50 years weren’t unique. It’s just capitalizing on human behavior. It’s people that make opportunities when others are frozen by fear or excited by greed. Human behavior allows for success if you are able to detach yourself emotionally.

In 1951, I got out of school at 20 years old. At the time there were two publishers of stock information, Moody’s and Standards and Poor’s. I used Moody’s and went through every manual. I recently bought a copy of the 1951 Moody off of Amazon. On page 1433, there’s a stock you could have made some money on. The EPS was $29 and the Price Range was from $3-$21/share. On another page, there is a company that had an EPS of $29.5 and the price range was $27-28, 1x earnings. You can get rich finding things like this, things that aren’t written about.

A couple of years ago I got this investment guide on Korean stocks. I began looking through it. It felt like 1974 all over again. Look here at this company...Dae Han, I don't know how you pronounce it, it’s a flour company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 20 companies like this.

The point is nobody is going to tell you about these companies. There are no broker reports on Dae Han Flour Company. When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses. Not all of them will be good, but some will and those will make you rich. And this didn’t happen in 1932, this was in 2004! These opportunities will be there in the next 30 years. You’ll have streaks where you’ll find some bad companies and a few times where you’ll make money with everything that you do.

The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.

In your investing life you will have several opportunities and one or two that can’t go wrong. For example, in 1998 the NY fed offered a 30-year treasury bonds yielding less then the 29-½ year treasury bonds by 30 basis points. What happened was LTCM put a trade on at 10 basis points and it was a crowded trade, they were 100% certain to make money but they could not afford any hiccups. I know more about human nature; these were MIT grads, really smart guys, and they almost toppled the system with their highly leveraged trading.

This was definitely a good time to act.

You have often spoken of the difficulties of compounding large sums of money. But in an article I read, you were quoted as saying that you think you could compound 50% returns on small sums of money, say $1 million. Where could you find those kind of investments in today’s market?

I was misquoted in that article. I get together with about 60 people every couple years and get their expectations of returns. Of those investors, I think there’s a half dozen who could get those kinds of returns - but they’re only going to find those returns in small places.

I stumble onto those things occasionally but I’m not looking for them. I’m looking for things that Berkshire Hathaway can do.

Could you describe the capital allocation process you follow? How do you determine the charges for capital to your different managers?

There is no better way to make managers understand how valuable capital is than to charge them for it. The amount charged to them can depend on elements such as the history of the subsidiary and the level of interest rates, and has varied from 14 to 20 percent at times. The important thing, Buffett emphasized, is that “we don’t want managers to think of other people’s money as “free" money.

What filters do you use when looking at companies?

[CM: Well, opportunity cost is a huge filter in life. If you've got two suitors who are eager to have you, but one is way better than the other, you're going to choose that one rather than the other. That's the way we filter stock buying opportunities. Our ideas are so simple. People keep asking us for mysteries, but all we have are the most elementary ideas.]

We know instantly whether a business is something we're going to understand, and whether it's a business that's going to have a sustainable edge, and that gets rid of a very significant percentage of opportunities. I'm sure people regard me and Charlie as very arbitrary--in the middle of the first sentence, we'll say, "We appreciate the call, but we're not interested." I'm sure that if they explain something I might get buttered on it, but we really can tell in the middle of the first sentence whether those two factors exist ... We can sometimes tell by who we're dealing with, whether a deal is ever going to work out or not. I mean, if there's an auction going on, we have no interest in talking about it. If someone is interested in doing that with their business, then they're going to want to sit down and renegotiate everything with us all over again after the deal is done ...We don't want to listen to stories all day, and we don't need brokerage reports. There's other things to do with your time.

[CM: Another filter is the concept of the quality person, which most people define as someone very much like themselves. (laughter) There are so many wonderful people out there, and there are so many awful people out there. And there are signs, like flags, waving over the awful people. And generally speaking, those people are to be avoided.]

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[Q - Besides the type of management that you look for, when you look at financials you make decisions rather quickly. In regards to the financial information and the business overall what factors do you look at?]

We make quick decisions because we have filters before we get to the point of making a decision.

Filter #1 – Can we understand the business? What will it look like in 10-20 years? Take Intel vs. chewing gum or toilet paper. We invest within our circle of competence. Jacob’s Pharmacy created Coke in 1886. Coke has increased per capita consumption every year it has been in existence. It’s because there is no taste memory with soda. You don’t get sick of it. It’s just as good the 5th time of the day as it was the 1st time of the day.

Filter #2 – Does the business have a durable competitive advantage? This is why I won’t buy into a hula-hoop, pet rock, or a Rubik’s cube company. I will buy soft drinks and chewing gum. This is why I bought Gillette and Coke.

Filter #3 – Does it have management I can trust?

Filter #4 – Does the price make sense?

Since 1972 we have made no change in the marketing, process etc. Take See’s candy. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.

How would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?

Well, it depends whether they are going to be an active investor. Graham distinguished between the defensive and the enterprising and that. So if you are going to spend a lot of time on investment, you know I just advise looking at as many things as possible and you will find some bargains. And when you find them, you have to act. It doesn't -- it hasn't changed at all since I was here in 1950, 1951. And it won't change the rest of my life. You start turning pages. When I got out of school, I turned every page in Moody's 10,000-some pages twice, looking for companies. And you have to find them yourself. The world isn't going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time. The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Most of you don't look like you are overburdened with cash anyway. Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don't want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it.

[Becky - Does that mean you think we are through the roughest times? You had always kept the cash word around, too.]

We always keep enough cash around so I feel very comfortable and don't worry about sleeping at night. But it's not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. The worst -- the financial panic is behind us. The economic spillout which came to some extent from that financial panic is still with us. It will end. I don't know if it will end tomorrow or next week or next month. Or maybe a year. But it won't go on forever. And to sit around and try and pick the bottom, people were trying to do that last March and the bottom hadn't come in unemployment and the bottom hadn't come in business but the bottom had come in stocks. Don't pass up something that's attractive today because you think you will find something way more attractive tomorrow.

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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.

What impacts have Graham/Dodd and Phil Fisher had on your investment philosophy? What percentage of your investment philosophy would you attribute to each of them?

Well, good things would have happened with following either party. Graham obviously had more influence on me than Phil. I worked for Ben, I went to school under him, and his three basic ideas: look at stocks as businesses; have a proper attitude toward the market; and operate with a margin of safety--they all come straight from Graham. Phil Fisher opened my eyes a little more toward trying to find a wonderful business. Charlie did more of that than Phil did, but Phil was espousing that entirely, and I read his books in the early 60s. Phil's still alive, and I owe Phil a lot, but Ben was one of a kind.

[CM: Ben Graham was a truly formidable mind, and he also had a clarity in writing, and we talk over and over again about the power of a few simple ideas thoroughly assimilated, and that happened with Graham's ideas which came to me indirectly through Warren, but some also directly from Graham. The interesting thing for me is that Buffett the former protégé--by the way Buffett was the best student Graham had in 30 years of teaching at Columbia--became better than Graham. That's the natural outcome--as Milton said, "If I've seen a little farther than other men, it's by standing on the shoulders of giants." So, Warren stood on Ben's shoulders, but he ended up seeing more than Ben. No doubt somebody will come along and do a lot better than we have.]

I enjoyed making money more than Ben. With Ben it really was incidental, at least by the time I knew him. The process, the whole game, didn't interest him more than a dozen other things may have interested him. With me, I just find it interesting, and therefore I've spent a much higher percentage of my timing thinking about investing, and thinking about businesses. I probably know way more about businesses than Ben ever did. He had other things that interested him. I pursued the game quite a bit differently than he did, and therefore comparing the record is not proper.

Since Ben Graham isn't around anymore, what money managers do you respect today? Is there a Ben Graham today?

You don't need another Ben Graham. You don't need another Moses. There were only Ten Commandments; we're still waiting for the eleventh. His investing philosophy is still alive and well. There are disciples of him around, but all we are doing is parroting. I did read Phil Fisher later on, which showed the more qualitative aspects of businesses. Common stocks are part of a business. Markets are there to serve you, not to instruct you. You can often find a couple of companies that are out of line. Find one; get rich. Most people think that what the stock does from day to day contains information, but it doesn't. It isn't just something that wiggles around. The stock market is the best game in the world. You can take advantage of people who have no morals. High prices inside of a year will typically be 100% of the low price. Businesses don't change in value that much. That is simply crazy. There are extreme degrees of fluctuation, and Mr. Market will call out the prices. Wait until he is nutty in one direction or the other. Put in a margin of safety. Don't find a bridge that says no more than 10,000 pounds when you have a 9800 pound vehicle. It isn't a function of IQ, but receptivity of the mind.

When investing you don't have to invest in all 10,000 companies available, you just have to find the one that is out of line. Mr. Market is your servant. Mr. Market is your partner and wants to sell the business to you everyday. Some days he is very optimistic and wants a high price, others he is pessimistic and will sell at a low price. You have to use this to your advantage. The market is the greatest game in the world. There is nothing else that can, at times, get this far out of line with reality. For example, land usually only fluctuates within a 15% band. Negotiated transactions are less volatile. Some get this; others don't. Just keep your wits about you and you can make a lot of money in the market.

If you were to teach an investment course, besides works by Ben Graham and Phil Fisher and your book on the instalment basis, what would be on the syllabus?

[Q - how would you teach the next generation of investors?]

Buffett: I had 49 university groups, in clumps of six, [visit me] last year. [An education in] investing requires only two courses: How to Value a Business, and How to Think About Markets. You don’t have to know how to value all businesses. Start with a small circle of competence, things you can understand. [Look for] things that are selling for less than they’re worth. Forget about things you can’t understand. You need to understand accounting, which has enormous limitations. [You need to] understand when a competitive advantage is durable or fleeting. Learn that the market is there to serve you, not instruct you. In the investing business, if you have an IQ of 150, sell 30 points to someone else. You do not need to be a genius. You need to have emotional stability, inner peace and be able to think for yourself, [since] you’re subjected to all sorts of stimuli. It’s not a complicated game; you don’t need to understand math. It’s simple, but not easy.

Munger: Exactly half of future investors are going to be in the bottom 50%. There is so much that’s false and nutty in business schools. Reducing the nonsense would be a good goal.

Buffett: Emotional makeup is more important than technical skill.

Munger: Absolutely. If you think your IQ is 160 and it’s really 150, you’re a disaster.

Buffett: A student in one of the groups asked me, “What are we learning that’s wrong?”

Munger: How do you answer in only one hour? [laughter]

Buffett: [My experience] has given me a jaundiced view of academia generally. Efficient market theory—that everything is priced appropriately—is bunk. There’s a certain degree to which ideas that are nutty take hold and propagate. Max Planck [remarked about] the resistance of the human mind to new ideas: “Science advances one funeral at a time.”

What's the temperament of successful investors?

[CM: I think there's something to be said for developing the disposition to own stocks without fretting.]

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.

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.

[CM: 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.]

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.

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[CM: We read a lot. I don’t know anyone who’s wise who doesn’t read a lot. But that’s not enough: You have to have a temperament to grab ideas and do sensible things. Most people don’t grab the right ideas or don’t know what to do with them.]

The key is to have a “money mind,” which is not IQ, and then you have to have the right temperament. If you can’t control yourself, you’re going to have disasters. Charlie and I have seen it. The whole world in the late 1990s went a little mad in terms of investments. How could that happen? Don’t people learn? What we learn from history is that people don’t learn from history.["Grade yourself on your temperament. Temperament is the ability to not be swayed by the market. See what you are supposed to see." - UCLA Q&A]

Do you agree with Philip Fisher's two reasons to sell?

To sell the business is written in the ground rules. Never going to be a takeover or sell business because street thinks unfocused. I don't quite agree with Fisher, think can ride some stocks forever.

[CM: Better off when you had 50 years ahead of you. Almost never sell operating businesses, and if we do, we do so because they can't fix their problem.]

[BRK2005 - We won’t sell a business just because it’s underperforming.]

What tells you when an investment has reached its full potential?

I don’t buy Coke with the idea it will be out of gas in 10 years or 50 years. There could be something that happens by I think the chances are almost nil. So what we really want to do is buy businesses that we would be happy to own forever. It is the same way I fell about people who buy Berkshire. I want people who buy Berkshire to plan to hold it forever. They may not for one reason or the other but I want them at the time they buy it to think they are buying a business they are going to want to own forever.

And I don’t say that is the only way to buy things. It is just the group to join me because I don’t want to have a changing group all the time. I measure Berkshire by how little activity there is in it. If I had a church and I was the preacher and half the congregation left every Sunday. I wouldn’t say, “It is marvelous to have all this liquidity among my members.”

Terrific turnover... I would rather go to church where all the seats are filled every Sunday by the same people. Well that is the way we look at the businesses we buy. We want to buy something virtually forever. And we can’t find a lot of those. And back when I started, I had way more ideas than money so I was just constantly having to sell what was the least attractive stock in order to buy something I just discovered that looked even cheaper. But that is not our problem really now. So we hope we are buying businesses that we are just as happy holding five years from now as now. And if we ever found a huge acquisition, then maybe we would have to sell something. Maybe to make that acquisition but that would be a very pleasant problem to have.

We never buy something with a price target in mind. We never buy something at 30 saying if it goes to 40 we’ll sell it or 50 or 60 or 100. We just don’t do it that way. Anymore than when we buy a private business like See’s Candy for $25 million. We don’t ever say if we ever get an offer of $50 million for this business we will sell it. That is not the way to look at a business.

The way to look at a business is this going to keep producing more and more money over time? And if the answer to that is yes, you don’t need to ask any more questions.

Could you explain more about the circle of competence?

We are best at evaluating businesses where we can come to a judgment that they will look a lot like they do now in five years. The businesses will change, but the fundamentals won’t. Iscar will be better – maybe a lot bigger – in five years, but the fundamentals will be the same. [In contrast,] look at how much telecom has changed.

Charlie says we have three boxes: In, Out and Too Hard. You don’t have to do everything well. At the Olympics, if you run the 100 meters well, you don’t have to do the shot put.

Tom Watson [the founder of IBM] said, “I’m no genius. I’m smart in spots and I stay around those spots.” We have a lot of managers who are the same. You don’t want to compete with Pete Liegl [the CEO of Forest River, Inc.] because he’ll kill you in the RV business. But he doesn’t try to tell us how to run the insurance business.

I was virtually there at the birth of Intel. I was on the board of Grinnell College with Bob Noyce [one of the founders of Intel] and Grinnell invested $300,000 into it at inception. [I easily could have as well, but] I had no idea then and still don’t now what Intel will look like in five years. Even people in the industry don’t. Some businesses are very, very hard to predict.

[CM: A foreign correspondent, after talking to me for a while, once said: “You don’t seem smart enough to be so good at what you’re doing. Do you have an explanation?” [Laughter]]

Buffett: Was he referring to me or you? [Laughter]

[CM: I said, “We know the edge of our competency better than most.” That’s a very worthwhile thing. It’s not a competency if you don’t know the edge of it.]

[BRK2007 - What makes the difference is whether the people running them know their strengths and weaknesses and play when it is to their advantage and do nothing when it is not.]

What two industries are the first you should learn when developing your circle of competence?

Look for simple businesses. If I gave you $10M to invest right now and you only had three weeks to spend it and you could only spend it in Omaha, you’d look for simple, understandable, strong businesses. You look at the Nebraska Furniture Mart (NFM). You wouldn’t look at the third best fast food chain. You might look at McDonald’s, because it is number one and will probably always been number one. They have share of mind. What about Oracle? Too hard. GM? Too hard. You can’t predict the future for these two companies. Too many variables.

Investment knowledge is cumulative, and things you learn will make you better in the future. Stick to things you understand. Mrs. B at NFM wouldn’t get paid in Berkshire stock. Why? She doesn’t know stocks, but she knows furniture down cold. How do you beat Bobby Fisher? Play him in anything except chess. Even young people have a circle of competence even if they don’t have their thoughts perfectly organized.

Is there a moral connection to who you invest in?

Charlie and I went to Memphis to look at a chewing tobacco company. In the end, we decided we didn’t want to own it. We would buy stock in a tobacco company, but we didn’t want to own it.

A good example is Charlie’s favorite company, Costco. They are the #3 distributor in the US of cigarettes, but you wouldn’t avoid buying it because of that. You’ll drive yourself crazy trying to keep track of these things. Our philosophy is that it’s impossible to grade marketable securities, but we’ll buy the stocks without any problems, but we just won’t be in certain businesses.

My view is that energy production should move to nuclear. It’s clean, cheap and safe. Coal emissions are bad for the environment; however it’s still a good company. It’s impossible to grade marketable securities on moral activity. Berkshire Hathaway has and will buy what trades, but will not buy companies that engage in certain behaviors. PetroChina owns 40% of the oil in the Sudan that is government owned. If they did not own it, someone else would. Also, you have to keep in mind, if PetroChina did not buy it its possible the Sudanese would own 100% of the oil rights and that’s not so good either.

I find it funny that people find time to protest PetroChina for ownership of the Sudanese oil, but with the $300 billion or so of imported goods from China, these same people don’t protest Chinese goods. They protest investment in Chinese companies though.

Who do you think will be one of the next greatest investors and are you partial to favoring someone with a similar investment style as yours?

We just finished looking for someone. The Board has 3 candidates to replace me as CEO and 4 candidates to replace me as investor. They are all doing fine where they are, but they would be willing to come over to Berkshire for less pay.

In 1969, I wound up my partnership and I had to help people find someone to manage their money. I recommended Bill Ruane of Sequoia Fund, Sandy Gottesman, who is currently on the board at Berkshire, and Walter Schloss, who I wrote about in “The Superinvestors of Graham and Dodds-ville”. There’s no way they could miss.

But I don’t know many of the newer investors, they’re not my contemporaries. It’s not enough to just look at track records. They aren’t predictive and there will always be a few people that do well. I know guys who can make 50% a year with $5 million, but not with $1 billion. The problem with guys that do well is they attract so much money that it neutralizes their advantage. It’s hard to identify them, and even harder to make a deal to keep them from attracting other capital. It’s like betting on a 12 year old horse that won at 3 years old. It’s also important to avoid managers who use leverage. It’s the reason that investors with 160 IQs flame out.

What do you think of discounted cash flow (DCF) models?

Buffett: All investing is laying out cash now to get some more back in the future. The concept of “a bird in the hand” came from Aesop in about 600 BC. He knew a lot, but not that [he lived in] 600 BC. He couldn’t know everything. [laughter] The question is, how many birds are in the bush? What is the discount rate? How confident are you that you’ll get [the bird]? Et cetera. That’s what we do. If you need to use a computer or calculator to figure it out, you shouldn’t [buy the investment]. Those types of [situations] fall into the “too-hard” bucket. It should be obvious. It should shout at you, without all the spreadsheets. We see something better.

Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.

Buffett: The priesthood has to look like they know more than “a bird in the hand.” You won’t get tenure if you say “a bird in the hand.” False precision is totally crazy. The markets saw it in the Long-Term Capital Management [hedge fund] in 1998. It only happens to people with high IQs. The markets of mid-September last year were [such that] you can’t calculate standard deviations. People’s actions don’t observe laws of math. It’s a terrible mistake to think higher math will take you a long way— you don’t need to understand it, [and] it may lead you down the wrong path.

Could you explain your opportunity cost decisions of the past year?

Buffett: Opportunity costs have been in the forefront of our minds during the last 18 months. It’s tougher to calibrate A, versus B, versus C in a fast-changing environment. Tougher and possibly more profitable. We got lots of calls [for potential investments]—most we ignored. We were called by Goldman Sachs on a Wednesday for $5 billion, and we [already] had a $5 billion commitment to Constellation Energy, $3 billion on Dow Chemical, $6.5 billion on the Wrigley Mars deal. We never want to get dependent on banks. It’s a good sign that we haven’t had the flurry [of phone calls] like last year. Normally, we would not have sold Johnson & Johnson if it were 10 – 15 points higher, [but we wanted to have a comfortable amount of cash on hand]. Our definition of comfortable is very comfortable.

[Comment: The real cost of any purchase isn’t the actual dollar cost. Rather, it’s the opportunity cost — the value of the investment you didn’t make, because you used your funds to buy something else.]

What are your views on diversification?

I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund, and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.

In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great.

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The question is about diversification. I have a dual answer to that. If you are not a professional investor. If your goal is not to manage money to earn a significantly better return than the world, then I believe in extreme diversification. I believe 98% - 99% who invest should extensively diversify and not trade, so that leads them to an index fund type of decision with very low costs. All they are going to do is own part of America. And they have made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all. That is the way they should approach it unless they want to bring an intensity to the game to make a decision and start evaluating businesses. Once you are in the businesses of evaluating businesses and you decide that you are going to bring the effort and intensity and time involved to get that job done, then I think diversification is a terrible mistake to any degree. I got asked that question the other day at SunTrust. If you really know businesses, you probably shouldn’t own more than six of them.

If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don’t diversify personally. All the people I’ve known that have done well with the exception of Walter Schloss, Walter diversifies a lot. I call him Noah, he has two of everything.

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[Q - How do you get confident enough with that [smaller] level of diversification?]

WB: If we were running only our own money, putting 75% of our net worth in a single position is not a problem if it is something we really have high confidence in. Putting 500% or more of your net worth in a position is a problem. Several times I have had 75% of my non-Berkshire net worth in a situation. You will see things where it would be a mistake not to act. You won’t see them often, and the press and your friends won’t be talking about them. Wouldn’t you say, Charlie? 75% is not a real significant amount?

CM: Sometimes, I have had more than 100% in an individual investment.

WB: You just had a good banker. Look at LTCM — they put 25x their money in things that had to converge but couldn’t play out the hand. There are people in this room with more than 90% of their worth in Berkshire. I saw things in 2002 in junk bonds that would have been worth going heavily into. You could have bought Cap Cities in 1974 — selling for one-third the property value, with the best manager, and in a good business. You could have put 100% in Coca-Cola when we bought it and that wouldn’t have been a dangerous position.

CM: Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the exact rule is the opposite. The ‘know-nothing’ investor should practice diversification, but it is crazy if you are an expert. The goal of investment is to find situations where it is safe not to diversify. If you only put 20% into the opportunity of a life-time, you are not being rational. Very seldom do we get to buy as much of any good idea as we would like to.

Would you consider spinning off some companies to realize value?

Buffett: We will not be spinning off any companies. We can’t wait to throw them [people who suggest spin offs] out of the office. We have a real advantage in allocating capital—moving money around. When we buy companies from people, we buy them for keeps. People can trust us to keep our word on this.

Munger: Wall Street sells that stuff [spin-offs] for fees. It doesn’t really do much for anyone. Short of some regulatory change, we’re unlikely to [spin something off].

Buffett: We have listened to presentation after presentation by investment bankers, but there is always a fee.

[Comment: A similar question was asked and addressed earlier in the meeting. Short of indefinite operating losses or intractable labor problems, Buffett is not going to spin-off subsidiaries like some poker player passing cards to his right in hopes of “realizing value,” when doing so would damage his reputation as a buyer (and keeper) of businesses.]

Why would you hold stocks forever, if the fundamentals change permanently? (Buy and hold)

Buffett: We don’t—we sell plenty. If we lose confidence or conditions change, we sell. When in doubt, we keep holding. But for [our wholly-owned] companies, we hold and won’t sell unless a company promises to lose money indefinitely, or there’s a labor problem. We buy for keeps and won’t sell, even if the offer is for more than [the company is] worth. If we were wrong, we sell. Last year, I sold a couple of billion dollars’ worth of Johnson & Johnson just to raise cash for other purposes—an unusual situation. Someone asked us earlier what we’d do differently if we owned the whole company [Berkshire]. The answer is: nothing. We run Berkshire as if we owned 100%. Our peculiarity is our commitment to buy for keeps. People who sell their businesses to Berkshire know we won’t hire some management consultant or leverage it up, and that’s a real advantage.

Munger: The Berkshire system has legs, as they say in show business.

Why do you think more people don't follow your advice?

The advice doesn’t promise enough...it’s not a “get rich quick” scheme, which is what a lot of other philosophies promise.

Why do you think that despite making your methods publicly available, that relatively few people have been able to emulate your success?

I asked Graham the same question. Everyone took his class at ColumbiaBusiness School. He used current examples, and by the end of the semester you would have a portfolio that would’ve made you money. Graham lived a life of sharing. He may have had more money hoarding, but lived happier because of it. The money’s just a figure in the paper, perhaps he would’ve died with 86 million instead of 42 million, but it doesn’t really matter. 90% of the people that took his class ended up doing something else.

At age 11 I started investing, purchasing three shares of Cities Service Preferred. I had read every book on investing in the Omaha library. I was really into charting and technical analysis. I loved it, but didn’t make any money from it. At 19 I read Graham’s “The Intelligent Investor” and it changed my world. Did Ben lose because I read his book? Maybe we competed and he made less money, but it didn’t matter to Graham.

The philosophy either takes immediately or it doesn’t at all. The reason gets down to temperament. People want to make money fast, but it doesn’t happen that way. Graham’s philosophy doesn’t promise enough for many people. You don’t know when it will happen, but you just wait for the fat pitches within your circle of competence. It’s not as exciting as guessing whether the stock price will go up the next day. Most investors in internet companies didn’t know the market cap. They were buying because they thought the stock would move, but if you asked them to write “I would buy XYZ company for $6 billion because”, they wouldn’t get halfway through the sentence. It’s the classic tortoise versus hare, bound to work over time. Charlie and I have educated competitors. Most don’t compete with us, though. It’s fine, we have more than enough money.

What have been your best investments ever?

See’s was very important to us to learn about [running a] business, and to provide cash for a lot of other things.

[Also,] buying the first half of GEICO for $40 million, given what we’ve gotten out of it and its future potential. (We later paid $2 billion for the 2nd half.) GEICO still has enormous possibilities for growth.

In the past I’ve touted the American Express card – well today, I’m going to tout the GEICO credit card. That being said, I advise you to pay off your credit card. It’s a terrible mistake to get hooked on revolving credit at high interest rates.

I met with 21 groups of students last year and what I tell them is, even if you don’t remember anything else I say, please don’t get hooked on credit card debt.

GEICO is a great, great business model, run by a superb person and businessman, Tony Nicely.

[CM: The search expenses that brought us Ajit Jain – I cannot think of a better investment. This is a good life lesson: getting the right people into your system is the most important thing you can do.]

Could you give us your definition of stock market risk

We think first in terms of business risk. The key to Graham's approach to investing is not thinking of stocks as stocks or part of the stock market. Stocks are part of a business. People in this room own a piece of a business. If the business does well, they're going to do all right as long as long as they don't pay way too much to join in to that business. So we're thinking about business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature--there are just certain businesses that are very risky. Back when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial airplane as a sort of bet-your-company risk because you would shell out hundreds and hundreds of millions of dollars before you really had customers, and then if you had a problem with the plane, the company could go. There are certain businesses that inherently, because of long lead time, because of heavy capital investment, basically have a lot of risk. Commodity businesses have a lot of risk unless you're a low-cost producer, because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. We had fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren't the low-cost producers so it was a risky business. The guy who could sell it cheaper than we could made it risky for us. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself--whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market. The stock market is there to serve you and not to instruct you. That's a key to owning a good business and getting rid of the risk that would otherwise exist in the market.

You mention volatility--it doesn't make any difference to us whether the volatility of the stock market is a half a percentage of a point a day, or a quarter percent a day, or five percent a day. In fact, we'd probably make a lot more money if volatility was higher because it would create more mistakes in the market. Volatility is a huge plus to the real investor. Ben Graham used the example of Mr. Market. Ben said that just imagine that when you bought a stock you in effect bought into a business where you have this obliging partner who comes around every day and offers you a price at which he'll either buy or sell and that price is identical. No one ever gets that in a private business, where daily you get a buy-sell offer by a party. But you get that in the stock market, and that's a huge advantage. And it's a bigger advantage if this partner of yours is a heavy-drinking manic depressive. (laughter) The crazier he is, the more money you're going to make. So, as an investor, you love volatility. Not if you're on margin, but if you're an investor you're not on margin, and if you're an investor you love to get these wild swings because it means more things are going to get mispriced. Actually, volatility in recent years has dampened from what it used to be. It looks bigger because people think in terms of Dow points, but volatility was much higher many years ago than it is now. The amplitude of the swings used to be really wild and that gave you more opportunity. Charlie?

[CM: Well it came to be that corporate finance departments at universities developed the notion of risk-adjusted returns. My best advice to all of you would be to totally ignore this development. Risk had a very good colloquial meaning, meaning a substantial chance that something could go horribly wrong, and the finance professors sort of got volatility mixed up with a bunch of foolish mathematics and to me it's less rational than what we do. And I don't think we're going to change.]

Finance departments believe that volatility equals risk. They want to measure risk, and they don't know how to do it, basically. So they said volatility measures risk. I've often used the example of the Washington Post's stock. When I first bought it in 1973 it had gone down almost 50%, from a valuation of the whole company of close to $170 million down to $80 million. Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for $80 million than if you bought it for $170 million. That's something I've thought about ever since they told me that 25 years ago and I still haven't figured it out. (laughter)

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One key aspect to risk is how long you expect to hold an investment, i.e., stock in Coca Cola might be very risky if bought for a day trade or to hold for only a week. But, over a 5 or 10 year period it probably has almost no risk at all.

The myth that volatility of a stock somehow equates to risk was discussed. In fact, volatility often creates great opportunity, in Buffett's view. The following comments on risk in investments were in the 1993 Annual Report, on page 14:

"Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire's capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart- and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury".

Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong".

For owners of a business - and that's the way we think of shareholders - the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?

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"We regard using [a stock's] volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. Some great businesses have very volatile returns -- for example, See's usually loses money in two quarters of each year -- and some terrible businesses can have steady results.

[Munger: "How can professors spread this? I've been waiting for this craziness to end for decades. It's been dented, but it's still out there."]

If someone starts talking to you about beta, zip up your pocketbook."

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We think the best way to minimize risk is to think. Our default is [to have our capital] in short-term instruments and only do something when it makes sense.

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[RE: Beta]

Volatility does not measure risk. The problem is that the people who have written about and taught volatility do not understand risk. Beta is nice and mathematical, but it’s wrong. Past volatility does not determine risk.

Take farmland here in Nebraska: the price of land went from $2,000 to $600 per acre. The beta of farms went way up, so according to standard economic theory, I was taking more risk buying at $600. Most people would know that’s nonsense because farms aren’t traded. But stocks are traded and jiggle around and so people who study markets translate past volatility into all kinds of measures of risk. The whole concept of volatility is useful for people whose career is teaching, but useless to us.

Risk comes from the nature of certain kinds of businesses by the simple economics of the business, and from not knowing what you’re doing. If you understand the economics and you know the people, then you’re not taking much risk.

Munger: We’d argue that what’s taught is at least 50% twaddle, but these people have high IQs. We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them. [Laughter]

Buffett: We are willing to lose $6 billion in one catastrophe, but our insurance business over time is not very risky. If you own a roulette wheel, you sometimes have to pay 35-to-1, but that’s okay. We would love to own a lot of roulette wheels.

How much and how does risk factor into your investment decisions? Would you invest in emerging markets?

In general, emerging markets are not great for me because I need to put a lot of money to work. Risk does not equal beta. Risk comes around because you don’t understand things, not because of beta. There are normally 10 filters or so that I go through when I hear an idea. The first is can I understand the business and understand the downside not just today but five to ten years from now. There have been very few times that I’ve lost 1% of my net worth. I might be risk averse but I am not action adverse. Mrs. B saved $500 over the course of 16 years to start and build Nebraska Furniture Mart. Tom Watson Sr of IBM said, “I’m smart in spots and I stay in those spots.” I just stay within my circle of confidence. When I bought Nebraska Furniture Mart in 1983, Mrs. B took cash and not Berkshire stock. Why? She didn’t understand the value of stock. She understood cash and that is what she took. I need only need to be right a few times and can let thousands of ideas go by.

Ted Williams, who wrote the “Science of Hitting,” broke the strike zone into 92 ball shaped sections. He knew, if hit in his sweet spot, he’d hit 430, a little further out, and he’d hit 350. You have to know your sweet spot. The beautiful thing about investing is that it’s a “No called strike game” where unlike baseball the only strikes in investing are when you swing. I don’t have to swing.

When I do invest, I don’t care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2. Avoid debt. I decided early on that I never wanted to owe more than 25% of my net worth, and I haven’t… except for in the very beginning. I like to play from a position of strength. I always try to have the odds in my favor. When I go to Vegas, I don’t go around putting $5 dollars on the blackjack tables. If someone wants to come to my room and put $5 on my bed, well that’s fine. I like those odds better.

What do you think of setting an asset allocation?

We don’t hold any committee meetings. The business of saying you should have 50% in stocks, 30% in bonds…it’s nonsense.

The idea of recommending that assets should be split 60/40 [between stocks and bonds], and then have a big announcement that you’re moving to 65/35 is pure nonsense. It just doesn’t make any sense.

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[CM: Berkshire doesn’t do much conventional asset allocation. We just search for good opportunities and don’t want to put up artificial barriers. In this sense, we’re totally out of step with modern portfolio management, but we think they’re wrong.]

Well over 80% of our assets are in the U.S.

[CM: When have you ever done a big asset allocation?]

Never. But if junk bonds had stayed low for longer, we could have invested $30 billion instead of $7 billion.

