Morning Session

1. Welcome

WARREN BUFFETT: Morning. I’m Warren, he’s Charlie. We work together. We really don’t have any choice because he can hear and I can see. (Laughter) I want to first thank a few people. That cartoon was done by Andy Heyward who’s done them now for a number of years. Andy writes them. He goes around the country and gets voices dubbed in. It’s a labor of love. We don’t pay him a dime. He comes up with the ideas every year. He’s just a terrific guy. He’s unable to be here today because his daughter is having a Bat Mitzvah. But he’s a very, very creative fellow. He did something a few years ago called “Liberty’s Kids.” And if you have a child or a grandchild that wants to learn American history around the time of the Revolution, it’s a magnificent series. I think it’s maybe as many as 40 or so half-hour segments and it’s appeared on public broadcasting. It will be appearing again. You can get it and video form.

And, like I say, it’s just a wonderful way to — I’ve watched a number of segments myself. It’s a wonderful way to get American history. The only flaw in it is that the part of Ben Franklin is handled by [former CBS News anchor] Walter Cronkite, and Charlie is thinking of suing. A little bit upsetting when Charlie is available. Incidentally, we have “Poor Charlie’s Almanack” next door in the exhibition hall. And it’s an absolutely terrific book that Peter Kaufman has put together. And I think it’s going to be a seller, a huge seller, long after most books have been forgotten. It’s Charlie at his best. And Charlie’s at his best most of the time, but it’s a real gem. I want to thank Kelly Muchemore, who puts all of this together. I don’t give it a thought. Kelly takes charge of this. She works with over 200 people from our various companies that come in and help make this a success. She does it flawlessly. As I mentioned in the annual report, Kelly’s getting married in October.

So this is just a warmup. I mean, we’re expecting a much bigger event than this come October.

2. Where daughter Suze draws the line

WARREN BUFFETT: I want to thank my daughter Suze, who does millions of things for me. She puts together that movie. She does draw the line, occasionally. A few years ago — we have a dinner at [Omaha steakhouse] Gorat’s the day after the meeting. And we were in having — the whole family was there — having dinner. The place was packed and there was a big line that had formed outside. Be sure not to go to Gorat’s unless you have a reservation tomorrow, because they’re sold out. But the big line had formed and it started raining cats and dogs. And the waitress came to me. We were eating. Waitress said, “I got to tell you,” she said. “It’s raining like crazy outside and there’s a long line and [Walt Disney CEO] Michael Eisner is standing out there getting soaked.”

So I turn to Suze — and Michael and Jane [Eisner] are friends of my mine, good friends — and I said to Suze, “Why don’t you go out there and help them out before they get drenched.” And she looked at me and said, “I waited in line at Disneyland.” (Laughter) That seems to strike a responsive chord.

3. Day’s agenda

WARREN BUFFETT: We’ve flipped things this year. We’re going to have the business session at about 3:15. The plan is to have questions and answers. We have 12 microphones here. We have an overflow room that’s filled also, so we got another few thousand people there. We’ll break at noon and when we break at noon — and anybody that’s been in the overflow room that wants to come in here, they’ll be, I’m sure, plenty of seats in the afternoon session. We will start the questioning as soon as I get through with a few preliminary remarks. We’ll go to noon. We’ll take a break, you’ll have lunch. Many people find that it helps the digestion to shop while you eat. And we have thoughtfully arranged a few things next door that you can participate in while you eat your lunch. Even if it doesn’t help your digestion, it will help my digestion if you shop during that period.

4. Buffett on what he won’t talk about

WARREN BUFFETT: During the question period, we can talk about anything that’s on your mind. Just, there’s 2 1/2 subjects that we can’t talk about. We can’t talk about last year’s Nebraska football season. We’ll correct that next year. But that’s off limits. We can’t talk about what we’re buying and selling. I wish we were doing more of it, but we’re doing a little, and I’ll make reference to something on that a little later. And finally, in connection with the investigation into the insurance industry practices that’s taking place, there are broad aspects of it we can talk about. I can’t talk about anything that I or other people associated with Berkshire have disclosed to the investigators. And there’s a very simple reason for that: to protect the integrity of any investigation like this, they do not, the investigators, do not want one witness talking with other witnesses, because people could tailor their stories or do various things.

And so, witnesses are not supposed to talk to each other and, of course, if you talk — we don’t do that. And then beyond that, if we were to talk in a public forum, that could be a way of signaling people as to what you’ve said and then they could adapt accordingly. So investigators, one thing they like to do, is they like to work fast if they can because they don’t want people collaborating on stories . And they — and to protect the integrity of the investigation, we won’t get into anything that’s specific to something that I or people associated with Berkshire may have told the authorities. But there may be some broader questions that that we can talk about.

5. Preliminary Q1 earnings

WARREN BUFFETT: I can give you a little preliminary view of the first quarter with certain caveats attached. These figures — our 10-K — or 10-Q — will be filed in the end of next week. And I caution you that, particularly in insurance underwriting, it’s been a better quarter than — considerably better quarter — than I would normally anticipate. One of the reasons for that is that our business actually does have some — the insurance business has some — seasonal aspect. Now, it doesn’t have a seasonal aspect, particularly, at GEICO or at National Indemnity primary business. But when you get into writing catastrophe business, and we’re a big writer of catastrophe business, the third quarter — the biggest risk we write in big cat area is hurricanes. And those are concentrated — they’re actually concentrated in the month of September. In this part of the world, 50 percent of the hurricanes, roughly, occur in September and about maybe 17 and-a-half percent in October and August, and the balance, maybe, in November and July. But there’s a concentration in the third quarter.

So when we write an earthquake — I mean when we write a hurricane policy, for example — we may be required to bring the earnings in monthly on the premiums. But all of the risk really occurs — or a very great percentage of it — late in the third quarter, and we don’t have any risk in the first quarter of hurricanes. So we earn some premium during that quarter that really has no loss exposure. And then we get that in spades come September. Even allowing for that we had an unusually good quarter. And I would still stick by the prediction I made in the annual report where I said that if we don’t have any really mega catastrophes, I think we’ve got a decent chance of our float costing us zero or less this year, which means, in effect, we have 45 billion or so of free money. In the first quarter, our insurance underwriting income — and all of these figures are pretax — our insurance underwriting income came to almost $500 million, which was about 200 million better than a year ago. And GEICO had a very good quarter for growth. We added 245,000 policyholders, which is almost 4 percent, in one quarter to our base.

We were helped very much by this huge reception we’re getting in New Jersey, because we weren’t in there a year ago, so we’re getting very good-sized gains there. We’re not getting 4 percent in a quarter from around the country, but the boost from New Jersey took us up to that. And GEICO actually wrote at a 13 percent underwriting profit in the first quarter, which is considerably better than we expect over the full year. And we’ve reduced rates some places. And it’s been an extraordinary period for auto insurers, generally. But all of our companies in the insurance business did well in the first quarter. Our investment income was up something over 100 million pretax. Our finance business income was up, maybe, $50 million pretax. MidAmerican was about the same. And all of our other businesses, combined, were up about — close to $50 million pretax, led by Johns Manville, had the biggest increase. That businesses is very strong, currently. So if you take all of our businesses before investment gains, which I want to explain, if you take them all before investment gains, our pretax earnings were up 400 million or a little more.

Now, investment gains or losses: we don’t give a thought as to the timing of those. We take all investment actions based on what we think makes the most economic sense, and whether it results in a gain or a loss for quarter is just totally meaningless to us. A further complicating factor, slightly complicating factor, is that certain unrealized investment gains or losses go through the income statement, whereas others don’t. That’s just the way the accounting rules are. Our foreign exchange contracts are valued at market, really, every day, but you see it at quarter end. And those foreign exchange contracts, which total about 21 billion now, a little more than 21 billion, had a mark-to-market loss of a little over 300 million in the first quarter. And they bob up and down. I mean, sometimes they bob as much as 200 million or more in a single day. And those mark-to-market quotations run through our profit and loss statement. Whereas if we own some Coca-Cola stock and it goes up or down, that does not run through our income statement. But with foreign exchange contracts, it does.

So there’s a $310 million mark- to-market — it shows as realized, it actually isn’t — investment loss on that. And overall, the investment losses, including that 310, came to about 120. In other words, there was 190 million, or something like that, in other gains. As I say, that means — at least to us — that means nothing. And to underscore that point, if later in the year the Procter and Gamble-Gillette merger takes place, we are required under accounting rules, when we exchange our Gillette for Procter and Gamble stock, we are required under accounting rules to show that as a realized gain. Now that will show up as, probably, four-and-a-fraction billion dollars. We haven’t realized any gain at that time, in my view. I mean, we’ve just swapped our Gillette stock for Procter and Gamble stock, which we expect to hold for a very long time. So it’s no different, in our view, than if we’d kept our Gillette stock. But the accounting rules will require that.

So if in the third quarter of this year the P&G-Gillette merger goes through, you will see this very large supposed capital gain recorded in our figures at that time. And I want to assure you that it’s meaningless and you should ignore that as having any significance, in terms of Berkshire’s performance. So, first quarter has gone by. We’ve got a good start on operating earnings this year. We won’t earn at the rate of the first quarter throughout the year, in my view. I think it would be very unlikely, in terms of operating earnings. But the businesses are performing, generally, very well.

6. Insurance acquisition coming

WARREN BUFFETT: One other thing I should mention, and then we’ll get on to the questions, that we can’t announce the name, because it isn’t quite complete in terms of the other party, but we will probably announce, very soon, an acquisition that is a little less — somewhat less — than a billion dollars, so it’s a huge deal, in reference to Berkshire’s size But it is in the insurance field. I mean, we love the insurance business. It’s been very good to us. We have some terrific managers in that field. You’ll see it in the first quarter figures, but you’ll also see how we feel about the business by the fact that this acquisition, which I would say is almost certain to go through, will probably get announced in the next few weeks. We’re looking for bigger acquisitions. We would love to buy something that cost us 5 or $10 billion. Our check would clear, I assure you. I think we ended the quarter with about 44 billion of cash, not counting the cash in the finance operations.

So, at the moment, we’ve got more money than brains and hope to do something about that.

7. Q&A begins

WARREN BUFFETT: Now we’re going to go around the hall here. We’ve got 12 microphones and — get oriented here — and we’ll turn the spotlight on the microphone that is live. People can line up to get their questions asked. I think we’ve got two microphones, also, in the overflow room. And like I say, after lunch everybody should come in here because there’s enough people that get so enthralled with shopping that they don’t return. They’d rather shop than listen to me and Charlie, and we’ll have plenty of seats for everybody in this main hall after lunch. And so, with that, let’s go to — have I forgotten anything, Charlie?

CHARLIE MUNGER: No.

WARREN BUFFETT: OK. (Laughter) That may be the last you hear from him. You never can tell.

8. What Buffett looks for in managers

WARREN BUFFETT: We’ll go to microphone number 1, please.

AUDIENCE MEMBER: Simon Denison-Smith from London. You talk a lot about the importance of selecting terrific managers. I’d just like to understand what your three most important criteria are for selecting them, and how quickly you can assess that.

WARREN BUFFETT: Yeah. I’ll give you two different answers. The most important factor, subject to this one caveat I’m going to give in a second, is a passion for their business. We are frequently buying businesses from people who we wish to have continue manage than them and where we are, in effect, monetizing a lifetime of work for them. I mean, they’ve built this business over the years. They’re already rich but they may not be rich in the liquid sense. They may have all their money, or a good bit of it, tied up in the business, so they’re monetizing it. They may be doing it for estate reasons or tax reasons or family reasons, whatever. But we really want to buy from somebody who doesn’t want to sell. And they certainly don’t want to leave the business. So we are looking for people that have a passion that extends beyond their paycheck every week or every month for their business. Because if we hand somebody a hundred million or a billion dollars for their business, they have no financial need to work. They have to want to work. And we can’t stand there with a whip.

We don’t have any contracts at Berkshire. They don’t work, as far as I’m concerned. So we hope that they love their business and then we do everything possible to avoid extinguishing, or in any way dampening, that love. I tell students that what we’re looking for when we hire somebody, beyond this passion, we’re looking for intelligence. We’re looking for energy. And we’re looking for integrity. And we tell them, if they don’t have the last, the first two will kill you. Because if you hire somebody without integrity, you really want them to be dumb and lazy, don’t you? I mean, the last thing in the world you want is that they are smart energetic. So we look for those qualities. But, we have generally — when we buy businesses, it’s clear to us that those businesses are coming with managers with those qualities in them. Then we need to look into their eyes and say, do they love the money or do they love the business? And if they love — there’s nothing wrong with liking the money.

But if — what it’s really all about is that they built this business so they can sell out and cash their chips and go someplace else, we have a problem, because right now we only have 16 people at headquarters and we don’t have anybody to go out and run those businesses. So we — it’s necessary that they have this passion and then it’s necessary that we do nothing to, in effect, dampen that passion. Charlie?

CHARLIE MUNGER: Yeah. The interesting thing is how well it’s worked over a great many decades and how few people copy it. (Laughter and applause)

9. Buffett on beer industry and its history

WARREN BUFFETT: Go to microphone 2, please.

AUDIENCE MEMBER: Good morning, Warren and Charlie. My name is Walter Chang and I’m from Houston, Texas. Can you describe how you made your investment decision to invest in Anheuser-Busch and how you estimated its intrinsic value? How long did it take you to make this decision? And is Budweiser inevitable, like Coca-Cola?

WARREN BUFFETT: I’m still drinking Coca-Cola. The meeting might get a little exciting if I we were drinking Bud here. (Laughter) We don’t get into much in the way of description of things we might be buying or selling, but the decision takes about two seconds. But I bought 100 shares of Anheuser about — I haven’t looked it up — but I would say, maybe, 25 years ago when I bought 100 shares of a whole lot of other things . And I do that so I can get the reports promptly and directly. You can get them to your brokerage firm, but I’ve found that it’s a little more reliable to put the stock in a direct name. So I’ve been reading the reports for at least 25 years and I observe, just generally, consumer habits, and at a point — currently, the beer industry sales are very flat. Wine and spirits have gained in that general category at the expense of beer. So if you look at the industry figures, they’re not going anywhere. Miller’s has been rejuvenated to some degree.

So Anheuser, which has had a string of earnings gains that have been quite substantial over the years and market share gains, is experiencing, as they’ve described — and they just had a conference call the other day — is experiencing very flat earnings, having to spend more money to maintain share, in some cases, having promotional pricing. So they are going through a period that is certainly less fun for them than was the case a few years ago. And it’s a fairly easy-to-understand product and consumer behavior is fairly easy to understand. It’s a very, very — exceptionally strong business. In fact, what’s happened in the beer industry over the last 50 years has been fascinating to me and to Charlie because this is a brewing town that we grew up in, and Charlie knew the members of the Storz family, a number of them, well. Storz had over 50 percent of the Omaha market in beer post-World War II and then basically disappeared as the national brands took over. So it’s an interesting phenomenon. Beer business is not going to grow significantly in the U.S.

Worldwide, beer is popular in a great many places, and Anheuser will have a very strong position in it. But I would not expect the earnings to do much for some time, but that’s fine with us. Charlie?

CHARLIE MUNGER: Yeah. At our scale of operation now, if we’re ever going to buy into a terribly well-regarded company, we almost need a little patch of unpleasantness. (Laughter)

WARREN BUFFETT: That’s been the best time to buy Berkshire, incidentally, too. I mean, we do — What we’re looking for is businesses with a durable competitive advantage. I don’t think there’s any question that Anheuser has a very, very strong consumer position. Now, as I said, Miller has been rejuvenated to some degree. But the other thing about it is, of course, in beer you do not see the prevalence of private labels or generic products that you see in a great many consumer products that are being — that had strong positions over the years, that are being attacked . That’s a small plus. But beer consumption per capita is going no place. And there’s nothing that will change that. Interestingly enough, the average person in this climate drinks about 64 ounces of liquid a year. And I think it’s roughly 27 percent of that will be carbonated soft drinks. So almost — and, of course, of that Coca-Cola will be about — Coca-Cola products — will be 40odd percent.

So, of the 64 ounces of liquid that Americans are drinking every day, you can figure something like 11 ounces of that, man, woman, and child, will be a Coca-Cola product. Beer, as I remember — I could be wrong on this — but I think beer is about 10 percent of all liquids. So, one out of every 10 ounces that’s consumed by Americans of any kind of liquid is, I believe, is beer. Coffee, incidentally, despite what you read about — you know, the popularity of Starbucks, which is very real, of course, — but coffee has just gone down and down and down over the last 30 or 40 years. Charlie, you have any thoughts about your consumption habits? That you can talk about? (Laughter)

CHARLIE MUNGER: Well, there are people here that may remember Metz beer. In this country, we had more breweries — there were hundreds — and small places would have two or three brands. And this trend toward concentration into a few giants is, I think, permanent.

WARREN BUFFETT: Yes. Schlitz was number one, as I remember, after World War II, for a while. I think Anheuser was number four at that time. There’s an interesting book, if you’re a beer enthusiast, it came out a few years — a few months — ago, maybe a little longer than that, by a Wall Street Journal reporter that sort of toured the country sampling beers. I don’t know how it affected his writing. But it’s a pretty good book, if you like reading about the history of beer.

10. Competition from hedge funds

WARREN BUFFETT: Let’s go to number 3.

AUDIENCE MEMBER: Greetings from Bonn, Germany. I’m (inaudible). Thank you for another great year added to your track record of investing. And thank you again for allowing us to be partners at these favorable terms. This year, I want to ask you another question about how you see Berkshire positioned versus others. Last year, I asked you how you see the increased competition for buying companies through the rise of the private equity industry and how that affects Berkshire’s ability to buy great businesses at fair prices, and you basically said that there are still enough business owners who would rather sell to Berkshire versus a private equity fund. This year, I would like to hear your views on the hedge fund industry. We see hedge funds going into all investment strategies. We know that you have spoken about the fees of the hedge fund industries, but I would like to hear from you how you see Berkshire positioned. Are returns in strategies like merger arbitrage, like convertible bonds — are returns going down because of the increased competition? And are there other factors where Berkshire can be unique versus the hedge funds?

WARREN BUFFETT: Well, that’s a great question. It’s the $64 question. There’s no doubt about it that there is far more money looking at deals now than five years ago, and they’re willing to pay out more for the good, but mundane, businesses that we’ve been successful at buying in the past. And you mentioned the private equity firms and they’re bigger than ever. The hedge funds have gotten into the game, to some degree. And if someone is auctioning off a business today — this has changed just very slightly in the last four or five weeks because of some change in the junk bond market, but not in any significant degree — there were people lined up to bid on almost anything. In fact, you have private equity firms selling their businesses to other private equity firms. And there are a lot of companies that are being sold, that are being sold to someone who’s buying them to resell in a fairly short period of time. We can’t compete in that field and that’s, you know, that’s a source of distress to us. But that’s the way it is.

We will — it won’t go on forever, in our view. We still occasionally, as this deal I mentioned to you, the party on the other side and we just — we made a deal that did not go through an auction process. And we see that occasionally, but we don’t see it anything like we saw it four or five years ago. So, in terms of the near-term outlook for Berkshire, in terms of doing what it’s important that we do, do successfully, which is buy businesses and keep adding to this collection, we are not positioned favorably at all for that. And we do find it extraordinary, both Charlie and I have over the decades, just how fast things can change. There have been at least three times, maybe more, where it’s looked to me in my own career, where it looked like there was so much money sloshing around that it would be impossible to do intelligent things with money. And I actually terminated a partnership back at the end of 1969 because I felt that that the money was coming out, you know, of the woodwork.

There were all kinds of people that wanted to use it and compete, and I just didn’t feel we could do intelligent things. Within four years, I saw the greatest opportunities that I’ve ever seen in my lifetime. And we’ve had several experiences like that. You know, in 1998, when Long-Term Capital Management got in trouble in the fall of 1998 and other things were happening, you had incredible opportunities available in the investment world. Now, people were just as smart then. They had all these people with 150 IQs running around, and they actually had money. But the world became paralyzed for a short period. And you literally had so-called “on- the-run” Governments, which were the most recent issue, and “off-the-run” Governments, which were issued by the same government, the United States government, payable in dollars. You had a 30-basis point differential between the 30-year and the 29-and-a-half year. Both bonds issued by the U.S. government, you know, one a half-year shorter. Both quite liquid, but the “on-the-run” being more liquid.

And a 30-basis point differential in yield means about a three-point difference in price. Well, you wouldn’t believe that could happen in the United States of America in 1998, but it did happen. And I think I have a slide here. Mark, if it — if we can put that up — that shows what high-yield bonds —the situation in those, just really less than three years ago. In the fall of — yeah, there it is —I n the fall of 19 — in the fall of 2002, you had all these high IQ people in the financial world. You had lots of money. And I don’t know how easy it is to read those figures, but you’ll see that a bunch of high-yield bonds — this actually is a table that involves a friend of mine, but we were doing pretty much the same thing. And you can see that he was buying bonds at anywhere from a 25 percent to 60 or 70 percent yield basis, and within 12 or 14 months had sold these same bonds on a 6 percent yield basis. You don’t need to do that very many times in a lifetime.

But that was two-and-a-half years ago after all these people had graduated with MBAs, and studied modern finance theory, and had money coming out of their ears, and all had a desire to make money, and yet conditions like that could exist. We bought about seven billion of junk bonds during that period, because it was a fairly short period. But things do happen that change the landscape dramatically, I mean really dramatically, in financial markets from time to time. But right now, we are positioned very badly in terms of buying businesses, and it’s a big negative. And your Berkshire stock will not do as well under these conditions as it would do if the conditions of five years ago or 20 years ago existed. And I don’t have any magic solution for that except just to tell you what the facts are. Charlie?

CHARLIE MUNGER: Yeah. A lot of the buying by private equity funds in both real estate and stocks, and for companies, is fee-motivated. In other words, the investment manager will rationalize any price paid because he likes the extra fees for managing the extra assets. I have a friend that tried to buy warehouses with a lot of family money and he just stopped. Whatever he bid was always topped by some professional manager, managing other people’s money on a fee basis. So this is a very peculiar era where all these asset classes have been driven to very high valuations, by all historical standards. Some investment operations are very ethical in this (inaubible). I think Howard Marks is here today. He sent a lot of money back, and stopped soliciting money from his clients in certain activities where the opportunities went away. That’s the right way to behave, but it’s not normal.

WARREN BUFFETT: Yeah, I don’t think he’ll mind — I didn’t know Howard was here today — but those actually are Howard’s figures for one of his funds. And like I say, we were doing similar things. We didn’t know it at the time but we found out we had some similar positions later on. About five or six years ago, when the terms of these deals were somewhat different, I actually had a fellow call me, whose name most of you would recognize, and he started asking me questions about the reinsurance business because he was in — he said he was thinking about buying a given company, which got sold, and he didn’t really know much about the business, but that unless he spent these x dollars, he was going to have to give it back to his investors in a few months because the term of the initial sign up period expired at that point, and any unexpended funds were to be returned. And he was going to get 2 percent a year on those funds regardless of how they did. So he was looking at businesses that he didn’t understand with the hope that he can place the money.

Charlie and I are at a disadvantage in buying businesses because we have almost all of our net worth in the downside as well as the upside. You know, if we had a 2 percent fee and 20 percent of the profits and a goodbye kiss for the losses, you know, that’s a different equation than exists at Berkshire. We run it as if it’s 100 percent our money, which it is close to 100 percent of our net worth. And we will own the downside. And we don’t get paid for spending the money, we get paid for making money. And it’s tough — competing right now is tough and likely to be relatively futile, although we have one or two things that could happen that could involve the expenditure of real money.

