Berkshire Hathaway Annual Meeting 2003 Transcript

Warren Buffett [00:00:03] (Applause) We promise not to sing. Good morning, and we’re delighted to have you all here. One of the things that makes it fun to run Berkshire is that we see real shareholders, that we have, we probably have a larger proportion of our shares held by individuals and not by institutions than virtually any large company in America. And that’s the way we like it, and that’s… We love it when you come and we get to see you. You buy our products. You know, there’s still a few things left downstairs, so feel free to leave anytime during the meeting when Charlie’s talking to go down and make a few purchases.

Now we’re going to do as we always done. First of all, I’d like to, I would like to give very special thanks to Andy Heyward. Andy, would you stand up if you will, please? Andy is the man that, there he (Applause) is. Andy does those cartoons. He recruits Walter Cronkite and Bill Gates, and he does the script. He gets Charlie and me to do recordings, and it’s just wonderful, the production he’s put on.

And for those of you, I, last year I mentioned a program that’s on public broadcasting called Liberty’s Kids. It’s running in consecutively, there’s a, I think, 40 episodes at… It tells the story really of the founding of the country, and it’s a marvelous, it’s a marvelous way to learn history. I’ve watched a number of the sessions myself, and it, you know, kind of comes back to me from my early days, grade school and high school. And he’s done, I think, the parents of America and the country a real service in producing this, and I will predict that 100 years from now people will be watching Liberty’s Kids. So I really salute Andy Heyward, and be sure to catch it on public broadcasting. And Andy, thanks for a wonderful (Applause) production.

Now we’re going to follow our usual procedure of leisurely proceeding through the formal part of the business in 3 or 4 minutes, and then we will, I’ll have a few comments actually on our business, and then, and a couple of acquisitions, and then we will spend the rest of the day until 3:30, with a break for lunch, we will spend here to answer any questions you have. We have microphones in various zones, and we will proceed around and try to get everything, every, any subject that’s on your mind, fire away. And I’ll answer the easy ones, and Charlie will answer the tough ones.

So now we will go through the formal part of the business. They’ve written a little script for me, and I will go through this. The meeting will now come to order. I should introduce Charlie over here, not that he needs an introduction, but Charlie. (Applause)

Charlie and I have been partners of one sort or another since 1959. We both grew up a good bit here in Omaha, but we didn’t know each other at the time. We both worked at the same grocery store. We had a similar experience. We found that neither one of us liked hard work. And if you go down to the Western Heritage Museum, they just opened an exhibit of that grocery store. It’s a permanent exhibit, and naturally I love that. Charlie worked there a few years before I did in the past, but we didn’t actually meet until I was 28 to 29, and Charlie was a few years older, as he still is.

And we have, we’ve worked together now for, in one way or another, for 44 years. We, we’ve never had an argument. You, we disagree sometimes on things. He, you have to learn to calibrate Charlie answers. He, when I ask him whether he likes something, if he says no, that means we put all our money in it. I mean, that is a huge… If he says that’s the dumbest idea I’ve ever heard, that’s a more moderate investment that we make. And then you have to calibrate his answers, but once you learn to…

We have our, we have our directors with us, and I’ll introduce them. We have, if you’ll stand, please, as I call your name, and then you can, it’ll be hard to do, but you can withhold your applause till they’re all sanding. Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson and Walter Scott Jr. In addition to Charlie, that, those are the directors of Berkshire (Applause) Hathaway.

As we mentioned in the annual report, we will be adding some directors who meet the four tests that I laid out in the report. We’ll be adding some of those probably within the next year. When we’re required, whenever we’re required to do so, we will be doing it, and we will have people who have a lot of their own money on the line, just like you do in Berkshire, and they will prosper or suffer in relation to how Berkshire does and not in relation to their director’s fees or other things. So they will be selected for business savvy, which they will have. They will be selected for interest in the company, which is almost guaranteed by their holdings. They will be selected by their shareholder orientation, which again I think that their holdings will produce. And we will, we will have those people on board probably by our next meeting.

Also with us today are partners in the firm of Deloitte & Touche, our auditors. They are available to respond to appropriate questions you might have concerning their firm’s audit of the accounts of Berkshire. And I might say that almost any question would be appropriate. Mr. Forrest Krutter is secretary of Berkshire. He will make a written record of the proceedings. Miss Becki Amick has been appointed inspector of elections at this meeting. She will certify to the count of votes cast in the election for directors. The name proxy holders for this meeting are Walter Scott Jr. and Marc D. Hamburg.

We will conduct the business of the meeting and then adjourn to the, adjourn the formal meeting. After that we will entertain questions that you might have. Does the secretary have a report of the number of Berkshire shares outstanding, entitled to vote and represented at the meeting?

FKForrest Krutter [00:07:10] Yes, I do. As indicated in the proxy statement that accompanied the notice of this meeting that was sent to all shareholders of record on March 5, 2003, being the record date for this meeting, there were 1,309,423 shares of Class A Berkshire Hathaway common stock outstanding, with each share entitled to one vote on motions considered at the meeting, and 6,763,493 shares of Class B Berkshire Hathaway common stock outstanding, with each share entitled to 1/200th of one vote on motions considered at the meeting. Of that number, 1,071,967 Class A shares and 5,022,875 Class B shares are represented at this meeting by proxy’s return through Thursday evening, May 1.

Warren Buffett [00:07:56] Thank you. That number represents a quorum, and we will therefore directly proceed with the meeting. First order of business will be a reading of the minutes of the last meeting of shareholders. I recognize Mr. Walter Scott, who will place a motion before the meeting.

WSWalter Scott Jr. [00:08:12] I move that the reading the minutes of the last meeting of the shareholders be dispensed with and the minutes approved.

Warren Buffett [00:08:20] Do I hear a second? Motion has been moved and seconded. Are there any comments or questions? We will vote on this motion by voice vote. All those in favor say, say aye. Opposed, you can signify by saying, “I’m leaving.” The motion is carried.

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

WSWalter Scott Jr. [00:09:11] I move the Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson and Walter Scott Jr. be elected as directors.

Warren Buffett [00:09:23] Sounds good to me. It has been moved in second of the Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson and Walter Scott Jr. be elected as directors. Are there any other nominations? Is there any discussion? The nominations are ready to be acted upon. If there are any shareholders voting in person, they should now mark their ballots on the election of directors and allow the ballots to be delivered with the proxy holders. Please also submit to the inspector of elections a ballot on the election of directors, voting the proxies and accordance with the instructions they have received. Miss Amick, when you’re ready, you may give your report.

BABecki Amick [00:10:09] My report is ready. The ballot of the proxy holders, in response to proxies that were received through last Thursday evening, cast not less than 1,058,800… The certification required by Delaware law of the precise count of the votes, including the additional votes to be cast by the proxy holders in response to proxies delivered at this meeting, as well as any cast in person at this meeting, will be given to the secretary to be placed with the minutes of this meeting.

Warren Buffett [00:10:50] Thank you, Miss Amick. Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson and Walter Scott Jr. have been elected as directors.

The next item of business is a proposal put forth by Berkshire shareholder Christopher J. Fried, the owner of two Class B shares. Mr. Fried’s motion is set forth in the proxy statement and provides that the sh… shareholders request the company allow Class B shareholders who own at least seven registered shares of Class B stock to become eligible to participate in the shareholder-designated contributions program. The directors have recommended that the shareholders vote against this proposal. We will now open the floor to recognize Mr. Fried, or is designated to present his proposal.

[00:11:35] Shareholder (Chris Fried): Thank you, Mr. Buffett. Good morning, my fellow shareholders. My name is Chris Fried, and I am here to present a shareholder proposal. This proposal is designed to extend the shareholder-designated contribution program to include Class B shareholders. Let me first start off by saying, in our shareholders owner manual there is a statement that I like to quote at this time: “Although our for is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners and of ourselves as managing partners. We do not view the company itself as the ultimate owner of our business assets, but instead view the company as a conduit through which our shareholders own the assets.”

With that in mind, I present the following proposal for a vote. This proposal would extend the shareholder contribution program to Class B shareholders who own at least seven registered shares of Class B stock. Under my proposal, each Class B stock would be allocated 1/30th the value to Class A donation rate. Currently the Class A rate is $18, which translates to 60 cents per Class B share. The required minimum seven registered shares results in no less than $4.20 being donated by a Class B shareholder. This figure is important, for when inflation is taken into account, the donation rate will be on par with the original 1981 donation level, when the shareholder proposal designated program in was initiated.

I do understand that there are certain perks involved with owning a Class A share. However, those perks should only be limited to voting rights and the ability to convert Class A shares to Class B shares. Therefore, I believe that is an appropriate to extend the shareholder-designated program to Class B shareholders. If Berkshire Hathaway is to truly follow, truly follow what it pro… preaches about this firm being a partnership among all of its shareholders, then Class B shareholders must have the right to at least had the option to take part in the shareholder-designated contribution program. Thus I ask my fellow Berkshire Hathaway shareholders to vote an affirmative on this matter. Thank you for your time.

Warren Buffett [00:14:22] Thank you, Mr. Fried, and you’re absolutely right that Charlie and I do regard our shareholders as partners, and we have ever since we really started. In fact, Berkshire in a sense evolved out of a couple of partnerships. Charlie had a partnership, I had a partnership, we made an investment in certain things, and a lot of our original partners are still with us as shareholders. The partnership, our partnerships have… And when we set forth, or when we issued the Class B shares some years ago, we set forth the relative terms of the, of the partners, and the Class A and the Class B are quite similar in economic terms, but they’re not identical.

And at the time we issued those shares to a new group of partners, Class B partners, we explained quite clearly, I believe, exactly what differences there were. There was a difference in voting rights. There was a difference in the, the Class A could be converted to B but not the reversed. And there was a different in the shareholder-designated contribution program. Ever since we issued those shares, I don’t know, maybe six or seven years ago, we in effect have had a compact with both the A and B shareholders that they, that we would treat the two classes in a way consistent with what was explained at the time of issuance.

So if we were to change the vote, the conversion ratio or the shareholder-designated contribution program, we would in effect be changing a deal that was made and that has been recognized as having been made ever since the B shares were issued. People have bought the A shares in preference to B because of certain reasons. People have bought the B shares for other reasons. But they have relied on the fact that we would abide by what we said we would do at the time we issued those shares.

We’ll not take anything away from the B, we’ll not take anything away from the A. We’ll run things just as they are, and in the future… You know, I happen to have shares con… My holdings concentrated in A shares, but the A will never get any advantage over the B except for the ones we laid out at the time of issuance of the, the B. And it would actually be unfair to A shareholders, and particularly to A shareholders who bought since the B was issued, to tell them that the economic relationship between the A and B was being changed, even though only in a slight way, to the benefit of the A, benefit of the B and the detriment of the A. We wouldn’t do that in either direction. So that’s why we recommended to vote against it. Charlie, do you want to add anything?

Charlie Munger [00:17:22] Well, not only is all of that true, but the cost of getting down to all the, would, it would be a very inefficient process.

Warren Buffett [00:17:31] Yeah, that, well, of course that, and that’s the reason back when we issued the B. I mean, we anticipated that, so it just, it seemed like something that would offer very little value to the B at a, at a significant cost to the company, and therefore we spelled it out quite clearly, I believe, in the original prospectus, and it’s been spelled out in every annual report subsequently. So it’s the deal. And the deal is not, is also that we never change things to benefit the A in any way over the B, except as originally explained in the original prospectus and subsequently in all the annual reports.

Is there a second to Mr. Fried’s motion? What do we do if we don’t get a second, Charlie?

Charlie Munger [00:18:19] It does.

Warren Buffett [00:18:20] Okay. I guess it just died. But there’s nothing inappropriate about bringing something like that up. I mean, I understand exactly, you know, what you’re thinking about, but I think you have to think of fairness to both classes. Moving right along. Figuring out where we are, I guess we’re moving along to adjournment of the meeting, and after that we will have the question, questions we talked about and also tell you a little bit about the business since the annual report come out, as came out. Walter Scott, do you have a motion to put for the meeting? Do we have a second? Motion to adjourn has been made and seconded. We will vote by voice. Is there any discussion? If not, all in favor say aye. All opposed say no. The meeting’s returned. (Applause)

Now I’d like to bring you up the date on a couple of things, and then we will proceed with questions. We have eight microphones placed around the auditorium here, and we will proceed regularly around and just keep going around and around. And Marc, do we have any microphones in the Music Hall or not? I’m not a… Maybe if Marc could come up and inform me whether there’s crowd Music Hall or not. We can…

MHMarc Hamburg [00:20:03] There’s two microphones in the music, 9 and 10. 9 and 10 are in the Music Hall.

Warren Buffett [00:20:08] And are there quite a few people there?

MHMarc Hamburg [00:20:11] Full. It’s full.

Warren Buffett [00:20:12] Yeah? Oh, okay. We haven’t put microphones out on the sidewalks yet, but we’ll get to that someday.

We’ve made, we’ve contracted to make two acquisitions this year. You just read about one, perhaps, in this morning’s paper. It was, went on the tape at 7:45 yesterday morning, Central time. And that involved the contract to buy McLane from the Walmart company. McLane is a very large wholesaler to all kinds of institutions, but convenience stores, quick-serve restaurants, the Walmart operation itself, theaters, restaurants. And this year we’ll probably do something like $22 billion of business. So it’s a very substantial enterprise, with distribution centers around the country, with much in the way of transportation equipment.

Walmart had owned McLane’s since about, I believe, 1990. It grew substantially while they owned it. It’s been run by a terrific manager who’s here with us today, Grady Rosier, and Grady took the business from $3 billion to $22 billion or thereabouts. Walmart, for very good reasons, wants to specialize in what they do extremely well, and through Goldman Sachs and Company we were approached by them a little while back about the possibilities of buying the business. It’s a b… It really makes sense for both sides, because Walmart knows what to do with the capital very, very well in their own business and has lots of opportunities, and this was something of a sideline to them.

On the other hand, their ownership of McLane resulted in certain people that would be logical customers of McLane’s not wanting to do business, because they didn’t want to do business with a competitor. And we plan to see all those people very soon and explain to them that that’s no longer the case, and they can sleep well at night doing business with us and not worry about benefiting their competitor at Walmart.

So this deal, a representative of Walmart came up last Thursday to Omaha, a week ago this past Thursday, a CFO, and we made a deal in maybe an hour or two and shook hands. And when you shake hands with Walmart, you have a deal. And so the time remaining until yesterday morning, a contract was draw, was put together, and it must go through the Hart-Scott-Rodino process in, to be cleared. But there’s obviously no conflict, so we fully expect that in just a few weeks that McLane will become part of Berkshire.

And it’s serves presently about 36,000 of the 125,000 or so convenient stores. If you take the 50 largest convenience store chains in the country, it does 58% of the business with those companies. Sells each convenience store an average of perhaps $300,000 or slight bit more of product a year, which those convenience stores then resell to the consumer. It also serves about 18,000 quick-served restaurants, primarily those operated by Yum Brands, the Taco Bell and Pizza Hut and the Kentucky Fried Chicken group. And it will have opportunities to serve many more as we go along.

So we’re delighted. If any you get a chance to see Grady, or better yet, if any of you own a convenience store, step forward and we’ll be glad to give you our card. It’s really, you know, Walmart knows that we will be a good owner. They know we’ll be good for the people that work at McLane. They know our check will clear, that we won’t, you know, make a proposition and then run into contract later on. And it’s just an ideal way to do business, and we’re delighted to add McLane to the Berkshire group of companies.

It’s a very narrow margin business, obviously. I mean, when you get up to $22 billion of sales and you’ve got Hershey and Mars and people like that on one side, and you’ve got buyers like 7-Eleven and Walmart on the other side, they’re not going to leave a lot in between. But you have to perform a valuable service for them in order to earn, you know, say 1 cent on the dollar pre-tax. But McLane’s knows how to do it. It’s a very efficient operation, and it will continue to deliver value to both the, their vendors and their, and their customers.

The other, the other acquisition that is in the works is Clayton Homes. Clayton is the class of the manufactured home industry, and the acquisition came about in kind of an interesting way. Every year for the last five years, a group of about 40 finance students from the University of Tennessee in Knoxville would come up to Omaha, and they would have a lot of fun in Omaha. They go to the Furniture Mart, and then in the afternoon they’d come to Kiewit Plaza, and the 40 students or so, with their professor, Al Auxier, would have a session with me. We just have a classroom session for a couple of hours, and wonderful group of students, and generally at the end of the session they would give me a football or a basketball. They’ve got a great women’s basketball team at the University of Tennessee. And so, and we’d have a good time together.

And matter of fact, a year ago when they came up, Bill Gates by chance was in town, so I presented him as a substitute teacher, which is a post he always wanted, and students got quite a surprise. This year when they came, 40 or so students, we had a good session together, a couple of hours at Kiewit Plaza, and when they got through they gave me a book, and it was the autobiography of Jim Clayton, who started and ran Clayton Homes and buil… build it into a huge success. And he’d written a nice inscription inside.

And I mentioned to the students and the professor that, that I was a admirer of Clayton. I’d followed the manufactured home industry in other ways, not always so successfully, and I’d seen what Clayton had done. And so I said I was, you know, I look forward to reading the book, which I did. And then I called Kevin Clayton, Jim Clayton’s son, and the, and Kevin is the CEO of the company, and I told him how I’d enjoyed his dad’s book, and I said we still had a little money left in Omaha, and if they ever decided to do anything, you know, we would be interested. And I suggested at what price we might be interested, and a phone call or two later, a couple of phone calls, we made a deal. And I had not been to Knoxville. You know, I checked out a few manufactured homes, suggested that my family a repo. But that deal came about in that manner, and that’s the way things tend to happen at Berkshire, at… You know, the phone rings, or we pick up the phone in this particular case.

And the manufactured home industry got into significant trouble, very significant trouble, because credit terms, that went, well, they went crazy on credit four or five years ago. And when you go crazy on credit, you suffer in a very big way, and that’s what happened in that industry. Conseco, that some of you may have read about, ended up holding, or servicing, I should say, the $20 billion worth of manufactured home credit, and they got in big trouble for that and other reasons. And Oakwood, where we owned some junk bonds, went into bankruptcy. They’re big operation in the country. Most of the, a couple of the other biggest players in the industry are losing significant money. Manufactured home manufact… The companies have lost the ability to securitize the receivables they get when they sell these, when they sell homes.

And so the industry has been in the tank. This year, well, this past year there were maybe 160,000 new manufactured homes sold, but there were also about 90,000 repos came back, and that depresses the market enormously. And like I say, financing sources have dried up. A lot of people that lent money have left the field. So for the strong, as Clayton is, and particularly with a financial backer like Berkshire…

20% or so of all the new single-family homes are manufactured homes in this country. I mean, you can, we can put you in one for about $30 a square foot, and if you compare that to a site-built home, it’s quite a deal. I mean, I was amazed. They have 2,500-square-foot homes, two stories. I mean, it, it’s changed a lot over the last 30 or 40 years. And we’ve got an operation that is, that even the competitors would admit, it’s clearly their class of the op, class of the field.

But even for Clayton, financing was getting more difficult. I mean, the lending community got burned very badly in manufactured homes, and people have sworn off them from the lending standpoint. And Clayton did securitize an issue in February of this year, but they had to keep more of the bottom layers of the securitization themselves. So it’s, it, it’s a good marriage, and it’s one where we will be useful to them, and we should do very well together in the future.

The first quarter, I’ll just… I don’t have final figures yet, and we’ll put this, what I say today, we’ll put it on the website so that you have that, everyone has the information before the opening on Monday. But the economy, as you know, has been quite sluggish. It’s really been sluggish for a very long time. It’s interesting, I wrote in a letter that’s also on the website, right after September 11th, I put something up there, and I said that we were in a, we had been in a recession, which was not something that was generally acknowledged at that time, and I thought would be longer and deeper than most people anticipated.

And what has happened is that really since late 2000, housing and autos have done quite well, but the rest of the economy has just been plain sluggish, and it continues. And during that time we’ve dropped the federal funds rate dramatically, down to one and a quarter percent. Charlie and I weren’t, probably would have predicted that we might ever see that in our lifetime, and maybe it’ll even go lower. And we’re running a huge budget deficit now. But business continues to be sluggish, so our non-insurance businesses generally did not do great in the first quarter.

Our insurance businesses, that extraordinary L… well. And we will show, when the first quarter report is published, we will show an underwriting profit of about $290 million pre-tax, which is after about $140 million of charges for retroactive insurance, the acquisition costs on that, which, I’m sure many of you that don’t love accounting… All I can tell you is that it’s a, it’s a charge that many companies don’t bear, but that we willingly bear because it pro… gives us benefits. But our $290 million is after that charge. Our float grew by probably at least $1.3 billion, so we’re up to $42.5 billion or so of float.

And people, that means people have, are letting us use that money. And as I meant, as I said, in the first quarter did it not only cost us nothing to used the money, but in effect people paid us to use the money, which we would like them to continue to do. And I don’t see our float growing much from this point. Charlie said last time that it was impossible for it to grow, but it probably would. I don’t know whether he’ll change his opinion on that.

But I think, I really think our insurance businesses are in exceptionally good st… We have some of the best insurance businesses in the, in the world. GEICO’s premium volume was up a little over 16% in the first quarter. In April it was up just a, right at 17%. It had a 6%, roughly, underwriting profit in the first quarter. Gen Re, thanks to an incredible job by Joe Brandon and Tad Montross, has turned the corner in a big, big way and showed an underwriting profit in the first quarter. Ajit made so much money I don’t want to even tell you about it. Some of our primary operations… Yeah, you should give him a hand. I mean, that (Applause)… When you get Charlie to clap, you know he’s made us a lot of money.

Particularly US Liability and National Indemnity primary operations, that, and our Homestate Company, they’ve all done, they’re all doing remarkably well. And I, you never know what’s going to happen in insurance. I mean, there could be a, you know, there could be an 8.0 earthquake in California or Tokyo, or there could be one in New Madrid, Missouri, as there was a couple hundred years ago, and it could happen tomorrow. There could be huge hurricanes this summer, whatever. But I, we, I can’t imagine having a much better group of companies or managers than we have. And I, and they’re all, they’re all working well now. For a while Gen Re was a drag, but that’s not true now.

And I think that we have an excellent chance of having very low cost, and perhaps even no cost or negative cost, of float over the next five years or so, or really as far as the eye can see. Now that doesn’t mean it won’t fluctuate around, but if you average it out, I think we will have our float at a very cheap price. And it’s, you know, as Martha would say, having $42.5 billion for nothing is a good thing.

That, now with that, I think we’ve covered… The first quarter was a good quarter overall. It’s the best operating earnings we’ve ever had. Now, we’ve got more capital now than we’ve ever had, and, but nevertheless it will be a good quarter. And I would estimate, I think it’s fair to say, Marc, that from operating earnings we will have something like 1.7, in the range of $1.7 billion. We had some securities gains too, but I don’t count those, because they can do anything from quarter to quarter. We don’t pay any attention to the timing of those. But we, from a straight operating standpoint, $1.7 billion or so after tax. Am I safe with that number, Marc? Okay. What could he say? We don’t change numbers at Berkshire, I promise you that. There a lot of companies do, but we… Fewer now than did a few years ago. But we… So we’re going to get the question.

Say, Charlie, do you have anything added about acquisitions or operations or anything else you’d care to say?

Charlie Munger [00:37:20] Well, I hate to be an optimist, but…

Warren Buffett [00:37:24] Does he ever?

Charlie Munger [00:37:26] We have really added a lot of wonderful business, businesses to Berkshire in the last few years. It’s been some delightful business.

Warren Buffett [00:37:37] That’s all you’re going to get out of them, (Applause) folks.

Okay, we’re going to start around, and we, and we’ve added two microphones to the, to the Music Hall, and let’s start with zone 1, which is over on my right. And do we have the first question?

[00:38:07] Shareholder (George Brumley, Durham, North Carolina): Good morning. I’m George Brumley from Durham, North Carolina. My first question is related to Executive Jet.

It’s been almost 5 years since the acquisition of Executive Jet, a purchase in a much different economic and geopolitical environment. What business metrics do you use to measure success in an industry with as much flux as this one, and what has changed in those metrics since the time of acquisition? What are the prospects for Europe, and have those prospects changed? While none of the competitors approach Executive Jet in terms of scale and scope, what impact are they having on the competitive environment? And lastly, would you please explain the long-term aspect of the business model as many of the jets age out of the program?

Warren Buffett [00:38:58] Okay. Okay, George, I got through college answering fewer questions than that. (Laughter) But George, George’s uncle was best man at my wedding, so he gets all he wants at…

The NetJets, as you will see in the first quarter, had a significant loss. A large portion of that loss was caused by the write-down of planes, because there of… I love it, they call it, they call it in the trade, they call them pre-owned planes. I call them used planes. But the, they do the same thing in manufactured homes, so they call them pre-owned homes instead of used homes. But in any event, putting aside the euphemisms, there, the used plane market… Well, the business aircraft market is very soft. The used plane market has had, has far more planes for sale than, say, three or four or five years ago. That’s going to affect the production of new planes, already has, and it affects pricing in used planes.

And we have bought back planes from people leaving the programs, with which we do and will continue to do. But we have bought, during a declining market, some of those, and we have had write-downs in connection with those planes, and you will see in our first quarter report… I believe that that’s probably the only operation we have that’s losing money. And we have, it’s a popular product. It’s a growing business. It’s going to be a very big business in my opinion over the years, and we see it every day. I mean, we ride a lot of business, and customers are joining us.

There are three main competitors. I think it’s fair to say that they’re losing significant get money from operations, forgetting about any markdowns they might have on their own inventories. Our market share, we get figures from the FAA as to registrations and as to people that are selling their planes, and our share of market, which was always the largest, has gone up dramatically in the last couple of years. It’s gone up to roughly 75% in terms of value of planes, and we’re talking 75% of the four-company market. It’s gone up even higher than that in terms of net planes, in other words, new planes sold less planes coming back.

But the price, the pricing we are receiving does not… In the, in the US, it’s, it would be, absent this one write-down, it would be very, very modestly profitable. In Europe we are, we have lost and we are losing significant amounts of money. Business jets in Europe, the total is about one… And I’m talking about ours, I’m talking about all, about roughly 1/10th the number is in the United States, even though the population is similar. So we have grown from a small base quite rapidly over there. Nobody else will be taking us on.

