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Notes from the 2003 Berkshire Hathaway Annual Meeting

By Whitney Tilson ( [email protected] )

Note: This is not a transcript. No recording devices were allowed at the meeting, so this is based on many hours of rapid typing, combined with my memory (egads!). I have reorganized the content of the meeting by subject area. All quotes are Buffett's unless otherwise noted. Words in [brackets] are my comments or edits.

For more on this meeting, see my 5/5/03 column, Report from Berkshire's Meeting . For my columns and notes on previous Berkshire and Wesco meetings, click here.

To read the transcript formatted in MS Word, click here. To download a Word version, RIGHT-click here and select "Save Target As."


Q1 Results

The economy has been quite sluggish -- it has been for a very long time. Right after 9/11, I posted a letter that said we had been in a recession [even prior to 9/11]. Since 2000, housing and autos have done very well, but everything else has been quite sluggish. Interest rates are down to 1.5%, but business continues to be sluggish.

So, our non-insurance businesses didn't do so great in the first quarter. But insurance businesses did great. The first quarter will show $290 million of pre-tax income, after $140 million in charges for retroactive insurance contracts. And, our float grew $1.3 billion to $42.5 billion in float. (Float is what people pay us to use the money.) I don't see our float growing much from this point, but Charlie said that at last year's annual meeting [and it's grown 8.8% from Q1 02 to Q1 03].

I think our insurance businesses are in exceptionally good shape. We have some terrific businesses. Geico's premium volume was up 16% in Q1, with a 6% underwriting profit. Gen Re, thanks to Joe and Tad, has turned the corner in a big way. And Ajit Jain [of National Indemnity] made so much money in the first quarter that I don't even want to tell you about it. [Audience and Munger applauded.] When you see Charlie clap, you know he's made us a lot of money.

You never know what's going to happen in insurance -- there could be a big earthquake tomorrow or huge hurricanes -- but I can't imagine having a better group of companies and people. For a while Gen Re was a drag, but that's not true right now. We have a very good chance of having low or no cost float for as far as the eye can see. Having $42.5 billion for free is a good thing.

Q1 was a very good quarter. Pre-tax operating earnings were around $1.7 billion (not including securities gains). [Buffett later clarified that after-tax earnings, including securities gains, were also about $1.7 billion.]

Munger: I hate to be an optimist, but we have really added a lot of wonderful businesses to Berkshire over the past few years.

Berkshire's Float

I wish our float would keep growing at 10%/year as long as it's profitable. But with $42.5 billion of float and a US P&C [property and casualty insurance] market of $500 billion, we are 8-9% of the market so it's going to be much harder to grow at significant rates in the future. What we really want is low-cost float. That's what I tell my managers.

Every once in a while, we get off track. I don't think most companies in the P&C business will generate float at an attractive cost. You have to be exceptional, and we have some exceptional businesses. If GEICO grows 16%, it adds $1 billion of float. GEICO will grow -- I'd bet my life on that.

Munger: With interest rates where they are right now, the float we've built up isn't worth so much to us right now. We have $16B of cash earning very low rates. But eventually we'll get more than 2%.

Buffett: We're getting a lot more than 2% [I think he was referring to the total return from Berkshire's float]. We have roughly $16 billion in cash, excluding the finance operation, and we're getting about 0.75% on it [1.25% pre-tax], which does not make us salivate. But we'd rather avoid salivation than have problems.

We earned $1.7 billion in Q1, pretty much all cash, plus $1.3 billion of float, so there's a lot of money coming in. We're getting chances to deploy it. If we get it at low cost, then it's pretty close to equity.



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

Wal-Mart, for very good reasons, wants to specialize on what they do extremely well. We were approached by Goldman Sachs to buy the business a week ago. It makes sense for both sides. It was a sideline business for Wal-Mart. Their ownership of McLane resulted in certain people who would be logical customers not to do business with McLane because they didn't want to do business with a competitor. We'll be seeing them soon to explain that they can sleep well at night buying from us.
A representative of Wal-Mart, the CFO, came up to Omaha last Thursday. In one hour, we had a deal and shook hands, and when you shake hands with Wal-Mart, the deal is done. There needs to be regulatory review, but we fully expect that in just a few weeks, McLane will become part of Berkshire.

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

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

Clayton Homes

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

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

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

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

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

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


We took a loss in the first quarter and will have a loss for the year. It's our only business that's losing money.

The used aircraft market has excess capacity, which is pushing down prices. We bought back some planes from our owners, which we've always done and will continue to do. [Because NetJets owns both new and used aircraft -- before selling them to fractional owners -- I believe it had to take a non-cash charge in Q1 for the decline in this asset's value.]

We're slightly profitable in the US and losing money in Europe. 1/2 of all [business jet] miles flown in Europe are by Americans, and this will rise. We've made a huge investment Europe and there will be no competitors behind us.

There are three major competitors. We have always been the biggest and our market share is rising. At 75% recently. I believe all of our competitors are losing money on an operating basis -- not even including asset write-downs. I think some of them will exit the industry -- look at Raytheon's recent prospectus. There will be a shake out, and we will not be one of the ones shook.

This will eventually be a huge business for us -- 10 times what it is currently.

MidAmerican Energy Holdings and Investment Opportunities in the Energy Sector

MidAmerican is already a big part of Berkshire. It could be much bigger if PUHCA [Public Utility Holding Company Act] were repealed. It was enacted in 1935 in response to abuses -- it was needed then, but it's now outdated. A couple of companies could be in bankruptcy if we hadn't stepped in [to buy some of their assets last year].

I think there's a reasonable chance of repeal [of PUHCA, and if so] MidAmerican could be quite a bit bigger and could be a whole lot bigger. We might acquire a natural gas pipeline or a utility. We'll look at what comes along and we're always ready to act. We'll look at some big deals this year -- whether we'll get one done is another matter. The good thing about this sector is that you're always talking about big deals.

There's fabulous management at MidAmerican. Dave Sokol and Greg Abel have done things that have made Berkshire money that hasn't benefited MidAmerican -- they didn't get paid a dime. They are terrific assets, and we love the idea of pouring money behind them.

Munger: The interesting thing is the field is so big -- it's enormous. One thing a modern civilization needs is energy.

Value Capital

Value Capital is run by Mark Byrne. We've made a lot of money with the Byrne family. [Jack Byrne turned around GEICO in the 1970s, making Berkshire a ton of money, and has recently been doing the same with White Mountains Insurance, in which Berkshire also has an investment.] Mark is a very bright guy and runs a hedge fund specializing in fixed income securities around the world. The Byrnes have put in money, but we own 95% of the capital -- though we are exposed to no further risk. Value Capital uses some leverage, but not as much as similar funds. We're comfortable with it, as long as Mark has upside and downside, which he does. We disclose the numbers. Value Capital has $600 million or so, including $200 million of retained earnings. We do not regard it as a business part of Berkshire. We are a limited partner (even if accounting rules say we have to consolidate it). There are no guarantees, but we're very happy with it. I've looked at Mark's portfolio and I like the positions.

