How Inflation Swindles the Equity Investor

This article orginally appeared in Fortune Magazine in May 1977.

How Inflation Swindles the Equity Investor

The central problem in the stock market is that the return on capital hasn´t risen with inflation. It seems to be stuck at 12 percent.

by Warren E. Buffett, FORTUNE May 1977

It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market's problems in this period are still imperfectly understood.

There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn't going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.

It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their Value in real terms, let the politicians print money as they might.

And why didn't it turn but that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.

I know that this belief will seem eccentric to many investors. Thay will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company's earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by compa-nies during the postwar years will dis-cover something extraordinary: the returns on equity have in fact not varied much at all.

The coupon is sticky

In the first ten years after the war - the decade ending in 1955 -the Dow Jones industrials had an average annual return on year-end equity of 12.8 percent. In the second decade, the figure was 10.1 percent. In the third decade it was 10.9 percent. Data for a larger universe, the FORTUNE 500 (whose history goes back only to the mid-1950's), indicate somewhat similar results: 11.2 percent in the decade ending in 1965, 11.8 percent in the decade through 1975. The figures for a few exceptional years have been substantially higher (the high for the 500 was 14.1 percent in 1974) or lower (9.5 percent in 1958 and 1970), but over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter).

For the moment, let's think of those companies, not as listed stocks, but as productive enterprises. Let's also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an "equity coupon".

In the real world, of course, investors in stocks don't just buy and hold. Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity, coupon but reduces the investor's portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to, the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.

Stocks are perpetual

It is also true that in the real world investors in stocks don't usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they've had to pay more than book, and when that happens there is further pressure on that 12 percent. I'll talk more about these relationships later. Meanwhile, let's focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return - just like those who buy bonds.

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.

Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity "coupons" won't. It is true, of course, that for a long time a 12 percent coupon did not appear in need of a whole lot of correction.

The bondholder gets it in cash

There is another major difference between the garden variety of bond and our new exotic 12 percent "equity bond" that comes to the Wall Street costume ball dressed in a stock certificate.

In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor's equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.

The good old days

This characteristic of stocks - the reinvestment of part of the coupon - can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950's and early 1960's. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent via s of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can't pay far above par for a 12 percent bond and earn 12 percent for yourself.

But on their retained earnings, investors could earn 22 percent. In effert, earnings retention allowed investots to buy at book value part of an enterprise that, :in the economic environment than existing, was worth a great deal more than book value.

It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 1960's, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to reinvest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.

If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a f urther unusual characteristic - which was that most of the coupon payments could be automatically reinvested at par in similar bonds - the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy - and, of course, they paid happy prices.

Heading for the exits

Looking back, stock investors can think of themselves in the 1946-56 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966, Such a marking-up process temporarily allowed investors to achieve a return that exceeded the inherent earning power of the enterprises in which they had invested.

This heaven-on-earth situation finally was "discovered" in the mid-1960's by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percept and the reinvestment "privilege" began to look different.

Stocks are quite properly thought of as riskier than bonds. While that equity coupon is more or less fixed over periods of time, it does fluctuate somewhat from year to year. Investors' attitudes about the future can be affected substantially, although frequently erroneously, by those yearly changes. Stocks are also riskier because they come equipped with infinite maturities. (Even your friendly broker wouldn't have the nerve to peddle a 100-year bond, if he had any available, as "safe.") Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return - and 12 percent on equity versus, say, 10 percent on bonds issued py the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.

But, of course, as a group they can't get out. All they can achieve is a lot of movement, substantial frictional costs, and a new, much lower level of valuation, reflecting the lessened attractiveness of the 12 percent equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the course of discovering that there is no magic attached to any given coupon level - at 6 percent, or 8 percept, or 10 percent, bonds can still collapse in price. Stock investors, who are in general not aware that they too have a "coupon", are still receiving their education on this point.

Five ways to improve earnings

Must we really view that 12 percent equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation?

There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales.

And that's it. There simply are no other ways to increase returns on common equity. Let's see what can be done with these.

We'll begin with turnover. The three major categories of assets we have to think about for this exercise are accounts receivable inventories, and fixed assets such as plants and machinery.

Accounts receivable go up proportionally as sales go up, whether the increase in dollar sales is produced by more physical volume or by inflation. No room for improvement here.

With inventories, the situation is not quite as simple. Over the long term, the trend in unit inventories may be expected to follow the trend in unit sales. Over the short term, however, the physical turnover rate may bob around because of spacial influences - e.g., cost expectations, or bottlenecks.

The use of last-in, first-out (LIFO) inventory-valuation methods serves to increase the reported turnover rate during inflationary times. When dollar sales are rising because of inflation, inventory valuations of a LIFO company either will remain level, (if unit sales are not rising) or will trail the rise 1n dollar sales (if unit sales are rising). In either case, dollar turnover will increase.

During the early 1970's, there was a pronounced swing by corporations toward LIFO accounting (which has the effect of lowering a company's reported earnings and tax bills). The trend now seems to have slowed. Still, the existence of a lot of LIFO companies, plus the likelihood that some others will join the crowd, ensures some further increase it the reported turnover of inventory.

The gains are apt to be modest

In the case of fixed assets, any rise in the inflation rate, assuming it affects all products equally, will initially have the effect of increasing turnover. That is true because sales will immediately reflect the new price level, while the fixed-asset account will reflect the change only gradually, i.e., as existing assets are retired and replaced at the new prices. Obviously, the more slowly a company goes about this replacement process, the more the turnover ratio will rise. The action stops, however, when a replacement cycle is completed. Assuming a constant rate of inflation, sales and fixed assets will then begin to rise in concert at the rate of inflation.

To sum up, inflation will produce some gains in turnover ratios. Some improvement would be certain because of LIFO, and some would be possible (if inflation accelerates) because of sales rising more rapidly than fixed assets. But the gains are apt to be modest and not of a magnitude to produce substantial improvement in returns on equity capital. During the decade ending in 1975, despite generally accelerating inflation and the extensive use of LIFO accounting, the turnover ratio of the FORTUNE 500 went only from 1.18/1 to 1.29/1.

Cheaper leverage? Not likely. High rates of inflation generally cause borrowing to become dearer, not cheaper. Galloping rates of inflation create galloping capital needs; and lenders, as they become increasingly distrustful of long-term contracts, become more demanding. But even if there is no further rise in interest rates, leverage will be getting more expensive because the average cost of the debt now on corporate books is less than would be the cost of replacing it. And replacement will be required as the existing debt matures. Overall, then, future changes in the cost of leverage seem likely to have a mildly depressing effect on the return on equity.

More leverage? American business already has fired many, if not most, of the more-leverage bullets once available to it. Proof of that proposition can be seen in some other FORTUNE 500 statistics - in the twenty years ending in 1975, stockholders' equity as a percentage of total assets declined for the 500 from 63 percent to just under 50 percent. In other words, each dollar of equity capital now is leveraged much more heavily than it used to be.

What the lenders learned

An irony of inflation-induced financial requirements is that the highly profitable companies - generally the best credits - require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago - and are correspondingly less willing to let capital-hungry, low-profitability enterprises leverage themselves to the sky.

Nevertheless, given inflationary conditions, many corporations seem sure in the future to turn to still more leverage as a means of shoring up equity returns. Their managements will make that move because they will need enormous amounts of capital - often merely to do the same physical volume of business - and will wish to got it without cutting dividends or making equity offerings that, because of inflation, are not apt to shape up as attractive. Their natural response will be to heap on debt, almost regardless of cost. They will tend to behave like those utility companies that argued over an eighth of a point in the 1960's and were grateful to find 12 percent debt financing in 1974.

Added debt at present interest rates, however, will do less for equity returns than did added debt at 4 percent rates it the early 1960's. There is also the problem that higher debt ratios cause credit ratings to be lowered, creating a further rise in interest costs.

So that is another way, to be added to those already discussed, in which the cost of leverage will be rising. In total, the higher costs of leverage are likely to offset the benefits of greater leverage.
Besides, there is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire. At the low inflation rates of 1965-65, the liabilities arising from such plans were reasonably predictable. Today, nobody can really know the company's ultimate obligation, But if the inflation rate averages 7 percent in the future, a twentyfive-year-old employee who is now earning $12,000, and whose raises do no more than match increases in living costs, will be making $180,000 when he retires at sixty-five.

Of course, there is a marvelously precise figure in many annual reports each year, purporting to be the unfunded pension liability. If that figure were really believable, a corporation could simply ante up that sum, add to it the existing pension-fund assets, turn the total amount over to an insurance company, and have it assume all the corporation's present pension liabilities. In the real world, alas, it is impossible to find an insurance company willing even to listen to such a deal.
Virtually every corporate treasurer in America would recoil at the idea of issuing a "cost-of-living" bond - a noncallable obligation with coupons tied to a price index. But through the private pension system, corporate America has in fact taken on a fantastic amount of debt that is the equivalent of such a bond.

More leverage, whether through conventional debt or unbooked and indexed "pension debt", should be viewed with skepticism by shareholders. A 12 percent return from an enterprise that is debt-free is far superior to the same return achieved by a business hocked to its eyeballs. Which means that today's 12 percent equity returns may well be less valuable than the 12 percent returns of twenty years ago.


More fun in New York

Lower corporate income taxes seem unlikely. Investors in American corporations already own what might be thought of as a Class D stock. The class A, B and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these "investors" have no claim on the corporation's assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D sharaholders.

A further charming characteristic of these wonderful Class A, B and C stocks is that their share of the corporation's earnings can be increased immedtately, abundantly, and without payment by the unilateral vote of any one of the "stockholder" classes, e.g., by congressional action in the case of the Class A. To add to the fun, one of the classes will sometimes vote to increase its ownership share in the business retroactively - as companies operating in New York discovered to their dismay in 1975. Whenever the Class A, B or C "stockholders" vote themselves a larger share of the business, the portion remaining for Class D - that's the one held by the ordinary investor - declines.

Looking ahead, it seems unwise to assume that those who control the A, B and C shares will vote to reduce their own take over the long run. The class D shares probably will have to struggle to hold their own.


Bad news from the FTC

The last of our five possible sources of increased returns on equity is wider operating margins on sales. Here is where some optimists would hope to achieve major gains. There is no proof that they are wrong. Bu there are only 100 cents in the sales dollar and a lot of demands on that dollar before we get down to the residual, pretax profits. The major claimants are labor, raw materials energy, and various non-income taxes. The relative importance of these costs hardly, seems likely to decline during an age of inflation.

Recent statistical evidence, furthermore, does not inspire confidence in the proposition that margins will widen in, a period of inflation. In the decade ending in 1965, a period of relatively low inflation, the universe of manufacturing companies reported on quarterly by the Federal Trade Commission had an average annual pretax margin on sales of 8.6 percent. In the decade ending in 1975, the average margin was 8 percent. Margins were down, in other words, despite a very considerable increase in the inflation rate.

If business was able to base its prices on replacement costs, margins would widen in inflationary periods. But the simple fact is that most large businesses, despite a widespread belief in their market power, just don't manage to pull it off. Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade. If such major industries as oil, steel, and aluminum really have the oligopolistic muscle imputed to them, one can only conclude that their pricing policies have been remarkably restrained.

There you have, the complete lineup: five factors that can improve returns on common equity, none of which, by my analysis, are likely to take us very far in that direction in periods of high inflation. You may have emerged from this exercise more optimistic than I am. But remember, returns in the 12 percent area have been with us a long time.


The investor's equation

Even if you agree that the 12 percent equity coupon is more or less immutable, you still may hope to do well with it in the years ahead. It's conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variable's: the relationship between book value and market value, the tax rate, and the inflation rate.

Let's wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it's all very simple. If a stock has a book value of $100 and also an average market value of $100, 12 percent earnings by business will produce a 12 percent return for the investor (less those frictional costs, which we'll ignore for the moment). If the payout ratio is 50 percent, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings.

If the stock sold at 150 percent of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4 percent return on his $150 cost. The book value of the business would still increase by 6 percent (to $106) and the market value of the investor's holdings, valued consistently at 150 percent of book value, would similarly increase by 6 percent (to $159). But the investor's total return, i.e., from appreciation plus dividends, would be only 10 percent versus the underlying 12 percent earned by the business.

When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80 percent of book value, the same earnings and payout assumptions would yield 7.5 percent from dividends ($6 on an $80 price) and 6 percent from appreciation - a total return of 13.5 percent. In other words, you do better by buying at a discount rather than a premium, just as common sense would suggest.

