Morning Session

1. Welcome

WARREN BUFFETT: (Applause) Thank you. Good morning. Some of you may have noticed a stunt man was used in that [video shown before the meeting]. (Laughter) Arnold [Schwarzenegger] just couldn’t handle some of those scenes. (Laughter) Before we get started, I’d especially like to thank Andy Heyward, who’s here today and if we can — I don’t know whether we can find him out in the crowd, it’s a little hard to see from up here. But Andy runs DiC Productions. He does that cartoon for us and let’s give him a big hand. (Applause) Andy has produced a really extraordinary series telling the story of the beginning of this country called “Liberty’s Kids.” It’s been on public broadcasting the last couple of years. It’s great for kids but it’s great for adults, too. I’ve watched a number of sessions myself. And this summer, in July, it will go on sale at Walmart, a very special celebration.

And for those of you who want to pick out something good for your children or your grandchildren, I can’t think of a better series to have them watching. And thanks again Andy. And thanks also to Kelly Muchemore who puts this whole production on. (Applause) This is Kelly’s show. She, along with that dog Dudley, who you saw in the movie — Dudley is a regular at Berkshire Hathaway. We don’t count him in the 15.8 [employees at headquarters], but she, along with Dudley, handle everything. I don’t even give a thought to what’s going to happen here, as might become evident during the meeting. (Laughter) She is responsible for putting up that whole exhibition arrangement and really the whole thing. So, Kelly, I don’t know where you are exactly, but in any event, thank you very much. (Applause)

2. Formal business meeting begins

WARREN BUFFETT: Now, we’ll go through the business part of the meeting. And it may take a little longer than usual, but please be patient. And I’d like to start out by calling the meeting to order. I’m Warren Buffett, chairman of the board of Berkshire Hathaway, and I welcome you to this meeting. This hyperkinetic fellow next to me is Charlie Munger — (laughter) — the vice chairman. And we will have a good time, and I hope you do, too. We work together because he can hear and I can see. I mean, it’s — (laughter) — there are times where we can’t remember each other’s name, but we have a lot of fun together. Now, any shareholder who wishes to speak regarding the shareholder proposal expected to be presented by Human Life International, or any other matters germane to the shareholder’s meeting, should now go to microphone zone 1, which is in section 121 over on my right. Or section 2, which is at section 221, I believe that’s higher up on my right. And — let me see if I have that right.

Yeah, or go to section 7, which is — or section 105 — which is microphone 7 on my left. Or to section 205, which is microphone 8. If you’ll go to — if you’re going to want to talk about anything concerning the business of the meeting, not the questions afterwards, but just that relates to the matters germane to the meeting, please go there now, because I’m not going to be able to spot people in a crowd this size. And when it comes time to do the business, we’re going to ask anybody that cares to speak up on the business to be at those microphones. And that will be in just a couple of minutes. Now after adjournment of the business meeting, I’ll respond to questions that you may have that relate to the businesses of Berkshire but that don’t call for any action at the meeting. We had some complaints after last year that some people were asking six or seven-part questions. At least, that’s the reason I’m giving that we’re eliminating those. The bigger reason is Charlie and I can’t remember the first part by the time you get to the fifth part.

(Laughter) So, we are asking you to ask only one question. And don’t try to get too clever about working three or four into a single question. And that will give more people a chance to get their questions asked. Only one question at a time and we will go around from microphone to microphone and get as many in as we can. Now, we’re going to do this until noon and then we’ll take a break for lunch and we’ll come back about one and we’ll continue until 3:30. And anything goes on the questions. We’ll answer almost anything, except questions about what we may be buying or selling. You’re free, of course, to wander around, go over and buy things. You know, we have a lot of things for sale over there. It’s — as I’ve pointed out in the past, it’s better form to leave while Charlie is speaking than when I’m speaking, but you can — (laughter) — use your own judgment on that. Now, I do want to remind you that any audio or video recording of this meeting is prohibited.

That if anybody’s seen recording the proceedings, we will have to ask you to leave. So, if you see anybody doing that, we would appreciate it if you would just inform one of the staff personnel around. Because there’s certain copyrighted material that we use and people, like Judge Judy, give us permission to use a segment like that. But it’s not intended to be used in any commercial way. So, we do ask that no recording take place.

3. Directors introduced

WARREN BUFFETT: Now, I’ll first introduce the Berkshire Hathaway directors that are present, in addition to myself and Charlie. Now, I’ll ask the directors to stand as their names are read and ask that you withhold applause, if any — (laughter) — until all are introduced. We have — I don’t know whether we have anybody here from CalPERS, but they can register their own views as we go along. (Laughter) And it is difficult to see from here, so if you’ll just stand as I mention your name and remain standing until the end, when we will see whether you get any applause. Susan T. Buffett. Howard G. Buffett. Malcolm G. Chace. David S. Gottesman — Sandy had a conflict today. There’s a bat mitzvah, I believe, for a granddaughter, so he’s coming in tomorrow for our director’s meeting on Monday. Charlotte Guyman. Donald R. Keough. Thomas S. Murphy. Ronald L. Olson, and Walter Scott Jr. And now you can go crazy. (Applause)

4. Four questions for the auditors

WARREN BUFFETT: Also with us today are partners in the firm of Deloitte & Touche, our auditors. They are available to respond to appropriate questions you might have concerning their firm’s audit of the accounts of Berkshire. In that regard, I wish to report that at Berkshire’s audit committee meeting held on March 2nd, 2004, Deloitte & Touche responded to the four questions I suggested be asked to the independent accountants by all audit committees. And we’re going to put these up in just a second. With respect to Berkshire, the questions and the auditors’ responses will be shown on the following slides. And I might mention that I really do think these questions should be asked of all auditors, at least annually, perhaps even quarterly. And I really think that, if such a procedure had been followed over the years — don’t eat them all Charlie. (Laughter) If such procedures had been followed over the years, there would have been a lot less trouble in corporate America. I mean, for many years, particularly in the ’90s, I think there was a weakening, frankly, in auditor vigilance.

And the trick, as I’ve said, is really to have the auditors more worried about the audit committee than they are worried about the management. And it’s quite natural when they’re, essentially, hired by the management and when they see the management regularly and they only see the audit committee infrequently, that it’s tempting to listen a little bit more to management than the audit committee. But these questions, if asked, in my view — and if the answers are put on the record — I think it would have a very helpful effect on behavior. Because once on the record, it means the auditors — it means they’re on the line. And I’ve been on a lot of boards of directors and I’ve seen, in retrospect, things go by that I wish had been called to my attention by the auditors. So we have these four questions. And if we’ll put up the first one — and I’d like to explain one item. Do we have those up? Yeah. You can read the question and these are the responses, as we go along, that the auditors have given to these questions.

Now you’ll notice on the first one that there is one item that — and incidentally, we owe a shareholder, who I think is going to speak later — it was his suggestion that we actually present these at the meeting. And I think it’s a good suggestion. And I think if more companies did it, it would be a good idea. So I thank him for the suggestion. The major item, which is not material, as auditors define it, but the major item in which we disagree and use a method which I will explain further — actually, it’s been changed — but concerns the purchase of life insurance policies, or the reinsurance of people who are purchasing life insurance policies, their so-called viatical settlements. And we have had a business, of sorts, in that. And it’s likely to even be a larger business in the future. And what takes place there is that somebody, usually elderly, has a life insurance policy and they’d rather have the money themselves than have their heirs get it later on. So, they want to cash out early. And as you know, a life insurance policy typically has a cash surrender value.

And sometimes those cash surrender values are quite low in relation to the actuarial value of the policy. So sometimes those people wish to sell a policy. We had a case the other day where a 79-year-old woman had an insurance policy amounting to some $75 million. I’ve never met her, but she must be quite a woman, but — (Laughter) The cash surrender value of that policy was $2 million. Clearly, for even a 79-year-old in the best of health, that was an inadequate sum for her to receive. But yet she wished to have the cash herself rather than eventually die and leave it to her heirs. So, we paid — or we actually reinsured a transaction where somebody else did it, and we took only 50 percent of it, but I’m going to use a hundred percent figures. We reinsured — we bought that policy for $10 million. And under accounting rules — GAAP accounting — we — it is recommended that we write that policy down immediately to the cash surrender value of 2 million. Well obviously, we think it’s worth 10 million or we wouldn’t have paid 10 million for it today.

But the rules, as they become more clear, say write it down immediately. I happen to think that rule is wrong. But last year, at the end of the year, there had been a total of $73 million applicable to such policies that reflected our purchase price as opposed to the cash surrender value. In the first quarter of 2004, our activity has stepped up in this field some — the people we reinsure have stepped up their activities, so we get our 50 percent. And that amounts to — it’s going to amount in the first quarter to about 30 million. So, we have adopted — even though we think it’s in incorrect — we have adopted the GAAP accounting. And you will see in the first quarter report of Berkshire the charge for the 73 million of last year plus the 30 million in the first quarter this year. And that gets charged, believe it or not, to realized capital gains. And so, by buying these policies for X on one day and immediately writing them down substantially, that becomes a realized capital loss on our book. Now later on, we expect to get a perfectly satisfactory return from these policies. But that is the main item that is referred to in the auditor’s answer on question one.

Now, if we’ll go to number 2. You have time to read that. I like the idea of this question being asked. I’ve read many reports where the footnotes are such that even if I reread them several times, I still don’t know what’s happened. And we try to write everything in plain English at Berkshire, and we try to explain things within the body of the letter that might give people the wrong impression if they simply looked at the figures, or that they might not be able to discern. Because Berkshire’s gotten so large that we — there are all kinds of things that are lumped together in the consolidated statements, that I think it’s more helpful if we look at separately. We’re going to work at — annually — at trying to disaggregate numbers and information in a way that makes it most useful without turning out something as long as the World Book. Third item is very simple. And the fourth item relates to something that became very prevalent in corporate America in the 1990s, which was moving around numbers from one quarter to another or moving them for one year to another. And I have seen a lot of that. It’s deceptive.

I like the statement that the two fellows at Google made the other day where they essentially said that if numbers are lumpy or peculiar when they get to them, they’re going to be lumpy or peculiar when they get to the public. And if there’s some reason that requires explanation as to why they’re lumpy, that the management should explain them. But the one thing they shouldn’t do is start playing games from quarter to quarter or year to year in terms of moving numbers around. And that became very fashionable. I hope it’s on the way to being moderated and we will continue to — each year, we will give you these questions at the meeting and we will report on the auditor’s answers.

5. Election of directors

WARREN BUFFETT: Mr. Forrest Krutter is secretary of Berkshire. He will make a written record of the proceedings. Miss Becki Amick has been appointed inspector of elections at the meeting. She will certify to the count of votes cast in the election for directors. The named proxy holders for this meeting are Walter Scott Jr. and Marc D. Hamburg. 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 to all shareholders of record on March 3rd, 2004, being the record date for this meeting, there were 1,278,436 shares of Class A Berkshire Hathaway common stock outstanding with each share entitled to one vote on motions considered at the meeting, and 7,766,293 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, 1,121,231 Class A shares and 6,473,904 Class B shares are represented at this meeting by proxies returned through Thursday evening, April 29th.

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

WARREN BUFFETT: Do I hear a second?

VOICE: Seconded.

WARREN BUFFETTT: Motion has been moved and seconded. Are there any comments or questions? We will vote on this motion by voice vote. All those in favor say “aye.”

VOICES: Aye.

WARREN BUFFETT: Opposed? Motion’s carried. First item of business at this meeting is to elect directors. If a shareholder is present who wishes to withdraw a proxy previously sent in and vote in person on the election of directors, he and she may do so. Also, if any shareholder that is present has not turned in a proxy and desires a ballot in order to vote in person, you may do so. If you wish to do this, please identify yourself to meeting officials in the aisles who will furnish a ballot to you. Would those persons desiring ballots please identify themselves so that we may distribute them? And I now recognize Mr. Walter Scott to place a motion before the meeting with a respect to election of directions.

WALTER SCOTT: I move that Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, David S. Gottesman, Charlotte Guyman, Donald R. Keough, Thomas S. Murphy, Ronald L. Olson, and Walter Scott Jr. be elected directors.

WARREN BUFFETT: Is there a second? It’s been moved and seconded that Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, David S. Gottesman, Charlotte Guyman, Donald R. Keough, Thomas S. Murphy, Ronald L. Olson, and Walter Scott Jr. be elected as directors. Are there any other nominations? Is there any discussion? Is there anybody that is at the microphones that would —

AUDIENCE MEMBER: Yes. Paul Tomasik, Thornton in Illinois. I like the idea of inside directors. I think they’re necessary. However, I think we should have the best available. In particular, I’d like you to consider the CEOs of the Berkshire subsidiaries. If you compare their qualifications to Susan Buffett’s and Howard Buffett’s, I think you’ll find that the CEOs have superior qualifications, particularly, business savvy and the ability to stand up to a forceful CEO. I’d like to point out that we’ll hear how many of these CEOs are independently wealthy and could easily say, “Take this job and shove it.” So this is why I am withholding my votes for the directors. Thank you.

WARREN BUFFETT: Thank you. Charlie, do you have any thoughts on that?

CHARLIE MUNGER: I think we should go on to the next item. (Laughter and applause).

WARREN BUFFETT: The 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 election. Would the proxy holders please also submit to the inspectors of elections a ballot on the election of directors voting the proxies in accordance with the instructions they have received. Miss Amick, when you are ready, you may give your report.

BECKI AMICK: My report is ready. The ballot of the proxy holders, in response to proxies that were received through last Thursday evening, cast not less than 1,123,189 votes for each nominee. That number far exceeds a majority of the number of the total votes related to all Class A and Class B shares outstanding. The certification required by the Delaware law of the precise count of the votes, including the additional votes to be cast by the proxy holders in response to the 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. Chase, David S. Gottesman, Charlotte Guyman, Donald R. Keough, Thomas S. Murphy, Charles T. Munger, Ronald L. Olson, and Walter Scott, Jr. have been elected as directors.

6. Proposal to publish political contributions

WARREN BUFFETT: The next item is business is a proposal put forth by Berkshire shareholder Human Life International, the owner of one Class B share. Human Life International’s motion is set forth in the proxy statement and provides that the company be required to publish annually a detailed statement of each contribution made by the company and its subsidiaries in various political causes. The directors have recommended the shareholders vote against the proposal. We will now open the floor to recognize the appointed representative of Human Life International to present their proposal. Is someone here to present that?

TOM STROBHAR: Yes, Mr. Buffett. My name is Tom Strobhar and I do represent Human Life International. And I’m here to present the shareholder resolution regarding political contributions. But before I do, I’d like to give you a little background. Some of you may remember, two years ago, there was a resolution asking the company to end its charitable giving program. The resolution said corporate charitable contributions should help, not hinder, the company and suggested certain contributions, especially those related to abortion and population control, were doing just that. This proposal was soundly defeated by the shareholders, receiving less than 3 percent of the vote. Oddly enough, a little over one year later, Mr. Buffett, in his wisdom, did terminate this program citing the adverse impact his philanthropic interests were having on the livelihoods of some employees at the Pampered Chefs division. At the time of the resolution, we first learned that Mr. Buffett and Mr. Munger were directing their money to their personal foundations rather than more recognized public charities. While previous chairman’s letters extolled the high participation levels among eligible shareholders, no mention was made that Mr.

Buffett, who accounted for 31 percent of the equity of the company, was giving away almost 55 percent of the charitable gifts. Why all of you B shareholders, who probably comprise a majority of the people in this audience, were excluded from giving, and whose vote on this proposal was dramatically diluted down to 1/200th of the value of an A share — which obviously is not quite democratic. I refer you to the 1983 Chairman’s Letter. In addressing why he wouldn’t split the stock, Mr. Buffett describes something he calls “shareholder eugenics.” Mr. Buffett laments how it’s impossible to screen entering members of the shareholder “club” for quotes, “intellectual capacity, emotional stability, moral sensibility, or acceptable dress.” Splitting the stock and lowering the price of admission to the club — Class B shareholders take note — “would attract an entering class of buyers inferior to the existing class” and “downgrade the quality of our present shareholder group,” end quote. All told, Mr. Buffett gave to his private foundation almost $100 million, much of it other shareholders’ money.

This money, in turn, was devoted almost exclusively to population control seeking to lessen the number of people at a time when Western nations, especially those in Europe and Japan, face economic calamity from a baby bust. How do charitable contributions relate to political contributions? It wasn’t until there was a resolution on charitable contributions that we received some disclosure. So too, with the resolution I’m about to present, did we find out the company gave a very modest $200,000 to various political candidates or causes. While the charitable contributions may have been too much, the political contributions may be too little. Not necessarily from the company, but from other shareholders. If there are politicians or causes in which there is legitimate business interest in supporting, why not give the shareholders the opportunity to help them also? By publishing the list, the word goes out to our thousands of shareholders who may wish to do the same with their own money. It costs little to publish, provides for transparency, checks any personal abuse, and sets an example to the rest of corporate America. It also provides an opportunity for all the members of our shareholder club, even B shareholders, to get involved and help this company and help their investment.

And with that, I’d like to read the actual resolution, which I’m required to do. “Within one month, after approval by the shareholders of this proposal, management shall publish in The Buffalo News a detailed statement of each contribution made by the company or of any of its subsidiaries, either directly or indirectly, within preceding fiscal year, in the respect of any political campaign, political party, referendum or citizen’s imitative, or attempts to influence legislation, specifying the date and amount of each contribution and the person or organization to whom the contribution was made. “Subsequent to this initial disclosure, management shall cause like data to be included in each succeeding report to the shareholders. If no such disbursements were made, to have the facts so noted in the annual report.” This proposal, if adopted, will require the management to advise its shareholders how many corporate dollars are being spent for political purposes, and to specify what politicians or political causes the management seeks to promote with these funds. Political contributions are made with the dollars that belong to the shareholders of the group and they are entitled to know where their dollars are being spent. A vote for this proposal is a vote for full disclosure. Thank you.

WARREN BUFFETT: Is there anyone else that would care to speak on the motion? Charlie, do you have any comment?

CHARLIE MUNGER: Well, I preferred our old charitable giving program to the way most corporations do it in America — (applause) — where the controlling officers decide. However, it’s a dead horse. It’s gone and there’s no point beating on the corpse. (Laughter)

WARREN BUFFETT: The dead horse will now speak. (Laughter) I just want to add one point, because it a little different than occurs at many other corporations. To my knowledge or memory, I don’t believe Charlie and I have ever asked any employee or any vendor to Berkshire — any employee of Berkshire or a vendor to Berkshire — for either political contributions or charitable contributions. There’s been no — there’s been no use of our positions to, in effect, extract money for our own personal causes, either in the charitable area or the political area. Is that correct, Charlie?

CHARLIE MUNGER: Yeah, but we don’t deserve too much credit for not asking other people for charitable contributions. (Buffett laughs) Think what the reciprocity implications would be.

WARREN BUFFETT: Yeah. (Laughter) But it’s a fairly common activity. So here we are. We’ll — if any shareholder’s voting in person, they should now mark their ballots in the — on the motion and allow the ballots to be delivered to the inspector of elections. Would the proxy holders please also submit to the inspector of elections a ballot on the proposal, voting of proxies in accordance with the instructions they have received? Miss Amick, when you are ready, you may give your report.

BECKI AMICK: My report is ready. The ballet of the proxy holders, in response to proxies that were received through last Thursday evening, cast 27,287.605 votes for the motion and 936,045.815 votes against the motion. 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 votes will be given to the secretary to be placed with the minutes of this meeting.

WARREN BUFFETT: Thank you, Miss Amick. The proposal fails.

7. Shareholder proposal to “tell us the rules” on motions

WARREN BUFFETT: Does anyone have any further business to come before this meeting before we adjourn? If so —

AUDIENCE MEMBER: Yes.

WARREN BUFFETT: —they should approach microphone 1 to be recognized. I believe we have someone.

AUDIENCE MEMBER: Yes. Paul Tomasik, Thornton in Illinois. I have a proposal to put written rules for this meeting, the formal part, on the web, in order that this meeting can be conducted fairly and with good faith. Would you like a little more comment?

WARREN BUFFETT: No.

CHARLIE MUNGER: No.

WARREN BUFFETT: The faster you can make it, the better. But go to it. (Applause)

AUDIENCE MEMBER: Well, that’s it —

WARREN BUFFETT: That’s it.

AUDIENCE MEMBER: — on that one.

WARREN BUFFETT: OK. (To person sitting next to him) Is that a motion?

WARREN BUFFETT: Well, do you want to — would you place all — if you have more motions, would you place them, or is that it?

AUDIENCE MEMBER: No, certainly. The other three motions are to put the bylaws and the articles of incorporation up on the website, to write it into the bylaws how shareholders should present motions, and the fourth, to write it into the bylaws how shareholders can make director nominations. To sum up, what these motions ask for is just tell us the rules. We’ll follow them. That’s it. Thank you.

WARREN BUFFETT: OK, thank you. I actually think you came up with a very good suggestion on the audit committee report, which we’ve incorporated. I don’t really think this would add much, but if there are any shareholders voting in person, they should now mark their ballots in the motion — on the motion — and allow the ballots to be delivered to the inspector of elections. Would the proxy holders please also submit to the inspector of elections a ballot on the proposal, voting the proxies in accordance with the instructions they’ve received. Miss Amick, when you are ready, you may give your report.

BECKI AMICK: My report is ready. The ballot of the proxy holders cast 1,153,600.52 votes against the motion. 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 votes will be given to the secretary to be placed with the minutes of this meeting.

WARREN BUFFETT: Thank, Miss Amick. The proposal fails. I now recognize Mr. Walter Scott to place a motion before the meeting.

WALTER SCOTT: I move the meeting be adjourned.

WARREN BUFFETT: Is there a second?

VOICE: I second.

WARREN BUFFETT: A motion to adjourn has been made and seconded. We will vote by voice. Is there any discussion? If not, all in favor say “aye.”

VOICES: Aye.

WARREN BUFFETT: All opposed say “no.” The meeting’s adjourned. OK, now we’re — (Applause)

8. Rebuttal of calls for Buffett to leave Coca-Cola’s board

WARREN BUFFETT: Now we’re going to move into the questions and answers, at least questions. And just ask one as we spelled out before. And we will start with microphone 1, which is in section, what, 121 on my right. And we’ll keep moving 1 through 12 until we get till noon. Microphone 1.

AUDIENCE MEMBER: Jonathan Mills (PH) from London, England. I wondered if you could comment on the views of those people who have stated that, because of so-called conflicts of interest, you should leave the board of Coca-Cola and whether you had any intention of doing so.

WARREN BUFFETT: That we should do what with the board?

AUDIENCE MEMBER: Leave the board. That you personally should leave the board of Coke.

WARREN BUFFETT: I would say that whoever suggested that should do 500 sit-ups. (Laughter) Actually, Charlie and I — certainly I have — well, I’ll Charlie speak for himself — we like the idea and we’ve encouraged the idea of shareholders behaving like owners. I mean, shareholders have too often behaved like sheep in this country and they got shorn, in many cases. And big institutional shareholders have sat on the sidelines while some things that might possibly have been corrected, had they gotten active, took place. So we have — we actually applaud the idea of shareholders behaving like owners. The question is whether they, you know, can behave like intelligent owners. And I think that in the last year or two, as they’ve sort of woken up, they’ve searched for checklists of one sort or another to determine whether directors are appropriate in a given company or not. And frankly, checklists are no substitute for thinking. The real job of the directors is to come up with the right CEO for a company and prevent him or her for overreaching. If they do that job well, the rest takes care of itself.

And you have to think some to determine whether that’s taking place. You can’t solve it by just running down a little checklist. I think it was Bertrand Russell who said, “Most men would rather die than think. Many do.” (Laughter) And I think we’ve seen a little bit of what he was thinking about in some of the voting. I think it’s absolutely silly, frankly, if Berkshire Hathaway owns 200 million shares of Coca-Cola, $10 billion worth, to not be able — it’s a little silly not to think that the interest that Berkshire Hathaway has in selling some hours of training at FlightSafety would cause me to do something counter to the interests of the shareholders, when we have $10 billion riding on that side of the table. I mean, it’s almost absurd, and somebody doesn’t understand proportionality at all when they come to that sort of conclusion. I also think it’s absolutely foolish if — just to use Coca-Cola as an example. I think the directors of Coca-Cola haven’t even looked, but I think we probably received something like $100,000 a year.

And if we were to go out into the welfare line and pick somebody out who has no income and say, “We’d like you to become a director,” and that person would get $100,000 a year, which would be their entire income, and to say that person would be independent — you know, while they would be 100 percent dependent on their income — that person would be independent. Whereas Berkshire Hathaway, or myself representing Berkshire Hathaway with 10 billion of stock — and receiving the same $100,000 a year — is not regarded as independent. So I encourage — I encourage institutional shareholders to — and large owners — to behave like owners. But I also encourage them to really think logically, as owners should think, in determining what causes they take on and how they vote. Charlie? (Applause)

CHARLIE MUNGER: Yeah, I think that they, corporate America, needs a fair amount of reform. But the cause of reform is hurt, not helped, when an activist makes an idiotic suggestion — (laughter) — like the one that — (applause) — having Warren Buffett on the board of the CocaCola Company is contrary to the interest of the Coca-Cola Company. Nutty activities do not help the cause for which the person speaks.

WARREN BUFFETT: It’s a little bit like having a slicing machine in an orchard where you’re gathering together apples but you’re also picking up a lot of rocks in the process and sticks and stones. So you have a slicing machine with a conveyer belt. And the slicing machine is programmed so that every time something is red and round comes down the line, it slices and comes down, but it doesn’t come down on the rocks and everything and ruin the blades. And, of course, that’s fine until a red balloon comes down the line and then you get a big pop and the machine has followed its little guidelines but it’s not slicing apples anymore. And I think — I just — actually, institutions are coming new to really thinking about how they behave as owners. And you would hope that, in the evolutionary nature of learning — that not too many years distance — distant — they would actually think about what’s good for the shareholders of the company.

