Morning Session

1. Welcome

WARREN BUFFETT: Morning. Morning. I’m Warren Buffett, chairman of Berkshire, and — this is my partner. This hyperactive fellow over here is Charlie Munger. (Laughter) And we’ll do this as we’ve done in the past, following the Saddam Hussein school of management, we’re going to go through the business meeting in a hurry, and then we’re going to do questions. And we’ll do those until 3:30, with a break at noon, when we’ll take off for 30 minutes or so while you can grab lunch. And those of you — there’s — we’re operating in an overflow room as well — so those of you who are in the overflow room now can join the main floor after the noon break, because we’ll have plenty of room then. We’ll go until 3:30. We’ll try to get to all the questions we can. We’ve got 11 zones, ten of them in this room, and we’ll just make our way around them.

I’ve got a little map here, which I’ll get oriented on here in a second. And let’s see. And I think we’ll get through the business meeting now. Incidentally, I don’t see that movie before it’s shown, but that was one of our directors singing at that final session there. (Applause) We keep costs down at Berkshire. (Laughter)

2. Board of directors introduced

WARREN BUFFETT: OK, the meeting will now come to order. I’m Warren Buffett, chairman of the board of directors of the company and I welcome you to this 1998 annual meeting of shareholders. I will first introduce the Berkshire Hathaway directors that are present in addition to myself. So we have — and I can’t see very well with the lights here, but if you’ll stand as I name you. Susan T. Buffett, the vocalist. (Applause) Howard G. Buffett, the non-vocalist. (Applause) Malcolm G. Chace. (Applause) Charlie, you’ve met. And Ron Olson. (Applause) And Walter Scott Junior. (Applause) Also with us today are partners in the firm of Deloitte and Touche, our auditors. They are available to respond to appropriate questions you might have concerning their firm’s audit of the accounts of Berkshire. Mr. Forrest Krutter is secretary of Berkshire. He will make a written record of the proceedings. Miss Becki Amick has been appointed inspect of elections at this meeting.

She will certify to the count of votes cast in the election for directors. The named proxy owners for this meeting are Walter Scott Junior and Marc D. Hamburg. Proxy cards have been returned through last Friday, representing 1,039,276 Class A Berkshire shares, and 1,080,509 Class B Berkshire shares to be voted by the proxy holders as indicated on the cards. The number of shares represents a quorum and we will therefore directly proceed with the meeting. We will conduct the business of the meeting and then adjourn the formal meeting. After that, we will entertain questions that you might have.

3. Minutes and shares outstanding

WARREN BUFFETT: First order of business will be a reading of the minutes of the last meeting of shareholders. I recognize Mr. Walter Scott Jr., who will place a motion before the meeting. WALTER SCOTT JR.: I move the minutes — the reading — reading of the minutes of the last stockholders meeting be dispensed with.

WARREN BUFFETT: Do I hear a second? (Voices) A lot of seconds. The motion has been moved and seconded. Are there any comments or questions? We will vote on this motion by voice vote. All those in favor say aye.

VOICES: Aye.

WARREN BUFFETT: Opposed? Motion’s carried. Does the secretary — (laughter) — have a report of the number of Berkshire shares outstanding, entitled to vote, and represented at the meeting?

FORREST KRUTTER: Yes, I do. As indicated in the proxy statement that accompanied the notice of this meeting that was sent by first-class mail to all shareholders of record on March 6, 1998, the record date for this meeting, there were 1,199,680 shares of Class A Berkshire Hathaway common stock outstanding, with each share entitled to one vote on motions considered at this meeting. And 1,245,081 shares of Class B Berkshire Hathaway common stock outstanding, with each share entitled to 1/200th of one vote on motions considered at the meeting. Of that number, 1,039,276 Class A shares and 1,080,509 Class B shares are represented at this meeting by proxies returned through last Friday.

WARREN BUFFETT: Thank you, Forrest. If a shareholder is present who wishes to withdraw a proxy previously sent in and vote in person on the election of directors, he or she may do so. Also, if any shareholder that is present has not turned in a proxy and desires a ballot in order to vote in person, you may do so. If you wish to do this, please identify yourself to meeting officials in the aisles who will furnish a ballot to you. Those persons desiring ballots, please identify themselves so that we may distribute them.

4. Election of directors

WARREN BUFFETT: The one item of business at this meeting is to elect directors. I now recognize Mr. Walter Scott Junior to place a motion before the meeting with respect to election of directors.

WALTER SCOTT JUNIOR: I move that Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Junior, be elected as directors.

WARREN BUFFETT: Is there a second? It’s been moved and seconded that Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Junior be elected as directors. Are there any other nominations? Is there any discussion? Nominations are ready to be acted upon. If there are any shareholders voting in person, they should now mark their ballots on the election of directors and allow the ballots to be delivered to the inspector of elections. Would the proxy holders please also submit to the inspector of elections a ballot on the election of directors, voting the proxies in accordance with the instructions they have received. Miss Amick, when you are ready you may give your report.

BECKI AMICK: My report is ready. The ballots of the proxy holder, in response to proxies that were received through last Friday, cast not less than 1,039,298 votes for each nominee. That number far exceeds the majority of the number of the total votes related to all Class A and Class B shares outstanding. The certification required by Delaware law of the precise count of the votes, including the additional votes to be cast by the proxy holders in response to proxies delivered at this meeting, as well as those cast in person at this meeting, if any, will be given to the secretary to be placed with the minutes of this meeting.

WARREN BUFFETT: Thank you, Miss Amick. Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Junior have been elected as directors. After adjournment of the business meeting, I will respond to questions that you may have that relate to the businesses of Berkshire that do not call for any action at this meeting. Does anyone have any further business to come before this meeting before we adjourn?

5. Adjournment of formal business meeting

WARREN BUFFETT: If not, I recognize Mr. Walter Scott Junior to place a motion before the meeting.

WALTER SCOTT JUNIOR: I move this meeting be adjourned.

WARREN BUFFETT: Second? (Laughter) Motion to adjourn has been made and seconded. We will vote by voice. Is there any discussion? If not, all in favor say aye?

VOICES: Aye.

WARREN BUFFETT: All opposed say I’m leaving. This meeting is adjourned. (Laughter and applause) Charlie and I may not get paid much, but we work fast on an hourly basis. (Laughter)

6. Q&A session begins

WARREN BUFFETT: Now, we’re going to do this by zones, and I think you can see who is manning each — yeah, I see we’ve got a number out there already. And please ask just one question. The only thing that I can think of that we won’t discuss is what we’re buying or selling or may be buying or selling, but we’ll be glad to talk about anything that’s on your mind. So let’s go right to zone 1 and start in.

7. Price/earnings explanation

AUDIENCE MEMBER: Thanks for the beautiful — beautiful weekend in Omaha. I’m Mike Asale (PH) from New York City, with a question for Warren and Charlie about what makes a company’s price-earnings ratio move up relative to other companies in its industry. How can we, as investors, find companies, and even industries, that will grow their relative price-earnings ratios as well as their earnings? And thank you for the wonderful weekend and for sharing your brilliance with the shareholders.

WARREN BUFFETT: Oh, thank you.

AUDIENCE MEMBER: Thank you. (Applause)

WARREN BUFFETT: You know, it’s very simple, the price-earnings ratio — relative price-earnings ratios — move up because people expect either the industry or the company’s prospects to be better relative to all other securities than they have been — than their proceeding view. And that can turn out to be justified or otherwise. Absolute price-earnings ratios move up in respect to the earning power — or the prospective earning power of — that is viewed by the investing public of future returns on equity, and also in response to changes in interest rates. And in the recent — well really, ever since 1982, but accentuated in recent years, you’ve had decreasing interest rates pushing up stocks, in aggregate. And you’ve had an increase in corporate profits. Return on equity of American businesses improved dramatically recently. And that also — and people are starting to believe it, so that has pushed up absolute price-earnings ratios. And then within that universe of all stocks, when people get more enthusiastic about a specific business or a specific industry, they will push up the relative P/E ratio for that stock or industry. Charlie, you got anything?

8. No “degree of difficulty” bonus

CHARLIE MUNGER: Yes, I think he also asked, how do you forecast these improvements in priceearnings ratios.

WARREN BUFFETT: That’s your — that’s your part of the question. (Laughter)

CHARLIE MUNGER: Around here I would say that if our predictions have been a little better than other people’s, it’s because we tried to make fewer of them. (Laughter and applause)

WARREN BUFFETT: We also try not to do anything difficult, which ties in with that. We really do feel that you get paid just as well — you know, this is not like Olympic diving. In Olympic diving, you know, they have a degree of difficulty factor. And if you can do some very difficult dive, the payoff is greater if you do it well than if you do some very simple dive. That’s not true in investments. You get paid just as well for the most simple dive, as long as you execute it all right. And there’s no reason to try those three-and-a-halfs when you get paid just as well for just diving off the side of the pool and going in cleanly. (Laughter) So we look for one-foot bars to step over rather than seven-foot or eight-foot bars to try and set some Olympic record by jumping over. And it’s very nice, because you get paid just as well for the one-foot bars.

9. Efficient market hypothesis “contaminates” business schools

WARREN BUFFETT: OK, zone 2.

AUDIENCE MEMBER: Good morning. My name is Joe Lacey (PH). I’m from Austin, Texas. In this era when the financial departments of the institutions of higher learning are referring to you as an anomaly, and they preach the efficient markets hypothesis, saying that you can’t outperform the market, where does one go to find a mentor like you found in Ben Graham? Someone you can ask questions to regarding value investing.

WARREN BUFFETT: My understanding is that the University of Florida has instituted a couple of courses that, actually, Mason Hawkins gave them a significant amount of money to finance. And I believe they’re teaching something other than efficient markets there. There’s a very good course at Columbia I know that gets a lot of visiting teachers to come in. I go there and teach occasionally, but a number of practitioners do. So there — I think the efficient market theory is less holy writ now than it was 15 or 20 years ago in universities, but it’s — there’s a lot of it taught, but I think you can find more diversity in what is being offered now than ten or 20 years ago. And I’d recommend, you know, looking into those two schools. You know, it’s really quite useful. If you had a merchant shipping business, if all of your competitors believe the world is flat, you know, that is a huge edge, because they will not take on any cargo to go to places that are beyond where they think they will fall off. And so we should be encouraging the teaching of efficient market theories in universities. (Laughter) It amazes me.

But, you know, I think one time that — was it Keynes that said that most economists are most economical about ideas? That they make the ones they learned in graduate school last a lifetime. (Laughter) And what happens is that you spend years getting your Ph.D. in finance and you learn theories with a lot of mathematics in them that the average layman can’t do. And you become sort of a high priest. And you get an enormous amount of yourself and ego, and even professional security, invested in those ideas. And it gets very hard to back off after a given point. And I think that to some extent has contaminated the teaching of investing in the universities. Charlie?

CHARLIE MUNGER: Well, I would argue that the contamination was massive. (Laughter) But it’s waning.

WARREN BUFFETT: Yeah, it is waning.

CHARLIE MUNGER: It’s waning. The good ideas eventually triumph.

WARREN BUFFETT: Yeah. The word “anomaly” I’ve always found interesting on that, because, you know, after a while — I mean Columbus was an anomaly, I suppose, for a while. But what it means is something that the academicians could not explain, and rather than re-examine their theories, they simply discarded any evidence of that sort as anomalous. And I think when you find information that contradicts previously cherished beliefs, that you’ve got a special obligation to look at it and look at it quickly. I think Charlie told me that one of the things Darwin did was that whenever he found anything that contradicted some previous belief, he knew that he had to write it down almost immediately because he felt that the human mind was conditioned, so conditioned to reject contradictory evidence, that unless he got it down in black and white very quickly his mind would simply push it out of existence. Charlie knows more about Darwin than I do. Maybe he can explain that.

CHARLIE MUNGER: Well, I don’t know about Darwin, but I did find it amusing. One of these extreme efficient market theorists explained Warren for many, many years as an anomaly of luck. And he got the six sigmas, six standard deviations of luck. And then people started laughing at him because six sigmas of luck is a lot. So he changed his theory. Now Warren has six or seven sigmas of skill. (Laughter)

WARREN BUFFETT: No.

CHARLIE MUNGER: So you see —

WARREN BUFFETT: I’d rather have the six sigmas of luck, actually. (Laughter)

CHARLIE MUNGER: The one thing he couldn’t bear to leave was his six sigmas. (Laughter)

10. “Time is the enemy of the poor business”

WARREN BUFFETT: Let’s try zone 3.

AUDIENCE MEMBER: My name is Warren Hayes (PH). I’m from Chicago, Illinois. I understand from various publications, like Outstanding Investor Digest, that many of the best value investors are buying high-quality, multi-national Japanese companies that are trading below net-net working capital value. Do you agree that these values exist in Japan? And would you consider a purchase of some of them?

WARREN BUFFETT: Well, Henry Emerson, who publishes the Outstanding Investor’s Digest is here, so I will give a tout on it. I read the Outstanding Investor’s Digest, OID, and it’s a very good publication. And I have read some of the commentary about Japanese securities. We’ve looked at securities in all major markets, and we certainly looked at them in Japan, particularly in recent years when the Nikkei has so underperformed the S&P here. We’re quite a bit less enthused about those stocks as being any kind of obvious bargains than the people that you read about in OID. The returns on equity in most areas of Japanese business, returns on equity are very low. And it’s extremely difficult to get rich by owning — by being the owner of a business that earns a low return on equity. You know, we always look at what a business does in terms of what it earns on capital. We want to be in good businesses. Where you really want to be is in businesses that are going to be good businesses and better businesses ten years from now. And we want to buy them at a reasonable price.

But many years ago we gave up what I’ve labeled the “cigar butt” approach to investing, which is where you try and find a really kind of pathetic company, but it sells so cheap that you think there’s one good free puff left in it. And — (laughter) — we used to pick up a lot of soggy cigar butts, you know. I mean, I had a portfolio full of them. And there were free puffs in them. I mean, I made money out of that. But A, it doesn’t work with big money anyway, and B, we don’t find many cigar butts around that we would be attracted to. But those are the companies that had low returns on equity. And if you have a business that’s earning 5 or 6 percent on equity and you hold it for a long time, you are not going to do well in investing. Even if you buy it cheap to start with. Time is the enemy of the poor business, and it’s the friend of the great business.

I mean if you have a business that’s earning 20 or 25 percent on equity, and it does that for a long time, time is your friend. But time is your enemy if you have your money in a low-return business. And you may be lucky enough to pick the exact moment when it gets taken over by someone else. But we like to think when we buy a stock we’re going to own it for a very long time, and therefore we have to stay away from businesses that have low returns on equity. Charlie?

CHARLIE MUNGER: Yeah, it’s not that much fun to buy a business where you really hope this sucker liquidates before it goes broke. (Laughter)

WARREN BUFFETT: We’ve been in a few of those, too.

CHARLIE MUNGER: Right. (Laughter)

WARREN BUFFETT: Yeah, Charlie and I, we — or at least I have, I’ve owned stock in an anthracite company. There are probably people in this room that don’t know what anthracite is. Three railway companies. Windmill manufacturers. What other gems have we had, Charlie?

CHARLIE MUNGER: Textiles. (Laughter)

WARREN BUFFETT: Yeah, textiles. Don’t even think. (Laughter) Yeah, Berkshire was a mistake, believe it or not. I mean we went into Berkshire because it was cheap statistically just as a general investment back in the early ’60s, and it was a company that in the previous ten years had earned less than nothing. I mean it had a significant net loss over the previous ten years. It was selling well below working capital, so it was a cigar butt. And it was — I mean we could have done the things we’ve done subsequently from a neutral base rather than a negative base, and actually it would have worked out better, but it’s been a lot of fun.

11. Munger wants “a good idea we can understand”

WARREN BUFFETT: Number four.

AUDIENCE MEMBER: Hello. My name is Martin Weigand from Bethesda, Maryland. Again, I want to thank you for your letters and principles. They’re a great help for small business people running their business. My question is, last year you said you had filters in your mind to help you quickly analyze businesses. How do your filters take into account the very fast changes of technology and the way that businesses communicate with their customers, take orders, things like that?

WARREN BUFFETT: Well, we do have filters, and sometimes those filters are very irritating to people who check in with us about businesses, because we really can say in ten seconds or so “no” to 90 percent-plus of all the things that come in, simply because we have these filters. We have some filters in regard to people, too. But the question of technology is very simple. That doesn’t make it through our filter. I mean, so if something comes in where there’s a technological component that’s of significance, or where we think the future technology could hurt the business as it presently exists, we look at, you know, we look at that as something to worry about. We will — it won’t make it through the filter. We want things that we can understand, which filters out a lot of things. (Laughter) And we want them to be good businesses, and we want the people to be people we’re very comfortable with. That means ability and integrity. And we can do that very fast.

We’ve heard a lot of stories in our lives, and it’s amazing how they — you can become quite efficient in, probably, getting 95 percent of the ideas through in a very short period of time that should get through. Charlie?

CHARLIE MUNGER: Yeah, we have to have an idea that is A, a good idea, and B, a good idea that we can understand. It’s just that simple. And so those filters are filters against consequences from our own lack of talent. (Laughter)

WARREN BUFFETT: Filters haven’t changed much over the years, either. (Laughter)

12. “A lot of different talents” within Berkshire

WARREN BUFFETT: OK, area five.

AUDIENCE MEMBER: Hi. I’m Allan Maxwell. I live in the wonderful tropical island of O-maha. (Laughter)

WARREN BUFFETT: That’s right up there with Aksarben. That’s Nebraska spelled backwards. (Laughter)

AUDIENCE MEMBER: Everybody in this room’s got to be wondering the same question. Who, in your opinion, both of you, is the next Warren Buffett?

WARREN BUFFETT: Charlie? Who’s the next Charlie Munger? Well, let’s try that first. That’s a more difficult question. (Laughter)

CHARLIE MUNGER: There’s not much demand. (Laughter) I don’t think there’s only one way to succeed in life, and our successors, in due time, may be different in many ways. And they may do better.

WARREN BUFFETT: Incidentally, we have a number of people in the company, some of whom are in this room today, and the ones you saw on that screen, who are leagues ahead of Charlie and me in various kinds of abilities. I mean a lot of different talents. We’ve got a fellow in this room today who’s the best bridge player, probably, in the world. And Charlie and I could work night and day, and if he spent ten minutes a week working on it, he’d play better bridge than we would. And there are all kinds of intellectual endeavors that, for some reason or another, one person’s a little bit better wired for than someone else. And we have people running our businesses that if Charlie and I were put in charge of those businesses, we couldn’t do remotely as well as they do. So there’s a lot of different talents. The two that we’re responsible for is, we have to be able to keep able people, who are already rich, motivated to keep working at things where they don’t need to do it for financial reasons. I mean it’s that simple.

And that’s a problem any of you could think about, and you’d probably be quite good at it if you gave it a little thought, because you’d figure out what would cause you to work if you were already rich and didn’t need the job. Why would you jump out of bed and be excited about going to work that day? And then we try to apply that to the people who work with us. Secondly, we have to allocate capital. And these days we have to allocate a lot more capital than we had to allocate a decade ago. That job is very tough at present. Sometimes it’s very easy. And it will be easy at times in the future and it’ll be difficult at times in the future. But there are other people that can allocate capital, and we have them in the company. Charlie, you have any —?

CHARLIE MUNGER: No.

13. One of the few reasons to sell a stock

WARREN BUFFETT: OK. Number 6.

AUDIENCE MEMBER: Good morning. My name is Jad Khoury (PH). I’m from Gaithersburg, Maryland. I just want to thank you for sharing your wisdom. And my question is, what criteria do you use to sell stock? I kind of understand how you buy it, but I’m not sure how you sell.

WARREN BUFFETT: Yeah. Well, the best thing to do is buy a stock that you don’t ever want to sell. I mean — and that’s what we’re trying to do. And that’s true when we buy an entire business. I mean, we bought all of GEICO or we bought all of See’s Candy or The Buffalo News. We’re not buying those to resell. I mean, what we’re trying to do is buy a business that we will be happy with if we own it the rest of our lives, and we expect to with those. It’s the same principle applies to marketable securities. You get extra options with marketable securities. You can add to holdings. Obviously easier — we can never own more than a hundred percent of a business, but if we own 2 percent of a business and we like it at a given price, we can add and have 4 or 5 percent. So that’s an advantage.

Sometimes, if we need money to move to another sector, like we did last year, we will trim some holdings, but that doesn’t mean we’re negative on those businesses at all. I mean, we think they’re wonderful businesses or we wouldn’t own them. And we would sell A, if we needed money for other things. The GEICO stock that I bought in 1951, I sold in 1952. And it went on to be worth a hundred or more times — before the 1976 problems — 100 or more times what I’d paid. But I didn’t have the money to do something else. So you sell if you need money for something else. You may sell if you believe the valuations between different kinds of markets are somewhat out of whack. And, you know, we have done a little trimming last year in that manner. But that could well be a mistake. I mean the real thing to do with a great business is just hang on for dear life. Charlie?

CHARLIE MUNGER: Yes, but the sales that do happen, the ideal way is when you found something you like immensely better. Isn’t that obvious that’s the ideal way to sell?

WARREN BUFFETT: And incidentally, the ideal purchase is to find — is to have something that you already liked be selling at a price where you feel like buying more of it. I mean, we probably should have done more of that in the past in some situations. But that’s the beauty of marketable securities. You really do — if you’re in a wonderful business, you do get a chance, periodically, maybe to double up in it, or something of the sort. If the market — if the stock market were to sell a lot cheaper than it is now, we would probably be buying more of the businesses that we already own. They would certainly be the first ones that we would think about. They’re the businesses we like the best. Charlie?

CHARLIE MUNGER: Nothing more.

14. Make up your own mind

WARREN BUFFETT: OK. Zone 7.

AUDIENCE MEMBER: Good morning, Mr. Buffett, Mr. Munger. My name is Ron Wright (PH) from Iowa City, Iowa. New companies have always been an interest to me. Is it reasonable to assume an Omahabased company with only $5 billion in the bank might succeed in telecommunications?

WARREN BUFFETT: Well, I think that a new company with 5 billion in the bank is probably better off than most new companies. (Laughter) Be like Jennifer Gates, as a newborn. (Laughter) I think you’re probably referring to a company that was created out of one of our local operations that’s run by Walter Scott, one of our directors, from the Kiewit Company, Level 3. I can tell you, it’s got very able management. And I’ll take your word for it that it’s also got 5 billion in the bank, but you’ll have to make your own judgment on the stock. I know Charlie won’t comment on that one. (Laughs)

15. Buffett jokes about Nebraska football’s Tom Osborne

WARREN BUFFETT: Zone 8.

AUDIENCE MEMBER: Yes, good morning. This is Mo Stintz (PH) from Omaha, Nebraska. In the past you’ve often said that the insurance operation is the most important business in Berkshire’s portfolio. Is that true? And what are numbers two and three? I’d also like to ask, is it true that Charlie chose the colors for the cover of this year’s annual report?

WARREN BUFFETT: Did Charlie chose them? (Laughs) He had nothing to do with them. I chose them. (Laughter) They were a tribute to the Nebraska football team and Tom Osborne, who you saw. (Applause) Tom, incidentally, has a very low-key style, and Bobby Bowden, a few years ago, was in Lincoln. And he said that on their first date that Nancy had to slap Tom three times. And somebody said, “Was he that fresh?” And she said, “No, I was just checking to be sure he was alive.” (Laughter) Tom had a fairly conservative offense for a time in the past, although it hasn’t been so conservative the last few years, but somebody said at that time the most reckless thing he did was to eat some cottage cheese the day after the expiration on the carton by then. (Laughter) But I — no, I chose the colors. Now what was the question? (Laughter) What was the question, Charlie? Do you remember? A memorable question, but give it to us again. (Laughter)

16. Proud not to have a strategic plan

WARREN BUFFETT: Are we back there in zone 8? Oh, the number — yeah, sure. The question was about the insurance business, which we have said will be, by far, the most important business at Berkshire. We said that many, many years ago, and it’s proven to be the case. It obviously got a big leg up when we purchased all of GEICO. Insurance, as far as the eye can see, will be, by far, the most significant business at Berkshire. And the question about two and three: in terms of earnings, FlightSafety is the second largest source of earnings. But we don’t really think of them that way. I mean we do know our main business is insurance, but we really have a lot of fun out of all of our businesses. And I had a great time out at Borsheims yesterday, or at a Dairy Queen. So it will be accident, to some extent, over the next ten years, what ends up being the second or third or fourth largest. That’ll be determined by opportunity. We bid on certain businesses — or negotiated on them — that could have been very large businesses if they become part of Berkshire.

And that’ll happen again in the future. So we have no predetermined course of action whatsoever at Berkshire. We have no strategic planning department. We don’t have any strategic plan. We react to what we think are opportunities. And if it’s a business we can understand, and particularly if it’s big, you know, we would love to make it number two. Charlie?

CHARLIE MUNGER: I also want to say proudly that we have no mission statement.

WARREN BUFFETT: No. (Laughter and applause) It’s hard to think of anything that we do have, as a matter of fact. (Laughter) Yeah, we have never had — I mean I’m sure you all know this. We’ve never had a consultant. And we try to keep things pretty simple. We still have 12 people at headquarters. We have about 40,000 people that now work for Berkshire. And we hope to grow a lot, but we don’t hope to grow at headquarters. (Laughter)

17. In “good shape” to handle Y2K problem

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: Yes, my name is Patty Buffett and I’m from Albuquerque, New Mexico.

WARREN BUFFETT: I like your name. (Laughter)

AUDIENCE MEMBER: Thanks. In your opinion, what effect will the year 2000 compliant issue have on the U.S. stock market and the global economy?

WARREN BUFFETT: Well, I get different reports on 2000, but the main report I hear — I think, you know, we — you wouldn’t want to rely on me on this, but you could rely on our managers. And I think we’re in good shape. It’s costing us some money but not huge amounts of money to be prepared for 2000. With companies in which I’m a director, you know, I hear some reasonably good-sized numbers. Those numbers are in their annual reports and described as to the cost of compliance. But what I’m told by people that know a lot more than I do, is that they think probably that the weakest link may be in governmental units. They seem to think that in terms of where they stand versus the commercial sector, in terms of reaching where they need to be by 2000, that there’s some areas of both national and state and local governments, and foreign government, where they’re really behind the curve. Now, that is not an independent judgment of mine.

But somebody said, “You want to be very careful about making a phone call at five seconds before midnight at the millennium because you may get charged for 100 years,” you know. (Laughter) So it’ll be interesting. I don’t think it’s going to affect Berkshire in any material way, and I certainly have a feeling that the world will get past it very easily. But it is turning — it is expensive for some companies, and it’s going to be very expensive for governments. Charlie?

CHARLIE MUNGER: Yeah, I find it interesting that it is such a problem. You know, it was predictable that the year 2000 would come.

WARREN BUFFETT: Yeah. (Laughter and applause) Yeah. Yeah, we decided that back in 1985, actually. (Laughter) We didn’t welcome it, understand. That’s not Berkshire’s style, though. (Laughs) It is fascinating, isn’t it, when you think about it, that a whole bunch of people with 160 IQs that could build up such a problem, but here we are. And — (laughter) — that’s why we stick with simple things. (Laughter)

18. Laws needed to check campaign spending “arms race”

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: My name is Kristin Cham (PH). I’m from Springfield, Illinois. And I’m a proud shareholder of Berkshire Hathaway. (Applause)

WARREN BUFFETT: We’re glad to you have you here.

AUDIENCE MEMBER: I’ve heard a little about your thoughts on trying to control campaign spending. Could you tell us more about your thoughts and efforts on this topic? Thank you.

WARREN BUFFETT: Charlie, did you get all of that?

CHARLIE MUNGER: I think it was campaign spending.

WARREN BUFFETT: Oh, campaign spending. Yeah, I have joined something that Jerry Kohlberg — this is personal. This has nothing to do with Berkshire — that Jerry Kohlberg spearheaded. And it’s taken a position — and probably 30 or so mostly business people — taken a position against soft money, and also taken a position on very fast disclosure of campaign finance money, because I personally think that the arms race, in terms of campaign spending by businesses, you know, has just begun. It doubled in the last election. But political influence — and I don’t mean that by buying a vote, but I mean just in terms of having a (inaudible) in Washington or in other state capitols. Political influence has been an underpriced product in the past. I mean, the government is enormously important in this country to most companies. It was amazing how cheap — cheaply — it could be — attention could be purchased. But the price is going up, and there will be an escalation.

And I don’t think it’s easy — if you’re the manager of a business and you own 1/10th of 1 percent of it and you’re in a business that’s heavily affected by government, I don’t think it’s very easy to tell your board of directors that you’re going to take a hands-off approach. So I think legislation is needed in that arena, and there are over a hundred campaign finance reform bills that have been introduced. Everybody wants to have their name on a bill. They just don’t want to have it passed. (Laughter) And, you know, John McCain’s been working hard on it. And it’s something I think we have to come to grips with because it’s going to be a battle of the wallets for influence.