How often do you review each position in your portfolio?

Buffett: It breaks down into two periods of my life: when I had more ideas than money, I was constantly reviewing my portfolio, figuring out which stock to unload to buy a new one.

Today, I have more money than ideas so we aren’t really thinking of selling when the alternative is cash. But we’re always collecting information on every company we own – it is a continuous process, but not with the idea that daily, weekly or monthly activity will result.

If we needed money for a very big deal, $20-, $30- or $40-billion, and we had to sell $10 billion in equities, we’d use information we’ve been collecting daily to decide what to sell.

Munger: Even in Warren’s early days, he wasn’t thinking about his #1 choice [his single favorite stock] – he could put that aside [because he’d never sell it].

Buffett: We think about adding more to certain stocks and have done so. We add to ones that look attractive and that we can buy. If you look at the portfolio at the end of 2007 you’ll see that certain positions have been increased by billions of dollars. We like many of our positions and if they get cheap, we’ll buy more.

Sometimes there’s not enough stock or we might cross certain thresholds that cause reporting requirements or going above 10%, which triggers the short-swing rule.

Munger: It’s not as easy as it looks to buy these big positions. When we were buying Coca-Cola, we bought every share we could – we bought 30-40% of the volume, yet it still took us a long time to accumulate our position. However, we like it better when we have these problems now than when we didn’t earlier.

Buffett: We usually feel we can buy 20% of the daily volume and not move the market too much. That means if we want to buy $5 billion, we have to wait for $25 billion to trade and not a lot of stocks trade that much.

What are your expectations for future returns on stocks?

When I closed the Buffett Partnership, I felt (and wrote to my investors) that the prospective return was about the same for equities and municipal bonds over the next decade, and I was roughly right. It’s not the same today. I’d have 100% of bonds in short-term bonds. Forced to choose between owning the S&P 500 vs. 20-year bonds, I’d buy stocks – and it would not be a close decision. But I wouldn’t have an equity investment with someone who charged high fees.

We don’t have the faintest idea where the S&P or bonds will be in three years, but over 20 years we’d prefer to own stocks.

Munger: We think there will be a disruption not too many years ahead.

Buffett: Of course, you could have said that and have been right at any point in the past century – there are always disruptions – but stocks have still done well. We’d rather have good stocks than sit around and hope they get cheaper, so anytime we see something good, we buy, hopefully in size.

[Q - If you were to follow up on your Fortune article from 1999 about the lean and fat periods (Mr. Buffett on the Stock Market), what would you be writing? You talked about 17-year periods. How is it turning out now, since we’re halfway through the next one?]

There’s nothing magical about 17-year periods – I just had a little fun with it because there were two 17-year periods, and there are 17-year locusts.

In 1999, people were extrapolating from the experience of the previous 17 years and had unrealistic expectations. They were bound to be disappointed.

If I were writing something now, I’d say I’d have expectations beyond 4.75% – I don’t know how much more, but more for sure. I would not have high expectations for equities, but better than for bonds.

Munger: Since that article was written, the experience from owning equities has been pretty lean, so Warren’s been right so far and I suspect is right now to have modest expectations.

Buffett: It’s hard to be right every day or week or month – that’s what happens if you’re on TV too often. [Tilson - He mentioned 1974 and a few other years in which he made market predictions; I wrote a column about this in 1999, Buffett’s Prescient Market Calls, suggesting my readers heed Buffett’s warning in the Fortune article. Incidentally, Buffett’s Market Call #5 highlighted in my article proved to be particularly correct: from 1993-2002 the S&P 500 compounded at 9.4% annually, far less than the 16.1% of the 10 previous years]. But every now and then, things really get out of whack. But the gradations in between are too tough. If you own great businesses, you should just hold on most of the time, maybe sell if the valuations get extremely high and buy more if they get really cheap like in the early 1970s.

Do you expect the stock market premium to continue to be 6.5% over bonds?

I don't think that the stock market will return 6.5% over bonds in the future. Stocks usually yield a little more, but that isn't ordained. Every once in a while, stocks will get very cheap, but it isn't ordained in scripture that this is so. Risk premiums are mostly nonsense. The world isn't calculating risk premiums.

The best book prior to Graham was written by Edgar Lawrence Smith in 1924 called Common Stocks as Long Term Investments. It was a study that evaluated how bonds compared to stocks in various decades of the past. There weren't a whole lot of publicly traded companies back then. He thought he knew what he was going to find. He thought that he'd find that bonds outperformed stocks during periods of deflation, and stocks outperformed during inflationary times. But what he found was that stocks outperformed the bonds in nearly all cases. John M. Keynes then enumerated the reasons that this was so. He said that over time you have more capital working for you, and thus dividends would grow higher. This was novel information back then and investors then went crazy and started buying stocks for these higher returns. But then they started to get crazy, and no longer really applied the sound tactics that made the reasons given in the book true. Be careful that when you buy something for a sound reason, make sure that the reason stays sound.

If you buy GM, you need to write the price and the respective market valuation. Then write down why you are buying the business. If you can't, then you have no business doing it.

Quote from Ben Graham: “You can get in more trouble with a sound premise than an unsound premise because you'll just throw out the unsound premise”.

You have espoused a constant ROE on the stock market of about 13%, over time. Do you think that such an expectation is reasonable if you factor into equity and ROE the effect of stock options granted to managements? When option programs are present in a company, what do you think is a realistic way of valuing them on a cash basis?

The questioner is Jon Brandt, the son of a very good friend of mine for many years. Jon is referring to an article I wrote for Fortune in the 1970’s - and he’s also referring to the tremendous ROE shown on the S&P 500, which includes the effects of restructurings.

Even allowing for the effects of stock options, I have still been surprised by the returns on equity shown by the S&P 500. As for options, we look at what the value of average option issuance is going to be over the next five years and figure what they’d be worth as warrants to the [issuing] company. That’s what we use as a cost to shareholders.

This should be shown as an expense in the income statement. I think a number of auditors believed it should be a cost but their clients pressured them and caved, and then Congress got called in. I think it’s a scandal. Charlie?

[Munger: It’s fundamentally wrong not to have honest accounting. It’s wrong to have little corruptions, that later can become big corruptions. The accounting in America is corrupt. It is not a good idea to have corrupt accounting.

It’s like campaign reform. Once you get a number of players benefitting, it’s hard to get reform. It’s the same thing with options accounting. It would have been better to have reform a couple decades ago, when it wasn’t such a big thing.

That doesn’t mean that we’re against options. They could make sense here at some point, but not with Charlie and me.

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[CM: 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.]

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?]

[CM: 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.]

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.

Do you think investors expect too much?

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.

[CM: My attitude is slightly more negative than Warren's.]

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.

[CM: 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.]

Maybe we should export all economists to China.

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[Re: NYSE’s Merger with Archipelago]

I personally think it would be better if the NYSE remained as a neutral, not-for-big-profit institution. The exchange has done a very good job over the centuries. It’s one of the most important institutions in the world.

The enemy of investment success is activity. The exchange of yesterday will be better for the American investor. I know the American investor will not be better off if volume doubles on the NYSE, and I know the NYSE will be trying to figure out how to do that if it is trying to maximize its own earnings per share.

Trading is the frictional cost of capitalism. GM or IBM will not earn more money if their stock turns over more actively, but a for-profit NYSE will.

[CM: I feel the same, only more strongly. I think we have lost our way when people like the [board of] governors and the CEO of the NYSE fail to realize they have a duty to the rest of us to act as exemplars. I don’t think you want to turn the stock exchange of the country into an even larger casino than it is already.

You do not want your first-grade school teacher to be fornicating on the floor or drinking booze in the classroom; similarly you do not want your stock exchange to be setting the wrong moral example. I am appalled.]

I wish I’d gone to first grade where he did. (Laughter)

What's your investment hurdle rate?

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.

[CM: 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.]

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].

Do you prefer public or private investments?

Berkshire has previously said that they would prefer more private investments but have trouble finding suitable ones. At the present time, the public market offers more opportunity. There are very few good private situations around and those that are available tend to be overpriced. Berkshire has a billion dollars in cash at present.

Buffett says there is more possibility of significant "mispricing" in the public stock market. This is because emotion plays a larger role in the public market, and the very superficial knowledge with which most investors operate. Owners of significant private business on the other hand, tend to have a much better idea of what their businesses are really worth.

There is very tough competition currently for the few good private businesses of decent size from: MBO funds or LBO funds. Typically these funds are run by people using other people's capital; they benefit from upside but don't suffer as much from downside since it is not their money that is at stake. Therefore, they are less worried about overpaying for a business

Other public companies. They don't mind overpaying; management of these types of companies are often more focused on size, than on return on investment and often are not big shareholders. These types of buyers don't mind issuing new stock in payment, whereas Berkshire doesn't like to issue new common stock.

Buffett definitely feels that the "stock market is far less efficient than the private market".

Investors eventually repeat their mistakes. How can you prevent this--through fast growth or safety?

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety in terms of driving only drive a 4,000 pound truck across. It depends on the nature of the underlying risk. We don't get the margin of safety now that we got in the 1970s.

The best thing is to learn from other guys' mistakes. Patton used to say, "It's an honor to die for your country; make sure the other guy gets the honor." There are a lot of mistakes that I've repeated. The biggest one, the biggest category over time, is being reluctant to pay up a little for a business that I knew was really outstanding. The cost of that I think is in the billions, and I'll probably keep making that mistake. The mistakes are made when there are businesses you can understand and that are attractive and you don't do something about them. I don't worry at all about the mistakes that come about like when I met Bill Gates and didn't buy Microsoft or something like that. Most of our mistakes have been mistakes of omission rather than commission.

Why do large caps outperform small caps?

We don't care if a company is large cap, small cap, middle cap, micro cap. It doesn't make any difference. The only questions that matter to us:

  • Do we understand the business?
  • Do we like the people running it?
  • And does it sell for a price that is attractive?

From my personal standpoint running Berkshire now because we got, pro forma for Gen. Re, $75 to $80 billion to invest in and I only want to invest in five things, so I am really limited to very big companies. But if I were investing $100,000, I wouldn't care whether something was large cap or small cap or anything. I would just look for businesses I understood.

Now, I think, on balance, large cap companies as businesses have done extraordinarily well the last ten years--way better than people anticipated they would do. You really have American businesses earning close to something 20% on equity. And that is something nobody dreamed of and that is being produced by very large companies in aggregate. So you have had this huge revaluation upwards because of lower interest rates and much higher returns on capital. If America business is really a disguised bond that earns 20%, a 20% coupon it is much better than a bond with a 13% coupon. And that has happened with big companies in recent years, whether it is permanent or not is another question. I am skeptical of that. I wouldn't even think about it--except for questions of how much money we run--I wouldn't even think about the size of the business. See's Candy was a $25 million business when we bought it. If I can find one now, as big as we are, I would love to buy it. It is the certainty of it that counts.

What is the definition of Value vs. Growth stocks?

No two distinct categories of business. PV of cash a company generates is what the business is worth. No distinction in our mind between growth & value. All decision you decide how much value you are going to get. When we buy a stock we think of it in terms of buying the whole enterprise.

Aesop's wrote the first investment primer "A bird in the hand (Lay out cash today) is worth two in the bush". Esop forgot to say when you get the two in the bush and what the interest rate was. People associate growth with the birds in the bush but they still have to figure out when they get the birds. People often are not thinking of the mathematics implicit in what they are doing.

[CM: All intelligent investing is value investing; then acquire more than you are paying for. Investing is where you find a few great companies and then sit on your ass.]

From the partnership letters in 1964, you had a strategy called ‘generals relatively undervalued.’ We have recently begun to implement a technique where we buy something at 12x, when comps sell at 20x. Comps go to 10x. Is this pair trading?

Yes, we didn’t know we started so early. Ben Graham did it in 1920. He did pair trading. He was right 4 out of 5, but the last one would kill him. We shorted the market to some degree. We would borrow stocks from universities. We were early in this. We wouldn’t short a stock because it was unattractive but as a general market short [hedge]. I would borrow from the Treasurer of Columbia [University], “which ones do you want”, “just give me all of them”. It provoked some odd looks when I told the universities I wanted to short all of their stocks. It was not a big deal. We might have made a little money on it in the 1960s, but it is not something we do these days. If you have good long ideas on businesses that are undervalued, it is not necessary to short. 130/30 [simultaneously holding a 130% exposure to a long portfolio; and a 30% exposure to a short portfolio] is being marketed today. Many will sell you the idea of the day. No great statistical merit.

CM: We made our money by being long wonderful businesses, not by using a long-short strategy.

Importance of filtering out the noise?

[CM: Part of [having uncommon sense] is being able to tune out folly, as opposed to recognizing wisdom. If you bat away many things, you don’t clutter yourself.]

People get frustrated because they start to pitch something to us and when they get halfway through the first sentence, we say we’re not interested. We don’t waste a lot of time on bad ideas.

When humans compete against computers in chess, how can human compete? The human eliminates 99% of possibilities without even thinking about it – they get right down to few possibilities that have any chance of success. They get rid of the nonsense.

When people call you with bad idea, don’t be polite and waste 10 minutes.

What is the benefit of being an out-of-towner as opposed to being on Wall Street?

I worked on Wall Street for a couple of years and I have my best friends on both coasts. I like seeing them. I get ideas when I go there. But the best way to think about investments is to be in a room with no one else and just think. And if that doesn’t work, nothing else is going to work. The disadvantage of being in any type of market environment like Wall Street in the extreme is that you get over-stimulated. You think you have to do something every day. The Chandler family paid $2,000 for this company (Coke). You don’t have to do much else if you pick one of those. And the trick then is not to do anything else. Even not to sell at 1919, which the family did later on. So what you are looking for is some way to get one good idea a year. And then ride it to its full potential and that is very hard to do in an environment where people are shouting prices back and forth every five minutes and shoving reports in front of your nose and all that. Wall Street makes its money on activity. You make your money on inactivity.

If everyone in this room trades their portfolio around every day with every other person, you will all end up broke. And the intermediary will end up with all the money. If you all own stock in a group of average businesses and just sit here for the next 50 years, you will end up with a fair amount of money and your broker will be broke. He is like the Doctor who gets paid on how often to get you to change pills. If he gave you one pill that cures you the rest of your life, he would make one sale, one transaction and that is it. But if he can convince you that changing pills every day is the way to great health, it will be great for him and the prescriptionists. You won’t be any healthier and you will be a lot worse off financially. You want to stay away from any environment that stimulates activity. And Wall Street would have the effective of doing that.

When I went back to Omaha, I would go back with a whole list of companies I wanted to check out and I would get my money’s worth out of those trips, but then I would go back to Omaha and think about it.

There is always mention that some of your success could be attributed to not buying in to the Wall Street mania b/c you are in Omaha—what importance do you give to balance as it pertains to work and life and what do you do to maintain your appropriate balance?

I have so much fun that it’s not work. I get to do what I want, where I want – on a boat, wherever. My wife was responsible for bringing up the children. Neither of us had problems with that arrangement, and it made sense from an Adam Smith “division of labor” perspective. It will be a much tougher choice for women, and always be somewhat unequal. In my own life I did virtually no social functions or meetings that I didn’t want to do. In my adult business life I have never had to make a choice of trading between professional and personal. I have simple pleasures. I play bridge online for 12 hours a week. Bill and I play, he’s “chalengr” and I’m “tbone”.

After a talk at Harvard, I told them to work for who they admired the most, so they all become self-employed. It’s important to go to work for someone or some organization you admire. I’ve not seen many males having to make tough choices. But women are the ones who have tough situations.

There are a record number of ‘value’ investors here this year. Are there fewer $100 bills? Should I go to run a business instead of being a value fund manager?

WB: There will always $100 bills, but less at times. There are always conflicts. Asset gathering can be more important than asset managing. There will always be opportunities to outperform. People still make the same mistakes. Charlie has a company called the Daily Journal Company. I own 100 shares. I got their annual report, and in fiscal year 2009, they bought $15m of stock, and it is now worth $45m. They sat on cash for a long time, but opportunities come around. You have to be prepared to grab them. Definitely it is possible with moderate amounts of money. Charlie will be more pessimistic.

CM: Take the high road, it is far less crowded.

WB: Those who take the high road in Washington are seldom bothered with traffic.

WB: Money management – it is easy to scale up. It would have been harder for me to work as a plant manager. I wouldn’t want to become superintendent right about the time they are going to give me a gold watch.

Do you ever change your investing standards?

Did we change our standards? You know, I don’t think so, but you can’t be 100% sure. If you haven’t had a date for a month, you might say you wouldn’t have dated that girl on the first day – but I think we would have.

It does not reflect our giving up on finding an elephant of a business to acquire. We have plenty of cash and could sell stocks if we really needed to. We’re well prepared to acquire a very large business.

We acquired TTI in the first quarter, which is a terrific business. We wish it were five times bigger, but maybe some day it will be.

Munger: The one thing I think we can promise you is that we won’t make the kinds of returns buying the things we are now that we earned on the stuff we bought 10-15 years ago. There’s just too much money floating around.

Buffett: We won’t come close.

Munger: It’s a different world with more modest expectations.

Buffett: We hope you share them.

Have there been instances in your career where you have been tempted to deviate from your strategy and if so, how did you handle that?

I’m not that type. I’m not disciplined. [BRK2003 - I'd feel more qualified to talk about self-discipline if I weighed about 20 pounds less.] I just naturally want to do things that make sense. In my personal life too, I don’t care what other rich people are doing. I don’t want a 405 foot boat just because someone else has a 400 foot boat. Some of my friends have big boats where 55 people are serving 14. Of those 55, some will be stealing from you, some will be sleeping with each other, and I just don’t want to deal with that. My friends have the boats, so I’m the ultimate freeloader. I don’t need multiple houses. If I wanted to do something wild & crazy I could do it, but Anna Nicole Smith is gone. Reminds me of the story of the 60 year old man that got a 25 year old to marry him. When his friends asked how he did it, he replied, “I told her I was 90.”

When did you know you were rich?

I really knew I was rich when I had $10,000. I knew along time ago that I was going to be doing something I loved doing with people that I loved doing it with. In 1958, I had my dad take me out of the will, as I knew I would be rich anyway. I let my two sisters have all the estate.

I bet we all in this room live about the same. We eat about the same and sleep about the same. We pretty much drive a car for 10 years. All this stuff doesn't make it any different. I will watch the Super Bowl on a big screen television just like you. We are living the same life. I have two luxuries: I get to do what I want to do every day and I get to travel a lot faster than you.

You should do the job you love whether or not you are getting paid for it. Do the job you love. Know that the money will follow. I travel distances better than you do. The plane is nicer. But that is about the only thing that I do a whole lot different.

I didn't know my salary when I went to work for Graham until I got his first paycheck. Do what you love and don't even think about the money. I will take a trip on Paul Allen's Octopus ($400M yacht), but wouldn't want one for myself. A 60 man crew is needed. They could be stealing, sleeping with each other, etc. Professional sports teams are a hassle, especially when you have as much money as him. Fans would complain that you aren't spending enough when the team loses.

If there is a place that is warm in the winter and cool in the summer, and you do what you love doing, you will do fine. You're rich if you are working around people you like. You will make money if you are energetic and intelligent. This society lets smart people with drive earn a very good living. You will be no exception.

How important is conviction in investing?

You didn’t have to have a high IQ or a lot of investment smarts to buy junk bonds in 2002, or certain other things after Long-Term Capital Management blew up. You just had to have the courage of your convictions and the willingness to act when everyone else was terrified and paralyzed. The lesson of following logic rather than emotion is obvious, but some people can follow it and some can’t.

[CM: When we were young, there weren’t very many smart people in the investment world. You should have seen the people in the bank trust departments. Now, there are armies of smart people at private investment funds, etc. If there were a crisis now, there would be a lot more people with a lot of money ready to take advantage.]

But in 2002, there were all these people with lots of money [and the opportunities were still there].

[CM: When you have a huge convulsion, like a fire in this auditorium right now, you do get a lot of weird behavior. If you can be wise [during such times, you’ll profit].]

Three years ago, you could find a number of companies in [South] Korea with strong balance sheets trading at three times earnings.

[CM: But there was a huge convulsion there.] Buffett: But that was 4-5 years ago. It had already passed.

[CM: You couldn’t name 20 more examples like it. [e.g., there are only a few examples in recent times of such weird behavior leading to huge, obvious bargains in entire asset classes.]]

Even if I could, I wouldn’t! [Laughter]

How do you avoid misjudgement?

WB said repeatedly that it doesn’t take above a 125 IQ to do this...in fact, IQ over this amount is pretty much wasted. It’s not really about IQ. - Staying within circle of competence is paramount - When you are within the circle, keep these things in mind:

  • Don’t get in a hurry
  • You are better off not talking to others
  • Just keep looking until you find something (don’t give up)
  • Good ideas come in clumps – by time, by sector, by asset class

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[Avoiding Mental Mistakes]

The first step is to recognize the traps. Charlie, in Poor Charlie’s Almanack, talks about various traps, so read that book.

Our personalities are such that we’re probably less prone to falling into these traps, but it still happens – just less than before.

[CM: You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.]

It reminds me of the story about the two guys being chased by the bear and one guy says to the other, “I don’t have to outrun the bear. I just have to outrun you!” (Laughter)

[CM: Peter Kaufman did it. He came up with the idea and Warren got excited about it. It’s a ridiculous name [the title]. (Laughter)

If you assimilate everything that’s in that simple book, you’ll be far ahead in the game.]

It’s a sensational book. You’ll learn a whole lot about life – and making money.

How do you improve independent thinking?

Good question. Very tough. Right now, I would pay a hundred-thousand dollars for 10 percent of the future earnings of any of you. So, if anyone wants to see me after this is over. If that’s true, you’re a million dollar asset right now, right? If ten percent of you is worth a hundred-thousand? You could improve on that, many of you, and I certainly could have when I got out, just in terms of learning communication skills.

It’s not something that’s taught, I actually went to a Dale Carnegie course later on in terms of public speaking. But if you improve your value 50 percent by having better communication skills, it’s another 500-thousand dollars in terms of capital value. See me after the class and I’ll pay you 150-thousand. You can dramatically increase your value by improving oral and written communication skills.

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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.

What are the key traits needed to correct the crowd mentality?

CM: He wants to know how to become less like a lemming.

WB: I started investing when I was 11. I believe in reading everything in sight. I wandered around for 8 years with technical analysis. I read The Intelligent Investor, chapters 8 and 20 I recommend the most, and if you absorb it you won’t be a lemming. I read it early in 1950, and I think it’s as good a book now as then. You can’t get a bad result if you follow it. The Intelligent Investor has three big lessons:

  1. think of a stock as a part owner- ship of a business;
  2. the market is there to serve you, not instruct you; and
  3. always require a margin of safety. Berkshire shareholders are better than most at understanding that they own a part of a business.

Don't you have a lot of competition to buy great businesses? For example, from private equity funds?

You are absolutely correct that the private equity funds are a form of competition for Berkshire. Stocks sometimes trade well below intrinsic value, but businesses are sold in a negotiated transaction, so pricing doesn’t get as extreme. But our strong preference is to buy entire businesses at a fair price rather than stocks, even if stocks [can be acquired] a bit cheaper.

If someone wants what we are offering, we are pretty much one-of-a-kind. People can sell their company to us, yet continue to run it as they please as long as they want. So, if someone needs liquidity for tax or inheritance or other reasons, but doesn’t want to auction their business off like a piece of meat, they can come to us and they know they’ll get the response they want. We don’t get super bargains this way, but it allows us to put money to work at a sensible price.

Acquisitions don’t come along every day.

If I owned a business that my father had started and wanted to monetize it, I would sell to Berkshire because I wouldn’t want to split it up to auction it off, just as it would be silly to auction your daughter off to the man who bids the most.

There is no-one else who can make the promises we can make [not to ever sell the acquired company]. Most big companies can’t do that because what if the board decides it wants a pure play? I tell sellers that I’m the only one who can double cross you – nobody else can. We don’t have consultants or Wall Street advisors.

But, yes, we do have a lot of competition.

[CM: We’ve had private equity competitors for a long time, but one way or another we’ve managed to buy quite a few things.]

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We are positioned very badly in terms of buying businesses. Berkshire will not do as well as long as this persists.

[CM: A lot of buying is fee motivated. Managers want to earn the extra fees on the extra assets. I have a friend who buys warehouses, but he stopped bidding recently because he’s always being outbid. Howard Marks sent a lot of money back to investors, which is the right way to behave [I assume he’s referring to one of the Principals of Oaktree Capital Management]]

Five or six years ago, I got a call from a well-known investor who asked me a lot of questions about reinsurance. He didn’t know much about the business, but he was considering buying a reinsurance company because, as he explained to me, he would have to send his investors’ money back to them if he didn’t invest it in the next few months, and he was earning 2% [annually] on it.

We [unlike this gentleman] have all of our net worth on the downside as well. If we have 2 and 20 [2% management fee and a 20% performance allocation] on the upside and nothing but a goodbye kiss on the downside...

The competition right now is tough, so our efforts to buy businesses are likely to be futile. But there are 1-2 deals we might get done...

[CM: I don’t think there’s any business that we’ve bought that would have sold itself to a hedge fund. There’s a class of businesses that doesn’t want to deal with private-equity and hedge funds...thank God. (Laughter)]

We don’t see any deals [recently] that we wish we’d made – this wasn’t true in the past – even if the price had been 10% lower. We’re in a different world right now.

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There’s no doubt that there’s far more money looking a deals now than in the past. They’re willing to pay up to buy good but mundane businesses that we’ve historically bought and had success with. Now it’s not just private equity funds getting in – hedge funds are too.

There’s been a bit of a change in the past few weeks, as it’s gotten a little harder to borrow money, but overall, we can’t compete, which makes us feel distress.

But it won’t go on forever. In the near term, we are not positioned favorably at all, but you’d be amazed at just how fast things can change. Things happen to change the landscape. At least three times in my career, there’s been so much money sloshing around. It was so bad in 1969 that I closed my partnership. But only four years later, it was the best time to be a buyer in my entire life.

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[Re: Closed-End Funds]

History shows that over time, almost all closed-end funds go to discounts. Initially, if they’re sold with a 6% commission, the initial people only get 94 cents on the dollar. If I could buy an open fund at X or a closed-end fund at 120% of X, then you’d have to convince me that the management is something special to buy the closed-end fund.

Occasionally, Charlie and I have seen closed-end funds that trade at a premium for a long time. Eventually they will come back down to earth.

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[Q - Is the private-equity boom a bubble?]

We’re competing with those people, so I started to cry, thinking about the difficulty of finding things to buy.

Due to the nature of private equity, it’s not a bubble that will burst. They lock up their money for 5-10 years and buy businesses that don’t price daily. It takes many years for the score to be put on the board and the investors can’t leave. It’s not like leverage in marketable securities.

What would slow it down is if the spread between high-yield bonds and safe bonds widens. This would slow down deals, but won’t cause investors to get their money back.

There’s another factor: if you have a $20 billion fund and get a 2% fee, you’re getting $400M a year. But you can’t raise another fund with a straight face until you’ve invested it, so there’s a great compulsion to invest it quickly so you can raise another fund and get more fees.

We can’t compete against these buyers. We buy forever and it’s our own money. I think it will be quite some time before disillusion sets in [among the investors in private-equity funds].

Munger: It can continue to go on for a long time after you’re in a state of total revulsion. [Laugher]

Buffett: The voice of total optimism has spoken. [More laughter]

How do you learn who to trust and who not to trust?

I get letters all the time from people who have been taken advantage of in financial transactions. It’s sad. A lot isn’t fraud – just the frictional costs and the baloney. Charlie and I have had very good luck buying businesses and putting our trust in people – it’s been overwhelmingly good, but we filter out a lot of people. People give themselves away and maybe it’s an advantage being around awhile and seeing how people give themselves away by what they talk about and what’s important and not important to them. We’ve had a batting average I wouldn’t have thought we’d have. We haven’t batted 100%, but it’s above 90%.

Munger: We’re deeply suspicious if the proposition sounds too good to be true. I recall a deal that was pitched to us by someone who said the company only wrote fire insurance on concrete bridges covered by water. It’s like taking candy from a baby. [Laughter] We stay away from businesses like that.

Buffett: When they make certain kinds of comments, what they laugh about, if they say “it’s so easy.” It’s not so easy. We rule out people 90% of the time. Maybe we’re wrong sometimes, but what’s important is the ones we let in. In the 1970s when I referred my clients to three people [as he closed down the Buffett Partnership], when I thought who they should turn over 100% of their money to, there were hundreds of people with great records. I recommended Charlie, Sandy Gottesman and Bill Ruane. I couldn’t have told you which of the three would be the best, but the one thing I was sure of was that they were going to be sensational stewards of money and do what was right for clients rather then try to make 2x in commissions in a given year. Anytime someone who takes what I think is an unfair fee structure because they can get it, I rule them out.

What's your philosophy on partnering with others?

We normally don’t want to do deals with partners. If we like a deal, we want to do it all. We have a lot of money, so we don’t need a money partner. As for a knowledge partner, we don’t want to do a deal where we’re relying on someone else. We’ve made a few exceptions, but very few. Charlie, can you think of any?

Munger: You did something with Leucadia, but they brought us the deal. [Click here for an article about this deal.]

Buffett: That’s right. They were great. But they invited us to participate in their deal. We came in on the same terms they had. In general, we don’t partner with others on deals, but I’d do another deal with Leucadia if they came to me and I liked the deal. That was a very good experience.

We know that you are a big bridge player. Do you think that bridge correlates to investing? Are there any traits or characteristics that might carry over from one to the other?

Bridge is the best game there is. You’re drawing inferences from every bid and play of a card, and every card that is or isn’t played. It teaches you about partnership and other human skills. In bridge, you draw inferences from everything and that carries over well into investing. In bridge, similar to in life, you’ll never get the same hand twice but the past does have a meaning. The past does not make the future definitive but you can draw from those experiences. I think the partnership aspect of bridge is a great lesson for life. If I’m going into battle, I want to partner with the best. I was playing with a world champion and we were playing against my sister and her husband. We lost, so I took the scorepad and I ate it.

Valuation

How do you think about value?

The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price. I don’t care if they close the NYSE for 5 years. I care more about the business than I do about events. I care about if there’s price flexibility and whether the company can gain more market share. I care about people drinking more Coke.

I bought a farm from the FDIC 20 years ago for $600 per acre. Now I don’t know anything about farming but my son does. I asked him, how much it cost to buy corn, plow the field, harvest, how much an acre will yield, what price to expect. I haven’t gotten a quote on that farm in 20 years.

If I were running a business school I would only have 2 courses. The first would obviously be an investing class about how to value a business. The second would be how to think about the stock market and how to deal with the volatility. The stock market is funny. You have no compulsion to act and a bunch of silly people setting prices all the time, it is great odds. I want the market to be like a manic depressive drunk. Graham’s Ch. 8, in the book Intelligent Investor, on Mr. Market is the most important thing I have ever read. Now think about the NYSE. You have thousands of companies to choose from. For me, that universe has shrunk because I need to put large dollar amounts to work. Attitude is much more important than IQ. You can really get into trouble with a high IQ, i.e. Long-Term Capital. You need to have the right philosophical temperament.

How do you calculate 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.

What do you believe to be the most important tools in determining intrinsic value? What rules or standards do you apply when using these tools?

If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years ... Businesses have coupons too, the only problem is that they're not printed on the instrument and it's up to the investor to try to estimate what those coupons are going to be over time. In high-tech businesses, or something like that, we don't have the faintest idea what the coupons are going to be. In the businesses where we think we can understand them reasonably well, we are trying to print the coupons out. If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out--not by selling it to somebody else, that's just a game of who beats who--but by the asset itself ... If you're an investor, you're looking on what the asset is going to do, if you're a speculator, you're commonly focusing on what the price of the object is going to do, and that's not our game. We feel that if we're right about the business, we're going to make a lot of money, and if we're wrong about the business, we don't have any hopes of making money.

[CM: I would argue that one filter that's useful in investing is the idea of opportunity costs. If you have one idea that's available in large quantity that's better that 98% of the other opportunities, then you can just screen out the other 98% ... With this attitude you get a concentrated portfolio, which we don't mind. That practice of ours which is so simple is not widely copied, I don't know why. Even at great universities and intellectual institutions. It's an interesting question: If we're right, why are so many other places so wrong.]

There are several possible answers to that question! (laughter) The first question we ask ourselves is, would we rather own this business than more Coca-Cola, than more Gillette .... We will want companies where the certainty gets close to that, or we would figure we'd be better off buying more Coke. If every management, before they bought a business, said is this better than buying in our own stock or even buying Coca-Cola stock, there'd be a lot less deals done. We try to measure against what we regard as close to perfection as we can get.

Could you comment on the matter of intrinsic value as it applies to some of the Inevitables?

Well, we won't stick a price on it. They are absolutely wonderful businesses run by sensational people, and they are selling at prices that are higher than they've sold at most of the time. But they may well be worth it, either in present terms, or they may be a couple of years ahead of themselves. Gillette doesn't repurchase their shares ... Coke consistently repurchases their shares. We generally like the policy of companies that have really wonderful businesses repurchasing their shares. The problem with most companies repurchasing their shares is that they are frequently so-so businesses and they are repurchasing shares for purposes other than intensifying the interest of shareholders in a wonderful business. It's hard to do things intelligently with money in this world and Coke has been very intelligent about using their capital, particularly to fortify and develop their bottler network around the world, but there's only so far you can go with that, and to enhance the ownership of shareholders in a company like Coca-Cola [is great].

