(Notes taken by Professor David Kass, Department of Finance, Robert H. Smith School of Business, University of Maryland and Rahul Shah, MBA student)
Warren Buffett (WB) met with 20 MBA students from each of eight universities, including the University of Maryland, on November 15, 2013. The MBA students asked 16 questions in the following order:
(1) Has Berkshire Hathaway (BRK) lowered its hurdle rate as it grew larger?
WB: BRK does not have a hurdle rate. The added capital makes it harder to achieve superior returns. If I manage $1 million I will get better returns than managing $210 billion (BRK’s net worth). Size is the enemy of performance. I would still rather manage $210 billion than $1 million.
(2) In the past you said you attribute 85% of your investing to Benjamin Graham and 15% to Philip Fisher. Has that percentage changed?
WB: I developed my investment strategy under Graham. I went to Columbia and learned from Graham. With Graham’s approach, you cannot lose money over time. It’s very quantitative in nature, and you have to do reasonably well. On the other hand, it has less and less application as you get into bigger and bigger companies with larger sums of money. It’s better to buy wonderful businesses at fair prices than so-so businesses at low prices.
With the “cigar approach”, you can find a nasty cigar on the ground, with one puff left, can pick it up, light it and you get a free puff. You can keep doing this and get many free puffs. That’s one approach, that’s what I did. I looked for very cheap stocks quantitatively. After exposure to Fisher and Charlie, I started looking for better companies. Previously I was doing both. Now we are looking for good companies, not just cheap companies. Railroads are huge, and they will be good in 10 years, and 100 years from now. Burlington Northern is now earning $6 billion pre-tax, as compared to $3 billion a few years ago before we bought it. Moving much towards Fisher now and less Ben Graham because we are working with larger sums. With smaller sums, we would be looking at better margins/cheaper stocks.
When I got out of school, I went through Moody’s manual page by page. Got to page 1433 and learned the good ones were in the back. Western insurance company in 1951 was earning $29.09 a share, the year before $21.66. The price of the stock had traded between 3 and 13 the previous 12 months. The price was at 16 when I saw it, less than 1 x earnings. A few years ago, in 2004, someone told me I should look at Korea. I got a book from Citigroup which had 1 stock to a page. Describes all the publicly traded companies in Korea. Went through it and found about 20 companies (ex. Day-Han flower mills) it had book value, eps, and securities. Didn’t tell you anything about the share until you look at the price. Found about 20 like that in an afternoon and bought some of all of them, but didn’t know enough about all of them to load up on them. If you buy 20 stocks selling at 2 times earnings, you’re going to make money. That’s Ben Graham and you can make money doing this. If you’re working with bigger money, you have to do Fisher/Charlie style and buy big businesses. Berkshire now looks for large, very strong companies. Like Nebraska Furniture Mart – bought in 1983 and it’s probably earning 20 times as much now. Charlie told me – “You’re never going to disagree with me because you’re smart and I’m always right”.
(3) What is the process you follow in writing the annual shareholders letter? How do you decide what you’re going to write about?
WB: I finished the 2013 letter already, but I will send it out on Feb 28. I already know what I’m going to say, just have to fill in some numbers and send it off.
I try to think of my shareholders as my partners. I try to think of the information I would want them to send me if they were running the place, and I was the shareholder. What would I want to know? This is what I tell them. In my first draft, I address it to my sisters who don’t know a lot about finance. “Dear sisters”- I explain to them what they would want to know in their position. I also like to write one section that is a general teaching lesson that doesn’t directly apply to Berkshire. This year 2600 words (out of 11,500) are thoughts about investing. I’m talking to all people thinking about investing and how they should go about it. I take one subject and just write a chapter on this, annually. Some people are interested, some are not. If they’re going to have most of their money with me, I like to talk to them as if they are in the room with me — economic principles of BRK – so people know what we are all about.
In 1956 I bought a ledger for $0.49, two pieces of paper for a partnership document but didn’t worry about the partnership agreement. I just explained the ground rules in about half a page: This is what I can do, this is what I can’t do, this is how I intend to go about it, and this is how I measure my success. If this looks good to you, then buy in. If you don’t want to buy in, then don’t – we can still be friends. These ground rules are in the back of the Berkshire Hathaway report tailored to investors. In our ground rules, though our management is corporate our attitude is partnership. We consider you as partners. You need to have common ground, just like a marriage. It would be crazy to get married when you differ on important points. The annual shareholders report is ready now. BRK has unusual shareholders, many of whom have 80% of their net worth in BRK. I have almost 100% of my net worth in BRK. But if the market goes down 50% we might rewrite it (laughter).
