Morning Session

1. Formal business meeting begins

WARREN BUFFETT: (Video recording begins after meeting has started) … second or anybody would like to speak to that motion, might now work their way over to the microphone in zone 1. Could we have a spotlight on where that is? In that way, when we get to that point of the program — If anybody that would like to speak to the motion that was in the proxy statement, if you’ll work your way over to the microphone there then we’ll be ready at the time — you can be ready at the time when it will be appropriate to talk about it. And so we’ll get there in just a minute and if you’ll all wander over there that are interested. Also with us today are partners in the firm of Deloitte & Touche, our auditors. They’re available to respond to appropriate questions you might have concerning their firm’s audit of the accounts of Berkshire. Mr. Forrest Krutter, the secretary of Berkshire. He will make a written record of the proceedings. Miss Becki Amick has been appointed inspector of elections at this meeting. She will certify to the count of votes cast in the election for directors.

The named proxy holders for the meeting are Walter Scott Jr. and Marc D. Hamburg. We will conduct the business of the meeting and then adjourn the formal meeting. After that, we will entertain questions that you might have.

2. Berkshire’s shares outstanding

WARREN BUFFETT: Does the secretary 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, 2002, being the record date for this meeting, there were 1,323,707 shares of Class A Berkshire Hathaway common stock outstanding, with each share entitled to one vote on motions considered at the meeting and 6,290,415 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, 1,103,455 Class A shares and 5,260,231 Class B shares are represented at this meeting by proxies returned through Thursday evening, May 2nd.

WARREN BUFFETT: Thank you. That number represents a quorum and we will therefore directly proceed with the meeting.

3. Previous meeting’s minutes approved

WARREN BUFFETT: First order of business will be a reading of the minutes of the last meeting of shareholders. I recognize Mr. Walter Scott who will place a motion before the meeting.

WALTER SCOTT: I move that the reading of the minutes of the last meeting of the shareholders be dispensed with and the minutes be approved.

WARREN BUFFETT: Do I hear a second? The motion has been moved and seconded. Are there any comments or questions? Three second pause. We will vote on this motion by voice vote. All those in favor say aye. Opposed? The motion’s carried.

4. Susie Buffett “leads the ticket”

WARREN BUFFETT: The first item of business of this meeting is to elect directors. The shareholders present who wishes to withdraw a proxy previously sent in and vote in person on the election of directors here, he or she may do so. Also, if any shareholder that is present and 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. Would those persons desiring ballots please identify themselves so that we may distribute these? I now recognize Mr. Walter Scott to place a motion before the meeting with respect to election of directors.

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

WARREN BUFFETT: Is there a second? It has been moved and seconded that Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson and Walter Scott Jr be elected as directors. Sounds like a hell of a slate to me. 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. The proxy holders please all submit to the inspector of elections a ballot on the election of directors, voting the proxies in accordance with the instructions they have received. I will have to say at this point, deviating from my script, that — in the spirt of disclosure which now permeates the corporate world — I have a tally here from yesterday as to the number of votes each director has received. And the — I won’t give the affirmative votes, but the total — basically negative vote is a withhold vote — Charlie and I and Howie came in last, by a significant margin. Susie did the best.

She only had 1,000 votes against her, but Charlie and I had 16,000-some votes against us. So, I really suspect that Susie voted against us so that she could lead the ticket, but who knows? (Laughter) Miss Amick, when you’re ready you may give your report.

BECKI AMICK: My report is ready. The ballot of the proxy holders in response to proxies that were received through last Thursday evening has not less than 1,139,672 votes for each nomine. That number far exceeds a majority of the number of the total vote related to all Class A and Class B shares outstanding. The certification required by Delaware law of the precise count of the vote, including the additional votes to be cast by the proxy holders in response to proxies delivered at this meeting, as well as any cast in person at this meeting, 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 Jr. have been elected as directors. Next — (Applause)

5. Shareholder proposal on charitable contributions, abortion, and overpopulation

WARREN BUFFETT: The next item of business is the proposal put forth by a Berkshire shareholder, Gloria Jay Patrick, the owner of two Class B shares. Miss Patrick’s motion is set forth in the proxy statement and provides that the shareholders request the company to refrain from making charitable contributions. The directors have recommended that the shareholders vote against this proposal. We will now open the floor to recognize Miss Patrick or her designee to present her proposal. And I believe we have Mr. Mosher at the microphone in area one to speak to — to make the proposal and speak to it. Would you go ahead please, sir?

STEVEN MOSHER: Thank you, Chairman Buffett. I apologize if this is a little loud. I was told I would have to really project but I think you can hear me up there on the stage and I hope you can hear me up in the rafters. My name is Steven Mosher. I’m the chairman of the Population Research Institute, a nonprofit organization dedicated to making the case for people as the ultimate resource, the one resource that we, as investors, cannot do without, and to debunking the hype about overpopulation, what the New York Times has called, and I quote, “One of the myths of the 20th century.” Of course, we’re now living in the 21st century. I’ve written about the coming depopulation — that’s right, I said depopulation — in the Wall Street Journal and other publications. I say all this to explain why Gloria Patrick, a Berkshire Hathaway shareholder, has asked me to present her action at this meeting, the following proposal. And I do have one other qualification: I have nine children. Now when people gasp at this, I remind them that my children will be paying their Social Security one day.

Of course, if you invest in Berkshire Hathaway stock, you won’t need Social Security. I will present the proposal and then, with the chairman’s indulgence, spend a couple of minutes explaining why it’s necessary. Here is the resolution: Whereas, charitable contributions should serve to enhance shareholder value. Whereas, the company has given money to groups involved in controversial activities like population control and abortion. Whereas, our company is dependent on people to buy the products and services of the various companies we own. Whereas, our company is being boycotted by Life Decisions International and investmentrelated groups like Pro Vita Advisors because of these contributions. Resolved: The shareholders request the company to refrain from making charitable contributions. Let me take these very quickly, point by point. You all know shareholder money is entrusted to the board of directors to be invested in a prudent manner for the shareholders. I think you will all agree, as the resolution states, that charitable contributions should serve to enhance shareholder value. Indeed, this is already Berkshire Hathaway policy with regard to its operating subsidiaries.

As Chairman Buffett explained in his Chairman’s Letter of last year, quote, “We trust our managers to make gifts in a manner that delivers commensurate tangible or intangible benefits to the operations they manage. We did not invest money in this company so it could be given to someone else’s favorite charity.” I think you will also likewise agree that activities like population control and abortion are controversial. In fact, some of the charitable money has been given to Planned Parenthood, a group that is responsible for almost 200,000 abortions a year in the United States — (applause) — and in countless more through its population control programs worldwide. Now, we believe abortion is the taking of a human life, but even if you disagree on this fundamental point, you must concur that these ongoing boycotts of Berkshire Hathaway company products are not a good thing. Next, it should be self-evident that Berkshire Hathaway, like the economy as a whole, is dependent upon people. It is people who produce the products and services of the various companies we own, and it is people who buy them.

Now, you may think that there is the superabundance of people in the world and that we will never run short, but this is not true. Half of the countries of the world, including countries in Latin America, Africa, and Asia, now have birthrates below replacement. Europe and Japan are literally dying, filling more coffins than cradles each year. Dying populations may shrink the economic pie. We already see this happening in Japan and some European countries. How much of Japan’s continuing economic malaise can be directly traced to a lack of young people to power the economy? Dying populations may also make economic development nearly impossible. Russia is having trouble finding its feet economically. Why? Because of its ongoing demographic collapse, losing a million people a year. These problems will spread to many more countries in the near future. Charitable contributions to simple-minded population control programs, in which governments impose restrictions on childbearing, are not in Berkshire Hathaway’s interest. Such programs are not investing in humanity’s future, they are compromising humanity’s future and putting a roadblock in the way of future economic growth.

There is no global share buyback in store for those who fund population control programs, because such programs will rob the world of future consumers and producers and threaten to shrink the economic pie. Let me give you a concrete example of what I mean. Berkshire Hathaway owns Dairy Queen. Now, there are 103 Dairy Queens in Thailand. But Thailand, due to a massive population control campaign, now has a birthrate that is below replacement and falling. This means that its cohorts of young children are shrinking. There will be fewer and fewer families in the years to come and its population will eventually fall. Now, you may think Thailand has too many children. But is it possible for there to be too many children for Dairy Queen? According to Dairy Queen, the Dairy Queen concept especially appeals to, quote, “young families.” But there will be fewer young families in Thailand’s future and Dairy Queen’s future because of population control. So I urge you to vote yes on this resolution: let it be resolved that this company refrain from making charitable contributions. One final point.

Should you, on the other hand, both continue the current practice of making charitable contributions based on shareholder designations, I would urge you all to designate 501(c)(3)s, like the Population Research Institute, which are attempting to help the poor become the agents of their own development and not simply try to reduce their number through population control. Thank you, Mr. Chairman for this opportunity to speak. (Applause)

WARREN BUFFETT: Thank you. Do we have a — do we have a second to the motion? Ok, we have. And is there are any further discussion? Is there anyone there at the microphone that would like to talk? OK. If there’s no further discussion, we’ll have Miss Amick report on the votes cast on that. If anybody wishes to cast a vote in person, they can raise their hand and submit that, but we’ll have a preliminary report from Miss Amick.

BECKI AMICK: My report is ready. The ballot of the proxy holders in response to the proxies that were received through last Thursday evening cast 28,452 votes for the motion, and 1,014,353 votes against the motion. (Applause) As the number of votes against the motion exceeds a majority of the number of votes related to all Class A and Class B shares outstanding, the motion has failed. The certification required by Delaware law of the precise count of the vote will be given to the secretary and placed with the minutes of this meeting.

WARREN BUFFETT: Thank you, Ms. Amick. The proposal failed.

6. Formal meeting adjourned

WARREN BUFFETT: After adjournment of the business meeting, I will respond to questions that you may have that relate to the businesses of Berkshire but do not call for any action at this meeting. Does anyone have any further business to come before this meeting before we adjourn? If not, I recognize Mr. Walter Scott to place a motion before the meeting.

WALTER SCOTT: I move that this meeting be adjourned.

WARREN BUFFETT: Is there a second? Motion to adjourn has been made and seconded. We will vote by voice. Is there any discussion? If not, all in favor say aye. All say no? The meeting’s adjourned. Thank you. (Applause)

7. Mickey Newman introduced

WARREN BUFFETT: Now, before we get on to the questions, and when we get to the questions we will move through various zones sequentially, there are just a few special guests that I would like to recognize, and because of the crowd, I’ve not had an opportunity to make sure all of these special guests are here, but we will find out here shortly. The first guest, and I hope very much he’s here. He was planning to be here. It was — let’s see — 40 — 48 years ago this July or so — well about June — I got a letter from Ben Graham who I had been pestering for a job for about three years and getting no place, and then said the next time you’re in New York, come in and talk to me. So, I was there about ten hours later. I didn’t have a NetJets plane, so it took a little longer. And I went in to see Ben and he offered me a job and I took it on the spot. I didn’t ask what the salary was, or anything else, and a month or two later the family joined me.

I had — my daughter was already born and Susie was pregnant with Howie. And we moved back there and I went to work for Graham-Newman Corp. And, one of my three bosses — I had three bosses that — Ben Graham, Jerry Newman, and Mickey Newman. And Mickey was exactly ten years older than I was at that time and he’s exactly ten years older now. And Mickey was a major factor in a hugely successful — he ran the place — company that was not quite that successful yet in 1954 when I went back there: the Philadelphia and Reading Coal and Iron Company, as it was called then. And after I’d been there maybe a year — Mickey was in charge of Philadelphia and Reading — and a fellow named Jack Goldfarb came into the office, and I really didn’t know what was going on. I had a good bit of my net worth in Philadelphia and Reading, so I was interested, but Jack Goldfarb and Mickey were behind closed doors, largely. But when they emerged, the Philadelphia and Reading Company, which was controlled by Graham-Newman, had bought Union Underwear, which was the manufacturer of Fruit of the Loom product under a license at that time.

And, as I told in the annual report, was a very, very attractive buy, and Mickey made a number of good buys. And when — Mickey and I have talked and seen each other over the years, some, not a lot, but we would see each other. And when Fruit of the Loom entered bankruptcy a few years ago, Mickey called me and sort of said, what are you going to do about it? You should do something. And he was very helpful, particularly helpful, in introducing me to John Holland, who runs Fruit of the Loom, and who is a tremendous asset to the company. And, Mickey gave me lots of insights on that. And when I got discouraged with the bankruptcy procedure — and it is discouraging to try and buy a company out of bankruptcy — Mickey would gently prod me along. And so I believe, today, we have with us Mickey Newman and his son, who I last saw when he was a little red-headed kid, Bill. Mickey and Bill, if you’re here, if you’d stand up, it’d be great. Now, let’s see if they made it. There they are. Let’s have a spotlight on them.

(Applause) I can’t see very well from here whether Bill is still redheaded. But Mickey is 81, believe it or not. You won’t believe it if you meet him. And he’s been a tremendous help and a great friend over the years. And he accomplished much for us in the past year. We — I don’t think we would have Fruit of the Loom if it hadn’t been for Mickey, particularly nudging me along as we went through the process.

8. Scott and Fetzer’s Ralph Schey introduced

WARREN BUFFETT: I also hope we have today with us, and again, I didn’t get a chance to see them before the meeting, but are Ralph and Luci Schey here? Ralph and Luci? Did they — were they able to make it or not? Yeah, there they are. (Applause) Ralph is in the Berkshire Hathaway Hall of Fame. I mean, this is like being at Cooperstown, you know, and introducing Bob Gibson or Sandy Koufax. Ralph, for a great many years, added tremendous value to Berkshire at Scott and Fetzer. We wouldn’t be able to buy some of the things, like Fruit of the Loom, if it hadn’t been for the profits developed under Ralph’s management at Scott Fetzer. So I’m delighted that he and Luci can join us. (Applause)

9. Larry and Dolores Brandon introduced

WARREN BUFFETT: I believe, and I hope we have Larry and Dolores Brandon. Are they here? Show your — there they are. Let’s have a spotlight on them. (Applause) Delores is also known as “Dutchy” but we call her “Saint Dutchy” at Berkshire headquarters because she gave birth some years ago to Joe Brandon, and Joe has been doing a fabulous job for us at General Re. He took over early in September. It’s really going to be our number one asset. There’re been a lot happened since those days in September when Joe took over. I think you’re going to see some terrific results throughout our insurance business, but particularly at General Re. I wrote Dutchy a letter and I said, you know, it’s terrific what you’ve done for us, but — you know, I was a little like the farmer that went into the henhouse, and I, you know, pulled out an ostrich egg, and said to the hens, you know, I don’t like to complain, but this is just a sample of what the competition’s doing.

(Laughter) Well, I berated her a little bit for not having twins, because if she just had a twin for Joe, we’d own the world. But she tells me that — and she wrote me back and said — she really had done her best. I mean, she’d had seven children, five of whom are in the insurance business, and she has 19 grandchildren. So, we have people out on the road trying to sign up these grandchildren now and — (Laughter) If you get a chance, you know, tell her her productive years are not over. (Laughter)

10. Andy Heyward introduced

WARREN BUFFETT: And finally, we have with us today the fellow who put together that terrific cartoon. Anybody that can — even takes on the job of making me look like James Bond is a very brave person. And, Andy Heyward has a company called DiC Entertainment, which is a leading producer of children’s programming. When you turn on the television on Saturday morning, you will be seeing his output. And Andy puts this product together. He sends people to Omaha. He does it all. It’s his script, it’s his production. He does it on his own time, on his own nickel, he just — it’s his contribution to the Berkshire meeting. And it, I mean, it’s absolutely fabulous. And I have to tell you that this fall, Andy is going to have a series of 40 episodes that are called — I think it’s called “Liberty’s Kids.” It will be on public broadcasting at 4:30, five days a week. And it’s really the story of America.

It’s told — Charlie will like this — Charlie doesn’t know about this — it will be told through the eyes of three young apprentices in Ben Franklin’s print shop. And it will view the evolving of the American democracy and the Constitution, and all with Andy’s creative characters, but it will use the voices of various other people. And I’m flattered. I get to be James Madison in this. And we have Sylvester Stallone, we have Billy Crystal, we have Whoopi Goldberg. And Charlie will be crushed to find — I think its Walter Cronkite is going to be Ben Franklin. I mean, I think Charlie held out for too much money or something. (Laughter) But, it’s going to be a fabulous series. I mean, I am looking forward to this. It will run all this year, starting in the fall, and then it will run again in the following year. And it will be a great, great, piece for American children and American adults. I plan on watching it myself. And it will just be the story of how this country came about, through the eyes of these three young apprentices of Ben Franklin.

So, Andy is here with his son Michael, and if Andy and Michael would stand up, I’d like to give them a hand myself. Andy, where are you? (Applause) They’re here someplace. (Applause continues)

11. Berkshire managers praised

WARREN BUFFETT: We’ve got a lot of other special guests, but they’re up here in our managers’ section. You saw them up on the screen. They’re the people who make this place work. We have a larger and better cast this year than we’ve had even in the past, and it will grow in the future. This is a company of managers. And, you know, we confess to how little we do around headquarters, as you saw in the movie. And we now have, I think — I’m not sure of the exact number, whether we have 130,000 now, or something like that — people working all over the world in all kinds of occupations. And, I think they get a sense when they come here that they’re working for real people on this side, too. I mean, they get to see people who are actual owners. We have some institution holders, but we have 350,000 individual owners now, and I think — I believe — it’s correct to say that our stock turns over — less turnover — in the shares of Berkshire than in any other company of major size in the country.

Which means, in effect, we have more what I would call real owners, people who want to be in partnership with the kind of managers we have. And Charlie and I are very proud of them.

12. Q1 insurance update

WARREN BUFFETT: Now we’re going to get to the questions in just one second. I thought I would give you a little update on, particularly, the insurance aspects of the first quarter, because insurance cost us a lot of money last year. It’s our main business. It’s always going to be our main business. It’s a very, very big business, and it’s going to get bigger. And, there were some special events of last year, and there were some mistakes of our own that made it a bad year for insurance last year. Our float last year cost us almost 13 percent, and that’s a lot to pay for money. It’s not our record. We had a period in the ’80s when we ran into even more difficulties. But I think there’s been — well, I know there’s been — there’s been a change in the market. There’s been a change, to a degree, in the culture at a very important unit.

And, I think that, barring some really mega-catastrophe, and we’ll talk about those later — possibility — that we are — I think we’re doing pretty well. And if we could have the first chart that I — yeah — the first chart, which I can’t see myself here, but I think it will be the insurance underwriting results for the first quarter. And you will see that two good things happened in the first quarter. One is our float increased by $1.8 billion. That’s a lot of money to take in, net. I don’t think there’s any company, probably in the world, that had a gain in float that was even close to that. And we actually achieved that with a small underwriting profit. So the float not only cost of nothing in the first quarter, but we had a gain of a billion-eight in it. And all units contributed to that. (Applause) Our goal is to obtain more and more float at minimal or no cost.

And there have been a number of years in the past when we’ve run an underwriting profit, which means that the use of that money is essentially free, or even better than free. And we’ve had one very bad year, and a couple of so-so years before that. But I think our cost of float over the next few years, unless we get into an extraordinary catastrophe, I think it should be pretty satisfactory. Now, you’ll notice there’s a note down at the bottom that’s slightly technical, but it’s an important enough item in Berkshire, and in understanding our cost of float, that I thought I’d just devote a minute to it. If you find this uninteresting, you can live a happy life without understanding what I’m about to explain next. You may even lead a happier life if you don’t understand it. (Laughter) As I look at the people that understand it and don’t understand it, I’m not sure which group is happier. (Laughter) When we write — we write a good bit — and have written a good bit, I should say — of retroactive insurance.

Now, in retroactive insurance, a company may come to us that’s merging with another company, and they want to put a cap on their liabilities, or define them better, from past incidents. So they may come to us and say, we want you to pick up all the losses that are going to be paid from things that happened prior to, say, 1990. And we think that we owe $1 billion — have yet to be paid in losses from that period — but we want to protect ourselves up to, say, $2 billion, or some number like that. So they write us a check and we take over — this is called retroactive insurance — we take over their losses from the past for a specific period and for a specific amount. And, when we do that, the accounting — it’s not accounting you run into every day — we’ve explained it in the past — but it creates a charge which will occur over time in the future. And, as you can see, in the first quarter, the 20 million of underwriting profit we made was after a total of 112 million for the amortization of this charge that is set up.

So, if a company comes in and says, for example, we want you to protect us up to a billion-anda-half for losses that occurred in the past, and we’ll give you a billion dollars for it, we will debit cash for a billion dollars and we’ll debit this deferred charge for half a billion and we’ll set up a liability for a billion-and-a-half. And that 500 million we set up as a deferred charge, we amortize over a period of time as we expect to pay the claims. Now, there would be a lot of room for judgement — there is a lot of room for judgement — in terms of how fast we amortize that. We try to be conservative. We make an estimate of when we will pay those claims and how much we will pay, and we try to amortize it over a reasonable period. I’ve got another slide that shows how those amortization charges will work over time. And we’re going to put these slides on the internet, because we feel that our shareholders should understand the impact of these charges that will come against underwriting profits.

In the year 2002, we will have a 400 million-plus charge for this. It’s built into the figures now. And if we do 20 billion of premium volume, that’s about a 2 percent charge. So, to have our float be cost free, we have to make 400-plus million on underwriting elsewhere, in order to offset that. And as you can see, we did that the first quarter and we’ll find out whether we do it for the full year. It’s a — not many companies do this kind of business and it’s a big item with us, so I really want all the shareholders to understand it, and for that reason, we’ll put it on the internet. I should emphasize that in all of these contracts, we cap our liability. So a lot of these contracts apply to liabilities that primarily — or not primarily — but in a significant way, and often primarily, arise from asbestos. But when you read about asbestos claims accelerating and all of that, the numbers are capped in our case, in all of these contracts.

So really don’t care whether we pay it on an asbestos claim or whether we pay it on an old auto liability claim, or whatever. The question is whether we’ve been correct in estimating the speed at which we will pay. And in some cases, we may pay even less than our maximum amount. So, anyway, that’s available for those of you who have previously were unhappy not understanding this and now are thrilled to know how it all works. (Laughter)

13. GEICO growth resumes

WARREN BUFFETT: Now the final item, which is a little easier to understand, is — we talked in the annual report about how we expected growth to resume at GEICO. And I put up — again I can’t see what’s up there — but I assume that we have the GEICO policies in force figure and the increase by — Charlie hasn’t seen these, as a factor of fact, so I’ll give him the slide. And as you can see, growth, not at the rates of a couple of years ago, but quite a turnaround from last year. Growth has resumed at GEICO in a reasonable way. We figure each policyholder of a preferred nature is worth $1000 to us, at least, and so if we had 40,000 policyholders in a month, we’ve created, in our view, $40 million of value. And, of course, we have the earnings in the float, and so on, that goes with it. You’ll notice on the first slide, GEICO operated at a significant underwriting profit in the first quarter, so all of its float was free and its float has continued to grow.

We are — you saw one of our little squirrel ads there which I like — we are getting — we are not getting a whole lot more inquiries than a year ago, but we’re closing a significantly higher percentage of those that call. So our growth has been — has been picking up because our closure rate has increased quite substantially, and our retention rate of old policyholders, also, is increasing month by month. So we’ve got two trends that are quite favorable, in terms of adding business. And the third one of adding more inquiries is something that we are working on, and we’re delighted to spend a lot of money on it, if we can figure out the way to spend it intelligently. But, the increase in the retention ratio, the increase in the closure ratio, is resulting in very decent growth at GEICO. And it’s growth in all of our categories, in the preferred class, and the standard class, and the nonstandard class of business, whereas last year, the latter two fell. Well, that’s enough about the formal presentation.

14. How Buffett decides when to sell stocks

WARREN BUFFETT: Now, we’re going to go in the various zones. I promised a young shareholder in zone one that he would get to ask the first question and we’re ready for zone 1.

AUDIENCE MEMBER: Hello Mr. Buffett and Mr. Munger. My name is David Klein-Rodick from Lincolnshire, Illinois. Thank you for letting me ask the first question. I wanted to say I am sorry for the loss of your friend Mrs. Graham last year. My question is: you have said that your favorite time to own a stock is forever. Yet, you sold McDonald’s and Disney after not owning them for long. How do you do decide when to hold forever and when to sell? And also, are you and Mr. Munger wearing Fruit of the Loom? (Laughter and applause)

WARREN BUFFETT: Charlie? (Laughter) I think I better answer the question. I can answer unequivocally. I am wearing Fruit of the Loom. I’m not sure whether Charlie wears underwear. Do you? (Laughter)

CHARLIE MUNGER: I haven’t bought any new underwear in a long time and therefore I’m inappropriately attired. (Laughter)

WARREN BUFFETT: He’s waiting for a discount, don’t let him kid you. (Laughter) Well, the answer — it’s a very good question about selling. I mean, we — it’s not our natural inclination to sell. And on the other hand — and we have held the Washington Post stock since 1973. I’ve never sold a share of Berkshire, having bought the first shares in 1962. And we’ve held Coke stock since 1988. We’ve held Gillette stock since 1989. Held American Express stock since 1991. We had actually previously been in American Express in the ’60s and Disney. So, there are companies we are familiar with. We generally sell by — we would sell if we needed money for something else — but that has not been the problem the last 10 or 15 years. Forty years ago my sales were all because I found something that I liked even better. I hated to sell what I sold, but I also didn’t want to borrow money, so I would reluctantly sell something that I thought was terribly cheap to buy something that was even cheaper. Those were the times when I had more ideas than money.

Now I’ve got more money than ideas, and that’s a different equation. So now we sell — really when we think that we’ve — when we’re reevaluating the economic characteristics of the business. In other words, if you take the — don’t want to name names — but take a stock we’ve sold, of some sort. We probably had one view of the long-term competitive advantage of the company at the time we bought it, and we may have modified that. That doesn’t mean we think that the company is going into some disastrous period or anything remotely like that. We think McDonald’s has a fine future. We think Disney has a fine future. And there are others. But we probably don’t think that their competitive advantage is as strong as we might have thought — as we thought it was — when we initially made the decision. That may mean that we were wrong when we made the decision originally. It may mean that we’re wrong now, and that their strengths are every bit as what they were before. But, for one reason or another, we think that the strengths may have been eroded to some degree.

A classic case on that would be the newspaper industry, generally, for example. I mean, in 1970, Charlie and I were looking at the newspaper business. We felt it was about as impregnable a franchise as could be found. We still think it’s quite a business, but we do not think the franchise in 2002 is the same as it was in 1970. We do not think the franchise of a network television station in 2002 is the same as it was in 1965. And those beliefs change quite gradually. And who knows whether they’re precise — you know, whether they’re right, even. But that is the reason, in general, that we sell now. If we got into some terribly cheap market, we might sell some things that we thought were cheap to buy something even cheaper, after we’d bought lots and lots of equities. But that’s not the occasion right now. Charlie?

CHARLIE MUNGER: Nothing to add.

WARREN BUFFETT: He’s been practicing for weeks. (Laughter)

15. Cost of float is more important than its size

WARREN BUFFETT: OK, let’s go to zone 2.

