(Notes taken by Professors David Kass and Susan White, Department of Finance, Robert H. Smith School of Business, University of Maryland)
A one hour humorous film was shown in which there were a series of commercials for Berkshire products and numerous comedy routines. The highlights of the movie included an animated segment about Moody’s ruthless “MBA” trading machines that were planning to destroy the world. But Arnold Schwarzenegger suits up as “The Governator” (having stepped down as governor of California) and saves the world. There was also an appearance of Warren Buffett and Charlie Munger with the cast of “The Office”.
Warren Buffett (age 80) and Charlie Munger (age 87) then walk on stage and sit down. Buffett says “I can see and Charlie can hear, that’s why we work together”.
The format for asking questions was the same as that followed at the last two annual meetings. Half of the questions were selected by three business journalists: Andrew Ross Sorkin (The New York Times), Becky Quick (CNBC), and Carol Loomis (Fortune). Shareholders had e-mailed over 2,000 questions to the journalists, who then selected 27 questions relating to Berkshire and its operations. The journalists, who were seated on stage, alternated with shareholders in the audience in the asking of the questions.
Approximately 36,000 – 40,000 shareholders were in attendance, similar to last year’s turnout. (This is compared to previous records of 35,000 in 2009, 31,000 in 2008, 27,000 in 2007, and 24,000 in 2006.)
Buffett initially commented on first quarter earnings and related slides were projected on the screen. All of the businesses with the exception of those related to residential construction are getting better. Buffett believes that Berkshire Hathaway represents a cross section of the U.S. economy and includes a fair amount of international business as well. In the first quarter, Berkshire experienced the second worst quarter in the insurance industry in terms of catastrophes around the world. Usually the third quarter is the worst due to hurricanes in the U.S., with 50% occurring in September. In the first quarter there were some major catastrophes in Asia (Japan). These hit the reinsurance business very hard – probably about $50 billion for the industry. Based on Berkshire’s market share, the company expects to participate in about 3 – 5% of those losses. For the past 8 years the insurance business has been profitable, but that is unlikely in 2011 since the remainder of the year is unlikely to be hurricane-free. Buffett expects insurance underwriting to breakeven over time. If it does, Berkshire gets free use of the float.
Investment income was down and will go down because of the called (or soon to be called) preferred shares from General Electric, Goldman Sachs, and Swiss Re. They are losing at least three very high yield investments that cannot be replaced. Berkshire had full ownership of BNSF for a full year in the first quarter of this year. The entire railroad industry will have a good year. Their competitive advantage will grow as fuel prices increase.
Overall the business did well except for insurance. The three major catastrophes (Australian floods, New Zealand and Japan earthquakes) cost them an estimated $1.673 billion pretax. Nobody knows what the ultimate insured losses will be from the Japan earthquake. About 40% of the loss from Japan comes from a 5 year contract with Swiss Re. Swiss Re has told Berkshire that it will not be renewing the contract. Buffett joked that he wishes they had told him that three months earlier. As a result of tornadoes, 25,000 car owners will file auto claims. There has been an extraordinary tornado season this year, but those losses do not hit the reinsurance business much. The New Zealand earthquake has caused $12 billion in damage. There has been good growth in Geico policies and the company has been gaining market share. Buffett said there is $1 billion in Geico goodwill on the books which he estimates is worth $14 billion.
Buffett said investors should ignore gains or losses in Berkshire Hathaway’s securities and derivatives – this is a function of accounting methods. He said, suppose we own a security for quite a while and it sells for 80% of its value. We’re supposed to mark it down and go through the P&L account. We owned Wells Fargo, with some bought at higher prices that we’re required to mark down. We also had gains on some of the purchases, but we couldn’t hold the gains against the losses. The method we use requires greater markdowns, but saves money when we sell investments. If they had used an average cost method then they would not have had a markdown. But they chose the specific identification method instead because it saves money based on the time value of money. Investors should focus on the operating earnings of the businesses and the gain in book value instead.
With respect to Dave Sokol, his behavior was inexplicable and inexcusable. (Source: BRK website) “You know, I will never understand exactly why some of the events that transpired did transpire. And to some extent, in looking at what happened a few months ago with Dave Sokol’s failure to notify me at all that he’d had any kind of contact with Citigroup, in fact, he directed my attention to the fact that they represented Lubrizol and never said a word about any contact with them, and then the purchase of stock immediately prior to recommending Lubrizol (LZ) to Berkshire (BRK) , I think I – for reasons that are laid out in the audit committee report, which I urge you to read and which is on our website, I don’t think there’s any question about the inexcusable part that Dave violated our insider trading rules, and he violated the principles I laid out – I lay out every two years in a direct personal letter to all of our managers and which I’ve been doing for a long time. ..
The inexplicable part is somewhat – well it’s inexplicable..Dave to my knowledge made no attempt to disguise the fact that he was buying the stock, for example, by using a neighbor or cousin to buy instead. Dave left a total record of the purchase.
The second fact, which is puzzling, … but Dave has a net worth in very high numbers. He made I think close to $24 million. He earned it from BRK last year… But I will give you one instance that does make it puzzling.. Based on a five-year compounded gain in earnings, and we were starting from a high base, and we set a figure that no other utility company in the U.S. was going to come close to. But if that figure were achieved, we were going to give $50 million to Dave and $25 million to Greg Abel. And I had Dave come to the office … move forward at 16% compounded per year, here’s the payout. ..But he said there is just one change I would make… You should split it equally between me and Greg. It should be $37 and a half apiece… So we saw Dave transfer over 12 and a half million dollars to his junior partner. … and what really makes it extraordinary is that $3 million ten or so years later would have led to the kind of troubles that it’s led to…I had eight university groups, 160 students in on that Friday … and I spent most of the day with them. And the 10K and the 10Q that got printed out on Saturday have that date on them, the 15th, when I looked at LZ for the first time. He said, take a look at it, it might fit BRK. I said how come? He said I’ve owned it and it’s a good company. It’s a BRK type company. And you know I obviously made a big mistake by not saying, Well when did you buy it, but I think if somebody says I’ve owned the stock, you know it sounds like they didn’t buy it the previous week…
Munger: It’s a mistake to assume rationality will be perfect, even in good people.
