2003 年股东大会 · 下午场

Pretax operating profits clarification

WARREN BUFFETTOK. We have no afternoon movie, so we'll get to business in a second. And if everybody will just find their seats, please. I've been advised by [Berkshire CFO] Marc Hamburg to make sure I make clear what I may not have made clear earlier. In terms of the figures we gave you about the first quarter: A, I think I said we had 16 billion of cash or cash equivalents, which is correct. We had a $290 million pretax underwriting profit. I think I said that. What possibly I may have misstated, we had a billion-seven-hundred million, pretax operational gain. We had actually also, by coincidence, very close to a billion-seven of after-tax, counting securities gains. But our operating gain, excluding security gains, was about a billion-seven, pretax.

Read everything, ignore management, wait for "fat pitch"

WARREN BUFFETTLet's start right in at number 1.

AUDIENCE MEMBERYes. My name is Oliver Graussa (PH), and I'm from Vienna, Austria. And my question has two parts. And so, the first part is, how do you get a few excellent investment ideas to be so successful? Do you read any special newspapers or industry magazines? Or do you visit the headquarters or any subsidiaries of companies? And which sources of information, like books, for example, Value Line, Standard and Poor’s, Moody's, databases like Reuters, Bloomberg, DataStream, annual reports, internet, and so on, do you use to get the right impression of a company? And the second part, if you (crowd noise) think that a company like The Washington Post, GEICO, or Gillette has a very competitive product, what are the steps before you ultimately decide to invest in the company? Which publications do you read to get the best knowledge of the product? And how important is the balance sheet and profit and loss account statement of the company? Thank you very much.

WARREN BUFFETTThank you. The answer to the first part is sort of — and maybe the second part — is sort of all of the above. I mean we — (laughter) — read a lot. And we read daily publications, we read weekly or monthly periodicals, we read annual reports, we read 10-Ks, we read 10-Qs. And fortunately, the investment business is a business where knowledge cumulates. I mean, everything you learn when you're 20 or 30 — you may tweak some as you go along, but it all kind of builds into a knowledge base that's useful forever. And we — at least, you know, I read. Charlie used to read. May still read a fair amount. But I read a lot of 10-Ks, read a lot of annual reports. Forty or 50 years ago I did a lot of talking to managements. I used to go out and take a trip every now and then and really drop in on maybe 15 or 20 companies. I haven't done that for a long, long time. I find — everything we do, pretty much, I find through public documents. When I made an offer for Clayton Homes, I'd never visited the business. I'd never met the people. I'd done it over the phone. I'd read Jim Clayton's book. I looked at the 10-Ks. I knew every company in the industry. I look at competitors. And I try to understand the business and not have any preconceived notions. And there is adequate information out there to evaluate a great many businesses. We do not find it particularly helpful to talk to managements. Managements frequently want to come to Omaha and talk to me, and they usually have a variety of reasons that they say they want to talk to me, but what they're really hoping is we get interested in their stock. That never works. You know, managements are not the best reporting parties in most cases. The figures tell us more than a management does. So we do not spend any real amount of time talking to management. When we buy a business, we look at the record to determine what the management's like, and then we want to size them up, personally, as I said earlier, whether they will keep working. But we don't give a hoot about anybody's projections. We don't even want to hear about them, in terms of what they're going to do in the future. We've never found any value in anything like that. But just a general business knowledge, you know, what we've seen work, what we've seen has not worked. There's a lot you absorb over time. Charlie?

CHARLIE MUNGERYeah. The more basic knowledge you have, I think the less new knowledge you have to get. And the game is a lot like that fellow that plays chess blindfolded. He's got a memory of the board and everything that happened before. And that enables him to do the next move in a way he never could if you just showed him the board midgame, cold. And so there — and in terms of what publications, I don't know, Warren. I would hate to give up The Wall Street Journal.

WARREN BUFFETTOh, you'd also hate to give up The Buffalo News.

CHARLIE MUNGERYeah. (Laughter)

WARREN BUFFETTBut you could — well, you want to read lots of financial material as it comes along. And actually, The New York Times has a far better business section than they had 25 years ago. But you want to read Fortune, you know. You want to read lots of annual reports. You really want to have a database in your mind so that you can tell what kind of a business you're looking at, in general, by looking at the figures. It's far overrated — we never look at any analyst reports. I mean I don't think I've, you know, if I read one it was because the funny papers weren't available, you know — (Laughter) It just isn't — I mean, it — I don't understand why people do it. But there's a lot of data out there. And, you know, the beauty of it is — it's really what makes the investment game great — is you don't have to be right on everything. You don't have to be right on 20 percent of the companies in the world or 10 percent of the companies in the world or 5 percent. You only have to get one good idea every year or two. So it's not something — you know, when — I used to be very interested in horse handicapping, and the old story was — and I hope Bob Dwyer is still here — that, you know, you could beat a race but you can't beat the races. And you can come up with a very profitable decision on a single company. I would hate to be measured — if somebody gave me all 500 stocks in the S&P and I had to make some prediction about how they would behave relative to the market over the next couple years, I don't know how I would do. But maybe I can find one in there where I think I'm 9 in 10, 90 percent, in being right. It's an enormous advantage in stocks, is that you only have to be right on a very, very few things in your lifetime as long as you never make any big mistakes.

CHARLIE MUNGERWhat's interesting is that at least 90 percent of the professional investment management operations don't think the way we do at all. They just think, if they hire enough people, they can be better at determining whether Pfizer or Merck is going to do better over the next 20 years. And they can do that, stock by stock, all through the 500 and have wide diversification. And at the end of 10 years they'll be way ahead of other people, and, of course, they won't. Very few people have this idea of searching for just a few opportunities.

WARREN BUFFETTYeah. You wait for the fat pitch. Ted Williams wrote about that in a book called “The Science of Hitting.” He said the most important thing in being a good hitter, you know, is to wait for the pitch in the sweet spot, basically. But, you know, I've always said that the way to get a reputation for being a good businessman is to buy a good business. You know? (Laughter) It's much easier than taking a lousy business, you know, and showing how wonderful you are at it, because I haven't seen that done very often.

"We do our best to explain" Berkshire

WARREN BUFFETTNumber 2.

AUDIENCE MEMBERGood afternoon. David Winters. Mountain Lakes, New Jersey. Thank you again for hosting the Berkshire weekend. It's just great. Interest rates are the lowest they've been in, I think, two generations. Equity values, in aggregate, are still high. Berkshire has meaningful free cash flow, a short-duration bond portfolio, and you’re a buyer of low-multiple, high-quality private businesses, and a few stocks. Assuming that the stimulative economic policies to deal with the recession eventually cause interest rates to go up and, maybe, equity values to come down, Berkshire seems very well positioned to benefit. Would you comment? And also, are there any concerns on both of your parts about investors inadequately understanding the conglomerate structure of Berkshire and, therefore, improperly pricing the shares?

WARREN BUFFETTWell, to answer the second question first, we hope the latter wouldn't be true, because we do our best to explain it. I mean I used 14,000 words in the last annual report, which caused certain members of my family to ask whether I was getting paid by the word. (Laughter) The — we want you to understand Berkshire, and I hope that comes through. That's why we have these kind of meetings. That's why we spend a lot of time writing an annual report. We try to tell you what we would like if the position was reversed — if our positions were reversed. And we think that the information in the annual report, if read by somebody that — they have to have some understanding of business and accounting, but if they don't, you know, nothing is going to help, really, in terms of helping them with the business. But we think if they have some understanding of it, we have given them the information that Charlie and I would need in order to come up with our rough ideas of a valuation of Berkshire, and we hope we get across what it's all about. You know, there are a lot of companies in Berkshire, but it's not important that you understand the nuances of every single one. Looking at what happens in aggregate, in many cases, will be sufficient.

"Strange things happen" in markets

WARREN BUFFETTIn terms of how we're positioned, you know, we have 16 billion of cash, not because we want 16 billion of cash, or because we expect interest rates to go up, or because we expect equities to go down. We have 16 billion in cash because we don't see anything that makes us want to part with that cash where we feel we're getting enough for our money. But we would spend — we spent a Monday morning on the right sort of business, or even if we could find equities that we liked, or if we could find — like last year we found some junk bonds we liked. We're not finding them this year at all, because prices have changed dramatically. So, we're not really ever positioning ourselves. We're simply trying to do the smartest thing we can every day when we come to the office. And if there's nothing smart to do, cash is the default option. Charlie?

CHARLIE MUNGERIn terms of future opportunities, the issue is, is it at all likely that there'll be an opportunity like 1973-4, or 1982, even, when equities generally are just mouthwatering? I think there's a very excellent chance that neither Warren or I will live to see either of those occasions again. If so, Berkshire's not going to have a lot of no-brainer opportunities. We're going to have to grind ahead the way we've been doing it recently, which is not all bad.

WARREN BUFFETTIt's not impossible, though, we'll get some mouthwatering opportunities. I mean you just don't know in markets. It's unbelievable what markets do over time. And since you brought up interest rates, you know, in Japan the 10-year bond is selling to yield 5/8ths of 1 percent. Five-eighths of 1 percent. I don't think there's anybody in our annual meeting of 20 years ago, certainly including Charlie and myself, who would have dreamt that a 10-year bond of a country, you know, running a significant deficit would be selling at 5/8ths of 1 percent. I mean would you say so, Charlie? (Laughs)

CHARLIE MUNGERWould I ever. But strange things happen.

WARREN BUFFETTStrange things happen.

CHARLIE MUNGERBut if that could happen in Japan, something much less horrible for the investing class could happen in the United States. It's not unthinkable. I mean we could be in for a considerable period when the average intelligent, diversified investor in common stocks, using fancy paid advisors, just doesn't do very well.

WARREN BUFFETTBut you could argue that if what we warned against, and hope doesn't happen, with derivatives should happen, it might create enormous opportunities for us in some arena. I mean, you know, but we — wouldn't be good for society, but it might very well turn out to be good for us. If you get chaotic markets — you had a somewhat disorganized market in junk bonds last year, because there were a lot of them created much faster than the funds available to absorb them were coming in. Now, this year you have just the opposite situation. You have money pouring in to junk bond funds. Billion dollars a week, roughly, and that's changed the whole price situation. The world hasn't changed that much. It's just that the chaos has left the market for those instruments.

"Intrinsic value is terribly important and very fuzzy"

WARREN BUFFETTNumber 3.

AUDIENCE MEMBERYes. Hello. Paul Tomasik. Thornton, Illinois. Ben Graham and the model of value investing — I'd like to bring the discussion back to that. And what's interesting and exceptional about you, and Charlie, and Ben Graham, is the self-discipline. The incredible self-discipline. And if you look at the model and try to think how to present it to teach others that self-discipline, I think you have to make a little tweak to it in two areas. And that's what I'd like you to comment on. One, intrinsic value. It's always discussed that you calculate intrinsic value. But in practice, I think you find a number that is guaranteed — 99 percent likely — to be less than intrinsic value. Classic example was in 2000 when you said you'd buy shares back at 45,000. You weren't saying that Berkshire Hathaway's intrinsic value was 45,000. You were saying it was significantly more. And anyone who bought it for less than 45,000 is grateful to you. The other area is the hidden assumption in the model. And that is, it's assumed that once you find a value stock and you buy it, that the intrinsic value isn't going to go down. And that's a second part of the analysis that has to be part of the discipline. So even though you found a value stock, you still haven't done all the work. You have to analyze, is the intrinsic value going to go down. In particular, companies throw away intrinsic value is the most common. Management gives it away. That hasn't happened at Berkshire Hathaway, although I don't want to give an unqualified comment on that, since I see you're remodeling the offices, so we don't know how much intrinsic value's been thrown away there. So, if you could comment on the two things. Do you calculate intrinsic value, or a number that's absolutely positivity under intrinsic value, that's the number you put in the equation? And even when you find a stock selling for less than this lower bound of intrinsic value, do you still do the homework on the second part and analyze, will the intrinsic value go down in the future? Thank you.

WARREN BUFFETTYeah, I would feel somewhat better qualified to speak on self-discipline if I weighed about 20 pounds less, but — (laughter) — for the moment we'll ignore that. The second part of your question, relating to intrinsic value going down. Actually, if you compute intrinsic value as reflecting the discounted value of future cash flows, that should have, built into it, a calculation that allows for the fact that certain businesses are going to earn less in the future than now. It isn't that their intrinsic value goes down then, because you should build it into your calculation right now. But, you know, as we point out many times in the past, intrinsic value is terribly important and very fuzzy, and we do our best to work with — in the kind of businesses where we think that we have the highest probabilities — where our predictions are of a fairly highly probable nature. And that leaves out all kinds of companies. It's pretty good. We'll say it's something like a natural gas pipeline. I mean the chances of big surprises in a pipeline should be relatively small. That doesn't mean they're zero, but they're relatively small. Now, let's assume that you had a gas pipeline, which some have, where either the supply of gas is going to run down or where there are competitive pipelines that may be trying to take away your contracts that you wrote 10 years ago and expire in two years and you're going to have to cut prices. I would say that two years from now, when you have to cut prices, the intrinsic value hasn't gone down from today, if you properly calculate it today and build in the fact that profit margins in the future will be lower than today. We looked at a pipeline recently where we think they are going to be vulnerable to competitive price pressures because of alternate ways of getting gas to market through other pipelines. And the calculation is entirely different — the calculation isn’t different — the results are different, in terms of that pipeline versus the pipeline that is the low-cost way of delivering gas from one market to another, and will remain the low-cost producer. But it isn’t — if properly calculated, you build in the prediction of decline in future operating years. You don't wait till you get there to anticipate it. You know, Charlie's famous for saying that all he wants to know is where he's going to die so he'll never go there. (Laughter) Well, that's part of predicting in business. I mean, there — I love the — I really have never seen an investment banker's book. I hope to see one someday, and I hope I can survive the shock when I do see it, where the earnings of the business being offered go down. Lots of businesses' earnings go down. And they're going to go down. And I get all this nonsense, you know, where they project it out for 10 years and it always goes up. It just isn't the real world. And you have to analyze businesses — some businesses are going to be subjected to enormous competitive pressures that aren't extant today. And we made that mistake, for example, at Dexter Shoe. I mean we bought a business that was earning $40 million, or so, pretax. And we assumed that the future would be as good as the past, and we couldn't have been more — I couldn't have been more wrong. So that was a case of projecting into the future, conditions which were not going to exist in the future — competitive conditions. That's part of, you know, that's part of business. And I will tell you that, you know, 20 percent of the Fortune 500 — but I don't know which 20 percent — are going to be earning, you know, significantly less money probably five years from now than they are today. And that's what the game is all about. Figuring out what those future cash flows are likely to be. And when you can't — when you feel you can't come up with reasonable estimates in that respect, you move onto the next one. Charlie?