CHARLIE MUNGER: I don’t think any of the businesses that have sold to us over the years, which are run by the kind of people we like being associated with, would have wanted to sell to a hedge fund. So there exists a class of assets out there that doesn’t want to deal with hedge funds or private equity funds. Thank God. (Laughter)

WARREN BUFFETT: Yeah, we’ve seen no deal anybody else has made the last year that we wish we had made. Now that was not the case 15 or 20 years ago when there used to be plenty of deals made with other people that we would have liked to have made if they’d come to us . But I have seen nothing that — I’ve seen nothing that if it sold for 10 percent less than the advertised price that we would have had any interest in buying. So we are in a different world right now.

11. Buffett’s early interest in stocks

WARREN BUFFETT: Number 4.

AUDIENCE MEMBER: I’m Dudley Shorter (PH) from Council Bluffs, Iowa. When you were younger, what first sparked your interest in investing, and what advice would you give a younger person if they wanted to invest in the stock market? Thank you.

WARREN BUFFETT: Well, I’m not exactly — I got interested probably when I was, maybe, seven or thereabouts. I wasted my time before that. (Laughter) It’s a little like W.C. Fields. When he inherited some money, somebody asked him what he did with it and he said he spent half of it on whiskey and the rest he wasted. (Laughter) So there I was, dawdling around. But I got — my dad [Howard H. Buffett] was in the business, so I would go down to his office, and I would see these interesting books, and I would read them and I would go down — he was on the fourth floor of what’s now known as the Omaha Building at 17th and Farnam, and on the second floor was Harris Supplement Company, and they had a board, and I would go down there. The market was open on Saturdays in those days, so I could — for two hours — so I could go down on Saturday, and I saw all these interesting things going across the tape. And I just read a lot.

I probably took every book in the Omaha Public Library, every book they had on investing — or the stock market — basically. I was very interested in the New York Stock Exchange. I thought maybe I’d want to become a specialist when I grew up and maybe I still will. But the — I took all the books out. I read them. And finally, when I was 11, I bought three shares of stock and I didn’t know — I was fascinated by the subject. My dad got elected to Congress, so now the library became even bigger, and I took all the books I could out of there on markets. And I used a chart and do all that sort of thing. And then, finally, I read [Benjamin] Graham’s book when I was at the University of Nebraska, “The Intelligent Investor,” when I was 19, and that just changed my whole framework. But the advice I would give is to read everything in sight. And to start very young. It’s a huge advantage in almost any field to start young.

If that’s where your interest lies, and you start young, and you read a lot, you’re going to you’re going to do well. I mean there are no secrets in this business that only the priesthood knows. I mean, you know, we do not go into temples and look at tablets that are only available to those who have passed earlier tests or anything. It’s all out there in black and white. It’s a simple business. It’s not — it requires qualities of temperament way more than it requires qualities of intellect. I mean, if you’ve got more than 125 IQ, you can throw away the rest of the points or give them to your other members of the family or do something because you don’t need it in investing. But you do need a certain temperament that enables you to think for yourself. And then you have to develop a framework — and I developed it from reading Ben Graham, I didn’t come up with it myself — very simple framework. And then you have to look for opportunities that fit within that framework as you go through life, and you can’t do something every day.

You know, you can learn every day, but you can’t act every day. And I talked about reading the annual reports of Anheuser-Busch for 25 years, but I’ve read the reports of Coca-Cola and Gillette and all kinds of companies long before we invested in them. And if you enjoy the game, you know, you’ll find that like playing bridge or playing baseball or whatever, if you don’t enjoy it you probably won’t do well on it. But I would advise you to start early. Read everything in sight. Look for the successful framework that’s been successful for people, and there’s nothing like Graham’s, in my view, and you’ll have a lot of fun and you’ll probably make a lot of money. Charlie?

CHARLIE MUNGER: Well, I’m at a little disadvantage here. Warren has made himself into kind of a dean of investors, starting as a boy, and he has a greater respect for the process than I do. I have a good bit of [economist John Maynard] Keynes’ attitude that money management is sort of a low calling, compared to being a surgeon or a lot of other things.

12. CEOs should know more about investing

CHARLIE MUNGER: I think the corporate types — the corporate managers — ought to study investing better because they’d be better managers. And I think that everyone who thinks through the investment process learns more about how the world really works. And I think that’s very worth having. But I do not like as big a percentage of GDP as we now have going to money management and its attendant frictions. And I don’t like the percentage of the nation’s brainpower that is now in all of these different forms of highly-compensated money management. I don’t think it’s a good thing for the country, and I hate the fact that we’ve contributed to it by our own predilections.

WARREN BUFFETT: Charlie is only sitting up here next to me as part of his outreach program, actually. (Laughter) Please don’t take any pictures that you could blackmail him with, being associated with me. Charlie made a very good point there about how managers would do better if they understood investments. I find it absolutely fascinating, and I’ve seen this throughout my life, I’ve seen it close up. I will have friends who are CEOs of companies and they’ll have somebody else handle their money. If you say to them, you know, should you buy Coca-Cola or Gillette or something like that, they’ll say that’s much too tough. I don’t understand that sort of thing. What do I know about investing?

And then some investment banker walks in the next day with the idea they buy a $3 billion company, which is just buying a lot of shares of stock in one company, and they’ll run through some little two-hour presentation and turn it over to a strategic planning group and think that they are then the ones that should make that decision as to whether to buy multibillion-dollar businesses when they really don’t feel they’re qualified to make $10,000 decisions with their own money. And it’s extraordinary what you see in corporate America and the acquisition activity. It’s a little like they say about making sausage and making laws, it’s better unobserved. Charlie, you have any further thoughts on that? You’ve seen a lot of it with me. (Laughs)

CHARLIE MUNGER: Well, I do think that the present era has no comparable precedent in the past history of capitalism. I think we have a higher percentage of the attention of our intelligent classes into buying little pieces of paper and getting — trying to get rich doing it, and in promotional activities with big profit sharing fees. I can recall no past era which had a similar concentration of this type of activity. Can you, Warren?

WARREN BUFFETT: No, but I think you would say, probably, too, that we’ve seen sort of baby versions of this, something subsequently happened, that —

CHARLIE MUNGER: Oh, yes. If you want to talk about what are the future implications, a lot that I see now kind of reminds me of Sodom and Gomorrah, and —

WARREN BUFFETT: We weren’t there, incidentally. I mean — (Laughter)

CHARLIE MUNGER: No, but there’s a published account. (Laughter) And I think when you get as much sort of regrettable activity going on and sort of feeding on itself in frenzies of envy and imitation, that — it has happened in the past that there came bad consequences.

13. PetroChina investment

WARREN BUFFETT: On that cheery note, we’ll move to number 5.

AUDIENCE MEMBER: Good morning. My name is Molly Fanner (PH). I’m 11-years-old and I’m from Long Island, New York. I have two questions today and I have put them in the form of a poem. Mr. Buffett, Mr. Munger, to get here we had to fly. I came to hear your thoughts if PetroChina was at an all-time high. My second regards a job that I know is just right for me. To be a See’s Candy taster, my sisters and I would work for free. (Laughter)

WARREN BUFFETT: Well, if you come up front, I’ll put you to work.

AUDIENCE MEMBER: Borsheims was for my mom. And my father loves his stock. I have a future tasting chocolate. This weekend has really rocked. Thank you very much. And really, what is your view on PetroChina? (Laughter)

WARREN BUFFETT: If you come up at the break, Charlie and I will have taken all the pieces out of here that we like best, and you will get the rest. (Laughter) Charlie, do you have anything to add to that?

CHARLIE MUNGER: She wants to know what you think about PetroChina. (Laughter)

WARREN BUFFETT: It’s funny. I saw her out there in the shopping area and I knew that she had PetroChina on her mind. (Laughter) We bought PetroChina a few years ago, again, after reading the annual report. And fortunately it was in English. It was the first stock — Chinese stock — and really the last. I mean, it won’t necessarily be the last, but it’s the only one that we’ve owned so far. We put about $400 million into it. At the time, and still, it produces about 3 percent of the world’s oil, which is a lot of oil. It produces, probably, 80 percent or so as much as Exxon Mobil will produce. And it’s a huge company. Last year it earned $12 billion. Now, if you look at the Fortune 500 list, my guess is you won’t find more than about five companies in the United States that earn $12 billion or more. So it’s a major company. At the time we bought it, the total market value was 35 billion. So we bought it at about three times what it earned last year.

It does not have unusual amounts of leverage. It — in the annual report, they say something which very, very few companies do say, but which I think is actually fairly important. They say they will pay out about 45 percent of the amount they earn. So, if you can buy it at three-times earnings, what turned out to be three times earnings, and you get 45 percent of 33 percent, you know, you’re getting a 15 percent yield on your — cash yield — on your investment. It’s a very good annual report. Chinese government owns 90 percent of the company. We own 1.3 percent. If we vote with them, the two of us control the business. (Laughter) It’s a thought that hasn’t occurred to them, but I’ll keep pointing it out. (Laughter) But it’s, you know, it’s a very major business and a very, very attractive — at what was a very attractive price.

Unfortunately, the government shares and our shares have the same economic interest but they are classified differently, so that the government’s 90 percent are called one thing and the 10 percent with the public are called A-shares. And we have to report in Hong Kong when we own 10 percent of a company — or we did then — 10 percent of a company shares, so unfortunately the 10 percent applied only to the 10 percent of A-shares and so we had to reveal our ownership when we only had 1 percent of the economic interest in the company. So, we would have bought more but the price jumped up, and we are happy to have our 1.3 percent or whatever it is, and we think that they’ve done a good job in running the business. They’ve got large gas reserves, which they’re starting to develop now. But it’s a very major enterprise. Employs almost 500,000 people. And the interesting thing was, a few years ago relatively few people in the investment world probably even thought about the fact that PetroChina was over there and was a much larger business than most of the — well, just about any oil company in the world, except for BP and Exxon Mobil.

Charlie, do you have thoughts?

CHARLIE MUNGER: Yeah. It would be nice if this sort of thing happened all the time, but that hasn’t been true in recent years.

WARREN BUFFETT: But we never — I should emphasize — I mean, the annual report of PetroChina, which, like I say, it’s easy to read. Understandable. They declare their policies. Anybody could get it. You can read it. We did not — we did not go over and — we never had any contact with the management before we bought the stock. We’d never attended an investor presentation or anything of the sort. I mean, it’s right there in black and white, in a report that anybody can get. And we just sit in the office and read those things, and we were able to put 400 million out that’s now worth about a billion-two or something like that. It was interesting. At the time — I think I’m right on this — at the time, Yukos, which is the big oil company in Russia, was probably far better known among the investment community in the United States than PetroChina. And I compared the two. At the time, thought to myself, would I rather have the money in Russia or in China? PetroChina, in my view, was far cheaper.

And I felt that the economic climate was likely to be better in China, you know. Would I have — if it had been selling at the same multiple as a U.S. domestic company, would I have regarded it as more attractive? No. I mean, there’s some disadvantages, always, to being in a culture that you don’t perfectly understand, or where tax laws can change, your ownership rules can change. But the discount at which PetroChina was selling, compared to other international oil companies, was, in my view at the time, ridiculous. So, that’s why we bought it. And we will have the candy available for you at the break.

14. Profit margins squeezed by rising commodity prices

WARREN BUFFETT: Number 6.

AUDIENCE MEMBER: Good morning, gentlemen. My name is Matt Sauer (PH) and I’m from Durham, North Carolina. Many businesses are reporting rising costs and surcharges on such inputs as fuel, metals, and wood. They are often unable to pass along these costs to their consumers. If commodities stabilize at price levels above those of the past decade, will corporate margins be compromised into the future?

WARREN BUFFETT: Well, it’s a great question. I would say that that would depend very much on the industry you’re talking about. But, in our carpet business [Shaw Industries], for example, we’ve just been hit time after time, as I mentioned in the annual report, with raw material increases, because there’s a big petroleum derivative factor there. And we have lagged in terms of being able to put through those increases to our customers, simply because we want to protect the Nebraska Furniture Marts, or those that have ordered, for a reasonable period of time. And that squeezed margins in carpet. We use lots of natural gas at Johns Manville, use lots of natural gas at Acme Brick, and that’s tended to squeeze margins some. I think, over time — I think there has been a lot more inflation in these basic materials. Steel has been off the chart. I think, over time the businesses with strong competitive positions manage to pass through increases in raw material costs, just as they passed through increases in labor costs. But you get these temporary situations where, sometimes, the costs are increasing faster.

I don’t think — I don’t think the American industry — I mean, a higher cost for oil, when we import 10 million barrels a day or more of oil, if we’re paying $20-or-so more per barrel than we were a year or two ago, that’s $200 million a day, is a tax, but it’s more of a tax on the American consumer, probably, than on American business. The American business will probably be able to pass through most of those raw material cost increases. It is worth pointing out that corporate profits, as a percentage of GDP, are right at the all-time high, leaving out a few aberrational periods. And I would — you know, if I had to bet on the direction of corporate profits, as a percentage of GDP, over the next five years, I would bet they would go down somewhat. But that’s because they’re right at this very high level. Interestingly enough, while corporate profits, as a percentage of GDP, are at this very high level, corporate taxes, as a percentage of total taxes raised in America, are very close to an all-time low.

So, American businesses managed to pull off a situation where they’re making extremely good profits and paying a very small percentage of the total tax bill, as measured in this country historically. And I’m not sure whether that could, or should, or will continue, but it’s a very, very favorable period right now for corporate America. But that’s nothing to get bullish about, because you might expect something of a reversion to the mean. Charlie?

CHARLIE MUNGER: Well, I can’t add to that but I can restate it. It’s hard to know just which companies can pass through the increases in costs that come from higher commodity prices. And it’s also important to know.

WARREN BUFFETT: We like buying businesses where we feel that there’s some untapped pricing power. We haven’t been able to do much of that lately. But back in 1972, when we bought See’s Candy, I think it was either — was it $1.95 a pound?

CHARLIE MUNGER: Something like that.

WARREN BUFFETT: Yeah. And they were selling 16 million pounds of candy a year, making four million pretax, with about 25 million purchase price, which I would have very foolishly refused to budge on, and in history have cost us a lot of money. But one of the questions we asked ourselves, and we thought the answer was obvious, was, you know, if we raised the price 10 cents a pound, would sales fall off a cliff? And of course, the answer, in our view at least, was that no, there was some untapped pricing power in the product. And it’s not a great business when you have to have a prayer session before you raise your prices a penny. I mean, you were in a tough business then. And I would say you can almost measure the strength of a business over time by the agony they go through in determining whether a price increase can be sustained. And frankly, a good example of that is the newspaper business right now.

Because 30 years ago, when the — whatever the local daily would be had an absolute lock on the economics of the community, because it had the megaphone through which merchants had to talk if they were going to get their message across to their audience — at that time, rate increases, both circulation and advertising, were something that were almost a big yawn to most publishers. They did it annually. They did not worry about the fact that Sears or Walmart or Penney’s or whomever would pull their advertising. They did not worry that people would drop their subscriptions to the paper. And they went merrily along, increasing prices, and they increased them when newsprint went up and they increased them when newsprint went down, and it worked. And you got these very fat profit margins. And it looked like about as strong a business as you can imagine. Now publishers find themselves in a position where they agonize over rate increases, both in advertising and in circulation, because they’re worried about driving away advertisers into other media.

And they’re worried about people, when they get a 20 cent increase, you know, per month, or whatever it may be, in their circulation prices, deciding, well, I think I’ll just drop it. And when they drop it they don’t usually take it up again. So, that world has changed. And you could recognize the change in that world, simply, if you could get inside the mind of the publisher, in terms of how they felt about price increases. You can learn a lot about — you learn a lot about the durability of the economics of a business by observing the behavior of — the price behavior. I mean, you’re seeing that — talk about the beer business. Beer has moved up in price every year, but there have been some rollbacks in certain areas in the last year, which means that, you know, it’s getting a little bit more difficult to increase prices, even though they increase them at rates below inflation. And those are not — that’s not a good economic sign. Charlie?

CHARLIE MUNGER: I have nothing to add to that.

15. Tax rate not a factor in Berkshire dividend calculus

WARREN BUFFETT: OK, we’ll go to number 7.

AUDIENCE MEMBER: My name is Pete Banner (PH) from Boulder, Colorado. First of all, Mr. Buffett, Mr. Munger, we shareholders consider you our heroes. We appreciate and very much value who you are and what you do in the world. So, thank you.

WARREN BUFFETT: Well, thank you, Pete. And I will say in return that we think we’ve got the best group of shareholders in the world. And to some extent, it’s evidenced by the fact we have the lowest turnover, and, I think, the most knowledgeable group, incidentally, too, of shareholders. So, with that our mutual love affair can go on. (Laughter)

AUDIENCE MEMBER: Thank you very much. Secondly, with taxes as they are today, 15 percent on dividends, how do you feel about declaring a dividend?

WARREN BUFFETT: Oh, you were setting me up. (Laughter) No, there’s no question about the fact that dividends are lightly treated now for taxation purposes. But we have always said, and it’s been true, that if there were no tax on dividends, to this point at least, we would have followed an identical dividend policy, because the test with us is whether we think we can retain a dollar, and in turn — and have it worth, in present value terms, more than a dollar. If we can’t do that, we should distribute any money that we can’t — we can’t utilize on that basis. Now, when the cash piles up, like currently — it has currently — you can say it’s pretty dumb to hold, you know, billions of dollars at — last year the rates were less than 1 percent after-tax — and, you know, what are you doing for shareholders with that? And I would say that the burden of proof will certainly shift if, within a few years, we can’t use a lot more money intelligently than we are now.

But, if we were — at the time at which we feel that the present value of the earnings we retain is not greater than a dollar comes, and it could come, and it’s more likely to come when you get large like we are, then we should have a — not only a, you know, dividend policy that’s X percent of earnings, we should pay out very substantial sums. The test is whether the money can be used effectively within the business. So far, it has been. That doesn’t mean it was yesterday or the day before, but so far, it’s produced more than a dollar’s worth of market value for every dollar retained. But that will be discussed — our directors meet Monday — that will be discussed then, and you are certainly — if we sit here a couple of years from now and we have not successfully deployed more cash, then I think that the burden of proof has shifted dramatically to us to explain why we would be retaining earnings at that point. Charlie?

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

16. U.S. trade deficit’s economic threat

WARREN BUFFETT: Number 8?

AUDIENCE MEMBER: My name is Ola Larson (PH), from Salt Lake City, originally from Sweden. I read your annual report where you mentioned how the current account deficit, or a trade deficit, has to eventually come to an end. And in the report, you were reluctant to give views, a forecast of how this would come down from $2 billion a day. Would you, nevertheless, be willing to share some thought on what — how it might come down, if you have any views on this?

WARREN BUFFETT: Well, that really is the $64 question, because, we are, in my view — and Charlie doesn’t — he’s not as on board on this as I am, so it’s important that you listen to him on this, too. The — it does seem to me that a $618 billion trade deficit and a larger current account deficit, rich as we are, strong as this country is, that something will happen that will change that in a major way at some point, and that the longer that it goes before changing, the more likely it is that something fairly significant happens. But most economists — most observers — would still say that some kind of a soft landing is possible. Or they would say it’s likely. They never, to my mind, they never quite explain, you know, what the soft landing is. They just say it’s, you know, it’s likely to be a soft landing but it could be something different but we still think it will be a soft landing.

But I don’t know what a soft landing is, exactly, in the sense of how the numbers come down quite significantly, and if they don’t come down, the current account surplus — or deficit — means that we are transferring more and more wealth abroad and that we will, in addition to our trade deficit, we will, at some point, have a very significant deficit in terms of the net investment position that the rest of the world holds on us. So it becomes a compounding effect. I do recommend — there was an op-ed piece in The Washington Post on April 10 by [former Federal Reserve Chairman] Paul Volcker, and he has expressed himself some on this, and he gets into the question of whether it can be a soft landing or not. But I think he certainly expresses some real apprehension about whether a soft landing will be the likely result. In the kind of world we live in, with so much of the assets of the world, whether they be foreign exchange or whether contracts or whether they be stocks or bonds or junk bonds or whatever, I think as high a percentage is on what I would call a hair trigger now as has ever existed.

In other words, I think there are more people that go to bed at night with a position in foreign exchange, or bonds, or a carry trade, or stocks, or whatever, that some event that could happen overnight would cause them to want to change that position in the next 24 hours. I think that’s the highest, perhaps in history. Somebody [economist Thomas Friedman] has referred to it as the “electronic herd,” that it’s out there. I mean people can with — they can give vent to decisions involving billions and billions and billions of dollars, you know, with the press of a key, virtually. And that electric — I think that electronic herd is at an all-time high. I think that some exogenous event — it was almost Long-Term Capital Management in 1998 — but some exogenous event — and we will have them — will cause it — I think it could very well cause some kind of stampede by that herd. You can’t get rid — if you’re the rest of the world — you can’t get rid of dollars.

I mean, if you’re sitting in Japan, China, or someplace, and you own a lot of U.S. government bonds, if you sell them to somebody in the United States you get U.S. dollars. So you still have U.S. assets. If you sell them to somebody in France, you’ve now got euros but they’ve got the [debt.] You can’t you can’t get rid of those assets. But you can have people trying to head for the door very quickly with them, under certain circumstances. Volcker said, in this thing, he said in the second paragraph, “Yet, under the placid surface there are disturbing trends: huge imbalances, disequilibria, risks — call them what you will. Altogether the circumstances seem to me as dangerous and intractable,” and I emphasize intractable, “as any I can remember, and I can remember quite a lot.” Well, Paul Volcker can remember quite a lot. And I agree with that. I don’t — I have no idea — I have no idea on timing, whatsoever.

In economics, it’s far easier to tell what will happen than when it will happen. I mean, you can see bubbles develop and things, but you do not know how big the bubble will get. For example, you know, this happened five years ago in the market. So you — predicting timing is — I’ve just never been successful at it nor do I try to do it. Predicting what will happen, I think, is a much easier sort of thing. And I would say that what is going on, in terms of trade policy, is going to have very important consequences. It was not addressed in the last presidential campaign by either candidate in any meaningful way at all. Now, I’m not sure if, you know, you were standing up in front of the American people, and somebody is giving you three minutes to explain this whole situation, when 90 percent of your audience couldn’t define current account, you know, it’s not an easy game. But it’s an important one. Now, Charlie is less enthusiastic about our foreign exchange position, somewhat, than I am, so I want to yield the floor here for a significant period of time while he gives you the other view.

CHARLIE MUNGER: Well, I’m, if anything, a little more repelled than you are by the lack of virtue in the way our nation uses consumer credit and the way we run the public finances. And I have a feeling that eventually a lack of virtue is going to hurt one. Where we differ is that I agree with [18th century Scottish economist] Adam Smith that a great civilization has a lot of ruin in that, meaning it will bear a lot of abuse. And so I think there are dangers in the current situation that make it unwise for anybody to swing for the fences. But I don’t think that we have a certainty that the system won’t stand a lot more of the kind of abuse it’s getting now.

WARREN BUFFETT: What do you think the end will be?

CHARLIE MUNGER: Bad. (Laughter)

WARREN BUFFETT: I knew I could count on him. (Laughs) No, we are truly, in this country, like an incredibly, I mean incredibly, rich family that owns, we’ll say metaphorically, millions of acres of land. They can’t see, they can’t travel to the outer reaches of their domain. But, nevertheless, they sit on the front porch and wait for the produce to come in from this vast holding, and when they get it all they still want to consume about 6 percent more than everything that’s been produced on the farm. And they have the ability to do that by simply selling off a little piece of the farm every day, and every year, that they can’t even see. So they don’t feel any poorer at the end of the day or the end of the year, because it’s still, as far as their eyesight can see, they own everything that God ever created. And they can sell that little piece or they can mortgage it. They can send IOUs to these people that are giving them the extra goods to consume. And we are very, very, very rich family.