The bottling is actually kind of interesting ... Asa Canver back in the late 1880's essentially bought the whole Coca-Cola company for $2,000, and that may be the smartest purchase in the history of the world. Then in 1889, a couple of guys from Chattanooga came along, and in those days soft drinks were sold over the counter, and they said bottling's got a future and you're busy with the pump side of the business, so why don't you let us develop the bottling side of the business. And I guess Mr. Canver didn't think much of bottling, so he gave them a contract that gave them the rights, in perpetuity for almost all of the United States, and gave them the right to buy Coca-Cola syrup at a fixed price forever. (audience groans) So Asa, who had scored with his $2,000 in a major way, seems to have made one of the dumbest contracts in history.

And the Coca-Cola company was faced over the years with the problem of having this bottling system which soon became the dominant system of distribution for Coke, being subject to a contract where there was no price flexibility and where the contract ran for perpetuity. And of course every bottler on his deathbed would call his children and grandchildren around, and he would prop himself up, and he would croak out in his last breath, "Don't let 'em screw with the bottling contract." (laughter)

So the Coca-Cola company faced this for decades, and they couldn't really do anything about the bottling system for a long time, and Roberto and Don Keough and some other people spent 20, 25 years getting that rationalized ...it was a huge, huge project, but it made an enormous difference over time, and that's what I mean when I talk about intellectual capital. You know you're not going to get results on that in a day or a month or a year, but they decided that to get the job done they had to do this, and they used capital to get that job done, but they used capital beyond that to repurchase shares, and it's been very smart, and they're probably repurchasing shares even as we talk.

[CM: I do think the Coca-Cola company is one of the most interesting cases in the history of business, and it ought to be way more studied than it is. There's just lesson after lesson after lesson in the history of the Coca-Cola company. But it's too long a story for today.]

When you estimate intrinsic value in capital intensive companies like McDonald's and Walgreens where a very healthy and growing operating cash flow is largely offset by expenditures for new stores, restaurants, etc how do you estimate future free cash flow? And at what rate do you discount those cash flows?

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.

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We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind.

We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher? If government bonds are at 2%, we’re not going to buy a business that will return 4%.

I don’t call Charlie every day and ask him, “What’s our hurdle rate?” We’ve never used the term.

Munger: The concept of a hurdle rate makes nothing but sense, but a lot of people using this make terrible errors. I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about the returns from each.

The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. It’s like the mail-order-bride firm offering a bride who has AIDS – I don’t need to waste a moment considering it. Everything is a function of opportunity cost.

Buffett: I’ve been on 19 boards and seen a zillion presentations projecting a certain IRR [internal rate of return]. If the boards had burned them all, they’d have been better off. The IRR is based on what the CEO wants. The numbers are made up.

Munger: I have a young friend who sells private partnership interests to investors, and it’s hard to get returns in that field. I asked him, “What returns do you tell them you can get?” He said “20%.” I said, “How did you come up with that number?” He said, “If I told them anything lower, they wouldn’t give me the money.”

Buffett: There’s no one in the world who can earn 20% on big money. It’s amazing how gullible pension funds and other investors are. They want it so badly that they’ll believe even total nonsense.

Is the skill of judging risk just as important as calculating intrinsic value?

We perceive risk as items that impair future business. Wants to have mathematical risk on their side over a group of decisions. Not in the business of assuming a lot of risk in business. We look for moats around businesses. We look for castles (businesses) that have a moat surrounding it which is expanding as a primary consideration of a great business.

What valuation metrics do you use?

The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn't look at a single valuation metric like relative P/E ratio. I don't think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it's not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business's economic characteristics.

What do you think of the use of book values in making investment decisions?

Book value is virtually not a consideration in investment decision-making at Berkshire. Their pursuit of high return businesses usually leads to companies with minimal book values. He added that the book value approach could work well with small sums of money, like Graham had managed, and that the approach had worked well for Graham-type practitioners like Buffett’s friend Walter Schloss. The three most important concepts conveyed by Graham in “The Intelligent Investor” were the investor’s attitude toward the market, the “margin of safety”, and the practice of looking at companies as businesses, not stocks.

Munger proffered that “projections generally do more harm than good, and are usually prepared by persons who have some sort of an interest in the outcome of actions based on the projections. They often have a precision that’s deceptive.” Buffett added that they’ve never looked at a projection in connection with an equity or business that they’ve acquired. “It’s a ritual to justify doing what an executive or a board wanted to do in the first place.

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We have a bias toward investing in the U.S., but I bought my first stock outside the United States at least 50 years ago and we’ve looked at plenty of marketable securities overseas. It would make no difference to us if Coke was headquartered in Amsterdam.

But nobody outside the U.S. has heard of us. Eitan Wertheimer found us. The Iscar acquisition has contributed to our becoming better known. Eitan is going through a procedure to get us better known abroad. [Buffett did not give any details about this “procedure”.]

I haven’t done a good selling job abroad. We could be fairly criticized for not doing enough to become better known [overseas].

We own stocks in Germany and 4% of POSCO, which is based in South Korea – it’s now worth over $1 billion. I can think of a half dozen investments [we currently have] outside the U.S. We don’t have to report them in our [SEC Form] 13F, so they don’t get picked up like our domestic investments.

We have to report our holdings in Germany once we reach 3% ownership. So if we buy a $10 billion [market-cap] company, that means once we buy $300 million worth we have to tell the world, and Charlie and I don’t like doing that. It screws up our future buying, so the 3% rule is a real minus.

I can assure you that the entire world is on our radar screen and we hope to be on its radar screen.

Munger: John Templeton made a fortune being in Japan very early and stocks there went to 30-40x earnings. It was an admirable piece of investment, but you know, we did alright during the same period. [Laughter]

If you can’t talk with management, and can’t read the annual report, and didn’t know the price, but could only look at the financial statements, what metric would you look at?

WB: Investing is laying out money now to get more money later on. Let’s leave the market price out. If you were buying a farm, you would think about bushels per acre — you are looking to the asset itself. Ask yourself: do I understand enough about the business so that the financials will be able to tell me meaningful things that will help me to foresee the statements in the future? I have bought stocks the way you describe. They were in businesses I understood, and if I could buy at 40% of X, I’d be okay with the margin of safety. If you don’t tell me the nature of the business, financial statements won’t tell me much. We’ve bought many securities, and with most, we’ve never met management. We use our general understanding of business and look to specifics from financial statements.

CM: One metric catches people. We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.

WB: We could value an apartment if we knew where the apartment is, and we know the monthly checks. I have bought a lot of things off the financials. There is a lot I wouldn’t buy even if it had the best management in the world, as it doesn’t make much difference in a bad business.

How do you think about growth rates when you value businesses?

When the [long-term] growth rate is higher than the discount rate, then [mathematically] the value is infinity. This is the St. Petersburg Paradox, written about by Durand 30 years ago. [Click here for a copy of the original 1957 article. For more on this topic, I recommend Integrating the Outliers: Two Lessons from the St. Petersburg Paradox, by CSFB’s (now Legg Mason’s) Michael Mauboussin.]

Some managements think this [that the value of their company is infinite]. It gets very dangerous to assume high growth rates to infinity – that’s where people get into a lot of trouble. The idea of projecting extremely high growth rates for a long period of time has cost investors an awful lot of money. Go look at top companies 50 years ago: how many have grown at 10% for a long time? And [those that have grown] 15% is very rarified.

Charlie and I are rarely willing to project high growth rates. Maybe we’re wrong sometimes and that costs us, but we like to be conservative.

[CM: If your growth rate is so high that you conclude the business has an infinite valuation, you have to use more realistic numbers. What else could anyone do?]

How to Think About Businesses

What's your philosophy in buying businesses?

  • The first question I ask is: “Does the owner love the business or does he/she love the money?” It’s very easy to tell the difference.
  • I am proud to be able to provide a good home for many businesses. It is like finding a home for a painting. Business owners who are looking to sell can either sell their businesses to Berkshire (like putting painting in the Metropolitan Museum of Art) or sell to an LBO and let them tear it up, dress up the accounting, and resell it (like selling a painting to a porn shop).

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It's a question of being able to identify businesses that you understand and you are very certain about. If you understand those businesses, and many people do, but Charlie and I don't, then you have the opportunity to evaluate them. If you decide they're fairly priced and they have marvellous prospects, you're going to do very well. But there's a whole group of companies--a very large group of companies--that Charlie and I just don't know how to value. And that doesn't bother us. I mean, we don't know how to figure out what cocoa beans are going to do, or the Russian ruble--there's all kinds of financial instruments that we just don't feel we have the knowledge to evaluate. It might be a bit too much to expect somebody would understand every business in the world. We find some that are much harder for us to understand. When I say understand--my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few--six or eight, as you pointed out, or something like that. It would be better for you--it certainly would have been better for you if we had had the insights about what we regard as the more complicated businesses you describe--because there was and may still be a chance to make a whole lot more money if those growth rates that you describe are maintained. I don't think you'll find better managers than Andy Grove at Intel or Bill Gates at Microsoft and they certainly seem to have fantastic positions in the businesses they're in, but I don't know enough about those businesses to be sure that those businesses are fantastic as I am about being sure that Gillette and Coca-Cola's businesses are fantastic. You may understand those businesses better than you understand Coke and Gillette because of your background or just the way your mind is wired. But I don't, and therefore I have to stick with what I really think I can understand.

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We favor businesses where we really think we know the answer. If we think the business’s competitive position is shaky, we won’t try to compensate with price. We want to buy a great business, defined as having a high return on capital for a long period of time, where we think management will treat us right. We like to buy at 40 cents on the dollar, but will pay a lot closer to $1 on the dollar for a great business.

If we see someone who weighs 300 pounds or 320 pounds, it doesn’t matter – we know they’re fat. We look for fat businesses.

We don’t get paid for the past, only the future [profitability of a business]. The past is only useful to give you insights into the future, but sometimes there’s no insight. At times, we’ve been able to buy businesses at one quarter of what they’re worth, but we haven’t seen that recently [pause] except South Korea.

Munger: Margin of safety means getting more value than you’re paying. There are many ways to get value. It’s high school algebra; if you can’t do this, then don’t invest.

Munger: When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly.

Buffett: Let’s say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7% return, so you’d pay $1,000/acre. If it’s for sale at $800, you buy, but if it’s at $1,200, you don’t.

Buffett: If you’re going to buy a farm, you’d say, “I bought it to earn $X growing soybeans.” It wouldn’t be based on what you saw on TV or what a friend said. It’s the same with stocks. Take out a yellow pad and say, “If I’m going to buy GM at $30, it has 600 million shares, so I’m paying $18 billion,” and answer the question, why? If you can’t answer that, you’re not subjecting it to business tests.

We have to understand the competitive position and dynamics of the business and look out into the future. With some businesses, you can’t. The math of investing was set out by Aesop in 600 BC: a bird in the hand is worth two in the bush. We ask ourselves how certain we are about birds in the bush. Are there really two? Might there be more? We simply choose which bushes we want to buy from in the future.

The ability to generate cash and reinvest it is critical. It’s the ability to generate cash that gives Berkshire value. We choose to retain it because [we think we can reinvest each dollar to generate more than $1 of value].

If you were thinking about paying $900,000 or $1.3 million for a McDonald’s stand, you’d think about things like whether people will keep eating hamburgers and whether McDonald’s could change the franchise agreement. You have to know what you’re doing and whether you’re within your circle of competence.

Munger: We have no system for estimating the correct value of all businesses. We put almost all in the “too hard” pile and sift through a few easy ones.

Buffett: We know how to recognize and step over one-foot bars and recognize and avoid seven-foot bars.

What is 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!

[CM: 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.]

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.

[CM: I'm uncomfortable with that, which is why we say negative things [to discourage others from trying to do what we do]].

What makes a great business?

The best businesses can maintain their earnings without continued reinvestment, whereas in the worst you have to keep pouring money into a money-losing business.

The best business is being the best surgeon in town. You don’t have to do any reinvestment – the investment was the education. The surgeon will retain his earnings power, regardless of inflation.

[Untapped pricing power. The measure of a great business.]

We like buying businesses with some untapped pricing power. For example, when we bought See’s for $25 million, I asked myself, “If we raised prices by 10 cents per pound, would sales fall off a cliff?” The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices.

A good example is newspapers. The local daily paper controlled the market and every year they raised the [advertising] rates and circulation prices – it was almost a big yawn. They didn’t worry about losing big advertisers like Sears, JC Penney or Wal-Mart, or losing subscribers. They increased prices whether the price of newsprint went up or down.

Now, they agonize over price increases because they worry about driving people to other mediums. That world has changed.

You can learn a lot about the durable economics of a business by watching price behavior. The beer industry is able to raise prices, but it’s getting tougher.

When you are looking at a business in which to invest, what are your priorities?

You have to really understand the economics of a business and the kind of people you are getting into business with. They have to love their business. They have to feel that they have been creative, that it is their painting, I am not going to disturb it, just give them more canvas and more brushes, but its their painting, from our standpoint any way. The whole place will reflect the attitude of the person at the top, if you have someone at the top who doesn’t care, the people down below won’t care. On the other hand, if you have someone at the top who cares a great deal, that will be evident across the organization. [The type of people managing the business is a very important criteria, then?] Yes, contracts don’t protect you; you have to have confidence in the people.

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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.

What makes a company something that you like?

I like businesses that I can understand. Let’s start with that. That narrows it down by 90%. There are all types of things I don’t understand, but fortunately, there is enough I do understand. You have this big wide world out there and almost every company is publicly owned. So you have all American business practically available to you. So it makes sense to go with things you can understand.

I can understand this, anyone can understand this (Buffett holds up a bottle of Coca-Cola). Since 1886, it is a simple business, but it is not an easy business—I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and then I want the Duke who is in charge of that castle to be very honest and hard working and able. Then I want a moat around that castle. The moat can be various things: The moat around our auto insurance business, Geico, is low cost.

People have to buy auto insurance so everyone is going to have one auto insurance policy per car basically. I can’t sell them 20, but they have to buy one. I can sell them 1. What are they going to buy it on? (based on what criteria?) They (customers) will buy based on service and cost. Most people will assume the service is identical among companies or close enough. So they will do it on cost. So I have to be a low cost producer--that is my moat. To the extent that my costs are further below the other guy, I have thrown a couple of sharks into the moat. All the time you have this wonderful castle, there are people out there who are going to attack it and try to take it away from you. I want a castle I can understand, but I want a castle with a moat around it.

30 years ago, Eastman Kodak’s moat was just as wide as Coca-Cola’s moat. I mean if you were going to take a picture of your six-month old baby and you want to look at that picture 20 years from now or 50 years from now. And you are never going to get a chance—you are not a professional photographer—so you can evaluate what is going to look good 20 or 50 years ago. What is in your mind about that photography company (Share of Mind) is what counts. Because they are promising you that the picture you take today is going to be terrific 20 to 50 years from now about something that is very important to you. Well, Kodak had that in spades 30 years ago, they owned that. They had what I call share of mind. Forget about share of market, share of mind. They had something—that little yellow box—that said Kodak is the best. That is priceless. They have lost some of that. They haven’t lost it all.

It is not due to George Fisher. George is doing a great job, but they let that moat narrow. They let Fuji come and start narrowing the moat in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people’s minds, Fuji becomes more into parity with Kodak.

You haven’t seen that with Coke; Coke’s moat is wider now than it was 30 years ago. You can’t see the moat day by day but every time the infrastructure that gets built in some country that isn’t yet profitable for Coke that will be 20 years from now. The moat is widening a little bit. Things are, all the time, changing a little in one direction or the other. Ten years from now, you will see the difference. Our managers of the businesses we run, I have one message to them, and we want to widen the moat. We want to throw crocs, sharks and gators—I guess—into the moat to keep away competitors. That comes about through service, through quality of product, it comes about through cost, some times through patents, and/or real estate location. So that is the business I am looking for.

Now what kind of businesses am I going to find like that? Well, I am going to find them in simple products because I am not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Gates is the best businessman I have ever run into and they have a hell of a position, but I really don’t know what that business is going to look like ten years from now. I certainly don’t know what his competitors will look like ten years from now. I know what the chewing business will look like ten years from now. The Internet is not going to change how we chew gum and nothing much else is going to change how we chew gum. There will lots of new products. Is Spearmint or Juicy Fruit going to evaporate? It isn’t going to happen. You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.

Now give me some money and tell me to hurt somebody in some other fields, and I can figure out how to do it.

So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten (10) years from now. If I can’t see where they will be ten years from now, I don’t want to buy it. Basically, I don’t want to buy any stock where if they close the NYSE tomorrow for five years, I won’t be happy owning it. I buy a farm and I don’t get a quote on it for five years and I am happy if the farm does OK. I buy an apartment house and don’t get a quote on it for five years, I am happy if the apartment house produces the returns that I expect. People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business. That is what Graham—the most fundamental part of what he taught me.

You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn’t pay a totally silly price. That is what it is all about. You ought to buy businesses you understand. Just like if you buy farms, you ought to buy farms you understand. It is not complicated.

Incidentally, by the way, in calling this Graham-Buffett, this is pure Graham. I was very fortunate. I picked up his book (The Intelligent Investor) when I was nineteen; I got interested in stocks when I was 6 or 7. I bought my first stock when I was eleven. But I was playing around with all this stuff—I had charts and volume and I was making all types of technical calculations and everything. Then I picked up a little book that said you are not just buying some little ticker symbol, that bounces around every day, you are buying part of a business. Soon as I started thinking about it that way, everything else followed. It is very simple. So we buy businesses we think we can understand. There is no one here who can’t understand Coke.

If I was teaching a class at business school, on the final exam I would pass out the information on an Internet company and ask each student to value it. Anybody that gave me an answer, I’d flunk (Laughter). I don’t know how to do it. But people do it all the time; it is more exciting. If you look at it like you are going to the races--that is a different thing--but if you are investing.... Investing is putting out money to be sure of getting more back later at an appropriate rate. And to do that you have to understand what you are doing at any time. You have to understand the business. You can understand some businesses but not all businesses.

What types of businesses have the highest ROIC?

WB: You could run Coca-Cola with no capital. There are a number of businesses that operate on negative capital. Great magazines operate with negative capital. Subscriptions are paid upfront, they have limited fixed investments. There are certain businesses like this. Blue Chip Stamps - it got float ahead of time. There are a lot of great businesses. Apple doesn’t need very much capital. See’s needs little capital but it can’t get that large -- we can’t get people eating 10 lbs of boxed chocolate every day. Great consumer businesses need relatively little capital. Where people pay you in advance (magazines, insurance), you are using your customers’ capital. But the rest of the world knows this and they get expensive. It can be competitive to buy them. Business Wire – it doesn’t require capital. Many service businesses require little capital. When successful, they can be something.

CM: Nothing to add, the formula never changes.

WB: If you could own one business in the world, what would it be?

CM: You and I got in trouble many decades ago for this, naming the most fabulous business. High pricing power, a monopoly – we don’t want to name it publicly!

What businesses should we avoid?

In the textile industry, we always had new machinery that held the promise of increasing our profit, but it never did because everyone else bought the same machinery. It was sort of like being in a crowd, and everyone stands on tip-toes – your view doesn’t improve, but your legs hurt.

What have been your business mistakes?

How much time do you have? The interesting thing about investments for me and my partner, Charlie Munger, the biggest mistakes have not been mistakes of commission, but of omission. They are where we knew enough about the business to do something and where, for one reason or another, sat they're sucking out thumbs instead of doing something. And so we have passed up things where we could have made billions and billions of dollars from things we understood, forget about things we don’t understand. The fact I could have made billions of dollars from Microsoft doesn’t mean anything because I never could understand Microsoft. But if I can make billions out of healthcare stocks, then I should make it. And I didn’t when the Clinton health care program was proposed and they all went in the tank. We should have made a ton of money out of that because I could understand it. And didn’t make it.

I should have made a ton of money out of Fannie Mae back the mid-1980s, but I didn’t do it. Those are billion dollar mistakes or multi-billion dollar mistakes that generally accepted accounting principles don’t pick up. The mistakes you see. I made a mistake when I bought US Air Preferred some years ago. I had a lot of money around. I make mistakes when I get cash. Charlie tells me to go to a bar instead. Don’t hang around the office. But I hang around the office and I have money in my pocket, I do something dumb. It happens every time. So I bought this thing. Nobody made me buy it. I now have an 800 number I call every time I think about buying a stock in an airline. I say, “I am Warren and I am an air-aholic.” They try to talk me down, “Keep talking don’t do anything rash.” Finally I got over it. But I bought it. And it looked like we would lose all our money in it. And we came very close to losing all our money in it. You can say we deserved to lose our money it.

We bought it because it was an attractive security. But it was not in an attractive industry. I did the same thing in Salomon. I bought an attractive security in a business I wouldn’t have bought the equity in. So you could say that is one form of mistake. Buying something because you like the terms, but you don’t like the business that well. I have done that in the past and will probably do that again. The bigger mistakes are the ones of omission. Back when I had $10,000 I put $2,000 of it into a Sinclair Service Station which I lost, so the opportunity cost on that money is about $6 billion right now--fairly big mistakes. It makes me feel good when my Berkshire goes down, because the cost of my Sinclair Station goes down too. My 20% opportunity cost. I will say this, it is better to learn from other people’s mistakes as much as possible. But we don’t spend any time looking back at Berkshire. I have a partner, Charlie Munger; we have been pals for forty years—never had an argument. We disagree on things a lot but we don’t have arguments about it.

We never look back. We just figure there is so much to look forward to that there is no sense thinking of what we might have done. It just doesn’t make any difference. You can only live life forward. You can learn something perhaps from the mistakes, but the big thing to do is to stick with the businesses you understand. So if there is a generic mistake outside your circle of competence like buying something that somebody tips you on or something of the sort. In an area you know nothing about, you should learn something from that which is to stay with what you can figure out yourself. You really want your decision making to be by looking in the mirror. Saying to yourself, “I am buying 100 shares of General Motors at $55 because........” It is your responsibility if you are buying it. There’s gotta be a reason and if you can’t state the reason, you shouldn’t buy it. If it is because someone told you about it at a cocktail party, not good enough. It can’t be because of the volume or a reason like the chart looks good. It has to be a reason to buy the business. That we stick to pretty carefully. That is one of the things Ben Graham taught me.

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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.

[CM: 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.]

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The main mistakes we’ve made – some of them big time – are: 1) Ones when we didn’t invest at all, even when we understood it was cheap; and 2) Starting in on an investment and not maximizing it.

Charlie is a big fan of doing things on a big scale. But when I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored.

[CM: Do you have anything worse to confess than Wal-Mart?

I cost us about $10 billion. I set out to buy 100 million sharers, pre-split, at $23. We bought a little and it moved up a bit and I stopped buying. Perhaps I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot. There are other examples.

On the other hand, it doesn’t bother us. If every shot you hit in golf was a hole-in-one, you’d lose interest. You gotta hit a few in the woods.

We probably won’t make the kind of mistake that costs us a lot – though we did with Dexter Shoes. We’re more likely to make mistakes of omission, not commission, in the future.

[CM: Since mistakes of omission don’t appear in the financial statements, most people don’t pay attention to them. We rub our noses in mistakes of omission – as we just did.

How do you determine what is the proper price to pay for the business?

It is a tough thing to decide but I don’t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won’t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don’t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.

What we did know was that they had share of mind in California. There was something special. Every person in Ca. has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything--$60 million bucks and it still doesn’t take any capital.

And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas. And our company song is: “What a friend we have in Jesus.” (Laughter). It is a good business. Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts— somebody’s birthday or more likely it is a holiday. Valentine’s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three week period. Men buy on Valentine’s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads. So that Valentine’s Day is the biggest day.

Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.

Think of Disney. Disney is selling Home Videos for $16.95 or $18.95 or whatever. All over the world—people, and we will speak particularly about Mothers in this case, have something in their mind about Disney. Everyone in this room, when you say Disney, has something in their mind about Disney. When I say Universal Pictures, if I say 20th Century Fox, you don’t have anything special in your mind. Now if I say Disney, you have something special in your mind. That is true around the world.

Now picture yourself with a couple of young kids, whom you want to put away for a couple of hours every day and get some peace of mind. You know if you get one video, they will watch it twenty times. So you go to the video store or wherever to buy the video. Are you going to sit there and premier 10 different videos and watch them each for an hour and a half to decide which one your kid should watch? No. Let’s say there is one there for $16.95 and the Disney one for $17.95—you know if you take the Disney video that you are going to be OK. So you buy it. You don’t have to make a quality decision on something you don’t want to spend the time to do. So you can get a little bit more money if you are Disney and you will sell a lot more videos. It makes it a wonderful business. It makes it very tough for the other guy.

How would you try to create a brand—Dreamworks is trying—that competes with Disney around the world and replaces the concept that people have in their minds about Disney with something that says, Universal Pictures? So a mother is going to walk in and pick out a Universal Pictures video in preference to a Disney. It is not going to happen.

Coca-Cola is associated with people being happy around the world. Everyplace – Disneyland, the World Cup, the Olympics—where people are happy. Happiness and Coke go together. Now you give me—I don’t care how much money—and tell me that I am going to do that with RC Cola around the world and have five billion people have a favorable image in their mind about RC Cola. You can’t get it done. You can fool around, you can do what you want to do. You can have price discounts on weekends. But you are not going to touch it. That is what you want to have in a business. That is the moat. You want that moat to widen.

If you are See’s Candy, you want to do everything in the world to make sure that the experience basically of giving that gift leads to a favorable reaction. It means what is in the box, it means the person who sells it to you, because all of our business is done when we are terribly busy. People come in during theose weeks before Chirstmas, Valentine’s Day and there are long lines. So at five o’clock in the afternoon some woman is selling someone the last box candy and that person has been waiting in line for maybe 20 or 30 customers. And if the salesperson smiles at that last customer, our moat has widened and if she snarls at ‘em, our moat has narrowed. We can’t see it, but it is going on everyday. But it is the key to it. It is the total part of the product delivery. It is having everything associated with it say, See’s Candy and something pleasant happening. That is what business is all about.

What do you do if business changes are recognized?

If a good business is doing dumb things with your money, it is wise to get out. The option is always there to try to persuade the business to change its mind but this is difficult. Investment techniques must be simpatico with all.

Do you know of any examples of companies that have lost and regained their 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.

Impact of regulation on businesses?

In some businesses, regulatory changes have a big impact, others none. We just try to think intelligently about any business that we’re in. What regulatory changes might there be? What might the impact be? If we’re in furniture retailing, we’re not going to think about it. It’s up to Charlie and me to think about this and weigh it in our evaluation of a company.

[CM: In our early days, we tended to overestimate the difficulties of regulation. We refrained by buying the stocks of television stations because we thought it was peculiar that someone could ask to have the government pull your license any year – and the government could do it.]

Tom Murphy [the former head of Capital Cities and Cap Cities/ABC; click here to read a 2000 interview with him] was way ahead of us on this one.

Would you comment on the quality of earnings in capital-intensive businesses, like utilities?

Buffett: Capital-intensive industries outside the utility sector scare me more. We get decent returns on equity. You won’t get rich, but you won’t go broke either. You are better off in businesses that are not capital intensive.

Munger: A lot of moats have been filling up with sand lately.

Please talk about the shift to investing in capital intensive business and the ultimate impact on intrinsic value. Help us understand the time value of the necessary capital expenditures.

WB: It’s clear you understand the question well, and it as important a question as you can ask. We are putting big money in big businesses with good economics, but not as good as when we were dealing with smaller amounts. $40m of capital required in See’s and it earns much more than that. If we could put in more we would. But wonderful businesses don’t soak up capital – we had $2.2b operating earnings in Q1. We have to put it out as intelligently as we can. When we find them, we’ll buy them. Can we put it to work intelligently? We think capital intensive businesses we have bought are good, working well. But it can’t work brilliantly, we can’t spend all that money and still get high returns. But does that mean we should pay out excess capital instead? No, because we think they can earn a good return even with the need to make capital investments in certain businesses. We are better paying it out only if we can’t translate it into more than $1 of present value. In our judgment with BNSF we did it, but scorecard will only come in 10 to 20 yrs. In MidAmerican, we have done it. But it won’t be a Coca-Cola – which doesn’t need as much capital. I hope we don’t disappoint you. If anyone expects brilliant returns from this base at Berkshire, we don’t know how to do it.

CM: I’m just as good at not knowing as you are.

How do you place a value on intangible assets? What are the signs of great “moats” around a business and great managements? Do you place a dollar value on this? What discount rates do you use?

We use a treasury rate for comparability across companies and time. As far as we’re concerned, a dollar earned by The Lucky Horseshoe Company is the same as a dollar earned by an Internet company - even if the market is a lot more enthusiastic about the Internet company dollar.

Valuation is an art. Look at Wrigley: pick a figure for what the volumes will be, their prices, their competition, the likelihood of management being bright with cash. All of that figures into the moat and its size, and what that business will earn.

There aren’t many businesses with a terrific moat. Coke has a terrific moat, right down to the container. How many other products can people identify correctly when they’re blindfolded? Coke has not just market share, it has a great share of mind. People associate Coke with good things. Ten years from now, the moat formed by that share of mind will be even greater.

No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats. Maybe I’m being too hard on the academics.

[CM: You’re not sufficiently critical of the academics. They remind me of Long Term Capital Management - why do smart people do dumb things against their own self-interest?]

Now we have whole finance departments full of destructive self-pity, which is one of the most dangerous forces in the world. And you are paying to send your children to those schools!

Not too long ago, a reasonable person might have concluded that Kellogg and Campbell Soup had big moats around their businesses, but that has proven not to be the case and their stocks have languished. What might we learn from this?

I'm not an expert on these companies, but my understanding is that Kellogg pushed their pricing too far. They didn't have to moat they thought they had versus General Mills and other major competitors. Campbell's problems are more related to lifestyle changes of Americans. Soup fits in a little less well than it did 40 years ago.

With soft drinks, there has been no decrease in demand for decades. 30% of liquid consumption of Americans is soda and 40% of that is Coke products, so 1/8th of U.S. liquid consumption is Coke products.

Coffee and milk consumption has been declining every year -- it's clear where preferences go once people start drinking soda.

These trends are almost impossible not to happen in developing countries, where the consumption of Coke products is 1/50th what it is in the U.S. -- though Coke could screw it up by pricing too high.

Coke has also benefited from its relative price. Since 1930, its cost per ounce has only doubled. This very low price inflation has contributed to the increase in per capita consumption.

[Munger: "Kellogg's and Campbell's moats have also shrunk due to the increased buying power of supermarkets and companies like Wal-Mart. The muscle power of Wal-Mart and Costco has increased dramatically."]

There is always a battle between the retailers and manufacturers of branded products. In the 1930s, A&P had its own line of branded products that did very well. It would be interesting to know what happened.

What's your opinion of downsizing and outsourcing?

Whether or not such actions are necessary depends on the industry: if it’s a growing industry, you don’t need such measures. If there’s not enough growth in an industry to support all of the players, it’s in society’s best interests to have the most output produced with the least inputs - but society needs to help those who find themselves on the outside. “I believe this has been more of a media story than a real news story,” Buffett explained. “I don’t believe there’s a greater percentage of people displaced as a percentage of the work force than there was ten years ago.”

Munger’s take on the situation: “I can’t name a firm that was harmed by over-downsizing. I can rattle off name after name of ones that were ruined by bloat. It’s fashionable to say downsizing is wrong: I think it’s wrong that the firms got in such a state that they needed downsizing.

Can you comment on the impact of rising commodity prices on margins?

Our carpet business has been hit by rising commodity prices. Sometimes you can get into temporary situations in which you can’t raise prices fast enough to keep up with rising input costs. But the main impact of the rising price of oil – it’s an extra $200 million per day – is borne by American consumers.

Corporate profits are at an all-time high as a percentage of GDP. I’d bet that they go down in the next few years. Corporate taxes [as a percent of total taxes] are at an all-time low and there’s likely to be reversion to the mean.

Could you explain a little more about the mind of the consumer and the nature of the product? And explain how you actually apply these concepts to find the companies with the best potential?

When you get into consumer products, you're really interested in thinking about what is in the mind of how many people throughout the world think about a product now, and what is likely to be in their mind 5 or 10 or 20 years from now. Now virtually every person around the globe (maybe 75% of people) have some function in their mind about Coca-Cola. The name Coca-Cola means something to them. You know, RC Cola doesn't mean something to virtually anyone in the world. Well, it does to the guy who owns RC, but everybody has something in their mind about Coca-Cola, and overwhelmingly it's favorable. It's associated with pleasant experiences. Now part of that is that by this time, [Coca-Cola is found] where you are happy, it is at Disneyworld, it's at ballparks, every place you're likely to have a smile on your face, including the Berkshire Hathaway meeting I might add. (laughter) And that position in the mind is pretty firmly established, and it's established in close to 200 countries around the world. A year from now, it will be established in more minds and will have a slightly different overall position. In 10 years, the position will change just a little bit more. It's share of mind, not share of market that counts.