CHARLIE MUNGERYeah. We have this simple, old-fashioned discipline, which Warren likens to Ted Williams waiting for a fat pitch. I don't know about Warren, but if you said to me, "Charlie, you can go into the business of managing money the way other people do, where you're measured against indexes and you got consultants choosing consultants that are reviewing you to committees," I would just hate it. I would regard it as being put into shackles. And shackles where the very system was preventing me from delivering value. Warren, how would you feel about that —

WARREN BUFFETTYeah, we wouldn’t

CHARLIE MUNGER—chore?

WARREN BUFFETT— do it. We wouldn't do it. We never did do it, as a matter of fact. And one of the, you know, the initial — when we formed the partnership on May 5th, 1956, I passed out to the seven limited partners something called the "ground rules." And, you know, I said, "Here's what I can do and here's what I can't do. And here's some things I don't know whether I can do or not, maybe." It was fairly short. But the idea of setting out to do something that you know you can't do, that can’t be — you know, that's got to lead to problems. I mean, if somebody tells me I have to high jump seven feet, and we could even move that down to four feet now — (laughter) — you know, between now and sundown or I'll be shot, you know, I will go out and buy a bulletproof vest. (Laughter)

CHARLIE MUNGERYeah, the general system for money management requires people to pretend that they can do something that they can't do, and to pretend to like it when they really don't. And I think that's a terrible way to spend your life, but it's very well paid. (Laughter)

Freddie Mac, Fannie Mae, and systemic derivatives risk

WARREN BUFFETTNumber 4.

AUDIENCE MEMBERHi. I'm John Golob from Kansas City. I have a follow up question on derivatives. After the press zeroed in on the comments in your annual letter, the head of Fannie Mae got up and said, well, Mr. Buffett's criticisms don't apply to Fannie because, number 1, we have simple vanilla derivatives that are priced in the market. And secondly, we need derivatives to protect against interest rate risk. And I guess, given what happened to the savings and loan industry back in the '80s, that seems reasonable. So my first question is what is your rejoinder to Mr. Raines? And the second part of my question gets to your concern about the connection between derivatives and systemic risk. And that is, do Fannie and Freddie play a particularly prominent role in this concern? Thank you.

WARREN BUFFETTYeah. I have a lot of respect for Frank Raines. I think he's done a good job at Fannie Mae. I don't know the situation intimately. The problem, as you mention, is that an operation like Fannie Mae or Freddie Mac, or savings and loans in the past, had this problem, which is inherent in the mortgage instrument, in matching — or coming close to matching — assets and liabilities. And the reason they had that terrible problem, which did in many institutions, was the optionality in a mortgage instrument. And in a mortgage instrument, particularly as the years have progressed, you buy a — you know, if you buy a mortgage — or somebody else takes out the mortgage, you own it — you have a 30-year instrument if it's a bad deal and you have about a 30-minute instrument if it's a good deal. The buyer — the person who takes out the mortgage — can call off the deal at any time at relatively low cost. And the public has been sensitized to that more and more as time has gone by, so they've been quicker to refinance for very small differentials. Now, many years ago, they had what they called due-on-sale clauses in California. I think — were they invalidated, Charlie, or what happened with those? So that there were ways of shortening up the mortgage expected maturities. But it's a fundamental problem when you are operating on borrowed money in a very big way, which is what S&Ls did and what Fannie does, and Freddie, that you have this very long-term instrument, and it — but it can be very short-term if it becomes advantageous to you, and rates go down and you want to keep it. Or it becomes very long-term if rates go up and nobody wants to refinance. And under those circumstances, if you run a huge institution, or even a smaller one, but that has a high — highly leveraged, you are going to look for one way or another to try to match the duration of your liabilities as close as you can to the duration of your assets, and have various methods to protect yourself against the optionality that exists with the counterparty, in effect, your asset. That's not easy to do. And Fannie, and Freddie, and other institutions, attempt to do that through various types of derivative instruments, as well as other things, in terms of the kind of debt they issue themselves and so on. And they're very smart, and they do it — you know, my guess is they do a better job than Charlie and I could do at it, but it can't, by its nature, be perfect. And under some circumstances, where you get large gaps — the thing you worry about in financial markets, and it doesn't happen very often, but your — the thing that really destroys people are what the academics would call six-sigma, or five-sigma, or seven-sigma events, which are things that are never supposed to happen, basically. And sigma is a method of describing the probabilities that they will happen in any given period — the number of sigmas. Financial markets don't lend themselves well to modeling based on that. You know, they do most of the time, until it doesn't work. And when it doesn't work, you know, chaos reigns. And there are more six-sigma events that happen in financial markets — or theoretical six- sigma events — than any study of probability curves would ever come up with. And that’s — when you have gaps or discontinuities, when markets close, whatever it may be, those are what cause institutions to go out of business. And derivatives, in my view, anyway, accentuate the possibility of it happening and the extent of the damage, if and when it should happen. Again, we don't think we mathematically can tell you what the probabilities are of something like that, and we think anybody that does tell you, you know, is kidding you. And I've had managers of hedge funds sit down with me and tell me that they had, you know, a 28 percent probability of returns between 30 and 40 percent. Come up with all these exact figures. Anybody comes up with exact figures in finance, watch out. So, I would say that if I were running Fannie or Freddie, I would be terribly conscious of what was happening in there, and I would understand this basic problem I have, which I can guarantee you, Frank Raines understands extremely well, of the optionality built into his assets. And I would try to come as close to matching that. And if I did it through derivative instruments or whatever, I would try to match — I would try to reduce the troubles that could be produced by that optionality to a minimum. And then I would get very worried about who the counterparties were, because anytime somebody promises to pay you a lot of money if something terrible happens to you, you better be very sure that they can and will pay, because the terrible thing that's happening to you may be presenting terrible things to them. You know, that will happen in the insurance industry from time to time. And that's why reinsurance recoverables are a dangerous asset to have. It will happen in the derivative markets. When LTCM had troubles with one type of asset, they had troubles with a lot of types of assets, and everybody else they were doing business with was having a lot of troubles with those same things. And that's why the Federal Reserve stepped into something they never dreamt they would have stepped into. They stepped in to force, essentially, a solution, which may have been the right thing to do, incidentally. But they — for some obscure hedge fund that nobody in the world virtually had heard of, until that point, and had started threatening the U.S. — the stability of the U.S. financial system. Charlie?

CHARLIE MUNGERWell, I think you're right to point to this creditworthiness of the counterparty risk. My guess is that both Fannie and Freddie have been pretty intelligent at thinking through a whole lot of different scenarios where they'll be OK, or close to OK, if all the counterparties pay. And I would bet a lot of money that they weight the possibility that counterparties won't pay a lot lower than we do. I think a lot of the counterparties are behaving in a lot more dangerous way than Fannie and Freddie are, and that — and the counterparties can get in trouble because of that. And they can translate that trouble to people who assume that they're hedged.

WARREN BUFFETTAnd that's true of the mortgage guarantee institutions that take part of the risk away. Fannie and Freddie are very sophisticated institutions. Very, very sophisticated institutions. But if you depend too much on other people, there can be periods in financial history where all the sophistication in the world may not save you. The best thing to do is to be able to count on your own resources. And at Berkshire that's basically the way we operate. And it may be safer than necessary, but, you know, Charlie and I are rich enough already. We do not need to stay up at night.

"We do not run a big currency risk"

WARREN BUFFETTNumber 5.

AUDIENCE MEMBERMy name is Joseph Lapray (PH). I'm a shareholder from Minneapolis, Minnesota. Thank you for this opportunity to present a question. At last year's meeting, I believe that Mr. Munger made a comment to the effect that it was not inconceivable that the U.S. dollar could someday suffer a collapse in value, similar to that which had recently befallen the currency of Argentina. I am concerned that in the event of a collapse in the value of the dollar relative to foreign currencies, that Berkshire Hathaway's insurance operations may find themselves having to pay for replacing property whose cost is denominated in sharply-appreciated foreign currency. I have two specific questions. First, does Berkshire Hathaway have any way to protect itself from the effects of inflation induced by a possible currency collapse? And second, do you have any ideas about how individual investors can protect themselves from currency risk? Thank you.

WARREN BUFFETTYeah. I'll ask Charlie first to comment on whether he said exactly what the gentleman said last year.

CHARLIE MUNGERWell, I don't — I wasn't predicting that the United States would go to hell as much as Argentina has. (Laughter) What I was predicting is that all kinds of things could happen here that are unthinkable, based on past recent experience. And Berkshire, Warren, by and large, our liabilities are denominated in dollars.

WARREN BUFFETTRight.

CHARLIE MUNGERWe don't have a huge foreign currency exposure at all.

WARREN BUFFETTNo, well, we have — you know, we may have — we have a few billion dollars, at least, denominated in liabilities in other currencies, but we also have assets in those currencies, pretty much. So, we don't think about it day by day in terms of matching euro assets against euro liabilities. But in a general way, we don't get way out of whack, either. I mean, we do not have lots of liabilities around the world in other currencies which are only matched by assets in U.S. dollars. Most of our assets and liabilities, overwhelmingly, are going to be in U.S. dollars. But we’ll have a — you know, we will have, maybe at the present time, a couple of billion that — of liabilities, primarily in euros, and we have at least that much in the way of assets. So, we don’t run big — we do not run a big currency risk at Berkshire. Now, if you talk about the value of the dollar declining dramatically, you know, we all face that risk if we have a lot of dollar assets. I personally don't worry about the American currency getting worth far less, relative to other currencies, as much as I worry — I don't really worry about it. But I think there's a probability that sometime in the next 20 or 30 years that you could have rampant inflation in this country again. You'll have probably have it around the world. And it's probably more likely in a good many other countries than it is in the United States. But inflation is always a latent danger to an economy. I mean I always think of inflation as being in remission at all times, because it's something that has a cause that will recur, in terms of human behavior, from time to time, I think, in terms of how legislatures behave and governments behave. So, I think that the probability of high inflation at some point during the next, say, 20 or 30 years is — it's not a low probability. I hope it doesn't happen. Charlie, do you have anything?

CHARLIE MUNGERWell, in the long-term practically all currencies go to hell. In other words, it's a product, like the Roman — what was it, denarius or something? You take the British pound, you take the American dollar, so far. And if you want to go out 200 years, will some politicians in the United States ruin the currency? I think the answer is yes. But I wouldn't anticipate some horrible event in the near future. And — But if things really went to hell, Argentina started confiscating property of shareholders. And if that starts happening and the government is doing it, we probably won't be able to protect you. (Laughter)

WARREN BUFFETTThat sounds like kind of a nervous laugh to me. (Laughter)

Acquisition opportunities growing like a rolling snowball

WARREN BUFFETTNumber 6.

AUDIENCE MEMBERYeah, hi. I'm Gautam Dalmia (PH) from India. Sirs, if I would take you back to the start of your investing careers, I assume it would have been harder for potential acquisition opportunities to come by. The question I would like to ask you sirs is, how did you ensure then that you had good enough deal flows coming to you to be able to choose from? I have one more question. The Berkshire subsidiaries do not have a retirement policy. What are the implications of this on retaining and motivating employees who are potential successors to senior management?

WARREN BUFFETTFirst question about deal flow. It's a term I actually don't like very much, because we don't think of them as deals, exactly. That has a little too much of the connotation of something to be bought, and then again something to be sold. But we do like acquisition opportunities. And really that's just achieving that so that we get the calls when we should get the calls. And there aren't lots of those, because we're talking about good-sized businesses. We're talking about owners that love their businesses. And it's going to happen occasionally, but it's going to happen a few times a year, probably. I think in the U.S. now, that we get a pretty reasonable percentage of the calls that we should get, and that was not true 20 or 30 years ago. We didn't hear from anybody 20 or 30 years ago, to speak of, because we were looked at much more as being a marketable securities operation. And we just weren't as well known. It feeds on itself, obviously. If we acquire companies, and the people from whom we acquire them are happy about the deal, you know, we're going to hear from more people. We bought our first furniture operation in 1983. That really led to four other transactions, because the people in the first one were happy and they talked to us about the second one. And the people in the second one were happy and so on. So, you know, it's like — Charlie always describes compound interest as being like, you know, being at the top of a very large hill with wet snow and starting with a snowball and getting it rolling downhill. And that's a little bit like the acquisition situation works. We've been on a — by being around 38 years, it's been a long — it’s been a high mountain, in terms of the length the snowball is going. By now, it's going at a pretty good clip, and it's a pretty good size, and it attracts a lot of snow. And that's good for us. Outside the United States we do not seem to be on the radar screen, so we don't seem to hear about those as much. But we're hearing about enough in the United States. It's not a flow, in the sense of — I don't hear about one a week. You know, I don't, probably, hear about one a month. But the ones we want to hear about, most of them, I think, we're getting the calls now. I think we're getting a higher percentage of the calls now than ever in our history we would have gotten. And, you know, that's all to the good. And if we can do the same thing outside this country, that would be a plus, too. But this country's a big market and we'll just try and spread the word further. And Charlie, what was that other question?