And we produce a whole lot and we consume a little bit more than we produce. And we trade away a little bit of the farm or put a little bit of a mortgage on every day and the rest of the world is happy to take a little piece of our farm or take a mortgage on it because it’s such a terrific asset and we’ve behaved so well over the years. And so they’re willing to work a little harder to send us something so that we can consume a little bit more than we produce. It’s been going on a while. It’s accelerated a lot in the last few years. And more and more the rest of the world is owning part of us and we’re going to have to service that ownership, either through interest if they took it in IOUs, or in some other way. And it can go on a long time. But if it goes on a long time, the world will own a good bit of us and our children will be paying, one way or another, for the fact that we got to consume more than we produced.

It could happen — you could have — you’ve obviously had some less interest in the rest of the world accepting dollars by the fact that the dollar has declined somewhat in value in the last few years. In other words, the investment in us is always going to be equal to the overconsumption. I mean, it’s an equation. But if people get a little less excited about one — enthused about one side of the equation — it reflects itself in the pricing mechanism. And the world has demonstrated a diminishing enthusiasm for dollars in the last few years as they get flooded with them. We send $2 billion out every day, whether we like it or not and whether they like it or not. Now, the question is, does that reach some tipping point at some point or does some exogenous event come about that causes people to want to rush for exits? Who knows? I have a hard time thinking of any outcome from this that involves an appreciating dollar, but, as Charlie will point out in just a second, there have been times when we’ve been surprised. Charlie?

CHARLIE MUNGER: Yeah, the counter-argument is that, what does it matter if the foreigners own 10 percent more of the United States, if, at that time, the total wealth of the United States is 30 percent higher than it is now. And so, people who have that point of view just roll with it. And some of them think that if we didn’t manufacture anything in the United States and just sat here running hedge funds, we would have a wonderful economy because it comports with Republican principles.

WARREN BUFFETT: We could cut each other’s hair, too, actually, I mean — But back in the late 18th century, obviously, the idea of taxation without representation caused a certain amount of trouble, and ownership of the rest of the world — by the rest of the world of this country would be seen as a form of taxation, I think, 20 years from now, by the people who resided here. If we — if, instead of fighting the Revolutionary War, we’d simply made a deal with England and said we’ll give you three percent or five percent of our national product forever and you let us be free and we’ll just mail it — send the royalty over every day — that might have looked like a good alternative to war in, you know, in 1776. But I don’t think that subsequent generations would have reacted well. I mean, something would have happened over time. And I have a feeling that the idea of America paying tribute to the rest of the world because of the overconsumption patterns of a previous generation seems to be — I don’t think that’s a particularly stable scenario.

But that’s why we have only 21 billion in foreign exchange contracts. Charlie might have a little less, or maybe none, if he were running it entirely, and I might have somewhat more, if I didn’t know I’d have him sitting up here next to me next year. (Laughs)

17. Housing market bubbles and irrationality

WARREN BUFFETT: Let’s go to number 9.

AUDIENCE MEMBER: Hello. My name is Johann Freudenberg (PH) from Germany. What do you think would be the consequences of a strong decline of the housing market for sales of carpet retailers and manufacturers? Thank you.

WARREN BUFFETT: Well, if there’s a strong decline in the housing market, my guess is that whatever we lose in carpet we’ll be making up for somewhere else, because it would — a lot of the psychological well-being, as well as the financial well-being, of the American people is tied up with the fact — or comes from the fact that they feel so good about what has happened with their home ownership over the years. And with many people it’s been, by far, the bestbehaving asset that they’ve had. So, if there is indeed some kind of a bubble and it’s pricked at some point, my guess is that we would feel that in various ways in our operating businesses, but that in terms of what we could do with our capital, the net effect to Berkshire might well be quite positive. We’re not big on macro forecasts. I mean, this foreign exchange thing is quite different than what we’ve done over time and the way we’ve made money.

So, we are — it isn’t like we’ve got some great track record predicting macro factors and have made a lot of money doing that. We’ve made money by looking at things like PetroChina, or whatever it may be, and just deciding that here is a very good business that’s selling at a very cheap price. Certainly at the high end of the real estate market in some areas, I mean, you’ve seen some extraordinary movement. And I’ve referred to this before, but 25 years ago or so we saw the same thing in farmland in Nebraska and Iowa and surrounding areas. We had people running from cash — “cash is trash” — and people wouldn’t, you know — they were worried about the fact that inflation was out of control in the late ’70s, and before [former Federal Reserve Chairman Paul] Volcker did his stuff, people were fleeing from cash. And one of the ways they gave vent to that fear was to rush into farmland. There was a farm about 30 miles north of here that sold for about $2000 an acre in, roughly, 1980.

And a few years later, I bought it from the FDIC for $600 an acre. And you can say, how can you go crazy about farmland? It’s going to produce about 45 bushels an acre of soybeans, about 120 bushels an acre of corn. And there’s no way you could dream about a tripling, or the internet causing, you know, cornmeals to go up or something of the sort. But people went crazy on it. And the consequences were huge, in terms of banks failing, lots of banks failing in this area, banks that had gone through the Great Depression. But the people went — they just want a little crazy. People go crazy in economics, periodically, in all different kinds of ways. And, you know, you had the Resolution Trust Corp. come out of the savings and loan nuttiness that took place in real estate, where they finance everything that was put before them. And, you know, I will not — I don’t know where we stand in terms of the residential housing cycle in that it has different behavior characteristics, simply because people live in the houses in many, a great many cases.

So it will not behave, necessarily, the same as other markets. But when you get prices increasing at far, far greater rates than construction costs or inflationary factors, sometimes there can be some pretty serious consequences. Charlie?

CHARLIE MUNGER: Yeah. It’s — in a place like Omaha, there’s not much of a housing price bubble, is there, Warren?

WARREN BUFFETT: No, there’s not been a bubble, but I would say that residential real estate, probably, has increased in price at a rate quite a bit faster than the general inflation rate.

CHARLIE MUNGER: Yeah, but if you get to Laguna, California or Montecito, California, or the better suburbs of Washington, D.C., you have a real asset price bubble. I have a relative that, to move to a good school district in the suburbs of Virginia, she had to pay four times as much as she can get from selling her nice Omaha house.

WARREN BUFFETT: Yeah. Well, I sold —

CHARLIE MUNGER: So that’s a price bubble.

WARREN BUFFETT: I sold a house a few months ago in Laguna for $3 1/2 million. Now it sold the first day, so I probably listed it too cheap. So don’t count on me for residential real estate advice. But that house, the physical house, would probably cost a half a million or thereabouts. So, in effect, the land went for $3 million, implicitly, and the land is probably on the area of 2000 square feet, which is a little less than one-twentieth of an acre. Now, you’ve got streets and all that sort of thing involved. But basically, I think that land sold for about $60 million an acre, which that fellow that you saw in the farm outfit in the movie finds like — sounds like a pretty, pretty fancy price for almost any kind of land. Charlie, you’ve witnessed it firsthand, though, out there.

CHARLIE MUNGER: Well, yeah. There’s — one of the Berkshire directors lives adjacent to what I regard as a pretty modest little house, which sold for $27 million recently. Now these are houses that look right at the ocean, and there isn’t a great deal of available shoreline in California, and there are a lot of people. But you have some very extreme housing-price bubbles going on. And you would think there might be a real possibility that it could go in the other direction someday.

WARREN BUFFETT: At $27 million, I’d rather stare at my bath tub. (Laughter)

18. Catastrophe insurance: “everything correlates”

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: David Winters, Mountain Lakes, New Jersey. How do you try to manage risk at Gen Re and National Indemnity to be comfortable and maximize returns? Especially, how do you prevent a catastrophic loss or unexpected correlation? Thank you.

WARREN BUFFETT: Yeah, well, that’s a very good question because we are doing things in different parts of our insurance operation where there is correlation. And there’s not only correlation among the insurance risks. I mean, just, you know, take a major, really major, earthquake in California, in the wrong place. There have been about 25 6.0s or larger in the last hundred years, but most of them don’t occur where a lot of people are. But if you get the wrong one in the wrong place, it would not only hit National Indemnity and General Re, as you mention, but it might very well have a severe effect on See’s Candy. It might very well have a severe effect on Wells Fargo. We don’t own Freddie [Mac] or Fannie [Mae] now, but we owned Freddie at one time. It could have had a severe effect on Freddie. It can have all kinds of secondary and tertiary effects that you might not think of initially. So, we find when there’s trouble, everything correlates.

And it’s — part of my job is to have at least a general idea of the sort of risk that the various enterprises might be running operationally, and then integrate that into my own notion of the risk that we run, in terms of investments, in terms of all kinds of things. And, you know, that is my job. The most likely mega-cat, at any time, is a hurricane. But we have more exposure to that. On the other hand, if you’re talking 25 billion and up, maybe 100 billion and up, insured catastrophes, you know, a quake might be just as likely as some Force 5 hurricane that would come in at the wrong place. But that — my job is to think absolutely in terms of worst case. And to know enough about what’s going on, in both investments and operations, to make sure that no matter what happens, you know, I don’t lose sleep that night, you know, over what can, you know, whether there’s a 9.0 quake someplace or whether there’s a Force 5 hurricane that actually goes up the East Coast and enters at places that very seldom does it enter.

Long Island, for example: huge amount of exposure. How often is Long Island going to, you know, really have a major hurricane? Not very often. I think there was one back in the ’30s, but there were potato fields there in the ’30s and now there’s all kinds of insured value. Everything will — everything that can happen, will happen. I mean, in terms of our — what we know of history in this country, last three or four-hundred years, and then with the most severe quake, by far, was at New Madrid, Missouri. And who would have guessed, you know, that that quake would happen? And there were two subsequent quakes that were far enough apart so that didn’t exactly seem like aftershocks. All three of those were higher than 8 on the Richter scale. Nobody thinks about that, but they’ve had them in Charleston, South Carolina. They’ve had, I mean, it’s — you will see things, maybe not in your lifetime, but if you take the centuries, some extraordinary things can happen. And it’s Berkshire’s job to be prepared, absolutely, for the very worst.

And, by and large, I would think hurricanes and quakes are the biggest thing now, but a few years ago we did not have nuclear, chemical, and biological risks excluded in policies, and we had huge exposure, subsequently gotten rid of. But we take on large risks. I’ll give you a couple of examples. Just the other day — and nobody else will write this stuff, basically, because they would want to reinsure it with somebody else and they’re not set up to do it — but one large airport, one large international airport, came to us and we wrote a policy for $500 million, excess of 2 1/2 billion, from any action that was not caused by nuclear, chemical, or biological sources. So, if that airport is taken out in some way, but not by nuclear, chemical, or biological activities, the first 2 1/2 billion, somebody else worries about, and we get the next half-billion. There’s a — sublimit is only a billion-six can be counted for business interruption. So you would need — and that airport would have to be out for a couple of years to have a billion-six of business interruption.

So you need 900 million of physical damage on top of that. But somebody is willing to buy that policy and there is a real risk. We insured the NCAA Final Four down in St. Louis against being canceled, not postponed, or having the games, those final four games, moved to another city. But if it was canceled totally, and again, not through nuclear, chemical, or biological, we would have paid $75 million. Same thing at the Grammys. I mean, we take on risks that very few people want to write. But in the end, we’re willing to lose a lot of money in one day, but we’re not willing to do anything that causes us any discomfort, in terms of writing checks the following morning. Incidentally, while I’m on the nuclear — while we’re talking about the pleasant subjects — I recommended in the annual report that book, “Nuclear Terrorism.” And if you go to lastbestchance.org, you can obtain, or will soon be able to obtain, a tape, free, that the Nuclear Threat Initiative has sponsored, which has a dramatization of something that is now fictional, but it’s not fanciful.

It’s something that could happen, and which the Nuclear Threat Initiative is working to minimize the chances of. And on that program, in addition to this dramatization of what could happen in that field, you have [former Senator] Sam Nunn and Senator [Richard] Lugar with [NBC News anchor] Tom Brokaw, discussing the subject. It’s an important subject. It didn’t get a lot of attention, again, in this last campaign, although I think both candidates fully recognize the importance. But we would regard ourselves as vulnerable to extinction, as a company, if we did not have nuclear, chemical, and biological risks excluded from virtually all of our policies, although we intentionally take on the risk periodically, but only in an amount that we feel we can handle. We do not write it and give it away for free. And we do not want to write it promiscuously, because there could be events happen that would make it impossible for our checks to clear the next day, and we’re not going to get ourselves in that position. Charlie?

CHARLIE MUNGER: Yeah. We’re likely to do better than most other people in dealing with what concerns you. We care more about it, that kind of correlation. We just naturally have minds that think about tidal waves in California, where they’ve never had one in modern California civilization. Can you imagine what a 60-foot tidal wave would do in California? There’s nothing physically impossible in having a 60-foot tidal wave in an earthquake zone, which California is in. But it’s never happened in modern history. But it’s the kind of thing that we do think about. And you think any other company has as much, as rigorous, nuclear and so on, exclusion as we do?

WARREN BUFFETT: Well, nobody’s attacked it any more vigorously than we’ve attacked, I would say. I mean, what you have here is, individually, we probably worry more about the downside than that just about any manager you can find. And collectively, you know, it’s Armageddon around here every day. (Laughs) But that’s — you know, we care about that. We’ve never used a lot of borrowed money. Back when I started out, I mean, I had $10,000. But I just didn’t want to borrow any significant amount of money. There’s no reason to. You know, we’re living fine. We were living fine when I had $10,000. And the idea that you risk what you need and is important to you for something that you don’t need and it is unimportant, is just craziness. And we try to run Berkshire that way. And you know, I had a 98- year-old aunt, my Aunt Katie [Buffett], that died last year. She had everything she had in Berkshire.

And the idea that I should be doing something to try and add a few dollars to my net worth, or a few percentage points to the record, and be risking the fact that she would go back to Social Security, is, you know — I just think that’s kind of crazy for a manager. But, you know, maybe if I had a two-and-twenty percent arrangement with my Aunt Katie, I’d be — differently, but I hope not. (Laughs)

19. Public education reform

WARREN BUFFETT: Number 11.

AUDIENCE MEMBER: Hello. My name is Martin Wiegand from Chevy Chase, Maryland. On behalf of the assembled shareholders, we appreciate you and the Berkshire staff hosting this weekend and would like to thank you for building this community of shareholders.

WARREN BUFFETT: Martin, thank you. (Applause) I should point out that I dated Martin’s aunt, but she only went out with me once. Maybe you could explain that, Martin. (Laughs)

AUDIENCE MEMBER: New board member Bill Gates has been talking about education reform in America, and columnist George Will quoted you in an article about Patrick Byrne’s efforts to reform education in America. Could you share with us some of your thoughts about these two efforts, or your efforts, to reform education? Thank you.

WARREN BUFFETT: Well, interestingly enough, we just dedicated a school here in Omaha yesterday which is named after my Aunt Alice, who taught in the Omaha public schools. And we’ve — I think we’ve maintained quite an excellent public school system in Omaha. We also have an outstanding parochial school system here. You know, it takes the interests of parents and, frankly, it takes the interests of the well-to-do in the school system to keep a first-class school system. I’ve said that, to some extent, a public — a good public school system is a lot like virginity. It can be preserved but not restored. In Omaha, we preserved it, but you preserve it by having the parents interested and involved in the public school system. And Patrick’s got an ingenious idea to make sure that more of the money goes to teaching and less to administration and overhead. There’s a variety of ideas around about how to correct a system where it’s broken.

And Charlie, as a big Ben Franklin enthusiast, has always said that an ounce of prevention is worth a pound of cure, and I think we’ve been spending that ounce of prevention, or providing it, here in Omaha. I think it’s a — you know, Charlie will have a lot more to say on this. I admire the fact that people like Patrick and Bill Gates and a lot of other people, John Walton and Teddy Forstmann, all kinds of people — Bob Wilmers, up in Buffalo — are attacking the problem. It’s probably the — next to the nuclear, chemical, and biological problem — I mean, it’s the number one problem of the country is making sure that the educational system is the best in the world. We’ve got the resources and we’re not providing it, we’re not delivering it. So, it’s very complicated when you operate through thousands and thousands of school districts and you work with many, many unions, and you’ve had, to a great extent in many areas, the rich opt out of the system and set up a separate system.

You know, I am not as concerned about the public golf courses in Omaha as I might be if I played them every day instead of playing at a country club. And if you have a two-tier school system, one for the rich and one for the poor, it’s going to be hard to pass bond issues that benefit the people that don’t have the money to send their kids to private schools. I’m a big believer in the public school system, though, in terms of equality of opportunity in this country. (Applause) Charlie’s thought about education. He’s actually come close to running a school. Cares about it enormously, so I’ll turn it over to him.

CHARLIE MUNGER: Well I learned something rather interesting about Omaha public schools on my way to this meeting. I stopped to sign some books in a warehouse in South Omaha, and one of the very nice people in the warehouse was married to an eighth grade teacher in the Omaha public schools. And we got to talking about “No Child Left Behind.” And he said his wife, this eighth grade teacher, had a very interesting system. For the numerous children who couldn’t read, she records “books on tape,” speaking slowly in her own voice. And when some children are reading the books, other children are listening to the tapes, and that way the children who listen to the tapes are not left out when they ask questions about what went on in the books Well, this is “No Child Left Behind,” in a sense, but it’s also a failure, in a sense. And I think it’s very hard for a civilization to fix the situation once somebody is in the eighth grade and can’t read. So I think there’s a lot of failure, even in relatively advantaged places like Omaha. And it’s very serious failure.

We never should have allowed it to happen.

WARREN BUFFETT: Yep. My friend Bill Ruane, who is here — I believe he’s here — is doing something extraordinary, in terms of a program he has teaching kids to read. In fact, journalists who are here should seek out Bill and learn something about the story of what he’s done in the last 10 years, in terms of moving reading abilities, and kids’ enthusiasm for reading, which is more important because it’s, you know — I talked about our managers and the important thing is that they have a passion for their business. Well, passion for reading can be developed and Bill has shown that in programs that he — I think he first started them in Harlem. He sort of adopted a block up there and went from there. And he would be a very interesting fellow to get some views from on this subject. You know, we’ve had this great success story in this country and a lot of it is because of people have had something closer to equality of opportunity in the United States than they’ve had in most parts of the world.

And you do not have equality of opportunity when my kids get to go to some school where I can attract outstanding teachers and where they’re in the company of other kids that are also motivated and they’re getting encouraged at home and all sorts of other things, and somebody else, who is born into a less advantageous family, really doesn’t have a chance. They go into something that’s close, maybe, to an armed camp where the teachers are just sort of pushing them through. And there’s no stimulus from the other kids except to do things that are counter to the interests of society. And that just isn’t a situation that really should be allowed to exist in a country where the GDP is almost $40,000 per capita

20. Bill Gates tops Churchill, Jesus, and Napoleon in survey

WARREN BUFFETT: Let’s go on to number 12. Oh, incidentally, I have to make one — It was mentioned about Bill Gates being a director and I did — I got a little survey here that came out. Pricewaterhouse and the Financial Times cooperated on the survey. And they asked CEOs around the world to choose — if they could pick anybody to choose from history or today to join their company’s board, who would they choose? And I’m happy to report that Bill came in number two. And, actually, number three was Winston Churchill. [Auto executive] Carlos Ghosn came in fourth. Jesus Christ came in fifth. Napoleon Bonaparte was sixth. And I won’t give you the rest of the list but —

CHARLIE MUNGER: Who was one?

WARREN BUFFETT: Well, one was [former General Electric CEO] Jack Welch. I knew you’d ask. (Laughs) But we didn’t ask Jack, we asked Bill. So, actually, I thought this quite an interesting list because I think many of the CEOs of the world would prefer people that are dead to be on their board. (Laughter and applause)

VOICE: It’s too funny.

21. Zero-down mortgages fueling housing price bubble

WARREN BUFFETT: Now let’s see. Where were we? We were going to number 12.

AUDIENCE MEMBER: Hello, my name is Robert Piton (PH) from Chicago, Illinois. And on that note, maybe a merger of some sorts between Berkshire and Microsoft is in the works.

WARREN BUFFETT: I keep hinting but it doesn’t do any good. (Laughs)

AUIDENCE MEMBER: The question that I have is, do you think the shift in the banking system during the ’90s to finance home purchases with zero percent down impacted the overall savings rate, as home purchases are the largest investment most people make, and the overall rise of home prices driven by these marginal buyers? If so, how would you suggest that we correct the problem.

WARREN BUFFETT: Yeah. Of course, any time a home is constructed, it represents somebody’s savings. I mean, the home buyer may buy it for nothing down, but that means he’s borrowing 100 percent of the mortgage through a mortgage that somebody else has saved somewhere, maybe intermediated three or four times or something of the sort. But home construction comes about through savings. Now there’s no question that terms have become easier and easier, and I’ve talked to certain mortgage bankers about this subject, but terms have become easier and easier as prices have increased. Now, that is absolutely counter to, you know, how people think about lending in general. Generally, the more the asset class becomes inflated, the less a prudent banker will lend. But of course, in this country, now you have mortgages intermediated in a way that the person buying the mortgage, in the case of — I’m thinking of Freddie [Mac] and Fannie [Mae] and other forms like that, so we’re talking about the lower-priced houses — but the mortgage buyer does not need to care about what kind of mortgage — what kind of a financial transaction the purchase is.

All they have to do is look at the guarantee, and they look at that rather than whether somebody’s put any money down, or anything of the sort. So I think you’ve had easy financing facilitating a boom in real estate prices, even at the higher levels. And I think that that that, which has occurred in other asset classes in the past — I mean, that farm bubble I talked about was facilitated by the fact that banks in small towns, who generally had been very conservative in lending, went crazy around 1980 and they lent amounts that the farm itself could never repay. They started saying a farm was an asset appreciation investment, not an income investment. And once you talk about something that’s an asset appreciation investment, ignoring the underlying economics of what you’re lending on, you’re really talking about the bigger-fool game. You’re saying, you know, this is a silly price but there’ll be a bigger fool that comes along. And that actually can be a profitable game for a while. But it’s nothing that bankers should engage in. So I would say that easy lending, obviously, does contribute to, overall in the country, to a lower savings rate.

But, in effect, somebody has to save for somebody else to borrow. And what is happening now is the rest of the world is saving. So then in the U.S. — in global terms, I’m talking — but the rest of the world is saving. And they’re sending us $2 billion — I mean, we’re sending them, in effect, claims for ownership of $2 billion — they’re investing $2 billion a day in the United States. But they — a lot of economists will say, well, that’s what’s really going on. The world loves our assets so much and they have so much confidence in America that the present current account deficit is driven by the fact they want to invest. I don’t believe that at all. I think it’s just silly, frankly, to make that argument. They are investing because they have to, because of our consumption habits, and not because they want to. And I think the declining dollar is evidence of that. Charlie?

CHARLIE MUNGER: I’ve got nothing to add to that. It’s obvious that the easy lending on houses causes more houses to be built and causes housing prices to be higher, probably, in the new field. Eventually, of course, if you construct enough of new anything, you can have a countervailing effect. If you build way too many houses, you’d eventually cause a price decline

WARREN BUFFETT: I’ll give you a fanciful illustration. Let’s just assume that Omaha had a totally constant population. No one was allowed to leave. No one entered. Birth rate equals death rate, all of that sort of thing. So the population was constant, and nobody could build any more houses. We just passed a city ordinance to that effect. But every year, everybody sold their house to their neighbor. So, first year, everybody sold their $100,000 house to their neighbor, and they both switched houses, and that was fine. And then the next year, they agreed we were going to do it at 150,000. And you’d say, well, how could that be? Well, we would all go to Freddie or Fannie and get our mortgages guaranteed for a larger amount, and somebody in New York or Tokyo or someplace would buy the Freddie or Fannie paper. And we’d have an influx of $50,000 per household. We’d all have the same number of houses. We’d all be living one house to a family.

