What is your investment process?
[When asked about the relative attractiveness of bonds, arbitrage, etc., Buffett replied:]
Charlie and I are competent to make judgments on certain things, and not other things. We try to focus on what we can understand, which is a reasonable amount.
In the summer to mid-fall of 2002, when junk bonds became very attractive, we bought a lot. But we did not make a big decision to buy junk bonds – it’s just that a lot of them got really cheap.
We have an open mind – whatever we see on a given day that overcomes our resistance to take risk, we’ll do. Charlie and I do not have a checklist to prioritize categories. I hope he gets a good idea, he hopes I have one and if we find one, then we move, hopefully in a big way. It has to be big.
We’re recently made big investments in currencies and viatical settlements. We don’t do arbitrage any more because we’re too big.
[Charlie Munger: We have a lot of cash because we don’t like any of those fields at the moment. Trying to prioritize among things we’re unlikely to do is pretty fruitless.
[Q - How do you get better at valuing companies?]
Warren Buffett: Very very good question. I started out not knowing anything about valuing companies. Ben Graham taught me a way to value certain type of business, but the selection of available companies dried up. Charlie taught me about durable competitive advantage. Not how big circle of competence is, but knowing where the edges are is most important. Think about businesses in your own home town. Ask questions about the businesses. Which do you want to buy into, which are hard to compete with, talk about businesses with people. What is working, what is not? You have to ask. You would be surprised at how many companies I know nothing about. The goal is to find companies that will be around for 20 years and offer a margin of safety. You have to recognize your limitations to be successful in this business. 6-7yrs ago I looked at Korean stocks, and I could see a number of businesses that met margin of safety. I bought 20 and diversified.
Charlie Munger: Obviously if you want to get good at something which is competitive, you have to think about it and practice a lot. You have to keep learning because world keeps changing and competitors keep learning. You have to go to bed wiser than you got up. As you try to master what you are trying to do – people who do that almost never fail utterly. Very few have ever failed with that approach. You may rise slowly, but you are sure to rise.
Warren Buffett: When did you start valuing businesses?
Charlie Munger: I never took a business class, except accounting. When I was a boy, there was a man who came to the club every day at 10:30am. I asked my dad about him – he had such a good life! My Dad said, “He gathers up and renders dead horses.” I learned from that. Many businesses are sold under distress. Life is hard to get near top, and hard to hold position once attained. I think you could predict that Kiewits would win, they cared more. I would not have bet on anyone else. Half Dutch half German – and that is coming from me, I’m named Munger. I was automatically doing it – what was working and what wasn’t. If you have that temperament, you will gradually learn. If you don’t have that temperament, I can’t help you.
Warren Buffett: Avoiding the dumb things is the most important. Learn more, know limitations, avoid the dumb things. Charlie often thought about his client’s business. He was incapable of thinking about a business without noticing the fundamental economics.
Charlie Munger: I had a client who sold a Caterpillar dealership business for a crazy price to an oil business. The oil business had consultants and a concept and a strategy!
Have you ever bought a company where the numbers told you not to? How much is quantitative and how much is qualitative?
The best buys have been when the numbers almost tell you not to. Because then you feel so strongly about the product. And not just the fact you are getting a used cigar butt cheap. Then it is compelling. I owned a windmill company at one time. Windmills are cigar butts, believe me. I bought it very cheap, I bought it at a third of working capital. And we made money out of it, but there is no repetitive money to be made on it. There is a one-time profit in something like that. And it is just not the thing to be doing. I went through that phase. I bought streetcar companies and all kinds of things. In terms of the qualitative, I probably understand the qualitative the moment I get the phone call. Almost every business we have bought has taken five or ten minutes in terms of analysis. We bought two businesses this year.
General Re is a $18 billion deal. I have never been to their home office. I hope it is there. (Laughter) “There could be a few guys there saying what numbers should we send Buffett this month?” I could see them going once a month and saying we have $20 billion in the bank instead of $18 billion. I have never been there.
Before I bought Executive Jet, which is fractional ownership of jets, before I bought it, I had never been there. I bought my family a quarter interest in the program three years earlier. And I have seen the service and it seems to develop well. And I got the numbers. But if you don’t know enough to know about the business instantly, you won’t know enough in a month or in two months. You have to have sort of the background of understanding and knowing what you do or don’t understand. That is the key. It is defining your circle of competence.
Everybody has got a different circle of competence. The important thing is not how big the circle is, the important thing is the size of the circle; the important thing is staying inside the circle. And if that circle only has 30 companies in it out of 1000s on the big board, as long as you know which 30 they are, you will be OK. And you should know those businesses well enough so you don’t need to read lots of work. Now I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the “Scuttlebutt Approach.” I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Everytime I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, “If you could only buy stock in one coal company that was not your own, which one would it be and why? You piece those things together, you learn about the business after awhile.
Funny, you get very similar answers as long as you ask about competitors. If you had a silver bullet and you could put it through the head of one competitor, which competitor and why? You will find who the best guy is in the industry. So there are a lot of things you can learn about a business. I have done that in the past on the business I felt I could understand so I don’t have to do that anymore. The nice thing about investing is that you don’t have to learn anything new. You can do it if you want to, but if you learn Wrigley’s chewing gum forty years ago, you still understand Wrigley’s chewing gum. There are not a lot of great insights to get of the sort as you go along. So you do get a database in your head.
I had a guy, Frank Rooney, who ran Melville for many years; his father-in-law died and had owned H.H. Brown, a shoe company. And he put it up with Goldman Sachs. But he was playing golf with a friend of mine here in Florida and he mentioned it to this friend, so my friend said “Why don’t you call Warren?” He called me after the match and in five minutes I basically had a deal.
But I knew Frank, and I knew the business. I sort of knew the basic economics of the shoe business, so I could buy it. Quantitatively, I have to decide what the price is. But, you know, that is either yes or no. I don’t fool a lot around with negotiations. If they name a price that makes sense to me, I buy it. If they don’t, I was happy the day before, so I will be happy the day after without owning it.
What is it that really piques your interest in a stock? What tells you that it could be interesting?
We're so limited now because we can only go into very big companies. Charlie and I are probably familiar with every company in the United States--in a general way--that we can have the kind of position we would need to have [to make a difference in Berkshire Hathaway's performance]. We look for the ones where we think we know what they're going to look like in 10 years. If the price gets attractive and we know a little about the management, and we're quite sure--within a range--what they're going to look like in 10 years, we're in our area. We buy them when the prices are right, like Coca-Cola was some years back.
What's your acquisition criteria? What has made you successful in this area where most others have failed?
We look for people who have a passion for their business. We frequently buy businesses the owners still manage, where they are monetizing a lifetime of work. They often don’t want to sell but need to for estate planning or other reasons.
They need to have a passion because we don’t have any employment contracts – because we don’t think they work – we don’t stand over them with whips, and they’re already rich. We just try not to kill or dampen their love for their business.
We also look for three things: intelligence, energy and integrity. If you don’t have the latter, then you should hope they don’t have the first two either. If someone doesn’t have integrity, then you want them to be dumb and lazy. (Laughter)
We look them in the eyes and ask, “Do they love the business or the money?” If someone wants to cash out, then we have a problem because we only have 16 people at Berkshire’s headquarters and can’t run it ourselves.
Munger: The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it. (Laughter)
We criticize it [acquisitions], but then we do it. But we have different motivations.
We’ve been reasonably successful in having people run their businesses with the same passion as before we bought them.
Gillette, the oil companies, etc. all went out and bought a lot of businesses and tried to run them themselves. We’re under no illusions that we can do that. We think that having lots of Executive Vice Presidents, directives from headquarters, centralized Human Resources etc. can destroy the incentives of the people who’ve already gotten rich, and we’re counting on them making us rich.
The successor to me will come from Berkshire, knows our system, has seen that it works, and will be surrounded by people who believe in it. So it’s not going to be so hard to keep this train going down the tracks at 90 miles per hour.
[Charlie Munger: Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. (Laughter)
But if you’re going to provide minimal oversight, you have to buy carefully. It’s a different model from GE’s. GE’s works – it’s just very different from ours.]
We are a conglomerate – and we hope to become more of a conglomerate.
We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.
[BRK2006 - Update on acquistions]
Russell is in process – it’ll probably be a couple of months before completion. I described the Business Wire acquisition in the annual report. I got a letter from Cathy [Baron Tamraz, CEO of Business Wire]. [Regarding the purchase of GE’s Medical Protective Corporation,] I knew [GE CEO Jeff] Immelt wanted to shed some insurance assets and I suggested we’d be interested in that part of it, so we talked and made a deal.
One thing we haven’t done is participate in auctions. I get books occasionally and the projections are just plain silly. Maybe that’s why they don’t sign them. I’d love to make a bet with the investment bankers about whether the companies achieve the earnings in the pitch books.
The calls we want to get are from people who care about their business, who for tax or family-ownership reasons want to sell to us. They’re looking to change the ownership structure, not the operating personality and culture of the company they care deeply about.
The owners of Iscar are keeping 19% [I think he meant 20%]. They think [Berkshire] is the best place for their business and their people, and where they’ll have the most opportunity to grow. I don’t know how many stories you read about a $4 billion deal that doesn’t say anything about an investment banker on either side.
[Charlie Munger: The interesting thing about it to me is the mindset. With all these “helpers” running around, they talk about doing deals. We talk about welcoming partners. The guy doing deals, he wants to do a deal and then unwind it in the near future. It’s totally opposite for us. We like to build lasting relationships. I think our system will work better in the long term than flipping deals.
I think there are so many of them [helpers] that they’ll get in each other’s way. I don’t think they’ll make enough money to meet their expectations, by flipping, flipping, flipping.]
By charging fees, fees, fees. [Laughter]
[Charlie Munger: Warren talked to guy at an investment bank and asked how they made their money. He said, “Off the top, off the bottom, off both sides and in the middle.” [Laughter]]
[A shareholder asked if he’d be interested in buying Oriental Trading Company, a direct marketer of novelties and gift items, which is based in Omaha.] I looked at Oriental Trading a few years ago. I didn’t know it was for sale again. I don’t know, but I suspect some private group bought it and is now selling it. We see that all the time. They invariably try to sell it quickly to a strategic buyer, which is another way of saying someone who pays too much. Anytime someone calls me and says we’d be a logical strategic buyer, I hang up the phone faster than Charlie would.
The idea that we’re going to find a business to buy from a guy who’s been thinking from the moment he bought only about how he’s going to spruce it up and get out, is very low. It’s Fund A selling to Fund B to Fund C. The irony is that the same pension fund may be invested in all three funds, so they’re just paying all of the money managers to flip it to one another.
[Charlie Munger: In the 1930s, there was a stretch where you could borrow more against the real estate than you could sell it for. I think that’s what’s going on in today’s private- equity world.]
What's your acquisition strategy? How do you get deals?
We'd like to keep buying businesses like the eight we bought last year. Our first preference has always been to buy outstanding operating businesses outright. We've made money in stocks, especially in the 1970s, but the climate is not so favorable now.
There are enough businesses that meet our criteria to do two acquisitions per year on average. What we'd really like to do is a $10-15 billion acquisition, but it's hard to find one that's not being auctioned, which we don't do.
We haven't had much luck buying businesses overseas, but that's because our phone hasn't rung. We're not on the radar screen, but we're hoping this will change.
Our best source of deals is word of mouth, generally in industries we're invested in. Sort of like NetJets, where 70% of our new customers are referred by current customers.
It’s important to note that in this world where many businesses get dressed up and auctioned off, we occasionally hear from people who consider their business too important to auction off. We don’t participate in auctions. I can’t recall buying a business at auction, can you Charlie?
[Charlie Munger: I can’t remember one.]
People who won’t put their business up for auction like a piece of meat and care about the home in which their business resides are the type of people we want to be partners with. It says something very important about how much they care about their business, their customers and their employees. We’ve acquired a number of businesses like this in the past couple of years and the crowning one is Iscar. I’m going to Israel in September to see if there are any more girls like Iscar there.
[Tilson Notes - I think the Iscar acquisition is fantastic news for three reasons:
We don't like the term "deal flow" because we don't view them [businesses we might buy] as deals. We look at deals a few times a year. In the US, we get a pretty reasonable percentage of the calls we should get. We didn't get those calls 20-40 years ago because we weren't as well known.
It feeds on itself. If we acquire companies and people say good things, we'll hear from more. We acquired one furniture company, which led to four more.
It's like a snowball. By being around 38 years, it's been a high mountain [and Berkshire is now a] big snowball and attracts a lot of snow.
Outside the US, we don't see many deals because we're not as well known.
