Notes From Berkshire Hathaway 2014 Annual Meeting

These are my notes from the Berkshire Hathaway 2014 Annual Meeting:

 

Berkshire Hathaway Annual Meeting
May 3, 2014

(Notes taken by David Kass, Department of Finance, Robert H. Smith School of Business,
University of Maryland)

A one hour humorous film was shown in which the highlight was an animation of a future Winter Olympics taking place in Omaha.  In a U.S.-Russia hockey gold medal showdown, Russia’s skaters – large and muscular – threaten to “beat” the relatively diminutive American team “into borscht”.  The U.S. skaters are led by Warren Buffett, Charlie Munger (Berkshire Vice Chairman), and Bill “Goalie” Gates.  With the score tied late, coach Ajit Jain (Berkshire Reinsurance CEO) calls a time out and designs a trick play.  He holds up a small white board containing several complex mathematical equations (that have nothing to do with hockey) and states that this play has “an 87-percent chance of success”.   When play is resumed, a desk from Nebraska Furniture Mart appears on the ice and is moving in the direction of the Russian goalie.  Charlie Munger, who was moving the desk forward and hiding behind it, suddenly appears and shoots the puck into the net.  The U.S. wins 4-3.

The video also humorously depicted Warren Buffett and Paul Anka singing a rendition of “My Way” – originally made famous by Frank Sinatra and written by Anka.

Warren Buffett (age 83) and Charlie Munger (age 90) then walk on the stage and sit down.  The format for asking questions was similar to the last five annual meetings.  One-third of the questions were selected by three business journalists:  Andrew Ross Sorkin (CNBC and the New York Times), Becky Quick (CNBC), and Carol Loomis (Fortune).  Shareholders had e-mailed over 2,000 questions to the journalists, who then selected 18 questions relating to Berkshire and its operations.  The journalists who were seated on the stage, alternated with analysts Gregg Warren (Morningstar), Jonathan Brandt (Ruane, Cunniff, and Goldfarb), and Jay Gelb (Barclay’s Capital), and with shareholders in the audience in the asking of questions.

Approximately 40,000 were in attendance.  (This is compared to previous records of 36,000 – 38,000 in 2010-2013, 35,000 in 2009, 31,000 in 2008, 27,000 in 2007, and 24,000 in 2006.)

Buffett initially commented that first quarter operating earnings declined slightly primarily as a result of insurance underwriting.  He mentioned that on a quarterly basis this segment’s earnings are not very meaningful and are often foreign exchange related.

A shareholder proposal to require Berkshire to initiate cash dividends was overwhelmingly defeated, with only 2% of the shares voting for it.

Questions were asked in the following order:

(1) Loomis:  Coca-Cola’s Board of Directors recently approved a very generous compensation plan.  You did not vote against it.  You abstained.  Why did you abstain?

Buffett:  I spoke to Muhtar Kent and told him we were going to abstain since we thought the compensation plan was excessive.  That was the most effective way for Berkshire to behave.  We did not want to go to war with Coca-Cola.

Munger:  I think we did everything right.  I think you handled the whole situation well.

Buffett:  The resulting dilution from this plan is 2.5%, which is much lower than the number calculated by David Winters.

(2) Brandt:  Is Berkshire’s hands off policy consistent with 3G’s hands on approach?

Buffett:  The two styles do not blend well.  There will be more opportunities to partner with 3G.  They are excellent at running businesses.

Munger: I do not think we have ever had a policy of rewarding overstaffing.

(3) Audience:  Other countries are lowering taxes and reducing debt.  Can you speak to Obama to change our direction?

Buffett:  American business is doing extremely well.  Corporate taxes as a percentage of GDP has declined from 4% to 2% since World War II, while other taxes have increased.  U.S. earnings on net tangible assets, the measure of overall profitability, is the envy of the world.

(4) Quick:  Berkshire has underperformed the S&P 500 average return over 5 years.  Are you changing your yardstick?

Buffett:  We are not changing our yardstick.  I have said that we will underperform in good years.  Over any cycle, we will outperform.

Munger:  Warren talks about increasing book value after paying full corporate taxes at 35%.  Indices do not pay taxes.  In the last 10 years, Berkshire’s pretax profits increased by $60 billion.  If this is failure, I want more of it.

(5) Gelb:  You mention that Berkshire is undervalued relative to its intrinsic value.  What can you do about it? Would you consider an IPO of the operating units?

Buffett:  No with respect to IPO’s.  GEICO is carried at $1 billion and it is worth $20 billion.  We will buy our stock at prices below 120% of book value.

(6) Audience:  Berkshire buys whole companies.  Acquisitions can be disruptive.  What does Berkshire do to gain trust?

Buffett:  We keep our word.  We have to be careful about what we promise.  We cannot promise no layoffs.  We can promise we will not sell their business as long as they are not having continuing losses and there are no labor problems.  We have sold only a few businesses, including the original textile business.  We let managers continue to run their businesses.