9. Surviving inflation

WARREN BUFFETT: Let’s go to microphone number 2, please.

AUDIENCE MEMBER: Mr. Buffett, Mr. Munger, good morning. My name is Zachys Sarris (PH) and I am from Athens, Greece. There is a widespread perception that we’re heading towards an inflationary environment. What advice would you give to investors who need to preserve their capital and their purchasing power in such an environment?

WARREN BUFFETT: The best thing is to have a lot of earning power of your own. If you’re the best brain surgeon in town, or even the best lawyer in town, you will retain purchasing power, in terms of your income, no matter what happens, you know, whether people are using seashells for money, or whatever as time goes by. In the investment world, it’s tougher. But Charlie and I think the best answer is to own fine businesses that will be able to price in inflationary terms and will not have huge capital investment that is required to handle the larger dollar volume of sales. Some years ago, I used See’s Candy in our — in the annual report — as an example of the kind of business that, more or less, can handle an inflationary world and maintain investment and value, no matter what happens to the currency. Unfortunately, most businesses will not come out well in real terms during inflation. Their earnings may go up a fair amount over time, but they’re compelled to put more and more dollars into the business just to stay in the same place.

You know, the worst kind of a business is one that’s — makes you put more money on the table all the time and doesn’t give you greater earnings. So you really want a business that can have pricing that reflects inflation and does not have very much capital investment that reflects inflation. But inflation is the enemy of the investor, in terms of real returns. As you know, there are, in this country as well as a half a dozen other countries, there are what they call “inflation protected bonds” — we call them TIPS in the United States — where the income is adjusted — or, the principle amount is adjusted — to inflation. And that’s not a bad investment for people that have worries about inflation heating up. And I think, incidentally, we’re starting to see it heat up in this country. Charlie?

CHARLIE MUNGER: Yeah, most people are going to get a very small real return from investment after considering inflation and taxes. I think that’s an iron law of the world and if, for a brief period, some of us do better than that, we ought to be very thankful. One of the great defenses to being worried about inflation is not having a lot of silly needs in your life. In other words, if you haven’t created a lot of artificial demand to drown in consumer goods, why, you have a considerable defense against the vicissitudes of life.

WARREN BUFFETT: Charlie, we’re selling consumer goods in the other room. (Laughter) It’s OK to talk that way at home, but — (Laughter)

CHARLIE MUNGER: It doesn’t do any good there. (Laughter)

WARREN BUFFETT: I know the feeling. (Laughter)

10. Reluctance to hold special meetings for analysts

WARREN BUFFETT: Let’s go to microphone 3.

AUDIENCE MEMBER: Good morning, gentleman. My name is Larry Coats, from Durham, North Carolina. Mr. Buffett, after last year’s meeting, my longtime friend and business partner George Brumley [III] sent you a letter addressing several issues. Having participated in the preparation of that letter and on his behalf, I thank you for your response.

WARREN BUFFETT: Thank you.

AUDIENCE MEMBER: In such, you suggested that many of those issues would be appropriately addressed in this forum. In his honor, I’d ask you to address just one of those, and that is the ultimate generational transfer of Berkshire away from its current base of long-term, selfselected, and well-informed shareholders, and the potential of instituting a series of analyst meetings to address the relative lack of interest in, and ownership, and understanding of, Berkshire by institutional shareholders and investors. Thank you and good morning.

WARREN BUFFETT: Well, thank you. I mean, George was a wonderful man. A great analyst and a friend. I have some problem with having meetings with subgroups of investors, such as institutional investors. If we had something like that, I think we would want it to be open to everybody. And, you know, that gets to be quite a production. But I can understand, you know, why A) you’d like to see our managers and hear what they have to say about their businesses. We try to convey a lot about the businesses in the report, but — Charlie, do you have any thoughts on that?

CHARLIE MUNGER: I don’t think it fits our temperament at all well. Many corporations have a huge amount of effort spent in talking to groups of analysts. One of Berkshire’s strengths has been that we don’t spend time in that way. That’s a very time-consuming process. And it does give some shareholders some advantage over others. We try and be more egalitarian in events like this and the way we write the annual report, et cetera.

WARREN BUFFETT: Yeah, we really like the group of shareholders we have. I mean, we’re not about enticing new people into it. But I know your point also is that the present shareholders could better understand Berkshire if they would listen to Bob Shaw talk about Shaw Carpet or Rich Santulli talk about NetJets. And the truth is, it is fun to listen to those people. But one of the things we promise managers when they join up with us, too, is they that they don’t have to listen to bankers, they don’t have listen to investment analysts. They just get to run their businesses. They can devote a hundred percent of their time to it. And people like that, and they’re more productive because of it. I mean, we really place no impediments in the way of our managers doing what they do best and what they like to do best, which is run their businesses. And frankly, a number of them have expressed to me that they’re very happy because they existed in a different mode before.

And in that mode, they would spend maybe 25 percent of their time on activities that they didn’t enjoy and they didn’t feel were very productive. So we want to get across the information about our businesses to you. And believe me, when I write the report and Charlie looks at it, we say to ourselves, “Are we telling you what we would want to know about if our positions were reversed, if we were on the receiving end?” And we really try to put in the report everything that’s germane to evaluation. Now, if you have a market cap of 130 billion, you know, it’s really not too important to get keen insights into some business that’s making a relative small amount of money. But anything that counts — and really, you have to look at them in aggregates — we want to get across to you. So, you know, it’s — I’m very respectful of your suggestion. It’s conceivable to do it. The Washington Post has a shareholder day, because their annual meeting is turned into a farce often because it’s largely dominated by people who are complaining about this story or that story.

But the shareholder day is very useful and they do have their managers there and talk about it. But I really think if we spend six hours here answering your questions about the business and we do a half-way decent job of writing the annual report, we should get across the essential information. And we’re really not trying to get across — we’re not trying to talk to an audience that is trying to get some special insight into what next quarter or next year is going to look like. We’re really looking for owners who join us in what we regard as kind of a lifelong investment. And I would say that certainly analysts, like your group, have exactly the same objective we do and want to understand the business that way. But my experience, you know, in talking to hundreds of them, is that there are relatively few that are actually thinking about, “What do we buy and put away forever?” Like, we’d buy a farm or an apartment house or something. So we’ll consider it, but I don’t want to make any promises.

11. Compensation plans: specific to the business, simple, and generous

WARREN BUFFETT: Go to number 4, please.

AUDIENCE MEMBER: Good morning, gentleman. My name is Matt Sauer and I’m from Durham, North Carolina. Regarding compensation, you have commented along the lines of people willing to bet big on their (inaudible) usually have a lot of bet on. A MidAmerican regulatory filing indicated some attractive prospective compensation possibilities for its senior executive team, subject, of course, to meeting profitability milestones. Perhaps you might provide some details on the thought process that went into crafting that compensation structure, and in doing so, use this specific example as a reminder about Berkshire’s compensation philosophy, related to pay for performance versus the more popular approaches. If it’s easier to figure out and administer, better for owners, and can still attract talented people, why don’t more companies adopt such practices?

WARREN BUFFETT: Yeah, we — you could make a lot of money working for Berkshire. Not if you’re chairman or vice chairman, but there’s a chance to make a lot of money. But it will relate to performance. No one is going to make lots of money at Berkshire for average performance. And you mentioned the MidAmerican situation. We’ve got some extraordinary management at MidAmerican. And it’s — in terms of how that compensation arrangement was worked out, I was thinking one day about what would be appropriate for the two individuals who are key to the success of MidAmerican. And I took a yellow pad and I spent about three minutes sketching out a proposal. And I went to Walter Scott, who is our partner in the business and now actually heads the comp committee. And I said, “Walter this is an idea I have, what do you think of it?” And he looked at it and he said, “It looks fine to me.”

And we talked to the two managers about it and actually, as we presented it, we had it so that something over 50 percent went to the CEO, Dave Sokol and something under 50 percent went to the number two man, Greg Abel, who’s enormously well named. And when we gave it to David, he said, “Let’s just” — he said, “I like it fine, but let’s make it 50/50.” That’s the extent of it. As you have commented, that’s wildly different than the approach at companies. I mean, most companies go through very elaborate procedures in working out executive compensation. I don’t think that Charlie and I have spent ever, maybe five minutes, on thinking about any. We have an arrangement at See’s Candy with Chuck Huggins. We worked it out in 1972. It’s still in force now. John Holland took over Fruit of the Loom a couple of years ago. I met with him for a couple of minutes, suggested something, takes up a paragraph or two. And that’s what we’ll have with John the rest of his life.

It’s not highly complex. You have to understand the businesses. There is no one formula we could use at Berkshire that would fit across our businesses, that’s asinine. You don’t want them complicated. We don’t have anything that goes on for pages and pages. It’s not needed. It establishes a relationship between us and the manager that’s not good. So all of our stuff is very, very simple. At GEICO we have two variables and they’re what count, you know. So we make — from Tony Nicely on down, we have everybody participating based on that. We worked that out whenever we took over at GEICO and it’s worked fine since and it’ll keep working. But we do not bring in compensation consultants. We don’t have a human relations department. We don’t have — at the headquarters, as you could see, we don’t have any human relations department. We don’t have a legal department. We don’t have a public relations department. We don’t have an investor relations department.

We don’t have those things because they make life way more complicated and everybody gets a vested interest in going to conferences and calling on other consultants and it takes on a life of its own. In the typical large corporation, there’s a comp committee. And, as I pointed out in the past, they don’t put Dobermans on the comp committees, usually. They — they look for Chihuahuas that have been sedated and — (Laughter) I’ve been on 19 boards. They put me on one committee once, and I was chairman and I got outvoted. Do you remember that, Charlie? (Laughs)

CHARLIE MUNGER: I certainly do.

WARREN BUFFETT: Yeah. The —

CHARLIE MUNGER: By two very fine guys.

WARREN BUFFETT: Yeah, terrific guys, actually. And they — you know, the nature of it is that now, particularly with Sarbanes-Oxley, there’s lot of committee meetings. The directors meetings are filled up with process. And you have on one side of the table, some people that usually are spending an hour or two and getting presented with a bunch of material by the human relations department and some outside consultants. And I’ve never seen the head of a human relations department or a consultant come in and say, “This bozo you’ve got is only worth about half what you’ve been paying him.” This just isn’t going to happen. So it’s, you know — it’s a situation where the intensity of interest on both sides is seldom equal. The directors are often dealing with something my friend Tom Murphy in the past has called, “play money,” and the CEO is dealing with something very dear to his heart. So you’ve got to expect a situation like that to get gamed over time. Not over time, promptly, actually.

And there is some change in that that’s taking place. But it’s not being — in large part, it’s not being led by CEOs and it’s difficult for directors to do — to get a lot done. They get handed a sheet of paper that shows them comparables elsewhere, and everybody thinks their CEO is in the top 25 percent or something. And so there’s a ratcheting effect that takes place. And now stock options are coming out of favor, so restricted stock comes in. But the idea is to keep the pie very large for CEOs. And if I needed the money, I’d probably be doing the same thing. Charlie?

CHARLIE MUNGER: Well, I would rather throw a viper down my shirtfront than hire a compensation consultant. (Laughter and applause)

WARREN BUFFETT: Tell me which kind of consultants you actually like, Charlie? (Laughter) He’s not going to answer that.

12. We don’t think about investing “categories”

WARREN BUFFETT: We’ll go to number 5. (Laughter)

AUDIENCE MEMBER: Warren and Charlie, good morning. My name is Mo Spence from Waterloo, Nebraska. Years ago, you listed the four or five investment vehicles you considered appropriate for Berkshire, including, I believe, common stocks, long-term debt, and arbitrage opportunities. In light of your comments in this year’s annual report, I was wondering if you could review that list, in order of preference, and specifically comment on them, including the current environment for arbitrage.

WARREN BUFFETT: Yeah. Well, the items you name — and you could break that down by highgrade bonds, you know, versus junk bonds. The items you mention are all alternatives. You know, Charlie and I sit around and think about what’s the best thing to do with Berkshire’s money. It’s a fairly simple proposition. And we have a number of things that we feel competent to make judgments on, and we have a number of things that we’re not competent to make judgments on. So we narrow — we hope to narrow the field to investments that we think we can understand. And there are a reasonable number of those, although there are a lot that we can’t understand. Anything I would say today, you know, can change tomorrow. We don’t think about the categories by themselves. Now, in a period like summer to mid-fall of 2002, when junk bonds became very attractive, we bought a lot of them. But we didn’t make some great decision to buy junk bonds, we just started seeing things, individual items, that started screaming at us, you know, “buy, buy, buy.”

And then that came to an end. And so we don’t go to the office in the morning thinking what category — how do we prioritize our categories. You know, we have an open mind and whatever we see that day that overcomes, or that crosses the threshold to where we take money out of short-term cash and move into it. It could be arbitrage — it’s unlikely to be arbitrage now, because that’s a game that, to play on a scale that would have a meaningful effect at Berkshire, is hard to do. I mean, take very big deals, and it’s something we’ve done successfully in the past. We’ve made a lot of money over the years in arbitrage and quite consistently sometimes in the past. But we don’t — Charlie and I do not have a checklist that we talk about every day, or every month, or every year, in terms of prioritizing categories. We just hope — I hope he gets a good idea, he hopes I get a good idea. And when we get one, we move in a big way.

They have to be big now and that’s a limiting factor in terms of what’s available for us. As you know, if you read the annual report, you know, we took a significant position in currencies. We’re buying viatical settlements, in terms of the transaction I mentioned a little earlier. We’re open to anything we can understand. Charlie?

CHARLIE MUNGER: Yeah, you really asked us to determine an order of precedency among two or three activities we don’t have much interest in at the moment. And that’s not something we spend a lot of time at. In other words, we have all this cash because we don’t much like any of those fields at the moment. And spending all the time thinking about orders of precedency among things you clearly are not going to do is pretty fruitless for us.

WARREN BUFFETT: Yeah, I thought I had a slide here but I don’t. But it — when we were buying junk bonds in the summer to fall of 2002, we were literally buying securities — and we limited it to the kind of junk bonds we can understand, which is far from the whole universe — but we were literally buying things on a 30, 35, 40 percent yield to maturity basis. Now, we buy those with a mental attitude of buying common stocks. Interestingly enough, within 12 months, some of those same securities that were yielding 30 or 35 percent went to prices where they yielded only 6 percent. I mean, that is truly remarkable when you think about that happening in a country that was not in the throes of depression or anything. I mean, prices do amazing things in securities markets. And when they do something that strikes us as amazing in our direction, you know, we will act. But we do not know today what we’re going to be doing tomorrow. We have — you know, we have some things — a few things we may be doing.

They’re likely — It’s likely we’re doing them tomorrow, but there’s — we don’t hold any committee meetings on this. And there’s, you know, this business where somebody says, “You should have 50 percent of your money in bonds and 35 percent, you know, in equities, and 15 —.” We don’t go through anything like that. I mean, we regard that as nonsense. Any further thoughts, Charlie? No further thoughts, evidently. (Laughter)

13. “Very dangerous to project out high growth rates”

WARREN BUFFETT: Microphone 6.

AUDIENCE MEMBER: Good morning, gentleman. My name is Tony Ado (PH) and I come from New Jersey. Mr. Buffett, my question is on business valuation and growth. In one of your letters, you mentioned the discounting formula on earnings divided by the difference between the discount and the growth rate. But if the growth rate is larger than the discount rate and if we use this formula, then we get a negative number. And one way around this — let’s call it method A — is to have two growth stages, one with a high growth and the second stage with a low growth. And the second way, method B, would be to estimate how much the earnings is on the third year for the company and then multiply this by the average price-to-earning ratio to get the price in the tenth year. I don’t know if you use the method A or method B, but if not, I would like to ask, Mr. Buffett, how do you estimate how much a company is worth if the growth rate is larger than the discount rate?

WARREN BUFFETT: Well, you put your finger on an interesting mathematical relationship. Because if you’re using a present value discount formula and you put in a growth rate that is higher than the discount rate, as you have postulated, the answer, of course, will be infinity. And there are a lot of managements around who like to think their stocks are worth infinity, but we — (laughs) — haven’t found one yet. That precise subject was covered in a paper called “The St. Petersburg Paradox” by a fellow named [David] Durand probably 30 years ago. And somewhere, we probably have a copy at our office. My guess, if you go to Google and you put in the name Durand and you put in St. Petersburg, you may be able to call up that article, although they aren’t necessarily terrific on old articles. So if you’d like it, we would — if you’ll let somebody know in our office, we’ll look around a little and see if we can find that. It gets very dangerous to project out high growth rates because you get into this paradox.

If you say the growth rate of a company is going to be 9 percent between now and judgment day and you use a 7 percent discount rate, it goes off, you know, you get into infinity. And that’s where people get in a lot of trouble. The idea of projecting out extremely high growth rates for very long periods of time has caused investors to lose, you know, very, very large sums of money. There aren’t many companies — just take a look at the Fortune 500, go back 50 years — they’re commemorating that — and look at the companies that were there and how many have really maintained rates much above 10 percent. It’s not an easy hurdle. And when you get up to 15, you know, you’re in the atmosphere and rarified atmosphere. So that’s — there’s a real danger in projecting out high growth rates. And Charlie and I will very seldom — virtually never — get up into high digits. You can lose a lot of money doing that. You may miss an opportunity some time, but I haven’t seen people who have been consistently successful doing that. And you do run into this paradox you mentioned. Charlie?

CHARLIE MUNGER: Well, you’re obviously right, when you get a mathematical result that is infinity, to back off and realize that can’t happen. And, of course, what people do is they project that the growth rate will reduce and, indeed, eventually stop. And then you get more realistic numbers. What else could anyone do?

14. NYSE specialist system has “worked pretty well”

WARREN BUFFETT: OK, we’ll go to microphone 7. I believe that’s over here.

AUDIENCE MEMBER: Yes, My name is Jack Oneil (PH). I’m from New Brighton, Minnesota. Thank you for the opportunity to ask questions here and for the opportunity to learn from you and Charlie. I had a two-part question and I’m striking the first part, which dealt with my concern over how long the country can continue with this ballooning national debt. My second — my question then is, what is your opinion of the need for specialists on the New York Stock Exchange? Thank you.

WARREN BUFFETT: Charlie, you want to tackle that one? (Laughs)

CHARLIE MUNGER: Well, thank you, Warren. (Laughter) Generally speaking, I think the specialist system has worked pretty well over the years. There may have been a few troubles lately, but averaged out, it’s worked pretty well for a long time. And I’m not all that horrified that some people who stand there all day make a fair amount of money.

WARREN BUFFETT: Charlie actually had a specialist firm, you should know that. That’s why I turned the question over to him, despite his snide remark. (Laughter) How long were you and Jack [Wheeler] the specialists in General Motors on the Pacific Coast Stock Exchange?

CHARLIE MUNGER: About 13 years.

WARREN BUFFETT: Yeah —

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: You’re looking at an experienced specialist.

15. Buffett predicts “big problems” from derivatives

WARREN BUFFETT: Let’s go to number 8.

AUDIENCE MEMBER: Good morning, gentleman. I’m Neil Steinhoff from Phoenix, Arizona. Thanks for the tips on TIPS. Also thanks for the information in the newsletter — your annual letter — about the books. I particularly enjoyed “Bull!” by Maggie Mahar, I think it was. I’m concerned about the future for a number of different reasons, in America. The debt, both accumulated by the government and personally, the stock buybacks, which are benefiting the top five executives, continues. The insanity of derivatives and the overpriced market with a P/E, which is also insane. Any comments?

WARREN BUFFETT: Well, which one do you want us to comment on? You only get one question. (Laughter)

AUDIENCE MEMBER: Derivatives.

WARREN BUFFETT: Derivatives. Well, Charlie and I have expressed ourselves on derivatives. You know, we don’t think the probability, in any given year, is necessarily very high, that derivatives will either lead to or greatly accentuate some financial trauma. But we think it’s there. And I think it’s fascinating to look at something like Freddie Mac, where you had an institution that perhaps even hundreds of financial analysts were looking at — certainly many, many dozens of financial analysts were looking at. You had an oversight office. You had a creature that was created by Congress, presumably with committees that would be interested in their activities. You had on the board two of the smartest and highest-grade people that you could have, in terms of fixed income markets, in Marty Leibowitz and Henry Kaufman, and you had a bunch of other very good directors, too. And, with an auditor present, they managed to misstate earnings by some $6 billion in a fairly short period of time. Now, all of that wasn’t accounted for by derivatives, but a very large portion of it — 6 billion, that, you know, that is real money even — well, in any place.

A large part of that was facilitated by activities and derivative instruments. Now you can look at the Freddie Mac annual report for 2000, whatever it is, ’2 or 2001. And you can read the footnotes and you can read the auditor’s certificate. And you can look at bunch of high-class, very smart directors. And you can be comforted by the fact that dozens of people in Wall Street, who are paid just to follow relatively few stocks, were studying this, and that they had conference calls all of the time. And in the end, what happened? It was 6 billion. It probably could have been 12 billion if they’d wanted. A lot of mischief can happen with derivatives. And as we’ve pointed out, Charlie and I have seen it happen.

When there’s a derivative transaction, particularly a complicated one — the plain vanilla ones, probably people will not get in big trouble on — but when you have a complicated derivative transaction, and the trader at investment house A is on one side and a trader on investment house B is on the other side, and they record a transaction — which has to be a zero-sum game between the two of them — and both put on the books a profit that day — I’ve never seen one where they both put on a loss that day — it lends itself to mischief. And the scale is absolutely huge and getting larger all the time. And I will tell you that I know the managements of some of the companies that have big derivative activities, and they do not have their minds around what is happening. We didn’t have our mind around what was happening at Gen Re Securities. We couldn’t. We tried to get our mind around it. We couldn’t do it. And that was far from, you know, the most extensive or complicated derivative operation around. We had the same experience at Salomon. But whatever the figures were at Salomon, they would be a great multiple today.

And there was a Sunday in 1991 when we were preparing — or we had the lawyers preparing — bankruptcy papers at Salomon. And if the Treasury hadn’t reversed itself, we would have found a judge some place in Manhattan. He probably would have been watching baseball, eating popcorn. And we would’ve walked up to his door and said, “You know, here is a situation with Salomon. There’s these 1.2 trillion of derivative contracts that the guy on the other side thinks is good and they’re not going to be any good,” and a lot of other things, and, you know, “It’s your baby.” A lot of things correlate in the securities world that people don’t expect to correlate. And there are people following similar strategies all over the world, as happened when Long-Term Capital had its problems. And the world — the financial world — operates on a hair trigger, to some extent. People want to jump the gun and move just ahead of the other fellow.

And when you get huge amounts of transactions, which many people only vaguely understand, you are creating a potential huge problem that may come about because of some other exogenous event that triggers defaults on a huge scale. And that can be very disruptive to financial markets. So we think they’re dangerous as used in society. We use them ourselves, incidentally. You know, we get them collaterized. We’ve made money off of them. But I would predict that sometime, in the next 10 years, that you will have some very big problems that will either be caused by, or accentuated in a big way, by people’s activities in derivatives. Charlie?

CHARLIE MUNGER: Yeah, I think part of the trouble in — you were talking about — came because people didn’t think enough about the consequences of the consequences. That’s a common error. You start trying to hedge against interest rate changes, which is a very complicated thing to do when you’ve got a mortgage portfolio where people have options to pay the mortgages off early. And then, under the accounting conventions, the hedges started making the quarterly results lumpy instead of nice and regular, the way all the institutional analysts like them. So then they gave us another bunch of derivatives to smooth out the returns. Well, now you’ve morphed into lying. Well, it’s complicated enough to start with. But when you add lying to the process, it’s a Mad Hatter’s Tea-Party. And yet, this happens with eminent directors of vast financial sophistication sitting on the board. It shows that the sophistication won’t save you. Somebody has to have the common sense to say, “We’re just not going there.” It’s too tough.

WARREN BUFFETT: Charlie was on the audit committee at Salomon and changed it into, you know, six and seven hours meetings. I think you found mismarks that were in the tens of millions of dollars on a single contract with a place with many — you know, tens of thousands of contracts. Isn’t that correct?

CHARLIE MUNGER: I think it’s fair to say that it was bonkers and that the accountants sold out.

WARREN BUFFETT: Uh-huh. (Laughter) It’s interesting stuff. You might — if you feel in kind of a nasty mood, you might go to a shareholders meeting of some company that has very large positions in derivatives and grill the CEO a little bit about some of the more esoteric transactions. They get very, very complicated. They get mind-boggling, in terms of trying to figure out the consequences. And the one thing you can be sure of is that the trader that puts them on will certainly want to mark them at a profit, either immediately or within a year or two, because he gets his bonus too often based on the figures for that year, and will be done in 20 years, because some of these are very long-dated. Will be gone — when the consequences fall to the firm. Anytime you have incentives, with people who are quite smart, to mismark things, you’re going to get mismarks, or temptations to take on risk in an inappropriate manner. Originally with derivatives, the argument was made that it would disperse risk.

That, you know, the Coca-Cola Company faced foreign exchange risk, or some bank faced, you know, interest rate risk. And the theory was that you would use these derivatives to spread risk around the system. And indeed, there are many people that make that argument now. I would say that that may work in that manner a great percentage of the time. But the time that counts is when the system has intensified risk and placed enormous credit risk on very, very few institutions. Believe me, the Coca-Cola Company is in a better position to accept foreign exchange or interest rate risk in a year than some derivatives dealer who has tons of positions on. And I think, actually, there is much more risk in the system because of derivatives than the proponents of derivatives would say has been dispersed because of the activities.

16. Bill Gates as next Berkshire chairman?

WARREN BUFFETT: Microphone 9, please?