I don't hear about one [deal] a week or even a month. But most we want to hear about, we get a good percentage of the calls. It would be a plus [if we were to see more deals] outside this country.
[Charlie Munger: The general assumption is that it must be easy to sit behind a desk and people will bring in one good opportunity after another -- this was the attitude in venture capital until a few years ago. This was not the case at all for us -- we scrounged around for companies to buy. For 20 years, we didn't buy more than one or two per year.]
We didn't have the money to do many deals. When we bought National Indemnity, it was a big deal for us. We hope there's a lot of mountain left and a lot of wet snow.[Charlie Munger: It's fair to say that we were rooting around. There were no commissioned salesmen. Anytime you sit there waiting for a deal to come by, you're in a very dangerous seat.]
What sources of investment ideas are available today?
First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don't understand and can't reasonably predict. An example is chewing gum versus software. You also have to recognize what you can and cannot know. Put everything you can't understand or that is difficult to predict in one pile. That is the too-hard pile. Once you know the other pile, then it's important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don't want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis. We're getting ready to make a $5 billion investment and this was the process I used.
Do you have any investing tips?
[Munger: "To some extent, stocks are like Rembrandts. They sell based on what they've sold in the past. Bonds are much more rational. No-one thinks a bond's value will soar to the moon."
"Imagine if every pension fund in America bought Rembrandts. Their value would go up and they would create their own constituency."]
How do you build your investment knowledge?
We read a lot: daily publications, annual reports, 10Ks, 10Qs, business magazines, etc.
Fortunately, the investment business is one where knowledge accumulates and builds into a knowledge base that's useful. There's a lot to absorb over time. 40-50 years ago, I visited a lot of companies, but haven't done this in a long, long time.
[Charlie Munger: The more basic knowledge you have, the less new knowledge you have to get. The guy who plays chess blindfolded [a chess master comes to Omaha during Berkshire's annual meeting weekend and, in an exhibition, plays multiple players blindfolded] -- he has a knowledge of the board, which allows him to do this.
I'd hate to give up The Wall Street Journal.]
You'd also hate to give up the Buffalo News [which Berkshire owns]. [Laughter.] You want to read a lot of financial publications. The New York Times has a much better business section than it had 25 years ago. Read Fortune.
I don't read any analyst reports. If I read one, it's because the funny pages weren't available. I don't know why anyone does it.
Is there an organizational model that allows you to deal with all the information?
The beauty of valuing large companies is that it is cumulative. If you started doing it 40 or so years ago, you've really got a working knowledge of an awful lot of businesses. There aren't that many, to start with. What are there, 75 or so important industries? You get to understand how they all operate, and you don't have to start over again every day, and you don't have to consult a computer or anything like that. So, it has the advantage of the accumulation of useful information over time. Why did we decide to buy Coca-Cola in 1988? Well, it may have been because of a couple of small, incremental bits of information, but that came into a mass that had been accumulated over decades. That's why we like businesses that don't change very much.
Do you have advice for the individual investor to help them narrow the stock universe?
They ought to think about what he or she understands. Let's just say they were going to put their whole family's net worth in a single business. Would that be a business they would consider? Or would they say, "Gee, I don't know enough about that business to go into it?" If so, they should go on to something else. It's buying a piece of a business. If they were going to buy into a local service station or convenience store, what would they think about? They would think about the competition, the competitive position both of the industry and the specific location, the person they have running it and all that. There are all kinds of businesses that Charlie and I don't understand, but that doesn't cause us to stay up at night. It just means we go on to the next one, and that's what the individual investor should do.
So if they're walking through the mall and they see a store they like, or if they happen to like Nike shoes for example, these would be great places to start? Instead of doing a computer screen and narrowing it down?
A computer screen doesn't tell you anything. It might tell you about P/Es or something like that, but in the end you have to understand the business. If there are certain businesses in that mall they think they understand and they're public companies, and they can learn more and more about them.... We used to talk to competitors. To understand Coca-Cola, I have to understand Pepsi, RC, Dr. Pepper.
[Charlie Munger: And Cott. Cott is the one you have to understand more than anything else. [Note: Cott is a Canadian company specializing on low-priced, private-label soft drinks.]]
What advice would you give to new investors?
I think you should read everything you can. In my case, by the age of 10, I’d read every book in the Omaha public library about investing, some twice. You need to fill your mind with various competing thoughts and decide which make sense. Then you have to jump in the water – take a small amount of money and do it yourself. Investing on paper is like reading a romance novel vs. doing something else. [Laughter] You’ll soon find out whether you like it. The earlier you start, the better.
At age 19, I read a book [The Intelligent Investor] and what I’m doing today, at age 76, is running things through the same thought process I learned from the book I read at 19.
I remain big on reading everything in sight. And when you get the opportunity to meet someone like Lorimer Davidson, as I did, jump at it. I probably learned more in that four hours than in almost any course in college or business school.
Munger: Sandy Gottesman, a Berkshire director, runs a large, successful investment firm. Notice his employment practices. When he interviews someone, he asks: “What do you own and why do you own it?” If you’re not interested enough to own something, then he’d tell you to find something else to do.
Buffett: Charlie and I have made money in a lot of different ways, some of which we didn’t anticipate 30-40 years ago. You can’t have a defined roadmap, but you can have a reservoir of thinking, looking at markets in different places, different securities, etc. The key is that we knew what we didn’t know. We just kept looking. We knew during the Long Term Capital Management crisis that there would be a lot of opportunities, so we just had to read and think eight to ten hours a day. We needed a reservoir of experience. We won’t spot every one, though – we’ve missed all kinds of things.
But you need something in the way you’re programmed so you don’t lose a lot of money. Our best ideas haven’t done better than others’ best ideas, but we’ve lost less. We’ve never gone two steps forward and then one step back – maybe just a fraction of a step back.
Munger: And of course the place to look when you’re young is the inefficient markets. You shouldn’t be trying to guess if one drug company is going to have a better pipeline than another.
Buffett: You should do well in games with few other players. The RTC [Resolution Trust Corporation] was a great example of a chance to make a lot of money. Here was a seller [government bureaucrats] with hundreds of billions of dollars of real estate and no money in the game, who wanted to wrap up quickly, while many buyers had no money and had been burned.
There won’t be any scarcity of opportunity in your life, although there will be times when you feel that way.
[Re: Ongoing Learning]
I haven’t been continually learning the basic principles [of sound investing], which are still Ben Graham’s. They were affected in a significant way by Charlie and Phil Fisher in terms of looking at better businesses. And I’ve learned more about how businesses operate over time.
You need an intellectual framework, which you can get mostly from The Intelligent Investor. Then, think about businesses you can get your mind around if you really work at it. Then, you will do well if you have the right temperament.
[Charlie Munger: I’ve watched Warren for decades. Warren has learned a lot. He can pooh pooh investing in PetroChina, but he’s learned, which has allowed him to [expand his circle of competence so he could invest in something like PetroChina.
If you don’t keep learning, other people will pass you by.
Temperament alone won’t do it – you need a lot of curiosity for a long, long time.]
It’s hard for individual investors to successfully pick stocks or time the market. The best investment you can make is in your own abilities. Anything you can do to develop your own abilities or business is likely to be more productive than investing in foreign currencies.
If you own your own business in America [and you run it well, you’ll do OK].
When I was seven years old, I first took an interest in stocks. My dad was in the business, so I’d go with him to the office and I saw interesting things. [When I was a little older,] I went to the library and read every book on markets and investing.
When I was 11, I bought my first stock – three shares. I was following charts. When I was 19, I read The Intelligent Investor and it changed my whole framework.
My advice is to read a lot. There are no secrets in the business that only the priesthood knows. It’s all right there.
It requires qualities of temperament way more than qualities of intellect.
Once you have a 125 IQ, much more doesn’t matter. Look for opportunities that fit your framework. Try to learn every day, but you can’t act every day. It’s important to enjoy the game, just as it is to enjoy bridge or baseball [if you’re going to play those games seriously].
Ben Graham said you’re neither right nor wrong if you’re investing with the crowd – you’re right if your facts and reasoning are right. Once you have the facts, you have to think about what they mean. You don’t take a survey.
You should focus on what’s important and knowable. There are many things that are important but now knowable, like [whether there will be] a nuclear attack tomorrow. You can’t focus on those.
As Ben Graham said in chapter 8 of The Intelligent Investor: The market is there to serve you, not instruct you. If it does something silly, it gives you a chance to do something. It just sets prices. If it doesn’t give you an opportunity, go play bridge and come back the next day. And the nice thing is that the prices will be different.
During the Long-Term Capital Management crisis, we were getting calls on Sunday from people. By the way, you can make a lot of money on calls on Sunday – that means things are really screwed up. Just make sure you’re the callee and not the caller.
At that time, there was [an unprecedented] 30 basis point spread between on- versus off-the-run 30-year Treasuries. All you have to do [in such situations] is make sure you can play out your hand under all circumstances. If you can and you have the right facts – and you let the market serve rather than instruct you – you can’t miss.
Munger: I’d say some of you probably can miss. [Laughter]
Advice for getting into investing?
I love the treasure hunt. Learn as much as you can. Just jump right into the pool.
Where is a good place for new investors to invest right now?
That’s very difficult - we don’t have one-line advice on that. Maybe for a small investor, continuous investment in index funds might work - but not for us. I like the businesses we’re in, so I wouldn’t be giving up any of my businesses.
Investors have to remember: corporate profits are going up, but stocks are going up faster. How can that continue indefinitely? Investors can only earn what companies themselves can earn; the government or the markets themselves don’t kick anything in. How can you get anything more out of a farm than what it grows?
There’s nothing magical added by the stock market to corporate returns. It just doesn’t create more earnings to pay out to investors. If you trace out the mathematics of the market’s logic, you begin to see the limits to the logic.
We think we’re in a pretty good group of businesses for the world we face. We don’t know which will be super-winners, but we think a significant number will do okay. We don’t buy businesses with much thought of world trends, but we do think about businesses subject to foreign competition, with high labor content and a product that can be shipped in.
I bought into an airline [US Air] with high seat-mile costs of 12 cents. It was protected, but that was before Southwest showed up with 8-cent costs.
The variables you name don’t bother us. We have good businesses, deal from strength, always have a loaded gun and have the right managers and people and an owner-oriented culture.
Munger: We learned about foreign labor competition in our shoe business. It reminds me of Will Rogers, who said he didn’t think man should have to learn easy lessons in such a hard fashion. You should be able to learn not to pee on an electrified fence without actually trying it. [Laughter]
What advice would you give to non-professional investors?
Are investors more or less knowledgeable today compared to ten years ago?
There is no doubt that there are far more “investment professionals” and way more IQ in the field, as it didn't use to look that promising. Investment data are available more conveniently and faster today. But the behavior of investors will not be more intelligent than in the past, despite all this. How people react will not change – their psychological makeup stays constant. You need to divorce your mind from the crowd. The herd mentality causes all these IQ's to become paralyzed. I don't think investors are now acting more intelligently, despite the intelligence. Smart doesn't always equal rational. To be a successful investor you must divorce yourself from the fears and greed of the people around you, although it is almost impossible.
Do you think Ponzi was crazy? The tech and telecom madness that existed just 6 years ago is right up there with the craziest mania's that have ever happened. Huge training in capital management didn't help.
Take Long Term Capital Management. They had 100's of millions of their own money, and had all of that experience. The list included Nobel Prize winners. They probably had the highest IQ of any 100 people working together in the country, yet the place still blew up. It went to zero in a matter of days. How can people who are rich and no longer need more money do such foolish things?
Your thoughts on index funds?
Just pick a broad index like the S&P 500. Don't put your money in all at once; do it over a period of time. I recommend John Bogle's books -- any investor in funds should read them. They have all you need to know."
[Charlie Munger: One could imagine a period like Japan 13 years ago, however, in which indexing over time wouldn't work.]
[When asked whether one should buy Berkshire, invest in an index fund, or hire a broker, Buffett replied:]
We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund – where you don’t put the money in at one time, but average in over 10 years –you’ll do better than 90% of people who start investing at the same time.
[Charlie Munger: It’s hard to sit here at this annual meeting, surrounded by smart, honorable stock brokers who do well for their clients, and criticize them. But stock brokers, in toto, will do so poorly that the index fund will do better.]
If you were today 20-something years old would you primarily be searching for: a) Situations reminiscent of 1957 – akin to Daehan Flour Mills, or b) Situations reminiscent of 1987 – akin to Moody’s Corporation?
Either is fine. a) is better for small sums. b) is better for large sums
[Mr. Buffett, on June 23, 1999 you shared with Business Week:
If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.]