And we’d have marked up our houses, and we now have a bigger mortgage, but we’d have $50,000 more of income that year, just to service a little higher mortgage. And we’d do the same thing the following year for 200,000, and so on. Now, that would be very transparent, and people might catch on to the fact there was something funny going on in Omaha. But you can have an accidental aggregation of behavior that somewhat leads to the same effect. I mean, if you keep marking up something, and in the process, the payment for the marked up price comes from someone else who feels they are bearing no risk because they’ve got the government guarantee in between, the money can just flood in and everybody feels very happy for a long time. And we don’t have anything like the fanciful thing I’ve set forth, in terms of Omaha. But we have certain aspects of that, I think, going on in the economy. Charlie, would you — I’m throwing this one at you. Would you agree or not?

CHARLIE MUNGER: Yeah, I do agree with that. You have varied Ponzi effects in various parts of any modern economy. And they’re very important and they’re very little studied in economics.

22. “Not enthused” about gold

WARREN BUFFETT: Let’s try number 13. I think, maybe, that’s in the other room and we’ll see whether we get a response and if not we’ll —

AUDIENCE MEMBER: Good morning, Mr. Buffett and Mr. Munger My name is Martin O’Leary (PH) and I’m from Austin, Texas. Mr. Buffett, given your past essays concerning the U.S. dollar and foreign exchange forward contract holdings that you have, and many countries’ economic policies that have a tendency to debase their currencies, do you think that gold can be considered a viable investment alternative to paper currencies?

WARREN BUFFETT: Yeah, we’re not enthused about gold. People, historically, have felt that was the first refuge from a currency that was going to be — decline in value. But, you know, so is a barrel of oil. So is an acre of land. So is a piece of Coca-Cola. So is See’s Candy. See’s candy — if the dollar goes down 50 percent, we will be selling See’s candy for double the present price. We’ll be getting the same real price for See’s candy. People will work the same number of minutes or hours per week in order to buy a pound or two-pound box of the candy. So we would much prefer a — some asset that is going to be useful whether the currency is worth what it is today, or 10 percent of what it is today, or whether people are using seashells in order to transact business. Because people will go on eating and they’ll go on drinking and doing various things. And their preferences will translate, in real dollars, into more or less the same economics for us.

And we would not trade the ownership of those kind of assets for us for a hunk of yellow metal, which has very little real utility except for people who are looking to flee from the dollar and, in our view, really haven’t thought through the consequences of what fleeing would — where they should flee. Charlie?

CHARLIE MUNGER: Yeah. If you have the opportunities of Berkshire Hathaway, averaged out, gold is a dumb investment.

WARREN BUFFETT: My dad [Howard G. Buffett] was a huge gold enthusiast. So I sat around the dinner table — my two sisters are here, too. They will testify to it. We sat around listening to the virtues of gold, and that was in, we’ll say, 1940. And gold, at that time, was $35 an ounce. And we would’ve had some storage and insurance costs. And, you know, here it is, 65 years later. World wars, nuclear bombs, all kinds of things. And the compound rate from $35 to a little over $400, less those expenses, is not something that causes me to salivate.

23. The danger of earnings expectations

WARREN BUFFETT: Number 14. Do we have a second microphone in the overflow room? Oh, there’s only one in there. OK, then we’ll go back to number one.

AUDIENCE MEMBER: Andrew Noble (PH) from England. Apart from the catastrophic insurance events or Armageddon scenarios that you’ve been talking about earlier, in relation to the operations of Berkshire Hathaway, what are your greatest fears?

WARREN BUFFETT: Well, the greatest, I would say — we don’t worry about the economics of the businesses we have. We’ve got a very diverse group. By and large, they’re very good businesses. By and large, they’re run by some of the best managers in the country. But we worry about something going wrong. I mean, you know, you heard about the Salomon [Brothers] thing in the movie. And, I mean, we’ve got 180,000 people out there, and I’ll guarantee you something is going wrong someplace, as we talk. That’s just the nature of it. But, what you hope is that it’s relatively unimportant or that we catch it. And — but that’s, you know, that is something that we know will happen. We try to have a culture that minimizes that. And I think we do have a culture that minimizes that. We — it’s very important, in our view, to have the right incentives. And many places, we think, have incentives that aren’t so good.

I mean, when I get on an airplane, and we own the company, like NetJets, the last thing in the world I want to tell the pilot is that I’m running late and I hope we can get to New York a little faster. I mean, that is dumb, to incent a pilot, who may be worried that, you know, somehow you affect his job or something, to get in a hurry about the takeoff or the checklist or whatever it may be. And companies do that time after time in their compensation plans or things that they incent people, in our view at least, some of the wrong things. That doesn’t mean nothing wrong will happen under any circumstances. But you should not have a system that causes people to, for example, worry about quarterly earnings. None of our — our managers do not submit budgets into Omaha. I have no idea what we’re going to earn next quarter. And I have no implicit body language out there, or anything of the sort, to our managers that I’m hoping to earn X dollars per share in the quarter.

Because in the insurance business particularly, you can report any numbers, basically, that you want to, if you write long-tail business for a short period of time. And, you know, we’ve got 45 billion of loss reserves. Well, who knows whether the right figure is 45 billion or 46 or 44? And if the desire is to report some given number in a given quarter, instead of saying 45 billion, you say 44-and-three-quarters billion, or something of the sort. So we have no incentives, in terms of how people are paid, or in terms of the fact they just don’t want to let me down. Let’s assume at the start of the year I asked everybody to submit budgets and then I went on Wall Street and preached a bunch of numbers. Even if their compensation didn’t depend on it, the managers would feel, you know, we don’t want to let Warren down on this.

So, you know, we’ll take an optimistic view of reserves, and that’s easy to do, at the end of the quarter and we won’t let him down and then he won’t look like a jerk in front of Wall Street. So we try to avoid that sort of thing. But even then, that is what we worry about. We don’t worry about this place making money. I mean, we’ll make money. And if we don’t, it’s my fault. That’s not that’s not the problem. The problem right now, in addition to the one we just talked about, the problem is deploying capital, and that’s my job, too. And, you know, I haven’t done a very good job of that recently, but with a little luck, you know, we will — and a different kind of market situation — we will get a chance to do that. Charlie?

CHARLIE MUNGER: Yeah. Well, if you stop to think about it, the history of much of which we don’t like in modern corporate capitalism comes from an unreasonable expectation, communicated from headquarters, that earnings have to go up with no volatility and great regularity — corporate earnings, I mean. That kind of an expectation from headquarters is not just the kissing cousin of evil. It’s the blood brother of evil. And we just don’t need that blood brother in our headquarters.

WARREN BUFFETT: Businesses do not meet expectations quarter after quarter and year after year. It just isn’t in the nature of running businesses. And, in our view, people that predict precisely what the future will be are either kidding investors, or they’re kidding themselves, or they’re kidding both. Charlie and I have been around the culture, sometimes on the board, where the ego of the CEO became very involved in meeting predictions which were impossible, really, over time. And everybody in the organization knew, because they were very public about it, what these predictions were and they knew that their CEO was going to look bad if they weren’t met. And that can lead to a lot of bad things. You get enough bad things, anyway, I mean. But setting up a system that either exerts financial or psychological pressure on the people around you to do things that they probably really don’t even want to do, in order to avoid disappointing you, I mean, I just think that that’s — it’s a terrible mistake. And, you know, we’ll try to avoid it.

24. We look for managers with great track records

AUDIENCE MEMBER: (Gap in video recording resumes in middle of question) — quality is largely innate. So if these characteristics are inherent and you were to attempt to consistently identify future great managers or entrepreneurs before there’s a track record, how would you go about doing it? And in particular, could there be a way to know that — before someone’s made a lot of money, before they built the business that they love and feel passionate about, that they will develop those types of qualities later in life?

WARREN BUFFETT: That’s a terrific question. And we have dodged it, largely, over the years by actually buying businesses from people where we’ve seen the record. In other words, I’m not sure I can go — in fact, I’m quite sure I can’t go — to an MBA class of 50 and sit down and talk with each one, examine their grades, examine their extracurricular activities, and whatever, talk to their parents, I’m not sure I could rank those 50 very well in terms of their potential for future business success. And, of course, some of it would depend on what areas they entered into in business. So, I think it’s tough. I think it’s tough to go out to the practice tee, where people are not actually hitting balls but just taking practice swings, and say which one is, you know, is a 2 handicap and which one’s a 15 handicap, and which ones, you know, can make it on the tour I think I can tell a little bit, maybe, but not — but it’s very hard to calibrate.

And I don’t think we’ve had much success, but we also haven’t tried very much, to identify people before they’ve had a record, to try and identify the ones that are superstars. Instead, we’ve taken the easy way, and we go — and if somebody comes to us with a business that’s done phenomenally for 10 or 15 or 20 years, or maybe for 50 years, and we’ve seen how — what their batting average is — we’ve actually seen they batted .350, or whatever it may be, in the major leagues. And we just make the assumption that we won’t screw it up by hiring them. And we also make the assumption that they’ll live to be 100 or 120 or something and we buy the business. And that’s far easier — it is far easier to tell the great baseball batters after you’ve seen a couple seasons of their batting than it is to go to a college — in college baseball teams or high school baseball teams — and pick out the superstars.

The one interesting thing, and I wish I could remember where I saw this study and it may not even be a valid study, but I do remember seeing something many, many years ago where they tried to correlate business success with various variables. And they took grades in school and whether they got MBAs and all that sort of thing, and they found that the best correlation was with the age at which they started their own business first. The people that got very interested in starting a lemonade stands, or whatever, tended to have better — it tended to correlate better with business success than other variables. We have found ourselves — we’ve got a lot of MBAs running businesses for us, but they ran them for a long time before we hired them or before we made the deal. And we’ve got others that never set foot in a business school. And I do think there’s a lot to wiring. I think there’s also a lot to working with the wiring you have and developing it over time. I don’t think that it’s all innate, and I don’t think you can’t improve.

I know you can improve on what you’re given at birth, but I do think an awful lot of it is wiring, more so than I would have thought 30 or 40 years ago. I’ve certainly seen it in business. I can — there are people, no formal business train — Charlie never went to business school, I mean, but he thought about it. I mean, I never heard him — Charlie say anything dumb about business yet, except when he disagrees with me. (Laughs) The truth is I’ve never heard him say anything dumb about business, period. And there are other people. I’ve never heard [GEICO CEO] Tony Nicely say anything dumb about business, ever. They just — they’re wired so that they — that the, you know — it doesn’t flicker. I mean, they get the answers. It doesn’t mean they can — you know, they’d be a great ballroom dancer or a great baseball player, you know, or a great politician, but they are wired for business. Charlie?

CHARLIE MUNGER: Yeah. Part of it is intelligence and part of it is temperament. I don’t know if Bill Ginn is in the audience, but by the time I was 14 years of age, I knew Bill Ginn would be rich. He was a classmate of mine in high school, and a very intelligent man, and he wanted to be rich. And he was sensible in the way he handled life. I think sensible people with the right temperament and the right intelligence, if they live long enough in our system, will get rich. But temperament is, I think to some extent, inherited, too. Don’t you?

WARREN BUFFETT: Yeah. His daughter, incidentally, is a partner with my daughter in a knit shop, which I hope you patronize while you’re — (Laughs) We’ve united the Ginn and the Buffett family. (Laughs) Charlie, when did you first think business was something of interest to you?

CHARLIE MUNGER: Very early. (Laughter) I loved games of chance and I love trying to learn how to win at them.

WARREN BUFFETT: Yeah. It’s interesting for me, you know, simply to think about the question of whether the Final Four of the NCAA will be will be canceled, as opposed to postponed or transferred in locale, and decide if we’re going to pay out $75 million the next day if it is canceled, and how much we want to receive in today to take care of that. And that probably wouldn’t interest — all kinds of people that wouldn’t be interesting to. And since my dad wouldn’t let me become a bookmaker, I went into investments. (Laughter)

25. Cologne Re stake

WARREN BUFFETT: Number 3.

AUDIENCE MEMBER: Good morning. Jens (PH) from Germany. After buying almost all of Cologne Re, how happy are you about the progress, and what are the plans for the remaining minority shareholders?

WARREN BUFFETT: Yeah. General Re, at the time we bought it in 1998, owned something in the 80s of Cologne Re, a large German company that they bought this 80-odd percent in, a few years earlier. It’s actually slightly more complicated than that because there was an arrangement where a certain purchase was deferred, but as a practical matter they owned in the 80s. Right now, Gen Re owns about 91 percent of Cologne Re. That’s a subject that, obviously, it’s not pressing with us, because we’ve owned it for seven years without taking our interest up, except periodically through small purchases. And there’s no particular reason to — why 100 would be better than 91 percent. But if the price is attractive and shares are offered to us, we will always contemplate buying it. But it’s not key to any strategy.

26. Munger defends AIG

WARREN BUFFETT: Number 4.

AUDIENCE MEMBER: I’m Christian Tukenberger (PH) from Switzerland, Europe. What do you think of the two insurance — reinsurance, AIG and Converium, from Switzerland? Thank you.

WARREN BUFFETT: Well, I’m going to give you a chance at a second question because I don’t really think I should comment on AIG. There’s, you know, they have said that they’re going to have their 10-K. They hope to have it by, I guess, today. I haven’t received any late word whether it’s been filed but they have — there’ll be more disclosure on the situation at AIG, and I really don’t know anything about what will be in that statement, and I’ll just — I’ll wait to read it. I’ll read it with interest. But I — I have no particular insights on that. Converium has had troubles in the United States, has been announced, but they also raised additional money. But again, I don’t really have any specific commentary on those two companies. Charlie?

CHARLIE MUNGER: Well, I’ll be bold enough to make one comment about AIG. (Laughter) I think whatever comes along, people are going to find that a lot that was very right was done over the years by AIG. There’s a lot of ability in that place.

WARREN BUFFETT: Oh yeah. Extraordinary. I mean, Hank Greenberg was — he was the number one man in insurance. I mean, he developed an extraordinary company, in his lifetime. It wasn’t that much when it was handed to him. And he became the most important factor, I would say, by some margin, in the property-casualty business. But in terms of evaluating where it stands now and what will be revealed when the 10-K comes out, I just have no idea.

27. Fannie Mae, Freddie Mac, and the home mortgage mess

WARREN BUFFETT: Number 5.

AUDIENCE MEMBER: Good morning. My name’s Mike Nolan. I’m here from Montclair, New Jersey with my 18-year-old son Brian, who’s experiencing his first Berkshire annual meeting. My question, and you touched on it a little bit in a couple of earlier questions, deals with the current regulatory environment in Washington, which appears to be growing much more negative on Fannie Mae, Freddie Mac, Farmer Mac, and so forth. What might the implications for the U.S. consumer specifically, and the U.S. economy generally, be if the GSEs are effectively bridled or significantly restricted from their past charters? Could this prick what you earlier referred, and some private economists are calling, a real estate bubble and what will be the fallout?

WARREN BUFFETT: Yeah. The GSEs, in effect, expanded their original charter and reason for being. The thought, originally, was that they would guarantee mortgages and they had this very limited, I think, two-and-a-quarter billion dollar line of credit from the Treasury. But they were they were brought in, to an extent, to do what FHA and VA had done for mortgages in their arena, was to give people confidence in borrowing money — or in lending money — far away from their own geographical location. I mean, when the local — when I borrowed money on my house in 19 — bought it 1958 — I mean, I went down to see Mr. Brownlee (PH) at the Occidental Building and Loan, and he, you know, he knew something about me, and he knew something about my parents, and he knew where the house was and all of that. But as the mortgage market became more institutionalized and it became more — the source of funds became geographically far more distant from the user of the funds, in order to have a market in which — which would be efficient, the GSEs were a very logical development.

And the GSEs came in, Freddie and Fannie, and the idea was that for a fee, which used to average about 25 basis points, they would guarantee these mortgages so somebody living 3000 miles away could buy them through securities and not worry about the individual property. And then, the portfolio operations developed over the following years and, of course, they enabled the GSEs to earn high rates of return on capital, because, in effect, the GSEs were looked at as government guaranteed so that people would lend them money without worrying about the degree of leverage employed. And, in effect, the GSEs became huge — they hugely developed what might be called the carry trade, using the government’s credit, in effect, and the spread between what they paid on their money and what they got on mortgages. So that became the dominant source of their earnings. They got very carried away with delivering promised rates of growth. I remember reading in the Freddie Mac report some years ago, where they talked about delivering in the mid-teens or low-teens or something like that.

And I thought to myself, you know, that this is madness, because you can’t do that when you’re running a big carry trade operation. Interest rate — the slope of the curve will develop. There’s no way to lend money for 30 years to somebody who can pay you off 30 seconds later, to actually match assets and liabilities in a way that’s risk-free. The only way you could do it would be to issue a 30-year bond of your own, which you could call 30 seconds later, and people don’t buy those bonds. So, as a practical matter, you could not perfectly handle the risk of significant interest rate changes. But the GSEs got caught up with delivering increasing earnings all the time to Wall Street. So they first enlarged their portfolios and later, as we’ve seen, they got involved in some accounting shenanigans, which really sort of boggle the mind when you think of two of the most important institutions in the country, with all kinds of financial experts on the board and top-named auditors and everything, and turning out that billions and billions and billions of dollars were misreported. It shows you what can happen in a system.

Now Congress is reacting, administration is reacting, [Federal Reserve Chairman] Alan Greenspan is reacting, in terms of saying that, you know, what have we created? What is this — the situation where these two companies have a trillion-and-a half or more of mortgages they own, and people really think the federal government is on the hook, and the federal government does — wants to say it isn’t on the hook. But the truth is, it is on the hook. And institutions worldwide own the credit — own the securities — based on this implied promise. And it was all being done just because, basically, these companies wanted earnings per share to go up. Now, they say they did it to maintain an orderly market, and all that stuff, in the mortgages. But they were really set up to guarantee mortgage credit. And there’s going to be reaction in Congress. It will be a huge fight. Both of those institutions have been heavy supporters of various legislators over the years. They’ve got lots of clout. Not as much clout as they had a year ago, but they’ve got lots of clout in Congress.

And on the other hand, people have lost faith, to some degree, in what they’ve done. And they’ve also seen that the consequences of the government issuing a blank check to two institutions that are trying to produce annual gains in earnings per share of 15 percent, and doing it by accounting means when they ran out of the ability to do it by other means. So it’s something that Congress should be giving a lot of attention to. They can’t cut them off, in my view and, I think, most people’s view. They can’t say get rid of your portfolios or anything like that. So my guess is that some kind of a curtailment comes in, some kind of tougher accounting requirements come in, sometimes it may be tougher capital ratios. And that over a long period of time, the government tries to figure out something that sort of eases them out of this position, where they were basically backing two entities that, at times, acted like the two biggest hedge funds in history. Charlie?

CHARLIE MUNGER: Yeah. Well, he was asking, partly, is what happens if the government reins these two institutions in and forces a big reduction in asset base.

WARREN BUFFETT: I don’t think they’ll — I don’t think the government is going to do something worse, they sell off hundreds of billions of dollars of mortgages, at all. But if they curtail it — let’s just say they say that from now on you got to operate in a runoff mode for a few years. There are plenty of people out there to buy mortgages. They’re already buying the securities of Fannie Mae and Freddie that are financing the mortgages. So it isn’t like Fannie and Freddie, independently, were coming up with the funds to finance these mortgages. They got them from somebody else and that somebody else can leave Freddie and Fannie out of the picture and buy the mortgages through some other form. It would not be the end of the world, at all, if Freddie and Fannie no longer had new portfolio purchases. I don’t think it would change things in any significant way, in terms of the cost of homeownership or anything else. How about you, Charlie?

CHARLIE MUNGER: Well, I agree. I don’t think it would have enormous macro effects if future growth were curtailed. I do think a lot of the troubles that came, came from a large use of derivative books, and from Fannie and Freddie both believing a lot of silver-tongue salesmanship from derivative traders. And, as many of you know, I think there is much wrong with derivative accounting and derivative trading operations in the United States, and I don’t think the full penalties have yet been paid.

WARREN BUFFETT: When you can have a $5 billion mismark in one direction at one of these — and bear in mind these are among the most scrutinized companies in the world, and with outstanding people on their boards, in terms of financial expertise — if you can have a $5 billion mismark in one direction, while at the same time the other one has a 9 billion mismark in the other direction, you know, I would say we’ve come a long way from Jimmy Stewart and “It’s a Wonderful Life.” (Laughs)

CHARLIE MUNGER: Yeah.

28. UK reporting requirements are a deterrent

WARREN BUFFETT: Number 6.

AUDIENCE MEMBER: Hi, this is Peter Webb from London, U.K. The question I wanted to ask you: I’ve been an investor for many years and done very well following a similar sort of style to yourself. So thank you for that. The big question I have is —

WARREN BUFFETT: Would you want to quantify that? You can always send us a check. (Laughs)

AUDIENCE MEMBER: But if there’s a deal to be had, maybe we can speak afterwards.

WARREN BUFFETT: OK. (Laughs)

AUIDENCE MEMBER: The question that I have for yourself and Charlie is, over the time I’ve bought many different companies in the U.K. and Europe, and I’ve seen many American value funds buying the same companies, but I see very little activity from Berkshire and its subsidiaries. And I didn’t know whether that was a reflection on your views on U.K., Europe, and the world. Whether you just see a lack of investment opportunity? Is it outside your sphere of competence? Or is there some other reason that I see less activity from you in Europe?

WARREN BUFFETT: Yeah, it’s a good question. We own, of course, as you know, 80 percent or so of MidAmerican Energy, which has a very large business in the U.K., but that’s an operating business. As you know, in the U.K. there’s a rule that requires reporting when you own three percent of a company’s stock. And actually, there’s some conditions under which the ownership will be reported even sooner than that three percent. There’s a provision that — I think if there is an inquiry or anything, that it has to be responded to. So, if you take a company with a market cap of, you know, £5 billion, if we bought £150 million of it, we would have to report, and that tends to mess up subsequent purchases. So, we bought stock — we own stock in Diageo, which was Guinness at the time. We’ve owned stock in some other U.K. companies.

But we’ve thought twice before going over three percent, because of the reporting requirements, and then we’d have to report if we were selling, and all of that. So that’s a deterrent, but it’s not an overwhelming deterrent. And if we, you know, if we get a chance to buy a significant piece of something that we think is cheap, particularly if we could buy it in one purchase. But there’s a lot of special rules that kick in, over in the U.K., that do not in the United States. Incidentally, there was something in the Journal the other day that said that we had to report if we bought over five percent of a company within 10 business days in the U.S. That is not true. That was a mistake in the report. But it is the case in the U.K. that at 3 percent, reporting is triggered. But there — we would feel very comfortable with lots of U.K. businesses. And, you know, they’d have — it’d be the same criteria we applied over here: a durable competitive advantage, and a management that we like and trust, and a reasonable price.

And we have seen some of those. There was an insurance company in the U.K., a year or so back, that I would very much have liked to have bought, but we couldn’t come to terms on price. But we have no bias whatsoever against buying businesses in the U.K. And as I say, we’ve — at Yorkshire and Northern Electric, you know, we have a business that, shows in our report, made close to $300 million after-tax. And actually, considering my views on currency, you know, I would have — I’d give a slight edge to buying something where the earnings would be in sterling in the future, rather than in dollars. Charlie?

CHARLIE MUNGER: Well, I regard it as kind of amusing that we ended up preferring the currencies of Europe when it’s so much more socialized than the United States is. That’s a queer occurrence.