Disney, same way--Disney means something to billions of people. If you're a parent with a couple of young children, and you've got 50 videos that you can buy, you're not going to sit down and preview an hour and a half of each video before deciding which one to stick in front of your kids. And you've got something in mind about Disney that you don't have about ABC Video Company, or you don't even have about 20th Century, and you don't have about Paramount. That name to billions of people has a meaning, and that meaning is overwhelmingly favorable, reinforced by the other activities of the company. Just think what someone would pay to buy that share of mind. You can't do it. You can't do it by a billion dollar advertising budget, or a 3 billion dollar advertising budget, or by hiring a twenty thousand supersalesmen. So you've got that. Now the question is what does that stand for 5 or 10 or 20 years from now. You know there'll be more people, you know there'll be more people familiar with Disney, and you know that there will always be parents who are interested in having something for their kids to do and that kids will love the same sort of things. That's what you're trying to think about with a consumer products company.

That's what Charlie and I were thinking about when we bought See's Candy. Who's face lights up on Valentine's Day when you hand them a box of candy from some nondescript company and you say, "Here, honey, I took the low bid?" You have many millions of people who got handed a box of [See's] candy and it wasn't that much thereafter that they got kissed for the first time. So the memories are good, the associations are good. A position in the mind is what counts in a consumer product. But it's a total process ... a very good product may need tons of infrastructure. I had a case of Cherry Coke waiting for me at the Great Wall of China. You've got to have the product there when people want it. In World War II, General Eisenhower said to Mr. Woodruff that he wanted a Coca-Cola within arm's length of every American servicemen in the world, and they built a lot of bottling plants to take care of that. That sort of positioning can be incredible. It seems to work especially well for American products. People want certain American products worldwide ... our music, our movies, our soft drinks, our fast food. I can't imagine a French firm, or a German firm, or a Japanese firm selling 48% of the world's soft drinks. It's part of American culture and the world hungers for it. Kodak, for example, somehow does not have the same place in the world's mind now that it did 20 years ago ... Fuji pushed their way to more parity with Kodak. You don't want to ever let them do that. That's why you can see a Coca-Cola or a Disney doing things that you think, well this doesn't make a whole lot of sense, that if they didn't spend this $10 million, wouldn't they still sell just as much Coca-Cola. You don't know which dollar is doing it, but you do know that virtually everybody in the world has heard of your product and has a favorable impression of it .... With See's Candy, we're no better than the last customer who's been served their candy, but as long as we do the job on that, people can't catch us. We can charge a little more for it because people are not interested in taking the low bidder. Private labels stalled out in the soft drink business, because people want the Real Thing.

[CM: I think the See's candy example has an interesting teaching lesson for all of us. It was the first time we really stepped up for brand quality and it was a hard jump for us ... If they had demanded an extra $100,000 for the See's Candy company, we wouldn't have bought 'em, and that was after Warren was trained by the best one of the greatest professors of his era ... We just didn't have minds well-enough trained to make an easy decision right. But we did buy it, and as it succeeded we kept learning. I think that shows that the name of the game is continuing to learn, and that brings along the delicate problem that people sometimes talk about "two ageing executives," but I don't know what the hell that means as an adjective, because I don't know anybody who is going in the other direction. (laughter)]

WB: If we hadn't have bought See's, we wouldn't have bought Coca-Cola in 1988, so you have give See's a significant part of the credit for the $11 billion plus profit we've got in Coca-Cola at the present time.

What do you think the best quality is in a business or a person?

There are many important qualities to have in a business and many important qualities in a person. In a business always look for a great product at a fair price, and with honest reliable management. In a person, I think that honesty, brains, and hard work are very important qualities. People who demonstrate these consistently, will usually be successful in whatever they do.

How do you grow a small business into a big business?

WB: Berkshire was a small business at one time. It just takes time. It is the nature of compound interest. You can’t build it in one day, or one week. Charlie and I never tried to do a masterstroke to convert Berkshire into something four times bigger. We just consistently kept doing what we understood and, if you have fun doing it, then it’ll be something quite large at some point. Nothing magical. It would be nice to multiply money in a few weeks. In a general way, we have done the same things for years. We will have more businesses in a few years - some will do worse, but most will do better. It is an automatic formula for getting ahead, but not galloping. We are happy not doing anything at all. As Gypsy Rose Lee said, ‘I have everything I had before, just two inches lower.’ [laughter] We want everything in two years to be higher.

CM: It’s the nature of things that most small businesses will never be big businesses. It is the nature of things that most big businesses fall into mediocrity or worse. Most players have to die. We have only made one new business, and that is the reinsurance business run by Ajit. We only created from scratch one small business into a big one. We’ve only done it once. We are a one-trick pony.

WB: Without Ajit, we wouldn’t have done it all. CM: The best investment we ever made was the fee we paid to an executive recruiter to find Ajit Jain.

WB: We went into the muni bond [insurance] business. Ajit got the company up, licensed and running. In Q1’08, our premium volume was $400 million. Our volume was bigger than anyone else, and I wouldn’t be surprised if it was bigger than all the rest combined. They did 278 transactions. All done in an office with 29 or 30 people. One of the interesting things about it was that almost all the business was from people who already had insurance from others who are rated AAA. So we pay out only if the muni defaulted AND the bond insurer didn’t pay. We wrote for 2.25% when the original guy charged 1%. This tells you something about AAA in bond insurance in 2008. Ajit has done a remarkable job. We wrote a couple policies for Detroit sewers, and people have found these bonds trading at a better price than others only insured by other bond in- surers. I congratulate Ajit for it.

How do you build the culture of a new organization or change that of an existing one?

Buffett: It is much easier to create a new culture from scratch. It is very hard to change existing cultures. At BRK it would be impossible to change the culture. Accordingly, it is much better to start from scratch than to change a culture. I've had the luxury of time with Berkshire. I didn't have to fight anything. As we added they became completentary. It took decades. If you tried to change it, people would reject it.

Munger: My failure rate was 100%. (Referring to changing of existing culture)

Alternatives to Common Stock

Your opinion on derivatives?

[2003 - Re: 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].

[CM: 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.

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.

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We don’t think that in any year the chance is very high that derivatives will lead to or greatly accentuate a financial trauma, but we think it’s there.

It’s fascinating to look at a company like Freddie Mac: an institution that dozens of financial analysts were looking at; that had an oversight office; that was created by Congress with committees to oversee it; that had two smart, exceptional board members, Marty Leibowitz and Henry Kaufman; and that had auditors present – yet Freddie misstated earnings by $6 billion in a short time. That’s big money. And a large part of it was facilitated by derivatives. You can go back and read the footnotes, listen to the conference calls, etc. and you wouldn’t have known. In the end, it was $6 billion, but it could have been $12 billion if they’d wanted.

Derivatives can lead to a lot of mischief. When you have a complicated derivative transaction, and a trader with investment house A on one side and investment house B on the other side, and on the day the deal is done, both record a profit, this can lead to mischief – and the scale is getting bigger every day.

I know the managements of many large financial institutions and they don’t have their minds around this. We tried at Gen Re [where we had a small derivative book] and couldn’t.

Whatever problems there were at Salomon [during its crisis years ago], they’re far, far worse now [systemwide].

In 1991, if the government hadn’t reversed himself [in its plans to take actions that would have put Salomon out of business], we were preparing documents [to file for bankruptcy. Had this happened,] We had $1.2 trillion [notional value] of derivative contracts that others were counting on, that would have gone bad. All sorts of securities transactions wouldn’t have settled, accounts in Japan and the UK would have been affected, etc. For instance, Salomon had a relationship with a bank in Germany which took large deposits in Germany and lent the money to Salomon. All kinds of things would have come out. You don’t need to put these strains on a system that’s already highly leveraged.

When you get huge amounts of transactions, which not many people understand, you create a huge problem that may be triggered by an exogenous event.

We use derivatives – we get them collateralized – and we’ve made money on them. But I predict that sometime in the next 10 years, we will have a big problem caused by or exaggerated by derivatives.

[CM: People don’t think about the consequences of the consequences. People start by trying to hedge against interest rate changes, which is very difficult and complicated. Then, the hedges made the results [reported profits] lumpy. So then they use new derivatives to smooth this. Well, now you’ve morphed into lying. This turns into a Mad Hatter’s Party. This happens to vast, sophisticated corporations.

Somebody has to step in and say, “We’re not going to do it -- it’s just too hard.”

It was bonkers and the accountants sold out.]

If you want to have a little fun, go to the annual meeting of a big financial company and ask about the details of a complex transaction. They won’t know – but you can be sure the trader who did it will be well paid for it.

Any time you have situation where smart people can make money by taking risk, you’ll get it.

Derivatives were supposed to spread risk, and some make that argument today. This may be true much of the time, but what about when risk becomes highly concentrated in a few institutions? Coke is better able to take currency risk than most trading desks. Overall, there’s much more risk in the system because of derivatives.

[In response to a shareholder who compared super cat reinsurance risk to derivative risk, Buffett responded:]

The derivative contracts that Gen Re wrote are not similar to the super cat insurance we’re writing. We’re reinsuring personal or business risks others don’t want to or are unable to bear. In our view, it made no sense to be in the derivatives business.

[CM: They’re radically different. Derivatives are full of clauses that say if one party’s credit gets downgraded, then they have to put up collateral. It’s like margin – you can go broke. In attempting to protect themselves, they’ve introduced instability. Nobody seems to have recognition of what a disaster of a system they’ve created. It’s a demented system.

Had Berkshire not bought Gen Re, which was rated AAA, it could have run into terrible financial difficulty post-9/11, especially if they’d recognized their actual liabilities. They would have been downgraded, which could have triggered things in derivative activities which would have triggered coming up with loads of cash.

The system wasn’t built to last. Many CEOs at major financial institutions don’t really comprehend that. When you get margin calls for huge amounts of money, it only has to be one day when you can’t meet it [and you can be forced to file for bankruptcy]. In 1987, there was a large wire transfer that was late arriving at a Chicago brokerage house, and it came close to unraveling the system (the money finally showed up).

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[Q - How dangerous are derivatives to the financial system and what can be done to mitigate potential damage from them?]

We’ve tried to mitigate it [raise warning flags about the dangers of derivatives] a little by talking about it, but realize there is nothing inherently evil about derivatives. We have at least 60 of them and will be discussing them at our upcoming Berkshire board meeting.

Derivatives are expanding rapidly, in more and more imaginative ways. They introduce invisible leverage into the system. In the 1930s, after the crash, the government concluded that leverage contributed to the crash and that it was dangerous. So the U.S. government empowered regulators to deal with this. For decades, they policed it and it was taken seriously when the Fed increased or decreased margin requirements.

But the introduction of derivatives has made any regulation of margin requirements a joke. The regulation still exists, but it’s an anachronism.

I believe that we may not know when it becomes a super danger or when it will end precisely, but I believe it will go on and increase until very unpleasant things happen because of it.

You saw one example of what can happen under forced sales in October 1987. It was driven by portfolio insurance, which was a joke. It was a bunch of stop/loss orders, but done automatically, and it was merchandized. People paid a lot of money for people to teach them how to put in a stop/loss order. When a lot of institutions do this, the effect is pouring gas on a fire. They created a doomsday machine that kept selling and selling.

You can have the same thing today because you have fund operators with billions of dollars – in aggregate, trillions of dollars – who will all respond to the same stimulus. It’s a crowded trade, but they don’t know it and it’s not formal. They will sell for the same reasons. Someday, you will get a very chaotic situation.

As for what could trigger this and when, who knows? Who had any idea that shooting an archduke would start Word War I?

Munger: The accounting being enormously deficient contributes to the risk. If you get paid enormous bonuses based on profits that don’t exist, you’ll keep going. What makes it difficult [to stop] is that most of the accounting profession doesn’t realize how stupidly it’s behaving. One person told me the accounting is better because positions are marked to market and said, “Don’t you want real-time information?” I replied that if you can mark to market to report any level of profits you want, you’ll get terrible human behavior. The person replied, “You just don’t understand accounting.”

Buffett: When we went to close out Gen Re’s derivatives book, we took a $400 million loss on a portfolio that was “marked to market” by the prior management and auditors – and I’m not criticizing our auditor. Any auditor would have said the same. I wish I could have sold to the auditors instead!

Take a dry cleaning business that owes $15. Their books show a $15 accounts payable and the other company shows an offsetting $15 accounts receivable. But there are only four big auditing firms, so in many cases, if they’re auditing my side, the same firm may be valuing or attesting to the value of what’s on the books of the person on the other side. I will guarantee you that if you add up the marks on both sides, they don’t add up to zero. We have 60 or more derivative contracts, and I’ll bet the other side isn’t valuing them like we are. I have no reason to mark the value up – we don’t get paid for that. If I value it at $1 million on our side, the other side should be marking it at minus $1 million, but I guarantee the numbers are widely different. Auditors should check both sides of derivative trades and the “marks” should sum to about zero. They don’t.

Munger: As sure as God made little green apples, this will cause a lot of trouble. This will go on and on, but eventually will cause a big denouement.

What are your views on derivatives and how do you think they have affected the global market?

In my 2002 letter to shareholders I referred to them as “weapons of mass destruction.” Derivatives are really just a way to create a product with a very long fuse, for example, 100 years, as opposed to stocks which settle in 3 days. That kind of system allows claims to be built up. AIG called me in September and told me they were about to get downgraded which would have required higher posting requirements. Now this is an enterprise that has been built up over decades and was effectively destroyed in 48 hours by these products. With derivatives, you’re exposed to counterparties and thus reliant on others. These claims built up over time to the tune of billions of dollars and when one falls, the whole system falls. Derivatives are not evil by themselves but rather everyone needs to be able to handle them. System wide, they’re rat poison. Berkshire holds many derivatives but we always hold the money at Berkshire.

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[Q: Given the large amount of value that’s been destroyed by the use of derivatives, is it appropriate for Berkshire to hold large derivative positions?]

Buffett: Yes, derivatives pose problems to the world. Our job is to make money over time, and our use of derivatives doesn’t impinge on Berkshire’s capital — we have posted collateral of less than 1% of our total marketable securities. I said in 2002 that we use them. We think that as long as we explain [our use of] derivatives, the benefits outweigh the costs. We received $4.9 billion in premiums [for writing equity puts] and can use this money for 15 – 20 years. I personally think that we’ll make money on our equity put options. We’d have to lose money over 15 – 20 years [to lose on our equity puts]. We had a financial hurricane, [yet regarding] the equity put contracts, there’s a good chance we’ll make money on those. During the last week we modified two put contracts—reducing the term to about 10 years and reducing the strike price from 1,514 to 994. Our shareholders are intelligent enough to understand [the situation] if we explain it.

Munger: I would agree that there should be limits, and we have stayed well short of the limit that’s appropriate.

[What do you think Ben Graham would think about derivatives?]

Buffett: He would not like them. They cause risk to run wild. They increase risks and strains, but if some were mispriced, he’d act accordingly. But he wouldn’t get into a position of letting others get him in trouble. After 1929, Congress decided it was dangerous to borrow against securities, so the Fed was empowered to regulate margin levels. But derivatives made those rules a laughing stock. Derivatives came to be a way around margin regulations. They also allowed longer settlement periods, another danger. Buy Galbraith’s The Great Crash.

Munger: There’s a deeper problem. [Concerning derivatives trading] the dealer has two advantages: [1] a croupier-style house advantage, and [2] the dealer plays in the same game and is a better player and knows what the client is doing [buying and selling]. It’s a dirty business. We don’t need more of this kind of thing in America; we need less.

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[Q: What useful function do derivatives serve? Why aren’t derivatives illegal?]

WB: Charlie may have more to comment.

CM: The usefulness of derivatives is overstated. We’d still have oats and wheat if we didn’t have derivative markets. The test is not ‘is there any benefit’, but is the NET benefit or disadvantage useful or better without. My own view is that if we had only [exchange traded] [Ed: another notetaker heard: agriculture and metals] and banned the rest – the world would be better place.

WB: BNSF has diesel contracts. If I was running the place, I wouldn’t hedge - unless you are smarter than the market in diesel fuel. If you are you shouldn’t be running a railroad, you should be run a diesel trading business. If you have someone in charge of running that hedge, they will hedge it. If he thinks that will make him a better manager of railroads, then fine, let him do it, but I will hold CEO responsible for running it over time. I wouldn’t condemn anyone for hedging diesel fuel. But I do think if you put up (slide4) – from Chapter 12 of Keynes General Theory – it is by far the best description of the way capital markets function. It is descriptive and prescriptive. Usually only the first two sentences are quoted, but it is better as a whole paragraph:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

Wall Street is mix of casino and a very important social operation – and once academia got behind derivatives and schools taught more about how to price a derivative instead of valuing a business, the trouble began. In 1982 Wall Street allowed speculation in SP500 futures. I wrote letter to Congressman Dingle which was published in Fortune Magazine. What I forecasted occurred then it got squared, with new ways to gamble.

CM: Warren wrote the only letter saying the idea is insane. Only difference is then not very many people listened to him.

WB: It doesn’t make any sense that the tax treatment on gambling on S&P 500 contracts is better (partial long term capital gains treatment) than buying and holding individual stocks for less than a year (SP500 contract is taxed 60% long-term gain and 40% short term, even if you hold it for 60 seconds). This distortion came about as a result of the power of a small group of lobbyists. Charlie do you know why this is?

CM: It is neither fair nor sensible. The idea that the tax treatment on something that is held for 3 seconds is different than something that is held for less than a year (some long term gains treatment for the former and none for the latter) is insane. If someone with money and interest cares a lot and others are indifferent, that someone wins in front of the legislative bodies. As Bismarck said, don’t watch sausage making or law making.

What's your opinion of stock options?

[Munger: "If you look at the impact of stock options, you'll see a lot of terrible behavior. To give a lot of options to a CEO who built the business and is in his 60s to incent loyalty is demented. Would the doctors at the Mayo Clinic or the lawyers at Cravath in their 60s work harder if they had options?"]

If can lead to extremely capricious compensation results that have no link to a person's results.

A CEO could simply put money in the bank and grow the business, so there should be a cost of capital factor built into any compensation plan. Also, options should not be issued when the stock is below intrinsic value.

[Munger: "The theory that options have no cost has contributed to a lot of excesses, which is bad for the country because corporate compensation is perceived as unfair."]

Well-fed CEOs are descending on Washington to persuade your Congressmen not to require expensing of options because they'd get less. It's sort of shameful.

All of the opposition to options comes from people who would get fewer of them. If there was a rule saying the CEO's salary didn't count as an expense [and there was a proposal to rescind this rule], you can bet they'd be in there fighting to keep the status quo.

[Q: Wouldn't expensing stock options be double counting, since they're already factored into the diluted share count?]

No. When you issue options at the market price, there's no dilution until the stock rises, but diluted and basic shares are the same.

I don't have any objection to options under certain conditions -- I just think they should be recorded as an expense.

We'll take options from certain companies in lieu of cash as payment for insurance -- even 10-year, 50% out-of-the-money options.

[CM: "A stock option is both an expense AND dilution. To argue anything else is insane. I'd rather make my money playing piano in a whorehouse than account for options as recommended by John Doerr."]

"Look at Dell. They're buying and selling millions of options, but at the same time people are saying companies don't know how to value them. It's specious. A disconnect.

I can figure out what I'd pay for an option on a private business, a public company, an apartment house, a farm, etc. EVERY option has value. People that get them understand this better than those that give them.

We don't blindly use Black-Scholes; we apply judgment.

We would pay something for just about any option.

[CM: "Black-Scholes works for short-term options, but if it's a long-term option and you think you know something [about the underlying asset], it's insane to use Black-Scholes."

Companies will do everything they can to reduce the value of options they grant. We've sat in on these meetings. They assume that options have a shorter life than they really do, etc.

[CM: "The only thing that's consistent is that the whole thing is disgusting."]

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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.

[CM: 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.]

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. We knew what we were giving up -- it had a negative coupon, but options have value.

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.]

[CM: 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.]

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].

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Congress has no business legislating accounting. It was a disgrace when Congress 10 years ago effectively bludgeoned Arthur Leavitt into backing down on expensing stock options, at the behest of big corporate contributors. In a very significant way, this accelerated the [accounting] abuses of the late 1990s.

The Senate voted 88-9 to say that it’s more important to have stock prices go up than to have accurate expenses. All of the big auditing firms endorsed their big clients’ views, so they could report higher earnings. They [the auditing firms] have now shifted completely [and support expensing options].

The compromise was the firms were given the choice of expensing options or showing their cost in the footnotes – and 498 of the S&P 500 companies chose the latter.

I suggest that you write to your Congressmen and tell them that FASB knows more about acting than they do.

In Google, type in “Indiana” and “pi” and you’ll find a site [here’s one] that relates how, in 1897, the Indiana state legislature voted to round pi to 3.20 because it’s an easier number to work with. It passed the Indiana House, but by the time it got to the Senate, a few people managed to get it shot down.

In 1993, the U.S. Senate cleansed the record of the Indiana House by changing the rules on something they knew nothing about [stock options]. 88 senators declared the world was flat because big donors said it was thus.

[CM: The people who voted this way were way worse than in Indiana. Those people were stupid. These people [the 88 Senators] are stupid and dishonorable. They knew it was wrong and did it anyway.]

Would you use stock options to enter a position in a public company?

WB: If you want to buy or sell a stock, you should buy or sell a stock. We sold puts on Coca-Cola once, but usually it is best to just buy stock. Using option technique is an idea where you get to buy a stock cheap. Four out of five times you may get it right and one time you may miss the opportunity to buy. We virtually have never used options to enter or exit a position. We have sold long-term equity put options described in our press release. We don’t get involved in fancy techniques.

CM: If I remember right, a public authority was wondering if they should set up an option exchange mar- ket. Warren was alone in the opinion of opposing it. You wrote a letter saying it wouldn’t do any good to throw out margin rules in this fashion. It doesn’t serve the country. I always thought Warren was totally right. Turning financial markets into gambling markets to enrich the croupiers doesn’t make sense.

WB: A University of Chicago Graduate student asked me once, what are we being taught that is wrong? In business school the amount of time spent teaching option pricing is total nonsense. You only need two courses, (1) how to value a business, and (2) how to think about stock market fluctuations. The thing is that instructors know the formulas and you don’t, so they have something to fill the time. It has nothing to do with investment success—what matters is buying businesses at the right price. If you were teaching Biblical studies and you could read the Bible forward, backward, and in four different languages, you would find it hard to tell everyone that it comes down to the Ten Commandments. The priests want to spend a lot of time preaching. You must have an attitude where you aren’t influenced by the market. You need a mind- set, and you need to have the attitude to divorce your- self from letting the market influence you.

What's your opinion of gold as an investment?

We’re not enthused about gold. People say it’s a hedge against inflation, but that’s also true of oil, land, Coca-Cola, See’s Candies, etc. I’d much prefer to own land in Nebraska or an apartment house or an index fund as a store of value. We’d rather own an asset that will be useful even if the currency drops to 10 cents on the dollar. People will always need to drink and eat [referring to Coke and See’s]. We wouldn’t trade ownership of businesses for a hunk of yellow metal.

[CM: If you have the opportunities of Berkshire, an investment in gold is dumb.]

Gold would be way down my list as a store of value. I’d much rather own 100 acres of land in Nebraska or an apartment house or an index fund.

The Dow went from 66 to 11,000 or 12,000 during the last century, and you got paid a lot of dividends along the way. Gold went from $20 in 1900 to $400 in 2000, plus you’d have to pay insurance and storage costs, so it’s not a good store of value.

I’m not advocating paper money – it’s good to worry about this. But I’d rather sell one pound of candy. That will retain its value even if the currency is seashells.

Gold has done very badly [as an investment] in the past and I see no reason why it will work well in the future. All that happens is that it is taken out of the ground in South Africa and put back in the ground in Fort Knox. (Laughter)

[CM: Gold was good to have if you were a well-to-do Jewish family in Vienna in 1935 because of the situation [just before the Nazis took over]. But if you’re in our position, gold has no interest.

When would you exchange shares for gold?

The idea of exchanging a producing asset for a non-producing asset seems foreign to me.

What is your opinion on exchange-traded funds and how to do you accurately judge them?

ETF’s are a fairly low cost way to get into a market or industry. We don’t hold any and never will. I recommend index funds for people who don’t want to spend time studying the market. They are good for 95% of the population. If you don’t bring anything to the game, you shouldn’t expect to win.

Muni bond defaults you described in 2008 -- they haven’t materialized. Should investors worry about getting higher returns?

WB: Harrisburg PA defaulted on a bond recently. Harrisburg may get stuff worked out, but [Assured Guaranty] now paying interest. I think it is hard for federal government to turn away a state having fiscal difficulties. Not sure how to tell governor of State X you were going to stiff arm him after you supported GM. You worry about correlation and contagion in bond insurance. Most insurers have enormous obligations based on their capital. I think they have had a very optimistic attitude. I thought I was getting paid fairly 1.5yrs ago, but not now. So we’ll let someone else do it.

CM: I would try to invest in places that were prosperous and disciplined. As Ben Franklin said, it is hard to hold an empty sack upright, and integrity matters.

WB: Taxpayers in disciplined areas won’t put up with it all.

CM: Bad behavior is contagious. I would rather be with the disciplined.

Experience with junk bonds?

When we were buying junk bonds, we focused on ones we could understand. They were yielding 30%, 35%, 40% to maturity. We thought of them like equities. Within 12 months, they went to yielding 6%. This is amazing, given that there were no major events. Prices do amazing things.

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In insurance, we think a lot more about low-probability events than most people. We think more about big events in the financial arena than the natural arena. Financial markets have vulnerabilities that we try to think of and build in ways to protect us against them – and even some capabilities where we might profit in a huge way.

[CM:: The temporary collapse in junk bonds, where they got to 35-40% yields, was just a strange thing. There was absolute chaos at the bottom tick. Apply this behavior to stocks – it’s not hard to imagine a big crunch coming along.]

It’s a fascinating thing to me: in 2002, there were tens of thousands of smart people, money was available, everyone had the desire to make money, yet look at what happened [to the prices of junk bonds]. Extraordinary things happened. Can these be the same people [buying such bonds yielding 6% today] who let them sink to such levels?

Wall Street is awash in money and talent, but you get these absolutely extraordinary swings. It doesn’t happen with apartments and other types of assets.

At the minimum, you want to protect yourself from this type of insanity from wiping you out – and better yet, make a profit from it.

There are discounts in the fixed income market. Will you take advantage?

We have seen some important dislocations. I’ve brought some figures. [Buffett grabs a stack of printouts.] Tax exempt money market funds [auction facilities]. $330 billion of them. Repricing of first-grade munis every 7 days. LA County Museum of Art. Jan 24th: 3.1%. Jan 31st: 4.1%. Feb 7th: 8%. Feb 14th: 10%. Fell back down to 3% on Feb 21st. Now 4.2%. Somehow, rates were much higher on Valentine’s Day. Look at the bid sheet of Citigroup. Repricing every 7 days. You would find the same issue on several different pages. The same broker, at the same time, was quoting different prices on different pages for the same issue. On one page we bid 11%, and someone else bid 6%. You found this in 1974, and after LTCM [the 1998 Long-Term Capital Management blowup]. These are great times to make extra money. Auctions in esoteric securities. We have $4 billion invested in it.

We will have made some insignificant money in this for a few months. There may be opportunities that we can’t spot. If you have enough time, you can figure out some things that are really mispriced. We don’t play with that; we just don’t have enough time. If you spend enough time you may find those that Charlie and I can’t find because we just can’t look at that many things.

CM: What is interesting is how brief these opportunities are. Some idiot bought munis, bought 20x what he could afford on an incredible margin. Those things were dumped on margin calls and suddenly got really mispriced. The dislocation was very brief, but very extreme. The moves are fast and short. You must think fast and resolutely. You have to be like a man who stands by a stream where fish come by once a year.

WB: 2002 junk bond market happened. CM: Very big dislocations happen about twice a century. WB: That means we only have four or five times we can do it. [laughter]

Can you give us your insights on the oil and silver markets?

He asked you, Charlie!

[CM: The price of oil eventually has to go up. It doesn’t mean you can make money on it, once you figure in the interest cost.]

Investing in ethanol?

Charlie and I do not know enough about the [ethanol production] business to evaluate it. We’ve been approached many times and they’re quite popular, but trying to figure out the economics of an ethanol plant will depend on government policy and a lot of other variables we’re not good at predicting. It’s also a very hot area for investors right now, and our general experience is that we don’t participate in things that are hot and easy to raise money for.

I have a brother who’s on the ethanol board of Nebraska and [if he becomes richer than me, I’ll reconsider my views on ethanol]! [Laughter]

There’s no question that ethanol usage will grow. But generally speaking, agricultural processing – companies like Cargill and ADM [Archer Daniels Midland] – have not been great businesses and have not earned high returns on tangible capital. Ethanol could prove to be an exception, but I’m not sure how you gain a significant competitive advantage with any particular ethanol plant.

[CM: My attitude is even more hostile than Warren’s. I know just enough about thermodynamics to understand that if it takes too much fossil-fuel energy to create ethanol, that’s a very stupid way to solve an energy problem. [Laughter]]

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Munger: Even McCain has had a counter-revelation: he’s decided ethanol is wonderful, now that he’s recognized that that’s how they think in Iowa. [Laughter]

I think the idea of running vehicles on corn is one of the dumbest ideas I’ve ever seen. Governments, under pressure, do crazy things, but this is among the craziest. Raise the cost of food so you can run these autos around? You use up just about as much hydrocarbons making ethanol as it produces, and its cost doesn’t even factor in the permanent loss of topsoil. I love Nebraska to the core, but this was not my home state’s finest moment.

Any comments on commodities?

I don’t think there’s a bubble in agricultural commodities like wheat, corn and soybeans. But in metals and oil there’s been a terrific [price] move. It’s like most trends: At the beginning, it’s driven by fundamentals, then speculation takes over. With copper there was a little shortage and then people got worried [and then the price skyrocketed]. As the old saying goes, “What the wise man does in the beginning, fools do in the end.” With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.

Once a price history develops and people hear that their neighbor made a lot of money on something, envy sets in and that impulse takes over. We’re seeing that in commodities – and housing as well. Orgies tend to be wildest toward the end.

But you never know when it will end. The eyes of the world that never looked at silver at $1.60 are now looking at it. [The price of silver today is around $14/oz.] My guess today is that copper is responding more to speculative pressures than fundamentals.

[CM [dripping with sarcasm]: I think we’ve demonstrated our expertise in commodities, if you look at our activities in silver. [Laughter]]

I bought it very early and sold it very early. We made a few dollars. We’re not good at figuring out when a speculative game will end.

It’s like Cinderella at the ball. At the start of the party, the punch is flowing and everything’s going well, but you know that at midnight everything’s going to turn back to pumpkins and mice. But you look around and say, ‘one more dance,’ and so does everyone else. Everyone thinks they’ll get out right at midnight.

This is what’s happening with copper today, Internet stocks in 1999 and uranium stocks in the 1950s. The party does get to be more fun – and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice.

We had a lot of silver at one time, but we don’t have it now. My original decision was that the production and reclamation of silver were running at 100 million ounces less than the consumption. Now a lot of consumption has gone down, for example in photography, but that’s where a lot of reclamation is as well, so it balances out. Silver was out of balance, but there’s now a lot above ground and a huge amount could be removed from other uses, which could increase supply, which is what happened when the Hunt brothers tried to corner the market in the early 1980s [actually 1979-80].

There are few pure silver mines – most silver is produced as a byproduct from other mining – so it’s not easy to bring on added production. I thought silver would get tight. I was early and sold early.

[To the questioner:] You’re right that a commodity doesn’t earn anything, so unlike a company, in which earnings are accumulating every year, you have to sit with a commodity and hope for a shift in the supply and demand. It’s a big drawback.

[CM: We didn’t get where we are by owning non-interest-bearing commodities. It’s a good habit to trumpet your failures and be quiet about your successes.]

Well, we have a lot of to trumpet then! [Laughter]

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[RE: Investing in silver]

I’m not sure who we sold our silver too, but whoever bought it was a lot smarter than I was. I bought it too early and sold it too early, but other than that it was a perfect investment. [Laughter] Charlie had nothing to do with it – it was all me.

Munger: I think we demonstrated how much we know about silver. [Laughter]

Buffett: When we bought it, we got a lot of letters about conspiracy theories of one sort or another. Silver responds to supply and demand, like any commodity, which is what determines its price (although the Hunt brothers changed that for a short while and regretted it).

[Q - Have you considered investing in metals to protect the company against inflation?]

We would not necessarily view metals investing as protection against inflation. The best protection is your own earnings power, whether the currency is in seashells or paper money. A first-class surgeon or teacher will do alright in terms of commanding the earning power of other people. The second best protection is owning a wonderful business, not metals or raw materials or minerals.

The truth is, if you own Coca-Cola or Snickers bars or anything that people are going to want to give a portion of their current income to keep getting, and it has low capital-investment requirements, that’s the best investment you can possibly have in an inflationary world.

But an inflationary world is not a good thing. We try to own good businesses. I think Berkshire wouldn’t do as well in real terms during periods of high rates of inflation vs. low rates, but we’d probably do better than most businesses.

We have no opinion on commodities. If we’re in an oil stock, it means we think it offers a lot of value at this price. If we think oil is going up, we could buy oil futures, which we did once.

We think Posco is the best steel company in the world. When we bought it, it was at 4-5x earnings, had a debt-free balance sheet and was the low-cost producer.