[At a talk to Columbia students in 1993 you shared:
When I got out of Columbia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody's industrial manual, banks and finance manual and public utilities manual. I went through all those page by page.
I found a little company called Genesee Valley Gas near Rochester . It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.
I found Western Insurance in Fort Scott, Kansas. The price range in Moody's financial manual...was $12-$20. Earnings were $16 a share. I ran an ad in the Fort Scott paper to buy that stock.
I found the Union Street Railway, in New Bedford, a bus company. At that time it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.]
[Along similar lines, in late 2005 I understand you explained to a group of Harvard students the following:
Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified. Korea rebuilt itself in a big way post 1998. Companies overbuilt their balance sheets – including Daehan Flour Mill with 15,000 won/year earning power and selling at “2 and change” times earnings. The strategy was to buy the securities of twenty companies thereby spreading the risk that some of the companies will be run by crooks. $100 million was quickly put to work.]
[The “1987” Fisher Approach -The following excerpts from an article written by Carol Loomis published on April 11, 1988 in Fortune provide interesting clarity on the modus-operandi of Berkshire circa 1987:
Unusual Profitability (High ROE with Low Debt; i.e. high ROIC) - …But in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned, after taxes, $100 million. That's a return on equity of 57%, and it is exceptional. As Buffett says, ''You'll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.''
Unusual Growth (Opportunities for Reinvestment of Retained Earnings) - …Some folks of the right sort, by the name of Heldman, read that ad and brought him their uniform business, Fechheimer, in 1986. The business had only about $6 million in profits, which is an operation smaller than Buffett thinks ideal. …A few hundred miles away at Fechheimer ( …1987 sales: $75 million)
Paying for Quality - …By 1972, Blue Chip Stamps, a Berkshire affiliate that has since been merged into the parent, was paying three times book value to buy See's Candies, and the good-business era was launched. ''I have been shaped tremendously by Charlie,'' says Buffett. ''Boy, if I had listened only to Ben, would I ever be a lot poorer.]
What's your opinion of cigar butts vs quality businesses?
[Charlie Munger: If See's Candy had asked $100,000 more [in the purchase price; Buffett chimed in, "$10,000 more"], Warren and I would have walked -- that's how dumb we were.]
[Ira Marshall said you guys are crazy -- there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See's, you could say Berkshire was built on constructive criticism. Now we don't want any more today. [Laughter]]
The qualitative [evaluating management, competitive advantage, etc.] is harder to teach and understand, so why not just focus on the quantitative [e.g., cigar butt investing]? Charlie emphasized quality [of a business] much more than I did initially. He had a different background.
It makes more sense to buy a wonderful business at a fair price. We've changed over the years in this direction. It's not hard to watch businesses over 50 years and learn where the big money can be made.
Even when you get a new important idea, the old ideas are still there. There wasn't a strong line of demarcation when we moved from cigar butts to wonderful businesses. But over time, we moved.
If you were starting out today, what would you do the same or differently?
We started out this snowball at the top of a very long hill. My advice is either start very early or live very long. I guess I’d do it the same way: maybe I’d start with small companies and buy good businesses. Or little pieces of ‘em called stocks.
[Charlie Munger: The first $100,000 is probably the hardest part. Staying rational and significantly underspending your income helps, too.]
If we were to do it over again, we’d do it pretty much the same way. The world hasn’t changed that much. We’d read everything in sight about businesses and industries we think we’d understand. And, working with far less capital, our investment universe would be far broader than it is currently.
There’s nothing different, in my view, about analyzing securities today vs. 50 years ago.
We formed our first partnership 50 years and two days ago, on May 4, 1956, with $105,000. If we were starting again, Charlie would say we shouldn’t be doing this, but if we were, we’d be investing in securities around the world. Charlie would say we couldn’t find 20, but we don’t need 20 – we only need a few that can pay off very big. We’d also be buying [stocks in] smaller companies.
If we were planning to buy [entire] businesses, we’d have a tough time. We’d have no reputation and only $1 million.
Charlie started out in real-estate development because with only a little capital, brain power and energy, you could magnify the returns in real estate unlike in other sectors.
I’d just do it one foot in front of the other over time. But the basic principles wouldn’t be different. If I’d been running a little partnership three years ago, I’d have started out 100% in Korea.
Munger: You should find something to invest in and then compare everything else against that. That’s your opportunity cost. That’s what you learn in freshman economics, even if it hasn’t made it into modern portfolio theory. That’s why modern portfolio theory is so asinine.
Buffett: It really is.
Munger: When Warren said he’d put 100% of his fund in Korea, maybe he wouldn’t quite do that, but pretty much. Most people won’t find a lot of great things [to invest in]. Instead, you’ll want to find a few things that are much better than anything else. Act on these.
[RE: How Buffett Would Invest with a Small Amount of Money]
If I were working with a very small sum – you all should hope this doesn’t happen – I’d be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you’re investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can’t do it, but if you know what you’re doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $5 billion in a stock. It won’t work – it’s not even close.
If Charlie and I had $500,000 or $2 million to invest, we’d find little things we could do, not all of it in stocks.
Munger: But there’s no point in our thinking about that now.
You have to find your passion in life. I would choose the same job. I enjoy it. It is a terrible mistake to sleepwalk through your life. Unless Shirley MacLaine is right, you won’t have another one. My dad had a business with [investment] books on his shelves, and they turned me on. This was before Playboy. If he was a minister, I’m not sure I would have been as enthused. If you have obligations, you have to deal with realities. I tell students to go work for an organization you admire or an individual you admire, which usually means that most MBAs I meet become self-employed. [laughter] I went to work for Ben Graham. I never asked my salary. Get the right spouse. Charlie talks about the man who spent twenty years looking for the perfect woman and found her. Unfortunately, she was looking for the perfect man. If you are lucky, you will be happy and as a result, you will behave better. It makes it easier.
Charlie Munger: You’ll do better if you have passion for something in which you have aptitude. If Warren had gone into ballet, no one would have heard of him.
Warren Buffett: Or would have heard of me very differently. [laughter]
[Q - With small sums of money, what strategies would you pursue?]
Warren Buffett: If I were working with small sums of money, it would open up thousands of possibilities. We have found very mispriced bonds. We found them in Korea a few years ago. You could make big returns but had to be of small size. I wouldn’t be in currencies with a small amount of money. I had a friend who used to buy tax liens. I’d look in small stocks or specialized bonds. Wouldn’t you say that, Charlie?
Charlie Munger: Sure.
[Q - If you were starting a $26 million fund, what would you do differently with a smaller asset base? How many positions would you hold, and what kind of turnover would you have? What would you do if some investments lost 50% and some gained?]
Buffett: We would hold the half-dozen stocks we liked best. We would do the same thing if they lost 50%. Cost has nothing to do with it. We look at price and think about what something is worth. Keep it in the few you know.
Munger: He [Buffett] has tactfully suggested you adopt a different way of thinking. [laughter]
[Comment: As Buffett stated, cost basis has nothing to do with investment judgment (apart from tax considerations). Nevertheless, many investors (like the questioner) pay way too much attention to what they’ve paid, rather than its value.]
According to a business week report published in 1999, you were quoted as saying “it's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?
Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access.
You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.
Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.
The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn't have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.
I know more about business and investing today, but my returns have continued to decline since the 50's. Money gets to be an anchor on performance. At Berkshire's size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.
Do you believe that we'll have significant mispricings again? And if you were 26 today how would you generate the 50% returns that you said you might do with smaller amounts of capital?
Attractive opportunities come from observing human behavior. In 1998, people behaved like frightened cavemen (referring to the Long Term Capital Management meltdown). People make their own opportunities. They will be frozen by fear, excited by greed and it doesn’t matter what their IQ, degrees etc is. Growth of 50% per year is with small capitalization, not large cap. The point is I got rich looking for stock with strong earnings.
The last 50 years weren’t unique. It’s just capitalizing on human behavior. It’s people that make opportunities when others are frozen by fear or excited by greed. Human behavior allows for success if you are able to detach yourself emotionally.
In 1951, I got out of school at 20 years old. At the time there were two publishers of stock information, Moody’s and Standards and Poor’s. I used Moody’s and went through every manual. I recently bought a copy of the 1951 Moody off of Amazon. On page 1433, there’s a stock you could have made some money on. The EPS was $29 and the Price Range was from $3-$21/share. On another page, there is a company that had an EPS of $29.5 and the price range was $27-28, 1x earnings. You can get rich finding things like this, things that aren’t written about.
A couple of years ago I got this investment guide on Korean stocks. I began looking through it. It felt like 1974 all over again. Look here at this company...Dae Han, I don't know how you pronounce it, it’s a flour company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 20 companies like this.
The point is nobody is going to tell you about these companies. There are no broker reports on Dae Han Flour Company. When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses. Not all of them will be good, but some will and those will make you rich. And this didn’t happen in 1932, this was in 2004! These opportunities will be there in the next 30 years. You’ll have streaks where you’ll find some bad companies and a few times where you’ll make money with everything that you do.
The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.
In your investing life you will have several opportunities and one or two that can’t go wrong. For example, in 1998 the NY fed offered a 30-year treasury bonds yielding less then the 29-½ year treasury bonds by 30 basis points. What happened was LTCM put a trade on at 10 basis points and it was a crowded trade, they were 100% certain to make money but they could not afford any hiccups. I know more about human nature; these were MIT grads, really smart guys, and they almost toppled the system with their highly leveraged trading.
This was definitely a good time to act.
You have often spoken of the difficulties of compounding large sums of money. But in an article I read, you were quoted as saying that you think you could compound 50% returns on small sums of money, say $1 million. Where could you find those kind of investments in today’s market?
I was misquoted in that article. I get together with about 60 people every couple years and get their expectations of returns. Of those investors, I think there’s a half dozen who could get those kinds of returns - but they’re only going to find those returns in small places.
I stumble onto those things occasionally but I’m not looking for them. I’m looking for things that Berkshire Hathaway can do.
Could you describe the capital allocation process you follow? How do you determine the charges for capital to your different managers?
There is no better way to make managers understand how valuable capital is than to charge them for it. The amount charged to them can depend on elements such as the history of the subsidiary and the level of interest rates, and has varied from 14 to 20 percent at times. The important thing, Buffett emphasized, is that “we don’t want managers to think of other people’s money as “free" money.
What filters do you use when looking at companies?
[Charlie Munger: Well, opportunity cost is a huge filter in life. If you've got two suitors who are eager to have you, but one is way better than the other, you're going to choose that one rather than the other. That's the way we filter stock buying opportunities. Our ideas are so simple. People keep asking us for mysteries, but all we have are the most elementary ideas.]
We know instantly whether a business is something we're going to understand, and whether it's a business that's going to have a sustainable edge, and that gets rid of a very significant percentage of opportunities. I'm sure people regard me and Charlie as very arbitrary--in the middle of the first sentence, we'll say, "We appreciate the call, but we're not interested." I'm sure that if they explain something I might get buttered on it, but we really can tell in the middle of the first sentence whether those two factors exist ... We can sometimes tell by who we're dealing with, whether a deal is ever going to work out or not. I mean, if there's an auction going on, we have no interest in talking about it. If someone is interested in doing that with their business, then they're going to want to sit down and renegotiate everything with us all over again after the deal is done ...We don't want to listen to stories all day, and we don't need brokerage reports. There's other things to do with your time.
[Charlie Munger: Another filter is the concept of the quality person, which most people define as someone very much like themselves. (laughter) There are so many wonderful people out there, and there are so many awful people out there. And there are signs, like flags, waving over the awful people. And generally speaking, those people are to be avoided.]
[Q - Besides the type of management that you look for, when you look at financials you make decisions rather quickly. In regards to the financial information and the business overall what factors do you look at?]
We make quick decisions because we have filters before we get to the point of making a decision.
Filter #1 – Can we understand the business? What will it look like in 10-20 years? Take Intel vs. chewing gum or toilet paper. We invest within our circle of competence. Jacob’s Pharmacy created Coke in 1886. Coke has increased per capita consumption every year it has been in existence. It’s because there is no taste memory with soda. You don’t get sick of it. It’s just as good the 5th time of the day as it was the 1st time of the day.
Filter #2 – Does the business have a durable competitive advantage? This is why I won’t buy into a hula-hoop, pet rock, or a Rubik’s cube company. I will buy soft drinks and chewing gum. This is why I bought Gillette and Coke.
Filter #3 – Does it have management I can trust?
Filter #4 – Does the price make sense?
Since 1972 we have made no change in the marketing, process etc. Take See’s candy. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.
