What explains the extraordinary success of Berkshire Hathaway?
Munger: You won’t have anything like the past to look forward to. Berkshire’s results have been so extreme that it’s hard to think of a precedent in the history of the world. The balance sheet is gross considering the small beginnings of the place.
What has caused this extreme record to go on for such a long time? I would argue that it started with a young man reading everything when he was 10 years old, becoming a learning machine. He started this long run early. Had he not been learning all this time, our record would be a mere shadow of what it is. And he’s actually improved since he passed the age at which most other people retire. Most people don’t even try this – it takes practice.
So it’s been a long run, with extraordinarily concentrated power by a man who is a ferocious learner. Our system ought to be more copied than it is. The system of passing power from one old codger to another is not necessarily the right system at all.
Berkshire has a very strong culture that will continue after we are gone. We have the talent here to do a lot of wonderful things over time, but they won’t be brilliant things – except once in a blue moon – because we have too much money. The key is to avoid making mistakes. We have the right vehicle with the right standards. This is a very rational place.
Over the years, what has Berkshire Hathaway come to mean to you?
Berkshire is my way of teaching those things that mean the most to me and what I want to get out to others.
What is the intrinsic value of Berkshire? Can you use book value as a guide to company valuations?
Really wonderful businesses need no book value. Book value is not a great proxy for intrinsic value and it is not a substitute. Berkshire was not worth book value in 1965, intrinsic value was below book value, now the business is worth a great deal more than book value. Book value is not a bad starting point for Berkshire when trying to calculate intrinsic value. We generally do not look at book value when evaluating a stock.
[Re: How would Warren value Berkshire?]
I’d think about what’s there, what are they trying to do, what’s it worth if they don’t succeed in deploying additional capital, and what it’s worth if they do. What are the resources available to keep adding to the collection of businesses? I think you’ll find the information [in the annual report] that you need to evaluate Berkshire. Don’t take it out to 4 decimal places. If Charlie and I had to write down a number, it would be different but in the same ballpark.
What Berkshire will be worth 10 years from now will depend on earnings, the quality of those earnings and the liquid assets we have. We keep working on it, but we’re so big. There’s no way in the world we can replicate the past, but hopefully we do a reasonable job.
[Charlie Munger: Quickly get rid of the no-brainer decisions. Just go through the cash and investments, which are easy to value. The insurance operation is very interesting and look at the way the cash is deployed.]
I don’t think we’ll hit any home runs under any circumstances.
A normal level of cash for Berkshire might be about $10 billion. Because of the catastrophe-insurance business we’re in, we don’t scrape the bottom of the barrel [in terms of cash reserves]. We might temporarily dip below $10 billion – about one year’s worth of earnings, incidentally – but we don’t need anything like $40 billion. We’d be much happier if we had the excess invested in things we love.
I think, according to the 10-Q, we have $37 billion in cash [$37.675 billion, to be precise], not counting the finance businesses, and we spent $4 billion on Iscar and we’re spending on some other things.
We’d like very much to spend down to $10 billion and we spend all of our time on this. We have one idea at present that could take up to $15 billion of cash, but it’s a low probability. We’ll get more choices in the utility area.
While we don’t like having excess cash, we like doing dumb deals even less because we’re stuck with them forever. You’re right that we should be uncomfortable that we have this cash, but [the alternative of doing bad deals is far worse].
I think it’s likely, but far from certain, that three years from now we will have significantly less cash and hopefully far more earnings power. We love having $4 billion in Iscar rather than it sitting around in short-term bonds. You’re right to keep jabbing us, but we jab ourselves. Neither one of us likes having cash.
We’re the biggest player in the world in catastrophe insurance, and people come to us because we’re so liquid, but we don’t need so much cash.
We spent $3.5 billion at the Berkshire level in PacifiCorp. Come back next year and I hope we have less cash.
[Charlie Munger: Compare Berkshire 10 years ago to today. Despite much difficulty putting cash to work, we’ve bought a lot of great things and we’re not altogether gloomy about how things are going. [Translation: He’s doing handsprings about how Berkshire is doing!]]
Intrinsic value is simply the sum of all future cash flows a business generates between now and judgment day, discounted back at the proper rate. But that’s pretty nebulous. To value the businesses we own presently, we try to give you information to make a reasonable judgment about that. We own securities, which are easy to value, and operating businesses. We try to give you the information we use to value them.
Since Berkshire retains all of its earnings, it becomes very important to evaluate what we’ll do with earnings over time.
If you’d looked at the intrinsic value of Berkshire in 1965, we had a textile business worth $12 [per share], but that wasn’t all. You had to evaluate not only the business, but also the skill with which retained earnings would be used.
It’s the same situation today: we will put to work billions of dollars this year and in the future. If we do this effectively, each dollar has a value of more than $1. We have $80,000 [per share] in marketable securities. If our insurance business breaks even, that’s free to us. We’re trying to add to our collection of operating businesses and they’ll add to earnings.
If Charlie and I wrote down our estimates of Berkshire’s intrinsic value, they wouldn’t be exactly the same, but they would be close.
[Q - what do you think about the market’s valuation of Berkshire shares? The stock price is off more than the decline in Berkshire’s operations.]
Buffett: You put your finger on something. We think our investments are worth more than they’re carried for. [If you] leave out insurance earnings from underwriting, last year and this, earnings power was below normal. We have good businesses overall. A few have problems, but many will do fabulously well. It’s okay to look at Berkshire as two parts: securities, and non-underwriting earnings power. We hope both will increase over time. Berkshire is cheaper in relation to intrinsic value at the end of 2008 than 2007. That’s true of most companies. Our focus is for operating earnings to rise. Everything is affected by everything else in the financial world.
Munger: Last year was a bad year for a large “float” business. But long term, having float that you’re getting at less than free will be a big advantage. Some buyer bought 10,000 Berkshire shares at the absolute peak. Our casualty insurance is probably the best in the business. [So are] our utilities. Iscar is better than others. Down the list, we have extraordinary businesses, and it’s not easy to collect the best businesses, but we think we’ve done it. If you think it’s easy to get in Berkshire’s position, you are living in a different world than the one I inhabit.
Buffett: The insurance business is a remarkable business. In the September 2008 meltdown, people started behaving differently, like a bell had been rung. It hurt jewelry, carpet, NetJets. But the phones started ringing at GEICO. Thousands more came to the website to save money. Saving $100 became important. We added 665,000 policyholders in 2008, and [we added] 505,000 in [just] January through April 2009. GEICO is the low-cost producer of auto insurance. It builds a lot of value over time. We had 2 – 5% market share when Tony Nicely took over; 8% now. We’re the third largest auto insurer in the country, and the fundamentals are in place to take that higher.
How do you manage Berkshire Hathaway?
What do you tell your managers at Berkshire?
I send one message out every year and a half or two years. They get one letter from me every couple of years. And basically it says, run this business like it's the only business that your family can own for the next 100 years. You can't sell it. But every year don't measure it by the earnings in the quarter that year. Measure it by whether the moat around that business, what gives it competitive advantage over time has widened or narrowed. If you keep doing that for 100 years, it's going to work out very well. Then I tell them basically if the reason for doing something is everybody else is doing it, it's not good enough. If you have to use that as a reason, forget it. You don't have a good reason for doing something. Never use that.
What is your fondest hope for Berkshire?
Warren Buffett: I hope for two things: decent performance, and that the culture is maintained. We are shareholder- and manager-oriented. We want to be the best home in the world for wonderful family businesses. I fully expect that what we have tried to build into Berkshire will live into the future far beyond my tenure as CEO. We have great candidates to succeed me and we have a Board and managers that have all seen what works. We have a very fine and strong culture. I am sure it will be continued, and that we will get good results. I hope in 20 years that fine businesses will immediately think that if they have to sell their business, they would sell it to Berkshire.
Charlie Munger: I would like to see Berkshire observed even more as an exemplar, and that we have even more influence on changes in other places. Things that have happened here would be useful to other companies.
Warren Buffett: We also want it to have the oldest living managers. [laughter; standing ovation].
What can go wrong at Berkshire?
We don’t worry about our businesses. We have a diverse group of good businesses with great managers. What we worry about is something going wrong. We have 180,000 employees, so it’s guaranteed that something will go wrong. We know it will happen. We just try to have – we do have – the right incentives in place.
For example, when I get on a NetJets flight, even if I’m in a hurry, I don’t say to the pilot, “Hey, I’m in a hurry. Can you speed it up.” The last thing I want is a pilot rushing through his pre-flight checklist, etc.
But companies do this all the time in the way they incentivise people. They should not have a system that encourages a focus on quarterly earnings. Our managers have no quarterly budgets – I don’t know what our numbers are going to be next quarter. I’m also careful not to communicate anything to the contrary via body language.
Insurance companies in particular can report pretty much any numbers that they want. With $44 billion of reserves, it would be easy to adjust the reserves to show whatever profit was desired.
Even if quarterly numbers weren’t tied to our managers’ compensation, if I went to Wall Street and promised X, the managers, who wouldn’t want to let me down, might play some games to achieve X.
[Charlie Munger: What we don’t like in modern capitalism is the expectations game. It’s not the kissing cousin of evil; it’s the blood brother.
People who predict precisely are either kidding themselves or others. We’ve seen people get their egos involved. And everyone in the organization knows what the CEO has promised in public. It’s setting up a system that sets up financial or psychological pressure for people to do things they probably don’t want to do. It’s a terrible mistake.
What is Berkshire's cost of capital?
[Munger: "Obviously, consideration of costs is key, including opportunity costs. Of course capital isn't free. It's easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital. They say that if you're generating a 100% return on capital, then you shouldn't invest in something that generates an 80% return on capital. It's crazy."]