You can find some businesses with minimal capital investment. See’s Candy does not require much capital investment. It’s a small business, but a wonderful business – a far better business, adjusted for size, than any steel or oil business. We do everything we can to make it bigger.

We do not have a bias toward any commodity-related business. If we have any bias, it’s against.

Munger: We’re going to be investors in businesses, not commodities, and that has to work better over time.

What are the future trends in coal? Does the cost advantage outweigh the environmental impact?

WB: In the short term, the world will use more coal. There is an environmental disadvantage to it. We will slowly figure out ways to do things coal does now that are environmentally more friendly. But it won’t happen fast. If you shut down coal plants, we wouldn’t be able to hold this meeting. At MidAmerican, we have put in a lot of wind capacity, probably more than anybody. But we are dependent a lot on coal, and now it is cleaner than it was. It is a worldwide problem, with the Chinese building a lot of coal plants. Per capita, Americans have done a lot of negative things to this planet, so it is hard for us to preach. It will take a leader who can lead on this.

CM: I ask the people who are very against coal, ‘which would they rather use up first, coal or hydrocarbons?’

Coal is less desirable as a chemical feedstock to feed the world. [So, oil is more important to feeding the world]. There is an environmental reason for pro-coal use. Most people don’t think this way, but I do.

WB: Charlie doesn’t take comfort in numbers [having the herd agree with him].

Could you comment on your currency position?

We have about $21 billion in about 11 foreign currencies. We have $60-70 billion in things that are denominated in US Dollars. We still have a huge US bias. If Martians came down with currency certificates and could choose any currency on earth, I doubt it would be 80% in US Dollars.

We are following policies that make me doubt that our currency will not follow a downward spin. We lost $307 million this quarter. The net gain since we started holding foreign currencies in 2002 is $2.1 billion. We have to mark these future contracts to market daily. If we owned bonds instead of sterling forward contracts, it wouldn't fluctuate around so much.

Identifying bubbles is fairly easy. You don't know how big they will get and you don't know when they will pop. You don't know when midnight will hit, but when it does, it turns carriages to pumpkins and mice. What markets will do is pretty easy. When they will do it is more difficult. Some people want to stick around for the last dance, and they thought that a bigger fool would be just around the corner tomorrow.

When we bought those junk bonds, I didn't know we would make $4 billion in such a short time. It would have been better if it wouldn't have happened so quickly, as we would have gotten a bigger position.

Do you hedge and what are your thoughts on the U.S. dollar?

WB: We are happy to invest in businesses overseas, as I don’t think currencies will depreciate in a big way. We could offset but, overall, the US is following policies that will make the US dollar weaker. I’d bet weaker over the next 10 years, so we feel no need to hedge earnings generated overseas. If I landed from Mars today, with a billion Mars dollars, and was thinking about where to put money... What would I like to exchange? I wouldn’t put one billion Mars dollars into US dollars. I don’t mind earnings overseas. We own 200 million shares of Coca-Cola. That is $600 million of earnings to us, and $500 million of that comes from the rest of the world. I think it’s a net plus over time. We are not in the business of hedging currencies.

CM: Nothing to add.

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Buffett: I will guarantee you that the dollar will buy you less 5, 10, 20 years from now. The same thing is happening around the world, so it’s difficult to predict [the outlook for] dollars versus other currencies. Governments around the world are running very significant deficits—appropriately—to offset the recession. So the relative effects are unpredictable. Policymakers do not know the outcomes of today’s actions. We are doing things to lose purchasing power. You can bet on inflation.

Munger: In my life I have had the most privileged era to live in. I remember 2¢ postage stamps. A little inflation won’t ruin the lives of any of us. The trick is to avoid galloping inflation. That’s a problem Warren and I are going to quit claim to the next generation.

[The Dollar vs. the Euro. - a shareholder from Ireland asked whether the gains from any European acquisitions could be adversely affected by a loss in value of the U.S. dollar versus the Euro.]

Buffett: I’m no good at predicting the dollar versus the Euro. You can hedge currencies, but I don’t recommend it.

Munger: You’re pretty good.

Buffett: We did make a couple billion. [laughter] We’ll keep doing things that make sense. There are a lot of companies we feel comfortable with. We have a lot of indirect sources and direct sources of earnings outside the U.S., but no predetermined goal by location. Some opportunities will be found abroad, some won’t. We don’t wake up in the morning saying we want to have more [investments] in Germany or Spain.

Munger: There’s plenty of wrong on both sides of the Atlantic; plenty wrong and plenty right. It’s not clear that our messy details are any worse than Europe’s messy details.

What are your views on the dollar?

My views [on the likelihood of the dollar weakening] are as strong as ever, perhaps a bit stronger. It’s almost certain that the U.S. currency will weaken over time as a result of the fiscal and monetary policies we’re currently following. I don’t know about the next six months, but certainly over time.

We are doing less directly in currency futures because the carry costs have gone from positive to negative. In my view, there are considerably better ways to protect against the dollar getting weaker in the future. For example, we like to invest in companies, like Iscar, whose earnings are primarily in other currencies. We earn a lot of money in other currencies.

[Buffett read a quote about the dangers of running a large current-account deficit that ended, “Countries that have gone down this path inevitably run into trouble.”] Guess who said that? Alan Greenspan. When he said that in 2002, the current account deficit was $385 billion. Now it’s double that. In his later years as Fed chairman, he didn’t emphasize this view as much, but he didn’t repudiate it either.

It’s going to lead to trouble. People talk about a soft landing, but they don’t ever say how. [Current Fed Chairman Ben] Bernanke said he expects a soft landing, but also said there’s the possibility of something worse.

One possible outcome is significantly higher inflation. As you owe more and more, it’s tempting to devalue the currency in which the debts were incurred.

Munger: Generally speaking, it can’t be good to be running a big current-account deficit and a big fiscal deficit and to have both growing. A great civilization may be able to stand something like that for a longer period than you’d imagine at the outset, but you’d think at the end there’d be a comeuppance and you’d have to adjust and it would be painful. Do you agree Warren?

Buffett: Yes. I don’t see how people say it’s sustainable.

The longer it goes on, the greater the net debt position builds up and the more people see it. And then something perhaps extraneous causes some big adjustments to take place and the result is chaos, in which currency adjustments play a part. But it’s impossible to predict this.

Years ago, portfolio insurance was popular. People were selling this as a sophisticated way to manage money and mitigate risk – and they earned a lot selling it. Then October 19, 1987 came along. A relatively small portion of American investments were being guided by this doctrine, but just this small amount of money was the leading factor in a 22% one-day drop [in the Dow]. Everyone thought they were being reasonable, but they created a doomsday machine.

I think the odds of something like this – though not this exactly – is magnified today compared to the 1980s. I don’t know who will yell fire, but when it happens, I’m sure the currency markets will play a role in the race for the door.

Early on in you career you bought some land and then rented this out to some local farmers? Why didn’t you pursue this type of investment in real estate?

I made an initial investment farm real estate when I was 14. Someone else handled the whole transaction; I just bought 40 acres. A guy would farm the land and harvest X number bushels of soybean and sell if for $X per bushel at the market and say here is your check. I did virtually nothing for this investment. I had no idea if he actually harvested what he said he did, or if he sold the bushels he said he sold, or for that matter what price he sold it at. It’s kind of like the guys who kept all his cows in with a big herd. As they are taking them to market, the owner of the big herd says, sorry but all of your cows died. How would you know which cows were yours?

In 1980 with the S&L crisis, land was selling for $2,000 an acre. Well, an acre produced 120 bushels of corn or 45 bushels of soybeans. At a couple dollars a bushel, this was basically $80 an acre in revenue. At the time with the interest rates, you would pay $150 per acre in interest. So you were taking in $80 and paying out $150, it just did not make sense. The bankers went crazy lending money at $2,000 an acre prices for farms at 10% interest rates to produce $80 an acre in crops. Well after a bunch of people lost big time, the FDIC took control of the farms and ended up selling them at $600 an acre, which at the time was a good deal. The FDIC took over hundreds of farms because people went crazy and lost their shirts.

The S&L’s lost their fundamentals and the Government owned $100 million worth of properties they needed to dump at a low cost. This was an opportunity to make some money, however I still don’t like farms because they are too passive.

I still don’t like farming. My son likes farming, I don’t.

Accounting, Corporate Finance, and Investing

What adjustments to reported earnings do you make?

[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.

[CM: I think that, every time you saw the word EBITDA [earnings], you should substitute the word "bullshit" earnings.]

Recommendation of a book on accounting?

I haven't read an accounting book in 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.

[CM: 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]].

What can be done to improve the accuracy of financial statements of financial institutions? What can be done to improve the integrity of financial statements?

WB: It is a very tough thing. I still lean strongly towards fair value accounting—it is hard to use, but should we use cost? I think there are more troubles when you start openly valuing things at prices that don’t matter instead of best estimates, even if inaccurate. I would stick with financials reporting assets at fair value. When you get into CDO-squared [Collateralized Debt Obligation-Squared], the documentation is enormous. If you read a standard residential security prospectus it consists of thousands of mortgages, then different tranches. Then, you take a CDO and you take junior tranches on a whole bunch of juniors— put them together, and diversified in theory—a big error to start with. That was nuttiness squared. You had to read 15,000 pages to understand a CDO and 750,000 pages to evaluate one single security in a CDO-squared. To let people use the 100 cents they paid as the stated value versus the 10 cents it trades at in the market is an abomination. Fair value discipline, mild as it may be, may keep managements from doing some stupid things. I lean toward the market value approach. When you get towards complex instruments, I don’t know how you value it. Charlie, back at Salomon, I think you found one mismarked by $20 million, right?

CM: A lot goes on in the bowels of American industry which is not pretty. A lot of people got overdosed on Ayn Rand. They would hold that even an axe murderer in a free market is a wise development. I think Alan Greenspan did a good job on average, but he overdosed on Ayn Rand, in that whatever happens in a free market is going to be all right. We should prohibit some things. If we had banned the phrase, “this is a financial innovation which will diversify risk,” we would have been far better off.

Would you comment on companies you say use questionable accounting practices to make their operations look good?

We follow a policy of “criticize by practice, and praise by name.” You could say we hate the sin, but love the sinner. So I can’t really name names of companies that I think are doing this kind of thing; I’ve found that if you go around criticizing others, pretty soon the criticism comes back on you.

[CM: I don’t think they want names - I think she’s asking about the practice in general.

That’s different, then. The practices relate to accounting charges, done to smooth out earnings and make future earnings look good. It has become totally fashionable among managements to play with the timing of expenses.

Options expense recording has become optional as well; I haven’t seen tons of firms jumping on the chance to record stock compensation expense. And I think it’s deceptive to see it presented in the footnotes, the way it’s reported, because of the assumptions companies are using in valuing the options.

The thinking of these executives goes like this: “ Why should I penalize my shareholders for not doing something that others will do to help theirs?” And the bad practices become the norm.

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[CM: I certainly hope that we're better underwriters than Munich Re.]

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.

What does it mean to own stock in a company?

Owning stock in a company means that you own a piece of that company. If you own stock in the McDonald's company for example, it means you are one of the owners of McDonald's. Each piece of stock is called a share, and the more shares you own, the more of the company belongs to you. When the company is successful, your stock will become more valuable, too.

Where can you buy stock with the cheapest commissions?

There are many places to buy stocks, and the commissions all vary. It is important in life to look not for what is cheapest, but where the most value is delivered. I suggest that you ask your parents if they can check some of them out with you. Maybe you can make a chart where you can compare the costs on one side, with the services offered on the other. It will be a good exercise, and whether you buy stocks or not, you will learn from the process.

How do you know when you are going to lose money and when you aren't? Since the stock market changes every minute.

That is a very good question. The answer is you don’t know when you are going to make money or lose money. You are right, the stock market changes every minute. Because of that, you should never buy a stock expecting to make money in the short term. When you buy a stock, you are actually buying a share of that company. If it is a good company then you will make money over time as its value goes up. When you buy a stock, you need to imagine that the stock market will be closed for 20 years and you will not be able to look at its price. That way, you wont be distracted by the short term ups and downs. A company will be successful if it offers good products and services at a fair price while being run by honest, capable managers. Over the long run, such companies tend to appreciate and go up in value.

What's the role of the board of directors?

Most writers and shareholders probably have a little bit of a distorted view of how most large corporations have operated over the years. For a long time, most directors were sort of like potted plants. Management had its agenda and didn’t want input on major matters and Charlie and I can testify that we’ve had very little success in influencing big issues. If someone’s spent 20-30 years rising to become CEO, they don’t want a board telling them what to do. It’s changed a little bit today in terms of process.

Overwhelmingly, the most important job of the board is to pick the right CEO. If you were on the board of Cap Cities and you hired Tom Murphy, case closed.

The second most important job of a board is to prevent the CEO from overreaching. A board should bring independent judgment on acquisitions. There’s a natural tendency for CEOs to want to become bigger by spending other people’s money. The deal is already done by the time the board knows about it. The investment banker comes in and I’ve never seen a banker say, “This is a dumb idea.”

When a significant deal comes along, it’s a chance for the board to weigh in and discuss the economics of what’s going on. But the CEO doesn’t bring a deal unless he wants it done and so he stacks the deck.

Munger: I think big deals, on average in America, are contrary to shareholders’ interest.

Buffett: In most stock deals, the CEO thinks about what he’s getting, but not what he’s giving. You have to make sure you think about this. I can’t ever think of a discussion [when I was on a board] of weighing what you’re giving away vs. what you’re getting in a stock deal. If more value is being given away, then don’t do it! When I gave away 2% of Berkshire to buy Dexter shoes, it was one of the dumbest things ever. Not 2% of Berkshire then, but 2% of Berkshire today!

Munger: Fortunately, you’ve made some good decisions.

Buffett: Or half of you wouldn’t be here. It gets swept under the rug.

We owned a bank that went to acquire a smaller bank. The CEO of the smaller bank held out for a high price and various terms and conditions and, because he was taking stock, had one last condition for the acquiring bank: “Promise never to do a deal this dumb in the future.” [Laughter]

I’ve been on some terrific boards. The best was probably a local business, Data Documents. Every board member had a significant percentage of his net worth in the company and every decision was made for business reasons.

In contrast, the standard now is when deal is possible, trot in the investment bankers. I know the answer: they always say, “This is a great deal.”

At Berkshire, almost everyone on the board has a lot of Berkshire stock. They’re in the same position as shareholders. They don’t have D&O [Directors and Officers] insurance and they bought the stock in the open market. It’s a real owners board.

Your thoughts on EBITDA?

It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.

We won't buy into companies where someone's talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don't, I suspect you'll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft -- they'll never use EBITDA in their annual report.

People who use EBITDA are either trying to con you or they're conning themselves. Telecoms, for example, spend every dime that's coming in. Interest and taxes are real costs."

Opinion on share buybacks? and dividends?

The equation is simple, but practice doesn’t always follow logic. Assuming you’ve been honest with shareholders [in communicating enough information so they can estimate intrinsic value], then if your stock is far below intrinsic value, buying it back adds a lot of value. The Washington Post did this and Teledyne bought back 90% of its stock over time.

Today, stock buybacks are popular. The underlying rationale – not the professed rationale – is that people hope the stock price won’t go down. But often this doesn’t make sense for shareholders. If the stock is underpriced, buy it back with excess cash; if it’s overvalued, don’t buy a single share.

If we wanted to return cash to shareholders, we’d go to them and say, “Our stock is cheap and we’re going to return cash to you by buying it back.”

In terms of dividends, you get into an expectational problem. Most public companies don’t bounce around their dividend from year to year (although this is very common in private companies and Berkshire subsidiaries) because investors come to rely on it. So once you establish a dividend policy at a public company, think a long time before changing it.

[CM: The total amount paid out in dividends is roughly equal to the amount lost in trading and investment advice, so net dividends to shareholders are zero. This is a very peculiar way to run a republic.]

In a Fortune article I published in 1999 [Mr. Buffett on the Stock Market, 11/99], the frictional costs are equal to the total amount paid out in dividends.

Companies should be paying out dividends. Take See’s Candies: we haven’t figured out a way to grow it, so we can’t reinvest, so something approaching a 100% payout [of profits] would make sense [were it a public company]. Most managements want to ensure regularity [of dividends], so they go with a conservative level [below 100%].

We think about this at Berkshire. If we didn’t think we could put it [all of our excess cash] to work, then we’d pay it out. But we expect – and this is reasonable, I think – that we will have the chance to put it to work.

[If we decided to return cash to shareholders and] if our stock wasn’t underpriced, then we’d probably pay out a dividend – but don’t count on it anytime soon.

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One reason not to pay a dividend is taxes, but we’ve always said that even if we could have paid a tax-free dividend, we would not have done so. Our test has been whether, if we retain a dollar, will it be worth more than a dollar in present value. So far we’ve always passed this test.

But it’s no fun sitting on $40 billion, which earned less than 1% last year after tax. The burden of proof will shift in the next few years. We always ask, “Can we use the money effectively within our business?” So far, the answer has been yes. This will be discussed at our board meeting on Monday.

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Most of the time, we wouldn’t be able to buy an amount of our stock that would be material to our remaining shareholders. We probably have less opportunity to do so than other large companies.

[Buffett then put up this chart, which showed share turnover last year for the following companies: Berkshire Hathaway 14%, Exxon Mobil 76%, General Electric 48%, General Motors 487%, Wal-Mart 79%]

Look at these turnover figures. I think Berkshire has lower turnover by some margin than any major company in the U.S. I put Wal-Mart up there because the Walton family owns more of Wal-Mart than I do of Berkshire, so [our low share turnover is] not just because of that.

Our shareholders are long-term and loyal owners. We have the most honest-to-god attitude of ownership of any public company. People buy it to own it. It does mean that if it gets cheap, we won’t be able to buy much. But that’s OK. We’re not looking to make money off shareholders by buying them out at a discount.

The motivation for buying back stock used to be just because companies thought their shares were cheap. Thirty or forty years ago, it was very fertile to invest in companies that were buying back their stock. The most extreme case was Teledyne – we made some money investing there.

But that’s being swamped today by companies doing it because it’s in fashion or to prop up the stock. The SEC has rules to prevent propping up the stock on a daily basis [but companies still try to do it]. We wouldn’t do it for those reasons.

A few years ago, when we were willing to buy back our stock, the fact of writing about it [in the 1999 annual letter, page 16] eliminated the opportunity.

[It’s very interesting that Buffett had this slide prepared in advance. I think it’s because he knows his stock is cheap – we think it’s as cheap as it was on March 10, 2000, the only time he’s ever been willing to buy it back – and the company is much stronger and has a much brighter outlook than it did then. Buffett no doubt expected that he might catch some flak from shareholders for not announcing a buyback, but rather than addressing that question directly, he chose to deflect it by basically arguing that even if that would be the best use of Berkshire’s capital right now, the stock is too illiquid to buy back much stock anyway.

All of this being said, even if the stock were more liquid, I’m not pounding the table for share repurchases in light of the acquisition of Iscar. I’m drooling at the prospect of more acquisitions like this one – as are, I’m sure, Buffett and Munger.]

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[Q - You've previously encouraged companies to repurchase stock. Please could you address the issue of Berkshire buying back its own shares?]

Buffett: My comments go back a lot of years. I haven’t written about other companies repurchasing in about 10 years. Repurchases in recent years were foolish, because they paid too much. They were trying to give out buy recommendations that weren’t justified. In the 1970s and 1980s, we encouraged others to repurchase because [shares] were demonstrably cheaper than anything else. We only felt in 2000 that we wanted to do so, because Berkshire’s intrinsic value [didn’t match] its stock price. But it was self-defeating [the announcement of Buffett’s intention to repurchase sent Berkshire’s stock higher]. [Repurchases] should be quite compelling, and that doesn’t exist now. Ninety percent of repurchases in the last five years were at silly prices and not in the interest of shareholders. Managers did it because it was what everyone else was doing. It’s interesting how many companies bought at two times current prices that aren’t [buying] now.

Why do you not believe in dividends when Benjamin Graham believed in them?

WB: I had to show a little individuality. [laughter] I do believe in dividends, including dividends at companies where we own stock. The test on dividends is, ‘can you create more than one dollar of value with the one you retain?’ It would be a mistake for See’s to retain money because they have no ability to use the cash they make to generate a high return internally. We hope to move the capital to a place where it will be worth $1.20. If we do that, taxable or not, they are better off if we retain money. But when the time comes that we don’t think we can use money effectively, we will pay it out. But because we have the ability to redistribute money in a tax-efficient way within the company, we have more reason to retain earnings in the company. We like companies where we have investments to pay to us the money they can’t use effectively.

CM: Costco paid no dividend when they were growing rapidly. As St. Augustine said: “God give me chastity, but not yet.”

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[Q - From 2003 through 2008, Berkshire’s market price didn’t increase by the amount of retained earnings, why don't you change Berkshire’s dividend policy?]

Buffett: If we had to sell our business on December 31, 2008, we would have had a loss. Reinvested earnings did not produce [gains]. We use book value as a proxy for business value. We measure against the S&P 500—our intrinsic value has never had a five-year period when we underperformed the S&P 500.

Munger: I don’t get too excited about these oddball things that come along once in 50 years. I think Wells Fargo [for example] will come out of this mess much stronger.

Buffett: In a terrified market, Wells Fargo got to below $9—when aspects of their business were never better, and their business model is fabulous. Pushed by a student, I said that if I had to put all of my money in one stock, it would be Wells Fargo at $9.00. Wells will be a lot better off a couple of years from now than if all this business had never happened, unless they have to issue lots of shares, which they shouldn’t. You never want to be in a position to have to sell [due to a margin call] or emotionally. Why would someone sell Wells Fargo at $9.00 when they bought it at $25.00, and now it’s better off? It’s crazy. I own a farm about 30 minutes from here, and if you own a farm, you don’t get a price on it every day. Look at the asset for value, not the price—as you would with a farm. People let the stock price, not business results, [affect their assessment of a company]. Read Chapter 8 of The Intelligent Investor. The fact that a [price] quote is available every day turns into a liability.

Your thoughts on inflation?

The best thing to combat the threat of inflation is to have a lot of earnings power of your own. If you’re the only surgeon in town, you’ll be OK [because you can simply raise your prices to keep up with inflation and people will pay it]. Charlie and I think it’s best to own fine businesses that can price in inflationary terms and don’t require big capital investments. See’s Candies can handle an inflationary world and maintain value.

Unfortunately, most businesses will not come out well in real terms. Earnings might be up, but the business will be compelled to invest more and more dollars into the business to stay in place. The worst businesses compel you to put more and more in, without any rise in profits.

TIPS [Treasury Inflation Protected Securities] are not a bad investment for people worried about inflation heating up, which we’re seeing signs of.

[CM: Most people will see declining returns [due to inflation]. One of the great defenses if you’re worried about inflation is not to have a lot of silly needs in your life – if you don’t need a lot of material goods.]

Buffett: Charlie, we’re selling a lot of material goods in the other room, so keep quiet. [Laughter.]

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The talk of deflation was total nonsense.

You would think that the trade deficit, which has resulted in a weaker currency, would have led to higher inflation.

The price of oil has risen far more in dollars than in euros.

So, inflation matters. It’s always there and is something we think about. But See’s Candies will do fine in an inflationary environment.

[CM: So far, the weak dollar has acted to restrain inflation.]

Yes. For example, we’re paying less for shoes, few of which are made in the U.S. anymore.

We don’t want to be long the long bond [e.g., he thinks there’s risk of rising interest rates].

But if you’d told me two years ago what the macro conditions would be today, I’d have been very surprised by where interest rates are today [i.e., he thought they’d be higher].

[CM: There won’t be an automatic correlation between interest rates and inflation – there will be weird things.]

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[Q - An 11-year-old from New Jersey asked how inflation will affect his generation. How is Buffett preparing for inflation?]

Buffett: Inflation is going to affect you. Long term, even a small amount is bad. It’s certain we’ll have inflation over time. Volcker opined against an FOMC [Federal Open Market Committee] 2% target for inflation. It is something of a slippery slope. Current policies are bound to have inflationary consequences. Inflation is a classic way to reduce the cost of external debt. Federal revenues are going down. Politicians say that taxpayers pay for this or that, but if taxes are less now, who’s paying? The real payers are [those affected by] the shrinkage of the value of the dollar down the road. The people who are really paying are those that are buying fixed income investments now—the Chinese, for example. That’s the ultimate price of stimulus. The easiest thing to do [inflate] is the likeliest. The best protection from inflation is your own earning power. The second best is owning a wonderful business, such as Coke, that doesn’t require capital. With Coke, you’ll get your share of national earnings.

Munger: The young man should become a brain surgeon and buy Coke stock, not [government] bonds.

Buffett: I get paid by the word. He doesn’t. [laughter]

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[PIMCO’s] Bill Gross has written about whether inflation is being captured correctly. If you go out to the Nebraska Furniture Mart, you’ll see that prices haven’t moved up much over time. And in some areas, like DVD players, prices are down 75%, so there’s been deflation.

But when I see that “core” inflation excludes food and energy, I can’t think of anything more core than food and energy. Also, the CPI [consumer price index, the official measure of inflation] uses a computed rental price, but this does not reflect new housing prices. The rental factor has significantly lagged the rise in housing.

But if you own your own house and drink Coke, you’re less affected – my CPI, for example, hasn’t changed very much. But if you’re buying a house and drive 40 miles to work every day, your CPI has gone up a lot.

Munger: I see almost no change in the price of the composite product that flows through Costco [Munger is a Director of Costco]. I don’t feel sorry for the people who pay $27 million for an 8,000-square-foot condo in Manhattan. So inflation comes in places.

Buffett: Costco’s and Wal-Mart’s LIFO adjustments are almost nothing – it’s inconsequential. [LIFO stands for “last-in, first-out”, and means that when a product is sold from inventory, its cost is based on the price paid for the latest such items purchased by the company. If the cost of the product is rising rapidly, this can cause the old inventory to become valued at less than the current market cost, necessitating a LIFO adjustment. In contrast, if there’s no inflation, the LIFO adjustment is nil.] You’re dealing with $200 some billion in sales at Wal-Mart and the LIFO adjustment would pick up any inflation [but it’s not there].

In our jewellery stores, there have been big LIFO adjustments recently. It’s the same with our steel operations. Carpet prices went nowhere for 20 years, but because it’s petroleum based, it’s moved up a lot recently and now we have $100 million or so in LIFO adjustments.

Overall, for a typical young family, the CPI probably understates inflation in terms of their living situation.

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[Q - Inflation problem you talked about in 2008 letter, but you didn’t mention inflation in 2009 letter. Why?]

WB: I may be biased, as I have always worried about inflation. And there has been a lot of inflation. I was born in 1930 and the dollar is down 90% since then but we’ve done okay. I think prospects for inflation around world have increased. Situations that governments have been forced into or allowed to embrace may cause it. Weaning ourselves from medicine may be harder than original illness, there is massive debt. I don’t see any way countries running high debt to GDP over time doesn’t have diminution of currency over time. I wrote OpEd in NYT last year. I would bet on higher inflation, and maybe a lot higher.

CM: Again, I agree.

[Q - What are key metrics you look for on inflation, and catalysts for a future rise?]

WB: You give me credit for more brainpower than I actually bring to the question. You can’t look at any metric. If it gets going, it creates its own dynamic and is very hard to stop. We saw it in 1970s until Volcker came in with a sledge hammer. Prime rate was at 21% and governments up to 15%. We had a demonstration project 30 yrs ago. If we continue today’s policies, something like that could be possible. Trend is not destiny. We have power to control our future. We do it through elected representatives If inflation gets into saddle, faith in institutions could break down.

Currencies are a poorer bet than they have been in a long time but I do not know what that means for the near future. Remember that your money can be inflated away but your talent cannot. As long as you are the best at what you do you will be entitled to your portion of profits.

CM: Contribute the most to civilization and counter the effects of inflation. To outsmart others isn’t the best way to do it. If you are best painter or best brain surgeon, you will always command your share of the economy around you. Talent is terrific asset to deal with it. The best defense is to contribute to the world and to try to make yourself more talented.

Do you see deflation as a threat to our investments?

I have a tough time envisioning a world in which we have to worry about deflation - but I don’t have much of a record on that, being a macro kind of issue. Deflation, if you think about it, helps investors and savers, because it raises the value of your cash.

Truth is, I don’t know how it would affect us.

What's your opinion of Enron and creative accounting?

[CM: "Creative accounting is an absolute curse to a civilization. One could argue that double-entry bookkeeping was one of history's great advances. Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform. Enron was the most obvious example of a business culture gone wrong in a long, long time.]

To the extent people will look more carefully at companies, Enron was a plus to the American economy.Enron will have a distinct beneficial effect on auditors, and it was much needed.

[CM: "It will have a distinct beneficial effect on one less auditor.

I think it would have been a shame if Salomon had gone under. Charlie and I may disagree on this one. What about the innocent bottom 40,000 people at Arthur Andersen?

[CM: "I regard it as very unfair, but capitalism without failure is like religion without hell. When it gets this bad and there's a lack of system for control -- which Arthur Andersen didn't have -- maybe a firm should just go down."]

What if we did something terrible? Would it be fair for all of Berkshire's employees to suffer?

[CM: "We couldn't do anything that would bring down Berkshire…Arthur Andersen was particularly vulnerable because it was a partnership. A partnership must be extra careful in its behavior, choosing clients, etc."]

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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.

[CM: 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?]

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.

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Any accounting that gives people a rationale to reduce reserves even further is bad. There’s such a tendency to reduce reserves for long-tailed [insurance] policies – to understate them – especially if the CEO is retiring or options are vesting.

In derivatives, both sides book a profit; this is especially true of traders who are on commission.

We’re three years into unwinding Gen Re’s derivatives book and you would not believe the complexity. Most of it was marked to market, so you’d think it would only take a few days to unwind.

I don’t think any regulator or auditor [has any hope of getting a handle on any big derivatives book].

[CM: The stupid and dishonest accountants allowed the genie of totally inappropriate accounting to descend on derivatives books. And once this has happened – people get status, etc. – it’s impossible to get it back into the bottle.

The housewife preparing her toast in the morning just isn’t worried about a derivatives blowup.

The people with vested interests in the status quo are very powerful. If you’re going to try to fix this, you’re going to have a very interesting life.]

What's your opinion of day trading?

Buffett: If you take the percentage of bonds and stocks held by people who could change their minds tomorrow based on what the Fed does, etc., it’s gone up a lot. I call it an electronic herd, who change what they do every day or minute. The turnover of stocks has gone from 40% to over 100%, and the turnover of bonds has gone up dramatically as well. There’s nothing evil about it, but it’s a different game and there are consequences. If you’re trying to beat the other fellow on a day-to-day basis and you’re watching the news or the other fellow, and you think he’s going to push the sell button, you’ll try to push it quicker.

When Charlie and I were at Salomon, they talked about 5- or 6-sigma events, but that doesn’t mean anything when you’re talking about real markets and human behavior. Look at what happened in 1998 and in 2002. You’ll see it when people try to beat the markets day by day.

When I set up my partnership [the Buffett Partnership], I told my partners they’d hear from me once a year.

Munger: When people talk about sigmas in terms of disaster probabilities in markets, they’re crazy. They think probabilities in markets are Gaussian distributions, because it’s easy to compute and teach, but if you think Gaussian distributions apply to markets, then you must believe in the tooth fairy. It reminds me of when I asked a doctor at a medical school why he was still teaching an outdated procedure and he replied, “It’s easier to teach.” [Laughter]

Buffett: It’s very disturbing to spend years learning higher mathematics and then learn that that stuff has no utility or that there’s even counter-utility. It’s hard to change, so people just keep on teaching [incorrect things].

What's your opinion on asbestos liability?

Asbestos is a big part of our liabilities. But we are capped, which is a good thing because asbestos continues to explode. Last year, we said it would be worse than anyone expected and it has been and will continue to be. Many companies thought to be insulated are being dragged in.

Asbestos is actually creating some opportunities for Berkshire to buy companies that went bankrupt due to asbestos claims -- free of asbestos liabilities. We probably wouldn't own Johns Manville were it not for asbestos.

It's a cancer on the American corporate world and it's growing.

[CM: "Asbestos has morphed into a situation with enormous amounts of fraud, etc. People with serious injuries are being hurt [as more and more money flows to the plaintiff's bar and claimants with no current injuries]. The Supreme Court has practically invited Congress to step in, but Congress has refused due to the influence of the trial lawyers. I'd be surprised if there's a constructive solution in the next five years. I expect there will just be more of the current mess.

There was a solution, but the Supreme Court didn't allow it.

We've very careful to avoid asbestos liabilities. I'm not worried about our insurance companies [via-a-vis their exposure to asbestos].

You have a plaintiff's bar -- going beyond asbestos -- that will take any human adversity and try to make a profit out of it by suing those with deep pockets.

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[CM: What’s happened in asbestos is that a given group of people get mesothelioma – a horrible cancer that comes only from asbestos exposure and kills people. Then, there’s another group of claimants who smoked two pack of cigarettes a day and have a spot on their lung. Then you get a lawyer who gets a doctor to testify that every spot is caused by asbestos. Once you effectively bribe a doctor, then you can get millions of people to sue on fears of getting cancer.