How would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?
Well, it depends whether they are going to be an active investor. Graham distinguished between the defensive and the enterprising and that. So if you are going to spend a lot of time on investment, you know I just advise looking at as many things as possible and you will find some bargains. And when you find them, you have to act. It doesn't -- it hasn't changed at all since I was here in 1950, 1951. And it won't change the rest of my life. You start turning pages. When I got out of school, I turned every page in Moody's 10,000-some pages twice, looking for companies. And you have to find them yourself. The world isn't going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time. The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Most of you don't look like you are overburdened with cash anyway. Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don't want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it.
[Becky - Does that mean you think we are through the roughest times? You had always kept the cash word around, too.]
We always keep enough cash around so I feel very comfortable and don't worry about sleeping at night. But it's not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. The worst -- the financial panic is behind us. The economic spillout which came to some extent from that financial panic is still with us. It will end. I don't know if it will end tomorrow or next week or next month. Or maybe a year. But it won't go on forever. And to sit around and try and pick the bottom, people were trying to do that last March and the bottom hadn't come in unemployment and the bottom hadn't come in business but the bottom had come in stocks. Don't pass up something that's attractive today because you think you will find something way more attractive tomorrow.
We have $16 billion in cash not because of any predictions [about a market decline], but because we can't find anything that makes us want to part with that cash. We're not positioning ourselves. We just try to do smart things every day, and if there's nothing smart, then we sit on cash.
What impacts have Graham/Dodd and Phil Fisher had on your investment philosophy? What percentage of your investment philosophy would you attribute to each of them?
Well, good things would have happened with following either party. Graham obviously had more influence on me than Phil. I worked for Ben, I went to school under him, and his three basic ideas: look at stocks as businesses; have a proper attitude toward the market; and operate with a margin of safety--they all come straight from Graham. Phil Fisher opened my eyes a little more toward trying to find a wonderful business. Charlie did more of that than Phil did, but Phil was espousing that entirely, and I read his books in the early 60s. Phil's still alive, and I owe Phil a lot, but Ben was one of a kind.
[Charlie Munger: Ben Graham was a truly formidable mind, and he also had a clarity in writing, and we talk over and over again about the power of a few simple ideas thoroughly assimilated, and that happened with Graham's ideas which came to me indirectly through Warren, but some also directly from Graham. The interesting thing for me is that Buffett the former protégé--by the way Buffett was the best student Graham had in 30 years of teaching at Columbia--became better than Graham. That's the natural outcome--as Milton said, "If I've seen a little farther than other men, it's by standing on the shoulders of giants." So, Warren stood on Ben's shoulders, but he ended up seeing more than Ben. No doubt somebody will come along and do a lot better than we have.]
I enjoyed making money more than Ben. With Ben it really was incidental, at least by the time I knew him. The process, the whole game, didn't interest him more than a dozen other things may have interested him. With me, I just find it interesting, and therefore I've spent a much higher percentage of my timing thinking about investing, and thinking about businesses. I probably know way more about businesses than Ben ever did. He had other things that interested him. I pursued the game quite a bit differently than he did, and therefore comparing the record is not proper.
Since Ben Graham isn't around anymore, what money managers do you respect today? Is there a Ben Graham today?
You don't need another Ben Graham. You don't need another Moses. There were only Ten Commandments; we're still waiting for the eleventh. His investing philosophy is still alive and well. There are disciples of him around, but all we are doing is parroting. I did read Phil Fisher later on, which showed the more qualitative aspects of businesses. Common stocks are part of a business. Markets are there to serve you, not to instruct you. You can often find a couple of companies that are out of line. Find one; get rich. Most people think that what the stock does from day to day contains information, but it doesn't. It isn't just something that wiggles around. The stock market is the best game in the world. You can take advantage of people who have no morals. High prices inside of a year will typically be 100% of the low price. Businesses don't change in value that much. That is simply crazy. There are extreme degrees of fluctuation, and Mr. Market will call out the prices. Wait until he is nutty in one direction or the other. Put in a margin of safety. Don't find a bridge that says no more than 10,000 pounds when you have a 9800 pound vehicle. It isn't a function of IQ, but receptivity of the mind.
When investing you don't have to invest in all 10,000 companies available, you just have to find the one that is out of line. Mr. Market is your servant. Mr. Market is your partner and wants to sell the business to you everyday. Some days he is very optimistic and wants a high price, others he is pessimistic and will sell at a low price. You have to use this to your advantage. The market is the greatest game in the world. There is nothing else that can, at times, get this far out of line with reality. For example, land usually only fluctuates within a 15% band. Negotiated transactions are less volatile. Some get this; others don't. Just keep your wits about you and you can make a lot of money in the market.
If you were to teach an investment course, besides works by Ben Graham and Phil Fisher and your book on the instalment basis, what would be on the syllabus?
[Q - how would you teach the next generation of investors?]
Buffett: I had 49 university groups, in clumps of six, [visit me] last year. [An education in] investing requires only two courses: How to Value a Business, and How to Think About Markets. You don’t have to know how to value all businesses. Start with a small circle of competence, things you can understand. [Look for] things that are selling for less than they’re worth. Forget about things you can’t understand. You need to understand accounting, which has enormous limitations. [You need to] understand when a competitive advantage is durable or fleeting. Learn that the market is there to serve you, not instruct you. In the investing business, if you have an IQ of 150, sell 30 points to someone else. You do not need to be a genius. You need to have emotional stability, inner peace and be able to think for yourself, [since] you’re subjected to all sorts of stimuli. It’s not a complicated game; you don’t need to understand math. It’s simple, but not easy.
Munger: Exactly half of future investors are going to be in the bottom 50%. There is so much that’s false and nutty in business schools. Reducing the nonsense would be a good goal.
Buffett: Emotional makeup is more important than technical skill.
Munger: Absolutely. If you think your IQ is 160 and it’s really 150, you’re a disaster.
Buffett: A student in one of the groups asked me, “What are we learning that’s wrong?”
Munger: How do you answer in only one hour? [laughter]
Buffett: [My experience] has given me a jaundiced view of academia generally. Efficient market theory—that everything is priced appropriately—is bunk. There’s a certain degree to which ideas that are nutty take hold and propagate. Max Planck [remarked about] the resistance of the human mind to new ideas: “Science advances one funeral at a time.”back to the questions.
What's the temperament of successful investors?
[Charlie Munger: I think there's something to be said for developing the disposition to own stocks without fretting.]
I think it's almost impossible to do well investing over time without this. If the market closed for years, we wouldn't care. Would still keep making Sees candy, Dilly bars, etc.
If you focus on the price, you're assuming that the market knows more than you do. That may be the truth, but in that case you shouldn't own it. The stock market is there to serve you, not to instruct you.
Focus on price and value. If a stock gets cheaper and you have some cash, buy more. We sometimes stop buying when prices goes up. This cost us $8 billion a few years ago when we were buying Wal-Mart. When we're buying something, we want the price to go down and down and down.
You don't have to be right on everything or 20%, 10%, or 5% of businesses. You only have to be right one or two times a year. I used to handicap horses. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn't do a very good job. You only have to be right a few times in your lifetime, as long as you don't make any big mistakes.
[Charlie Munger: What's funny is that most big investment organizations don't think like this. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach.]
Ted Williams, in his book The Science of Hitting, talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way.
[Charlie Munger: We read a lot. I don’t know anyone who’s wise who doesn’t read a lot. But that’s not enough: You have to have a temperament to grab ideas and do sensible things. Most people don’t grab the right ideas or don’t know what to do with them.]
The key is to have a “money mind,” which is not IQ, and then you have to have the right temperament. If you can’t control yourself, you’re going to have disasters. Charlie and I have seen it. The whole world in the late 1990s went a little mad in terms of investments. How could that happen? Don’t people learn? What we learn from history is that people don’t learn from history.["Grade yourself on your temperament. Temperament is the ability to not be swayed by the market. See what you are supposed to see." - UCLA Q&A]
Do you agree with Philip Fisher's two reasons to sell?
To sell the business is written in the ground rules. Never going to be a takeover or sell business because street thinks unfocused. I don't quite agree with Fisher, think can ride some stocks forever.
[Charlie Munger: Better off when you had 50 years ahead of you. Almost never sell operating businesses, and if we do, we do so because they can't fix their problem.]
[BRK2005 - We won’t sell a business just because it’s underperforming.]
What tells you when an investment has reached its full potential?
I don’t buy Coke with the idea it will be out of gas in 10 years or 50 years. There could be something that happens by I think the chances are almost nil. So what we really want to do is buy businesses that we would be happy to own forever. It is the same way I fell about people who buy Berkshire. I want people who buy Berkshire to plan to hold it forever. They may not for one reason or the other but I want them at the time they buy it to think they are buying a business they are going to want to own forever.
And I don’t say that is the only way to buy things. It is just the group to join me because I don’t want to have a changing group all the time. I measure Berkshire by how little activity there is in it. If I had a church and I was the preacher and half the congregation left every Sunday. I wouldn’t say, “It is marvelous to have all this liquidity among my members.”
Terrific turnover... I would rather go to church where all the seats are filled every Sunday by the same people. Well that is the way we look at the businesses we buy. We want to buy something virtually forever. And we can’t find a lot of those. And back when I started, I had way more ideas than money so I was just constantly having to sell what was the least attractive stock in order to buy something I just discovered that looked even cheaper. But that is not our problem really now. So we hope we are buying businesses that we are just as happy holding five years from now as now. And if we ever found a huge acquisition, then maybe we would have to sell something. Maybe to make that acquisition but that would be a very pleasant problem to have.
We never buy something with a price target in mind. We never buy something at 30 saying if it goes to 40 we’ll sell it or 50 or 60 or 100. We just don’t do it that way. Anymore than when we buy a private business like See’s Candy for $25 million. We don’t ever say if we ever get an offer of $50 million for this business we will sell it. That is not the way to look at a business.
The way to look at a business is this going to keep producing more and more money over time? And if the answer to that is yes, you don’t need to ask any more questions.
Could you explain more about the circle of competence?
We are best at evaluating businesses where we can come to a judgment that they will look a lot like they do now in five years. The businesses will change, but the fundamentals won’t. Iscar will be better – maybe a lot bigger – in five years, but the fundamentals will be the same. [In contrast,] look at how much telecom has changed.
Charlie says we have three boxes: In, Out and Too Hard. You don’t have to do everything well. At the Olympics, if you run the 100 meters well, you don’t have to do the shot put.
Tom Watson [the founder of IBM] said, “I’m no genius. I’m smart in spots and I stay around those spots.” We have a lot of managers who are the same. You don’t want to compete with Pete Liegl [the CEO of Forest River, Inc.] because he’ll kill you in the RV business. But he doesn’t try to tell us how to run the insurance business.
I was virtually there at the birth of Intel. I was on the board of Grinnell College with Bob Noyce [one of the founders of Intel] and Grinnell invested $300,000 into it at inception. [I easily could have as well, but] I had no idea then and still don’t now what Intel will look like in five years. Even people in the industry don’t. Some businesses are very, very hard to predict.
[Charlie Munger: A foreign correspondent, after talking to me for a while, once said: “You don’t seem smart enough to be so good at what you’re doing. Do you have an explanation?” [Laughter]]
Buffett: Was he referring to me or you? [Laughter]
[Charlie Munger: I said, “We know the edge of our competency better than most.” That’s a very worthwhile thing. It’s not a competency if you don’t know the edge of it.]
[BRK2007 - What makes the difference is whether the people running them know their strengths and weaknesses and play when it is to their advantage and do nothing when it is not.]back to the questions.
What two industries are the first you should learn when developing your circle of competence?
Look for simple businesses. If I gave you $10M to invest right now and you only had three weeks to spend it and you could only spend it in Omaha, you’d look for simple, understandable, strong businesses. You look at the Nebraska Furniture Mart (NFM). You wouldn’t look at the third best fast food chain. You might look at McDonald’s, because it is number one and will probably always been number one. They have share of mind. What about Oracle? Too hard. GM? Too hard. You can’t predict the future for these two companies. Too many variables.
Investment knowledge is cumulative, and things you learn will make you better in the future. Stick to things you understand. Mrs. B at NFM wouldn’t get paid in Berkshire stock. Why? She doesn’t know stocks, but she knows furniture down cold. How do you beat Bobby Fisher? Play him in anything except chess. Even young people have a circle of competence even if they don’t have their thoughts perfectly organized.
Is there a moral connection to who you invest in?
Charlie and I went to Memphis to look at a chewing tobacco company. In the end, we decided we didn’t want to own it. We would buy stock in a tobacco company, but we didn’t want to own it.
