[0:01]
WarrenYou've heard us talk here about the importance of our managers. However, occasionally, Charlie and I get involved in management ourselves, and we would normally be too modest to claim any great accomplishments, but we have had one rather incredible performance, which since Charlie participated in as well as I do, I think if we put up the slide on the company that Charlie, and I've managed personally, you'll see that this entity, you can't, Charlie, here it is right here. It's one where we took over 30-odd years ago, and as you can see, the 46,000. Excuse me, are you sure? Oh, okay. Oh, I guess we better put up the next slide. They got that first one. They got it reversed. It was, we were doing 120 million, one we took over, and we're now doing $46,000 a year, but we may get a bounce one of these years. That was a company that also had a lot of float, and we were attracted to. And the interesting thing is, you know, this was Blue Chip stamps, although Blue Chip was a copy of a sort of Spurray and Hutchinson, which really was the main inventor of trading stamps on any large scale in the country, and they go back to the 19th century. But if you think of it. about it, S&H stamps, green stamps, or blue chip stamps, had many similarities to frequent flyer miles. You know, the only difference being that, you know, you got them a lot of, like grocery stores and all of that, and then you had to lick and put them in a book, and what, whereas now it's all done electronically. But the basic underlying business was very similar to frequent flyer miles, which had this incredible hold on the American public. But somehow we were not able to make the transfer. We haven't yet made the transformation. Let's put it at the transformation. that way, from the lickett stamp to something that the public will accept. But we've still got $47,000 of revenue annually from the entire state of California. So we're building a base. Charlie and I continue to spend most of our time working on this one. Let's go to Area 7. I think we stopped in Area 6 last time, and we'll go from there.
QuestionerYes, my name is Mort November. I'm from Cleveland, Ohio. I'm here with my wife Iris, who in 1986 founded the Statue of Liberty Collectors Club. I wanted to tell you personally what Berkshire Hathway has meant for me. By owning it, we have become philanthropists in Cleveland. And the way it happened is we sold all our other stock.
[3:14]
OtherIt was never any fun owning it. And I could never understand that my stock went down and the CEO's bonuses went up. bonuses went up. So got rid of that and we took all of that money and we're doing things for children in Cleveland. On May 16th, we're sending a group, thank you. On May 16th for the 10th year in a row, we're sending a group of children from Cleveland Municipal Schools who win the trip by doing good work in their class and good work in the community to Dearborn Michigan, Henry Ford Museum, Greenfield Village. It's a lot of fun for them and it's really a lot of fun for us. We invested in a building in the Cuyahoga National Park for campers and hopefully we'll be able to help put up in addition to a library in East Cleveland, Ohio, which really needs all the help it can get. So my wish for you, gentlemen, is that you have many, many more years of good health and that we have the opportunity to see you on this stage, or any stage for as many years as you want. I salute you both. Thank you. Thank you.
WarrenIt's terrific what a number, a large number of Berkshire shareholders, particularly the ones perhaps, well maybe not particularly, but in the Omaha area, because they go way back to the partnership in a number of them in their mid-70s or thereabouts. But there have been a lot of things that have come out of the stock. In fact, there's been a suggestion that somebody may do a book on some of the things that have flowed from various Berkshire shareholders. I'm sure many of you know about the case of Don and Mid Offmer. Don went to Central High here in Omaha. Mid Offmer's mother, Maddie Top, was a wonderful woman who was the customer when I started selling securities when I was 20 or 21, and she ran a dress shop. And they left about $750 million to a group of mainly four or five charities, one of which was the University of Nebraska. But there have been all kinds of things, and there may actually be something done on that at some point. But I'm glad to hear what you're doing in Cleveland. Let's hear from Area 8, please.
QuestionerHi, my name is Jennifer Perlman from Toronto, Canada. Mr. Buffett, in 1998, you were asked to comment on the pharmaceutical industry. And at that time, your answer was that you considered it a mistake, not to comment on the pharmaceutical industry. not to have taken a basket approach to the industry. I was wondering if you could revisit the issue now that valuations have contracted so dramatically,
[6:08]
Questionerand also considering that health care spending is outpacing inflation, and that there are significant modes in the industry. I was wondering if you could share with us your thoughts on the healthcare industry at large.
WarrenWell, Charlie may be better equipped on that than I am, but certainly it's been as an industry, a very, very good business over time. I mean, if you take the aggregate capital in it and what it's earned over time, it's been a very, a very good business. And we did make a mistake. Your memory is 100% accurate and what we said earlier meetings, because we should have taken a package approach. We actually did buy a tiny, tiny bit, but that's worse than buying none almost. I mean, it's just aggravating back there in 93. There's certainly the kind of businesses that... that as an industry we can understand, we would not have great insights on specific companies. So if we did something, we would be more inclined to do it on an industry-wide basis. It's hard to evaluate the individual companies. As you know, Bristol-Myers has recently had a big stumble, and even Merck has fallen back. So it's hard to pick the winners, but that's no reason not to have a basket approach to the industry. And at some valuation level, it would be something we would think very hard about. And it's something where we could put quite a bit of money if it happened, which is another plus to us. Charlie?
CharlieWell, having failed to get it right the last time, we'll probably fail to get it right the next time. I don't know what he had for lunch.
OtherOkay, we'll go to number one.
WarrenWell, wait a second. Is there anybody at number nine?
OtherProbably not now.
WarrenYes, there is. Okay, good enough. Nine.
OtherPhil McCaw from Greenwich, Connecticut. Could you discuss if and how you take into account the individual balance sheets of the Coca-Cola bottleers to the Coca-Cola company, and if you view various regulatory control issues as a potential problem for Coca-Cola?