(7) Sorkin:  Since your son, Howard, voted for the generous Coca-Cola compensation plan as a director, how will he be the protector of the culture at Berkshire?

Buffett:  As a director of companies, I have voted for compensation plans that did not make any sense.  Boards of Directors are both business organizations and social organizations.  In 55 years of being on boards of many companies, I’ve never seen a compensation plan get a dissenting vote.  The board delegates this function to its compensation committee.  Also, “independent” directors receiving $200,000 or $300,000 per year are not independent.  For going to work 6 times a year, it is good work.  Boards do not look for Dobermans, they want Cocker Spaniels with their tails wagging.  Howard is there to facilitate a change if the Board decides it is needed.

Munger:  In life you have to pick your spots (when to disagree).

Buffett:  If you keep belching at the dinner table, you will soon be eating in the kitchen.  People need to pick their spots or they will not only be ignored, but also not heard on other issues.

(8) Gregg Warren: The measure of good management is the ability to realize high returns on capital.  But the size of Berkshire can make this difficult.  What is the cost of capital now, with the addition of capital intensive firms?

Buffett:  Size is an anchor to performance. The cost of capital is what can be produced by our second best idea. Our best idea has to exceed that.  I have never seen a CEO wanting to do a deal and a CFO say it didn’t exceed the cost of capital.  We are constantly measuring that opportunity cost.  The real test over time is that a dollar we retain produces more than a dollar of market value.

Munger:  We do not use the phrase “cost of capital”.  Warren’s definition of adding more in market value than we put in will never be taught in business school.  It is simple – we are right and they are wrong.

(9) Audience:  Did you buy Nebraska Furniture Mart at 85% of book value or 2x earnings?

Buffett:  No, we did no buy it that cheaply.  We paid 11 or 12x pre-tax for 80% of the company and it was not a discount to book value.  It had $100 million sales, pretax 7% margin, or about 4.5% after tax.  It was a great business, but not a bargain.  We had a record $40 million in sales for the shareholder week last year.  We are up 7% now vs. last year.  On Tuesday we did $7.8 million.  We own the largest furniture store in Reno and Las Vegas.  The new Dallas store will do more business than any other home furnishings store in the world, by a factor of 2. It has 1.8 million square feet.

(10) Loomis: You have stated that our wife’s estate should have 10% in short term government bonds and 90% in a low cost S&P 500 index fund.  Why an index fund instead of shares in Berkshire?

Buffett:  When I die, every single share will go to five foundations.  They will be distributed over ten years after my estate is closed.  My instructions are not to sell any shares until they have to be sold.  My views on Berkshire are solid.  I cannot think of anything better to do with them.  For my wife, it is not about maximizing capital, but maximizing safety.

(11) Brandt:  Burlington Northern has done well, but hasn’t Union Pacific grown earnings faster?

Buffett: We have handled more volume than in the past.  We have had a lot of service problems on the northern route.  We have been spending more money than Union Pacific, trying to anticipate problems.  When you get a big increase in volume on that one route, from Bakken shale oil, there are a lot of trains running now that were not running five years ago.  Matt Rose (BNSF) might address problems of cold weather.

Rose:  Industry grew at over 100,000 units and we handled 53% of the units.  Oil came a lot faster than we expected, and we have been spending to build into it.  The weather we had this past winter was the worst I have seen in my 13 years as CEO.  We had 83 inches of snow in Chicago. There were many days with below zero temperatures in Minnesota.  We handled 206,000 units last week.  No railroad has handled 205,000 units.  We are making investments.

Buffett:  We will spend $5 billion on the railroad this year.  No railroad has spent close to that. We are functioning better and earnings are likely to be better.  We are dealing with 23,000 miles of track.  One weak link is Chicago for all four railroads.

(12) Audience:  Berkshire uses natural gas to generate electricity.  How can we get an adequate supply of natural gas, and if the price goes up, how can we sell electricity and earn a satisfactory return?

Buffett: We are the largest alternative energy source in the country.  By 2015, 40% of our electricity in Iowa will come through wind.  It is unlike any other company you can find in the country. Greg Abel will answer questions on natural gas.  I am not worried about the issue that you raised.  We have the opportunity to shift to coal.

Abel:  Matt (Rose) touched on the very cold winter we had in the Midwest. We were challenged.  Natural gas was available to heat homes and keep lights on.  This past year we were in renewables, 39% wind in Iowa (2013).  We can meet the needs of our customers in a cost effective way.  When we pay more for gas, we have pass-throughs back to our customers.

Buffett:  Our gas pipelines move about 8% of the natural gas in the U.S.  Gas into this area comes through a pipeline we own.  We renamed our energy unit to Berkshire Hathaway Energy (from Mid-American Energy).  When we bought it from Enron and Dynergy, they had skimped on maintenance.  It was ranked #42 out of 42.  Last year it was ranked #1.  Went from last to first under Greg’s management.  #2 was our other pipeline, so we are running 1 and 2 at the moment.

