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What's On Your Mind, Mr. Buffett ? 2017

The Warren and Charlie Show 2017
Edited excerpts from Warren Buffett and Charlie Munger's marathon banter at the 2017 Berkshire Hathaway Annual Meeting

THE WELLS FARGO SCANDAL
A major part of the problem was the decentralized structure which gave too much autonomy to the bank’s leadership. How do you satisfy yourself Berkshire is not subject to the same risk?

Warren Buffett: We count very heavily on principles of behavior rather than rules. Charlie and I believe if you establish the right sort of culture, and that culture to some extent self-selects who you hire as directors and managers, that you will get better results that way in terms of behavior than a thousand-page guidebook. You’re going to have problems regardless. The real question is whether the managers are thinking about finding and correcting any bad behavior, and whether if they fail in that, whether the message gets to Omaha and whether we do something about it.

Clearly, at Wells Fargo there was an incentive system built around the idea of cross-selling a number of services per customer, and the company in every quarterly investor presentation highlighted how many services per customer. It was the focus of the organization – a major focus – and undoubtedly people got paid and promoted based on that number, at least partly based on that number. It turned out that was incentivizing the wrong kind of behavior. Bad behavior has to stop when the CEO learns about it. The main problem is they didn’t act when they learned about it. It’s bad enough having a bad system, but they didn’t act.

Charlie Munger: It doesn’t mean everyone should solve their problems by having more compliance. We’ve had less trouble over the years by being careful of whom we picked to have power and having a culture of trust. I think we have less trouble, not more.

HIS INVESTMENT STYLE
> In the HBO documentary, Becoming Warren Buffett, you had a great analogy comparing investing to baseball. Ted Williams knew his sweet spot was a pitch right down the middle. What attributes make a sweet spot that you will invest in?

Warren Buffett: It would tend to be a business we can look out 5, 10 or 20 years and decide that the competitive advantage that it had at the present would last over that period, and it would have a trusted manager that would not only fit into the Berkshire culture but was eager to join the Berkshire culture, and then it would be a matter of price. When we buy a business, essentially we are laying out a lot of money now based on what we think that business would deliver over a period of time. The higher certainty in which we make that prediction the better we feel about it.

The first outstanding business we bought, which was kind of a watershed event, was See’s Candies, a relatively small company. When we looked at See’s Candies, in 1972, we asked would people still want to be eating and giving away that candy in preference to other candy. We paid $25 million for it, net of cash, and it was earning about $4 million pre-tax then. We took $2 billion or something like that out of it since. We felt that people would not necessarily be buying a lower priced candy. And we made a judgment about See’s Candies, it would be special – probably not in the year 2017 – but we thought it would be special in 1982, 1992, and fortunately we were right on it. We are looking for more See’s Candies, only a lot bigger.

Charlie Munger: We were very lucky early to buy horrible businesses because they were real cheap. They gave us a lot of experience trying to fix unfixable businesses as they headed downward toward doom. We were very good at avoiding it thereafter. I would argue our early stupidity helped us.

CONTINUOUS LEARNING
Mr. Munger, in your career and business dealings, which one sticks out in your mind as your favorite?

Charlie Munger: I don’t think I’ve got a favorite. The one that probably did us the most good as a learning experience was See’s Candies. The power of the brand, the unending flow of ever increasing money with no capital. I’m not sure we would have bought Coca-Cola if we didn’t buy See’s. I think a life properly lived is just to learn, learn, learn all the time. I think Berkshire has gained enormously in their investment decisions by learning through a long period. Every time you appoint a person who has never had big capital allocation experience, it’s like rolling the dice. We are better off because we’ve done it for so long. But the decisions blend. The one feature that comes through is the continuous learning. If we had not kept learning, you wouldn’t even be here. You would be alive probably, but not here.

Warren Buffett: There’s nothing like the pain of being in a lousy business to make you appreciate a good one. We bought a department store in Baltimore in 1966 – there’s really nothing like having the experience of trying to decide whether you will put a new store in an area that hasn’t developed and where it won’t support it, but your competitor may move there first. Then you have the decision of jumping in. Now you have two stores where even one store isn’t quite justified. How to play those business games, you learn a lot by trying. What you really learn is which ones to avoid. If you stay out of a bunch of terrible businesses, you are off to a great start. We’ve tried them all.

INVESTING IN TECHNOLOGY
> For years, you stayed away from technology companies saying they are hard to predict and didn’t have moats. Then you invested in IBM and recently in Apple. Do you view IBM and Apple differently and what have you learnt about investing in technology?