CHARLIE MUNGERWell, he talked some about deal flow, and there's a general assumption that it must be easy to somehow arrange things that you just sat behind a desk and people brought in one wonderful opportunity after another, and you finally selected two out of 100 and it would be a virtual cinch. That was the attitude in venture capital until the last two or three years. We didn't have any of that in the early days, right, Warren?

WARREN BUFFETTNo, that's right.

CHARLIE MUNGERWe were finding our own securities. And we were just looking at the public markets to see what was available in securities. And when we started buying companies, there must have been 20 years when we didn't buy more than one or two a year.

WARREN BUFFETTYeah. They were fairly few and far between. And we didn't have the money to buy very big ones, either. I mean it was a big deal when we bought Associated Cotton Shops for what, in effect, was 4 million, or when we bought Hochschild Kohn when we had to come up with 6 million of equity, as I remember, for that deal. And National Indemnity, itself, was 7 million for National Indemnity, and I think a million-4, a million-7 for National Fire Marine. And I mean that was all we could handle in those days. So the snowball has, you know, it's built up as it's gone down the mountain. And we hope there's a lot of mountain left and a lot of wet snow, and we're looking for it.

CHARLIE MUNGERBut it's fair to say that we were rooting around for those opportunities. We weren't sitting behind our desks and waiting for some commission salesman to come in and present us with opportunities to sign our name. I can't think of anything we bought in the early days that way.

WARREN BUFFETTNo, no.

CHARLIE MUNGERWarren, you chased down Jack Ringwalt. Didn't you go to him?

Buffett tells how he didn't let Jack Ringwalt wriggle out of National Indemnity deal

WARREN BUFFETTWell, Jack Ringwalt, who ran National Indemnity, and some of you here in the room knew, Jack was a very interesting guy and a friend. And Jack, for 15 minutes every year, would want to sell National Indemnity. Something would make him mad. A claim would come in or something of the sort. (Laughs) So, for 15 minutes every year he would want to sell. And a friend of mine, Charlie Heider — who may be here today — and I had discussed this phenomenon of Jack being in heat once a year for 15 minutes. (Laughter) And I told Charlie if you ever caught him in this particular phase to let me know. And there was a day that Charlie called and said, "You know, Jack's ready." And I said — (laughter) —"Well, get him over here." So, he came about 11:30 and we made a deal in that 15-minute zone. (Laughter) And this is absolutely true. It's a fascinating story, because Jack, having made the deal — and we really did make it in 15 minutes — Jack, having made the deal, really didn't want to do it, and — but he was — he wouldn't have backed out of a deal. But he said to me after we'd shaken hands, he said, "Well," he says, "I suppose you'll want audited financial statements." And if I'd said yes, he would’ve said, "Well, that's too bad then. We can't have a deal." (Laughter) So, I said, "I wouldn't dream of looking at audited financial statements. They're the worst kind," you know. (Laughter) And then Jack said to me, he says, "I suppose you'll want me to sell my agencies,“ and, “— to you as well." And I said, "Jack, I wouldn't buy those agencies under any circumstances." If I'd said yes to that, he would have — that I wanted him to sell the agencies — he'd say, "Well, yeah, I wouldn't be able to do it, Warren. We must have misunderstood each other." So, we went through about three or four of those. And finally, Jack gave up and sold me the business. He was an honorable guy, because he really, I don't think, wanted to do it, but we met down at Charlie's office at 19th, I think, and Douglas, and Jack was about 10 minutes late picking up this 7 million for National Indemnity. He was about 10 minutes late, because he was looking for a parking meter with a few minutes left on it. (Laughter) And that's when I knew he was my kind of guy. (Laughter)

CHARLIE MUNGERBut at any rate, this process is not easy, and practically anything where you sit behind that desk and this wonderful deal flow is just coming by, you're in a very dangerous seat.

No telecom stocks, but maybe junk bonds

WARREN BUFFETTNumber 7.

AUDIENCE MEMBERGentlemen, my name is Jim Maxwell (PH). I am from Omaha, Nebraska. You put your toe in the water, so to speak, with Level 3 when you gave a deal, or, you know, got involved in that deal with them. And I'm wondering if there's anything — any area — in the telecommunications industry that appeals to you now, or any specific company that appeals to you? Much more importantly, I want to ask about Global Crossing. They're in bankruptcy court right now. The U.S. military uses them for communications. Data, telecommunications, or something like that. There are two companies that want to buy their assets out of the bankruptcy court. One is a Chinese company. One is a company from Singapore. The U.S. says, "No way, José." They don't want China to get control of the assets of Global Crossing, mainly because of the military security. In the last week, the Chinese company has backed out. The Singapore company has come in and said, "We will buy the 80 percent stake and — that is now available." But still, if that sale goes through Global Crossing will not be in U.S. hands. Part of my concern is, if these two companies were in a relationship that was friendly, they were willing to be together, I could see the possibility that they would — the Singapore company would sell, later, its portion to the Chinese company. Have you ever considered — and if not, why not — buying the assets out of the bankruptcy court, which would be a fire sale? I think that would be good for Berkshire Hathaway. In addition, it would be good for the United States and for future generations. I would suggest that would be your civic duty, gentlemen. (Laughter)

WARREN BUFFETTWell, I hope I don't get arrested for leaving without doing this. (Laughter) I, frankly, don't have the faintest idea how to evaluate telecommunications companies down the road. That doesn't mean I don't understand, at all, what they do. I probably understand a little bit of what they do. But in terms of figuring out the future economics in that business, what they’re going to — this player or that player is going to look like five or 10 years down the road, I simply don't know. And I think it’s — it looks like the people who thought they knew three or four years ago didn't know either, I might add, but that's another question. Charlie, what do you know about the telecommunications business?

CHARLIE MUNGERA little less than you do. (Laughter)

WARREN BUFFETTHe's in trouble. (Laughs) We don't have any idea. You know, if you take — pull out a name, BellSouth, Verizon, I have no idea how that all comes together five or 10 years from now. I mean, I know people are going to be chewing Wrigley's chewing gum or eating Hershey bars or Snickers bars five, or 10, or 15, or 20 years from now. They're going to be using Gillette blades, they'll be drinking Coca-Cola, you know. And I have some idea what the profitability of each one of those will be over time and all of that. I don't have any idea how telecommunications shakes out. And I wouldn't believe anybody in the business that told me they knew because, you know, what would they have been telling me five years ago? So, it's just a game I don't understand. That isn't — there's all kinds of things I don't understand. I don't know what cocoa beans are going to do next year. You know? I mean, it’d be a lot easier if I did. I could just make all my money on cocoa beans and be much simpler than trying to run a whole bunch of businesses out of Berkshire. But there’s — I don't worry about what I don't know. I worry about being sure about what I do know. And telecommunications doesn't fall within that group.

CHARLIE MUNGERMostly, Berkshire, in its history, has bought common stocks that practically couldn't fail. But occasionally, Berkshire just makes an intelligent gamble where there's plenty of chance of failure, but there's enough chance of success so the gamble is worth taking. And I think it's fair to say that telecommunications falls in that so far.

WARREN BUFFETTYeah. We might buy some junk bonds in that business. In fact, we have in several areas. But as I put in the annual report, we expect losses in junk bonds. We expect, over all the probabilities, we'll have a decent result — maybe better than decent. But we do expect losses, because we are dealing with institutions that have demonstrated that they don't have large margins of safety in their operations. Sometimes — not at all in Level 3, but sometimes, we're dealing with managements that are quite suspect. And I would say that in the history of Global Crossing you had that, although that doesn't attach itself to the assets now. But very often in the field, when people get highly leveraged, sometimes they get tempted to do things that they wouldn't be tempted to do otherwise. And that's happened in the junk bond field, obviously, and always will happen. But that's the reason we expect to have significant losses, and actually we’ve — they haven't been that significant. We've had losses. And — but they — we haven't seen our biggest loss yet, believe me, in junk bonds. But we'll make a lot of money out of some of them, too. It's a different field. It's like being an insurer of substandard risks. You'll have more accidents, but you can charge a premium that makes it work out. But our business — in general, when we buy businesses, we want to buy superior risks. We don't want to buy a hundred businesses for operation by ourselves, with the idea that 15 of them are going to be train wrecks and that the other 85 will take care of it. That's not our approach to building Berkshire. Charlie, got anymore?

CHARLIE MUNGERNo.

Nobody can "successfully dethrone Coca-Cola"

WARREN BUFFETTNumber 8.

AUDIENCE MEMBERYes. My name is Pete Banner (PH) from Boulder, Colorado. First of all, Mr. Buffett and Mr. Munger, most of us consider you fellows our heroes, and thank you for that. (Applause)

WARREN BUFFETTWell, thank you.

AUDIENCE MEMBERYes. On a lighter note, versus the chaos —

WARREN BUFFETTYou can stay on the same note. It doesn't bother us. (Laughter)

AUDIENCE MEMBERI wanted to ask what prompted you — considering your general aversion to technology — what prompted you to invest $100 million in Level 3 Communications convertible bonds? And if I get a twofer, I'd like to know, do you still consider Coca-Cola as you once described as "The Inevitable."

WARREN BUFFETTYeah. The answer to the second one first. The — Coca-Cola I think has — ever since I described it that way, in terms of the — I talked about in terms of the probabilities that they would dominate the soft drink market and not lose market share in any way. That they would grow over time. You know, it's happening year after year. I don't think the global market share of Coca-Cola products has ever been higher than it is now, and I don't see anything that changes that in the future. I mean, it is a huge distribution system that has been getting into the minds of more and more consumers since 1886, when John Pemberton, you know, Jacob's Pharmacy in Atlanta, first served up the first one. It is in the minds of people, the product, all over the world, and it — there'll be more people and it will be in their minds more firmly. And over time, they should make a little more per drink. So, I don't know how in the world anybody would successfully dethrone Coca-Cola.

Buying Level 3 bonds is a "bet on the people"

WARREN BUFFETTIn terms of Level 3, we like the people. We think they're smart people, and they owed too much money, you know. And they recognized it. And they've done some very intelligent things, in the way of attacking that problem, and, you know, we bet on the people. Charlie knows way more about the physical world than I do, but, you know, I have yet to see an electron. And I just have no working relationship with them at all. I can't identify with them. So, I do not know a lot about the technology. I never would. I mean you could explain it to me and I could probably regurgitate it on some test or something, but I wouldn't really understand it. But I think I understand the people involved, and we were quite willing to make that bet. It's of a different sort than we usually do, but we did it and we're happy we did it. Charlie?

CHARLIE MUNGERNothing more to say.

Why Berkshire invested in Mark Byrne's hedge fund, Value Capital

WARREN BUFFETTNumber 9, please.

AUDIENCE MEMBERHi, this is Steve Rosenberg (PH) from West Bloomfield, Michigan, now living in New York. Mr. Buffett, the values that you and Charlie stand for and your supreme integrity are an inspiration. Thank you both for serving as such exceptional role models. I have three quick questions for you. The first involves Value Capital — (applause) — L.P. Your preliminary FIN 46 disclosure appears to indicate leverage employed of roughly 20 billion in assets, 60 million in equity, or 30 to 35 times. Without revealing any proprietary strategies, how do you derive comfort from this investment given your aversion to risk, other highly-levered partnership blowups, your enthusiasm in shutting down Gen Re Securities’ black box activities as soon as possible, and all of this, aside from the fact that it's less than 1 percent of Berkshire's equity, and that Mark Byrne is running it? My second question involves manufactured housing. Can you comment some more on your enthusiasm for the underlying economics of the business, given what appears to be a commodity product with a high level of seller fragmentation, over-capacity, and large blowups on the financing side? And what advantage — even if Berkshire's advantage is in the financing, why not stick only to the financing and not the manufacturing? And my final question involves the gains on securitization that you see in that segment. Does the preponderance of gains reported indicate a mispricing of credit risk somewhere in the chain, perhaps analogous to the disconnect you were talking about between triple-B and triple-A spreads in the synthetic market and in the bond market? Thank you.

WARREN BUFFETTWhy don't you elaborate on that third point on securitizations just a bit more? I'm not sure I totally have your point on that.

AUDIENCE MEMBERJust the fact that usually you see gains rather than losses on securitization —

WARREN BUFFETTOh yeah.

AUDIENCE MEMBER— all the time. Does that indicate that somewhere, when you're slicing and dicing it, someone is paying too much, not taking the credit risk into — not valuing it properly.

WARREN BUFFETTYeah. OK. Three questions. Value Capital is run by Mark Byrne, as you mentioned. We've made a lot of money with the Byrne family. We made money with Jack, and we like Mark and Patrick, who we know — Charlie and I know very well. And Mark is a very, very bright guy who runs what is, in effect, a hedge fund specializing in fixed income-type securities around the world. And Mark and his family have significant money of their own in Value Capital, but we have 95, or so, percent of the capital in there. And we do not in any way guarantee their obligations. Mark operates with a degree of leverage that is less than most people that operate in that field, but it's a lot compared to the way we operate at Berkshire. And that's OK with us. We wouldn't do it with a hundred percent of our money. We wouldn't do it with 50 percent of our money. But we think it's a reasonable business, as run by Mark, as long as he's got a lot of money on the downside as well as the upside, which he does. And he's a very decent guy, in addition to being a very smart guy. So, we're comfortable with that. It may have to get — the figures may have to get consolidated in our balance sheet. We disclose them all now in our first quarter report. You will see them set out. And, in effect, we've got 600 and some million, a couple hundred million of retained earnings that Mark has earned for us, and we feel quite comfortable with that as an investment. We do not regard it as a business part of Berkshire. The consolidated financial statements may make it look like we do, but it is not. We are a limited partner. We have a corporation in between. We have no guarantees of anything they do. And we're very happy with Mark running that piece of money, even though he does it, as you say, in fixed-income strategies that involve a lot of — they involve derivatives, they involve borrowed money. But I've looked at the positions and they all make sense to me. And they would make sense, because Mark is a very smart guy, and the money means a lot more to him than it does to us. So, we feel OK with that. We don't like the idea of consolidating, in the sense that we don't think it will make — we think it makes our figures less representative of what's really going on than the way we handle it presently, but the rules are the rules and we'll do what they say. The second point. Charlie, do you want to comment on Value Capital at all?