AUDIENCE MEMBER: I’m John Bailey from Boston, Massachusetts and I hope I’m not asking you to repeat your insurance presentation, but I have a question about the growth of our float. There’s an increasingly popular piece of analysis out there where people project the growth of float for a large number of years into the future in order to determine the value of our business here. But I wanted to ask more fundamentally, the existing float that we have runs off annually at a pretty considerable rate. In order to maintain that, we have to replace it through our operations. And then going the next step, to achieve the growth, we have more than replace it. And so I wanted to ask you to address the characteristics of the — maybe the non-GEICO insurance businesses — that should give us the confidence to expect large amounts of replacement and growth float, at reasonable costs, going forward?

WARREN BUFFETT: Yeah, in a sense, float is somewhat similar to being in the oil business. I mean, you know, every day, some goes out as you pay claims, and the question is, did you find more oil than you produced that day? And it’s very relevant. It’s a good question to, you know, what is the permanence of the float? What is the cost of the float? What’s the likelihood of it growing? Could it actually run off? As you saw up on the slide, we have $37 billion-plus of float. I think we have more float in our property-casualty business. A little bit of that float is in General Re’s life and health business, but very small. So, basically you’re looking at property-casualty float when you look at that 37 billion. I believe that’s more than any company has in the United States and it’s possible — I haven’t checked Swiss Re and Munich — but it’s even possible it’s larger than anybody in the world.

Now, if you go to 30th and Harney Street, here in Omaha, you’ll see National Indemnity building. It’s the same building that was there when we bought the company in 1967 from Jack Ringwalt, when it had, maybe, 12 million of float. And I had no idea that that 12 million, or whatever the number was, would turn into 37 billion. I mean, sometimes I can’t really quite figure out how it happened. But in any event, it did, and it’s — we don’t want people focusing on growth in our insurance business. I mean, we want them focusing on intelligent growth when we can do it at a GEICO or whatever it may be. But I think it’s suicide, from a business standpoint, to tell a bunch of insurance managers to go out and grow a lot. So, you can say, well, with that lack of push from the home office, you know, how is that 37 1/2 billion going to grow? And I would say, just as I would have said to you for the last, you know, 30-odd years, I don’t know.

But I think that — well, I can tell you this, that our float would have less natural runoff than the float from just about any company in the world. I mean, we have a longer duration to our float because it arises from these retroactive contracts and from reinsurance, long-tail reinsurance, and that sort of thing. So, our float has less natural erosion than any — just about any — that I know of in the world, but it erodes. It is a long-lived oil field, but it — we’re pumping it every day. You know, if I had to bet my life on whether the float would be higher or lower three years from now, or five years from now, I would certainly bet it would be higher. And it’s turned out, over the decades, that it’s grown at a very significant rate. But I don’t want to push anybody to do it. It grew at $1,800,000,000 the first quarter. Now, there are a few special transactions in that, but we seem to attract special transactions.

There’s nothing more important to Berkshire than to — to have that float, at least, be maintained, but I would say grow. And it will grow, I think. And to have it be obtained at low cost. That float did us no good last year at all. That float was — lost us a lot of money in the year 2001, because it cost us, I think, 12.8 percent. And we didn’t have a way to make money with 12.8 percent money. We will make a lot of money if we can obtain a float at no cost, as we did in the first quarter. The answer to your question is that without knowing any specifics that — without being able to promise you any specifics — you know, I think the float is more likely to grow than to erode. I said last year at this meeting that there — you know, that the float of the American propertycasualty business was 300-and-some billion, and I thought we were sneaking up on 10 percent of it. I was corrected later on. Ferguson pointed out to me that — he sent me the figures. The float of the American property-casualty business is well over 400 billion.

But even at that, you know, we are 8 or 9 percent, or some figure like that, of the float of the whole country. And, obviously, we can’t grow at the same percentage rate starting from that kind of a base as we could when we started back in 1967. But I still think we can grow it. Charlie?

CHARLIE MUNGER: Yeah, I think the questioner realizes that growing float at a good clip, with very low costs, is extremely difficult. It is. It’s almost impossible. But we intend to do it anyway. (Laughter)

WARREN BUFFETT: See, of the two variables, though, that the most important thing to do is to focus at getting it at a very low cost. If we get $37 billion at no cost, or very low cost, you know, then if we don’t do — if we don’t make money with that, shame on us. I mean, the troops have delivered and then it’s up to Charlie and me to figure out ways to use that money. So the important thing is the cost of the float and not the size of the float, although, obviously, we would like it to grow and we will do what we can to make sure that happens.

16. Asbestos liability risks and opportunities

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: Good morning, gentlemen. My name is Hugh Stephenson. I’m a shareholder from Atlanta. My question is on asbestos liability tort cases. It seems like this is growing to be a bigger and bigger problem, including more and more companies, including a number of companies in the Dow Jones 30 industrials. What do you see for Berkshire as the risks and opportunities in the operating and insurance businesses? And, if you two were in charge of writing or structuring a settlement for the whole problem, how would you do it?

WARREN BUFFETT: OK, I’m going to let Charlie tackle most of that, because he’s — we’ve both done a lot of thinking on it. I think Charlie’s thinking is — I know — it’s better, and it may even be more extensive. Asbestos, as I mentioned in some of these retroactive contracts, is a big part of the liability, but it really doesn’t make any difference, unless — it’s much more dependent on the speed of payments than the amount of payment. We are capped on all those types of contracts. So, there’s a figure in the annual report about aggregate asbestos and environmental liability. And that number may look quite big compared to some other insurance companies — but most of that, there’s a limit on. And, it’s a good thing, because asbestos continues to explode. It’s just — we talked about it last year at this meeting, and I said no matter how bad you thought it was, it was going to be worse. And it has been worse. And it will be worse.

And you make a very good point when you bring up the fact that many companies that are thought to be, or have been thought to have been, insulated from the asbestos litigation have now been dragged in one way or another. And that won’t stop, either. Ironically, it’s not impossible that that asbestos litigation actually produces some opportunities for Berkshire, in terms of buying companies out of bankruptcy, free of their asbestos liabilities. We did that — although it occurred much earlier in the — but we bought Johns Manville, which was the, in my memory, was the first major company, really big company, to go into bankruptcy and be forced there by asbestos liability. That happened back in the early ’80s. And that subsequently, they were cleansed of their liability by, in effect, giving a very high percentage of the company and its debt to the plaintiffs. And their lawyers, I might add. And when we came along a year ago, I mean, that was all past history. But we probably wouldn’t own the Johns Manville company if it hadn’t been for some asbestos litigation that started 20 years ago or more.

We may see, actually, more companies that end up in Berkshire that have been forced into bankruptcy through asbestos. But it is a — it’s really a cancer on the American corporate world. And it’s one that growing. And I think I’ll let Charlie talk about it.

CHARLIE MUNGER: Well, the asbestos liability situation in the country is morphed into a very disadvantageous situation where there’s an enormous amount of fraud. And the wrong people are getting money, and there are vast profits for people who are arranging the fraud. And so it isn’t a good situation. There’s also real liability to people who have serious injuries, and some of those people are being deprived because the meritless claims are taking so much of the money that there isn’t adequate money for the people who had the worst injuries. The Supreme Court has practically invited Congress to please step in and create a solution, but, deterred by the plaintiffs contingency fee bar, Congress has refused to do anything. This is not a good situation, and if you can do anything about it, why, I would encourage you to do so.

WARREN BUFFETT: What do you think it will look like in five years, Charlie?

CHARLIE MUNGER: I would be surprised if there were a constructive solution. I think we’ll have more of the mess we have now.

WARREN BUFFETT: It’s huge, too. I mean, you — there are companies that some of you may own stock in that had huge potential liabilities. They didn’t think they had those liabilities, even, maybe, a few years ago. But, they’re finding ways to drag in almost anyone. And, you know, it’s a concern when we buy businesses, because we are a deep pocket. And a tiny — a smaller — company may not have been worth people investing lots of hours on a speculative idea that they could create some kind of a connection with, you know, the ABC Company and hundreds of thousands of people that are claimed to be sick. But, it gets more interesting if Berkshire — it could get more interesting — if Berkshire’s involved. So, it’s a real problem for corporate America and they have not been able, in effect, to come up with a solution. There was a solution, as I remember, and the Supreme Court didn’t allow it. Isn’t that right, Charlie?

CHARLIE MUNGER: That’s right.

WARREN BUFFETT: Yep. We will be very careful, both in our insurance operations, but just as importantly, in our acquisitions and all of that, in terms of avoiding unnecessary exposure to asbestos liability. I’m not terrified at all about our insurance operation, in terms of what’s there from the past. I’m not saying that I know with any precision what the amounts will be, but I — that is not at the top of my list. But, essentially you will have a plaintiffs bar that, going beyond asbestos, will try to turn any kind of human adversity into a claim against somebody that’s got a lot of money. And that’s going on with mold. I mean, you may have seen Ed McMahon is suing his insurer for $20 million for the mold in his house. I just wish I could get some of that mold. I mean — (laughs) —

CHARLIE MUNGER: You probably have it.

WARREN BUFFETT: Yeah. (Laughter) I hope you’re referring to the house. (Laughter)

17. How to pick a stock index fund

WARREN BUFFETT: OK. Area 4.

AUDIENCE MEMBER: Good morning. My name is Tedd Friedman. I’m from Cincinnati, Ohio. You said in the 1996 annual report that most investors will find that the best way to own common stocks is in an index fund that charges minimal fees. Two questions. First: there are a lot of different index funds that hold different baskets of stocks. What criteria would you use, or recommend, to select an appropriate index fund? Second: The price-to-earnings ratio of the S&P 500 is significantly higher than its historical average. What benchmark should an investor use in purchasing this index?

WARREN BUFFETT: Yeah, I would say that in terms of the index fund, I would just take a very broad index. I would take the S&P 500, as long as I wasn’t putting all my money in at one time. If I were going to put money into an index fund in relatively equal amounts over a 20 or 30-year period, I would pick a fund — and I know Vanguard has very low costs. I’m sure there are a whole bunch of others that do. I just haven’t looked at the field. But I would be very careful about the costs involved, because all they’re doing for you is buying that index. I think that the people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them, because it’s just a matter of math. If you have a very high percentage of funds being institutionally managed, and a great many institutions charge a lot of money for doing it and others charge a little, they’re going to get very similar growth results but different net results.

And I recommend to all of you reading — John Bogle’s written a couple of books in the last five years, and I can’t give you the titles but they’re very good books, and anybody investing in funds should read those books before investing, or if you’ve already invested, you still should read the books. And it’s all you need to know, really, about fund investing. So I would pick a broad index, but I wouldn’t toss a chunk in at any one time. I would do it over a period of time, because the very nature of index funds is that you are saying, I think America’s business is going to do well over a — reasonably well — over a long period of time, but I don’t know enough to pick the winners and I don’t know enough to pick the winning times. There’s nothing wrong with that. I don’t know enough to pick the winning times. Occasionally, I think I know enough to pick a winner, but not very often.

And I certainly can’t pick winners by going down through the whole list and saying, this is a winner and this isn’t and so on. So, the important thing to do, if you have an overall feeling that business is a reasonable place to have your money over a long period of time, is to invest over a long period of time, and not make any bet, implicitly, by putting a big chunk in at a given time. As to the criteria as to when you should or shouldn’t, I don’t think there are great criteria on that. I don’t think price-earnings ratios, you know, determine things. I don’t think price-book ratios, price-sales ratios — I don’t think any — there’s no single metric I can give you, or that anybody else can give you, in my view, that will tell you this is a great time to buy stocks or not to buy stocks or anything of the sort. It just isn’t that easy. That’s why you go to an index fund, and that’s why you buy over a period of time. It isn’t that easy.

You can’t get it by reading a magazine. You can’t get it by, you know, watching television. You can’t — you’d love to have something that said, you know, if P/Es are 12 or below or some number, you buy, and if they’re 25 or above, you sell. It doesn’t work that way. It’s a more complex business than that. It couldn’t be that easy when you think about it. So, if you are buying an index fund, you are protecting yourself against the fact that you don’t know the answers to those questions but that you think you can do well over time without knowing the answers to those questions, as long as you consciously recognize that fact. And, you know, I would — if you’re a young person and you intend to save a portion of your income over time, I’d just say, just pick out a very broad index — I would probably use the S&P 500.

But I think if you start getting beyond that — starting to think you should be in small caps this time and large caps that time, or this foreign stock — and as soon as you do that, you know, you’re in a game you don’t know — you know, you’re not equipped to play, in all candor. That would be my recommendation. Charlie?

CHARLIE MUNGER: I think his second worry is that common stocks could become so high-priced that if you bought index funds, you wouldn’t expect to do very well. I didn’t think I’d live long enough to think that was likely to happen, but now I think that may happen.

WARREN BUFFETT: But, probably what you’re saying there is they could get to a level and be at — they’d have to be at a sustained level like that for a long time.

CHARLIE MUNGER: They could be there and stay there for a long time.

WARREN BUFFETT: In which case, you might make 3 or 4 percent. But would there be any way better than that around, under those circumstances, anyway? And pass the peanut brittle, please. (Laughs)

CHARLIE MUNGER: Well, in Japan, where something like this happened, the returns from owning a nice index over the last 13 years or so is negative. Can something as horrible as that happen here? I mean, is it conceivable? I think the answer is yes.

WARREN BUFFETT: But the option in Japan, of course, is to have deposits in a bank, or own Japanese bonds, at somewhere between 0 and 1 or 1 1/2 percent. So, if rates on everything get very low, which means stocks sell very high, you know, then it just means that you live in a different world than existed 20 or 30 years ago when, generally, capital got paid better.

CHARLIE MUNGER: I must say that we have very good packaging.

WARREN BUFFETT: Yeah. (Laughs) Normally he does this in a less formal manner, but he’s on his good behavior today.

CHARLIE MUNGER: We’re protecting the integrity of the peanut brittle.

WARREN BUFFETT: That is true. The package — the nature of anything with butter in it, you know, is that it starts going downhill from the moment you make it. And therefore, the packing has to be extraordinary in order to meet the quality standards that Charlie and I insist on. (Laughter)

18. Effect of 9/11 on insurance underwriting

WARREN BUFFETT: OK, we’ll go to zone 5.

AUDIENCE MEMBER: Mr. Buffett and Mr. Munger, my name is Thomas May (PH). I am 12 years old. I live in Kentfield, California. This is my fifth annual meeting. I know you lost a lot of money as a result of 9/11. But I would like to know how 9/11 changed your life and your investment strategy?

WARREN BUFFETT: Well, I think it, in a sense, is changing — good question. And, it made everybody, I think, in the country aware, I mean, we’ve gone through world wars and all of that, and essentially felt quite protected within these borders. And I have been quite worried about — Charlie can attest to — you know, the possibility, particularly of some kind of nuclear device in this country, by — probably more likely by terrorists than by some, at least, declared act of war by another state. And 9/11 made everybody realize that as humans have not progressed, particularly, in terms of how they behave with each other over the years, they have progressed enormously in their ability to inflict damage on those they hate for one reason or another. And that has increased, you know, for a long time. In the world, if you didn’t like somebody, the most you could do was throw a rock at them. And that went on for millennia, and then it moved into what you might characterize, ironically, as more advanced states. And in the last 50 years, it’s increased exponentially.

And so now people who are megalomaniacs, or psychotics, or religious fanatics, or whatever, and who hate others in some unreasonable way, now have means at their disposal to inflict a whole lot more damage, incredibly more damage, than they had not too many decades ago. And 9/11 brought that home to everybody, something they probably understood subconsciously and didn’t think about very often, to something they thought about much more intensely and it’s become much more real to them. It hasn’t really changed my view about — I mean, in the sense that I — you know, there are millions and millions and millions of people in the world that hate us. And most of them can’t do anything about it. But, a few have always tried to do something about it, and now the instruments they can use, in the most extreme, in a sense, being the human bombs that have appeared in the Middle East, but there’s more ability to — incredibly more ability — for the deranged who want to inflict harm to do harm. And that’s the reality.

In terms of the business aspects of it, in your question, obviously the area at Berkshire that it effects most significantly, by miles, is insurance. And prior to 9/11, even though we recognized that there could be huge monetary damages that flowed from the activities of what I would call deranged people, we hadn’t really written the contracts in such a way as to either get paid for taking that risk or to exclude the risk. In other words, we were throwing it in for nothing. We had excluded risk for war. I mean, we knew that we’d seen what had happened in England in the 40s, and so we had taken account of something that some of us had seen with our own eyes, but we didn’t take account of something that we knew is possible, but we just hadn’t seen. And that’s, you know, that’s the human condition, to some degree. Since September 11th, everybody in the insurance business recognizes that they had exposures that they weren’t charging for, and they either had to exclude those exposure or they had to charge for them.

We have written — first thing we had to do, of course, is we had lots of policies on the books that left us exposed to this, and most of those policies ran for a year, starting at different points. Those have run off to a great degree, but they’re not entirely run off. The other thing we did was on new policies. We have sold a fair amount, quite a large amount, of terrorism insurance that excludes what we call NCB, nuclear, chemical, and biological, as well as fire following nuclear. And, we can take a fair amount of exposure to that sort of terrorism, because it doesn’t — it won’t aggregate. It aggregated at the Twin Towers in a way that — World Trade Center — in a way that just about was as extreme as you could get for non-NCB-type activities. I mean, that was a huge amount of damage done without nuclear, chemical, or biological.

But we can have tens of billions of dollars with NCB excluded throughout a greater New York area, or something, but we can’t have hundreds of billions of exposure that would be exposed, say, to, nuclear activities, because there an act or two, or three, coordinated, could cause damage that would destroy the insurance industry. And if we had coverage on that, it would destroy us as well. So, we write very little — we do write a little, because we can take —we can lose a billion or two billion dollars, and if we got paid appropriately for taking the risk, you know, that’s a business we’re in. But we can’t lose 50 or 100 billion dollars. And, so we take a little bit — we take a few risks that involve nuclear, chemical, or biological, but, generally speaking, the terrorism insurance that we’re writing, and we’ve written a fair amount of it, excludes those particular risks. You can say, you know, take biological. How could that be something significant from an insurance standpoint?

Well, many people don’t realize it, but the World Trade Center loss was, by a huge margin, the largest workers’ compensation loss in history. We think of it as property damage, but, in the end, close to 3000 people had died who were working at the time they died, and therefore, covered by workers’ compensation. If the same thing had happened at Yankee Stadium while they were all watching a baseball game, or some other place, they wouldn’t have been covered by workers’ compensation. So it was happenstance, to some degree. But that was — became the largest workers’ compensation loss in history by a huge margin. Now, if you were trying to cause huge damage in this country, and you could figure out something in the way of a biological agent — and there are people working on this — that could be injected into the ventilation systems, or whatever, of large plants, large office buildings, you could create workers’ compensation losses that, you know, would just totally boggle your mind.

And anybody that was working on such a thing, you have to expect they would — if they thought they had perfected it — would try to do something close to simultaneously in areas where there would be thousands and thousands of people working. And it could make the World Trade Center loss look like nothing. So, we have to be, basically, vigilant, in how much risk we let aggregate in something of that sort. People have always been vigilant about how many houses they’ll insure along a shoreline, or, in terms of physical risk, you know, they don’t want too many homes or factories on the San Andreas Fault, or something of the sort, because they recognize that as having aggregation possibilities. But now you have to think about things that man may plan in the way of catastrophes that will have aggregation possibilities, and that is something that’s pretty much been introduced into the insurance world’s thinking since September 11. And I can tell you, you know, we think a lot about it.

But — I mean, the social consequences are far worse than insurance, but we have to think about how we’d pay our claims, because if we ever do anything really foolish and endanger — take an aggregation — that would cause us to lose the net worth of Berkshire, we would not only not be able to pay the claims of the people in that disaster, but there are other people that suffered injuries 15 years ago, paraplegics and all that, that we’re making payments to for the rest of their lifetime. And we wouldn’t be able to make those payments. And we’re not going to run our business that way. Charlie?

CHARLIE MUNGER: Yeah. To the extent that September 11th has caused us to be less weak, foolish, and sloppy, as we plainly were in facing some plain reality, it’s a plus. We regret, of course, what happened, but we should not regret at all that we now face reality with more intelligence. This inconvenience that we all have, this tightening of immigration procedures, etc., should have been done years ago.

WARREN BUFFETT: The most important thing in investments is not having a high IQ, thank God. I mean, the important thing is realism and discipline. And you don’t need to be extraordinarily bright to do well in investments, if you are realistic and disciplined. And the same thing applies in insurance underwriting. It is not some arcane science that, you know, the ability to which to do successfully is given only to a few, or which requires the ability to do — mathematics have very little to do with it. There’s an understanding of probabilities and all that, a kind of gut understanding, that’s important. But it does not require the ability to manipulate figures — does not — you know, you can do it without calculus, you can do it — you can really do it with a good understanding of arithmetic and an inherent sense of probabilities. As Charlie says, to the extent that — I think we’ve always, from the investment standpoint, you know, if we’ve had any distinguishing characteristics, it would be that, in terms of realism and discipline. And generally that means finding what you don’t know. In insurance underwriting, it’s the same thing.

You have to have — you have to be realistic about what you can understand and what you can’t understand, and therefore, what you can insure and what you can’t insure. And you have to be disciplined about turning down all kinds of offerings where you’re not getting paid appropriately. And September 11th drove home those lessons and probably redefined getting paid appropriately in certain cases.

19. All banks aren’t the same

WARREN BUFFETT: Area 6?

AUDIENCE MEMBER: Hello. My name is Everett Puri (PH). I’m from Atlanta. I wanted to ask you to comment on the relative P/E multiples of bank stocks versus the S&P. They seem to be at 30, 35 to 50-year year relative lows to the S&P, and I was wondering if that’s the result of the market — a change in the market’s perception of the forward growth rates of banks or if the market has perceived that there’s a change in risk there.

WARREN BUFFETT: You’re asking about the performance of what group compared to the S&P?

AUDIENCE MEMBER: Banks.

WARREN BUFFETT: Banks? Well, and what was your assertion about the performance, historically?

AUDIENCE MEMBER: Well —the relative multiple of bank stocks versus the S&P. Back in the ’40s — ’40s, ’50s, ’60s, they commonly traded at, say, one times the S&P multiple and now they’re maybe half that level.

WARREN BUFFETT: Yeah. Harry Keith (PH) used to have a lot of figures on this. I don’t really think about them. I mean, the appropriate multiple for a business, relative to the S&P, will depend on what you expect that business to achieve in terms of returns on equity, and incremental returns on incremental equity, versus that S&P. I mean, if you’ve got two types of businesses, and we’ll say the S&P earns X on equity, and can deploy an additional amount of capital at Y, and then you compare that with any other business, and that’s how you determine which one is cheaper. I would not characterize all banks as the same. I mean, we have in this room John Forlines, who runs the Bank of Granite — Granite, North Carolina — and they’ve earned 2 percent on assets without taking any real risks for decades. It’s a tremendous record. And then you have other banks that have been run by people that took them right into the ground.

I mean, whether it was First Pennsylvania, going back 30 years ago, I think it was John Bunting, and they — they’re not a homogeneous group. We own a couple of — stock — in a couple of banks. We own stock in M&T, that has an exhibit downstairs today. We own stock in Wells Fargo. And we think those institutions are somewhat different than other businesses. So, I don’t think there’s — it goes back to that earlier question. People always want a formula. You know, they — I mean, they go to the Intelligent Investor and they think, you know, somewhere they’re going to give me a little formula and then I can plug this in and I know I’ll make lots of money. And it really doesn’t work that way. What you’re trying to do is look at all the cash a business will produce between now and judgment day, and discount it back at a rate that’s appropriate, and then buy it a lot cheaper than that. And, whether the money comes from a bank, whether it comes from an internet company, or whether it comes from a brick company, the money all spends the same.

Now the question is, what are the economic characteristics of the internet company or the bank or the brick company that tell you how much cash they’re going to generate over long periods in the future. And I would come to a very different answers, you know, on M&T Bank versus some other bank. So, I wouldn’t want to have a single yardstick, or a, you know, relative P/E that I went by. I think that banks have sold — a good many banks have sold — at very reasonable prices. We bought all of a bank in 1969. We bought a bank in Rockford, Illinois. Charlie and I went and looked — we must have looked at a half a dozen banks at that — you know, in a two or three-year period.

CHARLIE MUNGER: Absolutely.

WARREN BUFFETT: Yeah. We trudged around and we found some very oddball banks that we liked. And they were characterized by very little risk on the asset side and very cheap money on the deposit side. And even Charlie and I can understand that. And low prices, incidentally, too. And then they passed the Bank Holding Company Act in 1969, and they killed off our chances to do anything further in buying all of banks. So, we look at banks. We will own bank stocks from time to time in the future. We’ll probably buy stocks in other banks. We’ve also seen all kinds of banks ruined. I think it was, what was the fellow? M.A. Schapiro, who came up with the statement, he said, “There are more banks than bankers.” And if you think about that a bit, you’ll see what I mean. (Laughter) There have been — you know, there have been a lot of people that have run banks in a very injudicious manner, but that’s made for opportunities for other people. A lot of banks have disappeared over time.

I mean, up in Buffalo, where Bob Wilmers runs M&T, there were some other very prestigious institutions that went right down the tubes. And a lot of that happened in the early ’90s or late ’80s. I wouldn’t look for a single metric like relative P/Es to determine what — how — to invest money. You really want to look for things you understand, and where you think you can see out for a good many years, in a general way, as to the cash that can be generated from the business. And then, if you can buy it at a cheap enough price compared to that cash, it doesn’t make any difference what the name attached to the cash is. Charlie?

CHARLIE MUNGER: Yeah, I think the questioner is, maybe, even asking the wrong people that question. I would argue that Warren and I have failed to properly diagnose banking. I think we underestimated the general good results that would happen because we were so afraid of what non-bankers might do when they were in charge of banks.

WARREN BUFFETT: There are a number of banks, that over the last five or six years, on tangible net worth, the number net of goodwill, but on tangible net worth have earned over 20 percent on equity. You would think that would be difficult for an industry to do dealing in a commodity like money, and, of course, the banks will argue it’s not a commodity — but it’s got a lot of commodity-like characteristics —and you would think those kind of returns in a world of 6 percent long-term interest rates and much lower, you would think that would be very hard — well, you would have though it wouldn’t have occurred, you’d think it would be hard to sustain. We been wrong in the sense that banks have earned a lot more money on tangible equity than Charlie and I would have thought possible. Now, I think, to some extent, they’ve done because they stretched out equity much further than was the case 20 or 30 years ago. I mean, they operate with more dollars working per dollar of equity than people thought was prudent 30 or 40 years ago.

But, however they’ve done it, they’ve earned — a number of banks have earned — very high returns on equity in recent years. And, if you earn high enough returns on equity and you can keep employing more of that equity at the same rate — that’s also difficult to do — you know, the world compounds very fast. You know, banking as a whole has earned at rates that are well beyond, on tangible equity, you know, well beyond, I think, what much more glamorous businesses have earned in recent years. Charlie, you have any further thoughts on that?

CHARLIE MUNGER: No, I say again, we didn’t diagnose it as it actually turned out and, even worse than that, we haven’t changed. (Laughter)

WARREN BUFFETT: And even worse than that, we won’t. (Laughter)

20. Detecting fraud and the evils of EBITDA

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: Good morning, Mr. Buffett and Mr. Munger. My name is Andrew Sole, and I’m a shareholder from New York City. I have two questions. The first one, I’d like to direct to Mr. Munger. Pertaining to cash flow analysis, given the practices of numerous corporations of deliberately fabricating cash flow numbers, which occurred in some of the telcos, where they characterized like-kind exchanges as product sales. How do you ferret out this type of fraud? What do you recommend a shareholder, an individual investor, to do, short of obtaining a degree in forensic accounting to uncover this type of fraud? And the second question is, on a lighter note, what books would either of you gentlemen recommend to shareholders that you read this year that you liked?