Buffett: (to Munger): Do you have any explanation for the irrational?
Munger: Yeah. I think hubris contributes to it.” (Source: BRK website.)
Loomis: We’re each getting questions via email in the multi-hundreds, maybe thousands.
Buffett and Munger: We don’t know the questions.
Munger: We don’t know the answers either.
Questions were asked in the following order:
(1) Loomis: Question from a long time shareholder – Why wasn’t Buffett ruthless (Salomon Brothers quote) and fire Sokol on the spot when he learned of the details? Why was the press release so indirect? Why didn’t he express more anger? Why did he handle the matter so inadequately?
Buffett: In between January 14 and March 14, Sokol gave no indication that he had had any contact with Citi of any kind. Apparently, Citi had met with him in October and talked about potential BRK takeover candidates. He said Evercore and Citi represented LZ. When the deal was announced, Buffett got a call from John Freund who works for Citi in Chicago and has handled a lot of BRK’s equity business for decades. Buffett has a direct line with Freund, who called to congratulate Buffett on the LZ deal. He then mentioned that Citi’s team had worked with Sokol on the purchase and said they were proud to be part of it. The fact that Citi had been involved was news to Buffett and what Freund said immediately set off some yellow lights. Buffett then had BRK’s CFO, Mark Hamburg, call Sokol, who readily gave him the information on when he had bought the stock and how much he owned. Then he was asked about Citi’s participation. At that point, Sokol said that he called Citi just to get a phone number, which turned out to be somewhat of an understatement.
As a result of the deal, LZ had to issue a proxy statement. BRK was not issuing shares, so no proxy was necessary. Law firm Jones, Day worked with LZ on the proxy. Given what Freund had said, Buffett eagerly awaited to see the first draft. Buffett was leaving for Asia and wanted to see what LZ had to say about the Citi matter. Ultimately, the LZ proxy had a lot of information on Sokol’s involvement with Citi. At that point BRK’s law firm Munger, Tolles got involved and discussed with the LZ lawyers the discrepancy between what Sokol said and what the proxy stated.
Ron Olson (of Munger, Tolles, and Olson) was on the trip to Asia with Buffett. All he and Buffett knew at that point was that partners at Munger, Tolles were interviewing Sokol and others. They talked to Sokol at least three times about stock purchases and the relationship with Citi. Buffett decided that when they got back they would need to have a BRK board meeting on this matter. Specifically, Buffett wanted to know what the lawyers had found out in their interviews. Soon after, a letter was delivered by Sokol’s assistant (that was unexpected) in which Sokol said he was retiring at a high point. Buffett doesn’t know if the questioning had affected his attitude or this decision. Buffett immediately realized that the resignation could save BRK some money. If they had fired him, there could have been an argument regarding whether he was fired with or without cause. Given that he retired, there was likely to be no litigation and no severance costs.
Buffett thought it was proper to inform shareholders of Sokol’s resignation and he drafted a press release that laid out the good things Sokol had done. He also laid out some actions that he thought were not illegal (based on what he knew then). He then talked to Charlie and Ron Olson about the press release and they had no problems with it. Next he ran it by Sokol to make sure the facts were accurate. But Sokol objected to the idea that one reason he retired was that he had had his hopes of succeeding Buffett dashed. Accordingly, Buffett was willing to take that part out after Sokol affirmed all the other facts. Finally, even after a second viewing, Sokol said it was OK.
But, as Buffett would later find out from the LZ proxy, Sokol had known that LZ had an interest in being acquired even though the press release said the opposite. Sokol made no attempts to correct the facts on CNBC when he was interviewed. In the meantime, BRK delivered (through its law firm) some information to the head of the enforcement division of the SEC that detailed the facts regarding the stock purchases. In that case, BRK acted very promptly to make sure that the SEC was well versed in what had taken place up to that point. From his standpoint, Buffett thought Dave was gone and that there was little chance of future litigation. He also knew that he had presented some very damaging information to the SEC. But people are upset about the lack of outrage and Warren pleads guilty on that. His defense is that Sokol had contributed so much to BRK that he decided to focus on the positives instead. He believes Sokol’s actions were not the result of dashed hopes of being Buffett’s successor. Sokol didn’t expect to succeed Buffett. Buffett said he acted promptly when he knew the information. He called the head of SEC enforcement as soon as he knew and turned over damning evidence to the SEC and the public. He said he was guilty of not showing outrage.
Munger: That press release was not the cleverest press release in the history of the world. The facts were complicated and they did not foresee the reaction from the public and from shareholders. However, you do not want to make decisions in anger. Tom Murphy always told the people at Cap Cities that “you can always tell someone to go to hell tomorrow if that is such a good idea”. In this case, it was important to remember a man’s virtues and faults.
Buffett: We should not be surprised that Charlie approved the press release. Warren and Charlie have never had an argument even though they have worked together for 50 years.
(2) (Audience): What do you think will be the effect POMO (Permanent Open Market Operations) of the Federal Reserve ending its QE2 (Quantitative Easing) program at the end of June on the economy and stock market?
Buffett: With POMO, you’re one acronym ahead of me. QE2 is the most advertised open market purchase in history, in terms of timing and the amount purchased. Therefore, he does not think that something that well known (ending of QE2) can have any effect because the information has already been discounted by the markets at this point in time. Therefore, he sees no significant impact on the stock or bond markets.
(3) Quick: You have an emphasis on hiring and retaining managers who are talented. How do you know there are there no more “Sokols” among Berkshire’s managers?
Buffett: The potential for there to be more Sokols is a reason why Howard Buffett will be the Chairman when Warren Buffett dies. You can always make a mistake in choosing a CEO. In this case it is very unlikely but it is not impossible. The leading candidate now is straight as an arrow. Removing CEO’s has become less tough over time, especially when moral or ethical issues are involved. But, it is still difficult. An independent chairman who owns a lot of stock represents a safety measure to protect against a wrong decision. The directors will be thinking about the quality of the person as a human being as much as thinking about managerial skills. The directors are likely to find someone who cares more about BRK that he does about himself and they have multiple candidates who fulfill that. It’s easier to change a bad CEO but harder to replace a mediocre one.
(4) (Audience): If you were going to live another 50 years, what sector or asset class would you add to your circle of competence and why?