WARREN BUFFETT: You actually prefer them or not, Charlie? (Laughs)

CHARLIE MUNGER: Well, certainly in recent — over a considerable period of recent months — we’ve actually preferred the currencies of socialized Europe to our own currency. I just regard that as an odd occurrence for both of us. That wouldn’t have happened.

WARREN BUFFETT: No. Up till three years ago, if I came back from Europe and I had a euro in my pocket I couldn’t wait to run to the bank or someplace. I was afraid it would depreciate before I could get rid of it. But I changed my views a few years ago. We hope to buy businesses, and stocks, other places in the world. And Charlie mentions the difference in political climate. One thing: you read about slow growth in Europe and Japan and all those, and it’s true. But usually — but the growth figures that you see are usually not on a per capita basis. And since the population of Europe has been, generally, very little changed, whereas the population of the United States grows one or one- and-a-half percent a year, if you look at growth figures in the United States and somebody says three- and-a-fraction percent, that’s not on a per capita basis. I mean, you’ve got to — you have to deflate that by the growth in population.

Whereas, if you read about the growth in Europe, generally, you’re dealing with a population base that hasn’t changed. So the differences in growth rate on a per capita basis are not as wide as the headlines would suggest.

29. Legal liability for someone else’s accounting?

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: Gentlemen, my name’s Mike McCloskey. I’m from Toronto, Canada. My question is: what obligation does a financial intermediary, or a party to a transaction, have to ensure that the other party to the transaction properly accounts for it.

WARREN BUFFETT: Well, that question may come up in a very real sense. (Laughs) But, you know, we have lots of reinsurance transactions, obviously. Banks have lots of transactions with people. Certainly, if you knowingly are doing something that causes a company that are participating in it, you know, you may have very serious obligations on that. But on the other hand, if you’re — I mean, we reinsure hundreds of companies. They have legal departments. They have auditors. And there could be somebody out there today — well, they could be doing anything with their accounting. It probably wouldn’t be limited to the contract they had with us. It might well be other things. But it really gets down to whether there’s knowing participation, I would say. Isn’t that right, Charlie?

CHARLIE MUNGER: Well, as you say, it’s a subject rife with ambiguities and different issues. You have had some bartender liability, if you serve a drink to somebody that’s already inebriated, why, some people say the bartender is liable. On the other hand, radio stations are allowed, in America, to sell advertising time to people that use it for perfectly obvious fraud, and nobody ever sues the radio station. It’s very hard to predict what things are going to get legally shifted around so a supplier gets liability for its customer’s behavior.

30. Invest in yourself and ignore asset allocation

WARREN BUFFETT: Number 8.

AUDIENCE MEMBER: My name is (UNINTEL). I live in Sacramento, California. My question is related to the issue of U.S. trade deficit again and its implications on the future value of the dollar. Do you think an individual or a business owner here in U.S. should be concerned about the purchasing power of his future dollar earnings or savings, and diversify his or her investments in non-dollar-based securities?

WARREN BUFFETT: I think it’s very tough for individuals to either select individual stocks, select individual times to enter the market, select currencies. I mean, I just think that’s a game that they tend to get interested in at the wrong time. There’s some adverse selection, in terms of when people who do not follow stocks carefully get interested in stocks. I think that, you know, the best investment you can have, for most people, is in your own abilities. I mean, when I talk to students, you know, I would pay a student — in many cases, I would be glad to, you know, pay them $100,000, cash up front, for 10 percent of all their future earnings. So, I’m willing to pay 100,000 for 10 percent of them, I’m valuing the whole person at a million dollars, just capital value standing there in front of me. And those — anything you do to develop your own abilities is probably going to be — or your own business — is probably going to be more productive for you than starting to think about individually making commitments into foreign exchange.

If you have a good business in this country earning money in dollars, you’ll do ok. I mean, you may live in a world 20 years from now where a couple percent of the GDP is going to service the debts and the ownership that we’ve created now by running these deficits. But you’ll do fine in America. So, I wouldn’t worry about that much. Charlie?

CHARLIE MUNGER: Well, if you look at Berkshire, you will find that it really doesn’t do much of conventional asset allocation to categories. We are looking for opportunities and we don’t much care what category they’re in, and we certainly don’t want to have our search for opportunities governed by some predetermined artificial bunch of categories. In this sense, we’re totally out of step with modern investment management, but we think they’re wrong.

WARREN BUFFETT: Yeah. And incidentally, we have 80 percent of our money, or more — well over 80 percent — tied to this country and to the dollar. So it’s not like, you know, we’ve left the country or anything of the sort.

CHARLIE MUNGER: When have you done a big asset allocation strategy?

WARREN BUFFETT: Never.

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: Yeah. We end up with peculiar asset mixes. I mean, if the junk bond thing had gone on a little longer, instead of having 7 billion in there, we might have had 30 billion in. But we were doing that simply based on the fact that it was screaming at us. And we do the same thing with equities. I mean, back — for many years, we had more than the net worth of Berkshire in equity positions. But they were cheap.

CHARLIE MUNGER: And I want you to remember one of my favorite sayings as you do this asset allocation. “If a thing’s not worth doing at all, it’s not worth doing well.” (Laughter)

WARREN BUFFETT: You can see why Ben Franklin turned the mantle over to Charlie. (Laughter)

31. Lunch break

WARREN BUFFETT: We’re going to take a break now, so you can all go out there and enjoy yourself in the adjoining room, and have lunch, and we’ll be back here at 12:45. And those in the other room might come back to this area because I think we’ll have enough seats for everybody after lunch.

Afternoon Session

1. Q&A resumes

WARREN BUFFETT: OK, we’re going to start in just a minute or two, if you have a chance to sit down. OK, let’s go to station 9. And I’ve — I’ll — we will go till 3 o’clock. We’ll break until 3:15, when we’ll convene the business meeting. No one has submitted any proposals for that meeting, so it may be relatively short. At 4 o’clock, Charlie and I will meet in another room here — I’m not sure where — with any of those of you from outside North America that are here. We would like to especially thank you for coming this long distance.

2. We’ll “do pretty well” when inflation is high

WARREN BUFFETT: So, with that, we’ll go to area 9.

AUDIENCE MEMBER: Good afternoon. My name is Ken Goldberg from Sharon, Massachusetts — Massachusetts, having the distinction of being the birthplace of Benjamin Franklin. And, thanks to New Jersey, the only state in the Union where one cannot buy GEICO auto insurance. (Laughter) Earlier this morning, you discussed policies that have eroded, and that threaten to continue to erode, the U.S. dollar. In some of your earlier letters to shareholders, you warned about the dangers of inflation and cautioned that shareholders should fully take inflation into account when evaluating the performance of a business. To what degree do you expect a large decline in the value of the dollar to trigger inflation that would adversely impact Berkshire’s equity holdings and its businesses? And to what extent should we calibrate Berkshire’s overall performance against the backdrop of a weakening dollar?

WARREN BUFFETT: Well, we think, by and large, we have businesses that will do pretty well in inflation. But inflation destroys value, but it destroys it very unequally. The best business to have during inflation is one that retains its earning power in real dollars without commensurate investment to, in effect, fund the inflation-produced nominal growth. The worst kind of business is where you have to keep putting more and more money into a lousy business. In effect, the airlines have been hurt by inflation over the last 40 years, because now they have to put a whole lot of money in a lousy investment, which is a plane, compared to 30 or 40 years ago. And they have to stay in the game. They have to keep buying new planes. And the new planes cost far more now, and the returns continue to be inadequate. So the best protection is a very good business that does not require big capital investment. And, you know, the best investment at all — of all — I mean, if you’re the leading brain surgeon in town or the leading lawyer in town or the — whatever it may be — you don’t have to keep re-educating yourself to be that in current terms.

You bought your expertise when you went to medical school or law school in old dollars, and you don’t have to keep reinvesting. And you retain your earning power in current dollars. We — Charlie and I are always suspicious that inflation will regain some of the momentum it had a couple of decades ago. We always think it’s in sort of remission. We thought the talk about deflation was total nonsense. And certainly, the trade picture is one that you would think would accentuate any inflationary trends that might otherwise be experienced. I mean, obviously, the price of oil in euros has gone up far less than the price has gone up in dollars. And you and I are buying gasoline in dollars, so we have seen a bigger increase in our fuel costs because of the decline of the dollar than we would’ve seen if we lived in Europe, or some other — or Australia, for that matter. So, it’s — inflation is always a factor in calculating the kind of investment, the kind of business, that we want to buy. But it doesn’t — it isn’t like it crowds out all other factors. I mean, it’s always been with us.

We’ll think about it always. See’s Candy has done fine during an inflationary period because it does not have huge capital investments that have to be made in current dollars. Other businesses we have, you know, if we’re — the public utility business, for example — it costs a lot more money to maintain capital expenditures now in dollar terms than it would’ve 30 years ago. So you have to keep putting more and more money into a public utility. And you’d better hope that the rate of return allowed is commensurate in times of high inflation the same way that it might have been in low inflation with a lower rate of return. Charlie?

CHARLIE MUNGER: Yeah. Well, so far, the facts that are driving the dollar down in relation to other currencies have been restraining inflation in the United States. In other words, it’s the competitive export advantages of the other people that are — that have so far restrained inflation here. So, it’s —

WARREN BUFFETT: Yeah, you’re paying less for shoes. You know, we got killed in the — in parts of our shoe business. And 30 years ago, of the billion-plus pairs of shoes used in the United States, a very high percentage were made here. And now, virtually none are. But if they were all being made here, you would be paying more for shoes. There’s no question about that.

CHARLIE MUNGER: Yeah.

3. Buffett: Don’t bet against America

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: I’m a physician from St. Louis. And I want to thank you and everyone here, because I’m one of these doctors that really doesn’t know anything about money or finance. The money comes in, but I don’t know what to do with it. I’m not able to really evaluate the financial strength of a company, but I can evaluate the ethical strength of a company. And that’s why I feel real comfortable — I think most of us here — having our savings in Berkshire Hathaway. And the —

WARREN BUFFETT: Thank you. (Applause)

AUDIENCE MEMBER: This question has probably been asked in different ways already, but several years ago, a fellow I know who was — had been manager of Magellan Fund — warned that we were going to have a terrible decade or so in the stock market because of all the things people have brought up so far. The increasing interest rates, and runaway spending, and decreasing dollar, and stagflation may be right around the corner, Social Security problems. And even what Charlie Munger referred to, is that most of our best and brightest graduates, I find, are going into money management rather than — they’re not becoming doctors or molecular biologists or Ph.D.s in chemical engineering. And so, in view of the fact that a year or two ago, people — there was still an ebullience of emotion about the stock market going up and making everyone rich just by having their money in the stock market — it seems like that ebulliences dropped, and I’m hearing, in anticipation of a bear market. And you wrote, I think several years ago, that it’s hard to make money in a bull market. And the real opportunities come in a bear market.

So, I’m wondering if you would give us a clue as to what your strategies are going to be, if it’s really true that the market gets dismal over the next few years.

WARREN BUFFETT: Well, if the market gets cheaper, we will have many more opportunities to do intelligent things with money. Now whether we will blow on the money in the meantime or something is another question. But, you know, we are going to be buying things — one thing or another — operating businesses, stocks, high-yield bonds, whatever — we’re going to be buying things for as long as I live, just like I’m going to be buying groceries —

CHARLIE MUNGER: Longer than that, Warren.

WARREN BUFFETT: Yeah. (Laughter) Yeah. Charlie’s just waiting to take over after I’m — (Laughter) And I’m going to be buying groceries the rest of life. Now, would I rather have grocery prices go up or down if I’m going to be buying groceries tomorrow and next week and next month and next year? And the answer is obviously, if I’m a net buyer, I would — I will do better if prices are lower. We have no — we’re not good at forecasting markets. I mean, we, in a general way, knew that we were getting enormous bargains in the mid-’70s. We knew that the market went crazy to some extent in the late ’90s. But we don’t have much — we don’t spend any time — Charlie and I spend no time — thinking or talking about what the stock market is going to do, because we don’t know. We do know, sometimes, that we’re getting very good value for our money when we buy some stocks or some bonds, as it may be.

But we are not operating on the basis of any kind of macro forecast about stocks. And there’s always a list of reasons — you gave a few — there’s always a list of reasons why the country will have problems tomorrow. But there’s always a list of opportunities which don’t get mentioned quite as often. So, we don’t sit down and make a list of the bad things that are happening in the economy and the good things that are happening, and therefore expecting the stock market — It might not — it doesn’t behave that way even if you could correctly forecast some of the bad things or good things. Overall, I’m an enormous bull on the country. I mean, over time — I mean, this is the most remarkable success story in the history of the world, if you think about it. I mean, in 1790 we had less than four million people in this country. We had — there were 290 million people in China. There were 100 million people in Europe. You know, and they all had the same intellect we had. They’re in the same general climate. They had lots of natural resources.

And 215 years later, those 3.9 million people, I think, actually, you know, have 30 percent or so of the world’s GDP. So, it does not make sense to bet against America. That doesn’t mean all our policies are smart or anything, but I would not — I do not get pessimistic on the country. You know, I worry about the — I mean, the big worry is what can be done by either terrorists or governments that have access to nuclear, chemical, or biological weapons. But, in terms of the basic economics of the country, your children are going to live better than you live. And your grandchildren are going to live better than your children live. And we do not focus on macro factors. Charlie?

CHARLIE MUNGER: Well, I agree with you that the economics of the country are probably going to increase for a considerable period ahead. But I suspect that, in very important ways, we are at or near the apex of a great civilization. (Laughter)

WARREN BUFFETT: You heard it here first, folks. (Laughter) If you leave the NCB — nuclear, chemical, biological — out of it, I do not feel that way. But, you’ll get to see which one of us is right 20 or 30 years from now. It — I have seen more people pass up opportunities because they get focused on a single economic variable or a single problem that the country faces, and they forget about the good things. I mean, if you can buy very good businesses at attractive prices, it’s crazy to say, “I think I’ll sit this out because it might get a little cheaper next year,” or something of the sort, and because the world’s going to go to hell. We just — we’ve never operated that — we’ve never decided not to buy a business we liked because of a macro view. Have we?

CHARLIE MUNGER: Not yet.

WARREN BUFFETT: OK. (Laughter) It’s hard to get him to really agree with you. (Laughter) I’ve been working on it for years.

4. GM and Ford haunted by past commitments

WARREN BUFFETT: Number 11.

AUDIENCE MEMBER: Hello. My name is Randall Bellows. I’m from Chicago. And many years ago, Lauren, my wife, did a portrait of you drinking a can of Coke. Next year I’ll bring one, drinking a can of Bud.

WARREN BUFFETT: I think you’d better stick with Coke. (Laughs)

AUDIENCE MEMBER: Oh, OK. I would like you to speculate on a couple of questions. The first is, given the competitive disadvantage of General Motors and Ford with their huge health care liability costs for their employees and retirees, what do you think might happen there? Do you think there might be a bankruptcy to get rid of the liabilities or a government bailout? And along that line, Charlie, you spoke several years ago about tort issues. Do you feel there’s anything coming in the way of asbestos reform or correction for those issues and the insurance companies that have been paying those billions? Thank you.

WARREN BUFFETT: Well, I would say that Rick Wagoner at General Motors and Bill Ford at Ford, both have been handed, by managers of the past, extremely difficult hands to play. They’re not the consequences of their own doing at all, but they have walked into what people call legacy situations. But they have inherited a cost structure brought about by contracts that were put in place, maybe decades ago, that make it very difficult for them to be competitive in today’s world. I mean, just imagine if Ford or General Motors had signed contracts that made them pay several thousand dollars a ton more for steel than their competitors did. I mean, it would — people would immediately feel that was untenable. So, General Motors and Ford are in the position of having commitments, which are, in strong contractual terms, to pay sums for retired, particularly, workers in both the annuity field and in the health field that are staggeringly high compared to some of their competitors. And their competitors can buy steel at the same price, and they can buy aluminum at the same price, they can buy rubber at the same price.

And when you get all through with it, if they have huge advantages on the health care and the annuity side, it’s not going to be a fair fight. And those contracts, to some day — to some extent — go back to when General Motors had, for example, 50 percent-plus of the U.S. auto market. And now it has 25 percent. But I think even if it had 50 percent today it would be having trouble. So, it’s a very, very tough situation. I’m not sure what I would do if you put me in charge of — I mean, as Bill Buckley said many years ago when he ran for mayor of New York, they said, “What’s the first thing you’re going to do if you get elected?” He said, “I’ll ask for a recount.” (Laughter) Well, that’s a little the way I would feel if I got elected CEO of General Motors. From the standpoint of the UAW, you know, they have a contract, they made a deal. And they’ve got $90 billion in the pension fund.

It’s kind of interesting. The pension fund of General Motors possesses roughly $90 billion. The health care fund has a little more, too, another 20-some billion as I remember. The whole equity of General Motors is selling for about 14 billion. So after all these years, there’s 90 billion set aside for the retirees, and there’s 14 billion of equity value that’s been heading south for the owners. And, it would seem that if General Motors had a steel contract that called for — let’s say there’s a ton of steel in every car — and I’m not saying there is — and if they were paying $2,000 a ton over market — or what their competitors were paying — people would say that that is not a viable situation for the long term. But they’re in a similar situation because the contracts they voluntarily signed. And part of the reason they signed those — and undoubtedly — was that they bore no accounting consequences at the time. It’s a terrible mistake for managers not to think in terms of reality rather than the accounting numbers.

But back in the ’60s, you did not have to account for pensions on an accrual basis. And up till the ’90s, you didn’t have to account for health care — or the late ’80s, whenever it was — on an accrual basis. And so people said, “Well, if we don’t have to count it, it isn’t real.” Well, believe me, it’s real. And the managers today are facing the consequences of that. So, you know, they’ve got very tough hands to play. And, you know, I read about it in the papers. I don’t know what’s going on there necessarily, but something will have to — in my view — something will have to give in that matter. And before you answer the asbestos thing, Charlie, what do you think about them?

CHARLIE MUNGER: Warren gave a very optimistic prognosis — (laughter) — in my view. I think — just because it hasn’t happened yet doesn’t mean that the problem isn’t real. If you jump out of the window on the 42nd floor, and you’re still doing fine on the way down as you pass the 20th — (laughter) — it doesn’t mean you don’t have a serious problem. (Laughter) If I were the governor of Michigan, or the president of the United States, or a director of General Motors or Ford, or a family member of Ford, I would want to address the problem right now. I do not think it’s getting better or that Yehuda is going to come over the mountain with a magic wand and make it go away. I think it would be better faced.

WARREN BUFFETT: You want to try the asbestos? (Laughter) Give us another cheery — (Laughter) Around the office he’s known as Pollyanna. (Laughter)

5. Munger: “Terrible” and “gutless” behavior led to asbestos problem

CHARLIE MUNGER: Well, the asbestos thing has involved terrible behavior by some lying doctors, terrible behavior by a bunch of lawyers who suborned perjury, and gutless behavior by certain important courts, and even more gutless behavior by politicians who take care of themselves first, naturally. And it’s — these are the forces that are bearing on the problem. It’s obviously not going to be handled very well. So, it’s a perfectly terrible situation. You keep hoping that it will be so obviously bad that it will finally be addressed. Some of that happened in California. The workmen’s comp system in California had immense fraud in it, particularly egregious fraud by lots of doctors and lots of lawyers and lots of claimants. And it was so awful that it affected the whole employment prospects in California. And with the [California Governor Arnold] Schwarzenegger revolution, that was partly corrected — I would say maybe 15 percent corrected. And, but it took —

WARREN BUFFETT: Five hundred pushups, Charlie.

CHARLIE MUNGER: What?

WARREN BUFFETT: Five hundred pushups unless it’s 100 percent. (Laughter)

CHARLIE MUNGER: So, I think that if it gets bad enough, there is some possibility there will be more correction. In a sense, it’s totally crazy for a court system to be paying tons of money to people that have smoked two packs of cigarettes all their life and have one little spot on a lung that no honest doctor would know what the hell it caused. And they aren’t yet sick, and they’re nearly dead anyway from their other behaviors and longevity. And it’s just, it never should have been allowed. But once you get a powerful political force, even judges fear consequences. And it’s very easy just to drift along with an evil system. Luckily, we aren’t using this particular — there are two kinds of asbestos, one of which is virtually harmless and the other which caused all this damage. And we stopped using the damaging asbestos. And eventually the asbestos problem will go away. But how many people it will leave in some kind of financial wreckage before the storm is over, I can’t tell. I don’t think the last Indian has bit the dust, do you, Warren?

WARREN BUFFETT: No, I’m — no.

CHARLIE MUNGER: I think the — but the behavior is so terrible. It’s that kind of behavior that makes me talk about apexes of the civilization.

6. Our successors will provide the “same wonderful lack of oversight”

WARREN BUFFETT: Number 12.

AUDIENCE MEMBER: Now, Mr. Buffett and Mr. Munger, my name is Marc Rabinov from Melbourne, Australia. I think it’s rare for diverse collections of businesses to be successful. And I believe an important part of Berkshire’s success has been your skillful oversight of the wholly-owned subsidiaries. My question is, what advice would you give to your successor in managing our diverse portfolio of businesses?

WARREN BUFFETT: Yeah, well, it’s a very good point that Charlie and I have been known to rail a bit about companies that go and buy this business and that business. And, of course, that’s exactly what we’ve done ourselves over the years. I think the motivations have been somewhat different, perhaps, than in many of the cases. And then I think the way we’ve approached it has been different. We’ve — we have been reasonably successful although we’ve had some notable failures. But we’ve been reasonably successful in creating a climate where the people who built the businesses continue to run them with the same enthusiasm and energy after they sell to us that they possessed early on. And I think that you can find all kinds of illustrations in the histories of businesses that are diversified. I mean, Gillette bought 20-some businesses. I remember, back in the ’60s, Coke bought all kinds of businesses. And certainly the cigarette companies did, all kinds of people. The oil companies for a while were doing it. And generally, the experiences were not very good when they got outside of their own fields.

But I think when those companies bought businesses, they really thought they were going to take them over and run them themselves. And Charlie and I are under no illusions that we can run the businesses that we buy as well as, or nearly as well as, the people that have been running them over time. And, we don’t have group vice presidents that — in Omaha — we don’t have a whole bunch of directives going out. We don’t have companies that were run one way and then we’re going to run them entirely differently, and have them reporting in all kinds of special ways to us, and have a human relations department and a public relations department, then the legal department — all kinds of things in Omaha — telling them how to run their businesses. We think that destroys — can destroy — many good businesses — certainly can destroy the incentive of the people that have already gotten rich to stay around and make us rich in turn. So, I think that has been an important difference. I think it’s been demonstrated well enough to all of those around Berkshire that it’s been a very good place, generally, I think, for people, in terms of how they feel about working there.

And I think they recognize it works. So, the successor, to me, will come from within Berkshire. They will have seen how it worked. They will believe in it. They will be surrounded by people who have worked in this manner. And I don’t think it will be the most difficult job in the world to keep that engine going down the tracks at 90 miles an hour. I mean, it isn’t like they have to create the system. They will inherit a system. And I would be amazed if any of the three successors that we will talk about with the directors on Monday, if any of them would not recognize the inherent special values in the system as it now works and take up one of these other models that clearly has been disastrous for one company after another that’s diversified. Charlie?

CHARLIE MUNGER: Yeah. I don’t agree with you that the success at Berkshire has come from our oversight of the subsidiary —

WARREN BUFFETT: No.

