May 2, 2011
“I’ve been fly so long I fell asleep on the f!@#$ng plane”
—Lil Wayne, Right Above It
“I’m not a businessman; I’m a business, man.
Let me handle my business, damn!”
—Jay-Z, Diamonds Are Forever Remix
Berkshire investors have seen their money grow more than 3,400x in the last 46 years. That’s over 20% per year compounded annually. For perspective, Google—one of the greatest venture capital investments of all time—returned its investors just 400x. But Google was just one investment in a fund, so investors in the fund saw substantially lower performance than 400x. While both venture capital as an industry and the S&P 500 were basically flat from 2000 to 2010, Berkshire returned 76% on an asset base of more than $100B. Most venture funds manage $1B or less so this feat is doubly impressive.
I’ve been a long-time fan of Warren Buffett and his investment philosophy. My favorite Buffett book is The Essays of Warren Buffett: Lessons for Corporate America. The book has a unique style that organizes Buffett’s writings by category. This style is easy to parse and I try to emulate it here.
The morning started at 8:30 with a 50-minute movie comprised of several 30-second-to-5-minute clips that showcased Berkshire’s businesses and parodied Buffet and Munger. Some highlights:
- Buffett’s testimony to congress after the Saloman Brothers failure when Buffett famously said, “Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless.” Buffett is talking about Berkshire not Salomon. This quote was referenced later in the day to talk about the Sokol incident.
- “Michael’s Replacement,” which hilariously posed Warren Buffett as the replacement to Michael Scott in the TV show The Office. 
Management’s Presentation And Discussion of 1Q11 Earnings
- It was the worst quarter in decades for reinsurance. Normally Q3 is worst for Berkshire’s insurance businesses because of hurricanes. Reinsurance will probably lose money for FY11. For perspective, the New Zealand earthquake did $12B in damage to 5M people. This is 10x the per-capita impact of Katrina victims. Buffett still very bullish long term on its reinsurance business (property & casualty).
- Berkshire called its warrants on Goldman in April. Berkshire made a killing on this deal. Buffett doesn’t expect to be able to replace with similar investments soon.
- GEICO goodwill is carried at cost on books ($1B). Estimated goodwill value has grown to $14B. “This is an asset every bit as valuable as those on our balance sheet.” Each policy holder adds ~$1,500 in goodwill value (Buffett didn’t say how he calculates this). 381K subscribers = $500M in goodwill. “A significant percentage” of policy holders have been active 10+ years.
- Goofy GAAP rule resulted in an unrealized loss on Wells Fargo stock that flowed through to the income statement. Buffett notes that similar unrealized gains don’t offset this loss in accounting terms. If Berkshire had used the average cost method, they wouldn’t have recorded this loss, but Berkshire uses specific cost for tax purposes. More goofiness: the GAAP rule specifies “other than temporary impairment,” but doesn’t say what temporary means.
Comments And Q&A on Dave Sokol
- Sokol was the manager of MidAmerican Energy and NetJets and was widely rumored to be next in line to succeed Buffett, until he failed to properly disclose his long position in Lubrizol when he recommended it for investment to Berkshire. 
- Buffett: “inexplicable and inexcusable,” just like Salomon
- Buffett: “There are plenty of activities that are unsavvy in the world that are committed by people with lots of money.”
- Buffett mentioned the movie clip of his testimony to congress. Many shareholders surprised why he wasn’t more “ruthless.” Buffett said he didn’t have all facts until Mar 15 and wanted to be careful to avoid a lawsuit over firing Sokol.
- Buffett mentioned a lot of good that Sokol did, including voluntarily handing over $13M in compensation to a fellow manager.
- Munger was more cynical: “A surprising amount of the time rational people do foolish things. Hubris can be a part of it.”
- Buffett: The most interesting part of every proxy statement is basically the history of transaction-this is the first thing I read as it gives you a blow by blow on every deal.
- Buffett: “The meek shall inherit the earth but will they stay meek?”
General Q&A started at 11am.