(4) Why did you convert Goldman Sachs warrants into a smaller stake in the company?
WB: Goldman Sachs and GE, we helped finance them in 2008 which I never dreamt would happen (Imagine GE calling you, telling you they need your financing assistance). BRK received warrants with preferred stocks, expiring in 5 years (Sept 2013). Warrants to buy $5 billion Goldman Sachs common stock and $3 billion GE common stock. If we exercised, we would have had to invest an additional $8 billion. These two companies didn’t want to issue all of those new shares. Earlier this year we decided, they didn’t want to issue all of those shares, we didn’t want to spend $8 billion. Let’s do a settlement, both wanted to. We didn’t have to lay out cash and they didn’t need to issue all of those shares. BRK ended up with Goldman Sachs shares valued close to $2 billion without any outlay of BRK’s cash. GE was only $200 million. BRK has only one big warrant issue remaining, with Bank of America. We have warrants that entitle us to buy 700 million shares at $7.14 a share ($5 billion) through August 2021. We’ll hold the warrants until the dividend becomes high or we’ll hold until right before the expiration. Goldman Sachs and GE deals are interesting – who would have guessed those 5 years ago. The money market failed because of Lehman. Money market funds held a lot of Lehman paper. It happened overnight, 30+ million Americans who believed money markets were safe, and then Lehman fails. This caused a major money market fund to “break the buck” and lose value. It became a great silent electronic run on money markets. There was $3 1/2 trillion in money market funds and $175 billion of funds flowed out in the first three days after Lehman failed. All money market funds held commercial paper. Companies like GE had a lot of commercial paper. After this, American industry literally stopped. George Bush said, “If money doesn’t loosen up, this sucker will go down” – I believe this was the greatest economic statement of all time. This is why he backed up Paulson and Bernanke. Companies were counting on the commercial paper market. In September 2008, we came right to the abyss. If Paulson and Bernanke had not intervened, in two more days it would have been all over. BRK always has $20 billion or more in cash. It sounds crazy, never need anything like it, but some day in the next 100 years when the world stops again, we will be ready. There will be some incident, it could be tomorrow. At that time, you need cash. Cash at that time is like oxygen. When you don’t need it, you don’t notice it. When you do need it, it’s the only thing you need. We operate from a level of liquidity that no one else does. We don’t want to operate on bank lines. There is no authority for the US Treasury to guarantee money market funds. Their power comes from Congress. Paulson set up an exchange stabilization fund in September 2008 to guarantee money market funds. This stopped the run of money market funds and it was all over. Something like that will happen maybe a couple of times in your lifetime. Two things when it happens again – don’t let it ruin you, and if you have money/guts, you’ll have an opportunity to buy things at prices that don’t make sense. Fear spreads fast, it is contagious. Doesn’t have anything to do with IQ. Confidence only comes back one at a time, not en masse. There are periods when fear paralyzes the investment world. You don’t want to owe money at that time, and if you have money then you want to buy at those times. “Be greedy when others are fearful, and fearful when others are greedy”.
(5) How has your understanding of markets contributed towards your political views?
WB: I wouldn’t say knowledge of markets has. My political views were formed by this process. Just imagine that it is 24 hours before you are born. A genie comes and says to you in the womb, “You look like an extraordinarily responsible, intelligent, potential human being. Going to emerge in 24 hours and it is an enormous responsibility I am going to assign to you – determination of the political, economic and social system into which you are going to emerge. You set the rules, any political system, democracy, parliamentary, anything you wish, can set the economic structure, communistic, capitalistic, set anything in motion and I guarantee you that when you emerge this world will exist for you, your children and grandchildren. What’s the catch? One catch – just before you emerge you have to go through a huge bucket with 7 billion slips, one for each human. Dip your hand in and that is what you get – you could be born intelligent or not intelligent, born healthy or disabled, born black or white, born in the US or in Bangladesh, etc. You have no idea which slip you will get. Not knowing which slip you are going to get, how would you design the world? Do you want men to push around females? It’s a 50/50 chance you get female. If you think about the political world, you want a system that gets what people want. You want more and more output because you’ll have more wealth to share around. The US is a great system, turns out $50,000 GDP per capita, 6 times the amount when I was born in just one lifetime. But not knowing what slip you get, you want a system that once it produces output, you don’t want anyone to be left behind. You want to incentivize the top performers, don’t want equality in results, but do want something that those who get the bad tickets still have a decent life. You also don’t want fear in people’s minds – fear of lack of money in old age, fear of cost of health care. I call this the “Ovarian Lottery”. My sisters didn’t get the same ticket. Expectations for them were that they would marry well, or if they work, would work as a nurse, teacher, etc. If you are designing the world knowing 50/50 male or female, you don’t want this type of world for women – you could get female. Design your world this way; this should be your philosophy. I look at Forbes 400, look at their figures and see how it’s gone up in the last 30 years. Americans at the bottom are also improving, and that is great, but we don’t want that degree of inequality. Only governments can correct that. Right way to look at it is the standpoint of how you would view the world if you didn’t know who you would be. If you’re not willing to gamble with your slip out of 100 random slips, you are lucky! The top 1% of 7 billion people. Everyone is wired differently. You can’t say you do everything yourself. We all have teachers, and people before us who led us to where we are. We can’t let people fall too far behind. You all definitely got good slips.