A corporation's cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do.
I've listened to many cost of capital discussions and they've never made much sense. It's taught in business school and consultants use it, so Board members nod their heads without any idea of what's going on.
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?
[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.]
You've targeted Berkshire Hathaway's book-value growth at 15%. You have come through at about 24%. That is a big gap of 9% between your modesty and the outcome. Why is there such a big gap?
I don't think it was modesty. For one thing, we've had a terrific market that has reappraised all businesses in the last 10 or 15 years. So when we really started worrying about future performance, the key factor was having larger amounts of capital. There's no question that the larger the amount of capital, the harder the job is. We were fortunate that that ascension in capital happened to coincide with things that just lifted all the boats substantially. We have had better luck than I would have guessed we would have had 10 years ago. It's been aided by a huge tailwind, and absent that tailwind we wouldn't have done as well. We won't have that tailwind in the future, I can assure you of that, but we will have a larger amount of capital. If Charlie and I could make a deal to increase the intrinsic value of Berkshire by 15% a year over the next 10 years, we would sign up now. I don't want you to even tempt us with lower numbers. If we paid no dividend at all over a 10 year period, you can figure out where a 15% rate would take us. We hope to get there, but we think that is absolutely tops. When the market starts underperforming businesses, the rate could be very substantially lower than that.
[Charlie Munger: Well, the questioner came from Singapore which has perhaps the best economic record in the history of developing an economy and therefore he referred to 15% per annum as modest. It's not modest--it's arrogant. Only someone from Singapore would call it modest. (laughter)]
Be careful, Charlie, or we'll have a voice vote that we should move to Singapore. This is a group that wants performance. Large sums of money aren't going to compound at super rates. Anybody that manages large sums of money that promises or implies that they can achieve really outstanding returns--I'd stay away from them. The numbers just get too big. You've seen some of that with certain money management organizations in recent years. 15% on an intrinsic value which is substantially greater than our book value--it gets to be a very, very big number. We need huge ideas--we don't need thousands of ideas. I mean, we might need them, but we could never come up with them. What we look for is the very large idea. But we're not finding them now. We'll keep looking, and every now and then we will find something. If you think you have any chance of doing better than 15%--and believe me, that's not a number I would want to sign my name to--you're going to disappointed in Berkshire. We don't want to disappoint you, so that's the reason we try to be realistic about expectations.
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.
Intrinsic value is a range.
Why don't more people copy Berkshire as an investment vehicle--a corporation that pays no dividend?
There are other things to copy about Berkshire, but they don't get copied either. It was always interesting to me that everyone read Graham, and they didn't misread him, it's just that they didn't like following him. In terms of not paying dividends, we don't pay dividends because we think we can turn every dollar we make into more than a dollar in market value. The only reason for us to keep your money is to make it worth more by us keeping it than it would be worth if we gave it to you. That's the test, if we come to the conclusion that we can't do that, we should distribute it to you.
The interesting thing is we have certain businesses, See's Candy being one, where we don't have a way to intelligently use all of the money that See's generates within See's candy company. So if See's were a stand-alone company, it would pay very large dividends, not because it had a dividend paying policy, but because it wouldn't have a way of using, in this case, $30 million a year in intelligently expanding that business. We hope that in the overall Berkshire Hathaway scheme of things, that we can intelligently use the money that the companies in aggregate generate for us and we think so far we have, and we think the prospects are reasonably good that we can continue to do that. But dividend policy should really be determined by that criteria, also keeping in mind the possibilities of repurchasing stock. If Coke had paid no dividends, and simply repurchased shares and developed the bottling system, the shareholders probably would have been even better off. They've been sensationally well as it is, but they probably would have been even better off than they have been with the dividend policy they have. And that's true for Gillette and Disney...
[Charlie Munger: That is not the standard thing that's taught in the corporate finance departments of our major universities. Why do we have this simple idea and they have another one? I've tried to understand why they think the way they do, and I have great difficulties with it. I've just concluded that they're wrong.]
What would Berkshire be like if you hadn't met Charlie Munger?
It would be very different, but I could say the same thing about a lot of other people, too. I've had a lot (at least a dozen) of heroes, including my parents. Charlie and I didn't meet until 1959, although he grew up a half a block from where I lived. Charlie was 35 and I was 29. We've been partners ever since. He is very strong-minded, but we've never had an argument that whole time. I've never been let down once. It must be a terrible feeling to be let down by a hero.
Hang around people who are better than you all the time. You do pick up the behavior of people who are around you. It will make you a better person. Marry upward. That is the person who is going to have the biggest effect on you. A relationship like that over the decades will do nothing but good.
What happens when CEOs call you?
I sit and wait for the phone to ring. I can give most answers in less than a minute. Deals? I like to hear price first. No point hearing the rest if the price isn’t good. Ponzio (terrible name for a business man) pitched the custom frame business in ten minutes. I got the price, liked it and did the deal. Custom frame business can’t be replicated. Met Ponzio later for one hour and never saw him again.
How to evaluate Berkshire or MSFT if it does not pay dividends?
It won’t pay any dividends either. That is a promise I can keep. All you get with Berkshire, you stick it in your safe deposit box and then every year you go down and fondle it. You take it out and then you put it back. There is enormous psychic reward in that. Don’t underestimate it.
The real question is if we can retain dollar bills and turn them into more than a dollar at a decent rate. That is what we try to do. And Charlie Munger and I have all our money in it to do that. That is all we will get paid for doing. We won’t take any options or we won’t take any salaries to speak of. But that is what we are trying to do. It gets harder all the time. The more money we manage the harder it is to do that. We would do way better percentage wise with Berkshire if it was 1/100th the present size. It is run for its owners, but it isn’t run to give them dividends because so far every dollar that we earned or could have paid out, we have turned into more than a dollar. It is worth more than a dollar to keep it. Therefore, it would be silly to pay it out. Even if everyone was tax-free that owned it. It would have been a mistake to pay dividends at Berkshire. Because so far the dollar bills retained have turned into more than a dollar. But there is no guarantee that happens in the future. At some point the game runs out on that. That is what the business is about. Nothing else about the business do we judge ourselves by. We don’t judge it by the size of its home office building or anything the like the number of people working there. We have 12 people working at headquarters and 45,000 employees at Berkshire, 12 people at HQ and 3,500 sq ft. and we won’t change it.
But we will judge ourselves by the performance of the company and that is the only way we will get paid. But believe me, it is a lot harder than it used to be.
Reporting 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.
[Charlie 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.]
Why don't you meet with analysts or large shareholders?
I have some problems with having meetings with some sub-groups of investors. If we had them, I’d want meetings with everyone. We try to convey a lot about our business in our annual report.
I don’t think it fits our temperament at all. Many corporations spend a lot of time talking to analysts. One of our strengths is not doing this. It’s very time-consuming and gives some shareholders an advantage. We’re very egalitarian.
[Charlie Munger: We like our current shareholders and don’t want to entice anyone to become one. It would help current shareholders to hear our CEOs [of the Berkshire operating subsidiaries], but we promised them they could spend 100% of their time on their business. We place no impediments on them running their businesses. Many have expressed to me how happy they are that they don’t have to spend 25% of time on activities they didn’t like.]
We ask ourselves: “Are we telling you what we’d want to know if our positions were reversed?” We really try to put everything in our annual report that’s germane to that. Anything that counts, in aggregate, we include.
The Washington Post has a shareholder day, which is very useful, because the annual meeting has turned into a farce, with so many people complaining about particular articles that were in the paper. But I really think that if we spend six hours here and spend time writing the annual report, we can convey the information we need to.
We’re not trying to appeal to people who care about next quarter or year. We want to appeal to people who view this as a lifetime investment. There are relatively few investors who think about buying and putting it away forever like a farm.
[Re: Berkshire’s Annual Report]
In it, we tell you everything I’d want to know if our positions were reversed. If I had 100% of my net worth in the stock and had been on a desert island for a year, it has everything I’d want to know. We don’t leave anything out. You could drown people in information that doesn’t make much difference. We explain it in the way we think about it. It’s the report I would make to Charlie or he’d make to me if one of us were running the business and the other were inactive.
Why did BRK buy so many debt instruments during the crisis period as opposed to equity? e.g. Harley Davidson debt at 15% vs. equity at $14 now at $33?
Buffett: I’m not sure you would have asked that when we did the deal. Questions like this make sense now (in hindsight) but the answer was not so obvious last year. I don’t know if Harley Davidson stock is worth $20 or $30. I like a business where customers tattoo their name on their chest - I’m not sure you can go around questioning those guys! [laughter]
I thought I knew they wouldn’t go out of business. I knew enough to lend them money but not enough to buy shares. There are different risk profiles between debt and equity. We knew that HOG was not going out of business and that a 15% return was going to look very attractive. It was a simple decision about whether HOG was going to go broke or not. I didn’t have to think about what was going to happen to the motorcycle industry. In general, BRK needs to have some money in stocks and some in other assets but stands ready to invest in anything that comes. They had the opportunity to put money to work when others couldn’t and they took advantage.
If Goldman had said 12% non-callable – I might have taken that. Harley paper could be sold at 120, so there was some capital gain. If I can make money with a simple question: ‘will they go bust or not?” then I don’t have to answer the tougher questions on the equity, where will margins go and motorcycle sales and demand...
Munger: Very good response – we knew enough about debt, not equity. Very often in a distressed situation, when you buy the bonds, you should look at the equity. To some extent we are constrained by our fiduciary responsibility to people who hold our stock. It is a good question.