During the postwar years, the market value of the Dow Jones industrials has been as low as 84 percent of book value (in 1974) and as high as 232 percent (in 1965); most of the time the ratio has been well over 100 percent. (Early this spring, it was around 110 percent.) Let's assume that in the future the ratio will be something close to 100 percent - meaning that investors in stocks could earn the full 12 percent. At least, they could earn that figure before taxes and before inflation.


7 percent after taxes

How large a bite might taxes take out of the 12 percent? For individual investors, it seems reasonable to assume that federal, state, and local income taxes will average perhaps 50 percent on dividends and 30 percent on capital gains. A majority of investors may have marginal rates somewhat below these, but many with larger holdings will experience substantially higher rates. Under the new tax law, as FORTUNE observed last month, a high-income investor in a heavily taxed city could have a marginal rate on capital gains as high as 56 percent. (See
"The Tax Practitioners Act of 1976.")

So let's use 50 percent and 30 percent as representative for individual investors. Let's also assume, in line with recent experience, that corporations earning 12 percent on equity pay out 5 percent in cash dividends (2.5 percent after tax) and retain 7 percent, with those retained earnings producing a corresponding market-value growth (4.9 percent after the 30 percent tax). The after-tax return, then, would be 7.4 percent. Probably this should be rounded down to about 7 percent to allow for frictional costs. To push our stocks-asdisguised-bonds thesis one notch further, then, stocks might be regarded as the equivalent, for individuals, of 7 percent tax-exempt perpetual bonds.

The number nobody knows
Which brings us to the crucial question - the inflation rate. No one knows the answer on this one - including the politicians, economists, and Establishment pundits, who felt, a few years back, that with slight nudges here and there unemployment and inflation rates would respond like trained seals.

But many signs seem negative for stable prices: the fact that inflation is now worldwide; the propensity of major groups in our society to utilize their electoral muscle to shift, rather than solve, economic problems ; the demonstrated unwillingness to tackle even the most vital problems (e.g., energy and nuclear proliferation) if they can be postponed; and a political system that rewards legislators with reelection if their actions appear to produce short-term benefits even though their ultimate imprint will be to compound long-term pain.

Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it. (This schizophrenia hasn't caused them to lose touch with reality, however; Congressmen have made sure that their pensions - unlike practically all granted in the private sector - are indexed to cost-of-living changes after retirement.)

Discussions regarding future inflation rates usually probe the subtleties of monetary and fiscal policies. These are important variables in determining the outcome of any specific inflationary equation. But, at the source, peacetime inflation is a political problem, not an economic problem. Human behavior, not monetary behavior, is the key. And when very human politicians choose between the next election and the next generation, it's clear what usually happens.

Such broad generalizations do not produce precise numbers. However, it seems quite possible to me that inflation rates will average 7 percent in future years. I hope this forecast proves to be wrong. And it may well be. Forecasts usually tell us more of the forecaster than of the future. You are free to factor your own inflation rate into the investor's equation. But if you foresee a rate averaging 2 percent or 3 percent, you are wearing different glasses than I am.

So there we are: 12 percent before taxes and inflation; 7 percent after taxes and before inflation; and maybe zero percent after taxes and inflation. It hardly sounds like a formula that will keep all those cattle stampeding on TV.

As a common stockholder you will have more dollars, but you may have no more purchasing power. Out with Ben Franklin ("a penny saved is a penny earned") and in with Milton Friedman ("a man might as well consume his capital as invest it").


What widows don't notice

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn't seem to notice that 6 percent inflation is the economic equivalent.

If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises. At around 920 early last month, the Dow was up fifty-five points from where it was ten years ago. But adjusted for inflation, the Dow is down almost 345 points - from 865 to 520. And about half of the earnings of the Dow had to be withheld from their owners and reinvested in order to achieve even that result.

In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value. And with 7 percent inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.

I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I Would like to be your broker - but not your partner.

Even the so-called tax-exempt investors, such as pension funds and college endowment funds, do not escape the inflation tax. If my assumption of a 7 percent inflation rate is correct, a college treasurer should regard the first 7 percent earned each year merely as a replenishment of purchasing power. Endowment funds are earning nothing until they have outpaced the inflation treadmill. At 7 percent inflation and, say, overall investment returns of 8 percent, these institutions, which believe they are tax-exempt, are in fact paying "income taxes" of 87½ percent.


The social equation

Unfortunately, the major problems from high inflation rates flow not to investors but to society as a whole. Investment income is a small portion of national income, and if per capita real income could grow at a healthy rate alongside zero real investment returns, social justice might well be advanced.

A market economy creates some lopsided payoffs to participants. The right endowment of vocal chords, anatomical structure, physical strength, or mental powers can produce enormous piles of claim checks (stocks, bonds, and other forms of capital) on future national output. Proper selection of ancestors similarly can result in lifetime supplies of such tickets upon birth. If zero real investment returns diverted a bit greater portion of the national output from such stockholders to equally worthy and hardworking citizens lacking jackpot-producing talents, it would seem unlikely to pose such an insult to an equitable world as to risk Divine Intervention.

But the potential for real improvement in the welfare of workers at the expense of affluent stockholders is not significant. Employee compensation already totals twenty-eight times the amount paid out in dividends, and a lot of those dividends now go to pension funds, nonprofit institutions such as universities, and individual stockholders who are not affluent. Under these circumstances, if we now shifted all dividends of wealthy stockholders into wages - something we could do only once, like killing a cow (or, if you prefer, a pig) - we would increase real wages by less than we used to obtain from one year's growth of the economy.

The Russians understand it too

Therefore, diminishment of the affluent, through the impact of inflation on their investments, will not even provide material short-term aid to those who are not affluent. Their economic well-being will rise or fall with the general effects of inflation on the economy. And those effects are not likely to be good.

Large gains in real capital, invested in modern production facilities, are required to produce large gains in economic well-being. Great labor availability, great consumer wants, and great government promises will lead to nothing but great frustration without continuous creation and employment of expensive new capital assets throughout industry. That's an equation understood by Russians as well as Rockefellers. And it's one that has been applied with stunning success in West Germany and Japan. High capital-accumulation rates have enabled those countries to achieve gains in living standards at rates far exceeding ours, even though we have enjoyed much the superior position in energy.

To understand the impact of inflation upon real capital accumulation, a little math is required. Come back for a moment to that 12 percent return on equity capital. Such earnings are stated after depreciation, which presumably will allow replacement of present productive capacity - if that plant and equipment can be purchased in the future at prices similar to their original cost.


The way it was

Let's assume that about half of earnings are paid out in dividends, leaving 6 percent of equity capital available to finance future growth. If inflation is low - say, 2 percent - a large portion of that growth can be real growth in physical output. For under these conditions, 2 percent more will have to be invested in receivables, inventories, and fixed assets next year just to duplicate this year's physical output - leaving 4 percent for investment in assets to produce more physical goods. The 2 percent finances illusory dollar growth reflecting inflation and the remaining 4 percent finances real growth. If population growth is 1 percent, the 4 percent gain in real output translates into a 3 percent gain in real per capita net income. That, very roughly, is what used to happen in our economy.

Now move the inflation rate to 7 percent and compute what is left for real growth after the financing of the mandatory inflation component. The answer is nothing - if dividend policies and leverage ratios Terrain unchanged. After half of the 12 percent earnings are paid out, the same 6 percent is left, but it is all conscripted to provide the added dollars needed to transact last year's physical volume of business.

Many companies, faced with no real retained earnings with which to finance physical expansion after normal dividend payments, will improvise. How, they will ask themselves, can we stole or reduce dividends without risking stockholder wrath? I have good news for them: ready-made set of blueprints is available.

In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a (Con Ed reputation. Con Ed, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn't have the money to pay the dividend, Candor was rewarded with calamity in the marketplace.

The more sophisticated utility maintains - perhaps increases - the quarterly dividend and then asks shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in spirits (particularly the underwriters).


More joy at AT&T

Encouraged by such success, some utilities have devised a further shortcut. In this case, the company declares the dividend, the shareholder pays the tax, and - presto - more shares are issued. No cash changes hands, although the spoilsport as always, persists in treating the transaction as if it had.


AT&T, for example, instituted a dividend-reinvestment program in 1973. This company, in fairness, must be described as very stockholder-minded, and its adoption of this program, considering the folkways of finance, must he regarded as totally understandable. But the substance of the program is out of Alice in Wonderland.


In 1976, AT&T paid $2.3 billion in cash dividends to about 2.9 million owners of its common stock. At the end of the year, 648,000 holders (up from 601,000 the previous year) reinvested $432 million (up from $327 million) in additional shaves supplied directly by the company.


Just for fun, let's assume that all AT&T shareholders ultimately sign up for this program. In that case, no cash at all would be mailed to shareholders - just as when Con Ed passed a dividend. However, each of the 2.9 million owners would be notified that he should pay income taxes on his share of the retained earnings that had that year been called a "dividend". Assuming that "dividends" totaled $2.3 billion, as in 1976, and that shareholders paid an average tax of 30 percent on these, they would end up, courtesy of this marvelous plan, paying nearly $730 million to the IRS. Imagine the joy of shareholders, in such circumstances, if the directors were then to double the dividend.


The government will try to do it

We can expect to see more use of disguised payout reductions as business struggles with the problem of real capital accumulation. But throttling back shareholders somewhat will not entirely solve the problem. A combination of 7 percent inflation and 12 percent returns with reduce the stream of corporate capital available to finance real growth.


And so, as conventional private capital-accumulation methods falter under inflation, our government will increasingly attempt to influence capital flows to industry, either unsuccessfully as in England or successfully as in Japan. The necessary cultural and historical underpinning for a Japanese-style enthusiastic partnership of government, business, and labor seems lacking here. if we are lucky, we will avoid following the English path, where all segments fight over division of the pie rather than pool their energies to enlarge it.


On balance, however, it seems likely that we will hear a great deal more. as the years unfold about underinvestinent, stagflation, and the failures of the private sector to fulfill needs.



About Warren Buffett

The author is, in fact, one of the most visible stock-market investors in the U.S. these days. He's had plenty to invest for his own account ever since he made $25 million running an investment partnership during the 1960's. Buffett Partnership Ltd., based in Omaha, was an immensely successful operation, but he nevertheless closed up shop at the end of the decade. A January, 1970, FORTUNE article explained his decision: "he suspects that some of the juice has gone out of the stock market and that sizable gains in the future are going to be very hard to come by."

Buffett, who is now forty-six and still operating out of Omaha, has a diverse portfolio. He and businesses he controls have interests in over thirty public corporations. His major holdings: Berkshire Hathaway (he owns about $35 million worth) and Blue Chip Stamps (about $10 million). His visibility, recently increased by a Wall Street Journal profile, reflects his active managerial role in both companies, both of which invest in a wide range of enterprises; one is the Washington Post.

And why does a man who is gloomy about stocks own so much stock? "Partly, it's habit," he admits. "Partly, it's just that stocks mean business, and owning businesses is much more interesting than owning gold or farmland. Besides, stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices."

Buffett On Life"

Buffett On Life"

1. “Chains of habit are too light to be felt until they are too heavy to be broken.”
2. “We enjoy the process far more than the proceeds.”
3. “You only find out who is swimming naked when the tide goes out.”
4. “Someone’s sitting in the shade today because someone planted a tree a long time ago.”
5. “A public-opinion poll is no substitute for thought.”

Buffett On Helping Others

Warren Buffett's quotes on helping others:

1. “If you’re in the luckiest 1 per cent of humanity, you owe it to the rest of humanity to think about the other 99 per cent.”
2. “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
3. “I don’t have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It’s like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don’t do that though. I don’t use very many of those claim checks. There’s nothing material I want very much. And I’m going to give virtually all of those claim checks to charity when my wife and I die.”
4. “It’s class warfare, my class is winning, but they shouldn’t be.”
5. “My family won’t receive huge amounts of my net worth. That doesn’t mean they’ll get nothing. My children have already received some money from me and Susie and will receive more. I still believe in the philosophy - FORTUNE quoted me saying this 20 years ago - that a very rich person should leave his kids enough to do anything but not enough to do nothing.”

Buffett's Funny Quotes

Buffett's Funny Quotes:

1. “A girl in a convertible is worth five in the phonebook.”
2. “When they open that envelope, the first instruction is to take my pulse again.”
3. “We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’”
4. “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
5. “In the insurance business, there is no statute of limitation on stupidity.”

