(Notes Taken by Professors David Kass and Sarah Kroncke, Department of Finance, Robert H. Smith School of Business, University of Maryland)
Dr. David Kass with Warren Buffett
Warren Buffett (WB) met with 20 MBA students from each of eight universities, including the University of Maryland, on March 11, 2011. He began his two-hour Q & A session by mentioning that he would answer questions on any topic except what Berkshire is planning to buy or sell. He further stated that he tapes his mouth shut at night so he would not say what to buy or sell in his sleep. The MBA students asked 21 questions in the following order:
(1) Do you believe that Africa will be the major driver of world growth in the years ahead?
WB: China will be a bigger driver of growth in the next 10-20 years. They are growing from a smaller base than that of the U.S. The U.S. and the rest of the world will be growing rapidly as well. The U.S. can’t grow as fast as China on a per capita basis. People are becoming more productive, so output per capita will increase. The question is how will this output get distributed.
(2) Can you explain your philosophy of not splitting your stock?
WB: Berkshire wants to attract shareholders who focus on long run earnings. Investors should not buy a stock just for a split. In the mid-1990’s Berkshire effectively split its stock by issuing class B shares to thwart someone who was planning to sell unit trusts in Berkshire that was tax inefficient. Many people who would have bought shares in that unit trust would have sold at a loss and been upset with Berkshire. Berkshire did split its B shares in February 2010 when it acquired Burlington Northern (BNI) in order to offer BNI shareholders holding less than $3,000 of stock the opportunity to participate in a tax free deal. Berkshire does not want to attract shareholders who are focused on next quarter’s earnings or stock splits. A company’s value is the same regardless of how many pieces you slice it into. Berkshire measures its success over time by how little turnover there is in its shares.
(3) If you were to meet Benjamin Graham tomorrow, what would be your critiques, or what things did he get wrong?
MBA student trip to see Warren Buffett, March 2011
WB: Read every book on investing in the library by the time he was 11 and bought his first stock. Read the Intelligent Investor in 1949 or 1950 when it was published. There is nothing in the book that needs to be changed. Its main principles are: (1) margin of safety, (2) buying dollar bills at a discount, and (3) awareness of the inability to predict the future. In 1970 or 1971 Benjamin Graham, who was ill, asked him to revise the book. He may have added something about inflation, but the fundamentals have remained the same for himself and Charlie (Munger).
(4) Looking back at the financial crisis, did you learn anything that you didn’t know before?
WB: Learned how bad things could get. Knew there was a housing bubble, but surprised by the speed at which it spread, the way the dominoes toppled, and the need for the government to act. In September, when Lehman went down, that Sunday, if Ken Lewis (Bank of America) had not bought Merrill Lynch (ML), ML would have gone down on Monday. Everyone was terrified. No one trusted anyone else or even placing their money under a mattress. Berkshire sold a $5 million Treasury Bill in December 2008, due in April 2009, for $5,000,070. The purchaser would get back $5 million at maturity and earn a negative return (losing $70). People didn’t trust each other. Banks didn’t trust each other. Bernanke, Paulson, and Geithner understood that speed was needed. President Bush said the most important 10 words in economic history: “If money doesn’t loosen up, this sucker is going down”. He backed up Paulson. There are certain chairmen, presidents, and Treasury secretaries that might have frozen. If anyone had frozen for a few weeks, it would have been too late. Congress did not get it at first. When they initially voted down TARP, the Dow Jones Industrial Average tumbled 750 points that day, coming close to a financial Armageddon. This was potentially a lot more serious than the 1930’s, although there was a worse social impact at that time. After Lehman failed, money market funds held $3.5 trillion which was equal to one-half domestic deposits at banks. In three days, $175 billion (or 5% of money market funds) was removed from money market accounts. To whom would these funds liquidate assets (commercial paper)? Only the government could have stepped in, which it did. At that time Berkshire had already committed to come up with $6.6 billion to assist Mars in its purchase of Wrigley. He has never seen a panic period like this one. One should buy what you can pay for. If you are smart you do not need to borrow. If you are dumb, you do not know what to do with the amount you borrow.