New Investment Sectors for Berkshire
- Buffett: New sector would need to be large so Berkshire could deploy capital e.g. markets of $10B+
- Buffett: “The tech. field would be terrific.” Likely to be a few enormous winners and a lot of failures. Degree of disparity of results between tech companies is likely to be very high.
- Munger: Tech or energy. “I think we are the wrong people to develop the expertise. We might find someone else.”
- Buffett: Lubrizol was a business I didn’t know anything about—chemistry. What is important is that I understand the economics of the industry—competitive moats, ease of entry. When we decided to purchase See’s Candy, I asked myself “If I had $100M could I take on See’s?” I said no, so I bought. With Coke, I asked myself “If I had $100B could I take on Coke?”—same answer. For Lubrizol, when it comes to entry it’s easy but cost (declining marginal costs to scale) and scaling is hard. Their #1 market share is very durable and the industry is going to be around for a very long time (making fuel additives to make truck engines last longer and be more efficient).
- Munger: Very small markets (relative to other markets that petrol companies do business in) make Lubrizol’s market unattractive to enter.
- Buffett: Doing stock deals is to give away a part of our existing companies. As much as we like new companies we don’t want to give up current ones.
- Munger: We have an enormous amount of capital and we won’t always be so inactive.
- Buffett: I don’t see how anybody can be other than enthused about this country. Since 1776 we’ve had the most incredible economic story in the history of the world. Since 1930 our standard of living has increased 6-to-1. Other countries have nothing happen for centuries. Our system works remarkably well despite its hiccups.
- Buffett: When I was finishing school, Ben Graham told me: “If you start investing in stocks now, they are too expensive; you should wait a while.” There’s always been an excuse not to start. Our country does well but not in a straight line. The potential of the US has not been exhausted but what we have done is being replicated by some state-run economies like China.
- Munger: “The world is going to go on. You can be cheerful when things are down.”
- Buffett: A great civilization has a lot of ruin in it. If I were in the womb today and had a choice I’d be born in the US.
- Buffett: If you can have a product that requires very little capital to grow then your services will grow in price to compensate for inflation. The worst kinds of businesses in an inflationary environment are those with inventories and receivables. When we bought them, See’s Candy did $30M in revenue on $9M in tangible assets. Now they’re doing $300M on $40M.
- Munger: We’re lifelong learners.
Berkshire Issuing a Dividend
- Buffett: Not likely for Berkshire to issue a dividend. By not issuing a dividend, shareholders are getting $220B for $160B of value today. 
- Buffett: Wells Fargo and USB are among the best banks, if not the best. As a whole banking profit will go down because leverage is also going down. 25–30% return on equity won’t be repeated and shouldn’t in the future (because it requires too much leverage).
- Buffett: Read Jamie Dimon’s letter to J.P. Morgan and M&T CEO Robert Wilmer’s letter on banking.
- Munger: Traders make money by outsmarting their customers.
- Munger: Gold—even at 1500($/ounce)—still has a way to go to catch up with Berkshire (BRK has returned over 3,400% since inception).
- Buffett: There are 3 categories of investment:
- Currency: Cash, bonds, etc. which is a bet on the government. Almost all currencies have declined over time. Easier for governments to work with a currency that declines over time, so they will likely keep declining. Unless we are paid very well, currency investments don’t make sense.
- Non-productive assets: Items that you buy that don’t produce anything but you hope others will pay for later. If you bought all the gold in the world, it would take up about 67 cubic feet. And you could get a big ladder and climb up and sit on top of your gold cube and fondle it. But that’s about it—gold has no productive use. Keynes described this as men not choosing the prettiest girl but the girl whom others will think is the most pretty.
- Productive assets: Something that will pay you, like a farm. You can make a rational calculation and your success can be measured internally. We don’t run around getting a price quote on our farm. Productive assets can be used to buy more productive assets.
- Buffett: I prefer to bet in good producing businesses over time. Rising prices create their own excitement—people see their neighbors making money and they want to get in on it too. People like to get in on excitement.