Buffett: Junior securities do better, but senior securities help you sleep better. We have $60bn of liabilities, some out 50yrs. We like running it safe. We could do things when others were paralyzed.
In the Annual Reports, look-through earnings, and unaudited financials, are no longer included. Why has it changed?
Warren Buffett: On financials, we do break out four ways which we think makes it clear. We don’t want to break out into 70 different groups. Too much information obfuscates. It is divided into regulated, insurance, and so on. Now look-through earnings – some of that I don’t repeat every year. We try to run at 12k words, if you extend it too much... well, let’s just say that no one has told me it is too short. Every other year I may break down operating and investment look-through earnings. I am writing it to my two sisters, very intelligent and interested people, but not familiar with all the lingo. I want them to understand how I am thinking about the business and by definition, how I think they should think about it. And to answer questions that I think would be in my mind.
Charlie Munger: Details can change as facts change. Undistributed earnings of shares we own but don’t control are much less important now than they used to be. They aren’t more than 15% of reported earnings – they used to be much higher percentage. People understand Coca-Cola and Amex aren’t included in earnings.
Berkshire has the best and most loyal investors. How do you attract and retain a shareholder base?
Warren Buffett: If you are running public company, you can have Osama Bin Laden and the Pope as shareholders. You don’t elect them, they elect you. If you want the shareholder body to be in synch with you, you have to let them know exactly what kind of institution you plan to run. To some it says come in, to others it says stay out. Phil Fischer once wrote – restaurant says French food, and inside serves French food – all good. You can’t have hamburgers on the sign outside and French food inside. That’s when you run into trouble. We want people who think like we do. If you think earnings qtr on qtr are important, you will be disappointed. We try to advertise what we are, and we try to deliver. We think we have best shareholders that want to buy the business and partner with us and we’ll treat them like partners. In turn they give us comfort.
Charlie Munger: Warren and I started managing money for family and friends. Then we morphed into a public company. That is how we treat them still. That is not put on, that is what we do. Many shareholders are hostile force putting undue pressure on managers. We stayed with it, and we got into this by accident.
Warren Buffett: We also did not have investor relations department. It is ridiculous, to cater to expectations of people which you can’t do. Someone will own your shares in the end, they won’t be unowned. Get the ones who will be in synch. Tell them accurately.
Charlie Munger: We shouldn’t be as critical of people who came up a different way. Warren Buffett: We’ll give up being critical for 5-10 minutes then. [laughter]
What is the current acquisition appetite and outlook? Has the phone been ringing?
Buffett: The phone does not ring much at BRK. They have said they want larger deals so that weeds out a lot of phone calls. Hurdle now is $75m or 100m pretax, so not many calls, if we get a three or four calls a year, that is good. We are as interested as ever. We wrote a big check and shares for BNSF. I would love it if Monday morning a deal came in.
Munger: Amazing we have been as successful as we have. It is human revulsion which drives this, they don’t want to sell to another place which is fee driven. We have a screening device protecting us from wrong sort of people. We get offered things from people who wouldn’t sell to anyone else.
Buffett: Iscar said that they wanted to sell to BRK or no one. Another company had 3 options-- sell to a competitor (where it would probably would have been worth more), sell as an LBO (where the company would be a piece of meat to be re-sold), or sell to BRK (because they were the only player left). This scenario plays out all the time but it is somewhat accidental. People want to monetize their business, often so they can give away money. BRK is a logical and ready buyer in a lot of deals but they can’t accelerate this process in any way. Another business we own, the competitor wanted to buy them – to dismantle something he spent 30 yrs building. It was probably worth more to the competitor. The other option was a leveraged buyout firm (they call them private equity now) and he didn’t want his place as a piece of meat to be resold. I don’t come to you because you are attractive but you are the only one left! They want a permanent home. Periodically that comes up – we are logical place. We are ready to act when it happens. If it is a $10bil deal I’ll do it.
Munger: It isn't over. The acquisition pace will be slower than in other years, but it isn't over – and not so bad since we are all so much richer than the earlier days.
There are a lot of questions you do not get asked. So, what questions would you ask yourselves regarding BRK’s financials?
Buffett: Can you keep using all the capital you generate effectively for a long time? There comes a point where the numbers get big enough that it becomes very hard to move the needle with capital allocation. It is hard to create more than $1 for each $1 invested. He thinks that BRK can go further now than he would have thought 30 yrs ago but there is a limit. There will come a time when they cannot intelligently use the amount of capital they accumulate and at that point they will do what’s best for BRK shareholders.
Munger: There is not a lot to say about things that need to be done differently at BRK. It is interesting that they got into BYD even though it is a type of tech company that they had talked about avoiding in the past. He thinks it is because they have learned and that the BYD investment is likely to work out very well. BYD can help solve significant problems of the world and shareholders should take pride in that. He feels the same way about BYD as he did about Peter Kiewet. He and Warren have found a way to invest in their own kind, except these people are better. He said he would not have been good at venture capital.
BYD has already accomplished things that seemed impossible to do but they have done them. He does not think this is the last thing that BRK does that will seem a bit unusual. In terms of the BNSF deal, he knew it was better for their shareholders but it was also good for BRK shareholders. So, who cares who does better? He likes the fact that a lot of engineers are being added to BRK.
Also, he thinks that they will find people at BRK on the investing side that are almost as good as Warren. Some of these people may even have what Warren lacks. So, it won’t be all negative when Warren is not around.
What would BRK’s exposure be in another global financial meltdown?
Warren Buffett: Assuming a full meltdown, we would be hurt badly. But we bet government could solve panic. In 2008 many thought yes they could, but would they? Or would it get muddled up in Congress? We went all in, and government succeeded. If we talk about a massive nuclear attack, who knows. But if we have something huge, it won’t be because of our insurance business. Berkshire can withstand it. There could be situation where world might paralyze. Government now better understands the situation however. They did move quickly. Things will work in the US unless the system is destroyed. Land doesn’t go away, people don’t get less innovative, the productive resources are still here. We don’t see that happening. Things do correlate on the downside, but we are built to withstand.
Charlie Munger: I’m not worried about it.
Warren Buffett: Huge amounts of debt won’t do us in.
What economic laws have worked best for Berkshire?
It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord. Moats might be a natural franchise, brand loyalty, or being a low-cost producer. In a capitalistic society, all moats are subject to attack: if you have a good castle, others will want it. What we want to figure out is what keeps the castle standing and how smart is the lord. [Charlie Munger:we also like to look for low agency costs on that lord, economies of scale and “economies of intelligence.”]
Buffett elaborated on the “economies of intelligence”: the idea is to find businesses where you have to be smart only once instead of being smart forever. Retailing is a business where you have to be smart forever: your competitors will always copy your innovations. Buying a network TV station in the early days of television required you to be smart only once. In that kind of business, a terrible manager can still make a fortune. Given the choice between the two (a business where you have to be smart forever or one where you have to be smart once), Buffett advised, pick the great business - be smart once.
What’s the cheapest form of financing for Berkshire Hathaway? Would it make sense to issue bonds right now?
For us, the best source of financing is our cheap float. Not every insurance company has float as cheap as ours; for us, it’s low-cost. Bonds simply wouldn’t be as cheap for us, so we wouldn’t be issuing any here.
Do you have an opinion on whether BRK should or shouldn't be included in the S&500?
The S&P people agree that Berkshire Hathaway should be included in the index, but for the liquidity situation. Indexing has worked out to be way more popular than anybody ever thought it would be ten or fifteen years ago, including ourselves. The amount of money going into index funds keeps going up; if you added Berkshire Hathaway to the S&P 500, there would be an instant market order for six or seven percent of the outstanding shares immediately - something like 100,000 shares a day. That wouldn’t be good; the price of the stock would go up, but no one would buy it. It wouldn’t be right to add the stock to the index, then not let it be bought.
One solution: if it was added to the index, we could sell shares to absorb demand and neutralize the effect of the incremental demand. The problem is, we don’t want to sell equity just to be in an index. Maybe we could do something like what has been done in Australia: phase in the weighting over a twelve-month period. That would result in a market order for 100,000 shares a month, something more manageable. S&P has never done something like that before, but if indexing continues to grow, they’ll have to do something like that.
Something that you ought to take note of - many companies do worse after being added to the S&P index. When a stock gets added, there’s an artificial demand for the stock that just can’t last forever. Shorting the stocks that get added can make you money, after they take that initial jump.
[Charlie Munger: My guess is that Berkshire Hathaway will eventually be added to the S&P 500. Maybe not soon, but someone will figure out a way.]
How much has Berkshire Hathaway done in the way of philanthropy?
There’s a discussion of our shareholder contribution program contained in the annual report. And apart from our shareholder contributions, we contributed about $2.6 billion to the federal government this year.
There are other ways we contribute to society. To the extent that we are low cost providers of things people want, we help out those who want those goods and services. Take GEICO, for instance. To the extent that GEICO is more efficient at delivering insurance to customers, let’s say, by 15%, on $4 billion of premiums written, there is a $600 million contribution to insurance consumers overall.
We are not big believers of giving away the assets of owners to what we like. We don’t think that companies should pass out dollars to pet charities of the CEO. And we won’t do that here. (Applause).
[Charlie Munger: I am a little different on the subject from Warren. And I applaud the shareholder’s question of “isn’t there more to living than just piling up money?” I do think it’s important to set an example.]
[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.
[Charlie 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.]
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.
Buffett: You have to pick the things that are important to you. For many people, it’s their church or their school or schools generally. To some extent, you should give to whatever gives you the most satisfaction.
I like to think of things that are important but don’t have natural funding constituencies, but for most people there’s nothing wrong with giving to things that give them satisfaction. You don’t have to be as objective about that as you are when picking securities. I’d go where my gut told me.