Buffett On Success

Warren Buffett on success:

1. “Of the billionaires I have known, money just brings out the basic traits in them. If they were jerks before they had money, they are simply jerks with a billion dollars.”
2. “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”
3. “You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
4. “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.”
5. “You only have to do a very few things right in your life so long as you don’t do too many things wrong.”

Buffett On Investing

Here are Buffett's most famous quotes on Investing:

1. “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
2. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
3. “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
4. “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
5. “Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful”.”

Timeless and Time-Tested Warren Buffett Watch Predictions

Timeless and Time-Tested Warren Buffett Watch Predictions

Posted By: Alex Crippen

Gerald Herbert / AP

As a new year approaches, it is customary for journalists to make predictions about the future. This time around, CNBC.com has a collection of prognostications from CNBC bloggers on a special page: Predictions '09.

Last year around this time, Warren Buffett Watch offered its Eight Predictions for '08 .. and Beyond.

In keeping with Buffett's long-term way of looking at things, the eight predictions were intentionally on the 'timeless' side of the predicting spectrum.

Here they are again, with a little bit of editing. This could be the start of a new holiday tradition!

-----------------

Warren Buffett became one of the wealthiest people in the world by making predictions and putting money behind those predictions. Every time he buys a stock or a business or some other investment, he's forecasting the future.

Judging by the incredible returns of his holding company Berkshire Hathaway, Buffett and his colleagues are very good at making those predictions.

Of course, it helps when you can give your predictions plenty of time to come true. That's one reason Buffett's favorite holding period for investments in "outstanding businesses with outstanding managements" is "forever." After all, "We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely."

With that in mind, here are Warren Buffett Watch's 'timeless' predictions.

1. Recessions can't be avoided forever. As 2007 was coming to a close, Buffett told our Becky Quick that if unemployment picks up significantly, the "dominoes" will fall and the U.S. economy will fall into recession in 2008. He was right, but not alarmed. "It is the nature of capitalism to periodically have recessions. People overshoot." (He told Becky she's young enough to expect to see 6 or 7 or them.)

AP The economic downturn takes its toll at the almost-empty Bayshore Town Center Mall in Milwaukee, Wisconsin.

2. We'll survive current and future recessions just as we've survived past problems. As Buffett told us in August, 2007, (and repeated throughout 2008): "We've got a wonderful economy... There's never been anything like that in the history of the world. We live seven times better than the people did a century ago on average... We've had problems all along. If you look at the last century, we had that Great Depression and World War Two, we had the Cold War, we had the atomic bomb, but the country does well."

3. Recessions will create opportunities. "I made by far the best buys I've ever made in my lifetime in 1974. And that was a time of great pessimism and the oil shock and stagflation and all those sort of things. But stocks were cheap." Fast-forward to October, 2008, and Buffett's Why I'm Buying U.S. Stocks Now.

4. All stocks won't be cheap. Like Ted Williams waiting for the right pitch, a successful investor waits for the right stock at the right price, and it doesn't happen every day. "What’s nice about investing is you don’t have to swing at pitches. You can watch pitches come in one inch above or one inch below your navel, and you don’t have to swing. No umpire is going to call you out." You get in trouble, Buffett says, when you listen to the crowd chanting "Swing, batter, swing!"

5. The crowd will make mistakes. Buffett cites this piece of advice from his mentor Benjamin Graham: "You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else."

6. Investors will mistakenly think falling stock prices are bad. "If they reduce the price of hamburgers at McDonald's today I feel terrific. Now I don't go back and think, gee, I paid a little more yesterday. I think I'm going to be buying them cheaper today. Anything you're going to be buying in the future, you want to have get cheaper."

Walt Disney (1950) Cinderella rushes for the exit as midnight approaches

7. Good times will prompt bad decisions. In his 2000 Letter to Berkshire shareholders, Buffett compared the crowd that buys big when prices are high to Cinderella at the ball. "They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."

8. There will be more dancing at another wild party followed by another painful hangover. Looking back at the Internet bubble, Buffett is quoted as saying, "The world went mad. What we learn from history is that people don’t learn from history."

New Interview With Warren Buffett

Addison Wiggin at Agora Financial sat down with Warren Buffett for an interview. He published that interview in his new book, I.O.U.S.A – One Nation. Under Stress. In Debt, which is out this week.

On our national debt problems...

We're transferring small bits of the country – ownership of the country, or IOUs – to the rest of the world. But our national pie is still growing.

We're like a very, very, very, rich family that owns a farm the size of Texas, and we have all this output coming from the farm. Now, because we consume a little more than we produce, we're selling bits of that farm daily, a couple billion worth. Or we're giving a small mortgage on it which we don't even notice, but it builds up over time.

So even though we own a little less of the farm, or we create these IOUs against it, our equity in the farm actually increases somewhat. That's why people will benefit over time. But they won't benefit as much as if they hadn't given the IOUs or sold off little pieces of the farm.

On gold...

Over time, people have dug up gold from the ground in far remote areas and then they've shipped it thousands and thousands of miles. And they've put it in the ground over here and hired guards to stand over it. So the real utility of gold is not that high. It's been something that people turn to, but it has not been a very good investment.

On China and globalization...

In 1790, there were about 4 million people in the U.S. and about 290 million in China. They were just as smart as we were. They had a climate that was about the same as ours. And yet we did enormously well over the next 217 years... as compared to China.

Now, why did we do that? Well, we had a market system, a rule of law, and equality of opportunity... and that system unleashed the potential of citizens in the United States to an extent far greater than in many countries including, up until recently, China.

About the risk of default of U.S. government bonds...

The U.S. government bond is absolutely certain to be paid. It's just total nonsense when people talk about the U.S. going bankrupt. I mean, the U.S. government will always pay its debts. The purchasing power of the dollar you receive is likely to be less than the dollar you invested, so you have purchasing power risk... But you should not be afraid of government bonds in terms of being paid.

The unique situation in the U.S. now...

Many years ago, when we lent a lot of money to various emerging countries and were having trouble getting paid back, somebody said that they found it very hard to imagine some Philippine or Thailand worker spending a couple of extra hours every week in the hot sun merely so Citicorp could increase its dividend twice a year. At a point, people say, "To hell with it."

It's much easier just to inflate your way out of it. If you're a South American or Asian country that owes money in dollars, it gets very binding to pay back in dollars. But if you owe it in your own currency, you just print more currency. And we have the ability to print currency. We can denominate debt in our own currency, whereas many countries can't because people don't trust them.

On government economic policies and crises...

We came fairly close to the whole system imploding in the 1930s because of economic conditions. People became very responsive to communism... When people are scared about economics, they'll listen to whoever is the most persuasive... One thing I don't like about the consequences of sustained large trade deficits is I think it makes the potential for demagoguery and really foolish policies more likely over time.

When you think about the history of this country, our economic policies have been pretty darn good. I mean, any country that delivers a seven-for-one increase in per capita living in a century has done an awful lot of things right. It's never happened before in the history of mankind.

What the right policies are...

You want a system where Mike Tyson is fighting for the heavyweight championship and Jack Welch is running General Electric. But you don't want Mike Tyson to be running General Electric and Jack Welch in the heavyweight championship. Government allocation of resources has tended, too often, to misallocate, and I think a market system does a pretty good job of allocating.

Wrapping up...

It's been a marvelous time to be alive. It wasn't really a whole lot better to live in the fourth century BC than the fourth century AD. But it's been a lot better to live in the year 2007 than it was in the year 1807.

...Even those on the low end are doing far better than people on the high end were doing 100 years ago. There're many, many things that a person earning a normal wage in this country can do and enjoy that John D. Rockefeller couldn't do and enjoy. So a rising tide has lifted all the boats... The average American is going to live better 10 years from now, 20 years from now, and 50 years from now.

History of Warren Buffet

In 1947, a seventeen year old Warren Buffett graduated from High School. It was never his intention to go to college; he had already made $5,000 delivering newspapers (this is equal to $42,610.81 in 2000). His father had other plans, and urged his son to attend the Wharton Business School at the University of Pennsylvania. Buffett stayed two years, complaining that he knew more than his professors. When Howard was defeated in the 1948 Congressional race, Warren returned home to Omaha and transferred to the University of Nebraska-Lincoln. Working full-time, he managed to graduate in only three years.

Warren Buffett approached graduate studies with the same resistance he displayed a few years earlier. He was finally persuaded to apply to Harvard Business School, which, in the worst admission decision in history, rejected him as "too young". Slighted, Warren applied to Columbia where famed investors Ben Graham and David Dodd taught - an experience that would forever change his life.

If Buffett's lifestyle seems out of step, so is his investment strategy. At a time when day traders bid up stocks based on nothing but rumor and momentum, when bond investors place pricey and complex bets on such arcane financial instruments as interest-rate futures, it's hard not to think of Buffett as a kind of museum piece. His approach is simple, even quaint. Ignoring both macroeconomic trends and Wall Street fashions, he looks for undervalued companies with low overhead costs, high growth potential, strong market share and low price-to-earning ratios, and then waits for the rest of the world to catch up.

As often as not, Buffett's business instincts become conventional wisdom. Consider Coca-Cola Co. In 1988, when Buffett started buying the global soft-drink giant, it was a Wall Street wallflower, trading at $10.96. But Buffett saw two things that were not reflected in the balance sheet: the world's strongest brand name and untapped sales potential overseas. As Coca-Cola's earnings grew, so did investor interest. In less than five years, the stock soared to $74.50. Buffett's current stake is valued at some $13 billion.

Americans tend to revile their billionaires as much as they respect them (just look at Gates or Michael Eisner). But somehow, Buffett has managed to emerge as a kind of American folk hero. His famously literate dispatches in Berkshire Hathaway's annual reports -- in which he is as likely to quote the Bible and John Maynard Keynes as Yogi Berra and Mae West -- are read as much for their gee-whiz Midwestern wit as they are for their business insights. Berkshire's Web site is a modest affair, with a few links to some Berkshire-owned businesses and a message from Buffett, a self-described "technophobe," asking for suggestions how the site might be improved. Dozens of books and hundreds of Web sites dissect his investment decisions. And then there are Berkshire Hathaway's annual shareholder meetings in Omaha, which Buffett's biographer Ron Lowenstein compares to "an Elvis concert or a religious revival," and which Buffett himself calls "Woodstock for Capitalists." Investors have been known to purchase a single Berkshire share just for the opportunity to pick the master's brain each spring.

Going Short On Warren Buffett

Here's an interesting piece by Motley Fool editor, Rick Aristotle Munarriz. He think BRK will underperform the market over the next few years and has shorted the stock. However, as one of the commentors has pointed out, shorting BRK here has a negative margin of safety!

Three weeks ago, I told you I realized that I will never own shares of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).

This morning, I took the next logical step. I shorted Berkshire in Motley Fool CAPS, the community-driven stock-rating website. And just to get more bang for my virtual buck, I bet that both classes of shares will underperform the market over the next few months.

I'm clearly in the minority. Less than 2% of those rating Warren Buffett's legendary company on CAPS agree with me. The vast majority of CAPS participants believe that Berkshire Hathaway will continue to beat the market.

I don't see it that way, and not just because of Buffett's own cautious tone during this month's annual shareholder meeting

Take the Warren Buffett quiz
I've hit a sore spot in you. I can tell. You love Berkshire, Buffett, and Charlie Munger. You think I'm wrong, and if you're an investor, I hope you're right. You have real money at stake here. I'm just betting against the company in a stock-market simulation.

But how well do you know Berkshire? Maybe you were one of the 30,000 cheerleaders in Nebraska three weekends ago. Maybe you're one of the few who can rattle off the names of the roughly 70 operating companies under Berkshire's watch.

Prove it.

I have a few simple questions for you. The answers follow.

1. Berkshire Hathaway has improved its book value per share at a compounded annual rate of 21.1% from 1965 to 2007. That's impressive. When was the last calendar year in which Berkshire topped that 21.1% average?

2. How old is Warren Buffett?

3. From 1965 to 2000, how many times did Berkshire fail to grow its book value per share? How many times has it failed to grow since then?

4. Berkshire's book value outpaced the S&P 500 in all but three years between 1965 and 1998, an amazing track record over 34 years. How many times has the company come up short over the past nine years?

5. How much in unrealized capital gains was Berkshire sitting on at the end of 2007?

Here are the answers
1. Believe it or not, you have to go back to 1998 to find the last time Berkshire topped its compounded average. That annual compounded metric has been falling every year since then.