And, like I say, if I were running some other company, and my competitors were spending money to get the attention of would-be legislators, or actual legislators, it’d be very difficult to take some high and mighty position that I wasn’t going to do it myself, and my board and my shareholders might ask me why I was taking that position. We are lucky, basically, to be in a business that’s relatively unaffected by legislation, although we will — we’re going to pay a lot of tax this year. I said two years ago that it would only take 2,000 entities in the whole United States — businesses, individuals, any kind of entity — to pay the same amount of taxes as Berkshire, and that would take care of the entire budget. You’d need no Social Security taxes. You’d need no nothing. I think we’re going to be able to say that again this year. I think that if you multiply our tax by 2,000 you will more than account for the entire federal budget, including Social Security and everything else.

So you might say, “Why aren’t you in Washington lobbying for a capital gains rate at corporations that’s the same as individuals?” or something, but we basically haven’t played that game. We feel very fortunate. I’ll say this. I would rather, in this country, be a huge taxpayer myself than be somebody who needed the other end of it, the government dispensing. I mean, if anybody here is paying taxes and they want to — (applause) If you’d like to shift positions with somebody in a veteran’s hospital or, you know, that has a couple of children by age 19 and is getting a check from the government, you know, I don’t want to shift positions. I’m happy to be paying the taxes.

19. “The secret of life is weak competition”

WARREN BUFFETT: Zone 11, please. I think 11 is probably the remote — yeah. So we’re going to hear this from the overflow room. Are we there?

AUDIENCE MEMBER: Yes. Good morning, Mr. Buffett, Mr. Munger. My name is Patrick Rown (PH) from Charlotte, North Carolina. And I’ve watched returns on equity for the banking sector in the U.S. go up a good bit over the last few years. And returns on tangible equity for some of the major banks that have led to consolidation have gone up a good bit more. Leads me to wonder whether these returns are sustainable over the near-term or the longer-term, five, 10 years out.

WARREN BUFFETT: Well, that’s the $64 question, because the returns on equity — and particularly tangible equity, as the gentleman mentioned — and particularly tangible equity in the banking sector, even — those returns have hit numbers that are unprecedented. And then the question is, if they’re unprecedented, are they unsustainable? Charlie and I would probably think the — we would certainly prefer — we would not base our actions on the premise that they are sustainable. Twenty percent-plus returns on tangible equity — or on book equity — and much higher returns on tangible equity. In the banking field, you have a number of enterprises that on tangible equity are getting up close to the 30 percent range. Now, can a system where the GDP in real terms is growing, maybe, 3 percent — where in nominal terms this grows 4 to 5 percent — can businesses consistently earn 20 percent on equity? They certainly can if they retain most of their earnings, because you would have corporate profits rising as a percentage of GDP, to the point that would get ludicrous.

So under those conditions, you’d either have to have huge payouts — either by repurchases of shares or by dividends or by takeovers, actually — that would keep the level of capital reasonably consistent among industry, because you couldn’t sustain — let’s just say every company retained all of its earnings and they earned 20 percent on equity — you could not have corporate profits growing at 20 percent as a part of the economy year after year. This has been a better world than we foresaw, in terms of returns, so we’ve been wrong before. And we’re not making a prediction now, but we would not want to buy things on the basis that these returns would be sustained. We told you last year, if these returns are sustained and interest rates stayed at these levels or fell lower, that stock prices, in aggregate, are justified. And we still believe that. But those are two big ifs. And a particularly big if, in my view, is the one about returns on equity and on tangible assets. It goes against — it certainly goes against classic economic theory to believe that they can be sustained. Charlie, how do you feel about it?

CHARLIE MUNGER: Well, I think a lot of the increase in return on equity has been caused by the increasing popularly of Jack Welch’s idea that if you can’t be a leader in a line of business, get out of it. And if you have fewer people in the business, why, returns on equity can go up. Then it’s got more and more popular to buy in shares, even at very high prices per share. And if you keep the equity low enough by buying shares back, why, you could make return on equity whatever you want. It would be that, to some extent, a slow revolution in corporate attitudes. But Warren is right. You can’t have massive accumulations of earnings that are retained and keep earning these rates of return on them.

WARREN BUFFETT: An interesting question is to think about, if you had 500 Jack Welches and they were running the Fortune — they’re cloned — and they were running all of the Fortune 500 companies, would returns on equity for American business be higher or lower than they are presently? I mean if you have 500 sensational competitors, they can all be rational, but that doesn’t — and they will be. And they’ll be smart and they’ll keep trying to do all the right things. But there’s a self-neutralizing effect, just like having 500 expert chess players or 500 expert bridge players. You still have a lot of losers if they get together and play in a tournament. So it’s not at all clear that if all American management were dramatically better, leaving out the competition against foreign enterprises, that returns on equity would be a lot better. They might very well drive things down. That’s what, to some extent, can easily happen in securities markets. It’s way better to be in securities markets if you have a hundred IQ and everybody else operating has an 80, than if you have 140 and all the rest of them also have 140.

So the secret of life is weak competition, you know. (Laughter) Somebody said, “How do you beat Bobby Fischer?” You play him in any game except chess, well — (Laughter) That’s how you beat Jack Welch. You play him in any game except business, although he’s a very good golfer, I want to — (laughs) — point out. He shot a 69 a few months ago when I saw him at a very tough course. Jack manages to play 70 or 80 rounds of golf a year, and come in sub-par occasionally, while still doing what he does at GE. He’s a great manager. But 500 Jack Welches, I’m not at all sure would make stocks more valuable in this country.

20. Book recommendations

WARREN BUFFETT: Zone 1.

AUDIENCE MEMBER: I’m Ben Knoll and I’m from Minneapolis. And first, I just wanted to thank you for providing your past annual letters to the shareholders, and Mr. Munger for providing your speech to the graduate students at USC a couple years ago. Drawn a lot of insights from that, not only in investing but also in my day job as a business manager. And I’m wondering if you could help me with my summer reading list and provide some additional suggestions for reading in the fields of investing and management, other than the standards of Graham and Fisher and so forth.

WARREN BUFFETT: Charlie?

CHARLIE MUNGER: Yeah. I have recently read a new book twice, which I very seldom do. And that book is “Guns, Germs and Steel” by Jared Diamond. And it’s a marvelous book. And the way the guy’s mind works would be useful in business. He’s got a mind that is always asking why. Why, why, why. And he’s very good at coming up with answers. I would say it’s the best work of its kind I have ever read.

WARREN BUFFETT: I read a little easier book — (laughter) — recently. I’m not even sure of the title. I don’t pay much attention to titles when I get into the book, but it’s something to the effect of “The Quotable Einstein.” I mean it’s a lot of his commentary over the years, and it’s great reading. “The Fermat Theorem” was the book that — that isn’t an exact title either — but it’s the story of the discovery of the answer. That’s a very interesting book. One of our shareholders from Sweden gave me a copy of that when I was in New York and I’ve enjoyed it.

21. Higher rates would hurt Freddie and Fannie

WARREN BUFFETT: Zone 2.

AUDIENCE MEMBER: Marc Rabinov. I’m a shareholder from Melbourne, Austria. Gentlemen, we have large holdings in Freddie Mac and Fannie Mae, and as you both know, they were quite — well, they were hurt quite a lot when interest rates went up in the past. I’m wondering if you think there’ll be hurt again when interest rates go up in the future?

WARREN BUFFETT: Well, the question about Freddie Mac and Fannie Mae on interest rates, they are not as interest rate sensitive as people formerly thought they were. But it would be the pattern, and I have a feeling that if interest rates got extremely low, so that there was a huge turnover in the portfolio, and then rates went up dramatically, that even though they have various ways of protecting themselves against interest rate scenarios, that that might get very tough. I think there would be some kind of squeeze there. They may have good answers as to why that wouldn’t happen, incidentally, because they certainly worry about every kind of interest rate scenario. That’s their job. But I think, in a sense, very low interest rates are more of a long-term threat, because if you get a portfolio chock full of, say, 4 percent mortgages or something of the sort, and then you had a huge move upward, that would be quite painful for some period of time, no matter what you’ve done in the way of hedging. Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

WARREN BUFFETT: Yeah. That’s what happened to the savings and loans, in effect, you see, 25 years ago or whenever it was. And Freddie and Fannie have other functions, and they’ve got a lot of advantages, but they have a savings and loan-type operation. They just do it on a very big scale and they get their money from — in a very different manner than from millions of depositors. But the basic economics have some similarly.

22. No worries about tough times: “It’s a lot of fun”

WARREN BUFFETT: Zone 3.

AUDIENCE MEMBER: Jane Bell (PH), Des Moines. Since I became a Berkshire Hathaway shareholder I’ve been coming to these meetings. This is my second. (Laughter)

WARREN BUFFETT: I’ve been coming to these meetings ever since I’ve been a shareholder. (Laughter)

AUDIENCE MEMBER: Mr. Buffett, I’m a partner and owner in a consulting business, and we tell our clients and potential clients that we design solutions for what keeps them awake at night. Mr. Buffett, from your perspective as an investor, what keeps you awake at night?

WARREN BUFFETT: Well, that’s a good question. And that’s one I always ask the managements of our subsidiaries, as well as any new investment. I want to know what their nightmare is. Andy Grove, in his book “Only the Paranoid Survive,” talks about the silver bullet for a competitor. So in terms of, if you only had one silver bullet, which competitor would you fire it at? And it’s not a bad question. And your question’s a little broader. If you only had one worry that you could get rid of, what would it be? I would say that, and I think I speak for Charlie — (inaudible) — but we really don’t worry. You know, we will do the best we can, and when we have capital allocated, sometimes it’s very easy to do. Sometimes it’s almost impossible to do. But we’re not going to worry about it, because, you know, the world changes. And if we had something we were worried about in the business, we would correct it.

I’m not worried about any — I’m not really worried about — you know, we can lose a billion dollars on a California earthquake. But I’m not worried about it, although I have a sister who’s in the audience that lives in California. I told her to call me quickly if the dogs start running in circles or anything like that. (Laughter) But there’s — you know, if you’re worried about something, the thing to do is get it corrected and get back to sleep. And I can’t think of anything I’m worried about at Berkshire. That doesn’t mean that I have any good ideas as to what we should be doing with a whole lot of money that we have around. But, you know, I can’t do anything about that except keep looking for things that I might understand and do something with the money. And if they aren’t there, they aren’t there. And we’ll see what happens tomorrow and next week and next month and next year. Charlie, what are you worried about?

CHARLIE MUNGER: Well, in the 30-some years I’ve been watching you, I would say what it takes to make you not sleep at night is an illness in the family. Short of that, Warren likes the game. I like the game. And even in the periods that look tough to other people, it’s a lot of fun.

WARREN BUFFETT: It’s a lot of fun.

CHARLIE MUNGER: It’s a lot of fun. (Laughter)

WARREN BUFFETT: In fact it probably is the most — (applause) — it’s sort of, it is the most — I mean we define tough times differently than other people would, but our idea of tough times is like now, and our idea — we don’t feel it’s tough times when the market’s going down a lot or anything of the sort. So we are having a good time then. I mean we don’t want to sound like undertakers during a plague or anything, but — (Laughter) But there really — you know, it makes no difference to us whether the price of Berkshire is going up or down. We’re trying to figure out ways to make the company worth more money years down the road, and if we figure that out, the stock will take care of itself, so — And usually when the stock is going down, it means other things are going down. And it’s a better chance for us to deploy capital, and that’s our business. So you will not see us worrying. Maybe we should. You know, “What, me worry?” (Laughs)

23. “What is important and what is knowable?”

WARREN BUFFETT: Zone 4.

AUDIENCE MEMBER: My name is Paul Yoon (PH) from L.A., California. Mr. Warren Buffett, Mr. Charles Munger, I am one of the persons who highly admire you both. I have two questions. Question one: your view on the world financial business environment in the next decade. Question two — (laughter) — U.S. position for economic competition in the next decade. Thank you.

WARREN BUFFETT: Well, you’ve asked two big questions, but you’re going to get very small answers, I’m afraid. (Laughter) And that’s no disrespect. But we — we just — we don’t have that. We don’t think about those things very much. We just are looking for decent businesses. And incidentally, our views in the past wouldn’t have been any good on those subjects. We try to think about two things. We try to think about things that are important and things that are knowable. Now, there are things that are important that are not knowable. In our view, those two questions that you raised fall in that. There are things that are knowable but not important. We don’t want to clutter our minds up with those. So we say, “What is important and what is knowable?” And what among the things that fall within those two categories can we translate into some kind of an action that is useful for Berkshire.

And we really — there are all kinds of important subjects that Charlie and I, we don’t know anything about, and therefore we don’t think about them. So we have — our view about what the world will look like over the next ten years in business or competitive situations, we’re just no good. We do think we know something about what Coca-Cola’s going to look like in ten years, or what Gillette’s going to look like in ten years, or what Disney’s going to look like in ten years, or what some of our operating subsidiaries are going to look like in ten years. We care a lot about that. We think a lot about that. We want to be right about that. If we’re right about that, the other things get to be — you know, they’re less important. And if we started focusing on those, we would miss a lot of big things. I’ve used this example before, but Coca-Cola went public in, I think, it was 1919. And the first year one share cost $40. The first year it went down a little over 50 percent.

At the end of the year, it was down to $19. There were some problems with bottler contracts. There’s problems with sugar. Various kinds of problems. If you’d had perfect foresight, you would have seen the world’s greatest depression staring you in the face, when the social order even got questioned. You would have seen World War II. You would have seen atomic bombs and hydrogen bombs. You would have seen all kinds of things. And you could always find a reason to postpone why you should buy that share of Coca-Cola. But the important thing wasn’t to see that. The important thing was to see they were going to be selling a billion eight-ounce servings of beverages a day this year. Or some large number. And that the person who could make people happy a billion times a day around the globe ought to make a few bucks off doing it. And so that $40, which went down to $19, I think with dividends reinvested, has to be well over $5 million now.

And if you developed a view on these other subjects that in any way forestalled you acting on this more important, specific narrow view about the future of the company, you would have missed a great ride. So that’s the kind of thing we focus on. Charlie?

CHARLIE MUNGER: Yeah, we’re predicting the currents that will come, just how some things will swim in the currents, whatever they are.

24. Praise for Value Line’s “perfect snapshot”

WARREN BUFFETT: Zone 5, please.

AUDIENCE MEMBER: Good morning, Marc Gerstein from Value Line. Mr. Buffett, considering the large amounts of demands on your time, how do you go about reviewing the entire spectrum of choices in the equity markets?

WARREN BUFFETT: Give me that last part again? I got the demands on my time and —

MARK ERSTEIN: How do you and Mr. Munger manage to review the whole spectrum of choices in the equity markets?

WARREN BUFFETT: A fat pitch coming up. (Laughter) But I don’t mind it at all, because the truth is that we get — I don’t even know what we pay for Value Line. Charlie and I both get it in our respective offices, but we get incredible value out of it because it give us the quickest way to see a huge number of the key factors that tell us whether we’re basically interested in the company. And it also gives us a great way — good way — of sort of periodically keeping up-to-date. Value Line has 1,700 or so stocks they cover, and they do it every 13 weeks. So it’s a good way to make sure that you haven’t overlooked something if you just quickly review that. But the snapshot it presents is an enormously efficient way for us to garner information about various businesses. We don’t care about the ratings. I mean that doesn’t make any difference to us. We’re not looking for opinions. We’re looking for facts.

But I have yet to see a better way, including fooling around on the internet or anything, that gives me the information as quickly. I can absorb the information on — about a company — most of the key information you can get — and probably doesn’t take more than 30 seconds in glancing through Value Line, and I don’t have any other system that’s as good. Charlie?

CHARLIE MUNGER: Well, I think the Value Line charts are a human triumph. It’s hard for me to imagine a job being done any better than is done in those charts. An immense amount of information is put in very usable form. And if I were running a business school we would be teaching from Value Line charts.

WARREN BUFFETT: And when Charlie says the charts, he does not mean just the chart of the price behavior. He means all that information that really is listed under the charts that —

CHARLIE MUNGER: Oh yeah.

WARREN BUFFETT: The detailed financial information. You can run your eye across that. The chart of the price action doesn’t mean a thing to us, although it may catch our eye, just in terms of businesses that have done very well over time. But we — price action has nothing to do with any decision we make. Price itself is all-important, but whether a stock has gone up or down, or what the volume is, or any of that sort of thing, that is — as far as we’re concerned, you know, those are chicken tracks, and we pay no attention to them. But that information that’s right below the chart, in those 10 lines or so — 15 lines — if you have some understanding of business, that’s a — it’s a perfect snapshot to tell you very quickly what kind of a business you’re looking at.

25. Insurance mergers haven’t hurt GEICO

WARREN BUFFETT: Zone 6, please.

AUDIENCE MEMBER: David Winters from Mountain Lakes, New Jersey. With the consolidation in the insurance industry, how do you think that will affect Berkshire’s insurance businesses and the long-term development of the float? And if I may, not to encourage your dogma to run over your karma, but how do you think your policy of partnership and fair dealing has enhanced or detracted from your investment returns? Thank you.

WARREN BUFFETT: Now, with the consolidation taking place in insurance, it’s been taking place for some time. There have been some big mergers over the years. It should — there are developments in insurance. We mentioned the super-cat bonds, which are not bonds at all. But that has an effect. But I would say that there’s no merger that has taken place that I regard as being detrimental, either to our GEICO business or to our reinsurance business. That has not been a factor, and I think if there were some more mergers it would not be a factor. I see no way that any entities being put together would change the competitive situation in respect to GEICO. GEICO operating just as it does, independently, is as competitive as can be, and it would not benefit by being part of any other organization. And our reinsurance business is much more opportunistic. And it’s not consolidation there, it’s just lack of fear, generally, by competitors who can price — particularly cat business — at a rate that could be totally inadequate, as I use in an illustration in the report. But nevertheless, it could appear to be profitable for a long time.

And there’s probably more of that going on now, and there’ll probably be a lot more going on in that arena. We have some sensational insurance businesses, though. I have to tell you that — I don’t think you really have to worry too much about how we do in insurance in the future. We have a number of GEICO people here today. I hope you got a chance to meet them. GEICO — and you saw Lorimer Davidson. I really was hoping he could be here, but Davy is 95 years old. I went to visit him a few months ago, and it just isn’t easy for him to get around. But he built a sensational company and it stumbled once. Jack Byrne got it back on track and Tony Nicely’s got it going down the track at about a hundred miles an hour and it’s getting faster all the time. So we’ve got a great business there. Charlie?

CHARLIE MUNGER: Nothing to add.

26. “Wonderful companies” should buy back stock

WARREN BUFFETT: Zone 7.

AUDIENCE MEMBER: Yes. Bill Ackman from New York. Is there a price at which it’s inappropriate for a company to use its capital to buy back its stock?

WARREN BUFFETT: Give me that again?

AUDIENCE MEMBER: Example. Coca-Cola at 40 P/E. Is that a smart place for Coke to deploy capital?

WARREN BUFFETT: Well, it sounds like a very high price when you name it in terms of a P/E to buy back the stock at that sort of number. But I would say this: Coca-Cola’s been around a hundred and — what, 12 years now, and there are very few times in that 112 years, if any, when it would not have been smart for Coca-Cola to be repurchasing its shares. Coca-Cola is, in my view, among businesses that I can understand, it’s the best large business in the world. I mean it is a fantastic business. And we love it when Coke repurchases shares and our interest goes up. We owned 6.3 percent of Coca-Cola in 1988 when we bought in. We actually increased that a little bit a few years later. But if they had not repurchased shares, we probably would own about 6.7 percent or 6.8 percent of Coke now. As it is, we own a little over 8 percent, through repurchases. There are going to be about a billion eight-ounce servings of Coke sold around the world — Coca-Cola products — sold around the world today.

Eight percent of that is 80 million and 6.8 percent is 68 million. So there are 12 million extra servings for the account of Berkshire Hathaway being sold around the world. And they’re making a little over a penny a serving, so, you know, that gets me kind of excited. (Laughter) I think it — all I can tell you is, I approve of Coke repurchasing shares. I’d a lot rather have them repurchasing shares at 15 times earnings, but when I look at other ways to use capital, I still think it’s a very good use of capital. And maybe the day will come when they can buy it at 20 times earnings, and if they can I hope they go out and borrow a lot of money to ton of it at those prices, and — I think we will be better off 20 years from now if Coke follows a consistent repurchase approach. I do not think that is true for many companies. I mean I think that repurchases have become en vogue and done for a lot of silly reasons. And so I don’t think everybody’s repurchase of shares is well reasoned at all.

You know, we see companies that issue options by the ton and then they repurchase shares much higher, you know — I started reading about investments when I was six, and I think the first thing that I read was, you know, buy low, sell high. But these companies, through their options, you know, they sell low and then they buy high. And they’ve got a different formula than I was taught. So there are a number that we don’t approve of. When we own stock in a wonderful business, we like the idea of repurchases, even at prices that may give you nose bleeds. It generally turns out to be a pretty good policy. Charlie?

CHARLIE MUNGER: Well, I think the answer is that in any company the stock could get to a price so high it would be foolish for the corporation to repurchase its shares.

WARREN BUFFETT: Sure.

CHARLIE MUNGER: And you can even get into gross abuse. Before the crash, the Insull utilities were madly buying their own shares as a way of promoting the stock higher. It was like a giant Ponzi scheme at the end. So there’s all kinds of excess that possible, but the really great companies that buy at high price- earnings, that can be wise.

WARREN BUFFETT: Our interest in GEICO went from 33 percent to 50 percent without us laying out a dime, because GEICO was repurchasing its shares. And we’ve benefitted substantially. But we benefitted a lot more, obviously, when prices were lower. I mean we would — our interest in The Washington Post company has gone from nine and a fraction percent, to 17 and a fraction percent over the years without us buying a single share. But The Post or Coke or any number of companies don’t get the bargain in repurchasing now that they used to. We still think it’s probably the best use of many in many cases.

27. Berkshire insurance float has a negative cost

WARREN BUFFETT: Zone 8.

AUDIENCE MEMBER: My name is Hutch Vernon. I’m from Baltimore, Maryland. My question has to do with float. You said in the annual, and you’ve said in the past, that float has had a greater value to Berkshire than an equal amount of equity. I wondered if you could clarify that statement. Is that because the float has been generated at such a low cost relative to an imputed cost for equity, or is there something else behind that statement?

WARREN BUFFETT: No, it’s because the float, which is now, we’ll say, 7 billion, comes to us at a negative cost. We would not make that statement if our float was costing us a couple percent a year, even though float would then be desirable. Highly desirable. But our float is even better than that, or it has been, and so it comes to us with a cost of less than zero. It comes to us with a profit attached. So if we were to replace — if we were to get out of the insurance business and give up the 7 billion of float and replace it with 7 billion of equity, we would have less going for us next year than under the present situation, even though our net worth would appear to be 7 billion higher. And I have said, if we were to make the decision — if we were offered the opportunity to go out of the insurance business, and that 7 billion liability would — as part of that decision — would evaporate from our balance sheet, so that our equity would go up 7 billion, with no tax implications, we would turn down that proposition.

So obviously we think that 7 billion, which is shown as a liability, when it’s part of a — viewed as part of an insurance business, is not a liability at all in terms of real economic value. And of course, the key is not what the float is today, and not what the cost is today. The key is what is the float going to be 10 or 15 years from now, and what is the cost going to be 10 or 15 years ago. And, you know, we will work very hard at both increasing the amount of float and keeping the costs down somewhere close to our present level. That makes it a very attractive business when that can be done. GEICO’s a big part of doing that, but we’ve got other things, other insurance operations, that’ll be important in that, too. And we may have others besides that in the future. Charlie?

CHARLIE MUNGER: Yeah. If the float keeps growing, that is a wonderful thing indeed. We really have a marvelous insurance business. In addition to having this remarkable earning power, it’s way less likely to get really clobbered than most insurance businesses. So I think it’s safer on the downside and has a better upside.

WARREN BUFFETT: And it may sound strange, but we don’t regard losing a billion dollars in a California quake as getting really clobbered. I mean that is —

CHARLIE MUNGER: No, no.

WARREN BUFFETT: — I mean that’s part of the game. There are many companies that have greater exposure than that that really aren’t getting paid for it. And you don’t see it specifically, but any company that has a ton of homeowners’ business in Florida or Long Island or along the coast of Texas, may have exposures many times our billion, and really not even be getting paid appropriately or specifically for taking that risk.

28. Not worried Japan might “dump” U.S. bonds

WARREN BUFFETT: Zone 9.

AUDIENCE MEMBER: Hi, my name is Mary Semler (PH) from Seattle, Washington. Japan is a major holder of U.S. Treasurys. Given the troubled Japanese economy, do you foresee Japan cashing in their U.S. investments to bail themselves out? Why or why not?

WARREN BUFFETT: Probably didn’t get all that. I was busy chewing.

CHARLIE MUNGER: I didn’t get that, either.

WARREN BUFFETT: I was busy chewing here and —

AUDIENCE MEMBER: Japan is a major holder of U.S. Treasurys. Given the troubled Japanese economy, do you foresee Japan cashing in their U.S. investments to bail themselves out? Why or why not?

WARREN BUFFETT: The problems with the Japanese economy and does that mean that — are you thinking particularly about them dumping Treasurys or something of the sort?

CHARLIE MUNGER: That’s exactly what she’s —

WARREN BUFFETT: Yeah. (Laughter) Well, you know, it’s very interesting. All the questions about what so-called foreigners do with investments. Let’s just assume the Japanese, or any other country, decides to sell some U.S. government holdings that they have. If they sell them to U.S. corporations or citizens or anything, what do they receive in exchange? They receive U.S. dollars. What do they do with the U.S. dollars? You know, I mean they can’t get out of the system. If they sell them to the French, you know, the French give them something in return. Now the French own the government securities. But really as long as we, the United States, run a deficit — a big deficit — a trade deficit — we are accepting goods and giving something in exchange to foreigners. I mean when they send us whatever it may be — and on balance they send us more of that then we send over there — we give them something in exchange. We give them — we may give them an IOU. We may give them a government bond. But we may give them an investment they make in the United States.

But they have to be net investors in this country as long as we’re net consumers of their goods. It’s a tautology. So I don’t even know quite how a foreign government dumps its government bonds without getting some other type of asset in exchange that may have an effect on a different market. The one question you always want to ask in economics is — and not a bad idea elsewhere, too — but is, “And then what?” Because there’s always a second side to a transaction. And just ask yourself, if you are a Japanese bank and you sell a billion dollars’ worth of government bonds — U.S. government bonds — what do you receive in exchange, and what do you do with it? And if you follow that through, I don’t think you’ll be worried about foreign governments selling U.S. bonds. It is not a threat. Charlie?

CHARLIE MUNGER: If I owned Japan, I would want a large holding of U.S. Treasurys. You’re on an island nation without much in the way of natural resources. I think their policy is quite intelligent for Japan, and I’d be very surprised if they dumped all their Treasurys.

WARREN BUFFETT: If they’re a net exporter to us, though, what choice do they have? When you think about it. If they send over more goods to us than we send to them — which has been the case — they have to get something in exchange. Now for a while they were taking movie studios in exchange, you know — (Laughter) They were taking New York real estate in exchange. I mean they’ve got a choice of assets, but they don’t have a choice as to whether — if they send us more than they get from us — whether they get some investment asset in return. I mean it’s amazing to me how little discussion there is about the fact that there’s two sides to an equation. But it makes for better headlines, I guess, when read the other way.

29. Mild endorsement for some Social Security money in stocks

WARREN BUFFETT: Zone 10.

AUDIENCE MEMBER: This is John Vaughan (PH) from Detroit, Michigan. Nebraska’s Senator Kerrey has proposed private investment accounts for up to two percentage points of the current payroll tax. His words were, and I quote, “People want more than just a transfer payment. They want wealth.” Do you approve this proposal? And if you do, would you recommend passive investing, i.e. index, or if you recommend active investing, would you and Charlie want to give it a shot? (Laughter)

WARREN BUFFETT: Well, I talked with Bob Kerrey about that, and Bob does like the idea of giving everybody some piece of the American economy and an interest in it. As you know, he’s proposed, really, sort of small grants to the 3 1/2 million or so children born every year, and then some buildup of that account. Senator Moynihan has come up with something recently in conjunction with Kerry. I personally would not like to see any major amount of Social Security — and Moynihan was talking about 2 percent. And actually, I suggested the idea that maybe 2 percent out of the 12 and a fraction percent, at the option of the beneficiary — Social Security participant — could be devoted to some other system, but then they would only get 5/6ths of the basic Social Security benefit. I don’t think you could drop it below that, because you wouldn’t want people turning 65 — or maybe a more advanced age in the future, 70 — and not having the safety net of Social Security. So I wouldn’t want to drop it below about 5/6ths of the present benefits.