CHARLIE MUNGERNo.

Clayton Homes is "class player" in manufactured homes industry

WARREN BUFFETTOK. (Laughter) The second. Manufactured housing. You know, it is — I mean practically everybody in manufactured housing is losing money now, and Clayton is making money. They've had much sounder policies, in terms of how they've operated over the years. One of the things they do — most of their houses are sold through their own retail units. They have about, I think, 297 or so retail outlets of their own. And those managers are on a 50/50 profit split, basically, as I remember it, with Clayton. And they're responsible for all of the paper they generate. So, unlike what was going on a few years ago in manufactured housing, where a manufacturer would sell a house, maybe a floor plan, to a dealer. And then that dealer could borrow, maybe — if I he got some kind of a purchaser on the note, maybe 125 or 130 percent of invoice price, if he could just create a warm body out there someplace that would give him some apparent down payment. That situation was just built for disaster. But at Clayton, the profit or loss off that person who buys the product goes till the obligation is fully paid for. So if a dealer takes inadequate down payments or sells to people he shouldn't be selling to, it's going to be his problem, and he's going to get the repo back. He's going to have to sell it himself. He's going to get the loss on the paper charged to him. And that produces an entirely different kind of behavior at the retail level than occurred with many of the other manufactured housing manufacturers. But it's not an easy business. It’s — Clayton does it the right way. And in fact, if you read Jim Clayton's book, he will — he tells in there about the time he bought his first home in Indiana. And he tells about a little of the funny business that went in, in terms of how the manufacturer behaved. And he described some of the systems that people use to gain the financing. And those activities are coming home to roost in a huge way for both the manufactured housing companies and for the people that finance the retail paper. Clayton did it right, basically, and they'll continue to do it right. Even so, there is such a stain over the whole manufactured housing industry, in terms of financing, that even — Clayton is the only one that has — is able to securitize. And, as I said earlier, they cannot securitize to the extent — without us — they wouldn't be able to securitize to the extent that they could have a year ago. It's an industry in big trouble. I think we'll do fine in it, because I think we're in with a class player. I think they've got these systems in place that have the right incentives, which you need all the way through the system. And I think Berkshire will make them even stronger, because we will not securitize. We'll keep it for the portfolio. The gains on securitization — the point you made is essentially correct, that some of the — when you see a company with lots of gains on securitization, you ought to get a little suspicious. I don't want to get into more detail than that because it's an accounting question. Charlie?

CHARLIE MUNGERI've got nothing to add to that, either.

Goodwill impairment charge not needed for Gen Re

WARREN BUFFETTNumber 10.

AUDIENCE MEMBERPhil McCaw (PH), Warren, from Connecticut. Could you comment on Gen Re and goodwill impairment charges since you purchased it, and how it's evolved in your thinking, and if it even became a part of your thinking?

WARREN BUFFETTSure. The question is — relates to the fact that, if you buy a business at a price over tangible assets, that you set up a goodwill account. And if at any time in the future that that goodwill becomes impaired, you should, and must, if the accounting is proper, run a charge to reduce that goodwill item. You run a charge through the income account. We have a large goodwill item for Gen Re, because it was the biggest acquisition we ever made. We paid substantially more than book. And the question is whether that goodwill is impaired. And certainly, if the operations of Gen Re of the last couple of years — not including this year — but of the years '98 through 2001, more or less, were representative of the future, you would say that there has to be a big goodwill charge there, and I would agree with you. I think that as Gen Re is operating now, and had the capacity to operate — and it's being realized now, thanks to a couple of great managers we've got there — I think that — I personally think that Gen Re is worth more now today than at the time we bought it. And I think you will — its float has increased substantially, and I think that you will see the float turn out to be cost-free over time. One thing I should have mentioned, actually, is — and I looked at a draft of our 10-Q. We have to — I think we should put this in there. We — Gen Re, up until this year, was discounting worker's comp reserves at 4 1/2 percent, which was not conservative. That — we inherited that situation. But we have changed that to discounting comp reserves going forward at 1 percent. So the accounting is more conservative going forward now — 2003 — by a fair margin, than it was in prior years and in a method we inherited. So that the figures you see would be somewhat better if we had continued the old discounting at 4 1/2, rather than go to the new discount rate. And in the draft I saw, the 10-Q, that wasn't in there. I think we should get that in there, [Berkshire CFO] Marc [Hamburg], while I think of this. Charlie?

We "deplore solving operating problems by accounting maneuvers"

CHARLIE MUNGERYeah. That accounting issue is of a type that is very common within Berkshire. We are so horrified by the terrible business decisions we see made all around us by people who are relying on over-optimistic accounting, that we tend to almost reach for opportunities to make our accounting very conservative. Way more than other people. We think it protects our business decision-making, as well as our financial integrity. I don't know why we ever got into this business of trying to get the accounting result as close to the chalk as we could possibly get it. What is wrong with the world when everything is a little bit under-reported? I mean —

WARREN BUFFETTYeah, generally people think that reporting, you know, and transparency and all that, has improved over the years. And I felt much better working with the financial statements in 1960 than I feel working with financial statements in 2000. And, frankly, in many ways I thought they taught me more about what the company was really about than the current ones do, even though there was far less detail. And what we really deplore is solving operating problems by accounting maneuvers. And, you know, Gen Re had some problems in the mid-'80s, when everybody did, and they went to discounting their worker's comp reserves. And they — you know, it was a quick fix, but it's like heroin. And you get on it and it's not easy to get off. And we — Charlie and I have seen that time and time again. People that think, you know, trade loading, whatever it may have been, they think they're going to solve something by paying accounting games. And they're encouraged by their CFOs sometimes and frequently they were encouraged by their big-name auditors, in one way or another, to really play with the numbers. And it catches up with you. You might as well face reality immediately, and take whatever operating steps are necessary to solve problems. Or, if you can't solve them, just give up on them. But whatever you do, playing with the numbers, it never works, although I guess if you're 64 1/2 and you're going to retire at 65, it might get kind of tempting. (Laughs)

Munger on recognizing "bullshit earnings"

WARREN BUFFETTNumber 1.

AUDIENCE MEMBERGood afternoon, gentlemen. Andy Marino of Chapel Hill, by way of Boston. You have argued against the use of alternate measures of profitability, such as earnings before interest, tax, depreciation, and amortization, as measures of business performance. At the same time, you have frequently cited the incompleteness of generally accepted accounting in reflecting economic reality for some businesses, implying that there are some necessary and proper adjustments. Beyond what you recently described in the annual report as the folly of omitting depreciation, could you elaborate on your thoughts on other pitfalls of alternative financial presentations? Is EBITDA, in your view, just too often used as a shorthand for cash flow, or is the entire concept of recasting accounting data a suspect exercise? And which revisions might be appropriate, if any? And what might be viewed as red flags? And does it matter to you who is making those adjustments? Analysts, investors for their own purposes, or company managements, in terms of how that information should be viewed?

WARREN BUFFETTYeah. We regularly told you, for some years before the accounting change was made here a year or so ago — we told you, you should not count goodwill amortization. You know, it was required under GAAP, and we, obviously, complied with GAAP, but we told you every year, virtually, that I can remember, we said, "This is not really an economic expense." And we ignore it in our own calculations of earnings, in terms of what we will pay for businesses. We don't care whether there's a goodwill item or not, because it's immaterial to economic reality. So, we have been quite willing, at Berkshire, to tell our own owners to ignore certain things. And if they disagreed with us, they could look at the GAAP figures. But we felt they were getting misled by looking at the amortization of intangibles. That doesn't mean we think all intangibles were good, but we just — we did feel that that was a — that was an arbitrary decision that didn't make any sense at all. And we felt — obviously, as we've talked about — we felt the crazy pension assumptions have caused people to record phantom earnings, in many cases. So we're willing to tell you when we think there is data that is more important in economic analysis than GAAP figures. We'll talk to you about it. Not thinking of depreciation as an expense, though, strikes us as absolutely crazy. I can think of very few businesses — I can think of a couple — but I think of very few businesses where depreciation is not a real expense. Even at our gas pipelines, I mean, you know, at some point, A, they'll need repairs, but beyond that, at some point they become obsolete. I mean there won't be gas there 200 years from now, we know that. So, it — depreciation is real, and it's the worst kind of expense. It's reverse float. You know, you lay out the money before you get revenue. And you are out cash with nothing coming in. And depreciation — any management that doesn't regard depreciation as an expense, you know, is living in a dream world, but of course they're encouraged to do that, you know, by investment bankers who talk to them about EBITDA. And then, you know, certain people have built fortunes on misleading investors by convincing them that EBITDA was a big deal. And when we see companies that say, "Hey, we don't pay any taxes, you know, because we don't have any earnings for tax purposes, and don't count depreciation and all of that," you know, that's coming — in our view, many times that's coming very close to a flimflam game. You know, I get these people that show me — you know, they want to send me books with EBITDA in it, and I just tell them, you know, "I'll look at that figure when you tell me you'll make all the capital expenditures." If I'm going to make the capital expenditures, there's very few businesses where I think I can spend a whole lot less than depreciation year after year and maintain the economic strength of the business. So I think the EBITDA has been a term that has cost a lot of investors a lot of money. You saw it in the telecom field. I mean the idea — they were spending money so damn fast, you know, I mean they couldn't have it coming in the door fast enough from investors. And then they pretended the depreciation was not a real expense. That's nonsense. I mean it couldn't be worse. And a generation of investors where sort of brought up to believe in that. We, at Berkshire, will spend more than our depreciation this year. We spent more than our depreciation last year. We spent more than our depreciation the year before that. You know, depreciation is a real expense, just as much as, you know, the expenditure for lights. It's not a non-cash expense. It's a cash expense. You just spend it first, you know. I mean the cash is gone, and it's a delayed recording of cash. How anybody can turn that into something they use as a metric that talks about earnings is beyond me. Charlie?

CHARLIE MUNGERYeah, I think you would understand any presentation using the word EBITDA, if every time you saw that word you just substituted the phrase, "bullshit earnings." (Laughter and applause)

WARREN BUFFETTI knew he'd do it sooner or later, folks.

CHARLIE MUNGERAnd the man —

WARREN BUFFETTHe made it through the morning, but never all day. (Laughter)

CHARLIE MUNGERAnd the man asked the question also, says, "What remaining big accounting troubles exist?" The real lollapalooza is pension fund accounting, and, to some extent, post-retirement medical liabilities. Those are horribly understated now in America, and they're very big numbers.

WARREN BUFFETTI've looked at financial statements, and you've seen them too in the last few months, where companies are recording pension income in the hundreds of millions, while at the same time being underfunded in their pension plan in the many billions. And, you know, they just aren't facing up to reality at all, and they don't want to because they want to take the hit. And they’re this — you know, it's the same mentality as stock option expenses. And they are paying people with stock options. But, you know, we pay people with cash bonuses, and I suppose, you know — well, it isn't really true, but we might like it if we didn't have to record cash bonuses as an expense. I mean it's a way we pay people. And you can say, "Well, why don't you put it in the footnotes and leave it out of the income account like they do with option expenses," which is a form of compensation, too. But the — you know, the answer is that a bunch of people who cared very much about having their stocks float to unreasonable prices, at least in our view, found they could do it a lot easier if they didn't count compensation expenses. And, you know, why not put all expenses in footnotes? Just have an item there that says "sales" and then have the same figure for net profit. And then just have all the — (laughter) — expenses in the footnotes, you know. And people with a straight face, you know, say, "Well, it's in the footnotes, so therefore everybody knows about it and we don't have to count it — put it in the income account." It's amazing what people with high IQs will do to rationalize their own, you know, their own pocketbooks. And Charlie has another explanation for why there's been this denial of the reality of expense — option expense — in terms of people's ego getting involved with their own records. You want to elaborate on that, Charlie? Don't name names. (Laughter)

CHARLIE MUNGERNo, I'm so tiresome on this subject, and I've been on it for so many decades. It's such a rotten way to run a civilization. To make the basic accounting wrong is very much like making the engineering wrong when you're building a bridge. And when I see reputable people making these perfectly ridiculous arguments to the effect that it's unthinkable that options be expensed.

WARREN BUFFETTOr it's too difficult to value them.

CHARLIE MUNGERWell, because it's too difficult to value, or God knows what reason. And a lot of them are people you'd be glad to have marry your daughter. (Laughter)

WARREN BUFFETTYeah, because they're rich, for one thing. (Laughter)

CHARLIE MUNGERYet, the truth of the matter is they're somewhere between crazy and crooked. (Laughter)

WARREN BUFFETTPut him down as undecided. (Laughter) It’s really astounding. The interesting thing is, of course, now, is that the four auditing firms left, what they call the Final Four now in the auditing — (Laughter) They have now — and listen, I'm glad they did it, too. And I tip my hat to them for doing it. But they've now said that they really do think options are an expense. So this is — You know, it kind of reminds of you what happened during the Reformation, isn't it? You know, when you'd have these places sway back and forward, you know, as they get carried by one argument or the other. In fact, I think there was that famous vicar of Bray who would swing from Catholicism to Luther, back and forth, as this little town went back and forth in Germany. And finally, the townspeople gathered and they said to the vicar — they said, "It's understandable that we're confused by all that's going on in theology, and we really don't know much about it, and so we swing back and forth." But they said, "We find it a little disgusting that you, a man of the cloth, would also keep swaying back and forth." And they said, "Have you no principle?" "And he said, "Yes, I have one principle." He says, "It's to remain the vicar of Bray." (Laughter) I think we've seen a little of that in the auditing profession, but I think they've actually found the true religion now, so I don't want to sit here and criticize them. But, you know, you now have four firms that lobbied against options being counted as an expense in 1993 that have written the FASB and say that options should be an expense. And I don't know how in the world something could have not been an expense in 1993 and be an expense in 2003. Certainly didn't apply to utility bills or, you know, raw materials or anything of the sort. But that's the human condition.