AUDIENCE MEMBER: Good morning. Robert Piton (PH) from Chicago, Illinois. Thank you very much for your countless insights about investing, and life, for that matter. My question has to do with Bill Gates. You’ve gone on record stating that Bill Gates is the smartest person you’ve probably met in your life. Charlie, sorry to break it to you.

WARREN BUFFETT: No, and I haven’t said that quite — but you’re close. (Laughs)

AUDIENCE MEMBER: I’m close. And you’ve also mentioned that he can do your job, but you probably could not do his.

WARREN BUFFETT: That’s entirely correct.

AUDIENCE MEMBER: OK. So that being the case, given his aptitude, his accomplishments, his ability to keep great people together within Microsoft, would you consider having him become the future chairman of Berkshire in one of two ways. Either a merger — and if a merger doesn’t make sense because it’s a technology company and you don’t understand it, so you don’t want anything to do with Microsoft. With the second being he resign his post as chairman of Microsoft in order to keep the masterpiece that you’ve assembled together, as well as keep these very talented managers of all the Berkshire Hathaway companies together, with a leader that you so respect because of his accomplishments and aptitude.

WARREN BUFFETT: Did Bill put you up to this? (Laughter)

AUDIENCE MEMBER: He did not.

WARREN BUFFETT: No, I know that. You know, it’s not a crazy suggestion, but we’ve got a better answer. Bill could do my job very well. And I could not do his job. But we also have at least four people within the Berkshire organization that, in many respects, could do my job better than I do. And probably in one or two respects, they might not be as good at certain parts of it. But they would be terrific successors. We’re more blessed in that situation than we’ve ever been in the history of Berkshire. If you go back 15 years, we did not have four. And as we add businesses, it’s not inconceivable that more potential future leaders come with those businesses. So we’re well-equipped. And we would — we will — barring something terribly unusual — we will have a leader that succeeds me that comes from within Berkshire and has been around for a long time. One advantage of that — and this would not be necessarily a disadvantage if it were Bill — but one advantage to that is that we really like the culture at Berkshire.

And having someone that has operated in that culture for a number of years, I think, is a plus. Plus, you know, we’ve seen how they work and we know their pluses and minuses. We are very well-equipped now. And Bill, I think — to the extent that he spends less time at Microsoft and he will probably be — you know, the Gates foundation will take up, perhaps, more of his time — I don’t really think he is looking for my job, although he may salivate at the pay level that’s available. (Laughter) Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

17. Reading list for improving investment knowledge

WARREN BUFFETT: OK, we’ll go to number 10.

AUDIENCE MEMBER: My name is Oliver Graussa (PH) and I’m Vienna, Austria. I have studied economics and I’ve read about 40 books about investing and want to be such a successful investor as you have been. Mr. Buffett and Mr. Munger, when both of you were younger and had much less capital for investing, how many — which publications were the best to get a few excellent investment ideas to be so successful? And how many hours per week, on average, did you spend with reading about companies? Thank you.

WARREN BUFFETT: Well, when we were younger, we spent — probably Charlie, compared to now, spent a lot more time — I spent a fair amount more time — looking at companies. But we would — if we were doing it over again, we would do it over again pretty much the same way. We would look at everything in sight that we thought we could understand. And it — the world hasn’t changed in that respect. There may be some more people doing it, but there are a lot more companies to look at now. And we would — we would read everything in sight about the businesses and the industries we thought we could understand. We would look for things that jumped out at us as being very cheap in relation to the value. And we would have one enormous advantage because we would be working with far less capital, which means the universe of potential ideas would be far greater. But there’s no — there’s nothing different, in my view, about analyzing securities now than there was 50 years ago. Charlie?

CHARLIE MUNGER: Yeah, we read a lot and we thought a lot. I don’t know anybody who is wise who doesn’t read a lot. On the other hand, that alone won’t do it. You have to have a temperament, really, which grabs the correct ideas and does something with those ideas. And I think most people who read a lot don’t have the necessary temperament, and they grab the ideas or they’re simply confused by the mass of material. And, of course, that won’t work.

WARREN BUFFETT: Yeah, there’s probably something — Phil Carret used to talk about having a “money mind,” and I would call it a “business mind.” And, you know, there are people that are better with, you know, identical IQs, that are better adapted for one than the other. And the temperament is all important. I mean, if you can’t control yourself, no matter what the intellect you bring to the process, you know, you’re going to have disasters. And Charlie and have seen one after another that — It’s not a business that requires extraordinary intellect. It does require extraordinary discipline. That shouldn’t be so difficult. But as I look around the world sometimes, apparently it is quite difficult. I mean, the whole world went a little mad a few years back in terms of investments. And you say to yourself, “How could that happen? Don’t they learn anything for the earlier ones?” But, you know, what we learn from history is that people don’t learn from history. And you certainly see that in financial markets all the time.

Incidentally, you mentioned books. Charlie, you didn’t recommend any books this year?

CHARLIE MUNGER: Well, one book I really like I couldn’t buy because it’s published only in England. But it’ll get here in due course. And that’s called “Deep Simplicity” by John Gribbin. It’s a perfectly marvelous book. And of course, that’s a great title: “Deep Simplicity.” That’s what we’re all looking for.

WARREN BUFFETT: I’ve been reading “A Short History of Nearly Everything.” It’s very impressive to — you know, to read about people pondering how to figure out the weight of the Earth or something in the 18th century. And you would think that minds that would do that would do very well in financial matters. But, you know, if you remember, Isaac Newton spent a significant part of his life trying to turn lead into gold. And he might have made a good stockbroker. (Laughter) But it didn’t do much for him financially. Charlie knows more about Isaac than I do, so —

CHARLIE MUNGER: Well, and he lost an enormous —

WARREN BUFFETT: Yeah, in the bubble —

CHARLIE MUNGER: —chunk of his net worth in the South Sea Bubble. So he invested in an absolute crooked mania. And here was the smartest man in the world. So just IQ points alone won’t do it.

18. Admiration for Treasury’s crack down on tax shelters

WARREN BUFFETT: Microphone 11, please.

AUDIENCE MEMBER: My name is Martin Wiegand from Bethesda, Maryland. Thank you for hosting this wonderful, educational, and fun weekend. We —

WARREN BUFFETT: Well, thanks for coming —

AUDIENCE MEMBER: —appreciate it.

WARREN BUFFETT: —Martin, yeah. (Applause)

AUDIENCE MEMBER: In this year’s annual report, you defended Berkshire’s tax payment record against criticism from certain newspaper columnists and Assistant Secretary [for Tax Policy at the U.S. Treasury] Pamela Olson. Compared to other large corporations, particularly insurance companies, does Berkshire pay its fair share so we can our Berkshire Activewear with the American flag on it with pride?

WARREN BUFFETT: Incidentally, Pamela Olson is here today. I don’t know whether she can stand up. But I owe her an apology. She’s done a great job as a public servant and I teased her a little bit in the annual report. But she actually has worked actively at the Treasury in cracking down on tax shelters and some things that Charlie and I think shouldn’t exist. So Pamela has my admiration. And, like I say, if she’s here and can stand up, we’ll give her hand. (Applause). Some of the tax shelter proposals — I met with her yesterday — and she told me of some things that I’ve sort of seen myself. But some of the things that have been done and, in some cases, sponsored by the most prominent auditing firms, you know, are absolutely disgusting, and are the reason why, in my view at least, the middle class probably pays a lot more than they should be in terms of raising the total funds that are needed to sustain the government. Berkshire, as we noted in the report, is a heavy contributor to the Treasury.

As I mentioned, if only 540 entities in the country paid what we pay in income tax, no one else would have to pay anything, no Social Security, no nothing. We have not — I mean, we may own tax-exempt bonds. We own dividends, which receive a dividend receive credit. But we pay on a very, very high percentage of our income — including capital gains — we pay at the full 34 percent corporate rate. So go out and buy the Fruit of the Loom underwear with the flag on it, you’re entitled to wear it. (Laughs) Charlie?

CHARLIE MUNGER: I’ve got nothing to add. But you understate the evil that crept into our leading accounts — accounting firms — when they started selling these fraudulent tax shelters in exchange for contingent fees. One of them actually explained to me that they were an ethical seller of fraudulent tax shelters. (Laughter) He said, “The other firms just sold these to anybody. And we just sold them to our 20 most important clients so they were more likely to stay secret.”

WARREN BUFFETT: Yeah. And of course, the lawyers would write the opinions so that, if they did get caught with these things that they hoped that no one even picked up because they were so obscure, convoluted, the lawyers wrote the opinions so that the — they could walk — you know, when the IRS came around, they could wave that letter and say, “Well, gee, we’re sorry we made a mistake, but we did it on the advice of counsel and therefore you shouldn’t assess fraud penalties or anything.” I mean, they would — we don’t want to leave the lawyers out of this, Charlie. (Laughs) We had people come to our office. Not the auditing firm that we use, I want to make that clear. But we had people come to our office from the top auditing firms with these propositions which they said we had to sign away a given percentage of the amount we saved. And then they would give us these proprietary methods, you know, which would usually involve about 20 off-shore trusts and partnerships around the world and all kinds of things.

Many of — part of the design being to have so many entities involved so that the numbers that popped up here or there on the return, that no agent could figure out what the totality of the transaction was. You know, it’s — those are — the people who don’t pay taxes because of that, increase the taxes of the people in this room. So we — I applaud Pamela for her efforts on that and a lot more are needed.

19. “If you’re innumerate, you’re going to be a klutz”

WARREN BUFFETT: We will go to number 12, please.

AUDIENCE MEMBER: Good morning. My name is Johann Freudenberg (PH) from Germany. Mr. Munger, you said in a speech that scientific reality is often only revealed by math, as if math, it’s a language of God. Could you elaborate on that, and especially tell us the reason why math often reflects reality? Thank you.

CHARLIE MUNGER: It’s just the way it is. (Laughter) If you — it’s as though God made the world so that only people fluent in math could understand it. I think you can handle an ordinary human activity pretty well. But if you want to understand, say, science, you can’t do it without math. That’s just the way it is. And in business, if you’re innumerate, you’re going to be a klutz.

WARREN BUFFETT: Keep talking, I’m chewing. (Laughter) We’ll go back — go ahead.

CHARLIE MUNGER: The good thing about business is you don’t have to know any high math.

WARREN BUFFETT: It may be a disadvantage to know high math, Charlie.

CHARLIE MUNGER: Yes, I think it is. Because you look for opportunities to use this marvelous, complicated tool. And by and large, that doesn’t work nearly as well as just using the simple math.

WARREN BUFFETT: Yeah. When my mother sang me songs about compound interest, there really wasn’t any need to go further. (Laughter)

20. Buffett’s $10 billion Walmart mistake

WARREN BUFFETT: Let’s go back to number 1.

AUDIENCE MEMBER: My name is David Farlow (PH) from Minnesota, Minneapolis. Thank you, Warren and Charlie. A few minutes ago you mentioned the importance of learning from history. What have you learned from the investments you did not make over the last few years that you now regret refraining from?

WARREN BUFFETT: Well, the mistakes we made, and we made them — some of them big time — are of two kinds. One is when we didn’t invest at all in something that we understood that was cheap, maybe because we weren’t even working hard enough at looking at the whole list, or because, for one reason or another, we just didn’t — we didn’t take action. And the second was starting in on something that could have been a very large investment and not maximizing it. Charlie is a huge believer in the idea that you don’t sit around sucking your thumb when you can — when something comes along that should be done that you pour into it. And that’s generally what we’ve tried to do. But there have been times — and it’s usually happened when I’ve started buying something at X and it went up to X plus an eighth or some intolerable amount like that — and I quit or waited for it to come back.

And we’ve missed, in some cases, billions of dollars of profit because of the fact that I’d gotten anchored, in effect, to some initial price when I could have paid more subsequently and it really was inconsequential.

CHARLIE MUNGER: Do you have anything worse to confess than Walmart?

WARREN BUFFETT: No, Walmart — I cost us about — it’s up to 10 billion now. (Laughter) I cost us about 10 billion. I set out to buy 100 million shares of Walmart, pre-split, at about 23. And Charlie said it didn’t sound like the worst idea ever came up with, which is — from him, I mean, it was just ungodly praise. (Laughter) And then, you know, we bought a little and then it moved up a little bit. And I thought, “Well, you know, maybe it will come back” or what — Who knows what I thought? I mean, you know, only my psychiatrist can tell me. And that thumb sucking, reluctance to pay a little more — the current cost is in the area of 10 billion. And there have been other examples, too. And there will probably be more examples in the future, unfortunately. But that is — that’s — on the other hand, it doesn’t bother us. I mean, you know, it’s maybe instructional to talk about it just a little and I’m glad to respond to the question.

But in the end, we’re going to make a lot of mistakes at Berkshire. And we’ve made them in the past, we’ll make them in the future. You know, if every shot you hit in golf was a hole-in-one, it wouldn’t be — you know, the game would soon lose interest. So you have to hit a few in the woods occasionally just to make it a little more interesting. We’ll try not to do that too often. But those will be the kind of mistakes we make. We probably won’t make the kind of mistakes — although we have — we made one with Dexter Shoe — but we probably won’t make the kind that cost us a ton of money. They’ll be much more of omission than commission, I think, you’ll find in the future. Charlie, you want to add any more?

CHARLIE MUNGER: Yeah. At least we are constantly thinking about the past occasions when we blew opportunities. Since those don’t hit financial reports, the opportunities you had but didn’t accept, most people don’t bother thinking about them very much. At least that is a mistake we don’t make. We rub our own noses in our mistakes in blowing opportunities, as we just did.

21. Very hard to find a good, honest stock advisor

WARREN BUFFETT: OK, number 2.

AUDIENCE MEMBER: Warren and Charlie, my name is Peter Brotchie from Beverly, Massachusetts. And I would like to thank you both for helping me become a better businessman and a better investor. Perhaps more importantly, you have created, by example, a kind of true north on the moral compass for me to steer by. While the education has been fantastic, I have found that the demands of owning a successful business and having a large family do not leave time to apply the research stance I have become so wonderfully accustomed to by being a member of this cult. Please imagine, for a moment, that you are 30 years younger, and have only —

WARREN BUFFETT: I like him.

AUDIENCE MEMBER: — a few holes left in your investment punch card. If you were in my situation, to the extent that you would diversify your holdings beyond Berkshire Hathaway, given this environment, how would you choose the investment managers? Or as Charlie has just discussed when addressing foundations, would you hunt for two more great companies to invest in via common stocks?

WARREN BUFFETT: Charlie, why don’t you take a swing at that?

CHARLIE MUNGER: Well, of course you’re hunting, that’s part of the fun of life. And — but I would say that the chief lesson would be that you’re unlikely to find very many in a whole lifetime. And when you find one in which you really have thought it out and have confidence, for God’s sakes, don’t do it in a niggardly fashion. The idea that very smart people with investment skills should have hugely diversified portfolios is madness. It’s a very conventional madness. And it’s taught in all the business schools. But they’re wrong. (Applause)

WARREN BUFFETT: The question of finding other advisers is a tough one. I mean, when I wound up my partnership in 19 — at the end of 1969 — and I had all these partners that had counted on me and I was going to mail them back a lot of money, you know, I felt an obligation to at least suggest some alternatives for them. And I recommended two people who I knew were exceptionally good and exceptionally honest. We put one of them on the board not long ago and reaffirmed it today — Sandy Gottesman. The other one was Bill Ruane. Now, I’d been around the investment world for a long time at that point, and those were the two I knew, but they were more or less contemporaries of mine. And I’d gotten to know them over the years and I’d seen them for a long time. So I not only knew their results, but I knew how they’d accomplished their results, which is terribly important. I don’t know that generation of managers now.

But the fact that, with the number of people I knew, that I could only come up with two, at a time when I was very active, says something about the difficulties of finding managers. The one thing I can almost guarantee to you is that the promotional types going around to solicit the institutional investors are very unlikely to meet any long-term tests of ability, and sometimes, integrity. It’s not an easy job spotting an investor. I think it’s probably easier, depending on the amount of time — you know, you mention having children and a business and the amount of time you can spend on. Every now and then you do — if you’re conscious of the investment world and you have some kind of sort of grounding knowledge about what’s going on, and you can see something, you know, as we did in junk bonds a couple of years ago, or as we did with all kinds of things, some years back, when stocks were cheaper. You will occasionally see something that you should load up on. And, as Charlie says, that’s what you really have to do. I mean, some of the people in this room loaded up on Berkshire many years ago.

And the truth was, they didn’t need diversification, you know. I loaded up on it. Charlie did. And you’ll see opportunities occasionally but you’re not going to see them every day or every week. If you think you’re going to see an opportunity every week, you’re going to lose a lot of money because people will come around and tell you that they’ve got them, and they may not be quite as flagrant as that fellow we had in the movie — (laughs) — but they’re a version of them. Charlie?

CHARLIE MUNGER: The business of selecting investment managers was recently shown to be even harder than I had previously thought it was. A significant fraction of the institutional investment managers who run the nation’s mutual funds actually accepted propositions to take bribes for betraying their own shareholders. It was as if a man came to you and said, “I have a wonderful proposition. Why don’t I kill your mother and we’ll split the insurance money?” And it was that ridiculous. And yet, a significant number of the people said, “Gee, I would like some insurance money.” And they just went right ahead.

WARREN BUFFETT: And they were already rich beforehand.

CHARLIE MUNGER: Yes. And they’ve destroyed themselves, many of them, by making this insane decision. And I think many of them will probably think the outcome is unjust.

WARREN BUFFETT: And the —

CHARLIE MUNGER: I mean the downfall they’ve had.

WARREN BUFFETT: And the interesting thing about it, of course, is that here is a huge industry that — where the people who weren’t doing it have a great interest in having that reputation of the industry not get stained. And a number of them had to know what was going on. I mean, this was — I don’t — it’s hard for me to imagine that people at most large mutual funds, even the ones that didn’t — that are mutual fund management companies — even the ones that weren’t engaging in the activities mentioned weren’t aware of it. I mean, you just — if you’re in an industry like that, you’re going to hear what’s going on. And the Investment Company Institute was busy patting itself on the back, you know, at one meeting after another and becoming very cozy with legislators. And there wasn’t one thing done until a whistleblower when to [New York State Attorney General] Eliot Spitzer and he got active in a very strong way with a very limited staff. And he uncovered, and put on the front pages, what was taking place.

But the industry itself, with hundreds and hundreds and hundreds of people that most have known what was going on — and it went on for a long time. Never said a word. It’s — you know, it makes you wonder a little bit.

22. Asset allocation models are “pure nonsense”

WARREN BUFFETT: Number 3?

AUDIENCE MEMBER: Hi, I’m Bob Klein (PH) from Los Angeles. You’ve touched on the issue of asset allocation — capital allocation — in response to previous questions. But I wonder if you could elaborate from a risk management perspective. Wall Street and financial planning firms charge a lot of money for their asset allocation models, say, 50 percent stocks, 40 percent bonds, et cetera. I know you take a more opportunistic approach to building your portfolio and managing risk, as you mentioned by — as you illustrated — by your junk bond example. And so I just want you to hammer out how you use price and value as a tool of risk management and asset allocation as opposed to coming at it with a pre-conceived idea of how much should be allocated to each asset class.

WARREN BUFFETT: Yeah, we think the best way to minimize risk is to think. (Laughter) And the idea that you have — you know, you say, “I’ve got 60 percent in stocks and 40 percent in bonds,” and then have a big announcement, now we’re moving it to 65/35, as some strategists or whatever they call them in Wall Street do. I mean, that has to be pure nonsense. I mean, 60/40 or 65/30 — it just doesn’t make any sense. What you ought to do is have — your default position is always short-term instruments. And whenever you see anything intelligent to do, you should do it. And you shouldn’t be trying to match up with some goal like that. I found it entertaining — I was just reading yesterday in an article, I think it was, about the two fellows at Google and all of the problems they’re going to have because they’re each going to get a few billion dollars. I mean, it was — I want to send a sympathy card.

I almost went down to Hallmark store because this article went on — they’ve got this terrible problem and that terrible problem and they’re going to need lawyers, and they’re going to need financial — they don’t need anybody. Those guys are smarter than the people that are coming to them. And they do not have a big problem, and they are very capable of thinking it through themselves. The people that have the problem are the people who want to sell their services to them and are going to have to convince them that they have a problem. But so much of what you see when you talk about asset allocation — it’s just merchandising. It’s a way to make you think that if you don’t know how to determine whether it should be 60/40 or 65/35, that you need these people. And you don’t need them at all in investing.

Most of the professionals that tell you that you’re going to get in great trouble unless you listen to them and sign up for their services, you know, they’re good at selling, but — It’s what my brother-in-law — former brother-in-law — that worked at the stockyards used to say was that people would bring in cattle or something. And I’d say to him, you know, “How do get the farmer to employ you to sell to Swift or Armour or Cudahy instead of the guy right next to you. I mean, you know, a cow is a cow and Armour’s going to buy it the same way.” And he gave me this disgusted look and he said, “Warren, it’s not how you sell them, it’s how you tell them.” Well, there’s a lot of that in Wall Street. Charlie?

CHARLIE MUNGER: Yeah, people have always had this craving to know the future. You know, the king used to hire the magician or the forecaster and he’d look in sheep guts or something for an answer as to how to handle the next war. And so there’s always been a market for people who purported to know the future based on their expertise. And there’s a lot of that still going on. It’s just as crazy as when the king was hiring the forecaster who looked at the sheep guts. And people have an economic incentive to sell some nostrum. It can be sold over and over and over again. The really interesting figures are when you combine the underperformance of the market, say, by the mutual fund industry, which is probably a couple of points per annum. And that understates it. Now, if you take all of the investors in the mutual funds who are constantly whipsawing from one fund to another by a bunch of brokers who want commissions, now you take a sub-normal performance and it goes on another three or four percentages points due to the shuffling of the mutual fund investments.

So the poor guy in the general public is getting a terrible result from contacting the experts. And these guys are hitting the Scout troop and the Community Chest drive and are locally reputable people. I think it’s disgusting. It’s much better to make a living by being part of system that delivers value to the people who are buying the product. But nobody refrains from creating gambling casinos or something, on my theory. If it’ll work to make money, why, we tend to do it in this country.

23. Workers’ compensation insurance fraud

WARREN BUFFETT: Microphone 4.

AUDIENCE MEMBER: Good morning Mr. Buffett and Mr. Munger. My name is Steven West and I am a framed art manufacturer in Morganton, North Carolina. I feel especially tied to Berkshire Hathaway as I am both a vendor to Nebraska Furniture Mart, Star Furniture, and RC Willey, and also a customer of Larson Jewel. My question relates to workers’ compensation fraud being committed by workers’ compensation carriers on manufacturers such as myself, a scandal which I believe is far greater than the scandals that have been mentioned heretofore at this meeting. As an example, in 1998, when I was trying to figure out why my experience mods were going way out of whack, I received a loss run and I believe, mistakenly, also a check run from my insurance carrier. It was shocking. Four losses for $152,000 they claimed to the state of North Carolina actually amounted to less than $6,000. And one claim, which they claim they spent $70,072 on, they actually only spent $86.88. Now naturally, this threw my company into the high-risk pool. It’s cost me hundreds of thousands of dollars.

And my question is, are they trying to pull the same stunt on Berkshire Hathaway companies, especially in labor intensive operations, such as Dairy Queen. Because I have not, in the intervening years, been able to get one single copy of a negotiated check out of these insurance company. They will not give it up, even under subpoena, and their behavior is entirely consistent with criminal fraud. Now, my question relating to the Berkshire Hathaway problems — or companies — is, are your managers attuned to this and are they receiving the actual copies of the negotiated checks that the insurance companies claim that they’re spending to settle workers’ compensation injury cases? Thank you.

WARREN BUFFETT: Yup. Well, I would say that there’s plenty of fraud in various aspects of insurance. In auto insurance, for example, I mean, obviously, we have fraud units, but I know you’re directing your question more to the insurance carriers than actually what takes place with policy holders and doctors and lawyers and various other parties. But we find that for every dollar we spend on fraud prevention or detection, I think we get back well over $10. In the comp field, workers comp, you know — we have lost more money in workers’ compensation insurance, I would guess — I may be wrong on this, but I would guess than just about any line. Not necessarily as a percentage of premiums, but in terms of aggregate dollars. It’s been a very tough period. So from the standpoint of — we have one small workers’ compensation direct operation in California called Cypress. And then Gen Re had — has written a lot of workers’ comp reinsurance and it’s been a bit of a blood bath. The rates have not covered the losses.

And I would say that there is a fair amount of fraud that enters into the losses we’ve experienced, or at least the industry’s experienced, particularly at the direct level. But I — in terms of your dispute with an insurance company, I don’t know what company that would be, but I would say that most — many companies that have been in the workers’ compensation business, particularly in California in recent years, wish they hadn’t been in the business. I mean, they have not been making a lot of money off of defrauding policy holders that I know about. But Charlie, do you have anything to say on that?

CHARLIE MUNGER: Well, the experience may be related. If a company gets into a lot of trouble from fraud practiced on it by lawyers, doctors, and claimants, and its own affairs are disrupted by fear and agony, that company is likely to start behaving badly with its own policy holders in order to lay the troubles off on somebody. I think that’s just human nature. But I don’t think the main fraud in workman’s comp is by the carriers against the small businessmen. It’s by the claimants, the attorneys, and the doctors, against the whole system. (Applause)

WARREN BUFFETT: That really would be our experience. As a sidelight, I noticed you were from Morganton, North Carolina. We have a business there, Carolina Shoe. We make work boots. And I give a talk at University of North Carolina some time ago. In fact, I think they have a tape of it still. And afterwards — I had mentioned in the talk that we had this business in Morganton. And one of students came up to me afterwards. And there were a number of them, and I shook his hand and, making idle conversation, I said, “Where are you from?” And he said, “I’m from Morganton.” And I said, “Oh,” I said, “Do you know Carolina Shoe?” And he thought a second, he said, “I don’t know her, but I think I know her family.” (Laughter) Never forgotten that fellow.