A good example is Charlie’s favorite company, Costco. They are the #3 distributor in the US of cigarettes, but you wouldn’t avoid buying it because of that. You’ll drive yourself crazy trying to keep track of these things. Our philosophy is that it’s impossible to grade marketable securities, but we’ll buy the stocks without any problems, but we just won’t be in certain businesses.
My view is that energy production should move to nuclear. It’s clean, cheap and safe. Coal emissions are bad for the environment; however it’s still a good company. It’s impossible to grade marketable securities on moral activity. Berkshire Hathaway has and will buy what trades, but will not buy companies that engage in certain behaviors. PetroChina owns 40% of the oil in the Sudan that is government owned. If they did not own it, someone else would. Also, you have to keep in mind, if PetroChina did not buy it its possible the Sudanese would own 100% of the oil rights and that’s not so good either.
I find it funny that people find time to protest PetroChina for ownership of the Sudanese oil, but with the $300 billion or so of imported goods from China, these same people don’t protest Chinese goods. They protest investment in Chinese companies though.
Who do you think will be one of the next greatest investors and are you partial to favoring someone with a similar investment style as yours?
We just finished looking for someone. The Board has 3 candidates to replace me as CEO and 4 candidates to replace me as investor. They are all doing fine where they are, but they would be willing to come over to Berkshire for less pay.
In 1969, I wound up my partnership and I had to help people find someone to manage their money. I recommended Bill Ruane of Sequoia Fund, Sandy Gottesman, who is currently on the board at Berkshire, and Walter Schloss, who I wrote about in “The Superinvestors of Graham and Dodds-ville”. There’s no way they could miss.
But I don’t know many of the newer investors, they’re not my contemporaries. It’s not enough to just look at track records. They aren’t predictive and there will always be a few people that do well. I know guys who can make 50% a year with $5 million, but not with $1 billion. The problem with guys that do well is they attract so much money that it neutralizes their advantage. It’s hard to identify them, and even harder to make a deal to keep them from attracting other capital. It’s like betting on a 12 year old horse that won at 3 years old. It’s also important to avoid managers who use leverage. It’s the reason that investors with 160 IQs flame out.
What do you think of discounted cash flow (DCF) models?
Buffett: All investing is laying out cash now to get some more back in the future. The concept of “a bird in the hand” came from Aesop in about 600 BC. He knew a lot, but not that [he lived in] 600 BC. He couldn’t know everything. [laughter] The question is, how many birds are in the bush? What is the discount rate? How confident are you that you’ll get [the bird]? Et cetera. That’s what we do. If you need to use a computer or calculator to figure it out, you shouldn’t [buy the investment]. Those types of [situations] fall into the “too-hard” bucket. It should be obvious. It should shout at you, without all the spreadsheets. We see something better.
Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.
Buffett: The priesthood has to look like they know more than “a bird in the hand.” You won’t get tenure if you say “a bird in the hand.” False precision is totally crazy. The markets saw it in the Long-Term Capital Management [hedge fund] in 1998. It only happens to people with high IQs. The markets of mid-September last year were [such that] you can’t calculate standard deviations. People’s actions don’t observe laws of math. It’s a terrible mistake to think higher math will take you a long way— you don’t need to understand it, [and] it may lead you down the wrong path.
Could you explain your opportunity cost decisions of the past year?
Buffett: Opportunity costs have been in the forefront of our minds during the last 18 months. It’s tougher to calibrate A, versus B, versus C in a fast-changing environment. Tougher and possibly more profitable. We got lots of calls [for potential investments]—most we ignored. We were called by Goldman Sachs on a Wednesday for $5 billion, and we [already] had a $5 billion commitment to Constellation Energy, $3 billion on Dow Chemical, $6.5 billion on the Wrigley Mars deal. We never want to get dependent on banks. It’s a good sign that we haven’t had the flurry [of phone calls] like last year. Normally, we would not have sold Johnson & Johnson if it were 10 – 15 points higher, [but we wanted to have a comfortable amount of cash on hand]. Our definition of comfortable is very comfortable.
[Comment: The real cost of any purchase isn’t the actual dollar cost. Rather, it’s the opportunity cost — the value of the investment you didn’t make, because you used your funds to buy something else.]
What are your views on diversification?
I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund, and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.
If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.
Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.
Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.
In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great.
The question is about diversification. I have a dual answer to that. If you are not a professional investor. If your goal is not to manage money to earn a significantly better return than the world, then I believe in extreme diversification. I believe 98% - 99% who invest should extensively diversify and not trade, so that leads them to an index fund type of decision with very low costs. All they are going to do is own part of America. And they have made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all. That is the way they should approach it unless they want to bring an intensity to the game to make a decision and start evaluating businesses. Once you are in the businesses of evaluating businesses and you decide that you are going to bring the effort and intensity and time involved to get that job done, then I think diversification is a terrible mistake to any degree. I got asked that question the other day at SunTrust. If you really know businesses, you probably shouldn’t own more than six of them.
If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don’t diversify personally. All the people I’ve known that have done well with the exception of Walter Schloss, Walter diversifies a lot. I call him Noah, he has two of everything.
[Q - How do you get confident enough with that [smaller] level of diversification?]
Warren Buffett: If we were running only our own money, putting 75% of our net worth in a single position is not a problem if it is something we really have high confidence in. Putting 500% or more of your net worth in a position is a problem. Several times I have had 75% of my non-Berkshire net worth in a situation. You will see things where it would be a mistake not to act. You won’t see them often, and the press and your friends won’t be talking about them. Wouldn’t you say, Charlie? 75% is not a real significant amount?
Charlie Munger: Sometimes, I have had more than 100% in an individual investment.
Warren Buffett: You just had a good banker. Look at LTCM — they put 25x their money in things that had to converge but couldn’t play out the hand. There are people in this room with more than 90% of their worth in Berkshire. I saw things in 2002 in junk bonds that would have been worth going heavily into. You could have bought Cap Cities in 1974 — selling for one-third the property value, with the best manager, and in a good business. You could have put 100% in Coca-Cola when we bought it and that wouldn’t have been a dangerous position.
Charlie Munger: Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the exact rule is the opposite. The ‘know-nothing’ investor should practice diversification, but it is crazy if you are an expert. The goal of investment is to find situations where it is safe not to diversify. If you only put 20% into the opportunity of a life-time, you are not being rational. Very seldom do we get to buy as much of any good idea as we would like to.
Would you consider spinning off some companies to realize value?
Buffett: We will not be spinning off any companies. We can’t wait to throw them [people who suggest spin offs] out of the office. We have a real advantage in allocating capital—moving money around. When we buy companies from people, we buy them for keeps. People can trust us to keep our word on this.
Munger: Wall Street sells that stuff [spin-offs] for fees. It doesn’t really do much for anyone. Short of some regulatory change, we’re unlikely to [spin something off].
Buffett: We have listened to presentation after presentation by investment bankers, but there is always a fee.
[Comment: A similar question was asked and addressed earlier in the meeting. Short of indefinite operating losses or intractable labor problems, Buffett is not going to spin-off subsidiaries like some poker player passing cards to his right in hopes of “realizing value,” when doing so would damage his reputation as a buyer (and keeper) of businesses.]
Why would you hold stocks forever, if the fundamentals change permanently? (Buy and hold)
Buffett: We don’t—we sell plenty. If we lose confidence or conditions change, we sell. When in doubt, we keep holding. But for [our wholly-owned] companies, we hold and won’t sell unless a company promises to lose money indefinitely, or there’s a labor problem. We buy for keeps and won’t sell, even if the offer is for more than [the company is] worth. If we were wrong, we sell. Last year, I sold a couple of billion dollars’ worth of Johnson & Johnson just to raise cash for other purposes—an unusual situation. Someone asked us earlier what we’d do differently if we owned the whole company [Berkshire]. The answer is: nothing. We run Berkshire as if we owned 100%. Our peculiarity is our commitment to buy for keeps. People who sell their businesses to Berkshire know we won’t hire some management consultant or leverage it up, and that’s a real advantage.
Munger: The Berkshire system has legs, as they say in show business.
Why do you think more people don't follow your advice?
The advice doesn’t promise enough...it’s not a “get rich quick” scheme, which is what a lot of other philosophies promise.
Why do you think that despite making your methods publicly available, that relatively few people have been able to emulate your success?
I asked Graham the same question. Everyone took his class at ColumbiaBusiness School. He used current examples, and by the end of the semester you would have a portfolio that would’ve made you money. Graham lived a life of sharing. He may have had more money hoarding, but lived happier because of it. The money’s just a figure in the paper, perhaps he would’ve died with 86 million instead of 42 million, but it doesn’t really matter. 90% of the people that took his class ended up doing something else.
At age 11 I started investing, purchasing three shares of Cities Service Preferred. I had read every book on investing in the Omaha library. I was really into charting and technical analysis. I loved it, but didn’t make any money from it. At 19 I read Graham’s “The Intelligent Investor” and it changed my world. Did Ben lose because I read his book? Maybe we competed and he made less money, but it didn’t matter to Graham.
The philosophy either takes immediately or it doesn’t at all. The reason gets down to temperament. People want to make money fast, but it doesn’t happen that way. Graham’s philosophy doesn’t promise enough for many people. You don’t know when it will happen, but you just wait for the fat pitches within your circle of competence. It’s not as exciting as guessing whether the stock price will go up the next day. Most investors in internet companies didn’t know the market cap. They were buying because they thought the stock would move, but if you asked them to write “I would buy XYZ company for $6 billion because”, they wouldn’t get halfway through the sentence. It’s the classic tortoise versus hare, bound to work over time. Charlie and I have educated competitors. Most don’t compete with us, though. It’s fine, we have more than enough money.
What have been your best investments ever?
See’s was very important to us to learn about [running a] business, and to provide cash for a lot of other things.
[Also,] buying the first half of GEICO for $40 million, given what we’ve gotten out of it and its future potential. (We later paid $2 billion for the 2nd half.) GEICO still has enormous possibilities for growth.
In the past I’ve touted the American Express card – well today, I’m going to tout the GEICO credit card. That being said, I advise you to pay off your credit card. It’s a terrible mistake to get hooked on revolving credit at high interest rates.
I met with 21 groups of students last year and what I tell them is, even if you don’t remember anything else I say, please don’t get hooked on credit card debt.
GEICO is a great, great business model, run by a superb person and businessman, Tony Nicely.
[Charlie Munger: The search expenses that brought us Ajit Jain – I cannot think of a better investment. This is a good life lesson: getting the right people into your system is the most important thing you can do.]
Could you give us your definition of stock market risk
We think first in terms of business risk. The key to Graham's approach to investing is not thinking of stocks as stocks or part of the stock market. Stocks are part of a business. People in this room own a piece of a business. If the business does well, they're going to do all right as long as long as they don't pay way too much to join in to that business. So we're thinking about business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature--there are just certain businesses that are very risky. Back when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial airplane as a sort of bet-your-company risk because you would shell out hundreds and hundreds of millions of dollars before you really had customers, and then if you had a problem with the plane, the company could go. There are certain businesses that inherently, because of long lead time, because of heavy capital investment, basically have a lot of risk. Commodity businesses have a lot of risk unless you're a low-cost producer, because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. We had fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren't the low-cost producers so it was a risky business. The guy who could sell it cheaper than we could made it risky for us. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself--whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market. The stock market is there to serve you and not to instruct you. That's a key to owning a good business and getting rid of the risk that would otherwise exist in the market.
You mention volatility--it doesn't make any difference to us whether the volatility of the stock market is a half a percentage of a point a day, or a quarter percent a day, or five percent a day. In fact, we'd probably make a lot more money if volatility was higher because it would create more mistakes in the market. Volatility is a huge plus to the real investor. Ben Graham used the example of Mr. Market. Ben said that just imagine that when you bought a stock you in effect bought into a business where you have this obliging partner who comes around every day and offers you a price at which he'll either buy or sell and that price is identical. No one ever gets that in a private business, where daily you get a buy-sell offer by a party. But you get that in the stock market, and that's a huge advantage. And it's a bigger advantage if this partner of yours is a heavy-drinking manic depressive. (laughter) The crazier he is, the more money you're going to make. So, as an investor, you love volatility. Not if you're on margin, but if you're an investor you're not on margin, and if you're an investor you love to get these wild swings because it means more things are going to get mispriced. Actually, volatility in recent years has dampened from what it used to be. It looks bigger because people think in terms of Dow points, but volatility was much higher many years ago than it is now. The amplitude of the swings used to be really wild and that gave you more opportunity. Charlie?