(6) You are one of the few male CEO’s who champions women in the workplace. Can you talk about your reasoning and how we can contribute our intelligence to the workplace? (from a woman speaker)
WB: We wrote the Declaration of Independence in 1776 – “All men are created equal” etc. In 1789 we wrote a Constitution – on second thoughts… blacks are only 3/5 of a person. They slipped up. They wrote in such a way that they didn’t have to use gender pronouns. They gave themselves away in presidency, they said “He”. Pretty soon all men are created equal became all males are created equal. Move forward to the Gettysburg address, Lincoln repeated the line about All men are created equal. Slipped over the fact that women couldn’t vote, couldn’t even inherit money in some states. Finally, in 1920, 131 years into this new venture of governance, “Oh yea, women should have a fair stake in vote.” After this, many justices were appointed before O’Connor was. Everyone had expectations of me as a child, but my sisters who were just as smart, were delegated to something different. Here is this country, think about how far we came from using half our talent. Now we are beginning to unleash the potential of the other half. If we only allow people to be CEO’s, accountants or lawyers if they are above 5’10”, and people under 5’10” must become nurses, etc. that would be crazy, we could not unleash potential. Same thing was the case for women. No one realized it, my dad didn’t, and my teachers didn’t. Women are obviously just as smart and work just as hard. No one is better at running our annual meetings than Carrie. I think its nuts for a CEO to pass up the most talented person based on their gender. But we are going in the right direction. We’re moving towards the ideals we set, but these ideals set by Jefferson weren’t practiced until much later.
(7) How do you assess management when acquiring a company?
I handed Mrs. B (Nebraska Furniture Mart) a big check, and none of them (managers of acquired firms) had to work anymore. But will they behave the same after they get the money and I get the stock certificate? Will they work just as hard when they’re putting money in their own pocket?
3/4 of our managers are independently wealthy. These people don’t need to go to work, but they are putting the work in. If I give him 4 billion dollars, will it be the same results next month? Next year? I don’t deal with contracts; I have to size up whether management is going to continue working that same way. Generally, I’ve been right in my assessments and I’ve gotten better. They don’t need me, I need them.
Why do I come to work? I can do anything I want to do, and yet I come out every morning and can’t wait to get into work. I enjoy working Saturdays, talking to students. Why do I do it? I get to paint my own painting. Berkshire Hathaway is my painting. People love creating things. I think I’m Michelangelo, painting the Sistine Chapel but it could look like a blob to someone else. Second thing – I want applause. I like it when people appreciate my painting. If others have their own paintings, then who am I to tell them how to paint it? (Just like management) I appreciate what they do. I know the game, so when I praise them, they know they’re getting approval from a critic they like. I have their stock certificate, but it’s still their business. It’s a good culture when managers really care about the business.
(8) Now information is everywhere. If you were born in Peru today, could you have thrived in the same manner?
WB: Yes, I do. Things are changing around the world. People are able to move within and up through socio-economic classes. America didn’t work harder when increasing GDP more than other countries, we allowed for equal opportunity. Didn’t even work smarter, just unleashed greater potential. The world is allowing for opportunities for all.
(9) What career path would you advise someone who wants to go into investing today?
WB: You just want to learn everything about it. There’s so much to learn. Learning what works and what doesn’t work, where value resides and where value doesn’t reside. Got my feet wet, at 11 years old (1942) I bought 3 shares of Cities Service Preferred at $38 1/4. At the same time, my older sister Doris bought also bought 3 shares and my dad bought 4 shares, so we had a round lot of 10 shares. My sister Doris complained about the price of the stock every day when going to school. So I sold it at $42. Two years later the shares sold for $200.
I would try to manage money with an audited record so that it would attract more people when doing well. I like running businesses better than investing. It is more fun building businesses than moving money around.
Todd Combs and Ted Weschler are each managing $6 1/2 billion. They each are earning less money than they would if they were running their own hedge funds. But they like being at Berkshire. They have enough money. They have the character that I admire.