WarrenYeah, well, certain Coca-Cola bottles became quite leveraged, the ones that were, in general, acquiring companies. Coca-Cola Enterprise certainly became very leveraged over, it started out fairly leveraged and it became more leveraged in recent times. And they have a business that's a solid, steady business, but it's not one with abnormal profitability. So it can take leverage in the sense that it won't be subject to huge dips, but it also is a business where it's very tough to increase margins significantly.
[9:02]
WarrenSo if most of the money goes to debt service, it's a business. You know, that is something that you have to take into account when you value the equity. It's a fairly capital-intensive business, the bottling business. On average, you'll probably spend between 5% and 6% of revenues on capital expenditures just to stay in the same place. And in a business that before depreciation makes an interest in taxes, makes maybe 15 cents on the dollar. having five or six cents on the dollar go to capital expenditures is a pretty healthy percentage of that. That's true at the Pepsi Cola bottling company, too. It's just the nature of the bottling business. It's a reason why I like basically the syrup business better than the bottling business. It's less capital-intensive. And then the bottling business is a perfectly decent business. It isn't a wonderful business because it's very competitive out there. I mean, on any given weekend, the big supermarket in town or the Walmart or whatever is going to be featuring one or the other of the colas, and it's going to be based on price. And you're going to read ads saying, you know, 12 for something or other or six for something or other. And it has become something where a lot of people will switch from one to another based on price on that weekend. And that makes it a tough business for bottlers. But it's a decent business. But it doesn't, in terms of the Coca-Cola company itself, its bottles are going to do perfectly okay over time. And they've got to earn enough money to be able to sustain that kind of capital expenditure and earn a cost of capital. And if they get in trouble, it's because they, if they pay too much for another bottle, it gets tough to, it gets tough to make the math work. Is there a second question about Coca-Cola then, too?
QuestionerWell, I was curious if you concern yourself when you see FASB-type issues come out about control.
WarrenNo, yeah, no, I understand. I'm combining all the balance sheets type thing. That really doesn't make any difference to us. I mean, in the end, the Coca-Cola company, there's no question about it in my mind. And a Coca-Cola company needs a successful bottling group in order to prosper as a syrup manufacturer. But the profitability of bottling will allow that. And the capital requirements at the big Coke, as it's called, are relatively minor, so most of the money they make can either be used as dividends or share re-purchases.
[11:59]
WarrenBut nobody's going to run out of money at Coca-Cola, nor are their bottlers basically going to run out of money. So it is not a big balance sheet issue at all. And whether the figures are consolidated or otherwise, the economics are basically the same. I mean, you have a, you know, it is not, there's not going to be a capital crunch of any kind. It would show different ratios if you consolidate and if you didn't, but it really wouldn't change the basic economics any. Charlie?
CharlieYeah, I don't think it changes anything on a basic level. But, ideally, in the world, you wouldn't have capitalization structures that are designed partly for appearances sake.
WarrenThank you. Thank you. We pay a lot of attention to what we regard as the reality of the balance sheets and economic conditions and cash situation, all of that of a business. And sometimes we think accounting reflects reality and sometimes we don't. It's a good starting point for us always. But, I mean, there are there's at least one company, at least last year, that was using a 12% investment return assumption on its pension plan. And there are other companies that use, I think, even below six, certainly six. And in the end, should we look at the figures the same of one company, particularly if the pension fund's a big element, that uses 12 and 6? No, we look at what it says they're using. But in our minds, we don't think the company that's using a 12% assumption is likely to do any better with their pension fund. That's the one of the ones that's using In fact, we might even think the ones using six is likely to do better because we might think they're more realistic about the world. So we start with the figures of the companies we look at, but we've got our own model in mind as to what they will look like. It's true of our, the businesses we own 100% of them. Some of them have some debt in them, some of them don't. Partly that situation's inherited. In the end, we've got the same metrics that apply to them whether they happen to have some debt on their own particular balance sheet or not, because in the end, we're not going to be willing to have very much debt at all at Berkshire. And where its place doesn't really make any difference because we're going to pay everything we owe no matter where it is. And it's almost an accident whether Company A or Company B has a little debt attached to it. Area 10, is there anybody there?
[14:37]
QuestionerYes, sir. My name is Adam Chud. I'm from Columbus, Ohio. I attend the Ohio State University. My question is your comments on the new standards for the accounting of Goodwill.
WarrenYeah, the question about the new standards for Goodwill. Actually, if you read, I think, the annual report, maybe the 2000 annual report, and maybe even earlier, but we prescribed, we said what we thought would be the preferable system for how Goodwill was handled, namely, that it would not be amortized, and that it would not be amortized. that combinations of companies be accounted for as purchases, and it pretty well is what ended up coming out of the accounting profession. So the goodwill rules now are in accord with what we believe they should be, and for a long time they weren't. You might argue that it was against our interest to have what we think proper accounting is put in, because Some people were averse to buying businesses because of a goodwill charge they would incur, whereas it didn't make, made no difference to us whatsoever. We just looked at the underlying economics. So we may have a little more competition even on buying businesses, simply because now competitive buyers are not faced with a goodwill charge, which may have bothered them but didn't bother us. I regard the present goodwill rules as making sense. Charlie?
CharlieWell, I agree.
WarrenOkay. Thank you.
QuestionerArea 1. My name is Martin Wieghan from Bethesda, Maryland. Thank you for hosting this wonderful and informative shareholder meeting. Thank you also for running a Berkshire in a manner that is an example to corporate America in the world. You make us proud to be shareholders. My question, you touched on just before the lunch break, did the compensation plans at Berkshire and its competitors have anything to do with the missed priced insurance policies they issued, and if so, has Berkshire as competitors, change their compensation plans to correctly price those policies? I asked you this last year, I think, but are you my Martin's son or grandson?
