Alternatives to Common Stock
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].
[Charlie 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.
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.
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.
[Charlie Munger: 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.
[Charlie Munger: 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).
[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.
[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:  a croupier-style house advantage, and  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.
[Q: What useful function do derivatives serve? Why aren’t derivatives illegal?]
Warren Buffett: Charlie may have more to comment.
Charlie Munger: 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.
Warren Buffett: 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.
Charlie Munger: Warren wrote the only letter saying the idea is insane. Only difference is then not very many people listened to him.
Warren Buffett: 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?
Charlie Munger: 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.
[Charlie Munger: "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.
[Charlie Munger: "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.
[Charlie Munger: "The only thing that's consistent is that the whole thing is disgusting."]
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.
[Charlie 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.]
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.]
[Charlie 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.]
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].
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.
[Charlie Munger: 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?
Warren Buffett: 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.
Charlie Munger: 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.
Warren Buffett: 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.
[Charlie Munger: 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)
[Charlie Munger: 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?
Warren Buffett: 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.
Charlie Munger: 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.
Warren Buffett: Taxpayers in disciplined areas won’t put up with it all.
Charlie Munger: 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.
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.
[Charlie Munger:: 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.
Charlie Munger: 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.
Warren Buffett: 2002 junk bond market happened. Charlie Munger: Very big dislocations happen about twice a century. Warren Buffett: 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!
[Charlie Munger: 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.
[Charlie Munger: 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]]
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.
[Charlie Munger: 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]
[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?
Warren Buffett: 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.
Charlie Munger: 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.
Warren Buffett: 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?
Warren Buffett: 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.
Charlie Munger: Nothing to add.
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.
© 1996- The Buffett