Gen Re and Goodwill

If you buy a business over tangible assets [e.g., you pay more than the value of the company's tangible assets], you set up a goodwill account [for the difference] and if it becomes impaired, you run a charge through the income statement. We took on a lot of goodwill when we bought Gen Re. If you looked at the last few years, you'd say Gen Re was impaired and we would have agreed, but I think Gen Re is now worth more today than when we bought it. It's generating substantial float and it's low cost.

Circle of Competence, Telecom, Level 3 and Junk Bonds

I don't have the faintest idea how to evaluate what telecom companies will look like down the road. I only understand a little of what they do. I suppose if you gave me some information, I could regurgitate it back to you but in terms of understanding their economic characteristics down the road, I don't know. Charlie, what do you know about the telecom business?

Munger: Less than you do.

Buffett: Then you're in trouble. I know people will be drinking Coke, using Gillette blades and eating Snickers bars in 10-20 years and have rough idea of how much profit they'll be making. But I don't know anything about telecom.

It doesn't bother me. Somebody will make money on cocoa beans, but not me. I don't worry about what I don't know -- I worry about being sure about what I do know.

Munger: Berkshire in its history has made money betting on sure things.

Buffett: We might buy some junk bonds in that business [telecom], and we have, but we expect losses in junk bonds -- though we expect a decent result -- because we're dealing with institutions that have demonstrated problems. In some cases -- not at all with Level 3 -- there are management issues. We expect to have significant losses, and we haven't seen our biggest loss yet, believe me.

It's like being an insurer of substandard risks -- you'll have more accidents, but can charge a premium.

We don't buy businesses in which 15 will be train wrecks and 85 will work out OK.

There are all kinds of businesses where you can't predict what they're going to earn, so we try to favor a few where we can.

At Level 3, they are fine people and they acknowledge that they borrowed too much money. I have yet to see an electron and have no working relationship with them at all. I don't know anything about the technology at all, but I understand the people involved. It's of a different sort [of investment] than we usually do, but we're happy we did it.

Acquiring More of Cologne Re

What really happened was Gen Re acquired a significant position in Cologne Re with a put and call arrangement for the remainder. It was a two-step purchase. So all along, we have accounted for it as if we would acquire it. We will have about 89% when the options exercise. There's nothing new about this arrangement and we made no new judgment or decision. Cologne is an integral part of Gen Re. We knew all along that we would own 89% of it.

PetroChina and Foreign Investments

We have five equity investments in foreign companies. We don't list all of our investments -- only those larger than $500 million -- and none of our foreign investments have hit our reporting threshold since Guinness. In the case of PetroChina, the government owns 95% of it, but Hong Kong stock exchange rules require disclosure if an investor owns more than 5% of a stock, and we own 13% of H shares. It's a fluke of reporting that we have to report it. We don't make any great judgment about China -- we simply look at investments around the world and buy things that make the most sense [offer the most value]. We prefer slightly things in the US and avoid some countries altogether.

Coca Cola's Inevitability

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


Deal Flow
We don't like the term "deal flow" because we don't view them [businesses we might buy] as deals. We look at deals a few times a year. In the US, we get a pretty reasonable percentage of the calls we should get. We didn't get those calls 20-40 years ago because we weren't as well known.

It feeds on itself. If we acquire companies and people say good things, we'll hear from more. We acquired one furniture company, which led to four more.

It's like a snowball. By being around 38 years, it's been a high mountain [and Berkshire is now a] big snowball and attracts a lot of snow.

Outside the US, we don't see many deals because we're not as well known.

I don't hear about one [deal] a week or even a month. But most we want to hear about, we get a good percentage of the calls. It would be a plus [if we were to see more deals] outside this country.

Munger: The general assumption is that it must be easy to sit behind a desk and people will bring in one good opportunity after another -- this was the attitude in venture capital until a few years ago. This was not the case at all for us -- we scrounged around for companies to buy. For 20 years, we didn't buy more than one or two per year.

Buffett: We didn't have the money to do many deals. When we bought National Indemnity, it was a big deal for us. We hope there's a lot of mountain left and a lot of wet snow.

Munger: It's fair to say that we were rooting around. There were no commissioned salesmen. Anytime you sit there waiting for a deal to come by, you're in a very dangerous seat.

The Story of Buffett Buying National Indemnity

Jack Greenwald would want to sell National Indemnity for 15 minutes per year -- a claim would come in that upset him or something like that. I discussed the phenomenon of Jack being "in heat" 15 minutes per year. One day, Charlie called and said Jack's ready and he came over and we made deal in 15 minutes.

Having made the deal, Jack really didn't want to do it. He tried to get out of it by saying, "I suppose you want audited financial statements." I said "No." If I'd said yes, he would have called off the deal. He said, "I suppose you want to buy the agencies." I said, "I wouldn't buy them under any circumstances." Again, if I'd said "Yes," he would have backed out. Finally, he gave up and I bought the business. He was an honorable guy. After we closed the deal, Jack was 10 minutes late to pick up the $7 million check because he was looking for parking meter with a few minutes left on it -- that's when I knew he was my kind of guy.

Bidding for Bankrupt Companies; Burlington Industries

We submitted a bid of more than $500 million for Burlington, which included $14 million in breakup fees. When we submitted the bid, it has to remain outstanding for many months. This has option value [to the company and its creditors]. For $14 million, we told creditors that they could sell business for that amount, or very close to it. That's a very low price for a put, but it's customary. A court said that's too much to charge, so they set up a new procedure that will end up having Burlington sold to someone else under the new procedure.

We'd never agree to anything like this except in the case of bankruptcy. Look at how stocks move 50-100% per year. We will not participate in a procedure in which we bid hundred of millions of dollars and then if there's a World Trade Center disaster or earthquake, our bid sits out there and we only get paid $5 million [to assume this risk].

It's tough to buy things out of bankruptcy, though we've done it twice successfully. We tried with Burlington and we spent a lot of time and money and it was not accepted. It's a lot easier to make a deal with Wal-Mart [e.g., McLane] where we sit for an hour and have a deal. But it's probably a necessary part of the procedure. You gotta follow the bankruptcy laws. If we have to bid where we have our bid sit out there, and get paid [only a] 1% [breakup fee], we won't make many bids.