QuestionerSon.
WarrenSon? Good enough. Martin's father and I went to high school together. Matter of fact, your Aunt Barbara and I went to high school together also, and she went out on one date with me, and that was the end. It was not. It was not because I didn't ask her out again. I picked her up in her hearse. I think that kind of put the... I think compensation plans lead to a lot of silly things, but I would say that at Berkshire's insurance companies,
[17:54]
WarrenI don't think our problems resulted from compensation plans at all. I think we had an enormous... We're talking about general... about General Rhee here, basically, because that's where we had the problem. I think General Rhee had an enormously successful operation, which went on for a long time, and I think that there was some drift away, perhaps because competitors were drifting away in a big way, too, from certain disciplines, and we paid a price for that. But I don't think the comp plans entered in any significant way, if at all, into the fact that we did drift away for a while. I think you want to have rational comp plans. I think we've got a rational comp plan at General Rhee, but it's quite similar to what we had before. And I just, I don't think that was the problem. I... It's very difficult. It's difficult in the investment world. When other people are doing things that look like they're working very well, you know, and they get sillier and sillier and sillier. It could be difficult for many people to not secure. come and do the same things. And that happens in investments, but it also happens in insurance. And it was, you know, it's a competitive world, and your people are out there every day, and they're competing against Swiss Re, and Munich Re, and employers re, and all of these people. And you've worked hard to get clients. And the client says, I want to stay with you. But the competitor says, if I go with him, I don't have to do this or that, or I can get a little cheaper or whatever. It's, you know, it's tough to walk away. And it may even be a mistake to walk away in certain cases. So I just think that there was a, what you might call, a cultural drift. I don't think it was a shift, but it was a drift. And I think it was produced in part by the environment in which the company was operating. And it took a jolt to get it back. And I think that it is back, I think it's probably stronger than ever in terms of what we have now, but I would not attribute it much to the compensation system. But I have seen a great many compensation systems that are abominations and lead to all kinds of behavior that I would regard not as in the interests of shareholders. But I don't think we've had much of that at Berkshire. Charlie?
CharlieYeah, I think if you talk generally about stock option plans in America, you see a lot of terrible behavior caused, and no doubt they do.
[20:41]
Charlieno doubt they do a lot of good at other places. But whether they do more good than harm overall, I wouldn't know. I think in particular, you have a corporation where a man has risen to be CEO. He now has hundreds of millions of dollars in the stock of the company. He's been loyal to the company, and the company's been loyal to him for decades. And he has his directors vote him a great stock option annually to preserve his loyalty to the loyalty to the company and his enthusiasm to the business when he's already old. I think it's bemented. How about when they grant options as he leaves the company? And I also think it's immoral. I think that there comes a time when, when, and I don't think you would improve the behavior of the surgeons at the Mayo Clinic or the partners of Kravath, Swain, and Moore, if you gave the top people stock options in their 60s. I mean, by that time, you ought to have settled loyalties. And you ought to be thinking more about the right example for the company than whether you take another $100 million for yourself.
WarrenYeah, well, we had a case. We've inherited some option plans because companies we merged with Adam and some cases they got settled for cash at the time, some cases they continued on depending on the situation. But more money has been made from options at Berkshire by accident and that, you know, this is not, it's just happened that way, but more money was made by people that had options on General Re stock during a period when General Re Re contributed to a decrease in value of Berkshire. So we had all of the other managers essentially, in great many cases, turning in fine results and we had a bad result at General Re and yet more money by a significant margin was made under options at General Re than had been made probably by... all other entities combined. But it was an accident, but that's the point. It can lead to extremely capricious compensation results that have no bearing on the performance of the people. In some cases, get great benefits. In other cases, people did great jobs, and their efforts were negated by results elsewhere. So it's, it would be very capricious At Berkshire, you can argue that at Berkshire, for those that succeed me and Charlie, that anybody that is in the very top position at Berkshire has got the job of allocating resources for the whole place. There could be a logically constructed option plan for that person,
[23:46]
Warrenand it would make some sense because they are responsible for what takes place overall. But a logically constructed plan would have a cost of capital build into it for every year. we don't pay on any dividends. So why should we get money from you free? We could put it in a savings account, and it would grow in value without us doing anything. And a fixed price option over 10 years would accrue dramatic value to whoever was running the place, if they had a large option, for putting the money in a savings account or in government bonds. So there has to be a cost of capital factor in to make options equitable. In my view, that there can be cases where they make sense. They should not be granted it below the intrinsic value of the company. I mean, the market, a CEO who says, you know, my stock is ridiculously low when a merger, when somebody comes around and wants to buy the company, but then grants himself an option at a price that he's just gotten through saying is ridiculously low, that bothers me. So if somebody says, you know, I wouldn't, we don't want to sell this company for less than $30 this year because it's going to be worth a lot more later on, you know, my notion is that the option should be at $30 even if the stock is $15. You know, otherwise you have a actually a premium build-in for having a low stock price in relation to value. And I've never gotten too excited about that. Charlie, do you have any further thoughts on options?
CharlieWell, we've been, we're so different from the rest of corporate America on this subject that, you know, we can sound like a couple of Johnny One Notes, but I don't think we ever quite tire of the subject. A lot is horribly wrong in corporate compensation in America. And the system of using stock options on the theory they really don't cost anything has contributed to a lot of gross excess. And that excess is not good for the country. You know, Aristotle said that systems work better when people look at the different outcomes and basically appraise them as fair. when large percentages of people look at corporate compensation practices and think of them as unfair, it's not good for the country. It will be hard to change, though, because basically the corporate CEOs have their hands on the hands on the switch. I mean, they control the process. You can have comp committees and all of that, but it's a practical matter. I've been on 19 public boards. Charlie's been on a lot of them,
[26:29]
Warrenand in the end, the CEOs tend to get pretty much what they want and what they want tends to go up every year because they see other people getting more every year and there's a ratcheting effect and the consultants fan the flames and it's very difficult to get change and right now you've got corporate CEOs descending upon Washington to doing everything from trying to persuade to threaten your elected representatives to not have options expensed and it's I think it's kind of shameful actually because it you This group who was getting fed very well under the system does not want to have those what clearly is a compensation expense recorded because they know they won't get as much. I mean, it's that simple and it's not based on anything much more complicated in area two.