24. Utility law repeal would help MidAmerican, but no bonanza

WARREN BUFFETT: Number 5.

AUDIENCE MEMBER: Good morning. Andrew Sole from New York City. I just want to preface my question by saying that I have a deep admiration and affection for both of you men. And in that spirit, I had got a Golden Retriever puppy a few months ago, and he’s been proudly named “Munger.”

WARREN BUFFETT: Is he housebroken? (Laughter)

AUDIENCE MEMBER: And Charlie, you’d be very proud. He’s just like you. I bring him to Central Park and hundreds of women flock over to pet him.

CHARLIE MUNGER: Really?

WARREN BUFFETT: He’s well-named. He’s well named. (Laughter)

AUDIENCE MEMBER: That’s serious, but this is also serious. My question has to do with the Public Utility Holdings Company Act, which obviously affects MidAmerica’s businesses. You’ve spoken that, if it were repealed, you’d be able to commit billions of dollars into the energy infrastructure for the country. And despite the fact that there was a massive blackout in this country over the last summer, the act has not been repealed. And I’m curious as to what effect it might have if PUHCA wasn’t repealed for MidAmerica.

WARREN BUFFETT: Yeah. The Public Utility Holding Company Act was passed in 1935. It was a reaction, and a justified reaction, to some real wild antics that had taken place in the ’20s in the public utility field that were most dramatic in the case of Sam Insull, but occurred with a lot of other companies, Associated Gas and Electric and various other companies. And there was pyramiding of the utility capital structure. And there were a lot of things that were wrong that were addressed in that act. And in our view, that act is long outmoded. And I think that — I mean, the SEC, which has responsibility for administering it, I think there’s a lot of feeling there that it’s long been unneeded. And I think that there’ve been various energy bills that have included the repeal of it. But there was no energy bill passed in the last year. So we live with the Public Utility Holding Company Act. And it does restrict what we do. It’s an interesting question, though, if it were repealed, whether that necessarily would open up lots of opportunities.

Because if it were repealed, it’s quite conceivable that a number of other companies would also be competing with us, in terms of possibly buying utilities that might have been difficult for us to acquire, or for them to acquire, back when the law was in existence. So I don’t want you to think that, if it gets repealed, that Berkshire Hathaway is necessarily worth a lot more money. But I do think it should be — I mean, I think it’s logical. It’s — there are lots of — there’s plenty of appropriate regulation in the public utility field and there are advantages to having strong companies like Berkshire Hathaway pouring money — energy requires enormous sums of money. And to the extent we can use capital advantageously in that business, we’re ready to do it. And it should not be impeded by the act. If I had to bet, that act will probably go off the books at some time. But it doesn’t seem to be, you know, in the immediate future. It will not necessarily mean we get a lot richer. Charlie?

CHARLIE MUNGER: Yeah, but if we had a wonderful opportunity in the field now, we would find a way to do it. Probably through MidAmerican, right?

WARREN BUFFETT: Well, we’d find a way to do it. Yeah. There’s been nothing that’s been presented to us that we couldn’t get done so far. Now it might involve a more awkward structure, but we have not — you know, there’s been nothing that we wish we could have done and when we got to the finish line, or a yard from the finish line, we said, “Well, we can’t do this because of the Public Utility Holding Company Act.” Now, there might have been other things presented if that act hadn’t been on the books. But it will be no bonanza for us at all if it goes away. It may make life simpler on some very large transaction.

25. Berkshire real estate business will grow

WARREN BUFFETT: Number 7? I’m sorry, number 6. I skipped 6. Number 6.

AUDIENCE MEMBER: Good morning. My name is Andy Lewis Charles from Miami. I think I speak for everyone when I wish both of you gentleman continued health. I would wish you continued wealth, but I think you have that covered.

WARREN BUFFETT: We could use more. (Laughter) Of each.

AUDIENCE MEMBER: Speaking of MidAmerican Energy, a unit company underneath it, HomeServices, I see as a great opportunity. I would love to see and hear your thoughts about the future growth potential for it, especially against large consolidators like Cendant Corporation. Thank you.

WARREN BUFFETT: Yeah, HomeServices will grow. HomeServices, as you know, owns a number — I can’t recall how many, but probably in the area of 15 or 16 maybe — controls a number of local real estate firms. And they retain all of their local identity. In that way, it’s somewhat akin to the whole Berkshire Hathaway model, where we leave our subsidiary companies quite autonomous and they operate as if they were — the managers operate as if they own them themselves. Well, HomeServices is somewhat along the same line in that we have no national identity, where Cendant works under a couple of big names. We’ve acquired one company in North Carolina here in the last month or 6 weeks, Prudential of North Carolina. And we will end up — unquestionably, in my view — we’ll end up buying either a few or a whole lot of additional companies over the next 10 years. We will — we’ve got great management. We like the business. We hear about opportunities from time to time. Last year, you know, we participated in roughly $50 billion of transactions.

And I think — I’m really vague on this one, but — I better not give you a percentage of the national total that is, but it’s a very small percentage. It’s a lot of transactions, a couple hundred-thousand transactions. We’re very big in Southern California, for example. We’re very big in Minnesota. We’re very big in Iowa. Very big right here in Omaha and in Lincoln. But there’s an awful lot of places where we aren’t at all. We like to buy leading firms as we go around. And we sometimes like to buy more than one in a community. It’s a good business. It’s a very cyclical business. Right now, it’s very good. We will go through periods in the next five years. I’m sure we’ll go through a period where it’s very slow. But we’ll keep buying. We’ll buy when business is slow, we’ll buy when business is good, depending on the price of the institution and the kind of business we’re buying.

I don’t know how big it can become. It will become bigger than it is now. Relative to Berkshire’s total market value, it may not be that — a huge factor. But it’s conceivable as we buy more operations, we’ll find other things to do with them, too. I mean, the purchase of a home is a big deal to people. You know, often they’re buying furniture at the same time and maybe we can make a suggestion or two. Charlie?

CHARLIE MUNGER: I’ve got nothing to add about that business.

26. Charity program reluctantly dropped after anti-abortion boycott

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: Good morning. I’m Jim Hayes (PH) from Alexandria, Virginia. I hate to beat a dead horse, but I really like the charitable plan. Suppose you brought it back and then personally opted out and then we floated you a bonus equal to what you might otherwise be entitled. Would you consider that?

WARREN BUFFETT: Are you talking about renewing the shareholder-designated contribution program?

CHARLIE MUNGER: Yeah.

AUDIENCE MEMBER: Yes. And then personally opting out, and then we could have a shareholders’ vote to grant you an option bonus or some kind of tax-advantaged bonus.

WARREN BUFFETT: Yeah, I think that might get a little complicated. Additionally, I wasn’t the only one giving money at all, nor was Charlie, to organizations, primarily pro-choice organizations, in fact over — I don’t know of any other than pro-choice organizations — that the people that were causing harm to the Pampered Chef representatives. We had dozens and dozens, maybe even hundreds, giving money on both sides of the issue. I mean, if you looked at one class — well, the largest classification of gifts went to churches. Probably the largest classification in that, I’m (inaudible) positive, were Catholic churches. And we had people giving money to everything in the world, which is exactly the way we wanted it. I mean, whatever — it’s the shareholders’ money. So even if you had the two of us opt out, we would have organizations that would get violent about the fact that some money was going to pro-choice organizations. And rather than take it out on us, whom they can’t hurt, they’ve taken it out on some very innocent people.

And neither Charlie nor I like the idea of somebody — you know, some woman that’s developed a living, you know, in Dubuque, Iowa or in Casper, Wyoming, having her livelihood destroyed because of what we’re doing. So reluctantly, we gave up the practice. I mean, we — actually, I received a letter one time from somebody — some organization was monitoring — said they didn’t give — they didn’t care if we were giving $10 million to pro-life organizations and $1 to pro-choice organizations, they were still going to boycott our people. Well, boycotts don’t bother me. We had some of that right along, always on a small scale. But — because they can’t — they basically can’t hurt us in any significant way. But they can hurt individuals very badly and we’re not going to have something around Berkshire that’s hurting a bunch of people that have devoted their lives to working with us. So we reluctantly gave it up. Charlie?

CHARLIE MUNGER: Well, as I said, it’s a dead horse and I miss it, too.

27. Buffett family and Berkshire managers will protect the company

WARREN BUFFETT: Number 8, please.

AUDIENCE MEMBER: Good morning. I’m Jay Leiber (PH) from Houston, Texas. Mr. Buffett, since I’m older than you and maybe even as old, or older, than Charlie, I feel like I can ask this question. And I’ll ask it as delicately as possible. When the time comes that you, I, and Charlie have gone to that big stock market in the sky, I understand that you planned — or at least, I have read — that you plan to give the bulk of your Berkshire Hathaway stock to your charitable foundation, along with your 30 percent of the votes of the company. If this is correct — and if it’s not correct, this question is moot — but if so, what assurance do the Berkshire Hathaway shareholders have that the company will continue to be run as honestly and straightforward as it is now, such as only 15.8 employees or so at headquarters and no —

WARREN BUFFETT: Yeah, the —

AUDIENCE MEMBER: — huge salaries or other ridiculous giveaways to dilute and weaken the equity of the shareholders at that time.

WARREN BUFFETT: Well, for a short while there’ll only be 14.8, actually. (Laughter) But it’s a good question — a very good question. Since you’re older than I, apparently, I hope we don’t go at the same time. The — There’s one slight twist to the estate plans we have. If I die first, all of my Berkshire goes to my wife. And if we died simultaneously, it would all go to the foundation. But all of the stock will end up in the foundation. In fact, if I died first, she might put my stock in the foundation before her death, but that would be up to her. But it will end up in the foundation — all of the stock. As you mention, it has 30-odd percent of the votes, although under the tax law, once it’s in the foundation, within five years, it would have to either convert to be some of it — it would have to get down to 20 percent of the vote. That’s required under foundation law.

In terms of how it would be run in the future, I think it has a far better chance than any company — any major company I know in the country — of maintaining the culture, because it has — it will have people running it who have grown up in the culture. Earlier, it was — the criticism was made about my wife and my son being on the board, but they are guardians of the culture. They are not there to profit themselves, they are there to profit as the shareholders profit, but also to keep the company in the same way as previously. One great example of that, of course, has been at Walmart where, when Sam Walton died, a not too dissimilar amount of stock was left among the family. And essentially the Walton family has, in my opinion, done a magnificent job, not only of selecting successors to run the place, but having successors who, if anything, reinforced the culture of Walmart. And it’s been an enormously successful arrangement. The Waltons are there, in case anything goes wrong, to make a change if needed, but they’re not there to run the business. And that’s exactly the pattern that we hope to have at Berkshire. And I think we have it.

I think I — you know, I can’t give you a hundred percent guarantee, but I would far rather bet on the integrity of the family that succeeds me, plus the managers that succeed me, at Berkshire remaining true than I would any other company in — for a long, long time — any other company I can think of. Charlie?

CHARLIE MUNGER: Well, I would have a reason to fret about this subject, just as you would. And I, of course, have known the members of the Buffett family that would be here after Warren is gone for decades. Don’t worry about it. You should be so lucky. (Laughter and applause)

WARREN BUFFETT: It’s a question we don’t wish to have an instant answer for, though, however. (Laughter)

28. Profits as GDP percentage won’t be moved by technology

WARREN BUFFETT: Number 9, please.

AUDIENCE MEMBER: Good morning. James Easterlin (PH) from Durham, North Carolina. My question — statement is, you have often written in reference to average corporate profitability remaining fairly consistent in the long run, such that return on equities are in the 12 percent range for U.S. companies, and after-tax profits as a percentage of GDP is sticky in the 4 to 6 1/2 percent range. And the question is, given the advances in technology that brought the inventory-to-sales ratios down to historic lows, given the widespread adoption of the EVA principles by companies, might you think that might change over time?

WARREN BUFFETT: Yeah, I don’t think any of the factors that you mentioned will act to move corporate profitability out of the range that has historically existed. It’s going to bob around, obviously, some, but I certainly don’t think EVA will do a thing for American corporations in terms of making them receive a greater share of GDP in profits. Technology, that’s just as likely to reduce profits as to increase profits. I mean, as the economic machine of the United States works better and better over time, the main beneficiaries are going to be consumers. If you took whoever you think is the best business manager in the United States and you put a clone of that person in charge of each one of the Fortune 500, the profits of the Fortune 500 would not necessarily go up, because there’s this competitive nature to capitalism where the improvement you get one day, your competitor gets the next day. And it very much tends to work to the benefit of consumers but not to increase overall profitability. We see that in the industries we’re in.

Every — we were in the textile business for a long time and various new products — various new machinery — would come along and it would promise to deliver a 40 percent internal rate of return and get rid of 43 employees or something like that. And, you know, we just did one after another of those, and when we got all through we didn’t make any money, because the other guy was doing the same thing. And I liken it to everybody at a parade — you know, a huge crowd watching it and somebody stands up on tiptoes and, you know, 10 seconds later, everybody in the crowd is up on tiptoes and they’re not seeing any better and their legs hurt. Well, that was the textile business. And there’s an awful lot of self-neutralizing things in capitalism. So I don’t really expect any of the factors you named, or any other factors that I can think of, that will move profits up as a percentage of GDP.

And indeed, I think that if you’re looking at GDP as being the national pie and profits being what investors get out of it, and the rest belonging to people who are out there working for a living every day, I don’t think the relative — the proportions — are inappropriate. Charlie?

CHARLIE MUNGER: I’ve got nothing to add to that.

29. Method for estimating a company’s future growth and establishing a margin of safety

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: Good morning. I’m Marc Rabinov from Melbourne, Australia. Mr. Buffett and Mr. Munger, I’d like to ask you, when you assess a business and derive its intrinsic value, how do you estimate the future growth of the business, and how do you decide what margin of safety to use? Thank you.

WARREN BUFFETT: It was the future growth and what, Charlie?

CHARLIE MUNGER: Well — I have difficulty understanding that question fully. He’s talking about how do we combine our estimates of future growth with our passion for having a margin of safety. Surely, you can handle that. (Laughter)

WARREN BUFFETT: Well, I can certainly handle it as well as you can. (Laughter) Every time he laterals them off to me, you know, he calls those audibles. (Laughter) You calculate — I think you take all of the variables and calculate them reasonably conservatively. But you don’t try and put too much windage in at every level. And then when you get all through, you apply the margin of safety. So I would say, don’t focus too much on taking it on each variable in terms of the discount rate and the growth rate and so on. But try to be as realistic as you can on those numbers, but with any errors being on the conservative side. And then when you get all through, you apply the margin of safety. Ben Graham had a very simple formula he used for just the most obvious situations, which was to take working capital — net working capital — and try and buy it at a third off working capital. And overall, that worked for him. But that method sort of ran out of steam when the subworking capital stocks disappeared. But it’s the same thing we do in insurance.

I mean, if we’re trying to figure out what we should charge for, we’ll just say, the chances of a 6.0 earthquake in California, well, we know that in the last century, I think that there have been 26 or so 6.0 or greater quakes in California. And let’s forget about whether they occur in remote areas, let’s just say we were writing a policy that paid off on a 6.0 or greater quake in California, regardless of whether it occurred in a desert and did no damage or anything. Well, we would look at the history and we’d say, “Well, there’ve been 26 in the last century.” And we would probably assume a little higher number in the next century, that’d just be our nature. But we wouldn’t assume 50. If we did, we wouldn’t write any business. So we would — we might assume a little higher. I would, if I was pricing it myself, I’d probably say, “Well, I’ll assume there are going to be 30, or maybe 32, or something like that.”

Then when I get all through, I’ll want to price the — I’ll want to put a premium on it that now puts in a margin of safety. In other words, if I figured the proper rate for 32 is a million dollars, I would probably want to charge something more than a million dollars to build in that margin of safety. But I don’t want to hit it at — I want to be conservative at all the levels and then I want to have that significant margin of safety at the end. And I guess that, as I understand the question, that’d be my answer. And Charlie, do you want to add to that?

CHARLIE MUNGER: Yeah, that book, “Deep Simplicity,” that I recommended to you says that you can predict out of those 26 earthquakes how the size will be likely to be allocated. In other words, there’s a standard power law that will tell you the likelihood of earthquakes of varying sizes. And of course the big earthquakes are way less likely than the small ones. So you count the math and you know the applicable power law and you guess as to how much damage is going to — it’s not that difficult.

WARREN BUFFETT: It becomes more difficult if somebody said they really want protect against a 9.0 or something like that. You know, is it one in 300 years? Is it one in a thousand years? You know, when you get really off the data points. But that is not what you’re looking at in investments. You don’t want to look at the things that are that — you don’t want to come up with the companies where you make the assumptions that get that extreme. And you don’t have to, that’s the beauty about investments. You only have to look at the ones that you feel capable of evaluating and you skip all rest.

30. No single formula for regulatory impact on businesses

WARREN BUFFETT: Number 11?

AUDIENCE MEMBER: Good afternoon. It’s James Tarkenton of Durham, North Carolina. Current examples, including discussion of media ownership rules, FCC regulation of the telecom industry, and proposed oversight changes for mortgage giants Fannie Mae and Freddie Mac are all examples of the legislative, regulatory, and lobbying process as an influence in shaping and reshaping economic moats. We would be interested in your comments on these and other examples of how competitive advantages are shaped by government. In general, how do you incorporate the impact of regulation on the size and ferocity of economic moats for various businesses?

WARREN BUFFETT: Well, that varies enormously by the business. I mean, there’re some businesses that we think that it’s not a very big factor, and there’s other businesses we’re in — the energy business, the insurance business — where regulatory change could have a huge impact. You know, we don’t have any one-size-fits-all type arrangement. We just try to think intelligently about any business we’re in. And if it’s — when we bought GEICO in 1995, or bought that last half of it or whichever year it was, the question, you know, whether the regulatory climate would change in some major way, you nationalize auto-insurance — well, all of those things go through our mind and we evaluate them. But there is no — there’s no formula. You know, if we’re — if we’re in furniture retailing, you know, that is not something we’re going to worry about.

We’re going to worry about plenty of things, in terms of competition, but there are different variables that apply with different intensity to each business we’re in. And it’s up to Charlie and me to try and think about any of the variables that might hit those businesses, and to weigh them appropriately, and to crank that into our evaluation. Charlie?

CHARLIE MUNGER: I think it would be fair to say that in our early days, we tended to overestimate the difficulties from regulation. We refrained from buying television station stocks for a long, long time because it seemed like such a peculiar asset when anybody could just ask to have your license jerked away from you each year and they could ask a government agency to do it. And — but it turned out, the way the system evolved, that almost never happened.

WARREN BUFFETT: Yeah, Tom Murphy figured that one out before we did. (Laughs)

CHARLIE MUNGER: Yeah, and we had it — we were slow on the learning curve. Murphy was way better at it than we were.

31. Buy Berkshire or low-cost index fund?

WARREN BUFFETT: Microphone 12, please.

AUDIENCE MEMBER: Hello, gentleman. My name is Vivian Pine and I’m from Tarzana, California. And my question is, for a new investor buying stocks today, would you recommend that they buy a low-cost S&P index fund or Berkshire Hathaway, and why?

WARREN BUFFETT: Well, we never recommend buying or selling Berkshire. But I would say that, among the various propositions offered you, a very low-cost index fund where you don’t put all your money in at one time. I mean, if you accumulate a low-cost index fund over 10 years with fairly regular sums, I think you will probably do better than 90 percent of the people around you that take up investing at a similar time. Charlie?

CHARLIE MUNGER: I would agree with that, totally. It’s awkward for us sitting here at these annual meetings where we have a sampling of some of the most honorable and skillful stockbrokers around who’ve done a wonderful job for their own clients and families. But the stockbroking fraternity, in toto, can be guaranteed to do so poorly that the index fund is a better option.

32. Leverage can prevent you from playing out a winning hand

WARREN BUFFETT: We’ll go to number 1 again.

AUDIENCE MEMBER: John Bailey from Boston. As of last week, my house is almost totally covered with Benjamin Moore now. (Laughter) But more seriously, you spent a fair amount of time talking about the low-probability transformative events. I recall a discussion on the probability of a nuclear event not occurring in any given year for, say, 50 years, at which point it begins to look like, over the time period, it’s pretty darn likely and therefore the expected value is a pretty big negative. There are some other things that could be happening that somebody might expect. For instance, perhaps there is, in fact, a ceiling on consumer debt coverage ratios. If they quit falling, there — that could be a big change. If you even listen to the United States Geological Survey, they’re now saying that sometime in the next 50 years, there could be a fall in the production of oil. And so, I’d like you to address how you conceive of the portfolio of businesses in the context of these possible transformative events, especially given that over this same time period of maybe the next 50 years, at some point, you’re not going to be able to personally revise the portfolio.

WARREN BUFFETT: Yeah, I think it’s a fair statement that over the next 50 years at some point, Charlie and I will not personally be able to — (laughs) — participate in portfolio revisions. The — Well, you’re quite correct that people tend to underestimate low-probability events when they haven’t happened recently and overestimate them when they have happened recently. That is the nature of the human animal. You know, Noah ran into that some years back. But he looked pretty good after 40 days. The — What you mention on the nuclear question, it’s a matter — you can do the math easily. What you don’t know is whether you’re using the right assumptions. But it — For example, if there is a 10 percent chance in any given year of a major nuclear event, the chance that you’ll get through 50 years without it happening, if the 10 percent is correct, is a half of 1 percent. I mean, 99 1/2 percent of the time a 10 percent event per year will catch up with you in 50 years.

If you can reduce that to 1 percent, there’s a 60 percent chance you get through the next 50 years without it happening. That’s a good argument for trying to reduce the chances of it happening. In terms of our businesses, I think Charlie and I are — I mean, we think about low-probability events. In fact, in insurance, we probably think about low-probability events more than most people who have been insurance executives throughout their years. It’s just our nature to think about that sort of thing. But I would say, if you talk about transforming events, or really talk about major events that could have huge consequences that are low probability, they’re more likely to be in the financial arena than in the natural phenomena arena. But we’ll think about them in both cases. But we do spend a lot of time thinking about things that can go wrong in a very big and very unexpected way. And financial markets are — they have vulnerabilities to that, you know, we try to think of and we try to build in ways to protect us against it and perhaps even build in some capabilities where we think we might profit in a huge way from it. Charlie?

CHARLIE MUNGER: Yeah, that temporary collapse in the junk bonds, where they got down, many of them, to 35 and 40 percent yields, that’s a strange thing. And to have all those things pop back — you know, quadrupling in a short time. There was absolute chaos at the bottom tick of that. And that isn’t as much chaos as you could have. And of course, it can happen in common stocks instead of junk bonds. So I think if you’re talking about the next 50 years, we all have to conduct ourselves so that we — it won’t be all that awful if a real financial crunch of some kind could come along. Either inflationary or a typical deflationary crunch of the time [kind] that people used to have a great many decades ago.

WARREN BUFFETT: Probably the most dramatic way in which we are — give evidence of our — of your worries, is we just don’t believe in a lot of leverage. I mean, you could have thought junk bonds were wonderful at 15 percent because they eventually did go to 6 percent, you would have made a lot of money. But if you owed a lot of money against them in between, you know, you wouldn’t have been around for the party at the end. So we believe almost anything can happen in financial markets. And the only way smart people can get clobbered, really, is through leverage. If you can hold them, you have no real problems. So we have a great aversion to leverage and we would predict that a very high percentage of the smart people operating in Wall Street, at one time or another, are likely to get clobbered through the use of leverage. It’s the one thing that forces you — it’s the one thing that ends — or can prevent you from playing out your hand. And all of the hands we enter into look pretty good to us. But you do have to be able to play them out.

And the fascinating thing to me is that — just take the junk bond situation. In 2002, you had people with terrific IQ — tens of thousands of them operating in Wall Street. You had the — money was available. They all had a desire to make money. And then you see these extraordinary things happen in markets and you say to yourself, you know, can these be the same individuals that two years later or two years earlier were buying these things at prices that were double or triple or quadruple what they sunk to in between? And did they all go on vacation? You know, did they lose their ability to raise money? No, the money was — you know, Wall Street was awash in money, and it was awash in talent, and yet you get these absolutely extraordinary swings. I mean, it doesn’t happen with apartment houses in Omaha or, you know, with McDonald’s franchises or farms or something. But it’s just astounding what can happen in the marketable securities department. And the big thing you want to do is, at a minimum, you want to protect yourself against that sort of insanity wiping you out. And better yet, you want to be prepared to take advantage of it when I happens.

Now it’s about noon, so we will come back and begin at microphone 2 about, say, a quarter of one.

Afternoon Session

1. Difficulties of judging whether a company has ethics

AUDIENCE MEMBER: (Note: Video recording begins with meeting already in progress.) After reading this story on Enron, I would like to ask you the following question. How does an entry-level employee in a large company find out if her employer operates with a long-term perspective, and with honesty and integrity?

WARREN BUFFETT: Well, that’s a very good question. I’m not sure I’m going to have an equally good answer. It — You know, you pick up signals — or frequently, you can pick up some signals — about what is going on at the top of a business if you’re at a lower level. But I would say it would be very easy to be fooled on that subject. Charlie and I would tend to be looking at things that they do in public in relation to their investors and the promises they make, and all of that sort of thing. But I think that might be tough for people, and it wouldn’t always give you a great guide. I’ve — we’ve been suspicious of companies, for example, that place a whole lot of emphasis on the price of their stock. I mean, when we see the price of a stock posted in the lobby of the headquarters or something, you know, things like that make us nervous. But I’m not so sure that’s, you know, that that would be enormously helpful.