Munger: We don't think a modest 2% fee was too much, but the court disagreed.


Information on Berkshire

We want you to understand Berkshire. I hope you see that. We want to you have the information we'd want if our positions were reversed. You need some basic information. We give information that Charlie and I would need to come up with our rough estimates of Berkshire's intrinsic value. You don't need to focus on all of the details, like whether we lease a particular building, but you can judge roughly in aggregate.

Munger: I think our reporting, considering the complexity of the enterprise, is better than that of any enterprise I know at giving shareholders the information they need. We do it conscientiously and I don't think it will get better.

Approach to Risk

We have some structured contracts with paraplegics who are depending on a piece of paper with our name on it that says we're going to pay them for the rest of their lives. So people who care about this should come to us.

What To Do With Berkshire's Cash

We have $16 billion in cash not because of any predictions [about a market decline], but because we can't find anything that makes us want to part with that cash. We're not positioning ourselves. We just try to do smart things every day, and if there's nothing smart, then we sit on cash.

Investment Hurdle Rates

10% is the figure we quit on -- we don't want to buy equities when the real return we expect is less than 10%, whether interest rates are 6% or 1%. It's arbitrary. 10% is not that great after tax.

Munger: We're guessing at our future opportunity cost. Warren is guessing that he'll have the opportunity to put capital out at high rates of return, so he's not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we'd change. Our hurdles reflect our estimate of future opportunity costs.

Buffett: We could take the $16 billion we have in cash earning 1.5% and invest it in 20-year bonds earning 5% and increase our current earnings a lot, but we're betting that we can find a good place to invest this cash and don't want to take the risk of principal loss of long-term bonds [if interest rates rise, the value of 20-year bonds will decline].

Smooth vs. Lumpy Earnings

We have a preference for a lot of money coming in all of the time. But we write huge insurance policies where money could come or go in big chunks. All other things being equal, we like smoothness, but we often get offered a spread to take on lumpiness.

Pepsi is running a contest in which one person will have a 1-in-1,000 chance of winning $1 billion -- a present value of $250 million [since the billion is paid out over time]. [If the person wins,] we will pay it. We are willing to assume that for a payment, and very few people would be. We would be willing to assume a $2.5 billion payout (but not $25 billion) if we got paid more than proportionally more.

Munger: If you're risking a $250 million payout and you have $60 billion of capital, it's not crazy. But I think it's crazy to do it based on someone else's circumstances or abilities.

Investment Mistakes

If we start buying a stock, we want to go in heavy. I can't think of a stock where we wanted to quit.

We've made some big mistakes starting to buy something that was cheap and within our circle of competence, but trickled off because price went up a bit. Good ideas are too scarce to be parsimonious with.

Munger: After nearly making a terrible mistake not buying See's, we've made this mistake many times. We are apparently slow learners. These opportunity costs don't show up on financial statements, but have cost us many billions.

What Do You Look for in a Manager?

We look for managers that have a passion for their business. We've had terrific luck with entrepreneurs who love their businesses like I love Berkshire. They'll tell me to butt out if I'm going to screw it up. They are part of Berkshire, but guard their businesses jealousy.

We got a book from an investment bank from someone who bought a business a few years ago [and now wanted to sell it]. The business was a piece of meat to them. What are the odds that they didn't doctor the books?

[I look for people who] have a lot of love for their business. There can't be a company in the country, if you could measure passion for the business, no-one would come close [to Berkshire].

Munger: What matters most: passion or competence that was born in? Berkshire is full of people who have a peculiar passion for their own business. I would argue passion is more important than brain power.

Buffett: By the time they get to us, if they didn't have brainpower, they wouldn't have gotten to us. We're not going to see an incompetent but passionate manager -- those got weeded out a long time ago. But I do have to weed out a manager who just wants to cash out.

We see lots of businesses that play games with their accounting and just want to cash out.

Berkshire's Compensation Systems

When a business requires no capital, we reward the manager on earnings. If it does [require capital], then we add a charge for the cost of capital. We don't have one compensation system.

We've never had problems with compensation. If capital is an important part of business, we include a charge for it. If not, if we don't.

Our compenastion systems are simple. This is not rocket science [though Corporate America seems to make it so]. Read proxy statements -- it's mind-boggling the complexity. Compensation consultants have to earn their fee [by coming up with a complex plan that they can] tweak each year. It's becomes an industry and it won't break itself up. True of any bureaucracy.

We could spend $1 million per year on something we could figure out in five minutes. Can you imagine a consultant giving you a one-page compensation agreement? They couldn't charge you a lot of money for that.

The main reason we get good results from our managers is that they like batting .400. Yes they like the pay, but it's incidental. It has to be fair, but that is not a complicated procedure. It's tailored to things under their control.

Some of our businesses are easy, so they much achieve high performance before [the CEO's] bonus kicks in. In tough businesses, lower performance requires as much hard work, so the hurdle is lower.

Morale is pretty good in Berkshire subsidiaries. Berkshires managers hardly ever leave. In 38 years, we've never had a CEO leave to work for a competitor. We face one management succession problem roughly every 18 months.

Do Berkshire's Manager's Enjoy Coming to the Annual Meeting?

We have many managers here. We don't require them to come. Some have rarely come. If they enjoy it, they come. We have a sensational group of managers. We don't get in their way and don't demand anything except that they work for the owners. I hope you thank them when they see them.

Munger: I don't think our managers who come to this meeting are picking up new tricks -- they know all the tricks related to their business -- but this is an interesting place and it gets more interesting every year and they like being part of it.

Buffett: In some cases, our managers will check with each other to see what they're paying for things, combine purchasing power, etc. Sometimes they save real money, but this is not organized by Omaha and nobody has to play.

Berkshire's Intrinsic Value

I think (and Charlie does too) that Berkshire's value has grown significantly over past few years.

Intrinsic value is the stream of cash from now until judgment day, discounted based on consideration of other uses. You have to understand what kinds of businesses you can make a reasonable assessment of. At Berkshire, you have two questions: 1) what its businesses are worth now, and 2) what we do with the capital. 35 years ago, people underestimated what we would do with the capital. But we're now in a whole different game, with lots more capital.

Stock Prices and Share Buybacks

In 1999 [the 1999 annual letter , published in early 2000, in which he offered to buy back shares at $45,000 or less], I thought Berkshire was more attractive than the general market.

We addressed share buybacks in the annual report released on the exact day that the Nasdaq hit its high and Berkshire hit its low [March 10, 2000]. Our preference is to buy business of a quality and managers of a quality comparable to those we already own. We would only buy back stock if we thought Berkshire was significantly undervalued and didn't think we could put money to work elsewhere.