I don’t — I think it’s a perfectly reasonable topic to discuss whether you want to take that 2 percent, then, and let people build up an account, perhaps tax-free, perhaps an IRA-type account, so they would have both wealth and the safety net. But I wouldn’t want to drop the safety net very far. And I think that I would not want to turn an army of salespeople loose on the American public with a mandatory 2 percent going in some direction. I don’t think that would be particularly healthy. Charlie?

CHARLIE MUNGER: I am much less enthusiastic than you are. (Laughter) In other words, your negative, or conservative, attitude is way more affirmative than mine. I think the idea of getting the government into promoting the value of equities — in Japan we have a taste of that now. The Japanese government has been using the postal savings system to buy equities massively year after year after year. I don’t think we need to get the government into the equity market. (Applause)

30. Business schools “incoherent” on cost of capital

WARREN BUFFETT: We go to zone 11, please.

AUDIENCE MEMBER: I’m Dale Max from University Park, Illinois. And I’ve got a question for each of you. A short question for Charlie, and maybe a little longer for Warren. My question for Charlie is, in a business school sense, what is the cost of capital for Berkshire Hathaway? And my question for Warren is that I’ve been on the internet and I look at Yahoo and they give you recommendations for companies. And when I search for Berkshire Hathaway, it shows that nobody is recommending Berkshire Hathaway — (laughter) — despite the fact that there are maybe a thousand people that are wearing signs here, “I love Berkshire Hathaway.” And of course I’ve got mine on, too. But what seems to be the problem in lack of recommendations?

WARREN BUFFETT: Well, we’re not recommending Yahoo, incidentally, either. (Laughter and applause) But I’ll let Charlie have that first question about the cost of capital, which has puzzled people for thousands of years. And then —

CHARLIE MUNGER: The way that is taught in most business schools now, I find incoherent. So I’m the one that asks that question and gets the incoherent answers. I don’t have a good answer to a question I consider kind of a stupid question.

WARREN BUFFETT: That isn’t —

CHARLIE MUNGER: What is the cost of capital at Berkshire Hathaway when we keep drowning in this torrent of cash which we have to reinvest?

WARREN BUFFETT: Yeah. There’s really only two questions that get to that, but you don’t need a mathematical answer. The first question is, is when you have capital, is it better to keep it or return it to shareholders? It’s better to return it to shareholders when you cannot create more than a dollar of value with that capital. That’s test number one. And if you pass that threshold, that you think you can achieve more than a dollar of value for every dollar retained, then you simply look around for the thing that you feel the surest about, and that promises the greatest return weighted for that certainty. So our cost of capital is, in effect, is measured by the ability to create more than a dollar of value for every dollar retained. If we’re keeping dollar bills that are worth more in your hands than in our hands, then we’ve exceeded the cost of capital, as far as I’m concerned. And once we think we can do that, then the question is, is how do we do it to the best of our ability?

And frankly, all the stuff I see in business schools — and I’ve not found any way to improve on that formula. Now the trouble that you may have is that many managements would be reluctant to distribute money to shareholders even if they would rationalize that they would do better than they actually do. But that’s — that may be a danger on it, but that won’t be solved by them hiring a bunch of people to come up with some cost of capital that also justifies them keeping the money, because that’s what they’ll do otherwise.

31. We prefer individual shareholders

WARREN BUFFETT: The question about recommending the stock, we very seldom had stock recommendations over the years. As I think back to 1965, I can’t think of a lot of brokerage reports that have recommended Berkshire. I’m not looking for any, you know, reports at all. We are not looking to have Berkshire sell at the highest possible price, and we’re not looking to try and attract people to Berkshire who are buying stocks because somebody else recommends them to them. We prefer people who figure out for themselves why they themselves want to buy Berkshire, because they’re much more likely to stick around if they enter the restaurant because they decide it’s the restaurant they want to eat at, than if somebody has touted them on it. And that’s our approach. So we do nothing to encourage. But I think even if we did, we probably wouldn’t generate a lot of recommendations. It’s not a great stock to get rich on, if you’re a broker.

CHARLIE MUNGER: Yeah, I think the reason — (Laughter and applause) I think one of the main reasons why it’s so little recommended in the institutional market is that it’s perceived as hard to buy in quantity. (Laughter)

WARREN BUFFETT: We prefer — we’ve got some good institutions as holders, including one that’s run by a very good friend of ours, but frankly it’s more fun for us to have a bunch of individual shareholders. I mean you see it — it translates — if there’s money made, it translates into changes in people’s lives and not some change in somebody’s performance figure for one quarter. And we think that individuals are much more likely to join us with the idea of staying with us for as long as we stay around. And, you know, that’s the way we look at the business. Very few institutions look at investments that way, and, frankly, we think they’re often less rational holders than we get with individuals.

32. “The earthquake doesn’t know the premium you receive”

WARREN BUFFETT: Number 1.

AUDIENCE MEMBER: Good morning. Good morning, gentlemen. I’m Hugh Stevenson (PH), a shareholder from Atlanta. My question involves the company’s super-cat reinsurance business. You’ve addressed some of this, but I would like for you to expound on it, please. You’ve indicated that you think this is the most important business of the company. And my question is, what do you think the long-term impact of catastrophe bonds and catastrophe derivatives will be on the float and the growth in float of the company? And I understand that the mispricing of risk in these instruments doesn’t really affect the way you price your business, but I’m wondering how you think it can affect the volume of the business. And I remember several years ago, Mr. Buffett, you talked about, you can never be smarter than your dumbest competitor.

WARREN BUFFETT: Right.

AUDIENCE MEMBER: And these are some potentially dumb competitors.

WARREN BUFFETT: You’ve got it. (Laughter) I just want to put an asterisk on one thing. We say insurance will be our most important business. We’ve not said the super-cat business will be our most important. Super-cat has been a significant part of our business, and may well over the years remain a significant part, but it is far less significant than GEICO. And I’ll mention a word or two about that. But the super-cat business, you can price wrong, as I illustrated in my report. You can be pricing it at half what it should be priced at. I used an illustration in the report of how you could misprice a policy that you should be getting, say, a million and a half for, namely a $50 million policy on writing — on something that had one chance in 36 of happening, so you should get almost a million and a half for it. I said if you price it at a million a year, you know, you would think you were making money after ten years 70-odd percent of the time.

The interesting thing about that is if you price it for a dollar a year you would have thought you made money 70-odd percent of the time, because when you are selling insurance against very infrequent events, you can totally misprice them but not know about it for a long time. Super-cat bonds open up that field wide open. I mean you’ve always had the problem of dumb competitors, but you have a much more chance of having dumb competitors when you have a whole bunch of people who, in the case of hedge funds who have bought some of these, where the manager gets 20 percent of the profits in a year when there are profits and there is no hurricane, and when there happens to be a hurricane or an earthquake he doesn’t take the loss. His limited partners do. So it’s very likely to be a competitive factor that brings our volume down a lot. It won’t change our prices. You know, the thing to remember is the earthquake does not know the premium that you receive. (Laughter) I mean the earthquake happens regardless.

So it doesn’t say — you know, you don’t have somebody out there on the San Andreas Fault that says, “Well, he only charged a 1 percent premium so we’re only going to do this once every 100 years.” (Laughter) Doesn’t work that way. So we will probably do a whole lot less volume in the next few years in the super-cat business. We have these two policies that run for a couple more years. But in terms of new business, we will do a whole lot less. GEICO is by far the most important part of our insurance business, though. GEICO in the 12 months ended April 30th had a 16.9 percent increase in policies in force. Year-end, I told you it was 16.0. A year ago, I told you it was 10. Year before that, I think it was six and a fraction. So its growth is accelerating and it should be in a whole lot more homes around the country than it is now, you know, by a big factor. And it will be, in my view. So that will be the big part of our insurance business.

But we may be in the insurance business in some other ways too as time goes along. It’s a business that if you exercise discipline you should find some ways to make money, but it won’t always be the same way. Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

33. What Buffett wants in an annual report

WARREN BUFFETT: OK. Zone 2.

AUDIENCE MEMBER: Hello. I’m Steve Davis (PH) from San Francisco. I’d like your advice on how to understand annual reports. What you look for, what’s important, what’s not important, and what you’ve learned over the years from reading thousands of reports? Thank you.

WARREN BUFFETT: Well, we’ve read a lot of reports, I will tell you that. And we — well, we start by looking at the reports of companies that we think we can understand. So we hope to find — we hope to be reading reports — and I do read hundreds of them every year — we hope to be reading reports of businesses that are understandable to us. And then we see from that report whether the management is telling us about the things that we would want to know about if we owned a hundred percent of the company. And when we find a management that does tell us about those things, and that is candid in the same way that a manager of a subsidiary would be candid with us, and talks in language that we can understand, it definitely improves our feeling about investing in such a business. And the reverse turns us off, to some extent. So if we read a bunch of public relations gobbledygook, you know, and we see lots of pictures and no facts, it has some effect on our attitude toward a business. We want to understand the business better when we get through with the annual report than when we picked it up.

And that is not difficult for a management to do if they want to do it. If they don’t want to do it, you know, we think that is a factor in whether we want to be their partners over a ten-year period or so. But we’ve learned a lot from annual reports. For example, I would say that the Coca-Cola annual report over the last good many years is an enormously informative document. I mean, I can’t think of any way if I’d have a conversation with Roberto Goizueta, or now Doug Ivester, and they were telling me about the business, they would not be telling me more than I get from reading that annual report. We bought that stock based on an annual report. We did not buy it based on any conversation of any kind with the top management of Coca-Cola before we bought our interest. We simply bought it based on reading the annual report, plus our knowledge of how the business worked. Charlie?

CHARLIE MUNGER: Yeah. I do think the — if you’ve got a standardized bunch of popular jargon that looks like it came out of the same consulting firm, I do think it’s a big turnoff. That’s not to say that some of the consulting mantras aren’t right. But I think there’s a lot — that for a sort of candid, simple, coherent prose — a lot to be said for it.

WARREN BUFFETT: Almost every business has problems, and we’d just as soon the manager would tell us about them. We would like that in the businesses we run. In fact, one of the things, we give very little advice to our managers, but one thing we always do say is to tell us the bad news immediately. And I don’t see why that isn’t good advice for the manager of a public company. Over time, you know, I’m positive it’s the best policy. But a lot of companies, for example, have investor relations people, and they are dying just to pump out what they think is good news all the time. And they have this attitude that, you know, you’ve got a bunch of animals out there to be fed. And that they’re going to feed them what they want to eat all the time. And over time the animals learn. So we’ve tried to stay away from businesses like that.

CHARLIE MUNGER: What you seldom see in an annual report is a sentence like this: “This is a very serious problem and we haven’t quite figured out yet how to handle it.” (Laughter) But believe me, that is an accurate statement much of the time.

VOICE: — just a moment. (Buffett leaves the table after someone tells him something in his ear.)

34. Munger goes it alone on Coke vs Pepsi

CHARLIE MUNGER: All right. Zone 3. (Laughter)

AUDIENCE MEMBER: I’m Leta Gurtz (PH) and I live in the area. And I would like to know what your prediction is for Coca-Cola’s long-term growth versus Pepsi-Cola’s recent efforts to increase the competitiveness with Coke?

CHARLIE MUNGER: Yeah. (Laughter) Long-term, I would expect Coke to continue to gain versus Pepsi. (Laughter and applause) (Buffett returns and sits down)

WARREN BUFFETT: What has he been doing while I was gone? What’d you say, Charlie? (Laughter) I knew I was taking a chance. (Laughter) What was the question?

CHARLIE MUNGER: I said that long-term I expected Coke to continue to gain versus Pepsi.

WARREN BUFFETT: Oh. Well. It’s those kind of insights as to why we keep him on the job year after year. (Laughter) In a moment of particular confidence, he one time told me the same thing about RC. (Laughter) Now, that was probably zone 3 you were answering, so we’ll go to 4. What have you got there? You got peanut brittle?

CHARLIE MUNGER: Um-huh. (Laughter)

35. Ignoring asset gains at Coca-Cola

WARREN BUFFETT: Zone 4, please.

AUDIENCE MEMBER: Nat Chase (PH), Houston, Texas. My first question’s on the quality of earnings and your evaluation of quality of earnings in the U.S. right now. And the second is, what multiples should be put on asset gains such as sale of bottling assets or reversal of merger reserves? Thanks.

WARREN BUFFETT: Yeah, well, taking the second question, for example, with Coca-Cola, the bottling transactions are incidental to a long-term strategy which, in my view, has been enormously successful to date, and which has more successes ahead of it. But in the process of rearranging and consolidating the bottling system, and expanding to relatively undeveloped markets, there have been, and there will be, a lot of bottling transactions. And some produce large gains. Some produce small gains. I ignore those in my evaluation of Coke. The two important elements in Coke are unit case sales and shares outstanding. And if the shares outstanding go down and the unit case sales advance at a good clip, you are going to make money over time in Coca-Cola. There have been transactions where people have purchased rights to various drinks. CocaCola’s purchased some of those around the world. And when you see what is paid for a million or 100 million unit cases of a business, and then you think to yourself that maybe Coke will add a billion and a half cases a year, that’s a real gain in value. It’s a dramatic gain in value.

And that is what counts, in terms of the Coca-Cola Company. If you think the Coca-Cola Company’s going to sell some multiples of its present volume 15 or 20 years from now, and you think there’ll be a lot fewer shares outstanding, you’ve gone about as far as you need to go. But I would pay no attention to asset gains. I would just take those out of the picture.

36. Stock options and inflated earnings

WARREN BUFFETT: Now, as to quality of earnings, Charlie and I feel that, in several respects, but in one important respect, that the quality of earnings has gone down. Not because the policy has changed, but because it’s just become more significant. And that’s in the case of stock options. We have — there are certain companies that we’ve evaluated for possible purchase where, in our calculation of earnings, the earnings are maybe 10 percent less per year per share than reported. And that isn’t necessarily the end of the world, but it is a difference in valuation that is significant and is not reported under standard accounting. So we think the quality of earnings as reported by a company with significant stock option grants every year, we think is dramatically poorer than for one where that doesn’t exist. And there are a lot of companies that fall in that category. Coca-Cola’s earnings are very easy to figure out. Just figure out what they’re, you know, what they’re earning per case from operations, and you’ll see over the years the earnings per case go up. And the cases go up and the shares go down.

And it doesn’t get much more complicated than that. Charlie?

CHARLIE MUNGER: You’ve said it wonderfully. (Laughter) I just wish we had more like that.

WARREN BUFFETT: Yeah. GEICO, the key — I mean the same way. It’s policies in force and underwriting experience per policy. And that is exactly the way, as noted in the annual report, we pay people there. We pay them, from the bottom to the very top, based on what happens with those two variables. And we don’t talk about earnings per share at GEICO, and we don’t talk about investment income. We don’t get off the track, because there are two things that are going to determine what kind of business that GEICO is over a long period of time. And policies at GEICO are unit cases at Coca-Cola.

37. Benjamin Graham and how Buffett would teach investing

WARREN BUFFETT: Zone 5.

AUDIENCE MEMBER: Hello, Mr. Buffett and Mr. Munger. My name’s James Claus (PH) from New York City. And I just wanted to ask you a question. Both you and Mr. Munger have repeatedly said that you don’t believe that business valuation is being taught correctly at our universities, and as a Ph.D. student at Columbia Business School, that troubles me, understandably, because in a couple of years I’ll be joining the ranks of those teaching business valuation. My question isn’t what sources, such as Graham or Fisher or Mr. Munger’s talks, you would point people that are teaching business valuation to, but do you have any counsel about the techniques of teaching business valuation?

WARREN BUFFETT: Well, I was lucky. I had a sensational teacher in Ben Graham, and we had a course there, there’s at least one fellow out in the audience here that attended with me. And Ben made it terribly interesting, because what we did was we walked into that class and we valued companies. And he had various little games he would play with us. Sometimes he would have us evaluate company A and company B with a whole bunch of figures, and then we would find out that A and B were the same company at different points in its history, for example. And then there were a lot of little games he played to get us to think about what were the key variables and how could we go off the track. I remember one time Ben met with Charlie and me and about nine or so other people down in San Diego in 1968 or so, when he gave all of us a little true/false test, and we all thought we were pretty smart — we all flunked. But that was his way of teaching us that a smart man playing his own game and working at fooling you could do a pretty good job at it.

But I would, you know, if I were teaching a course on investments, there would be simply one valuation study after another with the students, trying to identify the key variables in that particular business, and evaluating how predictable they were first, because that is the first step. If something is not very predictable, forget it. You know, you don’t have to be right about every company. You have to make a few good decisions in your lifetime. But then when you find — the important thing is to know when you find one where you really do know the key variables — which ones are important — and you do think you’ve got a fix on them. Where we’ve been — where we’ve done well, Charlie and I made a dozen or so very big decisions relative to net worth, but not as big as they should have been. And we’ve known we were right on those going in. I mean they just weren’t that complicated. And we knew we were focusing on the right variables and they were dominant. And we knew that even though we couldn’t take it out to five decimal places or anything like that, we knew that in a general way we were right about them.

And that’s what we look for. The fat pitch. And that’s what I would be teaching — trying to teach students to do. And I would not try to teach them to think they could do the impossible. Charlie?

CHARLIE MUNGER: Yes. If you’re planning to teach business valuation, and what you hope to do is teach the way people teach real estate appraising. So you can take any company, and your students, after studying your course, will be able to give you an appraisal of that company, which will indicate, really, its future prospects compared to its market price, I think you’re attempting the impossible.

WARREN BUFFETT: Yeah, probably on the final exam I would take an internet company, and I would say the final exam, the question is, “How much is this worth?” And anybody that gave me an answer I would flunk. (Laughter)

CHARLIE MUNGER: Right. Right.

WARREN BUFFETT: Make grading papers easy, too. (Laughter)

38. Munger: Wesco is a “historical accident”

WARREN BUFFETT: OK, zone 6.

AUDIENCE MEMBER: Good morning. Laurence Balter (PH), Carlsbad, California. Question for the two of you. There was an article, I think about last year in The New York Times, that regarded Wesco as a Berkshire Class C share-type company, and I’d like to know your comments on that. And the second question is, if I were to write you a check for the operating businesses that Berkshire owns, how much would it have to be?

WARREN BUFFETT: Big. (Laughter) Charlie is the resident expert on Wesco, so I’m going to let him address that side. He gets very eloquent on this.

CHARLIE MUNGER: Yeah. We always say that, per unit of book value, Wesco is worth way less than Berkshire, and indeed the market is saying the same thing. It is not a clone of Berkshire. It’s a historical accident. (Audience mumbling)

WARREN BUFFETT: We want it to do well, obviously, for Wesco. We own 80 percent of it and we’ve got strong feelings about the people who are partners there, particular the Peters family, who, in effect, invited us in 20-odd years ago and trusted us to manage a big part of their money, in effect, by letting us buy control. So we’ve got strong fiduciary feelings about it. It suffers in comparison with Berkshire because for one thing, anybody that wants a tax-free merger is going to want to come to Berkshire. You know, that’s just the way it is, unfortunately. And we are looking for big ideas, primarily, and the big ideas are going to fit into Berkshire. We would love to get ideas that fit into Wesco, and we had a very good one a couple years ago, thanks to Roy Dinsdale pointing me in the right direction. And we added Kansas Bankers Surety to Wesco, and it’s a gem. And it’s run by Don Towle, who’s done a terrific job. But that’s the exception, unfortunately.

Because if a FlightSafety comes along, it’s not going to fit Wesco. So we will do our best for Wesco, but the nature of things is that most of the opportunities that make a lot of sense are going to come to Berkshire. Charlie, do you have anything?

CHARLIE MUNGER: Nothing more.

39. Buy Berkshire or the stocks it buys?

WARREN BUFFETT: OK. Zone 7.

AUDIENCE MEMBER: My name is Bob Swanson (PH) from Phoenix. And I’m wondering, what are the advantages of investing in Berkshire Hathaway as opposed to investing in the stocks that Berkshire owns?

WARREN BUFFETT: Well, a lot of people do one or the other and some people do both. But you have to really make up your own mind on that. We’re not going to go to great lengths to tell you about everything that Berkshire is doing as we go along, and there could be some changes, and there will be things that can happen in Berkshire that I think you would have trouble duplicating elsewhere. But on the other hand, you know, if you’d put all your money in Coca-Cola some years back, you might have done better than if you’d put it in Berkshire. So we really make no recommendations as to what people do with their money. We do not seek to become investment advisors through, in effect, our portfolio actions at Berkshire. Charlie?

CHARLIE MUNGER: Amazingly, we hate it when people following us — follow us around buying what we buy. (Laughter)

WARREN BUFFETT: Nothing personal.

CHARLIE MUNGER: No. (Laughter)

40. Shareholders get info they need to value Berkshire

CHARLIE MUNGER: By the way, the questioner before this last one asked what is the market value under the hammer of all Berkshire’s operating subsidiaries, and the answer is you have to figure that out yourself. (Laughter)

WARREN BUFFETT: Mr. Nice Guy. (Laughter) Zone — But we give you the information, incidentally, where your judgment on it should be about as good as ours. There’s nothing mysterious about valuing The Buffalo News, or See’s Candy, or FlightSafety, or Dairy Queen. So you really have the same information we have in that. I mean if there’s material information that we aren’t giving you about any important Berkshire subsidiary, we’d like to give it to you, because we think you are entitled to have the information. It enables you to value the various pieces. Because of the aggregate size of Berkshire now, in terms of market capitalization and some of the positions we own, the smaller subsidiaries really cannot have that much effect. We love them just as much. I enjoy all of the businesses we’re in and I enjoy the people that run them.

So, we don’t make a — there’s not — we don’t differentiate in our attitude within the company, but in terms of the actual impact on the valuation of Berkshire, there are a number that really just don’t make that much difference in terms of figuring out whether Berkshire’s worth X or X minus a thousand or plus a thousand, because a thousand now is over a billion dollars, in terms of valuation. A billion is still a lot of money.

41. Three factors driving the bull market

WARREN BUFFETT: Area 8, please.

AUDIENCE MEMBER: Hello, Mr. Buffett, Mr. Munger. My name is Robert McCormick, I’m from Holdrege, Nebraska. And I would like to know how much you attribute the gains enjoyed by the stock market these past years to the baby boomer generation investing for their retirement?

WARREN BUFFETT: Yeah, I would say that, personally, I would not think that has much to do with it. I think the two big factors are in — well, there’s three big factors. One is the improved return on equity, which was a fundamental factor that pushed stock prices up. Two is a decline in interest rates that pushed stock prices up. And then finally, stock prices advancing, themselves, brings in buying. It doesn’t go on forever, but it creates its own momentum, to some extent, if you have these underlying factors that started to push it along. So I would say two of the three factors are fundamental and the third is a market-type factor that bull markets do feed on themselves, and I think that you’ve seen some evidence of that. But I don’t think that any specific — you know, the 401(k) factor or whatever it may be, was it by itself. But I do think money is pouring into mutual funds, for example, because people have had a very favorable experience with those funds. And that does bring investors along. People want to be on the train. Charlie?

And I think, incidentally, many of them have very unrealistic expectations.

CHARLIE MUNGER: Yeah. The general investment experience in the last, what, 18 years in common stocks has been awesomely high, I think by any past standards now, isn’t that right, Warren?

WARREN BUFFETT: Right. Well you’ve had — since 1982 you’ve had roughly tenfold in the Dow, and probably similar in the S&P. With a huge amount of money and with more participants all the time. And there are people coming into the market every day because they feel that they’ve missed the boat or they’re coming in heavier than they came in before, simply because they’ve had a pleasant experience. Past experience doesn’t — does not mean much, in terms of what you should expect from your investments. You will do well in your investments because you own or bought things at the right price and the businesses behaved well from that point forward.

CHARLIE MUNGER: Well, you won’t have 18 more years of 17 percent or 18 percent per annum. That I think we can virtually guarantee.

42. Buffett and Munger about equal at “goofing off”

WARREN BUFFETT: Area 9.

AUDIENCE MEMBER: Hello. I’m Tubby Stayman from Palm Beach, Florida. I know you enjoy bridge very much. I know you play my late husband’s convention. Tell me, how often are you able to devote to this wonderful game? How many times a week do you play other than the internet?

WARREN BUFFETT: I didn’t get all of that, Charlie? Did you?

CHARLIE MUNGER: How much bridge are you playing?

WARREN BUFFETT: Uh-oh.

AUDIENCE MEMBER: Yes. (Laughter)

WARREN BUFFETT: Well, this week — we should put this in the annual report, because it may be a material factor. (Laughter) I’m probably — at least ten hours a week. Maybe a little more. I don’t get any better by doing it, either, so it’s rather discouraging, but it is a lot of fun. And it has to have come out of reading time. I don’t think it’s hurt Berkshire yet, but that may be because we’re in a slow period generally. If the market goes down a lot, I promise to cut back on my bridge. (Laughter) Charlie?

CHARLIE MUNGER: Yeah. Well, I probably play three or four hours a week. But I don’t play on the internet.

WARREN BUFFETT: He plays a lot of golf, though. Confess Charlie.

CHARLIE MUNGER: Oh yes. (LAUGH)

WARREN BUFFETT: Yeah, we both spend about the same amount of time goofing off. I mean if you —(laughter) — want to know.

43. Defending Walt Disney-Capital Cities accounting

WARREN BUFFETT: OK. Area 10.

AUDIENCE MEMBER: Yes, my name is Cary Blecker (PH), also from West Palm Beach, Florida. With all due respect to Mr. Eisner if he’s in the audience, there’s been some criticism levied recently at the Disney Company, mainly from an accounting professor at one of the state universities in New York, in reference to Disney’s purchase of Capital Cities and the way they accounted for that purchase. Basically, what this professor is saying is that Disney somehow created a slush fund and is charging the expenses to the merger to this slush fund rather than earnings. If you’re familiar with this criticism, I’m wondering what you think of it? And if you’re not, are you familiar with the way Disney accounted for the purchase of Capital Cities?

WARREN BUFFETT: Yeah, I am familiar.

AUDIENCE MEMBER: Thank you.

WARREN BUFFETT: And actually, Abe Briloff, who wrote that, is a fellow who, in general, I admire. Abe wrote me a letter not more than about three or four weeks ago and asked me to talk at a university where he teaches. And I wrote him back and I told him I wouldn’t be able to do it because it’s not in proximity to where I’ll be. And I told him — and he asked me about the Disney thing. And I told him I disagreed with him on — I admire what Abe does in the attempt to have accounting reflect economic reality, but he and I don’t see it exactly the same on some points, although we would agree on other points. I think — I don’t think Disney is a very complicated enterprise to evaluate. I mean there are — when Cap Cities bought ABC, there were purchase accounting adjustments, and they tend to wash through, to some extent. I mean if you have programs that you’re stuck on, you may write those down from what the previous carrying cost was. Maybe the previous management should have written them down, too, at that point.

But I don’t think that — I think with Disney, what you see now is what you get. Charlie?

CHARLIE MUNGER: Yeah. I’ve got no great quarrel with the accounting at Disney. I think —

WARREN BUFFETT: Abe Briloff is a wonderful guy.

CHARLIE MUNGER: Yeah. He’s got a good sense of humor and he generally fights the right demons, but I don’t think you can criticize Disney’s accounting.

WARREN BUFFETT: We certainly disagree with Abe, who, like I say, I agree with Charlie, he is a good guy. But he — we disagree with him on amortization of intangibles entirely. So we would say that if Disney is charging, whatever it may be, probably 400 million a year for amortization of intangibles, which is not tax deductible, we would include that as a component of earnings. So there might be some plusses and minuses that you’d make in adjustments, but I would say, by the time you add back amortization of intangibles that we would probably think the economic earnings of Disney might well be more than the reported earnings in the next few years.

44. Buffett wants accounting change

WARREN BUFFETT: I think that the intangible amortization question — which the FASB is looking at now — I think it should be changed. I mean I think it absolutely distorts economic reality, and I think that it influences whether people go to purchase, or accounting, or pooling, and they do all kinds of acrobatics to try and get pooling accounting. And, you know, it shouldn’t make that kind of difference in reported numbers, based on whether a transaction, which has exactly the same economics, is done through a purchase or pooling. But I have seen managements, some I know quite well, arrange to do things on a pooling basis that they think — where if they were private they would do it on a purchase basis. And I think that’s nuts. And I think if accounting is pushing people to doing things that are nuts, that it’s time for accounting to look at itself. I would say that — (applause) — net, the economic earnings of Disney, in our view, are somewhat higher than reported earnings.

45. I’ll never know enough to buy tech stocks

WARREN BUFFETT: Zone 11, please.

AUDIENCE MEMBER: Good morning, Mr. Munger and Mr. Buffett. My name is Prakash Puram (PH) from Minneapolis. There seem to be great values in the technology sector that meet most of your criteria and philosophy in investing, with the exception of the simplicity criterion. Names like IBM, Microsoft, HP, Intel. Would you ever consider investing in companies in this sector in the future?