Warren Buffett: I do view them differently. When I started buying IBM six years ago, I thought it would do better in the six years that have elapsed than it has. I think Apple is much more of a consumer products business. In terms of sort of analyzing moats around it and consumer behavior, it’s obviously a product with all kinds of tech built into it. In terms of laying out what their prospective customers will do in the future as opposed to IBM’s, it’s a different sort of analysis. That doesn’t mean it’s correct. They are two different types of decisions. I was wrong on the first one. We will find out whether or not I am right on the second. I do not regard them as apples and apples, and I don’t quite regard them as apples and oranges. It’s somewhat in between on that.

Charlie Munger: We avoided tech stocks because we felt we had no advantage there and other people did. I think it’s a good idea not to play where the other people are better. If you ask me in retrospect what was our worst mistake in the tech field, I think we weren’t smart enough to figure out Google. Those ads worked so much better in the early days than anything else. I’d say we failed you there. We were smart enough to do it and didn’t do it. We knew that.

THE BET ON AIRLINES
> You avoided airlines in the past because of low switching costs, rising fuel prices, high price competition and limited buying power. After consolidation, are airlines different enough this time around? How do the airline competitive advantages compare to railroads?

Warren Buffett: The decision, with respect to our $10 billion investment in four airlines, has no connection with getting involved in the railroad business. You named a number of factors that make for terrible economics. It’s a fiercely competitive industry – the question is whether it’s a suicidal industry – which it used to be. It has been operating for some time now at 80% or better off capacity. You can see what deliveries are going to be. I think it’s fair to say they will operate at higher degrees of capacity over the next 5 to 10 years than historical rates, which caused all of them to go broke. 

They actually at present are earning quite high returns on invested capital – higher than even Fed Ex or UPS. It’s no cinch that the industry will have more pricing sensibility in the next 10 years than they had in the last 100 years, but the conditions have improved. If the company is worth the same amount and there are fewer shares of stock outstanding, over time we make decent money. All four of the major airlines are repurchasing their shares. There will be low-cost people that will come in, the Spirits of the world, Jet Blue, but my guess is all four of the companies will have higher revenue and fewer shares outstanding by a significant margin.

GROWING BERKSHIRE'S INTRINSIC VALUE
At what rate has Berkshire compounded intrinsic value and at what rate can intrinsic value be compounded in the future?

Warren Buffett: Intrinsic value can only be calculated in retrospect, but the true definition would be the cash to be generated between now and judgment day discounted at an interest rate that seems appropriate at the time. That’s varied enormously over a 30 or 40-year period. If you pick out 10 years, and you’re back to May of 2007, we had some unpleasant things coming up. I’d say we’ve probably compounded intrinsic value about 10% annually since then. I think that’s tough to achieve – almost impossible to achieve if we continue in this low interest rate environment. 

If you ask me to give the answer to the question – if I could only pick one statistic to ask you about the future before I gave the answer, I would not ask you about GDP growth or who was going to be president, I’d ask you what the interest rate is going to be over the next ten or twenty years on average. If you assume our present interest rate structure is likely to be the average, I would say it would be very difficult to get the 10%. If I were to pick for the whole range of probabilities on interest rates, I would say that that rate might be doable. 

If you’d say we can’t continue these low interest rates for a long time, I’d ask you to look at Japan 25 years ago. We couldn’t see how their low interest rates could be sustained. We are still looking at the same thing – I don’t think it’s easy to predict the course of interest rates at all. Unfortunately, predicting interest rates is embedded in giving a good answer to you. I’d say the chances of getting a terrible result in Berkshire are about as low as anything you could find. Chances of getting a sensational rate are also about as low as anything you could find. My best guess would be in the 10% range, but that assumes somewhat higher interest rates, not dramatically, but somewhat higher interest rates in the next 10 or 20 years than we experienced in the last seven years.

Charlie Munger: The future with our present size in terms of percentage rates of return is going to be less glorious than in the past. We keep saying that and now we are proving it.

Warren Buffett: Do you want to end on that note, Charlie?

Charlie Munger: I think we have a collection of businesses that on average has better investment values than say the S&P 500 average. I don’t think you shareholders have a terrible problem.

Warren Buffett: We do have more of a shareholder orientation than the S&P 500 as a whole. This company has a culture where decisions are made as a private owner would make them. That’s a luxury we have that many companies don’t have. One of the questions I ask the CEO of every public company that I meet: “What would you be doing differently if you owned it all yourself?” The answer is usually this, that and a couple of other things. If he would ask us, the answer is, we are doing exactly what we would be doing if we owned all the stock ourselves.