With large sums, I’d think about how the money could impact a big societal problem that doesn’t get enough attention.
Can you tell us what are your goals and expectations for the value of Berkshire Hathaway’s float?
The float has grown at a much faster rate than I thought it would in 1967 when we entered the business. I just tried to grow cheap float as fast as I could. It’s very much a goal of Berkshire Hathaway to grow it as fast as possible at a very cheap rate. The growth of Berkshire Hathaway will depend on how we grow that float.
Why has Berkshire Hathaway avoided the life insurance business? And also, can you explain why there are discounts on A or B shares from time to time?
We have no particular bias against the life insurance business; in fact, we’re in it through General Re. The problem with it is that it’s not terribly profitable, and you wind up basically managing equities for other people [so there is a sum certain at death]. We don’t want to wear two hats, just one for Berkshire Hathaway. We want to put our best equity ideas into Berkshire Hathaway and it wouldn’t be fair to other investor/policy holders out of the picture.
As for the occasional A and B share discounts: I wrote something on our website about this a while ago. Remember that the most that a B share can be worth is 1/30th of an A share. There’ll always be arbitrage between the two to keep it that way. Short the one that’s higher in value than the other, and buy the one that’s undervalued. I’d do it myself if it didn’t trigger tax liabilities. I understand that there are some tax-exempt investors who are doing that now.
How does Berkshire compensate it's managers?
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.
[Charlie 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.]
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.
[Charlie 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.]]
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!
You could make a lot of money working for Berkshire, but it will relate to performance. No-one’s going to make a lot of money for average performance.
We have some extraordinary management at MidAmerican [Energy Holdings]. In terms of compensation, there are two key individuals [David Sokol and Greg Abel]. For their compensation, I took a yellow pad, sketched out a proposal in two minutes, talked to Walter Scott (who’s our partner in this business) and when he said it looked OK, talked to the managers. The only change was that we had more than 50% of the rewards going to the CEO, David Sokol, and he said to make it 50/50.
Charlie and I spend a couple of minutes [designing compensation plans]. It’s not highly complex, but you have to understand the business. No one formula can work – that would be asinine. Take Chuck Huggins at See’s – he’s had the same plan for 30 years. For GEICO, there are two variables [that determine compensation] for Tony Nicely on down.
[From Buffett’s 1996 annual letter, the two are: "Today, the bonuses received by dozens of top executives, starting with Tony, are based upon only two key variables: (1) growth in voluntary auto policies and (2) underwriting profitability on "seasoned" auto business (meaning policies that have been on the books for more than one year). In addition, we use the same yardsticks to calculate the annual contribution to the company's profit-sharing plan. Everyone at GEICO knows what counts."]
We do not bring in compensation consultants and we don’t have a human resources department, legal department, etc. That makes life way to complicated, and people get vested in going to conferences.
In some businesses, like network television, you’ll earn a huge return on equity even if your nitwit nephew runs it (as long as you keep him out of the office). But other businesses are the opposite.
You should charge some cost of capital. Measure the key metrics, set a hurdle and only pay for adding value [above this hurdle], even if the returns appear low [but would have been a lot lower without the value the manager added]. If you had a group of network television stations, you would have 35% pretax margins if a chimp ran it, so you’d only pay for excess above this. It would be silly to have 10% or 15% hurdle, but a bad manager will try to get this.
In the end, if you have a great manager, you want to pay them very well.
[Our approach to compensation] is wildly different from the approach of most companies, which go through elaborate procedures. The typical corporation has a compensation committee, and believe me, they don’t ask Dobermans to be on it; rather, they want Chihuahuas who’ve been sedated.
I’ve been on 19 boards and only been asked to be on one compensation committee – and they regretted it. [In that case, because I opposed the compensation plan,] I was outvoted – by two smart, honorable people, by the way.
I’ve never seen a compensation consultant say: “This bozo you’ve got [the CEO] is only worth half what you’re paying him.”
It’s an unequal negotiation [between the board and the CEO]. The CEO really cares, but to the board, it’s play money. It’s hard for board members – they just get handed a piece of paper showing what the top quartile of comparable CEOs get paid, so there’s a ratcheting effect. In this kind of system, things will quickly get out of whack. There’s some change now, but it’s not being led by CEOs.
[Charlie Munger: I’d rather throw a viper down my shirt front than hire a compensation consultant.]
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.
[Charlie 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.]
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.
Your successor at Berkshire?
We have four people today in the organization who can do my job – in some cases better than I can, in some ways not quite as well. That wasn’t true 15 years ago.
We will have someone take over Berkshire who’s been in the organization a long time. One reason is that we like the culture and want someone who knows the culture and how it works. Also, we’ve gotten to know them and observe them.
If I die first, all my stock goes to my wife. She might put it in the [Buffett] foundation then, or it’ll go there when she dies. It has approximately 30% of the votes. By law, the foundation would have to get down to 20% within five years.
I think Berkshire has a far better chance than any major company of maintaining its culture [when Charlie and I are gone]. The people running it have grown up in the culture. My wife and son are there [on the board] as guardians of the culture.
A great example [of how this can work] is Wal-Mart when Sam Walton died. The Walton family has done a magnificent job of hiring successors to run the place and maintain the culture. The Waltons are there to step in if needed, but they don’t run the business.
I think my family and Berkshire’s managers will retain the culture.
Munger: If anyone would have a reason to worry, it would be me, but having known the Buffett family for decades, I say to you: “Don’t worry about it. You should be so lucky.”
[During the initial official-business part of the meeting, a shareholder asked Buffett why he had his son and wife on the board, rather than Berkshire operating managers, who (according to the shareholder) have more business experience. Buffett did not answer the question – perhaps because it was not the appropriate forum (the shareholder could have gotten in line and asked the question during the Q&A period) – but I think the answer is quite simple: Buffett is increasingly sensitive to making Berkshire a role model for good corporate governance (it always has been, but appearances are especially important these days). Hence, Berkshire added a number of world-class independent board members this year. However, Buffett also wants to be sure that Berkshire’s unique culture is maintained forever, and he trusts his wife and son to ensure this more than anyone else.]
Succession at Berkshire?
When we pass, nothing will change, but there will likely be a hiatus of sorts where people might not have the same feelings about selling their business to Berkshire. The phone might not ring for a while. But that will pass because the people the board has selected to run Berkshire are phenomenal and Berkshire will remain one of a kind.
[Regarding a shareholder’s idea of naming a COO today:] I don’t think it works well to have a half-and-half arrangement. We don’t need an operating guy – we have people running the businesses and the main thing is not to destroy or damage the spirit they have. And as long as I’m around, people will want to talk to me [about selling their businesses].
There will be [negative] stories a year after I die headlined “Berkshire: One Year Later,” but that will fade out and my successor will put his own particular stamp on the place. But he won’t mess with the culture – he’s too smart and it works too well. We’re a one-of-a-kind place for certain owners. They have a problem to solve and only we can offer a good home [for their business].
[Charlie Munger: Speaking for the Munger heirs, I hope they continue to wring the last drop of good out of Warren.]
At low pay! [Laughter]
If we thought there was some better way to make this place run better or ease the transition, we’d do it, but I don’t think there is.
The person [who would take over] knows the business, knows how to make good deals, and knows how to avoid other kinds of deals – which is equally important. Once it [the transition] happened, Berkshire might even be stronger than before because people would realize that it wasn’t just about an individual.
Even though Sam Walton died, Wal-Mart has become a stronger company.
In our shareholder letter and in this meeting, [we try to make clear what our culture is]. We want managers to join us who believe in what we do and make a lifetime commitment to join us. Once they join us, we want to act consistently and be consistent. They see that it works.
There are plenty of people who don’t believe in our culture and they don’t join us. It would be bad to have a mismatch. The nice thing about it is that our culture is so well defined that there are rarely mismatches.
We don’t have any formal training for our culture – it isn’t really necessary.
If I died tonight, there are three replacements. Any of them would not miss a beat in leading this culture.
[Charlie Munger: If Warren has kept the faith until he’s 75 years old, do you really think he’ll blow the job of passing that culture along? What could be more important? You all have a lot more things to worry about than the candle at Berkshire going out because some people eventually die.
We don’t train executives, we find them. If a mountain stands up like Everest, you don’t have to be a genius to figure out that it’s a high mountain.]
[RE: Berkshire’s Next Chief Investment Officer]
Buffett: I mentioned in the annual report that in looking for an investment manager to succeed me, we’re looking for someone who doesn’t only learn from things that have happened, but can also envision things that have never happened. This is our job in insurance and investments. Many people are very smart, but are not wired to think about things that haven’t happened before.
[In response to another question on the same topic:] We’re looking for one or more people – it’s entirely possible that it could be three or four people. We’re not looking for someone to teach – we’re looking for someone who knows how to do it.
We received about 600-700 applications, including one guy who recommended his four-year-old son. We’re heard from lots of good people, but the key is whether they could do it running $100 billion. We want to find someone who can run large sums of money mildly better than the market – and I emphasize mildly because there’s no way anyone can beat the S&P 500 by 10 percentage points per year [running such a large amount of money]. It isn’t going to happen. But a few percentage points per year is possible.
Anything times zero is zero and I don’t care how good the record is in every other year if one year there’s a zero. We’re looking for someone who is wired in such a way as to see risks that haven’t occurred and be cognizant of risks that have occurred. Charlie and I have seen guys go broke or close to it because 99 of 100 of their decisions were good, but the 100th did them in.
We want to give them each a chunk of about $5 billion and have them manage it for a period of time, as if they were managing $100 billion. Then [after watching them and evaluating them for a while], we’d turn over the entire portfolio to one or more of them.