CHARLIE MUNGER: — companies. It’s come from our lack of oversight of the subsidiary companies. And I think our successors will be able to provide the same wonderful lack of oversight — (laughter) — that we have provided. And if you’re not going to use a lot of oversight, you’ve got to be very careful in what you bring into your corporate family. And you’ve got to be very careful in treating, honorably and well, the people who are running the businesses over which you’re not giving any oversight to speak of. And I think our system is — it’s very different from a General Electric system. And I think their system works very well for them, but I don’t think it’s the only system in the world that works in corporate capitalism. And I think the Berkshire system will work very well after we’re gone.

WARREN BUFFETT: It’s a very simple system. I mean, GE works exceptionally well. But when I go back to some of the conglomerates — and that’s not a term that I shrink from, but most people do because they think it brings down their P/E or something — but we are a conglomerate. And I hope we become more of a conglomerate. The — we don’t — we haven’t succeeded because we had great complicated systems or some magic formulas we apply or anything. We’ve succeeded because we don’t have — we have simplicity itself. We take people that know how to play their game very well, and we let them play the game. And it’s just worked in one field after another. And every now and then we make a mistake. And we’ll — you know, there’ll be more mistakes made. But overwhelmingly, it works. And it doesn’t require some great business insight or anything like that, in terms of whoever’s running this place, to keep that kind of machine in motion. I mean, it is not complicated.

The bigger worry would be that the culture would get tampered with in some way and people would try to oversteer, basically. But that won’t happen. Our board won’t let it happen. And the ownership won’t let it happen. And I think we’ve got something that’ll work for a very, very, very long time. And that’s why I’m comfortable with the fact that every share I have will go to a foundation that I care about having — getting good financial results in the future. And I’m quite happy to have them have 100 percent of their money in Berkshire.

7. Berkshire’s best-ever investments: GEICO and Ajit Jain

WARREN BUFFETT: Number 1.

AUDIENCE MEMBER: Jonathan Mills (PH) from London, England. What has been the single best investment of your careers? And why do you consider it to be the best, excluding Berkshire Hathaway itself?

WARREN BUFFETT: Yeah, well probably the best investment, if you’re talking about business, was getting Charlie as a partner. And he works cheap, too. (Laughs) The — we’ve had — you can’t measure it by dollar terms because, obviously, we’re doing bigger things now than early on. I mean, See’s was an enormously important part of our success. It doesn’t contribute a huge percentage of our net income now, but it provided income that let us buy other things in the past. It taught us a lot of lessons about business, all kinds of things. So, we’ve — probably, in terms of what it’s done already and where it’s going to go over time, probably the single best investment was the first half of GEICO, which we purchased for $40 million. Now the second half cost us 2 billion. I’m glad I didn’t buy it in thirds. (Laughter) But, you know, that 40 million will — for half the company — will turn out very well. But GEICO — some of our businesses have growth potential, some don’t.

And we don’t require growth potential as part of a business. If a business makes good money and we can use it to buy other businesses, one of the advantages of the Berkshire system is we have a tax efficient and kind of frictionless way of moving money to the best opportunities. And GEICO, internally, has still enormous possibilities for growth. Incidentally, we’ve — you know, I watched that movie and I kept touting the American Express card. But here is our GEICO card, which I’m sure all of you are eligible for. And I don’t advise people using credit cards to revolve. But the truth is that people do, so use a GEICO card if you’re going to behave in — if you’re going to charge anything. I still advise you to pay off your account before it starts revolving. And I think it’s a terrible mistake for people to get hooked on revolving credit at high interest rates.

And I — that’s the first thing I tell students is that, if they don’t remember anything else I say, just, you know, don’t fool around with charge cards and run up balances that keep getting larger and larger. But GEICO — GEICO has well over six million customers now. As was mentioned, we entered New Jersey last year. We’re adding very rapidly there. It’s a great, great business model. And it’s run by a superb human being and businessman, Tony Nicely. And I think it’s got a huge potential. But I love them all.

CHARLIE MUNGER: Well, but GEICO, after all, cost $2 billion for the second half and —

WARREN BUFFETT: Right.

CHARLIE MUNGER: — a significant number of tens of millions for the first half. Now the search expenses that brought us Ajit Jain, now there was an investment that really paid a dividend. I can think of no higher return investment that we’ve ever made that was better than that one. (Applause) And I think that’s a good life lesson. In other words, getting the right people into your system can frequently be more important than anything else.

8. NYSE should not being trying to earn a profit

WARREN BUFFETT: OK. Let’s try number 2.

AUDIENCE MEMBER: I’m Maggie Gilliam (PH) from New York City. As someone who visited the New York Stock Exchange at a very early age and have been touting its merits over the years, could you comment a little bit about what you think of the shenanigans going on currently?

WARREN BUFFETT: Well —

CHARLIE MUNGER: Where?

WARREN BUFFETT: At the exchange.

CHARLIE MUNGER: Oh. Warren, you’re so good at this. (Laughter)

WARREN BUFFETT: You mean at shenanigans or — I personally think it would be better if the New York Stock Exchange remained as a neutral — and it’s not strictly a non-profit, it’ll earn some money — but as a not-for-big-profit, we’ll put it, institution. I mean, the exchange has done a very good job over centuries. It’s one of the most important institutions in the world. And the enemy of investment performance is activity. And the creator of profit in a profit-minded exchange is activity. So, I personally would rather not have an exchange which is trying to increase its earnings per share annually, and thereby wanting to encourage people to trade more actively and create more income for itself. That will not be, in my view, good for the American investor. So, I think that the exchange of yesterday may be better for the American investor than what looks like it may be the exchange of the tomorrow. Now there may be all kinds of reasons that are — people find compelling why they want to turn it into a for-profit exchange. But I know the American investor will not be better off if volume doubles on the New York Stock Exchange.

And I know that the New York Stock Exchange as a for-profit institution would be trying to figure out ways to have that volume increase and to perhaps even charge more money one way or the other. I mean, you know, the profit of an exchange, the profit of the people working on them, in a sense that’s the frictional cost of capitalism. That’s coming out of the earnings of the businesses. And, you know, IBM or General Motors or General Electric will not earn more money because their stock turns over more frequently. But a for-profit exchange will earn more money. And I do not like the idea of the exchange getting on the side that’s against the long-term interest of investors. Charlie?

CHARLIE MUNGER: Well, I feel, on this one, the same as you do with — much more strongly. I think we have lost our way when people like the governors of the stock exchange and the CEO fail to realize that they had a duty to the rest of us to act as exemplars, there was — of the right behaviors. Once your activity is that freighted with public significance, I think you’ve got a duty to create the right appearances. You have a duty as an exemplar. I mean, you do not want your first grade school teacher to be fornicating on the floor or drinking booze in the classroom or — And similarly, you — I don’t think you want your stock exchange to be all over the headlines with wretched excess. And I certainly don’t think you want to turn the major stock exchange of the country into even more of a casino than it is already. I think we have totally lost our way on this stuff. And I agree with Warren that it ought to be — (applause) — a public institution that cares deeply about its duties as exemplar.

WARREN BUFFETT: I wish I’d gone to first grade where he did. (Laughter)

CHARLIE MUNGER: I didn’t hear that.

WARREN BUFFETT: I said I wish I’d gone to first grade where you did.

9. Buffett (D) and Munger (R) both endorse Social Security

WARREN BUFFETT: Number 3. (Laughter)

AUDIENCE MEMBER: Good afternoon, gentlemen. My name is Glen Strong (PH). I’m from Canton, Ohio. I want to extend a warm thank you to Warren’s daughter, Susan, for the fine introduction that she provided for this gathering.

WARREN BUFFETT: Thank you. (Applause)

AUDIENCE MEMBER: Also, a special thank you to your wife, Susan. I thank her for the contributions that she made to the company and for the outstanding example that she obviously set for her husband and the many people that she must have come into contact with. (Applause) Today, I’m asking for your opinion on Social Security. Shall we call it the government-sponsored Ponzi scheme for retirees? I am interested in your views on private accounts, age adjustments for retirees, and tax adjustments for the employees. What would you promote if you were in the Oval Office? Thank you.

WARREN BUFFETT: Yeah, the Social Security was introduced in the, what, ’36 or ’37. My grandfather used to have Charlie bring two pennies to work at the Buffett & Son Grocery Store on Saturday in order to pay his share of Social Security. Didn’t want Charlie getting any false ideas that there was a free lunch in this world. And he gave him a half-hour lecture on the evils of socialism. So, we’ve had a lot of exposure to Social Security, the various arguments on it. It was proposed, of course, as insurance, because basically that was the only way [President Franklin] Roosevelt could get it passed. The idea of transfer payments did not — would not have washed in the ’30s, certainly. You know, and I think the first woman that received a Social Security check paid in a total of $22 or something and got 2,400. So, it wasn’t insurance. It wasn’t insurance at all.

And the transfer payment by the people who are in their productive years to the people who are past their productive years — and we’ll get into definitial require — terms as to whether it’s 65 or 67 now, you’re past productive years — but essentially it’s a transfer payment. I basically believe that anything that would take Social Security payments below their present guaranteed level is a mistake. I think that in this country — extraordinarily rich country — that the people in their productive years can take care of those outside in both areas, even though the ratio of productive to nonproductive has changed and is changing. But we take care of our young. And a rich country takes care of its young and it takes care of its old. And incidentally, taking care of its young, when we educate five children in the family, we don’t expect that family to pay, you know, five times the tax or something like that. We recognize that in taking care of the young, that it should not be based on a per capita basis or based on the size of the family. We provide good school — we try to provide good schools — and health and everything for the young overall as part of our overall responsibility.

I believe that a rich country should be doing the same for the older people. There are — you know, Charlie and I came into this world wired in a way that enables us to get very, very, very rich — rich far beyond any possible needs that we could have. And not everybody’s wired the same way. Now if you come into this world wired with an I.Q. of 85 or something of the sort, or disabled or whatever it may be, you know, you are not going to do as well in a market economy, remotely as well, as we do. But you still provide much of what makes Charlie and I very rich. And, you know, and when it comes to fighting in Iraq or something of the sort, you know, then that becomes an equal opportunity type thing. But when it comes to making a lot of money, it’s not equal opportunity in this country. So I believe that a rich country like ours should not give lower benefits than what takes place now. And I certainly don’t think that — and we’ve got all kinds of mechanisms for saving that are extremely good. We have 401(k)s in the country.

We have taxes on dividends and capital gains at 15 percent, so the money I earn gets taxed at a lower rate than the money that a receptionist in our office may earn. And I would not be doing so well if I were stuck over in Bangladesh or someplace. So this society is providing huge benefits to me that other societies would not. And I think that the obligation for the people who do well in this society is to provide a reasonable level of sustenance for those beyond their productive years. We’ve got the capability to do it. You know, right now we quit taxing for Social Security at $90,000. But — and that means that everybody in my office is paying — or most of them — are paying 12.4 — 12.2 or 12.4 percent, counting what the company contributes, toward this. People talk about double taxation of dividends; they’re getting taxed for Social Security and they’re getting taxed for income on their income. And they’re paying a higher rate, or an equal rate overall, in many cases, to the same rate — compared to the rate that I pay. And I think that’s sort of nonsense in this society.

So, I don’t want to do anything — anything — that hurts the level of the bottom 20 or 30 percent, in terms of their income. I see people living with fear about health care or living with fear about running out of money in their old age. And I think a society should try to minimize the fear that their inhabitants experience. And that doesn’t mean just fear of getting mugged or something. It means fear that the last 25 years of their life, they’re not going to have much income. So, I would — and the degree to which the administration or other people are worrying about the deficit in Social Security 25 years out, when they have a $500 billion deficit excluding the Social Security surplus now, I mean, just strikes me as nonsense. (Applause) Here we are deploring something that’s going to happen in 20 years that’s a fraction of what is happening right now while they’re cheering, you know, basically, and talking about further favoritism in the tax laws.

So, I have great trouble with people that say, you know, that this system can’t sustain — right now, 4 and a fraction percent of our GDP goes to Social Security. Fifty years from now, 6 percent — no, 6 and a fraction percent — well, believe me, our GDP will be far larger 50 years from now. And going from 4 percent to 6 percent does not strike me as a terrible prospect. If you ask me what I would do to change it now, I would means test it. I would lift the $90,000 way up. In fact, I might apply it, you know, on all income. Then you’d really get people’s attention. But — and I would gradually — and we’re in the process of doing this — but I would certainly increase the retirement age. I mean, the world in 2005 is much different than the world in 1937, in terms of longevity prospects and the ability to function productively. Charlie, what do you say?

CHARLIE MUNGER: Well, that’s the view from Berkshire’s Democratic chairman. (Laughter and applause) And the odd part of Berkshire on this issue is that the right-wing Republican who is speaking feels more strongly than Warren that the Republicans are out of their cotton-picking minds to be — (applause) — taking on this issue right now. I do not — If the country is going to get richer at 1 or 2 percent per annum for a long time ahead, and it’s going to have more old people who are living longer and spending money on medical care, the idea that eventually a higher share of GDP would be going through Social Security to retirees and so on than we now have is not anathema to me. It’s exactly — it’s an exactly logical way to be spending money under different circumstances. And if the government runs out a little short of money as it gets more Social Security obligations, I see nothing wrong with having some consumption taxes or whatever to pay in a reasonable way for what is a very reasonable expenditure. Social Security is very successful. Apart from the disability element, which is relatively small, there’s practically no fraud.

It’s hard to fake being dead. (Laughter) And furthermore, it’s a reward for work. All kinds of people are working in this country because they want to eventually qualify for Social Security, just as many people are doing dangerous military service because they want the pension that will come eventually. So, Social Security is a very capitalistic institution with profoundly good effects. It’s one of the most successful things the government has ever done in terms of efficiency and good effects. And a Republican administration that may shortly have to do something really unpleasant, like face down North Korea or Iran over atom bombs, is wasting its good will over some twaddle that a bunch of economists that haven’t thought it through properly devoutly believe? It’s a very sad occurrence. (Applause)

10. Don’t blame the ratings agencies

WARREN BUFFETT: Number 4.

AUDIENCE MEMBER: Thank you. Bill Ackman from New York, New York. Four of the handful of triple-A rated companies — AIG, Fannie Mae, Freddie Mac and MBIA — are under formal investigation for accounting shenanigans and are in the process of restating their financials. Like Charlie said before, I think of a triple-A rated company as an exemplar, a company that should behave with the highest accounting and ethical standards. My questions this leads me to are, how can investors comfortably invest in any financial service company when even — when a decent percentage of the triple-A rated companies have false and misleading financials? And I guess the follow-up question is, why don’t the rating agencies do some independent due diligence from an accounting standpoint so that they can help serve as a watch on this issue?

WARREN BUFFETT: Well, financial companies are more difficult to analyze than many companies. I mean, the — it is more — if you take the insurance business, you know, the biggest single element that is very difficult to evaluate, even if you own the company, is the loss and loss adjustment expense reserve. And that has a huge impact on reported earnings of any given period. And the shorter the period, the more the impact can be from just small changes in assumptions. You know, we carry, we’ll say 45 billion of loss reserves. But, you know, if I had to bet my life on whether 45 billion turned out to be a little over or a little under, I mean, it’d be a — I’d think a long time. And you could just as easily have a figure of 45 1/2 billion or 44 1/2 billion. And if you were concerned about reporting given earnings in a given period, that would be an easy game to play. In a bank, you know, it basically is whether the loans are any good. And I’ve been on the boards of banks. And that’s — you know, I’ve gotten surprises.

It’s tough to tell. It’s — financial companies — if you’re analyzing something like WD-40, you know, or See’s Candy, or our brick business, or whatever, you know, they may have good or bad prospects but you’re not likely to be fooling yourself much about what’s going on currently. But with financial institutions, it’s much tougher. Then you add — throw in derivatives on top of it, and, you know, it’s — no one probably knows, you know, perfectly, what some of the — or even within a reasonable range — the exact condition of some of the biggest, you know, banks in the world. And — but that brings you back to the due diligence question of the agencies. You had very high-grade, very smart — financially smart — people on the boards of both Freddie and Fannie. And yet, you know, one was five billion and one was apparently nine billion. Those are big numbers. And I don’t think those people were negligent. And it’s just, it’s very, very tough to know precisely what’s going on in a financial institution.

Charlie and I were directors of Salomon [Brothers]. And Charlie was on the audit committee. And I forget the size of a few of those things that you found. But, you know, what wasn’t found — and that doesn’t mean that people below are crooks or anything like that. It just means that it’s very tough with thousands and thousands and thousands of complicated transactions, sometimes involving — the computations involving — multiple variables, it can be very hard to figure out where things stand at any given moment. And, of course, when the numbers get huge on both sides, and you get small changes in these huge numbers, they have this incredible effect on quarterly or yearly figures because it all comes lumped in — those adjustments — come lumped in a short period of time. So I just think you have to accept the fact that insurance, banking, finance companies — we’ve seen all kinds of finance company — both frauds and just big mistakes over time — of just one after another over the years. And the — it’s just a more dangerous field to analyze. It doesn’t mean you can’t make money in it.

We’ve made a lot of money on it. But it’s difficult. Now, obviously a GEICO, where you’re insuring pretty much the same thing — auto drivers — and you get — your statistics are much more valid in something like that than they will be if you’re taking something that — like asbestos liability — you’re subject to far greater errors in estimation. Doesn’t mean that people aren’t operating in good faith. But, you know, I would take — just take the asbestos estimates of the 20 largest insurance companies. I will bet you they’re way off, but I don’t know in which direction. And that’s sort of the nature of financial companies. I wouldn’t fault the rating agencies in terms of not being able to dig into the financials and find things that — You know, all of the companies that you’ve talked about have had big name auditors. And our auditors at Berkshire, how many hours did they spend last year? You know, I don’t know whether — what it would be, probably 60, 70,000 hours.

And I’m sure at other — you know, if you take major banks, they’re spending more than that. But, you know, can they be certain of the numbers? I doubt it. Charlie?

CHARLIE MUNGER: Yeah. Warren is obviously correct that where you’ve got complexity, which by its very nature provides better opportunities to be mistaken and not have it come to notice, or to be fraudulent and have it not be found out, you’re going to get more fraud and mistakes than you are if you’re selling a business where you shovel sand out of the river and sell it by the truckload. And just as a business that sells natural gas is going to have more explosions than a business that sells sand, a business like these major financial institutions, by its nature, is going to have way more problems. And that will always be true. And it’s true when the financial institutions are owned by governments. In fact, some of the worst financial reporting in the world is done by governments and governments — institutions like government banks in China, et cetera. So, if you don’t like the lack of perfect accounting in financial institutions, you’re in the wrong world.

11. We like our stocks but aren’t buying more now

WARREN BUFFETT: Number 5?

AUDIENCE MEMBER: Good afternoon, Mr. Buffett, Mr. Munger. Thank you very much for your wisdom and all your investment advice. I’m Adrian Sherr (PH) and I’m from Hong Kong. Back in the old days in Hong Kong when somebody turned 100, they got to have tea at Buckingham Palace with the queen. I don’t know what you have here in America, but I hope that in 2030 we come back to watch you do 50 pushups at the White House. (Laughter)

CHARLIE MUNGER: It’s not the way to bet.

WARREN BUFFETT: Will you settle for 10? (Laughter)

AUDIENCE MEMBER: My question comes in two parts. Firstly, in 1968-69, you liquidated all your partnerships. And I guess, aside from your holdings in Berkshire Hathaway, you got completely out of the market and stayed out. In 2000-2001, you mentioned to us that in the coming decade the markets would go, at best, nowhere. However, despite $50 billion in cash, you and therefore us, remain substantially invested in the market. So my first question was, how and why is the investment climate different today than in 196869 that makes you comfortable remaining substantially invested?

WARREN BUFFETT: Yeah, well, we do own certain securities which we wouldn’t — we probably wouldn’t — buy at these prices. Some of them we would. Some of them we wouldn’t. We’re not unhappy with anything we own. We’re not happy with putting more money in, so we’re in a zone in some of those securities that — where we wouldn’t buy and we wouldn’t sell. Now part of it — that decision relates to the kind of quantities that we deal in. I mean, if we owned 100 shares of each one of the stocks that we own, you know, many billions of dollars’ worth, it would be an easier decision to go in and out. But we would face significant costs — including taxes, but on top of taxes — in trying to go in and out of the big positions we have. And basically we like the businesses. So, we are not unhappy. We may feel like we wouldn’t want to buy more here. But we are not unhappy about being in the businesses in which we have big equity holdings.

Now notwithstanding all of that, a lower percentage of our intrinsic value is represented by the common stocks we own than just about at any time of our history, with the exception of a couple — well, the period right there at the end of 1969 when we liquidated the partnership. So, we have not made any big statement by purchases of stocks or the ownership of stocks that says we — in any way — says that we think that this is a particularly attractive time to own them. But we are not unhappy with Coca-Cola. We are not unhappy with American Express. We are not unhappy with — we are not unhappy with Wells Fargo or Moody’s. Those are very, very good businesses that we own. Would we be buying them at today’s prices if we, you know — well, the answer is we’re not. You know, we’ve got money. And we may buy more later on. We’re more likely to buy more later on than to sell those sort of investments. But there is a zone, which because of size, because of taxes, where we would neither be a buyer nor a seller.

And we do not see lots of attractive stocks, but we also don’t think that there’s as much silliness in the market, by far, as there was 5 years ago roughly. Charlie?

CHARLIE MUNGER: Yeah. One of the things that’s interesting about Berkshire lately is that if you take the last four or five things we did in the stock market, with a goodly number of millions, but — billions, really — but small in relation to Berkshire’s overall size — our record is much like it used to be in some of the best days. Where we were able to move around with small amounts of money, the results were quite respectable. But where we were facing the problems of being enormously rich the way we were prevented from the nimble moneymaking record of the past, I don’t think that’s a permanent state of affairs, but it’s never going away either. But it —

WARREN BUFFETT: Explain that one. (Laughter)

CHARLIE MUNGER: Well, I mean, it’s that I think we may be able to deploy large amounts —

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: — of money eventually at very satisfactory rates. Whereas in recent times, we have deployed small amounts of money at very satisfactory rates. And better small than nil. And small is still billions. (Laughter)

12. “I don’t see gold as a store of value”

WARREN BUFFETT: Number 6. (Laughter)

AUDIENCE MEMBER: Good afternoon. My name is Mike McGowan (PH) and I’m from Pasadena, California. I had a pretty good question on Prop 13, but after watching the movie I don’t think I’ll ask it.

WARREN BUFFETT: Good. (Laughter)

AUDIENCE MEMBER: What I’d like to ask about, I guess, is one quibble and then a question. The question being about financial education, or a study of financial history, that might help people in handling these markets or in — just dealing with investing at or near the apex of Western civilization. When you mentioned your dad’s lectures about “buy gold” back in the 1930s, and then saying, “Well, 60 years later, it hasn’t done very well,” gold was pretty much pegged at a set price back in the ’30s for years and they didn’t really let it loose until 1971. And then it caught up. And then it’s kind of bounced around. If you looked at gold maybe now, and derivatives and real estate bubbles and lots of other things, maybe gold wouldn’t be such a bad investment, looked at in current terms. So, my question would be, do you consider that you have some sort of an obligation or duty as financial exemplars to maybe pay a little attention to that classical kind of gold is the benchmark or the bedrock of a financial system, to some extent?

And that it might be nice to talk about it, in your — at least your annual letter to your stockholders — about how people might protect themselves in what’s a fairly bubbleous kind of environment from, really, the decline in purchasing power or problems caused by the financial domination that we have today? Thanks.

WARREN BUFFETT: Yeah. I would say that gold would be way down on my list as a store of value. I mean, I would much prefer owning a hundred acres of land near here in Nebraska, or an apartment house, or an index fund. Gold, we’ll say, was freed up 30-odd years ago. But it adjusted to a market that still, if you go back to 1900, you know, you were talking $20 gold. Well, you take 20 to 400 in a hundred years. The Dow went from 60 to, what, 12- or 13,000 — 12,000 or whatever it might have been — in that same period, and paid you dividends during the time you owned it.