It’s part of a service that will be part of a very big business worldwide, in my view, over the years. I don’t think anybody else can come in after us. So I think it’s integral, and it is integral to our operation. Half the, roughly half the miles flowing in Europe arise from American owners, and that will just do nothing but get bigger over the years, because our number of owner… Every month our number of owners goes up, goes up significantly. We have people here from Marquis, who have essentially, they become a customer of ours, and then they resell cards for 25 hours, and they have added 40 or 50 customers a month in recent months. So it’s a popular service. It will be a much bigger business.

I think there will be a shakeout at some point, and maybe fairly soon. You can look at the Raytheon prospectus and, or the Raytheon 10K, and you will find some interesting information about their operation, and you can, it’s not hard to figure out what’s going on. I don’t know the answer as to when the shakeout will occur, but I can assure you that we will not be one of the shook. (Laughter) Charlie, do you want to comment on it?

Charlie Munger [00:43:47] No.

Warren Buffett [00:43:47] He’ll comment on the profitable operations. He gives me the one… The long-term business model is, is that basically we believe that, you know, perhaps 10 times the number of people that are now flying us, with us, will be flying with us some years in the future. That having the best service, the best record and the best policies for safety and security will leave us very dominant in the field, and that people will pay an appropriate price for the service. And we see all kinds of evidence of that, but we do not see a profit this year, in my view, at NetJets. Let’s go to number 2.

[00:44:39] Shareholder (Marc Rabinov, Melbourne, Australia): Good morning. I’m Marc Rabinov from Melbourne, Australia. I had two related questions for you gentlemen, basically both related to float. Float, as you indicated, very large part of our asset base. Assuming our policy holders continue to renew with us and we keep control of our combined ratio, can we count the float as pseudo-equity when calculating the intrinsic value of Berkshire? And the related question was, can we not expect the float to keep growing at, say, 10% per annum for the next 5 to 10 years, given that we’re still really a minority player in this segment? Thank you.

Warren Buffett [00:45:23] Well, I wish it would grow at 10% or so, at least if it were profitable, which I do have a belief that’s likely to be. Our float is 42 and a half billion on March 31st, roughly. I think the entire float of the American property-casualty industry, you know, could be something in the, roughly in the area of $500 billion. So we may be some figure like, you know, 8% or a little bit more, maybe even 9%, somewhere in that range, of the total PC float to the United States. Now, it’s true we have a little outside the country too, but the big part of the world PC market is in, is in the United States.

When we started out in 1967, I think maybe we had $10 million a float. So to go from $10 million to $42 billion frankly surprises me. But it also, it’s going to be much harder to grow at significant percentage rates in the future. And our goal, we would, we love the idea of growing, but what we really want is cost-free float. I mean, that is the goal. And growth is not, is not a, not at the top of the list at all. I mean, I hold our managers responsible not for delivering more float. I hold them responsible for delivering profitable float, and that is key in our mind, it, all the time. If it comes along, we love it, but we will find out whether it comes along or not.

The first part of your question: if indeed the $42.2 billion can be obtained at no cost, or even better yet at a profit, its utility to us is like equity. Now, you couldn’t realize it upon liquidation, or necessarily… Oh, you wouldn’t realize it on liquidation, and you, and you couldn’t necessarily realize it on sale. That would depend. So I’m not telling you how to count it, is in terms, whether you count it in terms of IC value. You have to make that decision. But it has the utility to us of 42 and a half million, 42 and a half billion of funds derived from equity without issuing common shares. And that’s one of the reasons we’ve always been so enthused about it now for, what, 35 or 36 years. It’s a great business for us.

And every now and then we get off the track. You know, we got off the track in the early ’80s. We had a problem or two in the, in the mid-’70s, and we had a problem with Gen Re for a few years. So it, there’s nothing automatic about it. And I will say this: I think for most companies in the PC business, the PC business is not a great business. It’s a commodity business to a, to too big a degree. So I do not think most companies in the PC business will get float at an attractive cost. We have to be an exception, but we have some exceptional companies and some exceptional managers, and I truly believe that we will obtain our float at considerably less cost than the industry, and that, that is the goal.

GEICO, if it would continue to grow at 16%, for example, this year, that adds a billion of premium volume. Well, that doesn’t generate as much float at GEICO as it generates at Gen Re, but it generates float. So GEICO’s float will grow. I would, you know, I’d bet my life on that. But certain of our other transactions are more opportunistic in nature, and that float could even shrink. And if the float shrinks, you know, that is, that’s fine with me, as long as we produce underwriting profits. We’ll go wherever it goes. Charlie?

Charlie Munger [00:49:14] Yeah, with interest rates as low as they are now, this float we have so laboriously built up isn’t worth so much to us on a short-term basis. After all, what, if, if the… What do we have, $16 billion of cash on hand earning a very low rate of return? So the incremental dollar of float doesn’t look all that advantageous now. But we have a more long-term view than that. We figure that eventually we’ll do a hell a lot better than 2%.

Warren Buffett [00:49:49] We’re not getting 2% on that $16 billion, Charlie. We have, we do have, incidentally, on March 31st we have roughly $16 billion in cash, not counting any cash in the finance operation, cuz that’s a little bit phony in terms of its utility. I mean, it’s offset by borrowed money. But it, in, other than the finance operation, we have right at $16 billion in cash and cash equivalents, and we also have a lot of bonds and things of that sort. On that $16 billion, you know, we are probably getting about 7/10 of 1%, 3/4 of 1%, called after tax, on $16 billion, which does not make us salivate. But we would rather, you know, avoid salivation and than to en… encounter problems.

And we will use… Walmart put out the figure yesterday of roughly one and a half billion for a combination of a small trucking company plus what they sold us. And we will, you know, we will use money, but money keeps coming in too. If we earn a billion-seven in the first quarter, that billion-seven is pretty much all cash. And then on top of that we had the billion, billion-three or so float increase. So float increase plus retained earnings, not counting securities gains, maybe $3 billion. Now, we’re not going to keep that up, but there’s a lot of money coming in, and, but we are getting some chances to deploy it. And if we deploy, if we get it at less than, at zero or less cost, it has, it’s very close to, in our, in, it has the utility of equity in a, in a very big way. Let’s go to number 3.

[00:51:39] Shareholder (Hugh Stevenson, Atlanta): Good morning, gentlemen. My name is Hugh Stevenson. I’m a shareholder from Atlanta. You had indicated in the past that you did not think that the volatility-based or Black-Scholes models for options pricing was correct. Would you share with us how you would evaluate those options as you use them in the business or see them in the marketplace? And also, if you would update us on your thoughts on the asbestos tort situation, given recent development of national settlement trust, etc.

Warren Buffett [00:52:13] Yeah, we, Charlie and I have thought about options all our life. I mean, my guess is Charlie was thinking about that in grade school. And, you know, and I, I mean, you have to understand… You don’t have to understand Black-Scholes at all, but you have to understand the utility, and in a general sense the value of options, and you have to understand the cost of issuing options, which is very unpopular subject in certain quarters. Any option has value. I mean, I bought a house in 1958 for $31,500, and let’s assume the seller of that house had said to me, “I’d like an option on it, good in perpetuity, at $200,000.” Well, that wouldn’t have seemed like it cost me much if I’d given it to them, but an option has value. Any option has value.

And that’s why some people who are, you know, kind of slick in business matters sometimes get options for very little or for nothing. I’m not talking about stock options. I’m just talking about an option to purchase anything. They get options for far less than really a market value would be. Black-Scholes is an attempt to measure the market value of options, and it cranks in certain variables. But the most important variable that cranks in, that, that might be subject… Well, might be a case where, if you had different views, you can make some money. But it, they, it, it’s based upon the past volatility of the asset involved, and past volatilities are not the best judge of value.

I mean, if you looked at a five-year option at Berk, on Berkshire stock at various times, Berkshire stocks had a fairly low betas, they call it. Betas is a measure that people in ac… academia always like to give Greek names of things that are fairly simple, and so that they have sort of a priesthood. You know, so it’s, you know, it’s like priest talking in Latin or something. I mean, it kind of cows the, the lity… But they, beta is a measure of past volatility. Berkshire’s had a low volatility, but that didn’t mean that the option value of it to anybody that really understood the business was low than a stock with a higher beta.

And I think Charlie, what’s Charlie said is that last year, is that over that, for longer-term options in particular, Black-Scholes can give some silly results. I mean, it misprices things. But it’s a mechanical system, and any mechanical system in securities markets is going to misprice things from time to time. And that’s, we made one, as I mentioned last year, we made one large commitment that basically was, had somebody on the other side of it, but using Black-Scholes and using market prices, took the other side of, and we made $120 million last year. And we love the idea of other people using mechanistic formulas to price things, because they may be right 99 times out of 100, but we don’t have to play those 99 times. We just play the one time when we have a differing view. Charlie, you want to comment on…

Charlie Munger [00:55:53] Yeah, Black-Scholes is a, what I would call a know-nothing value system. If you don’t know anything at all about value compared with price, in other words, if price is teaching you all that can be known, then Black-Scholes on a very short-term basis is a pretty good guess, you know, for what a 90-day option may be worth in some stock or another. The minute you get into longer-term options, where you don’t have the know-nothing factor so extreme, it’s crazy to use Black-Scholes. People use it just because they want some kind of a mechanical system. But at Costco, for instance, within a fairly short period, we issued stock options at 30 and we also issued stock options at 60, and Black-Scholes valued the options we issued at 60 as a strike price way higher than the options we issued at 30. Well, this is insane.

Warren Buffett [00:57:00] But we like a certain amount of insanity.

Charlie Munger [00:57:04] Yeah, well, it’s good for Warren, who picked up this extra $120 million. But so he, he’s fonder of this kind of insanity than I am.

Warren Buffett [00:57:15] No, we will pay you real money if you will deliver to our offices at Kiewit Plaza somebody who wants to use the Black-Scholes model and is willing to price 100 options for three years, willing to, using the Black-Scholes model, and letting us pick and choose among those. Because as Charlie says, it’s a know-nothing affair, and we are know-nothing guys in respect to an awful lot of things, but every now and then we find something where we think we know something. And anybody that’s using a mechanistic formula is going to get in trouble in that situation.

But options have value. I mean, we issued options in a sense last year when we, when we sold those, the $400 million of bonds, and we know what we’re giving up when we sell those bonds. I mean, we may have gotten, what, a negative coupon of sorts, but that’s because we gave up option value. And then it wasn’t, it isn’t truly a negative cost instrument at all, because options have value. Let’s go to number 4.

[00:58:26] Shareholder (Martin Wiegand, Bethesda, Maryland): Hello, my name is Martin Wiegand from Bethesda, Maryland, and first I’d like to thank you and all the folks working here at the microphones and staffing the booths for hosting this wonderful shareholders weekend. We enjoy your efforts. Thanks.

Warren Buffett [00:58:44] Martin.

[00:58:44] Shareholder (Martin Wiegand, Bethesda, Maryland): My question is about a company getting its employee compensation aligned with shareholder interest. Charlie Munger, in one of his outstanding Investor Digest interviews, cites the case of FedEx getting it right. In the newspapers we’ve all just read about American Airlines, Bethlehem Steel and a lot of other companies getting it wrong. I find precious little written about compensation systems. Would you share with us how you get it right at Berkshire companies? Also, your old golf coach and racetrack friend, Bob Dwyer, asked me if you would like to share with us you’re picking the Kentucky Derby.

Warren Buffett [00:59:21] Is Bob, is Bob back there with you, Martin? No? In the… Oh, Bob. Yeah, Bob. Bob and I did spend a lot of time at the racetrack in high school. He was, he was not only the basketball coach at Woodrow Wilson High, but he was also the golf coach, and whenever I wanted to go to the races, he would, he would write an excuse to my other teachers saying that we had to go out for the golf team. And then we would head off to Charles Town or Havre de Grace or Pimlico or someplace. And he cleaned, cleaned up his act subsequently. It’s good to have Bob with us. He was known for his famous three-iron shots. He was known as Trolley Wire Dwyer in, in those days. Charlie, do you want to talk about comp a little?

Charlie Munger [01:00:12] Well, as the shareholders know, our system is different from that of most big corporations. We think it’s less capricious. The stock option system will give extraordinarily liberal awards, sort of by accident, to some people, and it will deny other people any reward at all at some different time, in spite of great contributions made by the people who are getting nothing. So except where we inherit it, we just don’t use it. But we must be in a minority, far less than 1%.

Warren Buffett [01:00:52] Right. It’s where we like to be.

Charlie Munger [01:00:55] Right.

Warren Buffett [01:00:55] Oh, it’s interesting. We inherited some stock options at Berkshire, primarily in the General Re transaction, and not through any failing of anybody, or, or that there’s no dispersions to be cashed, but at all. But those options turned out to be quite valuable. They would not have been valuable if General Re had been left alone as a standalone company. They were, they profited from the fact that other parts of Berkshire did well, and the money went to the people that had these options, who delivered nothing to the performance of Berkshire for a while.

Now, that’s, that is not an indictment of anybody in the least to Gen Re. It’s an indictment of a, an option system which represents a lottery ticket and also a royalty on the passage of time. Because as you know, an option holder has benefits from retained earnings and benefits not at all from dividends, and that puts his interest, well, maybe quite contrary to that of the shareholders. So we believe in paying for performance, but we believe in tiring performance to what is actually under the reasonable control of the person that’s being measured. And we, to give a lottery ticket on the overall results of Berkshire Hathaway to someone who is running a business that’s 1% of the whole is really crazy.

And I would say that you have seen probably more misdirected compensation throughout the corporate system, corporate America, in the last 5 years, you know, then in the 100 years before that. It’s been extraordinary. And there was, there was wealth creation in the ’90s, just like in the ’80s and the ’70s and the ’60s and the ’50s, but there was a wealth transfer like never been experienced before. And, you know, you can’t blame people for wanting to cash in on it. You know, if anybody wants to walk up and hand me a half a dozen lottery tickets for the Nebraska Lottery, you know, I’ll accept them, but it will have nothing to do with how I do in terms of running Berkshire.

Actually, Charlie and I think a properly designed option system, which includes cost of capital and some other factors and ties it to the performance of the people involved, we think that can make sense when we’ve used various incentive programs that are similar to that. But the idea of just passing them out and telling people that for 10 years they get a free ride, and then repricing… You know, if your stock goes down, their stock doesn’t go down, their option price goes down. You know, that is not our idea of a great compensation system.

Charlie Munger [01:03:56] Yeah, if we’re, if we are right with our general approach, it has considerably important implications, because the natural implication is that more than 99% of corporate compensation systems are more than a little crazy in America. And I want to emphasize that Berkshire is not illiberal. I mean, we’ve got various incentive systems out where people make tens of millions and may make hundreds of millions. So we’re not against rewards for people who make vast contributions. But a system that’s basically capricious and which doesn’t tailor the results per person and proactivity very well, we just think it’s crazy.

Warren Buffett [01:04:45] We love to see people that associate with Berk making money, as long as they’re making money for you at the same time. It’s very simple, and, but we don’t want them to get a free ride off your money. Compensation is an interesting subject, and I’m going to write about it next year some. But, you know, it, it’s not a market system. You can read all you want. I mean, you know, the PR people will tell you, you know, the ex… Joe Smith’s conversation was determined by a market system, and he’s just like a baseball player or anything of the sort. But he’s not just like a baseball player. You know, the B player negotiates with somebody who’s spending his money to hire the baseball player and making a calculation whether he’s better off laying out the money out of his own pocket, the owner of the team, to get that player. But when you get a comp committee at a large American corporation, you have somebody with an enormous interest in the amount of comp on one side of the table, and you’ve got somebody on the other side of the table who was not picked because they were the Doberman of the board, but believe me, and who is dealing with what many times is what my friend Tom Murphy would used to call play money. I mean, it, you know, it’s almost meaningless to the person on one side of the table whether somebody gets 100,000 shares of restricted stock or a million shares of restricted stock, and it’s not meaningless to the guy on the other side of the table.

Almost every other negotiation in American business, you have some parody of concern, but you do not have a parody of concern, you know, in terms of the, in terms of comp at the top levels. You have a parody of concern when you get down to labor unions. I mean, the management wants to keep down the prices and the union wants to get more money, and you know, and that’s a real negotiation. And you have, you know, may, you have lots of other real negotiations in American business, but the compensation in many companies, not all obviously, but in many, many companies has not been a real negotiation at all.

And the management has hired comp consultants to come in, and I have never seen a comp consultant come in and say, “We ought to reduce this guy’s salary.” I’ve also never seen a comp consultant come in and say, “Why don’t you get rid of this bozo?” You know, I mean, they can’t all be wonderful, but, you know, can you imagine a comp consultant doing that? Never getting another assignment, and you know, wouldn’t happen. So it’s a bad system and it needs improvement, and it may be getting a little improvement.

And as I wrote in the annual report this year, what happens with comp is the acid test of corporate reform, ‘cuz frankly the CEOs of America, they don’t care whether their boards are diverse or not diverse or anything of the sort. They care about how much money they make, in a great many cases. And you the owners, and big owners in particular, you know, have to provide some countervailing force, or you’ll have what you’ve had in the last 20 years, which is an enormous disparity in the rates of compensation of people at the top compared to people at the bottom, and also a disconnect between the comp of people running businesses and the results of the owners who gave the money. So arise you a shareholder. Let’s go to number five.

[01:08:05] Shareholder (Matt Sauer, Durham, North Carolina): Good morning. Good morning, my name is Matt Sauer and I’m from Durham, North Carolina. In a 1977 Fortune magazine article titled “Inflation Swindles the Equity Investor,” you argued that corporate earnings in aggregate acted like a bond coupon and thus were negatively impacted by high inflation. Due to high inflation at the time, you posited a world where a 12% return on corporate equity would, was reduced to 7% after taxes and netted out to 0% in real terms.

You have been, you have been sounding downcast about the prospects for equities for several years, much of which we assume relates to extreme starting valuations. If inflation was deciding bad for investors in 1977, isn’t the relative lack of it in today’s economy at least one mark in the plus column for equity owners? Is there also a future inflation expectation component in your warnings that investors are likely to be disappointed by equity results?

Warren Buffett [01:09:21] Well, I would, there’s no question that the lack of inflation is a plus for owners. I mean, the real return you will obtain, in my view, from owning American business, if purchased at similar prices, the real return will be higher if we have peri… long periods of low or close to no inflation than if we had long periods of high inflation. I don’t think there’s any question about that, because that article went on to explain how you got taxed on nominal returns and fictitious returns in real terms. So your, your question is about which period is better for investors: a low inflation period over any long period is better for investors.

And the problem, as you pointed out also, was the starting point in terms of predicting modest returns for equity investors. The returns weren’t necessarily so modest. I particular, they were just modest compared to what people had begun to think returns would be. During that long bull market from 1982 to 1999, there were polls taken by Gallup, working with I think PaineWebber at the time, now they moved it over to UBS Warburg, that showed the expectancy of people in the stock market, and those returns that people expected got up to 14% or 15%, as I remember. And they were thinking they were going get 14% or 15% in a low inflation environment. Well, that, you know, that was dreaming.

And there’s nothing wrong in a low inflation environment at all in earning, you know, 6% or 7%. That’s probably as, as well, well, it is as good as going will happen, because in a low inflation environment, how much is GDP going to grow? Well, GDP, you know, if you have a 2% inflation and even 3% real growth, you’re talking about 5% in nominal terms, GDP growing. If GDP grows at that rate over time, corporate profits will grow more or less at that rate. And if corporate profits grow at 5% a year, the value of those corporate profits, the capitalized value, will probably grow at something like that over any long term with a sort of a normal starting point. And add that to dividends and you, you know, you will get 6% or 7% before frictional costs.

Investors incur a lot of frictional costs. They don’t have to, but they do, and that often is 1.5%, 2% of their investments. So the math isn’t bad. It’s just, it’s just bad for those people that got used to or expected very high returns based on looking in the rearview mirror back in 1998 or 1999. Charlie?

Charlie Munger [01:12:18] My general attitude is just slightly more negative than Warren’s.

Warren Buffett [01:12:22] You’ve heard it, folks. That isn’t the end of the world. I mean, in effect, if the people who own American business get 5% to 6% of the pie, $11 trillion economy now, someday a $20 trillion account, but if we get, if we get 5% or 6% of the pie, those of us who put our capital out to produce goods and services for American business, for American consumers, American population, is that a, you know, I don’t know whether that’s, you know, is exactly what somebody who designed the universe would come up with, but it doesn’t strike me as crazy in either direction.

You know, I think that’s a lot of goods and services to go to people that put up the capital. But you, and you’ve got it, you know, 100 million plus people in the working force that are working to turn that out for you using your capital, and it provides a, what I would regard as a pretty decent real return if you have low inflation. If you get into high inflation, as I wrote about back in ’77, you could easily have the real return to investors get to a very, very low number and perhaps negative.

I mean, inflation can swindle the equity investor, as I wrote back then, and I used 7,000 words to explain why. I will be glad to send you a copy of that article if anyone’s still interested. But inflation is the one thing that, over a long period of time, turn investors’ results in aggregate into a negative figure, and it’s the investor’s enemy. Charlie, does that bring forth any further thoughts?

Charlie Munger [01:14:06] I don’t think you’ll get perfect help on these subjects from the economics profession either. They have certain standard formulas. To an economist, when a manufacturing job goes to China, that’s just so much productivity increased. And if you ask one, “Well, suppose all of the manufacturing jobs in America went to China, wouldn’t that be a little too much efficiency increase?” and the answer would be no. And people get, actually get paid for thinking like this in major universities.

Warren Buffett [01:14:48] Yeah, if what would get across the point, of course, is if all the teaching of economics got exported to China, and which that point a new insight would appear. Number six.

[01:15:04] Shareholder (Jack Hurst, Philadelphia): Jack Hurst, Philadelphia. I have a question about the managers and a comment and a question about the insurance operation. These meetings are a lot more fun with more subsidiaries and more managers. I also think more educational, because you get to interact with them. Is there any feed, do you get any feedback from the managers that they enjoy coming here and they get anything out of the meeting?

Warren Buffett [01:15:32] Well, we have a number of our managers here, and I, I do, well, we don’t, but we don’t, we don’t require anybody to come. I mean, we have, we have managers that very, very seldom have come to a meeting, I, and I don’t keep names, I can’t even tell you which ones they are. But some, you know, if they enjoy it, they come. Many of them, of course, have operations down below selling you things, and some of them come to help out in that respect.

But we’ve got a, you know, we have a sensational group of managers. They run their own businesses. They’re extraordinary at doing what they doing. We don’t get in their way. We don’t, we don’t demand that, virtually, that they do anything except work for the owners. But you will, I hope you meet some of them here today, because they, you know, the ones that are here obviously enjoy interacting with the shareholders, and it’s fun to, it’s fun to put faces to functions. I mean, it, I enjoy it. I think they, a lot of them enjoy coming here.

And I, and the people that work down, are working downstairs, you know, they volunteer to come, and they enjoy seeing the shareholders and they enjoy bragging about their companies, and they’ve got a lot to brag about. And I hope, I hope you thank them when you see them, because, you know, it’s a lot of effort for them. When I, I got here at 6:00 this morning, but there were people that were here a lot earlier than that. They were working yesterday to get ready for this, and I want to thank them myself. Charlie?

Charlie Munger [01:17:18] I don’t think our managers who come to this meeting are picking up new tricks. Most of our managers know all the tricks that are related to their businesses. But I, this is a very interesting place, and it gets more interesting every year, and part of what makes it interesting is not discreditable, and I think people like being part of it.

Warren Buffett [01:17:48] Now, our managers, in a few respects, will occasionally work together. Sometimes a manager, subsidiary A, will check with some of the others, not through Omaha, directly themselves, and they will say, you know, “What are you paying for software?” or “What are you paying for, for UPS?” or whatever it is, “and can we make a better deal if we pool our efforts?” Or there are times when we have saved money, sometimes pretty real money. But that has never been instituted by Omaha. It’s never been overseen by Omaha. It’s because manager A decides to call manager B, and they, you know, they like each other, and they can, they can make their own operation better, sometimes by combining purchasing power, and occasionally by just having an idea here or there. But it’s, there’s no organized way of going at that in Berkshire, and nobody has to play. Number seven.

[01:18:46] Shareholder (John Bailey, Boston): I’m, I’m John Bailey from Boston. I’d like to ask about our consumer businesses, and which means that I have to ask about the consumer in general. The situation as I understand it is that over the last 30 years or so, the median consumer has seen his income rise only a little faster than inflation and much slower than GDP. Overall income inequality is at a 400-year high. The present value of lifetime income for the median person has improved slowly, yet the size of his lifetime liabilities, such as health care, housing, education and retirement, has ballooned.

The economic net worth, then, of the consumer may be poorer than they think. To cope, the median guy has put his wife to work, borrowed against the house and also the credit cards. So I think this may have some implications for the sustainability of consumer businesses, and seeing that we’ve been buying a number of them recently, how do we think about this problem, and are there any nonobvious risks that we should be considering?

Warren Buffett [01:20:09] The American consumer overall is, is better, but not dramatically, as better off than 10 years ago, even somewhat better off than 20 years ago. But you’re quite right in that there’s been considerable inequality in terms of the progress of people financially during that period. We don’t have broad ideas about, I mean, we don’t make decisions on what business we buy based on some sweeping future projections about things. We think, we think America will do pretty well over time. In fact, we’re quite sure it’ll do pretty well over time, and that our kids will live better than we live. My kids would say that wouldn’t be so difficult. But the, and the grandchildren will live better.

You know, that has been the history of the American economy. The real income per capita grew sevenfold, I believe, in the 20th century. That is huge. You know, it cost $18, as I remember, to make a three-minute station-to-station call from New York to San Francisco 40 years after the telephone was invented, and at the time the $18 was more than the average weekly wage in the United States. You know, think if some little kid had picked up the phone on the other end, and there went the whole weekly wage while you tried to get, you know, your daughter on the phone or whatever. So it, people will be better off in this country decade after decade, but we don’t, we’re not big on, on being futurologists or anything at Berkshire.

I will tell you this, in terms of our consumer businesses: right now they’re very soft. Our, our furniture and jewelry businesses generally, candy business, businesses dealing with consumer day by day, are soft, and the first quarter of their earnings were down. One of the things you have to think about, and people don’t, they don’t focus on this very much, but you read about GDP, and this is one reason I think, I really think we’ve been in a recession now, not a huge one, but, or not a violent one, but for over two years.