No comment on "opportunistic" bond strategies

WARREN BUFFETTNumber 2.

AUDIENCE MEMBERYes, hi. Sam Kidston. I'm a shareholder from Cambridge, Massachusetts. I have a couple of quick questions for you guys. First of all, other than your general criteria for investing in any company, what are your criteria for investing in banks? And has your general view toward investing in banks changed over time? Second question would be, in terms of a discount rate, do you feel it's appropriate to use your cost of capital at the current risk-free rate? And then in the past, you've mentioned that you do some sort of pseudo-bond arbitrage, and would you please specify what types of trades you do in this area?

WARREN BUFFETTOh, you would like our buys and sells for Monday morning? (Laughs) We don’t — we're not going to talk about specific strategies that, you know — we obviously they're profitable or we wouldn't be doing them, and we think other people might copy them if we talked about them, so — And we have pointed out, incidentally, and we will continue to point it out, that there's not a long life to these bond strategies. That doesn't mean we might not reemploy them when circumstances called for it later on. But they're not like earning money out of See's Candy or, you know, out of Fruit of the Loom or something. They're opportunistic situations that we're pretty well positioned to engage in at certain times.

Banks can be "surprisingly" profitable

WARREN BUFFETTThe question about banking, you know, banking — if you can just stay away from following the fads, and really making a lot of bad loans, banking has been a remarkably good business in this country. Certainly, ever since World War II, it’s — the returns on equity from — for banks that have stayed out of trouble has really been terrific. And there are many — there are certain banks, I should say — in this country that are quite large that are earning, you know, maybe 20 percent on tangible equity. And when you think you're dealing in a commodity like money, that's fairly surprising to me. So, I would say that I guess I've been surprised by the degree to which margins in banking have not been competed away in something as fundamental as money. How about you, Charlie?

CHARLIE MUNGERWell, what you're saying, in fair implication, is that we sort of screwed up the predictions, because banking was a way better business than we figured out in advance. We actually made quite a few billions of dollars, really, out of banking, and more in American Express. But basically that was while we were misappraising it. We did not figure it was going to be as good as it actually turned out to be. And my only prediction is that we'll continue to make failures like that. (Laughter)

WARREN BUFFETTIt's fairly extraordinary, in a world of — particularly a world of low interest rates, that you'd find financial institutions basically doing pretty much the same thing, you know, where A competes with B, and B competes with C, without great competitive advantage, and having them all earn really high returns on tangible capital. Now, part of it is that they push — they have pushed the loan-to-capital ratios higher than 30 or 40 years ago, but that — nevertheless they earn high rates of returns. They earn much higher rates of returns on assets alone, and then they have greater leverage of assets-to-capital so that produces returns on capital that really are pretty extraordinary. And, you know, banks — certain banks — get into trouble because they make big mistakes in lending, but it's not required of you, in that business, to get into trouble. I mean you can — if you keep your head about you, it can be a pretty good business.

Look at opportunity costs, not "cost of capital"

WARREN BUFFETTThe question about a discount rate, when you talk about our cost of capital, that's worth bringing up, because Charlie and I don't have the faintest idea what our cost of capital is at Berkshire, and we think the whole concept is a little crazy, frankly. But it's something that's taught in the business schools, and you have to be able to answer the questions or you don't get out of business school. But we have a very simple arrangement in terms of what we do with money. And, you know, we look for the most intelligent thing we can find to do. If we've got money around or — if we look — we don't buy and sell businesses this way, but in terms of securities we would — if we find something that's at 50 percent of value, and we own something else at 90 percent of value, we might very well move from one to another. We will do the most intelligent thing we can with the capital we have. And so, we measure alternatives against each other, and we measure alternatives against dividends, and we measure alternatives against repurchase of shares. But I have never seen a cost of capital calculation that made sense to me. How about you, Charlie?

CHARLIE MUNGERNever. And this is a very interesting thing that's happened. If you take the most powerful freshman text in economics, which is by [Greg] Mankiw of Harvard, and he says on practically the first page that "intelligent people make their decisions based on opportunity cost." In other words, it's your alternatives that are competing for the use of your time or money, that matter in judging whether you take action or not. And of course, those vary greatly from time to time and from company to company. And we tend to make all of our financial decisions based on our opportunity costs, just as like they teach in freshman economics.

WARREN BUFFETTYeah.

CHARLIE MUNGERAnd the rest of the world has gone off on some crazy kick where they can create a standard formula, and that's cost. They even get a cost of equity capital for some business that's old and filthy rich. It's a perfectly amazing mental malfunction.

WARREN BUFFETTYeah, it’s a — (Laughter)

PetroChina investment not a "big deal"

WARREN BUFFETTNumber 3. Is there anybody we've forgotten to offend? (Laughter)

AUDIENCE MEMBERHi. My name is Karen Kalish. I'm from St. Louis. And I think I'm the first woman to ask a question today. (Applause)

WARREN BUFFETTWe're all for that.

AUDIENCE MEMBERMy late uncle, Bill Shield at Robert W. Baird, first bought Berkshire for our family when it was $337. And I'm very grateful to you two, because I've been able to start a foundation in St. Louis and give money away. And I give it to reading and literacy programs. But I'm very curious about the Buffett-Munger philosophy and practice of philanthropy. And my second question has to do with China. You made an acquisition recently, PetroChina, and I'm curious of what you think about China.

WARREN BUFFETTWell, the second question, we have about — I think — about five equity investments in companies that are domiciled and that operate primarily, or entirely, outside the United States. We don't list all our investments. We listed, I believe, last year, all those above $500 million. And we have never had — I think maybe since Guinness some years back — I don't think we've ever had one hit the threshold of reporting in the Berkshire report, although we've owned some. And the Hong Kong stock exchange has just recently changed their requirements so that you have to report 5 percent of the holding of any company listed on the Hong Kong stock exchange. And our PetroChina holdings, actually, are now, whatever it is, 13 percent, but they're only 13 percent of something called the H shares. The Chinese government owns 90 percent of the company. The H shares own 10 percent. They sold that to the public a few years back. So we own 13 percent of a very small percentage. And it's kind of a fluke of reporting that we're required to report that particular holding. And like I say, we own four or so others in international securities. We don't make any great judgment about China. You probably know more about China than I do. We simply look at investments around the world and we try to buy into things that we think offer the most value. And if they’re in the United — we might prefer, slightly, that they be in the United States, and we might have strong preferences against — or strong biases against certain countries. We would regard the United States as number one because we understand the game the best here. We understand the tax laws and all that sort of thing, and the corporate cultures and so on. But we would regard a number of other countries as virtually equivalent to the U.S. And there's others that would have been marked down some, and then we'd have a whole bunch we wouldn't go into under any circumstances because we just don't understand them well enough. But, you know, we think we understand something like the oil business in China reasonably well. And at a price relative to what we think the future cash generation is, we would make a decision on something like that. But it's not a big deal. It’s a big — it became reportable because of this peculiarity of the law, where if you own a certain percentage of something that's only 10 percent of the whole pie, you still have to report it. The Chinese government is firmly in control of PetroChina. I mean, if we vote with the Chinese government, the two of us will control PetroChina. (Laughter)

Why we're giving money "back to society"

WARREN BUFFETTThe question about philanthropy. Charlie, you want to swing at that one first?

CHARLIE MUNGERI think it's fair to say that both of us feel that the very fortunate owe a duty to the general civilization, and even to the country of which he's a member. Whether you give as you go along or have the Buffett system of moderate giving as you go along and immense giving in due course, I regard as a matter of personal taste. I would understand the second position in that I would hate to spend all my time every day having people ask me for money. And I don't think Warren could stand it. Is that right, Warren?

WARREN BUFFETTLet's not even try. Let's not even try, Charlie. (Laughter) No, we — I mean, it's a matter of record, and it hasn't changed for, I don't know, 25 years, probably, but basically everything I have at the date of the later of the death of myself or my wife, goes to charity. I mean 99 and a significant fraction. And since my children are here, I'm not going to carry it out to 8 decimal places. But — (laughter) — you know, why not? It — Think of it this way. Here’s — let's just assume that, instead of being born as I was in a single birth, that I were in the womb and there was an identical twin next to me. Same DNA. Same everything. Personality. Propensity to work. Propensity to say — whatever. Identical twin. Wasn't Charlie. Might look like him, but — (Laughter) And there we are, the two of us. And a genie appeared. And the genie said, "I've got a proposition for the two of you. You're going to be born in 24 hours. Same talents. Everything identical. And one of you is going to be born in Omaha, and one of you is going to be born in Bangladesh. "And I'm going to let you two decide which one gets to be born in Bangladesh and which one gets to be born in Omaha. And I've got this system. And I’m going to — the way I'm going to work it is that we start the bidding, and whichever one of you bids the highest proportion of your estate to go to society when you die, gets to go — be born in the United States." I think you'd bet a hundred percent, you know. You hear all of this about, you know, grit and pluck and all of these things, and how, you know, you have applied yourself working all your life, and you've done all these wonderful things. Well, just imagine if I'd been born in Bangladesh. You know, and I'd walked down Main Street and said, you know, "I allocate capital." You know? "Let me show my stuff." (Laughter) I'd have died of malnutrition. I mean, it would — I wouldn't have made it through the first few months. The society that Charlie and I work in, I mean we were luckier than hell. I mean when we were born, the odds were 50-to-1 against us being born in the United States. So we hit the jackpot. And basically, it — you know, we've had all of the fun of working with this and working with good people. And money, obviously, opens lots of doors in life to interesting things. And it goes back to society. Like Charlie says, it can go back on the installment system through life. It can go back in a lump sum at death. I've mixed the two to some extent, but I weight heavily the lump sum. But, you know, that's where it belongs. I mean, it — there's no reason why little — generations of little Buffetts, now and the next one, you know, and a hundred years from now, should all be commanding the resources of society just because they came out of the right womb. You know, what sort of justice is that? So basically, it's going back to society. (Applause) Were my children applauding there? Did we check that out? (Laughter)

Many great businesses can't boost profits by spending more capital

WARREN BUFFETTNumber 4.

AUDIENCE MEMBERHi there. My name is Alex Rubalcava. I am a shareholder from Los Angeles. I have a question about the financial characteristics of the businesses that you like to acquire and invest in. In your reports and other writings, Mr. Buffett, you state that you like to acquire businesses that can employ a large amount of capital to high returns. And in reading the writings and speeches of yourself, Mr. Munger, I've seen you say in Outstanding Investor Digest and other publications, that you enjoy investing in companies that require very little capital. And I was wondering if these statements are at odds, or if they are two sides of the same coin? And if you could elaborate using Berkshire companies, that would be great.

WARREN BUFFETTSure. It's a good question. The ideal business is one that earns very high returns on capital and could keep using lots of capital at those high returns. I mean that becomes a compounding machine. So if you have your choice, if you could put a hundred million dollars into a business that earns 20 percent on that capital — say 20 million — ideally, it would be able to earn 20 percent on 120 million the following year, and 144 million the following year and so on. That you could keep redeploying capital at these same returns over time. But there are very, very, very few businesses like that. The really — unfortunately, the good businesses, you know, take a Coca-Cola or a See's Candy, they don't require much capital. And incremental capital doesn't produce anything like the returns that this fundamental return that's produced by some great intangible. So we would love the business that earn — that could keep deploying, in fact, even well beyond the earnings. I mean we'd love to have a business that could earn 20 percent on a hundred million now. And if we put a billion more in it, it would earn 20 percent more on that billion. But like I say, those businesses are so rare. There are a lot of promises of those businesses, but we've practically never seen one. There've been a few. Most of the great businesses generate lots of money. They do not generate lots of opportunities to earn high returns on incremental capital. You know, we can deploy X at See's and earn a lot of money, but if we put 5X in we don't earn any more money to speak of. We can earn high returns on X at The Buffalo News, but if we try to make it 5X we don't earn any more money. They just don't have the opportunities to use incremental capital. We look for them, but they don't. So, the great — you’ve seen — I mean, we will talk theoretically about the businesses that can earn more and more money with incremental capital at high returns. But what you've seen is that we've bought businesses, largely, that earn good returns on capital, but in many cases, have limited opportunities to earn anything like the returns they earn on their basic business with incremental capital. Now, the one good thing about our structure at Berkshire is that we can take those businesses that earn good returns in their business but don't have the opportunity for returns of those similar magnitude on incremental money, and we can move that money around to buy more businesses. Normally, if you're in the — take the newspaper publishing business, which has been a fantastic business over the years — you earned terrific returns on your own invested capital. But if you went out to buy other newspapers, you had to pay a very fancy price, and you didn't get great returns on incremental capital. But the people in that business felt that the only thing they knew was newspaper publishing or media of one sort or another, so they felt that their options were limited. We can move money anyplace that it makes sense, and that's an advantage of our structure. Now, whether we do a good job of it or not's another question, but the structure is enormously advantageous in that respect. We can take the good business, the See's Candy — See's has produced probably a billion dollars pretax for us since Charlie and I wouldn't have gone up 100,000, you know, back in 1972. If we tried to employ that in the candy business we'd have gotten terrible returns over time. We would have gotten anything to speak of. But because we moved it around it enabled us to buy some other businesses over time, and that's an advantage of our structure. Charlie?

CHARLIE MUNGERYeah. And if you take a business that is a good business, but not a fabulous business, they tend to fall into two categories. One is the business where the whole reported profit just sits there in surplus cash at the end of the year. And you can take it out of the business and the business will do just as well without it as it would if it stayed in the business. The second business is one that reports the 12 percent on capital but there's never any cash. It reminds me of the used construction equipment business of my old friend, John Anderson. And he used to say, "In my business, every year you make a profit, and there it is, sitting in the yard." And there are an awful lot of businesses like that, where just to keep going, to stay in place, there's never any cash. Now, that business doesn't enable headquarters to drag out all the cash and invest it elsewhere. We hate that kind of a business. Don't you think that's a fair statement?