2. Buffett is 77. He's in great shape, but he can't last forever. Even bulls are thinking about his eventual successor. If you're not concerned about that, then maybe you should be concerned about not being concerned. Sure, there are plenty of worthy replacements, but that's the problem. These days, there are a ton of Buffett wannabes in the form of private-equity firms and activist value investors. This is why Berkshire has had such a hard time finding good values. Remember when it bought See's Candies for five times pretax profits back in 1972? Compare that with how it overpaid for a chunk of Wrigley (NYSE: WWY) last month. This is the reality of what Berkshire has been reduced to buying, now that everyone is playing Buffett's game.

3. After a jaw-dropping streak, Berkshire proved fallible in 2001. The company's book value shed a mere 6.2% that year, but don't get too excited about the new streak of positive returns that began in 2002. We're still early in 2008, and Berkshire is off to a bad start.

4. After beating the market 91% of the time through 1998, Buffett has been outmaneuvered by the passive S&P 500 in three of the past nine years, and two of the past five. Berkshire hasn't topped the market by a double-digit figure since 2002.

5. Berkshire has $35.7 billion in unrealized gains. That's not supposed to send taxing fears down your spine, because it's a testament to Buffett's ability to buy great companies, such as Coca-Cola (NYSE: KO) and American Express (NYSE: AXP), when there were bargains to be had in the 1970s and 1980s. However, some of his more recent buys, including Kraft (NYSE: KFT) and US Bancorp (NYSE: USB), were still in the red at the end of 2007.

I hope I'm wrong
Again, I won't be happy if I'm right.

A lot of you no doubt own a piece of Berkshire. However, Buffett is concerned about the company's bread-and-butter insurance industry. The valuations it's snapping up are far removed from when Berkshire built its empire. Yet Buffett is still buying. In short, that's not the bandwagon for me.

Trains, sweets and watches - what Warren Buffett is looking for

by Graeme Wearden.

Warren Buffett, who today kicks off a whistle-stop tour of Europe, became the world's richest man thanks to a simple strategy - buying companies that he understands when they are available at a good price.

Avoiding the complicated financial techniques that caused the ongoing credit crisis, Buffett built up a $62bn (£31.68bn) fortune through a lifetime of sensible investing. Now he has Europe's family owned firms in his sights, with potential targets thought to include the confectionery firm Haribo – maker of the gummy bear. He is also rumoured to be casting his eye over the Swiss watchmaker, Swatch.

The 77-year old put his homespun values into action last month by teaming up with Mars to buy chewing gum maker Wrigley. Joking that he had been conducting an extensive taste test on Wrigley's products since he was seven, Buffett explained why he had not instead pounced on a bank savaged by the credit crunch.

"I understand a Wrigley or a Mars a whole lot better than I understand the balance sheet of some of the big banks. I know what I'm getting on this and [with] some of the large financial institutions, I really don't know what's there," he said.

This kind of no-nonsense approach to investing has won him many thousands of admirers, who flock to the annual meeting of his Berkshire Hathaway empire.

Buffett is also a big fan of Cherry Coke, downing as many as five cans a day. Typically of the man, he is also holds a large shareholding in Coca-Cola – another company whose products will always be in demand, he argues.

Back in the late 1990s, Buffett was criticised for ignoring the dotcom bubble while other investors flocked to put money into the next big thing. That now looks like one of his sager punts. Technology has little appeal to Buffett as an investment opportunity – he prefers more traditional industries, and is a particular fan of the railroad sector.

Railroads tick another Buffett box – he loves to build up stakes in industries that generate plenty of cash. Last year he kept building a stake in Burlington Northern Santa Fe, which runs one of the US's biggest rail networks.

But despite this track record the Sage of Omaha is not averse to the more exotic financial transactions, as long as he can see profit. Betting that the Brazilian currency would rise last year – it did – helped him to grow his fortune by $10bn, putting him top of the Forbes rich list.

He also loves to buy family owned firms, who he says are happier to sell to him than to a private equity firm which might want to make a quick return through a break-up.

Buffett has little time for reckless speculation, which is at its most dangerous in the boom times. Or as he puts it: "Nothing sedates rationality like large doses of effortless money."

And his visit to Europe this week fits with an earlier explanation of Berkshire Hathaway's strategy: "We attempt to be fearful when others are greedy and greedy when others are fearful."

After nine months of economic uncertainty and a credit crunch, the time for greed may have arrived.

Notes From the 2008 Berkshire Hathaway Annual Meeting

Berkshire Hathaway Annual Meeting, Omaha NE 2008
May 3, 2008

Typewritten notes courtesy of Peter Boodell

(As is standard, no recording equipment was used to reproduce these notes. As a result, these notes are recollections only – not quotes, and should not be relied upon. –PB)

A short introductory skit – Susan Lucci from All My Children walks on stage:

CM: Where could he be?

Susan Lucci: Detained at the TV studio. Hi Charlie, I’m Susan Lucci. He’s going to be a big star.
CM: You have some important qualities that Warren lacks.

SL: There are some changes we need to make. We need to change our dividend policy. We are so cheap to our shareholders.

CM: Sounds good to me.

SL: And I want guidance on earnings, weekly. And we need to pay our directors more than $900/yr. [directors stand up and applaud]

[WB walks in]

WB: What’s that talk about dividends? My show is Berkshire Hathaway – All My Children can’t do without you, and I can’t do without Berkshire.

SL: The deal is off?

WB: You’ve brought me back to my senses. Pick out anything you would like at Borsheim’s, and charge it to Charlie.

WB: We are going to follow usual procedure. We are going to answer questions between now and then, based on who gets lined up at microphone first. Our best estimate is 31k people are here to today.

We have Charlie Munger - he can hear and I can see - we work together for that reason. Hold your applause until the end. Howard Buffett, Bill Gates, Don Keogh, Tom Murphy, Walter Scott, Don Olson. The best directors in America.

We’ll take a break at noon.
Q1: Rajesh Vora, Bombay India. I salute your 100% honesty. What key states to correct crowd mindset?

CM: He wants to know how to become less like a lemming.

WB: Since you repeated the question, I’ll let you give first answer.

CM: He wants to invest less like a lemming.

WB: I started investing when I was 11. I believe in reading everything in sight. I wandered for 8 yrs with technical analysis. I read Intelligent Investor, chapters 8 and 20 I recommend, and if you absorb it you won’t be a lemming. I read it early in 1950, and I think as good a book now as then. You can’t get a bad result if you follow it. There is another book out there, Food You Will Enjoy about the Buffett family grocery store. Neither of us were any good at groceries. You don’t want to pay attention to my Grandfather’s advice on stocks. It has three big lessons, a) stock is a part of a business b) market serves you doesn’t instruct, and c) margin of safety. Berkshire holders are better than most at understanding that they own a part of a business.

Q2: George from Cologne Germany. How is operational integration of Cologne Re?

WB: 95% subsidiary of General Re, of which we own 100%. Oldest reinsurance company in world. It does a wonderful job. We have a process in place such that we will soon own 100% of Cologne. It runs fine as it is. They have run own portfolio, but I will take responsibility for Cologne’s investment portfolio. We will consolidate 100% rather than 95%.

Q3: Sam from Fort Lee. Recession, stock market up in April. What next?

WB: I could expand on that question, but I couldn’t answer it. Charlie and I haven’t the faintest idea where it goes next week, next month or next year. We are not in that business. It isn’t our game. We see 1,000s of companies priced every day. We ignore 99% of what we see. Every now and then, we find an attractive price for a business. When we buy it, we would be happy if market was closed for a few years. Wouldn’t get a price quote daily on a farm. We look at expected yield, cost of taxes. If you buy a farm, you would look at cost of fertilizers, what a farm produces relative to purchase price, price per acre, production per acre, etc.. We make judgments.

CM: Nothing to add.

WB: He’s been practicing for weeks.

Q4: Chandra from Seattle. I am bad at hiring good managers. How do you assess capabilities.

WB: You have to understand that we cheat. If you give me 100 mba’s (I am meeting over 30 schools this year), I no more could take the 100 and rank them - it would be impossible. We buy businesses with great management in place. We have seen their record. They come with business. Our job is not to select great managers, our job is to retain them. A majority are wealthy. They don’t have a monetary reason to work in many cases. We have nineteen people at headquarters, and 250k around world. Our job is to make sure they have same enthusiasm. We have to see passion in eyes and believe the passion will remain, but we can create an environment to keep them happy. At these annual meetings, we tell them what a great job they did and make them feel appreciated. We don’t have contracts – it doesn’t work. Our managers are appreciated. I can’t be of help if you are looking at group of MBAs. They know at this point in life how to fool you, what answers to give you. I would look for person with passion for job, doing more than their share, good communicators. At baseball you have to hang up cleats at 40, but our guys go on and on and on. Mrs B worked till 103, then died the next year. That’s a good lesson for our managers. [laughter]

CM: Story of Howard Amundsen, a young man asked him how do you get ahead? He replied, ‘I always keep a few million dollars lying around just in case a good opportunity shows up’.

Q5: Would you use stock options to enter a position in a public co?

WB: If you want to buy or sell a stock, you should buy or sell a stock. We sold puts on Coca-cola once, but usually it is best to just buy stock. Using option technique is an idea where you get to buy a stock cheap. 4 out of 5 times you get it right and one time you may miss the opportunity to buy. We virtually have never used options to enter or exit a position. We have sold long term equity put options described in press report. We don’t get involved in fancy techniques.

CM: If I remember right, a public authority was wondering if they should set up an option exchange market. Warren was alone in the opinion (against it). You wrote a letter saying it wouldn’t do any good to throw out margin rules in this fashion. It doesn’t serve the country. I always thought Warren was totally right. Turning financial markets into gambling markets to enrich the croupiers doesn’t make sense.
WB: A University of Chicago Graduate student asked me once, what are we being taught that is wrong? In business school the amount of time spent teaching option pricing is total nonsense. You only need 2 courses, how to value a business and how to think about stock market fluctuations. The thing is that instructors know the formulas and you don’t, so they have something to fill the time. It has nothing to do with investment success – what matters is buying businesses at the right price. If you were teaching Biblical studies and you could read the Bible forward, backward and in four different languages, you would find it hard to tell everyone that it comes down to the Ten Commandments. The priests want to spend a lot of time preaching. You must have attitude where you aren’t influenced by market. You need a mindset, and you need to have the attitude to divorce yourself from letting the market influence you.

Q6: Germany. You are both generous. Joys of giving, pitfalls of donating money?

WB: I’ve never given up anything that made a difference to me. There are people that drop in the collection plate an amount that makes a difference in their lives. I’ve never given a penny that way. I’ve lived a long time which gives you a huge advantage in accumulating money. I’m giving away excess, not necessity. What I am doing is useful, but it isn’t on a par with people who give real money. Doris gives away money and time which is a real cost – gives help beyond the money. She is retail, I am wholesale. You should give to things that you personally have interest in. I won’t prioritize your giving.

CM: Regarding pitfalls, I would predict that if you have an extreme political ideology, you are very likely to make a lot of dumb charitable gifts.

WB: If you hang around Charlie enough, you get the sunnyside of life.

Q7: Bombay. Ethical dilemma? Fruit of loom have competitors with sweatshops?

WB: We let managers run businesses, and their standards over the years have been extraordinary. I am very happy turning over keys of financial and business performance. I write them a letter every two years, and I ask them to send a letter with successor. I also tell them we have all the money we need. We never want to trade reputation for money. Not only do they behave to conform with the law, but act as if there was going to be a story in local paper in morning written by intelligent investigative reporter. There are no budgets, we have no incentives to cause people to do anything or push people to play games.

CM: We have no rule against foreign plants. We don’t favor foreign plants, we just do what makes sense. The US was doing one billion of shoes per year, 30yrs ago. We tried to compete, great brand and workmanship. We found out it wouldn’t work against shoes produced in china. There are one billion shoes now in USA but all produced outside of US. Some of those factories don’t have same norms. We won’t tell world how to run business. We have standards, but not all same as USA.

Q8: Financial foghorn. Iscar and tungsten. Will it affect profitability of Iscar? Why locating plant in China?

WB: Reason Iscar plant built in China was to serve China, growing. Nice to be near raw material, but geographic plant decision has nothing to do with changes in price of product. If you are creating higher value add like Iscar, there may be 3-6mnth adjustment to raw material prices. But there won’t be substitutes for tungsten as raw material for cutting tools in near term. Raw materials do get passed through. In carpet business, oil based raw materials are having more trouble passing costs. Over time it will pass through. But we’d be having trouble in that anyway. This candy will reflect sugar and cocoa over time. You can have squeezes here and there, not a big deal. Facility in Dalian – I have very high expectations for Iscar, exceeded in every way, both financial and human relations.