Munger: It reminds me of the young guy who went up to Mozart and said, “I’d like to write symphonies.” When Mozart said, “You’re too young,” the young man replied, “But you were young when you started.” Mozart pointed out, “Yes, but I wasn’t asking anyone else for advice on how to do it.”
Buffett: We’ll find some people. I had to do this years ago when I decided to close the Buffett Partnership in 1969 and had to recommend to my investors where they should put 100% of their money. There were many, many investors with great records, but I chose Charlie, Sandy Gottesman, and Bill Ruane. Charlie wasn’t interested in more partners, but Sandy Gottesman took some individual accounts and those investors have been very happy. Bill Ruane set up a separate mutual fund [the Sequoia Fund], which has also done very well.
So, I identified three people who were conservative, where there was no chance at all that they’d blow up, who were not only terrific investors, but also terrific stewards of capital who would treat investors right. They were my age, which helped – I now have to look at people in a generation where I don’t know many people.
In 1979, I picked Lou Simpson for GEICO. I’d never met him but once I did, it was clear that he’d get an above-average result and there was no chance of a bad result. [Buffett published Simpson’s spectacular record on page 18 of his 2004 annual report, showing that Simpson had compounded at 20.3% annually from 1980-2004 vs. 13.5% for the S&P 500.]
I have a job to do and I’ll do it.
[Q - Can you provide an update on the succession plan?]
Warren Buffett: We have three CEO candidates who could step in. The Board will pick someone for CEO. For investment officer, the Board has four names. As we’ve discussed, any one, or all four, would be good or better than me at this job. Any one of the four would be here tomorrow if I died tonight. They are all reasonably young, and all well to do.
Compensation is not a major factor. Any of the four would come. There’s no reason to come now. I worked for Ben Graham, but in the end I wanted to make the decisions. I prefer to make my own decisions. It is better in this case. When I’m not around to make decisions the Board will decide how many to use. They will be heavily influenced by the incoming CEO, by how he wants to work with them. There will be no gap. They could easily have a better record than my recent record.
Charlie Munger: We still have a rising young man here named Warren Buffett. I think we want to encourage this rising young man to reach his full potential.
Warren Buffett: On the corporate America aging issue, I think we are doing fine. Our average age is 80, so we are only aging at 1.25% per year — the lowest rate of aging in corporate America. If you have a 50-year-old management team, they age 2% every year. I think you run a bigger risk there. [laughing]
How did you select the four investment professionals who could succeed you in the CIO [Chief Investment Officer] position?
Warren Buffett: The criteria are in the 2006 Annual Report. Records are important. Human qualities are important. We think we can make those judgments, and we made an affirmative judgment on four. We need someone who can see risks, especially ones that haven’t happened before. All the banks have models, but they didn’t have the faintest idea [what could happen under new circumstances]. You need someone you trust with analytics, but one that also has the ability to contemplate new possibilities and risks. That is a rare quality. That inability to envision something not in the models can be fatal. Charlie and I spend a lot of time thinking about things that could hit us out of the blue that other people don’t include in their thinking. We miss a lot of opportunities. But we think it’s essential when managing other people’s money. You should read the 2006 Annual Report again.
Charlie Munger: You can see how risk-averse Berkshire is. We try to behave in a way so that no rational person will worry about our credit. We also try to behave in a way that if people don’t like our credit, we wouldn’t notice it for months. That double layering of protection against risk is like breathing. The alternative culture is that you call a man a Chief Risk Officer, but often he is just a man who makes you feel good while you do dumb things. Like the Delphic oracle, a dumb soothsayer, and people say how can he do dumb things if he has a PhD and can do all the advanced math? You crave a system such that you torture reality to fit a structure that doesn’t match with extreme situations in reality. You feel confident because you compute the risks, but you haven’t—you have just clobbered up your own head.
Warren Buffett: We run Berkshire so that if the world was working in a different way tomorrow, we don’t have a problem. We are not dependent on others. It may mean giving up earning a higher return 99% or 99.5% of the time in any given year, but we wouldn’t feel comfortable running the business any other way. Why be ex- posed to ruin and disgrace and embarrassment [for a few extra percentage points]? If we can earn a decent return on capital, what is an extra point? This cannot be farmed out. Management thought they were farming it out at some institutions.
How did the four CIO candidates perform last year, did they use leverage? (2010)
Warren Buffett: They did not distinguish themselves in 2008. In 2009 they did pretty darn well. It is not same four. None use leverage.
Charlie Munger: One I know made 200% with leverage of zero.
Warren Buffett: The list of four will move around but the portfolio manager positions are far less urgent than who is next CEO. If I die tonight, there will be a new CEO within 24 hours. All directors are comfortable with that. I can go on vacation on investments. Directors wouldn’t do it, but they could wait a month, 2 months – Coca-Cola won’t go away. They can be leisurely. We have a list of very capable people who would like very much to manage BRK money and would do well. That problem will get solved. In terms of the CEO question, you want an answer immediately and want to be prepared the next day. I did just have a physical however, and came out fine. It drives my doctor nuts the way I eat, but he can’t find anything wrong.
Charlie Munger: I am not most optimistic of the two people up here. And yet I am quite optimistic that the culture of Berkshire will last a long, long time and outlast the life of the founder.
Warren Buffett: I think we have the strongest culture of any large company, and they’ll love it after I’m gone. [clapping] Don’t clap there! [laughter]
How did the four investment managers waiting “in the wings” to eventually replace you perform in 2008? How would you rate these managers? Are all four still on the list?
Buffett: All four are still on the list of candidates. There are three candidates for the CEO position—all are internal candidates—and four possibilities for the investment manager—inside and outside Berkshire—one or more could be chosen. It’s up to the board. The CEO will come from inside. The [investment head candidates] did no better than match the S&P 500’s decline of 37% in 2008. They didn’t cover themselves in glory, but I didn’t either.
Munger: Every investment manager that I know of who I regard as intelligent and successful—they all got creamed last year.
Buffett: All four have better than average long-term records—modestly to significantly better than average over the past 10 years, and I suspect [they] will be better over the next 10 years. There were a lot of things that didn’t work last year. I did not change the list [of candidates]. If I dropped dead tonight, the board knows who the new CEO would be. The choice of the new investment manager will be made in consultation with the new CEO. The investment management position is not so critical [time-wise].
Munger: We don’t want an investment manager who thought he could jump into cash due to macroeconomic factors and then jump back [into stocks].
Buffett: We would exclude any such person.
[Comment: There is no such thing as an investor with above-average results every year, yet a remarkable amount of money has been lost chasing this nonexistent ideal. Importantly, as Buffett and Munger state, the job of a money manager is not to sell stocks before markets decline and then jump back in before markets gain. That’s just not possible, so attempts to do so reveal a lack of understanding about investing. Patient, long-term investors like Buffett and Munger ultimately take advantage of impatient, uninformed investors. The best long-term investment choices frequently don’t feel like the best short-term choices.]
Why are you reluctant to bring in your [CEO] successor now? Why not train him now?
[asked by Becky Quick - question from Irving Finster]
Buffett: Irving is a friend of mine. He’s had no success writing to me on this for 30 or 40 years, so he wrote to Becky. If there were a good way to inject [the new person now] to make him a better CEO, I would, but the truth is, the candidates are running major businesses today. It wouldn’t help to sit around [Berkshire’s] headquarters. We could meet every hour, and I could say, “Here’s what I’m thinking, what do you think?” I could throw him The Wall Street Journal. It’s a waste of time—they are 100% ready right now. The biggest job is that they will have to develop relationships with [Berkshire’s] managers, sellers of businesses, shareholders—different constituencies. Their biggest challenge will be to understand personalities. They have different batting styles, but they all hit very well. Charlie and I have worked together for decades, without constantly talking.
Munger: You’re more qualified to be CEO by successfully running your own business than watching someone else do it his way. Many successful models are a lot like Berkshire—like Johnson & Johnson, decentralized.
Buffett: Most managers at Berkshire are doing what they want—running their businesses. We don’t see an advantage in having a crown prince around. To name [the CEO] now could create problems.
Does Berkshire have a succession plan for Ajit Jain (the head of Berkshire’s insurance operations)?
Buffett: You can’t—it would be impossible to replace Ajit. We wouldn’t try. We won’t give as much latitude to his successor. Authority goes with the individual, not the position. In the insurance business, giving away your “pen” [underwriting authority] can do enormous damage. In 1980, Mutual of Omaha gave a pen to someone, and lost half their net worth. Ajit and I talk daily, because it’s so interesting—like how many years can you insure Mike Tyson—but I’m not needed. We won’t find a substitute for Ajit.
Munger: Invest in a business any fool can run, because someday a fool will. If it won’t stand a little mismanagement, it’s not much of a business. We’re not looking for mismanagement, even if we can withstand it.
Buffett: We do not assign tasks to people beyond their capabilities. Ajit is a one-off situation.
Ajit Jain is very important to National Indemnity. Do you expect National Indemnity’s float to rise going forward? Does it have competitive advantages beyond Ajit?
Warren Buffett: It has some advantages beyond Ajit, but he has maximized them. He has cadre of 30 people schooled in it, in such a way that would make the Jesuits look quite liberal in their methods. You can’t imagine a more disciplined operation. It would be a HUGE loss to Berkshire if anything happened to Ajit. But the Reinsurance group would still be special, and act smartly and quickly. Every year I think our float has peaked. Now it is $60bn and we have Equitas which is in runoff. I was ready to quit at $20bn, but now over $60bn, and things keep happening. Berkshire has, in my view, become the premier insurance organization in world. I don’t know how we could increase it significantly unless through some large acquisition – but there is nothing on horizon. We will have to fight to stay even from here. Various things could happen which would be valuable.