Buffett: He would pick a sector that is large enough so it would make a difference in BRK’s large portfolio. It would have to be in the technology field. Technology is going to be a huge field with huge winners but a lot of losers. Picking winners is going to be tough.
Munger: It would either be technology or energy. But we are the wrong people to develop that expertise. If it was going to happen, it would have happened. They want to identify someone else who has the abilities they lack.
(5) Sorkin: In the original press release regarding the Sokol matter, you said you were initially unenthused about making a deal to acquire LZ. But, in a short period, you warmed to the idea. How did that happen? What changed? Did Sokol convince you?
Buffett: Buffett didn’t know anything about the business and the chemistry of additives. All he cares about are the competitive dynamics including moats and durable competitive advantages. Buffett asked Sokol to discuss the company with Munger. But Sokol never called Munger, who didn’t know anything about the company either. Eventually Sokol passed along information to Buffett after having dinner with LZ CEO James Hambrick. As a result of that information, Buffett felt that he got an understanding of industry dynamics and how the oil industry is related to the additives business. Buffett realized that LZ had a durable competitive advantage. It had the number one market share in this business, a $10 billion market, and the position was sustainable; it had lots of patents and worked with customers on new engines. Lubricants help engines run longer and will always be around. The LZ management see BRK as an ideal home.
(6) (Audience): Using estimates of the values of the investment portfolio and the operating businesses, this shareholder calculated BRK’s intrinsic value at $185,000 per share vs. the current stock price (April 29, 2011) of only $124,750. Is BRK undervalued?
Buffett: Buffett and Munger do not consider BRK to be overpriced. They would not use BRK stock to acquire another company because of its valuation. In the LZ deal they did not use stock since they would be giving away the businesses they own at too cheap a price.
Munger: The right factors to look at when valuing BRK shares are operating earnings per share and investments per share. They will not always be as inactive as they are now. They will use stock in an acquisition if the business they are acquiring is good enough.
(7) Loomis: Why does Buffett have such a positive outlook for the U.S. economy? Why do you see gold nuggets when other people see salt?
Buffett: He doesn’t see how anyone could be anything but enthused about this country. When you go back to 1789, this country has been through the most extraordinary economic period in the history of the world. He was born in 1930 during the Great Depression with unemployment increasing to 25% and the Dow heading to 42. But the standard of living of the average American has increased 6:1 since then. There were centuries where the standard of living did not increase. There always have been negatives and problems. His father-in-law told him he was going to fail because the Democrats were in power and they were going to take the country to Communism. This country went through a civil war. There have been 15 recessions in U.S. history. We have a few lousy years from time to time. The growth may not be a straight line, but the power of capitalism is incredible. This is what is getting us out of this recession. Monetary and fiscal policy can help and were needed in 2008. At that point the government was the only entity that could do what was needed. In comparison, in the early 19th Century, people didn’t know what monetary and fiscal policy were. Recessions come and go when excesses come and go and capitalism corrects for this. The game is not over. The potential for the U.S. has not been used up. The rest of the world has caught up. Economies (e.g., China) are being opened up that have been dormant for centuries. They are not growing faster because they are smarter or work harder. They are tapping a system poised for growth.
Munger: The world will go on. In Europe 1/3 of the population died because of the Black Death.
(8) (Audience): Are Coke and See’s still great businesses to own in an inflationary environment?
Buffett: These businesses are superior. If you have a great consumer product that requires very little capital to grow and support that growth, and you do more volume as inflation grows, that is a wonderful asset to protect against inflation. The ultimate example of that is your own earning ability. People who have made investments in themselves, outstanding teachers and doctors, see their wages increase with inflation. They also don’t have to make an additional investment in themselves. People should think about a long term real estate asset like a farm where additional capital is not required to finance inflationary growth.
The worst businesses are the ones with huge receivables and inventories. Their volume stays flat and they have to come up with more money to finance that volume. BRK does not like businesses that require a lot of capital such as railroads and utilities. But Buffett and Munger believe that they should be able to generate a good return in the railroad because of the value it provides to the economy. The ideal business is one like See’s Candy. It was doing $25 million in revenue when they bought it in 1972. Now they are doing over $300 million in revenue. It took $9 million of tangible assets then and the business needs only $ 40 million in tangible assets now. If the price of candy doubles, fixed assets do not have to increase.
Munger: What’s interesting is that they didn’t always know that. Continuous learning is always required.
Buffett: Sometimes we forget this. The fact that they are investing in capital intensive businesses means that they unfortunately can’t buy more See’s Candies. They would love to find them, they just can’t. They have to invest so much that they can’t buy little businesses anymore. Therefore, they are not doing as well in buying investments or operating businesses because they have to put billions to work. There is a real disadvantage to size, but they like having a size problem.
(9) Quick: As you get closer to retirement, you will need income. What condtions are needed for BRK to consider paying a dividend?
Buffett: Buffett and Munger will pay a dividend when they have lost the ability to invest $1 in a way that creates more than $1 in present value for shareholders. At that point they would likely pay out 100% as a dividend. If you had a savings account that paid 5% and you had a choice between (a) taking $50 out and (b) leaving $50 in and later being able to sell it for 120% of its value (when you wanted to sell), wouldn’t you rather leave that money in the bank and let it grow? Every dollar that has stayed with BRK has grown much more than it would have if it had been paid in a dividend. As such, it is much more intelligent to leave a dollar in.
Of course, the execution of it can be a problem. Can they keep investing $1 and create more than a dollar of present market value? There is an end to that at some point. By leaving money with BRK people have a lot of money and they can cash out by selling shares. There will come a time, and it may come soon, when they can’t lay out $15 billion a year and get something back that is worth more than that for their shareholders. When a dollar only buys $.90 of value, then they will pay a dollar back to shareholders. The stock will go down that day and it should because paying a dividend means that the compounding machine is no longer working.
Munger: There’s nothing wrong with selling a little jewelry when you need cash.
(10) (Audience): BRK has large positions in Wells Fargo (WFC) and US Bancorp (USB). What is the outlook for these banks in the event of a tough economy and potential deflation?