Intrinsic value is a range. We'd leave a significant margin of safety. It's not our #1 preference -- we love adding good businesses to Berkshire. We'd have to give all shareholders relevant info. I think it's unlikely that that happens. It could happen though -- it almost happened in March 2000 and then things turned around very abruptly.

I have not thought stocks were cheap at all for quite some time. I've never wanted to encourage anyone to hold Berkshire. I've never sold a share. I think we had a great bubble.

We don't comment on specific stocks, including our own, and only occasionally comment on the market in general.

Currency and Inflation Risks

Berkshire has a couple of billion dollars of liabilities denominated in other currencies, but also has roughly the same amount of assets in other currencies -- we don't spend much time worrying about precisely balancing this. We have little exposure to currency risk.

Corporate Governance

We'll have new independent directors by next meeting. They will be experienced and have interests aligned with shareholders; they will own a lot of stock. Shareholder Resolution [A shareholder presented a resolution whereby anyone who owned 7 Berkshire B shares or more could participate in Berkshire's shareholder charity program. Under this proposal, each B share would be entitled to 60 cents/share.]

When we offered the B shares, we laid out certain rights and we're not going to give B shareholders any additional rights, but they can also be assured that we're not going to give A shareholders any additional rights either. A deal's a deal.

Munger: There are also significant administrative costs that would make the proposal impractical.

[Buffett then asked if someone wanted to second the motion. No-one did so it died.]

Munger's Influence on Buffett

Munger: I think there's some mythology in this idea that I've been this great enlightener of Warren. He hasn't needed much enlightenment. But we know more now than five years ago.

Relationship with Charlie Munger

Charlie and I have been partners in some way since 1959. We worked together in a grocery store and both came to the conclusion that we don't like hard work.

We have never had an argument. You just have to learn how to calibrate his answers. If you ask Charlie something and he says "no," then we put all of our money in it. If he says "that's the stupidest thing I've ever heard," then we make a more moderate investment. If you calibrate his answers and then you'll get a lot of wisdom.


Financial Guarantee Companies

In many cases, people participating in this [the credit guarantee] business don't know what they're doing. In the insurance business, people hand you money to put something on a piece of paper. What you put on that paper is very important, but the money can tempt you to do dumb things.

At a firm in Omaha a while back [he was referring to Mutual of Omaha], in a short time someone wrote a very few contracts [about 10] that wiped out half of the company's net worth.

If you're willing to do dumb things, people will find you. Even if you're in a rowboat in the ocean, the brokers will swim to you, with their fins showing. It's brutal. You'll see a lot of cash, won't see any losses for a little while, and then the roof will fall in.

I mentioned in this year's annual report that GEICO took in $70,000 [in the annual report, he said a net of $72,000; $3,051,000 in premiums for commercial umbrella and product liability insurance, offset by $2,979,000 in reinsurance purchased] for a few policies, and so far we've lost $93 million [$94.1 million from the annual report: "Of the total loss, uncollectable receivables from deadbeat reinsurers account for no less than $90.3 million.So much for 'cheap' reinsurance."]. We could only make 70,000. When you're playing in a game like that, you can't afford to make a mistake. A few mistakes can wipe out a lifetime of earnings. You make a few cents when you're right and lose a fortune if you're wrong.

Financial guarantors use back-tested arrangements, but the problem is correlation. When things go bad, all sorts of things correlate that no-one ever dreamed was possible. Look at what happened in the in energy sector. There's nothing more deadly than unexpected correlations.

To get a BBB credit enhanced to AAA, a guarantor might charge 15 basis points, but the spread is 100 basis points. That's not very smart [for the guarantor to charge such a low price].

They [the financial guarantors] are rated AAA for claims paying, but not generally AAA. Only one other insurance company, AIG, is rated AAA [like Berkshire is].

I would say you could get into a lot of trouble levered 140:1 issuing [financial] guarantees.

Munger: Accounting [for financial guarantees] is terrible, and is most terrible in accounting for guarantees a long way out. People pay attention to numbers without consideration for reality, which can lead to bad decisions.

Buffett: I will guarantee you that for every single contract written, there was recognized some sort of income entry and someone got paid for it. You know it's going to be a terrible contract. Nobody ever wrote a loss at the time, but if someone sold them to me, I would sell them at a loss.

I find it extraordinary that if Dealer A and Dealer B do a deal, both can write a profit, especially on a 20-year contract.

Derivatives and the Story Behind Pre-Releasing Part of the Annual Letter in Fortune

I was interested in the section on derivatives -- I thought it had a broader audience. It had no relation to Berkshire directly. The primary reason is that I hoped for a wider audience.

Charlie and I think that there is a low but not insignificant probability that at some time -- I don't know when; it could be three years, it could be 20 years -- derivatives could lead to a major problem. The problem grows as derivatives get more complex. We hoped to give a mild wakeup call to the financial world that there's a problem. In the energy sector, derivatives destroyed or almost destroyed institutions that shouldn't have been destroyed. [He mentioned Enron.]

Charlie and I would not know how to regulate it. We have some experience seeing specific dangers in that field and some insight into systemic problems that can arise. People don't want to think about it until it happens, but it is best thought about before it happens.

It's a low probability, but we think a lot about low probability events. We have some experience with Salomon and Gen Re. Charlie saw some things on Salomon's audit committee [that were very risky/questionable].

Munger: In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic than Warren. I'll be amazed if we don't have some kind of significant blowup in next 5-10 years.

Buffett: Derivatives are advertised as shedding risk for the system, but they have long crossed the point of decreasing risk and now increase risk. The truth is that Coca Cola could handle risk [I think he was talking about currency exposure], but now with every company transferring risk to very few players, they are all hugely interdependent. Central banks are exposed to weaknesses. If Salomon had failed, the problems for the rest of the system could have been quite significant. When you start concentrating risk in institutions that are highly leveraged, [watch out]. They have big trading departments with people who make a lot of money.

It's not a prediction, it's a warning.

Fannie Mae, Freddie Mac and Other Highly Leveraged Financial Institutions

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

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

If anyone uses precise figures in finance, be careful.

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

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

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

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

Other Insurance Companies

Munger: I certainly hope that we're better underwriters than Munich Re.

Buffett: Let's not name names. Munich Re is a fine company. Our policy is that we compliment by name and criticize anonymously. They [Munich Re] lost their AAA because they were too exposed on the asset side -- they would tell you this. They have an important position and we do a lot of business with them.

Some reinsurers we won't do business with. If there were a major financial or natural catastrophe, there are a number of reinsurers who wouldn't pay.


The Ideal Business

The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It's an enormous advantage.