(5) Does the U.S. have a sustainable competitive advantage versus the emerging countries?
WB: In the 1920’s 32% of Americans worked on farms. Today, that number is 3%. In the 1980’s Americans thought that Germany and Japan would dominate the world’s economies. However, over the next decade the U.S. created 20 million jobs. We have a system that works and encourages creativity. Since 1995, the Internet has changed the world.
(6) Question about WB convincing 60 billionaires to contribute a large percentage of their wealth to charities such as the Bill and Melinda Gates Foundation.
WB: What the billionaires have pledged to give away will not hurt them (lower their standard of living). WB is giving away 99% of his wealth and it leaves him with enough. Would rather that his wealth wipe out malaria over time rather than build the world’s biggest tomb, or buy ten 747’s. The middle class is the most philanthropic class in the world, contributing 2% of GDP to charity.
(7) In the past you have said your investment philosophy was 85% Graham and 15% Fisher. Has that changed?
WB: Started out looking for cigar butts with one puff left. There were lots available in the 1950’s. That approach does not work well with large amounts of money to invest. His philosophy has shifted slightly more toward Fisher. Berkshire currently has $150 billion in cash and investments. He met Charlie Munger in 1959 who argued for investing in wonderful businesses and sit with them as they get better over time. In 1951 WB picked up the Moody’s Manual for that year and found Western Insurance selling at ½ times earnings. A few years ago someone sent him a book entitled “Korean Stock Market”. He found 15 – 20 stocks selling for 2X earnings. It was like the old days. He has also made mistakes such as his 1968 purchase of Blue Chip Trading Stamps whose sales have dropped from $120 million at its peak to $18,000. Dexter Shoe was another bad business that he bought. You need to get on an 80 mph train that is speeding up.
(8) Question about the Omaha economy and more rural parts of the mid-west.WB: Omaha escaped much of the recession. Nebraska has the third lowest unemployment rate in the country. In the early 1980’s there was a recession and farm land crashed and many banks closed. Omaha used to be a major center for meatpacking and it was the fourth largest railroad center in the U.S. Now insurance is a major industry in Omaha. Entrepreneurs build businesses where they live and will continue to do so, spurring local economies. He always wanted to raise his family in Omaha, which is why he is there.
(9) Question about WB’s ability to evaluate management in place of companies he acquires.WB: In terms of evaluating management, it is very hard to do for public companies. You can look at the record (like baseball). When we buy a business it is for keeps. When someone comes to me and wants to sell a business and I hand him $1 billion, I have to decide if he’s going to have the same energy when he’s working for us as he had when building the business. We do not have any contracts with our managers. In the Fall of 2006 I received a 1 ½ page letter from a guy in Israel. I had not heard of the guy or his company before. He offered to come meet with me. After we met, I handed him $4 billion (Iscar) and was counting on him to run the business the same as before we gave him the money. Want managers to be passionate about their business. You cannot put passion into someone. It’s worked out most of the time. Every now and then we make a mistake. We want people who are in love with their business, not the money. (People who would say: “I’d rather go to work than anything else in the world”.) Our batting average is good and has probably gotten better over time. We are looking for the guy who is still in love with his business and for one reason or another, needs to monetize it. With respect to stocks, we are not interested in meeting with management. We do not want to see their projections. We look into their products and “moats” around the business.
(10) Question about advice in finding a job.
WB: Find the job that you would do if you were independently rich and not getting paid for it. He loves the job he is in. He jumps out of bed and tap dances to work. Upon graduation from Columbia (MBA), he offered to work for Ben Graham for nothing. Ben Graham said he was overpriced. He started selling securities in Omaha for three years. Then he was offered a job with Ben Graham. He never asked what his pay was. He didn’t know until he received his first pay check. Do what makes you tap dance. Take a job until you find the right job. Work for the person you admire most. Don’t wait for the dream job either. You should be close to a dream job 5 years out of school.