(13) Quick:  Are there any succession plans for Charlie?

Buffett:  Charlie is my canary in the coal mine.  He recently turned 90 and it is encouraging how he is handling middle age.  Whoever replaces me as CEO should choose someone to work closely with.  Having two people with complementary talents is a great way to operate.  Examples of this include Goizueta and Keogh at Coca-Cola and Tom Murphy and Dan Burke at Cap Cities.  No one has brought up a successor to Charlie.

Munger:  Most 90 year old men are gone soon enough.

(14) Gelb:  What are the implications for succession of Matt Rose moving up to Chairman at BNSF?

Buffett:  This move was made at Matt’s suggestion. We have succession plans in each of our subsidiaries.

Munger:  I wish my biggest problem was succession plans at Berkshire. We are in very good shape.

(15) Audience:  In the 2009 annual meeting you said if you were to invest in only one company, it would be Wells Fargo.  Is that still the case today?

Buffett:  Other than Berkshire, it’s a good question, but it is not going to get an answer.

Munger:  My answer is the same.

(16) Sorkin:  Proxy statements show salaries for only the highest paid executives.   Berkshire shows salaries for Warren and Charlie, but not for Ajit and Matt (Rose).  In the spirit of transparency, why not reveal additional salaries of Berkshire’s executives?  How much should Berkshire’s next CEO be paid?

Buffett: Berkshire’s next CEO will be paid a lot.  I will discuss this in next year’s annual report.  Berkshire follows SEC rules in reporting executive salaries.  If management listed additional salaries of senior executives, then those who are earning less are likely to be envious.  This would result in pressure to increase their salaries which would make shareholders worse off.  CEO’s would be paid a lot less if proxy statements hadn’t revealed how much others were being paid.

(17) Gregg Warren: Question about retained earnings and capital spending

Buffett:  BNSF and BH Energy are making large capital investments.  We will always keep at least $20 billion in cash.  We cannot depend on anyone else.  We have to maintain our strength.  We cannot let one moment destroy us.  Cash is like oxygen.  You don’t notice it 99.9% of the time.  But, when it is absent, it is the only thing you notice. Above $20 billion, we will try to find ways to invest it intelligently.  But we will never feel the need to spend it.

(18) Audience: Do you and Charlie argue and disagree?

Buffett: Charlie and I have never had an argument. We met when I was 29 and he was 35.  In those 55 years we have disagreed on lots of things.  But we have never had an argument.  We argue with others.

Munger:  Most of the time we think alike.  That is the problem.  If one of us misses something, then the other is likely to as well.

Buffett:  The really bad mistakes we have made were my mistakes.  I’m a little more inclined to act than Charlie.

Munger:  You once called me the “abominable no man”.

(19) Loomis: In an interview in April, you said you hoped to get questions on your weak points.  What are they and what can you do about them?

Buffett:  We have a lot of weak points. We point them out when we can.  If we executed sweep accounts for subsidiaries, we would have a few more dollars than we have now.  One weak point is that I am slow to make personnel changes.  There are times when our lack of supervision will make us miss something. Giving our mangers a lot of freedom enables them to accomplish a lot. We have no human resources office nor a general counsel office.  That is unthinkable for most companies.

Munger:  We over trust, but our results are better because of it.  We select people we can trust.  Places work better when they create a culture of deserved trust.

(20) Brandt:  See’s candies grew profits rapidly in the 80’s and 90’s, but why not during the last decade?

Buffett:  Boxed chocolates are not growing in the U.S. 100 years ago each city of any size had chocolate shops.  Loft’s owned candy stores in New York City.  Boxed chocolates have lost position to salty snacks.  See’s has done well relative to other chocolate companies.  What we were earning in California in the 1970’s was great.  We were unsuccessful trying to move nationally.  In the East they prefer dark chocolate, in the West it is milk chocolate.  We have done very well with See’s.  It has provided us with earnings to buy other businesses.  But it really opened my eyes to the power of brands.  We probably made the money in Coca-Cola because we bought See’s.

Munger:  The main contribution to Berkshire was ignorance removal.  If it weren’t for the fact that we were so good at removing ignorance, we would be nothing today.  The best thing about Berkshire is that we have removed a lot of ignorance.  The nice thing is we still have a lot more ignorance left.

(21) Audience: Question about Berkshire’s investment in Bank of America, its Tier 1 capital, its preferred stock held by Berkshire, and its recent accounting error.

Buffett:  Brian Moynihan months ago called me and asked if we would change our preferred Bank of America stock from cumulative to non-cumulative.  This would help Bank of America meet its regulatory capital standards. Brian Moynihan was willing to make the non-cumulative preferred non-callable for 5 years.  I agreed.  In a world of 5 basis point money, I get 5 year non-callable 6% preferred. The accounting mistake had been made with respect to some structured notes at Merrill Lynch.  That error does not bother me.  The error did not affect GAAP income.  They will pay a penalty, but that does not change my feeling about Bank of America and their management team.  Non-cumulative risk is very low for us, and 5 year non-callable is very good for us.