Buffett: These are among the best banks, if not the best, in the U.S. They are different from some other money center banks even though they are very large. In terms of banking as a whole, profitability will be considerably lower (in his view) in the period ahead in comparison to the early 2000’s. This is because the leverage will be reduced, which is good for society. It may be a bad thing for smart banks and good for the U.S. as a whole. Dumb banks did dumb things with leverage and it cost the rest of us. Even if future ROA is as good as it has been, there will be fewer assets per dollar of tangible assets, so ROE will go down. Buffett thinks these two banks are great businesses even though they won’t be as profitable when the leverage is down.
Banking is a fundamental business. Losses are going down and the worst is likely past. As John Stumpf from WFC said a few years ago, “I don’t know why we are trying to find new ways to lose money when the old ways are still working.” The banks always go crazy on the asset side but the federal government is behind the banks. The FDIC has handled the failure of around 3900 banks, 250 in the past few years, and the taxpayers have never paid a dime. All the money comes from FDIC assessments on other banks. If banks are just smart on the asset side, especially since money is so cheap and because of the implicit government guarantee, America should be a great place to lend money. BRK has added to its position in WFC and both companies are great institutions. But they will not earn 25% on tangible capital, and they shouldn’t either.
Munger: M&T Bank (MTB) is headed by a very sensible fellow and also has been a great company for BRK to own.
Buffett: The M&T annual letter, written by CEO Bob Wilmers, has a lot to say about the U.S. financial economy and is worth reading. Buffett highly recommends reading it because Wilmers is a very smart guy. Jamie Dimon’s letter from JP Morgan (JPM) is very good as well. It has a lot of good insight on the banking and economic scene. BRK does not own JPM stock, but people can learn a lot from the letter.
Munger: Because he talked about morality and business, Bob Wilmer sounds like an Old Testament prophet. He doesn’t like that banks make so much money in trading. He thinks these banks are just trying to outsmart their own clients. It is one of the best annual reports ever.
Buffett: Wilmers also discussed the fact that he doesn’t like that money flows to people who work with money. Sadly, this attracts people with a lot of ability to banking when they should be doing something else.
(11) Sorkin: Why hasn’t BRK invested in commodities? Won’t commodities like gold continue to appreciate?
Buffett: When Buffett started BRK in 1965, one share was worth about ¾ of an ounce of gold (when gold was $20 and the shares were $15). So, even with gold at $1,500, BRK has done a lot better. Buffett thinks the questioner is right about the risks of inflation. But people have to consider which of the three major categories of investments offer the best protection against inflation. You have to think very hard about which one you want to be in before you think about the specific choices within the category.
The first category is anything currency denominated (cash, bonds, and money market accounts). Any currency related investment is a bet on what the government will do in the future. Almost all currencies have lost value over time. It is built into any economic system that the economy will be easier to work with when the currency is depreciating as opposed to appreciating. The Japanese can reaffirm that with their experience with the appreciating yen. As a class, currency related investing does not make much sense.
The second category of investments is items that you buy that don’t produce anything but that you hope someone will pay you more later. The classic case is gold. If you take all of the gold in the world and put it into a cube, it would weigh 165,000 tons and would be 67 feet on each side. All you are doing when you buy gold is hoping that someone else will pay you more to own something that doesn’t do anything.
The third category of assets is producing assets. You buy a farm because you expect a certain amount of cotton or soybeans. You decide how much you will pay based on how much the asset will deliver over time. These are the assets that appeal to Buffett and Munger. BRK bought Iscar and LZ and they don’t go around getting a quote on them each day. They look at the results of the underlying businesses. This is the same for securities. They don’t care if the stock exchange is closed for a few years. They look at the productive assets at BRK that generate capital that can be used to buy more productive assets.
Rising prices create their own excitement, especially when it comes to gold. If your neighbor owns gold and he is making money and you are not, it can affect your behavior. People like to get in on things that are rising in price. But, over time, that is not a good way to get rich.
Munger: He finds it peculiar that people buy assets that work only if the world goes to hell. That is not a rational thing to do. Most people are better off buying BRK’s stock. Also, it is not a great way to make money buying paintings of soup cans (reference to paintings by Andy Warhol).
Buffett: People take gold out of the ground in South Africa and send it to New York and it goes back into the ground at the Federal Reserve. This process would seem very strange if you were watching from Mars. All of the gold in the world is worth $8 trillion. All of the farmland in the U.S. is worth $2 trillion. If you take 10 ExxonMobils, they would be worth $4 trillion. So you could have all of the gold in the world, or you could buy all of the farmland in the U.S., 10 ExxonMobils, and still have more than $1 trillion to walk around with.
Munger: You would need an army to protect that gold as well.
12. (Audience): How did you attract investors in your first funds? How did you keep them?
Buffett: We stumbled along. The first years of Buffett’s fund were very slow. Ben Graham referred some people to Buffett when Graham’s fund was winding down. For six years he worked in his home. When Charlie came along, Buffett told him that he had too much intellect to work in law.
Munger: We started as a family business. To keep and attract investors, it helps if you conduct yourself in a way that allows other people to trust you. It helps more if other people are right to trust you.
Buffett: With the fee structure these days, the skill of attracting money may be a more important quality than actually managing it.
Munger: He and Warren understood at a very young age that they should never take large fees from people. He wishes their example was more popular.
13. (Loomis): How does BRK differ from the conglomerates of the 1960’s and 1970’s?
Buffett: BRK is a conglomerate and there are some benefits to being one. For example, tax efficient transfers of money between businesses. The conglomerates from the 1960’s (e.g., ITT and Textron) became stock issuance machines in which the idea was to get the stock and the multiple to be very high so they could use their shares to buy something that trades at a lower multiple. If successful, EPS went up and this Ponzi scheme was accepted and supported by Wall Street. This was a perpetual motion machine that failed when when people realized the emperor had no clothes. One exception that succeeded was Teledyne, which subsequently bought back its stock. The old conglomerates have little relation to Berkshire Hathaway.
14. (Audience): What would Warren and Charlie like to be remembered for in 100 years?
Buffett: Old age.
Munger: Charlie wants to be known for a fortune fairly won and wisely used.
Buffett: He enjoys meeting and teaching students. He had excellent teachers including his father, Ben Graham, and Tom Murphy.