CHARLIE MUNGER: Yeah. I think you’re asking for a lot if you want some simple way of not being taken in by the frauds of the world. If you stop to think about it, enormously talented people deliberately go into fraud, drift gradually into it because the culture carries them there, and the frauds get very sophisticated and they’re very slickly done. I think it’s part of the business of getting wisdom in life that you avoid getting taken by the frauds. And so I think you’re asking a very good question, but I don’t think there is any short answer. I think there are whole fields that you can just quit playing because it looks like there’s too much fraud in it. And I think we do a lot of that, don’t we, Warren?

WARREN BUFFETT: Yeah. How many times have we been defrauded in the last 20 years?

CHARLIE MUNGER: Well, damn little that we can — it’s amazing how little.

WARREN BUFFETT: Yep.

CHARLIE MUNGER: And I’ve always said that the guy who takes us is going to have a modest little office and a modest demeanor and —

WARREN BUFFETT: He’ll carry around Ben Franklin’s autobiography, I can —

CHARLIE MUNGER: The kind of people who defraud us are not going to be the kind of people who are defrauding everybody else.

WARREN BUFFETT: Yeah. I mean, it’s a very good question. It’s tough to answer. But I will tell you that we haven’t, and we won’t get defrauded often. Now, that may mean we pass up a whole lot of other opportunities, too. But, for example, you raised the question about cash flow. I would say the number of times we’re going to buy into a company, whether it’s through stocks or through the entire company, where people are talking about EBITDA, is going to be about zero. I mean, we start out with — if somebody’s talking about EBITDA, you know — if we take all the people in the world that talk about EBITDA and all the people in the world who haven’t talked about EBITDA, there are more frauds in the first group, percentage-wise, by a substantial margin. Very substantial. I mean, it is, you know, it’s just a start. Now, that isn’t — you know, that — it’s very interesting to me.

If you look at some enormously successful companies, Walmart, General Electric, Microsoft, I don’t think that term has ever appeared in their annual reports. I mean, they just — so when people start talking about that sort of thing, either they’re trying to con you in some way, or they’ve conned themselves, to a great degree. I mean —

CHARLIE MUNGER: Or both.

WARREN BUFFETT: Yeah. Well, that often happens. I mean, if you set out to con somebody, after a while you con yourself, which is why some of the people in the internet stocks, you know, stayed with them. It’s — if somebody is — if they think you’re focusing on EBITDA, they may arrange things so that that number looks bigger than it really is. It’s bigger than it really is, anyway. I mean, the implication of that number is it has great meaning. You take telecoms, they’re spending every dime that comes in, I mean, in many cases. There isn’t — it isn’t cash flow. I mean, the cash is flowing out. But it — you know, you can look at the statement and there’s billions of dollars, supposedly, in depreciation and so on. But there — you know, interest is an expense. Actually, taxes are going to be an expense. Anybody that tells us that making a lot of money before taxes, in terms of EBITDA, is meaningful — you know, you get depreciation by laying out money ahead of time.

It’s the worst kind of expense. We look for float, where we get the money and then pay out later on. But depreciation occurs because you buy an asset first and then you get the deduction later on. It’s the worst kind of expense there is. And you start paying taxes when you actually make money, and when the depreciation runs out at some point. So these — it just amazes me how widespread the usage of EBITDA has become, and I would say there have been people who have tried to dress up financial statements in a way to appeal to people who are impressed by such a number. Charlie and I have found, actually, that — at least to us — many of the crooks look like crooks. Now, we have spotted — we haven’t shorted them — but we have spotted a lot of frauds over the years in public companies. And years before, you know, that the roof fell in. And they usually are people that tell you things that are too good to be true, for one thing. I mean, they, you know, they tell you very mediocre businesses are wonderful businesses for one reason or another.

Or they — they just have a smell about them, you know, in effect. Wouldn’t you say that’s true, Charlie?

CHARLIE MUNGER: Well, sometimes it’s amazingly obvious. Maxwell, of England, his nickname was the “bouncing Czech.” And three weeks before he went under, Salomon —

WARREN BUFFETT: (Inaudible)

CHARLIE MUNGER: — Salomon was aggressively seeking more business from him, with both Warren and I on the board. It shows how much influence outside directors often have.

WARREN BUFFETT: Yeah. Wall Street is —

CHARLIE MUNGER: Imagine extending credit to a guy whose nickname is the “bouncing Czech.” You’d think it — if you wrote it as satire, people would say it was too extreme to be funny. (Laughter)

WARREN BUFFETT: We have read — I mean, Charlie and I have — it’s a hobby keeping track of the Maxwells of the world, and the — They get — there’s a syndrome. I mean, they give off a lot of the same messages. I mean, Maxwell was a classic case, but there — time after time — Wall Street has no filter against them. Wall Street loves them, as long as, you know, as long as they’re pushing out securities and the commissions are there. Charlie and I could not have stopped Salomon from making a deal with Maxwell, you know, right to the last 30 seconds before he sunk, you know, under the ocean.

CHARLIE MUNGER: We didn’t stop First Normandy with Lou Simpson and Warren Buffett and Charlie Munger on the board.

WARREN BUFFETT: Yeah. First Normandy was a case of some guy that manufactured a record out in California that he claimed was from owning a bunch of securities, including Berkshire Hathaway. And, he was going to go public and Salomon was courting him. And this — the record was, you know, it was total baloney. And I think they actually went public for a day or so and then the SEC pulled it back.

CHARLIE MUNGER: Absolutely. They had the offering and then they canceled it before the money changed hands. But it was a very embarrassing episode. And we remonstrated against this obvious insanity, they told us the underwriting committee had approved it.

WARREN BUFFETT: I don’t think they changed underwriting committees, either. (Laughs)

21. Quick decision to buy Larson-Juhl

WARREN BUFFETT: OK. Zone 8.

WARREN BUFFETT: We’re a cheery group up here, aren’t we, on the human condition?

AUDIENCE MEMBER: Good evening from Germany. My name is Norman Reinzhoff (PH). I’m a shareholder for about 10 years. And I want to thank you gentlemen for your long-term performance. I brought you two of my favorite German chocolates. One for you, Mr. Buffett. One for you, Mr. Munger. And I will give them to you tomorrow at the steak house.

WARREN BUFFETT: How much do they sell for a pound? I’m just curious. (Laughter)

AUDIENCE MEMBER: Well, by the way, this is not the chocolate company you wrote to two years ago.

WARREN BUFFETT: Oh.

AUDIENCE MEMBER: They were sold about a week ago for a very low price.

WARREN BUFFETT: Is that —

AUDIENCE MEMBER: This can still be fixed. (Laughter) My question is concerning that what you were just describing as smelling. And, I mean, you told us in former shareholder meetings that if management loves money, do not invest. If they love what they do, preferably if they come tap dancing to the office every day, and all other things are right, then invest. That resonated to me very good with the biblical truth that not money itself, but love for money, is the root of all evil. As a principal that once made once made Prussia the largest of all kingdoms, namely the ethos of doing a job for its own sake. You tell us in this year’s report that you buy a company after talking to the owners for no more than 90 minutes. I’m wondering what kind of — is it the wisdom of experience, just like you described it, or do you do more background work before talking to the owners for 90 minutes? What’s the process like? Do you do background checks or do you talk to competitors? Do the other people in headquarters do that work for you? How does this whole thing work?

WARREN BUFFETT: Well, it’s a very good question. And all of the things you suggest might well make sense. I mean, talking to competitors, talking to ex-employees, talking to current employees, talking to customers, talking to suppliers, all of those things Phil Fisher laid out in a book over 40 years ago, and we have done a fair amount of that over the years. But, Charlie would have behaved exactly the same way I did on the company you’re referring to. I got a call from Craig Ponzio in December, on a Monday. It was about a company that made custom picture frames. I’d never heard of the company before. I’d never heard of Craig before. I didn’t talk to him on the phone much more than 15 minutes. He’s a very — he’d be here today but his wife became seriously ill, at least we hope it’s not serious, but at least there was a problem last night — but Craig talked to me, maybe 20 minutes. And, you can tell when — I mean, it’s just all the difference in the world.

And he laid out what the custom frame — how the — custom frame picture business works, and it’s not complicated. I hadn’t thought about it for 10 seconds in my whole life up till then, you know. I’d had some pictures framed — you know, I get around (laughs) But it’s not hard — I mean, if you think about it for 30 seconds, you — the economics of the industry will sort of make themselves manifest to you. There are 18,000 or so framers in the country. It’s a small business. So you’re dealing with thousands of people. Now, what’s important to those thousands of people that you’re dealing to? They’re doing 250 thousand, or 300, or 400 thousand dollars of business a year, and they have customers who come in periodically — like I come in once every three months, or every six months, and say, here, I’d like a frame, and they may ask me about what kind of frame I want or I may leave it up to them. It’s a service operation to a very great degree.

And Craig built something starting with, in 1980 or so, with 3 million of sales, he built an organization that became enormously responsive to these 18,000 or so framers. They call on those people five or six times a year. They get 85 percent of the frames to those people the next day when they order them. That’s what counts in that kind of a business. You know, you’re not supplying the Big Three with auto parts. You’re not — there’s all kinds of things that give it a distinctive economic character. So Craig told me about that, like I say, in not more than 20 minutes. And he told me the price and he told me the capital that was employed and he gave me some — a few figures. I knew in talking to him that he had a deal that made sense, you know, and I said, when can you come in? That was on a Monday. He said, I’ll be there Wednesday morning. And he came with Steve McKenzie, who is here today, and who I encourage you to meet, and I think they got there at nine and they left at 10:30, and we’d shaken hands.

I was hoping to see Craig at the — today — or tomorrow — but I won’t because of this illness. But, I haven’t seen Craig since, you know. I mean, we made — he got this money, he knew he was making a deal, he had a reason why he wanted — he wanted to sell it to somebody that would be sure to close, that would be a good owner, where the people who worked there wouldn’t be worried because he was leaving. He was leaving with a lot of money, and, you know, people — he wanted to be sure — a lot of people leave with a lot of money and they leave the employees behind and they don’t care what happens. But this guy cared. And I could tell that, and that’s a big plus with me. So, you know, I have not been to their headquarters yet. I plan to be at their headquarters. Steve, I apologize. But I understand what the business is about. And you can — most good businesses, you can understand what they’re about in a very few minutes, unless they’re a kind of business that you can never understand what they’re about.

I mean, there are other businesses, if you spent years on them you still wouldn’t understand what the hell is going on. I don’t know which one of — which American auto company is going to the best 10 years from now. And if I spent all year talking to dealers for Ford and Chrysler and General Motors, and I talked to suppliers, and I talked to people who are driving their cars, I still wouldn’t know anything about what it’s going to look like five or 10 years from now. But I know that you can’t crack our custom picture frame business. I mean, you cannot figure out a way to call on those 18,000 people that are in that business and figure out a way to divert their business to you when you can’t offer a frame as good as ours and you can’t offer service remotely like ours. So it’s a good business. And Craig was 100 percent up — I mean, he told me exactly what he wanted to receive for the business. He wanted cash. You know, that fits us. And there’s nothing complicated about it. I mean, you can drag it out for a long time.

But what would be the sense of it? I mean, if you’re going to make a deal, you’re going to make a deal. Charlie?

CHARLIE MUNGER: Yeah. If you stop to think about it, the ordinary result when a big publiclyheld corporation buys another corporation is that, maybe two-thirds of the time, it’s a terrible deal for the buying corporation and yet the people have taken an enormous time doing it. And we’ve bought all these businesses taking practically no time in doing it, and on average they’ve worked out wonderfully. Why is that? That’s a good question. The answer is we wait for the no-brainers. We’re not trying to do the difficult things.

WARREN BUFFETT: We’re for those.

CHARLIE MUNGER: Yeah. And we have the patience to wait. And then we’re so peculiar that there actually are a good number of businesses in America where they prefer selling to us than to other people. That’s very helpful.

WARREN BUFFETT: I just saw a review of a major company. Made 10 acquisitions in a recent five-year period. Every one of those 10 acquisitions was preceded by due diligence and all the baloney they go through, and they probably had an investment banker’s book and everything. Not one of the 10 in 2001 lived up — or was even close — to the expectations of the presentation that was made at the time of purchase. In aggregate, the 10 earned one-quarter of what they were projected to earn in 2001. In other words, the projections were for four times the actual earnings. And these were companies with strategic — this is a company with a strategic, you know, acquisition department with loads of people to go over the due diligence with investment bankers, quote, “helping them,” end quote, all along the way. And, you know, and 10 out of 10 failed miserably. And, you know, you have to ask yourself, how can you produce that? Because the world didn’t go to hell during that period, either. I mean, that was not a time when we went into a great depression or anything of the sort.

It’s — they were getting — they were buying what was getting sold to them, and it was fulfilling some things that the management — myths — that the management had about itself. And managements have many myths about themselves. And it isn’t that complicated if you just wait for the fat pitch. And the fat pitch doesn’t have to be somebody else doing something dumb or anything like that, because people don’t do that. People come to us, come for a good reason. I mean, they usually want a transaction that a) they want one they’re sure to close. They want —if a deal is made — and they want one that will leave the people happy, that are at the business. When it was announced at Johns Manville, I believe, that Berkshire was the buyer, I understand there was a standing ovation. And I’ve seen it at, you know, whether it’s Jordan’s or Star Furniture. People are concerned. If you’ve been working at a company for 20 years and you know that the owning family is getting older and has some problems to take care of, believe me, they talk in the hallways about that.

What’s going to happen when, you know, the family sells the place? And people worry about that. And to have an answer for them, so that they all sleep the night that it’s announced that the business has changed hands, means some —a lot — to some owners. And it doesn’t mean anything to other owners. I don’t think we’ve ever bought a business from a financial operator. Can you think of any, Charlie?

CHARLIE MUNGER: I can’t think of one. The — you know, somebody once defined hell, in a legal system, as a place with endless due process and no justice. And we’re getting close. And similarly, in the corporate world, if you have endless due diligence and no horse sense, you’ve just described a corporate hell, at least for the people who own the business.

22. Buffett shows little interest in cryonic suspension

WARREN BUFFETT: Go back to zone 1. Oh, I’m sorry. Excuse me one second. We have — we have — Mark, do we have a number of people in the music hall that — Pardon me?

VOICE: Yes.

WARREN BUFFETT: Do we have somebody at zone nine?

VOICE: Yes.

WARREN BUFFETT: OK.

AUDIENCE MEMBER: Mr. Buffett, my name is Luke Nosek from Palo Alto in California. The first thing I’d like is just to thank you for saving my shirt from the internet stocks for the last few years. And, actually, it’s not quite true. I lost my shirt but you did save my underpants. I bought the stock in late 2000. And, it’s actually not just been about the stock. It’s about — been about — learning from you and your investment philosophy and your character. It’s been very inspiring at the beginning of my professional life to have a mentor like that. And I would love to — (Applause) I think it’s been very inspiring for all of us for, I guess, it’s been almost 50 years of your investment professional life that’s been continuing to go over the top. I’d love that — for that — to continue for a long time. I’d love to see the next 50 years.

And, I don’t know if that’s possible, given current medical technology, but I have some friends in biotech who have been involved in companies that do something called cryonic suspension. And I’m curious if you’ve heard of it. It’s the process of — or looked into it — the process of freezing people as they’re dying, and —

WARREN BUFFETT: Just don’t do it too early with me. (Laughter)

AUDIENCE MEMBER: It’s, actually, legally, after pass away. But even if the risks are — even if the chances of it working are very small and the discount rate is huge over a long period of time, I wonder if you’d looked into it? What — if you would consider or think about that possibility? And again, thank you for your service and all the lessons for the last 50 years (inaudible)?

WARREN BUFFETT: Well, I appreciate the suggestion and there probably isn’t much downside to it. (Laughter)

CHARLIE MUNGER: It takes a lot of electricity to keep you frozen for all eternity. (Laughter)

WARREN BUFFETT: That’s all right. We get our electricity wholesale at MidAmerican. (Laughter) We’re for anything that extends our productive years. I must say, at 71, I can’t recall ever having any more fun than I’m having now. And I think Charlie seems to be in pretty good spirits too, so it — We are lucky to be in the business we’re in. I mean, just imagine, you know, if we’d been in — been halfway athletic, or anything like that, where you’re, you know, you — essentially you’re limited by age. But, there’s really no — there are no problems in this business. I mean, as long as I can kind of lift the phone up (laughs) and hear Craig on the other end, or if I can’t hear him, I get him to tell to Charlie and he can relay it on to me. It’s a very easy business to conduct throughout your life. And we’re fortunate that way.

23. Fruit of the Loom: good management for good company

WARREN BUFFETT: Zone 10, do we have anybody?

AUDIENCE MEMBER: Good morning. My name is Pamela Harrington and I live here in Omaha, Nebraska. And my question concerns your investment in Fruit of the Loom. Could you tell us about how that investment fits in with your philosophy about turnaround situations and your preference for businesses that have barriers to entrance? Thank you.

WARREN BUFFETT: Yeah. Well, Fruit of the Loom got in trouble for two reasons. One is they borrowed too much money. They borrowed about a billion, 200-million, and actually it went something beyond that because they were engaged in some other transactions that were off balance sheet and so on. So, it was a company that, in a financial sense, was out of control. Simultaneously with that, they had a lot of operating problems, too. But we were not going to inherit the capital structure and we were not going to inherit the management that had caused the operating problems. But, much to our pleasure, we were going to inherit a management that had done an incredible job in running the business for a long time prior to the sins of the recent period. And, we made a condition — I don’t think there’d probably ever been a condition made to a bankruptcy court proposal — where we said our offer is not contingent on financing, it’s not contingent on, you know, if war breaks out, our offer is still good and everything else.

But John — but we did make it contingent on John Holland being available to run the business, because John had done a sensational job of running the business before the difficulties of the excess leverage and operating insanities. And he was willing to come back, which was very important to us. And Fruit of the Loom has, I don’t know, between 40 and 45 percent of the men’s and boy’s market. It’s a product that has a deserved quality image. It’s accepted in a big way by very important retailers who were disturbed by things that took place prior to, and early in, the bankruptcy, but who loved the idea of having a product like Fruit of the Loom in their stores. And it’s a very low-cost producer of a very basic product. So, it fits us very well. And now the management can simply worry about building the brand and running plants as efficiently as possible. And there’s been some rearrangement of plants, as has happened throughout to many things connected with textiles. But it’s an absolutely first-class business.

And, you know, we’d like to get a little more share in the women’s market. We’d like to get a little more share in the men’s and boy’s market, too. But it’s made to order for us. But it’s only made to order with the present management. If we had to take on the management that was there for a few years, you know, we wouldn’t have bought it for a dollar. It would have been a disaster. And it was a disaster for a while. But fortunately, it’s a little like GEICO in the mid ’70s. I mean, GEICO was a marvelous company that got mismanaged in a big way for a while. But its fundamental advantages were there throughout the period, and what you had to do was get rid of the mismanagement and get back to the basics. Charlie?

24. Three book recommendations

CHARLIE MUNGER: Yeah, I don’t have anything on that subject, but I neglected to answer the question about what books would we recommend. The two books that I recommend this year were both sent to me by Berkshire shareholders who thought I might like them, and boy were they right. The first is called “Ice Age,” which is a description of the past history of glaciation in the last few hundred-thousand years and how they figured out what had happened and why it had happened. And I think it’s the best book of scientific explanation I have ever read. It’s been published in England and it’s going to be published in the United States this fall. And the airport has like 20 copies — PD Waterhouse — which they did by scrounging all of Canada. And so, I recommend that book to you, but a lot of you are going to have to wait for the fall, I think. The other book was “How the Scots Have Helped Create the Modern World.”

That’s a subject that’s always interested me, how a tiny, poor, little population of Celtic people had such a huge favorable impact on the world, starting from poverty. And, of course, it’s related to the Irish, who were a similar ethnic strain with a different religion. And, it was marvelous book. And I forget the author’s name, but I recommend both of those books to all of you.

WARREN BUFFETT: Yeah. I’ll recommend a book which may sound a little self-serving, but it nevertheless — I think — I think this group, many of you would enjoy reading about the Berkshire managers. And Bob Miles has brought out a book and it tells about the people who are handling your capital. And, I don’t think you could have a — well, I know you couldn’t have a better group. And so therefore, if you feel like reading about them, I would — Bob has done a good job of interviewing — and I would encourage you to read about them. And I think you’ll like your investment better after you read about the managers than if you just read what Charlie and I write.

25. How to make the “right” friends

WARREN BUFFETT: Let’s go back to zone 1. We’re going to break at noon, incidentally, and we’ll probably break for 30 minutes or thereabouts and then we’ll come back. Go ahead.

AUDIENCE MEMBER: Hello, Mr. Buffett and Mr. Munger. My name is Jesse Spong (PH) and I am 12 years old, from California. This is my second consecutive year in attendance. My parents brought me here to learn from you. My question is not about money. It’s about friendship. How do you remain friends and business partners for so long? And what advice do you have for young people like me in selecting true friends and future business partners? Thank you. (Applause)

WARREN BUFFETT: Well, when Charlie and I met in 1959 we were introduced by the Davis family, and they predicted that within 30 minutes we would either not be able to stand each other or we would get along terrifically. And that was a fairly insightful analysis, actually, by the Davises, because you had two personalities that both had some tendencies toward dominance in certain situations. But we hit it off. We have disagreed, but we have never had an argument that I can remember at all in 43 years. And yet we both have strong opinions and they aren’t the same strong opinions at times. But the truth is we’ve had an enormous amount of fun together, we continue to have an enormous amount of fun, and nothing will change that, basically. It may have worked better because he’s in California and I’m in Omaha, I don’t know. (Laughs) I’ll let Charlie comment on it.

CHARLIE MUNGER: Well, that’s a wonderful question you’ve asked, because Warren and I both know some very successful businessmen who have not one true friend on earth. And rightly so. (Laughter)

WARREN BUFFETT: That’s true.

CHARLIE MUNGER: And that is no way to live a life. And if by asking that question, you’re asking how do I get the right friends, you are really onto the right question. And when you get with the right friends, if you’ve worked hard at becoming the right sort of fellow, I think you’ll recognize what you have and then all you have to do is hang on.

WARREN BUFFETT: The real question — what is — the question is what do you like in other people? I mean, what do you want from a friend? And if you’ll think about it, there are certain qualities that you admire in other people, that you find likeable, and that cause you to want to be around certain people. And then look at those qualities and say to yourself, “Which of these is it physically or mentally impossible for me to have?” And the answer will be none, you know. I mean, you — it’s only reasonable that if certain things that attract you to other people that, if you possess those, they will attract other people to you. And secondarily, if you find certain things repulsive in other people, whether they brag or they’re dishonest or whatever it may be, if that turns you off, it’s going to turn other people off if you possess those qualities. And those are choices. You know, very few of those things, you know, are in your DNA. They are choices. And they are also habits.

I mean, if you have habits that attract people early on, you’ll have them later on. And if you have habits that repel people, you’re not going to cure it when you’re 60 or 70. So it’s not a complicated equation. And, as I remember, Ben Franklin did something like that one time. Didn’t he list the qualities he admired, and then just set out to acquire them?

CHARLIE MUNGER: Absolutely. He went at it the way you’ve gone after acquiring money. (Laughter)

WARREN BUFFETT: They’re not mutually exclusive.

CHARLIE MUNGER: No.

26. One thing you don’t need for investing

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: Hello, Mr. Buffett and Mr. Munger. My name is Kevin Hewitt (PH) and I’m a shareholder from Chicago, Illinois. This question is for you, Mr. Buffett, and Mr. Munger. Mr. Buffett, I’ve followed your career since I first read about you in the first edition of the Forbes 400 that came out in ’82. Reading your profile also led me to Ben Graham’s book, The Intelligent Investor. Since that time, I’ve followed the careers of — I’ve also followed the careers of other successful investors, such as Walter Schloss, Bill Ruane, Richard Rainwater, Robert Bass, and Edward Lampert. In following your career, and the careers of these other highly successful investors, it’s my observation and my firm belief that despite their obvious high level of intelligence and some of them having gone to some of the best schools in the country, none of these people, including yourself, were born great investors. Every one of these, including yourself, learned to be a great investor. Graham learned from his experience. You, Bill Ruane, Walter Schloss, learned from Graham.

Richard Rainwater learned from you, Bill Fisher, and Charlie Allen, and from reading Graham. Robert Bass and Ed Lampert learned from Richard Rainwater and, most likely, from reading Graham and Fisher as well. These observations lead me to the conclusion that despite intellectual brilliance, although that probably helps, I’ve come to the conclusion that great investors are made, not born. Do you and Mr. Munger agree with this conclusion? If so, why? If not, why not? And if you do agree, what things would you recommend that someone do if they wanted to become a great investor? Also, what mental attributes do you think a person should have if they want to try to become a great investor? Thank you very much.

WARREN BUFFETT: Yeah, I’d largely agree with what you said. I would say that there — I don’t know to what extent — an ability to detach yourself from the crowd, for example — I don’t know to what extent that’s innate or to what extent that’s learned — but that’s a quality you need. I would agree totally with you that a great IQ is not needed. I mean, you do not have to be terrifically smart to do well as an investor, at all. I would say you’re 100 percent right that I learned from Graham first in a very, very big way, and I learned something additionally from Bill Fisher, and I learned a lot from Charlie. And the proof is in my record, actually. From 11 to 19, I was reading Garfield Drew, and Edwards and Magee, and all kinds of — I mean, I read every book — Gerald M. Loeb — I mean, I read every book there was on investments, and I didn’t do well at all. And I had no real investment philosophy. I had a lot of things I tried. I was having a lot of fun.

I wasn’t making any money. And I read Ben’s book in 1949 when I was at University of Nebraska, and that actually just changed my whole view of investing. And it really did, basically, told me to think about a stock as a part of a business. Now, that seems so obvious. You can say, you know, that why should you regard that as the Rosetta Stone? But it is a Rosetta Stone, in a sense. Once you crank into your mental apparatus that you’re not looking at things that wiggle up and down on charts, or that people send you little missives on, you know, saying buy this because it’s going up next week, or it’s going to split, or the dividend’s going to get increased, or whatever, but instead you’re buying a business. You’ve now set a foundation for going on and thinking rationally about investing. And there’s no reason why you need a high IQ to do that. There’s no reason why you have to be born in some way.

I do think there’s certain matters of temperament that may be innate, they may be learned, they may be intensified by experience as you go on, partially innate, but then reinforced in various ways by your experience as you go through life, but that’s enormously important. I mean, you have to be realistic. You have to just define your circle of competence accurately. You have to know what you don’t know and not get enticed by it. You can’t be — you’ve got to have an interest in money, I think, or you won’t be good in investing. But I think if you’re very greedy, it’ll be a disaster, because that will overcome rationality. But I think the same books I read had really molded what I — how I — thought about businesses and investing. I think that they’re just as valid now. I mean, I haven’t seen anything in the last 25 years, and I read — I glance through — most of the books.

I’ve seen nothing to improve on Graham and Fisher in terms of the basic approach of going about investing, which is to think about stocks as businesses, and then think about what makes a good business. And really, that’s all there is to investing, and having a margin of safety, which Ben talks about, and so on. It’s not a complicated process, but it definitely requires a discipline. It requires insulating yourself from popular opinion. You just simply cannot — you can’t pay any attention to it. It doesn’t mean anything. So you can’t — the idea of listening to lots of people tell you things, it’s just a waste of time, you know. You’d be better off just sitting and thinking a little bit. I mean, there were no analyst reports on custom frame makers, you know. It just doesn’t — and they wouldn’t have been any good anyway. You just have to think, but you have to think about them in terms of their business characteristics and what they can earn on capital employed, and that sort of thing.