QuestionerGood afternoon. David Winters, Mountain Lakes, New Jersey. Mr. Buffett and Mr. Munger, thank you for hosting Woodstock for capitalists. I know it's a lot of fun for everybody and I think a lot of fun for you. Assuming growth of low-cost float and the sins of the past do not impede progress. Does the sheer size of the float create constraints that change the allocation of future investments to more high-quality fixed income obligations rather than equity coupons or workouts that can grow over time? It seems otherwise, Birchshire is incredibly well positioned if valuations ever decline.
WarrenWell, I think the answer is we probably are pretty well positioned if valuations decline. And it's a good question. If you have 37 billion afloat, are you going to be more constrained to conventional investments than if you were working with a half a billion or a billion as we were not so long ago? As long as you have a huge capital position, which we have and will continue to have, and as long as you have a lot of outside earning power, which we have and will continue to have, I don't think we're constrained very much. I mean, we'll always want to have a significant level of liquidity relative to any kind of payment pattern that we see for a good length of time. But we will probably be operating with so much capital and with so much earning power independent of the insurance business and with so much liquidity that we really will be able to make decisions as to where, how the assets should be deployed. in terms of simply where we see the best returns in virtually no risk. And sometimes we see virtually no risk in equities when they're extremely cheap.
[29:20]
WarrenWe don't see that situation now, but we could see it again. And I don't think we'll be very constrained when the time comes. Charlie?
CharlieYeah, our constraint doesn't come from structure. It comes from a lack of enthusiasm for stocks generally. The bonds are held as a default option.
QuestionerArea 3. Dear Mr. Buffett and Mr. Munger, my name is Adrian Churn. I'm a shareholder from Hong Kong. Thank you for your leadership and inspiration, as always. It's wonderful, always listening to you. If I may, I would like to ask of you both, gentlemen, a question in two parts. Perhaps I can ask the second part after you've answered the first part. The first part of the question relates to the Fortune article dated 10th of December you included now shareholder materials. In this article, you mentioned that one couldn't explain the remarkable divergence in markets by differences in the growth of GNP. However, one could explain the divergence by interest rates. The first question I have is this. I wonder, sir, if you were to look at the price of gold during the two periods of times you mentioned, that is to say, in 1948, 64 and 6481, if the explanation could be even more clear. Thus, the logical reason would be, be why the Dow in 48 was 177, and half the level of 1929 in 381 index points, is because of the 71% devaluation of the American dollar from 20.5 cents an ounce to 35 cents an ounce, which would put the fair value of the Dow at 166 after factoring in the record 50% per capita gain of the 1940s that you had mentioned.
WarrenYeah. I grew up in a household, and my sisters are here, where gold was talked about frequently. So I've been exposed to a lot of thinking on that over the years. I don't really think gold has really, the price of gold, I should say, has anything really to do with the valuation of businesses. It may reflect certain things that are going on in prices attached to those businesses at a given times. But I would not regard, I mean, the price of gold does not enter into my thinking in any way, shape, or form, in terms of how I value a business today, a year ago, 10 years ago, or tomorrow. When we look at Larson Jewell, the custom picture frame, operation. You know, I'm not thinking against, I'm not thinking of that in relating in any way to what gold is done. So I, it's just not a factor with us any more than other commodities would be. I mean, you know, whether it's wheat, whether it's cocoa beans or whatever.
[32:33]
WarrenIt has, you know, it has a certain hold on some people and they, they, but it's, we don't look at at it as an interesting investment and we don't look at it as a yardstick for valuing other investments. Charlie?
CharlieYeah, Warren is right when he says that interest rates are very important in determining the value of stocks generally. I think he's also right when he says gold is very unimportant.
QuestionerThe second part of the question? Thank you, sir. The second part of my question is this, given your assumptions on gold, If you were to factor a significant decline in the value of the dollar against gold, let's say 40% or more, and given the correlation of 1929, 48 and 6481 eras, positively to decline of the dollar, and the negative correlation in the other two areas that you had studied, would you care to adjust the 7% total annual return you were quoted as expecting for common equity in the coming decade? And in conjunction with that, would you care to comment on your expected rate of return on all other major asset classes, perhaps like bonds, real estates, and which would you believe offers the best value for investors? Thank you very much.