(11) What do you do everyday?
WB: He reads a lot, so does Charlie. They have been close friends for 52 years. They disagree, but never have any arguments. He reads books and 10K’s and 10Q’s. He now plays bridge over the Internet 12 hours per week, so he has less time for reading. He also watches YouTube.
(12) Question about China’s policies and impact on its growth.
WB: China changed its system and started to unleash the potential of its 1.2 billion people. In the last 30 years it has built its infrastructure. When forces are working together as they are in China, amazing things happen. The success the Chinese have achieved has reinforced what they are doing. They have come a long way. They have a long way to go. In the U.S. system, the right people are in the right jobs.
(13) Question about the Financial Regulation Bill.WB: We need something that will keep leverage under control. There is a natural tendency in a capitalist system to use leverage. Leverage is dangerous. If the financial regulation bill controls derivatives, it will be good. We also have the wrong incentives. If CEO’s succeed, they get doubly rich. If they fail, they are still rich. If a CEO needs big assistance from the government, then the CEO should go broke. At Berkshire we want a system that if Berkshire goes broke, so do Warren and Charlie. Freddie Mac and Fannie Mae resulted in the greatest losses to taxpayers. They (Fannie and Freddie) were a big part of the problem.
(14) Earlier this month, Bill Gross was quoted as saying June 30 would be D-Day for investors with QE2 going away. What do you think Bernanke should do?
WB: No one could have done better than Bernanke. He (Buffett) would not be buying $20 billion of Treasuries every week as is being done now. In addition to government’s fiscal and monetary policy, capitalism has its own regenerative capacity. We have had 15 recessions in U.S. history. They were called “panics” in the 19th Century. The regenerative capacity of capitalism was demonstrated before fiscal and monetary policy were introduced. Our current budget deficit represents 10% of GDP. It is the largest it has ever been except for World War II when it equaled 30% of GDP. This led to a vibrant economy and price controls. We are, therefore, experiencing the second greatest stimulus in the history of this country. Monetary policy (stimulus) is not needed now. It is dangerous. The Federal Reserve has its foot to the floor. Bernanke will quit monetary stimulus on June 30. The economy is fine. This expectation is baked in (built into the market).
(15) When you have made a mistake, what steps did you take to determine what went wrong?
WB: His circle of competence is growing over time. When investing in stocks, there are no called strikes. He waits for the pitch he wants. The mistakes he has made resulted from thinking he understood a business when he did not. He prefers to learn from other people’s mistakes (not from his own). On Dexter Shoe, he issued shares in Berkshire that are today worth $3 billion. Dexter Shoe went to zero. He is wrong from time to time, but overall has a good batting average. One should focus on the future. Don’t dwell on mistakes. Do not make a mistake with respect to the person you marry.
(16) When looking to invest in a company, how much consideration do you give to moral issues, such as environmental impact?
WB: Doesn’t think there is a perfect answer. In marketable securities Berkshire will buy whatever is out there (e.g., stocks and bonds of cigarette and liquor companies). Thirty years ago he was invited to a southern state to meet with management who wanted to sell a chewing tobacco company. The moat around the business was fabulous (brand loyalty). Pretax margins of 40% with low capital requirements. There was far less incidence of cancer from chewing tobacco than there was from cigarettes. Charlie and Warren discussed whether or not to acquire this company. They decided against it. Berkshire owns stock in Wal-Mart which is the largest seller of cigarettes in the U.S. They own stock in a company that wholesales to Wal-Mart. They own shares in Costco which is the third largest retailer of cigarettes. But they will draw a line at buying the entire business of the manufacturer.