See's has produced $1 billion pre-tax for us over time. If we'd deployed that in the candy business, the returns would have been terrible, but instead [we took the money out of the business and redeployed it elsewhere. Look at the results!]

Munger: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested -- there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business.

Buffett: We like to be able to move cash around and find it's best use. We'd love to have our companies redeploy cash, but they can't. Gillette has a great business, but can't sensibly reinvest all of the profit.

We don't think the batting average of American industry redeploying capital has been very great. We knock other people doing what has made us so successful.

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

Types of Businesses To Look For

We want a business that we think, if run well, is going to have a competitive advantage. We don't buy hula hoop or pet rock companies, or companies with explosions in demand but we don't know who the winners will be.

The Importance of Buying a Good Business

The way to get a reputation for being a good businessman is to buy a good business.

Cigar Butts vs. Quality Businesses; Learning from Constructive Criticism

Munger: If See's Candy had asked $100,000 more [in the purchase price; Buffett chimed in, "$10,000 more"], Warren and I would have walked -- that's how dumb we were.

Ira Marshall said you guys are crazy -- there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See's, you could say Berkshire was built on constructive criticism. Now we don't want any more today. [Laughter]

Buffett: The qualitative [evaluating management, competitive advantage, etc.] is harder to teach and understand, so why not just focus on the quantitative [e.g., cigar butt investing]? Charlie emphasized quality [of a business] much more than I did initially. He had a different background.

It makes more sense to buy a wonderful business at a fair price. We've changed over the years in this direction. It's not hard to watch businesses over 50 years and learn where the big money can be made.

Even when you get a new important idea, the old ideas are still there. There wasn't a strong line of demarcation when we moved from cigar butts to wonderful businesses. But over time, we moved.

Think Independently

When we were viewed as out of step a few years ago, I didn't care as long as I felt okay about how Berkshire was doing.

Calculating Intrinsic Value

Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you own a gas pipeline, not much is going to go wrong. Maybe a competitor enters forcing you to cut prices, but intrinsic value hasn't gone down if you already factored this in. We looked at a pipeline recently that we think will come under pressure from other ways of delivering gas [to the area the pipeline serves]. We look at this differently from another pipeline that has the lowest costs [and does not face threats from alternative pipelines]. If you calculate intrinsic value properly, you factor in things like declining prices.

When we buy business, we try to look out and estimate the cash it will generate and compare it to the purchase price. We have to feel pretty good about our projections and then have a purchase price that makes sense. Over time, we've had more pleasant surprises than we would have expected.

I've never seen an investment banker's book in which future earnings are projected to go down. But many businesses' earnings go down. We made this mistake with Dexter shoes -- it was earning $40 million pretax and I projected this would continue, and I couldn't have been more wrong.

20% of Fortune 500 companies will be earning significant less in five years, but I don't know which 20%. If you can't come up with reasonable estimates for that, then you move on.

Discount Rate Investors Should Use

We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.

Just because interest rates are at 1.5% doesn't mean we like an investment that yields 2-3%. We have minimum thresholds in our mind that are a whole lot higher than government rates. When we're looking at a business, we're looking at holding it forever, so we don't assume rates will always be this low.

Losing and Regaining Competitive Advantage

There aren't many examples of companies that lose and then regain competitive advantage. I have a friend who likes taking over lousy businesses and trying to turn them into great businesses [I wonder whether he was referring to Jack Byrne of White Mountains Insurance?]. I asked him for examples of this [bad businesses turning into good businesses] over the past 100 years [and he couldn't name very many].

Sometimes businesses have problems, but haven't lost their competitive advantages. When GEICO had problems [in the mid-1970s], the model wasn't broken.

One example: Pepsi lost its edge post-WW II when costs went up, but they successfully changed. To some extent Gillette lost its competitive edge in the 1930s to penny blades, but then regained it.

But generally speaking, when a company loses its edge, it's very difficult to regain. Packard [cars] went downscale one year and never regained its upscale image. Department stores have done this. You can always juice sales by going down market, but it's hard to go back up market.

Focus Investing

You don't have to be right on everything or 20%, 10%, or 5% of businesses. You only have to be right one or two times a year. I used to handicap horses. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn't do a very good job. You only have to be right a few times in your lifetime, as long as you don't make any big mistakes.

Munger: What's funny is that most big investment organizations don't think like this. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach.

Buffett: Ted Williams, in his book The Science of Hitting , talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way.

Temperament of Successful Investors

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

Buffett: I think it's almost impossible to do well investing over time without this. If the market closed for years, we wouldn't care. Would still keep making Sees candy, Dilly bars, etc.

If you focus on the price, you're assuming that the market knows more than you do. That may be the truth, but in that case you shouldn't own it. The stock market is there to serve you, not to instruct you.

Focus on price and value. If a stock gets cheaper and you have some cash, buy more. We sometimes stop buying when prices goes up. This cost us $8 billion a few years ago when we were buying Wal-Mart. When we're buying something, we want the price to go down and down and down.

Investor Expectations

The problem is the starting point in predicting modest returns for equity investors. [Expectations were too high.] In 1999, a Gallup poll showed people expected 15% [returns from stocks] in a low inflation environment. In a low inflation environment, how much will GDP grow? If there's 2% inflation and 3% [real] growth, that's 5%. This will be the rate of corporate growth, so if you add dividends, you get 6-7% [annualized returns] before frictional costs -- and investors incur high frictional costs (they don't have to, but they do) -- which adds up to 1.5%. [This 4.5-5.5% is] not bad.

Munger: My attitude is slightly more negative than Warren's.

Buffett: It [6-7% growth] is not the end of the world. If we get 5-6% of the pie -- those of us who put our capital out -- I don't know if it's exactly what someone who designed the universe would come up with, but I don't think that's crazy in either direction. It provides a pretty decent real return in a period of low inflation. If you get high inflation, you could get very low real returns, even negative.

Munger: I don't you'll get real help from me or from economists either. If an economist saw a job going to China, he doesn't care -- it saves costs. But if all the jobs go to China, what then? People actually get paid to say things like this.

Buffett: Maybe we should export all economists to China.

Meeting with Managements

Almost everything we learn is from public documents. I read Jim Clayton's book, for example. There is adequate information out there to evaluate businesses. We do not find it particularly helpful to talk to managements. Often managements want to come to Omaha to talk, and they come up with all sorts of reasons, but what they really hope is that we become interested in their stock. That never works. The numbers tell us a lot more than the managements. We don't give a hoot about anyone's projections. We don't want even want to hear about it.

Self-Discipline When Investing

I'd feel more qualified to talk about self-discipline if I weighed about 20 pounds less. [Laughter.]