When the government talks about GDP, they talk about GDP, we’ll say, going up 2%, but of course the population of the country, you know, goes up something over 1% per year. So it’s per capita GDP that counts, and that has gone very close to no place. But the more important factor, to some extent, is that GDP counts, to people that, you know, have you take off your shoes when you go to the, to get on an airplane, it, you know, it counts extra police, it counts all of these things that don’t really translate into any re… they translate into goods and services that the country wants, but they, but they’re not goods and services, I mean, they’re goods and services we wish we didn’t want.

And they, all of that counts the same way. If there’s a 20 guards at the airport instead of three guards, that goes into GDP, but does it make you feel any better about how you’re spending your paycheck every month? Probably not at. And when you get into a war, for example, if you drop planes into the ocean, you know, that’s part of GDP, the cost of manufacturing those planes, but it doesn’t do anything for you at your house.

So in terms of what I would call desirable GDP, I think my, my guess is that out of per capita basis that has gone no place in the last few years, as we’ve diverted resources to other things that don’t really translate to what goes into your house or onto your table. And the quality of GDP is something that is not really talked about very much when you pick up the economic reports every day. Charlie?

Charlie Munger [01:24:12] Yeah, and the type of figures you gave us about inequality tend to obscure a basic and important fact. If the same families were permanently at the top of the economic heap, there’d be huge resentments about current inequality. But when the coupon clippers and the du Pont family go down and somebody creates something like Pampered Chef and comes up, in a real sense something wonderful is happening in terms of equality, even though at the end it looks like there’s been no progress. That much churn makes people think the whole system is fair.

Warren Buffett [01:25:05] We prefer not to be part of the churn, though, actually, at this point. I mean, we were much more in favor of churn 30 or 40 years ago. Number eight, please.

[01:25:15] Shareholder (Johann Freudenberg, Germany): My, my name is Johann Freudenberg. I come from Germany. I would like to know the accounting book you like best. Thank you.

Warren Buffett [01:25:23] Well, it’s been a long time since I’ve read an accounting book. I, I read Finney back when I was in, in college, I remember that, and I, and I always liked accounting. And for any of you interested in business, you know, you basically can’t get enough accounting. But I don’t, you know, I not really up to date on accounting books. Maybe Charlie’s been reading some of those lately. I would hope, actually, that if you read the Berkshire reports over time, that you get certain, perhaps, lessons on accounting.

But I think you learn more accounting probably in terms of, well, I mean, want, you know, the basics of it, by reading good business articles that deal with accounting issues, accounting scandals, that sort of thing. I mean, that’s what you really need to know, is you need to know how the figures are put together, the underlying principles of it, and then you have to know what can be done with those. And you start with the accounting figures as the raw material of understanding a business, but you have to bring something additional to that. And I can’t think of any good books on that subject.

I think I’ve read a lot of good magazine articles that contributed to my knowledge over the years, and I’ve just, I’ve just, you know, I’ve read a lot of annual reports and seeing what people can do with accounting. And as I’ve said before, if I don’t understand it, I figure it’s probably because the management doesn’t want me to understand it, and if the management doesn’t want me to understand it, there’s probably something wrong going on. I mean, people don’t, don’t obfuscate with numbers usually without a purpose, and when you run into that, the best thing to do is just stay away. Charlie?

Charlie Munger [01:27:25] Yeah, asking Warren, you know, what good books he knows about accounting would be, it’s like asking him what good books does he have about breathing. The, and what the implication of that is, is that you start by learning the basic rules of bookkeeping, which are sort of like the basic rules of addition and subtraction, and then you have to spend a lot of time before that accounting gets related to the larger reality, and that’s a lifelong process.

Warren Buffett [01:28:05] Okay, we’re going to try and go to the Music Hall. Number nine.

[01:28:10] Shareholder (New York City): Is this working? Okay, good. …York City, and question as follows. Insurance companies: could you comment on insurance companies taking on credit risk through the sale of credit derivatives, the adequacy of the account, accounting for these derivatives? And finally, could you explain why the financial guarantee insurers, who are the primary sellers of these derivatives, have the same AAA rating Berkshire has, despite their more than 140-to-1 leverage and the correlated nature of the risk that they take on?

Warren Buffett [01:28:42] Well, I would, I think you should go to work for Standard & Poor’s or Moody’s. The question about credit insurance, or, or credit guarantees of one sort or another, and that’s become very popular, and it’s become actually popular with sort of the standard insurance, property casualty insurance companies in recent years. And I would say that in many cases the people participating in that business don’t really know what they’re doing.

It’s so easy in insurance business, it’s the curse of the insurance business, it’s also one of the benefits of it, is that people hand you a lot of money for writing out a little piece of paper. And what you put on that piece of paper is enormously important, but the money that’s coming in, that seems so easy, can tempt you into doing very, very foolish things.

We had a situation here in Omaha 15 or 20 years ago, in the mid-’80s, where Mutual of Omaha, largest health and accident association in the world, at least at one point, and they decided to go into the reinsurance, property casualty reinsurance business, and in a very, very, very short time they wrote not very many contracts, and it resulted in wiping out half of the net worth of everything that been built up over many, many decades.

If you are willing to do dumb things in insurance, the world will find you. I mean, you do not, you can be in a rowboat in the middle of the Atlantic and just whisper out, “I’m willing to write this,” and then name a dumb price, and you will have brokers swimming to you, you know, with their fins showing, incidentally. They, it’s, it is brutal. I mean, if you were willing to do dumb things, there are people out there, and it’s understandable, but they will find you. And you will get the cash up front, you will see a lot of cash, and you won’t see any losses, and you’ll keep doing it, because you won’t see any loss for a little while. So you’ll keep taking on more and more of this, you know, and then the roof will fall in.

And I mentioned in the annual report how GEICO had taken in, you know, 70-odd thousand, $70,000 of premiums in the early ’80s for a few policies, and they thought they were just picking cherries at the time, and they reinsured a lot of it. And so far we’ve lost $93 million. Now, the most we could make was 70-odd thousand, and I don’t know what the most we can lose is, but I know that $93 million has gotten my attention.

When you’re playing in a game like that, you can’t afford to make a mistake. I mean, it’s a, the m…, a single mistake, or a few mistakes that are correlated, as you’ve mentioned, because these things do correlate, a few mistakes will overcome a lifetime of savings. I mean, it is, you will make a few cents on the dollar when you’re right, and you will lose incredible sums when you’re wrong.

And in credit insurance, when you go around guarant…, a lot of people went around guaranteeing credits based on ratings, and they said, “Well, we’ll guarantee a whole bunch of single-A ratings,” or “We’ll create these structured arrangements that involve A-rated credits,” and they would use a lot of studies that would show that x% of A-rated credits defaulted per year, and you go back to the ’30s and all these back-tested arrangements. But the problem with that is that, what the questioner mentioned, is correlation. And when things go bad, all kinds of things correlate that no one ever dreamed correlated.

And what you had, of course, in the debt field, was you had a whole bunch of, say, telecoms or energy companies that were all rated similarly, but they were correlated in a huge way, and you weren’t getting a diversification, you were getting a concentration that would, you didn’t realize. And there’s nothing more deadly than unrecognized concentrations of risk, but it happens all the time.

So I would say we see a Baa credit enhanced to a AAA credit by somebody guaranteeing it, and they may guarantee it for 10 or 15 basis points, and yet the spread in market yield might be 100 basis points. That does not strike us as smart. And I would say this about the AAA rating: those, they have a AAA rating for claims paying, but they don’t carry, I don’t think, general AAA. There’s only, I think, eight or nine AAAs left in the United States, Berkshire Hathaway’s one of them, but I believe there’s only one other insurance company, which is AIG, and then there’s a half a dozen other companies.

So those companies are not in the same class credit-wise as Berkshire, nor are they recognized as being in the same class. But I would say you could get into a lot of trouble at 140-to-1 at some point, insuring credits. Charlie?

Charlie Munger [01:34:02] Yeah, he also asked about the quality of accounting, and in my view at least, the quality of accounting in America for derivative transactions is still terrible. And it’s terrible in that it’s too optimistic, and one of the places where it’s most terrible is when you talk about guaranteeing future credits way, way out, years ahead. That sort of thing just lends itself to people getting very optimistic in their assumptions and in their audited figures, and people pay attention to the audited figures, not the underlying reality. So therefore, if the accounting is lousy, the business decisions are lousy, and I think that’s going on mightily as we sit here.

Warren Buffett [01:34:54] Yeah, there are dozens of insurance organizations or trading organizations in the country that have written credit guarantee contracts in derivative form in the last few years, in fact on a huge scale. I will guarantee you, virtually, that every single one of those contracts that was written, in the first week, whoever wrote it, you know, recognized some sort of an income account, or an income entry, and that somebody got paid a little bit of money for writing each one of them. And you know that many of those are going to go bad, and maybe as a category that it’s going to be a terrible category, but nobody ever wrote a contract and recorded a loss at the time they wrote it. I mean, they just don’t do it.

And I will tell you that there are a lot of those contracts that, if somebody wrote them for me, 10 seconds later I would have paid somebody to take them off my hands, so that I would have regarded them as having a built-in loss. Nobody ever records a built-in loss on a derivative contractor. In fact, I find it extraordinary that you have two derivative dealers, and dealer A and dealer B write a ticket, and dealer A records a profit and dealer B records a profit, you know, particularly if it’s a 20-year contract. You know, I mean, that is the kind of world I’d love to live in, but I haven’t found it yet. Number 10.

[01:36:17] Shareholder (Jerry McLaughlin, San Mateo): And good morning, Charlie, Warren. Jerry McLaughlin from San Mateo, checking in from the Music Hall. You should see yourselves over here. We’re about 12-foot wall-size images of both of you, which is interesting, but the See’s candy box is so big, I understand what Tantalus went through now.

Warren Buffett [01:36:35] How many, how many people do you have in the Music Hall?

[01:36:39] Shareholder (Jerry McLaughlin, San Mateo): We probably want to get a cop to estimate, but I’d say it’s a couple of thousand. Anyway, moving right along. Hoping I can get a twofer here. One is, at Branders, small company we run, we’re seeing, we’re spending a lot more on employee benefits anymore. Health insurance in particular is going up and up again, and lots of times in the press years ago, and now getting a little bit, you’re hearing the drumbeat of a health care crisis and what it cost employers to provide health insurance. I got to figure that’s on the minds of a lot of Berkshire operating company managers.

I’m wondering whether both of you feel, I mean, is crisis the right word with respect to cost? Looks like bigger percentages of our GDP are going to health care. Is that because we think we’re getting better health care, or is it really just sort of inflationary?

Second thing is, at the risk of you thinking we’re all a bunch of kooks over here, a couple of people over in this side of the hall have asked me to ask you, Warren, whether you’re seriously considering being cryogenically frozen at some point, I think hopefully in the distant, distant future. Cryogenically frozen. Oh, you know, we had that last year. Yeah, and the guy who asked the question last year put me up to a follow-up form. Hey.

And finally, unrelated to those two, do I, do I look like I’m closer to where I need it? And last thing is, when you guys look at, when you guys look at companies, you’re thinking about earnings into the future. Just, do you have any rule of thumb how far in the future do you think you can look, typically, with a company you believe in, you think you understand the business? Is it 5 years, 10 years? Do you really think you’ve got, you know, sort of the perpetual, into infinity income stream to calculate the value on? Thanks.

Warren Buffett [01:38:13] Yeah, well, we don’t, we don’t project as far out as we might have to if we thought we could be successfully frozen. But we, we really, we’re going to own these businesses forever, so we want a, we want a business that we think is going to have, if run well, some kind of competitive advantage over many decades. I mean, we’re not going to resell them, and we better have something that is not only good now, but it’s going to stay good. So we don’t buy hula hoop companies or pet rock companies, and we don’t buy companies in industries that we think will have great explosions in demand, but with the, where we don’t know who the winners will be. So we look a long, we try, we like to think we’re looking a long way into the future.

On health care costs, the only companywide managers meeting we had, far fewer managers then, but we had a meeting of most of the then smaller number of managers 15 or 20 years ago, where we did talk about what the various companies were doing on health cost, because they were then the fastest increasing part of our cost structure. And today, workers’ compensation costs would probably be, and some other insurance costs unrelated to health would be also, would, at least in the last couple of years, have moved up even more dramatically than health costs.

But health costs are huge for us, in many cases, you know, running $6,000 or $7,000 per employee, but moving up at a fast rate. And, you know, that is an inflationary part of the U.S. economy that we can’t solve, and our employees can’t solve, and it becomes a big part of the kind of, in, it’s a raw material cost. We had, we had higher energy costs in the first quarter, but health costs are the ones that are going to just keep coming and coming, in my view, and I don’t have any great answers for it. Charlie runs a hospital and knows more, a lot more about the health system than I do, so we’ll see what he has to say.

Charlie Munger [01:40:27] Well, I would argue that the quality of the medical care delivered, including that from the pharmaceutical industry, has gone up enormously, and of course the cost has too. But it’s a much richer country, and I don’t think it’s crazy if the United States wants to spend 15% of GDP on health care, and if it went to 16% or 17%, I wouldn’t consider it the end of the world. Eventually, of course, there would be a place where it wouldn’t be smart to spend so much.

Warren Buffett [01:40:59] Do you think, if we’re spending 13% or 14%, and other countries there that seem to have fairly good systems are spending 7% or 8%, that we’re getting our money’s worth relative them?

Charlie Munger [01:41:11] Well, certainly they’re getting more value per dollar out of their 7% than we’re getting out of our 15%. So, but does that mean that it’s crazy for us to spend 15%? I don’t know. I would guess not.

Warren Buffett [01:41:26] But I don’t see any sign, any, from anything I see, that it isn’t continuing to go up. It’s a, I don’t know how much we, we never aggregate figures around Berkshire from various companies, because it wouldn’t mean anything, but we spend a lot of money on, on health care. It, and certain states, it’s far higher than others. It makes a lot of difference where you’re located. Number one.

[01:41:58] Shareholder (Justin Fung, California): Hello, Mr. Buffett and Mr. Munger. My name is Justin Fung. I am 13 years old, from California. This is my third consecutive year in attendance. First of all, I would like to wish you the best of health, so we continue, continue to Omaha for many years to come. Thank you. (Applause) Thank you for answering my question on friendship last year. My question this year is: how do you define success and happiness? Are they related, and how would one achieve that? Thank you.

Warren Buffett [01:42:38] Well, I tell, I tell college students that when you get to be my age, you will be successful if the people that, that you would hope to have love you do love you. I mean, you, if, Charlie and I know a few people that have got a lot of money, and they get testimonial dinners and they get their names on buildings, and the truth is nobody loves them. And, you know, not their family, not the people who named the buildings after him. You know, it’s sad, and it’s unfortunately, it’s, you know, it’s something you can’t buy. I mean, Charlie and I have talked a lot of times, if we could just buy a million dollars’ worth of love, you, you know, I mean, it would be so much more satisfactory than to try and be lovable, but it doesn’t work that way. You know, the only way to be loved is to be lovable. It’s, it’s, it’s you. I hate to tell you that at 13, but, and, but the nice thing about it, of course, is that, you know, you always get back more than you give. I mean, that, I don’t know whether it was Oscar Hammerstein or who said, you know, “A bell’s not a bell to you ring it, a song’s not a song till you sing it, love isn’t in the heart isn’t put there to stay, love isn’t love till you give it away.” And basically you’ll always get back more than you give away, and if you don’t give any, you don’t get any. It’s very simple.

I don’t know anybody my age that is loved by a lot of people, we had a dinner the other night, Don Keough was there, everybody loves Don Keough, you know, and for good reason, and there’s nobody I know that has, that commands the love of people around them, people they work with, their family, their neighbors, that is other than a success or feels other than a success. I don’t know how the people feel that, that where they know that nobody loves them, but I can’t believe they feel very good. So it’s very simple. You can’t get rid of love. If you try to give it out, you get it back more than you’ve given, and it’s, it’s the best thing. Charlie, what do you speak for?

Charlie Munger [01:44:53] Well, you don’t want to be like the motion picture executive in California, and they said the funeral was so large ‘cuz everybody wanted to make sure he was dead. And there’s a similar story about the minister saying at the funeral, “Won’t anybody stand up and say a good word for the deceased?” And there was this long silence, and finally one guy stood up and he said, “Well,” he said, “his brother was worse.” (Applause)

Warren Buffett [01:45:23] Look, I would say this, at 13, look around, you know, people older than you are, look around at your, you know, your older relatives or whatever, and you will not see an unhappy person who is loved by those around them. I mean, it’s, it, and it’s, I, most people in the, in this room are going to do very well financially. Most of the college students I talk to are going to do well financially, and some of them are going to have very few friends, real friends, as they get older, and others, people won’t be able to do enough for. And I see it around me all the time. So that’s our advice for the day on that. Number two. (Applause)

[01:46:16] Shareholder (Kevin Truitt, Chicago, Illinois): Hello, my name is Kevin Truitt. I’m a shareholder from Chicago, Illinois. Mr. Buffett, Mr. Munger, thank you for putting on this marvelous event for your shareholders and partners. I thoroughly enjoy and love coming here. I get so much education from this, and that, the people here are just wonderful. I have three hopefully short questions. The first two questions are for you and Mr. Munger, and the third question is for you.

My first question is: M…, Mr. Munger, you are largely credited with moving Warren away from the cigar butt approach to investing as it was practiced by Ben Graham. It’s been stated that it was the purchase of See’s Candy that taught you this important lesson of buying good businesses. At what point did you realize that this concept of buying good businesses was a better long-term investment strategy, and what was it in your discussions with Warren that allowed you to persuade him to move in that direction? Mr., Mr. Buffett, what was it in Mr. Munger’s arguments for buying good businesses that persuaded you to abandon the cigar butt approach and move in his direction?

My second question is: in both your experience, have you or Mr. Munger ever known of a company that has regained or replaced its competitive advantage once it was lost? My third question for you, Mr. Buffett, is: early in his career, Richard Rainwater sought you out and asked you what it took to become a successful investor. Can you tell us what he asked you and what you told him? Thank you.

Warren Buffett [01:48:00] Yeah, the last question, I don’t, I don’t remember at all. I mean, Rainwater called me a couple of times, but I don’t, I don’t, I don’t really remember the convers…, there a lot of years ago, and then I probably said the same, I would have said the same thing to him as if I got a question asked in this meeting. So I, I really had no contact with Richard Rainwater over the years. I like I say, I think I’m, I met him once, I believe, and he called a couple of times. So, Charlie, do you want to answer the first question about how you…

Charlie Munger [01:48:37] Yeah, well, I think there’s some mythology in this idea that I’ve been this great enlightener of Warren Buffett. Warren hasn’t needed much enlightenment, but we both kept learning all the time, so that the man we were 5 years earlier was less sensible than the man who ultimately was there. And See’s Candy did teach us both a wonderful lesson, and it’ll teach you a lesson if I tell you the full story. If See’s Candy had asked $100,000 more, Warren and I would have walked. That’s how dumb we were at that time. 10,000 more.

And one of the reasons we didn’t walk is, while we were making this wonderful decision, we weren’t going to pay a dime more, Ira Marshall said to us, “You guys are crazy. There’s some things you should pay up for: quality business, quality and so forth. You’re underestimating quality.” Well, Warren and I, instead of behaving the way they do in a lot of places, we listened to the criticism, we changed our mind, and that is a very good lesson for, for anyone. The ability to take criticism constructively is a, well, think of all the money we made for, from accepting that one criticism. And if you count the indirect effects from what we learned from buying See’s, you can say that Berkshire’s been built partly by learning from criticism. Now, we don’t want any more today.

Warren Buffett [01:50:29] Yeah, we also like the peanut brittle. So the, Charlie is playing that. I, I had learned investment, and got enormous benefit out of that learning, from a fellow who concentrated on the quantitative aspects, Ben Graham, and who, who didn’t dismiss the qualitative aspects, but he said you could make enough money focusing on quantitative aspects, which were more sure way of going at things and would enable you to identify the cigar butts. He would say that, that, you know, the qualitative is harder to teach, it’s harder to write about, it may require more insight than the quantitative, and besides, the quantitative works fine, so why try harder?

And on a small scale, you know, there, there was a very good point to that. But Charlie really did, wasn’t just Ira Marshall, but Charlie emphasized the qualitative much more than I did when I started. He had a different background, to some extent, than I did. He had, and I, I was enormously impressed by a terrific teacher, and for good reason. But it makes more sense, as we pointed out, to buy a wonderful business at a fair price than a fair business at a wonderful price. And we’ve changed our, or I’ve changed my focus anyway, and Charlie already had it, over the years in that direction. And of course we have learned by what we’ve seen. I mean, we, it’s not hard, when you’ve watched businesses for 50 years, you know, to learn a few things about them as to where the big money can be made.

Now, you say, when did it happen? It’s very interesting on that, because what happens, even when you’re getting a new important idea, is that the old ideas are still there. So there’s this flickering in and out of things. I mean, I mean, there was not, there was not a strong bright red line of demarcation where we went from cigar butts to wonderful companies, and it, but we’ve moved in that direction, occasionally moved back, because there is money made in cigar butts. But overall, we’ve kept moving in the direction of better and better companies, and now we’ve got a collection of wonderful companies.

In terms of competitive advantage and then regain, lost and then regained, there aren’t many examples of that. In the property casualty company, I’ve got a friend who always wants to buy lousy companies with the idea is going to change him into wonderful companies, and I just asked him, you know, “Where in the last 100 years you seen it happen?” I mean, GEICO got into trouble in the early ’70s, but it, it had a wonderful business model. It did get off the tracks, but it wasn’t because the model went astray. It’s because the, they started reserving incorrectly and went crazy on growth, and a few things like that, but the basic model was still underlying it.

You might argue that, that one company that lost its competitive position and then came back, in a different way, actually was Pepsi-Cola. I mean, they, they were “twice as much for a nickel, too.” They were selling on a quantitative basis, the fact that you got to guzzle more of the stuff for a nickel, “twice as much,” as the slogan went. And they lost that edge post World War II, went cost went up a lot, and so they basically changed their marketing approach successfully, and that’s very, very seldom done, but you have to give them credit for that. To some extent, Gillette lost its competitive position somewhat in the ’30s, lost market share against what they called penny blades and all that, and then regained it in a very big way in the next 10 or so years, when the market share went up enormously.

But generally speaking, if you lose your competitive position… The Packard Motor Company had the premier car in the mid-’30s. The Cadillac was not the premier, it was a Packard. And then they went down scale one year, and they never came back. They jumped their sales that one year, because everybody wanted to own a Packard, and now you could own one a little cheaper, but they never regained that upscale image again. And certain department stores have done that too. They’ve had a upscale image, and you can always juice up your sales, particularly if you got a great upscale image, by, by having, you know, this sale or that sale, and going down market. It’s very hard to go back up market again, and you’ve seen some great department stores that have had that, or, or specialty stores that have had that problem. Charlie, you got any thoughts on that?

Charlie Munger [01:55:20] No more.

Warren Buffett [01:55:20] Okay. Number three.

[01:55:21] Shareholder (Bruce Gilbert, New York City): Hi. I’m Bruce Gilbert, a stockholder from New York City. And about four or five years ago, I put most of my family’s portfolio, actually all of it, into Berkshire Hathaway. And over the past four or five years, the stock price has remained rather steady, and I’ve withstood the year 2000, when friends were making 50% and I was losing 50% on my investment. But I have to admit, when I read your Fortune article last year and you referred to the stock price as expensive, I felt badly.

Now, I spend my days sometimes having fun figuring out the value of Berkshire Hathaway, but at night, after that comment, I could also wake up in worry and fret. And I realize you talked recently a lot about the qualitative and quantitative aspects of things, and I guess I would like you, with your self-reflective position, and knowing that I’m asking you to do something like maybe talking about your breathing, what went into that comment to call the stock price expensive? In terms of your weights and measures, what price, what value, what do you think about the company and its stock price when you say it’s expensive?

Warren Buffett [01:56:35] I think if you, I, I don’t remember the exact wording of that article, but I, I’m quite sure that I told the author of that article, and I’m almost positive it was in the article, that I said it was, I thought it was more attractive than owning the general market or the S&P. So I was saying that I preferred it to the general market. I’m certainly happy having, you know, 99 in a large fraction percent of my net worth in it. I’ve never sold a share. I am not the least bit uncomfortable about holding until the day I die, and quite a bit thereafter.

But I have not thought stocks were cheap at all for some time, and I’ve never wanted to encourage anybody, particularly in the last few years, to buy Berkshire or any other stock, because the market, I felt that the, you know, I felt we had a great bubble. And, you know, I think Berkshire’s value has improved, I think Charlie does too, fairly significantly in, in recent years. And I, I would, if, if I had a chance to swap tax-free my Berkshire for the S&P 500 or for any mutual fund or anything, you know, I wouldn’t, I wouldn’t even, I wouldn’t give it a thought. But that does not mean I think, you know, either Berkshire or stocks are cheap. Charlie?

Charlie Munger [01:58:05] I’ve got nothing to add to that.

Warren Buffett [01:58:08] I don’t think we’ve ever, I don’t think we’ve ever recommended the purchaser or sale of Berkshire that I can remember. We, we did say it one time, we would repurchase shares, which has a certain underlying message to it, and we said at other times we wouldn’t buy shares. That doesn’t mean we’d sell shares at all, but we wouldn’t have bought them under the prevailing conditions. But we stayed away from recommending, actually, not only the purchase or sale, not only of Berkshire, but just of, of any other specific shares. We’ve only given our views occasionally on what we think about the level of the stock market generally. But I do think if you go back and look at that article, I wish I had it here, but I think you’ll find that I said I preferred it to equities generally.

Charlie Munger [01:59:04] It, I do think that there’s a lot to be said for developing a temperament that can own securities without fretting. I think that the fretful disposition is the, it’s an enemy of long-term performance.

Warren Buffett [01:59:20] Well, it’s, it’s almost, I think it’s almost impossible, if you’re, to do well in equities over a period of time if you go to bed every night thinking about the price of them. I mean, Charlie and I, I, we think about the value of them, but we, we would be happy, just as in that movie, if they close the stock exchange tomorrow. You know, Dick Grasso wouldn’t be happy, and Jimmy Maguire, our specialist, wouldn’t be happy. It wouldn’t bother me and Charlie at all. We would keep selling bricks, selling Dilly Bars, selling candy, writing insurance.

You know, a lot of people have private companies and they never get a quote on them. You know, we bought See’s Candy in 1972. We haven’t had a quote on it since. Does that make us wonder about how we’re doing with See’s Candy? No, we looked at the company results. So you, there’s nothing wrong with focusing on company results. Focusing on the price of a stock is, is dynamite, because it really means, means that you think that the stock market knows more than you do. Now, the stock market may know more than you do, but then you shouldn’t be in stocks.