WARREN BUFFETTYeah, that's a fair statement. We like to be able to move cash around and have it find its best use. And, you know — but that's our job. And sometimes we find good uses. It would be terrific if every one of our great businesses, and we've got a lot of great businesses, had ways to deploy additional capital at great rates, but we don't see it. And, frankly, you know, it doesn't happen — I mean Gillette has a great razor and blade business, I mean, fabulous. There's no way they can deploy the money they make in the razor and blade business to keep putting more money in that kind of business. It just doesn't take that kind of capital. They have to deploy some money of it, but it's peanuts compared to the profits. And the temptation then is to go out and buy other businesses, and of course that's what Charlie and I do when we face that, but we don't think that, overall, the batting average of American industry in redeploying capital has been great. Nevertheless, it's what we try and do every day. In a sense, we sort of knock the very procedure that has gotten us to where we are. Is that a fair statement, Charlie? (Laughs)

CHARLIE MUNGERAbsolutely. And that has always worried me. I don't like being an example of an activity where most people who try and follow it will get terrible results. And we try and avoid that by making these negative comments. (Laughter)

WARREN BUFFETTWe'd make negative comments anyway. (Laughs) Number 5. It's more fun.

Buffett: I don't ask my friends for favors

AUDIENCE MEMBERI'm Will Graves from Winter Park, Florida. I'm a graduate instructor with Webster University. And I'd like to address two questions to Mr. Buffett. I appreciate the accessibility of Mr. Buffett. He makes us feel so warm here. Could I call you Dad?

WARREN BUFFETTYeah. (Laughter)

AUDIENCE MEMBERI've got one question regarding a National Treasury situation and one considering a national treasure. Back in September 11, you appeared on "60 Minutes" and performed a national service, taking your valuable time and giving up your private life for a few moments by speaking about the general stock market, and how people should not be getting too excited, and they shouldn't be worried about investing for the long-term. And what I was wondering is, if you would ever consider making another appearance on "60 Minutes" at the time when whoever the president is at the time brings up the Social Security debate. I spend a lot of time with non-profit organizations, and the outrage that you hear from the working poor is that we talk about the tech turnaround, the tech profits of the last few years. They've gone through a whole cycle where people became multimillionaires at a time when the working poor never even got a minimum wage increase. And if you think of people like this who have a net worth of a thousand dollars or less, just as an example, and just imagine what it's like for them to be forced, in the future, to be horrible investors because the U.S. government forces them to have something called Social Security, which they can't get out of, and they get a lousy return. What I'm wondering is, if you would consider, when we have a candidate, whoever it might be at the time, say that you don't want to put a small portion of Social Security into the long-term stock market because it's a risky proposition? If you would take your track record on "60 Minutes" and say, "I don't think so." That's the first question. And number two, while I'm asking you to volunteer for something, I found myself being thrust into something in the last three weeks. I went to Cypress Gardens the last day with about 20,000 people there. And the lady was handing out 15,000 fliers. Several weeks from now I'll be before Governor [Jeb] Bush with the Friends of Cypress Gardens. We have a website, FriendsOfCypressGardens.org, trying to keep a developer from clear-cutting the trees in Cypress Gardens, a national treasure. And my question is, would you consider contacting your cousin, [musician] Jimmy Buffett, about possibly helping us in some way? Doesn't have to be money. It might be an appearance. Just might be some connections, where you might be able to help us in our efforts.

WARREN BUFFETTI get asked to contact — probably the one I get asked to get contact the most is Bill Gates, but I get asked to contact all kinds of people. And I mean, everybody is slipping me envelopes with letters in them, sending things to the office and saying, "Won't you get this person?" and all they can say is no. I don't do — I don't make requests of my friends, basically, for anything. And I just — I would spend the rest of my life doing it. They would feel — I would never know — (applause) — you know, what they were doing — you know, I would never know what they were doing because I was asking, versus what they really felt. I mean it's an impossible — from my standpoint at least — that's an impossible game to get into, in terms of that. I mean when [Washington Post publisher] Kay Graham was alive, everybody, you know, wanted her for one reason or another. And they've all got causes. And, frankly, they, you know, they want to use me to get her, or Jimmy Buffett, or whomever, to say yes to something that they're saying yes to, partially because they feel they don't want to say no to me. And I, you know, that — I just don't want to use my friendship for that purpose, frankly. And I don't do it, even for things that I strongly believe in, myself. I do them — they may know what I'm doing, and if they want to pick up on it, fine. But I have never — I can’t remember ever requesting anybody to make a contribution or do anything myself. I mean what I do is a matter of record, and, you know, if other people want to pick up on it, fine. But I’ve never had one of those honorary dinners where they send out, you know, to all the suppliers to Berkshire and everything and start leaning on them and saying, you know, "We're honoring Warren." Well, hell, if they want to honor me they can honor me without soliciting all my friends for money. I mean, I don't consider that much of an honor if the reason they picked me was because I got rich friends. So, I just don't do that.

"There's something unattractive about a very rich guy that pops off on everything"

WARREN BUFFETTOn the public policy question, what I did on September 11th, when [former General Electric CEO] Jack Welch and [former Treasury Secretary] Bob Rubin and I went on there, you know, I will do those things occasionally. I've written some op-ed pieces. I think — and I get tempted very often, in fact I've written some that I haven't sent in. But I do think that there's something unattractive about a very rich guy that pops off on everything. And you may think, by listening to us today that you've got two guys up here that do like to pop off on everything. And we do have opinions on almost everything. But I just think there are some things I get — you know, I wrote on campaign finance reform, and I've written on taxes. And I will do more of that, but I do try to hold myself in check, somewhat, because there's a little bit of, you know, this, "I'm rich, therefore I'm right"- type stuff that I don't think sits very well. And I know when I see it in other people I don't like it that, you know, "I'm a celebrity therefore, you know, you got to listen to me on everything that I say." It just — it turns me off at some point. But like I say, I have done it, and there could be occasions — and there will be occasions — I'm sure, when I'll cross my threshold level and figure I really want to say something and people can ignore it or otherwise. And — but I think there's some danger of overexposure on that sort of thing, and I think you've seen it with certain people. Charlie?

Keep Social Security money out of stocks

CHARLIE MUNGERWarren, would you agree or disagree that forcing a certain part of Social Security into common stocks is a good idea?

WARREN BUFFETTNo, I would not. Actually, I would not agree with the one that the gentleman suggested. I think that, actually, Social Security has been a tremendous thing for the working people of this country. It's been an intergenerational pact. It's not insurance. It simply says, like a family might say, except it extends the concept of family to the whole United States, that if you produce for this country when you're between the ages of — and I think the upper age limit should be extended — but between the ages of X and 65, that society will provide some base level of income for you for the rest of your life. And I think a rich society should do that. So, I think the when you have a $10 trillion society, you know — (applause) — we should do that.

CHARLIE MUNGERI would agree. I think Social Security, you can argue, is one of the most successful governmental programs we have. And people treat it as a pure disaster coming or something like that. That's not my view at all, and I wouldn't put it in common stocks, either. I think Social Security works pretty well just about the way we're doing it.

WARREN BUFFETTYeah, we will give a base income to every — and we should in this country — to everybody that leads a reasonably productive life. And they don't have to worry about how long — you know — whether they live to be 90 or 100. And people do worry in their old age. And we don't need a bunch of people who, you know, go off to war when we need to defend, you know, the rights of our country, and act in every way as good citizens, but they just don't happen to have the ability to make a lot of money, you know, well, like maybe Charlie and I can. I think they need a base level, and I think that an intergenerational compact like we have — it's really a magnificent idea. And I think the country's a lot better off for it. I think that telling them that they can save 500 bucks or a thousand bucks and put it into stocks and have everybody lobbying Washington about, you know, who will handle it. You know, everybody thought it was a great idea a few years ago, and I think it's a very bad idea, frankly. Charlie? (Applause)

CHARLIE MUNGERI like it a lot less than you do. (Laughter)

Simple compensation plans and no consultants

WARREN BUFFETTNumber 6.

AUDIENCE MEMBERGood afternoon. My name is Ravi Gilani. I come from New Delhi, India. I have questions regarding management policies. Since you follow quite different management policies, I would like to know the impact of them on the management CEO's motivation. Mr. Munger has mentioned that where capital is unimportant in a business, you tend to give the CEO a part of the earnings. You have also mentioned that you do not greet good work by raising the bar. Clearly, static earnings over a period of time may become successively less valuable. My question is in, now, four parts. Bearing the above in mind, could you give us an example of compensation policy in Berkshire subsidiaries which illustrate your thinking on the subject of executive compensation? Number two, though you do change — charge — subsidiaries for using capital, and believe in linking rewards to bottom line performance, Mr. Munger does not respect economic valued added as a concept. Could we have your thinking on EVA as a tool to monitor and reward corporate performance? Number three, do you restrict yourself to setting compensation policy for the CEO, or do you involve yourself in larger part of the organization? And finally, you do not have any retirement age for the CEO. Does it impact the morale, motivation, of the people below the CEO?

WARREN BUFFETTCharlie? (Laughter) He knew that was coming.

CHARLIE MUNGERWell, one, you're right. Where a business requires practically no capital, we tend to reward the management based on the earnings. The minute the business starts requiring capital we tend to put a capital factor into this compensation system. We don't have any one standard system. They're all different, based on accidents of history and circumstances. But where capital's an important factor, of course, we take it into account. As far as the effects on morale, as far as I've ever been able to see, the morale's pretty good in the Berkshire subsidiaries. And the Berkshire managers practically never leave. And my guess is we have about as low a turnover rate as any place around. Is that right, Warren?

WARREN BUFFETTOh, I'm sure of that. And besides, the "no retirement policy" is wonderful for my morale. (Laughter) And Charlie's. The — you also asked about EVA. We would not dream of using something like that, although I think actually a few of our subsidiaries may use it in some way. So, the subsidiaries set their policies for the pay of the people below the CEO, and the — all — they have all kinds of systems, because we have all kinds of businesses. And, frankly, we've never had big problems with compensation because, I think, our arrangements are rational. When capital is an important part of the business, we stick a charge for capital in. If it's an unimportant part of the business, we don't stick it in. We don't believe in making things more complex than needed. So, we don't try for little — all kinds of little refinements — which a compensation consultant would come in and tell you was needed, because that's how he would justify a large bill. And he would also come in and tinker with it a little the following year, and the following year, and so on. We have very simple systems on comp. But some of our businesses are terrific businesses, and so we have very high standards of performance before people get performance bonuses. Some of our businesses are very tough businesses, and the threshold is much lower, but the managerial talent needed to reach that threshold is just as much as in the — with the higher threshold in other businesses. It’s not a — compensation is not rocket science. I mean, people will want you to think it is, and you read these proxy statements and it blows your mind, what they get into. I mean, the proxy statements are thicker than the annual reports because they're talking about the compensation of people. And it is not that complicated. We’ve had — in 38 years, we have never had a CEO leave us to go to another business, except a few we’ve — where we've made the decision ourselves, but very few. And it is — you know, I see all of the time and effort put in because, frankly, it pays off for the CEO to do it. And then they create a whole department that spends all their time attending conferences about, you know, compensation methods, and they have consultants in, and it becomes an industry. And it isn't going to break itself up. I mean you — when you get those — when you get a huge bureaucracy involved in making all kinds of pay determinations and everything, it's never going to go away unless you do something about it. But that's true of any bureaucracy we run into. We don't have much bureaucracy at Berkshire done. I think that there's no question that our "no retirement policy" means that somebody who's just itching to be the CEO of a business, and they see that the CEO is 65, and then 70, and then 75, above them at some of our companies, is probably not going to stick around. I mean we don't develop, naturally, lots of number twos because we can't promise them that number one is going to go out the door. But as long as number one doesn't go out the door, from our standpoint, that's just fine. And we occasionally have to replace managements, but it's very occasional. I mean if — on an expectancy basis, you know, even with all the subsidiaries we have, you know, we may face one management succession problem, perhaps, every 18 months or something of the sort. And we've got all kinds of other businesses. So it's not a big deal at Berkshire.

CHARLIE MUNGERYeah. And on EVA, there are ideas implicit in that that we use. For instance, hurdle rates by — based on opportunity costs. Perfectly reasonable concept. But to us, that system, with all its labels and lingo, has a lot of baggage that we don't need. We just use the implicit, simple stuff that's buried in EVA.

WARREN BUFFETTYeah. We could spend a million bucks a year on consultants to get an answer we can get in five minutes, frankly. I mean it is — it just isn't that complicated. But can you imagine a consultant coming around and saying, "I've got a one-paragraph compensation arrangement for you?" Are they going to be able to send you a large bill for, you know, their consultancy? Of course not. So, they've got to make things complicated, and we don't believe in that. We want things that are very easy to understand, and we've just never had a problem with it. And we get good results out of our managers. The main reason we get good results out of our managers is that, you know, they like hitting .400. They like hitting .400 and being fairly paid, but they — the fact that they batted .400 is the biggest thing to them, in life. And it's, you know, it's sort of the way we feel. If we get a good batting average in our business performance, the pay is incidental. Now, it shouldn't be incidental to our managers. It's got to be fair or they're going to — nobody wants to work in an environment where they feel they're being treated unfairly, but — That is not a complicated procedure. And we do make them very specific to the enterprise that's under their control. We do not pay the people of See's Candy based on how The Buffalo News does or vice versa. And I can show you a lot of crazy compensation systems in corporate America where that really is the ultimate effect of what's happening.

Buffett OK with large brokerages holding his stocks

WARREN BUFFETTNumber 7.

AUDIENCE MEMBERGood afternoon. This is — I'm Paul Butterfield from Clarksville, Maryland. You wrote in the annual report about the dangers — the systemic dangers — of derivatives and the growth in derivatives. An example would be a six-sigma event that would cause domino effect and dangers to the solvency and operations of, maybe, financial institutions and other firms, possibly including brokerage firms. Would this — do you think this recommends to an individual investor that we might consider not holding stocks in street name?