- Munger: To buy an asset that only goes up if the world goes to hell doesn’t make a damn bit of sense.
- Buffett: You would have to buy all the new mined gold too, which costs $100B a year. You could buy all the gold in the world for about $8T. For that you could buy all the farms in the US for $2T plus 10 Exxon Mobiles at $500B a piece and still have $1T left over.
How Warren Buffett Raised His First Money
- Buffett: Family and friends had been asking him to manage their money when he was a trader on Wall Street. He called them.
- Buffett: I didn’t like the securities selling business. When I wanted to buy more of a declined stock, I felt bad trying to convince clients that bought at $20 to buy more at $10. I could not manage money as well as if I were working for myself. So I told my investors (in Berkshire), I won’t tell you what investments I’m going to make or why, but I’ll do with my money what I do with yours. For the first 6 years it was really slow. Then Charlie left law to join me (I pounded on him for years, told him he was too smart to do law).
- Munger: It helps you in life if you conduct yourself so others trust you.
Being a Conglomerate
- Munger: We are a conglomerate despite how people dislike that word.
- Buffett: One big advantage of being as conglomerate is tax efficient transfer (e.g. reinvestment) of money between subsidiaries.
- Buffett: In the past a lot of conglomerates played a game where the idea was to get your earnings multiple up high and buy something with a lower PE. It was as if everybody knew what the game was but thought it would continue to succeed, so they kept playing—it was like an unspoken conspiracy. Then someone said the emperor has no clothes.
How They’d Like To Be Remembered
- Munger: “A fortune fairly won and widely used.”
- Buffett: “A teacher.”
Monetary Policy And US Debt Ceiling
- Buffett: Purchase power of USD will decline but so will others. 80% of Coke earnings are non-Dollar. 16-to-1 depreciation of USD since 1930 but 6-to-1 standards of living increase. US people have still done well. I hate inflation but we’ve figured out how to deal with it pretty well.
- Buffett: If the US didn’t raise the debt sealing it would be the most asinine thing they’ve ever done. The whole topic is just a political bargaining chip. The US of 2011 has a different debt capacity than the US of 1911. But debt as a percentage of GDP growing is a bad thing. The US is not going to have a debt crisis any time soon as long as we can issue debt in our own currency. The only thing we have to worry about is the currency printing press and inflation.
- Munger: Country of Greece has a terrible culture—people don’t work, don’t pay taxes.
- Buffett: Giving up the right to issue debt in your own currency is a terrible mistake. The European Union members have made this same mistake and it has been terrible for them. All Greece can do now is beg their neighbors to bail them out.
- Munger: It seems now that both political parties are trying to do the most stupid thing possible and they keep surpassing each other.
- Buffett: I advise busy people to invest in index funds over picking stocks themselves. I wouldn’t be mad if I had to own an index fund but Berkshire is better still.
- Munger: I’d be mad if I had to own an index instead of Berkshire.
- Munger: Not so simple that you can grow a compliance organization to ensure compliance. Look at Wall Street—non-compliance is rampant despite huge compliance organizations. What works for us (Berkshire) is a culture of honesty.
- Munger: A big mistake we’re making is not learning enough from financial failure. I would have the tax system discourage frequent trading—securities should trade like real estate. Making people heros for trading is bad. I hate that 25% of our engineers are going into finance.
- Buffett: Futures profits are taxed 60% at long-term capital gains rates (15%) even if held for 10 seconds. Traders are paying less on ordinary income than the average American.
- Buffett: Any company that moves as fast as BYD will have delays and glitches. They got in trouble with auto sales. They tried to double auto sales every year and the succeeded for the first 5 years.
- Buffett: Finite supply of oil and over the long term prices are sure to go up. 88M barrels / day, 500K oil producing wells in the US.
- Buffett: Berkshire does not hedge oil. Initially BNSF hedged oil prices, but if we knew the direction of oil prices, we could just shut down the railroad and trade oil.