I mean, you, you should have, the stock market is there to serve you and not to instruct you. So you need, you need to formulate your ideas on price and value, and if the price gets cheaper and you have funds, you know, logically you should buy more, if, and we do that all the time. Where we make our mistakes, frankly, is where we focus on price and value and we start buying, price goes up a little and we quit, you know, like Charlie referred to, we might have done on See’s Candy. A mistake like that cost us $8 billion in the case of Walmart stock a few years ago, because it went up in price. And you know, we are not happy when things we buying go up in price. We want to go down and down and down, and we’ll keep buying more, and hopefully we won’t run out of money. Of course, that’s a different story. Charlie? Number four.

[02:01:20] Shareholder (David Anglin, St. Louis, Missouri): Hi. David Anglin from St. Louis, Missouri. Thanks for the weekend. It’s very nice. It’s always entertaining here. According to an article in the Economist, the AAA rating is very important quality for reinsurance to have. Swiss Re, Munich Re have, have lost their AAA ratings. Gerling is out of the ballpark. Will the reinsurance business at Berkshire become unintentionally exposed to higher risk because it is now a major reinsurer still holding a AAA rating, even though it practices a very severe underwriting discipline?

Warren Buffett [02:02:03] No, the triple-A can’t, can’t increase our risk, because it, it should not affect what we do. It may affect what gets offered to us. I, logically we should get business offered does first and last. I mean, we, we are the reinsurer that’s going to pay, for sure, 5 years from now, 10 years from now. So when you, I mean, we have contracts, we have, we have structured settlements with paraplegics that are counting on us to make a payment to them 50 years from now. Those people are in wheelchairs, they may be on, you know, they may be on oxygen, all kinds of things, and they are depending on a little piece of paper that has our name on it, and it says we’re going to pay them for the rest of their life. And it’s very, very important to them whose name is on it.

But that doesn’t cause us to do, it shouldn’t cause us to do anything at all stupid. It just means that people that care about security of future promises should come to us. But there’s no reason at all, because Munich or Swiss Re loses their triple-A, that we should underwrite in any way differently than we do now. It just should mean that we have more to choose from. And I can assure you that, that as these companies lose their AAA, and a number have in the last year, year and a half, we have been tightening our underwriting very materially at Gen Re. Now, it needed tightening, but we are now, in my view, we have the right, we have a, we have a great underwriting culture at Gen Re, and historically it had it. Most of the years it, it drifted away from that, but I think it’s back in spades now. So I don’t think you have to worry about that. Charlie?

Charlie Munger [02:03:57] Well, I, I certainly hope we are better underwriters than, than Munich Re.

Warren Buffett [02:04:03] Well, let’s not name names. No, no, Munich is a fine company. It, the rule at Berkshire is we praise by name and we criticize by category, and I do think Munich is a fine company. But they, they lost their AAA, frankly, because they probably had, they were too exposed on the equity side, on the asset side, in equities relative to net worth, and I think they probably agree with that. But they have a very strong and important position in insurance, and we do a lot of business with Munich Re, and we’ll continue to do so.

But there are others we won’t do business with, incidentally. I mean, there are some very weak reinsurers in the world, and if there were to be a major natural catastrophe, or if there were to be a major financial catastrophe, there are a number of reinsurers, in my view, that would not pay. And we conduct our affairs so we’ll always be able to pay. Number five.

[02:05:09] Shareholder (Olaf Heine, Germany): Good morning, gentlemen. My name is Olaf Heine, from Germany, and not surprisingly, I have a question concerning the German reinsurance market, fitting nicely in the context of the questions before. When you acquired General Re, I believe you inherited, also, a substantial stake in Cologne Re. Now, in your last letter to your shareholders, you hinted that a major reinsurance company might be in trouble, widely believed to be Gerling Re, just mentioned. You also mentioned, about an hour ago, that Germany was kind of a drag insurance-wise, if you, if I understand you correctly.

Warren Buffett [02:05:55] I, I don’t, I, yeah, I don’t believe I, I didn’t mean to say that. I…

[02:06:01] Shareholder (Olaf Heine, Germany): Okay, but it’s, it’s, it helps to formulate the question.

Warren Buffett [02:06:05] Okay, well, for the purpose of your question, we’ll assume I said it.

[02:06:11] Shareholder (Olaf Heine, Germany): Yeah.

Warren Buffett [02:06:11] But I didn’t say it.

[02:06:13] Shareholder (Olaf Heine, Germany): So now Gen Re decided to exercise a call option on the remaining shares of Cologne, another German reinsurance company, and my question simply is: what motivated you to do so?

Warren Buffett [02:06:26] Yeah, that, that’s a good question, and it was, it was mis…, it was sort of somewhat misreported in the press, what happened on that. What, what really happened is, Gen Re, I don’t know whether it would be about six or seven years ago now, acquired a significant position in Cologne from the controlling shareholder, with a put and call arrangement for the remainder. I don’t even know the history exactly of why they went for this two-step transaction, but basically it was a two-step purchase. So that all along we have accounted for Cologne as if we were going to exercise the option, because, in effect, if we didn’t exercise, they would exercise, and it was fate to comply that we would buy that stock, right from the start.

So we, we made no affirmative, we made an affirmative decision six or seven years ago to buy a very significant percentage of Cologne. We now have about 80, we will have about 89% when the options exercise. But there’s nothing new in the fact that we are now doing it. The put, the put and call arrangement, as I remember, became effective essentially this year, so this was the year that something had to be done, and was planned to be done all along. And it, it reflected no new judgment, no new decision about Cologne in the year 2003. It reflects the decision that was made in 1996 or ’97, whenever the original purchase was made.

And Cologne is an integral part of General, General Re. I mean, we, we knew all along that we would own 89% of it pursuant to this contract, and, and that’s always been in our thinking, from the moment we sat down with the Gen Re management to make a deal some years ago. So the, the press has sort of implied that there’s something new in this transaction that’s occurring this year, and there really isn’t. Number six. Charlie, you don’t have anything on that?

[02:08:42] Shareholder (Abhishek Dalmia, India): Good morning, Mr. Buffett. This is Abhishek Dalmia, coming from the land of Mr. Ajit Jain, who is India.

Warren Buffett [02:08:49] If you have any more like Ajit over there, send them. We need them.

[02:08:53] Shareholder (Abhishek Dalmia, India): Right. My question pertains to the allocation of a company’s free cash, and the question is, under what circumstances would Berkshire consider parting with its money for a shared buyback program as opposed to retaining it for future acquisitions? Thank you.

Warren Buffett [02:09:14] Yeah, that’s good question, and we addressed that a bit back a couple of years ago. In fact, I think our annual report for 1999 came out on March 12th. I believe it was March 12th, on a Friday or night or a Saturday morning, that was the day the NASDAQ hit its high and Berkshire hit its low, on that exact day. And we said we would, the next morning, on the internet, on a Saturday morning, we said we would repurchase, but we wanted you to have the annual report first, but we would repur… we might repurchase at those levels. And the NASDAQ never saw its of 5,100 again, and Berkshire never saw its level of whatever it was, 41,000 or thereabouts.

Our preference, and we stated this 20 years ago even, to was, is to buy businesses. We are, we want to add businesses of equality with managers of equality equal to those we already own at prices that make sense, and that’s our number one preference. If we thought Berkshire was significantly undervalued and we thought the likelihood of using the money to buy businesses, the probability was low, we would be buying stock in. We probably wouldn’t be able to buy a lot of stock in, but we would only buy stock in if we thought the stock was selling significantly below intrinsic value.

And there’s no magic figure for intrinsic value. Intrinsic value is a range. Charlie would name a different number than I would name, but our ranges would be quite similar if we were to write them down on a piece of paper now, but they wouldn’t be identical. So we leave us, we would leave a significant margin of safety and want to buy at a, what would be a clear-cut to us discount from the lower levels of intrinsic value we might calculate.

It’s not our, it’s not our number one preference to be, you know, we would rather add business. We love it when we add good businesses to Berkshire. But we would have to, if the, we could add the intrinsic value per share by repurchasing, and we’d given all the shareholders relevant information about the value so that we weren’t putting anything over on them, that they had the same information we had, we would buy in stock. I think it’s unlikely that happens, that we don’t find other opportunities to do things at a time like that, but it could happen, and it almost happened in March of 2000, and then things turned around very, very abruptly. Charlie?

Charlie Munger [02:11:55] I’ve got nothing to add.

Warren Buffett [02:11:57] Number seven.

[02:11:58] Shareholder (Ken Goldberg, Sharon, Massachusetts): Good morning. My name is Ken Goldberg from Sharon, Massachusetts. What is your long-term vision for MidAmerican Energy, and specifically, assuming the repeal of the Public Utility Holding Company Act, what is the nature of the type of assets that you would be interested in acquiring, be they generation, transmission, distribution type properties?

Warren Buffett [02:12:23] Yeah, MidAmerican already is a big part of Berkshire. I would say it’s likely to become much bigger. It will be easier to have it become much bigger if the Public Utility Holding Company Act, which was enacted in 1935, if it were repealed. Public Utility Holding Company Act, which is melodiously named, called PUHCA, was enacted in 1935 in a reaction to what Sam Insull and people like that had done in the 1920s. Is very understandable, but I really think it is quite outdated now. I mean, it is now 68 years later, and I think we bring something to the utility field. In fact, I think we brought it in the last year. There might well be a couple of companies that wouldn’t, would be in bankruptcy now, that if we hadn’t been in a position to act very quickly on certain things.

So, but whether without the repeal, and I think there’s a reasonable chance it’ll be repealed, but with or without repeal, MidAmerican, which is big now, will become quite a bit bigger, and it could become a whole lot bigger. Now, in terms of what kind of assets we’ll buy, we don’t have a, any clear-cut preference, for example, is the, whether it would be a natural gas pipeline or whether it would be a domestic utility, or conceivably a utility even in some country that we felt good about. We will look at things as they come along. We’re always ready to act.

I would say that it’s certain we’ll look at a few big deals this year. Whether we get one done or not depends on competition, depends on the sellers, and some things like that. But something will happen with MidAmerican over, you know, whether it’s this year or next year or the year after, we’ll get a shot at doing something significant. And the nature of the energy field is you’re talking big money always. I mean, these are not lemonade stands, and, you know, we’re talking into billions frequently on the kind of assets involved.

So it will be a, we got a, we got a fabulous management. We’ve got two people running that, and Dave Sokol and Greg Abel, who are terrific business people, you know, they, and incidentally, I should mention this publicly, they have done things that have made Berkshire significant money that had nothing to do with MidAmerican. They have, there was, they have spent their time and energy and weekends putting together a couple of things that MidAmerican itself could not do but Berkshire could, and they didn’t get paid a dime for that, and MidAmerica did not get paid a dime for that. So they have contributed to Berkshire’s welfare beyond what they’ve contributed simply as managers of MidAmerican. So it’s a terrific asset. We love the idea of pouring money behind them, and you’ll see something happen. Charlie?

Charlie Munger [02:15:24] Well, I, the really interesting thing about it is the fact that the field is so big. I mean, you’re talking about an enormous field. One thing a modern civilization needs is energy. So we’ll be very disappointed if there aren’t more activities.

Warren Buffett [02:15:42] Number eight. When we get through with number 10, we’re going to break for lunch, and then we’ll come back, can start all over again after 30 or 40 minutes. But I’d like to get through eight, nine, and 10. Eight.

[02:15:55] Shareholder (Norman Rentrop, Bonn, Germany): I’m Norman Rentrop from Bonn, Germany. Mr. Buffett and Mr. Munger, I have a thank you and a question for you. Thank you for allowing us shareholders to invest with you on equal terms, with almost no management fee and no performance fee. (Applause)

I came to fully appreciate it when I compared my 10 years of holding Berkshire Hathaway to a private equity fund, which over the same 10 years earned 19.8% before fees and 11.2% after fees. Now my question. Back in the 1950s and 1960s, when you had a partnership, Mr. Buffett, you asked for and got a performance fee of 25% of what was earned above 6% a year, correct? What caused you to switch from that performance fee to that no fees we are enjoying today? Was it the wisdom that to give is better than to receive? Try again. And do you feel that this switch from performance fee to no performance fee, that that is fully appreciated, and what did it mean to you personally?

Warren Buffett [02:17:24] Well, I appreciate what you had to say, and I will, I would pay to have the job I have. I would pay a lot of money, and I hope I don’t get tested on that. But I, you know, it’s, why in the world, if I can work with people I like and get the same result they have and end up with all kinds of money, you know, why do I need to make some further override on them? I’m, I was changing my position in life significantly when I started that partnership in 1956. A couple of the people that, well, I guess, yeah, Doris may be the only original partner here, but Doris, would you stand up? She joined on May 5th, 1956, wherever she is.

And the, you know, those people gave me their money, but I wasn’t, I needed some money then too, and I did get an override, which I thought was fair. I got no management fee at all, though. I never, I never charged. Today most of the people run hedge funds charge 1% a year and then some percentage the profits. I did not do that, and I did have all my money in after 1962, so that the downside would be equal to the upside.

But I’ve always felt about the people as partners, and when we got into Berkshire originally, when we got into Berkshire, Berkshire was owned by the partnership. So if I’d taken a salary then, I would have been double dipping, in effect, by getting money out of Berkshire before in turn the partnership participated. And frankly, by the time I got, while I was running Berkshire, I had all the money I needed, and, you know, I’d rather get the same result as my partners than have me get a different result. And it’s, it can’t make any difference. I mean, it’s, it’ll make a difference in the size of my foundation someday, perhaps, you know, but so what? I like living the way I live. Charlie?

Charlie Munger [02:19:19] Well, you raised a very interesting question, and it has parallels. If you go back, Carnegie was always very proud that the bulk of his fortune had been earned where he took no salary at all from Carnegie Steel. John D. Rockefeller the First took practically nothing in salary over the years. The original Vanderbilt prided himself on living on his dividends and taking no salary. And it was a, it was a common culture in a different era. And you realize that all those people had the psychology of being the founder, and maybe that’s what influenced Warren.

Warren Buffett [02:20:04] What influenced you, Charlie? Charlie doesn’t take anything either.

Charlie Munger [02:20:08] So I was delighted to get rid of the psychological pressure bought by, brought on me by getting fees based on performance. I think Warren was too. If you’re highly conscientious in your relations with other people, and you hate to disappoint, you’re going to suffer more if you are liberally rewarded with performance fees. So I think that was an enormous advantage to us. So I guess we should be thanking you.

Warren Buffett [02:20:48] I should… Bill Gates has never taken an option at Microsoft and takes a very small salary. And you’ll find it interesting, the only reason he takes the small salary is if that he feels that if there’s a bad year at sometime in the future, he wants to be able to take a cut in salary at the same time he’s asking other people to cut back. And that’s, and that’s the, that is the reason. I mean, he takes peanuts as it is, but he just figures that, that Bill is, Bill is a very conservative guy, and he figures that some year they’ll be a bad year, and he wants, if he’s asking other people to take a 5% cut, he wants to be able to take a 90% cut or something himself. But he’s never taken an option, and I don’t believe Steve Ballmer has either. They have, they have gotten rich with their shareholders and not off their shareholders, and that’s an attitude we admire. Number nine.

[02:21:37] Shareholder (Whitney Tilson, New York City): Good morning. I’m Whitney Tilson, a shareholder from New York City. There was a lot of talk among the Berkshire faithful when you took what I believe was the unprecedented step of pre-release a portion of your annual letter, published in Fortune, which focused primarily on the dangers of derivatives, which you called financial weapons of mass destruction. I have two questions related to this. The first to you, Mr. Buffett: could you tell us the story of how the Fortune article came about? Were you trying to draw extra attention to something that you feel strongly is a great risk to our financial system? And the second question to both of you: since you’re warning about derivatives, there’s been a huge rally in the credit markets in general. Does this reflect investors’ lack of concern for these systemic risks, or is it caused by other factors?

Warren Buffett [02:22:24] Yeah, the first question, my friend Carol Loomis is the editor of the Berkshire report, and we wouldn’t get out the report without her. I mean, she is the world’s greatest editor, in addition to being the world’s greatest business writer. So when I gave the report to her to edit, and it did not come back unmarked, I might add, she and I talked about, I was interested in having the section on derivatives because I thought it had a broader, I hoped it would have a broader audience than just the Berkshire annual report. And I felt that publishing it, which had no relationship to the Berkshire business basically, except the history of Gen Re’s involvement, would not be in any way compromising fair disclosure in terms of Berkshire’s results itself. So the primary reason for having it in Fortune was I hoped for a wider audience, basically, by having it in Fortune.

And, you know, Charlie and I think there is a low but not insignificant probability, and low, and sometime, maybe in three years, maybe in five years, maybe in 20 years, and very possibly never, that derivatives could accentuate in a major way a systemic problem, problem that might even arise from some other phenomenon. And we think that’s improp… inadequately recognized. We think the problem grows as derivatives get more complex and as their usage increases. So it was, it was a call, what we hoped was a mild wake-up call, to the financial world that these things could be very troublesome.

And of course we saw it in the energy field in the last two years. It almost destroyed, or destroyed, certain institutions that never should have been destroyed. And the, we also saw in 1998 the whole financial system almost become paralyzed, particularly in the credit markets, you know, by the action of a firm which was not solely based on derivatives but would not have gotten into as much trouble as it did without derivatives. So it’s a subject that no one quite knows what to do with. Charlie and I would not know how to regulate it.

But we think we have had some experience in seeing both the firm-specific dangers in that field, and we think we have some insight into the systemic problem, problems that could arise. And, you know, that people, people really, they don’t want to think about it until it happens. But there are some things in the financial world that are better thought of before they happen, even if they’re low probabilities. And we’re thinking about low probabilities all the time in terms of Berkshire. I mean, we don’t want anything to go wrong in a big way at Berkshire, and we therefore, I think, think about things that a good many people don’t think about, simply because we worry about that.

And when we get our social hats on, we think about it in terms of something like derivatives for financial systems of the world. And we have had some experience at both Salomon and at Gen Re, and Charlie was on the audit committee at Salomon, and he saw some things in the audit committee in relationship to trading itself, and derivatives in particularly, that made him wonder why in the world people were doing these sort of things. I let Charlie man on that.

Charlie Munger [02:26:24] Yeah, in engineering, people put big margins of safety into systems, atomic power plants being the extreme example. And in the financial world and derivatives, it’s as though nobody gave a damn about safety, and they just let it balloon and balloon and balloon, in usage and number of trades and so size of trades. And that ballooning is aided by this false accounting, where people are pretending to make money they’re not really making. I regard that as very dangerous. And I’m more negative than Warren, in the sense that I’ll be amazed, if I live another five or 10 years, if we don’t have some significant blow-up.

Warren Buffett [02:27:20] They’ve been advertised, and sometimes by some in a fairly prominent way, they’ve been advertised as shedding risk for participants in the system, and reducing risk for the system. And I would say that I think they have long crossed the point where they decreased risk to the system, and now they enhance risk. Because you’ve, the truth is, the Coca-Cola Company can bear the foreign exchange risk that they run or the interest rate risks that they run and all of that sort of thing. But when the Coca-Cola Company starts laying those off, and every other company in the world, major company does, with just a relatively few players, you have now intensified the risks that exist in the system. You have not, you have not shed risk at all. You have transferred it, and you have transferred it to very few players, and those players have huge interdependencies with each other, and to some extent central banks and all of those and similar institutions are vulnerable to the weaknesses of those institutions.

When Charlie and I were at Salomon, you know, they hated it if we brought up, and so therefore we didn’t do it, that we were too big to fail. But the truth was that if Salomon failed at that time, the problems for the rest of the system could well have been significant. They might have been, you know, who knows exactly what they would have been, but they could have been quite significant. And when you start concentrating risks in institutions which are highly leveraged, and who intersect with a few other institutions like that, all bearing same risks, all having the same motivations in the trading departments to take on more and more esoteric things because they can book more and more immediate profits, you are courting danger. And that’s why I wrote about it this time. And I, it’s not a prediction, it’s a warning. And number 10, and then we will break for lunch right after this.

[02:29:24] Shareholder (Ho Nam, San Francisco, California): Good morning. My name is Ho Nam from San Francisco, California. I have a two-part question regarding how you evaluate your managers. In your annual report, you wrote that Berkshire Hathaway owns good to great businesses and employees great to great managers, and we’re thankful for that. When you hire a manager, or evaluating the management team of a business you’re thinking about buying, what are the qualities you look for? And some of your managers were entrepreneurs who started their businesses from scratch, when their business models were unproven, and some of them took over businesses that were already performing well when they took charge. What are the qualities of a great entrepreneur that might be different from those of a manager who can be great at running a company that’s established, but not, may not be able to start a business from scratch and tinker around with a business model and figure out how to make it successful?

Warren Buffett [02:30:16] Yeah, well, we love managers that have a passion for their business. And what we’re buying a business, we have to ask ourselves, do they love the money or do they love the business? If they love the money, there’s nothing wrong with that, but they probably wouldn’t be running the business for us a year or two down the road. I think one difference is that people that create their own businesses, the entrepreneurs, probably on average would have a significantly greater degree of passion for those businesses than somebody that was just brought in a few years ago and sees themselves as making a profit in a few years on reselling the business and leaving. I, you’ll find exceptions in both camps.

But we’ve had terrific luck with the entrepreneurs who basically love their businesses the way I love Berkshire. I mean, they are not going to let anything happen to their businesses. They can, you know, they’ll tell me to butt out if I’m going to screw up something in their operations. And they don’t regard them, I mean, in a certain sense, I mean, they know they’re part of Berkshire, but they regard them, in a certain jealousy almost, as being their businesses, and we love it that way. And, you know, we can spot it when we see it, and when we also can avoid it.

We have never, I just got one in the other day, some, from an investment banker, on somebody that wants to resell a business they bought a few years ago. Well, you know, the chances that they haven’t doctored up the figures in some way or trying to sell, I mean, it, you know, they’re, it’s a piece of meat to of them. And if it’s a piece of meat to them, you know, what am I going to do with it? So we, if we make the proper judgment about the passion they have for their business, they’re going to keep running. They may have a lot of money in the bank, but they’re going to keep running the businesses for us because they love those businesses, and they really are motivated the same way I am.

You know, it really, it would do make any difference what I get paid. You know, I’m identified in my own mind with how Berkshire does. I really don’t care how the rest of the world thinks about how Berkshire is doing. I mean, in other words, when we looked like we were out of step a few years ago, that really doesn’t make any difference to me as long as I feel okay about how Berkshire is doing. But I do, you know, that’s how I measure what I’m doing every day, not by the price of the stock but by what’s going on in the business. And that’s what we have, a group of managers like that. And there, I don’t think there’s, well, there can’t be a company in the country, in my view, that if you could figure out some way to measure the passion involved in terms of running their business, I don’t think there’s anybody that could come close to matching the quantity that we have managed to marshal together at Berkshire. It’s been accidental over time, but it’s really almost unique. I think it is unique. Charlie?

Charlie Munger [02:33:16] Well, it’s very interesting to think about what matters most, the passion or the competence that was born in. Certainly Berkshire is full of people who have a peculiar amount of passion in their love for their own business. And I would argue that probably the passion is more important than the brand power.

Warren Buffett [02:33:40] Yeah, by the time they get to us, if they were passionate but incompetent, they don’t get to us. I mean, we, you know, they’re not going to be there unless they’re competent. But the question is whether they had a passion for money or a passion for their business, to some degree. And like, they all like money, I mean, and the reason, and they like it partly because it enables them to build the business they love. But they don’t, we’re not going to see an incompetent but passionate manager by the time we start laying out a lot of money for a business. They got weeded out a long time ago. So I don’t have to weed those out, but I do have to weed out the ones who want to cash a big paycheck and go off and do something else at some time. And like I say, we’ve had great luck at those, at that.

But we have literally, I mean, we see lots and lots of businesses owned by, usually owned by financial operator types, where it’s absolutely clear that, you know, they’ve come in, they’ve leveraged it up, they played games with the accounting, they, that is about run out, you know, and they want to sell it. And it’s, and interestingly enough, some, fairly often, those are built by, bought by other financial operators who think they’re going to play the game a second time. We are not interested in any of those at all. But what we are interested in is lunch, and we’re going to have that right now, and I’ll see you back here in about 30 minutes.

Okay, we have no afternoon movie, so we’ll get to business in a second, if everybody will just find their seats, please. I’ve been advised by Marc Hamburg to make sure I make clear what I may not have made clear earlier in terms of the figures we gave you about the first quarter. A, I think I said we had $16 billion of cash or cash equivalents, which is correct. We had a $290 million pre-tax underwriting profit, I think I said that. What are I, what possibly I may have misstated: we had a $1.7 billion pre-tax operational gain. We had actually also, by coincidence, very close to $1.7 billion of after-tax counting securities gains. But our operating gain, excluding security gains, was about $1.7 billion pre-tax. Let’s start right in, in the, at number one.

[02:36:37] Shareholder (Oliver Graussa, Vienna, Austria): Yes. My name is Oliver Graussa, and I’m from Vienna, Austria. I, my question has two parts. As the first part is, how do you get a few excellent investment ideas to be so successful? Do you read any special newspapers or industry magazines, or do you visit their headquarters or any subsidiaries of companies? And which sources of information, like books, for example, Value Line, Standard & Poor’s, Moody’s, databases like Reuters, Bloomberg, Datastream, annual reports, internet, and so on, do you use to get the right impression of a company? And the la… second part: if you think that a company like the Washington Post, GEICO, or Gillette has a very, very competitive product, what are the steps before you ultimate decide to invest in the company? Which publications do you read to get the best knowledge of the product? And how important is the balance sheet and profit and loss account statement of the company? Thank you much.

Warren Buffett [02:38:06] Thank you. The answer to the first part is sort of, and maybe the second part is sort of, all of the above. We, we read a lot, and we read daily publications, we read weekly or monthly periodicals, we read annual reports, we read 10-Ks, we read 10-Qs. And fortunately, the investment business is a business where knowledge accumulates. I mean, everything you learn when you’re 20 or 30, you may tweak some as you go along, but it all kind of builds into a knowledge base that’s useful forever. And we, at least, you know, I read, Charlie used to read, may still read a fair amount, but I read a lot of 10-Ks, read a lot of annual reports.