(22) Quick:  What is the outlook for NetJets?

Buffett:  This is a decent business.  It is not a rapid growth business.  We are 60% of the industry and no one else is a close second. We are going to China soon.

Munger: I recently bought 25 more hours.

(23) Gelb: How large an acquisition are you seeking?  Would you consider selling other stock holdings such as Wells Fargo, Coca-Cola, IBM, and American Express to fund an acquisition?

Buffett:  They (other stock holdings) could be a source of funds, but we are unlikely to sell them.  Our goal is to buy big businesses.  We are looking to add earning power to Berkshire. We do not get opportunities very often.  If the opportunity is large enough we can sell some of our securities.  We have $45 billion in cash and I am willing to take that position down to $20 billion. This could happen this year or in ten years.  We are looking for a business that will be earning money 20-30 years from now.  We have Todd and Ted thinking about marketable securities. But we are focused on looking to buy businesses. If we wanted to raise $10 billion, the stocks we would sell would not be the ones you mentioned.

(24) Audience:  Would you consider increasing Berkshire’s leverage by borrowing $30-$40 billion?

Buffett:  We can generate cash through our insurance float of $77 billion. We have a conservatively leveraged company and do not wish to change its path.  We do not want to have an impact on the value of AA debt bought by people in the past at par.  We have no problem leveraging the utility or BNSF.  Both could withstand more debt.  Another $30 -$40 billion of debt would add nothing and would cost very little.  We do not have great places to put it however, as evidenced by $25 billion of excess cash.  If we see a really good $50 billion deal, we would find ways to borrow the money after we did it.

Munger:  I think we would welcome it.  But we would not do it in advance.

(25) Sorkin: What are the risks in climate change on your investments?

Buffett: It can have an impact on insurance.  BNSF will carry less coal at some point. The impact of climate change on year to year catastrophe probabilities is very low.  We will continue to develop alternative forms of energy.  We are happy to carry coal.  We are a common carrier.  We might not want to carry ammonia, but since we are a common carrier, by law we have to carry whatever freight is offered to us. I do not think that climate change should be a factor in making investment decisions.

Munger: There clearly is global warming. But we are very well positioned long term no matter what the weather.  We will be producing more electricity from wind and sun. GEICO has made a lot of money from the Internet even though they did not plan on doing so.  They just stumbled into it.

(26) Gregg Warren: Todd and Ted are each managing $7 billion.  How will their roles expand?

Buffett:  They will be handling more money over time. It is better to move money to them and away from me over time. They are both terrific for Berkshire.  They know a lot about business and management. They are 100% attuned to Berkshire.  They know how I think. They have been a big plus for Berkshire.  They will be more important as the years go by.

(27) Audience: Since low interest rates have led to a housing bubble and possibly to a bond bubble, should interest rates be raised?

Buffett: This is a very interesting movie that we have not seen before and we do not know how it will end.  I think Bernanke was a hero at the time of the crash and subsequently.  He handled things very well. When the minutes of Fed meetings became available for 2007 and 2008, several members of the Fed were not getting it.  They did not seem to understand how serious things were.  He was not getting unanimous support from those around him. But he went ahead and did a masterful job.  Cash was king, but only if you used it.  People cling to cash at the wrong times.  Zero interest rates have had a huge effect on the economy and asset prices. This is not a bubble situation we are living in, but it is unusual.

(28) Loomis: Conglomerates have historically not worked particularly well. Aren’t the probabilities low that your successors will be able to make the Berkshire conglomerate work well?

Buffett:  This model has worked well for America since disparate businesses have performed well over time. Owning good businesses is a good idea. Litton Industries, Gulf & Western and LTV were put together on the idea of serial acquiring by issuing stock at 20x earnings to buy businesses at 10x earnings. It is an idea of fooling people to ride on a chain letter scheme.  I think our business plan makes sense. We have a group of diversified businesses and conservatively capitalized. Capitalism is about allocation of capital.  We have a system where we can allocate capital without tax consequences.  We can move capital to where it can be usefully employed.

Munger:  The Mellon brothers did very well for 50-60 years.  They were a lot like us. We are not a standard conglomerate like Gulf & Western.

(29) Brandt: Why is Forest River doing so well?

Buffett:  We bought Forest River (recreation vehicles) ten years ago.  Pete runs it, and he is not an MBA. Pete built a very successful but much smaller business. He sold it to private equity. They had different ideas and not long after it went bankrupt. He bought it out of bankruptcy and one day came to see me.  We went to dinner that night and he brought his wife and daughter, made a few promises, and we have lived happily ever after.  I’ve never been to the factory in Elkhart, Indiana — and I hope it is there.  We made a deal on incentive compensation and base compensation. It will do over $4 billion of revenue this year.  I have had three or four phone calls with him the whole time.  The IT department consists of 6 people.  It is his company and you work on narrow margins.  We could use 20 more companies like his.  It is the leader in its industry.