[Charlie Munger: Well it came to be that corporate finance departments at universities developed the notion of risk-adjusted returns. My best advice to all of you would be to totally ignore this development. Risk had a very good colloquial meaning, meaning a substantial chance that something could go horribly wrong, and the finance professors sort of got volatility mixed up with a bunch of foolish mathematics and to me it's less rational than what we do. And I don't think we're going to change.]
Finance departments believe that volatility equals risk. They want to measure risk, and they don't know how to do it, basically. So they said volatility measures risk. I've often used the example of the Washington Post's stock. When I first bought it in 1973 it had gone down almost 50%, from a valuation of the whole company of close to $170 million down to $80 million. Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for $80 million than if you bought it for $170 million. That's something I've thought about ever since they told me that 25 years ago and I still haven't figured it out. (laughter)
One key aspect to risk is how long you expect to hold an investment, i.e., stock in Coca Cola might be very risky if bought for a day trade or to hold for only a week. But, over a 5 or 10 year period it probably has almost no risk at all.
The myth that volatility of a stock somehow equates to risk was discussed. In fact, volatility often creates great opportunity, in Buffett's view. The following comments on risk in investments were in the 1993 Annual Report, on page 14:
"Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire's capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart- and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)
The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury".
Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong".
For owners of a business - and that's the way we think of shareholders - the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?
"We regard using [a stock's] volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. Some great businesses have very volatile returns -- for example, See's usually loses money in two quarters of each year -- and some terrible businesses can have steady results.
[Munger: "How can professors spread this? I've been waiting for this craziness to end for decades. It's been dented, but it's still out there."]
If someone starts talking to you about beta, zip up your pocketbook."
We think the best way to minimize risk is to think. Our default is [to have our capital] in short-term instruments and only do something when it makes sense.
Volatility does not measure risk. The problem is that the people who have written about and taught volatility do not understand risk. Beta is nice and mathematical, but it’s wrong. Past volatility does not determine risk.
Take farmland here in Nebraska: the price of land went from $2,000 to $600 per acre. The beta of farms went way up, so according to standard economic theory, I was taking more risk buying at $600. Most people would know that’s nonsense because farms aren’t traded. But stocks are traded and jiggle around and so people who study markets translate past volatility into all kinds of measures of risk. The whole concept of volatility is useful for people whose career is teaching, but useless to us.
Risk comes from the nature of certain kinds of businesses by the simple economics of the business, and from not knowing what you’re doing. If you understand the economics and you know the people, then you’re not taking much risk.
Munger: We’d argue that what’s taught is at least 50% twaddle, but these people have high IQs. We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them. [Laughter]
Buffett: We are willing to lose $6 billion in one catastrophe, but our insurance business over time is not very risky. If you own a roulette wheel, you sometimes have to pay 35-to-1, but that’s okay. We would love to own a lot of roulette wheels.
How much and how does risk factor into your investment decisions? Would you invest in emerging markets?
In general, emerging markets are not great for me because I need to put a lot of money to work. Risk does not equal beta. Risk comes around because you don’t understand things, not because of beta. There are normally 10 filters or so that I go through when I hear an idea. The first is can I understand the business and understand the downside not just today but five to ten years from now. There have been very few times that I’ve lost 1% of my net worth. I might be risk averse but I am not action adverse. Mrs. B saved $500 over the course of 16 years to start and build Nebraska Furniture Mart. Tom Watson Sr of IBM said, “I’m smart in spots and I stay in those spots.” I just stay within my circle of confidence. When I bought Nebraska Furniture Mart in 1983, Mrs. B took cash and not Berkshire stock. Why? She didn’t understand the value of stock. She understood cash and that is what she took. I need only need to be right a few times and can let thousands of ideas go by.
Ted Williams, who wrote the “Science of Hitting,” broke the strike zone into 92 ball shaped sections. He knew, if hit in his sweet spot, he’d hit 430, a little further out, and he’d hit 350. You have to know your sweet spot. The beautiful thing about investing is that it’s a “No called strike game” where unlike baseball the only strikes in investing are when you swing. I don’t have to swing.
When I do invest, I don’t care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2. Avoid debt. I decided early on that I never wanted to owe more than 25% of my net worth, and I haven’t… except for in the very beginning. I like to play from a position of strength. I always try to have the odds in my favor. When I go to Vegas, I don’t go around putting $5 dollars on the blackjack tables. If someone wants to come to my room and put $5 on my bed, well that’s fine. I like those odds better.
What do you think of setting an asset allocation?
We don’t hold any committee meetings. The business of saying you should have 50% in stocks, 30% in bonds…it’s nonsense.
The idea of recommending that assets should be split 60/40 [between stocks and bonds], and then have a big announcement that you’re moving to 65/35 is pure nonsense. It just doesn’t make any sense.
[Charlie Munger: Berkshire doesn’t do much conventional asset allocation. We just search for good opportunities and don’t want to put up artificial barriers. In this sense, we’re totally out of step with modern portfolio management, but we think they’re wrong.]
Well over 80% of our assets are in the U.S.
[Charlie Munger: When have you ever done a big asset allocation?]
Never. But if junk bonds had stayed low for longer, we could have invested $30 billion instead of $7 billion.
How often do you review each position in your portfolio?
Buffett: It breaks down into two periods of my life: when I had more ideas than money, I was constantly reviewing my portfolio, figuring out which stock to unload to buy a new one.
Today, I have more money than ideas so we aren’t really thinking of selling when the alternative is cash. But we’re always collecting information on every company we own – it is a continuous process, but not with the idea that daily, weekly or monthly activity will result.
If we needed money for a very big deal, $20-, $30- or $40-billion, and we had to sell $10 billion in equities, we’d use information we’ve been collecting daily to decide what to sell.
Munger: Even in Warren’s early days, he wasn’t thinking about his #1 choice [his single favorite stock] – he could put that aside [because he’d never sell it].
Buffett: We think about adding more to certain stocks and have done so. We add to ones that look attractive and that we can buy. If you look at the portfolio at the end of 2007 you’ll see that certain positions have been increased by billions of dollars. We like many of our positions and if they get cheap, we’ll buy more.
Sometimes there’s not enough stock or we might cross certain thresholds that cause reporting requirements or going above 10%, which triggers the short-swing rule.
Munger: It’s not as easy as it looks to buy these big positions. When we were buying Coca-Cola, we bought every share we could – we bought 30-40% of the volume, yet it still took us a long time to accumulate our position. However, we like it better when we have these problems now than when we didn’t earlier.
Buffett: We usually feel we can buy 20% of the daily volume and not move the market too much. That means if we want to buy $5 billion, we have to wait for $25 billion to trade and not a lot of stocks trade that much.
What are your expectations for future returns on stocks?
When I closed the Buffett Partnership, I felt (and wrote to my investors) that the prospective return was about the same for equities and municipal bonds over the next decade, and I was roughly right. It’s not the same today. I’d have 100% of bonds in short-term bonds. Forced to choose between owning the S&P 500 vs. 20-year bonds, I’d buy stocks – and it would not be a close decision. But I wouldn’t have an equity investment with someone who charged high fees.
We don’t have the faintest idea where the S&P or bonds will be in three years, but over 20 years we’d prefer to own stocks.
Munger: We think there will be a disruption not too many years ahead.
Buffett: Of course, you could have said that and have been right at any point in the past century – there are always disruptions – but stocks have still done well. We’d rather have good stocks than sit around and hope they get cheaper, so anytime we see something good, we buy, hopefully in size.
[Q - If you were to follow up on your Fortune article from 1999 about the lean and fat periods (Mr. Buffett on the Stock Market), what would you be writing? You talked about 17-year periods. How is it turning out now, since we’re halfway through the next one?]
There’s nothing magical about 17-year periods – I just had a little fun with it because there were two 17-year periods, and there are 17-year locusts.
In 1999, people were extrapolating from the experience of the previous 17 years and had unrealistic expectations. They were bound to be disappointed.
If I were writing something now, I’d say I’d have expectations beyond 4.75% – I don’t know how much more, but more for sure. I would not have high expectations for equities, but better than for bonds.
Munger: Since that article was written, the experience from owning equities has been pretty lean, so Warren’s been right so far and I suspect is right now to have modest expectations.
Buffett: It’s hard to be right every day or week or month – that’s what happens if you’re on TV too often. [Tilson - He mentioned 1974 and a few other years in which he made market predictions; I wrote a column about this in 1999, Buffett’s Prescient Market Calls, suggesting my readers heed Buffett’s warning in the Fortune article. Incidentally, Buffett’s Market Call #5 highlighted in my article proved to be particularly correct: from 1993-2002 the S&P 500 compounded at 9.4% annually, far less than the 16.1% of the 10 previous years]. But every now and then, things really get out of whack. But the gradations in between are too tough. If you own great businesses, you should just hold on most of the time, maybe sell if the valuations get extremely high and buy more if they get really cheap like in the early 1970s.
Do you expect the stock market premium to continue to be 6.5% over bonds?
I don't think that the stock market will return 6.5% over bonds in the future. Stocks usually yield a little more, but that isn't ordained. Every once in a while, stocks will get very cheap, but it isn't ordained in scripture that this is so. Risk premiums are mostly nonsense. The world isn't calculating risk premiums.
The best book prior to Graham was written by Edgar Lawrence Smith in 1924 called Common Stocks as Long Term Investments. It was a study that evaluated how bonds compared to stocks in various decades of the past. There weren't a whole lot of publicly traded companies back then. He thought he knew what he was going to find. He thought that he'd find that bonds outperformed stocks during periods of deflation, and stocks outperformed during inflationary times. But what he found was that stocks outperformed the bonds in nearly all cases. John M. Keynes then enumerated the reasons that this was so. He said that over time you have more capital working for you, and thus dividends would grow higher. This was novel information back then and investors then went crazy and started buying stocks for these higher returns. But then they started to get crazy, and no longer really applied the sound tactics that made the reasons given in the book true. Be careful that when you buy something for a sound reason, make sure that the reason stays sound.
If you buy GM, you need to write the price and the respective market valuation. Then write down why you are buying the business. If you can't, then you have no business doing it.
Quote from Ben Graham: “You can get in more trouble with a sound premise than an unsound premise because you'll just throw out the unsound premise”.
You have espoused a constant ROE on the stock market of about 13%, over time. Do you think that such an expectation is reasonable if you factor into equity and ROE the effect of stock options granted to managements? When option programs are present in a company, what do you think is a realistic way of valuing them on a cash basis?
The questioner is Jon Brandt, the son of a very good friend of mine for many years. Jon is referring to an article I wrote for Fortune in the 1970’s - and he’s also referring to the tremendous ROE shown on the S&P 500, which includes the effects of restructurings.
Even allowing for the effects of stock options, I have still been surprised by the returns on equity shown by the S&P 500. As for options, we look at what the value of average option issuance is going to be over the next five years and figure what they’d be worth as warrants to the [issuing] company. That’s what we use as a cost to shareholders.
This should be shown as an expense in the income statement. I think a number of auditors believed it should be a cost but their clients pressured them and caved, and then Congress got called in. I think it’s a scandal. Charlie?
[Munger: It’s fundamentally wrong not to have honest accounting. It’s wrong to have little corruptions, that later can become big corruptions. The accounting in America is corrupt. It is not a good idea to have corrupt accounting.
It’s like campaign reform. Once you get a number of players benefitting, it’s hard to get reform. It’s the same thing with options accounting. It would have been better to have reform a couple decades ago, when it wasn’t such a big thing.
That doesn’t mean that we’re against options. They could make sense here at some point, but not with Charlie and me.
[Charlie Munger: I don't know if we'll ever see stocks in general at mouthwatering levels that we saw in 1973-4 or 1982 even. I think there's a very excellent chance that neither Warren or I will see those opportunities again, but that's not all bad. We'll just keep plugging away.]
It's not out of [the realm of] possibility though. You can never predict what markets will do. In Japan, a 10 year bond is yielding 5/8 of 1%. [Who could have ever imagined that?]
[Charlie Munger: If that could happen in Japan, something much less bad could happen in the US. We could be in for a period in which the average fancy paid investment advisor just won't do very well.]
Chaotic markets might not be good for society, but create opportunities for us.
There were some great opportunities in junk bonds last year and we invested in a few. But money is pouring into junk bonds right now, $1 billion per week. The world hasn't changed that much.
Do you think investors expect too much?