WARREN BUFFETT: Well, the answer is no, and it’s probably pretty unfortunate, because I’ve been an admirer of Andy Grove and Bill Gates and, you know, I wish I had translated that admiration into backing it up with money. But the truth is, I don’t know where Microsoft or Intel — I don’t know what that world will look like in 10 years. And I don’t want to play in a game where I think the other guys have got an advantage over me, and — I could spend all my time thinking about technology for the next year and I wouldn’t be the hundredth or the thousandth or the 10,000th smartest guy in the country in looking at those businesses. So that is a seven or eight foot bar that I can’t clear. There are people that can clear it, but I can’t clear it. And no matter how I train, I can’t clear it. So, the fact that there will be a lot of money made by somebody doesn’t bother me, really.

And I mean there may be a lot of money made by somebody in cocoa beans, but I don’t know anything about them. And there are a whole lot of areas I don’t know anything about. So, you know, more power to them. And I think it would be a very valid criticism if Charlie and I — if it were possible that Charlie and I, by spending a year working on it, could become well enough informed so that our judgment would be better than other people’s, but that wouldn’t happen. And it would be a waste of time. It’s much better for us to swing at the easy pitches. Charlie?

CHARLIE MUNGER: Whatever you think you know about technology, I think I know less. (Laughter)

WARREN BUFFETT: That’s probably about true, incidentally. Charlie has a little more of — he understands some things in the physical world a lot better than I do.

46. We’ve “missed the boat” on share buybacks

WARREN BUFFETT: But anyway. We’ll go to zone 1.

AUDIENCE MEMBER: Good morning. I’m Murray Cass from Markham, Ontario. First off, against my dentist’s advice, I’d like to thank you for the free Coke and ice cream last night. (Laughter) Earlier this morning, Mr. Buffett, you mentioned that you liked when wonderful companies like Coke purchased their shares back. Similarly, I own shares in a wonderful company, that’s Berkshire. Should I be hoping that you buy your own shares back?

WARREN BUFFETT: Well, it’s interesting, we should have — perhaps we should have bought some shares back, but usually at the time we could have bought something else that also did very well for us. I mean maybe when we were buying Coke we could have been buying our own shares back. To some extent there hasn’t been that much trading in it. But I think it’s a valid criticism to say that we have missed the boat at various times in not repurchasing shares. We’ll see what we do in the future on it. If it looks like the best thing to do with money, it’s what we should be doing. And in the past, I’ve probably been not optimistic enough in respect to Berkshire compared to other things we were doing with money. Now, the money we spent buying the GEICOs and all of that has turned out to be a good use of money, too. But we’ve never wanted to leverage up. That’s just not our game. So we’ve never wanted to borrow a lot of money to repurchase shares.

We might advise other people to do it, but we would — it’s not our style ourselves. We’ve got all our money in the company. We’ve got all of our friends’ and our relatives’ money virtually. So we have never felt that we wanted to leverage up this company like it was just one of a portfolio of a hundred stocks. But it’s a valid criticism to say that we have not repurchased shares when we should have. And it’s also a valid criticism to say that we’ve issued some shares we shouldn’t have issued. Charlie?

CHARLIE MUNGER: Oh, I would agree with both comments.

47. “Smile train”

WARREN BUFFETT: Area two.

AUDIENCE MEMBER: Fellow investors of Berkshire and Hathaway, Warren Buffett and Charlie Munger. I am from originally China. Now I have a company in Michigan. I want to ask questions based on facts. I want to sell Coke, GEICO, and a little book called The Wizard of Omaha: The Investment Philosophy of Warren Buffett, in China. Through all the villages, the cities, little towns, I want to make that a reality. Cheers.

WARREN BUFFETT: Cheers. (Applause)

CHARLIE MUNGER: Cheers.

WARREN BUFFETT: Zone three. (Laughter)

AUDIENCE MEMBER: I have not asked the question.

WARREN BUFFETT: Oh, just warming up. OK. (Laughter)

AUDIENCE MEMBER: I will.

WARREN BUFFETT: They always tell me to get off the stage while you’re in good shape, but I’ll say it. (Laughter)

AUDIENCE MEMBER: I could (inaudible), but you missed your chance. (Laughter) I’m a owner of Berkshire and I spent 6 percent of my net worth to be engaged to Berkshire.

WARREN BUFFETT: Wise decision. (Laughter)

AUDIENCE MEMBER: I did better than guess who? Bill Gates. I notice Bill Gates and you were traveling on a slow boat in China. I want to go home, on a fast train. You want to cut me off?

VOICE: Do you have a question or —?

AUDIENCE MEMBER: If you want to cut off, fine. Up to the investors. (Applause) I’ll quit if you want to do that.

VOICE: Do you have a question? A question?

AUDIENCE MEMBER: I come long ways.

VOICE: OK. Ask your question.

AUDIENCE MEMBER: OK. I know I’m a problem for you. (Laughter)

VOICE: Not a problem. Just ask the question.

AUDIENCE MEMBER: But I’m here for a reason. Because I made some money, I’m go on a train. A smile train. Yesterday, or the day before, at the baseball I asked Mr. Warren Buffett, “Have you heard of the smile train?” He said, “No.” I’m back here to respond. This is a smile train.

WARREN BUFFETT: OK, we thank you. But I think that’s your question.

48. Why Buffett bought silver

WARREN BUFFETT: We’d better go to zone 4, I think. (Applause)

AUDIENCE MEMBER: Good morning, or afternoon, actually. My name’s Matt Schwab. I’m from New York. Pound Ridge, New York. I actually had a question about the silver purchase last year. When you announced it, you said that you believed that supply and demand fundamentals would only be established at a higher price — re-established at a higher price. I was just wondering if you could go into more detail about what some of those fundamentals are. I mean, we’ve read a lot about, like, battery technology and some other things.

WARREN BUFFETT: Yeah, we have no inside information about great new uses for silver or anything of the sort. But the situation — and you can get these figures and they’re not precise, but I think they’re in general — they’re generally accurate. You can see from looking at the numbers that aggregate demand, primarily from photography, from industrial uses, and from ornamental jewelry-type uses, is close. Call it 800 million-plus ounces a year. And there are 500 million or so ounces being produced of silver, annually, although there will be more coming on in the next couple of years. There’s more coming on right now. However, most of that silver is produced as a byproduct in the mining of gold or copper and lead zinc, so that since it’s a byproduct, it’s not responsive to — not very responsive to price changes, because obviously, if you’ve got a copper mine and you get a little silver out of it, you’re much more interested in the price of copper than silver.

So you have 500 million ounces or so of mine production, and you have 150 million ounces or so of reclaimed silver, a large part of which relates to the uses in photography. So there’s been a gap in recent years of perhaps 150 million ounces — but none of these figures are precise — which has been filled by an inventory of bullion above ground, which may have been a billion-two, or more, ounces a few years back, but which has been depleted. And no one knows the exact figures on this, but there’s no question that the bullion inventory has been depleted significantly. Which means that the present price for silver does not produce an equilibrium between supply, as measured by newly-mined silver plus reclaimed silver, and usage. And that — eventually something will happen to change that picture. Now, it could be reduced usage, it could be increased supply, or it could be a change in price. And that imbalance is sufficiently large, even though there is some new production coming on, and there’s the threat of digital imaging that will reduce silver usage, perhaps, in the future in photography.

But we think that that gap is wide enough so that it will continue to deplete inventories — bullion inventories — to the point where a new price is needed to establish equilibrium. And because of the byproduct nature, which makes the supply inelastic, and because of the nature of demand, which is relatively inelastic, that — we don’t think that that price change would necessarily be minor. It’s interesting, because silver has been artificially influenced for a long time. You saw that movie about — you know, it was William Jennings Bryan, who was editor of The Omaha WorldHerald and a congressman from Nebraska — and his brother was governor of Nebraska — who was the big silver man. And they used to talk 16-to-1. The 16-to-1 ratio, I think, goes back to Isaac Newton, when he was master of the mint. Charlie will know all about that, because he’s our Newtonian expert here. But that ratio had kind of a mystical significance for a while. Didn’t really mean anything.

And in 1934, the government passed an act called The Silver Purchase Act of, surprisingly, 1934, which set an artificially high price for silver at that time, when production and usage was much less. And the government, U.S. government, ended up accumulating two billion ounces of silver. Now, this was at a time when demand was a couple hundred million ounces a year, so you’re talking ten years’ supply. So there was an artificially high price for a while. By the early 1960s, that became an artificially low price of $1.29, and at that time I could see the inventories of the U.S. government being depleted, somewhat akin to what inventories are being depleted now. And despite the fact that Lyndon Johnson and the administration said they would not demonetize silver, they did demonetize it, and silver went up substantially. That was the last purpose we had of silver, but I’ve kept track of the figures ever since. The Hunt brothers caused a great amount of silver to be converted into bullion form, including a lot of silver coins.

So they, again, increased the supply in a very big way by their action in pushing the price way up to the point where people started melting it down. So you had this — dislocations in silver over a 60-plus year period, which has caused the price to be affected by these huge inventory accumulations and reductions. And we think right now that — or we thought last summer when we started buying it — that the price we bought it, that that was not an equilibrium price, and that sooner or later — and we didn’t think it was imminent, because we don’t wait till things are imminent. You know, we were going to buy a lot of silver. We didn’t want to buy so much as to really disrupt the market, however. We had no intention of replaying any Hunt scenario. So we wanted to be sure we didn’t buy that much silver. But we liked it. Charlie?

CHARLIE MUNGER: Well, I think this whole episode will have about as much impact on Berkshire Hathaway’s future as Warren’s bridge playing. (Laughter) You’ve got a line of activity where once every 30 or 40 years you can do something employing 2 percent of assets. This is not a big deal for —

WARREN BUFFETT: No.

CHARLIE MUNGER: — Berkshire. The fact that it keeps Warren amused and — (Laughter)

WARREN BUFFETT: Yeah, I do like —

CHARLIE MUNGER: — and not doing counterproductive things — (Laughter)

WARREN BUFFETT: It makes me feel good about — it makes me feel better about all those pictures that people take over the weekend. (Laughs) They all use a little bit of silver. (Laughter)

CHARLIE MUNGER: At least it shows something that teaches an interesting lesson. Think of the discipline it takes to think about something for three or four decades, waiting for a chance to employ — (laughter) — 2 percent of your assets. I’m afraid that’s the way we are. (Laughter) It means there’ll be some dull stretches.

WARREN BUFFETT: Right. Yeah, it’s less than a billion dollars in silver. It’s $15 billion in Coke. You know, it’s a —

CHARLIE MUNGER: It’s a non-event.

WARREN BUFFETT: It’s 5 billion in American Express. I mean it is close to a non-event, but if you see it there — you know?

CHARLIE MUNGER: At least it shows the human personality at work. (Laughter) Very peculiar personality, I might add. (Laughter)

WARREN BUFFETT: Reinforced by a partner.

CHARLIE MUNGER: Yes. (Laughter)

49. I only talk to students

WARREN BUFFETT: OK, let’s go to area five.

AUDIENCE MEMBER: My family is a Class B shareholder. Thank you for issuing those shares. I have one observation and one question. Your Class B share is creating a new phenomenon in this country. These “baby shares” are not only attracting my baby boomer generation, but also X generation and (inaudible) generation, your grandchildren. My question is, this next generation would like to hear from you your investment discipline, your lifestyle, and your philosophy of contributing the wealth back to the society in a language they can understand and communicate back to their friends when they get back to school on Tuesday. Thank you.

WARREN BUFFETT: Thank you. (Applause) Well, I appreciate that, and I would say the only speeches I give — I get a lot of requests, perhaps because I don’t do them. But I get a lot of requests, including from a lot of our managers, in terms of trade conventions, all kinds of things. I don’t do — the only groups I talk to are students. And I try to talk to college and university students, although I talk to high school students, too. Whenever it fits, in terms of travel schedules. And I just think that if you’re going to spend your time with groups talking, that rather than entertain people, that it probably is better to talk to the group you talked about. Charlie and I are never reluctant to talk, so we do it. Charlie has given a couple of talks. One I sent you a few years ago from USC, but there’s been another one recently that I think everybody would profit by reading. So, it was reprinted in the Outstanding Investor Digest, but if you write Charlie, I’m sure he’ll send you a copy.

50. If forced to choose, we’d keep the operating businesses

WARREN BUFFETT: Area six, please.

AUDIENCE MEMBER: Hi, my name is David Oosterbaan. I’m from Kalamazoo, Michigan. This is a hypothetical question about Berkshire. It’s going to take a little imagination, I think. The scenario is as follows, that the U.S. Justice Department makes a ruling that Berkshire must split into two parts immediately. You and Mr. Munger must decide which part to keep. You can either choose your marketable securities, Coke, Gillette, Disney, et cetera, or you can choose your insurance and private businesses. Which one do you choose and why?

WARREN BUFFETT: Well, that’s an easy question for me. I would choose the operating businesses anytime, because it’s more fun. And I have a good time out of the investments too, but I like being involved with real people, in terms of the businesses where they’re a cohesive unit that can grow over time, and — You know, I wished we owned all of Disney or Coca-Cola or Gillette, but we aren’t going to. So if I had to give up one or the other, I’d give up the marketable securities. But it’s not going to happen, so we’re going to be happen in both arenas, and I look forward to being in both arenas for the rest of my life. Charlie?

CHARLIE MUNGER: Well, I’ll be in a hell of a fix if I am not in the same arena. (Laughter)

WARREN BUFFETT: We’d both be in a hell of a fix.

CHARLIE MUNGER: Yeah, yeah.

51. We’d be fine even if our top 25 execs all dropped dead

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: Yes, hello to Mr. Munger and Mr. Buffett. My name is Jerry Gonzalez (PH) from Plantation. My question is, what are your recommendations of Berkshire Hathaway if Charlie Munger were in charge, or your third man in charge — your third man, which I think you said, is the CEO of GEICO, what are your recommendations?

WARREN BUFFETT: I missed that.

JERRY GONZALES: If Charlie Munger were to stay in charge fully, 100 percent, or your third man, the CEO of GEICO.

CHARLIE MUNGER: Well, in due course this corporation will have a change in management. I’m afraid we have no way of fixing that. (Laughter) But we do not — apart from making sure we’ve got good options and having some system in place, we are not obsessing about a future management yet.

WARREN BUFFETT: No. The directors —

CHARLIE MUNGER: Warren plans to live almost indefinitely.

WARREN BUFFETT: Absolutely. (Laughter) Although I must say, at my last birthday somebody asked me how old I was. And I said, “Well, why don’t you just count the candles on the cake?” And he said he was driven back by the heat, so — (Laughter) But we’re not going to leave willingly. And we do — the directors know who — they have a letter that says who we think should be the ones to succeed us at both the operating aspect and the investment allocation aspect. And those letters can change over time as we keep hanging around. But I don’t worry about the fact that 99 percent-plus of my estate will be in Berkshire Hathaway stock or that a foundation will eventually receive that stock. So it doesn’t bother me in the least. I can’t think of a place I’d rather have it. And that includes my appraisal of the managers that we have who can step in and do what Charlie and I do. And who knows, one of them may even understand technology. (Laughter)

CHARLIE MUNGER: I think this place would have very respectable prospects if the top 25 managers all dropped dead at once.

WARREN BUFFETT: Well, that’s not an experiment we intended to pursue. (Laughter)

CHARLIE MUNGER: No, but I see no reason to think it wouldn’t continue to do quite well.

WARREN BUFFETT: Right.

CHARLIE MUNGER: It’s been lovingly put together to have a certain margin of safety.

WARREN BUFFETT: Right. We actually — if we have a choice, it’s number three through 23, though — 25 — that we’re interested in. (Laughter)

52. “Honesty will only do so much for you”

WARREN BUFFETT: OK. Area 8, please.

AUDIENCE MEMBER: This is Raul from Walnut Creek, California. Thanks Mr. Buffett, thanks Mr. Munger, thanks for your great company. I wish I had known about it 10 years ago. You are not only the greatest but the most honest. I want to commit 99 percent of what I have to Berkshire Hathaway, and I will. The question I want to ask is, how do you calculate the intrinsic value of the company? And based on intrinsic value, to me, Berkshire Hathaway looks a great bargain at these prices, especially based on look-through earnings. Is that true? And one last question I want to ask, just for fun. What do you think about telecom IPOs like Qwest, (inaudible)? They seem to pop up 50 percent at opening. Does it make any sense to invest in these? Thank you very much.

WARREN BUFFETT: Charlie, you want to tackle that?

CHARLIE MUNGER: I didn’t follow that all. Intrinsic value, we give you the facts and you make your own conclusions. I like the fact that you think we’re honest, but, you know, if you people keep bidding up the price of our stock, honesty will only do so much for you in the future. (Laughter)

WARREN BUFFETT: Yeah, we’ve never been tested. I mean we’re very lucky. We’ve never had anything that we needed, really, that we haven’t had. And, you know, who knows what the situation would be if your family was starving or something? So our intention is to continue the position where we’ll never be tested, too, I might add.

53. Intrinsic value: “Easy to say and impossible to figure”

WARREN BUFFETT: The intrinsic value question. I mean, by definition, intrinsic value is the present value of the stream of cash that’s going to be generated by any financial asset between now and doomsday. And that’s easy to say and impossible to figure, but it’s the kind of thing that we’re looking at when we look at a Coca-Cola, where we think it’s much easier to evaluate the stream of cash that comes in the future than it is in a company such as Intel, marvelous as it may be. It’s easier for us. Andy Grove may be better at figuring out Intel than Coke. And in Berkshire, it is complicated by the fact that we have no business that naturally employs all of the capital that flows to us, so it is dependent, to some extent, on the opportunities available and the ingenuity used when that cash pours in, as it does. Some businesses have a natural use for the cash. Actually, Intel has a good natural use for the cash over time as they’ve expanded in their business. And many businesses do. But we do not have a natural use. We have some businesses that use significant amounts of cash.

FlightSafety will buy a lot of — build a lot of simulators this year and they cost real money. But in relation to the resources available, we have to come up with new uses, new ways to use cash. And that makes for a more difficult valuation job than if you’ve got — well, the classic case used to be a water or electric utility where the cash could be deployed and the return was more or less guaranteed within a narrow range, and it was very easy to make calculations then as to the expectable returns in the future. But that’s not the case at Berkshire. We’ve got very good businesses, both directly and partially owned. And those businesses are going to do well for a long, long time. But we do have new cash coming in all the time, and sometimes we have good ideas for that cash and sometimes we don’t. And that does make your job more difficult, in terms of computing intrinsic value. We’ll have — yeah, we’re going to break after the next question. At that time — we break whenever Charlie and I run out of candy up here, actually.

(Laughter) We’re going to let everybody — you can get something to eat, if you want to stick around, and we will be here till 3:30 when we reconvene at 12:30. And those of you who have been with us this morning and had enough, we thank you for being here this weekend. We’ve had a terrific time with you, so I’m very appreciative of that.

54. “Multiple models is the game” for Munger

WARREN BUFFETT: Let’s have a question from zone 9 and then we’ll go to lunch.

AUDIENCE MEMBER: Good morning. My name’s Frank Gurvich (PH). I’m a shareholder from London, Ontario in Canada. My question is for Mr. Munger, and it concerns his models. And the question specifically is related to market valuation. I know I’m not going to get a prediction. That’s not your bag. What I’m curious about, is there any specific touchstone models that you reflect upon in trying to gain perspective at these markets where the historic valuations are quite high? And why do you draw on those models? And my second question is for Mr. Buffett and it relates to taxation. If you were able to trade your portion of your portfolio, at least, in a tax-exempt fashion, like 401(k) plans, or in Canada, the RSP plans, would you possibly trade more actively?

WARREN BUFFETT: Charlie, you want to answer yours first?

CHARLIE MUNGER: Yeah. Well, the Munger system for dealing with reality is to have multiple models in the head, and then run reality against multiple models. I think it’s a perfect disaster to look at reality through just one model or two. It’s — There’s an old proverb that says, “To the man with only a hammer, every problem looks pretty much like a nail.” (Laughter) And that is not our system. So I can’t sit here and run through all the models in my head, even though there aren’t that many. But multiple models is the game.

55. Buffett: Taxes don’t bother me

WARREN BUFFETT: The question about taxation. It would not — if we were running Berkshire absent a capital gains tax, I don’t think it would make much difference in what we do. I don’t think it would make — certainly it wouldn’t make a difference in causing us to trade actively. We own the businesses we want to own. We don’t own them because taxes have restrained us from selling them. And as I mentioned earlier, I’m fairly sure we’ll pay at least a billion dollars in income tax this year. We might not, but it looks that way to me, that we’ll pay a billion dollars. And I could do things that at least deferred, and perhaps — and I certainly could do things by doing nothing — that avoided paying that billion in tax, or a good bit of the billion, call it 800 million of the billion. But that is not a big factor with me. It’s never been a big deal with me. I paid my first income tax when I was 13, so I guess I got brainwashed at the time. And it doesn’t bother me a lot to be paying taxes.

I think, net, personally, I’m under-taxed in relation to what the society has delivered to me, and, you know, I don’t send along any voluntary payments to I.R.S., I want you to understand. (Laughter) But I really do. I mean, there’s nobody I want to trade places with because their tax situation is better than mine. So it would not increase the activity.

56. Looking for owners who love their business more than money

WARREN BUFFETT: I’ve been asked to take one more question from zone 10. I’m not sure why, but maybe because they see that I still have candy up here. (Laughter) So zone 10, please, and then we’ll break.

AUDIENCE MEMBER: Mr. Buffett and Mr. Munger, my name is Sanjiv Mirchandani, shareholder from Boston. First of all, thank you to both of you for everything. I have two questions. For you, Mr. Buffett, you obviously have filters that you apply on selecting people as you do on stocks. Can you tell us a little bit about what those filters are?

WARREN BUFFETT: Filters on people?

AUDIENCE MEMBER: Yes, in selecting — you have an ability to motivate people who have a lot of money to keep working. What do you look for to figure out who those people are?

WARREN BUFFETT: Well, that’s a key, key question, because when we buy businesses we don’t have managers to put in them. I mean we are not buying them that way. We don’t have a lot of MBAs around the office that we’re —

CHARLIE MUNGER: Thank God.

WARREN BUFFETT: Yeah. (Laughter) And, you know, I have not promised that they’re going to have all kinds of opportunities or anything. So as a practical matter, we need management with the businesses that we buy. And three times out of four, thereabouts, the manager is the owner and is receiving tens of millions, maybe hundreds of millions of dollars. So they don’t have to work. And we have to decide in that time when we meet them whether they love the business or love money. And we’re not making a moral judgment. Charlie may, but I’m not making a moral judgment about whether it’s better to love the business or love money, but it’s very important for me to know which of the two is the primary motivator with them. And we have had extremely good luck in identifying people who love their business. And so all we have to do is avoid anything that, on our part, that diminishes that love of the business or makes other conditions so intolerable that they overcome that love of the business. And we have a number of people working for us, they have no financial need to work at all.

And they probably outwork, you know, 95 percent or more of the people in the world, and they do it because they just love smacking the ball. And we almost — we virtually had no mistakes in that respect. And we have identified a number of people, Charlie and I have, in terms of proposals to us, where we’ve felt that they did really — they liked the money better than the business. They were kind of tired of the business. You know? And they might promise us that they would continue on and they would do it in good faith, but something would happen six months later or a year later and they’d say to themselves, “Why am I doing this, you know, for Berkshire Hathaway when I could be doing,” whatever else they want to do? I can’t tell you exactly how we — what filter it is that we put them through mentally, but I can tell you that if you’ve been around a while, you can — I think you can have a pretty high batting average in coming to those conclusions. As you can about other aspects of human behavior.

I’m not saying you can take a hundred people and take a look at them and analyze their personalities or anything of the sort. But I think when you see the extreme cases, the ones that are going to cause you nothing but trouble, or the ones that are going to bring you nothing but joy, I think you can identify those pretty well. Charlie?

CHARLIE MUNGER: Well, yeah, I think it’s pretty simple. You’ve got integrity, intelligence, and experience, and dedication. And that’s what human enterprises need to run well, and we’ve been very lucky in getting this marvelous group of associates to work with all these years. It would be hard to do better, I think, than we’ve done on that respect. Look around this place. I mean, and really, you young people look around this place. And look at how much gratification can come into these lives which have been mostly spent in deferring gratification. It’s a very funny group of people, you shareholders. (Laughter)

Afternoon Session

1. When is it time to buy a house?

WARREN BUFFETT: Let’s settle down please and we’ll — We’re going to go to — we skipped one last time so we’re going to go first to zone 4.

AUDIENCE MEMBER: Hello. My name’s Nelson Arata (PH), I’m from Southern California. And I have a question. It’s not really related to intrinsic value or any of that stock stuff, but more on — (laughter) — houses. I’m still quite young, I don’t have a house yet and I’m thinking about buying a house someday soon. And in order to do that I’m going to have to put a down payment, which means I might have to sell my shares. And I was wondering if you can provide some insight on when is the best time to buy a house and how much down payment — (laughter) — you should be putting down, in relation to interest rates and also in relation to available cash and the stock market.

WARREN BUFFETT: Well, Charlie’s going to give you an answer to that in a second. I’ll just relay one story, which was when I got married we did have about $10,000 starting off, and I told Susie, I said, “Now, you know, there’s two choices, it’s up to you. We can either buy a house, which will use up all my capital and clean me out, and it’ll be like a carpenter who’s had his tools taken away for him. (Laughs) “Or you can let me work on this and someday, who knows, maybe I’ll even buy a little bit larger house than would otherwise be the case.” So she was very understanding on that point. And we waited until 1956. We got married in 1952. And I decided to buy a house when it was about — when the down payment was about 10 percent or so of my net worth, because I really felt I wanted to use the capital for other purposes. But that was a way different environment in terms of what was available to buy.

In effect, if you have the house you want to buy, you know, I definitely believe in just going out and probably getting the job done. But in effect, you’re probably making something in the area of a 7 or 8 percent investment, implicitly, when you do it. So you know, you’ll have to figure out your own equation from that. Charlie probably has better advice on that. He’s a big homeowner — (laughter) — in both senses of the word.

CHARLIE MUNGER: I think the time to buy a house is when you need one. (Laughter)

WARREN BUFFETT: And when do you need one?

CHARLIE MUNGER: Well, I have very old-fashioned ideas on that, too. The single people, I don’t care if they ever get a house. (Laughter)

WARREN BUFFETT: When do you need one if you’re married, Charlie? I’ll follow up for the — (Laughter) You need one when your wife wants one.

CHARLIE MUNGER: Yeah, yes. (Laughter) I think you’ve got that exactly right. (Laughter)

VOICE: Mr. Buffett?

WARREN BUFFETT: Yeah.

VOICE: May I make an announcement?

WARREN BUFFETT: Sure.

VOICE: Gregory Crawford needs to go to the security office, please, for emergency message. Gregory Crawford to the security office for emergency message. Thank you.

WARREN BUFFETT: OK, hope it isn’t a margin call. (Laughter)

2. Executive compensation: Buffett slams big money for mediocrity

WARREN BUFFETT: OK, we’ll go to zone 1, please.

AUDIENCE MEMBER: I’m Ralph Bedford (PH) from Phoenix, Arizona. The question I’m going to ask does not pertain to Berkshire Hathaway, but I would appreciate it if you gentlemen, if you can, explain the justification and rationalization for the exorbitant salaries, bonuses, perks, directors’ fees, and other benefits that most public corporations are paying. (Applause)

WARREN BUFFETT: I would say this. In my own view, the most exorbitant are not necessarily the biggest numbers. What really bothers me is when companies pay a lot of money for mediocrity, and that happens all too often. But we have no quarrel in our subsidiaries, for example, for paying a lot of money for outstanding performance. I mean, we get it back 10 or 20 or 50-for-1. And similarly in public companies, we think that there have been managers — in our managers — who have taken companies to many, many, many billions of market value more than would’ve happened with virtually anyone else. And they sometimes take a lot of money for that. Sometimes, as in the case of Tom Murphy at Cap Cities, you know, it just didn’t make a difference to him. I mean, he performed in a way that would justify — would have justified huge sums, but it wasn’t — he would tell you that he had all the money he needed and he just didn’t care to take what the market might bear. But I am bothered by irrational pay systems. And I’m particularly bothered when average managers take really large sums.

I’m bothered when they design, or have designed for them, systems that are very costly to the company — maybe partly to make themselves look good because they want huge options themselves, so they feel if they give options widely throughout the company — so they design a system that is illogical company-wide because they want one that’s illogical for them personally. But large sums, per se, don’t bother me. I’m not saying, you know, whether any individual should — might want to take them or not. But I do not mind paying a lot of money for performance. It’s done in athletics, it’s done in entertainment, but in business the people who are the .200 hitters and the people who would not attract a crowd as an entertainer have worked it out so that — I mean, the system has evolved in such a way that — many of them take huge sums. And I think that’s obscene, but I can tell you, there isn’t much you can do about. The system feeds on itself. And companies do look at other companies’ proxy statements, every CEO does.