(30) Audience:  What is your view on oil sands and the impact on Berkshire?

Buffett:  Oil sands do not have a big impact on Berkshire. We have a crane business at Marmon that does a lot of business in oil development generally.  It is active in oil sands. We will have the transmission company covering 85% of Alberta, 8,000 miles or so of transmission lines. Oil sands are huge. We own some Exxon Mobil, they have oil sands. We are moving 700,000 barrels a day of crude oil on our railroad.  The railroad is twice as fast as the pipeline. We recently bought a company from Phillips 66 whose main product is a chemical additive that moves oil 10% faster than normal.  It takes a day off the trip.  I think the oil sands are an important asset for mankind over the centuries to come, but I do not think it will dramatically change anything at Berkshire.

Warren Buffett puts up a slide showing the performance from 2008-2013 of Hedge Funds (+12.5%) vs. the S&P 500 Index (+43.8%)

 

LUNCH  BREAK

 

(31) Quick:  Berkshire invested in Energy Futures Holding which went bankrupt.  Which Berkshire businesses are subject to technological change?

Buffett:  Energy Futures Holding was my mistake.  I assumed that gas prices would stay at current levels or go higher.  Instead, they went lower.  We view all of our businesses as subject to change.  GEICO set out in 1936 to operate with low costs and pass that on to customers as low prices for a necessity of having automobile insurance.  They started with mail offerings to government employees.  They adapted over the years to US mail, telephone, Internet and social media.  But along the way they stumbled and overexpanded by selling insurance to high risk individuals and they went broke.  We want our managers to anticipate change.  I have made mistakes in the past and will in the future.  In 1966 we bought a department store in Baltimore that went bankrupt.

Munger:  We remove ignorance piece by piece.  We had a sure to fail department store, a trading stamp business sure to fold, and a textile mill.  Out of that came Berkshire.

(32) Gelb:  What will Heinz earn over the next few years?

Buffett:  Heinz’s margins will improve as a result of restructuring which will result in lower costs.

(33) Audience:  Could you discuss Berkshire’s investments during 2008-9?

Buffett:  We invested $16 billion in September/October 2008 which was too early.  We also previously committed $6 billion in funding Mars (acquisition of Wrigley’s).  We bought BNSF in October 2009 and that will be a large part of our future.  We want to buy good businesses with great management at a reasonable price and try to build them over time.  We want to add them without issuing shares.

Munger:  Private businesses have now become a larger part of Berkshire than stock.

Buffett:  When we are right on stocks, it shows up in net worth.  When we right on businesses it shows up in future earnings.  We have bought a fair amount of Wells Fargo over the past few years.  But the most money was made by buying banks of lower quality.  They needed a better economy to recover.  But we were 100% comfortable buying Wells Fargo, and only 50% comfortable somewhere else.  So we went where we were most comfortable.

(34) Sorkin:  As a result of usage based pricing (Progressive) in the auto insurance industry and self-driving cars (Google), would you sell GEICO?

Buffett:  Knowing how customers drive is valuable input in assessing premiums.  Progressive has done a lot of work on it.  It’s called Snapshot.  Insurance is about evaluating the probability of loss in order to establish the proper premium.  We think we have a pretty good system, but we will continue to look at metrics.  I feel very good about GEICO and their ability to evaluate risk.   A self-driving car will be  a real threat to auto insurance although it would be great for society.  It would not cause us to think about selling GEICO.

Munger:  Some of these things take longer than you think.  I think self-driving cars having a huge impact on the market will take some time.

Buffett:  GEICO will be doing more business 5 years and 10 years from now.

(35) Greggory Warren:  Why has Berkshire deployed very little capital outside of the U.S.?

Buffett:  We have never turned down an opportunity to make a significant acquisition outside of the U.S. because we prefer to be home.  We have not had as much luck getting on the radar screen of owners around the world versus  the U.S.  Our strong suit is buying from founders.  In the U.S. everyone with size thinks of us.  This is not the same outside of the U.S.  Wertheimer (Iscar) wrote us a letter stating if they didn’t sell to us they would not sell.  I have been a little disappointed we haven’t had more luck.  Iscar has been wonderful.  I wish I could find a few more like it.

(36) Audience:  How do you figure out your circle of competence?

Buffett:  Be realistic in evaluating your talents and shortcomings. There are many CEO’s who have no idea where their circle of competence begins and ends.  We have managers who know and stay within their circle of competence.

(37) Loomis:  What is the rationale of comparing the S&P 500 index with Berkshire’s book value?

Munger:   It is ridiculous.  It is insane. It makes it hard for Warren to look good.  But he likes to climb mountains that are difficult.

(38) Brandt: Why did you pay high multiples for your recent purchases of Iscar and Marmon?

Buffett:  The multiple on Iscar was agreed as part of the original transaction.  Marmon was an installment sale.  We knew we would be paying more later on, but it was all built into the original deal.