I would just read the, you know, I would read the Graham and the Phil Fisher books. And then read lots of annual reports, think about businesses, and try and think about which businesses you understand and which you don’t understand. And you don’t have to understand them all. Just forget about the ones that you don’t understand. Charlie?

CHARLIE MUNGER: Yeah, I have a deeper level of generality. If you have a passionate interest in knowing why things are happening, you always are trying to figure out the world in terms of why is this happening or why is this not happening, that cast of mind, kept over long periods, gradually improves your ability to cope with reality. And if you don’t have that cast of mind, I think you’re destined, probably, for failure, even if you’ve got a pretty high IQ.

WARREN BUFFETT: I would say we’ve seen relatively little correlation between investment results and IQ. I mean, not that there are a whole bunch of people out there with 80 IQs that are knocking, you know, the cover off the ball, but there are all kinds of people with high IQs that get no place. And, yet, it’s probably, in a sense, it’s more interesting to look at why people with high IQs don’t succeed, and then sort of cast out those factors, see if you can cast them out in yourself, and leave a residual that will work. Because it’s like Charlie always says, “All I want to know is where I’m going to die, so I’ll never go there.” (Laughter) If you study the people who die financially, you know, with high IQs and say why do they die, you know, you’ll see certain overwhelming characteristics that are present in most of the cases.

And you’ve just got to make sure that either you don’t possess them, or if you do possess them, that you can get rid of them or control them in some manner.

27. Coca-Cola’s domestic marketing

WARREN BUFFETT: Area 3?

AUDIENCE MEMBER: Yes. Steve Pattice (PH), shareholder from Los Angeles. Good morning, Warren and Charlie. I’d like to address the domestic Coke business. It seems to me that Coke has been pulling back from what former great CEO Roberto Goizueta often said, and I paraphrase, we can’t control what soft drinks people buy at retail. But in public venues, including food service, we can control that. We’ve all heard about the marquee lawsuits that Coca-Cola has had, such as the NFL, United Airlines, and emerging restaurant brands like Baja Fresh Mexican Grill. But they’re also losing contracts with major — or minor — league baseball, college, and high school vendors. Furthermore, it’s my understanding that our competitor PepsiCo has been the fastest-growing domestic beverage company for three consecutive years. My question is has Coke’s vision changed, and is my perception that the domestic fountain division has lost their way correct?

WARREN BUFFETT: No, I would not say that’s correct, but I understand the reason for the question. Because there is the question, always, of the marquee-type accounts. I mean, the truth is, either of the two major colas that are going to be sold and associated with, say, the Olympics or Disney World, or whatever it is, is going to lose a lot of money, if only directly thought of in terms of those contracts. But there is that association over years. I mean, Coke wants to be where people are happy, and they want that in people’s minds. And that tends to be, you know, sporting events, it’s the Disneylands, Disney Worlds, of the world. But, in the end, can you have a determination to be at every one of them at any price? And the answer, obviously, is no. It was sort of interesting, about five years ago, or thereabouts, Coke took Venezuela, essentially, away from Pepsi. Pepsi — Venezuela was one of the few countries in the world in which Pepsi was the leader, and that was because the Cisneros family had developed the business down there very early.

So, Pepsi had 70 percent or 80 percent of the business. And in sort of a midnight raid, Coke bought the Cisneros operation, converted it all to Coke overnight, flew 747s in because they didn’t want to have — they wanted it to be a surprise, and they just reversed the whole situation in Venezuela. And, it actually — whether that is going to turn out to be smart or not is another question, because they paid a lot of money to do it. But in any event, Pepsi was very upset. And so, the University of Nebraska pouring rights came up, very shortly thereafter. And the universities, as you know, bid out these things to give sort of an exclusive to a given university. And Pepsi came in and bid about twice as much for the Nebraska pouring — the University of Nebraska — pouring rights, as was the sort of the standard, in terms of per-student at universities throughout the country, at Penn State or something. And I like to think that they were trying to stick it in the eye of Coke by doing that in Nebraska.

And I feel that the University of Nebraska really should give me credit for about 5 million a year of contribution to the university, because I don’t think Pepsi would have done it if it hadn’t been Nebraska. Now, the question is, people at Coke called me, and they said, you know, “Do you want us to go up against this?” And I said, you know, no. I mean, it’s nice to have everybody at University of Nebraska drinking Coke, but if we’ve got everybody at Penn State drinking Coke, I mean, it’s probably worth as much, as potential Coke customers. So, there is this bit where one organization or the other, particularly if they’ve lost one in the immediate past, may overbid a little for the next one. And you know, for United Airlines, the question is how far do you let United, or whomever it is, drive you, in terms of making that specific deal.

I would say that in something like the Olympics, you know, I think Eastman Kodak made a huge mistake when they let Fuji take away the Los Angeles Olympics 20 years ago or so, because it allowed Fuji to get put on a mental parity, to a degree, with Kodak, whereas Kodak had always owned that. And now Fuji was there with Coca-Cola and IBM and a few premier companies. And it was a mistake. So, in the end you end up overpaying, in any kind of an objective quantitative sense, for most of these marquee properties. But you can’t — it’d be foolish to think that you had to have them all. Coca-Cola, actually Pepsi-Cola — colas have generally declined, somewhat, as a percentage of per capita consumption in the United States. And Pepsi-Cola has lost considerably more than Coke. What has kept Pepsi doing well, basically, is Mountain Dew. Mountain Dew has been a very successful product for Pepsi, and that has gained share in carbonated soft drinks. Carbonated soft drinks — the average person in this room drinks 64 ounces of liquid a year. Carbonated soft drinks are just under 30 percent of that.

And beer and milk are each about 11 or 12 percent. They’re both down from 10 years ago. Carbonated soft drinks are up substantially. Bottled water is up somewhat, but the only two categories that are really up are carbonated soft drinks, from ten years ago, and bottled water. Coffee is down significantly. You think Starbucks has done a lot, but coffee just keeps going down and down and down. If you look at Coke, of the almost 30 percent of the liquids consumed in the United States, they have about 43 percent of the 30, in their arenas. So you’re talking 13 percent of all liquids, you know, tap water, everything else that the American water — the American people — drink, is a Coca-Cola product. And it’s off a couple tenths of 1 percent from the high, but it’s higher than five years ago, it’s higher than 10 years ago. And, actually, in the first quarter, it did quite well, too. So, I think there’s been no — I mean, I’m sure there’s been no loss of marketing vigor. Doug Daft is a marketer at heart.

He’s a, you know, he comes from the same — he’s put together the same way as — along the same lines — as Don Keough. There’ll never be another Don Keough. But Doug is the same type of guy. He’s in tune with the product. And I would — if I had to bet, I would bet the market share of Coke, in terms of both carbonated soft drinks and in terms — actually in terms of water. I mean, the Dasani — the gains in Dasani last year were like 95 percent, in the first quarter they were about 60 percent. Those were huge gains. And Pepsi got an earlier start with Aquafina. But Coke has almost closed that gap. Coke is a very, very powerful marketing organization. So 18, I think, point-seven billion cases, there’s nothing like it in the world. And I do not think they’ve lost their focus or drive in any way whatsoever. Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

WARREN BUFFETT: You might try Vanilla Coke, too. It’ll be out next month.

28. How long does it take to dig a moat?

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Good morning, Mr. Buffett, Mr. Munger. My name is Jerry McLaughlin. I’m from San Mateo, California. First, I just want to thank you for all the effort you put into the annual reports, the letters, and these conversations. I’ve learned a lot, and they’re terrific, which is why I’m here from half a country away. (Applause) You know, you’ve said that great companies are those that have an economic moat, and I understand that phrase to mean a sustainable competitive advantage. Do businesses begin their lives with sustainable competitive advantages, or must that be developed over a very long time? And then, what are the fundamental bases upon which you’ve seen companies successfully develop sustainable competitive advantages? Of those, which do you think is the most enduring and which is the least?

WARREN BUFFETT: Well, sometimes they can develop it very quickly. I mean, I would say that Microsoft, in terms of the operating system, you know, that was a relatively quick development. But that was an industry that was exploding, and things were changing very fast. On the other hand, if you go back to See’s Candy, which started in 1921, you know, there was no way you could build a sustainable competitive advantage, at least that would be recognizable, in times measured shorter than decades. I mean, you opened up one shop at a time, and nobody’d heard of you originally, and then a few people did. And boxed chocolates were something that, you know, people may have bought once or twice a year for a holiday occasion or whatever. So, you weren’t going to embed yourself in the minds of Californians in one or two or five years just because you were turning out, you know, outstanding box of chocolates. So it depends on the way the industry itself is developing. Walmart has done a fabulous job in a — an incredible job — in quite a short period of time.

But even they, you know, they took it in the small towns, and they progressed along, and refined their techniques as they went. But I would say that there could be things in new industries. I would say with NetJets, we have a sustainable competitive advantage. And that’s an industry that was only originated in 1986 when Rich Santulli got the idea, and it was in its infancy — I mean total infancy — for a good many years after that. But what he has built, and is building and fortifying, is that sustainable competitive advantage. But it depends very much on the industry you’re in. And I mean, Coca-Cola, 1886, Jacobs Pharmacy, Atlanta, Georgia, you know, John Pemberton came up with a product. And did he have a sustainable competitive advantage that day? If he did, he blew it because he sold the place for 2,000 bucks to Asa Candler. He did — and it took decades, thousands of competitors over that time, and — you know, but they were painting one barn at a time and designing one Saturday Evening Post ad at a time, and all of that.

And — and pebbles — you know, around the world in World War II, General Eisenhower went to Mr. Woodruff and he said, “I want a Coke within the arm’s length of every American serviceman.” He said, “I want something to remind them of home.” And so he built a lot of bottling plants for Coke around the world. And that was a huge impetus. But that was, what, 60 years or so after the product was invented. So it takes — it takes a long time in certain kinds of products, but I could see certain areas of the world where a huge competitive advantage is built in a very short period of time. I would say that probably, in terms of animated feature-length films, for example, Walt Disney did that. And after “Snow White” and a few more, it took him a while until he could cash in on it, but he — it became Disney and nobody else in that field for quite a while, and fairly quickly. Charlie?

CHARLIE MUNGER: Yeah, there are a lot of different models that create a sustainable competitive advantage. And there are also some models of where you can lose it very fast. Just ask Arthur Andersen. That was a very good name in America not very long ago. And I think it would be harder to lose the good name of Wrigley’s gum than the good name of Arthur Andersen. I think there’s some perfectly remarkable competitive advantages that people have gotten over time. And the great trouble with the investment process is that they’re so damned obvious that the stocks sell at very high prices.

WARREN BUFFETT: Snickers has been the number one candy bar for probably 30 or 40 years now.

CHARLIE MUNGER: Yeah, and —

WARREN BUFFETT: Well —

CHARLIE MUNGER: — in Russia, it turns out that everybody likes Snickers.

WARREN BUFFETT: What — how do you really knock it off? You know, I mean, we make candy, we would love to displace Snickers, but it’s hard to think of ways to knock them from the number one spot. I mean, my guess is that they’ll be number one in, you know, 10 years from now in candy bars, and the list doesn’t change much in that field because — if you think about the nature of how you make that choice as to what candy bar — If you were chewing Spearmint chewing gum five years ago, and you buy a pack of some chewing gum today, it’s likely to be Spearmint. I mean, there’s just things that you experiment a lot with, and there’re things that you don’t fool around with once you’re happy. And, you know, you can understand that if you observe your own habits and people’s habits around you. But there’s other — usually if something can gain competitive advantage very quickly, you have to worry about them losing it quickly, too.

I mean, when an industry is in flux, there are a lot of people that think they’re the survivors, or the ones that are going to prosper, where it turns out otherwise.

29. Bullish on Coca-Cola & Gillette

WARREN BUFFETT: Area 5.

AUDIENCE MEMBER: Mr. Buffett, my name is Pete Danner (PH) from Boulder, Colorado. And I would also like to thank you two for what you bring to the game. I heard your response to the Coke — to the question regarding Coca-Cola. In the annual report a few years back, you described Coca-Cola and Gillette as the two “invincibles.” With Pepsi as a strong competitor today, do you still continue to view Coca-Cola as the “invincible?” Additionally, with respect to American Express Company, with last year’s financial results at American Express, how do you now view American Express?

WARREN BUFFETT: Yeah, I think the term I used was “inevitables,” actually, but it’s very close to the same thing. And I would — and I think when I made that statement, I said Coca-Cola in soft drinks or Gillette in blades and razors. I mean, I did not extend them to the entire corporate portfolio, particularly in the case of Gillette, but to the blade and razor business. Gillette now has 71 percent, by value, of the blade and razor business in the world. Just think of that. I mean, 71 percent. Here’s a product that everybody knows what it does, they know how to — you know, they know where it’s sold, they know that it’s a high-margin business. I mean, it isn’t like the world — the capitalist world — is unaware of the money that could be made if they could knock off Gillette. But they can’t knock off Gillette, and it’s 71 percent. And that’s a little higher percentage than when I wrote about it.

Actually, Coca-Cola’s worldwide market share is a little higher now than it was when I wrote that five years ago. And I would say that five or 10 years from now I would be amazed if Gillette or Coca-Cola has lost market share in their respective fields. Coca-Cola sells half, roughly, of the soft drinks in the world, and soft drink consumption per capita goes up, basically, every year, and the per capitas go up — I mean the capitas — go up every year, also. So you get these gains, maybe they’re 3 percent or 5 percent in units, or 4 percent, 5 percent in the first quarter, but it was poorer than that. I think it was 3 percent last year. But when you have half the world, and the world’s population is growing at a little under 2 percent and you’re getting 3 percent or 4 percent from something as pervasive as soft drinks, you know, you are doing all right.

And it was crazy, in my view, for people to think that earnings can grow 15 or 18 percent a year in a business where units — we had half the world’s business, and units are going to grow fine — but they’re not going to grow anything like 15 or 12 percent or 10 percent. The Coca-Cola business has done fine. People went crazy, in terms of valuing some of these businesses a few years back, and I think we had some cautionary language in there, generally, about the valuations at which the businesses sold. But the businesses — at 71 percent in blades and razors, that is a — there’s some countries where it’s 90. In the U.S., it’s also about 70 percent. Those are huge market shares of something people use every day. In this country, you know, it’s a little over eight ounces per day, more like — well ,actually more like 9 1/2 ounces per day — for every man, woman, and child in the United States, out of the 64 ounces they drink. Well, you’re not going to have galloping percentage increases from that arena.

But the company’s made, basically, good progress. People got carried away from the stock — with the stock — and I would argue that they may have gotten encouraged a little bit too much by, not only Wall Street, but even by company pronouncements, in terms of attainable — possibly attainable — gains. There aren’t large companies —you know, there may be one someplace, somehow, very large now that will grow at 15 or 18 percent a year — but it just isn’t in the cards in the world. And we don’t want anybody to think Berkshire can do that either, because we can’t do it from a very large base. The world doesn’t allow that. But it does allow making reasonable progress, and certainly Coke and Gillette, in those areas where I said they were inevitable, have done very well. They haven’t — Gillette has not done as well with acquisitions, which is clear.

I mean, the Duracell — the Gillette acquisition of Duracell — resulted in giving 20-odd percent of the business for another business, and that business has not done nearly as well as either the management or the investment bankers thought it was going to do at the time the deal was made. Charlie?

CHARLIE MUNGER: Well, I would say, regarding that last instance, that that’s the normal result. When you try and — you’ve got a wonderful business and you issue shares in it to buy another business, I’d say at least two times out of three, it’s a terrible idea.

WARREN BUFFETT: Well, GEICO is a great example. GEICO is a wonderful business. Absolutely wonderful, gets more wonderful by the day, has the world’s best manager, Tony Nicely, running it. GEICO, in the last 20 years, went into three — at least three — other insurance businesses I can think of. They went into Resolute Insurance, which was a reinsurance operation started in the mid-80s. It was a disaster. They went into two others, Southern something or other, and another one that started with an M. I don’t know why in the hell they would go into them. I mean, they had a great, great insurance business, and there aren’t that many great insurance businesses. And neither one of those amounted to anything. I think, you know, they sold them off at some point. But why would you have an absolutely wonderful business and start one and buy two others that are obviously mediocre, where you bring nothing to the party? But managements — it’s very human to want to do that. It’s no great sin that the GEICO management did it, because we see it happen time after time after time.

I can tell you this: Charlie and I have no urges like that. I mean, we want to buy easy things. We do not have to prove our manhood by doing something terribly difficult. And I think a lot of managements feel that necessity. They’ve got a wonderful business — The cigarette companies did that. Cigarette companies had these great businesses, and, you know — it irritated them that they — they liked to think they’re business geniuses, so they would go out and buy other things and those other businesses, generally, did not do that well. I’m not saying they should’ve been in the cigarette business in the first place, but they were not business geniuses because they made a lot of money selling an addictive, you know, product. That did not make them business geniuses, and so they wanted to prove it other ways, and they bought businesses and fell on their face, in many cases. Charlie, do you have any more to add on cigarette companies?

CHARLIE MUNGER: No, but I think a lot of people rise to the top in publicly-held corporations, who come up in sales or, you know, engineering, or drug development, or what have you. It’s natural to assume once you’re sitting in the top chair that now you know pretty much everything. Or at least, how to get wisdom out of this wonderful staff and all these outside advisors that are now available to you. And so I think it’s very natural that perfectly terrible acquisition decisions get made, I’d say, more often than not.

30. Staying rational and avoiding confirmation bias

WARREN BUFFETT: Area 6. We have a break in about five minutes. In fact, we’ll do this question and then we’ll break.

AUDIENCE MEMBER: OK. My name’s Paul Tomasik from Illinois. I’d like to talk about your thinking, if you don’t mind. In the “Fortune” magazine article that you sent to all the shareholders, you referenced a practice by Darwin that when he found something that was contrary to his established conclusions, he quickly wrote it down because the mind would’ve pushed it out. And if you read “The Origin of Species,” Darwin’s very careful to avoid fooling himself. He very carefully asks and answers the hard questions. It’s a feedback mechanism, and you’ve picked up on one of his feedback mechanisms to avoid fooling yourself. So the two questions are this: If you look — model — how you think, Charlie thinks, how physicists think, how mathematicians think, you see the same pattern. You want to use logic. You’re dedicated to logic. But logic’s not enough. You have to avoid fooling yourself, so you build feedback mechanisms. So the first question is, do you see it that way?

That you’re thinking just like mathematicians, physicists, and some of the other exceptional businessmen, by being logical and being careful to have feedback mechanisms? And the second question is about other feedback mechanisms. Your partnership — sitting next to you is a great feedback mechanism. Hard to fool yourself when you partner with Charlie Munger.

WARREN BUFFETT: Right.

AUDIENCE MEMBER: This meeting’s a feedback —

WARREN BUFFETT: Hard to fool him, too. (Laughter)

AUDIENCE MEMBER: But that’s not an accident. The meeting is one level of feedback mechanism, the way you attack the annual report letter is a feedback mechanism. So you could comment, both of you, on other feedback mechanisms you developed? Thank you.

WARREN BUFFETT: Well, you’ve come up with two very good ones. I mean, there’s no question that Charlie will not accept anything I say because I say it, whereas a lot of other people will. You know, I mean, it’s just the way the world works. And it’s terrific to have a partner who will say, you know, you’re not thinking straight.

CHARLIE MUNGER: It doesn’t happen very often.

WARREN BUFFETT: There’s no question, the human mind — what the human being is best at doing is interpreting all new information so that their prior conclusions remain intact. I mean, that is a talent everyone seems to have mastered. And how do we guard ourselves against it? Well, we don’t achieve it perfectly. I mean, Charlie and I have made big mistakes because, in effect, we have been unwilling to look afresh at something. You know, that happens. But we do have — I think the annual report is a good feedback mechanism. I think that reporting on yourself, and giving the report honestly, whether you do it through an annual report or do it through some other mechanism, is very useful. But there — I would say a partner, who is not subservient, and who himself is extremely logical, you know, is probably the best mechanism you can have. I would say that on the contrary, to get back to looking things you have to be sure you don’t fall into, I would say the typical corporate organization is designed so that the CEO opinions and biases and previous beliefs are reinforced in every possible way.

I mean, having staff surround you that know what you want to do, you are not going to get a lot of — you’re not going to get a lot of contrary thinking. I mean, most staffs, if they know you want to buy a company, you’re going to get a recommendation. Whatever your hurdle rate, if it’s 15 percent internal rate of return, which very few deals ever work out at, you know, or 12 or — they’re going to come back, and they’re going to come back with whatever they feel that you want. And if you arrange your organization so that you basically have a bunch of, you know, sycophants who are cloaked in other, you know, titles, you’re not going to get — you are going to leave your prior conclusions intact, and you’re going to get whatever you go in with your biases wanting. And the board is not going to be much of a check on that.

I’ve seen very, very few boards that can stand up to the CEO on something that’s important to the CEO and just say, you know, “You’re not going to get it.” You’ve hit on a terribly important point. All of us in this room want to read new information and have it confirm our cherished beliefs. I mean, it is just built into the human system. And that can be very expensive in the investment and business world. And, like I say, I think we’ve got a pretty good system. And I think that most of the systems aren’t very good, that exist in corporate America, to avoid falling into the trap you’re talking about. Charlie?

CHARLIE MUNGER: Yeah, I think it also helps to be willing to reverse course even when it’s quite painful. As we sit here, I think Berkshire is the only big corporation in America that is running off a derivative book. And we originally made the decision to allow the General Re derivative book to continue, and it’s a very unpleasant thing to do to reverse that decision, yet we’re perfectly willing to do it. Nobody else is doing it, and yet it’s perfectly obvious, at least to me, that to say that derivative accounting in America is a sewer is an insult to sewage. (Laughter)

WARREN BUFFETT: I would second that. I might not have chosen those exact words, and we may not even use those words in describing why we got out of it, but — Yeah. And in the first quarter of this year, we’ll show quite a bit of income — and anything we say here, we ought to put on the internet, Marc — but I think we’ll show, what, 100 and, I don’t know, 60 million or something like that of financial — maybe it’s 140, I’ll take a look here. Well, you’ll have 160-odd million of income in that funny little line we have from financials income. But that will be after an $88 million loss, in terms of getting — the first steps — of getting out of the General Re — what used to be called General Re Financial Products — derivative book. You know, those losses were there. I mean, some of that is a shutdown loss, 30-odd, 30 million or thereabouts is severance pay and that sort of thing.

But the truth is that derivative accounting is absolutely terrible in this country, and there are a lot of companies that will not want to face up to what would be involved if they actually got out. Now you’re seeing derivative accounting unwound at Enron, in a very major way. And believe me, it’s not being unwound at a profit, except to the extent that the bankruptcy court lets them disaffirm certain contracts. I mean, it is — there was no place where there was as much potential for phonying numbers at a place like Enron than the derivative kind of data. They were marking-to-model, they were doing all these things. You give a whole bunch of traders the ability to create income by putting little numbers down on a piece of paper that nobody can really check, and it, you know, it can get out of control. It will get out of control. And so we decided, finally, to bite the bullet on it, and we’d get out of it. And it would — incidentally, we would not have reported $88 million of loss if we’d stayed in it.

Might have reported a tiny profit or something, but, in the end, you know, the loss was there. And there will be — it could well be — some more to come in that, because once you get into derivatives — I think our longest contract may run 40 years or something like that. The guy who put the 40-year contract on the book probably got paid, you know, that week for putting it on, virtually. And, you know, we’ve got a bunch of assumptions as to how it’s all going to work out over 40 years. You couldn’t devise a worse system. And, in the end, you know, we didn’t want to be in the business when we got in it, and we are now in the process of getting out. But you don’t get out of fast — out fast — in something like this. I mean, it’s, you know, it’s a little like hell. It’s easy to get into, and it’s hard — very hard — to get out of. (Laughs)

Afternoon Session

1. Blue Chip Stamps plunges under Buffett and Munger

WARREN BUFFETT: You’ve heard us talk here about the importance of our managers. However, occasionally, Charlie and I get involved in management ourselves. And we would normally be too modest to claim any great accomplishments. But we have had one rather incredible performance which, since Charlie participated in it as well I do — I think if we put up the slide on the company that Charlie and I have managed personally, you’ll see that this entity — you can’t — Charlie, here it is, right here. It’s one where we took over 30-odd years ago. And as you can see, the 46,000 became — what?

VOICE: That’s the wrong slide.

WARREN BUFFETT: Oh. Excuse me. Are you sure? Oh.

VOICE: Oh, yeah.

WARREN BUFFETT: OK. Well, I guess we better put up the next slide. We — (laughter) — they got that first one — they got it reversed. We were doing 120 million when we took over, and we’re now doing $46,000 a year. But we may get a bounce one of these years. (Laughter) That was a company that also had a lot of float — (laughs) that we were attracted to. And the interesting thing is, you know, this was Blue Chip Stamps. Although Blue Chip was a copy, of a sort, of Sperry & Hutchinson, which really was the main inventor of trading stamps on any large scale in the country, and they go back to the 19th century. But if you think about it, S&H Stamps — Green Stamps — or Blue Chip Stamps, had many similarities to frequent flyer miles. You know, the only difference being that, you know, you got them a lot at, like, grocery stores and all of that and then you had to lick them and put them in a book. Whereas now, it’s all done electronically.

But the basic underlying business was very similar to frequent flyer miles, which have this incredible hold on the American public. But somehow, we were not able to make the transfer. We haven’t yet made the transformation, let’s put it that way, from the lick-it stamp to something that the public will accept. But we’ve still got $47,000 of revenue annually from the entire state of California, so we’re building a base. (Laughter) Charlie and I continue to spend most of our time working on this one.

2. Shareholders share the wealth through philanthropy

WARREN BUFFETT: Let’s go to area 7. I think we stopped in area 6 last time, and we’ll go from there.

AUDIENCE MEMBER: Yes, my name is Mort November. I’m from Cleveland, Ohio. I’m here with my wife, Iris, who in 1986 founded the Statue of Liberty Collectors’ Club. I wanted to tell you personally what Berkshire Hathaway has meant for me. By owning it, we have become philanthropists in Cleveland. And the way it happened is we sold all our other stock. It was never any fun owning it, and I could never understand that my stock went down and the CEO’s bonuses went up. So, I got rid of that, and we took all of that money and we’re doing things for children in Cleveland. On May 16th, we’re sending a group — (applause) — thank you. On May 16th, for the tenth year in a row, we’re sending a group of children from Cleveland Municipal Schools, who win the trip by doing good work in their class and good work in the community, to Dearborn, Michigan, Henry Ford Museum, Greenfield Village. It’s a lot of fun for them and it’s really a lot of fun for us.

We invested in a building in the Cuyahoga National Park for campers, and hopefully we’ll be able to help put up an addition to a library in East Cleveland, Ohio, which really needs all the help it can get. So, my wish for you gentlemen is that you have many, many more years of good health and that we have the opportunity to see you on this stage, or any stage, for as many years as you want. I salute you both.