WarrenExcept under unusual circumstances, my expected rate, my expectancy on something like bonds is what bonds are producing at a given time. I don't think I'm smarter than the bond market. Now, you can say when those rates swing all over, does that mean I swing? all over? The answer is pretty close to yes. I mean, I don't know what the right rate for bonds is. I think that if there's, I'm very leery of economic correlations. I mean, I spent years fooling around with that sort of thing. And I mean, I, I correlated stock prices with everything in the world. And the, you know, the problem was when I found a correlation. I mean, it's, you know, you know, you know, you've seen these things on whether the AFC or the NFL wins the Super Bowl and all of that sort of thing. You can find something that correlates with something else. But in the end, a business or any economic asset is going to be worth what it produces in the way of cash over its lifetime. And if you own an oil field, if you own a farm, if you own an apartment house, you know, with the oil field, if you own an apartment house, you know, with the oil field, it's the life of the oil field. and what you can get out of it, maybe you get secondary recovery, maybe you get tertiary recovery,
[35:21]
Warrenwell, whatever it may be, it's worth the discounted value of the oil that's going to come out. And then you have to make an estimate as to volume and as to price. With a farm, you make an estimate as to crop yield and costs and crop prices. And the apartment house, you make an estimate as to rentals and operating expenses and how long it'll last and when people will build other new apartment houses that, the potential renters in the future we'll find preferable and so on. But all investment is is laying out some money now to get more money back in the future. Now there's two ways of looking at the getting the money back. One is from what the asset itself will produce. That's investment. One is from what somebody else will pay for it later on, irrespective of what the asset produces, and I call that speculation. So if you are looking to the asset itself, you don't care about the quote because the asset is going produce the money for you. And that's what society as a whole is going to get from investing in that asset. Then there's the other way of looking at it is what somebody will pay you tomorrow for it, even if it's valueless. And that's speculation. And of course, society gets nothing out of that eventually, but one group profits at the expense of another. And of course, you had that operate in a huge way in the bubble of a few years ago. You had all kinds of things that were going to produce. nothing, but where you had great amounts of wealth transfer in the short term. As investments, you know, they were a disaster. As means of wealth transfer, they were terrific for certain people. And they were, for the other people that were on the other side of the wealth transfer, they were disasters. We looked solely, we don't care whether something's quoted because we don't buy it with the idea of selling it to somebody. We look at what the business itself were produced. We bought Seas Candy in 1972. The success of that has been because of the cash it's produced subsequently. It's not based on the fact I call up somebody at a brokerage house every day and say, what's my Seas Candy stock with? And that is our approach to anything. On interest rates, I'm no good. I bought some REITs a couple of years ago because I thought they were undervalued. Why did I think they were undervalued? Because I thought they could produce 11 or 12 percent in terms of the assets that those companies
[37:45]
Warrenhad. And I thought an 11 or 12 percent. return was attractive. Now the reeks are selling at higher prices and, you know, they're not as attractive as they were then. But you just look at every asset class, every business, every farm, every reed, whatever it may be, and say, what is this thing likely to produce over time? And that's what it's worth. It may sell it vastly different prices from time to time, but that just means one person is profiting against another, and that's not our game. Charlie?
CharlieWhat makes common stock prices is so hard to predict, is that a general liquid market for common stocks creates from time to time either in sectors of the market or in the whole market, a Ponzi scheme. In other words, you have an automatic process where people get sucked in and other people come in because it worked last month or last year and it can build to perfectly ridiculous levels. and the levels can last for considerable periods. Trying to predict that kind of thing, sort of a Ponzi scheme, which is, if you will, accidentally thrown into the valuation of common stocks by just the forces of life. By definition, that's going to be very, very hard to predict.
WarrenThat makes it so dangerous to short stocks, even when they're grossly overvalued. It's hard to know just how overvalued. they can be common addition to the overvaluation that exists. And I don't think you're going to predict the Ponzi scheme effect in markets by looking at the price of gold or any other correlation. Charlie and I, I mean, pulling a figure out of the air, we have probably agreed on at least 100 companies, maybe more, that we felt were frauds, you know, bubble-type things. And if we'd acted on shorting those over the years, we might be broke now. But we were right on probably just about 100 out of 100. It's very hard to predict how far what Charlie calls the Ponzi scheme will go. It's not exactly a scheme in the sense that it isn't concocted, most cases, by one, but it's sort of a natural phenomenon that seems to, nursed along by promoters and investment bankers and venture capitalists and so on. But it's, it's, it's, it's, they all sit in a room and work it out. It just, it plays on human nature in certain ways, and it creates its own momentum, and eventually it pops, you know, and nobody knows when it's going to pop. And that's why you can't short, at least we don't find it, uh, makes good sense to short those
[40:51]
Warrenthings, but they are, it is recognizable. You know when you're dealing with those kind of crazy things, but you don't know when, how high they'll go or one of the land. or anything else. And people who think they do, you know, sometimes playing, and other people know how to take advantage of it. I mean, there's no question about that. You don't, you do not have to have a 200 IQ to see a period like that and figure out how to have a big wealth transfer from somebody else to you, you know, and, and that was done on a huge scale, you know, in recent years. It's not the, you know, it's not the most admirable aspect of capitalism.
OtherVery afore.
QuestionerYes, good afternoon, Mr. Buffett and Mr. Munger. My name is Ho Nam, and I'm from San Francisco, California. I have a question related to an issue you touched on a few moments ago. On the debate over whether or not stock options should be expensed and reflected on the income statement of companies. With the current system, shareholders are incurring the burden of stock options since exercised options dilute earnings per share. As a shareholder of companies that issue stock options, I think I'm okay with that, especially in entrepreneurial companies that may not have enough cash to attract talent from larger competitors, or in cases where you have younger employees or lower-level employees who do not have the cash to purchase stock without the use of options. I have a two-part question. If companies are required to expect, stock options and impacts to P&L, would that lead to double counting the impact of stock options? And the second part is, if the use of stock options are largely eliminated, might that impact the competitiveness of entrepreneurial companies which help drive innovation and growth and create more of a dividing line between shareholders and employees?