Things Learned Last Year
- Munger: “I’ve ignored tech all my life,” but I read In The Plex: How Google Thinks, Works, and Shapes Our Lives. I find it peculiar how these engineering cultures work. I think we’re here to learn as much as we can. Our job every day is to go to bed a little smarter than we woke up.
- Buffett: Would like to learn more about tech.
Too Big to Fail
- Buffett: Will always be an issue, so do things to reduce the propensity. Thinks that any organization that could be too big to fail needs to have a policy where the CEO and spouse go bankrupt if the company goes bankrupt, but added that in practice he’d prefer something “not quite so draconian.”
- Munger: A big part of the problem is that academia believes so many things that are wrong, particularly in finance and economics (especially Modern Portfolio Theory). Finance and economics are not hard sciences but they attract a lot of snake charmers.
Berkshire Vs. Inflation
- Buffett: We’ll try to beat inflation. Our economic future is tied with yours.
Whole Acquisitions Vs. Minority Stakes
- Buffett: I prefer large acquisitions but we buy equity when we can. We’re too big to get involved in minority stakes for most companies.
- Munger: We’ll always have a lot of marketable securities because of our insurance / reinsurance business (because Berkshire’s insurance subsidiaries invest float in marketable securities).
- Buffett: At this stage of the game we have some of the best businesses in the world coming to us and saying: “We’re looking to sell and Berkshire is the best home in the world for us.” I prefer this part of the game. Partnerships are fun.
- Munger: But the earlier part of the game was fun too—outsmarting other investors in marketable securities.
- Buffett: Insurance is really hard to do well and it’s harder than it looks. It’s very easy to incorrectly price unexpected bad events, and these mistakes can bankrupt you. It’s easy to be fooled into thinking you’re very profitable with just a few lucky years. A really bad event has perhaps a 1 in 36 chance of happening, so it will look like you’re doing very well until you run out of luck.
- Munger: Property and casualty insurance is a tough business itself. There are lots of opportunities to be stupid. It’s taken us years to get it right.
- Buffett: I can’t think of any decision he’s ever made that I would have made better. He is as rational a thinker as Charlie or anyone I’ve ever met. And he loves what he does. He’s creative. Ajit’s mind works like a machine day after day and he loves what he does—which is an important part of succeeding in any activity. I don’t know what his best deal was but my best deal was hiring him.
- Munger: The secret of success in a field is getting really interested in it.
- Buffett: Every Thanksgiving Ajit flies to London to see his family because they don’t have a Thanksgiving (to work instead). To an extraordinary degree he thinks of Berkshire first.
- Buffett: We have not created major earning power in any retail business. See’s Candy is the closest we’ve come.
- Buffett: Goodwill should not be looked at as a part of underlying economics of a business, but in terms of allocating capital, you have to take into account the goodwill. You’d have a figure of like $100B for Coke. Don’t amortize goodwill. I don’t think it makes sense to amortize goodwill, but write-offs make sense if you overpay. In terms of economics, look at the return on net tangible assets (i.e. exclude goodwill from return on invested capital calculations).
- Buffett: (Lubrizol as an example) Lubrizol is earning $1B pretax and we paid $9B for it (there was no debt for LZ but he notes to include debt in cost calculations), employing only $2B of net tangible invested capital. Judge us (Berkshire) on our $9B investment. Judge the manager on capital employed. It is a great business based on tangible capital employed.
- Munger: Unlikely to repeat an investment as good as LZ because equity prices are high right now.
- Munger: Costco is a business that became the best in the world through a culture of extreme meritocracy and strong ethics. They take all their operational cost advantages and pass them onto their customers. This of course builds huge customer loyalty. One store in Korea will do $400M in revenue this year. GM is a great counter example. IBM is too.
- Munger: If I ran a business school course, I would teach a chart of GM’s stock price and try to correlate that against all the things they did wrong. None of the case studies are properly taught in business schools anymore. Harvard Business School used to teach this way, but stopped because of inter-organization bureaucracy (professors in one field didn’t like professors in another field teaching about their field).