So I guess you just have to sort of pick up from coworkers, publications, pronouncements of the leaders, the sort of culture that was being presented to them and the world, and, you know, you might get suspicious about it. But I don’t think I have a really good answer for that, do you Charlie?

CHARLIE MUNGER: No, it’s obviously easy when you’ve got a caricature of a person like Bernie Ebbers or Kenny Lay. I think it’s easy to say that you’ve got almost a psychopath — (laughter) — in charge. But what fools you is a place like Royal Dutch. If I’d been asked to guess —

WARREN BUFFETT: Ah!

CHARLIE MUNGER: — major companies with sound, long-term cultures, and a good engineering values, and so forth, Royal Dutch would have been near the top of my list. And to have the oil reserves phonied for years, and internal reports of people who were tired of lying. If it can happen at Royal Dutch, believe me, it can happen a lot of other places.

WARREN BUFFETT: Yeah, Charlie and I would not have spotted it at Royal Dutch by any of the means that we normally use. In fact, we — as Charlie said, we might have used that as an example of some place that was almost certainly above reproach. And then you do read the emails and all that.

CHARLIE MUNGER: But we don’t learn, because I would still expect that Exxon’s figures were fair.

WARREN BUFFETT: Yeah. I think you — what was — what transpired in the 1990s, you know, was this gradual — and later on, not so gradual — embracing at the top of the feeling that anything goes. You know, I don’t — I’m not going to speculate as to the motives at the top of Shell. But there was so much going on where people saw the fellows — in most cases fellows, unfortunately — that were at their clubs, that they saw at other corporate meetings, were respected business leaders, they saw just one after another that were really cutting corners in one way or another. And, you know, situational ethics can take over in that. People do, I think, they sink faster to a lower prevailing morality than they rise to a higher prevailing morality. But they do move in the direction of what they perceive to be the prevailing morality of those around them, in many cases. And certainly the corporate world in the late 1990s, particularly, it was extreme on that.

2. Congress shouldn’t make (immoral) accounting rules

WARREN BUFFETT: And that leads me into — I ran into a friend at the lunch break who’s involved in these matters. And he suggested, and I’m delighted to put in a plug to encourage all of you to write your congressman and senators to give your views on whether stock options should be expensed, or whether indeed, whether Congress has got any business legislating on the question of what proper accounting is. It was a disgrace some 10 years ago when the United States Senate essentially threatened the accounting standards board with extinction and bludgeoned Arthur Levitt, then running the SEC, at the behest of a lot of rich contributors, to declare that — to override the accounting standards board’s pronouncement that options should be treated as expense. And it was — and I think in a very significant way, it accelerated the “anything goes” mentality of 1990s. At that point, when Congress says it’s more important to have stock prices go up than it is to tell the truth, and they voted 88 to 9 in order to do it, as I remember, I think there was a shift in morality among many corporate executives.

You may remember that the FASB then backed off, but still said that expensing was preferable. And having said it was preferable, 498 out of the 500 companies in the S&P took the less preferable method. All of the big auditing firms at that time endorsed their big clients’ views, in order to report higher earnings. Now, all four accounting firms say you should count them as expenses. Well, they’re right, now, but it just shows what was going on in that period when, on a question of accounting principles, and when really nothing has changed, when what were then five — the Big Five —have shifted 100 percent to where the Big Four are now, and, now, they say options should be expensed. So, if you are inclined to write your congressman or senator, tell him you really think the FASB knows more about accounting than they do. And I think you’ll be right. If you want to have some fun, go to Google and type in two words. Type in the word “Indiana,” and type in the word “pi,” that’s the mathematical symbol pi.

And when you do that, you’ll see a number of stories come up. And they relayed how in 1897, at the instigation of one legislator who was responding to a constituent, the House in Indiana voted almost unanimously, it may have even been unanimously, it says what it was on Google, to change the value of pi. (Laughter) I’m, you know, I’m not making this up. It’s checkable. And it seems that there was a fellow that thought he’d discovered some new relationship between circumference and diameter, and area, and a few things. And it came out to 3.20 if you worked through his formula. And he offered to give this royalty-free, as he put it, to the State of Indiana to teach its children so that they would have not only the truth, but they’d have an easier number to work with than the long decimal that heretofore had been thought of as pi. Well, that passed the Indiana legislature. And it passed the House. By the time it got to the Senate, there were a few people that were still clinging to the old values who managed to shoot it down.

But I would submit that in the — in 1993, that the U.S. Senate cleansed the record of the Indiana legislature by outdoing them in attempting to change the rules on something, on a subject, they knew nothing about. And I think some of the excesses of the 1990s that followed came about through the fact that they knew 88 senators were willing to declare the world was flat if constituents who had contributed enough money to them wanted it thus. Let’s — we pause now, go back to our schedule here. Number 3. Oh, Charlie, do you have anything to say about the Indiana legislature?

CHARLIE MUNGER: Well, I — the current members of Congress that want to retain the former abusive accounting, which are probably a majority of the House of Representatives, are way worse than the people who wanted to round pi to an even number. Those people were stupid. (Laughter) These people are mostly not stupid, but dishonorable. I mean, they know it’s wrong, and they want to do it anyway. (Applause)

3. “Too many conflicts” for a Berkshire fund management company

WARREN BUFFETT: Let’s go to number 3.

AUDIENCE MEMBER: Hi, my name is Nate Anthony (PH), from Hinsdale, Illinois. First, I would like to venture a response to an earlier question about the future of Berkshire. I believe it is our responsibility as shareholders to think for ourselves and ensure that Berkshire is run as respectably in the future it has been until now. You both have had a lot to say, both today and in the past, about how mutual funds should be run. But to my knowledge, we do not directly have a fund management business. What do you think about putting your words in action, and offering to have a Berkshire company manage the assets of funds where the directors are dissatisfied with present management?

WARREN BUFFETT: Yeah, the problem would be, there would be too many conflicts. You know, we’re managing so much of our own money at Berkshire that to take on the responsibility for managing another group of people to whom we would owe our best efforts, and handling that situation of wearing two hats ethically, I wouldn’t know how to do it. I certainly wouldn’t want to start a fund management company and be prorating all purchases between Berkshire and that fund management company, or the funds that it managed. I — we’ve thought about it plenty. I mean, we’ve had all kinds of propositions put to us. And obviously, we could sell it big time. But when we got through selling it, then we’d have the problem of administering it fairly. And I don’t know how we would do it. Charlie, do you?

CHARLIE MUNGER: No, that’s why we don’t do it. But — (laughter) — I must say it’s an attitude that doesn’t seem to bother many other people. (Laughter)

4. New Omaha convention center allows more people to attend

WARREN BUFFETT: Microphone 4, please.

AUDIENCE MEMBER: Norman Rentrop from Bonn, Germany. Two thanks and one question. My thanks go to both of you for allowing us investors to participate on equal terms with you. No management fees, no performance fees, no transaction fees. (Applause) My thanks also go to the people of Omaha for building this very fine new convention center. (Applause)

WARREN BUFFETT: Our thanks, too. I’ll interrupt you for just one second. We wouldn’t be able to hold this meeting if we’d been limited to the facilities we had last year. Last year we had the biggest facility in town. And I was told that we have at least 19,500 people here. And that would have been many, many thousands beyond what we could have had last year. And this is, — (applause) — this facility really does the job. Incidentally it’s known as the Qwest Center. If you read about it in the paper, they have a — they seem to have some unwritten rule — or maybe it’s a written rule — that they can’t use the name. So you will not see that name in the paper for reasons that absolutely baffle me. But this is the Qwest Center, and they’ve done a wonderful job with it. And Omaha has 19,500 people here today that otherwise might have to go to Kansas City. So, thank you for thanking them, and now, your question, please. (Applause)

5. “I’m the only one that can double-cross you”

AUDIENCE MEMBER: My question is your outlook on buying companies. You have taught us when stocks are priced high, and companies are priced low, then buy companies. In the 1960s and ’70s, we did see the rise of the conglomerates. Then came in the pure industry plays. Now, we see a huge amount of money in private equity. And somehow private equity is competing for buying companies. So my question is, what is your outlook on the future of the buyout and the buying company industry?

WARREN BUFFETT: Yeah, you’re absolutely correct that the private equity funds are a form of competition with Berkshire in buying businesses. We don’t really seek to buy businesses cheap, because you’re not going to get the chance to do that. We haven’t been able to do that. We do get occasional chances to buy them at what we would regard as fair value. You’ll never buy companies as cheap as stocks sometimes get. I mean, sometimes stocks sell for very low valuations compared to intrinsic value. Businesses just don’t do it. I mean, the reason is the prices of stocks, like those junk bonds we talked about earlier, are set in an auction market, and that market can do extreme things. But businesses are sold in a negotiated transaction, and that doesn’t get as extreme. Nevertheless, our preference — our strong preference — is that we would rather buy businesses at fair prices than stocks even a little cheaper. And the private equity funds are our competition. On the other hand, we have bought a reasonable number of businesses in recent years, and we’ll buy more in the future.

If somebody wants what we are offering, you know, we are somewhat one of a kind, in that we can — we will buy a business, and the people that sold it to us, if they built that business, are really able to run it as if it’s their own indefinitely in the future. So they — If they have a tax reason, if they have a family situation, or whatever, where they want to sell some business they love, and they don’t want to auction it off like a piece of meat, and they don’t want some guy buying it and then leveraging it up, and then reselling a couple years after changing the accounting or something of the sort, they come to us. And they know they’ll get the result they want. And that happens periodically. It doesn’t enable us to buy super bargains or anything like that. It just doesn’t work that way. But it does let us put the money to work at a sensible rate. There will be more people like that. Unfortunately, we need big businesses, and, you know, they don’t come along every day.

But as I’ve said, when they — if you find that kind of owner — If I owned a business that was big, and maybe my father had started, my grandfather had started, and I worked a long time for it but for one reason or another I had to monetize it, you know, I would sell to Berkshire. It’s very simple, because I wouldn’t regard the carving up of it to get perhaps the highest — a higher price — which might or not — might not be higher — but I wouldn’t regard that as the ultimate goal in life. I think it’s kind of crazy, you know, to spend — I think it’d be kind of silly to auction off your daughter to whatever, you know, whatever man is willing to pay the most for her. And I feel the same way about a business you’ve created lovingly over decades, and decades, and decades. And we will buy some more. It’s a matter of luck whether it happens in any given quarter, or even any given year. But there’s really no one else can quite make the promises that we can make.

I mean, the degree of ownership that I have in Berkshire, and the way I’ve got it set up for the future, where none has to be sold, you know, my promises will probably be about as good as you can get in that arena. Most big companies simply can’t do that. If their board of directors, you know, decides they wanted to have a pure play, as you put it, in something. You know, what can be done about it? I tell perspective sellers basically, “I’m the only one that can double-cross you.” I mean — and I can double-cross them. I mean, if I, the next day, want to pull something on them, I — it’s not contractual, what I’ve said to them, in all probability. But nobody else can. We’re not going to get some management consultants in, and they say you ought to rearrange the business, or we’re not going to get Wall Street dictating to us. And that’s, I think, a significant advantage over time.

I think it’ll enable us to buy businesses, but we do have a lot of competition, as you point out. Charlie?

CHARLIE MUNGER: Yeah, it’s been interesting, though, that we’ve had this private equity competition for a long time, and one way or another we’ve managed to buy a few things. (Laughter)

6. David Sokol defends MidAmerican’s environmental record

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

AUDIENCE MEMBER: Hello, my name is Dan Cunningham, and I’m from Boston, Massachusetts, home of the 2004 world champion Boston Red Sox. (Applause and laughter) Thank you, Warren and Charlie, for providing this forum, and teaching over the years. It’s much appreciated. In a recent New York Times magazine cover story titled, “Up in Smoke,” David Sokol, who runs Berkshire’s MidAmerican Energy business was cited as a prominent CEO actively working to roll back the United States Clean Air Act, which 80 percent of Americans view as crucial to our public health. MidAmerican, itself, was cited as a major mercury polluter, among other things. With this in mind, could you see a role for a type of independent oversight committee charged with the purpose of auditing for shareholders the social responsibility of Berkshire’s businesses? This committee would monitor costs that Berkshire’s businesses incur for our society, but do not show up anywhere in an income statement. Maybe in Berkshire’s case, this would be a fraction of a person instead of a committee. Thank you.

WARREN BUFFETT: Yeah. Is Dave here? I can’t, it’s hard for me to see here. Do you see Dave? Marc [Hamburg], is David here? We’ll go to a — yeah, he might — I’d like to have David respond to that, because, you know, I have seen MidAmerican actually lauded in many — a great many respects. I did not see that particular article, but I know that if there were anything being done, that had been judged wrong, I would have heard about it. So maybe David can address that, if he will. Well, he can — there’s a mic. Either come up here, or go to the microphone that’s nearest.

DAVID SOKOL: Yeah, Warren, this is David.

WARREN BUFFETT: Yeah, OK, uh-huh.

DAVID SOKOL: The article actually does not criticize MidAmerican for any air emissions. It criticized me for two years ago being a “Ranger” in President [George W.] Bush’s election. For what it’s worth, I’m no longer a Ranger, but that was the — the focus of the article was energy CEOs trying to influence legislation. That’s not why I was a Ranger, and frankly, MidAmerican’s environmental policies, I think, rank among the best in the industry.

WARREN BUFFETT: Thanks, David. Yeah, I’ve never seen any criticism of MidAmerican. And matter of fact — (applause) — David, could you tell them what happened with that J.D. Edwards study just recently?

DAVID SOKOL: Yeah, we were ranked nationally number two in the country for environmental reliability, availability, and customer satisfaction — number one in the Midwest out of 55 utility companies.

WARREN BUFFETT: Thanks, Dave. (Applause)

7. U.S. has “certainly benefited enormously” by immigration

WARREN BUFFETT: Number 6, please.

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. My name is Van Argyrakis. I’m from Omaha. Many U.S. multi-national corporations depend on the importation of foreign workers. What is your opinion on the current state of U.S. immigration law as it applies to the employment of highly-skilled permanent workers?

WARREN BUFFETT: Charlie, you want to comment on that?

CHARLIE MUNGER: Well, of course, that’s a subject on which reasonable minds disagree. My personal view is that I’m almost always glad to have very talented people come into the United States, and I’m almost never pleased when the very bottom of the mental barrel comes in. (Laughter)

WARREN BUFFETT: Yeah. We may differ just a bit on that one. (Laughter) The — this country has certainly benefited enormously over the decades, you know, by immigration. We started out with 4 million people in 1790. China had 290 million at that time, just about what we have now. Europe had well over 75 million. So you had 70 times as many people in China. You had, probably, 20 times as many people in Europe. We had the same degree of intelligence in China, or in Europe, as we had here. We had similar natural resources. And now this country has well over 30 percent of the GDP of the world. So it’s a pretty remarkable story. And how to attribute — or how to quantify the various components that entered into that is very difficult, but we’ve certainly been a country characterized by lots of immigration. And whether that is responsible in any way for the incredible record of this country, I don’t know. But I suspect that it was. And I think what Charlie would like to do is perhaps be the admitting officer. And — (laughs) — it would work —

CHARLIE MUNGER: You’re right.

WARREN BUFFETT: It would work pretty well if Charlie was, but in the absence of that I think — I don’t think, net, this country has been hurt by immigration over time.

8. Why we don’t split Berkshire’s stock

WARREN BUFFETT: Number 7?

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. I would like to thank you for being here. Well, my question pertains to price discovery and liquidity. It is a common perception that, unless there is adequate liquidity, price discovery is hurt. Now if liquidity helps price discovery, then does it make sense to split the stock of a company which has a low liquidity problem? As a corollary, why do you consider stock splits and bonus issues to be bad for shareholders in the long run? Thank you.

WARREN BUFFETT: Stock splits, and what else Charlie?

CHARLIE MUNGER: Bonus issues.

WARREN BUFFETT: And what’s the relation, I don’t get it.

CHARLIE MUNGER: He didn’t indicate a relation —

WARREN BUFFETT: Oh.

CHARLIE MUNGER: He just asked you to describe —

WARREN BUFFETT: It’s just two —

CHARLIE MUNGER: — what’s wrong with both.

WARREN BUFFETT: It’s two questions, then. (Laughter) Yeah, well, our — we have explained how we think about stock splits. There’s no religious view against them. We don’t think companies that do them are evil or anything of the sort. We do think we’ve got the best group of shareholders in the world, and I think that a meeting like this, to some extent, is evidence of it. We’ve got people that are more in sync, I think, with the policies of the company. We certainly have people who are more long-term in their view of Berkshire — or their intentions — regarding Berkshire. I think we have people that understand their investment in Berkshire better than — well, really better than other large American corporation. We’ve got the lowest turnover of any large American corporation. Now, why is that? Well, people can buy stock in any company they want to. I mean, you could have bought stock in Berkshire, or something else.

But there’s this self-selection process of who comes in, and there’s a self-selection process of the people that just say, you know, that company doesn’t interest me. And I would say that people who say they aren’t interested in a stock that sells in the thousands of dollars a share simply because it sells in the thousands of dollars a share, are not — would not as a group be as intelligent, and informed, and long-term in their outlook, and as in sync with the policies of management, as this group. It’s not a killer of a thing, obviously. But it’s a sign — it’s a symptom — of people with a somewhat different attitude toward the stocks they own. Now, somebody is going to — If we have a million and a half Class A equivalent shares — we have a little more than that — outstanding, somebody’s going to own them all. So it’s just a question of who is attracted and who is repelled to your — from your shares.

And I think not splitting, and some other things we do at Berkshire — a number of other things we do at Berkshire — has attracted a group of shareholders that really come the closest to an investment-oriented group, as is almost possible in a widely traded, widely available company. And we like the group we’ve got. We’re not looking for the people who think it would be a more attractive stock if, instead of selling at 90,000 a share, it sold at $9 a share. Nothing wrong with those people, but they are — If we were choosing partners, we would choose the group we have over the people who think a $9 stock is a wonderful thing. Charlie?

9. Munger: liquidity is not a “great contributor to capitalism”

CHARLIE MUNGER: Yeah, and on the second part of that question, I think the notion, which is taught in so much of modern academia, that liquidity is this — of tradable common stock — is a great contributor to capitalism — I think that is mostly twaddle. The GNP of the United States grew at very good rates long before we had highly-liquid markets for common stock. I don’t know where people got that silly notion. I think the liquidity gives us these crazy booms, which have many problems as well as virtues. And in England, if you’ll remember, after the South Sea Bubble, England banned tradable common stocks for decades. It was absolutely illegal to have a company so widely held you got a liquid market in the shares, and England did fine during that period when you didn’t have a stock market. So, if you think that liquidity is a great contributor to civilization, why then you probably believe that all the real estate in America, which is relatively illiquid, hasn’t been developed properly.

WARREN BUFFETT: The kings actually commented on the perversions brought about by liquidity. But of course, the truth is that Berkshire trades on average $50 million or so of stock a day. So there’s very few people that are going to have any problem with Berkshire, the liquidity in the stock.

CHARLIE MUNGER: But we’re trying to create more of them.

WARREN BUFFETT: Uh-huh.

CHARLIE MUNGER: More people who have this big liquidity problem, because they own so much stock.

10. Buffett’s moral distinction between owning a company or a stock

WARREN BUFFETT: Let’s go on to number 8, please.

AUDIENCE MEMBER: Hello, there. This is Michael Angelo (PH) from San Francisco. My general question is about how ethical concerns enter into your asset allocation decisions. So, for example, I think there’s some strong arguments that can be made that, say, Classic Coke should never be part of anyone’s diet. If such an argument could be made, and you were convinced of it, would that change the way that you viewed Coca-Cola Company as part of your portfolio?

WARREN BUFFETT: Well, I think that’s a hypothetical that simply wouldn’t happen. I mean, I’ve been drinking five of them a day, you know, and maybe it’s the combination of that and peanut brittle, you know, that does the job. But I just feel terrific. The — (Laughter and applause) We passed one time on the chance to buy an extraordinarily profitable company, because Charlie and I met the people that ran it. And they were perfectly decent people, too. And we went down in the lobby of the hotel that we met them in, and we just decided that in the end we didn’t want to be involved in that. On the other hand, I would have bought stock, as a publicly traded stock, in the same company. Charlie will give you his view on that later. So, I do not have a problem buying stock in companies — marketable securities — the bonds of companies in the market — that engage in activities that I wouldn’t probably endorse myself. I would have trouble owning outright, and actually directing the activities, of some of those companies.

But, you know, the — any major retailer in this country is — virtually — is going to be selling cigarettes, for example. And if they’re not declared illegal, it does not bother me to own — it would not bother me to own those retailers outright — or it does not bother me to own the stock.

CHARLIE MUNGER: Yeah, but you wouldn’t buy a company that made the tobacco and concocted the advertisements.

WARREN BUFFETT: No, we — and, you know, I can’t tell you perfectly why that, I mean, I can’t tell you that’s the perfect line, or I can’t tell you precisely why that’s where I draw it. But I will tell you that is where I draw it. We would not be in the manufacture of it, but I — we owned stock at one time in R.J. Reynolds. Before it had the LBO, we owned bonds in it. And, you know, I would still be doing it if I liked either the bonds or the stock. We would not buy the manufacturer. And like I say, we walked on one that — and we went down to the hotel to talk about it though, too. (Laughs) So we’d have to say that we were thinking about it, but we decided not to do it. Charlie?

CHARLIE MUNGER: We didn’t think very long. The — (Laughter) We don’t claim to have some kind of perfect morals. You can draw these lines where you wish. But at least we’ve got a huge area of things which is perfectly legal to do, that we think beneath us. So we won’t do them. And we see more and more in America, a culture where just anything that’s unlikely to send you to prison, which looks like it’ll make money, is OK. And that is a very bad development.

WARREN BUFFETT: Yeah, but I think it’s a little crazy myself — (applause) — to say that it’s terrible if people eat hamburgers, or eat — or drink Coca-Cola, or eat candy, or anything like that, because they’re likely to gain weight. That is a perfectly optional decision. And who knows whether somebody has lived a happier life, that lives to 75, and they’re overweight condition causes them to die a little sooner than if they lived to 85 and lived on carrots and broccoli, you know, has lived a better life. I know which one I prefer. (Laughter)

11. Give Buffett a salary bump for his retirement

WARREN BUFFETT: OK, number 9, please.

AUDIENCE MEMBER: Hi, Mr. Buffett. I’m Allan Maxwell. My wife and I are shareholders from Omaha. I’m going to keep things simple so you can understand them.

WARREN BUFFETT: Good. (Laughter) Allan’s a friend of mine, so he can get away with that.

AUDIENCE MEMBER: Thank you, Colonel. Excluding the Buffett’s stake, I’m going to combine A and B shares. And there are approximately 1 million A shares outstanding, correct?

WARREN BUFFETT: That’d be about right, uh-huh .

AUDIENCE MEMBER: OK, about. Your salary is approximately — or is — $100,000 a year.

WARREN BUFFETT: It’s been stuck there for a while. We’ll talk about the board. (Laughter)

AUDIENCE MEMBER: Well, you’ll be happy with my question.

WARREN BUFFETT: You can make it a motion —

AUDIENCE MEMBER: In other words —

WARREN BUFFETT: — if you’re heading where I think you are. (Laughter)

AUDIENCE MEMBER: In other words, we’re paying you 10 cents a share to manage a $90,000 investment. That’s remarkable in today’s corporate culture. Thank you, Mr. Buffett, thank you. (Applause)

WARREN BUFFETT: Yeah, thanks. Allan, thank you. But I have to tell you, as I did last year, I would pay to have this job. I mean, it doesn’t get any better than this.

AUDIENCE MEMBER: Well, rather than you doing something for us, I would like to suggest that we, the shareholders, do something for you. As a shareholder, I would be willing to pay you 25 cents an A share. (Laughter) That way you could save a little extra money for your retirement. (Laughter) Would you support such an idea?

WARREN BUFFETT: Allan, I’m getting Social Security now. (Laughter) And that really pretty well takes care of things. My family would go crazy if I made any more money. (Laughter)

AUDIENCE MEMBER: This would help you —

WARREN BUFFETT: But I appreciate the offer, however.

AUDIENCE MEMBER: My heart’s with you, thank you.

WARREN BUFFETT: OK, thanks, Allan. (Applause)

12. Why Berkshire’s insurance companies never have layoffs

WARREN BUFFETT: Let’s go to number 10, and see if we can get 50 cents. (Laughter)

AUDIENCE MEMBER: How about a dollar? (Laughter) David Winters, Mountain Lakes, New Jersey. Thank you, Warren and Charlie, for a fabulous weekend and for the discussion about governance in the mutual fund industry in the shareholder letter. Specifically, have you altered the compensation potential for the insurance underwriters to make sure, as Charlie has described, the incentive-caused bias creates an environment that encourages writing new policies that, when the tide goes out again in the property and casualty business, Berkshire Hathaway minimizes losses, maximizes float, while compensating underwriters for not writing business?

WARREN BUFFETT: Well, thank you, that feeds into an interesting set of slides I’ve got, if I can find them here to tell the projector what to put up, because that’s a very important point you raise. I mean, we are very big in insurance, and having the wrong incentives in place could be very harmful. So let’s put up a couple of slides. Let’s put up slide number one, if we would, please. Slide number one is the situation at Berkshire, and Shirley, I’ll give you one of these, but that’s the situation at Berkshire shortly before we bought National Indemnity. There’s our balance sheet there. And as you’ll notice, we just had a few million dollars extra. We had about $20 million tied up in the textile business. And then I heard that Jack Ringwalt wanted to sell his company. Some of you here in the audience know him. He — for 15 minutes every year, Jack would feel like selling his company. He would get mad at something or other.