WarrenYeah, the first question is that there really isn't the double counting necessarily. For example, let's just take a company with a million shares of stock outstanding, selling at $100 a share, and let's say that options are granted for 9 million shares, we'll make it extreme at $100 a share. At that moment, you've given 90% of the upside to the management. We're taking a very extreme example. That's been at a huge cost to the shareholders. Now, interestingly enough, if the stock was selling on $100 a share, the fully diluted earnings are exactly the same as the basic earnings in that year, because the dilution is not
[43:45]
Warrencounted at all unless the stock is selling above and then only by the difference in the market value of what it cost to repurchase the option shares. So there is not double, there is not double counting, and you could issue the very fact that you issued that million, the options on 9 million more shares at 100 would undoubtedly cause the price to actually fall well below 100. And there would be no dilution shown in terms of the way gap reports diluted earnings. The second question is to whether if you expense the options, it would discourage the option use. Well, the argument that is made when people issue options is doing more for the company than giving people cash compensation, maybe more convenient to cash compensation too for young and upcoming companies. But the fact that you are doing something in terms of paying people in a way that you say is even more effective than paying them in cash, to say that therefore you shouldn't have to record the payment, I've never really followed it. I don't have any objection to options under some conditions. I have never taken a blanket position that options are sinful or anything of the sort. I just say they are an expense. And to be truthful with people about what you're earning, you should record the expense. And if a company can't afford to be truthful, you know, I have trouble with that. And we will take, as we've said, you can pay your insurance premium to me in options. There'd be lots of companies. I'd be happy to take options in and give them credit. I take options above the market. Give me a 10-year option, 50% above the market in many companies, and we will take that. appropriate number of shares and take that in lieu of cash. But that means we simply like, you know, the value of what we're getting better than the equivalent amount of cash. And we think the company that gives it to us has incurred in an expense. We really say something of value. They've given some value up, and that's income to us, an expense to them. And I think all of the opposition at bottom to the expensing of options comes from people who know they're not going to get. as many options if they're expensed and they, you know, they would like cash not to be expensed, but they can't get away with that, you know, I mean, if you had, if you had an accounting rule that said the CEO's salary should not be counted in cash, believe me, the CEOs
[46:13]
Warrenwould be in there fighting to have that rule maintained. I mean, because no one would, they would feel that they were going to get more cash if it wasn't expensed and options are the same way. It said, another argument I get a kick out of, I just reading it the other day, where they say, well, options are too tough to value. Well, I've answered that in various forms, but I noticed that, what is it? Dell computer, it always has a great number of put options out, and it's going to cost them a lot of money on the put options they have out. And for a company to say we can't figure out the value of options, and therefore we can't expense them, and then at the same time being dealing in billions of dollars worth of options, they are saying we're out buying or selling options in the billions of dollars, but we don't know how to value these things. That strikes me as a little bit specious, a little disconnected, cognitive dissonance, as they say, Charlie?
CharlieYeah, I'm not at all against stock options in venture capital, for instance, but the argument that prominent venture capitalists have made that not expensing stock options is appropriate because if you expense them, it would be counting the stock options that the stock options double. That's an insane argument. The stock option is both an expense and a delusion, and both factors should be taken into account in proper accounting. John Doer, the venture capitalist, as he argues to the contrary, is taking a public position that were it offered to me as part of my employment. I would rather make my living playing a piano and a whorehouse.
WarrenWe always get to the good stuff in the afternoon. I hope the children are in bed.
QuestionerNumber five. Good afternoon. My name is Bob Baden from Rochester, New York. Mr. Munger, this morning, while discussing index funds, used the example of Japan as a real example of poor performance of a major index over a long period. Indeed, the S&P 500 index declined over 60% of a long period. 60% in real terms from the early 60s through the mid-70s. Could you discuss the mental models you use to consider the impact of inflation or deflation on your investment decisions and the likelihood of either occurring over the next decade?
CharlieWell, that's partly easy and partly tough. If interest rates are going to go way up, you can obviously have a lot of deflation of stock prices. And a lot of that happened in the American period you're talking about.
[49:30]
CharlieWhat's interesting about Japan is that I don't think anybody thought that a major, modern, Keynesian democracy pervaded by a good culture in terms of engineering, product quality, product innovation, and so forth. could have a period where you would have negative returns over 13 years without major depression either. I think that, and that it would occur while interest rates were going down, not up. I think that was so novel that the models of the past totally failed to predict it. But I think these anomalies are always very interesting, and I think it's crazy for Americans to assume that what's happening in Argentina and what has happened in Japan are totally inconceivable forever in America. They are not totally inconceivable. You had a huge bubble in equity prices in Japan, and now you've had interest rates go to virtually nothing. We've had the passage of time. The country hasn't disappeared. People are going to work every day, and you've had this, the Niki, you know, now at a third of what it's sold for. not that many years ago. It's an interesting phenomenon. And huge fiscal stimulus in the whole period from the government. Post-bubble periods, I think, depending on how big the bubble is, and how many were participating in, but post-bubble periods, I think, can produce fallout that not everyone will be terribly good at predicting.
QuestionerSix. Hi, I'm Steve Rosenberg. I'm 22 from Ann Arbor, Michigan. It's a privilege to be here. First, I'd just like to thank you both for serving as a hero and positive role model for me and many others. Much more than your success itself, I respect your unparalleled integrity. I have three quick questions for you. The first is how a youngster like myself would develop and define their circle of competence. The second involves the role of creative accounting and the stories of tremendous growth and success over many years. GE, Tyco, and IBM immediately come to mind for me, but I was hoping you could also discuss that issue in relation to Coke. Some people have said that their decision to lay off much of the capital in the system onto the bottlers who earn low returns on capital is a form of creative accounting. On the flip side, others counter that Koch's valuation at first glance on, say, a price-to-book metric is actually less richly valued than it seems. because they earn basically all the economic rents in the entire system.
[52:27]
QuestionerMy final question is, if you could comment on the A.W. Jones model, the long short equity model. I understand that it doesn't make sense for capital the size of Berkshire is to take that type of a strategy, but it just seems to me that playing the short-sighting combination also seems incredibly compelling, even giving the inherent structural and mathematical disadvantages of shorting. And I was wondering if you could talk a little bit more about why you would have lost money on your basket of 100 frauds. It's an industry question.