And they say, “Well, if Joe Smith is worth X I have to be worth more.” And they tell the directors that, “Certainly you wouldn’t be hiring anybody that was below average, so how can you pay me below average?” And the consultants come in and ratchet up the rewards. And it’s not anything that’s going to go away. It’s like we were talking about campaign finance reform earlier. The people who have their hands on the switch are the beneficiaries of the system. And it’s very hard to change the system when the guy whose hand is on the switch is benefitting enormously, and perhaps disproportionately, from that system. Charlie?

CHARLIE MUNGER: Well yeah, I’d like to report that the original Vanderbilt behaved even better than the people at Berkshire Hathaway. He didn’t take any salary at all. He thought it was beneath him as a significant shareholder to take a salary. That ideal, I’m afraid, died with him. (Laughter)

WARREN BUFFETT: Yeah, Charlie and I — our directors are paid $900 a year, but I tell them on an hourly basis they’re making a fortune because we don’t work them that hard. (Laughter) But Charlie and I did not think through, when we established that $900 a year, is that they set our salaries, too, so — (Laughter) We have not followed the standard procedure, which is to load it on the directors, and the directors shall load it on you.

CHARLIE MUNGER: I do think it will have pernicious effects for the country in its entirety as this thing keeps escalating, because I think you’re getting a widespread perception that at the very top, corporate salaries in America are too high. And that is not a good thing for a civilization, when the leaders are regarded as not dealing fairly with the institutions that they head.

WARREN BUFFETT: Yeah. If — (Applause)

CHARLIE MUNGER: And as for the corporation consultants who advise on salaries, all I can say is that prostitution would be a step up for them. (Laughter)

WARREN BUFFETT: Put him down as undecided. (Laughter)

3. Class B stock “worked out as well as possible”

WARREN BUFFETT: Zone two, please.

AUDIENCE MEMBER: I’m Dan Blum (PH), from Seattle, Washington via Cambridge, Massachusetts. I want to ask whether the issuance of Class B stock has achieved the objective which you announced for it, when it was created.

WARREN BUFFETT: Well, I would say this, that considering the alternatives we faced, which was the imminence of unit trusts that would’ve been promoted with heavy front-end commissions, with substantial annual fees, with bad tax consequences, and with, probably, a misrepresentation of the historical record in such a way that people who really didn’t know much about securities would’ve been enticed in — with that as an alternative I think the B stock was the best thing we could’ve done, and I feel good about how it’s worked out. I think that, you know, we didn’t set out to issue it. We don’t like talking anybody into buying our stock. But I don’t think in any way that the group we have here is diminished in the least by having a mix of B and A shareholders, as opposed to A only. The B has worked out as well as possible. I hope that, you know, we haven’t enticed anybody in with unreasonable expectations. That’s the biggest thing that Charlie and I worry about. And it’s hard not to have that happen with the historical record.

I know it would’ve happened in a big way with the unit trust. So, you know, it’s like making the mistake originally of starting with Berkshire, I think. We enjoy things as they come along and we’ve gotten a good group with the B shareholders, and we’re happy with the present situation. Charlie?

CHARLIE MUNGER: Yeah, we wanted to step hard on what we regarded as a disreputable financial scheme, and that we did. And — (Laughter)

WARREN BUFFETT: And I think the way we sold the B was such as to not — as to attract the kind of people who really did look at it on a long-term basis. We did everything we could to discourage people who thought they were going to make a lot of money in a hurry. So I think we attracted a whole new group of shareholders who are quite similar in perspective to the shareholder group that we already had, and that was our hope.

4. Berkshire’s investing minimum

WARREN BUFFETT: Zone 3, please?

AUDIENCE MEMBER: My name is Alan Rank from Pittsburgh. I first want to thank Susan Jacques for returning the cocktail yesterday, and I hope she was rewarded with good sales at Borsheims. Question is regarding the fact that you don’t report details of anything under $750 million, and with the change of the values of small-cap in relation to large-cap, would that be something that Berkshire or individuals might try to look as opportunity with the small-cap premium shrinking, as it has?

WARREN BUFFETT: We don’t worry about whether a stock is small-cap or large-cap except to the extent that by now we’ve gotten to a point where anything below a certain level just is not of interest to us because it can’t be material to our results, so — We never think of opportunities as existing because something is small-cap, or sectors, or all that, you know, what generally gets merchandised. So our cutoff point is set more or less at the point where we think it’s material. That’s not as defined by the SEC, we could have a higher limit. But we think when you get down below 2 percent of assets or thereabouts that the reporting of positions would not affect anybody’s calculation of intrinsic value or give them insights about the way we run the business, but it would be more for the people who were looking for things to piggyback on. And so we will move the cutoff point up as we go along.

Because of our size, we will never be in companies that have capitalizations that, you know, of a half a billion or a billion dollars, because we just can’t put enough money in it. Occasionally we’ll be in one just by accident. But we’re looking at things that we can put $500 million in ourselves, at least. At 500 million, a 5 percent position has a $10 billion market cap. That limitation has hurt, will hurt, is hurting, our performance to some degree. You would — if Berkshire were exactly 1/100th of its present size in all respects, owning the operating businesses it did but all 1/100th the size, our prospects would be better than they are with the kind of money we have presently. Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

5. “Sandy Weill is a very, very good manager”

WARREN BUFFETT: OK. Zone four, please.

AUDIENCE MEMBER: OK. My name is Tom Conrad (PH), I’m from McLean, Virginia. I just wanted to first thank you, Mr. Buffett and Mr. Munger, for each year answering our questions. I found myself at 5 a.m. standing outside the door here, and I don’t do that for anyone. (Laughter) And it’s a real pleasure to hear your answers. I have two questions. One is, with Travelers, the company Travelers, and their merger with Citibank, do you have confidence in the management of Sandy Weill? My second question is, you said it in a few meetings ago that diversification is a protection against ignorance. And it only takes three great companies to be set for an investment lifetime. And I invested in those three companies: Coca-Cola, Gillette, and Disney. And I went ahead and invested in a fourth company without asking you. I invested in Pfizer. And I just wonder what you think about the pharmaceutical industry, if you feel there’s some great companies in that industry. Thank you very much.

WARREN BUFFETT: Yeah. Well, A) we think Sandy Weill is a very, very good manager. Sandy is — I mean, the record is clear. It is not easy to manage in Wall Street, and Sandy has done an excellent job there as well as in other allied, or somewhat allied, fields. So his record is proven. And he has been (inaudible) ever since buying Commercial Credit from Control Data. He’s built a terrific company. And he built a terrific company in businesses that themselves aren’t necessarily so terrific, so it’s required real management skill.

6. Pharmaceutical stocks: “We stupidly blew that one”

WARREN BUFFETT: Pharmaceuticals, we missed. We would not have known how to pick out any single business, but we — single company — within the industry, but we certainly should’ve recognized — did recognize, didn’t do anything about it — that the industry as a whole represented a group that would achieve good returns on equity, and where some sort of a group purchase might’ve made sense. We did buy one a while back, but we didn’t — it was peanuts. And it would of been — it was within our circle of competence to identify the industry as likely to enjoy very high profits over time. It would not have been within our circle of competence to try and pick a single company. Charlie?

CHARLIE MUNGER: Yeah, we stupidly blew that one. (Laughter)

WARREN BUFFETT: We’ll blow more, too. (Laughter)

7. Decentralization “just short of total abdication”

WARREN BUFFETT: Zone five.

AUDIENCE MEMBER: Yes, sir. Good afternoon. My name is Matt Lovejoy from Lexington, Kentucky. And gladly, I’m not a consultant. (Laughter) I have a question, sir, Mr. Buffett, about your operating management style. In my opinion, the mainstream media minimizes the significance of your nonpublic operating investments. When you consider capital allocation in these companies, do you have the managers submit annual business plans? And if so, do you formally meet with those managers to see how well you can track progress against those plans?

WARREN BUFFETT: Yeah, that’s a good question. And the answer is that we may meet with some of them annually, we may meet with others semiannually, but we have no formal system whatsoever, and we will never have a formal system. We don’t demand any meetings of any of our managers. We have no operating plan submitted to headquarters. Some of the companies use operating plans themselves, some of them don’t. They are all run by people who have terrific records, and they have different batting styles. And we’re not about to tinker with somebody that’s batting with .375 just because somebody else holds the bat a little differently or uses a different weight bat, or something of the sort. So we believe in letting them do, currently and in the future, what has been successful for them in the past. And different people have very different styles. I’ve got my own style, you know? But we have managers that like to talk things over, we have other managers that like to go their own way.

And we have managers that have a by-the-book approach which works well, we have other managers who wouldn’t dream of that. We have managers that — most managers probably have monthly statements of financials. We have other managers that don’t. And that really isn’t a problem. What we want to have is good managers, and there’s more than one way to get to, at least, business heaven, and we have a number that have found different ways to get there. So we have never imposed — we have certain requirements because we’re a public company, and SEC requirements, and International Revenue Service coordination. But we’ve never imposed anything from the top on any of the operating managements. We have MBAs running companies, we have people who never saw a business school. And talent is the scarce commodity, and when you find talent and they’ve got their own way of doing things, we let it — we’re delighted to have them do it. More than letting them do it — we want them to do it their way. We don’t want to change them. Charlie?

CHARLIE MUNGER: Yeah, the truth of the matter is that we have decentralized power in the operating businesses to a point just short of total abdication. (Laughter) And we don’t think our system is right for everybody. It has suited us and the kind of people that have joined us. But we don’t have criticism for other people, like Emerson Electric or something, who have operating plans, and compare performance quarterly against plan and all that sort of thing. It’s just not our style.

WARREN BUFFETT: Yeah, we centralize money and — (laughs) — everything else we decentralize, pretty much, but — I don’t know whether you’ve met him here, but for example, Al Ueltschi is here. He started FlightSafety in 1951 and he’s — I don’t know what he’ll spend on simulators this year, but it could easily be a hundred million dollars or thereabouts. And he — if I spent hours with him, I couldn’t add 1/100th of 1 percent to his knowledge of how to allocate that money. It would be ridiculous. It’d be a waste of his time and it would be an act of arrogance on my part. And I have no worries about how Al allocates the money. And that’s an unusually capital intensive business compared to most of our businesses. There’s some that I get into the details more because I just worked with the person that’s running things a long time and we kind of enjoy it. Ajit and I talk virtually every night about the reinsurance business.

You know, I am not improving the quality of his decisions at all, but it’s an interesting game and I like hearing about it, and he doesn’t mind talking about it, so we talk them over. But that’s just a matter of personal chemistry. And as we add managers, we will adapt to them. We adapt our accounting systems, to a degree, to them. Now, we do have certain requirements that result from the SEC and IRS. But we don’t — our managers know their businesses and they know how to run them. And if they don’t — this hasn’t been the case — but if they didn’t, we would, you know, we’d do something about the manager, we wouldn’t try and build a bunch of systems.

8. Avoid the “Frozen Corporation”

WARREN BUFFETT: Zone 6, please.

AUDIENCE MEMBER: Good afternoon, gentlemen. My name is George Donner from Fort Wayne, Indiana. My question has to do with estimating the intrinsic value of a company, in particular the capital intensive companies like you were mentioning. I’m thinking of things like McDonald’s and Walgreens, but there are lots of others where you have a very healthy and growing operating cash flow, but it’s marginally or completely offset by heavy expenditures on putting up new stores or restaurants, or building a new plant. And so my question is, what do you do for your estimate of future free cash flow? And with Treasurys around — long Treasurys around 6 percent — at what rate do you discount those cash flows?

WARREN BUFFETT: Well, we discount at the long rate just to have a standard of measurement across all businesses. But we would take the company that is spending the money as it comes in, and they don’t get credit for gross cash flow, they get credit for whatever net cash is left every year. But of course, if they’re spending the money wisely, even though you have to discount it for more years, the growth in cash development should offset that or they weren’t investing it wisely. The best business is one that gives you more and more money every year without putting up anything to get it, or very little. And we’ve got some businesses like that. The second-best business is a business that also gives you more and more money. It takes more money, but the rate at which you invest — reinvest — the money to get that growth is a very satisfactory rate. The worst business of all is the one that grows a lot, and where you’re forced — forced, in effect — forced to grow to stay in the game at all, and where you’re reinvesting the capital at a very low rate of return.

And sometimes people are in those businesses without knowing about it. But in terms of discounting, in terms of calculating intrinsic value, you look at the cash that is expected to be generated and you discount back at — in our case, we use the long-term Treasury rate. That doesn’t mean that you pay the amount that that present value calculation leads to, but it means that you use that as a common yardstick, that Treasury rate. And that means that if somebody is reinvesting all their cash flow the next five years, they’d better have some very big figures coming in down the road. Because at some day, a financial asset has to give you back cash to justify you laying out cash for it now. Investing is the art, essentially, of laying out cash now to get a whole lot more cash later on, and something at some point better deliver cash. Ben Graham in his class, we used to talk about what he called the Frozen Corporation. And the Frozen Corporation was a company whose charter prohibited it from ever paying anything to its owners, or ever being liquidated, or ever being sold and —

CHARLIE MUNGER: Sort of like a Hollywood producer. (Laughter)

WARREN BUFFETT: Yeah. And the question was, what was such an enterprise worth? Well, that’s sort of a theoretical question, but it forces you to think about the realities of what business is all about. And business is all about putting out money today to get back more money later on. Charlie?

CHARLIE MUNGER: I do think there is an interesting problem that you raise, because I think there is a class of businesses where the eventual cash back part of the equation tends to be an illusion. I think there are businesses where you just keep pouring it in and pouring it in, and then all of a sudden it doesn’t work, and no cash comes back. And what makes our life interesting is trying to avoid those and get in the alternative kind that drowns you in cash. (Laughter)

WARREN BUFFETT: The one figure we regard as utter nonsense is the so-called EBITDA. I mean, the idea of looking at a figure before the cash requirements and merely staying in the same place — and there usually are — any business with significant fixed assets almost always has with it a concomitant requirement that major cash be reinvested in order simply to stay in the same place competitively and in terms of unit sales — to look at some figure that is before — that is stated before those cash requirements, is absolute folly and it’s been misused by lots of people to sell lots of merchandise in recent years.

CHARLIE MUNGER: It’s not to the credit of the investment banking fraternity that it has learned to speak in terms of EBITDA. I mean, the idea of using a measure that you know is nonsense, and then piling additional reasoning on that false assumption, it’s not creditable intellectual performance. And then once everybody is talking in terms of nonsense, why, it gets to be standard. (Laughter)

9. Checklist for selecting stocks

WARREN BUFFETT: Zone 7, please.

AUDIENCE MEMBER: Hi. My name is Brennan Vecchio (PH) and I’m in the Academy of Finance at Northwest High School in Omaha. Could you explain the criteria you look at when selecting your stocks?

WARREN BUFFETT: Well, we look at — I’m glad you came. I hope there’s a large group. I got a note, I think from your teacher, on that. (Applause) We look at it — the criteria for selecting a stock is really the criteria for looking at a business. We are looking for a business we can understand. That means they sell a product that we think we understand, or we understand the nature of the competition, what could go wrong with it over time. And then when we find that business we try to figure out whether the economics of it means the earning power over the next five, or 10, or 15 years is likely to be good and getting better or poor and getting worse. But we try to evaluate that future stream. And then we try to decide whether we’re getting in with some people that we feel comfortable being in with. And then we try to decide what’s an appropriate price for what we’ve seen up to that point. And as I said last year, what we do is simple but not necessarily easy. The checklist that is going through our mind is not very complicated.

Knowing what you don’t know is important, and sometimes that’s not easy. And knowing the future is definitely — it’s impossible in many cases, in our view, and it’s difficult in others. And sometimes it’s relatively easy, and we’re looking for the ones that are relatively easy. And then when you get all through you have to find it at a price that’s interesting to you, and that’s very difficult for us now. Although there have been periods in the past where it’s been a total cinch. And that’s what goes through our mind. If you were thinking of buying a service station, or a dry cleaning establish, or a convenience store in Omaha to invest your life savings in and run as a business, you’d think about the same sort of things. You’d think about the competitive position and what it would look like five or 10 years from now, and how you were going to run it, and who was going to run it for you, and how much you had to pay.

And that’s exactly what we think of when we look at a stock, because the stock is nothing other than a piece of a business. Charlie?

10. Easy decision case study: National Cash Register

CHARLIE MUNGER: Yeah. If finance were — when finance is properly taught, it should be taught from cases where the investment decision is easy. And the one I always cite is the early history of National Cash Register Company, and that was created by a fanatic who bought all the patents, and had the best salesforce, and the best production plants. He was a very intelligent man and passionately dedicated to the cash register business. And of course, the cash register business was a godsend to retailing when cash registers were invented. So that was the pharmaceuticals of a former age. If you read an early annual report prepared by Patterson, who was CEO of National Cash Register, an idiot could see that this was a talented fanatic. Very favorably located, and that, therefore, the investment decision was easy. If I were teaching finance, I would collect a hundred cases like that. And that’s the way I would teach the students.

WARREN BUFFETT: We have that annual report. What was that, 1904 or something, Charlie? But it’s really a classic report because Patterson not only tells you why his cash register is worth about 20 times what he’s selling for to people, but he also — (laughs) — tells you that you’re an idiot if you want to go in competition with him. It’s a classic.

CHARLIE MUNGER: It is just a (inaudible). But no intelligent person can read this report and not realize — (laughs) — that this guy can’t lose.

11. “Norman Rockwell frame of mind”

WARREN BUFFETT: Area 8, please.

AUDIENCE MEMBER: Good afternoon. My name is Robert Rowland (PH) from London, England. I’ve been in Omaha all weekend with my wife on the first leg of my honeymoon, and I’ve noticed you’re quite a buyer of nostalgic assets. Can I ask whether nostalgia is one of your filters? (Buffett laughs) Are there any assets like that left in the U.S. to buy? And if not, can I suggest you come to the U.K. where all we do is sell them? (Laughter)

WARREN BUFFETT: Well, I don’t want to interrupt your honeymoon. (Laughter) But if you’d send me a list of those companies over there that are long on nostalgia, that might be to our liking. Because Charlie and I tend to operate from sort of a Norman Rockwell frame of mind. And it is true that the kind of companies we like sort of do have a homey, Norman Rockwell, Saturday Evening Post-type character to them there. They have character. And they’re the kind of companies, I think, frequently, that people, when they join them, expect to spend the rest of their lives there rather than look at it as something to stick on their resume. And there are businesses like that. If you look at the businesses that we’ve bought in the last three or four years, there is real character to the businesses and to the people that build them.

And that’s why the people that build them stay on and feel very strongly about running them correctly, even though they have no financial consequence to themselves whatsoever, so — If you’ve got a list of those in England and you still have any strength left after your honeymoon, drop me a line. (Laughter)

12. A and B shares are nearly equivalent investment choices

WARREN BUFFETT: Zone 9, please.

AUDIENCE MEMBER: Good afternoon. Joshua Andrews (PH) from Omaha Northwest High School, Academy of Finance.

WARREN BUFFETT: Good.

AUDIENCE MEMBER: And on behalf of the Academy of Finance, we want to thank you for the tickets. There’s 33 of us in attendance today.

WARREN BUFFETT: Terrific. (Applause)

AUDIENCE MEMBER: We had the opportunity to play a national game, the Investment Challenge. And on the list of the stocks there were BRK A and BRK B. Can you explain what the difference of the two stocks are?

WARREN BUFFETT: Yeah, the difference between the Berkshire A and B is simply that an A can be converted to a B at any time in the ratio of one A into 30 Bs. The B cannot be converted into the A, so it’s a one-way street on conversion. The economic value of the B is exactly 1/30th that of the A. So anytime the A ever gets any money of any kind from dividends, or liquidation, or a merger, or something of the sort, for every $30 that you get on the A you’re going to get $1 on the B. The two differences are that there is less voting power, proportionately, in the B. And the B does not participate in a designated-contributions program that Berkshire runs, simply because that would be very, very hard to administer. And when we issued the B we pointed out those two differences. The B should never sell for more than 1/30th of the price of the A. When it sells just a tiny bit above that then arbitrage settles in as people buy the A and convert it to B, and sell the B.

Occasionally the B may be at a slight discount to the A because it’s not convertible the other way. But I think as a practical matter you can treat the A and B as very equivalent investment choices. There’s not enough difference to make it significant. Charlie?

CHARLIE MUNGER: Nothing further.

13. How teenagers can prepare for the future

WARREN BUFFETT: OK. Area 10, please.

AUDIENCE MEMBER: My name is Sheena Cho (PH) from the Academy of Finance. What recommendations would you give us as teenagers to prepare for our future and become as successful as you? (Laughter)

WARREN BUFFETT: Well, if you’re interested in business, I definitely think you ought to learn all the accounting you can by the time you’re in your early 20s. Accounting is the language of business. Now, that doesn’t mean it’s a perfect language, so you have to know the limitations of that language, as well as all aspects of it. So I would advise you to learn accounting. And I would advise you to be — in terms of part-time employment or anything else, work at a number of businesses. There’s nothing like seeing how business operates to build your judgment in the future about businesses. You know, when you understand what kind of things are very competitive, and what kind of things are less competitive, and why that works that way, all of that adds to your knowledge. So I would do a lot of reading. If you’re interested in investments, I would — A, I would take the accounting courses. I’d do a lot of reading about investments and I would get as much business experience.

I would talk business with people that are in business to find out what they think makes their operation tick, or where they have problems and why. I just think you just kind of sop it up every place that you can. And if it turns you on, you’ll do well in it. I mean, I think that, you know, certain activities grab different people. But if business is of interest to you, my guess is you’ll do well. And if you understand business you understand investments. Investments are simply business decisions in terms of capital allocation. I wish you well on it. Charlie?

CHARLIE MUNGER: Yeah, there’s also the little matter of underspending your income year after year after year.

WARREN BUFFETT: Which we have mastered. (Laughter)

CHARLIE MUNGER: Yes. That really works if you keep at it.

WARREN BUFFETT: Yeah, I mean, Charlie and I both — Charlie started having children at a rapid rate, so — and he was lawyer when there was not big money in then. But, I was — any money you save before you get out and start having a family is probably — any dollar — is probably worth $10 later on simply because you can save it. The time to save is young, and you’ll never have a better time to save than really, free formation of a family. Because the expenditures come along then whether you like them or not. So I — You know, work for yourself first and put the money aside. I was lucky that way, I didn’t have to pay for my own college. Probably wouldn’t have gone to college if I’d had to pay for it. But I, you know, I was able to save everything I made in my teens and those dollars got magnified quite a bit. Whereas the money I — when I started first selling securities, I mean, the money I made then was taken up by family needs to quite an extent. So start saving early.

A lot of it’s habit anyway, so it’s a great habit to have.

14. “We are not reluctant to invest abroad”

WARREN BUFFETT: OK, zone 1, please.

TONI: I’m Toni Ausnit (PH) from New York City, following up on the questioner from London. In light of the current dearth of investment opportunities, do you see yourselves investing in non-U.S. companies which are well-managed, understandable, and growing?

WARREN BUFFETT: Well, if we find such companies as you describe at a price that’s half attractive we’re perfectly willing to buy them. So the answer to that is yes. But we would be looking, to an extent, worldwide irrespective of market conditions in the United States. Now, market valuations in this country tend to be fairly well-matched in most of the major countries. So we don’t — there’s been a bull market all over the world in a huge way in the bigger markets. And so unfortunately — I mean, it would of been nice for us if the U.S. market had tripled and other markets had stayed the same, and then we would be very likely to be finding things abroad. We’re not finding them abroad, but we’re certainly looking for the kind of thing you’re talking about. We are not reluctant to invest abroad. And our two — well, all three of our largest holdings — American Express, Gillette, and Coke — and we’re talking about $25 billion of market value there that we have — all three of those have major businesses abroad.

And in the case of Coke and Gillette, it’s a majority of their earnings from abroad. So we’re interested and there’s better growth opportunities in many areas abroad than here. But we’re not finding bargains as we look around the world. Charlie?

CHARLIE MUNGER: Nothing more.

15. Philanthropy share sales won’t hurt stock price

WARREN BUFFETT: OK. Area two.

AUDIENCE MEMBER: My name is Henry Allen (PH), Mamaroneck, New York. Question I have is a little delicate, relates to my family and heirs rather than myself, because I’m a couple of decades older than you gentlemen. You’ve been very candid about the succession and the estate planning, but how will the recipients of huge grants — charitable grants — get the liquidity they need without — to use the money without unduly driving the stock down?

WARREN BUFFETT: Well, I don’t think that supply and demand, in terms of specific — you know, let’s just say that 3 percent of Berkshire were to be added to the supply, anyway. I don’t think that makes much difference. What really makes the difference is the prospects of the business. If my charitable foundation were operative today, it would have to sell — it would have to give away 5 percent of the value of the foundation every year. And if Berkshire paid no dividend, that means it would have to sell 5 percent of the holdings per year. I don’t think that the price of Berkshire would be materially different if there were a seller of — that would be, in this case, 2 percent of Berkshire’s capitalization — I don’t think it would be materially different. If it is, it probably should be different. I mean, there should be a reasonable amount of trading that can take place annually without affecting the price of the stock materially or the price of the stock is being propped for sort of unnatural reasons. So I wouldn’t really worry about that.

We had one shareholder die about a year, year and a half ago, that had 3/4 of 1 percent of the company, for example. It was sold in, I don’t know, six weeks or thereabouts, and they raised, at that time, $250 million or thereabouts from the sale. I am not worried about that. I’m worried about — I mean, I don’t worry — but the key factor is what are the prospects of the businesses? If the businesses are worth money — there are all kinds of companies on the New York Stock Exchange who are perfectly decent businesses where 30 or 40 percent of the stock turns over a year. And Berkshire’s price should not be way different if 10 percent trades a year as opposed to the present 3 percent. Charlie?

CHARLIE MUNGER: I agree with that. I don’t think there’d be any problem at all at the present time if the Buffett Foundation were selling 5 percent of its holdings every year.

WARREN BUFFETT: Could be 500 shares a week or something like that. But if there isn’t demand for 500 shares a week of A on a company with our capitalization, then the price probably is artificially wrong at that time.

CHARLIE MUNGER: But I just had lunch with Susie and it doesn’t look to me like she’s in any imminent danger of mortality. (Laughter)

WARREN BUFFETT: No. Yeah, it will — it will come into play when the survivor of the two of us dies and when the estate gets cleaned up and everything else. So I think — I certainly hope and I think it’s quite a ways away.

CHARLIE MUNGER: You people have more important things to worry about. (Laughter and applause)

16. Buffett’s favorite book on his philosophy

WARREN BUFFETT: Zone 3, please.

AUDIENCE MEMBER: My name is Jim Howard (PH). I’m from Syracuse, Indiana. My question is, does the book “Buffettology” by Mary Buffett present fairly, in all material respects, the calculations you use in evaluating a business for purchase, or did the lady just write a book?

WARREN BUFFETT: Well, it was written by two authors. But I would say that — no, I would say that in a general way, it gets at the investment philosophy. But I wouldn’t say that — it’s not the book I would’ve written, precisely, but I have no quarrel with it, either. I actually think by reading Berkshire’s reports, you should be able to get more — I would think you’d get more of our philosophy than in any other manner. I think Larry Cunningham, the fellow who held the symposium at the Cardozo School at Yeshiva, did the best job, actually, of sort of reconstructing the various things that have been written at Berkshire into sort of the best-organized presentation of our philosophy. So and he —

CHARLIE MUNGER: And he’s selling it right here. It’s a very practical —

WARREN BUFFETT: Yeah, he had it at Borsheims — in the mall outside Borsheims yesterday. And Larry did a very good job. You know, I had nothing to do with it, but I think that that — I really think he’s done a first-class job of sort of organizing by topic, I mean, all these things that I’ve sort of written annually and Charlie’s written over time. So that would be — that would probably be my — if I were picking one thing to read, that would probably be the one.

17. Disney sale in the ’60s was a “huge mistake”

WARREN BUFFETT: OK, zone 4, please.

AUDIENCE MEMBER: My name is Leigh (inaudible). I’m from Los Angeles, California. And I want to begin by thanking you for having Bob Hamman. It was a stroke of genius. I could shop at Borsheims and my husband was entertained while I did so. (Laughter)

WARREN BUFFETT: Well, Bob is not only the best bridge player around but he is an entertaining guy, too. We —

AUDIENCE MEMBER: He’s great.

WARREN BUFFETT: Yeah, he is great. I agree with you.

AUDIENCE MEMBER: My question. You owned Disney once before and sold it. You also owned advertising companies in the ’70s, I believe —

WARREN BUFFETT: Right.

AUDIENCE MEMBER: — and you sold them. Could we have some insight into your thinking as to why you sold them?