Munger:  The price went up because the value went up. We agreed we would pay value.

(39) Audience:  If you were 23 years old, in what non-tech industry would you start a business today and why?

Buffett:  I would probably do what I did when I was 23 years old.  I would look at a lot of companies and talk to many people, and learn about lots of industries.  I would see CEO’s of 8 or 10 coal companies.  I frequently did not make appointments, but they would always see me.  I would ask them if they had to put all of their money in any coal company except their own, and go away for 10 years, which one would it be?  Also, I would ask which would they short over 10 years and why?  If I did that I would know more about the coal companies than any manager would.  But you wouldn’t learn about how to start Google or Facebook that way.  You might find an industry that particularly interested you and you can start or go to work for someone good.

Munger:  There was a trick Larry Bird used.  He asked every agent why he should be selected to represent him, and which agent to use if Larry didn’t pick him as his agent.  Everyone listed the same guy as #2, so he went with everyone’s #2 and he negotiated the best deal in history.

Buffett:  I did the same thing at Salomon. On the weekend when Tokyo was opening Sunday at 6 p.m., I called in 8 people and I asked them who besides you would be the best person to run Salomon.  You really learn a lot by asking.  If you talk to enough people about something they know a lot about, you will learn a lot.

(40) Quick:  Hotel prices in Omaha have gone up a lot this weekend.  You have made negative comments about this.  But isn’t this supply and demand and capitalism?

Buffett:  Yes, that is why we encouraged Airbnb to come to Omaha.  Our attendance has grown above what we anticipated.  The three day minimums were irritating me.  Prices were getting high.  We didn’t want to cut back on demand.  We didn’t want to move to Dallas.  Omaha people love this event and people get a good impression of Omaha.  And we want hotels to make money.  Airbnb is a flexible supply arrangement and it makes a lot of sense.

(41): Gelb:  Will GEICO with a 10% market share and number 2 in the auto insurance industry, overtake State Farm with a 19% market share?

Buffett:  No one knows.  But we passed Allstate this year.  Based on current projections, we will be #1 the same year I am 100.  I tell GEICO I will do my part.  We will gain share as long as we take extremely good care of customers and we can properly rate risk.  Tony Nicely has done a great job.  In the 15 years prior to Tony taking over, market share hovered around 2%.  Since he took over in 1993, we have gained market share so we now have 10%.  It will keep growing.

Munger:  GEICO is like Costco.  They feel a duty to have a wonderful product and a wonderful price.  Companies like that get ahead over time.

Buffett: What is true about Costco is also true about GEICO.  People (employees) come to us and don’t leave us.

(42) Audience:  Who is more frugal, Warren or Charlie?

Munger:  In personal consumption, Warren is more frugal.

Buffett:  Would you care to give an example?

Munger:  Same house since the 1950’s.

Buffett: I moved in in 1958.

Munger: I moved in a year later and paid the architect $1900, 30% of the regular price.

Buffett:  I have everything in life I wanted.  My life would be worse if I had 6 or 8 houses.

Munger:  Frugality has helped Berkshire.  I look out at the audience, and I see frugal people. We collect these people.

Buffett:  But forget about that this weekend – the more you spend the more you save.

(43) Sorkin:  Should Berkshire follow Pfizer’s example of reducing taxes by moving some operations abroad?

Buffett:  No.  We could not have done Berkshire in any other country.  America has helped us become very rich. We do take tax credits.  Wind energy and solar deals won’t make economic sense otherwise.  We follow the rules. We don’t begrudge the taxes we pay.  We have earned a lot of money.

Munger:  It would be crazy to be this prosperous and try to take our taxes to zero.

(44) Gregg Warren:  Union Pacific generates 10% of revenue from freight to Mexico. How attractive is the Mexican freight market?

Buffett:  Union Pacific has a big edge because its route structure is much better than ours (BNSF). Our math does not work for Mexico.  We are thinking about other markets.  There are lots of ways to move more freight at BNSF.

(45) Audience:  How do you calculate intrinsic value?  Which company does Berkshire fear the most?

Buffett:  Ben Graham did not get specific about how to calculate intrinsic value.  It equates to private business value.  Intrinsic value is the present value of all cash that will be distributed in the future.  I do not see a big competitor to Berkshire. Private equity is buying businesses and leverage is cheap, so they are competing with us.  I do not see anyone who has a model or is trying to build a model which is going after what we are trying to achieve. Slowness (Berkshire) deters people.

Munger:  The Berkshire model has legs and will go a long time. We will be like Standard Oil.

(46) Loomis: Would you behave differently with higher inflation?

Buffett:  Inflation would hurt us, but other businesses would be hurt more.  Berkshire’s earnings would be up, its intrinsic value would be up, but intrinsic value per share in real terms would go down.

(47) Brandt:  What has been the return on acquisitions?

Munger:  The returns on all acquisitions in the U.S. have not been good.  Successful companies get talked into dumb deals.  This has been a successful path for us, but luckily many do not want to do what we do.