WarrenAnd we'll start, we'll go in reverse order. Many people think of AW Jones, who was a fortune writer at one time, and who developed the best known hedge fund, whenever it was in the early 60s, or thereabouts, maybe the late 50s even. And for some of the audience, the idea originally with A.W. Jones is that they would go long and short, more or less equal amounts and have a market neutral fund so that it didn't make any difference, which way the market went. They didn't really stick with that over time. And I'm not even sure whether A.W. Jones said that they would. But they, you know, sometimes they'd be 140% long and 80% short. so they'd have a 60% net long or whatever it might be. They had, they were not market neutral throughout the period, but they did operate on the theory of being long stocks that seemed underpriced and short stocks that were overpriced. Even the Federal Reserve, in a report they made on the long-term capital management situation a few years ago, credited A.W. Jones with being sort of the father of this theory of hedge funds. As Mickey Newman, if he stole, if he's still, here knows, I think it was in 1924 that Ben Graham set up the Benjamin Graham fund, which was designed exactly along those lines, and which even used paired securities. In other words, he would look at General Motors and Chrysler and the side which he thought was undervalued relative to the other and go long, one and short the other. So the idea, and he was paid a percentage of the profits, and it had all of the attributes of today's hedgefurt. funds, except that was started in 1924. And I don't know that Ben was the first on that, but I know that he was 30 years ahead of the one that the Federal Reserve credited with being the first, and that many people still talk about it being the first A.W. Jones. Ben did not find that particularly successful, and he even wrote about it some in terms of the problems
[55:19]
Warrenhe encountered with that approach. And my memory is that, that a quite high percentage of the paired investments worked out well. He was right. The undervalued one went up and the overvalued, or the spread between the two narrowed. But the one time out of four or whatever it was that he was wrong, lost a lot more money than the average of the three that he was right on. And, you know, all I can say is that I've shorted stocks in my life and had one particularly harrowing experience in 1954. And I have, I can't, I can hardly think of a situation where I was wrong if viewed from 10 years later, but I can think of some ones where I was certainly wrong from the view of 10 weeks later, which happened to be the relevant period, and during which my net worth was evaporating and my liquid assets were getting less liquid and so on. So it's all I can tell you is very difficult. And the interesting thing about it, of course, is AW Jones was a darling of the late 1960s. And Carol Loomis is here, and she wrote an article called The Jones Nobody Keeps Up With. And it's a very interesting article. But nobody was writing articles about A.W. Jones in 1979. I mean, something went wrong. And there were spinoffered from his operation. Carl Jones spun off from his operation. Dick Radcliffe spun off from his operation. You can go down the list. And out of many, many, many that left, they have very high percentage of them bit the dust, including suicides, cab driver, subsequent employment, the whole thing. And these people were, there was a book written in the late 60s, had a lot of pictures in. I don't remember the name of it, but it showed all these portraits of all these people that were highly successful in the hedge fund business. They didn't bring out a second edition. So it's just tough. Logically, it should work well. But the math of only, you can't short a lot of something. You can buy to the cows come home if you got the money. You can buy the whole company, but you can't short the whole company. I thought I'm Robert Wilson. There's some interesting stories about. He's a very, very smart guy. And he took a trip to Asia one time, being short. I think it was Resorts International. Maybe it was Mary Carter Payne. was still calling those days. And he lost a lot of money before he got back to this country. He's a very smart guy. He made a lot of money shorting stocks, but it just takes one to kill
[58:06]
CharlieWell, he asked about creative accounting, and he named certain companies. I wouldn't agree that all those companies were plainly sinful, although I'm sure there are very significant sins in the group as a whole. Creative accounting is an absolute curse to a civilization. You can argue that one of the great inventions of man was double entry, bookie. where we could keep our economic affairs under better control. And it was a North Italian development spread by a monk. And anything that sort of undoes the monk's work by turning this great system into kind of a tool for fraud and folly, I think does enormous damage to the country. Now, I think democracy is ordinarily set up, so it takes a big scandal to cause much reform. reform. And there may be some favorable fallout from Enron because that was certainly the most disgusting example of a business culture gone wrong than any of us is seen in a long, long, long time. What was particularly interesting was it took in eventually a lot of nice people that you wouldn't have expected to sink into the whirlpool. And, uh, and, and I think we'll always get Enron type behavior, but it may be moderated some in the next few years.
WarrenThe question of accounting and the economic profits to be gathered in the bottling system versus the production of the syrup at Coke. I've just gotten through reading the annual reports of Coca-Cola-Femson and Pan Amco, which are two big Latin American bottlers. I mean, they make pretty decent money, quite significant money. and there is more money in owning the trademark. It isn't the plants that make the syrup or anything itself. The trademark is where a huge amount of value is. The trademark is where a huge amount of value is and sees candy. You know, those are big, big assets. And I would say that you can make good money as a bottle, a lot of bottler. A lot of bottlers have become rich over the years. If I had a choice between owning the trademark and owning a bottling business, I'd rather own the trademark. But that doesn't mean the bottling business is a bad business at all.