40 or 50 years ago, I did a lot of talking to managements. I used to go out and take a trip every now and then and really drop in on maybe 15 or 20 companies. I haven’t done that for a long, long time. I find everything we do, pretty much, I find through public documents. When I made an offer for Clayton Homes, I’d never visited the business. I’d never met the people. I’d done it over the phone. I’d read Jim Clayton’s book. I looked at the 10-Ks. I knew every company in the industry. I look at competitors, and I try to, you know, I try to understand the business and not have any preconceived notions. And there is adequate information out there to evaluate a great many businesses.

We do not, we do not find it particularly helpful to talk to managements. Managements frequently want to come to Omaha and talk to me, and they usually have a variety of reasons that they say they want to talk to me, but what they’re really hoping is we get interested in their stock. That never works. You know, that managements are not, are not the best reporting, most case the figures tell us more than a management does. So we do not spend any real amount of time talking to management. When we, when we buy a business, we look at the record to determine what the management’s like, and then we want to size them up personally, as I said earlier, whether they will keep working. But we don’t, we don’t give a hoot about anybody’s projections. We don’t even want to hear about them, in terms of what they’re going to do in the future. We’ve never found any value in anything like that. But just a general business knowledge, you know, what we’ve seen work, what we’ve seen has not worked, there’s a lot you absorb over time. Charlie?

Charlie Munger [02:41:07] Yeah, the more basic knowledge you have, I think the less new knowledge you have to get. And the game is a lot like that fellow that plays chess blindfolded. He’s got a memory of the board and everything that happened before, and that enables him to do the next move in a way he never could if you just showed him the board mid-game cold. And so there, in terms of what publications, I don’t know. W… I would hate to give up the Wall Street Journal.

Warren Buffett [02:41:47] Well, you’d also hate to give up the Buffalo News.

Charlie Munger [02:41:50] Yeah, but you could. Well, you want to read lots of financial material as it comes along. And actually, the New York Times has a far better business section than they had 25 years ago. But you want to read Fortune, you want to read lots of annual reports. You really want to have a database in your mind so that you can tell what kind of a business you’re looking in at, in general, by looking at the figures.

Warren Buffett [02:42:22] It’s far overrate… We never look at any analyst reports. I mean, I don’t think I, you know, if I read one, it was because the funny papers weren’t available. You know, it just isn’t, I mean, it, I don’t understand why people do it. But there’s a lot of data out there, and, you know, the beauty of it is, it’s what makes the investment game great, is you don’t have to be right on everything. You don’t have to be right on 20% of the companies in the world, or 10% of the companies in the world, or 5%. You only have to get one good idea every year or two.

So it’s not something, you know, when I, when I used to be very interested in horse handicapping, and the old story was, and I hope Bob Dwyer is still here, that, you know, you can beat a race but you can’t beat the races. And you can come up with a very profitable decision on a single company. I would hate to be measured if somebody to gave me all 500 stocks in the S&P and I had to make some prediction about how they would behave relative to the market over the next couple years. I don’t know how I would do. But maybe I can find one in there where I think I’m 9 and 10, 90%, in being right, that the, it’s an enormous advantage in stocks. It’s, you only have to be right on the very, very, very few things in your lifetime, as long as you never make any big mistakes.

Charlie Munger [02:43:53] What’s interesting is that at least 90% of the professional investment management operations don’t think the way we do it all. They just think if they hire enough people, they can be better at determining whether Pfizer or Merck is going to do better over the next 20 years, and they can do that stock by stock all through the 500 and have wide diversification, and at the end of 10 years they’ll be way ahead of other people. And of course they won’t. Very few people have this idea of searching for just a few opportunities.

Warren Buffett [02:44:30] Yeah, you wait for the fat pitch. Ted Williams wrote about that in a book called The Science of Hitting, said the most important thing in being a good hitter, you know, is to wait for the pitch in the sweet spot, basically. But, you know, I’ve always said that the way to get a reputation for being a good businessman is to buy a good business. You know, there, it’s much easier than taking a lousy business, you know, and showing how wonderful you are at it, because I haven’t seen that done very often. Number two.

[02:45:05] Shareholder (David Winters, Mountain Lakes, New Jersey): Good afternoon. David Winters, Mountain Lakes, New Jersey. Thank you again for hosting the Berkshire weekend. It’s just great. Interest rates are the lowest they’ve been in I… Equity values and aggregate or still high. Berkshire has meaningful free cash flow, a short duration bond portfolio, and your buyer of low moldable, high-quality private businesses and a few stocks. Assuming that the stimulative economic policy is to deal with the recession eventually cause interest rates to go up and maybe equity values to come down, Berkshire seems very well positioned to benefit. Would you comment? And also, are there any concerns on both of your parts about invest… inadequately understanding the conglomerate structure of Berkshire and then therefore improperly pricing the shares?

Warren Buffett [02:45:54] Well, to answer the second question first, we hope the latter wouldn’t be true, because we do our best to explain it. I mean, I used 14,000 words in the last annual report, which caused certain members of my family to ask whether I was getting paid by the word. The, we want you to understand Berkshire, and I hope that comes true. That’s why we have these kind of meetings. That’s why we spend a lot of time writing an annual report. We try to tell you what we would like if the position was reversed, and if our positions were reversed. And we think that the information in the annual report, if read by somebody that, they have to have some understanding of business and accounting, but if they don’t, you know, it, nothing is going to help really in terms of helping them with the business. But we think if they have some understanding of, we have given them the information that Charlie and I would need in order to come up with our rough ideas of the valuation of Berkshire. And we, and we hope we get across what it’s all about. You know, there are a lot of companies in Berkshire, but it’s not important that you understand the nuances of every single one. Looking at what happens in aggregate, in many cases, will be sufficient.

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

Charlie Munger [02:48:07] In terms of future opportunities, the issue is, is it all likely that there’ll be an opportunity like 1973-74 or 1982, even when equities generally are just mouthwatering? I think there’s a very excellent chance that neither Warren or I will live to see either of those occasions again. If so, Berkshire is not going to have a lot of no-brainer opportunities. We’re going to have to grind ahead the way we’ve been doing it recently, which is not all bad.

Warren Buffett [02:48:47] It’s not impossible, though, we’ll get some mouthwatering opportunities. I mean, it, you just don’t know. In markets, it’s unbelievable what markets do over time. And since you brought up interest rates, you know, in Japan, the 10-year bond is selling to yield 5/8 of 1%. 5/8 of 1%. I don’t think there’s anybody in our annual meeting of 20 years ago, certainly including Charlie and myself, who would have dreamt that a 10-year bond of a country, you know, running a significant deficit, would be selling at 5/8 of 1%. I mean, would you say so, Charlie?

Charlie Munger [02:49:29] Would I ever. It’s, but strange things happen. Strange things happen. But if that could happen in Japan, something much less horrible for the investing class could happen in the United States. It’s not unthinkable. I mean, we could be in for a considerable period when the average intelligent diversified investor in common stocks, using fancy paid advisors, just doesn’t do very well.

Warren Buffett [02:49:57] But you can argue that if what we warned against, and hope doesn’t happen, with derivatives should happen, it might create enormous opportunities for us in submarina. I mean, you know, that we wouldn’t be, it might very well turn out to be good for us if you get chaotic markets. You had a somewhat disorganized market in junk bonds last year because there were a lot of them created, much faster than the funds available to absorb them were coming in. Now this year you have just the opposite situation, have money pouring into the junk bond funds, $1 billion a week roughly, and that’s changed the whole price situation. The world hasn’t changed that much. It’s just that the chaos has left the market for those instruments. Number three.

[02:50:55] Shareholder (Paul Tomasik, Thornton, Illinois): Yes, hello. Paul Tomasik, Thornton, Illinois. Ben Graham and the model of value investing. I’d like to bring discussion back to that. And what’s interesting and exceptional about you and Charlie and Ben Graham is the self-discipline, the incredible self-discipline. And if you look at the model and try to think how to present it to teach others that self-discipline, I think you have to make a little tweak to it in two areas, and that’s what I’d like you to comment on.

One, intrinsic value. It’s always discussed that you calculate intrinsic value, but in practice I think you find a number that is guaranteed, 99% likely, to be less than intrinsic value. Classic example was in 2000, when you said you’d buy shares back at $45,000. You weren’t saying that Berkshire Hathaway’s intrinsic value was $45,000. You were saying it was significantly more, and anyone who board it for less than 40,000, 45,000 is grateful to you.

The other area is the hidden assumption in the model, and that is, it’s assumed that once you find a value stock and you buy it, that the intrinsic value isn’t going to go down. And that’s a second part of the analysis that has to be part of the discipline. So even though you found a value stock, you still haven’t done all the work. You have to analyze, is the intrinsic value going to go down? In particular, companies throw away intrinsic value. Is the most common, management gives it away. That hasn’t happened at Berkshire Hathaway, although I don’t want to give an unqualified comment on that, since I see you’re remodeling the offices, so we don’t know how much intrinsic value has been thrown away there. So if you comment on the two things: do you calculate intrinsic value, or a number that’s absolutely, positively under intrinsic value? That’s the number you put in the equation. And even when you find a stock selling for less than this lower bound of intrinsic value, do you still do the homework on the second part and analyze, will the intrinsic value go down in the future? Thank you.

Warren Buffett [02:53:03] Yeah, I would feel somewhat better qualified to speak on self-discipline if I weighed about 20 pounds less, but for the moment we’ll ignore that. The, the second part of your question, relating to intrinsic value going down: actually, if you compute intrinsic value as reflecting the discounted value of future cash flows, that should have built into it a calculation that allows for the fact that certain businesses are going to earn less in the future than now. It isn’t that their intrinsic value goes down then, because you should build it into your calculation right now.

But, you know, as we’ve pointed out many times in the past, intrinsic value is terribly important and very fuzzy, and we do our best to work within the kind of businesses where we think we have the highest probabilities, where our predictions are of a high, a fairly highly probable nature. And there’s, that leaves out all kinds of companies. It’s pretty good, we’ll say it’s something like a natural gas pipeline. I mean, the chances of big surprises will, in a pipeline, should be relatively small. That doesn’t mean they’re zero, but they’re relatively small.

Now let’s assume that you had a gas pipeline, which some have, where either the supply of gas is going to run down, or where there are competitive pipelines that may be trying to take away your contracts that you wrote 10 years ago and expire in two years, and you’re going to have to cut prices. I would say that two years from now, when you have to cut prices, the intrinsic value hasn’t gone down from today, if you properly calculate it today and build in the fact that profit margins in the future will be lower than they… We looked at a pipeline recently where we think they are going to be vulnerable to competitive price pressures because of alternate ways of getting gas to market through other pipelines, and the calculation is entirely different. The calculations is different, the results are different, in terms of that pipeline versus the pipeline that is the lowering gap gas from one market to another and will remain the low-cost producer. But it isn’t, if properly calculated, you build in the prediction of decline in future operating. You don’t wait till you get there to anticipate it.

You know, Charlie’s famous for saying that all he wants to know is where he’s going to die, so he’ll never go there. Well, that’s part of predicting in business. I mean, there, I love the, I’m, I really have never seen an investment banker’s book, I hope to see one someday, and I hope I can survive the shock when I do see it, where the earnings of the business being offered go down. Lots of businesses’ earnings go down, and they’re going to go down. And I get all this nonsense, you know, where they project it out for 10 years and it always goes up. It just isn’t the real world.

And you have to analyze businesses. Some businesses are going to be subjected to enormous competitive pressures that aren’t extent today. And we made that mistake, for example, at Dexter Shoe. I mean, we bought a business that was earning $40 million or so pre-tax, and we assumed that the future would be as good as the past, and we couldn’t have been more, I couldn’t have been more wrong. So that was a case of projecting into the future conditions which were not going to exist in the future, competitive conditions. That’s part of, you know, that’s part of business. And I will tell you that, you know, 20% of the Fortune 500, but I don’t know which 20%, are going to be earning, you know, significantly less money probably five years from now than they are today. And that’s what the game is all about, figuring out what those future cash flows are likely to be. And when you can’t, when you feel you can’t come up with reasonable estimates in that respect, you move on to the next one. Charlie?

Charlie Munger [02:57:14] Yeah, we have this simple, old-fashioned discipline, which Warren likens to Ted Williams waiting for a fat pitch. I don’t know about Warren, but if you said to me, “Charlie, you can go into the business of managing money the way other people do,” or you’re measured against indexes and you got consultant choosing consultants that are reviewing you to committees, I would just hate it. I would regard it as being put into shackles, and shackles where the very system was preventing me from delivering value. Warren, how would you feel about that?

Warren Buffett [02:57:52] Yeah, we wouldn’t, we wouldn’t do it. We never did do it, as a matter of fact. And one, you know, the initial, when we formed the partnership on May 5th, 1956, I passed out to the seven limited partners to something called the ground rules, and I, you know, I said, here’s what I can do, and here’s what I can’t do, and there are some things I don’t know whether I can do or not. Maybe it was, it was fairly short. But the idea of setting out to do something that you know you can’t do, that can’t be, you know, that’s got to lead to problems. I mean, somebody tells me I have to high jump seven feet, and we can even move that down to four feet now, you know, between now and sundown, or I’ll be shot, you know, I will go out and buy a bulletproof vest.

Charlie Munger [02:58:42] Yeah, the general system for money management requires people to pretend that they can do something that they can’t do, and to pretend to like it when they really don’t. And I think that’s a terrible way to spend your life, but it’s very well paid.

Warren Buffett [02:59:02] Number four.

[02:59:02] Shareholder (John Golob, Kansas City): Hi, I’m John Golob from Kansas City. I have a follow-up question on derivatives. After the press zeroed in on the comments in your annual letter, the head of Fannie Mae got up and said, well, Mr. Buffett’s criticisms don’t apply to Fannie, because number one, we have simple vanilla derivatives that are priced in the market, and secondly, we need derivatives to protect against interest rate risk. And I guess, given what happened to the savings and loan industry back in the ’80s, that seems reasonable. So my qu… my first question is, what is your rejoinder to Mr. Raines? And the second part of my question gets to your concern about the connection between derivatives and systemic risk, and that is, do Fannie and Freddie play a particularly prominent role in this concern? Thank you.

Warren Buffett [03:00:07] Yeah, I have a lot of respect for Frank Raines. I think he’s done a good job at Fannie Mae. I don’t know the situation intimately. The problem, as you mention, is that an operation like Fannie Mae or Freddie Mac, or savings and loans in the past, had this problem, which is inherent in the mortgage instrument, in matching or coming close to matching assets and liabilities. And the reason they had that terrible problem, which did in many institutions, was the optionality in a mortgage instrument. And in a mortgage instrument, particularly as the years have progressed, you buy, you know, if you buy a mortgage, when somebody else takes out the mortgage, you own it. You have a 30-year instrument if it’s a bad deal, and you have about a 30-minute instrument if it’s a good deal. The buyer, the person who takes out the mortgage, can call off the deal at any time, with at relatively low cost. And the public has been sensitized to that more and more as time has gone by, so they’ve been quicker to refinance for very small differentials.

Now, many years ago they had what they called due-on-sale clauses. In California, I think, were they invalidated, Charlie, or what happened with those? That, so that there were ways of shortening up the mortgage expected maturities. But it’s a fundamental problem when you are operating on borrowed money in a very big way, which is what S&Ls did, and what Fannie does, and Freddie, that you have this very long-term instrument, and it, but it’s, it can be very short term if it becomes advantageous to you, when rates go down, and you want to keep it, or it becomes very long-term if rates go up and nobody wants to refinance.

And under those circumstances, if you run a huge institution, or even a smaller one, but that has a high, is highly leveraged, you are going to look for one way or another to try to match the duration of your liabilities as close as you can to the duration of your assets, and have various methods to protect yourself against the optionality that exists with the counterparty, in effect, your asset. That’s not easy to do. And Fannie and Freddie and other institutions attempt to do that through various types of derivative instruments, as well as other things in terms of the kind of debt they issue themselves and so on. And they’re very smart, and they do a, you know, my guess is they do a better job than Charlie and I could do at it. But I, but it can’t, by its nature, be perfect.

And under some circumstances, where you get large gaps, the thing you worry about in financial markets, and it doesn’t happen very often, but you’re wait… the thing that really destroys people are what the academics would call six sigma or five sigma or seven sigma events, which are things that are never supposed to happen, basically. And sigma is the method of describing the probabilities that they will happen in any given period, the number of sigmas. And financial markets don’t lend themselves well to modeling based on that. You know, they do most of the time, until it doesn’t work. And when it doesn’t work, you know, chaos reigns. And there are more six sigma events that happen in financial markets, or theoretical six sigma events, than any study of probability curves would ever come up with.

And that’s when, when I, when you have gaps or discontinuities, when markets close, whatever it may be, those are what cause institutions to go out of business. And derivatives, in our, my view anyway, accentuate the possibility of it happening, and the extent of the damage if and when it should happen. Again, we can’t, we don’t think we mathematically can tell you what the probabilities are of something like that, and we think anybody that does tell you, you know, is kidding you. And I’ve had managers of hedge funds sit down with me and tell me that they had, you know, a 28% probability of returns between 30 and 40%, come up with all these exact figures. Anybody comes up with exact figures in finance, watch out.

So I would say that if I were running Fannie or Freddie, I would be terribly conscious of what was happening in there, and I would understand this basic problem I have, which I can guarantee Frank Raines understands extremely well, of the optionality built into his assets. And I would try to come as close to matching that, and if I did it through derivative instruments or whatever, I would, I would try to match, I would try to reduce the troubles that could be produced by that optionality to a minimum. And then I would get very worried about who the counterparties were. Because anytime somebody promises to pay you a lot of money if something terrible happens to you, you better be very sure that they can and will pay, because the terrible thing that’s happening to you may be presenting terrible things to them. You know, that will happen in the insurance industry from time to time, and that’s why reinsurance recoverables are a dangerous asset to have.

It will happen in the derivative markets. When LTCM had troubles with one type of asset, they had troubles with a lot of types of assets, and everybody else they were doing business with was having a lot of troubles with those same things. And that’s why the Federal Reserve stepped in to, into something they never dreamt they would have stepped into. They stepped into forc… essentially a solution, which may have been the right thing to do, incidentally, but they, for some obscure hedge fund that nobody in the world virtually had heard of until that point, and it started threatening the, the US, the stability of the US financial system. Charlie?

Charlie Munger [03:06:46] Well, I think you’re right to point to this creditworthiness of the counterparty risk. My guess is that both Fannie and Freddie have been pretty intelligent at thinking through a whole lot of different scenarios where they’ll be okay, or close to okay, if all the counterparties pay. And I would bet a lot of money that they wait the possibility that counterparties won’t pay a lot lower than we do. I think a lot of the counterparties are behaving in a lot more dangerous way than Fannie and Freddie are, and that, and the counterparties can get in trouble because of that, and they can translate that trouble to people who assume that they’re hedged.

Warren Buffett [03:07:39] And that’s true. The mortgage guarantee institutions that take part of the risk away from Fannie and Freddie are very sophisticated institutions, very, very sophisticated institutions. But if you depend too much on other people, there can be periods in financial history where all the sophistication in the world may not save you. The best thing to do is to be able to count on your own resources, and Berkshire, that’s basically the way we operate. It, it may be safer than necessary, but, you know, Charlie and I are rich enough already. We do not need to stay up at night. Number five.

[03:08:20] Shareholder (Joseph Lapray, Minneapolis, Minnesota): My name is Joseph Lapray. I’m a shareholder from Minneapolis, Minnesota. Thank you for this opportunity to present a question. At last year’s meeting, I believe that Mr. Munger made a comment to the effect that it was not inconceivable that the US dollar could someday suffer a collapse in value similar to that which had recently befallen the currency of Argentina. I am concerned that in the event of a collapse in the value of the dollar relative to foreign currencies, that Berkshire Hathaway’s insurance operations may find themselves having to pay for replacing property whose cost is denominated in sharply appreciated foreign currency. I have two specific questions. First, does Berkshire Hathaway have any way to protect itself from the effects of inflation induced by a possible currency collapse? And second, do you have any ideas about how individual investors can protect themselves from currency risk? Thank you.

Warren Buffett [03:09:30] Yeah, I’ll ask Charlie first to comment on whether he said exactly what the gentleman said last year.

Charlie Munger [03:09:38] Well, I don’t, I wasn’t predicting that the United States would go to hell as much as Argentina has. What I was predicting is that all kinds of things could happen here that are unthinkable based on past recent experience. And Berkshire, Warren, by and large, our liabilities are denominated in dollars, right? We don’t have a huge foreign currency exposure at all.

Warren Buffett [03:10:09] No. Well, we have, you know, we may have, we have a few billion dollars, at least, denominated in liabilities and other currencies, but we also have assets in those currencies, pretty much. So we don’t think about it day by day in terms of matching euros, again, euro assets against euro liabilities, but in a general way, we don’t get way out of whack either. We, I mean, we do not have lots of liabilities around the world and other currencies which are only matched by assets and US dollars. Most of our assets and liabilities overwhelmingly are going to be in US dollars, but we’ll have a, you know, we will have maybe at the present time a couple of billion that, of liabilities, primarily in euros, and we have at least that much in the way of assets. So we don’t run big, we do not run a big currency risk at Berkshire.

Now, if you talk about the value of the dollar declining dramatically, you know, we all face that risk if we have a lot of dollar assets. I personally don’t worry about the American currency getting worth far less relative to other currencies as much as I worry, I don’t really worry about it, but I think there’s a probability that sometime in the next 20 or 30 years that you could have rampant inflation in this country again. You’ll probably have it around the world. And it’s probably more likely in a good many other countries than it is in the United States. But inflation is always a latent danger to an economy. I mean, I always think of inflation is being in remission at all times, because it’s something that has a cause that will recur in terms of human behavior from time to time. I think in terms of how legislators, legislator behave, and governments behave. So I think I think that the probability of high inflation at some point during the next, say, 20 or 30 years is, it’s not a low, it’s not a low probability. I hope it doesn’t happen. Charlie?

Charlie Munger [03:12:43] Well, in the long term, practically all currencies go to hell. In other words, it’s a product like the Roman, what was it, daus or something. You take the British pound, you take the American dollar so far, and if you want to go out 200 years, will some politicians in the United States ruin the currency? I think the answer is yes. But I wouldn’t anticipate some horrible event in the near future. And, but if things really went to hell, Argentina started confiscating property of shareholders, and if that starts happening and the government is doing it, we probably won’t be able to protect you.

Warren Buffett [03:13:40] That sounds like kind of a nervous laugh to me. Number 6.

[03:13:46] Shareholder (Gautam Dalmia, India): Yeah, hi, I’m Gautam Dalmia from India. Sirs, if I were to take you back to the start of your invest, investing careers, I assume it would have been harder for potential acquisition opportunities to come by. The question I would like to ask you, sir, is how did you ensure then that you had good enough deal flows coming to you to be able to choose from? I have one more question. The Berkshire subsidiaries do not have a retirement policy. What are the implications of this on retaining and motivating employees who are potential successors to senior management?

Warren Buffett [03:14:33] First question about deal flow, which, not, it’s a term I actually don’t like very much because I, we don’t think I’m as deals exactly. We, that has a little too much of the connotation of something to be bought and then again something to be sold. But we do like acquisition opportunities, and really, that’s just achieving that, so that we get the calls when we should get the calls. And there aren’t lots of those because we’re talking about good-size businesses, we’re talking about owners that love their businesses, and it’s going to happen occasionally, but it’s going to happen a few times a year, probably.

I think in the US now that we get a pretty reasonable percentage of the calls that we should get, and that was not true 20 or 30 years ago. We didn’t hear from anybody 20 or 30 years ago, to speak of, because we were looked at much more as being a marketable securities operation, and we just weren’t, we weren’t as well know. It feeds on itself, obviously. If we acquire companies and the people from whom we acquired them are happy about the deal, you know, we’re going to hear from more people. We bought our first furniture operation in 1983. That really led to four other transactions because the people in the first one were happy and they talked to us about the second one, and the people in the second one were happy, and so on.

So, you know, it’s like a, Charlie always describes compound interest as being like, you know, being at the top of a very, of a very large hill with wet snow and starting with a snowball and getting it rolling downhill. And that’s a little bit like the acquisition situation works. We’ve been on a, by being around 38 years, the, it’s been a, it’s been a long, it’s been a high mountain, and in terms of the length of snowball is going by now, it’s going at a pretty good clip and it’s pretty good size and attracts a lot of snow. And that’s good for us.

Outside the United States, we do not seem to be on the radar screen, so we don’t seem to hear about those as much. But we’re hearing about enough in the United States. It’s not a flow in the sense of, I don’t hear about one a week, you know. I don’t probably hear about one a month. But the ones we want to hear about, most of them, I think we’re getting the calls now. I think we’re getting a higher percentage of the calls now than ever in our history we would have gotten. And, you know, that’s all to the good. And if we can do the same thing outside this country, that would be a plus too. But the, this country is a big market, and we’ll just try and spread the word further. Charlie, what was that other question then?

Charlie Munger [03:17:25] Well, well, he talked some about deal flow, and there’s a general assumption that it must be easy to somehow arrange things that you just sat behind a desk and people brought in one wonderful opportunity after another, and you finally selected two out of a hundred, and it would be a virtual cinch. That was the attitude in venture capital until the last two or three years. We didn’t have any of that in the early days, right, Warren?

Warren Buffett [03:18:07] No, that’s right. We were finding our own securities, and we were just looking at the public markets to see is what was available in securities. And we started buying companies, there must have been 20 years when we didn’t buy more than one or two a year. Yeah, they were fairly few and far between, and we didn’t have the money to buy very big ones either. I mean, it was a big deal when we bought Associated Cotton Shops for what in effect was $4 million, or when we bought Hochschild Kohn when we had to come up with $6 million of equity, as I remember, for that deal. And National Indemnity self was $7 million for National Indemnity, and I think $1.4 million, $1.7 million for National Fire & Marine. And I mean, that was all we could handle in those days. So the snowball is, you know, it’s built up as it’s gone down the mountain, and we hope there’s a lot of mountain left and a lot of wet snow, and we’re looking for it to.

Charlie Munger [03:19:06] But it’s fair to say that we were rooting around for those opportunities. We weren’t sitting behind our desks and waiting for some commissioned salesman to come in and present us with opportunities to sign our name. I can think of anything we B in the early days that way. No, Warren, you chased down Jack Ringwalt. Didn’t you go to him?