WARREN BUFFETT: I’m not sure I want to give you any insight into that thinking. (Laughs) Well, we’ll start off with the fact that when I was 11, I bought some Cities Service preferred at 38 and it went to 200, but I sold at 40, so — (laughter) — grabbing my $2 a share of profit. So I — everything we’ve ever sold has gone up subsequently, but some of them have gone up more painfully, subsequently, than others. And certainly the Disney sale in the ’60s was a huge mistake. I should have been buying, forget about holding, and — That’s happened many times. I mean, we think that anything we sell should go up subsequently, because we own good businesses and we may sell them because we need money for something else, but we still think they’re good businesses, and we think good businesses are going to be worth more over time. So everything I sold in the past, virtually that I can think of, has gone on to sell at a lot more — for a lot more money. And I would expect that would continue to be the case.

That’s not a source of distress. But I must say that selling the Disney was a mistake, and actually the ad agencies had done very well since we sold them, too. Now, maybe some of that money went into Coca-Cola or something else, so I don’t worry about that. I would worry, frankly, if I sold a bunch of things right at the top, because that would indicate that, in effect, I was practicing the bigger fool-type approach to investing, and I don’t think that can be practiced successfully over time. I think the most successful investors, if they sell at all, will be selling things that end up going a lot higher, because it means that they’ve been buying into good businesses as they’ve gone along. Charlie?

CHARLIE MUNGER: Well, I’m glad that the questioner brought this touch of humility, because it is really useful to be reminded of your errors. (Laughter) And I think we’re pretty good at that. I mean, we kind of mentally rub our own noses in our own mistakes. And that is a very good mental habit. Warren can tell you the exact number of cents per shares that he sold at and compare it with the current price. It actually hurts him. (Laughter)

WARREN BUFFETT: It actually doesn’t hurt. (Laughs) The truth is, you know, because, you know, you just keep on doing things. But it is instructive to look at — to do postmortems on everything and say — as long as you don’t get carried away with it. But every acquisition decision, that kind of thing, you know, there should be postmortems. Now, most companies don’t like to do postmortems on their capital expenditures. I’ve been a director of a lot of companies over the years and they’ve usually not spent a lot of time on the postmortems. They spend a lot of time on telling you how wonderful the acquisitions are going to be, or the capital expenditures, but they don’t like to look so hard, necessarily, at the results.

CHARLIE MUNGER: Think of how refreshing a board of directors meeting would be if they sat down, “And now we’ll spend three hours examining all our stupid blunders and how much we’ve blown.”

WARREN BUFFETT: And then after that the compensation committee will meet. Now — (laughter) — that’s not going to happen. (Laughter)

CHARLIE MUNGER: Right.

18. Phil Carret is one of Buffett’s heroes

WARREN BUFFETT: OK. Area 5, please.

AUDIENCE MEMBER: My name is Keller, Harpel Keller, from Portland, Oregon. Two questions, one of a personal nature. Obviously there are many, many people here today. And I wonder if one of the true patriarchs of the investment business is here today, Phil Carret —

WARREN BUFFETT: Well, I’ll answer —

AUDIENCE MEMBER: Many of his friends and admirers would wish him well.

WARREN BUFFETT: Phil, up till a week ago was going to be here today. Phil is 101, wrote a book on investments in 1924, and I’ve known Phil for about 46 or ’7 years. And Phil has made all the meetings for a number of years, would be here today, and he broke a hip about five or six days ago. But he sent a message that he will definitely be here next year. (Laughter) And he will be, too. (Applause)

WARREN BUFFETT: Phil is a hero of mine. Go ahead.

19. End of Cold War isn’t an investing factor

AUDIENCE MEMBER: Second question. Has to do with Ben Graham. And he changed his valuation standards as the decades progressed. When he couldn’t buy stocks below a net-net, he changed his standards because the environment changed. Now, the world today seems to be a much different place than in 1989 when the U.S.S.R. collapsed. Even they are stumbling toward the free enterprise system. The Russian mafia is a perverse illustration of that. Now there is only one superpower in the world, the U.S.A., and we must be extremely grateful for the men who put us on the track to the free enterprise system. Now, the free enterprise system is out of the bottle, it’s not going to get back in. It seems to be expanding and accelerating around the world. With the resulting expansion of world trade, may that lead to a reevaluation of historical measures for measuring investments?

WARREN BUFFETT: Well, my answer to that would be that I doubt it, but I, you know, I also don’t know. But I don’t think that the end of the Cold War is something that I would factor into my evaluation of businesses. There are all kinds of events that happened, and their impact, in terms of being quantified, very difficult to figure over time, very difficult to isolate any single variable in a complex economic equation. So in terms of how the world was going to work ten years from now, or the returns are going to be on equity in business, you know, I don’t know what will be all the variables that impact on that. And obviously, right now people are very bullish about the fact that those returns — or something like those returns — will continue. But I don’t — I would not rely in making such a projection on the fact that the Cold War has ended or really any political or economic development around the world. I don’t know how to predict future earnings of American business.

And when I look at all of the great historic events of the past, nothing there gives me much in the way of a clue as to which ones would signal major changes in profitability of American business. Charlie?

CHARLIE MUNGER: Well, I think you raise one very interesting question. If the rest of the world becomes very much more prosperous, as it will if it adopts the free enterprise system, which investments are likely to do best? I would argue that the Cokes and Gillettes and so on are likely to be helped by a great increase in prosperity in what is now the Third World. And I’m not so sure that’s true of a lot of other businesses.

WARREN BUFFETT: Yeah, we like the international businesses we have. And as I say, our three top holdings all have a major international aspect to them, and really, in aggregate, a dominant international aspect to them. And there’s no question in my mind that a Coke will grow faster outside of the United States than in the United States, and the same is true of Gillette, maybe the same is true of American Express. So that’s built into what we — our evaluation of those businesses. But I felt that way before 1989, too. I mean, it’s very hard to evaluate how the ball is going to bounce, generally, around the world. But it is a plus to have products such as Gillette has or Coke has, that have demonstrated the fact that they travel extraordinarily well around the world, the people crave those products, and that they’re going to — no one’s going to find a way to do it better than those two companies in their respective fields. And they sell an inexpensive product, so all of that’s going for us.

But in terms of how stocks generally sell or the profitability of American business generally is in the future, it doesn’t help me much. Charlie, any more on that?

CHARLIE MUNGER: No more.

WARREN BUFFETT: OK.

20. Subsidiary managers are never second-guessed

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: Hi. My name is Bartley Cohen (PH). I just want to thank you for a great weekend. And my question is, after you bought Dairy Queen I heard they put Coca-Cola into all the stores, but yesterday when I went to the Nebraska Furniture Mart they said they don’t take American Express. And my question is — (crowd noise) — my question is, do you encourage the subsidiaries and the companies that you have stock to use each other’s products, or do you leave it up to the management of the subsidiary?

WARREN BUFFETT: Well, that’s a good question. And it does tell you something about the Berkshire method of operation. We tell each subsidiary to run their business in the way that they think is best for their operation. Borsheims takes American Express, See’s takes American Express, the Furniture Mart doesn’t, for example. But that’ll be true in other areas, too. If Harvey Golub at American Express — who has absolutely done a sensational job for us — if he wants to talk with — or have his representatives talk — with anybody at any of our operations, you know, we’re all for that happening. But we will never tell a subsidiary manager which vendor to patronize or anything of that sort. Once we start making decisions for our managers in that respect then we become responsible for the operation, and they are no longer responsible for the operation. They are responsible for their operations, and that means they get to call the decisions. And they should do what is best for their subsidiary, and it’s up to any other company that wants to do business with them to prove why that is best for them. That’s the Berkshire approach to things.

And I think on balance, our managers like it that way. So they’re not getting second-guessed and somebody can’t go over their head. I get letters all the time from people who are trying to jump over the heads of our managers, and they want us to say this advertising agency should be used or that, and that sort of thing. It doesn’t work at Berkshire. They deal with the managers of the businesses and they’re not going to get around them. Charlie? (Applause)

CHARLIE MUNGER: I love your answer. It gives Warren lots of time to read annual reports at headquarters. (Laughter)

21. Buffett smells trouble for tobacco companies in settlement

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: Hello, my name is Steve Errico (PH). I’m from New York. What do you think is likely to happen with respect to the tobacco settlement, and what do you think should happen? And secondly, McDonald’s and Dairy Queen are similar businesses. Was there a relationship between your acquisition of Dairy Queen and the disposal of McDonald’s? Thank you.

WARREN BUFFETT: Yeah, there’s no connection in the second case. They have certain similarities, but there’s certainly a lot of differences, too. You know, a Burger King and McDonald’s would be much more similar, or a Wendy and McDonald’s. But Dairy Queen is much more of a niche and away from that. The tobacco settlement’s interesting, just in terms of watching the dynamics of it. Because one of the things in labor negotiations that’s always a problem is that when you — as a manager you have a labor negotiation, at the end of the negotiation you as management are committed, and basically the union isn’t, because the union is going to have a vote on it. And that’s just the way it is. I mean, you can’t get away from that. But it is not fun to be in a negotiating position where you’re bound and the other side is not bound.

And although that wasn’t totally contractually necessarily the situation of tobacco area, it smelled like trouble to me for the tobacco companies — whether you feel they should’ve had that trouble or not — but it smelled like trouble to me when they were bound and you had another side that was not bound in any way, and where there were lots of political considerations, and where there was a lot of time was going to expire. I mean, that did not smell to me like a deal that would stick. And I don’t know any of the tobacco executives that were involved in that. I don’t know how much they agonized over getting in a position where they were bound and the other party wasn’t. But I can tell you from labor negotiations that that’s not a pleasant place to be, and it’s not a great strategic place to be. Charlie, what do you think of it?

CHARLIE MUNGER: I don’t feel I’ve got any great expertise in this situation.

WARREN BUFFETT: Well, neither did I, but I’m — (Laughter)

22. Buffett on inheritance: “Enough to do anything, not enough to do nothing”

WARREN BUFFETT: OK, zone 8, please.

JAIME MCMAHON: Hello, I’m Jaime McMahon (PH) from Birmingham, Alabama. And I was hoping that, Mr. Buffett and Mr. Munger, y’all would expand a little bit on your ideas of an inheritance, and the positive and negative influences that that can have on your heirs, and what you might be able to do as a businessperson, and an investor, and as a parent to sort of mitigate those negative influences.

WARREN BUFFETT: Yeah, well, I quoted — I think Kay Graham was quoting her father at the time but — some years back as saying, “If you’re quite rich, probably the idea of leaving your children enough so they can do anything, but not enough so they can do nothing, is not a bad formula.” I think, if you’re talking about people that aren’t quite rich, I’ve seen — you know, socially, I wouldn’t have a system that involved inheritances. But recognizing the situation that exists, I think probably at lower levels, that leaving to the children in this society is perfectly OK. But I believe enough in a meritocracy that if I were devising the system with a consumption tax and everything, I would probably make inheritance a form of consumption that would be very heavily taxed, because I don’t believe that because you happen to be the — come out of the right womb, essentially, that you are entitled to live an entirely different life than somebody who wasn’t quite as lucky, in terms of womb selection.

(Laughter) But in my own case, you know, I follow the “enough so they can do anything, but not enough so they can do nothing.” I think that society showered all these — I was very lucky, I was wired the right way at the right time in history to do very well in this kind of a market economy. Whereas Bill Gates has told me if I was born some thousands of years ago, I’d been some animal’s lunch. (Laughter) You know, I don’t run very fast. (Laughter) And there are different assets that are useful at different times. And I’ll add, I’m not wired to play championship bridge, or championship chess, or not wired to be a basketball star or anything. It just so happens I’m in an area where it pays off like crazy to be good at capital allocation. And that doesn’t make me a more worthwhile human being than anybody else or anything. It just means I was lucky. And should that luck, in effect, enable many generations of people that are good at womb selection to do nothing in this world? You know, I would have some reservations about that.

So that’s my own feeling on inheritance. But Charlie has a bigger family and he can give you a better answer.

23. Munger on inheritance: Few people are “ruined by money”

CHARLIE MUNGER: Well, I feel, in a capitalist system, that there should be an inheritance tax, and that once that’s been imposed and paid, what each person wants to do in his own testamentary arrangements is up to that person. I see very few people that I regard as ruined by money. Many of the people that I see ruined who have money would have been ruined without money. (Laughter) And I think the percentage of the people that are going to be living the life of the French aristocracy before the revolution is always going to be very small. And there are plenty of grasping people to take the money away from the incompetents who inherit it. I don’t think we have to worry about a whole class of incompetents ruling the world as their money cascades ever higher. So I like a fair amount of charity, and certainly some testamentary charity is OK. But I feel it’s an individual choice that people have to make.

WARREN BUFFETT: They get a choice there.

24. Two conditions needed for a market that’s not overvalued

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: My name is Samuel Wong from Irvine, California. I have two questions. Question number one, do you think the U.S.A. market is overvalued today? And question number two, would you buy Berkshire Hathaway stock today, considering the fact that they’ve had a nice ride up already this year? And if yes, presuming I have a kid, 20 years old, and he has $150,000 to invest in Berkshire Hathaway, and you won’t need the money until five years later, gradually, would you recommend to buy A share or B share, or the combination? Thank you.

WARREN BUFFETT: If you decide to buy Berkshire, I don’t think it really makes much difference whether you buy A or B. But we don’t make any recommendations about whether people buy or sell Berkshire. We never have and that’s a game we don’t want to get into. In terms of — overvalue — the question whether the market’s overvalued, generally, it’s simply as we said last year here in the annual report. It’s not — the general market is not overvalued if two conditions are met, which is — in our view — which is that interest rates remain at or near present levels or go lower or — and that corporate profitability in the U.S. stay at the present — or close to the present — levels, which are virtually unprecedented. Now, those are a couple of big ifs, as we pointed out. A lot of the stories that came out after the annual report would emphasize one aspect or another but it’s simply — and they say, “What does he mean by that?” Well, it means exactly what I say.

If the two conditions are met, I think it’s not overvalued. And if either of the conditions is breached in an important way, I think it will turn out to be overvalued. And I don’t know the answer, which is why I put it in the form that I did. It’s very tough at any given time to look forward and know what level of valuation is justified. You do know when certain dangerous things appear, and certainly if you’re predicating your answer that stocks are OK at these prices — if you come to that conclusion — you have to also come to the conclusion, in our view, that corporate earnings, at present levels, are likely to be maintained. And that’s a conclusion you would have to come to. I don’t think it’s obvious that that’s the case.

25. No exact formula on retaining earnings

WARREN BUFFETT: Area 10, please.

AUDIENCE MEMBER: Good afternoon. My name’s Stanley Harmon (PH) and I’m from Boston. You say that companies should only spend a dollar on capital expenditures if it will create more than $1 of market value. I’m wondering, how do you determine this? Is it based on A, historical returns on capital; B, a qualitative judgment of the company’s competitive position; C) a quantitative projection of returns on capital; or D, something else?

WARREN BUFFETT: Yeah. Well, it’s based on all of those factors you mention and more. But in the end we can say to date every dollar we’ve retained has been worthwhile, because on balance those dollars have produced more than a dollar of market value. It’s — actually, with a great many companies you can say that now, because things have turned out so well. But it would be a case — the check on it is, if after three or four years, you’ve found that the dollars we’ve retained hasn’t created more of that in value, then the presumption becomes very strong at that point that we should start paying out money. But almost any management that wants to retain money is going to rationalize it by saying, “We’re going to do wonderful things with the money we retain.” And we think there should be checks on that, which is why in the report, in the ground rules, I suggest making checks on the validity of those projections.

Charlie and I, if you ask us today whether the single dollar we retain from the earnings today, we’ve got a use for today that will produce more than a dollar of value, the answer is no. But we do think that based on history, that the prospects are better than 50 percent — well over 50 percent — that in the next few years, we would have an opportunity to do that. But there’s no certainty to it. Charlie?

CHARLIE MUNGER: Nothing more.

26. Berkshire stock tracks intrinsic value “better than most”

WARREN BUFFETT: OK. Area 1, please.

AUDIENCE MEMBER: Good afternoon. My name’s Gary Bialis (PH), I’m from Southern California. I want to thank you again for producing this Owner’s Manual that you did a couple of years ago. I find it quite useful and use it quite often. Two questions: can you tell me if the rule of thumb is still applicable regarding the statement in the Owner’s Manual, that the percentage increase in the book value tracks pretty well with the percent increase in intrinsic value? Or is the fact that you now have more owned businesses, especially ones like GEICO and FlightSafety, mean that the spread between those two has possibly narrowed?

WARREN BUFFETT: Well no, the two have tracked pretty well over the years. I mean, compared to the record of most businesses that are publicly owned, I would say that over the 33 or so year span, our market price has tracked intrinsic value more closely than, you know, 80 or 90 percent of the companies that we view, probably 90 percent. But that doesn’t mean it does it all the time. And there are times when the market price will outpace intrinsic value — the change in intrinsic value — and there are times when, obviously then, that it will lag behind. So it’s far from perfect but it’s better than most. Ideally, we would like it to track it perfectly. If we ran this as a private company and we met once a year, and set a price on the stock to have it traded once a year, and Charlie and I were responsible for setting that price, we would try to set a price that was as close to intrinsic value as we could. And that would be — to the extent that we could do it — it would be a perfect tracking. The market isn’t like that, and the market responds to a lot of other things.

So it’s perfect. It’s not getting more perfect, in our view. But we still think that Berkshire tracks it better than most companies. Charlie, you have —

CHARLIE MUNGER: Nothing to add.

27. KKR sale of Gillette shares “means nothing to us”

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: I’m Elizabeth Cruz (PH) from New York City. I have a question about Gillette. Another significant Gillette investor, KKR, recently sold over a billion dollars in Gillette shares, shares that they had acquired through Gillette’s acquisition of Duracell. Knowing that KKR has also been a successful investor, do you see this as a negative signal about Gillette’s future prospects, particularly on the eve of the launch of the Mach 3 razor? And what do you think their plans are for the remainder of their shares?

WARREN BUFFETT: Well, I think they may have even publicly stated — I’m pretty sure they have — the Duracell shares from which the Gillette shares came were held by a specific investment fund that was formed in, I don’t know what year, but a given year, and which is scheduled to disband at a certain point. So those shares, whether they were of Duracell or whether they’re of Gillette, were scheduled for disposition at some point within a given term. And I think that KKR made the decision — and they’ve made it with other stocks, too — is to have maybe three or so offerings between now and that terminal date for their partnership. And why they pick any one of — any given date, you know, is up to them and their advisors. It means nothing to us. I mean, if they didn’t have that kind of a fund and they decided to sell, it wouldn’t make any difference to them [us]. And I presume if we made a decision to sell, it wouldn’t make any difference in their case.

So we, you know, we form our ideas of valuation independent of anybody else’s thinking on it. But in the case of KKR, specifically, they have a termination date on a partnership that owned those shares, and have to dispose of them one way or another between now and the termination date, and probably decided that with the quantity of stock they had, that they were going to have several sales. The Mach 3 is terrific, incidentally. I’ve been using it since October. So Henry did not decide to sell that stock based on the Mach 3. (Laughter)

28. No split means “better class of shareholders”

WARREN BUFFETT: Area 3, please.

AUDIENCE MEMBER: I am Gertrude Goodman (PH) from Palm Springs, California. Mr. Buffett and Mr. Munger, there are many stocks that rise and eventually split. My question is, do you foresee in the near future a split for Berkshire Hathaway Class A?

WARREN BUFFETT: Well, that’s an easy one. (Laughter) No. The answer is no. We have no plans to split the A. In effect, we let people who want to split the A split it themselves into a B. So that anybody who owns the A can have a 30-for-1 split any morning they wake up and want to have such a split. (Laughter) Charlie, do you have any additional comment?

CHARLIE MUNGER: No, I think you said “no” perfectly. (Laughter and applause)

WARREN BUFFETT: We don’t take that attitude because we’re cavalier about how shareholders feel. We really think that in the long range interest of Berkshire that the policy we followed on not splitting has benefitted the company and shareholders. Nothing dramatic about it, but I think that we have a better class of shareholders, in aggregate, in this room, than we would have if we were selling at $3 a share, or $30 a share, or maybe even $300 a share.

29. “Book value is not a factor we consider”

WARREN BUFFETT: Area 4, please.

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. My name is Jack Sutton (PH) from New York City. I have two questions. The Japanese stock market has been likened to the U.S. market in 1974. With Japanese stocks selling at very low price-to-book values, as compared to U.S. stocks, would it not make sense to invest in a basket of Japanese stocks or an index fund of Japanese stocks? Question number two: Berkshire Hathaway tends to invest in companies with high margins and high return on common equity. Berkshire’s investment in the airline business seems to have digressed widely from those principles. Could you elaborate on why Berkshire invested in the airline industry, and would Berkshire consider new investments in the industry in the future?

WARREN BUFFETT: I’m going to the first question. The reason that — and I don’t know the exact figures — that Japanese stocks would sell at a lower price-book ratio than U.S. stocks is simply because Japanese companies are earning far less on book than American companies. And earnings are what determine value, not book value. Book value is not a factor we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been poor for a great many Japanese companies. Now, if you think that the return on equity of Japanese business is going to increase dramatically, then you’re going to make a lot of — I mean, and you’re correct, you’re going to make a lot of money in Japanese stocks. But the return on equity for Japanese businesses has been quite low, and that makes a low price-to-book ratio very appropriate because earnings are measured against book. And if a company’s earning 5 percent on book value, I don’t want to buy it at book value if I think it’s going to keep earning 5 percent on book value.

So a low price-book ratio means nothing to us. It does not intrigue us. In fact, if anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we’re looking at a poor business in the first case and a good business in the second case.

30. Airlines not “intriguing” enough to buy stock

WARREN BUFFETT: What was the other question on, Charlie?

CHARLIE MUNGER: Buying — airlines.

WARREN BUFFETT: Airlines. Yeah, I always repress everything on airlines. I don’t want to — (Laughter) No, we’ve never bought an airline common stock that I can remember. So what we did was we lent money to USAir for a 10-year period and we had a conversion privilege there. It looked like it — it was a terrible mistake. I made the mistake. But we got bailed out. But we — we never made the determination — when we bought our stock, USAir was selling at $50 a share or thereabouts, the common. And we didn’t have an interest in buying USAir at 50, or 40, or 30, or 20. And we got a chance to as things went along — (laughter) — all the way down to 4. (Laughter) And we never bought it. And we’ve never bought American, or United, or Delta, or any other airline. It is not a business that intrigues us.

We did think it was intriguing to lend money to them with a conversion privilege and it’s worked out now because we got lucky, and because Steve Wolf came along and really rescued the company from right at the brink of bankruptcy. But we’re unlikely to be in airlines, although again, we wouldn’t mind lending money to a lot of businesses that we wouldn’t buy common equity in. I mean, that could happen again in various industries, including the airline industry. Charlie, do you have anything to say on either the airlines or the Japanese market?

CHARLIE MUNGER: Well, the airline experience was very unpleasant for us. The net worth just melted. It was (inaudible) a billion and a half, and it just went a hundred million, a hundred million, a hundred million, and finally the cash is running down. It is a very unpleasant experience. (Laughter) We try and learn from those experiences but we’re very slow learners. (Laughter)

31. No “good returns” on Japanese stocks unless profits increase

WARREN BUFFETT: Japanese market (inaudible)?

CHARLIE MUNGER: Oh, the Japanese market. I suppose anything — (Laughter as Buffett reaches for box of candy) I suppose anything could happen. After all, we bought silver. (Laughter) But we have never made a big sector play on a country. In fact, we’ve almost never made a big sector play.

WARREN BUFFETT: We would have to come to the conclusion that Japanese business, instead of earning whatever it’s earning on equity now, is going to earn appreciably more on equity. I’ve got no basis for it — I wouldn’t argue if anybody else feels that way — I wouldn’t argue with them. But I have no basis for coming to that conclusion. And unless you come to that conclusion, you’re not going to make good returns. I mean, unless that happens, you’re not going to make good returns from Japanese stocks. You can not — you can’t earn a lot of money from businesses that are earning 5 percent on — or 6 percent — on equity. And I look at the reports but I don’t see the earning power now. Now, maybe it’ll all change. I mean, there’s talk of — there’s already been a small temporary tax cut, but corporate tax rates are quite high, as you know, in Japan. And they used to be 52 percent here in the United States, now they’re 35.

So you could have things happen that increase corporate profits, but I don’t have any special insight into that that anyone that reads the press generally would not have.

CHARLIE MUNGER: There are also readings in corporate culture that have to be made. Owning stock in a corporation where you know that if shareholders or somebody else has to suffer, the choice is likely to be that somebody else will be chosen. That is a different kind of a company to invest in than one that thinks that the principal purpose of life is to keep some steam boiler company going in a particular community or something, no matter how much the shareholders suffer. I think it’s hard to judge corporate culture in the foreign countries as well as we can judge it in our own.

32. “We’re only interested in price and value”

WARREN BUFFETT: Area five?

AUDIENCE MEMBER: Yvonne Edmonds (PH) from Cedar Mountain, North Carolina. I have a specific question but not a trivial one. You regularly compare Berkshire Hathaway’s performance to the S&P 500, which is very helpful and very interesting. But I haven’t seen a correlation coefficient between the S&P 500 daily — from day-to-day — performance — to close, say — and Berkshire Hathaway’s close. Now, it so happens for me — and I’m sure some other people in the audience — that I don’t always have access to newspapers — or the internet, for that matter — newspapers that publish Berkshire Hathaway performance on a daily basis, or even a weekly basis for that matter, or a monthly basis. It would be very helpful to know the extent of a correlation coefficient between those two variables. If you have that, would you let us know what it is? And if you don’t, would you please consider calculating it in the future?

WARREN BUFFETT: Well, it could be calculated but I don’t think it would have much meaning. I mean, it would be an historical correlation coefficient which, you know, I would be very reluctant to have people place any weight in. I try to indicate even the limitations of the yearly comparison of the relative performance, because what was doable by us in the past is not doable today. I mentioned in my annual report, the best decade I ever had on comparative performance by far was the 50s. Now, I don’t think it was because I was a lot smarter then — (laughs) — unwilling to accept that. But you know, I had some edge of — well, it’s probably 40-plus points per year. But I was working with it — that has no relevance to today whatsoever. It would be misleading to publish it or make calculations based on it. So I think that you would find — I don’t know what you’d find on a specific correlation between Berkshire and the S&P.

You’d find a lot of correlation — well, you might not find so much — you’d find it in intrinsic value between that and Coke, and a few stocks like that. But I don’t really think that’s particularly useful information going forward. We have no objection, anybody wants to make the calculation. But it wouldn’t be something that would be of any utility to us, and if we don’t think it’s utility to us, we don’t want to put it out for shareholders as being of possible utility. We do think that the S&P annual calculation has some meaning because it’s an alternative for people to invest. They don’t need us to buy the S&P. So unless, over time, we have some advantage over that, you know, what are we contributing? What value is added by our management? So we think that that’s — people should hold us accountable even though we would prefer not to be. Because it is a tough comparison for us as a tax-paying entity against a non — pre-tax calculation on the S&P.

But we don’t pay any attention to beta or any of that sort of thing. It just doesn’t mean anything to us. We’re only interested in price and value. And that’s what we’re focusing on all the time, and any kind of market movements or anything don’t mean anything. I don’t know what Berkshire is selling for today and it really makes no difference. You know, it just doesn’t make any difference. What does count is where it is 10 years from now. And I can’t tell you what it was selling for on May 4th, 1983, or May 4th, 1986, so I don’t care what it sells for on May 4th, 1998. I do care, you know, where it is, in general, 10 years from now, and that’s where all the focus is. Charlie?

CHARLIE MUNGER: Yeah, we’re publishing data in the form where we would like it if we were the passive shareholder. And so you’re getting the data and you’re getting it on a time schedule based on what we would want if we were in your position. And we don’t think — (laughter as Buffett holds up a Dairy Queen Dilly Bar that was just given to him) — and we don’t think the correlation coefficients would help us.

WARREN BUFFETT: We don’t think anything that relates either to volume, price action, relative strength, any of that sort of thing — and bear in mind, when I was in my teens I used to eat that stuff up. I mean, I was making calculations based on it all the time, and kept charts on it, even wrote an article or two on it. But it just — it just has no place in the operation now.

CHARLIE MUNGER: One of the pleasant things about dealing with Warren all these years is he’s never talked about a correlation coefficient. (Laughter) If the correlation isn’t so extreme you can see it with the naked eye, he doesn’t compute it. (Laughter)

33. Beware of companies that must “spend money like crazy”

WARREN BUFFETT: OK, we’re going to go to zone 6 and I’m going to have a Dilly Bar, and Charlie has got one here, too. (Laughter and applause) These are terrific.

AUDIENCE MEMBER: My question has to do with what you mentioned earlier about how companies have to reinvest a certain amount of cash in their business every year just to stay in place. And if one could say that the best businesses are the ones that not only throw off lots of cash, but can reinvest it in more capacity. But I suppose the paradox is that the better a company’s opportunities for making expansionary capital expenditures, the worse they appear to be as consumers of cash rather than generators of cash. What specific techniques have you used to figure out the maintenance capital expenditures that you need to do in order to figure out how much cash a company is throwing off? What techniques have you used on Gillette or other companies that you’ve studied?