- Buffett: I think if you are very rich and you bring your kids to think that they are more important or special simply because they came out of the right womb, that’s a terrible mistake. Charlie has raised 8 children who don’t have that sense. Also don’t incentivize your kids to outdo you as parents at whatever the parents happened to be good at.
- Munger: I don’t think you can raise children in an affluent family who love digging fence posts 16 hours a day. To some extent you are destroying their incentives no matter what. My advice is to lose your fight as gracefully as possible. Try to get them really interested in something.
- Buffett: The CEO of a couple hundred billion dollar company should be compensated well. In terms of mechanism, I’d do it with a specialized stock options package: I don’t think the strike price should be less than what the company would sell for. It would be crazy to sell your company for an artificially depressed price set by a lousy market. The strike price should instead be the intrinsic value of the business. Then subtract out some nominal rate because no management/bad management could still grow the company to some degree. Then subtract out dividends. With this kind of structure you can have a huge incentive.
- Buffett: The present compensation system has no relevance at all to what my successor will earn. The next CEO for Berkshire won’t make $100K (this is how much Buffett pays himself). The next CEO will make a lot of money and should make a lot of money. People earn well into 8 figures at Berkshire when they deserve it.
- Munger: I think somebody in America needs to be the example for not grabbing all they can.
- Buffett: Renewable energy companies are great ideas but we don’t consider them for investment. We look at earning power 3, 5, 10, 15 years compared to what we pay.
- Munger: With enough energy the water problem goes away.
- Buffett: “I think nuclear power is an important part of the energy equation.” 20% of US electricity comes from nuclear power. It’s safe. I don’t think it’s going to go anywhere for a while in the US because of the reaction to Tokyo.
- Munger: We can’t be so risk averse that things that have a tiny chance of disaster prevent us from running our business.
- Buffett: “I’m the Chief Risk Officer.” We are not doing anything that I know of that threatens me losing a night’s sleep over Berkshire’s wellbeing.
- Munger: Our Idaho nuclear plant is far safer and we’re learning how to make these plants safer as we go.
- Buffett: Many people have lost lives in coal mines. Zero have lost their lives to nuclear in the US. As a system it’s extremely safe—safer than coal.
- Munger: If a tsunami gets to Iowa it’s a hell of a tsunami.
- Buffett: Wind power investment still only makes sense with federal government credits. Iowa is a good wind state and so are the surrounding states. It made sense for us to locate lots of megawatts in Iowa. One asset of BRK is it pays a lot of taxes. Utilities have lots of depreciation. We can use taxes to build more windmills. It helps our Iowa customers (reminds me of Google’s initiatives to make the Internet faster—when your business has huge market share, doing things that benefit your competitors will deliver outsized benefits to you). We paid close to 2% of all corporate income taxes in the last 5 years.
Lubrizol No-Shop Bid
- Specifically, by not running a bid process for Lubrizol, did Lubrizol’s board violate fiduciary duty to shareholders?
- Munger: No, because our bid was contingent on Lubrizol not running a bid process. Are there any more easy questions?
- Buffett: We don’t conduct auctions as a policy. Auctions usually result in lower prices anyway.
- Buffett: Every time I make an investment, I’m thinking “What else can I do with X dollars?” I look at everything available that day and the likelihood of availability of deals in the near future.
- Buffett: One big error in business that individuals make is they try to measure each deal against the best one they’ve ever made. The goals is not to make a better deal than you’ve ever made before but to make the best deal you can at the time.
What They Read
- Buffett: Each day I read 5 newspapers and lots of 10Ks and 10Qs. I’m not a fast reader. It’s a huge advantage to read fast, but comprehension is more important.
- Munger: Speed is overrated. I had a roommate at Caltech who was slower than I was but never made mistakes. I was fast but made a lot of mistakes. What the hell difference does it make?
- Buffett: When we look at a business in the future, if we see growth in that picture that produces a high return on invested capital we love it. But we don’t rule out companies that don’t have large growth. Lubrizol probably won’t grow a lot but it will stay very profitable.