WARREN BUFFETT: Thank you. (Applause) It’s terrific what a number — a large number — of Berkshire shareholders, particularly the ones, perhaps — well maybe not particularly — but in the Omaha area, because they go way back to the partnership, and a number of them are in their mid-seventies or thereabouts. But there have been a lot of things that have come out of the stock. In fact, there’s been a suggestion that somebody may do a book on some of the things that have flowed from various Berkshire shareholders. And I’m sure many of you know about the case of Don and Mid Othmer. Don went to Central High, here in Omaha. Mid Othmer’s mother, Mattie Topp, was a wonderful woman, who was a customer when I started selling securities when I was 20 or 21, and she ran a dress shop. And they, you know, they left about $750 million to a group of mainly 4 or 5 charities, one of which was the University of Nebraska. But there have been all kinds of things.

And there may actually be something done on that at some point, but I’m glad to hear what you’re doing in Cleveland.

3. Hard to pick pharmaceutical winners

WARREN BUFFETT: Let’s hear from area 8, please.

AUDIENCE MEMBER: Hi, my name is Jennifer Pearlman from Toronto, Canada. Mr. Buffett, in 1998, you were asked to comment on the pharmaceutical industry, and at that time your answer was that you considered it a mistake not to have taken a basket approach to the industry. I was wondering if you could revisit the issue, now that valuations have contracted so dramatically. And also, considering that health care spending is outpacing inflation, and that there are significant moats in the industry, I was wondering if you could share with us your thoughts on the health care industry at large.

WARREN BUFFETT: Charlie may be better equipped on that than I am, but it certainly — it’s been, as an industry, a very, very good business over time. And if you take the aggregate capital in it and what it’s earned over time, it’s been a very good business. And we did make a mistake, your memory’s 100 percent accurate, in we’d — in what we said in earlier meetings, because we should have taken a package approach. We actually did buy a tiny, tiny bit, but that’s worse than buying none almost. I mean, it’s just aggravating — back there in ’93. It’s certainly the — they’re certainly the kind of businesses that, as an industry, we can understand. We would not have great insights on specific companies. So, if we did something, we would be more inclined to do it on an industry-wide basis. It’s hard to evaluate the individual companies. As you know, Bristol-Myers has recently had a big stumble, and even Merck has fallen back. And so, it’s hard to pick the winners.

But that’s no reason not to have a basket approach to the industry. And at some valuation level, it would be something we would think very hard about. And it’s something where we could put quite a bit of money if it happened, which is another plus to us. Charlie?

CHARLIE MUNGER: Well, I mean, failed to get it right the last time. We’ll probably fail to get it right the next time. (Laughter)

WARREN BUFFETT: I don’t know what he had for lunch. (Laughter)

4. Accounting at Coca-Cola and its bottlers

WARREN BUFFETT: OK, we’ll go to number 1. Well, wait a second, is there anybody at number 9? Probably not, now.

AUDIENCE MEMBER: Yes, there is.

WARREN BUFFETT: OK, good enough. Nine.

AUDIENCE MEMBER: Phil McCaw (PH), from Greenwich, Connecticut. Could you discuss if and how you take into account the individual balance sheets of the CocaCola bottlers to the Coca-Cola Company, and if you view various regulatory control issues as a potential problem for Coca-Cola?

WARREN BUFFETT: Yeah, well, certain Coca-Cola bottlers became quite leveraged, the ones that were, in general, acquiring companies. Coca-Cola Enterprises certainly became very leveraged over — it started out fairly leveraged, and it became more leveraged in recent times. And they have a business that’s a solid, steady business, but it’s not one with abnormal profitability. So, it can take leverage, in the sense that it won’t be subject to huge dips, but it also is a business where it’s very tough to increase margins significantly. So, if most of the money goes to debt service, you know, that is something that you have to take into account when you value the equity. It’s a fairly capital-intensive business, the bottling business. On average, you’ll probably spend between 5 and 6 percent of revenues on capital expenditures just to stay in the same place. And in a business that, before depreciation, makes — and interest and taxes — makes maybe 15 cents on the dollar, having 5 or 6 cents on the dollar go to capital expenditures is a pretty healthy percentage of that.

That’s true at the Pepsi-Cola bottling company, too. It’s just the nature of the bottling business. It’s a reason why I like, basically, the syrup business better than the bottling business. It’s less capital-intensive. And I think that the bottling business is a perfectly decent business. It isn’t a wonderful business because the — it’s very competitive out there. I mean, on any given weekend, the big supermarket in town, or the Walmart, or whatever, is going to be featuring one or the other of the colas, and they’re going to — it’s going to be based on price. And you’re going to read ads saying, you know, 12 for something or other, or 6 for something or other. And it has become something where a lot of people will switch from one to another, based on price, on that weekend. And that makes it a tough business for bottlers. But it’s a decent business. But it doesn’t, in terms of the Coca-Cola Company, itself, its bottlers are going to do perfectly OK over time.

And they’ve got to earn enough money to be able to sustain that kind of capital expenditure and earn a cost of capital. And if they get in trouble, it’s because, if they pay too much for another bottler, it gets tough to make the math work. Was there a second question about Coca-Cola then, too?

AUDIENCE MEMBER: Well, I was curious if you concern yourself, when you see FASB-type issues come out about control —

WARREN BUFFETT: No. Yeah, no, I understand. I’m talking —

AUDIENCE MEMBER: Combining all the balance sheets, type of thing.

WARREN BUFFETT: Yeah, that really doesn’t make any difference to us. I mean, in the end, the Coca-Cola Company, there’s no question about it in my mind, the Coca-Cola Company needs a successful bottling group in order to prosper as a syrup manufacturer. But the profitability of bottling will allow that. And the capital requirements at the — at Big Coke, as it’s called — are relatively minor, so most of the money they make can either be used as dividends or share repurchases. But nobody’s going to run out of money at Coca-Cola, nor are their bottlers, basically, going to run out of money. So, it is not a big balance sheet issue at all. And whether the figures are consolidated or otherwise, the economics are basically the same. I mean, you have a, you know, there’s not going to be a capital crunch of any kind. It would show different ratios if you consolidated and if you didn’t, but it really wouldn’t change the basic economics any. Charlie?

AUDIENCE MEMBER: Thank you.

CHARLIE MUNGER: Yeah, I don’t think it changes anything on a basic level. But ideally, in the world, you wouldn’t have capitalization structures that are designed partly for appearance’s sake.

AUDIENCE MEMBER: Thank you.

WARREN BUFFETT: We — thank you.

5. Accounting is a starting point, but it doesn’t always reflect reality

WARREN BUFFETT: We pay a lot of attention to what we regard as the reality of the balance sheets and economic conditions and cash situation, all of that of a business. And sometimes we think accounting reflects reality, and sometimes we don’t. It’s a good starting point for us always, but I mean, there are companies in the United — there’s at least one company, at least last year, that was using a 12 percent investment return assumption on its pension plan, and there are other companies that use, I think, even below six, certainly six. And in the end, should we look at the figures the same of one company, particularly if the pension fund’s a big element, that uses 12 and six? No, we look at what it says they’re using. But, in our minds, we don’t think the company that’s using a 12 percent assumption is likely to do any better with their pension fund than one of the one’s that’s using six. In fact, we might even think the one that’s using six is likely to do better because we might think they’re more realistic about the world.

So, we start with the figures of the companies we look at, but we’ve got our own model in mind as to what they will look like. It’s true of the businesses we own a hundred percent of. Some of them have some debt in them, some of them don’t, partly that situation’s inherited. In the end, we’ve got the same metrics that apply to them, whether they happen to have some debt on their own particular balance sheet or not, because in the end, we’re not going to be willing to have very much debt at all at Berkshire. And where it’s placed doesn’t really make any difference because we’re going to pay everything we owe, no matter where it is. And it’s almost an accident whether company A or company B has a little debt attached to it.

6. New goodwill accounting is “making sense”

WARREN BUFFETT: Area 10, is there anybody there?

AUDIENCE MEMBER: Yes, sir. My name Adam Chud. I’m from Columbus, Ohio. I attend the Ohio State University. My question is, your comments on the new standards for the accounting of goodwill?

WARREN BUFFETT: Yeah, the question about the new standards for goodwill. Actually, if you read, I think, the annual report — maybe the 2000 annual report, and maybe even earlier. But we prescribed — we said what we thought would be the preferable system for how goodwill was handled, namely, that it would not be amortized, and that combinations of companies be accounted for as purchases. And it pretty well is what ended up coming out of the accounting profession. So, the goodwill rules now are in accord with what we believe they should be. And for a long time, they weren’t. You might argue that it was against our interests to have what we think proper accounting has put in, because some people were averse to buying businesses because of a goodwill charge they would incur, whereas it didn’t make — it made no difference to us whatsoever. We just looked at the underlying economics. So we may have a little more competition, even, on buying businesses simply because now, competitive buyers are not faced with a goodwill charge which may have bothered them but didn’t bother us. I regard the present goodwill rules as making sense. Charlie?

CHARLIE MUNGER: Well, I agree.

WARREN BUFFETT: OK.

AUDIENCE MEMBER: Thank you.

7. I used a hearse to pick up your aunt for a date

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: My name is Martin Wiegand, from Bethesda, Maryland. Thank you for hosting this wonderful and formative shareholder meeting. Thank you also for running Berkshire in a manner that is an example to corporate America and the world. You make us proud to be shareholders. My question, you touched on just before the lunch break. Did the compensation plans at Berkshire and its competitors have anything to do with the mispriced insurance policies they issued? And if so, has Berkshire or its competitors changed their compensation plans to correctly price those policies?

WARREN BUFFETT: Incidentally, I asked you this last year, I think, but are you my Martin’s son or grandson?

AUDIENCE MEMBER: Son.

WARREN BUFFETT: Son, OK. Good enough. It — Martin’s father and I went to high school together. Matter of fact, your Aunt Barbara and I went to high school together also. And she went out on one date with me, and that was the end. (Laughter) It was not because I didn’t ask her out again. (Laughter) I picked her up in a hearse. I think that kind of put the — (Laughter)

8. General Re’s “cultural drift”

WARREN BUFFETT: I think compensation plans lead to a lot of silly things, but I would say that, at Berkshire’s insurance companies, I don’t think our problems resulted from compensation plans at all. I think we had an — and we’re talking about General Re here basically, because that’s where we had the problem. I think General Re had an enormously successful operation, which went on for a long time. And I think that there was some drift away, perhaps because competitors were drifting away in a big way, too, from certain disciplines, and we paid a price for that. But I don’t think the comp plans entered in at — in any significant way, if at all, into the fact that we did drift away for a while. I think it — I think you want to have rational comp plans. I think we’ve got a rational comp plan at General Re, but — and it’s quite similar to what we had before. And I just don’t think that was the problem.

It’s very difficult, it’s difficult in the investment world, when other people are doing things that look like they’re working very well, you know, and they get sillier and sillier. It’s — it could be difficult for many people to not succumb and do the same things. And that happens in investments, but it also happens in insurance. And it was, you know, it’s a competitive world, and your people are out there every day, and they’re competing against Swiss Re, and Munich Re, and Employers Re, and all of these people. And you’ve worked hard to get clients, and the client says, “I want to stay with you, but the competitor says if I go with him, I don’t have to do this or that, or I can get it a little cheaper,” or whatever. You know, it’s tough to walk away. And it may even be a mistake to walk away in certain cases. So, I just think that there was a — what you might call a cultural drift. I don’t think it was a shift, but it was a drift.

And I think it was produced, in part, by the environment in which the company was operating. And it took a jolt to get it back. And I think that it is back. I think it’s probably stronger than ever in terms of what we have now, but I would not attribute it much to the compensation system. But I have seen a great many compensation systems that are abominations and lead to all kinds of behavior that I would regard not as in the interest of shareholders. But I don’t think we’ve had much of that at Berkshire. Charlie?

9. “Demented” and “immoral” stock options

CHARLIE MUNGER: Yeah, I think if you talk generally about stock option plans in America, you see a lot of terrible behavior caused. And, no doubt, they do a lot of good at other places. But whether they do more good than harm overall, I wouldn’t know. I think, in particular, if you have a corporation where a man has risen to be CEO, and he now has hundreds of millions of dollars in the stock of the company. He’s been loyal to the company and the company’s been loyal to him for decades, and he has his directors vote him a great stock option annually to preserve his loyalty to the company, and his enthusiasm to the business when he’s already old, I think it’s demented.

WARREN BUFFETT: How about when they grant options as he leaves the company?

CHARLIE MUNGER: I — and I also think it’s immoral. I think that there comes a time when — (Applause) I don’t think you would improve the behavior of the surgeons at the Mayo Clinic, or the partners of Cravath, Swaine & Moore, if you gave the top people stock options in their sixties. I mean, by that time, you ought to have settled loyalties, and you ought to be thinking more about the right example for the company than whether you take another hundred million for yourself.

WARREN BUFFETT: Yeah, well, we had a case — (Applause) We’ve inherited some option plans because the companies we merged with had them. And in some cases they got settled for cash at the time, in some cases they continued on, depending on the situation. But more money has been made from options at Berkshire by accident, and that, you know, this is not — it just happened that way, but more money was made by people that had options on General Re stock during a period when General Re contributed to a decrease in value of Berkshire. So we had all of the other managers essentially, in a great many cases, turning in fine results, and we had a bad result at General Re, and yet more money, by a significant margin, was made under options at General Re than had been made probably by all other entities combined. But it was an accident, but that’s the point, it leads — it can lead to extremely capricious compensation results that have no bearing on the performance of the people that, in some cases get great benefits, and in other cases people did great jobs and were — their efforts were negated by results elsewhere.

So, it’s — it would be very capricious at Berkshire — you can argue that at Berkshire, for those that succeed me and Charlie, that anybody that is in the very top position at Berkshire has got the job of allocating resources for the whole place. There could be a logically constructed option plan for that person, and it would make some sense because they are responsible for what takes place overall. But a logically constructed plan would have a cost of capital built into it for every year. We don’t pay out any dividends, so why should we get money from you free? We could put it in a savings account and it would grow in value without us doing anything. And a fixed-price option over 10 years would accrue dramatic value to whoever was running the place, if they had a large option, for putting the money in a savings account or in government bonds. So, there has to be a cost of capital factor in to make options equitable, in my view, that there can be cases where they make sense. They should not be granted at below the intrinsic value of the company.

I mean, the market — a CEO who says, you know, my stock is ridiculously low when a merger — when somebody comes around and wants to buy the company, but then grants himself an option at a price that he’s just gotten through saying is ridiculously low, that bothers me. So if somebody says, you know, I wouldn’t — we don’t want to sell this company for less than $30 this year because it’s going to be worth a lot more later on, you know, my notion is that the option should be at $30 even if the stock is 15. You know, otherwise you have a — actually a premium built in of — for having a low stock price in relation to value. And I’ve never gotten too excited about that. Charlie, you have any further thoughts on options?

CHARLIE MUNGER: Well, we’ve been — we’re so different from the rest of corporate America on this subject that, you know, we can sound like a couple of Johnny One Notes, but I don’t think we ever quite tire of the subject. (Laughter) A lot is horribly wrong in corporate compensation in America. And the system of using stock options on the theory they really don’t cost anything has contributed to a lot of gross excess. And that excess is not good for the country. You know, Aristotle said that systems work better when people look at the different outcomes and basically appraise them as fair. And when large percentages of people look at corporate compensation practices and think of them as unfair, it’s not good for the country. (Applause)

WARREN BUFFETT: It will be hard to change though, because basically, the corporate CEOs have their hands on the switch. I mean, they control the process. You can have comp committees and all of that, but as a practical matter — I’ve been on 19 public boards, Charlie’s been on a lot of them. And in the end, the CEOs tend to get pretty much what they want. And what they want tends to go up every year because they see other people getting more every year. And there’s a ratcheting effect, and the consultants fan the flames. And it’s very difficult to get changed. And right now, you’ve got corporate CEOs descending upon Washington, doing everything from trying to persuade to threaten your elected representatives to not have options expensed. And it’s — I think it’s kind of shameful, actually. Because it, you know, this group, who is getting fed very well under the system does not want to have those — what clearly is a compensation expense recorded because they know they won’t get as much. I mean, it’s that simple.

And it’s not based on anything much more complicated. (Applause)

10. Float size isn’t limiting investments

WARREN BUFFETT: Area 2?

AUDIENCE MEMBER: Good afternoon. David Winters, Mountain Lakes, New Jersey. Mr. Buffett and Mr. Munger, thank you for hosting “Woodstock for Capitalists.” I know it’s a lot of fun for everybody, and I think a lot of fun for you, too. Assuming growth of low-cost float and the sins of the past do not impede progress, does the sheer size of the float create constraints that change the allocation of future investments to more high-quality fixed-income obligations rather than equity coupons or workouts that can grow over time? It seems otherwise Berkshire is incredibly well positioned if valuations ever decline.

WARREN BUFFETT: Well, I think the answer is we probably are pretty well positioned if valuations decline. And it’s a good question. If you have 37 billion of float, are you going to be more constrained to conventional investments than if you were working with a half a billion or a billion, as we were not so long ago? As long as you have a huge capital position, which we have and will continue to have, and as long as you have a lot of outside earning power, which we have and will continue to have, I don’t think we’re constrained very much. I mean, that — we’ll always want to have a significant level of liquidity, relative to any kind of payment pattern that we see for a good length of time. But we will probably be operating with so much capital and with so much earning power, independent of the insurance business, and with so much liquidity, that we really will be able to make decisions as to where — as to how — the assets should be deployed, in terms of, simply, where we see the best returns and virtually no risk. And sometimes we see virtually no risk in equities when they’re extremely cheap.

We don’t see that situation now, but we could see it again. And I don’t think we’ll be much — I don’t think we’ll be very constrained when the time comes. Charlie?

CHARLIE MUNGER: Yeah, our constraint doesn’t come from structure, it comes from a lack of enthusiasm for stocks generally. The bonds are held as a default option.

11. Price of gold not a factor in valuing a business

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: Dear Mr. Buffett and Mr. Munger, my name is Adrian Chur (PH), and I’m a shareholder from Hong Kong. Thank you for your leadership and inspiration, as always. It’s wonderful, always, listening to you. If I may, I would like to ask of you both gentlemen, a question in two parts. Perhaps I can ask the second part after you’ve answered the first part. The first part of the question relates to the Fortune article dated 10th of December you included in our shareholder materials. In this article, you mentioned that one couldn’t explain the remarkable divergence in markets by differences in the growth of GNP. However, one could explain the divergence by interest rates. The first question I have is this: I wonder, sir, if you were to look at the price of gold during the two periods of times you mentioned, that is to say 1948-’64 and ‘64-’81, if the explanation could be even more clear?

Thus, the logical reason would be why the Dow in ’48 was 177 was because — and half the level of 1929, of 381 index points — is because of the 71 percent devaluation of the American dollar from 20.5 cents an ounce to 35 cents an ounce, which would put the fair value of the Dow at 166, after factoring in the record 50 percent per capita gain of the 1940s that you had mentioned.

WARREN BUFFETT: Yeah, I grew up in a household — and my sisters are here — where gold was talked about frequently. So I’ve been exposed to a lot of thinking on that over the years. I don’t really think gold has really — the price of gold, I should say — has anything, really, to do with the valuation of businesses. It may reflect certain things that are going on in prices attached to those businesses at given times. But I would not regard — I mean, the price of gold does not enter into my thinking in any way, shape, or form, in terms of how I value a business today, a year ago, 10 years ago, or tomorrow. When we look at Larson-Juhl, the custom picture frame operation, you know, I’m not thinking against — I’m not thinking of that and relating it in any way to what gold has done. So, I — it’s just not a factor with us, any more than other commodities would be. I mean, you know, whether it’s wheat, whether it’s cocoa beans or whatever.

It has — you know, it has a certain hold on some people and they — but we don’t look at it as an interesting investment and we don’t look at it as a yardstick for valuing other investments. Charlie?

CHARLIE MUNGER: Yeah, Warren is right when he says that interest rates are very important in determining the value of stocks, generally. And I think he’s also right when he says gold is very unimportant.

12. Warning: Speculating is not investing

WARREN BUFFETT: And the second part of the question?

AUDIENCE MEMBER: Thank you, sir. The second part of my question is this: given your assumptions on gold, if you were to factor a significant decline in the value of the dollar against gold, let’s say 40 percent or more, and given the correlation of 1929-’48 and ‘64-’81 eras positively to the decline of the dollar, and the negative correlation in the other two areas that you had studied, would you care to adjust the 7 percent total annual return you were quoted as expecting for common equity in the coming decade? And in conjunction with that, would you care to comment on your expected rate or return on all other major asset classes, perhaps like bonds, real estates? And which would you believe offers the best value for investors? Thank you very much.

WARREN BUFFETT: Yeah. Well, except under unusual circumstances, my expected rate — my expectancy on something like bonds is what bonds are producing at a given time. I don’t think I’m smarter than the bond market. Now, you can say, when they — when those rates swing all over, does that mean I swing all over? The answer is pretty close to yes. I mean, that — I don’t know what the right rate for bonds is. I think that if there’s — I’m very leery of economic correlations. I mean, I spent years fooling around with that sort of thing, and I mean, I correlated stock prices with everything in the world. And the — and you know, the problem was when I found a correlation. I mean, it’s — (laughs) — you know, you’ve seen these things on whether the AFC or the NFL wins the Super Bowl and all of that sort of thing. You can find something that correlates with something else. But in the end, a business or any economic asset is going to be worth what it produces in the way of cash over its lifetime.

And if you own a — if you own an oil field, if you own a farm, if you own an apartment house, you know, with the oil field, it’s the life of the oil field and what you can get out of it. And maybe you get secondary recovery, maybe you get tertiary recovery. But whatever it may be, it’s worth the discounted value of the oil that’s going to come out. And then you have to make an estimate as to volume and as to price. With a farm, you might make an estimate as to crop yield, and cost, and crop prices. And the apartment house, you make an estimate as to rentals, and operating expenses, and how long it’ll last, and when people will build other new apartment houses that potential renters in the future will find preferable, and so on. But all investment is, is laying out some money now to get more money back in the future. Now, there’s two ways of looking at the getting the money back. One is from what the asset itself will produce. That’s investment.

One is from what somebody else will pay you for it later on, irrespective of what the asset produces, and I call that speculation. So, if you are looking to the asset itself, you don’t care about the quote because the asset is going to produce the money for you. And that’s how — that’s what society, as a whole, is going to get from investing in that asset. Then there’s the other way of looking at it, is what somebody will pay you tomorrow for it, even if it’s valueless. And that’s speculation. And of course, society gets nothing out of that eventually, but one group profits at the expense of another. And of course, you had that operate in a huge way in the bubble of a few years ago. You had all kinds of things that were going to produce nothing, but where you had great amounts of wealth transfer in the short term. As investments, you know, they were a disaster. As means of wealth transfer, they were terrific for certain people. And they were, for the other people that were on the other side of the wealth transfer, they were disasters.

We look solely — we don’t care whether something’s quoted because we’re not — we don’t buy it with the idea of selling it to somebody. We look at what the business itself will produce. We bought See’s Candy in 1972. The success of that has been because of the cash it’s produced subsequently. It’s not based on the fact that I call up somebody at a brokerage house every day and say, “What’s my See’s Candy stock worth?” And that is our approach to anything. On interest rates, I’m no good. I bought some REITs a couple of years ago because I thought they were undervalued. Why did I think they were undervalued? Because I thought they could produce 11 or 12 percent, in terms of the assets that those companies had. And I thought an 11 or 12 percent return was attractive. Now the REITs are selling at higher prices and, you know, they’re not as attractive as they were then.

But you just look at — every asset class, every business, every farm, every REIT, whatever it may be, and say, “What is this thing likely to produce over time?” and that’s what it’s worth. It may sell at vastly different prices from time to time, but that just means one person is profiting against another, and that’s not our game. Charlie?

13. Hard to predict when a bubble will burst

CHARLIE MUNGER: Yeah, what makes common stock prices so hard to predict is that a general liquid market for common stocks creates, from time to time, either in sectors of the market or in the whole market, a Ponzi scheme. In other words, you have an automatic process where people get sucked in and other people come in because it worked last month or last year. And it can build to perfectly ridiculous levels, and the levels can last for considerable periods. Trying to predict that kind of thing, sort of a Ponzi scheme which is, if you will, accidentally thrown into the valuation of common stocks by just the forces of life, by definition that’s going to be very, very hard to predict. But that’s what makes it so dangerous to short stocks, even when they’re grossly overvalued. It’s hard to know just how overvalued they can become in addition to the overvaluation that exists. And I don’t think you’re going to predict the Ponzi scheme effect in markets by looking at the price of gold or any other correlation.

WARREN BUFFETT: Charlie and I probably — I mean, I’m pulling a figure out of the air — we have probably agreed on at least a hundred companies, maybe more, that we felt were frauds, you know, bubble-type things. And if we had acted on shorting those over the years, we might be broke now, but we were right on probably just about a hundred out of a hundred. It’s very hard to predict how far what Charlie calls the Ponzi scheme will go. It’s not exactly a scheme in the sense that it isn’t concocted, for most cases, by one person. It’s sort of a natural phenomenon that seems to — nursed along by promoters and investment bankers and venture capitalists and so on. But they don’t all sit in a room and work it out. It just — it plays on human nature in certain ways and it creates its own momentum, and eventually it pops, you know. And nobody knows when it’s going to pop, and that’s why you can’t short, at least we don’t find it makes good sense to short those things.

But they are — it is recognizable. You know when you’re dealing with those kind of crazy things, but you don’t know when the — how high they’ll go or when it’ll end or anything else. And people who think they do, you know, sometimes play in it. And other people know how to take advantage of it, I mean there’s no question about that. You do not have to have a 200 IQ to see a period like that and figure out how to have a big wealth transfer from somebody else to you, you know. And that was done on a huge scale, you know, in recent years. It’s not the, you know — it’s not the most admirable aspect of capitalism.

14. Stock options as compensation isn’t sinful, but …

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Yes, good afternoon, Mr. Buffett and Mr. Munger. My name is Ho Nam (PH), and I’m from San Francisco, California. I have a question related to an issue you touched on a few moments ago on the debate over whether or not stock options should be expensed and reflected on the income statement of companies. With the current system, shareholders are incurring the burden of stock options since exercised options dilute earnings per share. As a shareholder of companies that issue stock options, I think I’m OK with that, especially in entrepreneurial companies that may not have enough cash to attract talent from larger competitors, or in cases where you have younger employees or lower-level employees who do not have the cash to purchase stock without the use of options. I have a two-part question. If companies are required to expense stock options and it hits — impacts the P&L, does it — would that lead to double-counting the impact of stock options? And the second part is, if the use of stock options are largely eliminated, might that impact the competitiveness of entrepreneurial companies which help drive innovation and growth and create more of a dividing line between shareholders and employees?

WARREN BUFFETT: Yeah, the first question is that there really isn’t the double-counting necessarily. For example, let’s just take a company with a million shares of stock outstanding, selling at a hundred dollars a share. And let’s say that options are granted for 9 million shares — we’ll make it extreme — at a hundred dollars a share. At that moment, you’ve given 90 percent of the upside to the management. We’re taking a very extreme example. That’s been a huge cost to the shareholders. Now, interestingly enough, if the stock was selling at $100 a share, the fully diluted earnings are exactly the same as the basic earnings in that year, because the dilution is not counted at all unless the stock is selling above, and then only by the difference in the market value and what it costs to repurchase the optioned shares. So, there is not double-counting.