Warren Buffett [03:19:26] Well, Jack Ringwalt, the ran National Indemnity, and some of you here in the room knew Jack, was a very interesting guy and a friend. And Jack, for 15 minutes every year, would want to sell National Indemnity. Something would make him mad, a claim would come in or something of the sort. So for 15 minutes every year he would want to sell. And I had friend of mine, Charlie Heider, who may be here today, and I had discussed this phenomenon of Jack being in heat once a year for 15 minutes. And I told Charlie, if you ever caught him in this particular phase, to let me know. And there was a day that Charlie called and said, “Jack’s ready.” And I said, “Well, get him over here.” So he came about 11:30, and we made a deal in that 15-minute zone. And it’s, this is absolutely true.

It’s a fascinating story because Jack, having made the deal, and we really did make it in 15 minutes, Jack, having made the deal, really didn’t want to do it. And but he was, he wouldn’t have backed out of a deal. But he said to me after this, after we’d shaken hands, he said, “Well,” he says, “I suppose you’ll want audited financial statements.” And if I’d said yes, he would, said, “Well, that’s too bad, then we can’t have a deal.” So I said, “I wouldn’t dream of looking at audited financial statements. They’re the worst kind,” you know. And then Jack said to me, he says, “I suppose you’ll want me to sell my agencies and to you as well.” And I said, “Jack, I wouldn’t buy those agencies under any circumstances.” If I’d said yes to that, he would have, he, that I wanted him to sell the agency, said, “Well, I wouldn’t be able to do it, Warren. I, we must have misunderstood each other.”

So we went through about three or four of those, and finally Jack gave up and sold me the business. He was an honorable guy, I mean, ’cause he really, I don’t think, wanted to do it. But we met down at Charlie’s office at 19th, I think, in Douglas, and Jack was about 10 minutes late picking up this $7 million for National Indemnity. He was about 10 minutes late because he was looking for a parking meter with a few minutes left on it, and that’s when I knew he was my kind of guy.

Charlie Munger [03:21:51] But at any rate, this process is not easy, and practically anything where you sit behind that desk and this wonderful deal flow is just coming by, you’re in a very dangerous seat.

Warren Buffett [03:22:04] Number 7.

[03:22:04] Shareholder (Jim Maxwell, Omaha, Nebraska): Gentlemen, my name is Jim Maxwell. I’m from Omaha, Nebraska. You put your toe in the water, so to speak, with Level 3 when you gave a deal, or, you know, got involved in that deal with them. And I’m wondering if there’s anything, any area in the telecommunications industry that appeals to you now, or any specific company that appeals to you. Much more importantly, I want to ask about Global Crossing. They’re in bankruptcy court right now. The US military uses them for communications, data telecommunications or something like that. There are two companies that want to buy their assets out of the bankruptcy court. One is a Chinese company, one is a company from Singapore. The US says, “No way, Jose.” They don’t want China to get control of the assets of Global Crossing, mainly because of the military security.

In the last week, the Chinese company has backed out. The Singapore company has come in and said, “We will buy the 80% stake,” and that is now available. But still, if that sale goes through, Global Crossing will not be in US hands. Part of my concern is, if these two companies were in a relationship that was friendly, they were willing to be together, I could see the possibility that they would, the Singapore company would sell later its portion to the Chinese company. Have you ever considered, and if not, why not, buying the assets out of the bankruptcy court, which would be a fire sale? I think that would be good for Berkshire Hathaway. In addition, it would be good for us, the United States, and for future generations. I would suggest that would be your civic duty, gentlemen.

Warren Buffett [03:24:06] Well, I hope I don’t get arrested for leaving without doing this. I frankly don’t have the faintest idea how to evaluate telecommunications companies down the road. That doesn’t mean I don’t understand at all what they do. I probably understand a little bit of what they do. But in terms of figuring out the future economics in that business, what they’re going to, this player or that player is going to look like five or 10 years down the road, I simply don’t know. I mean, it, and I think it’s, it looks like the people who thought they knew three or four years ago didn’t know either, I might add, but that’s another question. I, we, you know, Charlie, what do you know about the telecommunications business?

Charlie Munger [03:25:00] A little less than you do.

Warren Buffett [03:25:02] He’s in trouble. No, we don’t have any idea. You know, if you take, pull out a name, BellSouth, right? I have no idea how that all comes together five or 10 years from now. I mean, I know people are going to be chewing Wrigley chewing gum or eating Hershey bars or Snickers bars five or 10 or 15 or 20 years from now. They’re going to be using Gillette blades, they’ll be drinking Coca-Cola, you know. And I have some idea what the profitability of each one of those will be over time and all of that. I don’t have any idea how telecommunications shakes out, and I, and I wouldn’t believe anybody in the business that told me they knew, because, you know, what would they have been telling me 5 years ago?

So it’s just a game I don’t understand. The, that is, there’s all kinds of things I don’t understand. I don’t know what cocoa beans are going to do next year, you know. I mean, it’d be a lot easier if I did. I could just make all my money on cocoa beans and be much simpler to trying to run a whole bunch of businesses at a Berkshire. But there’s, I don’t worry about what I don’t know. I worry about being sure about what I do know, and telecommunications doesn’t fall within that group.

Charlie Munger [03:26:10] Mostly Berkshire and its history has bought common stocks that practically couldn’t fail. But occasionally Berkshire just makes an intelligent gamble where there’s plenty of chance of failure, but there’s enough chance of success so the gamble is worth taking. And I think it’s fair to say that telecommunications falls in that so far.

Warren Buffett [03:26:32] Yeah, yeah, we might buy some junk bonds in that business. In fact, we have several, in several areas. But as I put in the annual report, we expect losses in junk bonds. We expect, overall, the probabilities are we’ll have a, we’ll have a decent result, maybe better than decent, but we do expect losses because we are dealing with institutions that have demonstrated that they don’t have large margins of safety in their operations. Sometimes, not at all in Level 3, but sometimes we’re dealing with managements that are quite suspect, and I would say that in the history of Global Crossing you had that, although that doesn’t attach itself of the assets now.

But very often in the field, when people get highly leveraged, sometimes they get tempted to do things that they wouldn’t be tempted to do otherwise, and that’s happened in the junk bond field, obviously, and always will happen. But that’s the reason we expect, we expect to have significant losses. And actually, we’ve, they haven’t been that significant. We’ve had losses, and, but we haven’t seen our biggest loss yet, believe me, in junk bonds. But we’ll make a lot of money out of some of them too. It’s a different field. It’s like, it’s like being an insurer of substandard risk. You’ll have more accidents, but you can charge a premium that makes it work out. But our, our, in general, when we buy businesses, we want to buy superior risks. We don’t want to buy a 100 businesses for operation by ourselves with the idea that 15 of them are going to be train wrecks and that the other 85 will take care of it. That’s not our approach to building Berkshire. Charlie, got anyone?

Charlie Munger [03:28:21] No.

Warren Buffett [03:28:22] Number 8.

[03:28:22] Shareholder (Pete Banner, Boulder, Colorado): Yes, my name is Pete Banner from Boulder, Colorado. First of all, Mr. Buffett and Mr. Munger, most of us consider you fellas our heroes, and thank you for that. Thank you. (Applause) On a lighter note versus the chaos…

Warren Buffett [03:28:43] You can stay on the same note, it doesn’t bother…

[03:28:48] Shareholder (Pete Banner, Boulder, Colorado): I wanted to ask, um, what prompted you, considering your general aversion to technology, what prompted you to invest $100 million in Level 3 Communications convertible bonds? And if I get a twofer, I’d like to know, do you still consider Coca-Cola, as you once described, as the inevitable?

Warren Buffett [03:29:13] Yeah, the answer to the second one first. The Coca-Cola, I think ever since I described it that way, in terms of the, I talked about in terms of the probabilities that they would dominate the soft drink market and not lose market share in any way, that they would grow over time. You know, it’s happening year after year. I don’t think the global market share of Coca-Cola products has ever been higher than it is now, and I don’t see anything that changes that in the future. I mean, it is a huge distribution system that has been getting into the minds of more and more consumers since 1886, when John Pemberton, you know, Jacob’s Pharmacy in Atlanta first served up the first one. It is in the minds of people, the product, all over the world, and there’ll be more people, and it will be in their minds more firmly, and over time they should make a little more per drink. So it, I don’t know how in the world anybody would successfully dethrone Coca-Cola.

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

Charlie Munger [03:31:24] Nothing more to say.

Warren Buffett [03:31:26] Number 9, please.

[03:31:26] Shareholder (Steve Rosenberg, West Bloomfield, Michigan): Hi, this is Steve Rosenberg from West Bloomfield, Michigan, now living in New York. Mr. Buffett, the values that you and Charlie stand for and your supreme integrity are an inspiration. Thank you both for serving in such exceptional role models. I have three quick questions for you. The first involves Value Capital LP. Your preliminary FIN 46 disclosure appears to indicate leverage employed of roughly $20 billion in assets, $60 million in equity, or 30 to 35 times. Without revealing any proprietary strategies, how do you derive comfort from this investment, given your aversion to risk, other highly levered partnership blowups, your enthusiasm in shutting down Gen Re Securities’ black-box activities as soon as possible, and all this aside from the fact that it’s less than 1% of Berkshire’s equity and that Mark Byrne is running it?

My second question involves manufactured housing. Can you comment some more on your enthusiasm for the underlying economics of the business, given what appears to be a commodity product with a high level of seller fragmentation, overcapacity, um, and large blowups on the financing side? And what advantage, even if Berkshire’s advantage is in the financing, why not stick only to the financing and not the manufacturing? And my final question involves the gains on securitization that you see in that segment. Um, does the preponderance of gains reported indicate a mispricing of credit risk somewhere in the chain, perhaps analogous to the disconnect you were talking about between triple-B and AAA spreads in the synthetic market and in the bond market? Thank you.

Warren Buffett [03:33:01] Why don’t you elaborate on that third point on securitizations just a bit more? I’m not sure I totally have your point on that.

[03:33:09] Shareholder (Steve Rosenberg, West Bloomfield, Michigan): Just the fact that usually you see gains rather than losses on securitization all the time. Does that indicate that somewhere, when you’re slicing and dicing it, someone is paying too much, not taking the credit risk into, not value it properly?

Warren Buffett [03:33:23] Yeah, okay. Three questions. Value Capital is run by Mark Byrne, as you mentioned. We’ve made a lot of money with the Byrne family. We made money with Jack, and we like, we like Mark and Patrick, who we know, Charlie and I know very well. And Mark is a very, very bright guy who runs what is in effect a hedge fund specializing in fixed-income-type securities around the world. And Mark and his family have significant money of their own in Value Capital, but we have 95 or so percent of the capital in there, and we do not in any way guarantee their obligations. Mark operates with a degree of leverage that is less than most people that operate in that field, but it’s a lot compared to the way we operate at Berkshire. And that’s okay with us. We wouldn’t do it with 100% of our money, and we wouldn’t do it with 50% of our money, but we think it’s a reasonable business as run by Mark, as long as he’s got a lot of money on the downside as well as the upside, which he does. And he’s a very decent guy in addition to being a very smart guy, so we’re comfortable with that.

It may have to get, the figures may have to get consolidated in our balance sheet. We disclose them all now. In our first quarter report, you will see them set out, and in effect, we’ve got $600 and some million, a couple hundred million of retained earnings that Mark’s earned for us, and we feel quite comfortable with that as an investment. We do not regard it as a business part of Berkshire. The consolidated financial statements may make it look like we do, but it is not. We are a limited partner. We have a corporation in between. We have no guarantees of anything they do, and we’re very happy with Mark running that piece of money, even though he does it, as you say, in fixed-income strategies that involve a lot of, they involved derivatives, they involve borrowed money. But I’ve looked at the positions, and they all make sense to me, and they would make sense because Mark, very smart guy, and the money means a lot more to him than it does to us. So we feel okay with that.

We don’t like the idea of consolidating, in the sense that we don’t think it will make, we think it makes our figures less representative of what’s really going on than the way we handle it presently, but the rules are the rules and we’ll do what they say. The second point, Charlie, do you want to comment on Value Capital at all, or no? Okay.

The second, manufactured housing. You know, it is, I mean, practically everybody in manufactured housing is losing money now, and Clayton is making money. They’ve had much sounder policies in terms of how they’ve operated over the years. One of the things they do, most of their houses are sold through their own retail units. They have about, I think, 297 or so retail outlets of their own, and those managers are on a 50/50 profit split, basically, as I remember it, with Clayton, and they’re responsible for all of the, all of the paper they generate. So unlike what was going on a few years ago in manufactured housing, where a manufacturer would sell a house, I mean, it’d be floor-planned to a dealer, and then that dealer could borrow, maybe, if he got some kind of a purchaser on the note, maybe 125% or 130% of invoice price, if he could just create a warm body out there someplace that would a give him some apparent down payment. That situation was just built for disaster.

But at Clayton, the profit or loss off that person who buys the product goes till the obligation is fully paid for. So if a dealer takes inadequate down payments or sells to people he shouldn’t be selling to, it’s going to be his problem, and he’s going to get the repo back, he’s going to have to sell it himself, he’s going to get the loss on the paper charged to him. And that produces an entirely different kind of behavior at the retail level than occurred with many of the other manufactured housing manufacturers. But it’s not an easy business. It’s, Clayton does it the right way. And in fact, if you read Jim Clayton’s book, he will tell, he tells in there about the time he bought his first home in Indiana, and he tells about a little, the funny business that went in, in terms of how the manufacture behaved. And he describes some of the systems that people use to gain the financing, and those activities are coming home to roost in a huge way for both the manufacturers’ housing companies and for the people that finance the retail paper.

Clayton did it right, basically, and they’ll continue to do it right. Even so, there is such a stain over the whole manufactured housing industry in terms of financing that even Clayton is the only one that has, is able to securitize, and as I said earlier, they cannot securitize to the extent, without us they wouldn’t be able to securitize to the extent that even that they could have a year ago. It’s an industry in big trouble. I think we’ll do fine in, because I think we’re in with a class player. I think they’ve got these systems in place that have the right incentives, which you need all the way through the system. And I think Berkshire will make them even stronger, because we will not securitize, we’ll keep it for the portfolio.

The gains on securitization, the point you made is essentially correct, that some of the, when you see a, with lots of gains on securitization, you ought to get a little suspicious. I don’t want to get into more detail than that because it’s an accounting question. Charlie?

Charlie Munger [03:39:27] I’ve got nothing to add to that either.

Warren Buffett [03:39:30] Number 10.

[03:39:30] Shareholder (Phil McCaw, Connecticut): Phil McCaw, Warren, from Connecticut. Could you comment on Gen Re and goodwill impairment charges in the, in, since you purchased it, and how, how it’s evolved in your thinking, and if it even became part of your… Thank you.

Warren Buffett [03:39:45] Sure. The question is, relates to the fact that if you buy a business at a price over tangible assets, that you set up a goodwill account. And if at any time in the future that goodwill becomes impaired, you should, and must, if the accounting is proper, run a charge to reduce that goodwill item. You run a charge through the income account. We have a large goodwill item for Gen Re because it was the biggest acquisition we ever made. We paid substantially more than book, and the question is whether that goodwill is impaired. And certainly, if the operations of Gen Re of the last couple of years, not including this year, but of the years ’98 through 2001, more or less, were representative of the future, you would say that there has to be a good, big goodwill charge there, and I would agree with you.

I think that as Gen Re is operating now, and had the capacity to operate, and it’s being realized now, thanks to a couple of great managers we’ve got there, I think that, I personally think that Gen Re is worth more now, today, than at the time we bought it. And I think you will, it has, its float has increased substantially, and I think that you will see that float, you will see the float turn out to be coste over time.

One thing I should have mentioned, actually, is, and I looked at a draft of our 10-Q, we have to, I think we should put this in there. We, Gen Re, up until this year, was discounting workers’ comp reserves at 4.5%, which was not conservative, that we inherited that situation, but we have changed that to discounting comp reserves going forward at 1%. So the accounting is more conservative going forward now, 2003, by a fair margin, than it was in prior years and in the method we inherited. So that the figures you see would be somewhat better if we had continued the old discounting at 4.5 rather than go to the new discount rate. And in the draft I saw of the 10-Q, that wasn’t in there. I think we should get that in there, Marc, while I think of this. Charlie?

Charlie Munger [03:42:11] Yeah, that accounting issue is up at top, type that is very common within Berkshire. We are so horrified by the terrible business decisions we see made all around us by people who are relying on over-optimistic accounting that we tend to almost reach for opportunities to make our accounting very conservative, way more than other people. We think it protects our business decision-making as well as our financial integrity. I don’t know why we ever got into this business of trying to get the accounting result as close to the chalk as we could possibly get it. What is wrong with the world when everything is a little bit underreported? I mean…

Warren Buffett [03:43:02] Yeah, generally people think that reporting and, you know, and transparency and all that is improved over the years. You, I felt much better working with the financial statements in 1960 than I feel working with financial statements in 2000. And frankly, in many ways, I thought they taught me more about what the company was really about than the current ones do, even though there was far less detail. And what we really deplore is solving operating problems by accounting maneuvers. And, you know, Gen Re had some problems in the mid-’80s, when everybody did, and they went to discounting their workers’ comp reserves, and they, you know, it was a quick fix, but it’s like heroin, and you get on it and it’s not easy to get off.

And we, Charlie and I have seen that time and time again, people that think, you know, trade loading, whatever it may have been, they think they’re going to solve something by playing accounting games. And they’re encouraged, they’re encouraged by their CFOs sometimes, and frequently they were encouraged by their big-name auditors, in one way or another, to really play with the numbers. And it catches up with you. You might as well face reality immediately and take whatever operating steps are necessary to solve problems, or if you can’t solve them, just give up on them. But whatever you do, playing with the numbers is, it never, it never works. Although I guess if you’re 64 and a half and you’re going to retire at 65, it might get kind of tempting. Number 1.

[03:44:39] Shareholder (Andy Marino, Chapel Hill): Good afternoon, gentlemen. Andy Marino of Chapel Hill, by way of Boston. You have argued against the use of alternate measures of profitability, such as earnings before interest, tax, depreciation and amortization, as measures of business performance. At the same time, you have frequently cited the incompleteness of generally accepted accounting in reflecting economic reality for some businesses, implying that there are some necessary improper adjustments beyond what you recently described in the annual report as the folly of omitting depreciation. Could you elaborate on your thoughts on other pitfalls of alternative financial presentations? Is EBITDA, in your view, just too often used as a shorthand for cash flow, or is the entire concept of recasting accounting data a suspect exercise? And which revisions might be appropriate, if any, and what might be viewed as red flags? And does it matter to you who is making those adjustments, analysts, investors for their own purposes, or company managements, in terms of how that information should be viewed?

Warren Buffett [03:45:53] Yeah, we regularly told you, for some years before the accounting change was made here a year or so ago, we told you you should not count goodwill amortization. You know, it was required under GAAP, and we obviously complied with GAAP, but we told you every year, virtually, that I can remember. We said this is not really an economic expense, and we ignore it in our own calculations of earnings. In terms of what we will pay for businesses, we don’t care whether there’s a goodwill item or not, because it’s immaterial to economic reality. So we have been quite willing at Berkshire to tell our own owners to ignore certain things. And if they disagreed with us, they could look at the GAAP figures, but we felt they were getting misled by looking at the amortization of intangible. Um, that doesn’t mean we think all intangibles were good, but we just, we did feel that that was a, that was an arbitrary and decision that didn’t make any sense at all.

Um, and we’ve felt, obviously, as we’ve talked about, we’ve felt the crazy pension assumptions have caused people to record phantom earnings in many cases. So we’re willing to tell you when we think there is data that is more important in economic analysis than GAAP figures. We’ll talk to you about it. Not thinking of depreciation and expense, though, strikes us as absolutely crazy. I can think of very few businesses, I can think of a couple, but I think of very few businesses where depreciation is not a real expense. Even at our gas pipelines, I mean, you know, at some point they are a, they will need, they’ll need repairs, but beyond, at some point they become obsolete. I mean, there won’t be gas there 200 years from now, we know that. So that it, depreciation is real, and it’s the worst kind of expense. It’s reverse float. You know, you lay out the money before you get revenue, and you are out cash with nothing coming in. And depreciation, any management that doesn’t regard depreciation expenses, you know, is living in a dream world.

But of course, they’re encouraged to do that, you know, by investment bankers who talk to them about EBITDA. And then it, you know, certain people have built fortunes on misleading investors by convincing them that EBITDA was a big deal. And when we see companies that say, “Hey, we don’t pay any taxes,” and, you know, “because we don’t have any earnings for tax purposes,” and don’t count depreciation and all of that, you know, that’s coming, in our view, many times that’s coming very close to a flimflam game. You know, I get these people that show me, you know, they want to send me books with EBITDA, and I just tell them, you know, I’ll look at that figure when you tell me you’ll make all the capital expenditures. If I’m going to make the capital expenditures, there’s very few businesses where I think I can spend a whole lot less than depreciation year after year and maintain the economic strength of the business.

So I think, I think the EBITDA has been a term that has cost a lot of investors a lot of money. You saw it in the telecom field. I mean, the idea that they were spending money so damn fast, you know, I mean, they couldn’t have it coming in the door fast enough from investors, and then they pretended that depreciation was not a real expense. That, that’s nonsense. I mean, it couldn’t be worse. And a generation of investors were sort of brought up to believe in that. We at Berkshire will spend more than our depreciation this year. We spent more than our depreciation last year. We spent more than our depreciation the year before that. You know, depreciation is a real expense. It’s just as much as, you know, the expenditure for lights. It’s not a non-cash expense, it’s a cash expense. You just spend it first. You know, I mean, the cash is gone, and it’s a delayed recording of cash. How anybody can turn that into something they use as a metric that talks about earnings is beyond me. Charlie?

Charlie Munger [03:50:14] Yeah, I think you would understand any presentation using the word EBITDA if every time you saw that word you just substituted the phrase earnings.

Warren Buffett [03:50:24] I knew he’d do it sooner or later. (Applause) Folks, and the, he made it through the morning, but never all day.

Charlie Munger [03:50:36] And the man asked the question also says what remaining big accounting troubles exist. The real lalapalooza is pension fund accounting and, to some extent, post-retirement medical liabilities. Those are horribly understated now in America, and they’re very big numbers.

Warren Buffett [03:50:58] I’ve looked at financial statements, and you’ve seen them too, in the last few months, where companies are recording pension income in the hundreds of millions, while at the same time being underfunded in their pension plan in the many billions. And, you know, they just aren’t facing up the reality at all, and they don’t want to because they don’t want to take the hit. And they’re, this, you know, it’s the same mentality as stock option expenses. And they are paying people with stock options, but, you know, we pay people with cash bonuses, and I suppose, you know, we might, isn’t really true, but we might like it if we didn’t have to record cash bonuses and expense. I mean, it’s a way we pay people.

And you can say, well, why don’t you put it in the footnotes and leave it out of the income account, like they do with option expenses, which is a form of compensation too. But the, you know, the answer is that a bunch of people who cared very much about having their stocks float to unreasonable prices, at least in our view, found they could do it a lot easier if they didn’t count compensation expenses. And, you know, why not put all expenses in footnotes? Just have an item there that says sales, and then have the same figure for net profit, and then just have all the expenses in the footnotes, you know. That, and people with a straight face, you know, say, “Well, it’s in the footnotes, so therefore everybody knows about it and we don’t have to count it.” Put it in the income account. It’s amazing what people with high IQs will do to rationalize their own, you know, their own pocketbooks. And Charlie has another explanation for why there’s been this denial of the reality of expense, option expense, in terms of people’s ego getting involved with their own records. You want to elaborate on that, Charlie? Don’t name names.

Charlie Munger [03:52:49] Well, no, I’m so tiresome on this subject, and I’ve been on it for so many decades. It’s such a rotten way to run a civilization, to make the basic accounting wrong. It is very much like making the engineering wrong when you’re building a bridge. And when I see reputable people making these perfectly ridiculous arguments to the effect that, okay, it’s unthinkable that options be expensed, or it’s too difficult to value, well, because it’s too difficult of value, or God knows what reason, and there, a lot of them are people you’d be glad to have marry your daughter, and yet…

Warren Buffett [03:53:37] Yeah, because they’re rich, for one thing.

Charlie Munger [03:53:40] Yet the truth of the matter is, there’s somewhere between crazy and crooked.

Warren Buffett [03:53:49] Put him down as undecided. It’s really a, the interesting thing, is of course now is that the four auditing firms left, what would they call, the Final Four now in the auditing, they have now, and, and listen, I’m glad they did it, and I tip my hat to them for doing it, but they now said that they really do think options are an expense. So this is, you know, that it kind of reminds you of what happened during the Reformation, isn’t it? You know, when you’d have these places sway back and forward, you know, as they get carried by one argument or the other.

In fact, I think there was that famous vicar of Bray who would swing from Catholicism the Luther, back and forth, as this little town went back and forth in Germany. And finally the townspeople gathered, and they said to the vicar, they said, “It’s understandable that we’re confused by all that’s going on in theology, and we really don’t know much about it, and so we swing back and forth. But,” they said, “we find it a little disgusting that you, a man of the cloth, would also keep swaying back and forth.” They said, “Have you no principle?” And he said, “Yes, I have one principle,” he says. “It’s to remain the vicar of Bray.” Well, I think we’ve seen a little of that in the auditing profession. But I’m, I think they’ve actually found the true religion now, so I’m not, I don’t want to sit here and criticize them. But, you know, you have now have four firms that lobbied against options being counted as an expense in 1993 that have written the FASB and say that options should be an expense. And I don’t know how in the world something could have not been an expense in 1993 and be an expense in 2003. Certainly didn’t apply to utility bills or, you know, raw materials or anything of the sort. But that’s the human condition. Number 2.

[03:55:44] Shareholder (Sam Kidston, Cambridge, Massachusetts): Yes, hi, Sam Kidston. I’m a shareholder from Cambridge, Massachusetts. I have a couple of quick questions for you guys. First of all, other than your general criteria for investing in any company, what are your criteria for investing in banks, and has your general view toward investing in banks changed over time? Second question would be, in terms of a discount rate, do you feel it’s appropriate to use your cost of capital or the current risk-free rate? And then, in the past you’ve mentioned that you do some sort of pseudo bond arbitrage, and would you please specify what types of trades you do in this area?

Warren Buffett [03:56:22] Oh, you’d like our buys and sells for Monday morning. The, we don’t, we’re not going to talk about specific strategies that, you know, we obviously think they’re profitable or we wouldn’t be doing them, and we think other people might copy them if we talked about them. So, and we have pointed out, incidentally, and we will continue to point it out, that there’s not a long life to these bond strategies necessarily. That doesn’t mean we might not re-employ them when circumstances called for later on. But they’re not like earning money out of See’s Candy or, you know, out of Fruit of the Loom or something. They’re opportunistic situations that we’re pretty well positioned to engage in at certain times.