And so my friend Charlie Heider knew Jack pretty well, and I’d said to Charlie, “Charlie, next time Jack is in heat, have him, you know, get him over here.” (Laughter) And so Jack, early in 1967, came by 11:30, 11:45 in the morning, and said he’d had it with insurance, and with the insurance regulators and everything, he’d like to sell. So we bought it. Now, we bought, that was the — made a major — that’s when we really embarked on what has happened subsequently. As you can see from that slide, the following year the textile business made all of $55,000. So sticking with textiles would not have been a great idea. We spent $8 1/2 million to buy National Indemnity. Now, on the next slide, slide two, you will see a record like has never been, I don’t think there’s another insurance company in the world that has a record like this. That’s the premium volume of National Indemnity’s traditional business.

And you will see a company that went from 79 million in that first year of premiums — if you go all the way back to the time we bought it — it was 16 million, but by 1980 we were up to 79 million. And you will see that in what was known as the “hard market” of the mid-’80s, we got up to 366 million. And then we took it down — not intentionally, but just because the business became less attractive — all the way from 366 million down to 55 million. And now the market became more attractive in the last few years, and it soared up to almost $600 million. I don’t think there’s a public company in America that would feel they could survive a record of volume going down like that, year after year after year after year. But that was the culture of National Indemnity. It was the culture started by Jack Ringwalt, and it was the culture all the way through several other managers, Phil Liesche, and Rolly [Roland] Miller, to Don Wurster, who has done a fabulous job. And we don’t worry about premium volume.

But if you’re not going to worry about premium volume, then you have to take a look at slide three. Because if the silent message had gone out to our employees that unless you write a lot of business, you’re going to lose your job, they would have written a lot of business. You could — National Indemnity can write a billion dollars’ worth of business in any month it wanted to, all it has to do is offer silly prices. If you offer a silly price, brokers will find you in the middle of the ocean at four in the morning. I mean, you cannot afford to do that. So what we have always told people in our insurance businesses generally, specifically at National Indemnity, is that if they write no business, their job is not in jeopardy. We cannot afford to have our unspoken message to employees, that you write business, or your job, or the guy sitting next to you’s, you know, may be lost. So when we bulged up to 366 million, we — employment went up modestly, and when we went all the way down, you’ll see it trickle downward, but that was all by attrition.

We never had a layoff during that period. Other people would have, but we didn’t. And now we’re going back up some, and we’ll go back down again at some time in the future. Now, if you go to the next slide, you’ll see that that created an expense ratio that went up dramatically, up as high as 41 percent in 1999, as volume shrunk back. And when we were writing a lot of business, our expense ratio was as low as 25.9. Now, some companies would feel that was intolerable, but what we feel is intolerable is writing bad business. And again, we can take an expense ratio that’s out of line, but we can’t afford to write bad business. For one thing, if you get a culture of writing bad business, it’s almost important to get rid of. So we would rather suffer of having too much overhead, than we would want to teach our employees that to retain their jobs, they needed to write any damn thing that came along, because that’s a very hard habit to get rid of once you get hooked on it.

Now, move on to slide number five, you will see what the result has been of that policy. And it’s been that we had a few years, bad years, in the early ’80s — that’s what led to that hard market. But even with a high expense ratio, you’ll see that we made money underwriting in virtually every year. You’ll see the year 2001 at 108.4, but that will, in my view, that will come down. I think that will turn out to be quite a good year. These are the — that year is not fully developed yet. Now, you’ll see in 1980 — in ’86 — we had this incredible year, when we wrote at 69.3, that’s a 30 percent underwriting margin. And the nice thing about it is, we did it with the most volume we ever had to that point, 366 million. So we coined money when we wrote huge amounts of business, and we made a little money when we wrote small amounts of business.

So it’s absolutely imperative in our view, and I think we’re almost the only insurance company like this — certainly public — in the world that sends the absolutely unequivocal message to the people that are associated with us, that they will never be laid off because of lack of volume, and therefore, we don’t want them to write one bit of bad business. And we’ll make mistakes, and we’ll have a high expense ratio when business is slow, but we’ll win the game. And that’s what National Indemnity has done over a period of time. National Indemnity was a no-name company 30 years ago operating through a general agency system which everybody said was obsolete. It had no patents, no real estate, no copyrights, no nothing, that distinguished it, essentially, from other insurance — dozens of other insurance companies could do the same thing. But they have a record almost like no one else’s because they had discipline. You know, they really knew what they were about. And they’ve stayed with that. In fact they’ve intensified it over time. And their record has left, you know, other people in the dust.

It wouldn’t be a record you would point to Wall Street, you know, if you went to Wall Street with that record alone in 1990 or 1995, they’d say, “What’s wrong with you?” But the answer’s nothing’s wrong with it. And you put your finger on having the incentives in place to write the right kind of business for the shareholders at Berkshire. And we try to think those things through. I mean, you can’t run a — you can’t run an auto company without having layoffs. You know, you can’t run a steel company that’s this way. But this is the right way to run an insurance company. And that’s why these cookie-cutter approaches to employment practices, or bonuses, and all that are nonsense. You have to think through the situation that faces you in a given industry with its given competitive conditions, and its own economic characteristics. Charlie, you want to comment on that?

CHARLIE MUNGER: Well, the main thing is that practically nobody else does it. And yet to me it’s obvious it’s the way to go. There’s a lot in Berkshire that is like that. It’s just a little different from the way other people do it, partly the luxury of having a controlling shareholder of strong opinions. That accounts for this. It would be hard for a committee, including a lot of employees, to come up with these decisions.

13. “PetroChina was both cheaper and had less risk”

WARREN BUFFETT: We go to number 11. (Applause)

AUDIENCE MEMBER: Good afternoon, my name is Andy Peake, and I’m from Weston, Connecticut. As a keen China watcher, I was very interested in your PetroChina investment. Could you please tell us more about your thought process on investing in a complicated, opaque country like China, and PetroChina?

WARREN BUFFETT: Yeah, PetroChina itself is not a complicated or opaque company. You know, the country, you know, has obviously, different characteristics in many respects than the United States. But the company is very similar to big oil companies in the world. I — and I — PetroChina may have been the fourth largest — fourth most profitable — oil company in the world last year. I may be wrong on that. But they produce 80 or 85 percent as much crude daily as Exxon does, as I remember. And it’s a big, big company. And it’s not complicated. I mean, you know, obviously, a company with half a million employees, and all of that. But a big integrated oil company, it’s fairly easy to get your mind around the economic characteristics that will exist in the business. And in terms of being opaque, actually their annual report may well tell you more about that business, you know, than you will find from reading the reports of other oil giants.

And they do one thing that I particularly like, which other oil companies don’t, at least to my knowledge, is that they tell you they will pay out X percent, I think it’s 45 percent of their earnings, absent some change in policy. But I like the idea of knowing in a big enterprise like that that 45 percent of what they earn is going to come to Berkshire, and the remainder will be plowed back. It was bought not because it was in China, but it was bought simply because it was very, very cheap in relation to earnings, in relation to reserves, in relation to daily oil production, and relation to refining capacity. Whatever metric you wanted to use, it was far cheaper than Exxon, or BP, or Shell, or companies like that. Now, you can say it should be cheaper, because you don’t what’ll happen with it 90 percent owned by the government in China, and that’s obviously a factor that what — you stick in valuation. But I did not think that was a factor that accounted for the huge differential in the price at which it could be bought. And, you know, so far it looks OK on that basis.

We weren’t — we aren’t there because it’s China, but we’re not avoiding it because it’s China, either. We just — we stick in a fairly appropriate number. But if you read the annual report of PetroChina, I think that there’s no — you will have as good an understanding of the company as you would if you read the annual report of any of the other big oil majors. And then you would factor in your own thinking about whether there could be some huge disruption in Chinese-American relationships or something of the sort, where you would lose for reasons other than what happened in terms of world oil prices, and that sort of thing. But we’re happy with it. Charlie?

CHARLIE MUNGER: I’ve got nothing to add. If a thing is cheap enough, obviously you can afford a little more country risk, or regulatory risk, or whatever. This is not complicated.

WARREN BUFFETT: Yeah, you can — Yukos, as you know, is a very big Russian oil company. And in evaluating Russia versus China, in terms of country risk, you know, you can make your own judgments. But in our view, something like PetroChina was both cheaper and had less risk. But other people might see that differently.

14. Dubious asbestos claims are taking compensation from true victims

WARREN BUFFETT: We’ll go to number 12.

AUDIENCE MEMBER: Good afternoon, gentlemen. My name is Hugh Stephenson. I’m a shareholder from Atlanta, Georgia. This question is for both of you. If you would both comment on the subject of tort reform, specifically asbestos tort. And if you could construct an optimal solution, how would you construct it, balancing the interest of legitimate plaintiffs versus the attorneys, versus the opportunists?

WARREN BUFFETT: OK, Charlie’s the lawyer, so he’s going to get to answer this one.

CHARLIE MUNGER: As a matter of fact, that is an easy question. What’s happened in asbestos is that a given group of people get mesothelioma, that came — which is a terrible form of lung cancer that kills people — really only from asbestos. And those people got it from somebody’s asbestos. And that’s one group of claimants. Then there’s another group of claimants, and these are people who’ve smoked two packs a day of cigarettes most of their lives, and they’ve got one little spot here or there, in an elderly lung. And God knows what the spot is, but an enterprising lawyer can get an enterprising physician, who just happens to find that every damn spot in any lung must be asbestos-caused. And once you’ve got one expert witness whom you can bribe, in effect, to say that, you’ve got a claim that can be filed. And so you get millions of claims on behalf of people who have no symptoms, and who say that I’m worried about getting cancer from this spot that my attorney’s doctor says was caused as asbestos.

There isn’t enough in the companies that made the asbestos to pay off everybody. And what happens is that a huge percentage of the money does not go to the people that got the cancer, or another group of people who got terrible lung impairment that is obvious. But that’s another small group relative to these people who just have one little spot and are — and now say they are worried about getting cancer. And they can file those cases where they say they’re worried in some state, usually a southern state, where they’ve got a jury pool that just hates all big corporations. And so you’ve got an industry — and of course the lawyers who are representing the people that aren’t hurt are really stealing money from the people who are hurt. And the guy who gets mesothelioma doesn’t get as much as he should. And all these other people are getting money they’re not entitled to. It’s a bonkers system. But with federalism the way it is, there’s just no way to stop it. And the United States courts — United States Supreme Court — refused to enter it, and just grab hold and make a decision.

And so it just goes on, and on, and on, and the claims come in. I think the Manville Trust had more new claims come in last year than in any year in history.

WARREN BUFFETT: That’s correct.

CHARLIE MUNGER: And they have mined and sold asbestos for the last time, what 35 years ago, or —?

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: And it just never stops. The people who are trying to buy these people off, it’s like trying to douse a fire by pouring gasoline on it, because word processing machines can grind out these phony claims, and the doctors can ground up — grind out these phony opinions. And so, a huge proportion of all the money that’s available to pay people who’ve suffered from asbestos goes to lawyers, experts, doctors, contingent fees to the lawyers, defense lawyers. I think — is it something like 20, 25 percent of the money is flowing through to people who were injured? So it’s a total national disgrace. The only people who have the power to fix it would either be the Supreme Court of the United States or Congress. The Supreme Court — some people would say rightly, other people would say in too chicken a fashion — ducked the issue. That means the only party that has the power to fix it is Congress. And Congress so far, given the politics, has not fixed it. Once you get wrongdoers so rich, they get this enormous political power to prevent change in the laws that are enriching them.

I mean, it means that we should all be more vigilant about stepping on these wrongs when they’re small. Because when they get large, they’re very hard to stop. But it would be easy to fix this. The right way to fix it, we just are not going to pay off on these tiny claims.

WARREN BUFFETT: But Johns Manville — we own Johns Manville. They went bankrupt. They were the first, at least big one, that asbestos took into bankruptcy, and probably on the history of things, they somewhat deserved it, I think, Charlie. Isn’t that right?

CHARLIE MUNGER: Their behavior was among the worst in the history of American corporations.

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: They knew this stuff was causing terrible injury, and they deliberately covered it up, time after time, and year after year, to make more money. There’s no doubt about the guilt of the original management at Johns Manville.

WARREN BUFFETT: So they went bankrupt in the early ’80s, and out of that bankruptcy was formed something, as Charlie mentioned, called the Manville Personal Injury Trust. We’ve got — have no connection with that. I mean, this is a new company that we bought a few years ago, and this company has no connection with that except the historical — history. The — but the Manville Personal Injury Trust was established, and had over time — had a couple billion dollars in it. And as Charlie said, last year — it’s been around now for almost, I would say, close to 20 years — and last year they had a record number of claims introduced. They didn’t have a record number because of the incidents of asbestos compared to the ones that were prevailing at the time it was established, or something of the sort. It’s just that it’s become a honey pot. And as a result, the Mansville Personal Injury Trust is now paying out five percent because their 2 billion will only go so far. They’re paying five percent of claims.

So as Charlie says, the guy that’s got a — that has really been drastically injured by asbestos gets this tiny fraction, and the tens of thousands of claimants for whom it’s a gleam in the eye, or rather a gleam in their lawyer’s eye, perhaps, also get their five percent. And it’s, you know, it’s not the right way to do it, but it’s very hard to correct. We’ve observed the asbestos legislation over the — proposed legislation — over the last year. And in the end, what they came up with, we did not support because it didn’t get the answer that’s needed. And it was Charlie’s and, you know, my view that the Supreme Court, when they ducked it, I mean, they left open a can of worms which will be around for decades, and decades, and decades. And the right people will not get compensated.

CHARLIE MUNGER: And those of you who want to be cynical ought to look into it, and see the perjury. What’s happened, of course, is that all the really horrible people pretty well are broke and gone, and maybe there’s some money left in a trust here or there. But by and large, there isn’t enough money. But now, there’re, like, three solvent people left. And you’ve got some little spot, or something or other. And by a strange coincidence, every one of those people can only remember three names of products that —

WARREN BUFFETT: Might’ve caused it?

CHARLIE MUNGER: — somehow saw, that might’ve caused it. And it’s an amazing coincidence, the three that are left solvent are the only names he can remember. And so you — it’s obvious you have a vast amount of perjury being suborned by practicing lawyers. It’s not a pretty picture.

15. Dividends vs stock buybacks

WARREN BUFFETT: OK, let’s go to microphone 1.

AUDIENCE MEMBER: Hi, my name’s Charlie Rice, and I’m a stockholder in from St. Louis, Missouri. I’d appreciate hearing your comments on publicly-held companies using their cash for dividends versus stock buybacks?

WARREN BUFFETT: Well, we — the equation is pretty simple, but the practice doesn’t necessarily follow logic. The — It’s obviously — as long as you’re telling the truth to your shareholders about what’s going on so that you aren’t manipulating the stock downward or something — when a stock can be bought well below its business value, that probably is the best use of cash. It’s something The Washington Post did on a huge scale back in the 1970s. Teledyne may have bought 90 percent, or something, or close to it, of their stock back. And that was the reason a very significant percentage of companies bought stock back in the past, because they actually thought it was selling for less than it was worth. Like I say, that that can be abused if you do various things to bury your stock in one way or another, but that wasn’t the usual case. Stock repurchases were relatively unpopular in those days. They’ve become quite popular now.

And to the extent that I’ve been around a good number of them, and been able to pick up on what I thought was the underlying rationale, if not the professed rationale, you know, I think it’s often done for people that are hoping that it causes their stock price not to go down, and their — and often done at prices that don’t really make a lot of sense for continuing shareholders. If we wanted to return a bunch of cash to shareholders, we would — if our stock was undervalued — we would go to the shareholders, and say, “We think it’s cheap, and we think that this cash can be better used by you than by us. “And we will, therefore, have — be repurchasing at what we think is a discount intrinsic value.” And the people that remain will be better off, and the people that get out will get out at a little bit better price than they would otherwise. In terms of dividends, you get into an expectational situation. And for most companies that follow a — that pay a cash dividend — it doesn’t make sense to bounce around the dividend from year to year, although private companies frequently do that.

And we do it ourselves with our subsidiaries. They — some subsidiary can pay us a lot of money one year, and not so much money the next year. But with public companies, people do — a lot of people do buy stocks to obtain dividends, and they hope for regularity, and that there’s a signally aspect to it and everything. So I would say that once you establish a dividend policy with a public company, you should think a long time before you change that policy in a material way. But I think the best use of cash, if you don’t have a good use for it in the business, if the stock is underpriced, is to repurchase it. And if it’s overpriced, you got no business buying in a single share. But a lot of companies do it. Charlie?

CHARLIE MUNGER: Yeah, dividends are a very interesting subject. If you count the unnecessary stock trading, and the cost of investment advice, and the cost of making a lot of errors, and the trading costs in and out, I don’t think we’d be too extreme to say that now the total amount that’s paid out in dividends is roughly equal to the amount that is wasted in all this trading and investment advice. So that the net dividends that come to the shareholders are approximately zero. This is a very peculiar way to run a republic. And very few people comment about it.

WARREN BUFFETT: Yeah, actually I did in an article, some time ago in Fortune. The frictional costs to American shareholders in sort of changing chairs for all American business as a whole, those frictional costs, are probably not much different than the entire amount paid out by American corporations. So — but getting to the individual corporation level, a company that expects to regularly earn more than it can profitably employ in its business, should be paying out dividends. Take a subsidiary of ours like See’s Candy. We would love to expand See’s Candy to double or triple its present size, but it doesn’t work. We’ve tried it a lot of different ways. So it should be paying out its earnings. If it was a public company, and it was at one time, you know, you could argue that something approaching a 100 percent payout would make sense there. But most managements worrying about earnings falling off at some time in the future would rather establish a lower level, and therefore, ensure regularity of dividends by going with a conservative level. I — you know, we — It’s obviously something we think about at Berkshire when we have 30-odd billion dollars around.

If we can’t figure out a way to employ that over time, you know, it’s a mistake to keep it in corporate form. But we have this expectation, and I think it’s a reasonable expectation, that we get the — put it to work. If we ever came to a different conclusion, if our stock — we thought our stock was significantly undervalued, we’d probably figure in terms of disbursing it through repurchases, particularly where now dividends and capitals gains are neutral for individuals. And if our stock was not underpriced, and we fell, we would probably do something by a dividend. It’s not going to happen soon, however. (Laughs)

16. GEICO and Dell: the low cost is going to win

WARREN BUFFETT: Number 2.

AUDIENCE MEMBER: Good afternoon. My name is J.P., as in justice of peace, or Jell-O pudding. My last name is Tan, as in suntan. I flew in from the suntan city of Orlando, Florida where an elderly man told me, “J.P. Tan stands for just ‘perfect tan.’” Mr. Buffett, allow me to give you a big thank you before I ask my question. Some time ago I sent you my business analysis of your investment in Scott Fetzer Company. I was not sure if you even bothered to read it. Yet you were very kind to write me that my analysis of Scott Fetzer Company is very much on the money. You also invited me to my first annual meeting where I had the privilege of meeting Mr. Andrew Kilpatrick, who was kind enough to include my analysis of Scott Fetzer Company in his book, “Of Permanent Value: The Story of Warren Buffett.” I want to thank you for making this possible. Here comes my question. Mr.

Buffett, you have said that the nine most important words ever written about investing are these nine words: “Investment is most intelligent when it is most businesslike.” Mary Buffett said that you have built your entire business success upon these nine words. Investment is most intelligent when it is most businesslike. For this reason, I started businesslike.com, looking up to guide GEICO and Dell as direct marketing models, since they have the lowest cost structure. Please kindly share with us in elaborate details the direct marketing methods of GEICO and your friend, Michael Dell? (Laughter) WARREN BUFFETT (to Munger): What?

CHARLIE MUNGER: He wants you to analyze the marketing methods of GEICO — the directmarketing methods of GEICO — and Dell.

WARREN BUFFETT: Yeah, well, I’m not as familiar with Dell as I am with GEICO. The idea of direct marketing in auto insurance at GEICO came from Leo Goodwin, who — and his wife Lillian — who had come from USAA. And USAA was set up some years — and GEICO was set up in 1936 — USAA was set up, I believe, in the early ’20s, because military personnel moved around a lot, and they had trouble getting auto insurance. And a great organization was established. Leo Goodwin took that idea, and decided to broaden it beyond the officer ranks of the military. And first went to government employees generally, and now that’s been extended dramatically over the years to the American public as a whole. It’s a better system. You know, if you go back a hundred years, auto insurance when the auto first came in, was sold by the casualty affiliates of the big fire companies. That’s where — that — in the 1800s, the major insurance companies were fire companies, and casualty insurance was something that came along later.

And it was sold through a system whereby the agent got large commissions, where there was sort of cartel-like rates established through something called a “bureau.” And that system prevailed for several decades. And then State Farm came along, formed in the early 1920s. A farmer from Merna, Illinois in his 40s. No background in insurance, no capital, but he came in with the idea of having a captive insurance — agency force. And that brought down costs somewhat. And State Farm, in time, became the largest auto insurer in the country. And Allstate, which followed that system, became the second largest. And that was a better system, a better mouse trap. And then USAA, followed by Leo Goodwin at GEICO, came along what a direct-marketing operation that bypassed the agent and brought down costs further. Now, every American family, virtually, wants to have a car. They don’t want to have insurance, but they can’t drive their car without insurance. So they’re a buying a product they really don’t like very well. It cost them a significant part of their family budget. And cost, therefore, becomes very important.

It’s not a luxury item, it’s a mandatory item, virtually. And saving significant money makes a real difference in a lot of household budgets. So the low cost is going to win. And our direct operation — Progressive has a wonderful direct operation competing with us — we’re the two that will be slugging it out over the years — is a better system, and better systems win over time. Now, I — again, I’m not that familiar with Dell, but I have the impression that Dell is a very lowcost operation, enormously efficient. You know, very low amounts of inventory. And, you know, I would hate to compete with them. The — if they can — if they turn out a decent competitive product at the best price, you know, that system will win. You know, Charlie is a director of Costco, and Costco and Walmart figured out ways to do things at lesser costs that people needed — where people spent money in big quantity. And those two companies are winning. So, we have a terrific marketing operation, and a terrific insurance operation in GEICO. And in my view it will grow very, very substantially.

And we have a very tough competitor in Progressive, because they’ve seen how well our model works, and they, in effect, have shifted over. I mean, they’re not totally shifted over, but they’ve moved towards a direct operation, and away from an agency operation. It’s always a good idea to go with a low-cost producer over time. I mean, you could mess it up in other ways, but being a low-cost producer of something that’s essential to people, it’s going to be a very good business usually. Charlie?

CHARLIE MUNGER: Yeah, you’ve chosen a wonderful field. And if you fail in it, it’s your own fault. (Laughter)

WARREN BUFFETT: I should say also that that — those nine words, they came from Ben Graham, they didn’t come from me. But Ben said those, and they are very important words, although they tie in with some others that he said. But they are very important words.

CHARLIE MUNGER: Warren, I want make an apology, too, because last night I said that some of our modern business tycoons — and I remembered particularly Armand Hammer — were the type that, when they were talking, they were lying. And when they were quiet they were stealing. (Laughter) And some people got the impression that that was my witticism. That was said a great many decades ago about one of the robber barons.

WARREN BUFFETT: Well, if we start confessing here to the number of quotations we’ve stolen, we’ll be here all afternoon. (Laughter)

17. Praise for Google’s co-founders and their owner’s manual

WARREN BUFFETT: So let’s go on to microphone 3.

AUDIENCE MEMBER: Good afternoon. My name is Matt Lynch, and I’m from Palo Alto, California. Mr. Buffett, a couple of times today you alluded to Google and its co-founders. I was hoping you could share with us your thoughts and reactions to the owner’s manual the co-founders included in Google’s S-1 filed last week, especially in light of the similarities and differences between it and that of Berkshire Hathaway?

WARREN BUFFETT: Well, that’s a real softball for me. The obviously —

AUDIENCE MEMBER: You’re welcome.

WARREN BUFFETT: I’m very pleased that the Google — the fellows at Google decided — and they say they, it was, I think they used the word “inspired” by the Berkshire Owner’s Manual. And, you know, it obviously pleases us enormously that other people think that it’s a good idea to talk to their owners — or in their case, their prospective owners — in a very straight-forward manner. If you buy into Google, having read their owner’s manual, you know, you will — I think you’ll know the kind of people you’re associating with. You’ll know what they will do and won’t do. It’s the kind of thing that one person would say to another if you were setting up a partnership. And were — you said, you know, “I’d like you to join me in a partnership. I need your money. And here’s the way we’re going to do business.” And I think more companies — obviously, I think more companies ought to do it. It’s been simple for us at Berkshire.

We’ve had these principles in mind for a long time. And we really want people to understand those principles before they join with us. And the Google fellows, in a very straightforward manner, you know, I liked their prose. You know, it doesn’t mean I agree with every idea they have, but, you know, I do know what ideas they do have. And I hope more companies sign on for that sort of thing. Charlie?

CHARLIE MUNGER: Well, you know, most of the world does not, in any way, imitate Berkshire Hathaway. This is a quirky few. It may look — there may be 19,500 of you that came — but it’s still a quirky few by the standards of the country. And what’s interesting about Google is those two guys who created that are two of the smartest young men in the whole country. And it’s much more fun to be copied by people that smart, than — (Laughter)

WARREN BUFFETT: Hey, we even think they are smarter than we thought they were last week. (Laughter)

CHARLIE MUNGER: And we now think they’re a lot smarter, yeah. (Laughter)

WARREN BUFFETT: It’s going to be a lot of fun to watch that. I — and my guess is that their annual reports are going to make very good reading. They’re actually going to alternate the two of them in writing the reports. And I think you’ll know a lot about them, and a lot about their business if you read it. Although they had an interesting — as I remember, they had an interesting sentence of two in there, which I admired also, where they said that, you know, certain of the things that might affect their business prospects really would be better left unsaid, in terms of competition, and so on. And if so, they weren’t going to tell you. (Laughter)

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: I kind of enjoyed that.