But there’s not enough money [to pay all of the claimants], so people who are truly harmed don’t get enough. In a southern state with a jury pool that hates all big companies [you get big judgments], but lawyers are stealing money from people who are hurt and giving it to people who aren’t entitled. It’s a bonkers system, but with federalism [state’s rights], there’s no way to stop it. The Supreme Court refused to step in.

The Manville [Personal Injury Settlement] Trust [created when Johns Manville went into bankruptcy; it separated the operating company from the asbestos liabilities; Berkshire bought the operating company and the proceeds went into the trust to pay asbestos claims] had more new claims last year than in any year – and the company last mined and sold asbestos 35 years ago.

Trying to buy people off is like trying to put out a fire by dousing it with gasoline. With word processors, lawyers can easily produce countless claimants. But only 25% of the money goes to claimants – the rest goes to the lawyers, doctors, etc.

The only people who can fix it are the Supreme Court or Congress. The Supreme Court – some people would say rightly – refused to get involved [but I say] they chickened out. And Congress, given the politics, has yet to step in.

There’s an important lesson here: Once wrong-doers get rich, they get enormous political power and you can’t stop it, so the key is to nip things like this in the bud.

It would be easy to fix the problem: the right way is to say we’re not going to pay off all these little claims.]

We own Johns Manville and their behavior was reprehensible.

[CM: Johns Manville’s behavior was one of the worst in the history of Corporate America – they knew asbestos hurt people and covered it up to make more money.]

We have no connection to this. The Manville Trust has billions of dollars and has been around for close to 20 years.

It didn’t have a record number of claims last year due to new injuries. Rather, it’s a honey pot. But they’re only paying 5% on claims, so the guy who’s been drastically injured is only getting a small amount. It’s not the right way to do it.

Regarding the proposed legislation [in Congress]: in the end, we didn’t support it. It wasn’t the answer we needed.

The Supreme Court, when they ducked it, they left a problem that will be around for decades and decades.

[CM: If you want to be cynical, look at the perjury. There are only three solvent companies left [facing asbestos claims], so [surprise!] plaintiffs can only remember those three names [when recalling which products they were exposed to decades ago]. It’s a case of perjury being suborned by practicing lawyers.]

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[CM: There’s been terrible behavior by doctors, terrible behavior by lawyers, gutless behavior by courts, and even more gutless behavior by politicians, who [he said something disparaging about them].

You keep hoping that it will get so bad that things will change, that reform will happen. And it can happen: for example, the Workman’s Comp system in California. With the Schwarzenegger revolution in California, it’s been partly – maybe 15% – corrected. If it gets bad enough, it’s possible that it could be fixed.

It’s crazy that judges give money to people who smoked two packs of cigarettes a day for their entire lives, are dying, and have one little spot on their lungs.

Even asbestos will eventually go away, but who knows how much damage will be done before the storm passes.

But the behavior is so terrible It’s that kind of behavior that makes me talk about [the U.S. being at] the apex of its civilization.]

What are your thoughts on short selling?

It's an interesting item to study. It's ruined a lot of people. You can go broke doing it.

You'll see way more stocks that are dramatically overvalued than dramatically undervalued. It's common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it's not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it's worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, "Hey! Look at all that value creation!" and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas."

Everything we've ever thought about shorting worked out eventually, but it's very painful. It's a whole lot easier to make money on the long side. You can't make big money shorting because the risk of big losses means you can't make big bets.

[Munger: "Being short and seeing a promoter take the stock up is very irritating. It's not worth it to have that much irritation in your life."]

We would never short anyway because we're too big.

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[CM: "It's dangerous to short stocks."]

"Charlie and I have agreed on around 100 stocks over the years that we thought were shorts or promotions. Had we acted on them, we might have lost all of our money, every though we were right just about every time. A bubble plays on human nature. Nobody knows when it's going to pop, or how high it will go before it pops.

A.W. Jones, which had a long-short model, developed the best-known hedge fund in the late 1950s and early 1960s. They were market neutral, but didn't stick with it. Something went wrong with A.W. Jones. A very high percentage of its spin-off funds bit the dust. There were suicides and people lost their fortunes and had to drive cabs.

Ben Graham didn't find shorting particularly successful. Quite a high percentage of his paired investments worked, but he lost a lot on the few he lost on.

I had a harrowing experience shorting a stock in 1954. I wouldn't have been wrong over 10 years, but I was very wrong after 10 weeks, which was the relevant period. My net worth was evaporating.

Shorting is just tough. You must bet small. You can't short the whole company. It takes just one to kill you. As it rises, it consumes more and more money.

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There’s nothing evil about short selling. There are people on the short side who have done things to make some stocks go down – some of which is appropriate and some of which is inappropriate. People do that on the long side as well, so I have no ax to grind with short sellers. We have no problem with anyone shorting Berkshire stock. There’s nothing I’d like more than to be paid to lend my stock to shorts.

I do think it’s a very tough way to make a living, both financially and psychologically. If you buy something at $20, you can lose $20. If you short at $20, you’re loss can be infinite.

As you know, we have a friend who’s been outspoken on naked shorting [referring to Overstock CEO Patrick Byrne, who used to be President and CEO of Berkshire subsidiary Fechheimer Brothers]. I don’t have a great problem with it. If anyone wants to do that with Berkshire, more power to ‘em.

Companies with a large short interest very often have been revealed as frauds or semi- frauds – not the one my friend runs. Over the years, I’ve probably had 100 ideas of things to short and I would have eventually been right [on almost all of them]. But [because it’s so hard to get the timing right,] I likely wouldn’t have made much money and there would have been a huge opportunity cost. Someone who’s running a fraud is probably very good at it and can keep it going a long time. I would never put money with a short fund – not because I have any problem with it ethically, but because I question if they could make money over time.

[CM: It would be one of the most irritating experiences in the world to do a lot of work to uncover a fraud and then watch it go from X to 3X and watch the crooks happily partying with your money while you’re meeting margin calls. Why would you want to go within hailing distance of that? [Laughter]]

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I’ve never been in a position to ask a broker from whom I’ve bought to deliver the shares and not had it happen.

I don’t see the problem of people shorting stocks, assuming they’re not manipulating the market. I would welcome people wanting to short Berkshire. In fact, I’d lend them stock and earn extra income. They’re a certain future buyer.

If anyone wants to naked short Berkshire, they can do it until the cows come home. In fact, we’ll hold a special meeting for them. [Laughter]

The shorts generally have a tougher time of it in this world. More people are bullish on stocks. It’s a tough way to make a living. It’s very easy to spot a phony stock or a heavily promoted stock, but it’s hard to say when it will turn. If it’s trading at five times its intrinsic value, there’s no reason it can’t trade at ten times.

I don’t see shorts as any great threat to the world. If a lot of people want to short your stock, they have to pay you [for the borrow]. We did this with USG. One large brokerage firm approached us [about lending out our stock] and we were happy to do this. We charged them a lot. We even forced them to hold it for a certain period of time so we could continue to earn money on the borrow.

Munger: There’s tremendous slop in the clearance process. It’s not good for a civilization. It’s like having slop in the management of your nuclear power plants.

Buffett: If I buy 1,000 shares of GM and ask my broker to deliver it and he doesn’t, what’s the situation?

Munger: If you’re a private customer, you have to wait a while. There’s a lot of slop in derivative trading.

Buffett: But can’t I take my broker to court after three weeks?

Munger: I don’t think that there’s any court that can give you a stock certificate just because you want it.

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[Q - What do you think of short sellers being investigated for being publicly bearish and short selling companies? Is short selling healthy? Is a healthy discussion between bulls and bears healthy for the markets?]

Buffett: There is nothing wrong with people who are positive or negative speaking out as long as they are responsible for what they say. You can do things on the long or short side that are unethical or illegal. Anytime you attack conventional wisdom though, you will get a lot of negative feedback. When he and Charlie criticized the EMH (Efficient Market Hypothesis), it was so widely accepted people didn’t like their comments. In general he has no problem with short selling.

Munger: For the most part we are criticizing the wrong people (the short sellers). The people the criticisms should go to are the accountants who allowed the bad accounting should be held in the dock. The accountants let this happen, and they get very little criticism, and that is a mistake.

Opinion on IPOs?

[CM: It is entirely possible that you could use our mental models to find good IPOs to buy. There are countless IPOs every year, and I’m sure that there are a few cinches that you could jump on. But the average person is going to get creamed. So if you’re talented, good luck.

IPOs are too small for us, or too high tech, so we won’t understand them. So, if Warren’s looking at them, I don’t know about it.]

An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.

The seller of a $100,000 house in Omaha will never sell for $50,000. But if 100 entities each owned 1% of a basket of homes in Omaha, the price could be anywhere.

You’re way more likely to get incredible prices in an auction market.

Are corporate jets a waste of shareholders’ money?

I want to report that we’re solidly in favor of private jets. [Laughter]

Charlie used to travel by bus, and only when they had a senior discount. In recent years, I’ve shamed him into getting a NetJets share; I have two. Berkshire is better off because we use corporate jets. I don’t know which deals wouldn’t have been made, but I do know [that without a private jet] I would not have had the enthusiasm to travel thousands of miles to see deal after deal. It’s a valuable business tool.

It can be misused like everything else. I remember that one time we invested in a company and the CEO stopped in Omaha to see me. He used a grocery chain in Idaho to test products, but also had a lodge there. Properly used, corporate jets have been a real asset to Berkshire.

Munger: If the trappings of power are greatly abused, I think you would find those companies would be disappointing to investors. The Roman emperor who was best remembered was Marcus Aurelius – he had no trappings of power, though he could have. The best way to combat [the excesses of leaders] is to have examples of exemplary behavior.

Can you forecast the continuing debate between Efficient Market Theory (EMT) proponents and value investors? Are your designated successors “outliers” as well?

The market is generally fairly efficient in evaluating asset classes, but not always efficient in valuing specific businesses. I think EMT probably hit its peak in popularity twenty years ago; it became terribly popular in academia. You had to buy into it to get anywhere in academia. People would have had to give up the work on their Ph.D. theses if they rejected the EMT.

It doesn't appear to be as popular these days. I don’t know if it’s as much holy writ as it once was. Some schools are now offering other courses that really help you learn to value a company. But it’s hard to dislodge a belief that becomes dogma in finance departments.

[CM: The old guard of physicists also clung to their beliefs and wouldn’t accept the findings of the new crop of physicists. The old guard eventually died off, their teachings faded away, and the work of the new physicists became accepted. That will happen with the efficient market theorists, too.]

There’s something about the whole thing that’s always puzzled me. If companies are always valued perfectly because everyone else knows more than you do about everything, then there’s nothing else for you to do. I’ve always wondered what they talk about on the second day of class in that course. The first day they tell you that the markets are efficient and value everything just fine. So now what do we do?

How did you get to be so rich?

I was lucky to be born in a free country like America where I had all kinds of opportunities. And I had parents who made sure I understood the importance of a good education, and I learned at a very early age how important it is to work hard and be honest. I always had an interest in business, and learned how important it was to listen and learn. I only invest in a business I fully understand, and then I am patient and I let my investment grow. My advice to you is to work hard in school, and look for something you like to do. If you are happy, you will be successful.

What is your unified principle?

WB: In ten words or less. [laughter]

CM: Pragmatism. Partly we do it in our different ways because it suits us, and partly because it works better. It is just that simple. We’ve had enough good sense when something working well, keep doing it. The fundamental algorithm of life: repeat what works.

Thoughts on banks willingness to deal with shady characters?

Munger: It’s amazing what goes on. Salomon was at least as disciplined and rational as other investment banks, but by the end Salomon was begging for investment business from Robert Maxwell, whose nickname was “The Bouncing Czech.” You’d think if this was his nickname, investment banks wouldn’t be chasing his business.

The day they found him bobbing [in the water; he committed suicide as the scandal about his misdeeds broke], we [Salomon] sent money to him in exchange for money he was sending to us, but he didn’t pay. So, we went to England to collect from his sons and it was a mess. We got what we deserved.

To an investment banker, his earnings would be affected to a significant way if he wrote a few more tickets to Maxwell. You have to control this if guys can make money by bringing dubious things in the door.

[Buffett and Munger chuckled to themselves as they recalled Salomon doing business with another shady character they didn’t name. At the 2002 annual meeting, however, Munger identified the company as First Normandy, an IPO that Salomon had to pull before money exchanged hands when they discovered the promoter had completely manufactured his record. In fact, the company was called Normandy America Inc. and, according to a report on the SEC’s web site, “Normandy's stock commenced trading on the NASDAQ National Market System on August 15, 1995. One day later, Normandy withdrew its offering from the market and rescinded all trades.”]

[CM [dripping with sarcasm]: That was a wonderful experience. Warren, Lou Simpson and I were all on the board [of Salomon], we were the largest shareholders, and we said, “Don’t do business with this guy.” But they ignored us and said that the underwriting committee had approved it.]

He had a neon sign on him saying “CROOK.” He did go to jail. Incidentally, he claimed to have owned a lot of Berkshire stock and to have made a lot of money on it, but I checked the shareholder records and couldn’t see it. It could have been in street name, but for a block that big, I think I would have found it [so he was probably lying about his Berkshire holdings.

Risk of holding assets at banks or brokerage houses?

As a depositor in major banks and brokerages firms, I wouldn’t worry. We have a too-big-to-fail view toward large institutions to protect depositors – though this is not true of equity holders or margin accounts.

Any comments on the behaviour of accountants in tax avoidance schemes?

Some of the tax shelter proposals that were sponsored by the most prominent auditing firms were absolutely disgusting. [Such schemes are one of the] reasons why the middle class pays more taxes than it should.

Berkshire is a heavy contributor to the Treasury. As I pointed out in the annual report, if only 540 contributors paid what we did last year, no-one else would have pay anything – corporate, personal, social security, etc. taxes.

Sure, we buy tax-exempt bonds sometimes but we pay full 34% taxes on our capital gains.

[CM: You’ll better understand the evil when top audit firms started selling fraudulent tax shelters when I tell you that one told me that they’re better [than the others] because they only sold [the schemes] to their top-20 clients, so no-one would notice.]

And the lawyers wrote the opinions [blessing these schemes] – don’t leave them out.

We had people come to our office, from top auditing firms – but not our auditors [Deloitte & Touche] – and they wanted us to sign confidentiality agreements for schemes to set up 20 offshore trusts, etc. It was designed to be so complex and spread out that no [IRS] agent could figure out the totality.

It makes everyone else pay more. I was a little hard on Pamela Olsen [Assistant Secretary for Tax Policy at the U.S. Treasury, who Buffett criticized in his annual letter (pages 6-7) for accusing him of “playing the tax code like a fiddle”], but I applaud Pamela on her work exposing this.

Does protection of the banking system warrant the lack of public disclosure in Bank of America’s purchase of Merrill Lynch?

Buffett: That’s a very tough question. It was a very fragile situation. If Bank of America backed out, it would have set things in motion. It [Merrill] could not stand on it own. The CEO was in a tough spot. Would I have behaved differently than Bernanke or Paulson? Ask Charlie what he would do. [laughter]

Munger: You can legitimately criticize Bank of America’s acquisition of Merrill Lynch. But once they signed the contract, I believe Bank of America and the Treasury acted honorably. Read the “history of the deal” [section] in the proxy statements. Bank of America got two fairness opinions in 24 hours at a cost of $20 MM. They needed a fairness opinion on the fairness opinions. [laughter]

Buffett: I’m sure they hope you’ll be on the jury. [laughter]

[Comment: The “history of the deal” sections of proxy statements can make for fascinating reading.]

What is the main contribution to the stock market crash of this century?

This is a very difficult question to answer and even the smartest and best economists don't have a clear answer or agreement. One thing that we do know is that when a stock price goes down, there is less demand than there is supply at that price. More people want to sell their shares of that company, than want to buy, so the price keeps getting lower until somebody is willing to buy it.

Are investment banks so complex that the head is not aware of the risks?

WB: Exceptionally good question. The answer is probably yes in most places, though there are a few CEOs I respect a lot. Gen Re had 23,000 derivative contracts. I could have worked full time on that, and I probably still couldn’t have gotten my head around it all. And we had exposures that I thought were possible and heads of business units didn’t — I don’t want slim, I want none. I am Chief Risk Officer at Berkshire. If something goes wrong, I cannot assign it to a committee. I think big investment banks and big commercial banks are almost too big to manage effectively in the way they have elected to run their business. It will work most of the time. You may not see the risk. A 1-in-50-year risk - it won’t be in the interest of a 62 year old executive who is retiring at 65 to worry about it. I worry about everything. Many CEOs say they didn’t know about what was going on. It’s easier to admit he doesn’t know what’s going on than to admit that he knew what was going on and let it go on. I’ve been asked for advice on regulation. Somehow, the press hasn’t picked up on this too much. OFHEO [Office of Federal Housing Enterprise Oversight] supervised Fannie [Mae] and Freddie [Mac]—their activities had a public element, and were semi-regulated. For 200 people [at OFHEO] it was their sole job to examine the books. They were two-for-two with two of the biggest accounting scams in the history of the world. The person at the top must have it in their DNA to see risks. In many ways, there are firms that in terms of risk are too big to manage. If too big to fail, there are interesting policy implications.

CM: It is crazy to allow things, which are run with knavery, to get too big to fail. As an industry, there is a crazy culture of greed and overreaching and overconfidence, trading algorithms. It is demented to allow derivative trading such that clearance risks are embedded in the system. Assets are all “good until reached for” on balance sheets. We had $400 million of that at General Re, “good until reached for”. In the drug business, you must prove it is good. It is a crazy culture, and to some extent, an evil culture. Accounting people really failed us. Accounting standards ought to be dealt with like engineering standards.

WB: Salomon [Salomon Brothers during the 1991 scandal] was trading with Marc Rich who had fled the country. They said they wanted to keep trading with him. Only by total directive could we stop it. I think the Fed did the right thing with Bear [Stearns]. They would have failed on Sunday night, and walked to a bankruptcy judge. They had $14.5 trillion of derivative contracts — not as bad as it sounds, but the parties that had those contracts would have been required to undo the contracts to establish the liability from the estate. With the $400 million at Gen Re, we had 4-5 years. At Bear, it would have been 4-5 hours. It would have been a spectacle. Two of the witnesses at the testimony said, ‘we understood we couldn’t borrow unsecured, but we didn’t understand we couldn’t borrow secured.’ The world does not have to lend you money. If they don’t want to lend you money, an extra 10 basis points won’t make a difference. It depends on people’s willingness to lend you money, which comes down to how other people feel about you. If you are dependent on borrowed money, you have to wake up every day worried about what the world thinks of you.

What are the risks in the financial system? (2005)

I think our currency will weaken, but I’m not the Armageddon type. I think most of our citizens will be better off in 10 or 20 years.

I’m concerned about our political leadership, but as Peter Lynch once said, “Invest in businesses any idiot could run because someday one will.” (Laughter) We’ve had all sorts of bad Presidents, but have still done well. Our real GDP per capital rose seven-fold in the last century, which is remarkable.

Sure, the big consumer debt load and trade deficit could cause some financial market distress – there are great investment opportunities in dislocations – but the country will survive.

Eventually the country will do fine, but there’s a significant possibility of a chaotic situation.

[CM: We don’t have any great record making macroeconomic predictions. It’s obvious that we could have some kind of convulsion however.]

Far greater sums in one asset class after another are on a hair trigger. We’re piling up huge financial assets at intermediaries, which lend themselves to huge dislocations. We’ve turned over huge amounts of money to people who want to beat the S&P in the short term, and while they may appear to be independent, their actions are not independent. They can all try to head to the exits at the same time. But if you’re selling, you must find a buyer. The only way to sell a burning seat in the theater is to find someone else to buy it.

[CM: There’s way heavier leverage by hedge funds and [others] today.

I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant.

It’s not a smart thing for the country to legalize gambling [in the stock market] and make it very accessible.]

Is there anyone we’ve forgotten to offend? We don’t want to miss anyone. (Laughter)

[Q - Risks in the Global Financial System?]

Charlie and I are not as on board on this, so I’ll answer it and then Charlie can share his thoughts.

We have a $618 billion trade deficit and an even larger current account deficit. As large as we are, something will change [for the worse] and the longer it goes on, the worse it will be. Most economists say a soft landing is likely, but they don’t say what this [will look like]. How the numbers come down is quite significant. Paul Volcker has expressed apprehension about [the likelihood of] a soft landing.

There’s as high a percentage as there’s ever been of money on a hair trigger – in foreign exchange, stocks, bonds, the carry trade... When people go to bed at night – an electronic herd – that can sell billions of dollars at the press of a key. I think this is at an all-time high. An exogenous event, like Long Term Capital Management – and it will happen – could trigger a stampede.

If you hold dollars, you can’t get rid of them. You can’t sell them to the U.S., because you’d get dollar-denominated assets in return. And you can’t sell them to another country, like France [I forget the reason he gave].

[He read a quote from Paul Volcker’s recent article in the Washington Post and concluded:] The situation is dangerous and intractable and is at an all-time high. But I can’t predict the timing.

I would say that what’s going on with the trade deficit will have serious consequences. But in the last Presidential race, neither candidate addressed it, which is understandable. 90% of the American people can’t define “current account” and it’s hard to describe in three minutes. And it’s not the kind of issue that Betty [the average American voter], when she’s making her toast in the morning, asks herself, “Gee, that trade deficit is really unsettling me today.”

Charlie has a different view. Charlie?

[CM: If anything, I’m a little more repelled by the lack of virtue in how we as a nation run our financial affairs. Look at consumer credit... Things could get a lot worse.]

How do you think it will end? [CM: Badly.]

We’re like an incredibly rich family. We sit on the porch of our huge farm – so big that we can’t even see the end of it – and each year, we consume 6% more than the farm produces. To pay for this, each year we sell or mortgage a little bit of the farm that we can’t see, so we don’t even notice. We’re very, very rich and the rest of the world is happy to buy from us or lend to us, so each year they take a piece of our valuable assets – and they work very hard.

But we will have to service this. If it goes on for a long time, our children will pay. We’re sending $2 billion per day [overseas right now].

What will cause a crisis? I don’t know. Does it reach a tipping point, or will there be an exogenous event?

I have a hard time conceiving of any scenario in which the dollar appreciates.

[CM: The counter-argument is: what does it matter if foreigners own 10% of us over time, if the pie grows by 30%? [But I don’t buy this. Taken to its logical extreme,] what if we had no manufacturing and our only businesses were hedge funds?]

Imagine that if, instead of fighting the Revolutionary War, we’d instead agreed to give Britain 3% of our GDP each year. This might have looked good in 1776, but not to future generations. It’s like taxation without representation.

What can we learn from past blow-ups?

WB: They’re all a little different, and they all have similarities. This one had origins in the mortgage field and residential real estate. Trouble in one area has a way of spreading to another area. In my lifetime, I can’t remember one where this particular residential real estate bubble sent out the kind of shock wave and exposure of so many other bad practices and weaknesses elsewhere like this one. There isn’t any magic to analysis. There are stupid things that won’t be done soon again; and not the same way again. But variations of it will occur again. Humans are what lead to stupidity and behavior. Primal urges, wanting to believe in the tooth fairy that pops up from time to time, sometimes occur on a very big scale. I have no great insights on the solutions.

CM: It was a particularly foolish mess. We talked about an idiot in the credit delivery grocery business, Webvan. An Internet-based delivery service for groceries [that failed terribly]—that was smarter than what happened in the mortgage business. I wish we had those Webvan people back. I have a rule: The politicians are never so bad you don’t live to want them back. [laughter]

Do you think the bankruptcy process should be reformed?

We bought Fruit of the Loom out of bankruptcy and have invested in junk bonds [of bankrupt companies]. We got involved with Fruit of the Loom first by buying the bonds.

Munger: I think much of [how bankruptcy is handled] is pretty horrible. It’s a situation where courts themselves have gone into the business of bidding to attract bankruptcy proceedings. They’ve found that if they develop a process in which they over-pay people (lawyers, etc.), they can attract the most cases. It’s so upsetting to watch that I don’t follow it as much as I should. I’m an old man and I don’t like to have an upset stomach. [Laughter]

Buffett: We bought a lot of the Enron bonds called Ospreys. The Ospreys were a complex situation and we considerably more than tripled our money. In other situations, we got outbid, like with Burlington and Sitel. We owed all of the Sitel bonds, though, so we came out fine.

Anytime there’s something big and complicated, there might be some mispricing. But recently, [the mispricing has] been on the high side. Many people are looking [in this area], so it’s a field that does not have a lot of potential right now, but it will again.

Over the next 10-15 years, we’re likely to do something big in the bankruptcy area.

Munger: I remember the Eastern Airlines bankruptcy. The courts abused the senior bondholders to protect the employees and communities. Based on the law, you’d have come to one conclusion and the courts did the opposite.

There are a very interesting set of dynamics [involved in these types of cases].

Buffett: With Penn Central, a judge said it was too complex and came up with a quick, fast solution. It worked out well, but it wasn’t what the book said should be done. Judges can do what they want.

I remember a case in Cincinnati we talked about earlier [I’m not sure what he was referring to] and when we were on our way up there, I asked Charlie, “How much power does a judge have?”

Munger: And I answered, “As much as he thinks he has.”

Insurance pricing and risk?

In auto insurance, our policies are up more than premium volume, so the average premium is down a little bit. In reinsurance, in which we are a big player, there are great variances. For marine risks on the Gulf Coast (rigs, etc.), prices are up dramatically, as they should be. Premiums paid for this type of risk were $2.5 billion and the payouts were $15 billion [so obviously the pricing wasn’t sufficient].

In the past few years, we’ve been the largest writer of mega-cat insurance in the world, and I’m sure we will be this year. Prices are up a lot, but we don’t know if exposures are up even more. We don’t know if the experience of the last two years [the worst hurricanes in U.S. history] is to be relied upon more than the past 100 years. They tell you two different things. We do know that it would be silly to assume that the past two years [are outliers]. Atmospheric conditions and water temperatures have changed. This could change the propensity of hurricanes to occur and their severity. If the last two years are relevant [e.g., become the norm], then we’re not getting paid enough [for the reinsurance we’re writing currently].

The scary possibility is that the changes are continuous and that the changes in the past two years build up. It gets into chaos theory, whereby the output is not a linear relationship. You could dream up some very scary scenarios.

We are willing to write in certain areas and with certain coverages because we can sustain the losses. We’re willing to sustain big losses because [we have the financial strength and think we’re getting paid enough]. But it’s not like flipping a coin or rolling dice – there are many changing variables.

In the third quarter, we will have a lot of exposure to wind [damage claims] – but not as much as a couple of years ago. Prices are hardening in that particular area. If the prices go back to what they were last year, [we will write a lot less].

We don’t believe in modeling. The modelers don’t know a thing. It’s silly. We get paid for making guesses on it. Over a lifetime, we’ll know if we were right. Even if there are low losses this year, we won’t know if we’re right.

It’s still a business we like. If there’s a super-super catastrophe, say $250 billion (four times Katrina), we would pay maybe $10 billion. We could pay, and comfortably pay, but many others in the industry would be in trouble.

Over 5-10 years, we’ll know how well we did.

[CM: The record of the past, if you average it out, has been quite respectable. Why shouldn’t we use our capital strength to get into volatile areas that make others uncomfortable?

We’re getting close to 10% of the float of the American property and casualty insurance industry, so we can’t continue to grow as fast as we have, but it will be attractive. I’m aware of the risks like pandemics – you’re aware of them too – and we get offers every day.

We think about $20 billion or $50 billion events and up. It’s a question of making judgments of whether we’re getting paid enough. We’ll know in 30 years. If we have a lot of money then, we’ll know we were right. If we take a big loss this year, it doesn’t mean we are wrong. What will hurricane losses be in 10 years? I don’t know, but I’ll keep thinking about it every day.

[CM: The laws of thermodynamics are such that if the water is getting warmer – and I believe it is – the energy of the weather is going to go up.]

You have this possibility that a 1-2% change can lead to 100%+ increases in losses. That’s the game we’re playing, but if we don’t like the prices we’re being offered – and we haven’t in many areas – we don’t play and we’re happy to have someone take our place in line.

How do you manage insurance risk?

We are doing some things in insurance that have some correlations. For example, we have insured a lot of things in California and if you have the right earthquake at the right time, not only could National Indemnity and GEICO incur losses, but See’s and Wells Fargo would as well. And we used to own Freddie Mac [which would get hit as well].

I think about this a lot – it’s my job to think about the absolute worst-case scenario. No matter what happens, we’ll be OK.

The most likely mega-cat is a hurricane. In Long Island, there’s huge exposure [by the entire insurance industry]. The last big hurricane hit there in the 1930s [and insurance is being priced accordingly]. But everything that can happen will happen.

The most powerful earthquake in U.S. history – 9.0 – was in New Madrid, Missouri.

It’s Berkshire’s job to be absolutely prepared for the very worst. A few years ago, we didn’t have nuclear/chemical/biological risk exclusions [in our insurance policies] – we had huge risk, but it’s gone now.

We wrote a policy for $500 million in excess of $2.5 billion, not caused by a nuclear/chemical/biological attack, on a major international airport. There was a cap of $1.6 billion for business interruption, so there would have to be more than $900 million of property damage [before we’d have to pay anything].

We insured the [NCAA basketball] Final Four against being cancelled (not moved or postponed), excluding nuclear/chemical/biological attacks. We would have paid $75 million [in this event]. We also insured the Grammy’s in a similar way. We’re OK with losing a lot of money, as long as we’re being paid appropriately for the risk.

Nuclear/chemical/biological attacks are excluded from virtually all of our policies. We write it only when we’re specifically getting paid for it.

[CM: We care more about thinking about things that have never happened. Think of a 60-foot tidal wave hitting California. Can you imagine?

Is there any other company that has attacked [reducing the insurance risk of] nuclear/chemical/biological attacks as well as us?]

No-one has attacked it more vigorously than we have. It’s Armageddon here every day. (Laughter)

My aunt, who died last year, had everything she had in Berkshire [stock. With investors like this,] it would be crazy to take any risks to jeopardize this [company] to make an extra $100,000 or add a point to the track record. Maybe if I had a 2/20 [incentive fee structure; 2% management fee and 20% promote], I’d behave differently, but I sure hope not.

Can you comment on the consolidation taking place internationally in the insurance industry?

Consolidation is a funny thing. I don’t think it solves many problems: putting two lousy businesses together usually makes one big lousy business. The winners in the insurance business are going to be the people that have some franchise based on specialized business, management talents, or terrific distribution.

GEICO is the lowest cost auto insurance distributor on all fronts. USAA is the same way; in fact their ways of operating are a lot like GEICO’s - but they only offer their products to a narrow clientele, whereas GEICO offers theirs to a much wider group. In general, we’re well-positioned in the industry; we have the best insurance vehicle in the business.

How do you price super cat insurance policies?

Try to be as realistic as you can on those numbers [the key variables] – err on being conservative – and then when you’re through, make sure you have a margin of safety.

In pricing earthquake insurance, look at the number of major quakes in past century – there have been 26 – so we’d assume 30 or 32 going forward (not 50 or we’d never write any business). If we calculated the resulting price to be $1 million, then we’d price it at $1.2 million to build in a margin of safety.

[CM: Using the book Deep Simplicity [see link on page 33, below], you can predict how size is likely to be allocated. A standard power law will tell you how many earthquakes there will be of various sizes – many small ones, but big ones are less likely. So just do the math, apply the power law and calculate estimated damages.]

It’s difficult if someone wants to protect against a 9.0 quake, which happens only once every 1,000 years. But in investing, if it’s too hard, skip it.

Could you comment on fraud in the insurance industry?

[In response to a compliant by a shareholder that his insurance company had – he claimed – defrauded him on a Workman’s Comp claim, Buffett said:]

There is plenty of fraud in various aspects of insurance. In automobile insurance, we have fraud units.

We have lost more money in Workman’s Comp insurance than just about any other line in terms of aggregate dollars. It’s been a tough period. We have one small direct seller of Workman’s Comp insurance in California, and then Gen Re does Workman’s Comp reinsurance, and it’s been a bloodbath – the rates haven’t covered the losses. There’s been a fair amount of fraud, especially in the direct lines.

Many companies that have been in the Workman’s Comp business, especially in California, wish they hadn’t. They haven’t made money from it.

[CM: If a company gets into a lot of trouble by fraud practiced on it, and its own affairs are disrupted, then it’s just human nature to give customers a hard time.]

But the main fraud isn’t by insurance carriers against small businessmen, but by the doctors, lawyers, etc. doing it against the carriers.

Opinion on the likely housing bubble? (2005)

Americans feel very good about home ownership – for many people, it’s been their best-behaving investment. If it’s a bubble and if it’s pricked, it could affect some Berkshire businesses, but it would also let us put a lot of money to work [referring to a likely crisis that would depress stock prices and let them invest some of the $40+ billion cash hoard].

We’ve not made our money betting on macro stuff like foreign exchange; instead, it’s from buying cheap stocks like PetroChina.

25 years ago, we saw the same thing [a real estate bubble] with Nebraska farmland. People fled cash, saying “cash is trash.” A farm 30 miles north of here sold for $2,000/acre in 1980; I bought it later for $600/acre. People went crazy and the consequences were huge. Many banks failed, even ones that had survived the Great Depression.

I don’t know where we are with housing – people may behave differently because they live in it. But when you get prices increasing at a far greater rate than construction costs or inflation [there can be problems].