Critique of How Most Money Is Managed

Munger: We have this investment discipline of waiting for a fat pitch. If I was offered the chance to go into business where people would measure me against benchmarks, force me to be fully invested, crawl around looking over my shoulder, etc., I would hate it. I would regard it as putting me into shackles.

Buffett: I would hate it. In 1956 [when I started the Buffett Partnership], I passed out the ground rules, which said "here's what I can do and can't do." The idea of setting out to do what you know you can't do [is terrible].

Munger: The general systems of money management [today] require people to pretend to do something they can't do and like something they don't. It's a terrible way to spend your life, but it's very well paid.

Stock Market Predictions

Munger: I don't know if we'll ever see stocks in general at mouthwatering levels that we saw in 1973-4 or 1982 even. I think there's a very excellent chance that neither Warren or I will see those opportunities again, but that's not all bad. We'll just keep plugging away.

Buffett: It's not out of [the realm of] possibility though. You can never predict what markets will do. In Japan, a 10 year bond is yielding 5/8 of 1%. [Who could have ever imagined that?]

Munger: If that could happen in Japan, something much less bad could happen in the US. We could be in for a period in which the average fancy paid investment advisor just won't do very well.

Buffett: Chaotic markets might not be good for society, but create opportunities for us.

There were some great opportunities in junk bonds last year and we invested in a few. But money is pouring into junk bonds right now, $1 billion per week. The world hasn't changed that much.

Cost of Capital

Charlie and I don't know our cost of capital. It's taught a business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?

Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction.

Building Investment Knowledge

We read a lot: daily publications, annual reports, 10Ks, 10Qs, business magazines, etc.

Fortunately, the investment business is one where knowledge accumulates and builds into a knowledge base that's useful. There's a lot to absorb over time. 40-50 years ago, I visited a lot of companies, but haven't done this in a long, long time.

Munger: The more basic knowledge you have, the less new knowledge you have to get. The guy who plays chess blindfolded [a chess master comes to Omaha during Berkshire's annual meeting weekend and, in an exhibition, plays multiple players blindfolded] -- he has a knowledge of the board, which allows him to do this.

I'd hate to give up The Wall Street Journal .

Buffett: You'd also hate to give up the Buffalo News [which Berkshire owns]. [Laughter.] You want to read a lot of financial publications. The New York Times has a much better business section than it had 25 years ago. Read Fortune .

I don't read any analyst reports. If I read one, it's because the funny pages weren't available. I don't know why anyone does it.

Favorite Book on Accounting

I haven't read an accounting book years. I think I read Finney[?] in college. I'd suggest reading Berkshire reports and things like magazine articles about accounting scandals. You need to know how figures are put together, but also have to bring something else. Read a lot of business articles and annual reports. If I don't understand it [an annual report], it's probably because the management doesn't want me to understand it. And if that's the case, usually there's something wrong.

Munger: Asking Warren what good books he knows about accounting is like asking him what good books he has on breathing. You start with basic rules of bookkeeping, and then you have to spend a lot of time [to really become knowledgeable].


Gen Re was discounting Workman's Comp reserves at 4.5% -- figures we inherited. These were not conservative, so we're now using 1% in 2003 and going forward. Thus, our figures [reported profits in Q1] would be even better if we hadn't made this change.

Munger: This accounting change is typical of Berkshire. We're so horrified by aggressive accounting [that is rampant in Corporate America] that we reach for ways to be conservative. It helps our business decisions and protects Berkshire. How did we get in situation where we're all so close to the line?

Buffett: I felt much more comfort working with financial statements in the 1960s than today. There was more information then, even through there was less disclosure.

In the case of Gen Re, [having overly aggressive] Workman's Comp reserves was a quick fix, but it's like heroin. Like trade loading, people seek a quick fix. People are encouraged by their CFO or auditors to play with their numbers. It never works, though I guess if you're 64 and a half [years old and about to cash in your stock and retire], maybe it does. It's so much better to address problems.

[In a news conference on Sunday, Buffett was quoted as saying: "You would be amazed how compliant auditors have been in the past decade, not only co-operating but suggesting techniques for making numbers less useful -- less truthful -- to investors."]

The real problem is [accounting for] pension and healthcare liabilities. I've looked at companies recording pension income of hundreds of millions [of dollars] when their pension plan is underfunded by billions [of dollars]. It's the same mentality as stock options.

[I have written many columns about accounting shenanigans in: Corporations Favor Fudge , Where Has Corporate Integrity Gone? , More Earnings Shenanigans , IBM's Accounting Tricks , Lessons from the Enron Debacle , Lessons from Lucent's Cash Flow , Stocks to Avoid , More Stocks to Avoid , Another Financial Scandal? and Accounting for Non-Paying Customers .]

Adjustments to Reported Earnings; Depreciation and EBITDA

[When goodwill was required to be amortized,] we ignored amortization of goodwill and told our owners to ignore it, even though it was in GAAP [Generally Accepted Accounting Principles]. We felt that it was arbitrary.

We thought crazy pension assumptions caused people to record phantom earnings. So, we're willing to tell you when we think there's data that is more useful than GAAP earnings.

Not thinking of depreciation as an expense is crazy. I can think of a few businesses where one could ignore depreciation charges, but not many. Even with our gas pipelines, depreciation is real -- you have to maintain them and eventually they become worthless (though this may be 100 years).

It [depreciation] is reverse float -- you lay out money before you get cash. Any management that doesn't regards depreciation as an expense is living in a dream world, but they're encouraged to do so by bankers. Many times, this comes close to a flim flam game.

People want to send me books with EBITDA and I say fine, as long as you pay cap ex. There are very few businesses that can spend a lot less than depreciation and maintain the health of the business.

This is nonsense. It couldn't be worse. But a whole generation of investors have been taught this. It's not a non-cash expense -- it's a cash expense but you spend it first. It's a delayed recording of a cash expense.

We at Berkshire are going to spend more this year on cap ex than we depreciate.

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


Value of Stock Options

Charlie and I have thought about options all of our life. My guess is that Charlie was thinking about this in grade school. You don't have to understand Black-Scholes at all, but you have to understand the utility and value of options, and cost of issuing them -- a very unpopular topic in some quarters.

Let's say you sold a house and you asked for an option on the future appreciation of the house. Wouldn't you say that this option had value?

Any option has value, and that's why some people who are kind of slick in business matters get options for nothing or little -- far less than market value. The Black-Scholes model is an attempt to measure market value of options. It cranks in various variables, mainly past volatility of the asset involved, which are not the best judge of value. [For example,] Berkshire had a very low beta -- experts like to give complex Greek names to simple things -- but that doesn't mean the option value to anyone who understood it was lower than another stock with higher volatility.