And you can — you could issue — the very fact that you issued that million, the options on 9 million more shares at 100, would undoubtedly cause the price to actually fall well below 100 and there would be no dilution shown in terms of the way GAAP reports diluted earnings. The second question, as to whether, if you expense the options, it would discourage the option use. Well, the argument, you know, that is made when there — people issue options is that it’s doing more for the company than giving people cash compensation. It may be more convenient than cash compensation, too, for young and upcoming companies. But the fact that you are doing something in terms of paying people in a way that you say is even more effective than paying them in cash, to say that therefore you shouldn’t have to record the payment, I’ve never really followed. I don’t have any objection to options under some conditions. I’ve never taken a blanket position that options are sinful or anything of the sort. I just say they are an expense. And to be truthful with people about what you’re earning, you should record the expense.

And if a company can’t afford to be truthful, you know, I have trouble with that. And we will take, as we’ve said, you can pay your insurance premium to me in options. There’d be lots of companies I’d be happy to take options in and give them credit. I’d take options above the market. Give me a 10-year option 50 percent above the market in many companies, and we will take that — appropriate number of shares — and take that in lieu of cash. But that means we simply like, you know, the value of what we’re getting better than the equivalent amount of cash and we think the company that gives it to us has incurred an expense. We’ve received something of value, they’ve given something of value up, and that’s income to us and expense to them. And I think all of the opposition, at bottom, to the — to expensing of options comes from people who know they’re not going to get as many options if they’re expensed.

And you know, they would like cash not to be expensed, but they can’t get away with that, you know. I mean —

CHARLIE MUNGER: Yeah. (Laughter)

WARREN BUFFETT: If you had an accounting rule that said the CEO’s salary should not be counted in cash, believe me, the CEOs would be in there fighting to have that rule maintained. I mean, because no one would — they would feel that they were going to get more cash if it wasn’t expensed, and options are the same way. It’s another argument I get a kick out of, I was just reading it the other day, where they say, “Well, options are too tough to value.” Well, I’ve answered that in various forms, but I notice that — what is it, Dell Computer, you know, has a great number of put options out, and it’s going to cost them a lot of money on the put options they have out.

And for a company to say, “We can’t figure out the value of options, and therefore we can’t expense them,” and then at the same time be dealing in billions of dollars’ worth of options, they are saying, “We are out buying or selling options in the billions of dollars, but we don’t know how to value these things.” That strikes me as a little bit specious — a little disconnected, cognitive dissonance, as they say. Charlie?

CHARLIE MUNGER: Yeah, I’m not at all against stock options in venture capital, for instance. But the argument that prominent venture capitalists have made, that not expensing stock options is appropriate because if you expense them it would be counting the stock options double, that’s an insane argument. The stock option is both an expense and a dilution, and both factors should be taken into account in proper accounting. John Doerr, the venture capitalist, as he argues to the contrary, is taking a public position that, “Were it offered to me as part of my employment, I would rather make my living playing a piano in a whorehouse.” (Laughter)

WARREN BUFFETT: We always get to the good stuff in the afternoon. (Laughter) I hope the children are in bed.

15. Hard to predict what happens after a bubble bursts

WARREN BUFFETT: Number 5.

AUDIENCE MEMBER: Good afternoon. My name is Bob Baden (PH), from Rochester, New York. Mr. Munger, this morning, while discussing index funds, you used the example of Japan as a real example of poor performance of a major index over a long period. Indeed, the S&P 500 index declined over 60 percent, in real terms, from the early ’60s through the mid-’70s. Could you discuss the mental models you use to consider the impact of inflation or deflation on your investment decisions and the likelihood of either occurring over the next decade?

CHARLIE MUNGER: Well, that’s partly easy and partly tough. If interest rates are going to go way up, you can obviously have a lot of deflation of stock prices. And a lot of that happened in the American period you’re talking about. What’s interesting about Japan is that I don’t think anybody thought that a major modern Keynesian democracy, pervaded by a good culture in terms of engineering, product quality, product innovation, and so forth, could have a period where you would have negative returns over 13 years without major depression either.

WARREN BUFFETT: (Inaudible)

CHARLIE MUNGER: I think — and that it would occur while interest rates were going down, not up. I think that was so novel that the models of the past totally failed to predict it. But I think these anomalies are always very interesting, and I think it’s crazy for Americans to assume that what’s happening in Argentina, what has happened in Japan, are totally inconceivable forever in America. They are not totally inconceivable.

WARREN BUFFETT: You had a huge bubble in equity prices in Japan, and now you’ve had interest rates go to virtually nothing. You’ve had the passage of time, the country hasn’t disappeared. People are going to work every day, and you’ve had this — the Nikkei, you know, now at a third of what it sold for not that many years ago. It’s an interesting phenomenon.

CHARLIE MUNGER: And huge fiscal stimulus in the whole period from the government.

WARREN BUFFETT: Post-bubble periods, I think, depending on how big the bubble is and how many were participating in it, but post-bubble periods, I think, can produce fallout that not everyone will be terribly good at predicting.

16. Ben Graham and the long/short model

WARREN BUFFETT: Six?

AUDIENCE MEMBER: Hi, I’m Steve Rosenberg (PH). I’m 22, from Ann Arbor, Michigan. It’s a privilege to be here. First, I’d just like to thank you both for serving as a hero and positive role model for me and many others. Much more than your success, itself, I respect your unparalleled integrity. I have three quick questions for you. The first is how a youngster like myself would develop and define their circle of competence. The second involves the role of creative accounting in the stories of tremendous growth and success over many years. GE, Tyco, and IBM immediately come to mind for me, but I was hoping you could also discuss that issue in relation to Coke. Some people have said that their decision to lay off much of the capital in the system onto the bottlers, who earn low returns on capital, is a form of creative accounting. On the flip side, others counter that Coke’s valuation, at first glance on, say, a price-to-book metric, is actually less richly valued than it seems because they earn basically all the economic rents in the entire system. My final question is, if you could comment on the A.W.

Jones model, the long/short equity model. I understand that it doesn’t make sense for capital the size of Berkshire’s to take that type of a strategy. But it just seems to me that playing the short side in combination also seems incredibly compelling, even giving the inherent structural and mathematical disadvantages of shorting. And I was wondering if you could talk a little bit more about why you would have lost money on your basket of a hundred frauds.

WARREN BUFFETT: Yeah, it’s an interesting question. And we’ll start — we’ll go in reverse order. Many people think of A.W. Jones, who was a Fortune writer at one time, and who developed the best-known hedge fund, whenever it was, in the early ’60s or thereabouts, maybe the late ’50s even. And for some of the audience, the idea originally with A.W. Jones is that they would go long and short more or less equal amounts and have a market-neutral fund so that it didn’t make any difference which way the market went. They didn’t really stick with that over time. And I’m not even sure whether A.W. Jones said that they would. But they, you know, sometimes they’d be 140 percent long and 80 percent short, so they’d have a 60 percent net long, or whatever it might be. They were not market-neutral throughout the period, but they did operate on the theory of being long stocks that seemed underpriced and short stocks that were overpriced.

Even the Federal Reserve, in a report they made on the Long-Term Capital Management situation a few years ago, credited A.W. Jones with being sort of the father of this theory of hedge funds. As Mickey Newman, if he’s still here, knows, I think it was in 1924 that Ben Graham set up the Benjamin Graham Fund, which was designed exactly along those lines, and which even used paired securities. In other words, he would look at General Motors and Chrysler and decide which he thought was undervalued relative to the other, and go long one and short the other. So, the idea — and he was paid a percentage of the profits. And it had all of the attributes of today’s hedge funds, except it was started in 1924. And I don’t know that Ben was the first on that, but I know that he was 30 years ahead of the one that the Federal Reserve credited with being the first, and that many people still talk about as being the first, A.W. Jones. Ben did not find that particularly successful. And he even wrote about it some in his — in terms of the problems he encountered with that approach.

And my memory is that a quite high percentage of the paired investments worked out well. He was right. The undervalued one went up and the overvalued — or the spread between the two narrowed. But the one time out of four, or whatever it was, that he was wrong lost a lot more money than the average of the three that he was right on. And you know, all I can say is that I’ve shorted stocks in my life, and had one particularly harrowing experience in 1954. And I have — I can’t — I can hardly think of a situation where I was wrong, if viewed from 10 years later. But I can think of some ones where I was certainly wrong from the view of 10 weeks later, which happened to be the relevant period, and during which my net worth was evaporating and my liquid assets were getting less liquid, and so on. So, it’s — all I can tell you is it’s very difficult. And the interesting thing about it, of course, is A.W. Jones was a darling of the late 1960′s. And Carol Loomis is here, and she wrote an article called “The Jones Nobody Keeps Up With.”

And it’s a very interesting article, but nobody’s writing articles — nobody was writing articles about A.W. Jones in 1979. I mean, something went wrong, and there were spin-offs from his operation. Carl Jones spun off from his operation, Dick Radcliffe spun off from his operation. There were — you can go down the list. And out of many, many, many that left, they — a very high percentage of them bit the dust, including suicides, cab drivers, subsequent employment — the whole thing. And these people were — There was a book written in the late ’60s, it had a lot of pictures in it. I don’t remember the name of it, but it showed all these portraits of all these people that were highly successful in the hedge fund business, but they didn’t bring out a second edition. So, it’s just tough. Logically, it should work well, but the math of only — you can’t short a lot of something. You can buy till the cows come home if you’ve got the money. You can buy the whole company if need be, but you can’t short the whole company.

A fellow named Robert Wilson, there’s some interesting stories about him. He’s a very, very smart guy, and he took a trip to Asia one time, being short, I think it was Resorts International or maybe it’s Mary Carter Paint, it was still called in those days. And he lost a lot of money before he got back to this country. He’s a very smart guy, and he made a lot of money shorting stocks, but it just takes one to kill you. And you need more and more money as the stock goes up. You don’t need more and more money when a stock goes down, if you paid for it originally and didn’t buy it on margin. You just sit and find out whether you were right or not. But you can’t necessarily sit and find out whether you’re right on being short a stock. I think I’ll let Charlie comment on that before I go to your other two questions.

17. “Creative accounting is an absolute curse”

CHARLIE MUNGER: Well, he asked about creative accounting and he named certain companies. I wouldn’t agree that all those companies were plainly sinful, although I’m sure there are significant sins in the group as a whole. Creative accounting is an absolute curse to a civilization. You can argue that one of the great inventions of man was double-entry bookkeeping, where we could keep our economic affairs under better control. And it was a north Italian development, spread by a monk. And anything that sort of undoes the monk’s work by turning this great system into kind of a tool for fraud and folly, I think, does enormous damage to the country. Now, I think a democracy is ordinarily set up so it takes a big scandal to cause much reform. And there may be some favorable fallout from Enron because that was certainly the most disgusting example of a business culture gone wrong that any of us has seen in a long, long time. And what was particularly interesting was it took in, eventually, a lot of nice people that you wouldn’t have expected to sink into the whirlpool.

And I think we’ll always get Enron-type behavior, but it may be moderated some in the next few years.

WARREN BUFFETT: A question of accounting and the economic profits to be gathered in the bottling system versus the production of the syrup, Coke. I’ve just gotten through reading the annual reports of Coca-Cola FEMSA and Panamco, which are two big Latin American bottlers. And I mean, they make pretty decent money, quite significant money. And there is more money in owning the trademark. It isn’t the plants that make the syrup or anything to sell. The trademark is where a huge amount of value is. The trademark is where a huge amount of value is in See’s Candy. You know, those are big, big assets. And I would say that you can make good money as a bottler. A lot of bottlers have become rich over the years. If I had a choice between owning the trademark and owning a bottling business, I’d rather own the trademark, but that doesn’t mean the bottling business is a bad business at all. And it’s riding on the back of a trademark.

I mean, that is why a bottling system is valuable, is because it has the right to sell a trademarked product, which hundreds of millions of people every day are going to go in and ask for by name. And the right to distribute that product is worth good money. And it really — I don’t see any accounting questions in that sort of thing. In other words, if the Coca-Cola Company did not own a share in any of its bottlers, and for many years it either owned a hundred percent of a bottler, or a large part, or — and very few of those — or none of it. But if they owned no interest in their bottlers, I think the economics would be very, very similar to what they are now. I mean, the bottlers would still be able to borrow a lot of money because they would have contracts with the Coca-Cola Company, and that were important, and that would allow them to make decent money distributing the product. But they don’t make the kind of money that you make if you own the trademark. That’s just the way it works.

18. How to stay in your “circle of competence”

WARREN BUFFETT: What was the first question again that —

AUDIENCE MEMBER: It was how a youngster like myself would define and develop a circle of competence.

WARREN BUFFETT: Oh, yeah, that’s a good question. And I’m — you know. I’d — I would say this, if you have doubts about something being into your circle of competence, it isn’t. You know, I mean, in other words, I would look down the list of businesses and I would bet you that you can — I mean, you can understand a Coke bottler. You can understand the Coca-Cola Company. You can understand McDonald’s. You can understand, you know, you can understand, in a general way, General Motors. You may not be able to value it. But there are all kinds of businesses. You can certainly understand Walmart. That doesn’t mean whether you decide whether the price — what the price should be — but you understand Walmart. You can understand Costco. And if you get to something that your friend is buying, or that everybody says a lot of money’s going to be made, and you don’t — you’re not sure whether you understand it or not, you don’t.

You know, I mean, and it’s better to be well within the circle than to be trying to tiptoe along the line. And you’ll find plenty of things within the circle. I mean, it’s not terrible to have a small circle of competence. I’d say my circle of competence is pretty small, but it’s big enough. You know, I can find a few things. And when somebody calls me with a Larson-Juhl, that is within my circle of competence. I hadn’t even thought about it before, but I know it’s within it. I mean, I can evaluate a business like that. And if I get called — I got called the other day on a very large finance company. I understand what they do, but I don’t understand everything that’s going on within it, and I don’t understand that — whether I can continually fund it, you know, on a basis, independent from using Berkshire’s credit, and so on.

So, even though I could understand every individual transaction they did, I don’t regard the whole enterprise, or the operation of it, necessarily as being within my circle of competence. Charlie?

CHARLIE MUNGER: Yeah, I think that if you have competence, you almost automatically have a feeling of where the edge of the competence is. Because after all, it wouldn’t be much of a competence if you didn’t know its boundary. And so, I think you’ve asked a question that almost answers itself. And my guess is you do know what you’re perfectly competent to do, you know, all kinds of areas. And you do have all kinds of other areas where you know you’d be over your depth. I mean, you’re not trying to play chess against Bobby Fischer or do stunts on the high trapeze if you’ve had no training for it. And my guess is you know pretty well where the boundaries of your competence lies. And I think you also probably know pretty well where you want to stretch the boundary. And you’ve got to stretch the boundary by working at it, including practice.

WARREN BUFFETT: And one of the drawbacks to Berkshire, of course, is that Charlie and I, our circles largely overlap, so you don’t get two big complete circles at all, but that’s just the way it is. And it’s probably why we get along so well, too.

19. Population growth and “carrying capacity”

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: Good afternoon, gentlemen. Wayne Peters is my name, and I’m from Sydney, Australia.

WARREN BUFFETT: I’d have never guessed.

AUDIENCE MEMBER: No. (Laughter) I’ll speak a little slower so my accent doesn’t throw you.

WARREN BUFFETT: Good.

AUDIENCE MEMBER: My question goes further to the resolution on population control raised this morning. Firstly, can I just say I voted against it, and I guess that’s just the beauty of the democratic society? Of concern, however, was the gentleman’s implication that the world’s population has decreased, or is decreasing. Having read the book Charlie recommended last year, by Garrett Hardin, called “Living Within Limits,” I’ve got a reasonable feel and understand the population grew by about 1.7 percent last year, which is approximately 67 million people. In my terms, I’d relate that to approximately 4 times the population of Australia, clearly an alarming rate over the long term if you’re talking, you know, 500 or a thousand years. Reading between the lines, my guess is that the issue of population growth is likely to be a key focus of the Buffett Foundation. My question to you this afternoon is, how do you currently see this critical issue being tackled?

WARREN BUFFETT: Yeah, well, population projections are just that, they’re projections. And they’ve been notoriously inaccurate over the years. And the gentleman that made the motion referred to a recent New York Times story. And there are some — there are projections that, based on fertility rates and what happens to them in different countries, under different economic conditions and all that, I mean, you can come up with all kinds of projections. I don’t know the answer on it. Nobody does at any given time. And the carrying capacity of the Earth has turned out to be a lot greater than people have thought in the past, but there is some amount that does relate to the carrying capacity. It may have been expandable, but it’s not infinitely expandable. And I would suggest that the errors of being on the low side, in terms of population relative to estimated carrying capacity, the danger from those errors is far, far less than the dangers from overshooting, in terms of population compared to carrying capacity.

And since we don’t know what carrying capacity is or will be a hundred years from now, I think that, generally, that mankind has an interest in making sure it doesn’t overshoot, in terms of population. And if it — there’s no great penalties attached to undershooting at all that I see. And it’s very, you know, it’s the old analogy. If you were going to go on a spaceship for a hundred years and you knew in the back of the spaceship there were provisions — there were a lot of provisions, but you didn’t know exactly how much — in terms of filling the front of the spaceship with a given number of people, you would probably err on the low side. I mean, you would — and if you thought maybe it could handle 300, in terms of the provisions, I don’t think you’d put 300 people in there. I think you’d put about 150 or 200. And you’d figure that you just didn’t know, you know, for sure, the spaceship would get back in a hundred years. You wouldn’t know how much was in the back.

And you would be careful, in terms of not overshooting the carrying capacity of whatever the vehicle you were in. And we are in a vehicle called Earth. We don’t know its carrying capacity. We have learned that it’s a lot larger than might have been thought by Malthus or somebody a few hundred years ago, but that doesn’t mean it’s infinite at all. And I don’t — the one thing I will assure you is that the projections that were run in the New York Times, you know, a few weeks ago, are not going to be the ones that are going to be run 50 years from now, or 30 years from now. And it’s not the sort of thing that is cured after the fact. I mean, you’re not going to go around trying to intentionally reduce the population. It’s much better to prevent population growth than to try and correct afterwards. And Garrett Hardin has got some interesting stuff on that. Charlie?

CHARLIE MUNGER: Yeah, I will say that the whole controversy has been interesting in the way both sides don’t understand the other side’s model. But by and large, on the population alarm side, the ecology side, they’ve always underestimated the capacity of modern civilization to increase carrying capacity. And the more they underestimate, why the least — the less they seem to learn. That is not to the credit. And the other side has equal folly. I think it’s — I think you’re just talking about the human condition. It’s a complicated, controversial subject and people feel strongly about it, and they learn slowly. And I just think that’s the way it’s going to be as far ahead as you can see.

WARREN BUFFETT: I think the chances of a world inhabited by 15 billion people having behavior, on average, better than if the world were inhabited by 5 billion people is low, but you know, that is — we’ll never find a way to test that. But that’s my instinct on it.

20. Expect “satisfactory” results

WARREN BUFFETT: Number 8.

AUDIENCE MEMBER: My name is Bert Flossbach. I’m from Cologne, in Germany. And first of all, I would like you gentlemen, for all the monitoring you have done and the pristine investment philosophy, which is more and more followed in Germany as well. My question refers to the importance of realism. If the dim prospects of the — on the stock market Mr. Munger made earlier become true, and given that the size of Berkshire Hathaway diminishes the impact of small investments, what do you think would be the realistic return on the float over the next 10 years or 20 years?

WARREN BUFFETT: Well, I wish I knew. The only thing I can tell you is it’ll be less than it’s been in the last 20 years. But I think it’ll be satisfactory, compared to most alternatives. But I don’t know whether the alternatives are going to produce 4 percent a year or 8 percent a year. I don’t think they’re going to produce 15 percent a year. And I would think that if we obtain very low-cost float, which I think we should and I think we will, and we keep getting chances to buy businesses on reasonable terms, not sensational terms, and we get occasional market — which we’ve even had a few occasions of things we’ve done in the bond market the last few years. We haven’t made huge amounts of money, but we’ve made a pretty good amount of money. And we’ll see some things to do on equities.

I think overall, we can have a return that we won’t be ashamed of, but we won’t come close to a return that you might think, looking back, we could achieve, but — We don’t think the returns on equities are going to be terrible over the next 20 years. We just think that people whose expectations were built by 1982 to 1999 are going to be very disappointed. But there’s nothing wrong with earning 6 or 7 percent on your money. I mean, there — it’s — in a world of relatively low inflation, you know, how much more is capital entitled to than that? I mean, it has to come out of somebody. And to keep doing it on increasing amounts of money, if you earned much higher returns than that, you would have a whole shift in the national income stream over time. So, I think we’ll get chances to do things that will leave us satisfied, but the question is whether they leave you satisfied. Charlie?

CHARLIE MUNGER: Well, I certainly can’t improve on that, but it won’t stop me from trying to say something. (Laughter) The — I think one of the smartest things that a person can do under present conditions is just dampen the expectations way down from the investment achievements of the past, including, of course, with reference to Berkshire stock. I think that’s maturity and good sense. All that said, I like our model and I like what we have in place, and I like what’s been coming in recently. And I think we’ve had a lot of fun in the past, and some achievement, and my guess is we’ll continue to do that. And I’m just up here, most of the time, to indicate to the rest of you that maybe you’ve got 10 more tolerable years coming out of Warren — (laughter) — and I’m doing the best I can at that. (Applause)

21. Discipline is more important than location

WARREN BUFFETT: Number 9, please.

AUDIENCE MEMBER: Good afternoon. I’d like to get back to the basics and talk about the insurance side, which is the core of Berkshire. In ’98, when we bought Gen Re, they had a Lloyd’s syndicate, DP Mann, now known as Faraday. In addition, in 2000, we bought the Marlborough Agency. I’d like to get your perspective on what you see is happening at Lloyd’s and their future, as well as our commitment to the Lloyd’s market.

WARREN BUFFETT: Yeah, well, we do have what is now known as the Faraday syndicate. And actually, our takedown of their capacity, which I think was maybe, I don’t know, in the area of 30 percent a few years back, is now well into the mid-90s percent. So, we, in effect, have a much larger commitment, through Faraday, to the London market. And I would think we would do pretty well with that commitment. But in the end it really doesn’t make any difference whether you’re in London or whether you’re in Washington, as GEICO is, or whether you’re in — I mean, actually, for a while, Ajit lived here in Omaha, or whether, you know, you — it really depends —because you’re — it’s a worldwide market. You’re going to see things — assuming that you have a reputation for paying claims and for having the capital to do things, and being willing to act — you’re going to see things every place in the world. It’s really like investing.

I mean, you can invest, whether you’re in London or Omaha or New York. It doesn’t make any difference where you’re located. What counts is the ability to, and the discipline, to look at thousands of different things and select from them a group to do, because you can do anything in the world in insurance. I mean, we could write tens of billions of premiums in, you know, in a month if we just opened the floodgates, but it’s out there. There’s lots of business out there. There’s lots of investment opportunities — or investment choices — out there. And the question is, is what you say yes to and what you say no to. And that should be determined by what you are able to evaluate and, in the case of insurance, even if they’re attractive, preventing an aggregation risk that could cause you major embarrassment at some time. But we don’t have any — we don’t specifically think the London market is better than the U.S. — being domiciled in the U.S. — or vice versa. And as you know, we have an operation domiciled in Germany.

And that isn’t the key to it. You know, the key is having people making decisions daily where they accept risks they understand and that are properly priced, and avoiding undue aggregation, and the occasional problem, in terms of dealing with people that are less than honest. But the first two items are the important ones day in and day out. And that can be done at Lloyd’s, it can be done at Omaha. I mean, National Indemnity did not have any great geographical advantage in sitting at 30th and Harney, but it’s done very well, just in its primary business, ever since Jack Ringwalt founded it in 1941, or whatever year it was. I mean, it — and Jack Ringwalt — some of you here may have known him — Jack Ringwalt — a very good friend of mine — but Jack Ringwalt was not an insurance genius. And he never, you know, my guess is he never looked at an actuarial book in his life or even thought about it. But he just was an intelligent fellow who had enough sense to do — to stick with what he understood in virtually all cases, and to make sure that he got paid appropriately for the risk he was taking.

And he beat the pants off, you know, people that had been around for a hundred years in Hartford, who you know, had vast agency organizations and huge amounts of capital and actuaries and all kinds, you know, all kinds of data and everything. But they didn’t have the discipline that he had. And that’s what it’s all about. So, I don’t really relate it to geography. I would like to be exposed to as much business in the world as possible and have that exposure be manifested through people that have the disciplines I talked about. And if we can see everything that takes place in the world, and people want to come to us for one reason or another, often because of our capital position or our willingness to take on volatility — If those people come to us, wherever they come to us, and the people that they — who represent us use the guidelines we’ve talked about, we’ll do very well. And you know, the more places they have to intersect with us, as far as I’m concerned, as long as that intersection takes place with people who have that discipline. Charlie?

CHARLIE MUNGER: Yeah, the insurance business is a lot like the investment business at Berkshire. If you combine a vast exposure with a vast decline rate, you have an opportunity to make quite a few good decisions.

WARREN BUFFETT: And I think we’re making them now. You can check on me next year on that.

22. Life advice: take care of your most important asset

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: I’m Lowell Chrisman (PH), from Phoenix, Arizona. I am retired and teaching in — seniors in high school. I wish they could be here to hear you today. I’m teaching these people an investment course part-time. And the first class I went to, they asked me to teach them how to prepare for retirement. I would like to know what the two or three things are that you would suggest that I include in this course.

WARREN BUFFETT: Well —

CHARLIE MUNGER: What the hell does Warren know about retirement? (Laughter)

WARREN BUFFETT: Yeah. We haven’t even thought about it. Now, let me give you one suggestion for that group. I use this sometimes when I talk to high school — a bunch of high school seniors down in Nebraska Wesleyan, a few weeks ago. Tell the youngsters in the class, they’re probably around 16 or 17, and if they’re like I was when I was 16, you know, I was only thinking of two things. And Martin’s Aunt Barbara wasn’t going out with me, so I was down to cars. (Laughter) I tried hearses, but that didn’t work. The — And let’s assume, and I use this with — let’s assume a genie appeared to you when you turned 16, and the genie said, “You get any car you want tomorrow morning, tied up in a big pink ribbon, anything you name. And it can be a Rolls Royce, it can be a Jaguar, it can be a Lexus, you name it, and that car will be there and you don’t owe me a penny.”

And having heard the genie stories before, you say to the genie, “What’s the catch?” And of course, the genie says, “Well, there’s just one. That car, which you’re going to get tomorrow morning, the car of your dreams, is the only car you’re ever going to get. So you can pick one, but that’s it.” And you still name whatever the car of your dreams is, and the next morning you receive that car. Now, what do you do, knowing that’s the only car you’re going to have for the rest of your life? Well, you read the owner’s manual about 10 times before you put the key in the ignition, and you keep it garaged. You know, you change the oil twice as often as they tell you to do. You keep the tires inflated properly. If you get a little nick, you fix it that day so it doesn’t rust on you.

In other words, you make sure that this car of your dreams at age 16 is going to still be the car of your dreams at age 50 or 60, because you treat it as the only one you’ll ever get in your lifetime. And then I would suggest to your students in Phoenix that they are going to get exactly one mind and one body, and that’s the mind and body they’re going to have at age 40 and 50 and 60. And it isn’t so much a question of preparing for retirement, precisely, at those ages, it’s a question of preparing for life at those ages. And that they should treat the importance of taking care and maximizing that mind, and taking care of that body in a way, that when they get to be 50 or 60 or 70, they’ve got a real asset instead of something that’s rusted and been ignored over the years. And it will be too late to think about that when they’re 60 or 70. You can’t repair the car back into the shape it was. You can maintain it. And in the case of a mind, you can enhance it in a very big way over time.