[CM: In parts of California and in the Washington DC suburbs, there’s a bubble.]

I sold a house in Laguna Beach, CA for $3.5 million. The house was only worth about $500,000, so the land was being valued at $3 million. It was only a fraction of an acre, so the land was being valued at $60 million per acre. That’s a pretty fancy price for almost any land.

[CM: One of the Directors of Wesco told me that a modest house next to his recently sold for $27 million. There are some very extraordinary housing price bubbles going on and the consequences could be serious.]

The financing terms have become easier and easier as prices have risen, which is contrary to normal [and prudent] practices. But the financing process has become so disintermediated that the mortgage buyer doesn’t care. The easier financing has led to a boom in prices.

The Nebraska farm bubble was fueled by banks that historically had been conservative but went crazy. They said that a farm was an asset-appreciation investment, not an income investment – in other words, they were playing the greater fool game.

The rest of the world is saving. They’re investing $2 billion/day in the U.S. Some say they have so much confidence in the U.S. that they want to invest, but this is silly. They invest because they have to.

[CM: It’s obvious that easy financing [for houses] is fueling big price increases.]

Consider the following fanciful illustration. Let’s say we had a fixed population in Omaha and no new houses were built, but each year everyone sold their house to their neighbor and moved. In year one, the price was $100,000. In year two, the price jumped to $150,000, but Fannie and Freddie guaranteed the mortgage and sold it to Asian investors. This is an influx of $50,000 to the family income. In year three, the price jumps to $200,000 and the same thing happens.

Obviously, it is transparent what’s happening here, so it wouldn’t really happen, but you can have accidental behavior that leads to certain aspects of this.

[CM: There are Ponzi effects in any economy, and you can see that here.]

[CM: In a corporation like Berkshire, a subchapter C, owning real estate is very disadvantageous.

Investing in real estate is having a bubble of its own. My friends who own real estate are selling their worst assets and getting better prices than they’d imagined.]

I have less than 1% of my net worth outside Berkshire and when the Nasdaq hit its high, I had nearly all of it in REITs, which were selling at a discount to their liquidation values. REITs are quite attractive now, especially compared with 5-6 years ago when they were very unpopular.

It’s better to pay attention to something being scorned than championed. Munger: And REIT accounting is phony. Buffett: Other than that, we love REITs. (Laughter)

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Munger: Some of the worst sins in manufactured-housing financing have gone over to the financing of stick-built homes. A lot of ridiculous credit is being extended in the U.S. housing sector. There was a horrible aftermath in manufactured housing and my guess is that we’re likely to see something similar [as a result of the unwise credit being extended in the overall housing sector].

Buffett: Look at the latest 10-Qs of financial institutions and the levels of accrued, but not paid, interest. You’ll see some interesting things. It’s growing rapidly, which means the lenders are booking earnings, but not receiving the cash [e.g., borrowers are falling behind in their payments].

Dumb lending always has its consequences. You can have an epidemic and not realize it until you’re very far into it. You had it in commercial real estate in the 1980s and the RTC [Resolution Trust Corporation] was the result. A developer will build anything he can get financing for.

Munger: Some of the dumb lending is facilitated by contemptible accounting. The accounting profession [has continued to disgrace itself here].

Buffett: We developed a piece of property for 20 years in California.

Munger: I think we got our money out, plus interest [e.g., a terrible rate of return, given the time and effort].

Buffett: It’s not an exaggeration. The land value was $5-6 million when we sold. We finished at the wrong time. What do you think it would be worth now, Charlie?

Munger: $100 million.

Buffett: The swing in property values has been huge in some markets. What we see in our residential brokerage business [HomeServices of America, the nation’s second- largest realtor] is a slowdown everywhere, most dramatically in the formerly hottest markets. The high end and where properties were bought for investment and speculation are doing the worst.

If you buy a house for $300,000 and take a $270,000 mortgage, you’re going to stay there and continue to make your mortgage payments, even if the market value of the house falls (unless something bad happens to you like losing your job). But if you have investors and speculators holding the properties – effectively day traders in the condo market – that kind a speculation can produce a market that can move in a big way. First the buying and selling stops and then the market reopens. With stocks, they will trade every day, so you can’t kid yourself. If you own GM stock and it’s down on Monday, you know you’ve taken a loss. But in housing, there’s always the hope that you can find the one seller who will pay the price you want, who hasn’t heard that the market has collapsed.

In [Miami-]Dade and Broward counties in Florida, the average condo costs $500,000. [I may have the numbers slightly off here:] Not long ago, there were 3,000 condos listed and 2,900 sold every month. Today, there are 30,000 condos listed – worth $15 billion – and only 2,000 per month are selling. The whole supply-demand equation has changed.

We’ve had a real bubble to some degree. I would be surprised if there aren’t some significant downward adjustments, especially in the higher end of the housing market.

Munger: There’s a bubble among high-end apartments in Manhattan, but in Omaha, housing prices are reasonable.

How do you feel about the current real estate environment?

If you are buying to own a home, that is fine. Otherwise, it seems to be getting into bubble territory. We're not excited about real estate because generally there is not enough return at current prices.

Your views on the securitization of real estate?

There has been enormous securitization of the debt too of real estate and that is one of the items right now that is really clogging up the capital markets. The mortgage back securities are just not moving, commercial, not residential mortgage backs. But I think you are directing your question at equities probably. The equities, if you leave out the corporate form, have been a lousy way to own equities. You have interjected a corporate income tax into something that people individually have been able to own with a single tax, and to have the normal corporate form you have a double taxation in there. You really don't need it and it takes too much of the return.

REITS have, in effect, created a conduit so you don't get the double taxation, but they also generally have fairly high operating expenses. If you get real estate, let's just say you can buy fairly simple types of real estate at an 8% yield, or thereabouts, and you take away close to 1% to 1.5% by the time you count stock options and everything, it is not a terribly attractive way to own real estate. Maybe the only way a guy with a $1,000 or $5,000 can own it but if you have $1 million or $10 million, you are better off owning the real estate properties yourself instead of sticking some intermediary in between who will get a sizable piece of the return for himself. So we have found very little in that field.

You will see an announcement in the next couple of weeks that may belie what I am telling you today. I don't want you to think I am double crossing you up here. But generally speaking we have seen very little in that field that gets us excited. People sometimes get very confused about--they will look at some huge land company, like Texas Pacific Land Trust, which has been around over 100 years and has got a couple of million acres in Texas. And they will sell 1% of their land every year and they will take that (as income? Garbled) and come up with some huge value compared to the market value. But that is nonsense if you really own the property. You can't move. You can't move 50% of the properties or 20% of the properties, it is way worse than an illiquid stock. So you get these, I think, you get some very silly valuations placed on a lot of real estate companies by people who really don't understand what it is like to own one and try to move large quantity of properties.

REITS have behaved horribly in this market as you know and it is not at all inconceivable that they become a class that would get so unpopular that they would sell at significant discounts from what you could sell the properties for. And they could get interesting as a class and then the question is whether management would fight you in that process because they would be giving up their income stream for managing things and their interests might run counter to the shareholders on that. I have always wondered about REITS that have managements they say their assets are so wonderful, and they are so cheap and then they (management) go out and sell stock. There is a contradiction in that. They say our stock is very cheap at $28 and then they sell a lot of stock at $28 less an underwriting commission. There is a disconnect there. But it is a field we look at.

Charlie and I can understand real estate, and we would be open for very big transactions periodically. If there was a LTCM situation translated to real estate, we would be open to that, the trouble is so many other people would be too that it would unlikely go at a price that would get us really get us excited.

Where do you see the residential real estate market going in the next year or two?

Buffett: We don’t know. I see a lot of data. In the last few months, you’ve seen a real pick up in activity in California in the low to medium-priced homes at or below $750,000. There are many different markets, and many California markets will be difficult. There’s been no bounce in prices yet, though activity is up on lower prices. Looking at real estate brokerage data, it looks like something close to stability in California in the $750,000 and less segment at these much reduced prices. Mortgages being put on books today are much better than before. Interest rates are down and it’s easier to make payments. It’s improving. There are about 1.3 million households created in a year, but in a recession it tends to be lower. If you create 2.0 million houses a year, then you run into trouble. There’s an excess inventory of about 1.5 million now. With housing starts down to 500,000 [annual rate], the excess supply will be absorbed. We are eating up the excess at a rate of 700,000 – 800,000 units per year. It takes a couple of years. There are two options: blow them [the excess inventory] up—I hope they blow up yours [Charlie’s] instead of mine—or sell them. South Florida will be tough for a long time. You can’t do it in a day or a week, but it will get done. Then prices will stabilize. Then we can go to [building] one million per year. The situation is being corrected.

Munger: In places like Omaha, I would buy a house tomorrow, if I were a young person.

Buffett: There are approximately 80 million houses in the country, and about 25 million do not have a mortgage. The situation is being corrected.

Can you comment on the subprime market?

The subprime market, encouraged by lenders, intermediaries, builders, etc., led to a lot of people buying houses they couldn’t afford. There will be consequences for these people, but the question is whether it spreads. If unemployment and interest rates don’t go up, then it’s unlikely this factor alone triggers anything in the general economy.

In the 10Qs and 10Ks I’ve read, a high percentage of loans allowed people to make tiny payments early on, made up by higher payments later. I think this is dumb lending and dumb borrowing because someone who can only make 20-30% payments now isn’t going to be able to make 110% payments in the future. Those people and institutions were betting that house prices would keep going up. When this stops, you have a big supply of houses come on the market, like we saw in manufactured housing. You’ll see plenty of misery in that field – you’ve already seen some. But I don’t think it’ll be any huge anchor for the economy.

Munger: There’s been a lot of sin and folly, a lot of it due to accountants who let lenders book profits when no one in their right mind would have allowed them to book profits. If accountants lie down on the job, you see huge folly.

It’s in the national interest to give loans to the deserving poor. But the moment you give loans to the undeserving poor or the stretched rich, you run into trouble. I don’t see how people did it and still shaved in the morning, because looking back at them was a face that was evil and stupid.

Buffett: You’ve seen some very interesting figures in the past few months on people who didn’t even make the first or second payment. That shouldn’t happen. We saw this is in the manufactured-home sector. When someone only has to make a $3,000 down payment to someone who gets a $6,000 payment [the salesperson’s commission], then believe me, you’ll see a lot of bad behavior.

Securitization accentuated the problem. A local banker wouldn’t allow this because he’d see what’s going on, but when the loans are bundled and sold by Wall Street, that discipline disappears.

It will be at least a couple of years before real estate recovers. In some areas of the country, the [housing] inventory overhang is huge. The people who were counting on flipping the homes are going to get flipped, but in a different way.

Foreign Investments

What's your opinion on investing in foreign stocks?

We have a number of businesses that derive very significant percentages of their revenue from international operations. Coca-Cola earns 80% or more from their international operations; Gillette will earn two thirds or more from international operations, so we get a lot from outside the United States. It's a slight advantage to us having U.S.-domiciled companies. For instance, we get better treatment on the dividends if they are domestically based because of the way the U.S. tax laws go. But if Coca-Cola were domiciled in Amsterdam or if Gillette was in London, we would still be attracted to them to virtually the same degree we are now. We look at businesses domiciled outside this country--many don't meet our size requirements, but that's true here, too--but we have nothing against buying companies that are domiciled outside the United States. We will keep looking; we need to look everywhere with the kind of money we have today available for investment. Charlie?

[CM: Again, we have a wonderful way of playing the rapid development of companies outside the United States. So far, we haven't seen anything that has attracted us as being better. If you can sell Coca-Cola, do you really want to get into steel in Malaysia or something?]

Some things travel very well, and some things don't. Gillette travels, Disney travels, McDonald's travels, Coke travels; See's candy doesn't travel as well. It might if you spent 50 years working on it, but it's not an easy thing to travel. Actually, candy bars themselves don't travel very well; if you look at the top-selling candy bars in France or in England or in Japan, you don't find the similarity you find in terms of the best-selling soft drinks or movies or fast food hamburgers or razor blades.

[CM: Except Snickers! (laughter) For some reason, Snickers.

Charlie's got a lot of experience. You may want to invest where we invest, but you don't want to eat where we eat. (laughter)

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[Comments on investing in Europe]

One disadvantage to buying a stock in the UK is that you have to report your holding once you reach the 3% level. So, for a stock with a $5 billion market cap, we’d have to report [and likely run the stock up] once we’d acquired only $150 million. But in the past, we’ve owned Guinness, which is now owned by Diageo, so this is not an overwhelming disadvantage. We’d be very comfortable owning many UK companies.

Incidentally, contrary to what’s been reported, we do not have to report a 5% position within 10 days [referring to reports in The Wall Street Journal and elsewhere that Berkshire would have to file on its recently disclosed purchase of Anheuser-Busch stock if it held more than 5% of the shares outstanding].

[CM: Recently we’ve preferred the currencies of socialized Europe over the U.S. dollar. A queer occurrence...]

I remember when I’d come back from Europe and couldn’t wait to convert my euros back to dollars.

Europe isn’t doing as badly as you might think. Its growth rate is lower than ours, but our population is expanding a lot faster, so on a per capital basis, the gap is not as wide as you’d think.

What are your requirements for investments outside the U.S.?

We rule out any markets that aren’t big enough. We need to make investments in the hundreds-of-million-dollar-size range, so that rules out a lot of markets.

Transparency matters; the accounting doesn’t matter so much to us. As long as we are able to value what’s underneath of it, we’ll invest. Remember though, that something like 53% of all the value of the public companies in the world is here in the U.S., so we are a big piece of the pie.

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[RE: Declining U.S. Dollar]

We think the dollar, over time, unless policies change in a major way, will likely decline somewhat more against most major currencies. At one time, we backed this up with $22 billion in foreign currencies, but then the carry made that an expensive way to express that belief, so now we buy into companies that earn a lot in foreign currencies. It’s a factor, but not a 50% factor, in what we buy.

We’re following policies in this country that will lead to a decline in the dollar – the fundamental forces are fairly strong.

We own one currency position right now that will surprise you – we’ll tell you about it next year.

Munger: The inflation factor at Costco is zero. It’s perfectly amazing how well we’ve done so far.

Buffett: Look at oil going from $30 to $60 and the euro from 83 cents [per dollar] to $1.35, so the price of oil for Europeans has gone up very little – 25% vs. 100% for us. It’s easy to anchor on your own currency.

You’ll have to think more about currency than you have. Around the world, others think about currencies, but the average American hasn’t had to.

When looking at other countries Mr. Buffett, do you look at the country’s overall financial status or do you look at the financials of that specific company in a foreign country? You mentioned investing in Korean companies – do you ever look at the state of the country you are investing in?

We care about the country where the company is run. There is a disadvantage being outside of the US. A few years ago we were looking to invest in either PetroChina or Yukos in Russia. We ended up picking PetroChina because the political situation was more stable. It turned out to be a good decision. I care about the country and the geopolitical environment I am investing in.

The whole company was selling for $35 billion. It was selling for one-fourth of the price of Exxon, but was making profits equal to 80% of Exxon. I was reading the annual report one day and in it I saw a message from the Chairman saying that the company would pay out 45% of its profits as dividends. This was much more than any company like this, and I liked the reserves. If it were a US company, it would sell for $85 billion; it’s a good, solid company. I don’t understand the Chinese culture like I understand the US culture. However it said right in their annual report that they will payout 45% of their earnings as dividends, basically they say if they make money they will pay it out. I invested $450 million and its now worth $3.5 billion. I decided I’d rather be in China than Russia. I liked the investment climate better in China. In July, the owner of Yukos, Mikhail Khodorkovsky (at that time, the richest man in Russia) had breakfast with me and was asking for my consultation if they should expand into New York and if this was too onerous considering the SEC regulations. Four months later, Mikhail Khodorkovsky was in prison. Putin put him in. He took on Putin and lost. His decision on geopolitical thinking was wrong and now the company is finished. PetroChina was the superior investment choice. 45% was a crazy amount of dividends to offer but China kept its word. I am never quite as happy as I am in the US, because the laws are more uncertain elsewhere, but the point is to buy things cheap. Russia is just a bad geopolitical environment. On the other hand, China has kept their word on paying the dividends. In fact, when the dividends check comes in, it is calculated out 10 or so decimals, these guys keep their word. I don’t know the tax laws in China, but you can buy a good business cheap. At Berkshire Hathaway, you have to spend hundreds of millions of dollars to move the needle. We have a problem of finding things worth investing in.

1/8th of world is in India. Why aren’t you investing in India?

WB: That is a good question. We have connections there. In insurance, there are distinct restrictions at what we can do in India. As of yesterday, I agreed next March to go to India, because of what our Iscar business is doing there. India will grow, and Iscar belongs in every industrial country in world. We have good sized operation there. We don’t rule out India. Posco – they have big plans for India.

CM: One trouble that India presents is that the government is causing paralysis, endless due process. Planning, approvals, zoning is hard. Wise founder of modern Singapore said that China will grow faster than India because government causes less paralysis. Countries are different, and while we kind of admire the democracy that causes the paralysis, we still don’t admire the paralysis.

WB: Countries learn much from each other, and many have learned from USA. Maybe they can steal some ideas, and improve on us. We ought to figure out a lot of ways to do business in those countries. My preference is insurance which I understand. Both China and India do limit us right now, of what we can own and how much. Why put my managerial talent to work on something where we only own 20% vs 100%? But we remain interested because people in China and India will live better 20 yrs from now.

How large is the universe of companies whose intrinsic value you know? Why invest in South Korea or China?

WB: Our immediate decision is whether we can figure it out. We are thought to be rude sometimes, when really we are just being polite in not wasting someone’s time. We know very early in a conversation whether what someone is talking about is actionable. We don’t worry about stuff we miss. We know there are many things that we won’t know enough about when we finish thinking about it, so we throw it out. We make a decision in five minutes. We know about a lot of industries, and there are some things we don’t understand. We like to expand our universe of knowledge. If we can’t make a decision in five minutes, we can’t learn enough in five months. If we get a call, with a business for sale or I am reading a paper or 10-K [annual company SEC filing], we will move right then if there’s a big difference between price and value.

CM: We can make a lot of decisions about a lot of things very fast and very easily, and we are unusual in that. The reason is that there is such an enormous amount of things we don’t look at. If you don’t do star- tups, you blot a lot of complexity out of your life. What we found out is that there are still a lot of things to look at and that are available, even if we filter out all those things.

WB: There are a lot of giveaways in the first sentence or two. We waste a lot of time, but we waste it on things we want to waste it on.

Investing in Brazil?

Our problem with many markets is that we have to put out a lot of money because we’re so big. We have to invest hundreds of millions of dollars, which really narrows the companies and countries we can look at. In the case of PetroChina, the biggest company in the world’s most populous country, we were only able to invest $400 million.

In Brazil, there’s a great beer company a friend ran and we should have invested in it. He’s a great manager. Brazil wouldn’t be off limits, but we would have to be able to invest a lot of money in a good business we can understand at a good price. And it would have to be cheaper than a comparable U.S. company, to compensate for the extra risk and our relative lack of knowledge about the market.

Investing in Russia?

In 1998, via our ownership in Salomon Brothers, we were in the oil business and drilled for oil in Siberia. They were happy to have us drill, but when it came time to take the oil out, it was harder. Given that experience, [we won’t be rushing back to invest in Russia].

About three years ago, I had breakfast in Sun Valley with Mikhail Khodorkovsky [the former CEO of Yukos], who was considering a listing on the New York Stock Exchange. He’s now in jail and Yukos is in bankruptcy with tax claims. It’s a little hard to develop a lot of confidence that [Russia] has changed vis-a-vis its views toward capital, especially outside investors and capital.

[CM: [This reminds me of a story that ends:] “If they ever do find any oil, that old man will steal it.” I’m afraid we have the same problem today in many countries with oil.]

Charlie, didn’t we have the livelihood of our guys threatened [in Russia]? We sent guys to get the [oil-drilling] equipment and they were told that not only would they not get the equipment, but if they tried, the guys wouldn’t get out either. It wasn’t that long ago.

Investing in Africa?

[Q - In respect to Africa how would you find above average stocks given the information costs and limitations in Africa? What is your best advice about obtaining acceptable information? ]

There aren’t too many companies in Africa that are big enough for Berkshire to look at, except for maybe DeBeers, Anglo-American, or SAB Miller. Also, there isn’t a lot of information on these companies. I know South Africa has stock information available. The key is to get good information.

In comparison, Korea has plenty of information available. There is Kissline online. Within seconds I can get Korean Stock Exchange Information, Annual and even quarterly information. I’m not sure if the same is available online for South Africa. This is OK because I don’t need to win every game, just the ones I play.

I have three mailboxes in my office – IN, OUT, and TOO HARD. I was joking with the MIT students that I should have a TOO HARD bin and they made me one, so now I have it and I use it. I will only swing at pitches that I really like. If you do it 10 times in your life, you’ll be rich. You should approach investing like you have a punch card with 20 punch-outs, one for each trade in your life. I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime. You know what would happen? They would make sure that each buy was a good one. They would do lots and lots of research before they made the buy. You don’t have to have many 4X growth opportunities to get rich. You don’t need to do too much, but the environment makes you feel like you need to do something all the time.

May I ask you your reasons for coming to Germany?

WB: We want more family owners of German businesses. We want more owners who, when they think of the need to monetize, have Berkshire on their radar screen. We aren’t as prominent in Germany as we are in the US. We are looking for good companies and we want them to know us. We should be better known in a month.

CM: Germany is particularly impressive—an advanced civilization, especially in engineering and industrials, with German advancement and inventiveness. It is amazing the impact Germans have had on field after field in America. Look at all the machines in factories with German names.

WB: Sounds like Charlie should go to Germany.

Are you concerned with the effects of foreign economies and their weak currencies? These have played a role in Coca-Cola’s profitability recently - and Coke is trading at P/E multiple of 75. (1999)

I don’t have anything to offer on selling Coke [as an investment]. The dollar [and other currencies relative to the dollar] doesn’t concern me; it doesn’t affect my decision. In the last couple of years, yes, the dollar’s strength has hurt. But it’s in Coke’s best interests to have countries do well in the long run, to grow and increase the income of its population. The share of market and what we call the “share of mind” are the important things in Coke’s business.

It’s true that case growth slowed last year and continues to be slow, but that’s happened before. We’ll be around with Coke ten years from now.

Do you foresee Berkshire buying any businesses in India or China in the near future?

WB: We would like to. The odds are somewhat against buying anything outside of the USA. MiTek has possibilities outside the USA. If we get lucky, we’ll buy one or two businesses in the next 3 or 4 years. Where they’ll be, who knows? We wouldn’t rule it out. We looked at insurance in India and China, but they restrict ownership in any domestic insurance company. The limit is 25% in China, and I think 25% in India. We probably don’t want to go in to own [only] 25%. We want to have more ownership to make it worthwhile. You will see the day that Berkshire owns businesses, in my view, in both countries.

CM: Nothing to add.

Please talk about Greece, the future of the Euro and fiscal discipline in the world. Greece and other countries are clearly in trouble and BRK has investments in Europe. How is BRK positioned for currency failures? What is your advice to investors regarding the future of the Euro?

WB: Charlie and I haven’t talked about Greece recently, I’m interested in his opinion. We have a lot of exposure in many countries, but we have it both on asset and liability side. We have much net worth in euro assets, but also substantial liabilities in Euro as well. When we reinsured Equitas we took on billions of liabilities around the world and we were paid in USD. If Euro depreciates we benefit with Equitas, but we lose on other areas. I can’t tell you our net exposure on Euro or Sterling on any given day, we have no dramatic exposures in any currency. Doesn’t mean it isn’t important. Charlie will now clearly explain how important the Greek situation is and its affect on the global economy. [laughter]

CM: We are generally agnostic about currencies, about relative values. We are not agnostic about direction. Greece is an interesting example. Past conservatism in US gave the country wonderful credit. We used it to win World War II, help Germany and Japan in one of the most constructive foreign policy decisions in history of world. Now the US doesn’t have as good credit since it has been using it so heavily. Greece is just a start. It is dangerous when governments push their credit so hard. When you have blown it in past, it’s not as good today. Responsible voices are realizing we are nearer trouble from lack of government credit than ever before in my lifetime.

WB: You have to distinguish between borrowers in their own currency (like US and Japan) and those who borrow in other currencies because creditors don’t trust them. When weaker credits borrow in other currencies, it can really put you out of business really quickly. They can’t print USD. That has caused failures. The EU – it is a really interesting situation. Greece is sovereign but can’t print their own currency – they have Euro. Euro was an experiment, and it is a test case playing out here – of a country using a common currency but is sovereign on promises to citizens. I don’t know how it ends, but I’m not forecasting anything – I just try not to watch movies like that. This will be high drama. We don’t make big currency plays, and we did one a few years ago and did okay. I would say this - that events of last few years make me more bearish on ALL currencies holding value over time. If you really could run deficits of 10% of GDP and do it a long time – world would have done it more, because that is really fun! Most understand it can’t be kept up. How world weans itself off deficit financing will be interesting to watch. As long as US borrows in USD, there is no possibility of default. If world won’t take USD debt, we have problem. You don’t default when you print your own currency.

CM: Published statistics are misleading. Debts are stated in government bonds outstanding. The unfunded promises are miles bigger than bonds outstanding. They don’t bind if you grow GDP at 3% per annum per person, but if you get to where growth stops, you will have enormous social strains, and god knows what the impacts will be.

What is the most important thing you learn from China?

WB: China is an amazing economy. Growth on a per capita basis is amazing. There were 290M people in 1790 (and only 4M in the US) in China but for some reason for 170 yrs very little progress was made. The potential of the Chinese is now being realized. It is a sight to behold. However, they haven’t taught me to eat Chinese food.

CM: China has some very rare people in BYD. No other lesson is as important as that one.

WB: Sprite outsells Coke 2:1 in China. Amazing economy, growth will last a long time. In 1790, there were 4mil people in the US, and 290m in China. And there was very little growth in quality of living in China over those 200 years through 1990. They have major resources of land and minerals. Potential of Chinese is huge. Charlie and I are going over there at the end of September. They haven’t taught me how to eat Chinese food.

CM: I always knew Chinese people had potential for huge and rapid progress. I could see in Chinese Americans. They came to America as coolies or slaves, and they rose so fast. I underrated how fast it could happen – they are setting record for advancement of human civilization.

How will Buffett invest in China in the future? What will happen to the purchasing power of China’s large holdings in U.S. Treasuries?

Buffett: We respond to opportunities as we see them. We will see things to do over time. Some things are restricted to U.S. [investors] in China. We can’t own more than 24.9% of an insurance company in China. China is a huge market. We would have bought more than 10% of BYD, if they had let us. If we run a $250 billion trade deficit with China, they have $250 billion to do something with. The Chinese can’t get rid of their dollar holdings. Chinese dollar assets will increase as long as they run a [trade] surplus with the U.S. To date, they’ve acquired mostly U.S. government bonds. It’s a major problem for them to decide what to do with U.S. dollars. Anyone who owns dollar obligations outside the U.S. will have less purchasing power in the future.

Munger: If I were a Chinese finance minister, I would do what they’re doing. China has one of the most progressive economic policies in the world. I have nothing but admiration for Chinese economic policies. They will be very hard to compete with all over the world.

Why is car insurance business not expanding globally? Why not China?

WB: We’ve known for a long time that there is no shortage of drivers around the world. In China and India, we can only own a 24.9% stake, so we’d rather have our managers work hard on 100% than 24.9%. We have gone from 2.5% to 8% market share in Geico. We don’t think we can build those advantages in other markets in any reasonable time. I agree with Tony’s decision that now and probably for a long time to come that there is so much opportunity here in the US that we aren’t as interested in other places. Though we keep looking, and are well aware of possibilities. We didn’t not go because we didn’t know there were cars there.

What are your thoughts about Japan?

My thoughts about Japan? I am not a macro guy. Now I say to myself Berkshire Hathaway can borrow money in Japan for 10 years at one percent. One percent! I say gee, I took Graham's class 45 years ago and I have been working hard at this all my life maybe I can earn more than 1% annually, it doesn't seem impossible. I wouldn't want to get involved in currency risk, so it would have to be Yen-denominated. I would have to be in Japanese Real Estate or Japanese companies or something of the sort and all I have to do is beat one percent. That is all the money is going to cost me and I can get it for 10 years. So far I haven't found anything. It is kind of interesting. The Japanese businesses earn very low returns on equity - 4% to 5% - 6% on equity and it is very hard to earn a lot as an investor when the business you are in doesn't earn very much money.

Now some people do it. In fact, I have a friend, Walter Schloss, who worked at Graham at the same time I did. And it was the first way I went at stocks to buy stocks selling way below working capital. A very cheap, quantitative approach to stocks. I call it the cigar butt approach to investing. You walk down the street and you look around for a cigar butt someplace. Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it. So you pick it up and the puff is free--it is a cigar butt stock. You get one free puff on it and then you throw it away and try another one. It is not elegant. But it works. Those are low return businesses.

But time is the friend of the wonderful business; it is the enemy of the lousy business. If you are in a lousy business for a long time, you will get a lousy result even if you buy it cheap. If you are in a wonderful business for a long time, even if you pay a little bit too much going in you will get a wonderful result if you stay in a long time.

I find very few wonderful businesses in Japan at present. They may change the culture in some way so that management gets more share holder responsive over there and stock returns are higher. At the present time you will find a lot of low return businesses and that was true even when the Japanese economy was booming. It is amazing; they had an incredible market without incredible companies. They were incredible in terms of doing a lot of business, but they were not incredible in terms of the return on equity that they achieved and that has finally caught up with them. So we have so far done nothing there. But as long as money is 1% there, we will keep looking.

Does the Japanese economy affect your outlook?

We don’t really concern ourselves with the macro issues. We can’t rely on the macro to bail us out of a wrong decision on a [specific] business.

Look at See’s Candies. We bought it in 1972 and look what happened right afterwards. In 1973, the Arab oil embargo happened. Then inflation, followed by political turmoil. If we would have had a road map of 1972 to 1982, we’d have seen more inflation, a 20% prime rate, worldwide dissension. But knowing all those macro issues wouldn’t have helped us make a better decision to buy See’s Candies. It’s just more important to recognize a great business when you see it than it is to predict macro issues.

The Investment Industry

Is the individual investor even capable of assessing the riskiness of securities given the large number of institutions/hedge funds in the market?

I don’t think there is much being overlooked now, but I’m forced to look at big things. That’s the advantage you have over me. A few years ago a friend of mine mentioned that I should look at Korea. We bought Posco for 3-4 times post-tax earnings. I found 20 other companies selling at 2-3 times earnings and strong balance sheets. I diversified because I didn’t know the Korean market as well. We are looking for the very unusual. Occasionally things will happen in a securities market that are extraordinary. I like shooting fish in a barrel, but I like to make sure the water’s drained out.

We had that situation a few years ago with the 30 year versus 29 ½ year Treasury bonds. Because of less liquidity, the off-the-run bonds were selling for 30 basis points less, which translates into 3% of principal value. LTCM entered the trade at 10 basis points originally, but they overleveraged and were forced to unwind the position. If you went long/short you could make money really quickly.

Markets are efficient most of the time about most things. But for these opportunities, nobody will tell you about them. They won’t be on CNBC and they won’t be in brokerage reports. You have to go find them yourself. In 1951, after I graduated from school, I used Moody’s and S&P manuals as my sources of information. I went through them page by page. I was like a basketball coach looking for 7-footers. I still have to find out if he’s coordinated, and can stay in school. But if someone comes up to me that’s 5’6” and says, “Wait ‘til you see me handle the ball”, I say “No thanks”. On page 1443 of Moody’s, I found Western Insurance Securities. It had earned $21.66 per share 2 years ago, and earned $29.09 last year. Over the past year the stock was selling for between $3 and $13 per share. I still had to do the work to make sure the earnings were valid. The markets will get it right eventually. But they are there. You don’t have to find too many. Finding 10 of these opportunities in your lifetime will make you so rich. But you can’t be wrong. You can’t have any zeroes. A list of big numbers multiplied by zero will equal zero. You can’t go back to “Go”.

What do you think about all the money flowing into private equity and hedge funds? And do you see the future of buying businesses changing based on the considerable increase in private equity activity?

I'll tell you what I think of hedge funds. Hedge funds are a huge fad. You can pick any ten hedge funds and I'll bet that on average they will underperform the S&P over the next ten years. You can't create more money out of American business than the business itself creates; so most of these hedge funds will not be able to justify their outlandish fees over the long-term and they will disappear. on Wall Street, there are innovators, imitators, and total incompetents. I'm afraid that the majority of hedge funds around the globe now are run by the latter two categories of people.

What do you think about how most money is managed?

[CM: 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.]

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].

[CM: 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.]

Advice for finding good investment advisors?

The question of finding investment advisors is a hard one. When I was winding up my partnership [in the early 1970s], I was returning a fair amount of capital to people, and they asked me what to do with it. I recommended two people who I felt were exceptionally good and honest: Sandy Gottesman, who just joined Berkshire’s board, and Bill Ruane [of the Sequoia Fund]. They were contemporaries of mine, so I knew their results and how they’d achieved them, which is critical. I don’t know today’s managers, so I can’t recommend anyone.

The fact that I only knew two shows the difficulties of finding someone good. The promotional types going around to institutions today are not likely to be good – or have high integrity.