It was 66, I think, at the start of the century. And I forget where it ended, but it’s 11- or 12,000. And like I say, it was paying you something every quarter during that period. And if you owned gold, you paid $20 in 1900 or thereabouts. And then you — we’ll say you had $400 a hundred years later. And in the meantime, you paid insurance and perhaps some storage cost.

It really is not — it’s not a store of value. And it’s — I’m not arguing for paper money, but if you’re worried about paper money — And I think, you know, it makes a lot of sense to worry about paper money over long periods of time — but it’s just about — you know, it’s just about the last thing I would want to own under those circumstances. You know, it has — a farm has utility, an apartment house has utility, a business, you know, will produce earnings. And some businesses will produce them in real terms as they go along. You know, I’d rather have the ability to sell people a pound of candy 20 years from now. And if they’re dealing in seashells, I’ll get an appropriate number of seashells instead of paper money for it. But I — it — I just don’t — I don’t see gold as a store of value. And it’s — the truth is, it hasn’t worked very well.

But forget about whether it’s worked well the last hundred years or the last 50 years or the last 10 years, I see no reason, you know, why it would work well in the future. I forget whether we’re turning about three- or four-thousand tons of gold a year. And, you know, we take it out of the ground in South Africa and we put it in the ground at Fort Knox or someplace, you know, or in the New York Fed. I mean, and it doesn’t do much along the way, for anybody. So, I — Charlie, how do you feel about gold?

CHARLIE MUNGER: Well, I think gold was — and similar items — that was a great thing to have if you were a well-to-do Jewish family in Vienna in 1935, because you had hazards where that gold had enormous utility to you. But for Berkshire Hathaway sitting here in 2005, it just doesn’t interest us at all.

13. No stock bubble right now, but no bargains, either

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: My name is Al Henderson (PH) from Minnesota. I’d like to thank you both of you for being yourselves and doing so much for all of us and to help enrich ourselves and everyone else. My question I have is — actually, you already referred to it — that you devote very little time to looking at the total market and look for individual opportunities most. But I was wondering, in the past you made some excellent presentation on points to consider in projecting reasonable 10-year returns for the stock market and had to devise reduced expectations. Where do we stand now on your stock market and economic measurements and expected 10year returns?

WARREN BUFFETT: Yeah. Every now and then — I mean, and I agree — very infrequently, you probably can say something intelligent about markets as a whole. I mean, that you do see circumstances that are extreme enough that you can make a statement that is likely to look reasonably intelligent five or 10 years later. And I’ve seen a few of those times in my lifetime. I mean, I — and I’ve spoken out a couple of times. And I did in ’69 and ’74 and a few times. Most of the time, you know, you’re in some in between zone. Obviously, you get more for your money in equities now than you got, say, in the summer of 1999, which is when I delivered a talk out of Sun Valley that later got turned into an article for Fortune. But that was an — I spoke out then because it was extreme. I mean, I knew in a general way that I was going to be right, particularly in certain aspects of the market, but I didn’t know when, and then I didn’t know how right or anything of the sort.

And you could’ve done the same thing in the other direction back in the mid-’70s. I think that if you had to make a choice between owning long-term bonds, which are now yielding — the Treasury — only a little over 4 1/2 percent, or owning equities for the next 20 years, and you couldn’t make — change that decision, I would certainly prefer equities. But I think people that have expectations that they can earn more than 6 or 7 percent in equities, and certainly when they start expecting double digits, I think the degree to what they have expectations, they can do that or that they can find somebody else to do it for them, I think they’re making a big mistake. But 6 or 7 percent is not the end of the world at all. In fact, it — and it gets treated better taxwise right now than it has almost any — well, really anytime in my lifetime. So — I don’t think we’re in bubble-type, at all, valuations in equities. And I don’t think we’re anywhere close to — remotely close to bargain valuations.

And I don’t think it’s an extreme enough period that you can speak out in some very definitive way about the outlook. But if you told me I had to go away for 20 years and choose between what’s obtainable in an index fund of equities or be committed to long-term bonds, I would rather take equities. But I think you will get a chance to do something that is more screamingly intelligent in not too many years — and maybe a lot shorter — than the alternatives that you’re offered now. Charlie?

CHARLIE MUNGER: Well, I can’t improve on that at all.

14. “Bubble valuation problems” for real estate

WARREN BUFFETT: Well then we’ll go to number 8. (Laughter)

AUDIENCE MEMBER: Hello. My name is Hamid Rezapour. I’m from Orinda, California. I had a question about real estate. And I know this question was asked in previous shareholder meetings about, “How come Berkshire doesn’t invest in real estate?” And I believe the answer was that, “We like operating business.” So I want to make my question a little bit more specific towards commercial real estate. So, considering the characteristics of larger-size commercial real estate investments like REITs that can have the behavior and financial returns of an operating business, why not invest in real estate? Is it because you just don’t like the returns? Or the business is just not attractive?

WARREN BUFFETT: Yeah, well, Charlie got his start in real estate. Right, Charlie?

CHARLIE MUNGER: Yeah. I would say, number one, that in a corporation like Berkshire, that’s taxable under subchapter C of the Internal Revenue Code, owning real estate is grossly disadvantaged compared to owning it directly by individuals such as yourself. That’s number one. And number two, real estate — investment real estate — is having bubble valuation problems of its own right now. All my rich friends who own real estate are selling their worst properties. And they’re getting bids that come in higher than their highest expectations. And people are competing to take these things off their hands. I do not find it exciting. And it certainly doesn’t fit Berkshire. Name me a lot of C corporations that have been passive holders in real estate and have done well over a whole lot of years. It’s almost a null class.

WARREN BUFFETT: Yeah, Charlie and I — I mean, both — more Charlie than I — we’ve had certain personal real estate investments over time. And it — you know, it’s a field that, in general, we understand. We don’t bring that much special to the game, but we understand it. We’ve made money in it. And actually, at the time that the NASDAQ about hit its high, REITs were quite cheap in my view. And I have less than 1 percent of my net worth outside of Berkshire, but basically I had that portion all in REITs. They were all small ones at that time. And — but they were selling at discounts. At that time they were selling at discounts to the values of properties. And those values of properties were much more conservatively figured than today. Today, you have very fancy prices on real estate. And on top of that, you have the REITs often selling at a premium, though. So, I regard REITs as quite unattractive now, certainly compared to five or six years ago. But that’s a group of —

CHARLIE MUNGER: That’s for an individual, you regard them as unattractive?

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: And for a corporation, that much more so?

WARREN BUFFETT: Yeah, right. Right. It — the situation changed dramatically from five or six years ago. I mean, the stock market, in many respects, from the 1999-2000 period, is down significantly. REITs are up significantly. REITs were very unpopular five or six years ago. Now they’re popular. It’s better to pay attention to something that is being scorned than something that’s being championed. And there’s really been a big change in the REIT situation in the last five or six years.

CHARLIE MUNGER: And the REITs have phony accounting.

WARREN BUFFETT: Otherwise, we love them.

CHARLIE MUNGER: Yeah. (Laughter)

WARREN BUFFETT: You don’t want to bring up anything in these meetings. (Laughter)

15. Global prosperity helps the U.S.

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: Good afternoon. My name is Carlos Lock (PH). I’m from Lawrence, Kansas. The U.S. has had a dominant role in the world economy for about a hundred years. This dominance resembles that of an economic monopoly. Would you say that the U.S. is a quote- unquote, “a castle with a moat?” And if so, how can we make the moat any bigger? Thank you.

WARREN BUFFETT: Yeah, well, the U.S. has been pretty remarkable, as I indicated in my earlier comment. I mean, you know, essentially, the same population pool pretty much, and they’ve garnered over this 215-year period, a remarkable share of the world’s wealth. And it’s an interesting question as to just why this group of people here have been able to do so much better than the rest of the world, considering we’re not any smarter or anything of the sort. It’s not an economic castle anymore. I wouldn’t call it that. What we do is no secret. And I think that the relative importance of America — I mean, we have been a dominant factor in the world, and post-World War II — and I think it will decline somewhat, although I’m not an alarmist on that. But I think to some extent, the rest of the world, or much of the rest — or some of the rest of the world — is catching on and adopting, you know, sort of best practices, as they say in industry.

And our castle will grow in size, but there will be more castles around it. And I basically think that’s a very good thing for the world. I think the more prosperous, generally, the rest of the world is, you know, the better, generally, it will be for us. And, you know, I’ve talked about our trade problems. The more trade we have, the better. We had 1.1 trillion of real trade last year in the country. We would’ve — with the world — and then we had another 600 billion — 6/10ths of a trillion — that, unilaterally, we bought. Well, I would love to see the 1.1 trillion grow and grow and grow. It’d be good for us and good for the rest of the world. But I don’t think that our prosperity will come — in the future will come at the expense of the rest of the world at all. I do think that there were parts of the world that will grow economically from a lower base, but much faster than the U.S. And basically, I think that’s a good thing.

I mean, there are six billion people in this world, and a lot of them don’t live very well. And I would hope that 20 or 50 years from now that it’s a higher percentage of them would live well and that — but I don’t think it comes out of our hide at all. Charlie?

CHARLIE MUNGER: Well, I don’t think it comes out of our hide in that sense, but if we are now the richest and most powerful nation in the world and 50 or a hundred years from now we’re a poor third to some country in Asia, sure, we’re richer, but it’s a peculiar type of richness where you’ve lost your relative position in the world. It’s not all — I think if I had to bet, I would bet that the part of the world that does best is Asia, in terms of percentage gains per annum. And I think it might do amazingly well if it doesn’t blow up in some way. And if it does amazingly well, it will eventually be a much richer place than ours.

WARREN BUFFETT: Mm-hmm.

16. “Unwise” economic policies, but no “Armageddon”

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: Good afternoon, gentlemen. I’m Thorsten Kramer (PH) from Cologne, Germany. You’ve criticized the extraordinary large stake that the financial sector in the United States is currently representing in relation to GDP, which is also reflected in a total credit volume exceeding GDP by roughly 250 percent, significantly up from the level we’ve seen a decade ago. A current account deficit and budget deficit running at 6 percent of GDP, in combination with a still accommodating easy money policy, and high asset prices, will have to be consolidated sooner or later. How do you think the adjustment will take place? What are your two most likely scenarios how these huge imbalances might be consolidated? And is the dollar devaluation scenario your most favorite one?

WARREN BUFFETT: Well, as I said earlier, I don’t see how the situation resolves itself with a stronger dollar. Most people still seem fairly sanguine about the fact that there won’t be anything terribly bumpy about it, that there’ll be this so-called soft landing. And I don’t know whether that’ll be the case or not. But I would say that we’re running the risk of having markets that could get chaotic if certain events converged, superimposed upon those factors that you just listed. But I don’t — I’m not an Armageddon type at all on the economy. I mean, the things you named are important factors. I think that absent something happening in the terrorism field, I think that, you know, the citizens of the United States, on balance, will be living better ten years from now than now, and 20 years from now than now. But I do think that we’re following policies that are unwise. But we’ve done that plenty of times over history.

I mean, [investor] Peter Lynch has always said, you know, “Buy a business that’s so good that an idiot can run it, because sooner or later one will.” (Laughter) We’ve got a country that’s so good that we can have policies that are counterproductive — (applause) — and we’ll still come out OK. Just think of what we’ve had over the years. I mean, you know, Warren Harding, Chester Arthur? I mean, we’ve had a lot of things in this country. We had the Civil War. We had all kinds of things over the years. But the society has marched forward, with some fits and starts, but still at a very significant clip. The real GDP per capita is seven times, in the U.S., what it was a hundred years ago. Just think of that. One century in the human pageant, and a sevenfold increase in GDP per capita. It’s remarkable. So, I acknowledge, you know, consumer debt doing what it’s done and the trade deficit being what it is.

And I think that those things — particularly the trade deficit — should be addressed, and promptly. But I don’t think they pull down the whole place. They may create, you know, very severe dislocations in financial markets from time to time. But that’s been the history of this country. I mean, we have had very dramatic things happen in financial markets over the years. And the country survives despite that. And sometimes there’s great opportunity in those dislocations. There’s likely to be. So I’m not pessimistic about the U.S. at all. You know, I can’t imagine anyplace that I would rather be. But whether — when you say the two most likely outcomes, I think the eventual outcome is that the country does fine. But I think a — there’s a significant possibility that you do have some chaotic financial markets at one time or another. But we’ve had them historically. Charlie?

CHARLIE MUNGER: Yeah, we don’t have any great record as macroeconomic predictors. And I don’t see any reason why we should really start now. Obviously, there are more chances for convulsion now. I mean, everybody from [former Federal Reserve Chairman] Paul Volcker on has looked at the current figures and said we could have some kind of convulsion as a consequence of (inaudible). Apart from knowing that, we have no contribution to make.

WARREN BUFFETT: Yeah, I do think, as I mentioned earlier, that far greater sums, relatively, in one asset class after another, are held by people who — where it’s really on a hair-trigger type mechanism. So, the creation of lots of new financial instruments, the piling up of huge amounts by intermediaries or agency activities in terms of money management, I think they lend themselves to more explosive outcomes on any given day than might have been the case some years back when I was selling utility stocks to people, a hundred shares at a time in Omaha. I mean, those — that money was not on a hair-trigger basis. But as you turn it over to fund managers who think their job is to beat the S&P in — on a short-term basis — you are getting very short time horizons on huge amounts of money. And those people may think they are operating independently in one sense. But they’re responding to the same stimuli. And they can, as they did in the fall of 1998, they can all head for the exits — or try to head for the exits — at one time. And the thing about financial instruments is there is no exit.

I mean, the only way that you get rid of a financial — the only way you leave your seat in a burning theatre in financial markets is to find somebody else to take the seat. And that is not always easy.

CHARLIE MUNGER: I think it —

WARREN BUFFETT: However — go ahead.

CHARLIE MUNGER: — I think it’s also true that the amount of credit being used, not only by hedge funds but by ordinary investors, is way heavier than most people realize. It wasn’t even controversial in this country when we came to introduce single-stock futures and what — you know, commonly traded puts and calls. And ordinary people got in trouble. If I’d been running the country, I never would have allowed that. I don’t know what good it does for the country to have a wonderful — a lot of trading in puts and calls. One of my children knew a nice man who had a $2 1/2 million house and $5 million worth of wonderful securities. But he couldn’t live as comfortably — he never worked — as he liked to live on the income from his $5 million of securities. And he got in the habit of picking up easy money with the credit systems of the world. He kept selling naked puts secured by his account, including puts on a whole lot of internet stocks.

And in due time, he didn’t have the $5 million of securities, and he didn’t have the house, and he now works in a restaurant. That kind of self-destruction wasn’t possible before we created all these wonderful trading opportunities involving credit. It was not a smart thing for this country to do, to legalize gambling everywhere and to bring it in a more facile form into our investment practices. (Applause)

WARREN BUFFETT: Is there anyone we’ve forgotten to offend? I mean, we — (Laughter)

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: — we don’t want to miss anyone. (Laughter)

17. Why Berkshire’s board is better

WARREN BUFFETT: Number 11, please.

AUDIENCE MEMBER: Good afternoon, Mr. Chairman, Mr. Vice Chairman. My name is Andy Peake. I’m from Weston, Connecticut. Recently, we’ve seen a number of corporate boards take forceful action — Hewlett-Packard and Boeing, for example. We have also seen board members from WorldCom pay large amounts to personally settle lawsuits. Today we see Morgan Stanley embroiled in a bitter battle, largely based on divergent views of how to govern the firm. What responsibilities do directors have in this new environment? And what do you look for in your directors?

WARREN BUFFETT: Charlie, why don’t you take that one first?

CHARLIE MUNGER: Well, we are completely out of step with modern practices with directors. The modern practice is to have one from each diversity category, and to have a whole lot of people who need, more or less, the 100,000 or $200,000 per year that they’re paid for being a director. And people think this makes the system better. At Berkshire, all the directors are rich and they own a lot of stock in Berkshire. And they’re all very smart. And they don’t get any liability insurance provided by Berkshire. So, we’ve been waiting for our system to spread, but it — we seem to be losing. (Laughter)

WARREN BUFFETT: Yeah, it’s a tough job, at times, to be a director. The real problem that you can face, and may often face, is when you’re dealing with mediocrity. I mean, if you have a baseball team and you have a .240 hitter in the majors, a .240 hitter in the majors is still a pretty good baseball player. But if your job is to have a winning team, you get rid of him. And you find somebody that can bat .280 or .290 and field just as well. In business, the tough part is to get rid of something a notch or two above mediocrity, but not the best one that could be found.

And when people meet every couple of months, and they come from different parts of the country, and they have the normal social instincts — they don’t like to have rump meetings or to sort of talk behind people’s backs — it’s very difficult for a group, and particularly if it’s a group like Charlie described where a significant number of them, the directors’ fees they earn are important to their well-being, and they like — they’d love to be recommended for another board and add another $100,000 a year to their income. It’s very difficult for somebody to lead a charge and all of a sudden start at the meeting or trying to arrange a rump meeting of some sort to say, you know, “We really think this guy at the head of the table’s no good.” And changing — dealing with mediocrity is — or, like I say, a notch above it, is a difficult problem if you’re a board member. And we believe that, you know, independence is — it’s a state of mind.

I mean, it — and it’s a willingness, but not the eagerness, to challenge the ideas of others. And to — if you see a merger that doesn’t make sense — and Charlie and I have seen a lot of them, and we’ve been on the boards, and sometimes we’ve spoken up and sometimes we haven’t spoken up — to be able to — you know, you can — the group around you, in terms of social behavior, can only tolerate a certain amount of obnoxiousness on the part of yourself. You have to sort of ration it out. And so you save yourself for big ones. And then, it’s not necessarily an easy equation. And certainly, I would say, of the things I’ve seen proposed in the way of major acquisitions and — a significant percentage of them I wouldn’t do myself. But would I overrule somebody else? I wouldn’t get the votes probably anyway. And it’s a very difficult thing to do. You could occasionally fire a bullet if you think it’s important enough, and usually it doesn’t do any good.

So, I — we have a group that has — every one of them has significant money invested in Berkshire. They all bought it in the market just like you did. I mean, nobody — I mean, I’ve been on all these boards and they keep handing me things. And, you know, I had shares of this one and that one are given to me, or options or whatever, matching charitable contributions, all kinds of things. But we have real owners on our board. And what they make for being board members is really inconsequential, as I get reminded occasionally — (laughter) — compared to their investment. And they’re friends of mine. They’re smart. They’re very smart. I mean, they are hand-picked, in terms of business brainpower and quality of a human being. And I really think that, you know, we have the best board in the country.

But the people that want — who make their evaluations by checklist, you know, whether — either in terms of diversity or in terms of supposed independence — although I don’t know how anybody that’s getting half their income from board memberships can be independent — you know, we don’t — we may not stack up so well. But it’s the kind of board that I want to have, knowing that if I die tonight that virtually everything I have goes to a foundation. I want that foundation to have as much money over the years to spend as possible. And there’s no group of people I’d rather have in charge of the decision subsequent to my death than the people that we’ve got on our —

18. Short gap due to tape change at time of recording Text on screen: “Tape Change”

19. Gates is smart but we must stock to our “circle of competence”

WARREN BUFFETT: (Laughter) No, the answer is that Charlie and I, in managing Berkshire, try to do things — put money in things — that we understand. And when I mean understand, I mean, that we — where we think we know, in a reasonable way, what the economics will look like in five or 10 or 20 years. And Bill [Gates] is a lot smarter about a whole lot of things than I am. But it’s still Charlie and I that have the responsibility for managing the money. And we’ll stick in what we consider to be our circle of competence. And the fact that somebody else’s circle is wider or different, you know, that’s the way the world is. I’ll listen to any idea Bill has. Believe me, I will listen to him. I mean, he is a — he’s not only a smart manager, but he’s a smart investor. And I think, actually our ideas on investment overlap to quite an extent. But I still wish I’d bought a little Microsoft when I first met him. (Laughs) Charlie?

20. If corporate directors need the money, they’re not independent

CHARLIE MUNGER: I think what has happened at Berkshire is just wonderfully for the good. And I do think we have a perfectly marvelous board. What makes me sad, as I said earlier, is I don’t see more of the same practice followed elsewhere. A director getting $150,000 a year from a company, who needs it, is not an independent director. That director automatically becomes an inside director. And so it’s a typical government intervention. It’s just — it says it’s doing one thing and it does another.

WARREN BUFFETT: Yeah, I have never — I’ve been on 19 boards — I have never seen a director, where the directors’ fees were important to them, object to an acquisition proposal, object to a compensation arrangement of the CEO. It’s just never happened, you know — in my experience. And you know, they do not — they frequently do not — behave as they would if they owned the place. And basically we want people that behave as if they own the place.

CHARLIE MUNGER: The correct system is the Elihu Root system. Elihu Root, who had three different cabinet appointments, if I remember right, said no man was fit to hold public office who wasn’t perfectly willing to leave it at any time. And if Elihu Root didn’t approve of something the government asked him to do, he could always go back and be the most sought after lawyer in the world. He had an identity to go back to and he didn’t need the government’s salary. And I think that ought to be more the test in corporate directorships. Is a man really fit to make tough calls who isn’t perfectly willing to leave the office at any time? My answer is no.

WARREN BUFFETT: Yeah, we have one of our directors who was — who’s been removed twice from compensation committees of other corporations because he had the temerity to actually question whether the compensation arrangement being suggested was the appropriate one. I mean, it — the — it’s not — being put on the comp committee of American corporations, as I’ve said, they’re not — they’re looking for Chihuahuas, and not Great Danes and Dobermans and —

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: Yeah. And I hope I’m not insulting any of my friends that are on comp committees. (Laughs)

CHARLIE MUNGER: You’re insulting the dogs. (Laughter and applause)

21. Why we keep companies despite disappointing results

WARREN BUFFETT: OK, number 1. (Laughter)

AUDIENCE MEMBER: Hello. I’m Rory Johnson (PH). I’m from Suffolk in the U.K. Do you have, or are there, any appropriate criteria, beyond purely financial returns, in assessing the success or otherwise of your investments?

WARREN BUFFETT: Well, I would say that the financial returns, achieved in a way that we want them to be achieved, are the determinant of whether we’ve made an intelligent commitment. Now, we don’t get rid of companies that don’t meet our original expectations. There’s a section in the back of our annual report on the economic principles. And I forget which one it is. It’s toward the end. But we say that Charlie and I have this quirk, which business schools would teach is a mistake, in that if we have a business that’s underperforming and we could sell it and put — and achieve greater returns someplace else, we don’t do it. We say that if a business is going to permanently lose money, we’ll get rid of it. If it has major labor problems over a period of time, we might get rid of it. But we are not going to engage in what we call gin-rummy type management where we pick up one card and discard another.

And so we will not — if a business has been disappointing to us, but we like the people there and we’re not having — not because of labor problems — and we’re not going to have to put money in incessantly, we will stay with it when business school theory and management theory would say get rid of it and do something else. We don’t disagree with the people that do it that way. It’s just that we don’t want to live our lives that way. And if we owned 100 percent of Berkshire we wouldn’t do it that way. And we don’t — we just — we want the shareholders to know that we have this mindset that may produce slightly suboptimal returns because of our attitude. But that’s the way we’re going to play it, and we tell people ahead of time that that’s the way we’re going to play it. We like being associated with the managers that we are, even the ones that are in — facing headwinds.