But the most important asset your students have is themselves. You know, I will take a person graduating from college, and assuming they’re in normal shape and everything, I will be glad to pay them, you know, probably $50,000 for 10 percent of all their earnings for the rest of their lives. Well, I’m willing to pay them 10 percent for — $50,000 for 10 percent — that means they’re worth $500,000 if they haven’t got a dime in their pocket, as long as they’ve got a good mind and a good body. Now that asset is far, far more important than any other asset they’ve got, unless they’ve been very lucky in terms of inheritance or something, but overwhelmingly their main asset is themselves. And they ought to treat their main asset as they would any other asset that was divorced from themselves. And if they do that, and they start thinking about it now, and they develop the habits that maintain and enhance the asset, you know, they will have a very good car, mind, and body when they get to be 60. And if they don’t, they’ll have a wreck. Charlie?

(Applause)

23. Why Berkshire won’t be providing guards to airports

WARREN BUFFETT: Number 1?

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. I’m George Brumley, from Durham, North Carolina. It’s been reasonably argued that the most critical factor in evaluating a business is establishing the sustainability of a competitive advantage. Let’s assume that we have knowledge in hand about a few truly unique companies that possess sufficient strengths to out-duel the competition, and that we can therefore estimate future cash flows with relative certainty. I admit that getting this far is far from easy, moreover it seems that the wild card of an unchecked tort system has grave potential to turn even such sound analysis on its head. Predicted cash flows and reasonably estimated terminal values can be effectively driven to zero for business owners via a transfer to both litigants and litigators. My question is, how should intelligent investors attempt to factor such uncertainty into their valuations of potential investment opportunities?

WARREN BUFFETT: Charlie’s the lawyer, so I’ll tell him how — I’ll have him tell you how to protect yourself from his brethren.

AUDIENCE MEMBER: And I have quick follow-up.

CHARLIE MUNGER: I think it is entirely fair, as an investor, to just quitclaim certain areas of business as having too many problems. I almost feel that way about workman’s compensation insurance in California. In other words, the system morphs into something that is so unfair and so crazy that I’m willing to pretty much, at least, leave it behind. And I think there are all kinds of areas like that. Another fellow and I once controlled a company that invented a better policeman’s helmet. And we told them not to make it. We told them to sell it to somebody else who was judgmentproof or — we wanted the policemen to have the helmet, but we didn’t want to make it. I think there are whole areas of activity where, for the already rich, the tort system makes participation foolish. And I think you can sort of figure out where those are and avoid them. I don’t think the tort system is going to be fixed quickly.

WARREN BUFFETT: Yeah, George — actually, George Gillespie is, I think, here today. And he and I were directors of Pinkerton 20 years ago. And in fact, we owned a very significant percentage of Pinkertons, although it was controlled by the family foundation. But one of the interesting problems then was a question of whether we would want to supply guards, for example, at airports. And if you think about it, Berkshire, itself — well, forget about Pinkerton — would be absolutely crazy to go into the business of supplying guards to airports. We might be more responsible, in terms of selecting the guards. But if we were to have a guard, say, at that Portland airport from which a plane took off — or where from what the original boarding was of the people that took off from Logan — or we are the guards at Logan or wherever — we might have been held liable for billions and billions of dollars.

You know that people would have gone after us because we would have had deep pockets and we would have had an employee of ours, and people would have said that if it hadn’t for your employee, these people wouldn’t have all died, and everything else wouldn’t have happened. And for us to be in a business, like Charlie and the helmet business, I mean, for us to be in a business like that would be madness when some other guy operating out of his basement can have guards and if, you know, if they blow up the whole airport it doesn’t make any difference because he’s judgment-proof. So, it actually is a system that may discourage, perhaps, more responsible people from ever even dreaming of being in that kind of business. And unfortunately, I would say that the range of businesses, since 1980, when we were thinking about that sort of thing at Pinkertons, the range of businesses to whom such reasoning might apply has probably enlarged to a significant degree.

There’s just a lot of things that a rich corporation shouldn’t do because they will pay a price if they are wrong, or if even somebody maybe suspects they were wrong, that would be incredibly disproportionate to what somebody in different economic circumstances would bear. It’s absolutely a selection by the tort system of people that are going to provide certain services and products. And I don’t know any answer for that except to avoid it.

24. Finova deal won’t be as profitable as expected

WARREN BUFFETT: Now, you had another question, George?

AUDIENCE MEMBER: Yes, just briefly, if you could give us an update on the economics of the Finova deal?

WARREN BUFFETT: Well, the Finova deal is about like — well, it is like when we wrote the annual report. And actually, Finova’s annual report deals with this, too. I think most of you know the terms of it. We guaranteed what was originally going to be a $6 billion loan that enabled creditors to be paid a large percentage of their claim in the Finova bankruptcy. And we only took down 5.6 billion of the 6 billion because there had been payments made faster at Finova. Finova was a failed finance company, a very big one, and we were in partnership with Leucadia in this operation. And they have management responsibility, and they’re doing a fine job. That loan of 5.6 billion, on which, in effect, we make roughly a 2 percent override on 90 percent of the loan. So, if it had been 6 billion, we would have had a carry of 108 million a year, although it was going to come down. Now the loan is down to 3.2 billion, I believe. There was a bulk sale of some franchise receivables for about 500 million to GE Credit here not so long ago.

So the exposure’s down to 3.2 billion, but of course the 2 percent override is down to 2 percent on 3.2 billion. We feel — well, after September 11th, many of the assets at Finova were aircraft. And they were not the latest of aircraft, and they were not to the greatest of lessees in many cases. So there was a big hit to the aircraft portfolio, and there was — there were other receivables relating to resort properties and that sort of thing, which were also hit by anything that impacted travel and that sort of thing. So the portfolio was worth less — appreciably less — on September 12th than it was on September 10th. And that will not, in my view — our 3.2 billion, as far as I’m concerned, we’ve guaranteed it, but I think that is very close to 100 percent OK. And then there’s a group of bonds underneath it which are the residual bonds, you might say, of the ones that existed in the bankruptcy, because 70 percent got paid off and 30 percent didn’t. And we own that means of that residual — we own 13 percent or so.

Those bonds are going to be worth a lot less than we thought they were going to be worth the summer of last year. We bought our position at 67 cents on the dollar, and we’ve already — we got 70 cents on the dollar, plus these bonds, plus we get the override on the Berkadia loan. So we got all our money back, and then some, on the bonds that we bought, and we get the override on the Berkadia, so we will, in all likelihood, almost certainly, I would say — although, who knows? I mean, I didn’t know about September 11th — but we will almost — we’re very, very likely — to make a significant amount of money on the whole transaction, but not as much money as we thought we were going to make last summer. And we feel very pleased with the way Leucadia’s handling things, but there is not as much value in that portfolio today because of the events of September 11th. Charlie?

CHARLIE MUNGER: Yeah, it’s an interesting example of Ben Graham’s margin of safety principle. A whole lot has gone wrong that we didn’t predict, and yet we’re coming out fine.

WARREN BUFFETT: Yeah, we should make some hundreds of millions in aggregate over time on it, but a lot went wrong. But we, as Charlie said, we had a margin of safety when we bought into it, and we felt we had a margin of safety, and it turns out we needed it.

AUDIENCE MEMBER: Thank you.

25. “Hard to find real estate that’s really mispriced”

WARREN BUFFETT: Number 2.

AUDIENCE MEMBER: I’m Bob Kline (PH), from Los Angeles. I wonder if you could give us a glimpse into your investment process, the way you approach looking at a particular industry. And I wonder if you could use real estate as an example. I know real estate hasn’t been a big, huge part of Berkshire’s portfolio over the years. And I wonder if that’s because you view real estate as a commodity business or if, maybe, the cash flows from real estate tend to be more predictable than, perhaps, from some other industries, and thus, it tends to be less likely to be mispriced, and therefore less likely to find terrific bargains in real estate. So —

WARREN BUFFETT: Yeah, you’re — go ahead.

AUDIENCE MEMBER: So, just wondering if we could — if we were watching a discussion between you and Charlie hashing out the merits of real estate,[tell us] how it would go.

WARREN BUFFETT: Well, it would go like all our other conversations. He would say no for about 15 minutes — (laughter) — and I would gauge by the degree to which he — the emotion he put into his ’no’s as to whether he really liked the deal or not. (Laughter) But the — We’ve both had a fair amount of experience in real estate, and Charlie made his early money in real estate. The second point is the more important point. Real estate is not a commodity, but I think it tends to be more accurately priced — particularly developed real estate — more accurately priced most of the time. Now, during the RTC period, when you had huge amounts of transactions and you had an owner that didn’t want to be an owner in a very big way, and they didn’t know what the hell they owned, and all of that sort of thing, I mean, you had a lot of mispricing then. And I know a few people in this room that made a lot of money off of that. But under most conditions, it’s hard to find real estate that’s really mispriced.

I mean, when I look at the transactions that REITs engage in currently — and you get a lot of information on that sort of thing — you know, they’re very similar. But it’s a competitive world and, you know, they all know about what a class A office building in, you know, in Chicago or wherever it may be, is going to produce. So at least they have — they may all be wrong, as it turns out, because of some unusual events, but it’s hard to argue with the current conventional wisdom, most of the time, in the real estate world. But occasionally there have been some, you know, there could be big opportunities in the field. But if they exist, it will certainly be because there’s a — there’ll probably be a lot of chaos in real estate financing for one reason or another. We’ve done some real estate financing and you have to have the money shut off to quite a degree, probably, to get any big mispricing across the board. Charlie?

CHARLIE MUNGER: Yeah, we don’t have any competitive advantage over experienced real estate investors in the field, and we wouldn’t have if were operating with our own money as a partnership. And if you operate as a corporation such as ours, which is taxable under Chapter C of the Internal Revenue Code, you’ve got a whole layer of corporate taxes between the real estate income and the use of the income by the people who own the real estate. So, by its nature, real estate tends to be a very lousy investment for people who are taxed under Subchapter C of the code relating to corporations. So, the combination of having it generally allows the activity for people with our tax structure, and having no special competence in the field means that we spend almost no time thinking about anything in real estate. And then such real estate as we’ve actually done, like holding surplus real estate and trying to sell it off, I’d say we have a poor record at.

WARREN BUFFETT: Yeah, C corps really, it doesn’t make any sense. I mean, I know there are C corps around that are in real estate, but there are other structures that are more attractive. There really aren’t other structures — I mean, Lloyd’s is an attempt at it, to some degree — but there aren’t other structures that work well for big insurance companies, or — I mean, you can’t have a Walmart very well that does not exist in a C corp. So, they are not subject to S corp, or partnership competition, that determines the returns on capital in the discount store field. But if you’re competing with S — the equivalent of S corps — REITs or partnerships or individuals, you’ve just got an economic disadvantage as a C corp, which is, for those of you who don’t love reading the Internal Revenue Code, is just the standard vanilla corporation that you think of — all of the Dow Jones companies, all of the S&P companies, and so on.

And as Charlie says, it’s unlikely that the disadvantage of our structure, combined with the competitive nature of people with better structures buying those kinds of assets, will ever lead to anything really interesting. Although, I would say that we missed the boat, to some extent, during the RTC days. I mean, it was a sufficiently inefficient market at that time, and there was a lack of financing that— we could have made a lot of money if we were — had been geared up for it at that time. We actually had a few transactions that were pretty interesting, but not — but nothing that was significant in relation to our total capital.

CHARLIE MUNGER: We thought significantly about buying the Irvine Corporation —

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: — when it became available. So, but that’s the only big one I can remember that we seriously thought about.

WARREN BUFFETT: Yeah, and that was in 1977 or so, as I remember?

CHARLIE MUNGER: Way back.

WARREN BUFFETT: Yeah, Mobil Oil was interested, and you know, Don Bren ended up putting together a group for it. And that kind of thing could conceivably happen, but it’s unlikely.

26. The problem with how Black-Scholes values options

WARREN BUFFETT: Number 3?

AUDIENCE MEMBER: Hello, my name is Joseph Lepre (PH). I’m a shareholder from Minneapolis, Minnesota, and I’d like to thank you for this opportunity to ask a question. Mr. Buffett, you mentioned earlier today that you’d be willing to sell insurance in exchange for stock options. If possible, could you please describe a methodology for the valuation of stock options, particularly in cases where there is no market pricing data available for the option being valued?

WARREN BUFFETT: Yeah, I would — I could figure out what I would pay for an option on a private business. I could figure out what I could pay for an option on a public business. It might be a little easier. I could figure out what I’d pay for an option on an apartment house or a farm. I had a friend, I mean, when I was 20 years old, we developed a big plan and we were going to go out and option out — option farms, you know, outside of what were then the city limits of Omaha. And we figured that if we offered a farmer a modest amount, which would be annual income to him, to option his farm at double the price it was bringing then, that it would, you know, he would be happy to sell for double the price that year, and maybe we could do something. And it might have worked out OK. Every option has value. You know, I’ve got a house worth X. If you offer me a few dollars to give you an option at 2X for 10 years, I’m not going to take it, because there are all kinds of possibilities in terms of inflation. All options have value.

And people that get options usually understand that better than people that give options. I’m not talking about stock options now, but in other arenas. So we would be happy, you know. I mean, what I could get — let’s say — we’ll just pull one out of the air. Let’s take an untraded company like Mars, Inc. Would I be happy to have an option, a 10-year option on a piece of Mars, Inc. at some given price? Sure, I would. And there’s an amount I would take for that — I would take in lieu of getting cash if I was writing a big insurance policy with Mars, Inc. They’re not going to do this with me, but that — And I would be happy, you know, instead of if you buy homeowner’s insurance from me, if you want to give me an option on your house for 10 years, I’ll take that in lieu of the premium. I’ll make my own calculation as to value.

It won’t be Black-Scholes, although that might be the best arrangement under many circumstances, but I would probably crank into — in my own case. We’ve bought and sold options some. And as a matter of fact, on June 3rd, Berkshire Hathaway will receive $60 million if the S&P 500 closes at 1150-something or below. And two years ago, when the S&P was 14-something, we agreed for — on that June 3rd option, or whatever it was — $400 million nominal value, where, in effect the counter party would get the profit above 2,000 and something, 42 percent up from the current cash price. And we got the profit between 5 and 20 percent on the downside on a put. People who were calculating the values of options at that time, under traditional methods, felt that that was a cashless transaction — that the value of the call that we gave was equal to the value of the put that we received. You know, I decided differently. So, we don’t accept, blindly, option values as determined by the calculations of people who win Nobel Prizes. Instead, you know, we actually put an aspect of judgment into some.

There would be businesses that would come out with identical Black-Scholes values on options for 10 years, and we would pay a different amount for one than the other, maybe a significantly different amount. But we would pay something for just about any option. And you know, it is the nature of prices in this world to change, and economic conditions to change. And an option is a chance to participate in a change without giving up anything other than that original premium you pay. Many people just don’t seem to grasp that, but believe me, the people who are getting options on stock do grasp that. And the people who are giving them, which are the shareholders, you know, represented by a group like this, who don’t have any real voice in giving it, but they sometimes don’t fully realize what’s being given away. Imagine, you know, going up a few miles away from here and having two farms for sale. And you say to the guy, “How much do you want for them?”

and they both say a thousand dollars an acre, but the one guy says, “But every year, I want you to option, you know, I want you to give me 2 percent of the place back at a thousand. So, you know, at the end of 10 years, 20 percent of the upside belongs to me, but you’ve got all the downside.” I mean, which farm are you going to buy? The one without the options or the one with the options? It’s not very complicated. And we will — we are dead serious when we say we will take options in lieu of cash. Incidentally, the company that gives us those options in lieu of cash for an insurance premium has to record the expense in terms of the fair value of the option they’ve given us. The only item for which they don’t have to record that as expense is compensation. But if they give it to us for their light bill, or if they give it to us for their insurance premium, or they give it to us for their rent, they have to call it a cost.

But only when it comes to the CEO’s compensation, and other people like it, do they not have to record it as a cost, and that’s because they’ve been able to get Congress to bow to their will and to their campaign contributions. Charlie?

CHARLIE MUNGER: Yeah, the Black-Scholes crowd really did get a Nobel Prize for inventing this formula to value options, not executive stock options, but just options generally. And if you don’t know anything about the company, except the past price history of stock transactions —

WARREN BUFFETT: And dividends.

CHARLIE MUNGER: — and if it’s — and the dividend being paid — and if the option is over a very short term, it’s a very good way of approximating the value of the option. But if it’s a long-term option and you think you know something, it’s an insane way to value the option. And Wall Street is full of people with IQs of 150 that are using Black-Scholes to value options that shouldn’t be tortured into the model. And all of corporate — of America is using Black-Scholes to price stock options in the footnotes of the accounting statements, and they do that because it comes up with the lowest cost number.

WARREN BUFFETT: Well, they not only do that, but they assume the term is less than the actual term of the option. And I mean, they’ll do everything they can, and I’ve been in on these discussions. They’ll do everything they can to make the number look as low as possible. It’s that simple.

CHARLIE MUNGER: And they’re using a phony process to determine the number in the first place. So, it’s a Mad Hatter’s tea party, and the only thing that’s consisting — consistent — in it is that the whole thing is disgusting. (Laughter and applause)

27. Investment bankers are “in the lucky part of society”

WARREN BUFFETT: Number 4, please.

AUDIENCE MEMBER: I’m John Golob, from Kansas City. I’m mostly retired, but also teach a course on financial markets at the University of Missouri in Kansas City. I always tell my students that I learned much more about investing at Berkshire Hathaway meetings than I ever did from my professors at the Wharton School. (Applause) I have a general question about investment banks. Now, given your connection with Salomon, I’m always surprised at sort of the attitude you represent to this industry. Somehow I get the idea that you view them as just their main social value is charging very high fees for unnecessary churning. I’m wondering if you have any perspective on the general influence of investment banks in U.S. finance that is — rising or falling. I hate to be a Pollyanna, but I might hope that Enron-like debacles would reduce, maybe, the influence of investment banks, that people wouldn’t necessarily trust, you know, some of the advice they’re giving.

WARREN BUFFETT: I think Enron is bound to have some favorable fallout in various areas. I mean, it — to the extent that it causes people to look more carefully at how various entities behave and that sort of thing. No, I think Enron was a plus for the American economy. And the truth is our capital system, you know, despite all kinds of excesses and errors and everything else, you know, one way or another, we’ve come up in this country with 50-oddpercent of the world’s market value for 4 1/2 percent of the world’s population. So, you know, I’m not negative on how the American capital system has developed. I do get negative about how certain people behave within that system, but you know, they would behave badly in any system. So, you know, it’s the human condition. But that is, you know, Charlie and I still think we should criticize things that we think are improper, but we don’t criticize the whole system in any way, shape, or form. It’s — you know, it’s been a tremendous economic machine in this country.

But I would say that a market system, and I don’t have anything better than — in fact, I think a market system is responsible in a material way for the prosperity of this country. So, I have no substitute in mind for the market system. I do think it produces extraordinarily inequitable results, in terms of some overall view of humanity, and that that should be largely corrected by a tax system. I don’t think it should be any comparable worth system or anything like that. I just — the idea of the government trying to — (laughs) — assign all that just strikes me as wild. But the market system lets a fellow like me, you know, make so much money because I know how to allocate capital, you know, compared to a great teacher, or nurses, cancer — whatever. I mean, it just showers rewards on somebody that has this particular skill at this particular time. And that’s great for me, but it should — there — in a really prosperous society, that should — there should be some corrective aspects to that.

Because it really strikes me as inappropriate that the spread of prosperity in a hugely prosperous economy should be decided totally by the quirks of skills that come into play and get rewarded so hugely from the market system. So, I — but I, you know, I believe that — that’s why I believe in a progressive tax system, and so on. I would say, in terms of investment banking particularly — I mean — (laughs) — I was standing one time with an investment banker, and he was looking out the window, and he said, “Just look.” He says, “As far as you can see, nobody’s producing anything.” And I said, “Yeah, that seems to be a mandate they take pretty seriously, too.” (Laughter) But it — you know, there is a huge amount of money in a system, you know, with 14 trillion, or whatever it may be, of market values, and where people are spending other people’s money, and corporations, and where the more you spend for something, sometimes you get — gets equated with value as in fairness opinions, and all of that sort of thing.

It’s quite disproportionate to what I really think the ultimate contribution to the country is of various people, but I don’t have a better system — (laughter) — to substitute for it. I don’t want anybody to think — come away thinking that I think we ought to tinker with that very much. I think that the — I think your tax system should be the way that you distribute the prosperity in a somewhat better way. When we ask people to go to war, you know, or that sort of thing, we don’t take the person who’s made the most money and say, “Well, they benefited the most from society, so we’ll send them and put them in the front lines,” or anything like that. I mean, we — there’s various aspects of being a citizen in this country that I think should make sure the people that don’t get the great tickets for — that make them prosper in a market setting, they still should do pretty darn well, as far as I’m concerned.

And really, people like me shouldn’t, you know — It doesn’t make any sense to compensate me the way this world has. And it wouldn’t have happened if I’d been born in Bangladesh, or it wouldn’t have happened if I had been born 200 years ago. You know, somebody — another one of those genie stories. Imagine, you know, when I was — 24 hours before I was born and there had been some guy with exactly my DNA right next to me, who was also going to be born in 24 hours. And the genie had come to the two of us and said, “We’re now going to have a bidding contest. “And the one that bids the most of their future income gets to be born in the United States, and the one that loses in this is born in Bangladesh. And what percent of your future income will you give to be born in the United States?” I’d have gone pretty high in the bidding. (Laughs) You know, I mean, that would have been an interesting test of how important I thought my own abilities were compared to the soil in which I was going to be planted.

So, I, you know, I feel I’m lucky, and I am lucky, I mean, obviously. But I think we ought to figure out ways to take care of the people that are less lucky. And I think that investment bankers should consider themselves in the lucky part of society. And you know, there’s nothing wrong with what they do. Raising capital for American business is a fine thing and all that. I just think that they are paid, in relation to the talent and that sort of thing they bring to the game, I think they are paid obscenely high, but I think that’s true of me, too. Charlie?

CHARLIE MUNGER: Yeah, the — but I would argue that the general culture of investment banking has deteriorated over the last 30 or 40 years. And it — remember, we issued a little bond issue, Warren, way back?

WARREN BUFFETT: Yeah, 6 million.

CHARLIE MUNGER: Diversified Retailing. And we had this very high-grade investment bankers from Omaha and Lincoln. And they cared terribly whether their customers, whom they knew, were going to get their money back.

WARREN BUFFETT: Yep.

CHARLIE MUNGER: And they fussed over every clause in the indenture, and they talked about whether we were really OK. And so, that was a very admirable process that we were put through.

WARREN BUFFETT: Yeah, we were screened in that.

CHARLIE MUNGER: We were screened, and intelligently screened. And it may not have been too intelligent to let us through, but it was an intelligent process. And I’d say the culture on Wall Street lately has drifted more and more to anything that can be sold at a profit will be sold at a profit.

WARREN BUFFETT: Yeah. Can you sell it? That’s the question.

CHARLIE MUNGER: Can you sell it is the moral test. That is not an adequate test for investment banking. And —

WARREN BUFFETT: And there used to be two classes of investment bankers, too, really. I mean, there were the ones that did the screening and all of that. And then there was a really low-class element that essentially merchandised securities no matter what they were. And there were clean lines, but the lines have disappeared.

CHARLIE MUNGER: Yeah, so it hasn’t been good to have this deterioration of standards in high finance. And will it ever swing back? You would certainly hope so.

WARREN BUFFETT: You can see why were so popular at Salomon. (Laughter)

CHARLIE MUNGER: But in fairness, we had a very effective investment banking service from Salomon.

WARREN BUFFETT: That is true. That is true. And we — when we sold the B stock, for example, now we set the rules. And they wouldn’t have done it that way necessarily, but they did a very good job of doing it the way we asked them to do it. And so, we said we don’t want people hyped into the stock. We want a very low commission and we’re going to issue as much as the market takes so that nobody gets excited about the after-market behavior and buys because they think it’s a hot issue. I mean, we set a bunch of rules we thought were rational, and Salomon did a terrific job of following through on that and doing exactly what we asked them to. And it was successful by our standards. So, no, I would say they did a terrific job in that case.

CHARLIE MUNGER: And they thoroughly enjoyed doing it, the people working on the job.

WARREN BUFFETT: That’s true.

CHARLIE MUNGER: They’d never done one like it before.

WARREN BUFFETT: That’s true. Yeah. We’ve changed our whole opinion here in a matter of seconds. (Laughter)

CHARLIE MUNGER: Well, but there’s a lesson in that. Certain kinds of clients get higher quality service than other kinds of clients. In fact, there are many clients who should never be accepted at all at investment banking houses, yet they are.

WARREN BUFFETT: Are you thinking of the fellow at Normandy? (Laughter)

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: I mean, can I you imagine that guy even getting in the door? I mean, it just — it blows your mind. I mean, he went to jail subsequently. He should have.

CHARLIE MUNGER: He was married to his high school teacher, who was at least two decades older than he was.

WARREN BUFFETT: Charlie has more opinions on this kind of thing than I do, but go ahead. (Laughter)

CHARLIE MUNGER: There were enough peculiarities in the situation. (Laughter) I wouldn’t have thought it so peculiar, except that he was a man and she was a woman.

28. Dexter Shoe acquisition was a mistake

WARREN BUFFETT: OK, number 5. (Laughter)

AUDIENCE MEMBER: Good afternoon. Mike Envine (PH) from Chelmsford, Massachusetts. I noticed in the annual report that you took a charge-off for Dexter and put it under the management of H.H. Brown. And I was thinking back, I believe in 1985 you wrote about the process you went through in closing the textile business. And I was wondering if you could elaborate how this situation is different. I believe you indicated, in the textile business, that despite excellent management, it wasn’t possible to earn an economic return on the assets.

WARREN BUFFETT: Yeah. Did you say that we took a charge-off on H.H. Brown?

AUDIENCE MEMBER: No, I meant to say we took a charge-off on Dexter.

WARREN BUFFETT: Oh, Dexter, yeah, absolutely. We lost a very significant amount of money on Dexter, thanks to a dumb decision that I made, and maybe several dumb decisions. And I mean, that is a business that went offshore in a huge way. They’re close to 1,200,000,000 pairs of shoes made in — or used in this country. I never can figure out how they get to that number. I mean, I use a pair — (laughs) — about every five years. But four for every man, woman, and child. I don’t know, but that’s the number. And you know, I don’t know whether it’s 5 percent now, but it’s something in that area, are made in this country, and hundreds of thousands of jobs have gone offshore with that. The textile business, as you know, has gotten almost destroyed in this country. And when you have somebody like Burlington go into bankruptcy, you know, a wonderful company, spent lots of money on keeping their plants up to date and all of that sort of thing.

But in the end, you know, if you’re paying 10 times as much per hour for labor as somebody else, it’s awfully hard to be that good. And that’s going on in furniture manufacturing now, too. We have a number of furniture retailers and, you know, Bill Child, or Irv Blumkin will go over to the Orient fairly frequently now. We’ll buy — we buy a lot — a lot of furniture comes from there. And that trend is moving in that direction in a very significant way. And your question is — was your question why Fruit of the Loom would be different?

AUDIENCE MEMBER: No, I was just wondering if there’s any hope for Dexter, or if it’s going down the same path as with textiles?