(10) Question seeking advice for women.
WB: I recommend reading Personal History by Katherine Graham. Presidents came to see her. She overcame the handicap that her mother and husband told her she was nothing. Many women are succeeding today as CEO’s. Susan Jacques, CEO of Borsheim’s, is leaving to head the Worldwide Gem Association.
(11) You were the first person to use the term “moats” as competitive advantage. Morningstar has built on this. What do you think about Morningstar’s work on moats?
WB: I think they’re doing a great job. I came up with this term 40+ years ago because in capitalism, you have these economic castles. Apple, Microsoft, etc. Some have smaller castles. If you have a castle in capitalism, people are going to try to capture it. You need 2 things – a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle. How did Coca-Cola build their moat? They deepened the thought in people’s minds that Coca-Cola is where happiness is. The moat is what’s in your mind. Railroad moats are barriers to entry. Geico’s moat is low prices. Every day we try to widen the moat. See’s Candies creates a moat in the minds of consumers. It is a more effective gift on Valentine’s Day than Russell Stover. See’s Candies has raised its price every year on December 26 for 41 years. BRK bought See’s Candies for $25 million in 1972. Today it earns $80 million. Richard Branson failed 10 years ago with Virgin Cola. Snickers has been the number one candy bar for 40 years.
(12) How do you balance work/family life and what advice do you have for a young professional?
WB: The most important decision you’re going make is who you’re going to marry. What’s important is that what your thoughts are on big things, must make sure that your spouse has the same thoughts on the same big things. Don’t marry someone to change them. Marry someone who is a better person than you are. Always associate yourself with people who are better than you.
(13) Do you have a goal of beating the Dow Jones Industrials by 10 percentage points each year?
WB: Years ago, I was trying to beat the Dow (would be the S&P today). Goal was to beat the Dow by 10 points this year. If the Dow was down 20% and we were down 10%, that would be fine. We don’t have some number we expect to make from some business or security. We do what we can that we think is the best at the time. Is this the most intelligent thing we can do, within our circle of competence, that doesn’t strain our resources? Hopefully we say yes. We generally think the value of a company is the PV of cash flows until judgment day.
If you really get back to investments – 2600 year ago the expression was “A bird in the hand is worth two in the bush”. But you need to question it – How sure are you that there are two in the bush? How far is the bush? What is the interest rate? (laughter)
In investments, you lay out money now and get more money later on. Berkshire is putting more birds in the bush all the time.
If you are managing only $1 million, then you should be able to beat the S&P 500 by 10 percentage points with no risk or leverage.
(14) What was the most difficult negotiation you were ever involved in? How did you develop your strategy going in?
WB: Only really learned negotiations from my dad. People have different styles of negotiation. I don’t want to be in a negotiation where it “has to end” at some point. Don’t want them to have me by the throat while I have them by the throat. Either we give up or one strangles the other. My style is different from most peoples, just say what I do. If you do that throughout your life then stick to it. I can walk away from anything. I say I’ll pay $X, and normally this is the best deal. I don’t want to lowball, then you counter, and get to $X anyway. You spend time and money doing that. I just say what I’ll pay, and that works fine once you establish a reputation. You don’t want to get in a negotiation that you can’t afford to walk away from. Bargaining with people you love is a terrible mistake. It’s destructive. The most powerful force in the world is unconditional love.
(15) What has been your biggest investment mistake and how did you learn from it?
WB: It is better to learn from other peoples mistakes rather than your own. Look at all kinds of business failures. I don’t believe in beating yourself over it, you’re going to make mistakes. My biggest mistake was buying Berkshire Hathaway and trying to make it better. We had all of our money in a bad business, had a drag on all of this capital for 20 years. Even after acquiring National Indemnity. BRK to be the base of what we wanted to grow, this was a mistake. You cannot play the game without making mistakes. We bought Dexter Shoe for $400 million in BRK stock which is now worth $5 – $6 billion. Dexter Shoe went bankrupt as a result of foreign competition. We lost $2 billion in Energy Future Holding bonds which KKR had invested in. KKR lost $8 billion.
(16) When managing other peoples money and making mistakes, how do you deal with the responsibility/burden?
WB: I tell them I’m going to make mistakes, but the goal is to do this and this and this. I might make mistakes in order to do this, but I will still probably achieve this goal. I try to operate in a way where I can’t lose significant sums over time. I might not make the most money this way, but I will minimize the risk of permanent loss. If there’s 1 in 1000 chance that an investment decision can threaten permanent loss to other people, I just won’t do it.