As Charlie said, Black-Scholes can give silly results over longer term. Last year, we made one large commitment in which somebody on the other side was using Black-Scholes and we made $120 million. We love the idea of someone else using mechanistic formulas. They may be right 99% of the time, but we can pass 99 times and only invest the one time they're wrong.

Munger: Black-Scholes is a know-nothing system. If you know nothing about value -- only price -- then Black-Scholes is a pretty good guess at what a 90-day option might be worth. But the minute you get into longer periods of time, it's crazy to get into Black-Scholes. For example, at Costco we issued stock options with strike prices of $30 and $60, and Black-Scholes valued the $60 ones higher. This is insane.

Buffett: We like this kind of insanity. We will pay you real money if you deliver someone to our office who is willing to offer us three-year options that we can pick and choose from.

Options have value. We issued them last year when we sold $400M of bonds [the SQUARZ deal -- see my column, Berkshire's Unusual Security ]. We knew what we were giving up -- it had a negative coupon, but options have value.

Accounting for Stock Options

They [other companies] pay people with options, [whereas] we pay with cash bonuses. We'd love to not record this expense. Why the opposition? Some people [CEOs] care a lot. They argue that the cost of options is included in the footnotes [of the 10-K], [to which I say] why not pull all expenses in footnotes? Then you could just have two lines on the income statement: sales and the same amount on the next line, profits.

It's amazing what people with high IQs will do [for money]. Charlie has a theory [that it's more than money -- that it's driven by pride.]

Munger: I'm so tired of this subject. I've been on this topic for so long. It's such a rotten way to run a civilization to make the accounting wrong. It's like getting the engineering wrong when making a bridge. When perfectly reputable people say options shouldn't be expensed, it's outrageous.

Buffett: The auditors swing back and forth. Now four firms [the Big Four accounting firms] that lobbied against options as an expense in 1993 are on the other side. I don't know how this could be [options were not an expense then, but are now, but I'm happy to see it].

[For more on stock options, I wrote a three-part series on the topic: The Stock Option Travesty , Stock Options' Perverse Incentives , and Rebutting Stock Option Defenders .]

Compensation Systems

Munger: As the shareholders know, our system is different from most big corporations. We think it's less capricious. The stock option system may give extraordinary rewards to some people who did nothing, and give nothing to those who deserve a lot. Except where we inherit it [a stock option program], we don't use it.

Buffett: We inherited stock options, primarily with Gen Re. Those options turned out to be quite valuable. Would not have been if Gen Re had been a stand-alone. Not to criticize anyone, but some people made a lot of money who contributed nothing. Options are a royalty on the passage of time. They put management's interests contrary to the interests of shareholders.

We believe in tying incentives to things under management's control. To give a lottery ticket to someone who runs 1% of Berkshire is really crazy. We saw more crazy stuff in the 1990s than in the previous 100 years. There was wealth transfer that has never been experienced before. I'll accept lottery tickets, but they would have no impact on my decisions or behavior.

A properly designed option system, tied to performance, can be sensible. But to just pass them out, give a 10-year ride and grant more if the stock goes down, doesn't make sense.

Munger: If we're right, then it has considerable implications. [It would mean that] more than 99% of corporate compensation systems are more than a little crazy. We're not against vast rewards for people who deserve them, but [most stock options programs don't achieve this.]

Buffett: We love to see people at Berkshire making money, but only if they're making money for you. Compensation is an interesting subject and I'm going to write about it next year.

It's not a market system. Compensation people say it's like baseball negotiation [between a team owner and a star player], but it's not. The player is negotiating with someone who's paying the money. But at large corporations, on one side is guy who really cares and on the other side is the compensation committee -- generally people who are not picked for their strong spines -- to them, it's play money. It's almost meaningless to the guy on one side if the CEO gets 100,000 shares of restricted stock or one million, but the guy on the other side cares a lot. You get parity in negotiations with unions -- that's real negotiation.

I've never seen a compensation consultant say that the Board should reduce the CEO's salary or get rid of this bozo. They'd never get hired again. It's a bad system and needs improvement. There have been some improvements. It [improvement in this area] is the acid test of corporate reform.

Over time, a vast disparity in pay has arisen, and there's a disconnect between performance and pay. So arise, shareholders!

Buffett's Salary and CEO Compensation

[The questioner asked why Buffett doesn't charge a percentage management fee to Berkshire, given that he earned 25% of the profits above 6% each year when he ran the Buffett Partnership. Is it because he believes, as he's said before, that "it's better to give them to receive"?" Buffett replied, to great laughter, "Try again."]

I would pay a lot of money for the job I have. If I can work with people I like, why do I need to make a further override when I already have a lot of money? I was changing my life at the time [when I ran the Buffett Partnership] and I needed money then. I got no management fee at all.

Berkshire was originally owned by the [Buffett] partnership and I would be double dipping [to also take a fee from Berkshire]. By that time I had all of the money I needed. It [taking a percentage of Berkshire's profits] would make a difference in the size of my foundation, but I like the way that I live.

Munger: Carnegie was always proud that he took very little salary. Rockefeller, Vanderbilt were the same. It was a common culture in a different era. All of these people thought of themselves as the founder. I was delighted to get rid of the pressure of getting fees based on performance. If you are highly conscientious and you hate to disappoint, you will feel the pressure to live up to your incentive fee. There was an enormous advantage [to switching away from taking a percentage of the profits to managing Berkshire, in which their interests as shareholders are exactly aligned with other shareholders].

Buffett: Bill Gates takes a small salary -- the only reason he takes a salary at all is so that he can reduce it if they have a bad year. He wants to be able to take a 90% cut. He's also never taken a stock option. I think this is true of Steve Ballmer as well. They got rich with their shareholders, not off of their shareholders.

EVA Compensation Systems

We would not dream of using EVA [Economic Value Added], though some of our subsidiaries do. They set pay [scales] below the CEO level.

Munger: On EVA, there are implicit ideas that we use, such as hurdle rates, but the system has a lot of baggage.


The Banking Industry

Banking, if you can just stay away from following the fads and making bad loans, has been a remarkably good business. Since WW II, ROE for banks that have stayed out of trouble has been good. Some large well-run banks earn 20% ROE. I've been surprised that margins in banking haven't been competed away.

Munger: What you're saying is that we screwed up, because banking has turned out to be better than we thought. We made a few billion [dollars] from Amex while we misappraised it. My only prediction is that we will continue to make mistakes like that.

Buffett: It's pretty extraordinary that institutions competing against each other without real competitive advantages can all make high returns. Part of it is higher loan to value ratios than in past years. Some banks get into trouble making bad loans, but you don't have to.