(17) How have your expectations for the U.S. recovery changed your capital allocation?WB: He thought that the government would take enough action to get us past the panic and get the engine going again and to gather strength. His first choice remains with wanting to buy a large business. Otherwise, his second choice would be to buy securities. That did not change in the crisis. In the three weeks after Lehman failed, he invested $15.5 billion in several preferred stocks. He never wants investments to keep him up at night. In that regard, he was ultra conservative during the financial crisis by selling part of his stake in Johnson & Johnson, even though he did not need to, in order to pay for the preferred stocks.
(18) Question about oil and the current situation in the Middle East.
WB: The Middle East has been and will continue to be an unstable place. If the supply of oil from Saudi Arabia is disrupted, it will have big consequences. The oil shocks of the 1970’s resulted in oil going from $3 per barrel to $30. We paid a huge tax to OPEC. He expects to see the usage of oil decline in our lifetime (although the current usage of 86 million barrels of oil a day may increase to 100-110 million barrels per day before the decline begins). There are 500,000 oil wells in the U.S., producing an average of only 11 barrels per day. If oil prices have a sustained increase, there will be a windfall profits tax in the U.S. Therefore, higher oil prices are not a signal to buy oil stocks.
(19) Question about GEICO’s insurance model.
WB: Insurance in this country began with marine insurance, which was followed by fire insurance, and then by property insurance. State Farm introduced a mutual insurance model for auto insurance. Sears Roebuck, through its Allstate Insurance, copied this model. Then USAA offered auto insurance to the military with no agents (lowest cost). A husband and wife left USAA and started GEICO in 1936 offering a similar model of direct, no agent, low cost insurance to the public. GEICO initially marketed its insurance through mail and then TV, and finally through the Internet. GEICO is offering the same product today as it was 60 years ago. This is similar to Coca-Cola offering the same product since 1886, and likewise for Wrigley’s chewing gum for over 100 years.
(20) Question about Berkshire selling put options.
WB: Berkshire sold equity puts due in 15 – 20 years. They were in four different indices around the world. It was an insurance type transaction and they were sold on an uncollateralized basis. Berkshire did not want to receive calls for collateral along the way. He made the judgment that the odds were about 80% that Berkshire would not have to pay out anything. This looked good then and it still looks good now. Berkshire would not enter a contract if it could cause them to go broke.
(21) Question about income inequality in the U.S.
WB: During recent years of economic growth in the U.S., income inequality has grown. It’s going to exist in capitalism and it should. If everyone is promised to come out equal in the end, then we would have a different world. Suppose that 24 hours before you were born a genie appears and gives you an incredible responsibility to design an economic, political, and social system in which you are to emerge. Whatever you decide is the society for you, your children, your grandchildren, etc. You then ask the genie, “what’s the catch”? The answer is that just before emerging you have to go to the barrel with 6.5 billion tickets, one for each person in the world, but you do not know which ticket you will get (ovarian lottery.) A society with equality and no production would not be good. You should think of output, providing incentives to people, an abundant society, a market system. In the U.S. per capita GDP equals $47,000. We want freedom from fear of not receiving health care and not starving to death. An abundant society will take care of people that get a lousy ticket. Inequality of the tickets is what you want to deal with. We are working toward that in this society. Social Security is an attempt at that in our society. In the last 20 years we have been moving in the wrong direction. According to the IRS, in 1992 the 400 highest incomes averaged $45 million. In 2009, they averaged $350 million. The rest of the U.S. went no place over these years. The average tax rate for the highest income earners has declined from 28% down to 16% over this time period. His average tax rate is 16% on $16 million of income, largely from dividends and capital gains which are taxed at 15%. He has no tax shelters and does not consult tax advisers. He credits George Bush and the U.S. Congress. We have moved away from equality to taking care of the rich. If you and a twin were competing for a ticket in the U.S. or Bangladesh (with no income tax), you might bid 70% – 80% (of future wealth) to get the U.S. ticket. He is lucky that he is alive now rather than thousands of years ago. Otherwise he would have been some animal’s lunch. It would not have done him any good then to say “I allocate capital”. We should have a society that will incentivize people to work hard and the ticket you pick doesn’t destine you for a poor outcome.