WARREN BUFFETT: Well, if you look at a company such as Gillette or Coke, you won’t find great differences between their depreciation — forget about amortization for the moment — but depreciation and sort of the required capital expenditures. If we got into a hyperinflationary period or — I mean, you can find — you can set up cases where that wouldn’t be true. But by and large, the depreciation charge is not inappropriate in most companies to use as a proxy for required capital expenditures. Which is why we think that reported earnings plus amortization of intangibles usually gives a pretty good indication of earning power, and — I don’t — I’ve never given a thought to whether Gillette needs to spend a hundred million dollars more, a hundred million dollars less, than depreciation in order to maintain its competitive position. But I would guess the range is even considerably less than that versus its recorded depreciation. Businesses you have to worry about — I mean, an airline business is a good case. In the airlines, you know, you just have to keep spending money like crazy.

And you have to spend money like crazy if it’s attractive to spend money, and you have to spend it the same way if it’s unattractive. You just — it’s part of the game. Even in our textile business, to stay competitive we would’ve needed to spend substantial money without any necessary — any clear prospects of making any money when we got through spending it. And those are real traps, those kind of businesses. And they make out one way or another, but they’re dangerous. And in a See’s Candy we would love to be able to spend 10 million, 100 million, $500 million and get anything like the returns we’ve gotten in the past. But there aren’t good ways to do it, unfortunately. We’ll keep looking, but it’s not a business where capital produces the profits. At FlightSafety, capital produces the profits. You need more simulators as you go along, and more pilots are to be trained, and so capital is required to produce profits. But it’s just not the case at See’s.

And at Coca-Cola, particularly when new markets come along, you know, the Chinas of the world or East Germany or something of the sort, the Coca-Cola Company itself would frequently make the investments needed to build up the bottling infrastructure to rapidly capitalize on those markets, the old Soviet Union. So those are — those are expenditures — you don’t even make the calculation on them, you just know you’ve have to do it. You got a wonderful business, and you want to have it spread worldwide, and you want to capitalize on it to its fullest. And you can make a return on investment calculation, but as far as I’m concerned it’s a waste of time because you’re going to do it anyway, and you know you want to dominate those markets over time. And eventually, you’ll probably fold those investments into other bottling systems as the market gets developed. But you don’t want to wait for conventional bottlers to do it, you want to be there.

One of the ironies, incidentally — and might get a kick out of it, some of the older members of the audience — that when the Berlin Wall went down and Coke was there that day with CocaCola for East Germany, that Coke came from the bottling plant at Dunkirk. So there was a certain poetic — (crowd noise) — irony there. Charlie, do you have anything on this?

CHARLIE MUNGER: I’ve heard Warren say since very early in his life that the difference between a good business and a bad business is usually the good business just throws up one easy decision after another, whereas the bad business gives you a horrible choice where the decision is hard to make and, is this really going to work? And is it worth the money? If you want a system for determining which is a good business and which is a bad business, just see which one is throwing the management bloopers time after time after time. Easy decisions. It’s not very hard for us to decide to open a new See’s store in a new shopping center in California that’s obviously going to succeed. It’s a blooper. On the other hand, there are plenty of businesses where the decisions that come across your desk are just awful. And those businesses, by and large, don’t work very well.

WARREN BUFFETT: I’ve been on the board of Coke now for 10 years, and we’ve had project after project come up, and there’s always an ROI. But it doesn’t really make much difference to me, because in the end almost any decision you make that solidifies and extends the dominance of Coke around the world in an industry that’s growing by a significant percentage, and which has great inherent underlying profitability, the decisions are going to be right and you’ve got people there that will execute them well.

CHARLIE MUNGER: You’re saying you get blooper after blooper.

WARREN BUFFETT: Yeah. And then Charlie and I sat on USAir, and the decisions would come along, and it would be a question of, you know, do you buy the Eastern Shuttle, or whatever it may be? And you’re running out of money. And yet to play the game and to keep the traffic flow with connecting passengers, I mean, you just have to continually make these decisions — whether you spend a hundred million dollars more on some airport. And they’re agony because, again, you don’t have any real choice, but you also don’t have any real conviction that it’s going to translate — those choices are going to — or lack of choices — are going to translate themselves into real money later on. So one game is just forcing you to push more money in to the table with no idea of what kind of a hand you hold, and the other one you get a chance to push more money in, knowing that you’ve got a winning hand all the way. Charlie? Why’d we buy USAir? (Laughter) Could’ve bought more Coke.

34. Berkshire is prepared for adversity

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: My name is Bakul Patel (PH). I am from upstate New York. And my question is, is Berkshire prepared for 1929 style of depression or, like, a prolonged bear market that exists in Japan? And would it be as successful in those situations?

WARREN BUFFETT: Well, we are probably — we don’t expect what you’re talking about, but we are probably about as well-prepared as any company can be for adversity, because Berkshire has been built to last. Net, we would benefit over a 20-year period by having some periods of terrible markets periodically in that 20-year period. That doesn’t mean we’re wishing for them and it doesn’t mean they’re going to happen, but — We make our money by allocating capital well, and the lower the general stock market would be, the better we can allocate capital. So we’re well-prepared but we’re not necessarily expecting. Charlie?

CHARLIE MUNGER: Yeah, we are not going to ever sell everything and go to cash and wait for the crash so we can go back in. On the other hand, we are structured so that I think, net, a lot of turmoil in the next 20 years will help us, not hurt us. I don’t mean it’ll be pleasant to go through the downcycle, but it’s part of the game.

35. “We’re never going to give out advice on Berkshire stock”

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: My name is Pete Banner (PH) from Boulder, Colorado. First of all, Mr. Buffett and Mr. Munger, thank you for your genuine generosity today. Berkshire closed yesterday, the A share was about — or Friday — $69,000 and the B share was about $2,300. Do you feel that price is grossly overpriced, or grossly underpriced, or reasonably priced?

WARREN BUFFETT: Well, I’ll let Charlie answer that one. (Laughter)

CHARLIE MUNGER: I’m not going to say. (Laughter)

WARREN BUFFETT: No, we’re just never going to — we’re never going to give out advice on Berkshire stock. There’s no — You know, that is up to people who want to buy and sell it, and anything we would say could easily get magnified, and people would be acting on it months later, and who knows all the problems that it could produce, so —

CHARLIE MUNGER: It would be quite eccentric if we were to every day put out an announcement, “Now’s the time to buy, now’s the time to sell,” our own stock. Eccentric we are, but that eccentric we aren’t. (Laughter and applause)

36. George Burns: role model for surviving unhealthy habits

WARREN BUFFETT: Area 9.

AUDIENCE MEMBER: Irene Finster, your longtime partner from Tulsa, Oklahoma —

WARREN BUFFETT: Hi, Irene. Yeah, Irene has a soda fountain. You ought to go visit her. (Laughter)

AUDIENCE MEMBER: First I want to thank you for giving your shareholders the opportunity to select their own charities. And second, I’m very concerned about your health due to your diet — (Laughter) — of red meat —

WARREN BUFFETT: Irene. (Applause) Irene, these are our products that I’m eating. (Laughter)

AUDIENCE MEMBER: Red meat, candy, ice cream — (laughter) — and —

WARREN BUFFETT: And that’s just what I do — that’s what I do in public —

AUDIENCE MEMBER: —and Coke. (Laughter) And I want to know what your doctor says. (Laughter)

WARREN BUFFETT: My doctor says I must be heavily relying on my genes. (Laughter) No, I will tell you, I — I mean, Charlie and I are both very healthful. If you were in the life insurance business, you would be happy to write us at standard rates, I could assure you of that. (Laughter)

CHARLIE MUNGER: You know, they asked George Burns when he was 95, “What does your doctor say about smoking these big, black cigars?” And he said, “My doctor’s dead.” (Laughter and applause)

WARREN BUFFETT: Charlie and I played bridge with George when he was about 97, I’d say, at the Hillcrest Country Club. And there was a big sign behind him that said, “No smoking by anyone under 95.” (Laughter) And actually, at his 95th birthday party, he had about five very good-looking young girls that were there to greet him with a big cake and everything. And he looked them over one after another and he said, “Oh girls,” he said, “I’m 95. One of you is going to have to come back tomorrow.” (Laughter and applause) We’re very big on George Burns in recent years. (Laughter)

37. “We wait indefinitely”

WARREN BUFFETT: Area 10.

AUDIENCE MEMBER: My name is Hubert Vose (PH). I’m from Santa Barbara, California. Earlier this morning, you made a comment that if the market fell you would be spending less time on the internet because you’d be very busy. And this is reinforced an impression I have had that the cash flows of Berkshire Hathaway are enormous, but that possibly in the last 12 months you’ve been investing less than you had previously. And if so — if this is correct, what does that say about waiting for attractive values? How long are you willing to wait, and what does that say to the investment public in their own habits?

WARREN BUFFETT: Well, you’re correct that we have not found anything to speak of in equities in a good many months, and — The question of how long we wait, we wait indefinitely. We are not going to buy anything just to buy something. We will only buy something if we think we’re getting something attractive. And that — and incidentally, if things were 5 percent cheaper that — or 10 percent cheaper — that wouldn’t change anything materially. So we have no idea when that period ends. We have no idea whether — as I’ve said, it can turn out that these valuations are perfectly appropriate if returns on equity stay where they are. But even then, they aren’t in the least mouthwatering, so we won’t feel we’ve missed anything particularly if returns stay where they are. Because if it turns out that these levels are OK, they still will not produce great returns from here, in our view. That doesn’t mean you couldn’t have a tremendous market in the short-term or something of the sort. Markets can do anything.

And you look at the history of markets and you just see everything under the sun. But we will not — you know — we have no timeframe. If the money piles up, the money piles up. And when we see something that makes sense, we’re willing to act very fast, very big. But we’re not willing to act on anything that doesn’t check out in our view. There’s no — you don’t get paid for activity, you only get paid for being right. Charlie?

CHARLIE MUNGER: Yeah. An occasional dull stretch for new buying, this is no great tragedy in an investment lifetime. Other things may be possible in such an era, too. I mean, it isn’t like we have a quiver with only one arrow.

WARREN BUFFETT: We sat through periods before. I mean, the most dramatic one being the early ’70s — late ‘60s and early ’70s. For a long time it seemed — doesn’t seem so long when you look back on it, seems long when you’re going through it — but it — like having a tooth pulled or something, but it’s, you know, what can you do about it? The businesses aren’t going to perform better in the future just because you got antsy and decided you had to buy something. We will wait till we find something we like. We’ll love it when we can swing in a big way, though. That’s our style.

38. “Certified record of failure” in real estate

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: Larry Pekowski (PH), Millburn, New Jersey. Berkshire seems never to have made any real, pure real estate investments, not counting facilities the operating companies might own, with the exception of Wesco’s involvement in the residential project in California. I was wondering if you’ve ever looked at a real estate transaction and tried to apply the same filters, meaning competitive advantages, returns on capital, that you do in operating companies. And if not, is it a circle of competence issue, or is there something you find disinteresting about real estate?

CHARLIE MUNGER: (Inaudible)

WARREN BUFFETT: You want to take it? OK, Charlie wants to take this one.

CHARLIE MUNGER: Let me take this one, because here’s an area where we have a perfect record that extends over many decades. We have been demonstrably foolish in almost every operation that had to do with real estate we’ve ever touched. Every time we had a surplus plant and didn’t want to hit the bid and let some developer kind of take an unfair advantage of us, we would of been better off later if we’d hit the bid and invested the money in fields where we had the expertise. That housing tract that I developed because I didn’t want to let the zoning authorities rob me the way they wanted to. I wish I had let them. (Laughter) We have a certified record of failure in this deal. (Laughter)

WARREN BUFFETT: And the funny thing is, we understand real estate. (Laughter)

CHARLIE MUNGER: And we’re good at it. (Laughter and applause) Right.

WARREN BUFFETT: Actually, (inaudible), we do understand real estate. And Charlie got his start in real estate.

CHARLIE MUNGER: Yeah, be we understand other things better. And so the chances that we’re going to be big in real estate are low.

WARREN BUFFETT: Yeah. We’ve seen lots of things, and we’ve — the prices, you know, just don’t intrigue us, in terms of what we get for our money. I tried to buy a town when I was, what, 21 years old. The U.S. government had a town in Ohio for sale and it would of worked out very well. I’m always — there’s nothing about the arena that turns us off, but we don’t see great returns available. And like Charlie says, the few things — (inaudible) old plant or something, that is not — we have not been great at working our way out of those. Fortunately, they haven’t been very important in relation to the net worth of Berkshire.

39. Nike: “We keep all of those views to ourselves”

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: Good afternoon. My name is Fred Costano (PH) from Detroit, Michigan. My question concerns Nike. Nike is a company experiencing some short-term problems, but it’s a great company with an excellent track record. Phil Knight is similar to Bill Gates in the respect that he’s a marketing genius and is a very hard worker. Making sneakers is a very simple business with high margins. How do you view Nike and what do you think of the company?

WARREN BUFFETT: Well, I think Phil Knight is a terrific operator. I think — and he’s a competitor. He’s got a lot of money in Nike. But as terms of what we think of the stock, you know, we keep all of those views to ourselves pretty much.

40. Buffett doesn’t expect litigation over fats in food

WARREN BUFFETT: Area 3? (Laughter)

AUDIENCE MEMBER: Hello, my name is Ed Clinton and I’m from Chicago, Illinois. I’m wondering about the tobacco litigation. There’s also — there have been some comments about fatty food. Do you think there’s going to be a new trend of fatty food litigation coming out of the tobacco problems?

WARREN BUFFETT: Well, I sign a waiver before I — (laughs) — do any of that myself. No, I would doubt — I would — I do not see those two as being remotely similar. But Charlie, do you have any different views on it?

CHARLIE MUNGER: Well, I think the traditional tort system is particularly ill-suited for solving what might be called the tobacco health problem. So I regard that whole thing as sort of a Mad Hatter’s Tea-Party. And we sit out from afar.

41. Lots of credit to go around for strong economy

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Yes, I’m Fred Bunch from near Tightwad, Missouri. In light of the current —

WARREN BUFFETT: What was the name of that town? (Laughter)

AUDIENCE MEMBER: Tightwad, Missouri.

WARREN BUFFETT: Tightwad, Missouri, huh? (Laughter)

AUDIENCE MEMBER: There’s a bank there.

WARREN BUFFETT: Did they name it after me or Charlie? (Laughter)

AUDIENCE MEMBER: Well, either one, really. (Buffett laughs) You’d both fit in. (Buffett laughs) In light of today’s healthy growth and stability of the American economy at the present time and over the last five years or so, how much credit, if any, do you give the Clinton administration and why?

WARREN BUFFETT: Well, I give credit to — I give credit going back to Volcker, significant credit to Volcker. I give credit to Reagan. I give credit to — certainly to Greenspan and to Rubin, and I give credit to Clinton on that — I think that first tax bill was very important. It carried by one vote. And I think he may listen to Rubin. So I think there’s a lot to give credit for and I think you can spread it around a fair amount. Charlie may be less charitable here. Let’s see. (Laughter)

CHARLIE MUNGER: No, I’ve got no great quarrel with the way the country — the economy’s reformed. I think it’s way better than any of us would’ve predicted.

42. How Phil Fisher’s “scuttlebutt” method changed Buffett’s life

WARREN BUFFETT: Area 5?

AUDIENCE MEMBER: My name is Travis Heath (PH). I’m from Dallas, Texas. And my question regards what Phil Fisher referred to as “scuttlebutt.” When you’ve identified a business that you consider to warrant further investigation — more intense investigation — how much time do you spend commonly, both in terms of total hours and in terms of the span in weeks or months that you perform that investigation over?

WARREN BUFFETT: Well, the answer to that question is that now I spend practically none because I’ve done it in the past. And the one advantage of allocating capital is that an awful lot of what you do is cumulative in nature, so that you do get continuing benefits out of things that you’d done earlier. So by now, I’m probably fairly familiar with most of the businesses that might qualify for investment at Berkshire. But when I started out, and for a long time I used to do a lot of what Phil Fisher described — I followed his scuttlebutt method. And I don’t think you can do too much of it. Now, the general premise of why you’re interested in something should be 80 percent of it or thereabouts. I mean, you don’t want to be chasing down every idea that way, so you should have a strong presumption. You should be like a basketball coach who runs into a seven-footer on the street. I mean, you’re interested to start with; now you have to find out if you can keep him in school, if he’s coordinated, and all that sort of thing.

That’s the scuttlebutt aspect of it. But I believe that as you’re acquiring knowledge about industries in general, companies specifically, that there really isn’t anything like first doing some reading about them, and then getting out and talking to competitors, and customers, and suppliers, and ex-employees, and current employees, and whatever it may be. And you will learn a lot. But it should be the last 20 percent or 10 percent. I mean, you don’t want to get too impressed by that, because you really want to start with a business where you think the economics are good, where they look like seven-footers, and then you want to go out with a scuttlebutt approach to possibly reject your original hypothesis. Or maybe, if you confirm it, maybe do it even more strongly. I did that with American Express back in the ’60s and essentially the scuttlebutt approach so reinforced my feeling about it that I kept buying more and more and more as I went along. And if you talk to a bunch of people on an industry and you ask them what competitor they fear the most, and why they fear them, and all of that sort of thing.

You know, who would they use the silver bullet of Andy Grove’s on and so on, you’re going to learn a lot about it. You’ll probably know more about the industry than most of the people in it when you get through, because you’ll bring an independent perspective to it, and you’ll be listening to everything everyone says rather than coming in with these preconceived notions and just sort of listening to your own truths after a while. I advise it. I don’t really do it much anymore. I do it a little bit, and I talked in the annual report about how when we made the decision on keeping the American Express when we exchanged our Percs for common stock in 1994, I was using the scuttlebutt approach when I talked to Frank Olson. I couldn’t have talked to a better guy than Frank Olson. Frank Olson, running Hertz Corporation, lots of experience at United Airlines, and a consumer marketing guy by nature. I mean, he understands business.

And when I asked him how strong the American Express card was and what were the strengths and the weaknesses of it, and who was coming along after it, and so on, I mean, he could give me an answer in five minutes that would be better than I could accomplish in hours and hours and hours or weeks of roaming around and doing other things. So you can learn from people. And Frank was a user of it. I mean, Frank was paying X percent to American Express for his Hertz cars. And Frank doesn’t like to pay out money, so why was he paying that? And if he was paying more than he was paying on Master Charge or Visa, why was he paying more? And then what could he do about it? I mean, you just keep asking questions. And I guess Davy [Lorimer Davidson] explained that in that video we had ahead of time. I’m very grateful to him for doing that, because that was a real effort for him.

But that was really what I was doing back in 1951 when I visited him down in Washington, because I was trying to figure out why people would insure with GEICO rather than with the companies that they were already insuring with, and how permanent that advantage was. You know, what other things could you do with that advantage? And you know, there were just a lot of questions I wanted to ask him, and he was terrific in giving me the answer. It, you know, changed my life in a major way. So I have nobody to thank but Davy on that. But that’s the scuttlebutt method and I do advise it. Charlie?

CHARLIE MUNGER: Nothing to add.

43. “Real test is the gain in intrinsic value”

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: Hi, my name is Richard Lontok (PH) from Toronto, Canada. I have a question for both of you. Mr. Buffett, Berkshire Hathaway’s earnings in 1997 is less than that of 1996. What do you intend to do in 1998 to improve that earning. (Laughter) And Mr. Munger, I’ve been watching you and Mr. Buffett eating the See’s candies and drinking the Coca-Cola the whole day.

WARREN BUFFETT: Join in. (Laughter)

AUDIENCE MEMBER: Do you intend to do any commercials in the future like what Dave Thomas does with Wendy’s? (Laughter and applause)

WARREN BUFFETT: Which of us do you think should do them? (Laughs) Now you’re talking.

CHARLIE MUNGER: We aren’t old enough to be really good in a commercial. (Laughter) What we would like to do is have somebody up here happily eating See’s candy and answering these questions who’s about 110 years old. Now, that would really be helpful.

WARREN BUFFETT: We — in terms of the earnings, the final bottom line GAAP reported earnings mean absolutely nothing at Berkshire to us. Now, the look-through earnings which we publish do have some meaning, but even those have to be interpreted in terms of whether there was a super-cat occurrence, or whether GEICO had an unusually good year, and we try to mention those factors. But we do hope that the look-through earnings do build at a reasonable clip over time. But our final earnings include capital gains and we can report those in any number that we wanted to, and we pay no attention whatsoever to realized capital gains at Berkshire. The IRS does, but — and that’s why we may send them a billion or more dollars this year. But they mean nothing in terms of measuring our progress. The look-through earnings say something about it. That table, the first couple of pages, it shows our change in book value versus the S&P says something about it, not perfect. The real test is the gain in intrinsic value, for sure, over time.

And there’s no hard number for that, but so far Charlie and I judge it satisfactory, but we also judge it as non-repeatable. Charlie, anything more —?

CHARLIE MUNGER: No.

44. “We prefer what other people call risk”

WARREN BUFFETT: Area 7, please.

KEIKO MAHALICK: Good afternoon, Mr. Buffett and Mr. Munger. My name is Keiko Mahalick (PH) and I’m an M.B.A. student at Wharton, but please don’t hold that against me.

WARREN BUFFETT: We won’t. (Laughter) I never made it that far. I was an undergraduate student. (Laughs)

AUDIENCE MEMBER: Could you please explain how you differentiate between types of businesses in your cash flow valuation process, given that you use the same discount rates across companies? For example, in valuing Coke and GEICO, how do you account for the difference in the riskiness of their cash flows?

WARREN BUFFETT: We don’t worry about risk in the traditional — the way you’re taught, actually, at Wharton. We — (Laughter) But it’s a good question, believe me. But we are — if we could see the future of every business perfectly, it wouldn’t make any difference whether the money came from running streetcars or from selling software, because all the cash that came out, which is all we’re measuring between now and judgment day, would spend the same to us. It really — the industry that it’s earned in means nothing except to the extent that it may tell you something about the ability to develop the cash. But it has no meaning on the quality of the cash once it becomes distributable. We look at riskiness, essentially, as being sort of a go/no-go valve in terms of looking at the future businesses. In other words, if we think we simply don’t know what’s going to happen in the future, that doesn’t mean it’s necessarily risky, it just means we don’t know. It means it’s risky for us.

It might not be risky for someone else who understands the business. In that case, we just give up. We don’t try to predict those things. And we don’t say, “Well, we don’t know what’s going to happen, so therefore we’ll discount it at 9 percent instead of 7 percent,” some number that we don’t even know. That is not our way to approach it. We feel that once it passes a threshold test of being something about which we feel quite certain, that the same discount factor tends to apply to everything. And we try to do only things about which we are quite certain when we buy into the businesses. So we think all the capital asset pricing model-type reasoning with different rates of riskadjusted return and all that, we tend to think it is — well, we don’t tend to — we think it is nonsense. But we do think it’s also nonsense to get into situations, or to try and evaluate situations, where we don’t have any conviction to speak of as to what the future is going to look like.

And we don’t think you can compensate for that by having a higher discount rate and saying it’s riskier, so then I don’t really know what’s going to happen and I’ll have a higher discount rate. That just is not our way of approaching things. Charlie?

CHARLIE MUNGER: Yeah. This great emphasis on volatility in corporate finance we just regard as nonsense. If we have a statistical probability of putting out a million and having it turn into — Put it this way: as long as the odds are in our favor and we’re not risking the whole company on one throw or anything close to it, we don’t mind volatility in results. What we want is the favorable odds. We figure the volatility, over time, will take care of itself at Berkshire.

WARREN BUFFETT: If we have a business about which we’re extremely confident as to the business result, we would prefer that it have high volatility than low volatility. We will make more money out of a business where we know where the endgame is going to be if it bounces around a lot. I mean, for example, if people reacted to the monthly earnings of See’s, which might lose money eight months out of the year and makes a fortune, you know, in November and December — if people reacted to that and therefore made its stock as an independent company very volatile, that would be terrific for us because we would know it was all nonsense. And we would buy in July and sell in January. Well, obviously, things don’t behave that way. But when we see a business about which we’re very certain, but the world thinks that its fortunes are going up and down, and therefore it behaves volatile — with great volatility — you know, we love it. That’s way better than having a lower beta. So we think that — we actually would prefer what other people would call risk.

When we bought The Washington Post — I’ve used that as — it went down 50 percent in a matter of a few months. Best thing that could’ve happened. I mean, doesn’t get any better than that. Business was fundamentally very nonvolatile in nature. I mean, TV stations and a strong, dominant newspaper, that’s a nonvolatile business, but it was a volatile stock. And you know, that is a great combination from our standpoint.

45. We want shareholders who look at Berkshire the same way we do

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: Good afternoon, and thank you for staying around to answer our questions. I have two. First of all, would you give us what logic went into your decision to both buy and sell McDonald’s? And my second question goes to a term that you’ve used. You talked about the caliber of the shareholders at Berkshire Hathaway. How do you define the caliber and what difference does it really make?

WARREN BUFFETT: Well, it makes a lot of difference. Our idea of a high-caliber group is one that is just like us. (Laughter) And that’s not entirely facetious in that we basically want shareholders who look at the business the same way we do. Because we’re going to be around running something, and what could be worse than having a group out there had a whole different set of expectations than we did, and evaluated us in a different way, and all of this sort of thing? I mean, if you are going to — you’re going to have a given number of shares outstanding. Let’s say we have an equivalent of a million, two-hundred and some thousand A shares. Somebody’s going to own every single share. Now, would you rather have them owned by people who understand your business, who understand your objectives, who measure you the same way you do, who have similar time horizons, or would you rather have the reverse? It makes a real difference over time to be in with people that are compatible with you.

So it’s a significant plus to us, the operation of the business, and it leads to a more consistent relationship between price and intrinsic value when you have a group like that, because they understand themselves and the business, and they’re not likely to do silly things in either direction. So you get a much more consistent relationship than if we had a whole bunch of people who were thinking that the most important thing in evaluating this business was next quarter’s earnings. Question about McDonald’s simply is, you know, it’s an outstanding business and we don’t talk about it when we buy it, we don’t talk about it if we sell it. Charlie?

CHARLIE MUNGER: Yeah. The question of what difference does it make to the management who the shareholders are, well, if you are into what I call trustee capitalism, where the shareholders aren’t just a faceless bunch of nothings, you feel as a kind of a hair shirt, an obligation to do as well as you can by the shareholders. Well, wouldn’t you rather feel an obligation to people you liked instead of people you didn’t like? (Laughter)

WARREN BUFFETT: Yeah, let’s say you were running a business and — (applause) — and you had a choice of three owners. You could have a hundred percent of it owned by whatever your favorite philanthropy is, you could have a hundred percent of it owned by the U.S. government, and you could have a hundred percent of it owned by, you know, the worst person you can think of, you know, in your hometown. I mean, I think it would make a difference in how you felt about going to work every day.

46. “Get more quality than you’re paying for”

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: Yes, my name is Steve Jack (PH). I’m from Southern California. And my question has to deal with kind of quality versus price. I’ve been to three annual meetings and I’ve heard great things about Coke every year. But as far as I’m aware, you have not bought any additional shares of Coke over the last three years even though the stock has done just fine. If an investor has a relatively short timeframe, say three to five years, how much weight do you think one should give to quality versus price?

WARREN BUFFETT: Well, if your timeframe is three to five years, A) I wouldn’t advise it being that way. Because I think if you think you’re going to get out then, it gets more toward — leaning toward the bigger fool theory. The best way to look at any investment is, how will I feel if I own it forever, you know, and put all my family’s net worth in it? But we basically believe in buying — if you talk about quality meaning the certainty that the business will perform as you expect it to perform over a period of time, so the range of possible performance is fairly narrow — you know, that’s the kind of business we like to buy. And all I can say is that we like to pay a comfortable price, and that depends to some extent on what interest rates are. We haven’t found comfortable prices for the kind of businesses we like in the last year. We don’t find them uncomfortable, in the sense that we want to sell them.

But they’re not prices at which we — we added to Coke one time about, I don’t know, five years ago or thereabouts, and it’s conceivable we would add again. It’s a lot more conceivable we would add than subtract. But that’s the way we feel about most of the businesses. We did make a decision last year that we thought bonds were relatively attractive, and we trimmed certain holdings and eliminated certain small holdings in order to make a bigger commitment in bonds. Charlie?

CHARLIE MUNGER: Yeah. You talk about quality versus price. The investment game always involves considering both quality and price. And the trick is to get more quality than you’re paying for in the price. It’s just that simple.

WARREN BUFFETT: But not easy.

CHARLIE MUNGER: No, but not easy.

47. No interest in spinning off subsidiaries

WARREN BUFFETT: Area 10.

AUDIENCE MEMBER: Gentlemen, good afternoon. Jeff Kirby from Green Village, New Jersey. Would you comment please on tax-free spinoffs to shareholders in general, and particularly how you would feel about those were you to believe that a materially higher value would be ascribed to one of your operating companies in the public arena than as part of Berkshire Hathaway?