Tort Reform

I'm sympathetic to what you're saying [the questioner had suggested that Buffett use his clout to advocate for tort reform], but our clout is nothing compared to that of trial lawyers. It's appalling the friction costs to our society of tort insurance. People pay off rather than go through the nuisance of a suit. The people that pursue that activity pursue it not because it's right, but profitable.

But when I look at what's happened in Corporate America, I don't think they should get off scot-free. I just wish the people who engaged in the wrong-doing would pay, not the D&O insurance.

Munger: If you say the tort system includes Workman's Comp, which I would, I'd agree [that the system has serious problems]. In California, Costco has 1/3 of its employees but pays 2/3 of its total Workman's Comp [bill]. It's institutionalized fraud -- chiropractors, etc. all working together. It'll cost jobs. I had a friend who moved his plant from Texas, where his Workman's Comp was 30% [of wages] to Utah, where it was 2%. In California, it's gotten so bad that I think there will be reform, even though the legislature is controlled by Democrats.

Most of the time they [the plaintiffs' lawyers] are suing someone who has done something terrible. A lot of defendants who are screaming about plaintiffs bar have done some terrible things. The present system is crazy, but I don't know how to fix it.

Buffett: Would you make people who did wrong things pay a portion themselves?

Munger: I think it would be a great improvement if there were no D&O insurance . The counter-argument is that no-one with any money would serve on a board. But I think net net you'd be better off.

Healthcare Costs

We looked at healthcare costs, which were exploding a few years ago. Workman's Comp costs have risen dramatically, and are huge for us. $6,000-$7,000 per employee. That's in inflationary part of the US economy and we and our employees can't control it.

Health costs will keep growing and we don't have any answers. But Charlie runs a hospital, so maybe he'll have some insights.

Munger: The quality of the medical care delivered, including the pharmaceutical industry, has improved a lot. I don't think it's crazy for a rich country like the US to spend 15% of GDP on healthcare, and if it rose to 16-17%, it's not a big worry.

Buffett: But if other countries spend 7-8% [of GDP on healthcare] and have good systems, are we getting a good deal?

Munger: We're not on a dollar for dollar basis. But I'm not [troubled by how much we spend].

Impact of Inflation

There's no question that a lack of inflation is a plus for owners. The real return from owning American businesses will be better if there is low inflation over a long period.

The biggest danger [to investors] is high inflation. There's not a small chance of this in the next 20-30 years.

Social Security

Social Security is a good thing and it works well. Don't try to change it. The money should not be invested in stocks.


Happiness and Success

I tell college students, when you get to be my age you will be successful if the people who you hope to have love you, do love you. Charlie and I know people who have buildings named after them, receive great honors, etc., and nobody loves them -- not even the people who give them honors. Charlie and I talk about wouldn't it be great if we could buy love for $1 million. But the only way to be loved is to be lovable. You always get back more than you give away. If you don't give any you won't get any. Everybody loves Don Keough [former senior executive and Board member of Coca Cola]. There's nobody I know who commands the love of others who doesn't feel like a success. And I can't imagine people who aren't loved feel very successful.

Munger: You don't want to be like the motion picture exec who had so many people at his funeral, but they were there just make sure he was dead. Or how about the guy who, at his funeral, the priest said, "Won't anyone stand up and say anything nice for the deceased?" and finally someone said, "Well, his brother was worse."

Buffett: Most people in this room and most college students I talk to will have plenty of money, but some will have few friends.

View on Cutting Taxes on Dividends

Currently, I'm paying about the same percentage of my income to the government as my secretary does. I pay a higher income tax rate, but she pays higher Social Security taxes as a percentage of her income because taxes aren't charged on income above $68,400. At Berkshire, if we declared a $1 billion dividend and it were tax free, I might be paying 1/10th of the rate of my income as she would be.

Now, I could make argument that different structures shouldn't have different rates, but I can make no argument that will all the luck I've had that I would send 1/10th the portion of my income to the federal government that my secretary does. So I am not for the Bush plan.

Munger: I agree with you. Even if you assume that the whole economy would work better had we never had double taxation, having the envy and resentment of the richest paying low or no taxes screams of injustice. You have to have a fair system.

Buffett: The big benefits of no taxes on dividends will go to people like me and Charlie and that's not going to stimulate the economy, it will stimulate us.

Income Inequality, GDP, Decline in Consumer Spending

The American consumer overall is better off, but not dramatically better than 10 years ago. You're right that there's been increasing inequality. We don't make decisions on what business we buy based on some sweeping projections about what American consumers will do. We're very certain that Americans will do better over time. Average income per capita rose 7x in the 20th century. A simple phone call across the country used to cost a great deal relative to income. People will be better off decade after decade. We're not big on being futurologists.

Our consumer businesses -- candy, furniture, etc. -- are very very soft. They were down in Q1. I think we've been in a recession -- although not huge or violent one -- for two years. When government talks about GDP growing 2%, keep in mind that the population grows 1%. It's GDP per capita that counts. And GDP counts people who make you take off your shoes before you get on a plane. It counts good and services that we wish we didn't want. When you get into a war, if you drop planes into the ocean, it [building replacement planes] is part of GDP. Desirable GDP, my guess, has gone no place in the past three years. The quality of GDP isn't talked about very much.

Munger: Figures you gave on inequality obscure an important fact: if the same family were always on the bottom, then you'd have big resentments. But if DuPonts go down and Pampered Chef up, [that's good]. That much churn makes people think the system is fairer. Buffett: We don't like churn now, but we liked it more 30-40 years ago. [Laughter.]


[A shareholder asked Buffett to ask his cousin, Jimmy Buffett, to play at a charitable event to help save Cypress Gardens.]

I don't ask my friends to do such things because it puts them in an uncomfortable position. If they did it, I'd never know if they did so because I asked them or because they believed in it.

Munger: Both of us feel that those of us who have been very fortunate have a duty to give back. Whether one gives a lot as one goes along as I do or a little and then a lot [when one dies] as Warren does is a matter of personal preference. I would hate to have people ask me for money all day long. Warren couldn't stand it.

Buffett: Let's assume that I was in the womb and there was an identical twin next to me, and genie appeared and said "You're going to be born in 24 hours and one of you will be born in Omaha and one in Bangladesh. You two decide which is which. Let's start bidding and whichever one of you bids a higher percentage of your estate to society when you die gets to be born in Omaha. I think the bidding would be 100%. Imagine me in Bangladesh walking down the street saying "I can allocate capital." I wouldn't last very long.

When we were born, odds were 50 to 1 against us being born in the US. So we were lucky. My lump sum should go to society. There's no reason little Buffetts should be running around in 100 years rich because they were lucky.

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The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
- Warren Buffett
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