18. Buffett doesn’t see big changes for how homes are sold

WARREN BUFFETT: Number 4, please.

AUDIENCE MEMBER: Thanks, Warren, thanks. My question — my name is Chad Bliss (PH), Lincoln, Nebraska. My question pertains to MidAmerican Energy and the Home Service division. You said earlier that you would continue buying, you know, companies in the real estate industry. Given the growth in “for sale by owners,” discount brokers, also maybe even banks now, do you think the current business model of home services is sustainable, or do you think commissions need to be lowered?

WARREN BUFFETT: Yeah, I really do think it’s sustainable. It’s a good question. In fact, I forget where I saw the article a few weeks ago, maybe in the Sunday New York Times, about Barry Diller’s interest, I think through Lending Tree, on the internet. And there’ve been a lot of real estate sales-related operations that have been on the internet. And the internet is a threat to any business, including real estate brokerage. But, you know, when I think about the process of buying a home, and the degree of personal involvement involved in that, you know, the “for sale by owner.” They call them FSBOs in the business. I remember talking with my friend, Chuck Peterson about that 50 years ago, and FSBOs were with us then, and FSBOs are with us now. But my guess is that a very significant percentage of home transactions 30 years from now will be done through a pipeline, and through a distribution mechanism, or brokerage mechanism, like exists now. I do not see it changing dramatically, although there are people that are going to try and change it dramatically.

So you’ve got competitors. But I love the idea of expanding Home Services. Charlie?

CHARLIE MUNGER: Well, you tried to change it once yourself dramatically, right here in Omaha, and you fell on your ass. (Laughter) He tried to —

WARREN BUFFETT: His memory’s better than mine.

CHARLIE MUNGER: He tried to take away the — a good part of the home advertising business from the World-Herald to, you know, your then-little newspaper —

WARREN BUFFETT: Oh, right, it was very thin, yeah. (Laughs)

CHARLIE MUNGER: Yeah, yeah. And it didn’t work worth a damn.

WARREN BUFFETT: Yeah. (Laughter) And that’s the last time I call on him. The — (Laughter)

19. Remembering Phil Fisher

WARREN BUFFETT: Let’s go to number 5.

AUDIENCE MEMBER: Mr. Buffett, Mr. Munger, I’m Tim Medley from Jackson, Mississippi. Recently Mr. Philip Fisher died. At this meeting many years ago, you, Mr. Buffett, mentioned your fondness for chapters 8 and 20 of “The Intelligent Investor,” the first edition of “Security Analysis,” and you said, “Phil Fisher’s first two books.” And you Mr. Munger, have also been complimentary of Mr. Fisher’s writings and investment approach. I wonder if the two of you would tell us of your experiences with Mr. Fisher, the circumstances of your meeting, et cetera. And did his writings, or your discussions with him, start you thinking about the idea of the great business, or the franchise company, or was it simply an affirmation of thoughts which you had already begun to have? And anything else you would like to say about Mr. Fisher.

WARREN BUFFETT: Yeah, Phil Fisher was a great man. He died maybe a month ago, or thereabouts, and well into his 90s. His first book, and I believe it was “Common Stocks and Uncommon Profits,” it was written in 1958. And the second book was written a few years later, those two books were terrific books. And as with Ben Graham, you could really get it all by reading the books. I met Phil Fisher just once, and it was great. I enjoyed it, I loved it. He was nice to me. But similarly, actually, to my experiences with Ben Graham, I worked for him, I took his class and everything else — it was in the books. I mean, they were such good writers, and their thoughts were so clear, that you didn’t need to meet them personally. I enjoyed meeting them personally, obviously. But they got it across in words. And the only time I met Phil was some time after that 1962 book, or whatever it was, ’61 or ’62. And I was in San Francisco, I think it was in the Russ Building, I may be wrong on that. And I just went there.

I used to do that all the time when I was younger. I’d go to New York, and I’d just drop in on all kinds of people. And I guess they thought because I was from Omaha that, you know, one time and they’d be rid of me. So — (Laughs) And I would usually get in to see them. And Phil — I did that with Phil. And he was extraordinarily nice to me. But it wasn’t that I gained new ideas though, however, by meeting him, because I’d already read it in his books. And Charlie actually, I met Charlie in 1959, and Charlie was sort of preaching the Fisher doctrine, also, to me. Little different form, but his ideas paralleled those of Phil. So I was sort of getting it from both sides. It made a lot of sense to me. I don’t know what Charlie’s experiences were with Phil.

CHARLIE MUNGER: Well, I always like it when somebody who’s attractive to me, agrees with me. And therefore, I’ve got very fond memories of Phil Fisher. The basic idea of that it was hard to find good stocks, and it was hard to find good investments, and that you wanted to be in good investments. And therefore, you just find a few of them that you knew a lot about, and concentrate on those, it seemed to me such an obviously good idea. And indeed, it’s proved to be an obviously good idea. Yet, 98 percent of the investing world doesn’t follow it. That’s been good for us. It’s been good for you.

20. “No single yardstick” for compensation and incentive systems

WARREN BUFFETT: We’ll go to number 6, please.

AUDIENCE MEMBER: Good afternoon, my name is Stan Leopard, and I’m from Menlo Park, California. I’m very pleased to be here, Warren and Charlie. I first heard about you, Warren, in the late ’80s, and began reading your writings. Unfortunately I didn’t invest until the late ’90s. You have shaped my business thinking, and as I listen to you, and as I continue to read what you write, and the things you recommend to read, it continues to shape my thinking. My question’s about compensation. And I’ve seen your writing, and I heard the earlier comments today. And they still leave me, as a guy who is a business owner, not quite sure how to act to design compensation for managers. For most of my career, I’ve been the senior manager in my businesses, but now I’m in a situation where I’m looking to own a majority interest of businesses that I don’t manage every day directly, and I’m very concerned with this compensation issue.

When I think about things, like, return on equity, or growth, or risk, or like that, but if you could speak a little more towards the specific of how you approach the getting it to the right things to measure and incent, I’d appreciate that.

WARREN BUFFETT: Yeah. It’s a very good question, and it’s — you know, there is no formula that applies across all industries or businesses. You take something like return on equity. You know, if you pay way too much for the business that you buy, the person who runs it is going to get a lousy return on your equity. And they may get a good return on the tangible assets employed in the business, but your purchase price may defeat them, in terms of earning good returns. If you base the — on earnings on tangible equity, you know, there are businesses like a network television station where, you know, if you have an idiot nephew, you can put him in charge, and they’ll earn huge returns on equity as long as they manage to stay away from the office. So it’s — And there are other businesses where you have to be a genius to earn 7 or 8 percent returns on equities. So there is no single yardstick. To have a fair compensation system, both you and the manager have to really understand the economics of the business. In some businesses, the amount of capital employed is allimportant.

In some businesses, the amount of capital employed doesn’t mean anything. So we have certain businesses where we have charges for capital and all of that, and where we have other businesses where that would just be an exercise to go through, and it wouldn’t really change any results, anyway. We have a great preference for making them simple. I mean, we concentrate on the variables that count to us, and then we try to put that against the backdrop of the competitive nature, or the economic — the true economics — of the business they’re in, and really reward where they’re adding value, even if that value is from a very low base in a lousy business. And we make it — the base — very high if they’re in a very easy business. And it hasn’t been a problem. But I would say it would’ve been an enormous problem if we’d brought in some compensation consultants, because they would have wanted something that would spread across the whole group, and it would have had all kinds of variables.

And they particularly would’ve wanted something that would’ve to come in every year and redo in some way, so that they would have a continuing stream of income. You know, if I knew what kind of a business you were looking at it, it’s easier to talk about what kind of a system to have. If you had a group of television stations, just to pick an example — let’s say they were network television stations, all of a reasonable size. You know, you would probably figure that a chimpanzee could run the place, and have 35 percent pretax margins. And you might want to pay for performance above some number like that. But there’s — it’s silly to have something that starts at 10 percent or 15 percent, when you do that. And a lousy manager will always suggest an arrangement like that. Charlie and I have seen all kinds of compensation arrangements where, basically, you get paid for showing up. But they try to make it look, by constructing some mathematics around it, like, you really had to achieve something. But in the end, if you get a great manager, you want to pay him very well.

You know, we’ve got great managers, for example, at a place like MidAmerican. And somebody mentioned that there’s a big carrot out there for them if they achieve the results that we’ve set out. And that’ll be a check I’ll be very happy to write. Charlie?

CHARLIE MUNGER: Yeah, if you want to read one book that will demonstrate really shrewd compensation systems in a whole chain of small businesses, read the autobiography of Les Schwab, who had a bunch of tire shops — has a bunch of tire shops — all over the Northwest. And he made a huge fortune in one of the world’s really difficult businesses by having shrewd systems. And he can tell you a lot better than we can.

WARREN BUFFETT: Yeah, and he worked that out himself. I mean, it’s an interesting book, and, you know, selling tires, how do you make any money doing that? And —

CHARLIE MUNGER: Hundreds of millions selling tires.

WARREN BUFFETT: Yeah, yeah. It’s a — and people like Sam Walton. I mean, the compensation system, I will guarantee you, at Walmart, or Charlie’s involved in Costco, they’re going to be rational because you had very rational people running them. And they wanted to get the best — they wanted to attract good managers, and they wanted to get the best out of them. And they had no use in paying for mediocrity. But that does require a knowledge of the business. I mean, you don’t want to let — if you don’t understand a business, you know, you’re going to have a problem with both the manager and the consultant in terms of getting film-flamed on how you pay people.

21. Easier to find bargains among stocks than IPOs

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: Good day. My name is Martin Krawitz. I’m a shareholder from Sydney, Australia. (Applause) And thank you so much for some of your wonderful hospitality here. We’ve had a chance to get on some of Omaha’s 65 golf courses, and it’s just great being in the second-best country in the world. (Laughter) My question to you, sir, is regarding two IPOs. We had one of the authors about a book on yourself visit us in Sydney last year, and apparently you dislike IPOs. My question is, there are some really poor businesses that try and get passed off, but there are some good ones. There’s some government privatizations, or decentralizations, the demographics of baby boomers, and we have some friends wanted to exit some really good businesses. Could we as investors, and Berkshire Hathaway, not apply some of your disciplines to look at investing in some of these? And finally, would your answer be different in its applicability to Berkshire Hathaway as a company, as opposed to us as investors? Thank you, sir.

WARREN BUFFETT: Charlie?

CHARLIE MUNGER: Well, the first question, is it entirely possible that you could use our mental models to find good things to buy among IPOs, the answer is sure. There are a zillion IPOs every year. And buried in those IPOs, I’m sure there are a few cinches that a really intelligent person could find and pounce on. So, welcome. On the — But the average person buying IPOs is going to get creamed. So if you’re talented enough, why sure, that will work. The second question, I forget.

WARREN BUFFETT: About the government offering (inaudible).

CHARLIE MUNGER: About government spin-offs?

WARREN BUFFETT: Give him the spotlight again. There he is.

CHARLIE MUNGER: What was the second question?

AUDIENCE MEMBER: It was just would the attitude of Berkshire Hathaway be different if it was opposed to investors?

WARREN BUFFETT: Oh.

AUDIENCE MEMBER: Thank you.

CHARLIE MUNGER: Yeah, because the IPOs are normally small enough, so that they won’t work for us, or they’re high tech, where we couldn’t understand them. And so, by and large, if Warren is looking at them, why, I don’t know about it. (Laughter)

WARREN BUFFETT: Yeah, I mentioned earlier how you — an auction market, prevailing in the stock market, will offer up extraordinary bargains sometimes, because somebody will sell a half a percent, or one percent of a company at a price that may be a quarter of what it’s worth, whereas in negotiated deals, you don’t get that. An IPO situation more closely approximates a negotiated deal. I mean, the seller decides when to come to market in most cases. And they don’t pick a time necessarily that’s good for you. So, it has — I think it’s way less likely that, in scanning a list of a hundred securities that are trading in the auction market, well, in the — a hundred IPOs, if you scan a hundred IPOs, you’re going to come up with something cheaper than scanning a hundred companies that are already trading in the auction market. It is more of a negotiated sale. And negotiated transactions are very hard to get bargains.

If you take the houses in Omaha, you know, somebody that lives next door to somebody who sold their house for 80,000 or — dollars, and their house is more or less comparable, they’re not going to sell it for 50. It just doesn’t happen. People are — it’s too important an asset, and they’re cognizant of what it brings — what is being brought for similar properties. That’s what happens in negotiated sales. Now if, on the other hand, there were some — a whole bunch of entities that owned one percent of each house in Omaha, and you had an auction market on those one percentage points, they might sell at damn near anything. And occasionally, they sell at crazy prices. So you’re way — in my view — you’re way more likely to get incredible bargains in the — in an auction market. It’s just the nature of things. And the IPO is closer — sometimes there will be IPOs in terrible markets, and they may come very cheap. But by and large, that is not when IPOs come. They come when the seller thinks that the market is ready for them.

And they come with an informed seller thinking it’s a pretty good time to go public. And, you know, you’ll make better buys, in my view, in an auction market.

22. Buffett and Munger don’t shop at Whole Foods

WARREN BUFFETT: Number 8.

AUDIENCE MEMBER: Good afternoon Mr. Buffett, Mr. Munger. My name is Mark Stender (PH) from San Francisco. My question involves, if you live in California, which I understand you do some time of the year, it’s almost mandatory that you shop at Whole Foods Markets. They sell a lot of organic foods there. And I was wondering if anyone ever tried to feed you organic food, or organic food stock?

WARREN BUFFETT: I’ve never been near the place, but — (laughter) — Charlie, who I’ve never thought of as a health nut, but he may have some comment to make on this, being a Californian.

CHARLIE MUNGER: No, my idea of a good place to shop is Costco. (Laughter) Costco has these heavily marbled filet steaks in the — (laughter) — finest grade. And the idea of eating a little whole grain whatever and washing it down with some carrot juice has just never appealed to me. (Laughter)

WARREN BUFFETT: We don’t have a lot of arguments between the two of us about where to eat. (Laughter)

23. American business “has never let investors down”

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: Hello, thank you. I’m Sherman Silber from St. Louis. I’m a fertility doctor in St. Louis. We kind of view ourselves as the Berkshire Hathaway of infertility treatment. We don’t know anything, really, about business. We’re doctors and scientists. And so, first I’d just like to say, I really appreciate the people that you have on your board, and would like to keep it that way. Because we do know a lot about character, and I’m happy to have our savings safe with you and the people of character that represent the company. (Applause) I just had an opportunity a couple of weeks ago, I was talking to one of the former managers of the Fidelity Magellan Fund, managed huge amounts of money, and he never really met you. And I was saying, I may have a chance to ask Warren Buffett and Charlie Munger a question. What would that question be? I wanted to have some idea of something intelligent I could ask business-wise.

And he thought if he had the opportunity to talk to you, the best thing is to give you what would sound like a softball question, because you could maybe bring more profoundness to this than we hear, usually. What — In view of the Iraq war, consumer debt that’s increasing, declining job growth, declining pay in the jobs that are growing, prospects of increased interest rates, he has this view that the next five to 10 years are going to be very difficult. What would your view be about this — the investment future — for the next five to 10 years, in view of all these negative factors going on?

CHARLIE MUNGER: That’s too soft for me. I think Warren should take that. (Laughter)

WARREN BUFFETT: Well, I would say that at any given point in history, including when stocks were their cheapest, you could find an equally impressive number of negative factors. I mean, you can — you could’ve sat down in 1974 when stocks were screaming bargains, and you could’ve written down all kinds of things that would’ve caused you to say, you know, the future is just going to be terrible. And similarly, at the top, you know, or anytime, you can write down a large list of things that would be quite on the bullish side. We don’t pay — we really don’t pay any attention to that sort of thing. I mean, we have — You might say that our underlying premise — and I think it’s a pretty sound underlying premise — is that this country will do very well, and in particularly, it will do well for business. Business has done very well. You know, the Dow went from 66 to 10,000-plus in the hundred years of the 20th century. And we had two world wars, and nuclear bombs, and flu epidemics, and you name it, Cold War.

There’s always — there are always — there’s always problems in the future, there are always opportunities in the future. And in this country the opportunities have won out over the problems over time. And I think they will continue to do so, absent weapons of mass destruction, which is another question. And business won’t make much difference if anything really drastic happens along that line. So we don’t — I don’t — I can’t remember any discussions Charlie and I have had, ever, going back to 1959, that where we would’ve come to the conclusion at the end of them that we would’ve passed on a great business opportunity — a business to buy — because of external conditions. Nor did we ever buy anything that we thought was mediocre simply because we thought the world was going to be wonderful. The — It won’t be the American economy, in my view, that does in investors over a five, or 10, or 20year period. It will be the investors themselves. If you look at the record of the 20th century, you’d say how can anybody have missed, you know, in owning equities during that time?

And yet, you know, we had all kinds of people wiped out, you know, in the ’29-’32 period. We had all kinds of things that were bad. But if you had just owned stocks right straight through, didn’t leverage them, you know, you would — you’d have gotten a perfectly decent return. So we are unaffected, in essence, by the variables you mentioned. Just show us a good business tomorrow, and we’ll jump at the hook. Charlie?

CHARLIE MUNGER: Yeah, I think, but it’s also true that both of us have said at various times over the last three years that we wouldn’t be at all surprised if professionally invested money in America had a pretty modest result over a fairly extended period in the future, compared to the very dramatically high returns that it had achieved up to about three years ago. And so far that’s been proved out to be pretty much right.

WARREN BUFFETT: Yeah, our —

CHARLIE MUNGER: Certain stretches are easier than other stretches.

WARREN BUFFETT: Yeah, our expectations were more modest than most people’s a few years ago. We didn’t say the world was coming to an end or anything. We just said that people have gone crazy in certain sectors. And that anybody that thought that you could, you know, sit at home and day trade, and make double-digit returns over time, or do anything, or that you were entitled to that, you know, by just sticking a little money in your 401(k) or something, was really living in a fool’s paradise. But that was never accompanied by any predictions of disaster for the American economy as a whole, or for American business as a whole. It’s — People get crazy notions from time to time in financial markets. I commented on this earlier, but they just believe things that there’s — it’s hard to understand how they can believe. Now, to some extent they get sold that by other people. But American business, really, has never let investors down as a group, but investors have done themselves in quite frequently.

24. “Demented” derivatives aren’t like insurance

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: Sam Kidston, from Cambridge, Massachusetts. I’d like you to ask to discuss the similars and differences between what you do in your reinsurance operations, and what Gen Re did in its securities division, as it would seem that reinsurance is often a form of weather derivative. I would also like to ask you, why you are so comfortable writing what appears to be one type of derivative, and so uncomfortable writing another? Thank you.

WARREN BUFFETT: Yeah, the derivatives contracts that Gen Re wrote in Gen Re Securities, I would say bore very little relation to the insurance businesses we see. I mean, we are insuring against events that people either can’t or aren’t willing to take on the risk themselves. In the derivatives business, a lot of that was speculative activity of one sort or another. The more complex the arrangements were, the easier it was to claim that large profits were being made, when maybe large losses really awaited you over time. They were created transactions without much economic necessity. In a great many cases, they were just facilitating speculation. Insurance deals with taking on risks that people incur in their business or personal life, that they don’t want to bear themselves, or that they’re unable to bear themselves. There was very little connection between the business. I think that in going into the business, they dreamt up a lot of reasons for it. You know, they said they’re both in the risk business, and their clients were going to demand it and everything. But when people want to go into a business, they always dream up reasons. In our view, it made no sense whatsoever.

And I really see very little connection between them. Do you, Charlie?

CHARLIE MUNGER: They’re radically different. The derivatives business is chock full of clauses saying that if one party’s credit gets downgraded by a rating agency, they have to start posting collateral. And that’s just like a margin account. And when you sign pieces of paper like that, you can go absolutely broke, into default and catastrophe, and having other people liquidating your positions under distress conditions, et cetera, et cetera. So there’s a lot of irresponsible mechanics. In attempting to protect themselves, they’ve introduced this enormous instability into the system, through all these clauses about collateral posting. And nobody seems to recognize what a disaster of a system they’ve created in an attempt to make each party feel safer. It’s a demented system. And you don’t get properly paid in most cases for playing the game. And therefore, we’re not in it.

WARREN BUFFETT: Absent the ability to raise new capital at the time, and who knows whether that would’ve been — they’d been able to or not — Gen Re, which had been rated triple-A — it still is because Berkshire’s involved — but it had been rated triple-A — could well have run into really terrible financial difficulty post-September 11th, particularly if they’d fully recognized the liabilities that they’d already incurred, but not fully recognized, at that time. Because their capital would’ve shrunk, they would’ve had way more in equities, which would have shrunk further. And who knows how far, you know, at the time, how far it would have gone? Plus they would have had, in my view, they would have been downgraded quite significantly, and that might well have triggered things in their derivatives activities, which would have required coming up with loads of cash. It was not built to last. And it is now built to last. But I would say that that threat exists with other financial institutions as well.

But I think many of the CEOs — or some of them anyway, I should say — don’t really fully comprehend that. When you get margin calls for huge amounts of money, you know, it only has to be one day when you can’t meet it. That almost happened. If you go back to October of 1987, there was a large wire transfer that didn’t make it to the — for a while — it didn’t make it to the clearing house at the — in Chicago. And that came close to halting the whole system at the time, and we were very close to closing the exchange. And a lot of things would have unraveled. The money finally showed up. But it’s dangerous to have a system where people are depending on billions of dollars coming in from other people. Well, we had that on Salomon, on that Sunday in 1991. If Salomon had gone bankrupt, the next day you would have had people on the other side of 1.2 trillion of notional amount of — something like that — of derivatives, who would have had a contract with a party where they would have been dealing with a bankruptcy court.

You would have had all kinds of security settlements that wouldn’t necessarily have settled. You would have all kinds of confusion. And believe me, it would have been huge at that time, between what was going on in Japan, what was going on in the U.K., and what was going on in the United States, because the accounts were all intermingled. As a matter of fact, Salomon was a — was banking — was running a bank in Germany where — which took on large amounts of deposits from individuals, and just loaned it all to Salomon. So it would have had a receivable from a bankrupt company and owed money to I don’t know how many German depositors. There are all kinds of things that would have come out at that time. And who knows what the effect would be on the system? You don’t need to put more and more of those kind of linkages and strains on an economic system that already is pretty damn leveraged. Charlie, got any further thoughts? We love talking about disasters, so don’t stop us. (Laughs)

25. Salomon and Robert Maxwell, “The Bouncing Czech”

CHARLIE MUNGER: It’s simply amazing what goes in these seemingly rational places. Salomon was at least as disciplined, and honorable, and rational as the other leading investment banks. And yet, toward the end of our pleasant period, Salomon was begging for new investment banking business from [Robert] Maxwell. And his nickname was “The Bouncing Czech.” (Laughter) Now, and of course it wasn’t very much after that that he committed suicide after massive embezzlements of pension funds, and a huge collapse. Now, you’d think if a guy’s nickname was “The Bouncing Czech,” you wouldn’t be madly seeking his investment banking business. But all the leading investment banks were.

WARREN BUFFETT: Yeah, I’m fuzzy it on now, but actually the morning, or the day he was discovered to be bobbing around in the ocean, the — I think at Salomon, we had transferred a bunch of money to somebody over in Germany or Switzerland, and we were supposed to get some more money back that afternoon. This is basically correct — I may be a little bit off on the details — but the money that got sent, got sent. But the money was to be received, did not get received. And then we went over to England and tried to collect it from his sons, and we got stiff-armed in one way or another. I mean, we got what we deserved, frankly, in a transaction like that. But to the investment banker involved, his earnings that year was — were going to be affected in a significant way by whether he wrote a ticket or two more with Maxwell. And, you know, in the end, that carried the day. And it’s very hard to control people when their income depends on bringing in dubious people into the door.

They care enormously about it, and you’ve got this big system that doesn’t quite pick up on it. And Charlie’s mentioned before, you know, one of the underwriting clients that came forth, that Salomon took on, that professed to be doing wonderful things with money, and it turned out to be a huge fraud. Well, it’s tough to stop. You’ve got dozens and dozens of people running around out there all thinking about how big their bonus is going to be at the end of the year. And, you know, they are not inclined to run morality checks on who they do business with.

CHARLIE MUNGER: That was a wonderful experience. Warren and I, and Lou Simpson are all directors of a company, and we are by far the biggest shareholder. And we all said we should not be doing business with this guy. This is a very dangerous transaction. And they told us it had been approved by the underwriting committee. And of course that settled matters. And —

WARREN BUFFETT: This guy had a neon sign that sign that said “Crook” on him, as far as we were concerned.

CHARLIE MUNGER: And he was waving it vigorously, yeah. (Buffett laughs) But it had been through the underwriting committee. They — the transaction closed, but not financially. I mean, they had the underwriting, but they hadn’t had the financial closing.

WARREN BUFFETT: Yeah, they caught him on the way to the bank. (Laughs)

CHARLIE MUNGER: You’re right, they pulled back just from the edge of the precipice, from this big, fraudulent — and of course they got egg all over their faces. That phrase reminds me of one of the leading lawyers of yore, and he said, “Captain of my soul,” he says, “Or captain of my fate,” he says, “Hell, I don’t even pull an oar.” I mean, here we are — (laughs) — with all three of us on the board, you know, the biggest shareholder, and we can’t even stop one stupid little underwriting.

WARREN BUFFETT: He did go to jail, though, I think, didn’t he?

CHARLIE MUNGER: Yes.