WARREN BUFFETT: Oh, no, well, Dexter is now part of H.H. Brown, and it’s selling product which, overwhelmingly, is produced abroad. And H.H. Brown sells a very significant amount of product that’s produced outside the United States, although they still produce a lot of product in the United States. But — no, the Dexter — we will have a significant shoe business. The shoe business — we had some contracts on the books from Dexter that were unprofitable, and they will run for another quarter. But we made a fair amount of money in the shoe business in the first quarter. Justin made money. I think our shoe business will be OK. It won’t be a bonanza over time, but I think our shoe business — we’ve got very good management in there. We’ve got good management at H.H. Brown, and we’ve got good management at Justin. And I would expect that we would have a substantial and a reasonably profitable shoe business in the future, but we will not be able to do it with a hundred percent or 90 percent or 80 percent domestic-produced shoes.

And in that respect, I was very wrong in paying what I did, and paying it in the manner I did, which was stock in the case of Dexter, for a domestic shoe manufacturer. Charlie?

CHARLIE MUNGER: Yeah, that shows, which is important to show, that no matter how hard you work at having systems for avoiding error and practices of trying to stay within your circle of competency, et cetera, et cetera, you still make mistakes. And I think I can confidently promise that it won’t be our last mistake.

WARREN BUFFETT: OK, here’s our Blue Chip Stamps. (Laughter) But you know, you might think about this a bit, too. We had a lot of workers up in Dexter, Maine, and we’ve had a lot of workers at some of the H.H. Brown plants. And you know, we take a little hit financially and we make it up by some trading strategy in government bonds or something like that, that requires, you know, no effort and not really too much brain power. And when you think of the consequences to the people that have spent a lifetime learning one trade, you know, and who live in those areas, and through no fault of their own — none, I mean they’ve done a good job — they’ve done a great job — working. They’re productive, but in the end, you know, their cost was 10 times or more, and they weren’t getting paid that well, but 10 times what it could get done for elsewhere in the world. So, we haven’t really paid the price for that change in economic conditions.

I mean, it’s the people who work there, the people who work at Burlington, or wherever, where the jobs disappear. And that’s no argument for huge tariffs or anything of the sort. But retraining doesn’t do much good if you’ve worked in our textile mill, as many people did years ago, and you’re 60 years old and you only speak Portuguese. Or if you work in Dexter, Maine, and you’re 58. I mean, retraining, it gets kind of meaningless. So, we’re the lucky ones, you know, basically in these situations. And it is tough when you know one trade, particularly if you live in a small town, not lots of other employment opportunities or anything. So, you know, we have a charge-off and they have a huge change in their lives, basically.

29. Contrarian shareholder thinks annual report is too short

WARREN BUFFETT: Number 6.

AUDIENCE MEMBER: Jack Hurst (PH), Philadelphia. I have 3 questions, or 3 points. The first is, I want to thank you for the pleasure it is to shop at Borsheims or Nebraska Furniture Mart, or even Benjamin Moore. You have terrific people working there, and I’ve never been as satisfied with products as with what I’ve bought at those firms.

WARREN BUFFETT: Oh, well, thank you for that. And I thank you on behalf of the managements. They are terrific people that work at those companies.

AUDIENCE MEMBER: I agree with that. You’ve dropped quite a bit from the annual report. There must be some God-given decree that it be limited to 72 pages. But I wondered if you could put that in an internet message, such as that wonderful table about GEICO, its renewal policies and new policies, and the four pages at the end of the report about the business categories, where you separate the insurance from the finance from the manufacturing, and also that discussion that you had of look-through earnings. I think that it’s invaluable for looking at the company.

WARREN BUFFETT: OK, well, I appreciate the suggestions. And I —

AUDIENCE MEMBER: I have a third point. Oh, go ahead.

WARREN BUFFETT: But we do go through a — I mean, I don’t know whether 72 pages is the magic number, or when I get to about 11,000 words, but occasionally, you know, we do make an editorial decision. The look-through earnings, for example, didn’t seem that important, and they’re fairly easy to roughly calculate, for anybody that’s interested. But you know, they are something that if I wrote for 15,000 words, I would have included. So, I appreciate the suggestion on it, and I don’t think anybody’s accused me of writing too short a report — (laughter) — yet. But I’ll take — It’s certainly on the — it’s possible on the internet to put up anything, and we’ll put up any material we’ve given you here before the opening on Monday morning so that nobody has a jump on any information. We try to make it — I mean, I really want to cover the things that would be important to me if I were hearing about them on the other end.

And we try to keep it to some number of pages, but I’m glad you want more. (Laughs)

30. Simplicity helps keep audit fees low

AUDIENCE MEMBER: OK, the third point is — the first of March, the Wall Street Journal analyzed — or compared — the auditing fees by the fees related to audit services and other audit services for the 30 stocks in the Dow Jones Industrial Average. And there seems to be an inverse relation between the amount of non-audit fees with respect to market capitalization, an inverse correlation with that factor to the five-year compound growth of earnings, or the five-year total return for the companies. And for the top — for the companies with the lowest ratio of non-audit fees to market capitalization, the increase in earnings was 10 percent annually. The total return was 18 percent annually. For the other — for the total — it was 5.2 percent return annually on increase in earnings, and 11 percent increase in total return. Is it because these non-audit fees are non-productive that it has this result? Or is it a chance — just a spurious fluctuation? Or is there something to the relation?

WARREN BUFFETT: I don’t know the answer to that. And I hadn’t seen what you are referring to. But it doesn’t totally surprise me, because we like places that care about expenses. And you know, I’ve never — I think Jack Welch had something in his book about no, you know, no company ever getting — going broke from cutting expenses too rapidly. And when you see managements that are pretty lavish in what they toss around, you know, I think on balance that group doesn’t do as well for shareholders as the other, but I have no statistical way of proving that. And I don’t know a way that — I don’t know how you would set up a sample that would really be valid in terms of one kind versus the other kind. But what you say doesn’t shock me. We try to watch all expenses around Berkshire. And I think that, at our subsidiaries, we — generally speaking — we have managers that are very, very good about that.

And I think that our audit costs, relative to the size of the enterprise and all of that, I think, are fairly low, although they’re not as low as they were a few years back. But it’s something that we care about, I can assure you of that. I don’t know how to — I wouldn’t want to buy stocks, though, or sell stocks, based on any kind of statistical measure like that, even though that it looks good on what they call a backtest. Charlie?

CHARLIE MUNGER: Well, one of the reasons our audit costs are so low is we have this passion for keeping everything simple. We don’t want to be difficult to audit. And we prefer activities that are simple. If you take the See’s Candy company, the whole company goes to cash at the end of December every year, as if it were a farm where the crop came in and was sold in December. I mean, an idiot could audit the See’s Candy company without getting into trouble. (Laughter) And there’s a lot in Berkshire that’s like the See’s Candy company. It would be really hard to screw up.

31. Arthur Andersen as Enron’s collateral damage

WARREN BUFFETT: We don’t like complicated accounting. I mean, it — we really do like things that produce cash. And Enron is a good example. Enron’s grotesque in what happened. But there’s no question in my mind that auditors have been unduly compliant to client wishes over the last few decades, and more so as they went along, even to the point where they started suggesting what I would consider quite dubious accounting to people in mergers and so on, so as to make their figures look better later on. And I’ve seen it firsthand. So, I just — I think that although the auditors are supposed to work for the shareholders, that they got too much so they were working for management. But I think that Enron may push them back significantly, even in the other direction. So, I think Enron will have a distinct beneficial effect on auditing, and it was needed.

CHARLIE MUNGER: Well, it’s going to have a distinct beneficial effect on one fewer auditors. (Laughter)

WARREN BUFFETT: Yeah, although — (applause) — you know, it’s an interesting question, and Charlie and I may differ on this. I mean — I don’t think that — I don’t know how many people Andersen employed, but it was a huge number. And I certainly — it’s clear that the weaknesses and culpability at Andersen goes far beyond anything remotely we saw at Salomon. But it would have been a shame for Salomon, with 8,000 people, to have, actually, the bad acts of one guy, and the lapse in terms of reporting and all of that — which was a big mistake, but by a few other people — cause 8,000 people to get dislocated in their lives and lose their jobs. I don’t know, how do you feel, Charlie, about, you know, the bottom 40,000 people at Andersen who really didn’t have a damn thing to do with shredding or the Houston office or anything of the sort? I mean, their lives are really getting changed in many cases.

CHARLIE MUNGER: I regard it as very unfair and totally undeserved in all those cases. Yet even so, I think that capitalism without failure, as somebody once said, it’s like religion without sin or —

WARREN BUFFETT: Religion without hell.

CHARLIE MUNGER: — religion without hell. I think when it gets this bad, and the lack of adequate control mechanisms throughout the system, I mean, Andersen plainly didn’t have a good total system of control. And I think that it may be that capitalism should just accept this kind of unfairness in all these individual cases and let the firms go down.

WARREN BUFFETT: Well, let’s say you and I did something really terrible, Charlie, at Berkshire. How do you feel about the 130,000 people then? I mean, should they —

CHARLIE MUNGER: You’d feel terrible about them, and there’s no question about it. And — but I’ll tell you something, they wouldn’t go down. The way we’re organized, they wouldn’t go down. Warren, there’s nothing you can do that is going to destroy the value of the subsidiaries — (applause) — and the careers within the subsidiaries. You can blow your own reputation, you can blow the reputation at the holding company level, but you can’t destroy their livelihood. I — that is a good —

WARREN BUFFETT: Well, we can mess up —

CHARLIE MUNGER: — way to be organized.

WARREN BUFFETT: We can mess up their lives though, I mean, if they lost their funding. Or yeah, I mean, I agree with you about their —

CHARLIE MUNGER: Not very much.

WARREN BUFFETT: — viability, but you know —

CHARLIE MUNGER: Not very — Andersen was particularly vulnerable, being a professional partnership. But maybe you should be extraordinarily careful if you’re a professional partnership, with what clients you take on and how far you go for them. The law firms that I admire most have fairly strict cultures of risk control. I think it’s crazy, in the kind of world we inhabit, to operate in any other way.

32. No formula to pick out great investors

WARREN BUFFETT: OK, number 7. (Applause)

AUDIENCE MEMBER: My name is Rheon Martins (PH), from Cape Town, South Africa, and I became a big fan and avid reader of your ideas about 10 years ago. In 1999, I did an MBA and was nicknamed Warren Buffett, because I quoted you in all the classroom discussions. All I wanted to learn was how to value a stock and think about the stock prices, but sadly I was rather disappointed to find out that our MBA did not really teach that. Mr. Buffett and Mr. Munger, my question is this: if you had to predict who would be the superior investors from a group of young, bright people, who share your investment philosophy and possess the realism and discipline you referred to earlier, which characteristics or work habits would you like to know about the individuals in the group? And what weighting would you place on each factor to ensure the greatest probability of your prediction being correct?

WARREN BUFFETT: Well, that’s too easy a question for me, so I’ll let Charlie answer that. (Laughter)

CHARLIE MUNGER: I think the fair answer to that one is that I’m not capable of answering it.

WARREN BUFFETT: No, but I do — I think this: I think that’s exactly right. I mean, if you ask me what should — how should you pick a wife, you know, 18 percent to humor, 12 percent to looks, you know, 17 percent, you know, to parents. I can’t give you the formula, but I think you’ll make the right decision, you know — (laughter) — when you get — And I think if Charlie and I were around a dozen very bright MBAs with good records and all of that, and we spent some time with them, I think we’d have a reasonable chance of picking somebody from that group that might not necessarily be number one, but they would be in the upper quartile, in terms of how they actually turned out. And I — but I can’t tell you how to, you know, I can’t write out a software program or anything that will enable you to do that. It — you know, I had that problem exactly at Salomon that went — on that Saturday morning, whatever it was, August 17th, and I had to pick a guy to run the place.

And there were a dozen or so people that all thought that they were the ones, or a number of them thought they were the ones to run it. And they all had high IQs, and they all had lots of experience in investment banking and everything, and I — you know, in the end, I had to pick one. And I did pick the right one, I will say that. And you know, was I — could I be a hundred percent sure at that time it was the right one? Well, probably not, but I felt pretty sure I had the right one. And I can’t tell you — I’ve had people say to me, “Well, what did you ask them? And how did you evaluate it?” and all, because I only had about three hours to do it. And, I don’t know. I mean, I can’t write you out a set of questions that you should ask somebody. And, you know, some of it may be body language and different things of that sort. There are a lot of variables in it.

But I think, in the end, you would have picked the same person I picked if you’d been in that spot. You’d had to pick somebody in the three hours. And it — but quantifying it for you, I just — I can’t do it. Charlie, have you got —

CHARLIE MUNGER: Yeah, well, when multiple factors are causing success, you get these anomalies. You have two people who are going to be equally successful, and one is terribly good at A and terrible at Z, and the other is terribly good at Z — is very good at Z — and terrible at A. They’re equal. Which factor is most important? The answer, it doesn’t matter in that case. When you’ve got multiple factors, great strength in one will compensate some for weakness in another. And the factors can be quite different. I think the investment world is full of people who are succeeding based on quite different sorts of talent.

WARREN BUFFETT: We’ll try to do better next year.

33. Why See’s won’t be sold at Costco

WARREN BUFFETT: Number 8.

AUDIENCE MEMBER: Good afternoon. My name is Catherine Dorr (PH), from Minneapolis, Minnesota. This is my first time here. Thank you for hosting this meeting today. With the political and financial and corporate developments since September 11th, I am thankful every day that persons of your integrity and the managers that you have are still managing my inheritance money. And I believe that the character and integrity is the most important criteria. I can sleep well at night. I have two questions. The first one is for Mr. Munger. When will there be a permanent store location, not a cart, of See’s Candies at the Mall of America in Bloomington, Minnesota? (Laughter) This is the largest indoor shopping mall, I believe, in the country, and hosts thousands of domestic and foreign visitors each year. A hint, you can sell See’s Candies to other nationalities when they visit us. Also, is it possible for Costco stores to sell See’s Candies, since Mr. Munger has a shareholder interest in Costco? I would be interested in his answer. We could sell related products in our system. And I’ll wait for his answer to ask the second question to Mr. Buffett.

CHARLIE MUNGER: The — the short answer to your questions is that, under our decentralized system, decisions of that kind go, rightly, to the person in charge of See’s, who’s here, Chuck Huggins. And he may not be here through this afternoon session. He may have some limited interest, but Chuck can answer those questions. He knows a lot about candy.

WARREN BUFFETT: We had a Helzberg — we do have a Helzberg’s at the Mall of America though, incidentally.

CHARLIE MUNGER: We have a what?

WARREN BUFFETT: We have a Helzberg’s operation at Mall of America which does fine. And I would add, we have not done as well moving away from the West as Charlie and I might have — well, certainly as well as we hoped for when we originally bought See’s. I mean, we’ve done way, way better in terms of the overall result, but it has been interesting to us. Now, bear in mind, no one really makes any money with boxed chocolates through retail — through their own retail outlets in the United States, except for See’s. I mean, it — there’s only one pound per capita of boxed chocolates, roughly, sold in the United States. I’m told I gave the wrong figure on — I said 64 ounces per year on people drinking. You really don’t look like you only drink 64 ounces of liquid a year, it was a day. But on this one, it is one pound per capita per year on boxed chocolates. So, it is not a big business.

It’s not a business — well, the truth is hundreds and hundreds of firms, including some that were a lot larger than See’s, have failed. And there really is no one making any money elsewhere. Russell Stover makes very good money selling through a distribution channel that is different, but nobody’s found a way to do it in stores. We’ve found a way to do it in the West. We have not found a way to do it elsewhere. And it’s very irritating to me, and to Chuck, as far as that’s concerned, that we can’t figure out a way, because it’s so successful when it works, as it does in the West. But the answer is you can look at Archibald Candy, you know, the bonds are selling for 50. They own Fanny Farmer and Fannie May and Laura Secord up in Canada. It is a very tough business in this country, because Americans just don’t buy much boxed chocolate. They’re always happy to get it as a gift.

Everybody in this room would love to get a gift of it, and they may buy it when they’re here, but you don’t normally walk down the street and — or walk in a mall and buy it for yourself. It’s usually a gift or it’s usually at holiday time. So we don’t do as well as you might think we would when we get to very successful malls that are located in other parts of the country. We have opened holiday shops, kiosks really, at 50 stores at Christmastime, around the country, away from our natural territory. And we make some money out of that, but we wouldn’t make money if we were there year-round. And we’ve been thinking about it, I’ll guarantee you, for 30 years because it’s a terrific business where it works. And it’s a very good question you ask, because you would think, I mean and the Mall of America is an obvious example. Simon would be tough to deal with, the landlord, but we could figure out a way to do that. And the — but you would think we could make money at a Mall of America.

And we do fine with Helzberg’s there, but I’m not positive a candy store would work. But we may try one, just because you asked the question. We’ll — I’ll talk to Chuck about it. (Laughter)

AUDIENCE MEMBER: OK —

WARREN BUFFETT: How about Costco?

AUDIENCE MEMBER: My second question —

CHARLIE MUNGER: Oh, Costco —

AUDIENCE MEBER: Oh, I’m sorry.

CHARLIE MUNGER: Costco makes its own decisions, and so does See’s. And I wouldn’t think of getting into that one.

AUDIENCE MEMBER: Oh.

WARREN BUFFETT: Well, I’ll get into it. (Laughter) We don’t want people discounting our candy, it’s very simple, any more than Rolex wants somebody discounting their watches. And we will not — we’re not going to go through any distribution channel at See’s. We’re already getting a bargain at our retail prices — (laughs) — and we’re not going to go through any other distribution channel — any distribution channel at See’s that’s going to discount. And Costco has no interest, and I don’t blame them. I mean, they are based on giving people special prices. And that’s fine, and God bless them, and, you know, we’ll buy things from Costco, but we’re not going to sell a product where the price is part of the integrity of the product — we’re not going to sell it through a distribution system that — where discounting is basic to their whole approach. Costco is a wonderful operation, and See’s is a wonderful operation, and never the twain shall meet. (Laughter)

AUDIENCE MEMBER: Very logical.

34. Why Berkshire issued its B shares

AUDIENCE MEMBER: My second question is to Mr. Buffett. Since I am a new shareholder, and because this is my first attendance here, I am not sure if this question has been asked before or not. And if it is addressed in your publications, I may have overlooked it, so please bear with me. This is on the relationship between the A and the B shares. On page one of the booklet it states, quote, “Each share of Class A stock is entitled to one vote per share, and each class of — each share of Class B stock is entitled to 1/200th of one vote per share,” close quote. Calculating the voting weight per share would therefore be 200 Class B shares equaling one vote equally weighted of one Class A share. However, the Class B share price is 1/30th, traditionally, of a Class A share. Given that the B share owners are purchasing into the same corporation and assets as the A share owners, and the cash is just as green no matter which share you buy, therefore it would be logical that the voting weight and price relationship of the shares be proportional all around, either 1/30th or 1/200th of pricing and voting weight, respectively.

The question, therefore, is why are the B shares not given voting weight of 1/30th instead of 1/200th? Or conversely why the B shares are not priced at 1/200th of an A share? This may or may not be popular depending on with share you own. And I would appreciate your insight on that.

WARREN BUFFETT: Yeah, thank you. It’s a good question. I — you may not be aware of the history of the issuance, but we issued the B shares — there were no — I mean, they’re just a common share, so we renamed the old shares A shares. But we issued the B shares, whatever it was, what, seven or eight years ago, Charlie? Something like that. And we did that in response to some people, particularly a fellow in Philadelphia, who we felt was going to induce people who really didn’t understand Berkshire at all into a terribly expensive way of owning tiny pieces of Berkshire, probably sold on the basis of an historical record that we did not think was representative of what could be incurred in the future. In other words, we were disturbed by somebody who saw a chance to make a lot of money off of people who were really uninformed, using our stock as the vehicle. And we were going to reap the unhappiness of those people subsequently. They’re going to run into tax problems and various administrative cost problems, and so on.

So, to ward that off, and only to ward that off, I mean, we issued the B stock, which effectively put that fellow out of business, because it was a better vehicle for doing what he was going to try and get people to do, at great profit for himself. And when we issued it, it had not existed before, and we made — we put two differences in it from the A stock. A, we wanted to create a lower value per share, so we did it on a 1/30th basis. At the time, it was around $1,100 or thereabouts because the A was selling for in the low 30,000. But we put on the prospectus, which is a very unusual prospectus in other respects, we put on there we were going to differentiate the stock in only two ways, but we were going to differentiate it in those two ways. And one was the voting power, because we didn’t want to issue the stock and we didn’t want to change the voting situation much. And the second way was in terms of the designated charitable contributions, which we — the A was going to continue to enjoy and the B would not participate in.

And the reason the B wasn’t going to participate in it is because the amounts would have gotten to the point where it would have been an administrative nightmare. I mean, this year, we designated $18 on the A shares. We’ve got a lot of one-share B holders, which would be 60 cents. And it just — it does not make any sense. And we saw that, so we just said if you buy the B shares, you’re buying into an instrument which economically is equal to 1/30th of an A. In voting, it is not equal to 1/30th of an A because we don’t want to change the voting that much. And it does not — it has a slight economic difference in terms of the fact it doesn’t get to participate in the charitable contributions program, which is a very small item relative to the whole capitalization, but it’s still — it’s something.

But we do not — you’ll notice our A and B, compared to other companies that have different voting arrangements — I was just looking at one the other day where the premium for the voting stock is 10 or 12 percent, or something like that, relative to the economic interests. That’s because people assume that if, you know, if the company’s ever sold, or anything like that, the guy that owns the A will get treated better than the B. And Charlie and I have been in a situation where we got somewhat taken because of a situation — because of a relationship like that. We will treat the B exactly as the A, except for those two things, which, at the time of issuance, we set out as being differences. We set — and those two items, everybody saw coming into the picture, and they’re going to stay — they will stay as part of the picture. Actually, you know, in terms of when the meeting will be held two years from now, you know, we aren’t even going to vote by votes in a sense.

I mean, I’m going to get a sense of what people want to do, but I regard, in that respect, I think that it ought to be the most convenient for the most people, not for the most number of shares. A will not vote any different than B or anything because, you know, you’re all individual people and I want whatever works best for the most. But in terms of those two other items, they were set out that way and they’ll stay that way. If — you know, if we’d set out a different — we would not change the relationship once the — of the two stocks once they were issued. We would not benefit one relative to the other, but those are the terms of the two. Charlie?

CHARLIE MUNGER: Yeah, we had to issue the B stock to frustrate the ambitions of this jerk promoter. And — (laughter) — yet, we didn’t want to split the A stock down into — all of it — down to tiny little fractions, which would have frustrated him, but forced us to have a stock split we didn’t want. So, we created a vehicle which was — had these two slight disadvantages, and that kept most of our capitalization in its traditional A-stock and also frustrated the promoter. It’s an historical quirk. It’s an accident of life.

WARREN BUFFETT: And the B is sold at a remarkably consistent relationship to the A. If the discount got as low as — or as high, I should say, as — I think it was over 4 percent for a small period of time — but it’s, generally speaking, the B is sold at parity to slightly, very slightly, below parity. And indeed, A shares get converted to B, and that would not happen unless the B were at parity. So, it — I think it’s worked out pretty well. I mean, we didn’t — we backed into it, but I don’t think anybody’s been disadvantaged by it.

35. Leasing of silver doesn’t affect its price

WARREN BUFFETT: Number 9?

AUDIENCE MEMBER: I’m reading the question of Mark Rescigno (PH), from New York. “I’ve idolized you since I first heard of you 10 years ago. My only regret so far is that both of my children are girls, so I couldn’t name them Warren.”

WARREN BUFFETT: How about Warrenella? (Laughter)

AUDIENCE MEMBER: That might work. Is there any merit to the argument that leasing of silver is suppressing the price of the metal, and thereby not allowing it to reflect the fundamentals?

WARREN BUFFETT: Oh, you hear that all the time. I don’t think so. And in the end, the question of where it’ll sell will be affected by how much there is around and how much there isn’t. And people get upset with shorts and they get upset with forward sales by producers, and they get upset with leasing, and all of that sort of thing. But in the end, if silver gets tight, it will go up in price. And if it isn’t tight, it really doesn’t make much difference whether it’s leased or not. It’s like companies that get upset about the short position of their stock. I’ve even had a few people write me because there’d be some — I don’t care whether there’s a thousand shares short of Berkshire or 300,000 shares short, it really doesn’t make any difference, because someday, the people that are short have to buy and, you know, it’s part of markets.

So the leasing of silver takes place because somebody’s got some silver around, would rather get a small amount of income by leasing it to somebody that needs to use it for one reason or another. But it’s because the silver was sitting around in the first place that it’s available for lease. And it really doesn’t make much difference, I don’t think, in terms of pricing over time. Charlie?

CHARLIE MUNGER: I have nothing to say.

WARREN BUFFETT: Oh. (Laughter)

36. Buffett criticizes ABC News report on Kirby vacuums

WARREN BUFFETT: OK. It’s — we’ve got time for one more question from number 10, and that will complete the cycle, also. So, shoot.

AUDIENCE MEMBER: My name is Jerry Miller (PH), Highland Park, Illinois, shareholder. I don’t want to end this meeting on a down note, although I’m going to do it. (Laughter) Before I say that, I would like to make a positive statement, one of many, but I’ll hold it to one. I have —since I’ve been retired, I’ve gone to quite a few shareholders meetings. And I only wish there was some way I could force most of the CEOs to attend. They may not understand what’s going on, but I would just like them to see how a shareholders meeting should be handled. And now for the down — (applause) — a little bit. I’m downstairs. I can hear some good results. The — if you’re going to sit behind the desk that says the $37 billion buck stops here, you’re going to have to handle all questions.

The one that I was really surprised I didn’t hear, and I — today from anybody, including you — the two of you — would — Although they’ve taken the ‘E’ word away from us, and the ‘AA’ word away from us, I don’t want them to take the Berkshire Hathaway ‘K’ word away from us. Do you understand that? If you do, just wave a finger. And if not, I’ll explain it.

WARREN BUFFETT: Well, you’re 0 for 2 at the head table. So, you better explain it. (Laughter)

AUDIENCE MEMBER: This morning, I had to chide some of the fellows down the stairs at the Kirby. A couple of weeks ago, there was a stain — or a tarnish — appeared on the Berkshire Hathaway name, and a little crack appeared in the charisma. Did you happen to see the program?

WARREN BUFFETT: Yeah, I saw the program. And it was interesting because it was focusing on the sales practices — or alleged sales practices — of some people that don’t work for us, but work for distributors, just like salesmen work for Ford dealers or something of the sort. And particularly, it was talking about them selling to older people. And interestingly enough, over 10 years ago, we put in a policy, which to my knowledge is the only one like it in the country, in that anybody, anybody over 65 who buys a Kirby vacuum and is unhappy for any reason, any time, up to a year, 11 months and 29 days later, can tell us so and they get their money back without question. And I don’t know of another consumer durable sold like that in the country. And one of the interesting things was that the fellow they interviewed, who talked about his mother having bought one and being terribly unhappy about it, had actually used the product for eight or nine months and gotten a full refund. And that fact was not mentioned on the program, nor was the fact even that we had this policy. And I really regard that as rather extraordinary journalism.

AUDIENCE MEMBER: I trust you’re not dusting off — (applause) — your Salomon notes then to read to the Kirby people.

WARREN BUFFETT: No, I can understand your reaction to the program, because it was pointed out to ABC News several times prior to the program, that this policy existed, that 300-and-some people in the previous year, and if they gave us a trade-in on the — on it and we — and they decided to call it off 11 months later, we gave them their money back, plus a machine equal to the — or better than the machine they gave us. And not a word was said about that in the program. So, it — I do not regard it as a great moment in ABC journalism.