Charlie Munger: I agree with you, and I have nothing to add.
Your opinion of Google's emulation of Berkshire's Owner's Manual?
I’m pleased that the fellows at Google were, they say, inspired by the Berkshire Owner’s Manual, and that they think it’s good for companies to communicate with shareholders. If you read it [the Google Owner’s Manual], you know what they’re like.
It’s like writing a letter to your partner in a business, in which you’d say, “I’d like you to join me as a partner, I’d like you to invest your money, so here’s the information I want you to have and how I will treat you...”
I like their prose, though that doesn’t mean I agree with every idea. I hope more companies sign on for this.
[Charlie Munger:: Most of the world doesn’t in any way imitate Berkshire Hathaway. 19,500 Berkshire shareholders came [the announced attendance at this year’s annual meeting], but we’re the quirky few.
The Google guys are among the smartest in the country – it’s always nice to be imitated by smart people.]
[Charlie Munger:We think they’re a lot smarter this week than last [because they imitated us]. [Laughter.]]
What questions do the BRK audit committee ask the auditors?
[During the opening business-of-the-annual-meeting segment of the meeting, Buffett put four slides up, each with a question that the audit committee of Berkshire Hathaway asked the auditors, and the response. This was taken nearly word-for-word from his 2002 annual letter, so I’ve just reprinted this section from that letter below.]
If such questions were asked every year – or better yet, every quarter – there would be a lot fewer accounting problems…They should be asked and the answers should be put into the record. It would have a very helpful effect. It puts the auditors on the line. I’ve been on many boards and in retrospect many things went by that I wish the auditors had brought to my attention…I noticed that in Google’s Owner’s Manual, it said that if the numbers are lumpy when they come to us, they’ll be lumpy when we report them to you.
Excerpt from 2002 Berkshire Hathaway annual letter:
The Audit Committee
Audit committees can’t audit. Only a company’s outside auditor can determine whether the earnings that a management purports to have made are suspect. Reforms that ignore this reality and that instead focus on the structure and charter of the audit committee will accomplish little.
As we’ve discussed, far too many managers have fudged their company’s numbers in recent years, using both accounting and operational techniques that are typically legal but that nevertheless materially mislead investors. Frequently, auditors knew about these deceptions. Too often, however, they remained silent. The key job of the audit committee is simply to get the auditors to divulge what they know.
To do this job, the committee must make sure that the auditors worry more about misleading its members than about offending management. In recent years auditors have not felt that way. They have instead generally viewed the CEO, rather than the shareholders or directors, as their client. That has been a natural result of day-to-day working relationships and also of the auditors’ understanding that, no matter what the book says, the CEO and CFO pay their fees and determine whether they are retained for both auditing and other work. The rules that have been recently instituted won’t materially change this reality. What will break this cozy relationship is audit committees unequivocally putting auditors on the spot, making them understand they will become liable for major monetary penalties if they don’t come forth with what they know or suspect.
In my opinion, audit committees can accomplish this goal by asking four questions of auditors, the answers to which should be recorded and reported to shareholders. These questions are:
If the audit committee asks these questions, its composition – the focus of most reforms – is of minor importance. In addition, the procedure will save time and expense. When auditors are put on the spot, they will do their duty. If they are not put on the spot . . . well, we have seen the results of that.
The questions we have enumerated should be asked at least a week before an earnings report is released to the public. That timing will allow differences between the auditors and management to be aired with the committee and resolved. If the timing is tighter – if an earnings release is imminent when the auditors and committee interact – the committee will feel pressure to rubberstamp the prepared figures. Haste is the enemy of accuracy. My thinking, in fact, is that the SEC’s recent shortening of reporting deadlines will hurt the quality of information that shareholders receive. Charlie and I believe that rule is a mistake and should be rescinded.
The primary advantage of our four questions is that they will act as a prophylactic. Once the auditors know that the audit committee will require them to affirmatively endorse, rather than merely acquiesce to, management’s actions, they will resist misdoings early in the process, well before specious figures become embedded in the company’s books. Fear of the plaintiff’s bar will see to that.
Berkshire's board and corporate governance?
[Charlie Munger: We’re out of step. We don’t feel the need to have directors from every diversity category and pay everyone $100,000-$200,000 per year.
Our directors are all rich, own Berkshire stock, and don’t have any company-provided Directors and Officers insurance coverage.
We’ve been waiting for our system to spread and we’ve been losing. (Laughter)]
The real issue is mediocrity – there are too many .240 hitters on boards. Businesses often settle for a notch or two above mediocrity – there are strong human instincts at work.
For many directors, the director’s fees are an important part of their [total annual] compensation, and they want to be recommended for other boards, so this makes it difficult to arrange a rump meeting to say, “The guy at the end of the table [the CEO] is no good.” This is mediocrity that is tough to combat.
We’ve been on boards and they can only tolerate a certain amount of obnoxiousness, so we have to ration it out. (Laughter) It’s hard to overrule someone [the CEO] and we’re likely to lose anyway. Occasionally we fire a bullet, but it often does no good.
We have real owners on our board – they bought it just like you. [In contrast,] the boards I’ve been on just hand me stock and stock options.
Independence is a state of mind. We think we have the best board in the country, but people who evaluate boards by a checklist disagree.
[Charlie Munger: A director who gets $150,000 per year from a company and needs the money is not independent. [The new law requiring a majority of independent directors] is typical government intervention.]
I’ve been on 19 boards and I’ve never seen a director who needs the money oppose an acquisition or executive compensation. They just don’t behave as if they own it.
[Charlie Munger: Someone once said that no man who needs the salary that a politician receives should be allowed to hold office.]
One of our directors was asked to leave two compensation committees for having the temerity to question pay packages. They’re looking for Chihuahuas not Great Danes or Dobermans. (Laughter) I hope I’m not insulting any of my friends on compensation committees. (Laughter)Munger: You’re insulting the dogs. [The biggest laugh of the day.]
[RE: Majority Voting and Corporate Governance]
Munger: I don’t think it’ll have any effect at all on the ethics in corporate boardrooms. There are fads and fashions. I don’t think the troubles will be fixed by something like that.
Buffett: In the boardroom, it’s partly a business situation and partly a social situation. The key is: Do they think like owners and, even if they do, do they understand enough about business that their decisions are any good? We’ve been on many boards and I’ve never seen any difference in behavior based on the nature of the votes that got them there. But I think you’d be blown away by the difference in savviness and whether people think like owners.
There are all these fashions on corporate governance, but the key job of the board is to hire the right CEO, keep him from overreaching, and exercise independent judgment on important acquisitions. Even smart CEOs are motivated by other than rational reasons when it comes to acquisitions. Directors have not done well in these three areas over time.
The only cure to better corporate governance is if very large shareholders zero in on these things. If they focus on other issues, they’ll have fun and get in the papers, but won’t make a difference. But if the largest shareholders say, “This compensation plan doesn’t make any sense” and withhold their votes for directors, that will make a difference.
I just found out that some big institutions are even farming out their voting to someone else. I was amazed. They don’t want to think like owners and we all pay the penalty for that.
To effect change, large shareholders – not a coalition of small ones – need to act.
Given you [Buffett and Munger] are Berkshire’s sustainable competitive advantage, would you invest in Berkshire now?
Buffett: Our sustainable advantage is our deeply embedded culture, which would be hard to copy, and a different shareholder base—20% turnover versus 100% turnover in the S&P 500—and a unique offer to managers. I don’t see any other company in the U.S. that can adopt our model in any way. It’s a very, very long-lasting advantage. It’s not just us anymore. I don’t know how I’d copy it if I were elsewhere. People who want to join us won’t have another choice.
Munger: Stated differently, a lot of corporations are run stupidly from headquarters, driving divisions to increase earnings every quarter. We don’t do that. The stupidity of management practices in the rest of the corporate world will last long enough to give us an advantage well into the future.
What is the impact of Berkshire losing its AAA rating? What will it take to restore it?
Buffett: We won’t regain it soon, because ratings agencies won’t turn around that fast, even if warranted. It has very little material effect on our borrowing cost. I very much like having a AAA rating. We didn’t think we would be downgraded. We lose some bragging rights in terms of our insurance business, but nobody in insurance ranks ahead of us. We’re still an AAA in my mind. Committees don’t change their minds quickly. We regard meeting our obligations as sacred. It’s difficult for ratings agencies to quantify commitment of management. It [the downgrade] irritates me.
Munger: At least they showed a considerable independence. [laughter] Moody’s next change will be in the opposite direction, because we deserve it, and they’re smart.
Buffett: [When Charlie and I disagree], Charlie says, “In the end you’ll see it my way, because you’re smart and I’m right!” [laughter]
[Buffett continued with a discussion of how credit default swap (CDS) prices can be affected by factors other than perceived credit quality, but we don’t feel confident enough of his exact wording to quote or paraphrase him - our notes: Buffett noted that the ratings agencies often cite CDS prices to support their actions, but CDS prices can be affected by non-credit factors. For example, suppose that Berkshire writes an equity put option. Berkshire collects the premium and establishes a liability on its balance sheet. The other side of the transaction (the put buyer) creates an asset. Then, both sides mark the option to market. If things move in the buyer’s favor, they show a gain. However, the buyer’s auditors urge them to buy protection for their gain by purchasing a Berkshire CDS, since the buyer’s gain represents a potential receivable from Berkshire. If Berkshire writes a relatively large dollar amount of equity put contracts, the buying of Berkshire CDSs significantly increases—and this demand pushes Berkshire CDS prices higher, which to the casual observer would suggest that there’s increased risk in Berkshire. Got that? The bottom line is that the price of Berkshire CDS contracts can go higher without any increased risk associated with the company.]