The problem is the starting point in predicting modest returns for equity investors. [Expectations were too high.] In 1999, a Gallup poll showed people expected 15% [returns from stocks] in a low inflation environment. In a low inflation environment, how much will GDP grow? If there's 2% inflation and 3% [real] growth, that's 5%. This will be the rate of corporate growth, so if you add dividends, you get 6-7% [annualized returns] before frictional costs -- and investors incur high frictional costs (they don't have to, but they do) -- which adds up to 1.5%. [This 4.5-5.5% is] not bad.
[Charlie Munger: My attitude is slightly more negative than Warren's.]
It [6-7% growth] is not the end of the world. If we get 5-6% of the pie -- those of us who put our capital out -- I don't know if it's exactly what someone who designed the universe would come up with, but I don't think that's crazy in either direction. It provides a pretty decent real return in a period of low inflation. If you get high inflation, you could get very low real returns, even negative.
[Charlie Munger: I don't you'll get real help from me or from economists either. If an economist saw a job going to China, he doesn't care -- it saves costs. But if all the jobs go to China, what then? People actually get paid to say things like this.]
Maybe we should export all economists to China.
[Re: NYSE’s Merger with Archipelago]
I personally think it would be better if the NYSE remained as a neutral, not-for-big-profit institution. The exchange has done a very good job over the centuries. It’s one of the most important institutions in the world.
The enemy of investment success is activity. The exchange of yesterday will be better for the American investor. I know the American investor will not be better off if volume doubles on the NYSE, and I know the NYSE will be trying to figure out how to do that if it is trying to maximize its own earnings per share.
Trading is the frictional cost of capitalism. GM or IBM will not earn more money if their stock turns over more actively, but a for-profit NYSE will.
[Charlie Munger: I feel the same, only more strongly. I think we have lost our way when people like the [board of] governors and the CEO of the NYSE fail to realize they have a duty to the rest of us to act as exemplars. I don’t think you want to turn the stock exchange of the country into an even larger casino than it is already.
You do not want your first-grade school teacher to be fornicating on the floor or drinking booze in the classroom; similarly you do not want your stock exchange to be setting the wrong moral example. I am appalled.]
I wish I’d gone to first grade where he did. (Laughter)
What's your investment hurdle rate?
10% is the figure we quit on -- we don't want to buy equities when the real return we expect is less than 10%, whether interest rates are 6% or 1%. It's arbitrary. 10% is not that great after tax.
[Charlie Munger: We're guessing at our future opportunity cost. Warren is guessing that he'll have the opportunity to put capital out at high rates of return, so he's not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we'd change. Our hurdles reflect our estimate of future opportunity costs.]
We could take the $16 billion we have in cash earning 1.5% and invest it in 20-year bonds earning 5% and increase our current earnings a lot, but we're betting that we can find a good place to invest this cash and don't want to take the risk of principal loss of long-term bonds [if interest rates rise, the value of 20-year bonds will decline].
Do you prefer public or private investments?
Berkshire has previously said that they would prefer more private investments but have trouble finding suitable ones. At the present time, the public market offers more opportunity. There are very few good private situations around and those that are available tend to be overpriced. Berkshire has a billion dollars in cash at present.
Buffett says there is more possibility of significant "mispricing" in the public stock market. This is because emotion plays a larger role in the public market, and the very superficial knowledge with which most investors operate. Owners of significant private business on the other hand, tend to have a much better idea of what their businesses are really worth.
There is very tough competition currently for the few good private businesses of decent size from: MBO funds or LBO funds. Typically these funds are run by people using other people's capital; they benefit from upside but don't suffer as much from downside since it is not their money that is at stake. Therefore, they are less worried about overpaying for a business
Other public companies. They don't mind overpaying; management of these types of companies are often more focused on size, than on return on investment and often are not big shareholders. These types of buyers don't mind issuing new stock in payment, whereas Berkshire doesn't like to issue new common stock.
Buffett definitely feels that the "stock market is far less efficient than the private market".
Investors eventually repeat their mistakes. How can you prevent this--through fast growth or safety?
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety in terms of driving only drive a 4,000 pound truck across. It depends on the nature of the underlying risk. We don't get the margin of safety now that we got in the 1970s.
The best thing is to learn from other guys' mistakes. Patton used to say, "It's an honor to die for your country; make sure the other guy gets the honor." There are a lot of mistakes that I've repeated. The biggest one, the biggest category over time, is being reluctant to pay up a little for a business that I knew was really outstanding. The cost of that I think is in the billions, and I'll probably keep making that mistake. The mistakes are made when there are businesses you can understand and that are attractive and you don't do something about them. I don't worry at all about the mistakes that come about like when I met Bill Gates and didn't buy Microsoft or something like that. Most of our mistakes have been mistakes of omission rather than commission.
Why do large caps outperform small caps?
We don't care if a company is large cap, small cap, middle cap, micro cap. It doesn't make any difference. The only questions that matter to us:
From my personal standpoint running Berkshire now because we got, pro forma for Gen. Re, $75 to $80 billion to invest in and I only want to invest in five things, so I am really limited to very big companies. But if I were investing $100,000, I wouldn't care whether something was large cap or small cap or anything. I would just look for businesses I understood.
Now, I think, on balance, large cap companies as businesses have done extraordinarily well the last ten years--way better than people anticipated they would do. You really have American businesses earning close to something 20% on equity. And that is something nobody dreamed of and that is being produced by very large companies in aggregate. So you have had this huge revaluation upwards because of lower interest rates and much higher returns on capital. If America business is really a disguised bond that earns 20%, a 20% coupon it is much better than a bond with a 13% coupon. And that has happened with big companies in recent years, whether it is permanent or not is another question. I am skeptical of that. I wouldn't even think about it--except for questions of how much money we run--I wouldn't even think about the size of the business. See's Candy was a $25 million business when we bought it. If I can find one now, as big as we are, I would love to buy it. It is the certainty of it that counts.
What is the definition of Value vs. Growth stocks?
No two distinct categories of business. PV of cash a company generates is what the business is worth. No distinction in our mind between growth & value. All decision you decide how much value you are going to get. When we buy a stock we think of it in terms of buying the whole enterprise.
Aesop's wrote the first investment primer "A bird in the hand (Lay out cash today) is worth two in the bush". Esop forgot to say when you get the two in the bush and what the interest rate was. People associate growth with the birds in the bush but they still have to figure out when they get the birds. People often are not thinking of the mathematics implicit in what they are doing.
[Charlie Munger: All intelligent investing is value investing; then acquire more than you are paying for. Investing is where you find a few great companies and then sit on your ass.]
From the partnership letters in 1964, you had a strategy called ‘generals relatively undervalued.’ We have recently begun to implement a technique where we buy something at 12x, when comps sell at 20x. Comps go to 10x. Is this pair trading?
Yes, we didn’t know we started so early. Ben Graham did it in 1920. He did pair trading. He was right 4 out of 5, but the last one would kill him. We shorted the market to some degree. We would borrow stocks from universities. We were early in this. We wouldn’t short a stock because it was unattractive but as a general market short [hedge]. I would borrow from the Treasurer of Columbia [University], “which ones do you want”, “just give me all of them”. It provoked some odd looks when I told the universities I wanted to short all of their stocks. It was not a big deal. We might have made a little money on it in the 1960s, but it is not something we do these days. If you have good long ideas on businesses that are undervalued, it is not necessary to short. 130/30 [simultaneously holding a 130% exposure to a long portfolio; and a 30% exposure to a short portfolio] is being marketed today. Many will sell you the idea of the day. No great statistical merit.
Charlie Munger: We made our money by being long wonderful businesses, not by using a long-short strategy.
Importance of filtering out the noise?
[Charlie Munger: Part of [having uncommon sense] is being able to tune out folly, as opposed to recognizing wisdom. If you bat away many things, you don’t clutter yourself.]
People get frustrated because they start to pitch something to us and when they get halfway through the first sentence, we say we’re not interested. We don’t waste a lot of time on bad ideas.
When humans compete against computers in chess, how can human compete? The human eliminates 99% of possibilities without even thinking about it – they get right down to few possibilities that have any chance of success. They get rid of the nonsense.
When people call you with bad idea, don’t be polite and waste 10 minutes.
What is the benefit of being an out-of-towner as opposed to being on Wall Street?
I worked on Wall Street for a couple of years and I have my best friends on both coasts. I like seeing them. I get ideas when I go there. But the best way to think about investments is to be in a room with no one else and just think. And if that doesn’t work, nothing else is going to work. The disadvantage of being in any type of market environment like Wall Street in the extreme is that you get over-stimulated. You think you have to do something every day. The Chandler family paid $2,000 for this company (Coke). You don’t have to do much else if you pick one of those. And the trick then is not to do anything else. Even not to sell at 1919, which the family did later on. So what you are looking for is some way to get one good idea a year. And then ride it to its full potential and that is very hard to do in an environment where people are shouting prices back and forth every five minutes and shoving reports in front of your nose and all that. Wall Street makes its money on activity. You make your money on inactivity.
If everyone in this room trades their portfolio around every day with every other person, you will all end up broke. And the intermediary will end up with all the money. If you all own stock in a group of average businesses and just sit here for the next 50 years, you will end up with a fair amount of money and your broker will be broke. He is like the Doctor who gets paid on how often to get you to change pills. If he gave you one pill that cures you the rest of your life, he would make one sale, one transaction and that is it. But if he can convince you that changing pills every day is the way to great health, it will be great for him and the prescriptionists. You won’t be any healthier and you will be a lot worse off financially. You want to stay away from any environment that stimulates activity. And Wall Street would have the effective of doing that.
When I went back to Omaha, I would go back with a whole list of companies I wanted to check out and I would get my money’s worth out of those trips, but then I would go back to Omaha and think about it.
There is always mention that some of your success could be attributed to not buying in to the Wall Street mania b/c you are in Omaha—what importance do you give to balance as it pertains to work and life and what do you do to maintain your appropriate balance?
I have so much fun that it’s not work. I get to do what I want, where I want – on a boat, wherever. My wife was responsible for bringing up the children. Neither of us had problems with that arrangement, and it made sense from an Adam Smith “division of labor” perspective. It will be a much tougher choice for women, and always be somewhat unequal. In my own life I did virtually no social functions or meetings that I didn’t want to do. In my adult business life I have never had to make a choice of trading between professional and personal. I have simple pleasures. I play bridge online for 12 hours a week. Bill and I play, he’s “chalengr” and I’m “tbone”.
After a talk at Harvard, I told them to work for who they admired the most, so they all become self-employed. It’s important to go to work for someone or some organization you admire. I’ve not seen many males having to make tough choices. But women are the ones who have tough situations.
There are a record number of ‘value’ investors here this year. Are there fewer $100 bills? Should I go to run a business instead of being a value fund manager?
Warren Buffett: There will always $100 bills, but less at times. There are always conflicts. Asset gathering can be more important than asset managing. There will always be opportunities to outperform. People still make the same mistakes. Charlie has a company called the Daily Journal Company. I own 100 shares. I got their annual report, and in fiscal year 2009, they bought $15m of stock, and it is now worth $45m. They sat on cash for a long time, but opportunities come around. You have to be prepared to grab them. Definitely it is possible with moderate amounts of money. Charlie will be more pessimistic.
Charlie Munger: Take the high road, it is far less crowded.
Warren Buffett: Those who take the high road in Washington are seldom bothered with traffic.
Warren Buffett: Money management – it is easy to scale up. It would have been harder for me to work as a plant manager. I wouldn’t want to become superintendent right about the time they are going to give me a gold watch.
Do you ever change your investing standards?
Did we change our standards? You know, I don’t think so, but you can’t be 100% sure. If you haven’t had a date for a month, you might say you wouldn’t have dated that girl on the first day – but I think we would have.
It does not reflect our giving up on finding an elephant of a business to acquire. We have plenty of cash and could sell stocks if we really needed to. We’re well prepared to acquire a very large business.
We acquired TTI in the first quarter, which is a terrific business. We wish it were five times bigger, but maybe some day it will be.
Munger: The one thing I think we can promise you is that we won’t make the kinds of returns buying the things we are now that we earned on the stuff we bought 10-15 years ago. There’s just too much money floating around.
Buffett: We won’t come close.
Munger: It’s a different world with more modest expectations.
Buffett: We hope you share them.
Have there been instances in your career where you have been tempted to deviate from your strategy and if so, how did you handle that?
I’m not that type. I’m not disciplined. [BRK2003 - I'd feel more qualified to talk about self-discipline if I weighed about 20 pounds less.] I just naturally want to do things that make sense. In my personal life too, I don’t care what other rich people are doing. I don’t want a 405 foot boat just because someone else has a 400 foot boat. Some of my friends have big boats where 55 people are serving 14. Of those 55, some will be stealing from you, some will be sleeping with each other, and I just don’t want to deal with that. My friends have the boats, so I’m the ultimate freeloader. I don’t need multiple houses. If I wanted to do something wild & crazy I could do it, but Anna Nicole Smith is gone. Reminds me of the story of the 60 year old man that got a 25 year old to marry him. When his friends asked how he did it, he replied, “I told her I was 90.”