CM: I would say that short answer is that while we don’t like inflation because it is bad for country and civilization, we will probably make more money over time because there is inflation.

Q9: Melbourne Auz. Berkshire has bought a lot of shares in last twelve months in listed companies. Do you expect return to be between 7-10% pa over many years? Well below achievements in past.

WB: Yes. We would be very happy if we could buy pretax returns of 10%, dividends included. We would probably settle for a little less than that. Berkshire returns will be less, no question, in future than in past. We operate now in universe of marketable stocks with caps of 10bil, but really 50bil and up in order to have an impact. This universe is not as profitable. If we find 10bil, a 5% position is 500mil. If it doubles, we make 325m, this is less than 2/10ths of 1%. We have found things to do time to time to make money. They are nice, but don’t move needle much at Berkshire. Anyone who expects us to replicate past should sell their stock. We’ll get decent returns, but not indecent returns.

CM: You can take Warren’s promises to bank. We are happy making money at lower rate in future, and we suggest you adopt the same attitude. You may have better things to do with your money than buying Berkshire. You will find things that are more intelligent, if you spend the time. We don’t think it is the most attractive investment in world. We like buying good size to very large with good management. Nice formula, it should work well over time.

Q10: Pacific Corp / Klamath River.

WB: First dam built in 1907. We are prohibited from commenting on this. There are strong disagreements.

David Sokol: It was inappropriate for Mr Buffett to respond. These four dams on Klamath river, there are whole series of issues in the federal regulatory relicensing process. It will be ongoing for eight years. It won’t culminate for another six years. There are twenty eight various parties that are party to a discussion about what should or not happen with these assets. Of these twenty eight parties, there are four different directions that this process should go. We will be pleased to find a resolution. It is up to regulatory commission, state legislators, then each regulator in each state. When public policy moves in direction of removal, fish ladders etc. We are working constructively with each of the parties. We have met with each of the parties, and hope we find an acceptable compromise.

Q11: Dilesh, California. How do you maintain your good mental and physical health?

WB: You start with a balanced diet. [laughter] If Charlie and I can’t have a decent attitude, who can? We get to do what we like every day, and we work with people who love to do what they do. We are not forced to do what we don’t want. I get to do what I like everyday. We are very blessed in so many ways. How could you be sour? Charlie is 84 and I am 77. We have slowed down but we pretend we haven’t. There is no reason to look at minuses in life. It would be crazy. We count our blessings. Not much more to it than that.

CM: I wish we were poster boys for benefits of running marathons with slim bodies, but as much as you can tell we don’t pay attention to health advocates and dietary rules. I for one don’t plan to change.

WB: From moment we get up, till we go to sleep, we are associating with wonderful people. We are biased, we live in best country in world. We could have stayed in grandfather’s store and would have been terrible.

CM: You are in a job you would pay to have, and you are supposed to be an exemplar – there is a lot to be said for not paying yourself very well.

WB: On corporate compensations, the idea that you have to pay someone $10 million dollars in pensions just to keep him around… there’s something wrong in that.

CM: Executives should volunteer to get paid less.

Q12: Germany, high school. What should I do with my life?

WB: We prefer questions that are harder. [laughter]

Q12 cont: what would you do if you started over?

WB: You have to find your passion in life. I would choose same job. I enjoy it. It is a terrible mistake to sleep walk through your life. Unless Shirley Maclain is right you won’t have another one. Dad had a business, with books on his shelves and they turned me on. This was before Playboy. If he was a minister I’m not sure I would have been as enthused. If you have obligations, you have to deal with realities. Go to work for organization you admire or an individual you admire. Which also means most MBAs I meet would be self employed. [laughter] I went to work for Ben Graham. I never asked my salary. Get the right spouse. Charlie talks about the man who spent twenty years looking for a perfect woman and found her. Unfortunately she was looking for perfect man. If you are lucky, you will be happy and as a result you will behave better. It makes it easier.

CM: You’ll do better if you have passion for something in which you have aptitude. If Warren had gone into ballet, no one would have heard of him.

WB: Or would have heard of me very differently.

Q13: What advice would you give to the quieter population to raise their visibility and gain recognition they deserve?

WB: I avoided all classes that had public speaking, I got physically ill if I had to speak. I signed up for Dale Carnegie course. Gave them check for $100, then I went home and stopped payment on check. I was in Omaha, took $100 cash to Wally Kean, I took that Carnegie course, and then I went to University of Omaha to start teaching – knowing I had to get in front of people. Ability to communicate in writing and speaking – it is under taught – and enormously important. If you can communicate well, you have an enormous advantage. Force yourself into situations where you have to develop those abilities. At Dale Carnegie – they made us stand on tables. I may have gone too far. You are doing something very worthwhile if you are helping introverted people get outside of themselves.

CM: It is a pleasure to have an educator come who is doing something simple and important rather than foolish and unimportant.

WB: I hope he won’t name names [laughter].

Q14: Klamath River.

WB: Regulator will deal with issues, when government gets involved in eminent domain there are always tradeoffs. Overall you have people with widely different interests. A big interest is cost of electricity. Every commission who makes decision on coal vs gas makes a tradeoff, and tradeoffs are partly economic cost and partly other issues. FERC will listen to everyone. They have to listen to everyone. We will do exactly what they say. We follow the dictates of regulatory bodies. They give us a fair return. From the standpoint of profitability, it is neutral. Society will make the decision.

Sokol: We distributed a study that found an accumulation of bio-algae and microsystin. There are 27 other lakes in Oregon with that type of blue green algae. It is created from lakes that have high abundance of nutrients. Klamath lake is hyper-eutropic – great abundance of algae and nutrients. 4 reservoirs. FERC does take it into account. Some do not call for removal of dam. All the parties will need to come to agreement.

Q15: Henry Patner, from Singapore. From the partnership letters in 1964, strategy called generals relatively undervalued. We have recently begun to implement a technique, we buy something at 12x, when comps sell at 20x. Comps go to 10x. Is this pair trading?

WB: Yes, didn’t know we started so early. Ben Graham did it in 1920. He did pairs trading. He was right 4 out of 5, but the last one would kill him. We shorted market to some degree, and we would borrow stocks from universities. We were early in this. We wouldn’t short a stock because it was unattractive but as a general market short. ) I would borrow from Treasurer of Columbia, “which ones do you want”, “just give me any of them”. It provoked some odd looks. It was not a big deal, we might have made a little money on it in 1960s, but it is not something we do these days.. If you have good ideas on businesses that are undervalued, it is not necessary to short. 130/30 is being marketed today. Many will sell you the idea of day. No great statistical merit.

CM: We made our money by being long wonderful businesses, not in long short.

Q16: Germany, fixed income markets at discounts. Will you take advantage?

WB: We have seen some important dislocations. I’ve brought some figures. Tax exempt money market funds [auction facilities]. $330b of them. Repricing of first grade muni’s every 7 days. LA County Museum of Art. Jan 24th: 3.1%. Jan 31st: 4.1%. Feb 7th: 8%. Feb 14th: 10%. Fell back down to 3% on Feb 21st. Now 4.2%. Somehow rates were much higher on Valentine’s day. Look at bid sheet of Citigroup. Repricing every 7 days. You would find same issue on several different pages. Same broker at same time on different pages quoting different prices. On one page we bid 11%, and someone else bid 6%. You found this in 1974, after LTCM. These are great times to make extra money. Auctions in esoteric securities. We have $4bil in it. We will have made some insignificant money in this for a few months. There may be opportunities that we can’t spot. If you have enough time you can figure out something that are really mispriced. We don’t play with that, just don’t have enough time. If you spend enough time you may find those that Charlie and I can’t find because we just can’t look at that many things.

CM: What is interesting is how brief these opportunities are. Some idiot bought muni’s, bought 20x what he could afford at incredible margin, those things were dumped on margin calls and suddenly got really mispriced. The dislocation was very brief, but very extreme. The moves are fast and short. You must think fast, resolutely. You have to be like man who stands by a stream and fish comes by once a year.

WB: 2002 junk bond market happened.

CM: Very big dislocations happen about twice a century.

WB: That means we only have 4, 5 times we can do it

Q17: India, how to grow small business into big business?

WB: Berkshire was a small business at one time. It just takes time, it is nature of compound interest. You can’t build it in one day, or one week. Charlie and I never tried to do a master stroke to convert Berkshire into something four times bigger. We have felt and kept doing what we have understood consistently and have fun doing it then it’ll be something quite large at some point. Nothing magical. It would be nice to multiply money in a few weeks. In a general way we have done same things for years. We will have more businesses in a few years, some will do worse, most will do better. It is an automatic formula for getting ahead, but not galloping. We are happy not doing anything at all. As Gypsy Rose Lee said, I have everything I had before, just two inches lower. We want everything in 2 yrs to be higher.

CM: It’s nature of things that most small businesses will never be big businesses. It is the nature of things that most big businesses fall into mediocrity or worse. Most players have to die. We have only made one new business, and that is the reinsurance business – run by Ajit. We only created from scratch one small business into a big one. We’ve only done it once. We are a one trick pony.

WB: Without Ajit we wouldn’t have done it all.

CM: Best investment we ever made was the fee we paid to executive recruiter to find Ajit Jain.

WB: We went into muni-bond business. He got companies up licensed and running. In Q1’08, our premium was $400m. Our volume was bigger than anyone else, and I wouldn’t be surprised if bigger than rest combined. They did 278 transactions. All done in office with 29 or 30 people. One of interesting things about it, almost all the business was from people who needed the insurance. In every case they had insurance already from others, and they are rated AAA, so we paid if muni AND bond insurer didn’t pay. We wrote for 2.25%, original guy charged 1%. This tells you something about AAA in bond insurance in 2008. Ajit has done a remarkable job. We wrote a couple primaries for Detroit sewers, and people have found these bonds trading at better price than other bond insurers. I congratulate Ajit for it.

Q18: If you can’t talk with management, and can’t read annual report, and didn’t know price. But only looked at financial statements, what metric would you look at?

WB: Investing is laying out money now to get more money later on. Let’s leave market price out. Thinking about bushels per acre – you are looking to asset itself. Do I understand enough about business so that financials will be able to tell me meaningful things that will help me to foresee the statements in the future? I have bought stocks on the way you describe. They were in businesses I understood, and if I could buy at 40% of X, I’d be okay with margin of safety. If you don’t tell me nature of business, financial statements won’t tell me much. We’ve bought securities – and most we’ve never met management. We use our general understanding of business and look to specifics from financial statements.

CM: One metric catches people. We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that.

WB: Apartments. We could value it if you know where apartment is, and know the monthly checks. I have bought a lot of things off the financials. There is a lot I wouldn’t buy even if best management in world, as it doesn’t make much difference in a bad business.

Q19: Klamath River [again].

WB: Net benefits vs. losses must be weighed. There are lots of competing ideas and desires in a large society. It is up to government to sort it out. People are coming to different conclusions about trade offs, and generally those are at state level. The Oregon Public Utility Commission I am sure is aware of issue. They have to consider best way to generate electricity for citizens of Oregon.

Sokol: We want to clarify that we are not polluting water. We recognize various issues. We have a 50 year FERC license. A societal answer hopefully will be reached.

CM: I note how refreshing it is to find people addressing a pollution problem that has nothing to do with burning carbon.

Q20: Philadelphia, I’m 12 yrs. There are a lot of things they don’t teach you in school, what things should I be looking into?

WB: I’d read a daily newspaper. You want to learn about world around you. Bill Gates quit at letter P in World Book Encyclopedia. Just sop it up, and find what is most interesting to you. More you learn, the more you want to learn. It is fun.

CM: My suggestion is that the young person has already figured out how to succeed in life.

Q21: Germany. Wertheimer. Chocolate industry. I can not buy See’s Candies in Bonn Germany. See’s candies vs. Lindt. Sees’ 20% profit. Growth okay. Lindt does 14%, but now global. Which is better, high profits with low growth, or high growth with lower profits?