Charlie Munger: I think we have one other advantage. A lot of other people are trying to be brilliant. We are just trying to stay rational. It’s a big advantage. Trying to be brilliant is dangerous, particularly when you are gambling.

THE CHANGING NATURE OF BUSINESS
> Berkshire generates substantial cash flows. Are Berkshire shareholders better off if you continued to invest in capital-light businesses?

Warren Buffett: There’s no question that buying a high return on assets, very light capital-intensive business that is going to grow, beats the hell out of buying something that requires a lot of capital to grow. The five largest American companies by market cap [Apple, Alphabet, Microsoft, Amazon, and Facebook] have a market value over two and half trillion dollars. I don’t know what the aggregate market cap of the US market is – but they are probably getting up close to 10% of the whole market cap of the US. If you take those five companies, essentially you could run them with no equity capital at all. None. 

That is a very different world than when Andrew Carnegie was building a steel mill and getting very rich in the process or Rockefeller was building a refinery and buying tank cars. But generally speaking for a very long time in our capitalism, growing and earning large amounts of money required considerable reinvestment of capital and large amounts of equity capital. The railroad is a good example. That world has really changed. I don’t think people quite appreciate the difference. You literally don’t need any money to run the five companies that are collectively worth more than two and a half trillion dollars and who have outpaced any number of names that we are familiar with if you looked at the Fortune 500 list 30 or 40 years ago. 

We own a few businesses that earn extraordinary returns on capital, but they don’t grow. We still love them, but if they had yields that would grow, believe me, they would be number one on our list. We aren’t seeing those that we can buy. You’re absolutely right, that’s a far, far better way of laying out money than what we are able to do when buying capital-intensive businesses.

Charlie Munger: The capital-intensive companies of America at one time were wonderful investments. DuPont was sold at 20x earnings. They kept building more complicated plants and hiring more PhDs, chemists, it looked like they owned the world. Now most chemical products are commoditized – it’s a tough business being a big chemical producer. In come all these other people like Apple and Google, and they are just on top of the world. The world has changed a lot, and the people who made the right decisions of getting into these new businesses that are so different from the old ones have done very well. 

ON THE ABILITIES OF THE SUCCESOR
> Will bouncing ideas off one another on capital allocation continue long into the future?

Charlie Munger: It can’t continue very long.

Warren Buffett: Don’t get defeatish, Charlie. Any successor that is put in at Berkshire – proven capital allocation abilities are certain to be upper most in the Board’s mind, in the current case, in terms of my recommendation and Charlie’s recommendation, for what happens after we are not around. Capital allocation is incredibly important at Berkshire. Right now we have $280 or $290 billion of shareholders’ equity. If you take the next decade alone, nobody can make accurate predictions on it, but in the next ten years, if you take – appreciation right now is another $7 billion a year, or something on that order. The next manager during the decade will have to allocate maybe $400 billion or something like that. 

Ten years from now, you need a very sensible capital allocator CEO. We will have one. It would be a terrible mistake to have someone in this job where capital allocation will not be their main talent – it should be very close to their main talent. We have an advantage at Berkshire in that we do know how important that is. There is that focus on it. Many people get to the top through ability and sales, all different sides of business. They then have capital allocation sort of put in their hands. They may establish strategic thinking divisions and listen to investment bankers, but they better be able to do it themselves.

ON 3G CAPITAL'S METHODS
> Berkshire partners with 3G Capital on deals. What do you think of their extreme cost cutting and elimination of thousands of jobs?

Warren Buffett: The 3G management believes in having a company as productive as possible, and of course, the gains in this world for the people in this room and the people in Omaha and the people throughout America have come from gains through productivity. If there had been no change in productivity, we would be living the same life as people lived in 1776. The 3G people do it very fast, and they’re very good making a business productive with fewer people than operated it before. We’ve been doing that in every industry whether it’s steel or cars. That’s why we live as well as we do. We at Berkshire prefer to buy companies that are already run efficiently. Frankly, we don’t enjoy the process at all of getting more productive. It’s not pleasant, but it is what enabled us to progress.

Personally, we have been through the process of being in a textile business that employed a couple thousand people and went out of business over a period of time. It’s just not as much fun to be in a business that cuts jobs rather than a business that adds jobs. Charlie and I would probably forgo having Berkshire buy businesses where the main benefits would come from increasing productivity by actually having fewer workers. I think it is pro social to think in terms of improving productivity, and I think the people at 3G do a very good job.