WARREN BUFFETT: Well, there’s certainly been times in Berkshire’s history when certain components of Berkshire might well have sold at higher multiples as individual companies than the amount they contributed to the whole of Berkshire, although I don’t think that would be the case now. But our reaction to spinoffs would be — even if we thought there was some immediate market advantage, it would have no interest, basically, to us. We like the group of businesses we have as part of a single unit at Berkshire. We hope to add to that group of businesses. We will add to that group of businesses over time. And the idea of creating a lot of little pieces because we could get a little more market value in the short term, it just doesn’t mean anything to us. Charlie?

CHARLIE MUNGER: Yeah, it would add a lot of frictional costs and overheads. We have the — I don’t know anybody our size who has lower overhead than we do, and we like it that way.

WARREN BUFFETT: Yeah. (Applause) Right now our after-tax cost of running the operation has gotten down to a half a basis point of capital value. And when you think that many mutual funds are at 125 basis points that means they have 250 times — (laughs) — the overhead ratio to capitalization that we have —

CHARLIE MUNGER: And all they’ve got is a bunch of marketable securities, and we got that plus businesses.

WARREN BUFFETT: Yeah. We don’t need any more, incidentally —

CHARLIE MUNGER: We can get lower, Warren. (Buffett laughs) We can get a lot lower —

WARREN BUFFETT: Yeah, I know. I know. (Laughter) You think they’d [Berkshire’s board of directors] work for $500 a year instead of $900, Charlie? (Laughter) Groans from the front row.

48. Shareholders boost sales at Nebraska Furniture Mart and Borsheims

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. I was kind of curious if you could tell me, do you know or can you tell us how much business Nebraska Furniture Mart and Borsheims did this weekend? And secondly, do you have any interest in investing in the auto industry? And if not interested now, what would change your mind about this industry in the future?

WARREN BUFFETT: Well, the first question, I don’t know what the Mart did but I do know they had a lot of shareholders there. Got a verbal report on that. There would be less change in their normal — they do — you know, you’re talking about a company that — at the Mart — that does $800,000 a day on average. It is a big operation. So our shareholders have an impact, but not the relative impact that they would have at Borsheims. Borsheims did over twice as much this year as last year, and they had a big day. (Laughter)

49. No special insights into automobile industry

WARREN BUFFETT: And what was the other question, Charlie?

AUDIENCE MEMBER: — industry. The auto industry.

WARREN BUFFETT: Oh, the auto industry. Yeah, Charlie was big in General Motors in the mid’60s, right Charlie? It was your biggest commitment?

CHARLIE MUNGER: I had a temporary delusion. (Laughter) Luckily, it passed. (Laughter)

WARREN BUFFETT: Yeah. No, he made money on it.

CHARLIE MUNGER: Yes, I did.

WARREN BUFFETT: We — it’s the kind of industry that’s — it’s interesting for us to follow. I mean, many years ago it was the dominant factor — or overwhelming factor — in the economy. It’s diminished a fair amount but it’s still a very important industry. And it’s the kind of industry that anyone can follow. I mean, you have experience with the product and competing products, and you — everyone in this room understands in a general way the economic nature of the industry. But we’ve never felt that we understood it better than other people. So we’ve seen auto companies at very low multiples sometimes and with prices that in hindsight looked very attractive, but we never really felt that we knew who among the auto companies five years from now would have gained the most ground relative to where they are now, or that gained the most ground relative to what the market might expect. It just isn’t given to us, that knowledge. Charlie?

CHARLIE MUNGER: I agree.

50. Selling on internet could help Borsheims and GEICO

WARREN BUFFETT: Area two.

SCOTT RUDD: Hi, my name is Scott Rudd from Evening Prairie, Minnesota. And my question is this: ten years from now — and I’m referring to Borsheims as the retail part of it to the consumer, not so much the corporate division — ten years from now, what would be the three things that you would expect to change on a day-to-day operating basis, to change the most and affect your ability to be dominant in that area.

WARREN BUFFETT: Well, I think — are you talking about Borsheims specifically?

AUDIENCE MEMBER: Yes.

WARREN BUFFETT: Yeah, I think Borsheims — I won’t have three things — but Borsheims may be one of a couple of our companies where the internet could be a huge — have a huge potential for us. I don’t know if that’ll happen, but there’s no question that we operate — and I’ve got a message on the internet — at considerably — very considerably — lower gross margins than does a Tiffany or publicly-held jewelry operations. We are giving customers considerably more for their money. We’ve got way lower operating costs than the public companies. And I say on the internet, our operating costs are 15 to 20 percentage points, and even more in some cases, less than publicly-owned competitors. So we’ve got a lot to offer. Now, the big question people always have with jewelers is, “How do you know who to trust?” I mean, you know, it is an article that most people feel very uncomfortable buying. And I think that the Berkshire Hathaway identification can help people feel comfortable on it. I think that the experience of customers around the country as they see it.

And I don’t think that — I think it’s a product — it’s a high-ticket item, so saving money gets to be really important. Just like auto insurance, saving money gets to be really important. So I think that the internet could be of significant assistance to Borsheims in terms of spreading and facilitating its nationwide reputation. So Borsheims could have a lot of growth and the internet could be a big part of it. Our job is to get the message to people around the country that they can literally, you know, have us send a half a dozen items to them, that they can look at with no high-pressure salesmanship at all or anything of the sort, and look at the prices, decide what they want in their own homes, and they will do very well with us. And we have a lot of people taking advantage of that now. But we could have 10, or 20, or 50 times that number as the years go by. And I think we should work very hard on that. GEICO has possibilities through the internet, obviously, also.

Anything where you’re offering a terrific deal to the consumer, but one of the problems has been how do you talk to that consumer, you know, the internet offers possibilities (inaudible). The thing is that everybody in the world is going to be there, and why should they click on you instead of somebody else? Actually, the Berkshire Hathaway name may help a little bit on that, although GEICO’s name is extremely well known. GEICO is — I said in the annual report we were going to spend a hundred million dollars in — basically in promotion this year. We’ll spend more money than that. The brand potential in GEICO is very, very big. And we intend to push and push and push on that. Charlie?

CHARLIE MUNGER: Well all that said, if the internet helps some of our business, why certainly the CD-ROM and the personal computer combined to clobber World Book for us.

WARREN BUFFETT: Yeah, we paid our entry fee.

CHARLIE MUNGER: Yeah, we — (laughter) — it’s not all plus.

WARREN BUFFETT: No.

51. McDonald’s vs. Dairy Queen

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: My name is Jorge Gobbi (PH) from Zurich, Switzerland and my question refers to food businesses, mainly McDonald’s and Dairy Queen. Are there major differences in the investment territories fixed between McDonald’s and Dairy Queen? And if yes, would you explain them?

WARREN BUFFETT: Yeah, there are major differences. McDonald’s owns, perhaps, in the area of a third of all locations worldwide. I can’t tell you the exact percentage, but if they’ve got 23,000 outlets, they own many, many thousands of them, and operate them. And then of the remainder, they own a very high percentage and lease them to their operators, their franchisees. So they have a very large investment, on which they get very good returns, in physical facilities all over the world. Dairy Queen has — counting Orange Julius— 6,000-plus operations, of which 30-odd are operated by the company. And even those, some are in joint ventures or partnerships. So the investment in fixed assets is dramatically different between the two. The fixed-assets investment by the franchisee, or the person — his landlord — obviously is significant at a Dairy Queen. But it’s not significant to the company as the franchisor, so that the capital employed in Dairy Queen is relatively small compared to the capital employed in McDonald’s.

But McDonald’s also makes a lot of money out of owning those locations and receives — Whereas Dairy Queen will, in most cases, receive 4 percent of the franchisee’s sales, in terms of a royalty, at a McDonald’s there’s that — there’s more than that percentage, plus rentals and so on. So they’re two different — very different — economic models. They both depend on the success of the franchisee in the end. I mean, you have to have a good business for the franchisee to, over time, have a good business for the parent company. Both companies have that situation to deal with. Charlie?

CHARLIE MUNGER: I’ve got nothing to add. The 4 percent is not very much when you stop to think about providing a group of franchisees with a nationally recognized brand, and quality control, and all sorts of desirable business aids.

WARREN BUFFETT: No, 4 percent is at the low — if you look at the whole industry — 4 percent is in the lower part of the range. But it works fine —

CHARLIE MUNGER: Part of what attracted us was the fact that the charges to the franchisees are low at Dairy Queen.

WARREN BUFFETT: A successful franchisee can sell his operation for significantly more than he has invested in tangible assets. And we want it that way, obviously, because that means he’s got a successful business, and it means that, over time, we will have a successful business. You want — you want a franchise operation — you want the franchise operator to make money and you want him to create a capital asset that’s worth more than he’s put in it. That’s the goal.

52. Making money with the Byrne family

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Good afternoon, Mr. Munger and Mr. Buffett. My name is Patrick Byrne, I’m a shareholder, and I’m here from Cincinnati, Ohio, back again this year to ask a question to see if I can get the two of you to disagree on a subject. I’ve picked education as an area where we might see some daylight between the two of you. First though, on the subject of education, I’d like to offer some brief thanks. I’m lucky in that my parents, in the late ’70s, made the wise choice of buying some Berkshire stock and putting it in a college fund for my brothers and me, and that basically paid for our higher education. I suspect there must be thousands of people like us who had our education paid for by wealth that the two of you created, and we owe you. Although we probably all have been a lot better to skip college and keep the stock. (Laughter and applause) Well, on the subject of education, Milton Friedman has said, or has written, that if you really care about poverty in the U.S.

and the disadvantage of women and minorities and so on, and you could cure one single thing in the U.S., it would be the public education system. Mr. Buffett, of course you’ve been very publicly supportive and done many things, and I’m sure Mr. Munger has as well, for public education. But I noticed last year, in this annual meeting, Mr. Munger — or both of you, of course, criticized some aspects of higher education, like business schools. But Mr. Munger included — he was a tad critical, I would say, of the U.S. public education system. And I wonder if you two agree with what Friedman says and what you think the importance of public education is, and what might be done to improve it.

WARREN BUFFETT: I’m going to let Charlie go in a second, but I just want to say, Patrick Byrne is the son of Jack Byrne, who made a fortune for us by resuscitating GEICO when it got into trouble in the mid-’70s. In fact, I met Patrick’s dad on a Wednesday night, about 8 o’clock at night, in Washington, when GEICO was — it was bankrupt and it was about — very close to being declared so. And after talking with him about three hours that night, the next day I went out and bought 500 and some-thousand shares of GEICO, that Davy [Lorimer Davidson] referred to, at 2 1/8, so — which is forty cents on the stock that we paid $70 for later on. So Patrick’s dad — we may have made — (laughs) — we may have made the Byrne family more money; he made us a lot of money. Patrick is now running Fechheimers in Cincinnati and doing a sensational job.

His brother, Mark, on June 30, if we hit the target date, will be establishing a major operation in London and Bermuda that will — in which we will be a very large partner. So he’s only got one other brother left, and he’s out playing golf in California. But if times get tough we’re going to try and recruit him, too.

53. Fixing public education

WARREN BUFFETT: Charlie, with all that time to prepare, what do you have to say about education? (Laughs)

CHARLIE MUNGER: Well, I certainly agree with Milton Friedman, that there’s — it would be hard to name one factor, if we could fix it, that would be more worthy of fixing than education in the United States, particularly the lower grades in education where the failures are so horrible, in many big cities particularly. So yes, I think it’s a terrible problem and it needs fixing. Of course, it’s a huge debate as to what the best way is to fix it. And I am skeptical, myself, of big city school systems getting fixed under their own momentums. In other words, I’m quite sympathetic to the people who say we may have to go to an alternative, like vouchers. That the incentive structure has — (applause) — gotten so bad in some places that you can’t fix it with evolution; it takes revolution. Warren, you’re more optimistic about big city public schools —

WARREN BUFFETT: Well, I’m not necessarily more optimistic. I probably feel, though, that democracy without a good public school system available to the entire population is sort of a mockery. Because there’s so much — (applause) — inequality to start with. I mean, it isn’t just inequality of money. But I mean, my kids, whether they inherit any money, or your kids, whether they inherit any money, compared to the kids of somebody where both parents are struggling to keep the place going, or maybe just one parent, and living in poverty — I mean, it is so unequal to start with that if you accentuate that inequality by giving those who are generally higher up on the ladder also a far better education than you give those who have chosen the wrong womb, I think that’s just — I don’t think that society should tolerate that — a rich society — should tolerate it. That doesn’t mean it’s easy to solve. Because I’ve said a lot of times that, unfortunately, it seems like a good public school system is like virginity, that it can be preserved but not restored.

And it’s very hard, when you get a system that’s lousy, to do much about it, because under those circumstances the wealthy people are going to all opt out of the system, and they’re going to be less interested in the bond issues, they’re going to be less interested in the PTA, they’re going to be less interested in the outcome of the other people’s children, if they have all opted out for their own system. And to have one educational system for the rich and another for the poor, with the poor being — getting the poorer system — strikes me as doing nothing but accentuating inequality and other problems that result from that in the future. So I don’t know the answers on improving the system. You know, I read some of the experiments that take place.

But I do believe to start with that if you have a good public school system, as we do in Omaha, that you do your damndest to maintain that so that there is no incentive for the rich grandparent or the rich parent to say, you know, “I love the idea of equality, but I love my grandchildren or my child more, so I’m going to yank him from the public school system,” and then you get this sort of exodus which leaves behind only those who can’t afford to make that choice. And the problem I have with the voucher system, if there were a way — the idea of competition I like, you know, and I think a good parochial system does, for example, create a better public system — and I think we’ve had that situation in Omaha — but I think the voucher system, if it simply amounts to giving everyone an additional amount, simply means that the rich get X dollars of the public school system subsidized, but the poor still are — whatever that differential is — remains.

I mean, you could have a golf voucher system — because I play golf — I don’t play very often — but if I play at the Omaha Country Club then you could have a voucher system so that everybody in Omaha would have more access to the country club by giving everybody a thousand dollars a year to play golf. But it just means it would reduce my bill by a thousand bucks, but it still wouldn’t do the job for the guy who’s on the public course because he’d still be beyond his means to move to full-scale equality with me. I — you know, I don’t think there’s anything more important — and I agree with Charlie totally — I think the first eight grades, you know, you can forget it after that. If you have the first eight grades right, good things are going to flow. And if you have those wrong, you’re not going to correct it as you get beyond that point. And I think that — you know, I commend Walter Annenberg on the $500 million. I think it is very tough to see results in that arena. And if you find something that is producing results, I think it should be replicated elsewhere.

I think that, obviously — a fellow in Chicago says that the unions have caused considerable problems in getting adjustments made, but he had the political clout behind him to overcome some of those problems. It ought to be a top national priority. We have the money to educate everybody well in this country, and the question is, can we execute? And that’s something I hope good minds like Patrick’s work on. Charlie, you have anything for that?

CHARLIE MUNGER: Yeah. I think when something is demonstrably failing at performing the function to which it’s assigned by a civilization, just to keep pouring more and more money into a failing modality is not the Munger system. So I’m all for taking the worst places where there’s failure and trying a new modality. And it wouldn’t bother me at all to have vouchers only for the poor. But I think we have to do something in our most troubled schools to change our techniques. I think it’s insane to keep going the way we are.

WARREN BUFFETT: So you’d go for means-tested vouchers, basically?

CHARLIE MUNGER: Oh, I —

WARREN BUFFETT: I mean, I don’t disagree with that idea.

CHARLIE MUNGER: All I know is we’re — it is a terrible place to fail. And part of the trouble is ideological. If you have an absolute rule there can’t be any tracking by ability, no matter how much better reading can measurably be taught by systems that involve tracking, well, people that brain-blocked shouldn’t have the power. You know, we should — (applause) — do what works.

WARREN BUFFETT: You know, we got plenty — I mean, in Omaha, it works. The problem is that once it gets beyond a certain point on a downhill slope, essentially you have the citizens that are able to do something about it, essentially, opt out. And that — I don’t know —

CHARLIE MUNGER: I am a product of the Omaha public schools, and in my day, the people who went to private schools were those who couldn’t quite hack it in the public schools. That is still the situation in Germany today. I mean, private schools are for people who aren’t up to the public schools. I’d prefer a system like that. But once a big segment of that system measurably fails then I think you have to do something. You don’t just keep repeating what isn’t working.

WARREN BUFFETT: Well, I agree with that. Patrick, have you gotten your answer? (Applause)

54. “The truth is you can have the reputation that you want”

WARREN BUFFETT: Let’s go to area 5.

AUDIENCE MEMBER: My name’s Kevin Murphy, I’m from Camarillo, California. And my question is, what do you look for when determining if a person is honest or not?

WARREN BUFFETT: Now, that’s a good question, Kevin. You — I think, generally, Charlie and I can do pretty well with the situations we see, but we have to have some evidence of behavior in front of us. And I would say even there’s some occupations where we’re going to expect to find a higher percentage of people who behave well than in others. But if we work with someone over a period of a few months or more, I think we’ve got — we can come up with a pretty high batting average, in terms of how they behave. At Salomon, I think I was able to separate out the people who I felt very good about and the people I was a little more nervous about fairly quickly, among the ones I worked with actively. But how you spot that precisely, you know — leave your lunch money on their — (laughs) — on their desk sometime, Kevin.

Maybe you’ll find out in a hurry, but — (Laughter) We like people — you know, I mean, the great example, you know, is somebody like a Tom Murphy, where they’re just bending over backwards all the time to make sure that you get the better end of the deal. That doesn’t mean they aren’t competitive. I mean, if you play him at a golf game for money or something like that, you know, he wants to win in the worst way. But he — But there are people that just — they don’t take credit for things that they didn’t do. In fact, they give you credit for some of the things that maybe they did. You can get a feel for it over time. Charlie, you have any good guidelines on that?

CHARLIE MUNGER: Yes. I think that people leave track records in life. And so, somebody at your age should figure that by the time he’s 22 or ’3, well, he will have left quite a track record and the world will be able to figure you out. So I think that track records are very important. And if you start early, trying to have a perfect record in some simple thing like honesty, you’re well on the way to success in this world. (Applause)

WARREN BUFFETT: [Italian industrialist] Gianni Agnelli one time told me, he said, “When you get older, you have the reputation you deserve.” He said you can get away —

CHARLIE MUNGER: Yeah, yeah.

CHARLIE MUNGER: — with it for a while early on. But by the time anybody gets to be 60 or so, they very probably have the reputation they deserve. And the truth is you can have the reputation that you want. If you list all of the things that you admire in other people, you’ll find out that almost everything you list — you may not be able to kick a football 60 yards or something of that sort — but almost everything you list in the people that you admire and like, they’re qualities that you can have if you just set out to do that. Didn’t Ben Franklin do that, Charlie?

CHARLIE MUNGER: Oh, sure. I always say that the best way to get what you want is to deserve what you want.

WARREN BUFFETT: I’ll have some more peanut brittle. (Laughter)

55. No expectations of investment problems due to Y2K

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: I’m Nancy Sill (PH) from Atlanta, Georgia. You were asked earlier this morning a question about the year 2000 computer problem. Do you anticipate any negative financial impact to the economy or to our companies due to the millennium problem, and if so what financial strategies are you considering?

WARREN BUFFETT: Well, I don’t think there’ll be major problems for our companies. You know, there are going to be some problems — (laughs) — anytime you have something that big. If people didn’t see it coming in 1980 or 1985, they’re not going to be perfect at solving it by 2000, you can count on that. But I don’t think it has any investment consequences for Berkshire Hathaway that we should be considering now. And I do think you’ll see most of the problems in the governmental area. You know, maybe they won’t find your tax return for two or three years. (Laughter) Who knows? Charlie?

56. McDonald’s will keep its real estate

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: In your description of McDonald’s, you have a sense that there’s a great business buried in McDonald’s and two good businesses that are mixed in with it. And the problem is with the real estate and the operational business, that as the company is currently capitalized, they can’t earn the same kind of returns they can earn in the franchising business. You were, or still are, a significant shareholder of McDonald’s. I guess my question is, the solution is obvious: why don’t you push for a solution that creates the same opportunity to have at International Dairy Queen?

WARREN BUFFETT: Well, my guess is — I don’t know the details on it — but my guess is that with 23,000 locations all over the world, I think it would be extraordinarily difficult to separate the real estate business out from the franchising business at this point. I think they could’ve gone a different route. I’m not saying it would’ve been a better route at all. In fact, I think the odds are they followed the right route in owning and controlling so much real estate. But I just think the problems would be horrendous. Certainly you wouldn’t want to sell it and lease it back because you would not end up with more value, in my view, by doing that. And spinning it off in a real estate trust or something, with operating in 100-plus countries, and with all of the franchise arrangements, I think it would be a huge, huge problem. I would not want to tackle it myself.

So I think that you should look at McDonald’s — and I don’t know anything about their plans on this — but I think you should look at McDonald’s as being a very good business, but one that will continue in its present mode vis a vis the real estate. Although I think they’ve signaled that they’re going to do less on new properties — somewhat less — in connection with ownership, than they’ve done to this point. But there’s 23,000 locations out there and every operator, his own arrangement is very important to him. And it just — it would be a mammoth job, and I’m not sure how much extra value would be created in the end anyway. Charlie?

CHARLIE MUNGER: Yeah, the net returns on capital McDonald’s has earned all these years are high, even though they have owned a lot of their real estate. I think it’s hard to quarrel with the way they did it. They had the best record.

WARREN BUFFETT: And the multiple is not greatly different, in my view, than if the real estate were separate. You know, I mean, if you get all the real estate detached in some arrangement, you might get a little more out of it. But it doesn’t strike me as a big deal.

57. Berkshire is “poorly” structured for owning securities

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: Yeah, hi. I’m Rachel White (PH) from Missoula, Montana. And during the lunch break, I heard some people talking about double taxation and how that impacts Berkshire’s investment philosophy. So I was wondering if you could talk a little bit about it. I’m not sure I understood it. And if you could explain whether that impacts your investments.

WARREN BUFFETT: Well, we are structured very poorly. And if you were looking — if you’re going to start all over again and do most of the things we’ve done, you would probably not do it in corporate form, or precisely like we do it. I mean, what that gentleman was talking about in connection with McDonald’s applies much more to Berkshire Hathaway by far than McDonald’s, in terms of de-taxing part of the income stream. If we own Coca-Cola with a cost of a billion-two or a billion-three and a market value of 15 billion, we’re not going to sell it. But if we did sell it, we would incur a capital gains tax on the order, almost, of $5 billion. That means that the 15 becomes 10 billion. Now, if that 10 billion is reflected in Berkshire’s value and you bought your stock when we bought our Coke, then you pay a second tax, in turn, in reflection of the Coca-Cola appreciation that has taken place after tax. So it’s a very disadvantageous way of owning securities, to have a corporation in between you and the securities themselves.

If we ran as a partnership that would not be the case. I ran Berkshire Hathaway — I mean, I ran Buffett Partnership for many years and we only had one tax at the individual level. So our stockholders are — to the extent that we own marketable securities — and we own a lot of them — and to the extent that we have a lot of profits over time in those — own those securities in a disadvantageous way. Now, we also have a float, which helps us own them, which is a big plus. But corporate ownership of securities — if you have the option of owning them directly or through a partnership — corporate ownership is disadvantageous. And we’re stuck with it. We’ve had it for all these years. We’ve got no plans to do anything about it. We couldn’t, probably, do anything about it if we wanted to. So that is a drag on our performance, compared to what would be the situation if we operated as a partnership. And Lloyd’s syndicates, for example, didn’t have that problem. Some insurance companies that operate in Bermuda may not have that problem to the same extent.

Certainly partnerships don’t have that problem, to the extent they own securities. But it’s a fact of life with us and we’re going to pay a lot of taxes. Charlie?

CHARLIE MUNGER: Yeah, we have no cure for the corporate income tax, and it is a big disadvantage for the indirect owner of securities. So far we’ve surmounted it well enough but we’re carrying a load there.

WARREN BUFFETT: It’s become a bigger disadvantage since the individual rate went to 20 percent with our corporate rate being 35 percent. If we make a dollar on a stock, it becomes 65 cents, and to the extent that you’ve owned Berkshire, that 65 cents, now 20 percent off that, becomes 52 cents. Whereas if you’d owned the stock directly, you’d have had 80 cents. Now, when we owned GEICO and it wasn’t consolidated with us, you carried that one more extreme. I mean, GEICO had capital gains and we had a capital gain proportionately in GEICO, and so on. I mean, how you’re structured does make a real difference. But usually once you get into a given structure, you’re kind of stuck with it, as I indicated in the answer to the gentleman on McDonald’s.

CHARLIE MUNGER: Now, to the extent we have very long holding periods at the corporate level, the real mathematical disadvantage shrinks.

WARREN BUFFETT: Yeah, and we might not have been able to get the float that we have, if we hadn’t been operating it in a corporate structure, so that is a mitigating factor, too. But we like to have the mitigating factors without anything to mitigate, if we get our choice. (Laughter)

58. Due diligence is useless and misses the point

WARREN BUFFETT: Area 9, please.

AUDIENCE MEMBER: Good afternoon. My name is Fred Strasheim (PH) and I’m from here in Omaha. I have a question about your acquisition methodology. And I was intrigued to read in your annual report about your acquisition of Star Furniture. And as I understand the process you followed, Mr. Buffett, you met with Mr. — or you — I’m sorry, you reviewed financials for a brief period, liked what you saw, then you met with Mr. Melvyn Wolff for two hours and struck a deal. And you wrote you had no need to check leases, work out employment contracts, et cetera.

WARREN BUFFETT: Right.

AUDIENCE MEMBER: I think that most companies, when they do acquisitions, would feel the need to do a significant amount of legal due diligence, to do things like check the leases, check into things like undisclosed environmental liability, or perhaps threatened litigation. And I guess my question is, have you ever been burned by your approach?

WARREN BUFFETT: We’ve been burned by the — we’ve been burned only in the sense that we’ve made mistakes on judging the future economics of the business, which would’ve had nothing to do with due diligence. We regard what people normally refer to “due diligence” as, as really sort of boilerplate in most cases. It’s a process that big companies go through. And they feel they have to go through it. And they’re ignoring — oftentimes, in our view — they’re ignoring what really counts, which is evaluating the people they’re getting in with, and evaluating the economics of the business. That’s 99 percent of the deal. You know, you may run into an environmental liability problem, you know, one time in a hundred, or you may, you know, you may find a bad lease. I asked Melvin about, you know, “Do you have any bad leases?” I mean, that’s the easiest way to do it.

And I could read them all and try and look for every clause or something, but it isn’t going to — you know, that is not the problem. We’ve made bad — lots of bad deals. We made a bad deal when we bought Hochschild Kohn, for example, the department store operation, back in 1966. But it had — fine people — but we were wrong on the economics of the business. But the leases didn’t make any difference. You know, that sort of thing just was not important. And I can’t recall any time that what other people refer to as due diligence would’ve avoided a bad deal for us.

CHARLIE MUNGER: I can’t either.

WARREN BUFFETT: No. That’s 30-some years. And I — The key thing — you just don’t want to do — I go — I’m on various public company boards — I’ve been on 19 public company boards — and you know, their idea of the due diligence is to send the lawyers out and have a bunch of investment bankers come in and make presentations and all that. And I regard that as terribly diversionary, because the board sits there, you know, entranced by all of that, and everybody reporting how wonderful this thing is and how they checked out patents and all that sort of thing. And nobody is focusing really on where the business is going to be in five or 10 years. You know, business judgment about economics — and people to some extent — but the business economics — that is 99 percent of deal making. And the rest, people may do it for their protection. I think too often they do it as a crutch just to go through with the deal that they want to go through with anyway, and of course all the professionals know that. So believe me, they come back with the diligence, whether due or not.

And — (Laughter) We are not big fans of that. I don’t know how many deals we’ve made over the years, but I cannot think of anything that traditional due diligence has had a thing to do with.

CHARLIE MUNGER: No, we’ve had surprises on the favorable side a couple of times —

WARREN BUFFETT: That is true. That is true. The kind of people that we’ve generally dealt with have usually told us the bad things first and good things after we made the deal. We made a deal with a fellow over in Rockford in 1969, Eugene Abegg, Illinois National Bank and Trust Company. I made that deal in a couple of hours and, I mean, there just wasn’t any way that Gene was going to be hiding anything bad. For the next ten years when I went over there, every time I’d go to lunch he’d point out some building in town that we owned that wasn’t on the books, or some foundation we had that had money in it he hadn’t told me about. And he even gave me some bills, one of which I carry in my pocket, that he had still sitting around that were issued by the bank that were our own money which he never told me about. We could cut them out like paper dolls. I mean, Gene was not a guy to show all his cards.

(Laughter) And those are the kind of people we’ve generally dealt with, and I would certainly say that Melvyn and [his sister] Shirley [Toomin] fit that description in spades.