15. (Quick): The U.S. dollar is depreciating and the Federal Reserve is keeping rates low while other central banks are raising rates. What is BRK doing to protect against that?
Buffett: BRK had a small position in two currencies last year and made about $100 million. However, they have not been active in the currency market. Buffett thinks the purchasing power of the dollar and all currencies will decline. They don’t know which one will decline faster. Through BRK’s Coke stock (KO), it has a lot of non-dollar exposure. A dollar from 1930 is worth $.06 today. Despite that, BRK has done very well so far despite that inflation.
Munger: Modern Greece is an awful modern culture when it comes to paying taxes and managing money. The country has a dysfunctional government and people don’t want to work. But the people there are still surviving.
Buffett: We will see inflation but he would rather be born in the U.S. today than in any place in any time in history.
16. (Audience): Why should people invest in BRK rather than in a no-load fund?
Buffett: He advises people to buy index funds if they are not actively investing. If they have a day job and want to put money to work over time, they will do well buying index funds consistently over time. If he had to choose right now between investing in BRK and an index, he would choose BRK. But he would not be unhappy buying an index.
Munger: On the other hand, Charlie would be very unhappy if he had to own an index fund. He does not think the average return for the investor will be the same over the next 50 years as it was over the last 50 years. He thinks that an investment in BRK will be good, after understanding these lower expectations. That’s how he got married – his wife lowered her expectations.
Buffett: And he lived up to them.
17. (Sorkin): Can you explain the company’s policy regarding employees outside investing activities? Why aren’t all trades cleared through compliance?
Buffett: There are only three people at BRK who can exercise trades for the company. BRK also has very clear rules in terms of code of ethics. Their rules will get looked at again as a result of the Sokol matter. We’re not an investment advisory firm or a mutual fund.
Munger: The greatest institutions in the world select people they can trust. It is a great feeling to be trusted. Wall Street has huge compliance departments and yet plenty of scandals. A culture of trust is much more important than rules in preventing scandals.
18. (Audience): Are there any significant changes to the U.S. economic policy, tax laws, or Federal Reserve policy that need to be instituted to help boost the economy?
Buffett: The Fed has had its foot to the floor in terms of monetary policy. The Chairman reaffirmed the other day that this policy will continue for an extended period. Our budget deficit is providing a fiscal stimulus. We have used the monetary and fiscal levers in a way that was unprecedented. It was wise to use these policies, especially in 2008. But they are less important than people think they are. The natural powers of capitalism will be what take us out of this this.
Also, residential construction has flat-lined. When it comes back, we will see a pickup in employment. BRK has several companies that are doing well. For example, BRK subsidiary TTI is setting records. Iscar is doing well, mainly because its products are not used in building houses. The economy is coming back. When the housing market overhang dissipates, the economy will come back even more.
Munger: We should take an ax to the financial system and cut it down. We need to create tax systems that discourage trading. Stocks should trade at the same frequency as real estate and society does not need computers trying to outwit one another. We need to stop making heroes out of people who succeed in this business. There should be fewer algorithms in trading – this is legalized front running.
Buffett: If you buy an S&P futures contract and hold it for one second and then sell it, you get a 60% long term gain and a 40% short term gain. Congress has basically subsidized this type of trading. This activity gets 60% taxed at a 15% rate although it is a flicker on the screen.
Munger: Hedge fund managers get a lower tax rate than people who drive taxis and teach. That is just demented.
19. (Loomis): Both of you have expressed a positive view on BYD when the stake was bought. Is it still as attractive now? Are BYD’s delays affecting your confidence?
Buffett: Charlie is the BYD expert.
Munger: The current price is still higher than the price BRK paid. Any company moving as fast as BYD will have delays. But Charlie is encouraged by what is going on. They are having trouble in auto distribution because they have been trying to double their sales each year for the last six years and it worked for the last five years.
20. (Audience): is there an oil bubble? What are your thoughts regarding oil?
Buffett: They do not know where the price of oil will go in the short run. The world produces 88 million barrels of oil per day. There are 500,000 oil wells in the U.S. Oil will sell for a lot more one day. BNSF has hedged a lot of oil due to its diesel usage. The dollar will become less valuable over time so the dollar price of things will go up. The question of whether oil will go up enough to maintain purchasing power given the taxes on any gains is another matter. Therefore, he still thinks that productive assets will generate better returns over time. Smaller countries are smarter about how they grant concessions.
Munger: If they have invested in nothing but oil since the beginning, they would not have done as well as they have.
Buffett: We do not have an edge in betting on oil. He has no idea how to have an edge investing in commodities in general. He does know people who have an edge investing in stocks and distressed debt. There are few commodities where I would know the direction of movement. An intelligent person will make more money over time thinking about productive assets.
BRK Lawyer: (Stepped in to clarify his prior clarification). BRK has a restricted list of companies they are interested in.
21. (Quick): What were some of the most important things you learned in the past year?
Buffett: What I learned is to have Charlie write the next press release.
Munger: I approved that release with no objections. BRK shareholders will be in a lot of trouble if they are depending on Charlie to find Warren’s errors. I try to go to bed wiser than when woke up.
22. (Audience): Are the taxpayers once again at risk of having to bail out the too big to fail banks?
Buffett: There are institutions around the world that governments should probably bail out. But, if that happens, stockholders and managers should not be saved. Maybe some of the institutions should not be saved either. Fannie and Freddie have not reconstituted themselves, while Chrysler has. He was on the fence about the government saving the auto companies, but it looks like the government made the right decision. Right now in Europe they are thinking about whether countries are too big to fail. The problem of too big to fail will always be with us. We just have to reduce the propensity to fail. The CEO and spouse should be put at risk of going broke. This is especially true of the CEO, but the board should suffer huge penalties as well. Perhaps they should have to repay the last five years of director’s fees. If you run a firm that needs to be saved, then the person running that institution should be aware that it is very painful to fail. We should also reduce the amount of leverage in the system and we have made progress on that front. In Europe there are banks and countries that may be too big to fail. But this will always be the case. Better to come up with a right solution than an immediate solution.
Munger: Past depressions and panics always started on Wall Street and there was always bad behavior from people who were profiting from waves of excesses. Partly, the failure is based on stupidity. The academic institutions believe things that are not true. Finance and economics are not hard sciences. Finance attracts people who should have gone into snake charming.