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

Charlie Munger [03:58:12] Well, what you’re saying, in fair implication, is that we sort of screwed up the predictions, because banking was a way better business than we figured out in advance. We actually made quite a few billions of dollars, really, out of banking, and more in American Express. But, but basically, that was while we were, and my only prediction is that we’ll continue to make failures like that.

Warren Buffett [03:58:44] It’s fairly extraordinary, in a world of, particularly a world of low interest rates, that you’d find financial institutions that basically doing pretty much the same thing, you know, where A competes with B and B competes with C, without great competitive advantage, and having them all earn really high returns on tangible capital. Now, part of it is that they push, they have pushed the loan dep, you know, loan to capital ratios higher than 30 or 40 years ago. But that, nevertheless, they earn high rates of returns. They earn much higher rates of returns on assets alone, and then they have greater leverage of assets to capital, so that produces returns on capital that really are pretty extraordinary. And, you know, banks, certain banks, get into trouble because they make big mistakes in lending. But it’s not required of you in that business to get into trouble. I mean, you can, if you keep your head about you, it can be a pretty good business.

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

Charlie Munger [04:01:06] Never. And this is a very interesting thing that’s happened. If you take the most powerful freshman text in economics, which is by Mankiw of Harvard, and he says on practically the first page that intelligent people make their decisions based on opportunity cost. In other words, it’s your alternatives that are competing for the use of your time or money that matter in judging whether you take action or not. And of course, those vary greatly from time to time and from company to company. And we tend to make all of our financial decisions based on our opportunity cost, just doesn’t like they teach in freshman economics. And the rest of the world has gone off in some crazy kick where they can create a standard formula, and that’s cost. They even get a cost of equity capital for some business that’s old and filthy rich. It’s a perfectly amazing mental malfunction.

Warren Buffett [04:02:22] Yeah, a m… Number 3. Is there anybody we’ve forgotten to offend at…

[04:02:28] Shareholder (Karen Kalish, St. Louis): Hi, my name is Karen Kalish, I’m from St. Louis, and I think I’m the first woman to ask a question today.

Warren Buffett [04:02:37] We’re all for that.

[04:02:38] Shareholder (Karen Kalish, St. Louis): My late uncle, Bill Shield at Robert W. Baird, first bought Berkshire for our family when it was $337. And I’m very grateful to you two because I’ve been able to start a foundation in St. Louis and give money away, and I give it to reading and literacy programs. But I’m very curious about the Buffett-Munger philosophy and practice of philanthropy. And my second question has to do with China. You made an acquisition recently, PetroChina, and I’m curious of what you think about China.

Warren Buffett [04:03:13] Well, the second question. We have about, I think, about five equity investments in companies that are domiciled and that operate primarily or entirely outside the United States. We don’t list all our investments. We listed, I believe, last year all those above $500 million, and we have never had, I think maybe since Guinness some years back, I don’t think we’ve ever had one hit the threshold of reporting in the Berkshire report, although we’ve owned some. And the Hong Kong Stock Exchange has just recently changed the requirements so that you have to report 5% of the holding of any company listed on the Hong Kong Stock Exchange. And our PetroChina holdings actually are now, whatever it is, 13.3%, but they’re only 13.3% of something called the H shares. The Chinese government owns 90% of it, of the company. The H shares own 10%. They sold that to the public a few years back. So we own 13.3% of a very small percentage, and it’s a kind of a fluke of reporting that we’re required to report that particular holding. And like I say, we own four or so others in international securities.

We don’t make any great judgment about China. You probably know more about China than I do. We simply look at investments around the world, and we try to buy into things that we think offer the most value. And in, they’re in the, if they’re in the unit, we might prefer slightly that they be in the United States, and we might have strong preferences against, or strong biases against, certain countries. Um, we would regard the United States as number one, because we understand the game the best here, we understand the tax laws and all that sort of thing, and the corporate cultures, and so on. But we would regard a number of other countries that’s virtually equivalent to the US, and there’s others that would been marked down some, and then we’d have a whole bunch we wouldn’t go into under any circumstances ’cause we just don’t understand them well enough.

But, you know, we think we understand something like the oil business in China reasonably well, and at a price relative to what we think the future cash generation is, we would make a decision on something like that. But it’s not a big deal. It’s a big, it became reportable because of this peculiarity of the law where if you own a certain percentage of something that’s only 10% of of the whole pie, you still have to report it. The Chinese government is firmly in control of PetroChina. I mean, if we vote with the Chinese government, the two of us will control PetroChina. That’s a… The question about philanthropy. Charlie, you want to swing at that one first?

Charlie Munger [04:06:05] I think it’s fair to say that both of us feel that the very fortunate owe a duty to the general civilization, and even to the country of which he’s a member. Whether you give as you go along, or have the Buffett system of moderate giving as you go along and immense giving in due course, I matter regard as a matter of personal taste. I would understand the second position, in that I would hate to spend all my time every day having people ask me for money, and I don’t think Warren could stand it. Is that…

Warren Buffett [04:06:57] Let’s not even try. Let’s not even try, Charlie. No, oh, way. I mean, it’s a matter of record and hasn’t changed for, I don’t know, 25 years, probably. But basically everything I have, at the date of the later of the death of myself or my wife, goes to, goes to charity. I mean, that 99 and a significant fraction. And since my children here, I’m not going to carry it out to eight decimal places. But the, you know, why not? It, think of it this way. Here, here’s, here, let’s just assume that instead of being born as I was, in a single birth, that I were in the womb and there was an identical twin next to me. Same DNA, same everything, personality, propensity to work, propensity to say whatever. Identical twin, wasn’t Charlie. It might look like him, but.

And there we are, the two of us, and a genie appeared, and the genie said, “I’ve got a proposition for the two of you. You’re going to be born in 24 hours. Same talents, everything identical. And one of you is going to be born in Omaha, and one of you is going to be born in Bangladesh. And I’m going to let you two decide which one gets to be born in Bangladesh and which one gets to be born in Omaha. And I’ve got this system, and what, the way I’m going to work it is that you, we start the bidding, and whichever one of you bids the highest proportion of your estate to go to society when you die gets to go be born in the United States.” I think you’d bet 100%, you know it. You hear all of this about, you know, grit and pluck and all of these things, and how, you know, you’ve applied yourself working all your life and you’ve done all these wonderful things. Well, just imagine if I’d been born in Bangladesh, you know, and I’d walked down Main Street and said, “You know, I allocate capital, you know, let me show my stuff.” You know, I’d have died of malnutrition. I mean, it would, I wouldn’t have made it through the first few months. The society that Charlie and I work in, I mean, we were luckier in hell. I mean, when we were born, the odds were 50 to 1 against us being born in the United States. So we hit the jackpot. And basically, it, you know, we’ve had all of the fun of working with us and working with good people, and money obviously opens lots of doors in life to interesting things. And if it goes back to society, like Charlie says, it can go back on the installment system through life, it can go back in a lump sum at death. I’ve mixed the two to some extent, but I weight heavily the lump sum. But, you know, that’s where it belongs. I mean, it, there’s no reason why little generations of little Buffetts, now and the next one, you know, and 100 years from now, should all be commanding the resources of society just because they came out of the right womb. You know, what sort of justice is that? So, so basically, it’s going back to society. Were my children applauding there? Did we check that out? Number 4.

[04:10:28] Shareholder (Alex Rubalcava, Los Angeles): Hi there. My name is Alex Rubalcava. I’m a shareholder from Los Angeles. I have a question about the financial characteristics of the businesses that you like to acquire and invest in. In your reports and other writings, Mr. Buffett, you state that you like to acquire, um, businesses that can employ a large amount of capital to high returns. And in reading the writings and speeches of yourself, Mr. Munger, I’ve seen you say in Outstanding Investor Digest and other publications that you enjoy investing in companies that require very little capital. And I was wondering if these statements are at odds, or if they are two sides of the same coin, and if you could elaborate using Berkshire companies, that’d be great.

Warren Buffett [04:11:26] Sure, it’s a good question. The ideal business is one that earns very high returns on capital and could keep using lots of capital at those high returns. I mean, that becomes a compounding machine. So if you have your choice, if you could put $100 million into a business that earns 20% on that capital, say $20 million, ideally it would be able to earn 20% on $120 million the following year and $144 million the following year, and so on, that you could keep redeploying capital at these same returns over time. But there are very, very, very few businesses like that. The really, unfortunately, the good businesses, you know, take a Coca-Cola or See’s Candy, they don’t require much capital, and incremental capital doesn’t produce anything like the returns that this fundamental return that’s produced by some great intangible.

So we would love the business that earn, that could keep deploying, in fact, even well beyond the earnings. I mean, we’d love to have a business that could earn 20% on $100 million now, and if we put a billion more in it, it would earn 20% more on that billion. But like I say, those businesses are so rare. There are a lot of promises of those businesses, but we’ve practically never seen one. There’s been a few. Most of the great businesses generate lots of money. They do not generate lots of opportunities to earn high returns on incremental capital. You know, we can deploy X at See’s and earn a lot of money, but if we put, if we put 5X in, we don’t earn any more money, to speak of. We can earn high returns on X at the Buffalo News, but if we try to make it 5X, we don’t earn any more money. It, they just don’t have the opportunities to use incremental capital. We look for them, but they don’t.

So the great, you’ve seen, I mean, we will talk theoretically about the businesses are going to earn more and more money with incremental capital at high returns, but what you’ve seen is that we’ve bought businesses largely that earn good returns on capital, but in many cases have limited opportunities to earn anything like the returns they earn on their basic business with incremental capital. Now, the one good thing about our structure at Berkshire is that we can take those businesses that earn good returns in their business but don’t have the opportunity for returns of a similar magnitude on incremental money, and we can move that money around to buy more businesses. Normally, if you’re in the, take the newspaper publishing business, which has been a fantastic business over the years, you earned terrific returns on your own invested capital. But if you went out to buy other newspapers, you had to pay a very fancy price, and you didn’t get great return on incremental capital. But the people in that business felt that the only thing they knew was newspaper publishing, or media of one sort or another, so they felt that their options were limited. We can move money any place that it makes sense, and that’s an advantage of our structure. Now, whether we do a good job of… not, another question, but the structure is enormously advantageous in that respect. We can take the good business, the See’s Candy… See’s has produced probably a billion dollars pre-tax for us since Charlie and I… wouldn’t have gone up a 100,000, you know, back in 1972. If we tried to employ that in the candy business, we’d have gotten terrible returns over time. We wouldn’t have gotten anything to speak of. But because we moved it around and enabled us to buy some other businesses over time, and that’s an advantage of our structure. Charlie?

Charlie Munger [04:15:06] Yeah, and if you take a business that is a good business but not a fabulous business, they tend to fall into two categories. One is the business where the whole reported profit just sits there in surplus cash at the end of the year, and you can take it out of the business and the business will do just as well without it as it would if it stayed in the business. The second business is one that reports the 12% on capital, but there’s never any cash. It reminds me of the used construction equipment business of my old friend John Anderson, and used to say, “In my business, every year you make a profit and there it is, sitting in the yard.” And there are awful lot of businesses like that where just to keep going, to stay in place, there’s never any cash. Now, that business doesn’t enable headquarters to drag out a lot of cash and invest it elsewhere. We hate that kind of a business. Don’t you think that’s a fair statement?

Warren Buffett [04:16:09] Yeah, that’s a fair statement. We like to be able to move cash around and have it find its best use, and… but that, you know, that’s our job, and sometimes we find good uses. It would be terrific if every one of our great businesses, and we’ve got a lot of great businesses, had ways to deploy additional capital at great rates, but we don’t see it, and frankly, you know, it doesn’t happen. I mean, the Gillette has a great razor and blade business. I mean, fabulous. There’s no way they can deploy the money they make in the razor and blade business to keep putting more money in that kind of business. It just doesn’t take that kind of capital. They have to deploy some money, but it’s peanuts compared to the profits.

And the temptation then is to go out and buy other businesses, and of course that’s what Charlie and I do when we face that. But we don’t think that overall the batting average of American industry in redeploying capital has been great. Nevertheless, it’s what we try and do every day. In a sense we sort of mo… the very procedure that has gotten us to where we are. Is that a fair statement, Charlie?

Charlie Munger [04:17:21] Absolutely. And that has always worried me. I don’t like being an example of an activity where most people who try and follow it will get terrible results, and we try and avoid that by making these negative comments.

Warren Buffett [04:17:39] We’d make negative comments anyway. Number five. It’s more fun.

[04:17:43] Shareholder (Will Graves, Winter Park, Florida): I’m Will Graves from Winter Park, Florida. I’m an a graduate instructor with Webster University, and I’d like to address two questions to Mr. Buffett. I appreciate the accessibility of Mr. Buffett. He makes us feel so warm here. Can I call you Dad?

Warren Buffett [04:18:03] Yeah.

[04:18:04] Shareholder (Will Graves, Winter Park, Florida): I’ve got one question regarding a national treasury situation and one considering a national treasure. Back in September 11, you appeared on 60 Minutes and performed a national service, taking your valuable time and giving up your private life for a few moments by speaking about the general stock market and how people should not be getting too excited and they shouldn’t be worried about investing for the long term. And what I was wondering is if you would ever consider making another appearance on 60 Minutes at the time when whoever the president is at the time brings up the Social Security debate.

I spend a lot of time with nonprofit organizations, and the outrage that you hear from the working poor is that we talk about the tech turnaround, the tech profits of the last few years. They’ve gone through a whole cycle where people became multi-millionaires at a time when the working poor never even got a minimum wage increase. And if you think of people like this who have a net worth of $1,000 or less, just as an example, and just imagine what it’s like for them to be forced in the future to be horrible investors because the US government forces them to have something called Social Security, which they can’t get out of, and they get a lousy return. What I’m wondering is if you would consider, when we have a candidate, whoever it might be at the time, say that you don’t want to put a small portion of Social Security into the long-term stock market because it’s a risky proposition, if you would take your track record on 60 Minutes and say, “I don’t think so.” That’s the first question.

And number two, while I’m asking you to volunteer for something, I found myself being thrust into something in the last three weeks. I went to Cypress Gardens the last day with about 20,000 people there, and a lady was handing out 15,000 flyers. Several weeks from now I’ll be before Governor Bush with the Friends of Cypress Gardens. We have a website, friendsofcypressgardens.org, trying to keep a developer from clear cutting the trees in Cypress Gardens, a national treasure. And my question is, would you consider contacting your cousin Jimmy Buffett about possibly helping us in some way? Doesn’t have to be money. It might be an appearance, just might be some connections where you might be able to help us in our efference.

Warren Buffett [04:20:33] I get asked to contact… probably the one I get asked to contact the most is Bill Gates, but I get asked to contact all kinds of people. And I mean, everybody is slipping me envelopes with letters in them, sending things to the office and saying, “Won’t you get this person? You know, all they can say is no.” I don’t do… I don’t make requests of my friends, basically, for anything. And I just… I would spend the rest of my life doing it. They would feel… I would never know, you know, what they were doing. You know, I would never know what they were doing because I was asking versus what they really felt. I mean, it’s an impossible, from my standpoint at least, that’s an impossible game to get into.

In terms of… I mean, when Kay Graham was alive, everybody, you know, wanted her for one reason or another, and they’ve all got causes. And frankly, they, you know, they want to use me to get her or Jimmy Buffett or whomever to say yes to something that they’re saying yes to partially because they feel they don’t want to say no to me. And I, you know, that… I just don’t want to use my friendship for that purpose, frankly. And I don’t do it even for things that I strongly believe in myself. I do them, they may know what I’m doing, and if they want to pick up on it, fine. I mean, but I have never… I can’t remember ever requesting anybody to make a contribution or do anything myself. I mean, what I do is a matter of record, and, you know, if other people want to pick up on it, fine.

But I’ve never had one of those honorary dinners where they send out, you know, to all those suppliers to Berkshire and everything and started leaning on them and saying, “You know, we’re honoring Warren.” Well, hell, if they want to honor me, they can honor me without soliciting all my friends for money. I mean, that’s… I don’t consider that much of an honor if the reason they picked me was because I got rich friends. So I just don’t do that.

On the public policy question, what I did on September 11th, when Jack Welch and Bob Rubin and I went on there, that, you know, I will do those things. Al… I’ve written some op-ed pieces, I think, and I get tempted very, very often. In fact, I’ve written some that I haven’t sent in. But I do think that there’s something unattractive about a very rich guy that pops off on everything. And you may think by listening to us today that you’ve got two guys up here that do like to pop off on everything, but… and we do have opinions on almost everything, but I just think… there’s something things I get, you know… I wrote on campaign finance reform and I’ve written on taxes, and I will do more of that.

But I do try to hold myself in check somewhat, because there is a little bit of, you know, this “I’m rich, therefore I’m right” type stuff that I don’t think sits very well. And I know when I see it in other people, I don’t like it, that, you know, “I’m a celebrity, therefore, you know, you got to listen to me on everything that I say.” And it just turns me off at some point. But like I say, I have done it, and there could be occasions, and there will be occasions, I’m sure, when I’ll cross my threshold level and figure I really want to… I want to say something, and people can ignore it or otherwise. But I think there’s some danger of overexposure on that sort of thing, and I think you’ve seen it with certain people. Charlie?

Charlie Munger [04:24:04] Warren, would you agree or disagree that forcing a certain part of Social Security into common stocks is a good idea?

Warren Buffett [04:24:12] No, I would not. Actually, I would not agree with the one that the gentleman suggested. I think that actually Social Security has been a tremendous thing for the working people of this country. It’s been an intergenerational pact. It’s not insurance. It simply says, like a family might say, except it extends the concept of family to the whole United States, that if you produce for this country when you’re between the ages of… and I think the upper age limit should be extended, but between the ages of X and 65, the society will provide some base level of income for you for the rest of your life. And I think a rich society should do that. So I think that when you have a $10 trillion society, you know, we should do that.

Charlie Munger [04:25:02] I would agree. I think Social Security, you can argue it’s one of the most successful governmental programs we have, and people treat it as a pure disaster coming or something like that. That’s not my view at all. And I wouldn’t put it in common stocks either. I think Social Security works pretty well just about the way we’re doing it.

Warren Buffett [04:25:23] Yeah, we will give a base income to every… and we should in this country, everybody that leads a reasonably productive life. And they don’t have to worry about how long, you know, whether they live to be 90 or 100. And people do worry in their old age. And we don’t need a bunch of people who, you know, go off to war when we need to defend, you know, the rights of our country, and act in every way as good citizens, but they just don’t happen to have the ability to make a lot of money, you know, like maybe Charlie and I can. I think they need a base level, and I think that an intergenerational compact like we have is a… it’s really a magnificent idea, and I think the country is a lot better off for it.

I think that telling them that they can save 500 bucks or 1,000 bucks and put it into stocks and have everybody lobbying Washington about, you know, who will handle… you know, everybody thought it was a great idea a few years ago, and I think it’s a very bad idea, frankly. Charlie?

Charlie Munger [04:26:39] I like it a lot less than you do.

Warren Buffett [04:26:43] Number six.

[04:26:44] Shareholder (Ravi Gilani, New Delhi, India): Good afternoon. My name is Ravi Gilani. I come from New Delhi, India. I have questions regarding management policies. Since you follow quite different management policies, I would like to know the impact of them on the management, CEO’s motivation. Mr. Munger has mentioned that where capital is unimportant in a business, you tend to give the CEO a part of the earnings. You have also mentioned that you do not greed good work by raising the bar. Clearly, static earnings over a period of time may become successively less valuable. My question is in now four parts. Bearing the above in mind, could you give us an example of compensation policy in Berkshire subsidiaries which illustrate your thinking on the subject of executive compensation?

Number two, though you do change subs… charge subsidiaries for using capital and believe in linking rewards to bottom line performance, Mr. Munger does not respect economic value added as a concept. Could we have your thinking on EVA as a tool to monitor and reward corporate performance? Number three, do you restrict yourself to setting compensation policy for the CEO, or do you involve yourself in larger part of the organization? And finally, you do not have any retirement age for the CEO. Does it impact the moral, motivation of the people below the CEO?

Warren Buffett [04:28:29] Charlie? He knew that was coming.

Charlie Munger [04:28:33] Well, one, you’re right. Where a business requires practically no capital, we tend to reward the management based on the earnings. The minute the business starts requiring capital, we tend to put a capital factor into this compensation system. We don’t have any one standard system. They’re all different, based on accidents of history and circumstances. But where capital’s important factor, of course we take it into account. As far as effects on morale, as far as I’ve ever been able to see, the morale is pretty good in the Berkshire subsidiaries, and the Berkshire managers practically never leave. And my guess is we have about as low a turnover rate as any place around. Is that right, Warren?

Warren Buffett [04:29:37] Well, I’m sure of that. And besides, the no retirement policy is wonderful for my morale, and Charlie’s. You also asked about EVA. We would not dream of using something like that, although I think actually a few of our subsidiaries may use it in some way. So the subsidiaries set their policies for the pay of the people below the CEO, and the… and all, they have all kinds of systems, because we have all kinds of businesses. And frankly, we’ve never had big problems with compensation, because I think our arrangements are rational. When capital is an important part of the business, we stick a charge for capital in. If it’s an unimportant part of the business, we don’t stick it in. We don’t believe in making things more complex than needed.

So we don’t try for little… all kinds of little refinements, which a compensation consultant would come in and tell you was needed, because that’s how he would justify a large bill. And he would also come in and tinker with a little the following year and the following year and so on. We have very simple systems on comp. But some of our businesses are terrific businesses, and so we have very high standards of performance before people get performance bonuses. Some of our businesses are very tough businesses, and the threshold is much lower, but the managerial talent needed to reach that threshold is just as much as in the… with the higher threshold in other businesses.

It’s not… compensation is not rocket science. I mean, people will want you to think it is, and you read these proxy statements and it blows your mind what they get into. I mean, the proxy statements are thicker than the annual reports, because they’re talking about the compensation of people. And it is not that complicated. We’ve had, in 38 years, we have never had a CEO leave us to go to another business, except a few where we’ve made the decision ourselves, but very few. And it is… you know, I see all of the time and effort put in, because… put in because frankly it pays off for the CEO to do it. And then they create a whole department that spends all their time attending conferences about, you know, about compensation methods, and they have consultants in, and it becomes… it becomes an industry, and it isn’t going to break itself up.

I mean, you… when you get those… when you get a huge bureaucracy involved and making all kinds of pay determinations and everything, it’s never going to go away unless you do something about it. But that’s true… that’s true of any bureaucracy. We run into… we don’t have much bureaucracy at Berkshire. I think that there’s no question that our no retirement policy means that somebody who’s just itching to be the CEO of a business, and they see that the CEO is 65 and then 70 and then 75 above them at some of our companies, is probably not going to stick around. I mean, we don’t develop naturally lots of number twos, because we can’t promise them that number one is going to go out the door. But as long as number one doesn’t go out the door, from our standpoint that’s just fine. And we occasionally have to replace managements, but it’s very occasional. I mean, if on an expectancy basis, you know, with the… even with all the subsidiaries we have, you know, we may face one management succession polic… problem perhaps every 18 months or something of the sort, and we got all kinds of other businesses, so it’s not a big deal at Berkshire.

Charlie Munger [04:33:15] Yeah, and on EVA, there are ideas implicit in that that we use, for instance hurdle rates by op… based on opportunity costs, perfectly reasonable concept. But to us, that system, with all its labels and lingo, has a lot of baggage that we don’t need. We just use the implicit simple stuff that’s buried in EVA.

Warren Buffett [04:33:36] Yeah, we could spend a million bucks a year on consultants to get an answer we can get in 5 minutes, frankly. I mean, it is… it just isn’t that complicated. But can you imagine a consultant coming around and saying, “I’ve got a one paragraph compensation arrangement for you”? Are they going to be able to send you a large bill for, you know, their consultancy? Of course not. So they’ve got to make things complicated, and we don’t believe in that. We want things that are very easy to understand, and that… and we’ve just never had a problem with it, and we get good results out of our managers.

The main reason we get good results out of our managers is that, you know, they like hitting 400. They like hitting 400 and being fairly paid, but the fact that they batted 400 is the biggest thing to them in life. And it’s, you know, it’s sort of the way we feel. If we get a good batting average in our business performance, the pay is incidental. Now, it shouldn’t be incidental to our managers. It’s got to be fair, or they’re gonna… nobody wants to work in an environment where they feel they’re being treated unfairly. But that is not a complicated procedure, and we do make them very specific to the enterprise that’s under their control. We do not pay the people that See’s Candy based on how the Buffalo News does, or vice versa. And I can show you a lot of crazy compensation systems in corporate America where that really is the ultimate effect of what’s happening. Number seven.

[04:35:06] Shareholder (Paul Butterfield, Clarksville, Maryland): Good afternoon. This is… I’m Paul Butterfield from Clarksville, Maryland. You wrote in the annual report about the dangers of… systemic dangers of derivatives and the growth in derivatives. An example would be a Six Sigma event that would cause domino effect and dangers to the solvency and operations of maybe financial institutions and other firms, possibly including brokerage firms. Would this… do you think this recommends to an individual investor that we might consider not holding stocks in street name?

Warren Buffett [04:35:47] How do they… addressed that somewhat. There were some domino effects in the very early ’70s in Wall Street. I think certainly the failures of some brokerage firms in part led to failures of others. It wasn’t a classic domino situation. And of course, we had domino effects in banks if you go back 100 years in this country. Anytime you have financial institutions that interrelate in many ways and have big receivables and payables balances with everything, you’ve always got the danger of domino effects. And that’s a factor in the insurance business. It’s a factor in banking business. I think it’d be less in the brokerage business.

I would think if you owned securities in a cash account with any large Stock Exchange firm, I… you know, it wouldn’t worry me. We’ve got lots of… I’ve got lots of personal securities, you know, sitting with a very large Stock Exchange firm, and that does not bother me. But I mean, there obviously there have been little firms that have been fly-by-night types. And I don’t even know all the rules on margin accounts, but if somebody has got the right to repledge your securities and they get in trouble themselves, I don’t know. I don’t know anymore what the SIPC… there’s a SIPC protection, but I’m not… it’s not unlimited at your level. Yeah, yeah, I think that’s true. And know, I would think twice between having all my securities rehypothecated by somebody else, a cash account. I think the cash accounts are segregated, aren’t they, Charlie?

Charlie Munger [04:37:38] Yes.