WB: It doesn’t make difference. We want a company with durable advantage, which we understand, can trust management, at a good price. We’ve looked at every confectionary business. We can sometimes take action. If you have a good private business, the best thing to do is to keep it. No reason to sell it. You don’t need the billion – it’s just a farm. We never urge people to sell good businesses, and we don’t urge them to sell. They can keep more of the attributes they love by selling to Berkshire. We are a larger buyer. Most people shouldn’t sell us their business. We want them to think of us. We want to be on radar screen. We are going to get more on radar screen in Europe. There is a price we would buy stock in Lindt, but it is unlikely to sell there. Many CEOs want to sell to me, but there are thousands of businesses in the world. We should buy most attractive amongst ones we understand and like. Stocks give you bargains, but individual owners won’t. But we will do it at a fair price. We aren’t going to look for a given confectionary company.

CM: We don’t do anything when phrase regardless of price enters the equation. I watched a man who sold a business to known crook just for a higher price, but who you knew would ruin the business. It’s better to sell companies you created to someone who would be a good steward at a lower price.

Q22: How do you hedge euro?

WB: We are happy to invest in businesses overseas as I don’t think currencies will depreciate in a big way. We could offset, but overall the US will follow policies that will make USD weaker. I’d bet weaker over next 10 years, so feel no need to hedge earnings generated overseas. If I landed from Mars today, with a billion Mars dollars, and was thinking about where to put money… What would I like to exchange? I wouldn’t put 1bil Mars dollars into USD. I don’t mind earnings overseas. We own 200mil shrs of Coca-cola. That is $600m of earnings to us, and $500m from rest of world. I think a net plus over time. We are not in business of hedging currencies.

CM: Nothing to add.

Q23: With small sums of money, what strategies would you pursue?

WB: If I were working with small sums of money, it would open up thousands of possibilities. We found very mispriced bonds. We found them in Korea a few years ago. You made big returns but had to be small size. I wouldn’t be in currencies with small amount of money. I had a friend who used to buy tax liens. I’d look in small stocks or specialized bonds. Wouldn’t you say that Charlie?

CM: Sure.

Q24: St Louis. Huge confusion now, what advice do you have? Three candidates are pandering to voters – some not demonstrating profound understanding of economics. Decrease interest rates? Won’t we have gigantic inflation?

WB: Politics are difficult. Famous line about what would you do if elected? ‘I would demand a recount’. Truth is you get lots of pandering in policies proposed. Candidates are pretty smart about economics. Political process is something that doesn’t lend itself to Douglas Lincoln debates on fine points. I think current candidates will be better in office than on stump. We have a country that works well regardless of who is in office. You want to buy stock in a business that is so good because sooner or later an idiot will run it. I think we have three very good candidates. Motivations of people running it are better than their proclamations. You may win badge for courage but won’t win presidency in Iowa if against ethanol.

CM: When Enron shocked nation, our politicians passed Sarbanes-Oxley. We are currently shooting at an elephant with a peashooter. I confidently predict we will have changes in regulation, and they won’t work for everybody. Human nature always has incentives to rationalize and misbehave. We will have this turmoil as far ahead as you can see.

WB: I would gladly pay to have this job. Let’s assume I was campaigning for this job, and if so, my answers might be different. It is a corrupting process, naturally. There is a boom in oil and also in soybeans. Because of increases in food prices, would anyone expect to propose an excess profits tax on farmers? But what about an excess profits tax on Exxon? Situational ethics and policy making depends a lot on voters. Not sure I’d be able to do better, but if I wanted to be President, not sure my behavior wouldn’t be bad too. Any one of the three candidates will do well in White House. But I think they will do what is best for country.

Q25: Succession. Plan for CFO. Update?

WB: We have three CEOs who could step in. Board will pick someone for CEO. For investment officer, Board has four names. As we’ve discussed, any one or all of four would be good or better than me at this job. Any one of four would be here tomorrow if I died tonight. They are all reasonably young, and all well to do. Compensation is not a major factor. Any of four would come. No reason to come now. I worked for Ben Graham. But in end I wanted to make decisions, I prefer to make my own decisions. It is better in this case. When I’m not around to make decisions – Board will decide how many to use. They will be heavily influenced by incoming CEO by how he wants to work with them. There will be no gap. They could easily have better record than my recent record.

CM: We have a rising young man here named Warren Buffett. I think we want to encourage this rising young man to reach his full potential.

WB: On corporate America aging issue, I think we are doing fine. Our average age is eighty, so we are only aging at 1.25% per year – lowest rate of aging in corporate America. If you have 50 year old management team, they age 2% every year, I think you run bigger risk there.

Q26: New York City. American Express and Washington Post – big positions. How do you get confident enough?

WB: If we were running only our own money, 75% of net worth outside Berkshire has never been a significant amount. Several times I have had 75% of my non-Berkshire net worth in a situation. You will see things where it would be a mistake not to act. You won’t see them often, and the press and your friends won’t be talking about them.

CM: Sometimes I have had more than 100% in individual investments.

WB: You just had a good banker.

WB: Look at LTCM – they put 25x their money in things that had to converge – but couldn’t play out the hand. There are people in this room with more than 90% of their worth in Berkshire. I saw things in 2002 in junk bonds. You could have bought Cap Cities in 1974 – selling for 1/3 the property value, with best manager and in a good business. You could have put 100% in Coca-cola when we bought it and that wouldn’t have been a dangerous position.

CM: Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the exact rule is the opposite. The ‘know-nothing’ investor should practice diversification. Diversify– but it is crazy if you are an expert. If you only put 20% in the opportunity of a lifetime – you are a not being rational. Very seldom do we get to buy as much of any good idea as we would like to.

Q27: Boys town. I represent Parent’s TV Council. Want to keep toxic violence off television. Berkshire is a bad advertiser?

WB: Geico – we spend $700m on advertising. I don’t regard them as offensive. Please contact Tony Nicely, he is here. I can’t think of another company that advertises as much.

Q28: NJ. 45 yrs old, able to manage money of spouse and myself full time. Goes to marrying well. I wanted to ask diversification question. Each of us has a traditional and Roth IRA. Should assets in those accounts be separated, or managed as a single entity?

WB: Sounds like your marriage will last. Think of it as one unit. Don’t worry about location of assets. Just look at whole picture. Don’t treat in separate pots. I don’t think about what entities things are in. With that I’ll turn it to our marital expert Charlie Munger.

CM: Taxable income may be more suitable for tax deferral. Apart from that, all one pot.

Q29: Doug Hicks, Akron Ohio. Oil will run out this century. Considering US policy is to do nothing until last second, will we face World War III? Will oil companies go to zero?

WB: Oil won’t run out - it doesn’t work this way. At some point the daily productive capacity will level off and then start declining gradually. There is the depletion aspect and the decline curves. We are producing 86m barrels per day or so, more than ever produced. We are closer, by my calculations, to almost our productive capacity, than we have ever been. I think our surplus capacity is less, and quite a bit less, than in past. Whatever that peak is, whether 5 or 10 yrs, the world will adjust, and we will think about it. Adjustments will cause demand to taper off. I don’t know how much oil is there, but there are lots of barrels of oil in place. We never recover total potential. We may have better engineering recovery in future. It is nothing like an on and off switch. You may still have enormous political considerations to get access to avail oil since it so important. There is nothing you can do over short period of time to wean world off oil.

CM: If we get another 200 yrs of growth dispersed over the world while population goes up, all oil coal and uranium will run out so you will have to use the sun. I think there will be some pain in this process. I think it is stupid to use up hydrocarbons of world so quickly. Stupid when there are few and limited alternatives. What should we have done? We should have brought all the oil over from Middle East and put it in our ground. Are we doing it now? No. Government policy is behind in rationality. If we have prosperous civilization, we must use the sun.

WB: Charlie, what is your over/under for oil production in 25 yrs?

CM: Oil in twenty five years, down.

WB: If this is true, that is big number. China is doing 10m cars this year, so down in 25ys is significant.

Q30: Please name three policy decisions to better the country.

WB: Charlie will serve first term, so he’ll answer first.

CM: That takes us so far afield. Three perfect solutions to problems of mankind, we are not up to it.

WB: I would do something about tax system. Super rich pay more, middle class pay a little less.

Q31: Arizona. Food shortages, trends in next decade?

CM: I said last year that policy of turning American corn into motor fuel was one of dumbest ideas in future of the world. I fly here with a head of academics – he agreed, it was stunningly stupid. It is probably on its way out.

Q32: Timothy Ferris, Princeton guest lecturer. Imagine you are investing with small sums of money at 30yrs old, with your first $1mil. Your savings can cover expenses for 18 months. You are not a full time investor, no dependents. What advice do you have, please be as specific as possible.

WB: Put it all in a low cost index fund. Vanguard. Reliable, low cost. Not professional, thus an amateur. Unless bought during strong bull market, that investment would outperform bonds over long period of time and I would forget it and go back to work.

CM: The great horde of professionals taking croupier profits out of system, and most of them pretending to be experts. If you don’t have prospects as a professional investor, do an index fund.

WB: No one will give you that advice since it doesn’t make anyone money. You will get a good return. Why should you expect more than that when you don’t bring anything to the party?

Q33: Austin Texas. For children, can you give them advice about keeping up with the Joneses?

WB: Just keep up with the Buffett’s. [laughter] We’ve always been fans of living within your means and income. You’ll have a lot more income later on. They will follow example of their parents. Parents don’t covet other people’s belongings, don’t increase cost of living which is not necessarily increasing quality of living. If you go too tough on children they go crazy later on. There are plenty of people I don’t advise to save. If you already have money in 401k and Social Security with a little left, who is to say you should give up taking your children to Disney world and the associated happiness now for a 30foot boat later vs. 20foot boat later. There are benefits to spending now. It is not always better to save 10% than 5%, but definitely better than spending 105%. You need to live a life that is true to yourself. We don’t encourage extreme frugality. You are not a better or worse person if you live differently from your neighbor.

CM: Best method is to train your child.

Q34: Idaho. Are investment banks too complicated? Risks unknown.

WB: Exceptionally good question. Answer probably yes in most places, though there are a few CEOs I respect a lot. Gen Re had 23k derivative contracts. I could have spent full time on that, and I probably still couldn’t have gotten my head around it all. And we had exposures that I thought were possible and heads of business units didn’t – I don’t want slim, I want none. I am Chief Risk Officer. If something goes wrong, I can not assign to committee. I think big investment banks and big commercial banks are almost too big to manage effectively in way they have elected to run their business. It will work most of time. You may not see the risk. A 1 in 50 year risk - it won’t be in interest of 62 year old executive who is retiring at 65 to worry about it. I worry about everything. Many CEOs say they didn’t know about what was going on. It’s easier to admit he doesn’t know what’s going on than to admit that he knew what was going on and let it go on. I’ve been asked for advice on regulation. Somehow press hasn’t picked up on this too much. OFHEO supervised Fannie and Freddie – activities had public element, and were semi-regulated. For 200 people it was their sole job to examine the books. They were 2 for 2 with 2 of biggest accounting scams in history of world. Person at top must have it in their DNA to see risks. In many ways, there are firms that in terms of risk are too big to manage. If too big to fail, there are interesting policy implications.

CM: It is crazy to allow things to get too big to fail, run with knavery. As an industry, there is a crazy culture of greed and overreaching and overconfidence trading algorithms. It is demented to allow derivative trading such that clearance risks are embedded in system. Assets are all “good until reached for” on balance sheets. We had $400m of that at general re, “good until reached for”. In drug business you must prove it is good. It is a crazy culture, and to some extent an evil culture. Accounting people really failed us. Accounting standards ought to be dealt with like engineering standards.

WB: Salomon was trading with Marc Rich who had fled country. They said they wanted to keep trading with him. Only by total directive could we stop it. I think Fed did right thing with Bear. They would have failed on Sunday night, and walked to a bankruptcy judge. They had 14.5tril of derivative contracts – not as bad as it sounds, but the parties that had those contracts would have been required to undo the contracts to establish the liability from the estate. The $400m at Gen Re we had took 4-5 yrs, at Bear it would have been 4-5hours. It would have been a spectacle. Two of witnesses said at testimony, ‘we understood we couldn’t borrow unsecured, but we didn’t understand we couldn’t borrow secured’. The world does not have to lend you money. If they don’t want to lend you money, an extra 10bps won’t make a difference. It depends on people’s willingness to lend you money which comes down to how other people feel about you. If you are dependent on borrowed money, you have to wake up every day worried about what world thinks of you.

Q35: San Francisco. Petrochina in 2002, you just read annual report. Most professional investors have more resources at hand, wouldn’t you want to do more research? What do you look for in an annual like that? How could you make investment only on report?