Do you have a target rate of growth for Berkshire, given its size? Greater than 20% seems unlikely.
Buffett: It will be absolutely impossible to come anywhere near 20%. We hope to be a few percentage points better than the S&P 500. I used to say 10% better in the 1960s. We’ll use book value as a proxy for intrinsic value, [as we’ve] measured that way for 40 years and will continue to measure that way. If we don’t beat it at all, I’ll feel like I haven’t added anything.
Munger: In terms of the broader contribution to civilization, the best days of Berkshire are ahead. The future will be way better than the past.
Could you comment on union and other contracts at Berkshire subsidiaries?
Buffett: We don’t have any. We’re not big believers in contracts [when we buy businesses]. We don’t want relationships that are based on contracts. We buy [businesses] based on retaining [the former owners’] passion for the business. The compensation of the top person at each company [Berkshire subsidiary] is my responsibility. We have contracts on bonuses. Some businesses are profitable, some not. We have different arrangements for different businesses. We don’t try to hold people by contracts. Contracts wouldn’t work.
Munger: Our model is a seamless web of trust, earned by both sides. The Hollywood model is contracts, but no trust.
What is the worst-case scenario for Berkshire's insurance business?
Munger: Even a catastrophe with a $2 – 3 billion loss would not be a disaster [to Berkshire]. It’s a marvelous business.
Buffett: In a mega-catastrophe, at worst we’d pay 4 – 5% of the total [insurance] industry loss. We may be lower than that now, 3 – 4%. Katrina was close. There were total losses of $60 billion [for Katrina]. In a $100 billion catastrophe, we’d pay 3 – 4% of that. The worst situation would be if we ran into so much inflation that people expressed [such] outrage that we start nationalizing the insurance business. That would be a huge loss of an asset. It’s not probable. If there’s public outrage, politicians will do something when costs go way up on essential services.
Could Buffett share his attitude toward layoffs and job security at Berkshire subsidiaries?
Buffett: Business conditions can change dramatically. [If businesses] permanently contract, it leads to permanent layoffs. Sometimes it’s temporary. GEICO will hire around 1,000. Some people resist layoffs, [but] if the business changes in a material way, you’d better change your business model or someone else will cause you to. You tend to do it a little late even. On balance, we hope to avoid businesses that have those problems, but [sometimes] there are no alternatives. In the textile business, we ultimately laid off everyone. Sometimes you’re on the short end of creative destruction.
Munger: Some of our businesses have a shared-hardship model, but it’s not always easy to do. Ben Franklin said, “It’s hard for an empty sack to stand upright.” Sometimes you have to amputate a limb to save a life.
What's the interview process for Berkshire managers?
Buffett: We hire people who typically have proved themselves already. We find people who love their business. [We ask ourselves,] will they feel the same the day after the deal? We have no retirement age. The toughest problem is when managers lose their abilities. That’s the only part of my job I don’t like.
Munger: We’ve been very slow every time on these.
Buffett: I love Berkshire. I go to work every day and am excited about it.
You are giving a lot of BRK stock to the Gates Foundation each year and they are selling. Won’t the foundation selling create downward pressure on the stock?
Buffett: There are 5 foundations that get money each year. I give 1.5% of outstanding shares annually. If they sell 1.5% annually, you have 1.5% of shares being sold annually. That’s not a lot when you compare that to the daily sales on the NYSE. I never sell shares and will never sell one in my life. But only 1.5% should not move the price down in a year. By selling down my shares it has actually led to BRK having a better chance of being in the S&P 500 (as a result of the diminution of his concentrated holdings). If none of the stock had been given away there is no way to know where the stock would be--up or down--but the giveaways should not influence the stock price.
Munger: A stock distribution to aid charity is a non-event.
Managers are allowed to operate without interference with Omaha. What would happen if BRK found illegal activity? Would you intervene?
Buffett: Absolutely, we have to jump in. We have a hotline. Sometimes we get direct letters. I want to hear about problems. Important transgressions have come to our attention – we encourage that. I skip over the bad breath complaints. Alleged bad behavior will get investigated. I believes we have an internal audit function that works for BRK. Every now and then some transgressions get reported and come right to me.
I send a letter every 2 years and asks each manager. A letter goes out every two years, it is 1.5 pages. It asks each managers who they would select to replace them if they died that night and the reasons why I should choose this person. I also remind them that we have all the money we need. We don’t have a shred more of reputation than we need. It doesn’t hurt to repeat Solomon story. If the only reason you are doing something is the other guy is doing it, then don’t. I say to call me. Most realize that if they are thinking about calling me, it’s too close a call and should be avoided. We can cure any problem if we hear about it soon enough, but if allowed to fester it worsens. With 260k people I hope we hear about them fast. We care very much to protect reputation of Berkshire. We have all the money in the world, but we don’t have enough reputation.
Munger: Averaged out our reputation is good, and that is precious to us. We care more about reputation than business mistakes for sure. Protecting BRK’s reputation is essential. In a sense, you people are part of culture. The ideal is not to make as much money as possible within legal limits. We celebrate wealth only when it is fairly won and wisely used. That culture pervades the place, and we think is very helpful to us.
How is BRK ok with models used by its insurance companies after the widespread failure of models during the financial crisis? Are they different and/or safer than the ones that failed Wall Street?
Warren Buffett: We run significant risks from earthquakes. Not sure how much in Q1 from Chile. We have 20% of SwissRe. Our peak risks are earthquakes and hurricanes, 2 biggest in frequency and severity. Risk is probably down from a few years ago. Not down because of diminished appetite, but because rates weren’t attractive. If rates attractive, we would take on group of risks if something close to worst case was $5bil. We paid out $3bil in Katrina, over $2bil on 9/11. But none of this makes us uncomfortable.
Charlie Munger: Our difference is that we deliberately seek out big losses occasionally. Everyone else avoids that. That is competitive advantage, a capacity to endure fluctuating annual results.
Warren Buffett: People know what we do, they just don’t want to do it. I think it comes close to permanent advantage. I felt no different losing $3b in Katrina. That is our game. Our edge gets wider every year. In insurance we are in business of taking other guys’ desire to smooth earnings and in exchange take the lumps.
Charlie Munger: WB is in a different position. Other CEOs can’t look at mirror at end of year and say shareholders still love me. Amundsen, a famous businessman in Omaha – he wanted to own 100% of everything, so he could look in the mirror while shaving and say, “all my shareholders love me...”
Please discuss some of the synergies among BRK companies and whether or not you encourage companies to do business with one another. e.g. At my local Dairy Queen, they don’ t accept Amex, and they still sell Pepsi.
Warren Buffett: There are about 6000 dairy queen outlets. Company operated number 70. So 99% are franchised. At DQ we don’t control what the franchisees do. Most franchisees serve Coke, the enlightened ones. [laughter] It is entirely their business. It seems other franchise operations have more control, but DQ goes back before McDonalds, before Burger King, before all of them, back to 1930s. Agreements were done on old rules – which have less control now than others. You should keep asking for Coke, and maybe you can cause them to see the light. Synergies come at the operational level. We don’t tell them to do business with each other. The whole idea of Berkshire is that managers are responsible for their businesses and we don’t tell them what to do.
Charlie Munger: You [the questioner] have accurately described the way it is, and the interesting thing is that we like it that way. Warren and I would want that if we were a manager.
Warren Buffett: There is some merit to it -- if you tell people to work together, they do so only grudgingly.
If one day I apply as manager to Berkshire company, what should I work on now, and what should I do to become your successor?
Warren Buffett: Probably shoot me! Managers of our subsidiaries hire their own people. I make no decisions about who gets hired. They are responsible. There is the occasional resignation. We’ve had only 10-12 of those over 25 yrs. We have 21 people total at headquarters.
Charlie Munger: There is no indication that we would be particularly good at it [hiring] either.
Warren Buffett: I wasn’t going to mention that. But when you find someone outstanding, boy do they jump out! To advance generally in an organization, you want to think and work like you would if you were the owner of the place.
You stated your policy about retaining earnings in the 1984 annual letter. Would a distribution be warranted based on 2005-2009 stock performance?
Warren Buffett: What I wrote in 1984 [in the owner’s manual on this issue] was not well thought out. I pointed out that we would have flunked test in early 1970s (1974?). Every dollar left in business right now has about $1.30 of market value. Any time stock market went down a lot over 5 yrs, we still would have looked bad. And if stock market was going up, we would have looked good. I think still intellectually honest – not quite the John Kerry response when he once said “I voted for this before I voted against it.” We will continue to measure ourselves against this test. If we don’t meet it, we should go somewhere else.
Charlie Munger: I like people who parse through a long document, find an error, and rub my nose in it, especially your error Warren.
Can you comment on Berkshire's holdings? (2005)
We’re at the lowest percentage of public holdings ever [relative to all of Berkshire’s assets], except for when we were winding down [in the early 1970s].
We’re not unhappy with our public holdings like Coke, Wells Fargo and Moody’s, but would we buy more? Well, we’re not, so there’s your answer. But due to taxes, the size of our positions, etc., we’re not selling either.
We’re not in an attractive time. Munger: It’s not a permanent state of affairs, but it’s not going away.
We will still put large amounts of money to work at good rates, whereas now we’re only able to invest small amounts – where small is still billions.
Why don't you split the stock?
We have the best investors and the lowest turnover of any major company. Why? It’s a self-selection process. People who say they’re not interested in a stock that trades for thousands of dollars per share, simply for this reason, are probably not as intelligent or as in-sync as this group [referring to Berkshire’s current shareholders]. It’s a sign, a symptom.