23. (Sorkin): Why did Melinda Gates and Warren Buffett resign from the Board of Directors of the Washington Post Company (WPO)? Does this mean that Buffett will sell the stock?
Buffett: He will not be selling WPO stock. He remains a phone call away from anyone at the Post and they can save director fees and he could save travel time if he were not a director. His enthusiasm for the company is as high as its ever been. He is resigning in part because of his age (80). Melinda did not resign because of age. Charlie do you have any advice on being on a Board in general? Charlie is on the Costco Board.
Munger: He really likes the people at Costco. One of the best things in his life is interacting with those people.
24. (Audience): Will the falling dollar hurt the value of BRK shares? Is BRK doing anything with currency hedges?
Munger: The answer is no.
Buffett: They did own the Australian dollar last year and it helped them earn $100 million. They cannot predict future movements in currencies. Instead they try to think about increasing intrinsic value and earning power of the company every day.
25. (Loomis): Where do you see the equity portfolio going over the next few years?
Buffett: In general they prefer large acquisitions, but the equity portfolio is also important. Since they are investing billions, they hope for a small edge.
Munger: Now we have companies calling us about selling to us.
26. (Audience – Whitney Tilson): Is BRK undervaluing the insurance companies in their disclosures by only taking into account a breakeven in underwriting?
Buffett: Yes, but it is really hard to predict underwriting profits. They are being conservative in valuing the company with the assumption of breakeven underwriting. But if there was another Katrina, they could lose a lot of money in underwriting this year or every 5th year or every 10th year. As such it would not be appropriate to include a normalized underwriting profit for the insurance company.
Munger: Would Warren trade his insurance company for any large P&C insurer?
Buffett: No way. There is no other one in the world like theirs. If you look at GEICO, it is now the 3rd largest auto insurer in the US and has a very low combined ratio. Ajit has built a great reinsurance business. Montross has a great business at General Re.
Munger: Among the insurance companies, BRK is the best.
27. (Quick): Which businesses will do well and which will do badly in a high inflation environment?
Buffett: The ones that will do the best require little capital to facilitate inflationary growth and can raise prices. The value of the dollar has fallen 80 -85% since they bought See’s Candy and the company sells multiples of the initial amount of candy without much more capital. See’s sells 7 times more candy, but has 10 times the revenue. However, businesses like utilities that get bond-like returns and require a lot of capital would do badly in the case of high inflation. In these businesses, you get a fixed return and if yields go up, they are not going to do well in an inflationary environment.
Munger: Their capital intensive railroad business and utility operations are some of the best in the world, just like the insurance operations. It is not all bad to be world-class in your main businesses.
Buffett: The replacement value of BNSF’s assets (track, locomotives, bridges) is huge and will grow dramatically with inflation. The country will always need rail transportation and therefore BRK owns tremendous rail assets.
28. (Audience): Has BRK considered splitting it’s A shares? What are the pros and cons and potential effects?
Buffett: In effect, they have been split 1500 for 1 by having the B’s available. There is no real disadvantage to owning the B shares.
Munger: Warren used to say: “May you live until the A shares split”.
29. (Sorkin): Can you tell us how Ajit thinks about insurance and give us some examples of some policies he has written?
Buffett: He cannot think of any decision made by Ajit that could have been made better. Ajit loves what he does and is very creative. Through Ajit, BRK has moved into areas of reinsurance that others had not. As others have copied BRK, Ajit has moved into new niches. The best deal Warren has ever made was hiring Ajit. He always thanks Warren for his salary each year and Warren thinks he has left off a zero (Ajit is a bargain).
Munger: The secret to being successful in any field is getting very interested in it. This is true with Ajit. Every Thanksgiving Ajit flies to London because they don’t have Thanksgiving there. He loves what he does.
30. (Audience): Do you include goodwill in your ROE calculation and when do you write off goodwill?
Buffett: The AOL- Time Warner goodwill should have been written off. In general, goodwill should not be amortized, but should be written off when necessary. Coca-Cola didn’t have a lot of goodwill and now is worth $100 billion. Goodwill should not be used in evaluating a business. What management is doing and how the operating businesses are doing are the most important factors. The focus should be on the return on tangible assets. But when you are assessing how well Warren and Charlie are doing in calculating return on equity, you need to include goodwill.
31. (Loomis): If Charlie could teach finance, would he teach it based on companies that had done well and those that had done poorly? Would he give some examples?
Munger: Costco has taken all of its cost advantages and passed them on to its customers. This has generated a lot of customer loyalty. The company has a store in Korea that will do $400 million in revenue this year. Those numbers are not possible anywhere else in retailing. Such success also requires the right ethics and the right diligence. These are very rare. (Note: Munger is on the Board of Directors of Costco.) Normal businesses are like General Motors (GM), which became the most successful business in the world and then wiped out its shareholders in the last few years. If he were teaching he would go through Value Line on GM over a number of years and look at how a highly unionized business with tough competitors from Asia and Europe impacted the company. Its success turned into a disadvantage.
Buffett: (Joking): Charlie and Warren were on a plane that was hijacked and were about to be executed. Each got one final request. Charlie said he wanted once more to give his speech on the virtues of Costco along with illustrations. Warren then said, “Shoot me first.”
32. (Audience): If Warren and Charlie decided to have a child in the next five years, how would they incentivize him or her to compete against the highly motivated and hungry kids from the rest of the world?
Buffett: If you are very rich and you bring up your kids to think that they are privileged because they came out of the right womb, you are making a terrible mistake. Charlie has raised eight children and not one of them has that sense. But, you have to be careful to not give them an incentive to do better than their parents at what their parents are good at. If you are rich and your children turn out to have no incentives to succeed, don’t blame them – blame yourself.
Munger: Get kids interested in something and they will do well on their own.
33. (Quick): What compensation structure will be appropriate for the next generation of BRK leaders?
Buffett: It will be higher and it should be higher. BRK has a $200 billion market capitalization. Managers should be rewarded for creating value. Currently, some of BRK’s managers earn eight figures and they deserve it.
34. (Audience): Could you share your thoughts on depleting water supplies and food stocks and discuss how that affects your investment strategy?