WARREN BUFFETTCharlie, how do you — they addressed that, somewhat. There were some domino effects in the very early '70s in Wall Street. I think, certainly, the failures of some brokerage firms, in part, led to failures of others. It wasn't a classic domino situation, and of course we had domino effects in banks if you go back a hundred years in this country. Anytime you have financial institutions that interrelate in many ways, and have big receivables and payables, balances with everything, you've always got the danger of domino effects. And that's a factor in the insurance business. It's a factor in banking business. I think it'd be less in the brokerage business. I would think, if you owned securities in a cash account with any large stock exchange firm, you know, it wouldn't worry me. We’ve got lots of — I've got lots of personal securities, you know, sitting with a very large stock exchange firm, and that does not bother me. But I mean, obviously, there have been little firms that have been fly-by-night types. And I don't even know all the rules on margin accounts. But if somebody has got the right to repledge your securities and they get in trouble themselves, I don't know any more what the SIPC — there's a SIPC protection, but I’m —

CHARLIE MUNGERIt's not unlimited. You're liable.

WARREN BUFFETTYeah, I think that's true. And no, I would think twice between having all my securities rehypothecated by somebody else. A cash account. I think the cash accounts are segregated, aren't they, Charlie?

CHARLIE MUNGERYes.

WARREN BUFFETTYeah.

States shouldn't buy stocks with taxpayer money

WARREN BUFFETTNumber 8.

AUDIENCE MEMBERGood afternoon, Mr. Buffett and Mr. Munger. My name is John Norwood and I hail from Des Moines. Thank you for providing this opportunity to speak today. I have two questions, one as an individual investor and one as a state resident. The first has to do with intrinsic value. Can you provide some additional Cliff Notes for working with the Berkshire Hathaway annual report and calculating an intrinsic value for the stock? I'm a little bit hazy. And the second question has to do with public sector investing. As an example, the state of Iowa is considering the creation of a $1 billion Values Fund. What sorts of guidelines, strategies, and advice would you employ if you were responsible for investing this money on behalf of the general public? Are there any significant differences when representing shareholders versus the general public? Thank you.

WARREN BUFFETTYeah, elaborate if you will just a second, because I am not familiar with that billion dollar — is the state of Iowa literally creating a billion dollar fund to invest in equities on behalf of the people?

AUDIENCE MEMBERThat's what's being proposed.

WARREN BUFFETTIs that right? Oh. Charlie, what do you think about that? That's a new one to me.

CHARLIE MUNGERI think it's a pretty dumb idea. (Laughter and applause)

WARREN BUFFETTYeah. He lives in California. That's why I had him answer. I live right on the border here, so I — (Laughs) Yeah, I would — I mean, I guess Iowa doesn't have any bonded debt, so I'm not sure what — they probably wouldn't be creating a margin account. But I would think that most states or municipalities would want to let the citizenry invest on its own and would not want to be taxing people in order to set up an equity fund. So that strikes me as a pretty novel idea. Charlie —

CHARLIE MUNGERIn California, certainly the — of the investment management partnerships — use all kinds of political contributions to finagle their way into managing state pension funds, et cetera, et cetera. It's not a pretty scene. To the extent that Iowa can dampen it down, why, I think they're better off.

Intrinsic value: "fuzzy," but essential

WARREN BUFFETTThe question on intrinsic value — you know, we've written about it in reports. I don't think there's much additional to say. I mean, the intrinsic value of any financial asset, you know, is the stream of cash that it'll produce between now and Judgment Day, discounted by an interest rate that equates between all the different possible assets. That's true of an oil royalty, a farm, an apartment house, an equity, a business operation, you know, a lemonade stand. And that — you have to decide what sort of businesses that you think you can understand well enough to make a — some kind of reasonable calculation. It's not scientific, but it is the intrinsic value. I mean the fact that it's fuzzy to calculate doesn't mean that it's not the proper way to think about it. And at Berkshire, you've got two questions. You've got the question of what the businesses we own now are worth. And then, since we redeploy all the capital they generate, you have to figure out what you're willing to assume about what we do with the capital. And you can look back and say that, 35 years ago or so, that people perhaps underestimated what would be done with the capital that was generated, so that it looks very cheap if you look back on it now. But we're in a whole different game now with huge amounts of capital. And you have to make a decision as to whether the billions and billions and billions of dollars we generate will be deployed in a way that creates lots more cash later on. And it's what Charlie and I think about, but we can't give any prediction on it. Charlie?

CHARLIE MUNGERYeah, I think our reporting, considering the complexity of the enterprise as now constituted, is better than that of any similar enterprise I know, in terms of enabling a shareholder to calculate intrinsic value. So, I think we've done better than anybody else, and we do it conscientiously. And if you ask, "Will we improve from here?" I don't think so.

WARREN BUFFETTWe've worked hard at doing what you're talking about, and it — but even working hard at it, I mean, we've given you the data we would want ourselves. We don't know the answer, but we do know it's what you have to think about. And we do it when we buy McLane's, when we buy Clayton Homes. When we buy anything, we are attempting to look out into the economic future and say, "What kind of cash can this business generate over time? How sure do we feel about it? And how does the purchase price compare with that?" And if we feel we're getting a — we have to feel fairly good about our projections. Won't feel perfect, because we — no one knows the answer precisely. We have to feel pretty good about our projections, and then we have to have a purchase price that's rational in relation to those. And we get some surprises in both directions. Actually, if you go way back, we've had more pleasant surprises than we would have expected. But we won't get them from this point, mostly because of size, and also because the world's a little more competitive. Charlie?

CHARLIE MUNGERNothing more.

Munger: Tort lawsuit system is "crazy"

WARREN BUFFETTNumber 9.

AUDIENCE MEMBERMy name is Vic Cunningham. I'm a shareholder from Wilton, Connecticut. I heard your comments earlier about popping off. But actually, I find it admirable the way you guys, the two of you, have leveraged your clout as investors to be advocates for change. You know, your outspoken comments on expensing stock options promoted, you know, productive discussions, in not only corporate boardrooms throughout this country, but more importantly on Capitol Hill. Currently, tort spending in this country continues to rise as a percentage of GDP, and I would argue a lot of that's unproductive spending. Is there a point — and it seems like right now that, you know, they're trying to stretch their tentacles, not only from, you know, tobacco companies but to consumer product companies like McDonald's and possibly even Coca-Cola. Is there a point where you would use your considerable clout to try to guilt Congress into moving towards some kind of comprehensive tort reform for this country?

WARREN BUFFETTWell, I'm sympathetic to the — what you're saying. I would say that our considerable clout is nothing compared to the clout of the plaintiffs' lawyers. There's no question that — in a certain way, it's appalling when you look at the frictional costs to society of the tort system we have. But Charlie is a lawyer. He can probably speak much more intelligently than I can as to how you could modify this, because there are plenty of things wrong, too. I’ve — I mean it's sort of infuriating to see specious shareholder suits raised on, you know, any kind of a deal, just because there's a lot of DO — D&O insurance — and they know people will pay off rather than go through the nuisance of a suit. And we never — we don't pay off — but corporate America does. And so, it's a game. And the people that pursue that activity, you know, are not pursuing it, I think in many cases, because of a great pursuit of justice, but because it's a damn profitable sort of game. And, you know, the people that are paying. It usually doesn't come out of their own pocket, so it gets back to that — the lack of parity in the interest of the people on both sides. But then, when I look at some of the things that have happened in corporate America, I certainly don't want to get rid of the plaintiffs' lawyers either — entirely — because I think some terrible things have happened and I think people should pay. I just wish the people paid rather than the D&O carriers, because when a D&O carrier pays, or when a company pays, it — the costs get socialized, and the people that did the wrong things seldom pay out of their own pockets. I — Charlie, what — tell me, how do we improve the tort system?

CHARLIE MUNGERWell, if you define the tort system to include the workmen's compensation system, which I would, you get terrible abuses. In California, Costco has about one-third of its employees and two-thirds of its workmen's compensation expense. California is an institutionalized fraud. Fraudulent chiropractors, fraudulent lawyers, fraudulent what have you. And they put this enormous burden on business. And of course, eventually the jobs will leave. I had a friend who took a plant away from Texas where he had workmen's compensation expense of 30-odd percent, and took it to Ogden, Utah, where it went to 2 percent. So fraud, allowed to run, builds on itself. And then you've got all these lawyers and lobbyists who like the fraud. And chiropractors and God knows what. And so, it's a major problem. And in California, it's gotten so bad that my guess is there will be some reform, even with the two-thirds Democratic legislature.

WARREN BUFFETTWhat would you change, in terms of the shareholder situation?

CHARLIE MUNGERWell, that's harder, because if you take the worst of the plaintiffs' lawyers, half the time they're suing somebody that's behaved terribly. Now, they're suing in a process where a lot of money is paid out, as you say, on a socialized basis, and doesn't really go to the people that were hurt. So, they're like a public scold that gets paid an enormous sum out of the public. But certainly, a lot of the defendants in these cases that are screaming about the plaintiffs' bar have done some very regrettable things. So, I think that gets very hard to figure out what should be done. The present system is crazy, and I don't know how I'd improve it. You could easily improve it if you could count on government being rational and fair, but how do you do that?

WARREN BUFFETTWould you do anything toward making the people who are defendants in D&O situations pay any portion of it themselves or not?

CHARLIE MUNGERI think there would be a great improvement, net, in Omaha — in America — if there were no D&O insurance. Zero. I think people — (applause) — would behave a lot better. The counterargument is you'd never get anybody with any money who was willing to serve on a board. But my guess is that, net, even after taking into account that little problem, the system would work better than the present one.

"It's tough to buy things out of bankruptcy"

WARREN BUFFETTNumber 10.

AUDIENCE MEMBERJohn Goss (PH), Key West, Florida. You mentioned last year your frustration with buying companies out of bankruptcy. Were you surprised, from your past experience, that the court would not allow a breakup fee regarding your Burlington bid?

WARREN BUFFETTThat's a good question. We submitted a bid to the court. The management agreed to our offer and we submitted a bid in the bankruptcy of Burlington Industries. And our bid was 500-and-some million dollars. And we provided a — what's called a breakup fee. I'll get to that in a second, but I think it was $14 million. Now really, when we submit that bid of 500-and-some-odd million, our bid has to remain outstanding for a good many months. So in effect, by making that bid, I get back to the earlier statements I made about option value. For $14 million, we were telling the creditors of Burlington that, for a period of maybe four months or five months, that they could sell us that business for our number or, for a considerable period, they could get more money for it. Now that is a very low price, in my view, for a put. In fact, it's an inadequate price, but it's become sort of a customary percentage in terms of bankruptcy proceedings. The court said that that was too much to charge as a breakup fee, or what I would call a put fee, and so they have set up a new procedure, which will result in Burlington getting sold some months from now to people who follow this new procedure. I think that — I frankly think 14 million is inadequate, but it's roughly in the range of what has been allowed in many cases. But we would never agree to that sort of a sum for that sort of exposure, outside of bankruptcy. It just doesn't make any sense. The world changes too much. If you look at the value of businesses, as measured on the New York Stock Exchange, you'll see fluctuations of a hundred percent in a year. And for 2 or 3 percent, to commit 500-and-some million dollars at a fixed price for a business in a tough industry, I mean that’s — that does not make a lot of sense. I did it, so — but it got rejected. We would not — we will not participate in a procedure where we're going to bid hundreds of millions of dollars and where our bid has to remain outstanding. And if the — you know, if there’s a twin — if there's a World Trade Center disaster, or there's an earthquake in California, or there’s a suspension of trading on the stock exchange, or all kinds of things, that our bid sits out there and we've gotten paid $5 million or something for it. It just doesn't make any sense to me. So, it's tough to buy things out of bankruptcy, although we've done it twice now. And both situations have worked out well. But then we tried it a third time with Burlington, and we spent a considerable amount of time and money generating that bid. Weeks and weeks and a good many dollars, and it wasn't accepted. So, you know, when I look at these experiences, I say to myself it's a lot easier to make a deal with Walmart, where I talk with them for an hour and we shake hands and we got a deal. Or the other deals we've made in the last year where we buy Northern Natural in a day or two, or where we buy Kern River Pipeline in a few days, or the various businesses we've bought. And bankruptcy, I think it's probably a necessary part of the procedure. I mean you have to comply with bankruptcy laws. But I would say it's a very awkward way to buy a business. And if we have to submit bids that will remain outstanding for many months when people can top us, and only have a 1 percent fee for giving that sort of a put, we will not be making many bids. Charlie?

CHARLIE MUNGERWell, we know it was unreasonable, from our point of view, to have a transaction that didn't have that modest 2 percent commitment fee in it. The court had a different view, and he thought that the figure should have been different. And who knows. We'll see how it all works out.

"We like to go in heavy" when buying a stock

WARREN BUFFETTNumber 1.

AUDIENCE MEMBERGentlemen, Wayne Peters from Sydney, Australia. My question goes to stock reweightings. Could you describe your thought process in, firstly, determining your commitment weighting level in a new investment? Now, marketable securities is what I'm referring to. And secondly, your thoughts on potential reweighting. Your record, and clearly in the earlier days as opposed to now, would indicate that on average, you're either in a stock or out of it, though on occasion you've topped up and lightened up.

WARREN BUFFETTCharlie? I'll let you have one. (Laughs)

CHARLIE MUNGERI didn't fully understand that question.

AUDIENCE MEMBERCharlie, I was just referring to how you make an initial commitment to a marketable security investment, in regards to making it maybe a 5, 10, 15 percent commitment. How heavy you decide to go into a position, initially.

CHARLIE MUNGERWell, we ordinarily don't like small positions.

WARREN BUFFETTYeah, we like to go in heavy. I mean, if we want to invest in a business through the stock market, we want to put a lot of money in. You know, we do not believe in a little of this and a little of that. So, at our present size, we're limited primarily by the availability of the quantity we want, rather than restricting ourselves based on some percentage of a total portfolio. I can’t — it's very hard for me to think of a stock we quit on, in terms of buying, except because we were going to run into some 10 percent limit where we would get liable for short-swing profits or become insiders or that sort of thing. But we almost never want to quit. Isn't that right, Charlie?