By not splitting, we’ve helped attract the best shareholders – people who don’t care if the stock is at $90,000 or $9.
[Charlie Munger: I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle. The liquidity gives us these crazy booms, so it has as many problems as virtues.
After the South Sea bubble, England banned tradable stocks and England did fine during this period. If you think liquidity is a great contributor to civilization, then you probably think all real estate in America, which is mostly illiquid, is a problem.]
Berkshire trades $50 million per day, so very few people will have problem selling.
[Charlie Munger:: But we’re trying to create more people who have the problem of owning stock worth so much that liquidity is an issue.]
Berkshire has bought a lot of shares in the last twelve months of listed companies (2008). Do you expect returns to be between 7-10% over many years? Well below your achievements in the past.
Warren Buffett: Yes. We would be very happy if we could buy pre-tax returns of 10%, dividends included. We would probably settle for a little less than that. Berkshire’s re-turns will be less, no question, in the future than in the past. We operate now in a universe of stocks with market caps of at least $10 billion, but really $50 billion and up in order to have an impact. This universe is not as profitable. If we find one with a $10 billion market cap, a 5% position is $500 million. If it doubles, we make $325 million; this is less than 2/10ths of 1% for Berkshire. We have found things to do from time to time to make money. They are nice, but they don’t move the needle much at Berkshire. Anyone who expects us to replicate the past should sell their stock. We’ll get decent returns, but not indecent returns.
Charlie Munger: You can take Warren’s promises to the bank. We are happy making money at a lower rate in the future, and we suggest you adopt the same attitude. You may have better things to do with your money than buying Berkshire. You will find things that are more intelligent, if you spend the time. We don’t think it is the most attractive investment in the world. We like buying good-sized to very large businesses, with good management. It is a nice formula; it should work well over time.
How do U.S. government guarantees hurt Berkshire competitively?
Buffett: It hurts us that competitors can borrow, subsidized by the government— especially at Clayton Homes. The raw materials [funding] cost us more than a bank that’s in trouble. There are the blessed with government guarantees and those that are not. We have no guarantees. Except for our utility business and Clayton, we don’t borrow much money. Our $58 billion of float costs us less than zero, which is less than Wells Fargo’s 1.12% cost of funds.
Munger: Of course we’re at a funding disadvantage, but we’re not regulated like a bank.
Why shouldn't shareholders sell their Berkshire shares and buy what you're buying?
Buffett: The meeting gets written up a lot. Outstanding Investor Digest [does a good job]. There is something to be gained by personal contact. I like our partners to show up and see our products. [In terms of buying what we’re buying], others can’t buy with free float, although they may have tax advantages we don’t have. We don’t quarrel with those who buy what we buy. You can piggyback, but you can’t buy the [whole] businesses we do.
Munger: It’s generally quite smart to copy very successful investors.
Buffett: I did the same thing when I was young.
What safeguards are in place against breaking up Berkshire?
Warren Buffett: My stock will be sold over a period of years after my death. That takes a lot of time. Berkshire is a very large company and will get bigger over time, so it would be very difficult for someone to do a takeover of that size. It can’t happen at all until I die [since there are a lot of votes concentrated until then]. I told my lawyer I wanted a ten-year distribution period—to make sure my estate lasts quite a while, to which my lawyer said that was like telling his teenage son to have a normal sex life. If we do decent compounding, we’ll be one of the largest companies in the USA. It will be difficult to break us up.
Charlie Munger: Warren doesn’t plan to leave early. He wants people to say at his funeral, “That is the oldest looking corpse I’ve ever seen.”
Warren Buffett: I am unlikely to change my views on that subject. [laughter]
How do you stop Berkshire subsidiaries hoarding capital?
Berkshire wants the capital in the most logical place. Berkshire is a tax efficient way to move money from business to business, and we can redeploy capital in places that need them. Most of the managers of companies we own are already independently rich. They want to work, but don't have to. They don't horde capital they don't need.
What do you see as the net effect of government interventions on Berkshire’s business? Will there be new rules of the game?
Munger: It’s clear there will be new rules, but it’s not clear what the new rules will be. There’s been awesome lobbying from financial firms. Countering this lobbying pressure, there’s a climate of hatred in Washington D.C. at the financial industry that you could cut with a knife—it’s that thick. I don’t think you can predict. Berkshire has to adapt to whatever happens. If I had all the power, there would be a lot of government intervention.
Buffett: New rules will affect us one way or another. The biggest pressure is that the American public doesn’t like bankers now. They were worried about their money market funds not that long ago. Nobody’s going to jail, and that makes people mad. It’s much more fun if someone’s going to jail or tortured in some public fashion. People are mad at government or bankers, and you know where government wants that to go. The House 90% tax on AIG bonuses was uncontrolled fury. We’ll adapt to [the situation]. I won’t like it.
Does Berkshire hedge its currency exposure?
Berkshire doesn't hedge its currency exposure. Why spend money to hedge a 50:50 proposition, i.e. a random event.
What is your level of involvement when the company has an ethical dilemma? For example, Fruit of the Loom’s competitors have sweatshops.
We let managers run businesses, and their standards over the years have been extraordinary. I am very happy turning over the keys to the financial and business performance. I write them a letter every two years, and I ask them to send a letter with their successor. I also tell them we have all the money we need. We never want to trade reputation for money. Not only do they behave to conform to the law, but they act as if there was going to be a story in the local paper in the morning written by an intelligent, investigative reporter. There are no budgets. We have no incentives to cause people to do anything or push people to play games.
Charlie Munger: We have no rule against foreign plants. We don’t favor foreign plants; we just do what makes sense. The US was making one billion pairs of shoes per year, 30 years ago. We tried to compete with a great brand and workmanship. We found out it wouldn’t work against shoes produced in China. There are one billion pairs of shoes now in the USA but they’re all produced outside of the US. Some of those factories don’t have the same norms. We won’t tell the world how to run a business. We have standards, but not everyone’s are the same.
Can you comment on the protests by Salmon Fisherman of PacifiCorp’s Dams on the Klamath River?
Our position on it is quite simple: FERC [the Federal Energy Regulatory Commission] and other regulatory commissions have 27 different proposals in front of them from different interest groups. Some people have been hurt by what you describe, while others – several hundred thousand of them – like the cheap power. FERC will listen to the positions and make a decision. We are a public utility and we will do exactly what the people who regulate us say. It’s entirely a question for FERC and the state commissions.
We will not make the determination in the end. It will be made by FERC – the same as with coal, gas or wind generation. Any time you get into public-utility plants, some people are unhappy with the decisions because no one wants a power plant in their yard. People often aren’t happy with wind generation towers. But the world wants more electricity. So we will do exactly what FERC and the state commissions decide. As I said, there are 27 groups and they will hear the arguments of all 27 and come up with the public policy decision. It takes a lot of time.
I’m in a peculiar position on this, because when we bought PacifiCorp, Walter Scott and I signed affidavits saying, “I agree that we will not exercise decisions except those ministerial in nature.” We are recused from voting. This was part of the order that allowed MidAmerican to buy PacifiCorp. The acquisition went through in record time, by the way, because MidAmerican has such as a great track record of being responsive to regulators.
[Three questions about the Klamath River dams in Oregon, owned by PacifiCorp. Will you make PacifiCorp accountable? [Problem of green/blue algae, polluting the water and killing the salmon]]
Warren Buffett: The first dam was built in 1907. We are prohibited from commenting on this. There are strong disagreements.
DAVID SOKOL [Chairman of MidAmerican Energy, the Berkshire subsidiary that owns PacifiCorp]: It was inappropriate for Mr. Buffett to respond. These four dams on the Klamath River, there are a whole series of issues in the federal regulatory re-licensing process. It will be ongoing for eight years. It won’t culminate for another six years. There are twenty-eight various parties that are party to a discussion about what should or should not happen with these assets. Of these twenty-eight parties, there are four different directions that this process could go. We will be pleased to find a resolution. It is up to the regulatory commission, state legislators, and then each regulator in each state. We are working constructively with each of the parties. We have met with each of the parties, and hope we find an acceptable compromise.
Warren Buffett: Regulators will deal with those issues. When government gets involved in eminent domain, there are always tradeoffs. Overall you have people with widely different interests. A big interest is the cost of electricity. Every commission that makes a decision on coal vs. gas makes a tradeoff, and tradeoffs are partly an economic cost and partly other issues. FERC [Federal Energy Regulatory Commission] will listen to everyone. They have to listen to everyone. We will do exactly what they say. We follow the dictates of regulatory bodies. They give us a fair return. From the standpoint of profitability, it is neutral. Society will make the decision.
DS: We distributed a study that found an accumulation of bio-algae and microcystin. There are 27 other lakes in Oregon with that type of blue-green algae. It is created from lakes that have a high abundance of nutrients. Klamath is hyper-eutrophic — there’s a great abundance of algae and nutrients. There are 4 reservoirs. FERC does take it into account. Some do not call for the removal of the dam. All the parties will need to come to agreement.
Warren Buffett: The net benefits vs. losses must be weighed. There are lots of competing ideas and desires in a large society. It is up to the government to sort it out. People are coming to different conclusions about tradeoffs, and generally those are at the state level. The Oregon Public Utility Commission, I am sure, is aware of the issue. They have to consider the best way to generate electricity for the citizens of Oregon.
DS: We want to clarify that we are not polluting the water. We recognize the various issues. We have a 50 year FERC license. A societal answer, hopefully, will be reached.
Charlie Munger: I note how refreshing it is to find people addressing a pollution problem that has nothing to do with burning carbon.
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