Buffett: It is an important subject but does not affect our strategy. He would love to buy another MidAmerican or GEICO. He is looking at earnings 5, 10, and 15 years down the road. He does not worry too much about societal issues that may affect the global economy.
Munger: They don’t pay too much attention to the water issue. If there is enough energy, you can have enough clean water. Israel makes a lot of clean water from sea water. Regarding agriculture, one of the main reasons we need to be restrained in the use of hydrocarbons is because agriculture relies on them. We need to think about putting hydrocarbons into agriculture and not cars and homes.
35. (Sorkin): Regarding the purchase of LZ, why didn’t LZ seek other buyers?
Munger: BRK would not have done the deal if LZ had sought other buyers.
Buffett: We do not participate in auctions.
36. (Audience): In the future, how can we determine how good a job Warren does in allocating capital?
Buffett: The question to ask is “Are earnings going up commensurately with the amount of capital being retained? Over time, the market test of how well the stock does will be the barometer. But that measure can be volatile. It is not a perfect measurement, return on capital, but they know that they have to always try to earn a better return on capital. BRK should trade at a premium if they are doing a good job.
Munger: They have beaten the market over time, but they will not be able to replicate their past performance. However, there will be some outperformance in the future.
37. (Loomis): Five recent BRK deals (GE, Goldman Sachs, Swiss Re, Dow Chemical, and Wrigley) were very different in terms or rate of return (interest rates, dividends). What were the differences in those deals? Why would the Mars family (Wrigley) make such a deal at the time they did?
Buffett: The Mars family can speak for themselves. In terms of the five deals mentioned, each one was done at a different time. Market conditions were different and the opportunity costs of capital were different. The goal is to make the best deal you can at the time of the deal.
38. (Audience): What advice would you give to people who want to learn to read faster?
Buffett: Although he reads 5 newspapers and many 10K’s every day, he wishes he can read faster. He doesn’t know how effective speed reading classes are. But, if they are effective, then people should try to learn to read faster. Being able to do so is a huge advantage.
Munger: The value of speed is overestimated. He had a roommate who was very smart and took more time to do problems. But, he never made mistakes and Charlie (faster reader) often did. So, going slow is not all that bad.
39. (Quick): Are you worried about Congress playing politics with raising the debt ceiling? Would it affect BRK’s stock price if it wasn’t increased?
Buffett: If they did not raise the debt ceiling it would be one of the most asinine things that Congress ever did. The only bill to give competition to a failure to raise the debt ceiling would be in 1890 with a law to change pi to 3 so it would be easier for children to work with. With such a large deficit, it doesn’t make sense to have a debt ceiling. Also, the ceiling should change with inflation and growth, as debt capacity grows. Arguing about the debt ceiling wastes a lot of time playing games and leads to silly statements. We have better things to do. In the end, there is no chance that they will not increase the debt ceiling. The U.S. is not going to have a debt crisis as long as we keep issuing notes in our own currency. China has a high debt to GDP ratio and they can still borrow.
Munger: Both parties are competing with each other to see which is the most stupid. They keep topping each other.
40. (Audience): Today MidAmerican wants to build a nuclear power plant in Iowa. But because of the nuclear disaster in Japan, TEPCO may have liability of $140 billion. Can MidAmerican’s bond-like returns justify the mega-catastrophe risk?
Buffett: He doesn’t believe the type of exposure is the same. Nuclear power is an important part of the world energy equation. France has a high percentage of nuclear power and 20% of the U.S. power comes from nuclear energy. Nuclear power is important and safe. We should continue to develop it in the U.S. and around the world. More people have lost their lives from coal.
Munger: If a tsunami gets to Iowa, it will be one hell of a tsunami.
41. (Sorkin): Would BRK ever reinstate the shareholder charitable contribution program it had for 20 years?
Buffett: Warren and Charlie loved the program and the shareholders loved it as well. It was a tax efficient way for people to give away money. Nobody else copied it. Corporate America was not interested in letting the shareholders direct contributions. There were always some backlash against some of the charities that were being helped. They got letters when people were upset. Some people didn’t buy See’s Candy because BRK supported Planned Parenthood in California. But, Warren and Charlie didn’t worry about that. However, when they bought Pampered Chef, the company operated through 50,000+ independent contractors. These were largely women who wanted to supplement their incomes by selling products. Unfortunately, a campaign developed where people said that because BRK gave money to pro-choice organizations (which primarily reflected the views of shareholders), they were going to boycott these women. The women were being hurt by this boycott. So, BRK decided to end this program since these were not high income individuals who were being hurt.
42. (Audience): When you think about the long term cash flows of a company, do you try to estimate growth?
Buffett: Growth is part of the equation. They love profitable growth and would love to find a way to move See’s into new areas because it would likely be very profitable. But they can’t really do that. On the other hand, Coke has traveled well to 200+ countries for 100 years. They do not rule out low growth companies. LZ will have some growth over time.
Munger: Business schools teach people to make projections way into the future, using their computers. Then people use these projections in their business decisions. But these projections do more harm than good. We make rough projections in our heads.
Buffett: When they bought Scott Fetzer, it had been shopped by First Boston to a number of companies. Buffett sent a letter to the owner saying he would pay $60 per share and they made a deal even though they had never spoken before. The guy from First Boston was there the day of the closing and had a contract that gave him a commission even though he had never called BRK. The guy then mentioned to Charlie that his team had prepared a book for this deal and asked if he would like to see this book. Charlie said that he would pay that guy $2 million if he didn’t show him the book. In terms of LZ, the company had made projections already to 2013 and 2015 and Buffett said he did not want to see them. He has never seen a projection from an investment banker that showed that earnings were going to go down. It’s like asking a barber if you need a haircut. Instead, Buffett and Munger are doing projections in their heads. They have a model in their minds of what the company will look like in a few years and have an idea where they could be wrong.
Munger: He recommends to students that they learn to analyze companies the Buffett and Munger way, but pretend to do it the MBA way while they are in school.
43. (Loomis): Three stocks are mentioned in the recent BRK 13F as being owned by Warren Buffett directly. What are they?
Mark Hamburg (CFO): They are not owned by Buffett. But because he is a controlling shareholder, his name shows up in the filings. In reality, they are part of a retirement plan.