CHARLIE MUNGERWell, not unless the price goes up.

WARREN BUFFETTYeah. And of course that's where we made our big mistakes. I mean we have — or I've made the big mistakes, actually. I — There have been a couple of things that we knew enough to buy, that were in our circle of competence, where we could have bought lots of stock, except it went up a little bit and then we faded because of price. We didn't fade because we didn't want to put more than X dollars in. If we find an idea that we want to put $500 million in, we probably would be even happier if we could put 3 or 4 billion in. Good ideas are too scarce to be parsimonious with once you find them.

CHARLIE MUNGERYeah, having narrowly averted the mistake of being unwilling to pay up at See's Capital [Candies], we've gone on and made the same damn mistake several times, with respect to marketable securities. We evidently learn very slowly. (Laughter)

WARREN BUFFETTIt's cost us many, many, many billions of dollars, too.

CHARLIE MUNGERThose are opportunity cost billions. They don't show up on the financial statements, but the amount of money that's been blown by dumb decisions at headquarters at Berkshire Hathaway is awesome. (Laughter)

WARREN BUFFETTWell said.

CHARLIE MUNGERYeah. (Laughter)

Short-term rates don't affect investment decisions

WARREN BUFFETTNumber 2.

AUDIENCE MEMBERHi, I'm Steve Casbell (PH) from Atlanta. My question involves interest rates. When you calculate the intrinsic value of a business in a period of low interest rates, like we have currently, do you use a higher discount rate to factor in higher rates in the future? And also, when — do you ever look at a company's free cash flow yield relative to current rates? And if I could also get your thoughts on the dividend tax cut. If, by some miracle, the politicians think logically and get rid of the dividend taxes, would Berkshire ever pay a dividend?

WARREN BUFFETTThe question on discount rates, we use the same discount — I mean in theory — we would use the same discount rate across all securities, because if you really knew the cash they were going to produce, you know, that would take care of it. We may be more conservative in estimating the returns of cash from some, but the discount rate we would use is a constant. Now, in terms of where we commit, you know, we don't want to use the fact that short-term rates are 1 1/4 percent to think that something that yields us 3 percent or 4 percent is a good deal. So we sort of have a minimum threshold in our mind about which we’re — below which — we're unwilling to commit money. And we're unwilling to commit it whether interest rates are 6 or 7 percent, or whether they're 3 or 4 percent, or whether they're, on a short-term basis, 1 percent. We just — we don't want to get hooked into long-term investments at low rates just because they're a little bit better than short rates would be or low Government rates would be. So, we have minimum thresholds in our mind. I can't tell you precisely what they are, but they're a whole lot higher than present Government rates would be. And at other times, we'd be very happy owning Governments, just because we feel that they offer attractive enough rates. I would — when we're looking at a business, we're looking at holding it forever. And we want to be sure we're getting an adequate return on capital. We don't regard what we can get on short-term rates now as adequate, but we'll still sit in — rather than bend a little bit and start settling for lower rates for 30 years because rates for 30 days are so low, we would rather just sit it out and wait a while.

Dividends should be taxed

WARREN BUFFETTThe tax on dividends — you know, I've used this illustration before, but I'm paying about the same percentage of my income to the federal government as my secretary does. Now, I pay more in income tax rates than she does. I pay a higher marginal tax rate, by some margin, than she does. But she pays way more in Social Security taxes than I do, because I only pay on the first whatever it is, 70,000 or 80,000 of income. And so, she is paying, between what we pay at the company for her and what she pays, we're paying 12 percent or 13 percent or whatever it is of that. So, we both end up paying fairly similar percentages of our income to the federal government every year. If Berkshire were to declare a billion-dollar dividend, and my share of it was 330 million, and it were tax-free as the Bush people originally suggested — and it would be tax-free. I mean, we have lots of taxable earnings at Berkshire. You know, I might be paying 1/10th of the rate to the federal government of my income that she would be. Now, I can make the argument about the fact that structure shouldn't govern tax rates. That Subchapter S, and Subchapter C, and partnerships, and all of these things, that the tax codes should be neutral between them. And I've made those kind of arguments in the past. But I can make no argument in my mind that says that I, with everything that — you know, all the luck I've had in life, you know, I was wired a certain way at birth that enabled me to make a lot of money. And, frankly, it was better to be born a boy than a girl, in terms of money-making possibilities, in 1930. And probably still is, but not to the same degree. I mean the fact that I would send 1/10th the portion of my income in a year to the federal government that my secretary would, I — it just — it screams at injustice to me, in terms of what the society gives back to me. (Applause) So I am not for the Bush plan. Charlie?

CHARLIE MUNGERWell, I agree with you. Even if you assume that the whole economy would work better if we'd never gotten into this double-taxation system on corporate earnings, which I don't think is a clear thing anyway. But even if you assume that, I think when you live in a democracy where there's lots of envy and resentment and what have you, to have the absolutely most fortunate people paying practically no income taxes, I just think it's unacceptable. I think there has to be some fairness in some of these arrangements, even if there's some theoretical argument that the economy might work a little better some other way.

WARREN BUFFETTYeah, there are IRAs now, obviously, that work very well for people with modest amounts of dividends. That they — they're getting tax deferred for a very long period of time, which has huge benefits. The big benefits of exempting dividends would go to fellows like me and Charlie, you know. And that's not going to stimulate the economy. It's going to stimulate us, but — (Laughter) And it's going to result in us sending a very small percentage of the income — of our income — to Washington compared to what the people, you know, working in our shoe factories send. And that — you know, when somebody says, you know, "What did you do during the war, Grandpa?" I'm not sure that's what I want to explain to them.

Why Berkshire wants at least a 10 percent return

WARREN BUFFETTNumber 3.

AUDIENCE MEMBERGood afternoon. I'm Patrick Wolff from Arlington, Virginia. Charlie, I can't resist telling you that I'm actually the fellow who plays the chess games blindfolded.

WARREN BUFFETTYeah.

AUDIENCE MEMBERSo, I look forward to not seeing you there tomorrow. (Laughter)

CHARLIE MUNGERRight.

AUDIENCE MEMBERI actually have a two-part question. I'd like to ask you to elaborate a bit how you think about opportunity costs. And I’m — I think I'm going to be elaborating very much on the very last question that was asked. First of all, in the annual report you say explicitly that you look for a 10 percent pretax return on equity, in looking at common stocks. And I think you talked earlier about how you built up from that for 5 to 6 percent after-tax return, and then you layer on inflation, and then layer on taxes. My first question would be, how do you adjust that required rate of return across periods of time? So, for example, when interest rates are higher. And do you look for a different equity premium return over different periods of time? My second question would be, Warren, you just said that you actually would apply the same discount rate across the stocks. And I'm sure you know that modern finance actually suggests that you should not do that — that you should be thinking about the timing of cash flows and, in particular, the covariance with the general market. Now, you've made a point of emphasizing that when you think of risk, you think of risk primarily in terms of, will you get the cash flows that you predict you will get over time? Sort of numerator risk, if you think in terms of discounted cash flow, which I think everyone here will have to acknowledge — your results speak for themselves — has probably been a very effective way of thinking about risk. But there is a true economic cost to think about the timing of cash flows as well. And it may be a much smaller cost, but it is still a real cost. I might, for example, suggest you think about somebody deciding between two jobs. The jobs are completely identical and the person expects to make the same amount of money from each job, but there's one difference. And the difference is one job will pay him more when the economy's in the tank, and the other job will pay him more when the economy's going gangbusters. Now, if he asked you which job was actually worth more, my guess is you would tell him that the one that would pay him more when the economy's in the tank. And the reason is, if he wanted to make more money by moonlighting or doing something else, it'd be much easier when the economy's doing better. That's the essential logic behind the idea that you look at the covariance of when cash flows come in with the overall market. It's a real cost, even though it is difficult to measure, and even if it is a smaller risk than numerator risk, the risk of getting the actual cash flows, since it's a real cost, I imagine you must think about it. And so, my second question to you would be how do you think about it? And if you decide not to, why?

WARREN BUFFETTNow, first of all, I would like to say, Patrick, we appreciate you coming out, because Patrick — now, I don't know how many years it's been, but it's been a number, has volunteered on Sunday to play. Now, I think he's playing six people or so, blindfolded, simultaneously, and after hearing that question you can understand how he does it. (Laughter) But Patrick, as well as [champion bridge player] Bob Hamman, and then this year, [champion Scrabble player] Peter Morris and [champion backgammon player] Bill Robertie, all come out. And on Sunday they — we've got these extraordinary talents out there. And for people who like the various games they play, they devote an afternoon for it and ask nothing in return. So, I — we really appreciate it, Patrick, and I'll look forward to seeing if you're peeking out of your blindfold tomorrow. (Laughter) The question on opportunity costs and the 10 percent we mention. You know, basically that's the figure we quit on. And we quit on buying — we don't want to buy equities where our real expectancy is below 10 percent. Now, that's true whether short rates are 6 percent or whether short rates are 1 percent. We just feel that it would get very sloppy to start dipping below that. And we would add, we feel also, obviously, that we will get opportunities that are at least at that level, and perhaps substantially above. So, there's just a point at which we drop out of the game. And it's arbitrary. There’s no — we have no scientific studies or anything. But I will bet you that a lot of years in the future we, or you, will be able to find equities that you understand, or we understand, and that have the probability of returns at 10 percent or greater. Now, once you find a group of equities in that range, and leaving aside the problem of huge sums of money, which we have, then we just buy the most attractive. That usually means the ones we feel the surest about, I mean, as a practical matter. There's just some businesses that possess economic characteristics that make their future prospects, far out, far more predictable than others. There's all kinds of businesses that you just can't remotely predict what they'll earn, and you just have to forget about them. But when we get — so, we have, over time, gotten very partial to the businesses where we think the predictability is high. But we still want a threshold return of 10 percent, which is not that great after-tax, anyway. Charlie, do you want to comment on that portion of that question first?

CHARLIE MUNGERYeah. The — I think in the last analysis, everything we do comes back to opportunity cost. But it, to some extent — in fact, to some considerable extent — we are guessing at our future opportunity cost. Warren is basically saying that he's guessing that he'll have opportunities in due course to put out money at pretty attractive rates of return, and therefore, he's not going to waste a lot of firepower now at lower returns. But that's an opportunity cost calculation. And if interest rates were to more or less permanently settle at 1 percent or something like that, and Warren were to reappraise his notions of future opportunity cost, he would change the numbers. It's like [economist John Maynard] Keynes said, "What do you do when you change your view of the facts? Well, you change your conduct." But so far at least, we have hurdles in our mind which are basically — well, they involve, implicitly, future opportunity cost.

WARREN BUFFETTRight now, with our 16 billion that's getting 1 1/4 percent pretax, that's $200 million a year. We could very easily buy Governments due in 20 years and get roughly 5 percent. So, we could change that 200 million a year to 800 million a year of income. And we're making a decision, as Charlie says, that it's better to take 200 million for a while, on the theory that we'll find something that gives us 10 percent or better, than to commit to the 800 million a year and then find that, in a year or thereabouts, when the better opportunities came along, that what we had committed to had a big principal loss in it. But that’s — you know that’s not — it's not terribly scientific. But it — all I can tell you is, in practice, it seems to work pretty well. People —

CHARLIE MUNGERYears ago, when Warren ran a partnership, and to some extent the partnership that I ran was the — operated in the same way — we implicitly did what you're suggesting, in that part of the partnership funds were in so-called event arbitrage investments. And those tended to generate returns, occasionally, when the market, generally, was in the tank. And alternative investments would more mimic the general market. So, we were doing what this academic theory prescribes, you know, 40 years ago. And — but we didn't use the modern lingo.

WARREN BUFFETTYeah, we've got some preferences for having a lot of money coming in all the time. But we do go into insurance transactions with huge volatility, which could mean that a big chunk of money could go out at one time, or in a very short period of time. And we won't give up a lot in expectable return for smoothness, but if you give us a choice of having money come in every week and the same present value of money coming in in very lumpy ways that we wouldn't know about, we would choose the smooth. But if you give us a choice of a higher present value for the lumpiness, we will take the lumpiness. And that's usually the choice that's — I mean that's usually — we get offered that choice. And other people value smoothness so highly that we do get a spread, in our view, for lumpy returns.

Berkshire insures $1B Pepsi contest

WARREN BUFFETTWe are writing — and then we're going to close this up — but you will read a lot, or you may hear a lot, maybe you've heard it already, Pepsi-Cola's having a contest. They're going to have a drawing in September. The contest goes through a lot of little phases, but in the end, there's going to be one person who's going to have one chance in a thousand of winning a billion dollars. That billion dollars will have a present value of maybe 250 million. If whoever gets to that position hits the number, we will pay it. And we don't mind paying out $250 million as long as we get paid appropriately for us. And that would create bad cash flow that particular week. We're willing to — maybe even for two weeks. (Laughter) We're willing to assume that for a payment, and very, very few people in the world are. Even those that can afford it. We would even assume it for 2 1/2 billion, present value. We'd want more proportionally to assume it for that, but Charlie and I, I think, would agree that we would take that on if we got paid well enough for it. We wouldn't do it for 25 billion, but we will do things, and therefore, you know, we get the calls on that sort of thing. And that is more profitable business, over time, than bread and butter business. It also can, you know — it can lead you having an intense interest in watching the television show when the drawing takes place — (laughter) — making sure who draws the number, too. Charlie, you have anything to add? Then we'll —

CHARLIE MUNGERYeah, once you're talking about opportunity cost that's personal to yourself and your own situation and your own abilities, you've departed from modern finance, totally. And that's what we've done. We're intelligently making these guesses, as best we can, based on our own circumstances and our own abilities. I think it's crazy to do it based on somebody else's circumstances and somebody else's abilities.