Buffett:  CEO’s have animal spirits and supporting staff senses that they like to do things.  They keep coming in with deals. Investment bankers are calling daily.  All of these forces push towards deals. We are eager to do deals that make sense.

(48) Audience:  Do you believe that a financial crisis will occur as a result of criminal activity?

Munger:  Behavior on Wall Street has improved enormously since the financial crisis.

Buffett:  What about prosecuting individuals instead of corporations?

Munger:  Hardly anything changes people faster than prosecuting individuals. I think a few criminal prosecutions will change behavior a lot, and we will get a few.

Buffett:  I lean towards prosecuting individuals.  It is easier to prosecute a corporation.  A prosecutor will get a win against a company.  They will cave and write a check.  It is a more difficult job against individuals.  They are trying to stay out of jail.

(49) Quick: Is the railroad industry adequately insured in a worst case accident scenario?

Buffett:  We are on both sides of that since Ajit has offered some very high limits to all of the major railroads, but they do not like his price.  The four major railroads have the financial capacity to pay a huge award if there is damage, and as a common carrier, we all have to carry hazardous material.  They can buy insurance from Ajit, but no one has yet.

Munger:  British Petroleum was a big surprise.  No one thought that the loss from one well would be many billions of dollars.  The biggest rail accident cost $200 million.

Buffett:  The biggest risk is from a rogue state or terrorist act.  War acts are excluded from insurance. But you could have a terrorist act that would create damages like we have never seen.  There is a reasonable probability of this happening in the next 50 years.

Munger:  We saw what one pilot can do (Malaysia Airlines).

(50) Gelb: Why is Berkshire expanding into commercial insurance at a time when pricing is peaking?

Buffett:  We entered commercial insurance in the middle of last year. We had excellent talent who wanted to join us. We have a great amount of capital and a good reputation.  We think we have the ability to underwrite more intelligently than most, with bigger risks, and costs below average. We have Ajit overseeing the operation. We entered it because we had terrific people. We were not looking at the timing.  We will build a significant commercial insurance business over time and are likely to operate with better results than the competitors.

(51) Audience:  Would you consider buying a sports team or a sports manufacturing company?

Buffett:  I own 25% of a local minor league team, but it is not responsible for my position on the Forbes 400.  If you read that I am interested in buying sports team, then it is time to think about my successors. Sports equipment is not a good business. We own Spalding and Russell.  Generally speaking, it is not a particularly profitable business.

Munger: Whatever Warren likes about sports teams, I like less.

(52) Sorkin: Bill Ackman received permission to delay reporting his buying shares in Allergan. Is this similar to Berkshire and Coca-Cola?

Buffett:  I do not see the comparison to Coca-Cola.  We have never used derivatives to get around rules of reporting.  Activism?  It won’t go away and it scares the hell out of a lot of managers.  There are cases where corporate managers should be changed.  In general, if the activist gets the stock price to go up, that will end their interest.  They are not looking for long term changes in the business.

(53) Gregg Warren:  Which is better, buying a large collection of smaller companies that are growing or big elephants nearing maturity?

Buffett:  We would be delighted to buy something for $2 – $3 billion that will grow over time.  A subsidiary could buy something for a couple hundred million.  We are not passing on anything of any real size that will have an impact.  We had 25 bolt-on acquisitions last year.  One $30 billion transaction is equivalent to 10 $3 billion deals.  We are working to build earning power into Berkshire, so we are focusing on bigger deals.

(54) Audience:  What is the most difficult question on investing and what is the answer?

Munger:  I already answered that when I spoke about Berkshire’s comparison to index performance.  There are a lot of interesting questions that do not get much attention and there is a lot of irrationality.

(55) Audience:  Why are you investing in Berkshire Energy since it has a very low rate of return on assets?

Buffett:  We are looking forward to putting more capital in, as long as it is treated fairly.  We will get appropriate returns on that.  We prefer to put more capital in because we expect regulators will treat us fairly in the future. We have done better than others at delivering electricity and at lower rates charged by most. We have a deserved reputation with regulators, including safety.

Munger: The reinvested capital will give us a good return from a growing energy business.

Greg Abel (Berkshire Energy): We are generally in the lowest quartile in prices, if not the cheapest. We recently had our first rate increase in Iowa in 16 years and we do not anticipate another in the near future.  We try to keep our capital spending close to depreciation.  The major share of our capital expenditures is growth capital.  We service Google, with a relatively small data center, in Council Bluffs.  We supply them with very low rates and a significant portion comes from renewable energy.  They want to be associated with a utility producing green power.

(56) Audience: With respect to investment in education, what is different between the U.S. and China?

Munger:  I think America made a huge mistake letting public schools go to hell.  I think Asian cultures are less likely to do that. I wish we were more like them.

(57) Audience: Should the U.S. change the way it finances home purchases and is there a role for Berkshire?