WB: I read it in Spring 2002, and I never asked anyone else their opinion. I thought worth 100bil. It was selling for 35bil. What is sense of talking to management? It doesn’t make any difference. At value of 40bil, you would need to refine analysis. We don’t like things you have to carry out to 3 decimal places. If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision -- I would know they were fat. If you can’t make a decision on Petrochina off the figures, you go on to next one. You weren’t going to learn more if you thought their big field was going to decline out slightly faster, etc.

CM: We have lower due diligence expenses than anyone in America. I know of a place that pays over 200mil to its accountants every year, and I know we are safer because we think like engineers – we want margins of reliability. It is a very dicey process.
WB: If you think auditors know more about an acquisition then they should run the business and you should take up auditing. When we get call on Mars-Wrigley – I’m not going to look at labor or leases. Value of Wrigley does not depend on value of lease or environmental problem. There is a whole lot of trivia that doesn’t mean anything. I never made one that would have been avoided due to conventional due diligence. We would have lost deals. On big deals, people rely more and more on process. When people want a deal, they will come to us. They only wanted to deal with Berkshire - no lawyers involved and no directors involved. Got a call, it made sense, and I said yes. No material adverse change clause. Our $6.5bil will be available regardless, even if Ben Bernanke runs off to South America with Paris Hilton. That assurance is worth something. I’ll do it, but I need x,y,z – that is costly.

Q36: Norman Oklahoma (“we’ll forgive that as Nebraskans”) – Do you believe in Jesus Christ?

WB: I am an agnostic.

CM: I don’t want to talk about my relationships.

WB: Being an agnostic I don’t have to have an opinion.

Q37: What safeguards are in place from breaking up Berkshire?

WB: My stock will be sold over 12 yr period after my death. That takes a lot of time. You wouldn’t be dealing with a company that is much larger than we presently have, and large blocks – if someone wanted to try a 600bil takeover (and might be larger if you go out far enough), it will be hard. It can’t happen at all until I die (a lot of votes concentrated until then). I told my lawyer I wanted a ten year distribution period – to make sure estate lasts quite a while, to which my lawyer said that was like telling his teenage son to have a normal sex life. If we do decent compounding we’ll be largest in USA. Will be difficult to break us up.

CM: Warren doesn’t plan to leave early. “That is the oldest looking corpse I ever saw”.

WB: I am unlikely to change my views on that subject.

Q38: Chicago: economic characteristics of Kraft.

WB: Most of food businesses earn good returns on tangible assets. If you own important branded assets in this country, you have good assets, and it is not easy to take on those products. Just imagine Coca-cola. They sell 1.5bil servings every day. It has been in everyone’s mind since 1886 – associated with good value, happiness and refreshment. It is virtually impossible to take it on in huge way. It may not be same Kraft Koolaid. But I’m not sure I want to take on Koolaid. To implant RC Cola in people’s mind globally is very very difficult. A brand is a promise. Coca-cola delivers something to you. Virgin Cola – an unusual promise in a product. I couldn’t figure it out, and whatever it is it didn’t work. Don Keogh would know. Who would buy a can at 2cents a can less than Coca-cola? We feel pretty good about branded products as leaders in the field. There is nothing unusual about Kraft that’s different from Kellogg, some good factors are price. If you don’t pay too much, you will do okay. But you won’t get superrich, as attributes are well recognized.

Q39: Kevin True – Chicago IL. 4 CIOs. Criteria?

WB: Criteria in 2006 annual report. Records are important. Human qualities are important. We think we can make those judgments. We didn’t know if many would be good, so we made an affirmative judgment on four. We need someone who can see risks, especially ones that haven’t happened before. All the banks have models, but they didn’t have faintest idea. Need someone you trust with analytics, but also ability to contemplate new possibilities and risks. That is a rare quality. That inability to envision something not in models can be fatal. Charlie and I spend a lot of time thinking about things that could hit us out of the blue that other people don’t include in their thinking. We miss a lot of opportunities. But we think essential when managing other people’s money. You should read 2006 annual report again.

CM: You can see how risk averse Berkshire is. We try to behave in a way so that no rational person will worry about our credit. We also try to behave in a way that if people don’t like our credit we wouldn’t notice for months. That double layering of protection against risk is like breathing. The alternative culture is you call a man a Chief Risk Officer, but often he is man who makes you feel good while you do dumb things. Like the Delphic oracle, a dumb soothsayer, and how can he do dumb things if he has a PHD and can do all the advanced math! You crave a system such that you torture reality to fit a structure that doesn’t match with extreme situations in reality, you feel confident because you compute the risks, but you haven’t -- you have just clobbered up your own head.

WB: We run Berkshire so that if world working in different way tomorrow we don’t have a problem. We are not dependent on others. It gives up earning higher returns 99% or 99.5% of the time, but in one year – we wouldn’t feel comfortable running business that way – why be exposed to ruin and disgrace and embarrassment? If we can return a decent return on capital what is an extra point? This can not be farmed out. Management thought they were farming it out at some institutions.

Q40: German. How large is universe of companies whose intrinsic value you know? Why did you invest in Southern Korea or China?

WB: Our immediate decision is whether we can figure it out. We are thought to be rude, when really we are just being polite in not wasting someone’s time. We know very early in conversation whether what someone is talking about it actionable. We don’t worry about stuff we miss. We know there are many things we won’t know enough when we finish thinking about it, so we throw it out. We make a decision in five minutes. We know about a lot of industries, and there are some things we don’t understand. We like to expand universe of knowledge. If we can’t make a decision in five minutes, we can’t learn enough in five months. If we get a call, with business for sale – or I am reading a paper or 10k, we will move right then if big difference between price and value.

CM: We can make a lot of decisions about a lot of things very fast and very easily, and we are unusual in that. Reason is that there are such an enormous amount of things we don’t look at. If you don’t do startups, you blot out a lot of complexity out of your life. What we found out is that there are still a lot of things to look at and available even if we filter out all those things.

WB: There are a lot of giveaways in first sentence or two. We waste a lot of time, but we waste it on things we want to waste it on.

Q41: Carlos Slim?

WB: We had lunch 15yrs ago, with a couple of his boys.

CM: You speak to the total knowledge of both of us about Carlos Slim.

Q42: New York City. Coca cola Beijing Olympics, humanitarian values.

WB: I think Olympics should be allowed to continue forever with everyone participating. It is hard to grade a couple hundred couple countries. It is a terrible mistake to try to start grading, more that participate the better, I would not start getting punitive. I think it’s a terrible mistake to ban countries from Olympics. The United States only started allowing women to vote in 1920s and I consider that a huge violation of human rights, but we wouldn’t (want to) be banned from the Olympics the years prior. I think that overtime they are contributing and getting better.

CM: Warren understates my position. Many are distressed by imperfections in China, so I ask - is china more or less imperfect as decades have gone by ? it is moving in right direction. That is a good thing, and it is not good to pick worst thing about a person you don’t like and obsess about it.

WB: You do better with people you are working with if you nudge him/her a bit.

Q43: Scottsdale AZ. Coal industry? Does cost advantage outweigh environmental?

WB: In short term world will use more coal. There is an environmental disadvantage to it. We will slowly figure out ways to do things coal does now that are environmentally more friendly. But it won’t happen fast. If you shut down coal plants, we wouldn’t be able to hold this meeting. At Mid-American we have put in a lot of wind capacity, probably more than anybody. But we are dependent a LOT on coal, and now it is cleaner than it was. It is worldwide problem, with the Chinese building a lot of coal plants. Per capita Americans have done a lot of negative things to this planet so it is hard for us to preach. It will take a leader who can lead on this.

CM: People who are very against coal, so I ask, which would they rather use up first, coal or hydrocarbons? Coal is less desirable as chemical feedstock to feed the world [into fertilizers]. There is an environmental reason for being pro-coal use. Most people don’t think this way, but I do.

WB: Charlie doesn’t take comfort in numbers.

Q44: Stockton CA. Small regional banks - what would you look at before you buy?

WB: It is hard to make a categorical decision about regional banks. So much depends on character the institution. It will be reflection of CEO you have. A bank can mean anything. It can be an institution that is doing all sorts of crazy things. Bank of commonwealth was an example. We owned a bank in Rockford IL run by Dean Aback – he would always run a super-sound bank. You should know culture of management and institution before making decision to buy a bank. We own Wells Fargo and M&T, but it doesn’t mean they are immune. But likely they are immune from institutional stupidity. There was wise man that said there are more banks than bankers. If you think about that a while you will get my point.

CM: The questioner on to something. So many large banks have cast pall over industry. You are prospecting in a likely territory.

WB: If you took 20 largest and 20 smallest banks in Florida, don’t know you could tell difference.

CM: It is a territory that has some promise.

WB: That is a wildly bullish statement from Charlie.

Q45: Chicago: Iran, Syria?

WB: The great problem of mankind is that the genie is out of bottle on nuclear weapons. More and more will know how to do damage. Psychotics will wish ill will. Materials and deliverability is the choke point. People generally associate this risk with terrorists and rogue states. But I regard as big threat to future of mankind. We haven’t made much progress and we should be doing everything to reduce access to materials. We have a proposal to reduce rationale to have big weapons. World has 6.5bil people, and it is very likely that twice the number of people wish ill than when world had 3bil. We used to just pick up a stone and throw it at our neighbor, so massive damage was limited. Since 1945, it has changed everything in world except how men think. Exponential growth, and we haven’t gotten rid of the nuts. We live in a dangerous world. Getting more dangerous as we go along. In Cuba Missile Crisis it was probably 50/50 odds, we were lucky. It won’t go away. You would hope we have an administration which will try to figure out how to minimize the risk. It should be paramount to eliminate deaths on a large scale.

CM: Well, you can talk about death on a large scale. Population of Mexico probably had a population decline of 95% as result of European pathogens. It won’t wipe out the species. I hope that cheers you up.

WB: The cockroaches will survive.

Q46: Florida. Teach at community college in Florida, teaching students to invest in themselves. Financial independence and freedom. Slow and steady wins the race. Law of reciprocity. What else should I be doing?

WB: I’m ready to hire your entire class right now. Most important investment is in themselves. Potential horsepower is rarely achieved. Just imagine you are 16 – going to give you car of your choice. But only car you would get for rest of your life. How would you choose? Of course you will read manual 5 times. How would you treat it? Keep it garaged. Change oil twice as frequently, keep rust to minimum because you know it’ll last a life time. I tell students that you get only one body and one mind. Better treat it same way. Hard to change habits at age 50 or 60. Anything students do to invest in bodies and mind is good, particularly in the mind. We didn’t work too hard on bodies around here. It pays off in an extraordinary way. Best asset is your own self. You can become the person you want to be. When I get classes in university I ask them to buy one classmate to own for rest of life. They pick the person who not with highest IQ, but who are most effective, the ones you want to be around. These people are easy to work with, generous, on time, not claiming credit, helping others. There are things that turn other people on, and turning other people off. Those are good habits to develop.

CM: I have a specific suggestion that I would add to your extensive repertoire. I would teach them to avoid being manipulated by vendors and lenders. Cialdini has new book – it is called Yes, and I recommend it.

Q47: Chicago. Nine years old. I know you like baseball. My favorite team is Chicago Cubs. Would you like to buy Chicago Cubs from Sam Zell, is it a good investment?

WB: It’s been a good investment. Earnings haven’t gone up so much, though cable expanded the stadium. 40k seats in 1939, cable multiplied seats in a huge way and a lot of it went to players but some stuck to owners. When I was your age, I thought I would buy a team. If Cubs sell for $700m, I don’t think I would buy at that price – there is a psychic income to some owners. It is a way to instant celebrity. A certain percentage of people want the route to that life. Many people have loads of money. I’ve had calls from others on Cubs. I think I will leave that to you.

WB: Charlie is a harder sell. I might do something like that.

CM: You have already done it once.

WB: Touche.

Q48: Americans don’t save. Why, what can we do? Municipalities and Fed don’t save, Asians save 40% of income. Why is it that Americans do not save, what can we do to correct our long term problem?

WB: Savings rate has fallen, may be negative. But value of country in real terms increases decade to decade. It seems worth more than 20 yrs ago – something good has happened. Propensity to save seems innate in some places. I should have thanked Andy Hayward for cartoons in the movie. If you own Berkshire you are saving because we retain earnings and therefore you are net saving – and I have been doing it in Berkshire for 43 yrs. I don’t know that the saving rate – based on calculations on consumption and imports – is accurate. We are importing 700bil more of services than we are exporting. We are exporting claims against America. But we are so rich it may not be really apparent. Average standards are likely to improve, but may be disproportionate. Net real terms the value on per capita will very likely increase decade to decade. But it is nothing compared to China or Korea where savings rate is very high. We may not save very much because we don’t need to. We are a very rich country, and we may not need to save as much as other countries trying to reach their potential.