Buffett: He owns very few securities outside of BRK and spends most of his time on BRK investments. He does own some government bonds even though he has been telling people not to buy them. These bonds just represent a place to put his money and forget about it so he can focus on BRK.
44. (Audience): What are your views on investing outside of the U.S.?
Buffett: They use the same principles but are aware that they know less about taxes and customs when they invest outside of the U.S. They consider that uncertainty when making their investment decisions. PetroChina’s (PTR) stock was really cheap in 2003 as compared to its cash flows. Yukos in Russia was also cheap. But they felt more comfortable buying PTR than buying Yukos. He was impressed with PTR’s reports. PTR was also planning to pay out 45% of earnings as dividends, which is a very high ratio.
Munger: We have few investments in China. He also pointed to their lack of knowledge. He said a professor told him that Indians always walk in a single line. Munger asked, how do you know this? The professor said, I saw one and he did. Munger says you can’t make generalizations.
45. (Quick): What does BRK do with its cash?
Buffett: Short term money choices are lousy. They do not and did not own commercial paper or money market funds. Their money is held in Treasuries and they are getting paid nothing for it. They would never try to earn 30-50 basis points by going into something else that is more risky. Treasuries are an unattractive parking place, but are ones in which they know they can get their car back. During the crisis they needed money to facilitate the Wrigley deal and they could not show up on the day of the deal with a money market fund. They needed cash and that is why they keep it in Treasuries. Their ability to come up with cash when people need it or when others are scared has allowed them to do a number of great deals. (Joking): “Even if Ben Bernanke runs off to South America with Paris Hilton”, Warren needs to make sure his check is going to clear.
46. (Audience): Will Charlie host a meeting of his own since the Wesco annual meeting is no longer going to be held? Also, what are your thoughts on wind power?
Buffett: Wind power is terrific, but only when the wind blows – which is about 35% of the time in Iowa. This is a limitation and means that wind cannot be relied upon for a base load. The economics of wind only make sense with a tax credit from the government. On its own, an investment in wind power will not return a desirable return on capital. Iowa and the central U.S. are good for wind. BRK has located a large number of megawatts of capacity in Iowa with more under construction. The economics of wind power in the future will depend on the price you can get and on the tax credits. BRK pays around 2% of all corporate taxes. Therefore, the wind power tax credits allow BRK to invest in wind power and to keep rates unchanged for more than a decade.
47. (Sorkin): Was NetJets close to bankruptcy?
Buffett: NetJets would have gone into Chapter 11 if it had been a standalone company. In its history, BRK has had two insurance companies that would have entered Chapter 11 if they were standalone companies. BRK made them whole. He did the same with NetJets. BRK will always make its companies whole.
48. (Audience): What advice would you give young people entering the job market with high unemployment?
Buffett: Warren did a lot of reading when he was young. He practically lived at his local public library. Anything you can do to improve your skills is very beneficial. The only diploma hanging in his office (although he has earned a few others) is from a Dale Carnegie course that cost him $100 and he took in 1951. The communication skills he learned in that course were invaluable. If he had not learned how to communicate, he would not have gotten where he got. Try to find your passion early. Buffett and Munger advised against taking economics courses because it is a tough subject in an area where experts cannot agree with each other.
49. (Loomis): Does BRK’s equity ownership in Munich Re and Swiss Re increase BRK’s insurance risk too much?
Buffett: BRK has invested less than $4 billion in those companies, or about 2.5% of BRK’s net worth. This is not a high level of risk for BRK. BRK went through the worst quarter in Q1 of 2011 (Japan, etc.) and still made lots of money in its insurance businesses. They would love to have more reinsurance business on their books. They just can’t find it at the right prices.
50. (Audience): Can you tell us how you met Todd Combs and how can shareholders assess his performance?
Munger: Todd Combs sent Charlie a letter. Then Charlie had dinner with him and thought Warren should meet him as well. Todd has the advantage of thinking about financial companies like BRK for a long time.
Buffett: It is likely that there will be more than one money manager running BRK’s portfolio in the future. They choose people not just based on IQ or a good record. Whether they like you or not has to do with the type of person you are. Todd’s returns will be judged over five years, not over six months.
51. (Quick): Regarding the Johnson & Johnson (JNJ) acquisition of Swiss medical device company Synthes, did Warren support the deal? Did he have concerns over the deal like he had on the Kraft-Cadbury deal?
Buffett: He would have preferred JNJ to have used more cash in the deal. Instead they used 2/3 stock. If you use stock to pay a 20% or higher premium without a lot of synergies, that is not a good thing.
Munger: Warren knows a lot more about chocolate (Cadbury) and pizza (Kraft’s sale of frozen pizza business to Nestle) than he does about medical devices.
52. (Audience – Glenn Tongue of T2 Partners): What deal size is Warren looking for?
Buffett: The deal he mentioned earlier – the “elephant” he was working on – was too big to complete without using stock or borrowed money. BRK will only issue shares in small amounts in a deal. They will also never sell a business to buy another business. Cash balances will build month-to-month unless they do something. They can always sell portfolio securities if necessary. The LZ deal will require about $9 billion in cash. They are looking at some other similar sized deals and Buffett would be comfortable doing those in order to add to BRK’s earning power. But, they cannot do a big elephant deal now. They will not trade something that they have and need for something that they do not have and would like to have. BRK hates issuing shares because they are divesting themselves of their great businesses like GEICO and Iscar. They would rather buy more of these companies like they are doing with Marmon each year.
53. (Sorkin): Do you have any insight into the state of the residential and commercial real estate markets as a result of BRK’s position in businesses peripheral to real estate?
Buffett: In the short run, the impact of the crisis on residential and commercial real estate has been terrible for Shaw, Acme, and Johns Manville. This country will build houses commensurate with household growth and BRK’s companies are in a great position to make money when homebuilding normalizes. See’s Candy loses money eight months of the year. But they understand the seasonal patterns of the business and know that Christmas will come (‘They have 2000 years on their side”.) Looking at seasonal companies is like looking at cyclical companies. You just need a longer time frame. It does not matter if the returns come in a lumpy manner if they come consistently for 20 years.
Munger: We don’t care if it’s lumpy as long as it’s a good business.