When did you know you were rich?
I really knew I was rich when I had $10,000. I knew along time ago that I was going to be doing something I loved doing with people that I loved doing it with. In 1958, I had my dad take me out of the will, as I knew I would be rich anyway. I let my two sisters have all the estate.
I bet we all in this room live about the same. We eat about the same and sleep about the same. We pretty much drive a car for 10 years. All this stuff doesn't make it any different. I will watch the Super Bowl on a big screen television just like you. We are living the same life. I have two luxuries: I get to do what I want to do every day and I get to travel a lot faster than you.
You should do the job you love whether or not you are getting paid for it. Do the job you love. Know that the money will follow. I travel distances better than you do. The plane is nicer. But that is about the only thing that I do a whole lot different.
I didn't know my salary when I went to work for Graham until I got his first paycheck. Do what you love and don't even think about the money. I will take a trip on Paul Allen's Octopus ($400M yacht), but wouldn't want one for myself. A 60 man crew is needed. They could be stealing, sleeping with each other, etc. Professional sports teams are a hassle, especially when you have as much money as him. Fans would complain that you aren't spending enough when the team loses.
If there is a place that is warm in the winter and cool in the summer, and you do what you love doing, you will do fine. You're rich if you are working around people you like. You will make money if you are energetic and intelligent. This society lets smart people with drive earn a very good living. You will be no exception.
How important is conviction in investing?
You didn’t have to have a high IQ or a lot of investment smarts to buy junk bonds in 2002, or certain other things after Long-Term Capital Management blew up. You just had to have the courage of your convictions and the willingness to act when everyone else was terrified and paralyzed. The lesson of following logic rather than emotion is obvious, but some people can follow it and some can’t.
[Charlie Munger: When we were young, there weren’t very many smart people in the investment world. You should have seen the people in the bank trust departments. Now, there are armies of smart people at private investment funds, etc. If there were a crisis now, there would be a lot more people with a lot of money ready to take advantage.]
But in 2002, there were all these people with lots of money [and the opportunities were still there].
[Charlie Munger: When you have a huge convulsion, like a fire in this auditorium right now, you do get a lot of weird behavior. If you can be wise [during such times, you’ll profit].]
Three years ago, you could find a number of companies in [South] Korea with strong balance sheets trading at three times earnings.
[Charlie Munger: But there was a huge convulsion there.] Buffett: But that was 4-5 years ago. It had already passed.
[Charlie Munger: You couldn’t name 20 more examples like it. [e.g., there are only a few examples in recent times of such weird behavior leading to huge, obvious bargains in entire asset classes.]]
Even if I could, I wouldn’t! [Laughter]
How do you avoid misjudgement?
WB said repeatedly that it doesn’t take above a 125 IQ to do this...in fact, IQ over this amount is pretty much wasted. It’s not really about IQ. - Staying within circle of competence is paramount - When you are within the circle, keep these things in mind:
[Avoiding Mental Mistakes]
The first step is to recognize the traps. Charlie, in Poor Charlie’s Almanack, talks about various traps, so read that book.
Our personalities are such that we’re probably less prone to falling into these traps, but it still happens – just less than before.
[Charlie Munger: You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.]
It reminds me of the story about the two guys being chased by the bear and one guy says to the other, “I don’t have to outrun the bear. I just have to outrun you!” (Laughter)
[Charlie Munger: Peter Kaufman did it. He came up with the idea and Warren got excited about it. It’s a ridiculous name [the title]. (Laughter)
If you assimilate everything that’s in that simple book, you’ll be far ahead in the game.]
It’s a sensational book. You’ll learn a whole lot about life – and making money.
How do you improve independent thinking?
Good question. Very tough. Right now, I would pay a hundred-thousand dollars for 10 percent of the future earnings of any of you. So, if anyone wants to see me after this is over. If that’s true, you’re a million dollar asset right now, right? If ten percent of you is worth a hundred-thousand? You could improve on that, many of you, and I certainly could have when I got out, just in terms of learning communication skills.
It’s not something that’s taught, I actually went to a Dale Carnegie course later on in terms of public speaking. But if you improve your value 50 percent by having better communication skills, it’s another 500-thousand dollars in terms of capital value. See me after the class and I’ll pay you 150-thousand. You can dramatically increase your value by improving oral and written communication skills.
When we were viewed as out of step a few years ago, I didn't care as long as I felt okay about how Berkshire was doing.
What are the key traits needed to correct the crowd mentality?
Charlie Munger: He wants to know how to become less like a lemming.
Warren Buffett: I started investing when I was 11. I believe in reading everything in sight. I wandered around for 8 years with technical analysis. I read The Intelligent Investor, chapters 8 and 20 I recommend the most, and if you absorb it you won’t be a lemming. I read it early in 1950, and I think it’s as good a book now as then. You can’t get a bad result if you follow it. The Intelligent Investor has three big lessons:
Don't you have a lot of competition to buy great businesses? For example, from private equity funds?
You are absolutely correct that the private equity funds are a form of competition for Berkshire. Stocks sometimes trade well below intrinsic value, but businesses are sold in a negotiated transaction, so pricing doesn’t get as extreme. But our strong preference is to buy entire businesses at a fair price rather than stocks, even if stocks [can be acquired] a bit cheaper.
If someone wants what we are offering, we are pretty much one-of-a-kind. People can sell their company to us, yet continue to run it as they please as long as they want. So, if someone needs liquidity for tax or inheritance or other reasons, but doesn’t want to auction their business off like a piece of meat, they can come to us and they know they’ll get the response they want. We don’t get super bargains this way, but it allows us to put money to work at a sensible price.
Acquisitions don’t come along every day.
If I owned a business that my father had started and wanted to monetize it, I would sell to Berkshire because I wouldn’t want to split it up to auction it off, just as it would be silly to auction your daughter off to the man who bids the most.
There is no-one else who can make the promises we can make [not to ever sell the acquired company]. Most big companies can’t do that because what if the board decides it wants a pure play? I tell sellers that I’m the only one who can double cross you – nobody else can. We don’t have consultants or Wall Street advisors.
But, yes, we do have a lot of competition.
[Charlie Munger: We’ve had private equity competitors for a long time, but one way or another we’ve managed to buy quite a few things.]
We are positioned very badly in terms of buying businesses. Berkshire will not do as well as long as this persists.
[Charlie Munger: A lot of buying is fee motivated. Managers want to earn the extra fees on the extra assets. I have a friend who buys warehouses, but he stopped bidding recently because he’s always being outbid. Howard Marks sent a lot of money back to investors, which is the right way to behave [I assume he’s referring to one of the Principals of Oaktree Capital Management]]
Five or six years ago, I got a call from a well-known investor who asked me a lot of questions about reinsurance. He didn’t know much about the business, but he was considering buying a reinsurance company because, as he explained to me, he would have to send his investors’ money back to them if he didn’t invest it in the next few months, and he was earning 2% [annually] on it.
We [unlike this gentleman] have all of our net worth on the downside as well. If we have 2 and 20 [2% management fee and a 20% performance allocation] on the upside and nothing but a goodbye kiss on the downside...
The competition right now is tough, so our efforts to buy businesses are likely to be futile. But there are 1-2 deals we might get done...
[Charlie Munger: I don’t think there’s any business that we’ve bought that would have sold itself to a hedge fund. There’s a class of businesses that doesn’t want to deal with private-equity and hedge funds...thank God. (Laughter)]
We don’t see any deals [recently] that we wish we’d made – this wasn’t true in the past – even if the price had been 10% lower. We’re in a different world right now.
There’s no doubt that there’s far more money looking a deals now than in the past. They’re willing to pay up to buy good but mundane businesses that we’ve historically bought and had success with. Now it’s not just private equity funds getting in – hedge funds are too.
There’s been a bit of a change in the past few weeks, as it’s gotten a little harder to borrow money, but overall, we can’t compete, which makes us feel distress.
But it won’t go on forever. In the near term, we are not positioned favorably at all, but you’d be amazed at just how fast things can change. Things happen to change the landscape. At least three times in my career, there’s been so much money sloshing around. It was so bad in 1969 that I closed my partnership. But only four years later, it was the best time to be a buyer in my entire life.
[Re: Closed-End Funds]
History shows that over time, almost all closed-end funds go to discounts. Initially, if they’re sold with a 6% commission, the initial people only get 94 cents on the dollar. If I could buy an open fund at X or a closed-end fund at 120% of X, then you’d have to convince me that the management is something special to buy the closed-end fund.
Occasionally, Charlie and I have seen closed-end funds that trade at a premium for a long time. Eventually they will come back down to earth.
[Q - Is the private-equity boom a bubble?]
We’re competing with those people, so I started to cry, thinking about the difficulty of finding things to buy.
Due to the nature of private equity, it’s not a bubble that will burst. They lock up their money for 5-10 years and buy businesses that don’t price daily. It takes many years for the score to be put on the board and the investors can’t leave. It’s not like leverage in marketable securities.
What would slow it down is if the spread between high-yield bonds and safe bonds widens. This would slow down deals, but won’t cause investors to get their money back.
There’s another factor: if you have a $20 billion fund and get a 2% fee, you’re getting $400M a year. But you can’t raise another fund with a straight face until you’ve invested it, so there’s a great compulsion to invest it quickly so you can raise another fund and get more fees.
We can’t compete against these buyers. We buy forever and it’s our own money. I think it will be quite some time before disillusion sets in [among the investors in private-equity funds].
Munger: It can continue to go on for a long time after you’re in a state of total revulsion. [Laugher]
Buffett: The voice of total optimism has spoken. [More laughter]
How do you learn who to trust and who not to trust?
I get letters all the time from people who have been taken advantage of in financial transactions. It’s sad. A lot isn’t fraud – just the frictional costs and the baloney. Charlie and I have had very good luck buying businesses and putting our trust in people – it’s been overwhelmingly good, but we filter out a lot of people. People give themselves away and maybe it’s an advantage being around awhile and seeing how people give themselves away by what they talk about and what’s important and not important to them. We’ve had a batting average I wouldn’t have thought we’d have. We haven’t batted 100%, but it’s above 90%.
Munger: We’re deeply suspicious if the proposition sounds too good to be true. I recall a deal that was pitched to us by someone who said the company only wrote fire insurance on concrete bridges covered by water. It’s like taking candy from a baby. [Laughter] We stay away from businesses like that.
Buffett: When they make certain kinds of comments, what they laugh about, if they say “it’s so easy.” It’s not so easy. We rule out people 90% of the time. Maybe we’re wrong sometimes, but what’s important is the ones we let in. In the 1970s when I referred my clients to three people [as he closed down the Buffett Partnership], when I thought who they should turn over 100% of their money to, there were hundreds of people with great records. I recommended Charlie, Sandy Gottesman and Bill Ruane. I couldn’t have told you which of the three would be the best, but the one thing I was sure of was that they were going to be sensational stewards of money and do what was right for clients rather then try to make 2x in commissions in a given year. Anytime someone who takes what I think is an unfair fee structure because they can get it, I rule them out.
What's your philosophy on partnering with others?
We normally don’t want to do deals with partners. If we like a deal, we want to do it all. We have a lot of money, so we don’t need a money partner. As for a knowledge partner, we don’t want to do a deal where we’re relying on someone else. We’ve made a few exceptions, but very few. Charlie, can you think of any?
Munger: You did something with Leucadia, but they brought us the deal. [Click here for an article about this deal.]
Buffett: That’s right. They were great. But they invited us to participate in their deal. We came in on the same terms they had. In general, we don’t partner with others on deals, but I’d do another deal with Leucadia if they came to me and I liked the deal. That was a very good experience.
We know that you are a big bridge player. Do you think that bridge correlates to investing? Are there any traits or characteristics that might carry over from one to the other?
Bridge is the best game there is. You’re drawing inferences from every bid and play of a card, and every card that is or isn’t played. It teaches you about partnership and other human skills. In bridge, you draw inferences from everything and that carries over well into investing. In bridge, similar to in life, you’ll never get the same hand twice but the past does have a meaning. The past does not make the future definitive but you can draw from those experiences. I think the partnership aspect of bridge is a great lesson for life. If I’m going into battle, I want to partner with the best. I was playing with a world champion and we were playing against my sister and her husband. We lost, so I took the scorepad and I ate it.
© 1996- The Buffett