Warren Buffett [04:37:39] Yeah. Number eight.

[04:37:40] Shareholder (John Norwood, Des Moines): Good afternoon, Mr. Buffett, Mr. Munger. My name is John Norwood, and I hail from Des Moines. Thank you for providing this opportunity to speak today. I have two questions, one as an individual investor and one as a state resident. The first has to do with intrinsic value. Can you provide some additional Cliff Notes for working with the Berkshire Hathaway annual report and calculating an intrinsic value for the stock? I’m a little bit hazy. And the second question has to do with public sector investing. As an example, the state of Iowa is considering the creation of a one billion… $1 billion values fund. What sorts of guidelines, strategies, and advice would you employ if you were responsible for investing this money on behalf of the general public? Are there any significant differences when representing shareholders versus the general public? Thank you.

Warren Buffett [04:38:49] Yeah, elaborate, if you will, just a second, because I am not familiar with that billion dollar… Is the state of Iowa literally creating a billion dollar fund to invest in equities on behalf of the…

[04:39:04] Shareholder (John Norwood, Des Moines): That’s what’s being proposed.

Warren Buffett [04:39:06] Is that right? Charlie, what do you think about that?

Charlie Munger [04:39:10] That’s a new one to me. I think it’s a pretty dumb idea.

Warren Buffett [04:39:15] Yeah, he lives in California, that’s why had a Manser. I live right on the border here, so I… yeah, I would… I mean, I guess Iowa doesn’t have any bonded debt, so I’m not sure what they… probably wouldn’t be creating a margin account. But I would think that most states or municipalities would want to let the citizenry invest on its own and would not want to be taxing people in order to set up an equity fund. So I… that strikes me as a pretty novel idea. Charlie?

Charlie Munger [04:39:53] In California, certainly, the… of the investment management partnerships use all kinds of political contributions to finagle their way into managing state pension funds, etc., etc. It’s not a pretty scene. To the extent that… and damping it down, I think they’re better off.

Warren Buffett [04:40:15] Question on intrinsic value. You know, we’ve written about it in reports. I don’t think there’s much additional to say. I mean, that the intrinsic value of any financial asset, you know, is the stream of cash that it will produce between now and Judgment Day, discounted by an interest rate that equates between all the different possible assets. That’s true of an oil royalty, a farm, an apartment house, an equity, a business operation, you know, a lemonade stand. And that you have to decide what sort of businesses that you think you can understand well enough to make some kind of reasonable calculation. It’s not scientific, but it is… it is the intrinsic value. I mean, the fact that it’s fuzzy to calculate doesn’t mean that it’s not the proper way to think about it.

And at Berkshire you’ve got two questions. You’ve got the question of what the businesses we own now are worth, and then, since we redeploy all the capital they generate, you have to figure out what you’re willing to assume about what we do with the capital. And you can look back and say that 35 years ago or so, that people perhaps underestimated what would be done with a capital that was generated, so that it looks very cheap if you look back on it now. But we’re in a whole different game now, with huge amounts of capital, and you have to make a decision as to whether the billions and billions and billions of dollars we generate will be deployed in a way that creates lots more cash later on. And it’s what Charlie and I think about, but we can’t give any prediction on it. Charlie?

Charlie Munger [04:42:01] Yeah, I think our reporting, considering the complexity of the enterprise as now constituted, is better than that of any similar enterprise I know in terms of enabling a shareholder to calculate intrinsic value. So I think we’ve done better than anybody else, and we do it conscientiously. And if you ask, will we improve from here, I don’t think so.

Warren Buffett [04:42:27] We’ve worked… we’ve worked hard at doing what you’re talking about. And it… but even working hard at it, I mean, we’ve given you the data we would on ourselves. We don’t know the answer, but we do know it’s what you have to think about. And we do it when we… when we buy McLane, when we buy Clayton Homes, when we buy anything. We are attempting to look out into the economic future and say what kind of cash can this business generate over time, how sure do we feel about it, and how does the purchase price compare with that.

And if we feel we’re getting a… if we… we have to feel fairly good about our projections. Won’t feel perfect, because we… no one knows the answer precisely, but we have to feel pretty good about our projections, and then we have to have a purchase price that’s rational in relation to those. And we get some surprises in both directions. Actually, if you go way back, we had more pleasant surprises than what we would have expected, but we won’t get them from this point, because mostly because of size and also because the world’s a little more competitive. Charlie?

Charlie Munger [04:43:41] Nothing more.

Warren Buffett [04:43:42] Number nine.

[04:43:42] Shareholder (Vic Cunningham, Wilton, Connecticut): My name is Vic Cunningham. I’m a shareholder from Wilton, Connecticut. I heard your comments earlier about popping off, but actually I find it admirable the way you guys have… the two of you have leveraged your clout as investors to be advocates for change. You know, your outspoken comments on expensing stock options promoted, you know, productive discussions in not only corporate boardrooms throughout this country but, more importantly, on Capitol Hill. Currently, tort spending in this country continues to rise as a percentage of GDP, and I would argue a lot of that’s unproductive spending. Is there a point… and it seems like right now that, you know, they’re trying to stretch their tentacles not only from, you know, tobacco companies but to consumer product companies like McDonald’s and possibly even Coca-Cola. Is there a point where you would use your considerable clout to try to guilt Congress into moving towards some kind of comprehensive tort reform for this country?

Warren Buffett [04:44:46] Well, I’m sympathetic to the what you’re saying. I would say that our considerable clout is nothing compared to the clout of the… of the trial… of the plaintiff lawyers. That… there’s no question that in a certain way, it’s appalling when you look at the frictional cost to society of the tort system we have. But Charlie is a lawyer. He can probably speak much more intelligently than I can as to how you could modify this, because there are plenty of things wrong, too. I mean, it’s sort of infuriating to see specious shareholder suits raised on, you know, any kind of a deal, just because there’s a lot of D&O insurance, and they know people will pay off rather than go through the nuisance of a suit. And we’ve never… we don’t pay off, but corporate America does.

And so it’s a game, and the people that pursue that activity, you know, are not pursuing it, I think, in many cases because of a great pursuit of justice, but because it’s a damn profitable sort of game. And, you know, the people that are paying it, usually doesn’t come out of their own pockets. So it gets back to that, the lack of parity and the interest of the people on both sides. But then, when I look at some of the things that have happened in corporate America, I certainly don’t want to get rid of the plaintiff lawyers either, entirely, because I think some terrible things have happened, and I think people should pay. I just wish the people paid rather than the D&O carriers. Because when a D&O carrier pays, or when a company pays it, the costs get socialized, and the people that did the wrong things sell them pay out of their own pockets. I… Charlie, what… tell me what… how do we improve the tort system?

Charlie Munger [04:46:48] Well, if you define the tort system to include the workman’s compensation system, which I would, you get terrible abuses. In California, Costco has about one-third of its employees and two-thirds of its workman’s compensation expense. California is instit… institutionalized fraud: fraudulent chiropractors, fraudulent lawyers, fraudulent what have you. And they put this enormous burden on business, and of course, eventually the jobs will leave. I had a friend who took a plant away from Texas, where he had workman’s compensation expense of 30-odd percent, and took it to Ogden, Utah, where it went to 2%. So fraud allowed to run builds on itself, and then you got all these lawyers and lobbyists who like the fraud, and chiropractors and God knows what. And so it’s a major problem, and in California it’s gotten so bad that my guess is there will be some reform, even with the two-thirds Democratic legislature.

Warren Buffett [04:48:04] What would you change in terms of the shareholder situation?

Charlie Munger [04:48:08] Well, that’s harder, because if you take the worst of the plaintiffs’ lawyers, half the time they’re suing somebody that’s behaved terribly. Now, they’re suing in a process where a lot of money is paid out, as you say, on a socialized basis and doesn’t really go to the people that were hurt. So they’re like a public scold that gets paid an enormous sum out of the public. But certainly a lot of the defendants in these cases that are screaming about the plous bar have done some very regrettable things. So I think that gets very hard to figure out what should be done. The present system is crazy, and I don’t know how I’d improve it. You could easily improve it if you could count on government being rational and fair, but how do you do that?

Warren Buffett [04:49:06] Would you do anything toward making the people who are defendants in D&O situations panty portion it themselves, or not?

Charlie Munger [04:49:15] I think there would be a great improvement, net, in America if there were no D&O insurance. Zero. I think people would behave a lot better. The counterargument is you never get anybody with any money who was willing to serve on a board. But my guess is that net, even after taking into account that little problem, the system would work better than the present one.

Warren Buffett [04:49:47] Number 10.

[04:49:48] Shareholder (John Goss, Key West, Florida): John Goss, Key West, Florida. You mentioned last year your frustration with buying companies out of bankruptcy. Were you surprised, from your past experience, that the court would not allow a breakup fee regarding your Burlington bid?

Warren Buffett [04:50:04] That’s a good question. We submitted a bid to the court. The management agreed to our offer, and we submitted a bid in the bankruptcy of Burlington Industries, and our bid was $500-and-some million, and we provided a what’s called a breakup fee. I’ll get to that in a second, but I think it was a $14 million… Now, really, when we submit that bid of $500-some-odd million, our bid has to remain outstanding for a good many months. So in effect, by making that bid… I get back to the earlier statements I made about option value. For $14 million, we were telling the creditors of Burlington that for a period of maybe four months or five months, that they could sell us that business for our number, or for a considerable period they could get more money for it.

Now, that is a very low price, in my view, for a put. In fact, it’s an inadequate price, but it’s become sort of a customary percentage in terms of bankruptcy proceedings. The court said that that was too much to charge as a breakup fee, or what I would call a put fee. And so they have set up a new procedure which will result in Burlington getting sold some months from now to people who follow this new procedure. I think that I… I think, I frankly think $14 million is inadequate, but I… but it’s roughly in the range of what has been allowed in many cases. But we would never agree to that sort of a sum for that sort of exposure outside of bankruptcy. It just doesn’t make any sense. The world changes too much. If you look at the value of businesses as measured on the New York Stock Exchange, you’ll see fluctuations of 100% in a year. And for 2 or 3% to commit $500-and-some million at a fixed price for a business in a tough industry, I mean, that does not make a lot of sense. I did it, so… but it got rejected. We would not… we will not participate in a procedure where we’re going to bid hundreds of millions of dollars and where our bid has to remain outstanding. And if the… you know, if there’s a twin… if there’s a World Trade Center disaster, or there’s an earthquake in California, or there’s this Suess or suspension of trading on the stock exchange, or all kinds of things, that our bid sits out there and we’ve gotten paid $5 million or something for it, it just doesn’t make any sense to me.

So it’s tough to buy things out of bankruptcy, although we’ve done it twice now, and both situations have worked out well. But then we tried it a third time with Burlington, and we spent a considerable amount of time and money generating that bid, weeks and weeks, and a good many dollars, and it wasn’t accepted. So, you know, when I look at these experiences, I say to myself, it’s a lot easier to make a deal with Walmart, where I talk with them for an hour and we shake hands and we got a deal, or the other… or the other deals we’ve made in the last year, where we buy Northern Natural in a day or two, or where we buy Kern River pipeline in a few days, or the various businesses we bought.

And bankruptcy, I think it’s probably a necessary part of the procedure. I mean, you have to comply with bankruptcy laws. But I would say it’s a very awkward way to buy a business, and if we have to submit bids that will remain outstanding for many months, when people can top us, and only have a 1% fee for giving that sort of a put, we will not be making many bids. Charlie?

Charlie Munger [04:54:26] Well, we know it was unreasonable, from our point of view, to have a transaction that didn’t have that modest 2% commitment fee in it. The court had a different view, and he thought that the figure should have been different, and who knows. We’ll see how it all works out.

Warren Buffett [04:54:49] Number one.

[04:54:49] Shareholder (Wayne Peters, Sydney, Australia): Gentlemen, Wayne Peters from Sydney, Australia. My question goes to stock reweighting. Could you describe your thought process in, firstly, determining your commitment weighting level in a new investment, marketable securities is what I’m referring to, and secondly, your thoughts on potential reweighting? Your record, and clearly in the earlier days as opposed to now, would indicate that on average you either in a stock or out of it, though on occasion you’ve topped up and lightened up.

Warren Buffett [04:55:29] Charlie, I’ll let you have one.

Charlie Munger [04:55:31] I didn’t fully understand that question.

[04:55:34] Shareholder (Wayne Peters, Sydney, Australia): To how you make an initial commitment to a marketable security investment, in regard to making it maybe a 5, 10, 15% commitment. How heavy you decide to go into a position initially.

Charlie Munger [04:55:48] Well, we ordinarily don’t like small positions.

Warren Buffett [04:55:50] Yeah, we like to go in heavy. I mean, it… if we want to invest in a business through the stock market, we want to put a lot of money in. You know, we do not believe in a little of this and a little of that. So at our present size, we’re limited primarily by the availability of the quantity we want, rather than restricting ourselves based on some percentage of a total portfolio. I can’t… it’s very hard for me to think of a stock we quit on in terms of buying, except because we were going to run into some 10% limit where we would get liable for short swing profits or become insiders or that sort of thing. But we almost never want to quit. Isn’t that right, Charlie?

Charlie Munger [04:56:42] Well, not unless the price goes up.

Warren Buffett [04:56:44] Yeah, and of course, that’s where we made our big mistakes. I mean, we have… or I’ve made the big mistakes, actually. I… there have been a couple of things that we knew enough to buy, we’re in our circle of competence, where we could have bought lots of stock, except it went up a little bit and then we faded because of the price. But we didn’t fade because we didn’t want to put more than X dollars in. If we find an idea that we want to put $500 million in, we probably would be even happier if we could put three or four billion in. You know, we… good ideas are too scarce to be parsimonious with once you find them.

Charlie Munger [04:57:28] Yeah, having narrowly averted the mistake of being unwilling to pay up at See’s Capital, we’ve gone on and made the same damn mistake several times with respect to marketable securities. We evidently learn very slowly. It cost as many, many, many billions of dollars, too. Now, those are opportunity cost billions. They don’t show up in the financial statements, but the amount of money that’s been blown by dumb decisions at headquarters at Berkshire Hathaway is awesome.

Warren Buffett [04:58:08] Well said. Yeah. Number two.

[04:58:10] Shareholder (Steve Casbell, Atlanta): Hi, I’m Steve Casbell from Atlanta. My question involves interest rates. When you calculate the intrinsic value of a business in a period of low interest rates like we have currently, do you use a higher discount rate to factor in higher rates in the future? And also, when do you ever look at a company’s free cash flow yield relative to current rates? And if I could also get your thoughts on the dividend tax cut. If by some miracle the politicians think logically and get rid of the dividend taxes, would Berkshire ever pay a dividend?

Warren Buffett [04:58:53] The question on discount rates, we use the same discount… I mean, in theory, we would use the same discount rate across all securities, because if you really knew the cash they were going to produce, you know, that would take care… We may be more conservative in estimating the returns of cash from some, but the discount rate we would use is a constant. Now, in terms of where we commit, you know, we don’t want to use the fact that short-term rates are 1.25% to think that something that yields 3% or 4% is a good deal. So we sort of have a minimum threshold in our mind about which we’re… below which we’re unwilling to commit money, and we’re unwilling to commit it whether interest rates or 6 or 7%, or whether they’re 3 or 4%, or whether they’re on a short-term basis 1%.

We just… we don’t want to get hooked into long-term investments at low rates just because they’re a little bit better than short rates would be, or low government rates would be. So we have minimum thresholds in our mind. I can’t tell you precisely what they are, but they’re a whole lot higher than present government rates would be. And at other times we’d be very happy owning governments just because we feel that they offer attractive enough rates. I would… when we’re looking at a business, we’re looking at holding it forever, and we want to be sure we’re getting an adequate return on capital. We don’t regard what we can get on short-term rates now as adequate, but we’ll still sit… bend, you know, a little bit and start settling for lower rates for 30 years because rates for 30 days are so low. We would rather just sit it out and wait a while.

The tax on dividends, you know, I’ve used this illustration before, but I’m paying about the same percentage of my income to the federal government as my secretary does. Now, I pay more in income tax rates than she does. I pay a higher marginal tax rate, by some margin, than she does. But she pays way more in Social Security taxes than I do, because I only pay on the first, whatever it is, 70,000 or 80,000 of income. And so she is paying, between what we pay at the company for and what she pays, we’re paying 12 or 13%, or whatever it is, of that. So we both end up paying fairly similar percentages of our income to the federal government every year.

If Berkshire were to declare a billion dollar dividend, and my share of it was $330 million, and it were tax-free, as the Bush people originally suggested it, and it would be tax-free… I mean, we have lots of taxable earnings at Berkshire. You know, I might be paying one-tenth of the rate to the federal government of my income that she would be. Now, I can make the argument about the fact that structure shouldn’t govern tax rates, that Subchapter S and Subchapter… and Chapter C and partnerships and all of these things, that the tax code should be neutral between them. And I’ve made those kind of arguments the past.

But I can make no argument in my mind that says that I, with everything that, you know, all the luck I’ve had in life… you know, I was wired a certain way at birth that enabled me to make a lot of money, and frankly, it was better to be born a boy than a girl in terms of money-making possibilities in 1930, and probably still is, but not to the same degree. I mean, the fact that I would send one-tenth the portion of my income in a year to the federal government that my secretary would, I just… it screams at injustice to me, and in terms of what the society gives back to me. So I am not… I am not for the… I’m not for the Bush plan. But… Charlie?

Charlie Munger [05:02:51] Well, I agree with you. Even if you assume that the whole economy would work better if we’d never gotten into this double taxation system on corporate earnings, which I don’t think is a clear thing anyway, but even if you assume that, I think, even… you live in a democracy where there’s lots of envy and resentment and what have you, to have the absolutely most fortunate people paying practically no income taxes, I just think it’s unacceptable. I think there has to be some fairness in some of these arrangements, even if there’s some theoretical argument that the economy might work a little better some other way.

Warren Buffett [05:03:39] Yeah, there are IRAs now, obviously, that work very well for people with modest amounts of dividends, that they… they’re getting tax deferred for a very long period of time, which has huge benefits. The big benefits of exempting dividends would go to fells like me and Charlie, you know, and that’s not going to stimulate the economy. It’s going to stimulate us. But, and it’s going to result in us sending a very small percentage of the income… of our income to Washington, compared to what the people, you know, working in our shoe factories send. And that, you know, when somebody says, you know, “What did you do during the war, grle?” I’m not sure that’s what I want to explain to them. Number three.

[05:04:30] Shareholder (Patrick Wolff, Arlington, Virginia): Good afternoon. I’m Patrick Wolff from Arlington, Virginia. Charlie, I can’t resist telling you that I’m actually the fellow who plays the chess games blindfolded, so I look forward to not seeing you there tomorrow.

Warren Buffett [05:04:41] Right.

[05:04:42] Shareholder (Patrick Wolff, Arlington, Virginia): I actually have a two-part question. I’d like to ask you to elaborate a bit how you think about opportunity cost, and I think I’m going to be elaborating very much on the very last question that was asked. First of all, in the annual report you say explicitly that you look for a 10% pre-tax return on equity in looking at common stocks, and I think you talked earlier about how you built up from that, for 5 to 6% after tax return, and then you layer on inflation and then layer on taxes. My first question would be, how do you adjust that required rate of return across periods of time? So, for example, when interest rates are higher, and do you look for a different equity premium return over different periods of time?

My second… you just said that you actually would apply the same discount rate across the stocks, and I’m sure you know that modern finance actually suggests that you should not do that, that you should be thinking about the timing of cash flows and in particular the co-variance with the general market. Now, you’ve made a point of emphasizing that when you think of risk, you think of risk primarily in terms of will you get the cash flows that you predict you will get over time, sort of numerator risk, if you think in terms of discounted cash flow, which I think everyone here will have to acknowledge, your results speak for themselves. It’s probably been a very effective way of thinking about risk. But there is a true economic cost to think about the timing of cash flows as well, and it may be a much smaller cost, but it is still a real cost.

I might, for example, suggest you think about somebody deciding between two jobs. The jobs are completely identical, and the person expects to make the same amount of money from each job, but there’s one difference, and the difference is one job will pay him more when the economy is in the tank and the other job will pay him more when the economy is going gangbusters. Now, if he asked you which job was actually worth more, my guess is you would tell him that the one that would pay him more when the economy’s in the tank. And the reason is, if he wanted to make more money by moonlighting or doing something else, it’d be much easier when the economy is doing better.

That’s the essential logic behind the idea that you look at the co-variance of when cash flows come in with the overall market. It’s a real cost, even though it is difficult to measure, and even if it is a smaller risk than numerator risk, the risk of getting the actual cash flows. Since it’s a real cost, I imagine you must think about it, and so my second question to you would be, how do you think about it? And if you decide not to, why?

Warren Buffett [05:07:19] Now, first of all, I would like to say, Patrick, we appreciate you coming out, because Patrick, now I don’t know how many years it’s been, but it’s been a number, has volunteered on Sunday to play… now I think he’s playing six people are so blindfolded simultaneously. And after hearing that question, you can understand how he does it. The… but Patrick, as well as Bob Hamman, and then this year Peter Morris, and Bill Robertie, all come out, and on Sunday they… we’ve got these extraordinary talents out there, and for people who like the various games they play, they devote an afternoon for it and ask nothing in return. So we really appreciate it, Patrick, and I’ll look forward to seeing if you’re peeking out of your blindfold tomorrow.

The question on opportunity costs and the 10% we mentioned, you know, basically that’s the figure we quit on, and we quit on buying. We don’t want to buy equities where our real expectancy is below 10%. Now, that’s true whether short rates are 6% or whether short rates are 1%. We just feel that it would get very sloppy to start dipping below that. And we would add, we feel also, obviously, that we will get opportunities that are at least at that level and perhaps substantially above. So there’s just a point at which we drop out of the game, and it’s arbitrary. There’s no… we have no scientific studies or anything. But I will bet you that a lot of years in the future, we, or you, will be able to find equities that you understand, or we understand, and that have a probability… the probability of returns at 10% are greater.

Now, once you find a group of equities in that range now, and leaving aside the problem of huge sums of money, which we have, then we just buy the most attractive. That usually means the ones we feel the surest about. I mean, as a practical matter, that there’s just some businesses that possess economic characteristics that make their future prospects far… far more predictable than others. There’s all kinds of businesses that you just can’t… you can’t remotely predict what they’ll earn, and you just have to forget about them. But when we get… so we have, over time, gotten very partial to the businesses where we think the predictability is high, but we still want a threshold return of 10%, which is not that great after tax anyway. Charlie, do you want to comment on that portion of the… that question first?

Charlie Munger [05:10:11] Yeah, the… I think in the last analysis, everything we do comes back to opportunity cost, but to some extent, in fact to some considerable extent, we are guessing at our future opportunity cost. Warren is basically saying that he’s guessing that is in due course to put out money at pretty attractive rates of return, and therefore he’s not going to waste a lot of firepower now at lower returns. But that’s an opportunity cost calculation. And if interest rates were to more or less permanently settle at 1% or something like that, and Warren were to reappraise his notions of future opportunity cost, he would change the numbers. It’s like Keynes said, “What do you do when you change your view of the facts?” Well, you change your conduct.

Warren Buffett [05:11:07] But so far, at least, we have hurdles in our mind which are basically…

Charlie Munger [05:11:14] Well, they involve implicitly future opportunity cost.

Warren Buffett [05:11:18] Right now, with our $16 billion that’s getting 1.25% pre-tax, that’s $200 million a year. We could very easily buy governments due in 20 years and get roughly 5%. So we could change that $200 million a year to $800 million a year of income. And we’re making a decision, as Charlie says, that it’s better to take $200 million for a while on the theory that we’ll find something that gives us 10% or better, than to commit to the $800 million a year and then find that in a year thereabouts, when the better opportunities came along, that what we had committed to had a big principal loss in it. But that’s, you know, that’s not… it’s not terribly scientific, but it… all I can tell you is in practice it seems to work pretty well.

Charlie Munger [05:12:08] Years ago, when Warren ran a partnership, and to some extent the partnership that I ran, was the… operated in the same way, we implicitly did what you’re suggesting, and that part of the partnership funds were in so-called event arbitrage investments, and those tended to generate returns occasionally when the market generally was in the tank, and alternative investments would more mimic the general market. So we were doing what this academic theory prescribes, you know, 40 years ago, and… but we didn’t use the modern lingo.

Warren Buffett [05:12:48] Yeah, we’ve got some preferences for having a lot of money coming in all the time, but we do go into insurance transactions with huge volatility, which could mean that a big chunk of money could go out at one time, in a very short period of time. And we won’t give up a lot in expectable return for smoothness. But if you give us a choice of having money come in every week, and the pre… and the same present value of money coming in in very lumpy ways that we wouldn’t know about, we would choose the smooth. But if you give us a choice of a higher present value for the lumpiness, we will take the lumpiness. And that’s usually the choice that’s… I mean, that’s usually… we get offered that choice, and other people value smoothness so high… highly that we do get a spread, in our view, for lumpy returns.

We are writing… and then we’re going to close this up, but you will read a lot, or you may hear a lot, maybe you’ve heard it already: Pepsi-Cola is having a contest. They’re going to have a drawing in September. The contest goes through a lot of little phases, but in the end there’s going to be one person who’s going to have one chance in a thousand of winning a billion dollars. That billion dollars will have a present value of maybe $250 million. If whoever gets to that position hits the number, we will pay it. And we don’t mind paying out $250 million as long as we got paid appropriately for us, and that would create bad cash flow that particular week. We’re willing to, maybe even for two weeks. We’re willing to assume that for a payment, and very, very few people in the world are, even those that can afford it.

We would even assume it for $2.5 billion present value. We’d want more, proportionately, to assume it for that, but Charlie and I, I think, would agree that we would take that on if we got paid well enough for it. We wouldn’t do it for $25 billion. But we would… we will do things, and therefore, you know, we get the calls on that sort of thing, and that is more profitable business over time than bread and butter business. It also can, you know, it can lead to you having an intense interest in watching the television show when the drawing takes place, making sure who draws the number, too. Charlie, you have anything to add? Then we’ll…

Charlie Munger [05:15:24] Yeah, but once you’re talking about opportunity cost that’s personal to yourself and your own situ… you’ve departed from modern finance totally, and that’s what we’ve done. We’re intelligently making these guesses as best we can, based on our own circumstances and our own abilities. I think it’s crazy to do it based on somebody else’s circumstances and somebody else’s abilities.

Warren Buffett [05:15:50] Thanks for coming, and we… I hope we see you all next year.