- Munger: In our country business schools teach people to make long-term projections with computers. I’ve always regarded these projections as doing more harm than good. When an investment banker prepares one we tend to throw them out the window. I think enormous false precision comes into play with computer projections. Alternatively we make estimates off the top of our minds all the time, but we take this for what it is—a guess estimate. Lubrizol had already made projections to 2013 or 2015 and asked Warren if he wanted to see them. He said no.
- Buffett: It’s like asking the barber if you need a haircut. You don’t ask the investment banker if profits are going to go up. I’ve never seen an investment banker’s model that doesn’t show a company’s profits going up. Charlie and I have a model in our mind of what the company is likely to become over time and an idea of the potential error in our picture.
- Munger: If you’re in business school now I recommend you do it our way but if you’re in school you have to do it their way until you’re out.
Personal Holdings Aside from Berkshire Stock
- Buffett: I own very few securities. I like to focus on Berkshire. I have lots of government bonds but it’s not because they’re a great investment. It’s to say, push these aside so I can focus on Berkshire.
- Buffett: Outside the US we use our same evaluation techniques but we’re also aware that we’re more likely to be wrong or unaware of certain geopolitical issues. When we were looking at PetroChina we were also looking at Yukos. Yukos was cheaper but we didn’t like Russia. I’m not a geopolitical expert but I decided to buy PetroChina instead. One point about PetroChina: 45% dividend payout ratio was a big plus since it was way higher than any company in the US. We make adjustments for locales but the basics about business and industry economics and trust in management apply wherever we invest.
- Buffett: We don’t play around with short-term money. We didn’t own commercial paper before 2008. We don’t do money markets. We keep it all in treasuries. We get paid virtually nothing for it, but the very last thing we would do is risk our money for 30 for 50 basis points more. It’s a parking place and an unattractive parking place but we know our car is going to be there when we get back.
- Munger: We need to be able to deploy capital very quickly. Example of pipelines they engaged on a Saturday and bought on a Monday.
- Buffett: Our ability to come up with cash when we need it and the rest of the world doesn’t have it has made several deals happen. When somebody comes to us and says ‘we need a deal done’ and it’s big, we can do it.
- Buffett: We have fixed unprofitable companies inside Berkshire that would have gone bankrupt outside Berkshire.
- Buffett: I lived at the library for 3 or 4 years when I was 9 years old. It’s incalculable how much value you get from what you learn. My life would be a very different story if I had not worked to improve my communication skills. Starting out as a trader on Wall Street helped me realized this. Find something you are passionate about and then work to improve you skills in that area. You’ll do really well that way.
- Munger: Economics is really hard—most fields where not all experts agree are. Don’t hurry through economics—master the easy stuff first.
- Buffett: Harvard (Business School) rejecting me was one of the best things that happened to me in my life. My economics courses at Wharton didn’t help me much and we’re a significant part of my education.
Cash Vs. Stock Acquisitions
- Buffett: When you pay your own company’s stock to buy a new company, you’re saying one of two things: either your own existing companies are overvalued or you have a better use of the cash.
- Buffett: See’s Candy loses money 8 months a year but it’s still a great company. Why look at cyclical businesses differently? This is why we’re in the brick building business despite the housing downturn.
 Unfortunately video taping of any part of the shareholder meeting is illegal and I haven’t seen this video released by Berkshire online. Filmography was excellent—it included the entire cast of The Office and was filmed on the show’s set.
 Sokol bought $10M of shares in Lubrizol about one week before approaching Buffett with the deal to buy the whole company. When Buffett asked Sokol if he owned the company, he said “I’ve owned it,” without indicating that he just bought it last week. To Buffett this meant that he had owned it a long time—not just purchased it less than a week ago.
 Market value of equity is substantially higher than book value of equity for Berkshire. It would be interesting to compare its market value to economically adjusted book value, e.g. GEICO goodwill that Buffett says is worth $14B but has a book value of only $1B. Of course this would lower Berkshire’s price/book ratio, so attributing the entire price/book premium to Berkshire’s investment management ability isn’t telling the whole story.