Buffett: The 30 year fixed loan is good for home owners.  It kept costs down.  Government guaranteed part to keep cost down.  No private organization can do it.  It is an $11 trillion market.  Private industry cannot do it, rates would be higher.  How do you keep government in the picture without politics?  Fannie and Freddie did some dumb things on their own, but they were also prodded into doing dumb things by politicians.  I wrote an article when the savings and loans were falling apart.  I suggested the FDIC get the private sector into pricing and evaluating, with the government as the main insurer.  There might be a way that model works in terms of home mortgage insurance.  Berkshire likely would not be a player.  Others would be more optimistic in setting rates.  Private industry might price 5% and the government 95%, and maybe guaranteeing the privates if they went broke.  It is important to get the correct national policy.  It is being worked on.  It is unlikely that Berkshire would play any role.

Munger: When private industry was allowed to take over the system, we got the biggest thieves screwing it up.  As much as I hate government, I’m not trustful of private industry in this field.  The existing system is probably sound.  At the moment, Fannie and Freddie are being conservative and I think that is okay.  I’m not anxious to go back to the race to the bottom with investment banks creating phony securities.  Let them keep doing what they are doing.

Buffett:  The one thing that led Fannie and Freddie astray was serving two masters trying to deliver double digit earnings increases. It would have been fine if they just insured rather than buying portfolios and turning themselves into big hedge funds, and just borrowed cheap and lent long.

Munger:  I think it is a mistake to have private companies taking over the whole mortgage market.  There is no need to have private portfolios. I think that particular experiment in privatization was a total failure.  And we made a billion dollars out of it.  (Note:  Berkshire purchased a large stake in Freddie Mac in 1989 and sold it in 2000.)

Buffett:  I was not going to mention it.

(58) Audience (Whitney Tilson):  There is a new book originally published in Brazil in Portugese on 3G Capital that is now available in English.  Is there a Berkshire stamp of approval on their deals? What will happen to the Buffett brand under your successors when buying companies in the future?

Buffett:  It will become the Berkshire brand that continues without me.  The person who follows me will bring the same qualities, including the ability to write very large checks.  Our Brazilian friends are very smart, very focused, hard-working, determined, and never satisfied.  When you make a deal, they do not overreach, they do not over-promise.  We want to be a good partner as it attracts good partners.

Munger:  The way to get a good spouse is to deserve one.  It is the same with partners.  Behave correctly.  It is amazing how well it works.

Buffett:  What can we learn from 3G?

Munger:  They are very good at removing unnecessary costs. I do not consider that immoral, it is a service to civilization.  It should be done with some mercy.

(59) Audience: What will Berkshire look like in 20 years?

Buffett:  I plan on writing about that next year.  We will have more cash than we can intelligently deploy in the business. We might repurchase shares.  What is done will be in the interest of shareholders.

Munger:  It is not a tragedy to succeed so much that future returns go down.

(60) Audience:  How will change affect Berkshire?

Buffett:  Whenever an existing business is threatened it will fight back.  In the end, the better mousetrap (GEICO example) will usually win.  We stay away from businesses that we know will change and we do not know who the winners will be.  Our energy company and railroad are both very likely to be winners over time.

Munger: New technology will be very disruptive to many people.  Retailing in particular is facing major threats. It is changing the world.  It will hurt a lot of people.  Berkshire is by and large in good shape.

(61) Audience:  How can we teach financial literacy?

Buffett:  The earlier the better. Habits are a powerful force in everyone’s life.  We want to talk to people at a very young age.  There is a big problem with adult financial illiteracy.  Anything you can do very early through the school system would be good.

Munger: Not sure schools are at fault. The behavior of parents is very important.

Buffett:  Not everyone gets the right parents.

Munger: It is very hard to fix people who had the wrong parents. The main problems in education are probably not in the grade schools.  There is a lot of insanity at universities, in the economics departments.  When it gets more complicated doesn’t mean it gets a lot better.

Buffett: There was a period for 20 years when the net utility of finance majors’ knowledge was net negative.  I watched extraordinary universities teach people very dumb things.  To obtain positions in departments in those schools you had to subscribe to the orthodoxy.

Munger: You would have liked academics better if you had taken physics rather than finance.

(62) Audience: Would Berkshire consider breaking itself into four companies to unlock value and pay dividends?

Buffett:  We would lose significant value if we broke Berkshire into four companies due to the tax situation and capital allocation. Berkshire as currently conceived has the greatest value.  We had an overwhelming shareholder vote against paying a dividend. There is a way for investors to maintain their investment and still cash out annually and incur little tax.

Munger:  You are not being deprived when the stock doubles and you did not get a dividend.

Buffett:  Shareholders voted 45:1 against a dividend.  That margin surprised me.  It would be a mistake to change.

 

MEETING ADJOURNED

 

David I. Kass, Ph.D.
Tyser Teaching Fellow
Department of Finance
4412 Van Munching Hall
Robert H. Smith School of Business
University of Maryland
College Park, MD 20742

dkass@rhsmith.umd.edu
drdavidkass.com