Q49: Germany. May I ask you your reasons for coming to Germany?

WB: We want more family owners of German businesses. We want more owners who when they think of need to monetize, have Berkshire on their radar screen. We aren’t as prominent in Germany as in US. We are looking for good companies and we want them to know us. We should be better known in a month.

CM: Germany is particularly impressive, an advanced civilization especially in engineering and industrials, with German advancement and inventiveness. It is amazing the impact Germans have had on field after field in America. Look at all the machines in factories with German names.

WB: Sounds like Charlie should go to Germany.

Q50: California. What can we learn from past blow-ups?

WB: All a little different, all have similarities. This one had origins in mortgage field and residential real estate. Trouble in one area has a way to spread to another area. In my lifetime, I can’t remember one where this particular residential real estate bubble sent out the shock wave and exposure of so many other bad practices and weaknesses elsewhere like this one. There isn’t any magic to analysis. There are stupid things that won’t be done soon again, and not the same way again. But variations of it will occur again. Humans are what lead to stupidity and behavior. Primal urges, wanting to believe in tooth fairy that pop up from time to time, sometimes in very big scale. I have no great insights on solutions.

CM: It was a particularly foolish mess. We talked about an idiot in the credit delivery grocery business, Webvan. Internet based delivery service for groceries -- that was smarter than what happened in mortgage business. I wish we had those Webvan people back. I have a rule: The politicians are never so bad you don’t live to want them back.

Q51: How do we better measure leverage and accounting of assets, integrity?

WB: It is a very tough thing. I still lean strongly towards fair value accounting – it is hard to use, but should we use cost? I think there are more troubles when you start openly valuing things at prices that don’t matter instead of best estimates even if inaccurate. I would stick with financials reporting assets at fair value. When you get into CDOsquared, the documentation is enormous. If you read a standard residential security – it consists of thousands of mortgages, then different tranches. Then take CDO and take junior tranches on a whole bunch of juniors – put them together and diversified in theory – a big error to start with. That was nuttiness squared. You had to read 15,000 pages to get a CDO, then 750k pages to evaluate one security in a CDOsquared. To let people use 100cents they paid vs. the 10cents it trades at in market is an abomination. Fair value discipline, mild as it may be, may keep managements from doing some stupid things. I lean toward the market value approach. When you get towards complex instruments, I don’t know how you value it. Charlie, back at Salomon I think you found one mismarked by $20m, right?

CM: A lot goes on in bowels of American industry which is not pretty. A lot of people got overdosed on Ayn Rand. They would hold that even if an axe murderer in a free market is a wise development. I think Alan Greenspan did a good job on average, but he overdosed on Ayn Rand that whatever happens in free market is going to be alright. We should prohibit some things. If we had banned the phrase, “this is a financial innovation which will diversify risk”, we would have been far better off.

Q52: Finance and economics – our constitution.

WB: Do you have a question?

Q52 cont: No.

WB: I sort of suspected that.

Q53: Future of mass transit?

WB: Passenger traffic? [Yes.] The American public generally doesn’t like mass transit. Americans’ love affair with car, which translates into an aversion to mass transit, one person to a car seems to be popular method for moving around. We are unlikely to see expansion in mass transit. American public is genetically averse to mass transit. Seems to be human nature that people want to drive even if they have to pay $4 a gallon on gas and double on parking. I wouldn’t be optimistic about something that has long trend in human nature and that it would reverse all of a sudden.

CM: You have a more optimistic view of it than I have.

Q54: Tom Nelson, North Oaks MN. If you were in charge of country, how would you handle climate crisis.

CM: I’m in awkward position of agreeing with Al Gore, we shouldn’t be burning so many hydrocarbons. But his brain doesn’t work the way mine does, and you’ll have to judge for yourself.

WB: We’ll have a vote later.

Q55: To win, first you must not lose. If corporate default rates escalate, will the credit default swap problem materialize as a threat to financial system? You are great pricer of risk. You must consider selling insurance without pricing appropriately. Is there a chance CDS market may eclipse subprime?

WB: CDS notional is about 60trillion, there are lots of double counting, etc, but no doubt it is a lot of money. They are swaps, or insurance against companies going bankrupt. We have written two types of derivatives, and we have insured a swap that pays to someone else in event of default on high yield indices. I think we will make significant money. I think there is no question that corporate default rate will rise. That has been included in price in writing this insurance. Will CDS market lead to chaos? Probably not, but if bear had failed you would have had chaotic conditions. A CDS is a payment by one party to another. When someone loses money on a loan, they’ve lost real money, but there is not a swap of dollars immediately when loan goes bad. In CDS, there is an exchange of cash. Whether counterparties fail -- I don’t think it will happen. We’ve had enormous collateral payments from one firm to another in this recent crisis. Fairfax Financial made $1bil in CDS. This means another guy lost $1bil. They have been most volatile of instruments – and it really hasn’t created a problem in system. If Fed must step in, I don’t think it will be due to CDS. It may cause big losses, but will be matched by big gains by others. There is a problem of an overnight disruption in the system (bear, nuke bomb) – where discontinuity and collateral postings inadequate. At that time, large CDS exposure could exacerbate chaos to considerable degree.

CM: Could we have mess in CDS? Yes, but stupidity not as bad as sweeping bums off skid row to give them houses. There is an issue of insuring against outcome of losing money on $100mil bond issue, when you have $3bil of contracts on $100m bond issue – there are incentives to manipulate the smaller loss to make big collection on the larger position. It used to be illegal to buy life insurance on people you didn’t know, with big payoffs in event of their death. Why did we want enormous bets to be made in unregulated markets? We have a major nutcase bunch of regulators and proprietors in this field.

WB: Charlie 1 point, Invisible Hand 0 points.

Q56: Why do you not believe in dividends when Benjamin Graham believes in it?

WB: I had to show a little individuality. [laughter] I do believe in dividends, including dividends at companies where we own stock. The test on dividends is can you create more than one dollar of value than the one you retain. It would be mistake for See’s to retain money because they have no ability to use the cash they make to generate high return internally. We hope to move the capital to a place worth $1.20. If we do that, taxable or not, they are better off if we retain money. But when the time comes that we don’t think we can use money effectively, we will pay it out. But because we have ability to redistribute money in tax efficient way within company, we have more reason to retain earnings in company. We like companies where we have investments to pay to us money they can’t use effectively.

CM: Costco paid no dividend when they were growing rapidly. As St Augustine said: “God give me chastity, but not yet.”

Q57: Books to read?

WB: We try to have good selection in bookstore downstairs. I am partial to Larry Cunningham’s book.

CM: California did cause coal plants to be built near Grand Canyon. It caused an uproar. I think those things are about to be decommissioned. I’m glad to put climate back to you.

Q58: Texas. Do you forsee Berkshire buying any businesses in india or china in near future?

WB: We would like to. The odds are somewhat against buying anything outside of USA. Mitek has possibilities outside USA. If we get lucky, we’ll buy one or two in next 3 or 4 yrs. Where it is, who knows. We wouldn’t rule it out. We looked at insurance in India and China, but they restrict ownership in any domestic insurance company. Limit is 25% in China, I think 25% in India. We probably don’t want to go in to own 25%, we want to have more ownership to make it worthwhile. You will see day that Berkshire owns businesses in my view in both countries.

CM: Nothing to add.

Q59: Jim James, MN. Will you share your influences on you, your educators?

WB: Biggest educator was father. It is important who you marry. Those are great teachers. Ben Graham. Dave Dodd. I devour books. Charlie likes Ben Franklin. My grandfather at the family grocery store. Most important job you have is to be the teacher to your children. You are the big great thing to them, you don’t get rewind button, you don’t get to do it twice, teach by what you do not what you say. By the time they get formal school they would have learned more from you than school. Provide warmth and food and everything else. It won’t change when they get to graduate school – and you get no rewind button. You teach with what you do, not what you say.

CM: Differing people learn in differing ways. I was put together to learn by reading. If someone is talking to me – it doesn’t work as well. With a book, I can learn what I want at speed that works. It works for my nature. For those people who are like me, welcome, it is a nice fraternity.

WB: Did you learn more from your father? Your father probably had more impact on you before your readings?

CM: Father did have an impact. He always took more than his share of work and risk – that was helpful. Conceptual stuff – I learned from books. Those authors are fathers in a different sense.

WB: If you keep reading books, you’ll learn a lot. If you read 20 books, you can learn a hell of lot. Having right parents is very lucky. If you get the right spouse, that’s just doubled down.

Q60: Chicago. Thanks for respect for common shareholders. Executive pay - what can we do to get country and issue going right way?

WB: Compensation - you can’t do much. There are relatively few people that could do a lot, by withholding votes. Big shots don’t like being embarrassed. You want a good press. Press needs material. I don’t know how you create incentives for big institutions to do that. A lot of checklists institutions use are asinine. Issue du jour, people recommending how they vote – why can’t they make up their minds. Ben Graham bemoaned investors as a bunch of sheep. Press would do rest. But they won’t respond to you. Small shareholder can write persuasive notes. It takes real effective pressure to change behavior when self interest is in favor.

CM: In England, they got taxes up to 90%, so no possibility of earning large income. That was counterproductive. You can get politics of envy that ruins economics. I think people taking compensation have moral duty not to take it. Moral duty to be underpaid. If generals and archibishops can do it, why can’t leaders of large enterprise take less than the last dollar? That said, it is very difficult to implement.

WB: Envy is the silliest, because you feel worse and they feel fine but maybe they feel better. Rule out envy as part of your repertoire. Gluttony has some upside, with maybe some temporary side effects. Lust – of course I’ll let Charlie speak to that.

Q61: Pharma? (How do you valuate the pipeline of drug companies)

WB: Unlike many businesses, when we invest in pharma We don’t know answer on pipeline and it’ll be different pipeline 5 years from now anyway. We don’t know whether Pfizer or Merck etc have better chance, which of those will come out with a blockbuster. But we do feel we have a group of companies bought at a fair price that overall will do well - should offer chances for decent profits. These companies are doing very important things. I could not tell you potential in the pipeline. A group approach makes sense. Not the way we would go at banks. If you buy pharma at reasonable multiple, you will probably do okay 5 – 10 yrs from now.

CM: You now have a monopoly on our joint knowledge of pharmacology.

WB: He gets cranky at end of day. [laughter]

Q62: Wuxi China. Thank you for observations on Olympics. We came here to see how companies should be run. You did a quick trade on Petrochina. What comes to mind when selling? Any suggestions to these Chinese executives?

WB: I met Dr Gao recently from the China Investment Corp for lunch. I was very impressed with him – we had lunch in Omaha. Petrochina was at $35bil… and analysis was same when I thought value was 275b, and not undervalued. At $200-300 billion we thought it was fairly valued so we sold. It went up significantly afterwards because of A-share listing and at one point became the most valuable company in world by market cap. They’ve done terrific job. If it went to significant discount, we would buy again. I’m not so sure we don’t have a lot to learn from China vs. what we have to teach. China has a remarkable society. I traveled 45min outside of Dalian, and saw hundreds of plants developed in recent years. Chinese are starting to realize their potential. There is lots of ability but the system did not realize potential. I think it will continue to get better. I would look for best practices and I would discard rest. If you look at effective individual – why do people want to be around them? You should copy those qualities… I would look for what I admire and emulated, and try not to let things distasteful be copied.

CM: I hope you will go back to China and tell them that you found one individual that really approves the Confucius’ respect for elderly males.

Q63: Cynthia Beamon, California. What is your fondest hope for Berkshire?

WB: I hope for two things. Decent performance, and that the culture is maintained – we are shareholder and manager oriented. We want to be best home in the world for wonderful family businesses. I fully expect that what we have tried to build into Berkshire will live into future far beyond my tenure as CEO. We have great candidates that succeed me and we have board and managers that have all seen what works. We have a very fine and strong culture. I am sure it will be continued – and that we get good results. I hope in 20 yrs that fine businesses will immediately think that if they have to sell the business they would sell it to Berkshire.

CM: I would like to see Berkshire even more be deserved as an exemplar, and that we have even more influence on changes in other places. Things that have happened here would be useful to other companies.

WB: We also want it to have the oldest living managers. [laughter, applause]


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