[1:01:14]
WarrenAnd it's riding on the back of a trademark. I mean, that is why a bottling system is valuable is because it has the right to sell a trademark product, which hundreds of millions of people every day are going to go in and ask for by name. And the right to distribute that product is worth good money. And it really, I don't see any accounting questions in that sort of thing. In other words, if the Coca-Cola company did not own a share in any of its bottlers, and for many years it either owned 100% of a bottleer, large part, or very few of those or none of it, but if they owned no interest in their bottlers, I think the economics would be very, very similar to what they are now. I mean, the borrowers would still be able to borrow a lot of money because they would have contracts with the Coca-Cola company that were important and that would allow them to make decent money distributing the product, but they don't make the kind of money that you make if you own the trademark, just the way it works. What was the first question again? It was how a youngster like myself would define and develop a circle of competence. Oh yeah, that's a good question. You know, I would say this. If you have doubts about something being injured, your circle of competence, it isn't. You know, in other words, I would look down the lists of businesses, and I will bet you that you can, I mean, you can understand a Coke bottler. You can understand a Coca-Cola company. You can understand McDonald's. You can understand, you know, you can understand in a general way, General Motors. You may not be able to value it. But there are all kinds of business. You can certainly understand Walmart. That doesn't mean whether you decide what the price should be, but you understand Walmart. You can understand Costco. And if you get to something that your friend is buying, or everybody says a lot of money is going to be made and you don't, and you're not sure whether you understand it or not, you don't. You know, it's better to be well within the circle than to be trying to tiptoe along the line. And you'll find plenty of things within the circle. I mean, I mean, it's not terrible to have a small circle of competence. I'd say my circle of competence is pretty small, but it's big enough. You know, I can find a few things. And when somebody calls me with a Larson Jewel, that is within my circle of competence. I hadn't even
[1:03:45]
Warrenthought about it before, but I know it's within it. I mean, I can evaluate a business like that. And if I get called, I got called the other day on a very large finance company, I understand what they do. But I don't understand everything that's going on within it, and I don't understand whether I can continually fund it, you know, on a basis independent from using Berkshire's credit and so on. So even though I could understand every individual transaction they did, I don't regard the whole enterprise or the operation of it necessarily as being within my circle of competence. Charlie?
CharlieYeah, I think that if you have competence, you almost automatically have. a feeling of where the edge of the competence is. Because after all, it wouldn't be much of a competence if you didn't know its boundary. And so I think you've asked a question that almost answers itself. My guess is you do know what you're perfectly competent to do in all kinds of areas. And you do have all kinds of other areas where you know you'd be over your depth. I mean, you're not trying to play chess against Bobby Fisher or do stunts on the high trapeze if you've had no training for it. My guess is you know pretty well where the boundaries of your competence lies. And I think you also probably know pretty well where you want to stretch the boundary. And you've got to stretch the boundary by working at it, including practice. One of the drawbacks to Berkshire, of course, is that Charlie and I, our circles largely overlap. So you don't get too big complete circles at all. But that's just the way it is. Probably why we get along so well too. Number seven. Good afternoon, gentlemen. Wayne Peters is my name. And I'm from Sydney, Australia. I'd have never guessed. No. I'll speak a little slower so my accent doesn't throw you. Good. My question goes further to the resolution on population control raised this morning. Firstly, can I say I voted against it? And I guess that's just the beauty of the democratic society. Of concern, however, was the gentleman's implication that the world's population has decreased or is decreasing. Having read the book Charlie recommended last year by Garrett Harden called Living Within Limits, I've got a reasonable feel and understand the population grew by about 1.7% last year, which is approximately 67 million people. In my terms, I'd relate that to approximately four times the population of Australia.
[1:06:37]
Questionerclearly an alarming rate over the long term if you're talking, you know, 500,000 years. Reading between the lines, my guess is that the issue of population growth is likely to be a key focus of the Buffett Foundation. My question to you this afternoon is, how do you currently see this critical issue being tackled?
WarrenYeah, well, population projections are just that. They're projections, and they've been notoriously inaccurate over the years. And a gentleman that made the motion referred to a recent New York Times story. And there are projections that, based on fertility rates and what happens to them in different countries under different economic conditions and all that. I mean, you can come up with all kinds of projections. I don't know the answer on it. Nobody does at any given time. And the carrying capacity of the earth has turned out to be a lot greater than people have thought in the past. there is some amount that does relate to the carrying capacity. It may have been expandable, but it's not infinitely expandable. And I would suggest that the errors of being on the low side in terms of population rather to estimated carrying capacity, the danger from those errors is far, far less than the dangers from overshooting in terms of population compared to carrying capacity. And since we don't know what carrying capacity is or will be a hundred, years from now. I think that generally that mankind has an interest in making sure it doesn't overshoot in terms of population. There's no great penalties attached to undershooting at all that I see. And it's the old analogy, if you were going to go on a spaceship for 100 years and you knew in the back of the spaceship there were provisions, there were a lot of provisions, but you didn't know exactly how much. In terms of filling the front of the spaceship with a given number of people, you would probably air on the low side. I mean, if you thought maybe it could handle 300 in terms of the revisions, I don't think you'd put 300 people in there. I think you'd put about 150 or 200, and you'd figure that you just didn't know, for sure the spaceship would get back in 100 years. You wouldn't know how much was in the back. And you would be careful in terms of not overshooting the carrying capacity of whatever the vehicle you were in. And we're in a vehicle called Earth. We don't know its carrying capacity. We learn that it's a lot larger than might have been thought.
[1:09:06]
Warrenby Malthus or somebody a few hundred years ago, but that doesn't mean it's infinite at all. And I don't, the one thing I will assure you is the projections that we're running the New York Times, you know, a few weeks ago, we're not going to be the ones that are going to be run 50 years from now or 30 years from now. And it's not the sort of thing that is cured after the fact. I mean, you're not going to go around trying to intentionally reduce the population. It's much better to prevent population growth than try and correct afterwards. And Garrett Hardin has got some interesting stuff on that. Charlie?
CharlieYeah, I will say that the whole controversy has been interesting in the way both sides don't understand the other sides model. By and large, on the population alarm side, the ecology side, they've always underestimated the capacity of modern civilization to increase carrying capacity. And the more they underestimate by the least, the less they seem to learn. That is not to the credit.