Charlie Munger: I don’t see anything wrong with increasing productivity. On the other hand, there’s a lot of counter-productivity publicity to doing it. Just because you’re right doesn’t mean you should always do it.

ON INVESTING IN AMAZON
> You admire Jeff Bezos. Why have you not invested in Amazon?

Warren Buffett: I was too dumb to realize what was going to happen. I did not think Jeff could succeed on the scale he has or even think about the possibility of doing anything with Amazon web services or the cloud. If you asked me the chances that while he was building up the retail operation, he would also be doing something that was disrupting the tech industry – that would have been a longshot for me. I underestimated the brilliance of the execution. 

It is one thing to dream about doing this stuff online, but it takes a lot of ability. You can read his 1997 annual report, and he laid out a roadmap. He has done it and done it in spades, and if you haven’t seen his interview with Charlie Rose three or four months ago, go and listen to it because you will learn a lot, at least I did. The stock always looked expensive. I did not think he would be where he is today when I looked at it 3, 5, 8, or 12 years ago. Charlie, how did you miss it?

Charlie Munger: It was easy. What was done there was very difficult. It was not at all obvious that it was all going to work as well as it did. I don’t feel any regret about missing out on the achievements of Amazon. Other things were easier, and I think we screwed up a little.

VALUING THE CHINESE STOCK MARKET
> In looking at the Chinese market vs the US market, what is the best valuation method, market cap/GDP or the Cyclically Adjusted P/E?

Warren Buffett: Both of the standards you mention are not paramount at all in our valuation of securities. The present value of the future cash that can be taken out of the business is the important factor in valuing a business. People are always looking for a formula. There’s not an ultimate formula. You don’t know what to stick in for the variables. Every number has some degree of meaning. Valuation of a business is not reducible to any formula where you can actually put in the variables perfectly. 

The most important thing is future interest rates. People frequently plug in the current interest rate saying that’s the best they can do. The 30-year bond rate should tell you what people who are willing to put out money for 30 years and have no risk of dollar gain/loss at the end of the 30-year period expect to earn. I’m not sure I can come up with a better figure. That doesn’t mean I’m going to use the current figure either. 

Charlie Munger: The first rule of fishing is to fish where the fish are. A good fisherman can find more fish in China now. It’s a happier hunting ground.

LEAVING A MARK
> What would you & Charlie like to be known for, a hundred years from now?

Charlie Munger: My first memory, when Warren got on the subject, I asked Warren what he would like said at his funeral. He said, “I want them all to be saying that’s the oldest looking corpse I ever saw.”

Warren Buffett: That may be the smartest thing I ever said. To me, it’s pretty simple. I really like teaching. I’ve been doing it formally and somewhat informally all my life. I certainly had the greatest teachers you can imagine. If someone thought I did a decent job at teaching, I’d feel very good about that.

Charlie Munger: To making teaching endurable, there has to be a bit of wise-assery in it, and that we both have been able to supply.

Warren Buffett: Those of you who are old-time basketball fans, on Wilt Chamberlain’s tomb it was reputed that it was going to say, “At last, I sleep alone.”

UNFINISHED BUSINESS
> Everyone has a personal dream at a different age. What’s your dream now?

Charlie Munger: My dream? Well…

Warren Buffett: Let’s skip the first one.

Charlie Munger: Sometime when I’m especially wishful, I think, oh, to be 90 again! I’ve got some advice for the young. If you’ve got anything you really want to do, don’t wait till you’re 93 to do it.

Warren Buffett: That’s the same thing I would tell students. When you go out in the world, look for the job that you would take if you didn’t need a job. Don’t postpone that sort of thing. Kierkegaard said life must be evaluated backwards, but it must be lived forward. Charlie says all he wants to know is where he will die so he will never go there. You do want to do a certain amount of reverse engineering in life. That doesn’t mean you can do everything that way. Think about what will make you feel good when you get older about your life, and you atleast generally want to keep going in that direction. You need some luck in life, and you got to accept some bad things that are going to happen as you go along. Life has been awfully good to me and Charlie so we have no complaints.

Charlie Munger: You don’t want to be like the man who had his funeral and the minister said now is the time for someone to say something nice about the deceased, and nobody came forward. Surely, somebody can say something nice about the deceased? Finally one man came up, and he said, “Well, his brother was worse.” 

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