I mean, but in a sense you almost identify more with the ones that are facing headwinds because they’re doing a hell of a job under very tough conditions. And every business decision or investment decision isn’t going to work out perfectly. And some businesses are going to run into unexpected surprises. But the people that have gone in with us have stuck with us in times like that. And our attitude is we’ll stick with them. So to the — I would say that how the people behave with us after we buy the business is an important part of how we feel about, you know, the whole relationship as well as the returns achieved. Charlie?

22. Moral distinction between buying a stock and a company

CHARLIE MUNGER: Yeah. I think he’s asking in part, are there some businesses we won’t have as subsidiaries in Berkshire even though they’re wonderful businesses? So, are we rejecting some business opportunities on moral grounds?

WARREN BUFFETT: Yeah, well we’ve referred in past meetings to one we did on that basis. We will own stocks of companies where we wouldn’t want to own the whole business. I mean, you know, you can — I’m not sure that the logic is perfect on that, but we would not have trouble owning stock in a cigarette company. We wouldn’t want to manufacture cigarettes, you know. We might own a retail company that sells cigarettes. I mean, there’s all kinds of gradations. But we do not — there are things we don’t want to own and be responsible for their businesses, where we have no problem owning their stocks or bonds. And some years back, Charlie and I went down to, where, Memphis?

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: Yeah, we looked at a — and we were invited down, and we looked at a company that made a product that — perfectly legal — probably one of the best businesses I’ve ever seen, in terms of the economics of it.

CHARLIE MUNGER: Absolutely.

WARREN BUFFETT: Still doing very well. And we met in the room with — we went to a hotel. We met in the room with the people that had the business. And people were perfectly decent people. And they described the business to us. And we went down in the lobby. And as I remember, we sat down in the lobby and just decided that we didn’t want to be in that business. And, you know, the lines are not perfect on this sort of thing. I mean, it — I’m sure that there may be ads in the Buffalo News that are selling some investment service or something that I would cringe at if I knew the people involved or what they were selling. And it — if you own a big retail establishment, a retailer, general merchandise, you know, you’re probably going to be selling cigarettes when you don’t think that you should smoke yourself or that your children should smoke. And it’s — they’re not perfect.

But we have turned down some — the most dramatic being that one because we went — took us a trip of 1,000 miles or so to finally face up to the fact that we didn’t want to own it. Charlie, you have anything to add on it?

CHARLIE MUNGER: No, but that was interesting because we were young and poor then by modern standards. And, you know, we’re very human. And we could see it was just, like, putting $100 million in a bushel basket and setting it on fire as we walked away. And — (Laughter)

WARREN BUFFETT: You’re making me feel bad. (Laughter)

CHARLIE MUNGER: We made the decision all right and with no difficulty. But there was a certain twinge. (Laughter)

23. Munger’s collected wisdom

WARREN BUFFETT: Number 2.

AUDIENCE MEMBER: My name is J Dwight. I’m from a small town in Maine called Wilton, Maine. My question comes more of a request. And could Charlie Munger create a curriculum, or a list of reading and experiences, which he believes would lead to his concept of worldly wisdom? This would serve two great — three great purposes. One, it would pass on the most valuable possession — that is your knowledge and experience — to us and to others in the future. Two, it would preserve and enhance that wealth beyond the material riches endowed on future generations. And three, it would begin to remedy the stunted educations of those like — Mr. Munger — are plunging along with ordinary will, with time to improve ourselves. Thank you.

CHARLIE MUNGER: Well, of course, Peter Kaufman has tried to do that in that book that he stitched together out of my old speeches plus a lot else. And I didn’t want to do it. And he went and saw Warren, and Warren got enthusiastic. And Warren suggested this ridiculous name, “Poor Charlie’s Almanack.” (Laughter) And between the two of them, they really got me to do it. But the whole idea of doing it is with just the motivation you’re talking about. I think if you assimilate everything in that simple book, you will know a lot more than about 95 percent of your compatriots. And it’s not that hard to do. So, Peter Kaufman has made it easy for you.

WARREN BUFFETT: Yeah, I couldn’t be more enthusiastic about what you suggested. And it’s been done. And it’s a sensational book. And anybody that reads it is going to learn a whole, whole lot about life. And you’ll learn even — to get you to read it, I’ll tell you you’ll even learn something about making money. The — and it’s right next door here, they haven’t sold out.

24. Future of pharmaceuticals is “too hard”

WARREN BUFFETT: Number 3, please?

AUDIENCE MEMBER: Good afternoon. Scott Jeffords (PH) from Davidson, North Carolina. The major pharmaceutical companies have faced a myriad of fundamental and legal challenges in recent years. With that in mind, and given the apparent ongoing nature of those obstacles, how should investors be thinking about the long-term prospects for this very important industry?

WARREN BUFFETT: Well, my answer is, I don’t know. But maybe Charlie will. And it’s — you know, it’s a terrific question. It’s just that — that industry is in a state of flux now. It does very important things for mankind. It’s historically earned good returns — very good returns — on invested capital. But it’s going — it could well be that the world will unfold differently for those companies in the future than the past. It may — that may not be the case. And I’m — I don’t think I’m really qualified to give you a good answer on that because much of it is in the political realm. And my judgment about the — what politicians will do is probably not better than yours. Charlie?

CHARLIE MUNGER: I share Warren’s agnosticism on the subject. We just throw some decisions into the “too hard” pile and go on to others. (Laughter)

25. No “degree of difficulty” adjustment for investing

WARREN BUFFETT: Incidentally, there’s a lot of wisdom in that remark. I mean, there are things in life that you don’t have to make a decision on and that are too hard. And many years ago on one of the reports, I said one of the interesting things about investment is that there’s no degree of difficulty factor. I mean, if you’re going to go diving in the Olympics and try to win a gold medal, you get paid more, in effect, for certain kinds of dives than others because they’re more difficult. And they properly adjust for that factor. But in terms of investing, there is no degree of difficulty. If something is staring you right in the face and the easiest decision in the world, the payoff, can be huge. And we get paid, not for jumping over 7-foot bars, but for stepping over 1-foot bars. And the biggest thing we have to do is decide which ones are the 1-foot bars and which ones are the 7-foot bars so when we go to step we don’t bump into the bar. And that is something that I think we’re reasonably good at.

Now maybe we cast out too many things as being too hard and thereby narrow our universe. But I’d rather have the narrow — the universe be a little too — interpret it as being a little too — a little smaller than it really is, than being interpreted as larger than it is. Charlie?

CHARLIE MUNGER: Obviously.

26. Avoiding emotional investment traps

WARREN BUFFETT: 4. (Laughter)

AUDIENCE MEMBER: Good afternoon. I’m Whitney Tilson, a shareholder from New York City. And one of the things I find most refreshing and admirable about you, as corporate leaders, is that you’re very candid about making mistakes, and — as you put it last year, Mr. Munger — rubbing your noses in it. Last year, Mr. Buffett, you talked about the $10 billion mistake of starting to buy Walmart and then stopping after it had ticked up a little bit. Today, you seem to allude to a somewhat similar mistake. You bought a stake in PetroChina. Then after it was disclosed that you owned it, it popped up a bit. And obviously in hindsight, you could have made a lot of money had you continued buying it. If these emotional traps — I think you called it “anchoring” at last year’s annual meeting — are the traps that even people as experienced as you gentlemen are, occasionally fall into, I sort of wonder what hope do the rest of us have? So, my question is, is how do you — what are the mental tricks you have? Or how do you overcome these behavioral and emotional traps like anchoring?

And what advice do you have for us?

WARREN BUFFETT: Well, that’s a good question. And, of course, it first — the first step is in recognition of the fact that they can be traps and that you will be affected by them. And you will make some mistakes because of them. But Charlie in his — in “Poor Charlie’s Almanack,” which I probably do take credit for the name of, and the — he talks about the various psychological traps that people fall into. And simply reading that section, you will come away wiser than before you started on it. We will — our personalities are such that Charlie and I probably are a little less prone to some of those mistakes than other people are. But as our record clearly indicates, we still are prone to them. And we make them and we’ll make them again. We’re probably a little less inclined to make some of them than we were 30 or 40 years ago. But, you know, the nice thing about it is, though, is that if you make fewer of those mistakes than others, you know, they will continue making their share and you’ll get very rich. Charlie?

CHARLIE MUNGER: Yeah. You don’t have to have perfect wisdom to get very rich. All you’ve got to do is have slightly more than other people, on average, over a long time. (Applause)

WARREN BUFFETT: You know, it’s the old story about the guy outrunning the bear. I mean, I don’t have to outrun the bear. I just have to outrun that other fellow. And — (Laughter)

27. Low Treasury yields are a mystery

WARREN BUFFETT: Number 5.

AUDIENCE MEMBER: Hi, I’m Steve Casbell (PH) from Atlanta. With signs of inflation, you know, in commodities and oil, why do you think the 10-year is still — you know, the yield is 4.2 percent? And, you know, is it that the market sees signs of deflation coming in the future? And in addition to that, if you thought rates would stay at this level for an extended period, would you have a more favorable view of the market?

WARREN BUFFETT: Well, the answer to the second part is yes. I mean, if somebody guaranteed me that the 10-year rate would never go above 4.2 percent for the next 50 years, we would have to readjust, recalibrate every decision we make around Berkshire. I think it was [Federal Reserve Chairman] Alan Greenspan, I don’t know whether he’s talking about the 10-year or what is the closest thing now to the 30-year — we don’t issue 30-years anymore — but the — he referred to it as a conundrum. And after I looked it up, I decided I agreed with him. (Laughter) I don’t understand it. And — but that’s OK. There’s a lot of things in financial markets I don’t understand. And that doesn’t mean I have to make a decision. I don’t have to either go long or go short, the 10-year. Although by keeping as much money as we do short, we are in effect at least making the decision that we don’t want to be long, long bonds.

That doesn’t mean we think it necessarily would be smart to be short them. But we do not want to be long, longer bonds. And I — If you’d told me two years ago that every move that the Fed would make in the last two years, and you told me all the other variables that would take place, and you’d asked me what the 10year rate would be at this time, I would have been very wrong. So, you know, it’s not a game I’ve excelled at so far. I’m puzzled by it. And we’ll see where it is next year when we meet. Charlie?

CHARLIE MUNGER: Yeah, I think the one thing you can confidently predict is there won’t be some automatic and rational correlation between inflation and interest rates. There will be weird diversions.

WARREN BUFFETT: Do you want to elaborate on how these weird things will manifest themselves?

CHARLIE MUNGER: No, no. All I know is it happens.

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: Frequently very surprising.

WARREN BUFFETT: Well, it surprised us on this so far, didn’t it?

CHARLIE MUNGER: Sure.

WARREN BUFFETT: Yeah.

28. “Finite” insurance

WARREN BUFFETT: Number 6.

AUDIENCE MEMBER: Hi. Glenn Tongue from New York City. I hope this does not overstate your ground rules. I’ve read what you have written about finance reinsurance in the annual report. There’s been much erroneous stuff written recently about finite reinsurance. Can you simply explain the product and its importance to Berkshire?

WARREN BUFFETT: Yeah, well it’s a good question because the term has been used, “finite reinsurance.” And, you know, basically almost all insurance is finite. I mean, if you have a $200,000 homeowner’s policy, or if you have a 100/300 auto liability, that’s a finite policy. The insurance company will pay you that much and pay you no more. And with the exception of workers’ comp, and maybe there’s something else I’m forgetting about, but basically all insurance is denominated in some amount with a limit. That 500 million we wrote on that airport, I mean, we can lose 500 million but I don’t think we can lose 501 million. And so the — I think the term finite has gotten — it’s gotten to be convenient to use without anybody totally describing it well. Actually, when the SEC sent out its first request for information, I think they called it nontraditional insurance. And I think that may be a better term to use in terms of what’s being looked at.

And there is nothing wrong — I mean, there’s nothing wrong at all with finite insurance. We’re issuing finite insurance policies every day at our — on our auto policies and everything else. And there’s nothing wrong, in my view, at all with retroactive contracts. For example, we wrote — a few years back we wrote a — and this is very rough, but it’d been in the press, so that I’m not violating any confidences of clients — We wrote a contract as I remember — and I may be just a little off on this — that to pay, when INA was being sold to ACE, we — to pay 2 1/2 billion of claims from the past. And I think we got a premium around 1 1/4 billion on it. Now, we were making an estimate or a guess as to whether the whole 2 1/2 billion would be paid, how fast it would be paid, and a lot of things. And ACE, on the other hand, was getting rid of 2 1/2 billion of potential liabilities, and they did not have the capital strength of Berkshire. And that contract went before the Pennsylvania Insurance Department. It was improved.

I mean, it had value to both parties. It had — you can argue it had value to the public in that Berkshire was a stronger insurer. Actually, in the first quarter of last year in our 10-Q, you will see that we recorded a loss of $100 million because the payment pattern on that contract turned out to be faster than we anticipated. I mean, there was risk involved. But it was all retroactive and a perfectly proper contract, in my view, or I think anybody’s view. And we would do more of that business. In fact, we looked at a very, very big one here recently. What I think the — and understandably — the authorities are looking for is that contracts that had no purpose and that were possibly misused by some party in accounting. And the facts on that remain to be seen. But I think calling it finite, it just isn’t the right descriptive word. I think that, like I say, nontraditional — we can have a lot of non — we issue non-traditional products all the time. I mean, I talked last year about the billion-dollar thing for PepsiCo. That certainly isn’t traditional. But it’s real insurance.

And the question is whether risk is transferred. But the risk on the ACE contract, for example, was several. One is, we had a risk as to whether the whole 2 1/2 billion would be paid. Second, was how fast it would be paid. And the third risk is what you can do with the money in between. And money hasn’t been worth very much to us lately. So, there was risk in that. And that’s what insurance is all about. Charlie?

CHARLIE MUNGER: Well, I certainly agree with you about the word finite reinsurance. It’s — absolutely — you could hardly not invent a worse word to use to describe a new class of insurance. It’s just a meaningless rubric. And, of course, non-traditional is imperfect, too, because we have traditionally issued nontraditional insurance. (Laughter) And — but we have to use some words to describe what’s happening. There’s no question about the fact that the corporate world has gotten more and more interested over the last 10 years in having regularity in earnings reports. And they’ve turned to a huge variety of ways to try and do that. And reinsurance is a very minor part of the whole picture. But there has been more reinsurance sought because people were more anti-volatility, in terms of reported results.

WARREN BUFFETT: But, of course, insurance is a way to reduce volatility, and a perfectly proper way. I mean, if you pay $1,000 a year on your auto premiums for the next 30 years, it isn’t — You are going to have a more regular income stream than if you wait and have one $25,000 accident one year and don’t pay the premiums in the other years. So, I mean, people have bought insurance to reduce the volatility in their own personal results and their own business results. So, reducing volatility, per se, is not bad at all. It’s the reason —

CHARLIE MUNGER: No.

WARREN BUFFETT: — there are $400 billion worth of insurance premiums paid in this country every year. But that doesn’t — you know, you can also get into abuses of that. And that’s what they’re — the people are looking to find and see what the real situation is.

29. Buffett: I make mistakes but don’t agonize over decisions

WARREN BUFFETT: Number 7?

AUDIENCE MEMBER: Wow, this more nerve-wracking than I thought it would be. Hello, Warren, Charlie. My name is Aki Progakis. I’m from Montreal, Canada. Warren, I wrote a letter back in January. I wrote a letter to you recommending a beautiful Canadian retail company in which I described my analysis to you. I’d like to thank you for taking the time to respond to me. You said some nice kind words. That meant a lot to me. And I think you’re an amazing individual. My question go — (audio dropout) — people, what is the single most difficult decision you’ve had to make in your lifetime, whether it be business or personal?

WARREN BUFFETT: I think I’m going to let Charlie answer that one first. (Laughter)

CHARLIE MUNGER: Yeah. I would argue that that may be one that you shouldn’t ask. (Laughter and applause) Or let’s put it this way, I think you should answer it with several interesting examples before you ask us to answer it. (Laughter)

WARREN BUFFETT: That’s a (Inaudible). (Laughter) It’s interesting. As Charlie was talking, I was — I have — I can’t think of a lot of difficult — I can think of a lot of wrong decisions I’ve made. But I certainly can’t think of anything I agonized over making for any long period of time. Like I say, that isn’t — you know, I mean, it’s calling balls and strikes. I mean, you got a second there and if you don’t do it in that — you’re no longer an umpire. So, I’ve made plenty of wrong decisions. I’m going to make plenty more. That’s just part of living. But I don’t think in terms of being difficult as measured by the time it took me to do it or the — not a lot of them pop to mind. And if they do I’ll probably give you the same answer as Charlie. Charlie, have you thought of any more there while we were talking?

CHARLIE MUNGER: No. Let’s go on to another.

WARREN BUFFETT: OK. (Laughter) That was not a bad decision.

30. Real estate brokerage will get a “lot bigger”

WARREN BUFFETT: Number 8. (Laughter) But thank you.

AUDIENCE MEMBER: Good afternoon. My name is Franklin Grin (PH). I’m from Philadelphia. And I’m interested in real estate. You’ve already covered many different areas today about real estate, such as the real estate bubble, the long-run performance most people have obtained in their personal holdings of real estate, the GSEs, the REITs. But one of the things that appears in today’s newspaper is quoting Mr. Buffett about building a brokerage powerhouse. And that seems to say that you envision changes in the way in which people buy and sell their houses and other kinds of related things. So, I was wondering if you could tell me a little bit more about that area of where you envision Berkshire Hathaway going.

WARREN BUFFETT: Yeah, I’ll be glad to. But the — we are hoping to build a powerhouse that’s built very much on the model of today. In other words, we do not envision big changes in residential real estate brokerage, which is what we’re in. We — as we put in — they talk about sides in real estate, the buy side and the sell side. We participated in sides that totaled $50-odd billion last year. And we are the second largest residential real estate brokerage firm in the country. But we expect that business really to be conducted quite similarly in the future to how it has been in the past. Now there are people that disagree with that and think that way more will happen via the internet. But, you know, the purchase of a home is the single most important transaction for most people in their lifetimes. It’s — it can be partly emotional. It’s partly something that they appreciate people guiding them through. It’s something where I think one-on-one will be very important in the future as it has been so far.

And in this country, there are going to be millions and millions and millions of homes that get sold every year. It’s — just in terms of people moving and dying and moving up in their economic potential. So, there — the real estate brokerage business is going to be a very, very big business. And I think it will tend to be a very local business. And we have bought leading local firms in a number of markets. And they have retained their individual identity. We have not gone for a Century 21 or something approach, where we put them all under the umbrella of a single brand. Rather we have these individual brands in given communities. And they’re usually very strong brands in each community. But we’ve only scratched the surface. And I would expect — and it has nothing to do with the potential for real estate or anything. It just relates to the fact that tens and tens and tens of millions of people own their own homes. And some are going to move around every year. And there’s — I think that they’re going to continue to have a real estate broker involved in most of the transactions. And we would like to be very big in that business.

We already are big, but we’re going to — I would think it’s almost certain that we will be a lot bigger in that business five or 10 years from now — I mean, a lot bigger — than we are now. And it’s a question of acquiring these firms. Generally, they’re — you know, they’re proprietorships. They’re owned by a single individual or a family. And they come up periodically because of the family circumstances or the individual circumstances of somebody. But there’s a lot of them out there. And we’re a logical buyer. And we’ve been found to be a good owner. So I think it’s going to be a good-sized field for us over time. Charlie?

CHARLIE MUNGER: Yeah, we voted by buying the brokerage operation instead of the real estate. Obviously, we regard it as having better economics than the underlying real estate which Berkshire could buy.

31. Munger: “Stupid and dishonorable accountants”

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: Hello. My name is Martin White. I’m in the insurance business in London. And quite separately, together with other volunteers, I also help to run the only independent lobby group for private shareholders in the U.K. I would like to ask you your thoughts on two aspects of worldwide solvency and how assets and liabilities are recognized in everyone’s accounts. I suppose both are about whether the regulators have the bottle to do the right thing in spite of possible complaints from companies. One aspect is about how insurance liabilities and assets are valued for solvency purposes and the discussions that are going on to develop new accounting standards worldwide. The other aspect is about derivatives, the potential “weapons of financial mass destruction.” For those derivatives which don’t have quotes, I suspect we could find out how big a black hole there might be if the regulators around the world required everyone to report at the same date for each derivative they have, their current recognized asset or negative assets, and most importantly, who the counterparty was. So, the regulators, sharing information collected from both sides, could see what the worldwide aggregate misstatement was.

On insurance solvency, if we started with a fair attempt at mean discounted liabilities, and then added a large chunk for safety, and for reinsurance assets, did the same, discounted, but this time the safety chunk was deducted, life would be a lot simpler and there would be a lot more consistency and, I suspect, safety, than under the current undiscounted regime. I think both problems need regulatory attention. What are your thoughts?

WARREN BUFFETT: Well, on a subject of discounting reserves — which essentially means taking what you expect to pay in the future and then taking in the appropriate interest rate and carrying at some lower figure now, because you don’t have to pay now, but later — You know, I can certainly make the purist argument — or the argument of the purist — for the fact that that might be the most accurate way. And certainly, of course, in the life insurance field, it is prevalent. But I would say there has been such a tendency of managements to understate reserves worldwide, and in some cases by extraordinary amounts, that I think anything that pushes in the direction of carrying those reserves at even lower amounts — And I realize you stuck in that part about the healthy bumping of them, too — but I think anything that — any accounting that lets — gives people a rationale for making reserves even lower than they have been, on balance, is dangerous.

There is such a tendency on what they call long-tail business — or business where you don’t expect to actually make the payments for a few years or more — I think there’s such a tendency to view those with optimism, particularly when somebody’s going to retire in a couple years or their options are about to run out or whatever it may be, that I don’t like giving them the extra leeway of discounting on top of that. The derivatives question you raise is really interesting, but it would be mind-boggling to implement. I mean, it’s always fascinating to me how people can write a derivative contract, you know. And both sides of it — the trader will be, perhaps at least, showing a profit on it, you know, by the end of the month or something of the sort, that — you know, usually the contracts aren’t that precisely matched because you have all kinds of other contracts that bear on the one you’re doing.

But I would say that the trader’s estimate, and maybe the auditor’s estimate, of the value of all derivatives contracts outstanding in the world, would end up with — quite a large positive sum for something that essentially will wash out as a zero sum. And I can tell you from the fact that I inherited a book of 23,000 contracts that’s far, far, far from the largest or the second largest or the third largest in the world. And the complexity of those contracts, and the complexity of unwinding them now where we’re three years into it — and we’ve done an awful lot of it, but we’ve been operating in a benign environment — I don’t think any regulator, and I’m not sure any auditor, when you get up to really extensive derivative books, in effect, can get their minds around evaluation. I know that, you know, as I pointed out in our report, ours were supposedly marked to market. And people think of that as something that you just go out and hit bids and, you know, within a few days wind up something. And if you’re trading government bonds, you know, you can do that.

And if you’re trading actually active equities, you can do it. But when you start trading derivatives, it’s unbelievable what you can find. And I’ve had a couple of experiences with them. Charlie, what are your thoughts?

CHARLIE MUNGER: Well, my thoughts are that stupid and dishonorable accountants allowed the genie of totally improper accounting to come out of the bottle and descend in the derivative books of the world. Once that has happened and people have used it to create masses of assets and masses of earnings reports and bonuses and status and so on and so on and so on, getting the genie back in the bottle is no small task because you have these huge vested interests who are fighting you. And what ordinary housewife, as she puts the toast in in the morning, is thinking, “My god, I’ve got to do something about derivatives?” You know? (Laughter) So the people that are — have vested interest in the current system are powerful. And the rest of the people don’t care. And so this evil genie stays out of the bottle and does more and more mischief with each passing day. If you’re trying to fix this, you are going to have a very interesting life. (Laughter)