WARREN BUFFETT: He claimed, incidentally, to be a huge shareholder of Berkshire Hathaway. And had made all this money. And I went to the shareholder’s list, and admittedly he could have it in a street name someplace. But it was a big quantity, he claimed. Though we — I couldn’t find any record in any place. But he did have some kind of a little from an accounting firm that —

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: — was backing him up. Didn’t back him up all the way, though, it turned out. (Laughs)

26. Hedge funds are a fad with huge fees

WARREN BUFFETT: Number 11, please.

AUDIENCE MEMBER: Good afternoon, I’m Manuel Fernandez, from Mexico City, Mexico. And I want to thank you for your valuable lessons on how to be good partners, you — and for exporting some good ideas and principles to the world for free. My simple question is, do you think it makes sense for individual investors to invest a part of their capital in hedge funds, or a fund of hedge funds, somewhat like the $600 million investment Berkshire made in Value Capital?

WARREN BUFFETT: Yeah, I would say that people that are now investing in hedge funds, in aggregate, are going to be disappointed. You don’t get smarter because you’re running something called a hedge fund, or something called private equity, or something, you know, called anything — an LBO fund. But what you do gain periodically is the ability to merchandise those things. I mean, there are fads in Wall Street, and Wall Street will sell what it can sell, just remember that. You know, that may be as good as what the fellow quoted up in the upper levels there. And the hedge fund right now is in the midst of a fad. It’s distinguished not by the ability to make more money. It’s distinguished by the extraordinary amount of fees that are collected. And believe me, if the world on $600 billion of money, is paying 2 percent fees, and a percentage of the profits, and the losers go out of existence, and the winners continue for a while, and take money off the table, it is not going to be a great experience, in aggregate, for investors.

Obviously, there are a few smart, honest people out there running funds, and they can — they will do quite well. But if you buy them across the board, in my view, you’re going to get a bad result. Charlie?

CHARLIE MUNGER: Yeah, why would you want to invest with a guy whose basic thought process runs something like this, “If a second layer of fees on top of a first layer of substantial fees is good for an investor, then a third layer of fees must be better yet?” (Laughter) Why would you invest with somebody with a proposition like that?

WARREN BUFFETT: It — just the idea of taking two percent, you know, plus percentages on top of that, that reflects — you know, it may be what the traffic can bear, you know, Collis P. Huntington style, but that reflects an attitude toward people that we tend to regard as partners, investors — I just think it’s a basically unfair type of arrangement. And I don’t like getting in — in general, I think it’s a mistake to get in with people who propose unfair arrangements. You know, in effect they’re getting — probably getting four times standard fees to begin with. And then on top of that, they say we want part of the action. And I would guess in many of those cases, that they don’t have all of their own money in the fund themselves. Maybe they have a substantial sum outside. Charlie and I both run — ran — partnerships in the ’60s, and ‘50s with me, and into the ’70s with him, that would generally be classified as hedge funds. They had the compensation arrangement somewhat similar, although not like they are now.

And we did some — They had some similarities, but I don’t think we had quite the attitude toward the people who were trying to — that were asking to join us — that the present managers have. It’s — As Charlie said, the fund-to-funds type stuff, I mean, it’s really sort of unbelievable just piling on layer after layer on costs. It doesn’t make the companies that are underlying these stocks they buy any better. I mean, it — And believe me, people don’t become a genius just because you walk into some office, and it says “hedge funds” on the door. I mean they are — what they may be very good at is marketing. In fact, if they’re good at marketing, they don’t have to be good at anything else.

27. Basic principles and “uncommon sense”

WARREN BUFFETT: Number 12.

AUDIENCE MEMBER: My name’s Arturo Brulenborg (PH). I’m from Washington, D.C. I’ll be graduating from Harvard College in June and beginning a career in value investing, so I sure hope we’re all right in thinking that this century will be just as good as the last for value investors. You’ve been doing this since you were my age, if not younger. So I’m wondering what habit, or habits have contributed most to your ability to continue learning and improving your investment decisions in a changing business and financial environment?

WARREN BUFFETT: I would say that, at least in my case, I haven’t been continually learning, in terms of the basic principles. You always learn a little more about given techniques, or we learn — you know, I learn more about some industries over time, and therefore, maybe I’ve widened the universe in which I can operate, although more funds narrows it back down, unfortunately. But I know more about businesses than I knew 20 years ago, or 40 years ago. I haven’t really changed the principles. The last change — the basic principles are still Ben Graham. They were affected in a significant way by Charlie and Phil Fisher, in terms of looking at the better businesses. But they — but I didn’t leave any of — I didn’t leave Graham behind on that. And I really haven’t learned any new fundamental principles. But I may have learned a little bit more about how business operates over time.

And there’s really nothing — I mean, you ought to get an investment framework that comes straight from, in my view, from “The Intelligent Investor,” and from Phil Fisher, more from “The Intelligent Investor,” actually. And then I think you ought to learn everything you can about industries and businesses that — where you think you have the ability to get your mind around them if you work at them. And with that arsenal, you’ll do very well, and if you’ve got the temperament for the business. Charlie?

CHARLIE MUNGER: Yeah, well, of course I’ve watched Warren all these decades, and he’s learned a hell of a lot, even the last 20 or 30 years. So it’s a game of continuing to learn. And he can denigrate this little frou-frou that enables him to pick the biggest oil company in China, or this or that. But those basic principles alone, that he knew a long time ago, wouldn’t have given him the ability to make the recent investment decisions as well as he’s made them. It’s a life-long game, and it you don’t keep learning, other people will pass you by.

WARREN BUFFETT: I would say temperament, though, still is the most important, wouldn’t you, Charlie?

CHARLIE MUNGER: Yes, of course.

WARREN BUFFETT: Yeah, yeah.

CHARLIE MUNGER: But temperament alone won’t do it.

WARREN BUFFETT: No, temperament alone won’t do it.

CHARLIE MUNGER: You have to have the temperament, and the right basic idea. And then you have to keep at it with a lot of curiosity for a long, long time.

WARREN BUFFETT: But you don’t have to be blindingly, and have any blinding insights, or have a high IQ to look at a PetroChina for example, and —

CHARLIE MUNGER: No.

WARREN BUFFETT: You know, it, I mean, it’s a — when you get, you know, a company that is doing 2 1/2 million barrels a day, that’s 3 1/2 percent of the — or 3 percent — of the world’s oil production. You know, and they’re selling based on U.S. prices using WTI — you know, as West Texas Intermediate — as a base price, and where they have a significant part of the marketing and refining in a country, the tax rate’s 30 percent. They say they’re going to pay out 45 percent to you in dividends. Don’t have unusual amounts of leverage. If you’re buying something like that at well under half what — or maybe a third — of what comparable oil companies are selling for, that’s not high-level stuff. I mean, you have to read some — you have to be willing to read the reports. But I enjoy doing that. But you wouldn’t say that requires any high-level insights or anything, Charlie?

CHARLIE MUNGER: Well, when you were buying that block of stock, nobody else to speak of was buying. So —

WARREN BUFFETT: Thank heavens.

CHARLIE MUNGER: The insights can’t have been all that common. No, I think that takes a certain amount of what an old Omaha friend used to call “uncommon sense.” He used to say, “There is no common sense. When people say common sense, they mean uncommon sense.” Part of it, I think, is being able to tune out folly as distinguished from recognizing wisdom. And if you just got whole categories of things you just bat away, so your brain isn’t cluttered with them, then you’re better able to pick up a few sensible things to do.

WARREN BUFFETT: Yeah, we don’t consider many stupid things. You know, we get rid of them fast. And in fact, people get irritated with us, because they’ll call us, and when they’re in the middle of the first sentence, we’ll just tell them “forget it.” You know, and we don’t — we can see it coming. And, you know, that’s the way, actually, the mind works. There was a great article in The New Yorker magazine 30 years ago or so — little more than that. It was when the Fischer-Spassky chess matches were going on. And it got into this speculation of would the humans be able to take on computers in chess. And, you know, here were these computers doing hundreds of thousands of calculations a second. And they said, “How can the human mind, when all you’re really looking at is the future, you know, the results from various moves in the future, how can a human mind deal with a computer that’s thinking it at speeds that are unbelievable?” And of course, they examined the subject some.

And a mind, like — well, in fact, all minds, but some much better than others — but a Fischer or Spassky, essentially, was eliminating about 99.99 percent of the possibilities without even thinking about it. So it wasn’t that they could outthink the computer in terms of speed, but they had this ability in what you might call grouping, or exclusion, where, essentially, they just got right down to the few possibilities out of the zillions of possibilities that really had any chance of success. And getting rid of the nonsense, I mean, just figuring that, you know, people start calling you and say, “I’ve got this great, wonderful idea.” Don’t spend 10 minutes, you know, once you know in the first sentence that it isn’t a great, wonderful idea. Don’t be polite, go through the whole process. And Charlie and I pretty good at that. We can hang up very fast, right? (Laughter)

CHARLIE MUNGER: Well, there you have it. All you’ve got to do is go at it in the way that Vasily Smyslov did when he was the world champion, and — of chess — and just do the same thing in investments. (Laughter)

28. Estimating intrinsic value

WARREN BUFFETT: OK, microphone 1. (Laughs)

AUDIENCE MEMBER: Good afternoon, Mr. Buffett, Mr. Munger. My name is Richard Azar. I’m from Trinidad in the West Indies. You guys have been very generous with your intellect over the years. It’s been a huge help to me in my personal and financial life. I wondered if it was appropriate for me to describe the methodology in which I’m trying to determine the range of Berkshire’s intrinsic value, and if you can guide me on if my methodology is flawed, or is reasonably accurate.

WARREN BUFFETT: If it doesn’t take too long, we’ll be glad to, although I think I know the answer already. (Laughs)

AUDIENCE MEMBER: OK. We ended 2003 with about 5.422 billion of operating earnings. I estimated our look-through earnings to be approximately 915 million. So in total, that was about 6.337 billion of estimated look-through earnings. I knew that we spent a billion-two on CAPEX, and our net depreciation on tangible assets was 829 million. So, there was a difference there of 173 million. And we spent more on CAPEX over the appreciation, over the last few years. But in extrapolating out 20 years, I thought I might be kidding myself to ascertaining the differences between CAPEX and depreciation. And I’m using look-through earnings as a rough proxy for distributable earnings. And I’ve assumed that Berkshire can grow its look-through earnings at 15 percent per annum, from years one to five, and at 10 percent per annum, from years six to 20. And the business will stop growing after year 20, resulting in a 7 percent coupon from year 21 onwards. I discounted the cumulative flows in years one to 20 by 7 percent, and I discounted the terminal value by 7 percent.

I added the two together, to get what I thought was the intrinsic value of Berkshire’s cash stream. I knocked off 103 billion of liabilities and minority interests. I divided by 1,537,000 shares, to arrive at what I thought was a conservative calculation of the range of Berkshire’s intrinsic value. Am I off the mark, or is that the sort of methodology you might use yourself?

WARREN BUFFETT: Well — (Laughter and applause) — well, you’ve done your homework. (Laughter) The line of thinking is correct, it just depends on what variables you plug in. And we might have different ideas on variables, and neither one of us knows. But the approach, in general, the approach of trying to figure out distributable cash over a period of time. The business today is worth, the present value at some number — you’re using 7 percent, but the question of what number to use — But it’s worth the present value of all the cash it can distribute between now and Judgment Day. And if cash can be retained, and it’s at a rate higher — it produces — at a rate higher than your discount rate, obviously, you’ll get some benefit from that retention. But, you know, I would say that your assumptions about CAPEX, and related to depreciation, I would expect CAPEX to be, on average, a little more than depreciation unless we run into highly inflationary times. But of course, we have to keep buying businesses, and using the capital in the business that we retain.

If we retain those earnings, we have to use that to buy more businesses. And then the question is, what kind of returns can we expect on those? I don’t quarrel with the approach you’re using, but, you know, everybody has to do their own equation and plug in some numbers. And I think we might settle for lower numbers on earnings gains than you postulated because we’re very large, and it’s — it gets harder all the time to deploy the kind of funds that keep flowing into Omaha. Charlie?

CHARLIE MUNGER: Yeah, and you shouldn’t necessarily get overly excited about last year, as Warren said, that was a very unusual year when everything worked together pretty darn well.

WARREN BUFFETT: Except interest rates on —

CHARLIE MUNGER: Yeah, well, but a lot worked together very well. The interesting thing about Berkshire’s present valuation is how much cash, and cash equivalents it has to do something. And that is a very interesting question. How well are we going to do with this massive amount of investable cash and cash equivalents?

WARREN BUFFETT: Yeah, we should be out working now. I mean — (laughter) — that is the test. I mean, we’ve got a bunch of good businesses. We’ve got a lot of money that we’d like to use to buy more good businesses. We may get lucky and deploy that quite rapidly. We may wait a long time. Cash may pile up faster than we can use it, in which case we’ll have to rethink the whole game. But our hope is — and so far we feel OK about what’s happened in that — our hope is that we can deploy the money that flows in at — in businesses that come close to being as good as the ones that we’ve bought over the years.

29. Timing of Berkshire earning reports

WARREN BUFFETT: Number 2.

AUDIENCE MEMBER: Hi, Mr. Buffett, Mr. Munger, Whitney Tilson, a shareholder from New York City. It’s past three o’clock, and we’ve heard almost nothing about how these great businesses are doing right now, or at least in the first quarter. And I recall at last year’s annual meeting, you took the fairly unusual step, at least from my recollection, of putting up slides and actually giving us a preview of how phenomenally the businesses were doing. And I can imagine that if you had the wind to your back a year ago, the situations in the first quarter of this year, you must really, really have the wind at your back. And I was wondering if you can share with us what you can?

WARREN BUFFETT: Well, we can’t give you the speed of the wind. The — we’re going to have the 10-Q out when, Marc? Well, it’s going to be out in a few days. And if we throw out any numbers now, or make any commentary, we’d have to put that up on the website, and perhaps even try to cover the nuances in my voice. So I think you’ll just have to wait a few days, and they’ll go up, the figures will go up, at that time. And if there are any surprises, they will be surprises then, and everybody will get them at the same time. Incidentally, we’re going to have a little more trouble in the next year or two, because the — We like to publish everything — all the figures — or anything important if we can do it — we like to do that on Friday night after the close, or Saturday morning, so that everybody has an opportunity to look at them, and have a maximum amount of time to digest them before trading begins.

And the SEC is shortening up reporting times so that we’re going to be scrambling just to meet whatever day of the month it is that recording requirements are met. And so we may not — We won’t have the luxury — although we’ll try to do it when we can — we won’t have the luxury of picking the Saturday before the due date, and targeting that as our release date. You know, when we had 45 days, or what was it, yeah, 45 days to report, we could pick the Saturday before the 45 days. If that gets down to 30 days, you know, if the 30th day is on a Tuesday, we’re going to be hard put probably to get it done by that Tuesday. So we’ll obviously put it out after the close, so people have between four o’clock and the next morning to digest it. But we won’t be able to follow the procedure that we’ve followed to date, which we regard as the best procedure of all, giving people close to two days to digest whatever is in the figures. But I can’t help you, Whitney, on how the first quarter looks.

And Charlie, I don’t think you’ll want to add anything on that, will you? (Laughs)

30. Advice to young people: avoid credit card debt and hang out with people better than you

WARREN BUFFETT: OK, number 3.

AUDIENCE MEMBER: Hello, Mr. Buffett, and Mr. Munger. My name is Justin Fong. I am 14 years old, from California. This is my fourth consecutive meeting attendance. I read in a book that you prefer talking to young people about life and financial concepts because we still have time to implement them. Can you please share some of the concepts with us? Thank you.

WARREN BUFFETT: I didn’t catch the last part.

CHARLIE MUNGER: I didn’t. It’s something about sharing concepts. You want to repeat it?

AUDIENCE MEMBER: Can you please share the life and financial concepts that you prefer talking to young people about?

CHARLIE MUNGER: Share — he wants to know your life concepts, and financial concepts, that are useful to young people.

WARREN BUFFETT: (Laughs) — well, that’s a fairly broad question. But I think the financial concepts, you know, we’ve obviously spelled out in the reports. Charlie’s probably better on the life concepts than I am. It is true, that I do believe in spending the time that I spend giving talks, or answering questions, doing it with young people. I do, I’m sure, well over a dozen a year. And I just think that, obviously, young people are more receptive to change, or to actually at even forming habits that are going to be useful in life. And I think that people underestimate — until they get older — they underestimate just how important habits are, and how difficult they are to change when you’re 45 or 50, and how important it is that you form the right ones when you’re young. But Charlie, what do you have to say on that?

CHARLIE MUNGER: Well, all the trite stuff is what works. I mean, you avoid doing the really dumb things, like, racing moving trains to the crossing — (laughter) — experimenting with cocaine — (laughter) — risking getting AIDS or other unfortunate ailments. There are just a lot of standard things that take people down. And you just give those a wide berth. And then you want to develop a good character, and good mental habits, and you want to learn from your mistakes, every single one, as you go along. It’s pretty obvious, isn’t it? (Laughter)

WARREN BUFFETT: Yeah, we would say even though we issue lots of credit cards and everything, we’d say, probably, if I had one piece of advice to give to young people, you know, across the board, it would be just to don’t get in debt. It — The game plays a lot easier if you’re a little bit ahead of the game than if you’re behind the game. And Ben Franklin said that long ago in better terms, which Charlie can recite. But there’s a real difference. I get letters every day from people that are in all kinds of financial trouble. And often it’s health related, which is tragic. But very often it’s — it relates to debt. I mean, they get behind the game, and they’re never going to catch up. And often — it may surprise you — but often, I write these people — they’re very decent people, they’ve just made mistakes — and I just tell them the best course is bankruptcy. I mean, they are not going to catch up.

And they should start all over again, and they should never look at a credit card the rest of their life. And — but it would have been better if they’d gotten that advice a little earlier. But it’s very tempting to spend more than you earn. I mean, I — you know, it’s very understandable. But it’s not a good idea.

CHARLIE MUNGER: And of course you particularly want to avoid evil, or seriously irrational people, particularly if they are attractive members of the opposite sex. That can — (Laughter)

WARREN BUFFETT: Charlie knows more about this —

CHARLIE MUNGER: It can lead to a lot of trouble.

WARREN BUFFETT: The expert. The — yeah, the — you know — It’s better to hang out with people better than you. I found that very easy to do over the years. (Laughs) But if you’re picking associates, pick out those whose behavior is somewhat better than yours, and you’ll drift in that direction. And similarly if you hang out with a bad bunch, you’re very likely to find your own behavior worse over time. But all — like Charlie says, the trite advice which Ben Franklin was handing out a few hundred years ago, really works. You know, just — we’ve said it, but look at the people you like to associate with. You know, what qualities do they have that you can have if you want to? Look at the people that you can’t stand to be around. What qualities do you have that they have? Can you get rid of them? You can do all of that a young age. It gets harder as you go along. It’s not very complicated.

CHARLIE MUNGER: And my final word of advice would be, if this gives you a little temporary unpopularity in your peer group, the hell with them. (Laughter and applause)

WARREN BUFFETT: And as advice a little more applicable to me and Charlie, I was reading about a woman that was 103, and they said, “What do you like about being 103?” And she says, “No peer pressure.” (Laughter)

31. Buffett: Major commodity markets aren’t rigged

WARREN BUFFETT: We’ll go to number 4.

AUDIENCE MEMBER: Good afternoon. My name is Mike McGowan. I’m from Pasadena, California. Everything you just said seems to apply to precious metals, specifically silver —

WARREN BUFFETT: Applies to what? I’m sorry I missed that.

AUDIENCE MEMBER: Precious metals.

WARREN BUFFETT: Oh, sure.

AUDIENCE MEMBER: Specifically, silver. As I recall, Berkshire Hathaway bought 129 1/2 million ounces of silver. And at the time, you said supply/demand fundamentals were good, you saw inflation kicking back, and lots of other reasons. I’m assuming you still own at least 90 million ounces of that. The problem would be the pricing mechanism. Apparently the COMEX, or at least certain of the managers of the silver price on the COMEX, are in debt. The New York banks and financial institutions are short 400-plus million ounces. And it doesn’t look as if they really want the price to go anywhere. So given that Berkshire has all of this silver, do you see the price of silver actually trading in a free market at some point, or would you look at shares instead of the physical metal? And otherwise, we’re kind of at the point, I guess, where John Maynard Keynes said, “The market can remain irrational a lot longer than we can remain solvent.”

WARREN BUFFETT: The — we have no comment at all to make on our present position in silver, if any, we may — we could own more, we could own the same, we could own less, we could own none. So — and we won’t comment. We commented one time because the Bank of England asked us to comment. And since it was the only time the Bank of England had ever talked to me, I felt quite flattered. (Laughter) The — But I would say this. I would disagree very much with your thoughts that the market is in some way rigged, or something of the sort. The — there’s — I find that most of the people that write — or many of the people that write — on gold and silver tend to have various theories, some of which are conspiratorial, and there’s always, you know, the selling forwards is doing this and that to the market, or that somebody’s short. You know, the answer is that there’s plenty of silver above ground.

Whether there’s more or less than there was a few years ago, in terms of the supply-demand since then, I’m not a hundred percent sure. It’s tough to figure out what goes on in China in a lot of things. But I — there’s nothing flawed, in my view, about the market for silver, or copper, or gold, or really any commodity that I can think of that trades in real quantity. Charlie?

CHARLIE MUNGER: Yeah, I think it also should be pointed out that you’re asking for the opinions of people who have not particularly distinguished themselves in this arena. (Laughter)

WARREN BUFFETT: He was pointing at me. (Laughter) With good reason.

32. Buffett doesn’t see Wells Fargo as a “big player” in derivatives

WARREN BUFFETT: We’ll go to number 5.

AUDIENCE MEMBER: Good afternoon, Travis Keith (PH), from Dallas, Texas. The OCC’s quarterly report on bank derivatives shows that Wells Fargo has one of the largest derivatives portfolios of any U.S. bank. In spite of your high-profile criticism of derivatives, Berkshire added to its position in Wells Fargo last year. What about Wells Fargo’s derivatives portfolio did you find less objectionable, and what disclosure did you examine in considering the risks of Wells Fargo’s derivatives portfolio?

WARREN BUFFETT: I don’t have their report here, but without looking at it, I would be willing to bet that JPMorgan Chase has a derivatives portfolio that’s far, far greater than Wells. I do not think of Wells, and I may be wrong, I do not think of Wells as being a big player. Now, all the big banks have various derivative positions. But I do not — I don’t think of Wells as being a big player in the derivative game. And I — you can’t — There is no perfect measurement of the size of a derivative position. I mean, you hear all these huge numbers thrown around, and they sound great, but they tend to exaggerate things in a huge — in a very dramatic way, in terms of trillions of this or that. But so — You know, there can be — you could talk about a billion dollar notional amount of one kind of derivative, and it could have less danger in it than a $50 million position of — in some other type.

But I really don’t think you’ll find that Wells, particularly compared to a JPMorgan Chase, or a Citibank, or something of the sort, is a really big derivatives player. And Charlie and I — at least I — and think Charlie’ll agree — Wells, I think, is an extraordinarily well-managed bank. I disagree with them violently on expensing of stock options. I mean, Dick Kovacevich, who runs that, and I would have entirely different opinion. He’s written about it in the last couple of annual reports. And much as I — and I really admire the management. I think he’s done a great job — but much as I admire the management, I voted the other — our Berkshire stock — the other way, and for expensing options. And I noticed that 57 percent of the stock at this meeting just the other day voted to expense options. But even though I disagree with him on that particular accounting point, Wells has a — an absolutely terrific record. Dick is a terrific businessperson. And I think in terms of taking risk, or handling the risk that he necessarily takes, I think that I would rank him very way up there in terms of bank managers. Charlie?

CHARLIE MUNGER: I’ve got nothing to add to that.

33. Leverage is the biggest danger to investors

WARREN BUFFETT: OK, we’re going to take one more from number 6.

AUDIENCE MEMBER: Thank you very much, Mr. Munger and Mr. Buffett. My question regards — well, I’m Michael Stofski (PH) from New York. My question regards financial institutions and the potential of collapses. And how is Berkshire protected, and how can the individual investor protect themselves against potential bank failures, stock brokerage failures, and things like that?

WARREN BUFFETT: Well, I think as a depositor with large banks, or as somebody that leaves their securities with large brokerage firms, I really don’t think you to worry very much. We have a “too big to fail” doctrine operating in this country, relative to what you might call the innocent parties in big financial institution failures. We don’t have it in respect to the equity holders, nor should we have it. But I would not — I don’t worry about leaving my securities — my personal securities — or for that matter, Berkshire securities — with the large securities firms. I don’t worry about my bank accounts at big banks, so —

CHARLIE MUNGER: But you’re talking cash accounts?

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: Yeah, cash accounts.

CHARLIE MUNGER: Not margin.

WARREN BUFFETT: Yeah. And the — but if you, in terms of owning the equities of companies like that, or in terms of the fallout, the big thing that will — Really, the only way a smart person that’s reasonably disciplined in how they look at investments can get in trouble is through leverage. I mean, if somebody else can pull the plug on you during the worst moment of some kind of general financial disaster, you go broke. And Charlie and I both have friends that have — where that’s happened to them. But absent leverage, and absent just kind of going crazy in terms of valuation on things, the world won’t hurt you over time in securities. And, I mean, you won’t be subject to the financial cataclysms that — they don’t need to do you in. If you have any more money during periods like that, you buy. Berkshire, I think, is in an extraordinarily strong position in respect to any kind of a financial cataclysm. I think we would be definitely the last man standing, and then some.

And while we don’t go around, you know, like undertakers looking for a plague or anything like that, you know, we would probably do very, very well in the end. And that’s happened a couple of times, actually, in the past, where we’ve had cash, and we’ve had courage when the world was panicking, and it’s — we’ve done reasonably well during that period. And we’ve never gotten hurt by what was happening in the world around us, at least in the last 30 or 40 years. Charlie?

CHARLIE MUNGER: Well, I think that’s plainly right.