I read an article [in the Wall Street Journal last week] about the two fellows who founded Google and all the problems they’ll have with their new-found riches – I almost sent a sympathy card. [Laughter.] They don’t have a big problem. They’re smarter than the people coming to them. The people with the problem are the people trying to sell them services and want to convince them that they have a problem.

It’s merchandising. You don’t need these people at all in investing – all these professionals who say you’re going to be in big trouble if you don’t listen to them. They’re selling.

It reminds me of when I asked my former brother-in-law: “How do you get farmers to pay you to sell their cow to Swift or Armour?” He replied, “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.”

[The Investment Advisory Business]

[CM: Mutual funds charge 2% per year and then brokers switch people between funds, costing another 3-4 percentage points. The poor guy in the general public is getting a terrible product from the professionals. I think it’s disgusting. It’s much better to be part of a system that delivers value to the people who buy the product. But if it makes money, we tend to do it in this country.]

[Hedge Funds]

I think people who invest in hedge funds, in aggregate, are unlikely to do well. Hedge funds are in the midst of a fad. It’s distinguished by an extraordinary amount of fees. If the world is paying hedge funds 2% and a percentage of the profits, and the losers fade away, then it won’t be good for all investors. Obviously, some will do well, but not in aggregate.

[CM: Why would you want to invest with a guy whose thought process says, “If a second layer of fees is good, then let’s add a third layer.”]

Maybe [high fees] are what the traffic can bear, but that reflects an attitude. It’s a basically unfair arrangement. In effect, [hedge fund managers] are getting four times standard fees. And I’d bet they don’t have all of their own money in their own funds.

Charlie and I both ran partnerships that would generally be classified as hedge funds. There are some similarities, but I don’t think we had quite the same attitude that the present managers have.

The fund of funds stuff – it’s really unbelievable, piling on the layers of costs. People don’t become geniuses because on the door it says “hedge fund.” But they may be good at marketing – in fact, if they’re good at this, they don’t need to be good at anything else.

Comments on the mutual fund scandal? (2004)

[CM: The business of selecting investment managers was recently shown to be even harder by the revelation that a significant fraction of mutual fund managers took bribes to betray their own shareholders.

It was as if a man came up and said, “Why don’t we kill your mother and we’ll split the insurance money?” And many people said, “Why, yes, I’d like some of that insurance money.]

And they were already rich.

[CM: And many of them think what happened to them was unjust.]

Many people had to know what was going on. Many people at the big funds, even if they were not doing it themselves, had to know. The Investment Company Institute was patting itself on the back and getting cozy with legislators, but nothing was done until a whistleblower went to Spitzer and he publicized it.

Hundreds of people knew and it went on for a long time, but nobody did anything.

Why don't you start a mutual fund?

[Responding to a shareholder’s suggestion that they get into the money management business, Buffett replied:]

There would be too many conflicts. We’re managing too much money as it is and we can’t wear two hats. I certainly wouldn’t want to start a fund management company and then pro-rate purchases. I’ve been pitched many times [to start a fund company] and we could certainly sell it, but once we did so I don’t know what we’d do with it. Do you, Charlie?

Munger: No. That’s why we don’t do it. But that doesn’t seem to bother other people.

Opinion of money management as a job to aspire to?

[CM: I think money management is a low calling relative to being a surgeon. I don’t like the percentage of our GDP and brainpower and professional effort that’s in money management. I don’t think it’s a good thing for our country, and don’t expect it to end well.

The present era has no comparable precedent in the history of capitalism when so many people are trading pieces of paper. We have a higher proportion of the intelligent sections of society involved in buying and selling bits of paper and trying to make money doing it. There are more people doing this than at any time in history. A lot of this reminds me of Sodom and Gomorrah.]

When we’ve seen baby versions of this in the past, there have been future [very negative] implications [for the stock market].

[CM: When you get so much nonsense going on, it feeds on itself and creates a frenzy. [When this has happened historically,] there have been serious implications.]

What's your opinion of the wider money management industry?

Munger: There are certainly a lot more helpers. The ones who come here [to the Berkshire annual meeting] are the best of them, so don’t judge the class by the ones here.

The best thing you can do as you think about following in Warren’s footsteps is to reduce your expectations.

Buffett: If your wife is going to have a baby, you’d be better to call an obstetrician than do it yourself. If your pipes leak, you should call a plumber. Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It’s hard to think of another business like that. Can you, Charlie?

Munger: I can’t think of any.

Buffett: It’s become a bigger and bigger business. And the more you charge, the more money you bring in. It’s useful to get into a business like that. When I speak to students, I ask them to name a great business. One answer is running a business school, because the amount you charge is a sign of prestige. No one wants to go to the business school that charges $20,000 in tuition, but if the school charges $40,000, more do.

In the investment field, you now have large portions of investment managers that charge fees that, in aggregate, cannot work out for investors. Obviously, some [investments in high-fee managers] do [work out well]. But you can’t pay 2 and 20 [2% annual management fee and 20% of the profits, standard for private-equity and hedge funds], in which you pay the manager 20% of the profits if they make money and, if they don’t, they just close up and reopen later. If you charge this in an economy that’s only growing a few percent a year, the math doesn’t work. The question for you is how to pick out the exceptions [e.g., the managers who will outperform, even after fees]. Everyone who calls on you says they are the exceptions.

I will bet you that if you name any 10 partnerships with over $500 million in assets and put them up against the S&P 500, they will trail the S&P, after fees, over time.

If you know enough about the person and how they’ve done in the past, you can occasionally find someone. But if you’re running a big pension fund, with everyone calling on you, you will likely invest in the best salespeople.

Munger: I think it ought to be a crime [for an investment manager or his agent] to entertain a state pension-fund manager, and it should be a crime for that person to accept it.

The whole concept of the house advantage is an interesting one in modern money management. The terms of the managers of the private partnerships look a lot like the take of the croupier at Monte Carlo, only greater.

Buffett: Is there anyone we’ve forgotten to offend? [Laughter]

What effect does large institutional ownership have on stock price volatility?

Never has so much been managed by so few that care so much about what happens tomorrow. So much of the world of investing is people who are trying to beat indexes, and they have a willingness and eagerness to make decisions in the next 24 hours. This condition didn't exist years ago. It has created a “hair trigger” effect. An example of this hair trigger effect was Black Monday in '87. The cause was program trading and stop loss orders.

Industries

Do you invest based on trends or sectors?

We don’t play big trends like demographic trends. They just don’t mean that much. There’s too much money to be made year to year than worry about trends that take ten years to play out. I can’t think of one investment we’ve ever made based on a macro or demographic trend.

[CM: Not only that, but we’ve missed the biggest commodity boom in history – and we’ll continue to miss things like this!]

But we’ll search for new ways to fail! [Laughter]

What do you think about the utility industry?

I have thought about that a lot because you can put big money in it. I have even thought of buying the entire businesses. There is a fellow in Omaha actually that has done a little of that through Cal Energy. But I don't quite understand the game in terms of how it is going to develop with deregulation. I can see how it destroys a lot of value through the high cost producer once they are not protected by a monopoly territory.

I don't for sure see who benefits and how much. Obviously the guy with very low cost power or some guy has hydro-power at two cents a KwH has a huge advantage. But how much of that he gets to keep or how extensively he can send that outside his natural territory, I haven't been able to figure that out so I really know what the Industry will look like in ten years. But it is something I think about and if I ever develop any insights that call for action, I will act on them. Because I think I can understand the attractiveness of the product. All the aspects of certainty of users need and the fact it is a bargain and all of that. I understand. I don't understand who is going to make the money in ten years. And that keeps me away.

What do you think of utilities?

The production of electricity is a huge business and it's not inconceivable that we'd invest heavily here.

The Public Utilities Holding Company Act [PUCA], written in 1935, has a lot of rules about what the parent company of a utility can do. It was set up to check abuses that existed then, so it was appropriate at the time. But I don't think there's anything pro-social about limiting Berkshire Hathaway's ability to acquire utilities today. We might have done one or two acquisitions in past years but for PUCA.

[Regarding the Californian Power Crisis] With deregulation, the incentives [for power producers] were changed such that instead of wanting abundant supplies, they wanted tight supplies, which would result in higher prices.

You can't take utilities with a cost of X, invite new producers in with a cost of 3X, and expect prices to go down.

The old system strikes me as better for society.

[CM: "The old system had the NIMBY [not in my back yard] problem. If you let unreasonable, self-centered people make decisions, you'll get into trouble. We may be making the same mistake today with oil refineries."]

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[Re: How Technological Change Might Affect the Utilities Business]

We’re going to earn a return on capital employed whether we transmit it the old way or whether some new way emerges. We strive to serve our customers and keep their costs down as much as possible.

Even in terms of choosing which generating sources we use, we follow the will of the people in the states we serve. If they want to pick a more expensive way to generate for some reason, that’s okay with us. I don’t think anything will change our economics. We certainly don’t buy a utility expecting to do something else with it.

In the domestic soft drink model, is it winner take all, or is there room for three competitors?

Sure, there's room for more than one. I think Coke's market share will grow pretty much year after year. We're talking tenths of a percent, but tenths of a percent are important. The U.S. market is 10 billion cases, so one percent is 100 million cases. It's interesting how regional tastes can be: Dr. Pepper may have a far bigger market share in Texas than in Minnesota ... You can make money with a soft drink company that doesn't dominate the business. You can do a lot better with one that does dominate, but it's not winner take all. It's not like two newspapers in a town of 100,000 or 200,000. There are certain businesses that are winner takes all.

What do you think of the airline industry?

"The big problem is not aggregate costs, but costs versus competitors." Buffett recalled US Air's difficulties competing against Southwest and concluded, "If your costs are out of line, you're going to get killed eventually."

[Munger: "Airline pilot unions are really tough. It's interesting to see people paid as well as airline pilots to have such a tough union. No airline can afford a shutdown very long."]

If you're in a business that cannot take a long strike, then you're playing a game of chicken with labor. Ironically, if you're weak, you're in a stronger negotiating position.

What do you think of the banking business model?

  • Banking is a good business - many banks earn high returns on tangible equity
  • “Charlie and I have been surprised at how much profitability banks have, given that it seems like a commodity business.”
  • Underestimated how sticky customers are and how unaware they are of fees banks charge them
  • WFC - $4.00 per share after full taxes on $15 of tangible equity
  • If you have a well run bank, you don’t need to be the #1 bank in an area
  • Bank ROA is not highly correlated to size
  • You may have to pay 3x tangible equity to buy a bank
  • Only problem with banks is that sometimes they get crazy and do dumb things...’91 was a good example
  • If a bank doesn’t do dumb things on the asset side, it will make good money

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We've been somewhat surprised at how well banks have done. Some have generated 20% or greater returns on tangible equity over many years, though this is in part due to increasing leverage.

[CM: "We misdiagnosed it and, even worse than that, we haven't changed."

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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.

[CM: 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.]

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.

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Financial companies are more difficult to analyze than other companies. They can report whatever earnings they want – it’s an easy game to play. For banks, earnings depend on loans and the reserves set aside. It’s easy to change and manipulate the reserves.

With a company like WD-40 or a brick company, the financials are easy to analyze. But with financial [companies] it’s tough, especially when you throw in derivatives.

There were very high grade, financially sophisticated people who were on the boards of the GSEs [Government-Sponsored Enterprises, such as Fannie Mae and Freddie Mac] and they were not negligent, but it’s very tough [to detect the shenanigans that went on].

Charlie and I were on the board of Salomon and Charlie was on the audit committee, and [it’s just impossible to evaluate thousands of transactions]. You’ll just have to accept that with insurance companies, banks and other financial companies – it’s just a more dangerous field to analyze.

With GEICO it’s easier because the statistics are quite accurate – it’s short-tailed insurance. It’s not like asbestos.

I wouldn’t fault the ratings agencies. Even the big-name auditors didn’t catch it.

[CM: Where you have complexity, by nature you can have fraud and mistakes. You’ll have more of that than in a company that shovels sand from a river and sells it. This will always be true of financial companies, including ones run by governments. If you want accurate numbers from financial companies, you’re in the wrong world.]

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[Q - Small regional banks - what would you look at before you buy?]

WB: It is hard to make a categorical decision about regional banks. So much depends on the character of the institution. It will be a reflection of the CEO you have. A bank can mean anything. It can be an institution that is doing all sorts of crazy things. The Bank of Commonwealth was an example. We owned a bank in Rockford, Illinois, run by Dean Aback—he would always run a super, sound bank. You should know the culture of the management and the institution before making the decision to buy a bank. We own Wells Fargo and M&T, but it doesn’t mean they are immune. But likely they are immune from institutional stupidity. There was a wise man that said there are more banks than bankers. If you think about that a while, you will get my point.

CM: The questioner is on to something. So many large banks have cast a pall over the entire industry. You are prospecting in a likely territory.

WB: If you took the 20 largest and the 20 smallest banks in Florida, I don’t know if you could tell the difference.

CM: It is a territory that has some promise.

WB: That is a wildly bullish statement from Charlie. I may need to go start buying! [laughter]

You’ve recently invested in Goldman Sachs and GE. Is the financial sector a good buy right now?

No sector is a good buy unless you understand the business. However, I do believe that there is good value and great opportunity now in the financial sector because it is extremely unpopular. Sector’s themselves don’t make good buys, companies that are undervalued make good buys. You know how to value a business, you project the future cash flows discounted to present and buy with a margin of safety. The earnings prospects need to be greater than the current value. Anything that is unpopular is always great to look at. If I was getting out of school right now, I would take a look.

Your opinion of the gambling industry?

I don’t know about which stocks to recommend, but, as long as we’re talking about the legal ones, gambling companies will have a perfectly good future. The desire of people to gamble is very high, including in stocks. Day trading comes very close to gambling. People like to gamble. If there’s a football game, especially if it’s boring, you’ll enjoy it more if you bet a few bucks. The human propensity to gamble is huge.

When it was only legal in Nevada, you had to travel or break laws to gamble, but now states are legalizing it. The easier it is, the more people who will gamble. I bought a slot machine a long time ago and put it on the 3rd floor of my house. I could then give my children any allowance they wanted, as long as it was in dimes, and I’d have it all back by nightfall. I wanted to teach them a good lesson. My slot machine had a terrible payout ratio, by the way. [Laughter]

People will always want to gamble. I’m not a prude about it, but to quite an extent, gambling is a tax on ignorance. You just put it in and guys like me don’t pay the taxes – it relieves taxes on those who don’t gamble. I find it socially revolting when a government preys on its citizens rather than serving them. A government shouldn’t make it easy for people to take their social security checks and [waste them pulling] a handle. It’s not government at its best. I think other [negative social] things flow from [gambling] over time.

Munger: I would argue that casinos use clever psychological tricks [to get people to gamble], some of which are harmless, but a lot of grievous injury has been done. You won’t find a lot of gambling companies in Berkshire’s portfolio. [Applause]

Opinion on the healthcare industry and its 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.

[CM: 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.

But if other countries spend 7-8% [of GDP on healthcare] and have good systems, are we getting a good deal?

[CM: We're not on a dollar for dollar basis. But I'm not [troubled by how much we spend].]

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[Re: The Pharmaceutical Industry]

That industry is in a state of flux right now. It’s historically earned very good returns on invested capital, but it could well be that the world will unfold differently in the future than in the past. I’m not sure I can give you a good answer on that.

[CM: We just throw some decisions into the “too hard” file and go onto others.]

We get paid not for jumping over 7-foot bars but for finding 1-foot bars that we can step over.

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[CM: A lot of people have made a lot of money selling health insurance. I’ve seen it as Chairman of a central-city hospital [the Good Samaritan Hospital in Los Angeles]. You’re right that there have been a lot of bad ethics. A lot of good ethics, too.

Generally, [investing in the healthcare area] goes into the “too hard” pile – unless Warren’s been keeping something from me.]

No, we’ve never done anything in healthcare.

[CM: You [the shareholder who asked the question] are right though – the worst of the ethics is really bad.]

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[Re: fixing the U.S. Healthcare System]

Munger: It’s too tough. We can’t solve that one. We try to look for easy problems. We don’t try tough things. Sometimes life hands you a very tough problem you have to wrestle with – not financial problems for us, but personal ones.

If we were looking at a private-sector solution, we’d look for low distribution costs. You don’t want a lot of revenue soaked up in frictional costs, but I don’t know how to do that. If we’re paying 15% of GDP [for healthcare], you’d think someone would figure it out. Maybe this will come up in the upcoming presidential campaign.

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[Re: Pharma? How do you value the pipeline of drug companies?]

WB: Unlike many businesses, when we invest in pharma, we don’t know the answer on the pipeline, and it’ll be a different pipeline 5 years from now anyway. We don’t know whether Pfizer or Merck, etc, have a better chance, or which of those will come out with a blockbuster. But we do feel we have a group of companies bought at a fair price that, overall, will do well and should offer chances for decent profits. These companies are doing very important things. I could not tell you the potential in the pipeline. A group approach makes sense. It is not the way we would go at banks. If you buy pharma at a reasonable multiple, you will probably do okay 5-10 years from now.

CM: You now have a monopoly on our joint knowledge of pharmacology.

WB: He gets cranky at the end of the day. [laughter]

Berkshire has invested in several insurance companies, would you go into the health insurance business?

No. Health insurance is so ingrained into national policy that it is a tough business. It’s pretty adversarial. I’m not really that excited about it from a business perspective. I don’t want to write policies with high loan loss ratios. That being said, I would buy the stock of an undervalued healthcare insurer.

Insurance is an interesting business. You know, we underwrote a two year life insurance policy on Mike Tyson. I wanted an exclusion against women shooting him, but they wouldn’t let me.

Have you ever considered concrete as an understandable business for investment purposes?

They would have advanced raw materials. How we value a business is what the game is all about. If you cannot value a business, you cannot value a stock. The efficient market theory equates to "nobody knows anything". Investment-finance teaching in the US needs to focus on and not miss the opportunity to promote thinking intelligently about how to invest — and in doing so, the person becomes a better manager.

What do you think of the telecoms industry?

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?

[CM: Less than you do.]

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.

[CM: Berkshire in its history has made money betting on sure things.]

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.

Your opinion on the auto industry?

[GM CEO] Rick Waggoner and [Ford Chairman] Bill Ford have both been handed, by past managers, extremely difficult hands to play. They’re not the consequences of their own doing, but they have inherited a legacy cost structure, with contracts put in place decades ago, that make it very difficult for them to be competitive in today’s world.

GM and Ford don’t sign long-term contracts to pay high amounts for steel, but that’s what they’ve done with annuity and healthcare payments to employees. The result is such expenses are far higher than that of competitors, so it’s not a fair fight.

GM once had 50% market share, and it’s fallen to 25%. Even if it was still 50%, they’d still be in trouble.

I’m not sure what I’d do if I was elected CEO of GM. It reminds me of what Bill Buckley said when asked what he would do if he actually won his race for New York mayor back in 1965 and he said, “The first thing I’d do is ask for a recount.” (Laughter) Well, that’s what I’d do at GM.

The UAW says, “We have a contract and we have a deal.” GM has set aside $90 billion for pensions and another $20 billion or so for healthcare, yet has a market cap of only $14 billion. That’s not sustainable.... Something will have to give.

If a company had to pay an extra $2,000 per car more for steel, everyone would realize there was a crisis and demand a quick solution, but that’s not happening.

Part of the problem arose because [the actions of previous managements] bore no accounting consequences. Back in the 1960s, companies didn’t have to account for pension costs on an accrual basis, and didn’t have to do so for healthcare costs until the late 80s or early 90s. But those costs are very real...

[CM: Warren just gave a very optimistic prognosis in my view. Just because the full consequences haven’t yet hit, doesn’t mean there isn’t a huge problem. It’s as if someone jumped out of a window on the 42nd floor. As you go by the 20th floor, you’re still OK, but that doesn’t mean you don’t have a real problem. (Laughter)

If I was the President of the U.S., Governor of Michigan or the CEO of GM, I wouldn’t wait. I’d address the problem right now because no one’s coming to save you.]

What's your view of the newspaper industry? versus other media?

People will always want to be entertained and informed, but the choices for doing so were far fewer 50 or 60 years ago. As the years have gone by, technology has produced a variety of new ways to be informed or entertained, but we still only have two eyeballs and 24 hours per day. And any time there’s more competition, generally that’s bad for business.

Newspapers are still highly profitable, especially compared to tangible capital employed, but the outlook isn’t nearly as rosy as it was 20-30 years ago. The audience is going down and that has to erode the economics over time. People also like to talk about how more competition [is good for business, but it’s not true].

At one time, [the major television networks] had a license from the government and were the only three highways to the eyeballs of hundreds of millions of people for advertisers like GM, Ford and Gillette to choose from. But now there are many highways. It’s hard to imagine these businesses [the networks] getting better in aggregate over time.

The key would have been to buy the NFL [National Football League; e.g., content] at inception.

We still own World Book [encyclopedias]. At one time, we sold 300,000 sets for $600 each. The problem is [that with the advent of the Internet] you could get a good bit of the same information without cutting down tress, delivering the books, etc. The problem wasn’t that the product wasn’t worth the money, it’s that people have other alternatives. I don’t see anything that will change this.

[CM: It’s simplicity itself that its future will be way worse than its past.]

What multiple would you pay for a business earning $100 million, which is going down 5% per year, versus the same business with earnings growing 5% per year? I’m not saying those are the numbers I’d use for newspapers, by the way. I do not think newspaper circulation, or ad pages, will be larger in five years – even in areas of the country that are growing [in population].

Newspaper multiples are uncomfortably high if you believe profits are going to decline. Prices today do not reflect earnings declining at 5-6% per year. There’s also the risk that [owners of newspaper businesses] don’t fully recognize the situation and will buy other newspapers at too high a price.

This comes from someone who loves newspapers and couldn’t do without them. I read five newspapers every day. Charlie does too. But people can [do without them]. The decline, if anything, has accelerated somewhat. When they take people to the cemetery, they’re losing readers, but when they graduate from college, they’re not gaining any readers. The virtuous cycle isn’t true anymore, but prices don’t reflect this.

We love them as products and thought they were the greatest of companies with bulletproof franchises. We were wrong.

[CM: I have a greater sin to confess to. I once thought GM was a bulletproof franchise.

But we have a method of coping: we just put it in the “too hard” basket. If something is too hard, we move on to something that’s not too hard. What could be more simple?]

It used to be the easiest business model to understand.

In the 1991 annual report, I wrote about [advertising] preprints, and how there was nothing magical about the newspaper, but that it brought the preprints inside the house. [I’m not sure what Buffett was talking about here – the word “preprint” doesn’t appear in the 1989-1992 annual reports, but his discussion in his 1991 letter of the declining economics of the media business is fascinating and his conclusion was amazingly prescient: “Most media properties continue to have far better economic characteristics than those possessed by the average American business. But gone are the days of bullet-proof franchises and cornucopian economics.”]

It has been interesting for me to watch both direct owners and investors in the newspaper business resist seeing what’s right in front of them. It [newspapers’ superior economics] went so long the other way. You couldn’t make a mistake buying a monopoly newspaper business [meaning a town in which there was only one newspaper] until 1975 or 1980.

[CM: If the technology hadn’t changed, they’d still be great businesses. Network TV [in its heyday,] anyone could run and do well. If Tom Murphy was running it, you’d do very well, but even your idiot nephew could do well.

Fortunately, carbide cutting tools [such as those made by Iscar] don’t have these types of substitutes.]

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What advice do you have for long-suffering New York Times shareholders and what do you think of its dual-class share structure?

As for the “long suffering”, as you put it, shareholders of the New York Times, I don’t blame the Sulzbergers for what’s happened. [Here is the bio of Arthur Sulzberger Jr., the Chairman and Publisher of the New York Times Co., and here is a 2005 BusinessWeek article about the family, the company and the challenges they face.] We’ve said for a long time that we thought newspapers were overpriced because investors were looking in the rear-view mirror.

As for different share classes [which the NYT has], I own about 30% of Berkshire A and B shares, so there’s no voting difference.

The woes of the newspaper business have nothing to do with the dual-class structure.

Let’s suppose Mr. Gutenberg [Johannes Gutenberg was the inventor of modern printing] in the 1500s [actually 1400s; he lived 1400-1468] had become a day trader or hedge fund manager instead, so that we never had printing. But along came the Internet and cable TV [as we have today]. Now imagine that someone came along saying, “I have a great idea: let’s chop trees down, buy expensive printing presses and buy a fleet of delivery trucks, all to get pieces of paper to people to read about what happened yesterday.” I don’t think we’d be backing him. [Buffett’s point is that if newspapers didn’t exist, no one would create them now.]

It happened that newspapers came first and people have become accustomed to them. They have momentum on their side from the past, but I don’t care how smart you are, you’re not going to be able to do much to reverse their decline.

Some smart guy came to the Los Angeles Times and said he was going to take circulation up to 1.5 million. Well, it’s now at 800,000. I don’t know if even William Randolph Hearst could do much to change this.

The same thing happened to us with the World Book Encyclopedia – its sales have dropped from 300,000 to 22,000.

The companies that have not had dual-class structures have fared just as badly. For example, we own The Buffalo News, and earnings are down 40% from the peak. Despite terrific management and high market share, earnings are going down. It’s a fact of life.

Munger: He said the dual-class structure is intrinsically wrong. It was in the original contract when the New York Times Co. went public. Stamping your foot if you don’t like it strikes me as immature.

Buffett: Sulzberger [Arthur Sr.] would not slash staff and did not follow the typical business school approach – and look at his success. All the others fell by the wayside. I don’t know if 10-15 years from now, the New York Times will be viewed as having played an inferior hand.

The Los Angeles Times will have more trouble monetizing their reputation on the Internet when compared to the New York Times.

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[Q - Would there be a compelling price at which Buffett would add another newspaper to Berkshire’s portfolio?]

Buffett: There’s an evolutionary situation with newspapers. I read five a day and so does Charlie. We’ll be the last people reading a newspaper, with a land line by our sides. [laughter] Most newspapers in the U.S. we would not buy at any price. Twenty to forty years ago, they were essential to customers and advertisers. They had pricing power, but they’ve lost their essential nature—essentiality has eroded. Erosion accelerated dramatically, and it won’t end based on anything on the horizon. We do not see anything to reverse it. They are essential to advertisers only as long as they’re essential to readers. Ten years ago, the head of The Buffalo News said that on an economic basis, Berkshire should sell The Buffalo News. We could have sold the business for hundreds of millions. Not so today. As long as we’re not losing money forever and there are no union problems, we won’t sell. There are around 1,400 daily U.S. papers, and nobody has found the model that works. We’ll play it out as long as we can.

Munger: One hundred percent right. Monopoly daily newspapers were impregnable. It’s a national tragedy for newspapers to die off. They kept government more honest than they otherwise would be. What replaces it will be less desirable.

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[Q - Are you still down on newspapers? Ipad and other e-reading technologies – will it end up with contraction in earnings retained by content provider or by distributor?]

WB: When money at newspapers came from advertising – it was on average about 75%, they used to be only game in town, and what a difference that makes, when you aren’t the only game in town. It is very tempting, without substantial circulation, but the math is tough – printing costs are high and distribution is tough. But I don’t understand it, and I can’t make an affirmative decision. [ABC] puts out Fast Facts, I look at circulation of many papers. In Buffalo we were down less than many places. SF Chronicle was down 20%, Dallas too – many people are dropping the paper. World has changed about the essential value of newspapers. Nothing looked more bullet proof than daily newspapers 40 years ago, and that has melted away. It is a form of news and entertainment that has lost its immediacy, it is not the essential place to get information. You looked for stocks and weather and sports – advertisers were there because it was best and only microphone. The problem is self-reinforcing, subscribers leave and advertisers leave too.

CM: Independent newspapers due to accidents of history became dominant in their towns. The world was better because they were strong, because they kept the government in check – they were called the fourth estate. We are losing something that we have no substitute for. I don’t have the faintest idea what to do about it.

WB: Our newspaper hit 300k at peak on Sunday, and now down 100k. Philadelphia, was down 40k in a single year. The advertiser doesn’t need you. Your ability to price evaporates. We met Lord Thompson who owned paper in Council Bluffs. We asked him, “Have you ever been there?” “I wouldn’t dream of it” he said. We asked, “You seem to increase price every year. What can they do about it?” He replied “Nothing, I tell my US managers to price to make 40% pretax and above that it may be gouging.

CM: Politicians are not behaving better as newspapers are weakening. We are going to miss the newspapers’ power.

What are your views on the railroad industry?

I don’t think the railroad industry will be a lot more exciting, but the competitive position of the railroads has improved somewhat since 20 years ago. There’s been progress on labor issues and an improved competitive position vis-a-vis truckers. Higher oil prices hurt railroads, but hurt truckers more by a factor of four. What was a terrible business 30 years ago, operating under heavy regulation, has become decent and could be better over time. But it will never be a fabulous business – it’s too capital intensive.

When do you expect to see a return on investment in wind farms and other alternative energy sources?

Buffett: We have the largest wind farm capacity in the country. We are a net exporter of wind energy in Iowa. Iowa has been very receptive and progressive in wind energy. We haven’t raised rates in Iowa in about 10 years. We can use Iowa’s tax credits. We’ve developed a lot at PacifiCorp in wind. You’ll see more and more wind generation by MidAmerican [Energy Holdings].

Munger: Berkshire subsidiaries will be leaders in practically anything that makes sense for utilities. You bought a pipeline in about two hours, didn’t you?

Buffett: A durable advantage is that we can act fast. We went from a noontime phone call to a formal offer for Constellation [Energy] by that evening. It didn’t work out. We don’t ask the lawyers before we do it, we just do it. We can move fast when the time [is right]. We’ve got the money, and we’ve got the managers to handle the properties.

[Comment - If Berkshire has the largest wind generating capacity in the country, somebody needs to tell FPL Group, which makes the same claim. To date, wind power has been the most successful among the alternative energy sources.]

What industry will be the next growth driver in the 21st century and what do you see that supports that?

We don’t worry too much about that. If you’d look at the 1930s, nobody could have predicted how much the automobile and airplane would transform the world. There were 2000 car companies, but now only 3 left in the US and they are hanging on barely. It was tremendous for society, but horrible for investors. Investors would have had to not only identify the right companies, but also identify the right time. The net wealth creation in airlines since Orville Wright has been next to zero. If a capitalist had been at Kitty Hawk and shot him down, would have done us a huge favor. Or look at TV manufacturers. There are hundreds of millions of TV’s, RCA & GE used to produce them, but now there are no American manufacturers left.

If you want a great business, take Coca-Cola. The product is unchanged, they sell 1.5 billion 8 ounce servings per day 122 years later. They have a moat; if you have a castle, someone’s going to come after you.

Gillette accounts for 70% of razor sales at 80% gross margins and it is the same over time. Men don’t change much. Shaving might be the only creative thing they do, like painting the Sistine Chapel.

Snickers has been the #1 candy bar for the past 40 years. If you gave me $1 billion to knock off Snickers, I can’t do it. That’s the test of a good business. You don’t knock off Coke or Gilette. Richard Branson is a marketing genius. He came in with Virgin Cola, we’re not sure what the name means, perhaps it turns you back into one, but he couldn’t knock off Coke. We look for wide moats around great economic castles. Growth is good too, but we prefer strong economics. In the upcoming annual report I have a section titled “The Great, the Good, and the Gruesome” where I talk about these.

Specific Businesses

What was your thinking behind the purchase of Berkshire Hathaway?

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.

What is your analysis of Coca-Cola?

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.

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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.

Is it really a good idea to buy stocks in unhealthy products? e.g. Coca-Cola

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.]

How do you distinguish the Cokes of the world from the Proctor & Gambles of this world?

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.

Opinion on Coke and Gillette? (2002)

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.

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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.

Coke and Gillette are off something like 30% from their highs. Do you still consider them exciting businesses?

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.

What did you think of the Calpers/ISS proposal that you should not be on Coke’s audit committee?

[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.

Does McDonald's have the ability to dominate like a Coca-Cola or a Gillette?

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.)

Would you buy McDonald’s and go away for twenty years?

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.

Could you comment on more on McDonald's.....how does it stack up on the inevitables?

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.

Opinion of Procter & Gamble?

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.]

Reasoning behind the PetroChina investment?

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.]

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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.

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[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.

Reasoning behind the National Indemnity investment?

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.]

Reasoning behind the HomeServices investment?

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.]

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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.]

Reasoning behind the Geico investment? (and thoughts on low cost producers)

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.

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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.

Reasoning behind the Iscar acquisition?

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!]

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[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.”]

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[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.

Update on NetJets

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.

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[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.

What was the thinking behind the McLane purchase?

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.]

How did the Clayton Homes purchase come about?

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.

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[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.]

Thinking behind the investment in Anheuser-Busch?

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.]

Could you talk us through your thinking of the acquisition of Larson-Juhl?

[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.

BYD [Buffett’s recent Chinese investment] seems like a speculative or venture capital investment, instead of a “value” investment. Could Buffett explain?

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.

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[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.

Why did you invest in Harley-Davidson?

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.

Opinion of Fannie Mae and Freddie Mac? (2001)

[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.]

Opinion on Fannie Mae, Freddie Mac and Other Highly Leveraged Financial Institutions? (2003)

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.

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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”.

How did you decide to invest in Salomon?

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.

Is it true that Salomon almost caused a global financial crisis?

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]

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